UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarter Ended June 30, 2010
Commission File Number: 814-00754
SOLAR CAPITAL LTD.
(Exact name of registrant as specified in its charter)
(I.R.S. Employer
Identification No.)
500 Park Avenue, 5th Floor
New York, N.Y.
(212) 993-1670
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the registrant’s Common Stock, $.01 par value, outstanding as of August 3, 2010 was 33,168,872.
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2010
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1.
Report of Independent Registered Public Accounting Firm
Financial Statements:
Consolidated Statements of Assets and Liabilities as of June 30, 2010 (unaudited) and December 31, 2009
Consolidated Statements of Operations for the three and six months ended June 30, 2010 (unaudited) and June 30, 2009 (unaudited)
Consolidated Statements of Changes in Net Assets for the six months ended June 30, 2010 (unaudited) and the year ended December 31, 2009
Consolidated Statements of Cash Flows for the six months ended June 30, 2010 (unaudited) and June 30, 2009 (unaudited)
Consolidated Schedule of Investments as of June 30, 2010 (unaudited)
Consolidated Schedule of Investments as of December 31, 2009
Notes to Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults upon Senior Securities
Reserved
Item 5.
Other Information
Item 6.
Exhibits
Signatures
2
The Board of Directors and Shareholders
Solar Capital Ltd.:
We have reviewed the accompanying consolidated statement of assets and liabilities, including the consolidated schedule of investments, of Solar Capital Ltd. (the Company) as of June 30, 2010, and the related consolidated statements of operations for the three and six-month periods ended June 30, 2010 and 2009, changes in net assets for the six-month period ended June 30, 2010 and cash flows for the six-month periods ended June 30, 2010 and 2009, and the financial highlights (included in Note 11) for the six month period ended June 30, 2010. These consolidated financial statements and financial highlights are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial accounting and reporting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated financial statements in order for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated statement of assets and liabilities, including the consolidated schedule of investments, of Solar Capital LLC as of December 31, 2009, and the related consolidated statement of net assets for the year ended December 31, 2009 and we expressed an unqualified opinion on them in our report dated March 1, 2010.
/s/ KPMG LLP
New York, New York
August 3, 2010
3
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
(in thousands, except shares)
Assets
Investments at value:
Companies more than 25% owned (cost: $10,000 and $10,000, respectively)
Companies 5% to 25% owned (cost: $30,673 and $85,102, respectively)
Companies less than 5% owned (cost: $918,752 and $968,886, respectively)
Total investments (cost: $959,425 and $1,063,988, respectively)
Cash and cash equivalents
Receivable for investments sold
Interest and dividends receivable
Deferred borrowing costs
Fee revenue receivable
Deferred offering costs
Derivative assets
Prepaid expenses and other receivables
Total Assets
Liabilities
Senior unsecured notes payable
Payable for investments purchased
Dividends payable
Credit facility payable
Distributions payable
Due to Solar Capital Partners LLC:
Investment advisory and management fee payable
Performance-based incentive fee payable
Deferred fee revenue
Interest payable
Derivative liabilities
Due to Solar Capital Management LLC
Income taxes payable
Other accrued expenses and payables
Total Liabilities
Net Assets
Partners’ capital
Common stock, par value $0.01 per share 33,030,641 shares issued and outstanding
Paid in capital in excess of par
Distributions in excess of net investment income
Accumulated net realized gain
Net unrealized appreciation
Total Net Assets
Number of shares outstanding
Net Asset Value Per Share
See notes to consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF OPERATIONS
INVESTMENT INCOME:
Interest and dividends:
Companies 5% to 25% owned
Other interest and dividend income
Total interest and dividends
Total investment income
EXPENSES:
Investment advisory and management fees
Performance-based incentive fee
Interest and other credit facility expenses
Administrative service fee
Other general and administrative expenses
Total operating expenses
Net investment income before income tax expense
Income tax expense (benefit)
Net investment income
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS, FORWARD CONTRACTS AND FOREIGN CURRENCIES:
Net realized gain (loss):
Investments:
Companies less than 5% owned
Net realized loss on investments
Forward contracts
Foreign currency exchange
Net realized gain (loss)
Net change in unrealized gain (loss):
Companies more than 25% owned
Net unrealized gain (loss) on investments
Net change in unrealized gain (loss)
Net realized and unrealized gain (loss) on investments, forward contracts and foreign currencies
NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS
Earnings per share (see note 10)
5
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Increase (Decrease) in net assets resulting from operations:
Net realized loss
Net change in unrealized gain
Net increase in net assets resulting from operations
Dividends and distributions declared
Capital transactions:
Proceeds from shares sold
Common stock offering costs
Senior notes issued in Solar Capital Merger
Reinvestment of dividends
Net decrease in net assets resulting from capital transactions
Net increase (decrease) in net assets
Net assets at beginning of period
Net assets at end of period
6
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands except shares)
Cash Flows from Operating Activities:
Net increase (decrease) in net assets from operations
Adjustments to reconcile net increase (decrease) in net assets from operations to net cash provided by operating activities:
Net realized loss from investments
Net realized (gain) from foreign currency exchange on borrowings
Net change in unrealized (gain) on investments
Net change in forward contracts
(Increase) decrease in operating assets:
Purchase of investment securities
Proceeds from disposition of investment securities
Foreign tax receivable
Withholding tax receivable
Increase (decrease) in operating liabilities:
Net Cash Provided by Operating Activities
Cash Flows from Financing Activities:
Cash dividends paid
Cash distributions paid
Proceeds from borrowings on credit facility
Repayments of borrowings on credit facility
Net Cash Used in Financing Activities
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
CASH AND CASH EQUIVALENTS AT END OF PERIOD
Supplemental disclosure of cash flow information:
Cash paid for interest
Cash paid for income taxes
Non-cash financing activity:
Issuance of Senior Notes
7
CONSOLIDATED SCHEDULE OF INVESTMENTS
June 30, 2010
(unaudited)
Description(1)
Industry
Bank Debt/Senior Secured Loans – 22.4%
Asurion Corporation
Classic Cruises Holdings(5)
Emdeon Business Services LLC
Fulton Holding Corp
Ram Energy Resources, Inc.
Roundy’s Supermarkets, Inc.
ViaWest, Inc.
Total Bank Debt/Senior Secured Loans
Subordinated Debt/CorporateNotes – 71.6%
Ares Capital Corporation
Adams Outdoor Advertising
AMC Entertainment Holdings, Inc.
Booz Allen
Direct Buy Inc.
DS Waters
Earthbound
Fleetpride Corporation
FreedomRoads
Grakon, LLC(12)
Iglo Birds Eye Group Limited(3)(4)
Magnolia River, LLC
Midcap Financial Intermediate Holdings, LLC
ProSieben Sat.1 Media AG(3)(8)(12)
Rug Doctor L.P.
Seven Media Group Pty Limited(3)
Tri-Star Electronics International, Inc.
Wastequip, Inc.(13)
Weetabix Group(3)(7)
Total Subordinated Debt/Corporate Notes
8
CONSOLIDATED SCHEDULE OF INVESTMENTS (continued)
Preferred Equity – 0.1%
Wyle Laboratories
Total Preferred Equity
Common Equity / Partnership Interests / Warrants – 5.9%
Ark Real Estate Partners LP(9)(11)
Global Garden Products(3)(6)
Grakon, LLC
Great American Group Inc.(14)
Great American Group Inc.(15)
Great American Group Inc.(16)
National Specialty Alloys, LLC(10)
Nuveen Investments, Inc.
NXP Semiconductors Netherlands B.V.(3)
Total Common Equity/Partnerships Interests / Warrants
Total Investments
9
Industry Classification
Beverage, Food, and Tobacco
Personal, Food and Misc. Services
Aerospace & Defense
Insurance
Diversified / Conglomerate Service
Leisure, Motion Pictures, Entertainment
Farming & Agriculture
Cargo Transport
Home and Office Furnishing, Consumer Products
Finance
Retail Stores
Broadcasting & Entertainment
Automotive
Banking
Grocery
Real Estate
Hotels, Motels, Inns & Gaming
Healthcare, Education, and Childcare
Oil & Gas
Mining, Steel, Iron, and Nonprecious Metals
Electronics
Machinery
10
December 31, 2009
Bank Debt/Senior Secured Loans – 18.8%
Affinity 1st Lien
National Interest Security Corporation(11)
Subordinated Debt/Corporate Notes – 74.4%
Allied Capital
Casema B.V.(3)
Global Garden Products(3)(6)(12)
Grakon, LLC(13)
Jonathan Engineering Solutions Corp.(12)
Learning Care Group No.2, Inc
Pacific Crane Maintenance Company,L.P.(12)
ProSieben Sat.1 Media AG(3)(8)(13)
Wire Rope Corporation (nka WireCo World Group)
11
Common Equity / Partnership Interests / Warrants – 6.7%
Pacific Crane Maintenance Company, L.P.
12
Diversified / Conglomerate Manufacturing
Telecommunications
Printing, Publishing, Broadcasting
Containers, packaging and glass
Business Services
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization
Solar Capital Ltd. (“Solar Capital”, the “Company” or “we”), a Maryland corporation formed in November 2007, is a closed-end, externally managed, non-diversified management investment company that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). In addition, for tax purposes the Company intends to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”).
On February 9, 2010, Solar Capital Ltd. priced its initial public offering, selling 5.68 million shares, including the underwriters’ over-allotment, at a price of $18.50 per share. Concurrent with this offering, management purchased an additional 600,000 shares through a private placement, also at $18.50 per share.
Immediately prior to the initial public offering, through a series of transactions Solar Capital Ltd. merged with Solar Capital LLC, leaving Solar Capital Ltd. as the surviving entity (the “Merger”). Solar Capital Ltd. issued an aggregate of approximately 26.65 million shares of common stock and $125 million in Senior Unsecured Notes to the existing Solar Capital LLC unit holders in connection with the Merger. Solar Capital Ltd. had no assets or operations prior to completion of the Merger and as a result, the historical books and records of Solar Capital LLC have become the books and records of the surviving entity.
Solar Capital LLC, a Maryland limited liability company, was formed in February 2007 and commenced operations on March 13, 2007 with initial capital of $1.2 billion of which 47.04% was funded by affiliated parties.
The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. The Company invests primarily in middle-market companies in the form of mezzanine and senior secured loans, each of which may include an equity component, and, to a lesser extent, by making direct equity investments in such companies.
Note 2. Significant Accounting Policies
Basis of Presentation – The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with accounting principles generally accepted in the United States of America (“GAAP”), and include the accounts of the Company and its wholly-owned subsidiary, Solar Capital Luxembourg I S.a.r.l., which was incorporated under the laws of the Grand Duchy of Luxembourg on April 26, 2007. The consolidated financial statements reflect all adjustments and reclassifications which, in the opinion of management, are necessary for the fair presentation of the results of the operations and financial condition for the periods presented. All significant intercompany balances and transactions have been eliminated.
Interim financial statements are prepared in accordance with GAAP for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Articles 6 or 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for annual financial statements. In the opinion of management, all adjustments, consisting solely of normal recurring accruals considered necessary for the fair presentation of financial statements for the interim period, have been included. The current period’s results of operations will not necessarily be indicative of results that ultimately may be achieved for the fiscal year ending December 31, 2010.
Certain prior period amounts have been reclassified to conform to current period presentation. As required by ASC 260-10, the number of shares used to calculate weighted average shares for use in computations on a per share basis have been decreased retroactively by a factor of approximately 0.4022 for all periods prior to February 9, 2010. This factor represents the effective impact of the reduction in shares resulting from the Merger.
Accounting Standards Codification – The FASB established the Accounting Standards CodificationTM (“ASC”) on July 2, 2009 as the single source of authoritative GAAP to be applied by nongovernmental entities. The ASC supersedes all existing non-SEC accounting and reporting standards. All other nongrandfathered, non-SEC accounting literature not included in the ASC is no longer authoritative.
Following the ASC, the FASB no longer issues new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it issues Accounting Standards Updates, which serve to update the ASC, provide background information about the guidance and provide the basis for conclusions on the changes to the ASC. GAAP was not changed as a result of the FASB’s codification project, but the codification project changes the way guidance is organized and presented. As a result, these changes have a significant impact on how we reference GAAP in our financial statements for interim and annual periods.
Investments – The Company applies fair value accounting in accordance with GAAP. Securities transactions are accounted for on trade date. Securities for which market quotations are readily available on an exchange are valued at such price as of the closing price on the valuation date. The Company may also obtain quotes with respect to certain of its investments from pricing services or brokers or dealers in order to value assets. When doing so, the Company determines whether the quote obtained is sufficient according to GAAP to determine the fair value of the security. If determined adequate, the Company uses the quote obtained.
Securities for which reliable market quotations are not readily available or for which the pricing source does not provide a valuation or methodology or provides a valuation or methodology that, in the judgment of the Company’s investment adviser (the “Adviser”) or Board of Directors (the “Board”), does not represent fair value, shall each be valued as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Valuation methods, among other measures and as applicable, may include comparisons of financial ratios of the portfolio companies that issued such private equity securities to peer companies that are public, the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings and discounted cash flows, the markets in which the portfolio company does business, and other relevant factors.
When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the Company will consider the pricing indicated by the external event to corroborate the private equity valuation. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material.
Investments of sufficient credit quality purchased within 60 days of maturity are valued at cost plus accreted discount, or minus amortized premium, which approximates fair value.
Cash and Cash Equivalents – Cash and cash equivalents include investments in money market accounts or investments with original maturities of three months or less.
Revenue Recognition – The Company’s revenue recognition policies are as follows:
Sales: Gains or losses on the sale of investments are calculated by using the specific identification method.
Interest Income: Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as part of interest income. The Company has loans in its portfolio that contain a payment-in-kind (“PIK”) provision. PIK interest is accrued at the contractual rates and added to the loan principal on the reset dates.
Non-accrual: Loans are placed on non-accrual status when principal or interest payments are past due 30 days or more or when there is reasonable doubt that principal or interest will be collected. Accrued interest is generally reversed when a loan is placed on non-accrual status. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management’s judgment. Non-accrual loans are restored to accrual status when past due principal and interest is paid and, in management’s judgment, are likely to remain current.
U.S. Federal Income Taxes – The Company intends to elect to be treated as a RIC under subchapter M of the Code and operates in a manner so as to qualify for the tax treatment applicable to RICs. In order to qualify as a RIC, among other things, the Company is required to timely distribute to its stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. The Company, among other things, has made and intends to continue to make the requisite distributions to its stockholders, which will generally relieve the Company from U.S. federal income taxes.
Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4% excise tax on such income, as required. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned. For the six months ended June 30, 2010, no amount was recorded for U.S. Federal excise tax.
The Company is also subject to taxes in Luxembourg, through Solar Capital Luxembourg I S.a.r.l., a wholly-owned subsidiary. Under the laws of Luxembourg, the Company pays a corporate income tax and a municipal business tax on its subsidiary’s taxable income.
Capital Accounts – Certain capital accounts including undistributed net investment income, accumulated net realized gain or loss, net unrealized appreciation or depreciation, and paid in capital in excess of par, are adjusted, at least annually, for permanent differences between book and tax. In addition, the character of income and gains to be distributed is determined in accordance with income tax regulations that may differ from GAAP.
Dividends – Dividends and distributions to common stockholders are recorded on the ex-dividend date. Quarterly dividend payments are determined by the board of directors and are generally based upon taxable earnings estimated by management. Net realized capital gains, if any, are distributed at least annually, although we may decide to retain such capital gains for investment.
We have adopted a dividend reinvestment plan that provides for reinvestment of any distributions we declare in cash on behalf of our stockholders, unless a stockholder elects to receive cash. As a result, if our board of directors authorizes, and we declare, a cash dividend, then our stockholders who have not “opted out” of our dividend reinvestment plan will have their cash dividends automatically reinvested in additional shares of our common stock, rather than receiving the cash dividend. While we generally use newly issued shares to implement the plan (especially if our shares are trading at a premium to net asset value), we may purchase shares in the open market in connection with our obligations under the plan. In particular, if our shares are trading at a significant enough discount to net asset value and we are otherwise permitted under applicable law to purchase such shares, we intend to purchase shares in the open market in connection with our obligations under our dividend reinvestment plan.
Foreign Currency Translation – The accounting records of the Company are maintained in U.S. dollars. All assets and liabilities denominated in foreign currencies are translated into U.S. dollars based on the rate of exchange of such currencies against U.S. dollars on the date of valuation. The Company’s investments in foreign securities may involve certain risks such as foreign exchange restrictions, expropriation, taxation or other political, social or economic risks, all of which could affect the market and/or credit risk of the investment. In addition, changes in the relationship of foreign currencies to the U.S. dollar can significantly affect the value of these investments and therefore the earnings of the Company.
Derivative Instruments and Hedging Activity – In accordance with GAAP, the Company recognizes derivatives as either assets or liabilities at their fair value on its Consolidated Statements of Assets and Liabilities. At this time, the Company does not document formal hedge relationships because the hedged items are recorded at fair value with realized and unrealized gains and losses recognized in current earnings. Realized and unrealized gains and losses from derivatives are also
15
recorded in current earnings. Realized gains or losses from derivatives are recognized when contracts are settled. The Company primarily uses foreign exchange forward contracts to economically hedge its foreign currency risk. The fair value of foreign exchange forward contracts is determined by recognizing the difference between the contract exchange rate and the current market exchange rate. These fair values are recognized as either derivative assets or derivative liabilities in the Company’s Consolidated Statements of Assets and Liabilities. The Company may also borrow in foreign currencies on its multicurrency credit lines to reduce foreign currency exposure. Fluctuations in market values of assets and liabilities denominated in the same foreign currency offset in earnings providing a “natural” foreign currency hedge.
Deferred Offering Costs – Offering costs consist of fees paid in relation to legal, accounting, regulatory and printing work completed in connection with offerings of our common stock.
Use of Estimates in the Preparation of Financial Statements – The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.
Subsequent Events Evaluation – The Company has evaluated the need for disclosures and/or adjustments resulting from subsequent events through the date the financial statements were issued and determined that none are required.
Note 3. Investments
Investments consisted of the following as of June 30, 2010 and December 31, 2009:
Bank Debt/Senior Secured Loans
Subordinated Debt/Corporate Notes
Preferred Equity
Common Equity/Partnership Interests/Warrants
Total
As of June 30, 2010, the Company had one investment on non-accrual status with a market value of zero. In addition, two performing assets with a total market value of $14.1 million had cash interest payments applied as principal payments rather than being included in interest income because management believes, at this time, it is unlikely there will be full repayment of principal.
Note 4. Agreements
Solar Capital has an Investment Advisory and Management Agreement with Solar Capital Partners LLC (the “Investment Adviser”), under which the Investment Adviser will manage the day-to-day operations of, and provide investment advisory services to, Solar Capital. For providing these services, the Investment Adviser receives a fee from Solar Capital, consisting of two components—a base management fee and an incentive fee. The base management fee is determined by taking the average value of Solar Capital’s gross assets at the end of the two most recently completed calendar quarters calculated at an annual rate of 2.00%. The incentive fee has two parts, as follows: one part is calculated and payable quarterly in arrears based on Solar Capital’s pre-incentive fee net investment income for the immediately preceding calendar quarter. For this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus Solar Capital’s operating expenses for the quarter (including the base management fee, any expenses payable under the Administration Agreement, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-incentive fee net investment income does not include any realized capital gains computed net of all realized capital losses and unrealized capital depreciation. Pre-incentive fee net investment income, expressed as a rate of return on the value of Solar Capital’s net assets at the end of the immediately preceding calendar quarter, is compared to the hurdle rate of 1.75% per quarter (7% annualized). Our net investment income used to calculate this part of the incentive fee is also included in the amount of our gross assets used to calculate the 2% base management fee. Solar Capital pays the Investment Adviser an incentive fee with respect to Solar Capital’s pre-incentive fee net investment income in each calendar quarter as follows: (1) no incentive fee in any calendar quarter in which Solar Capital’s pre-incentive fee net investment income does not exceed the hurdle rate; (2) 100% of Solar Capital’s pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than 2.1875% in any calendar quarter; and (3) 20% of the amount of Solar Capital’s pre-incentive fee net investment income, if any, that exceeds 2.1875% in any calendar quarter. These calculations are appropriately pro-rated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter. The second part of the incentive fee is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory and Management Agreement, as of the termination date), commencing on February 12, 2007, and will equal 20% of Solar Capital’s cumulative realized capital gains less cumulative realized capital losses, unrealized capital depreciation (unrealized depreciation on a gross investment-by-investment basis at the end of each calendar year) and all capital gains upon which prior performance-based capital gains incentive fee payments were previously made to the advisor.
Solar Capital has also entered into an Administration Agreement with Solar Capital Management, LLC (the “Administrator”) under which the Administrator provides administrative services for Solar Capital. For providing these services, facilities and personnel, Solar Capital reimburses the Administrator for Solar Capital’s allocable portion of overhead and other expenses incurred by the Administrator in performing its obligations under the Administration Agreement, including rent. The Administrator will also provide, on Solar Capital’s behalf, managerial assistance to those portfolio companies to which Solar Capital is required to provide such assistance.
16
Note 5. Derivatives
The Company is exposed to foreign exchange risk through its investments denominated in foreign currencies. The Company mitigates this risk through the use of foreign currency forward contracts. As an investment company, all changes in the fair value of assets, including changes caused by foreign currency fluctuation, flow through current earnings. The forward contracts serve as an economic hedge with their realized and unrealized gains and losses also recorded in current earnings. The Company has no derivatives designated as hedging instruments. During the six months ended June 30, 2010 we entered into 41 foreign currency forward contracts with durations of 1 month and the average U.S. dollar value of foreign currency forward contracts was $21,531. During the year ended December 31, 2009, we entered into 81 foreign currency forward contracts with durations of 1 to 3 months and the average U.S. dollar value of foreign currency forward contracts was $29,757.
As of June 30, 2010, there were three open forward foreign currency contracts denominated in Euro, Australian Dollar and British Pounds, all of which terminate on July 8, 2010. As of December 31, 2009, there were nine open forward foreign currency contracts denominated in Euro, Australian Dollar and British Pounds, six of which terminated on January 15, 2010 and three of which terminated on February 16, 2010. At June 30, 2010 and December 31, 2009, there was no fixed collateral held by counterparties for the open contracts and no credit-related contingent features associated with any of the open forward contracts. The contract details are as follows:
Purchase:
Counterparty
USD / AUD
USD / EURO
USD / GBP
The following tables show the fair value and effect of the derivative instruments on the Consolidated Statements of Assets and Liabilities and the Consolidated Statements of Operations:
Fair Values of Derivative Instruments
Derivatives not designated as hedging instruments(a)
Foreign exchange contracts
Total derivative assets
Total derivative liabilities
17
Effect of Derivative Instruments on the Consolidated Statements of Operations
Derivatives not designated as
hedging instruments(a)
Location of Gain or (Loss)Recognized in Income onDerivative
Note 6. Borrowing Facility and Senior Unsecured Notes
On February 12, 2010, Solar Capital Ltd. amended and restated Solar Capital LLC’s $250 million Senior Secured Revolving Credit Facility (the “Credit Facility’), extending the maturity to February 2013 and increasing the total commitments under the facility to $270 million. Per the amended agreement, borrowings bear interest at a rate per annum equal to the base rate plus 3.25% or the alternate base rate plus 2.25%. The commitment fee on unused balances is 0.375%. The amendment also reduced the advance rates permitted on certain asset types and placed limitations on the secured borrowing amount. On May 26, 2010, the Credit Facility was amended to remove the limitations on the secured borrowing amount and increase the advance rates permitted on certain asset types. Total commitments under the Credit Facility have been increased to $355 million as a result of the addition of two new lenders on May 12, 2010 and June 23, 2010. The facility size may be increased up to $600 million with additional new lenders or the increase in commitments of current lenders. The Credit Facility contains certain customary affirmative and negative covenants and events of default, including the occurrence of a change of control. In addition, the Credit Facility contains certain financial covenants that among other things, requires the Company to maintain a minimum shareholder’s equity and a minimum debt to total assets ratio.
On February 9, 2010, through a series of transactions, Solar Capital LLC was merged with and into Solar Capital Ltd., a Maryland corporation, leaving Solar Capital Ltd. as the surviving entity. An aggregate of approximately 26.65 million shares of common stock and $125 million in senior unsecured notes (the “Senior Unsecured Notes”) of Solar Capital Ltd. were issued in connection with the merger. The Senior Unsecured Notes mature in February 2014 and have a coupon of 8.75%, payable quarterly in cash beginning May 1, 2010. The Senior Unsecured Notes are redeemable at any time, in whole or in part, at a price of 100% of their principal amount, plus accrued and unpaid interest to the date of redemption. Further, Solar Capital Ltd. must use the net cash proceeds from the issuance of any other senior notes either to redeem or make an offer to purchase the outstanding Senior Unsecured Notes at a price of 100% of their principal amount, plus accrued and unpaid interest to the date of redemption. The Senior Unsecured Notes subject Solar Capital Ltd. to customary covenants, including, among other things, (i) a requirement to maintain an “asset coverage ratio” of at least 2.00 to 1.00; (ii) a requirement that in the event of a “change of control” (as defined in the agreement governing the Senior Unsecured Notes) Solar Capital Ltd. will be required to offer to repurchase the Senior Unsecured Notes at a price of 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase; and (iii) a restriction on incurring any debt on a junior lien basis, or any debt that is contractually subordinated in right of payment to any other debt unless it is also subordinated to the Senior Unsecured Notes on substantially identical terms. The agreement under which the Senior Unsecured Notes have been issued contains customary events of default.
The weighted average annualized interest cost for all borrowings for the six months ended June 30, 2010 and 2009 was 7.65% and 1.95%, respectively. These costs are exclusive of commitment fees and for other prepaid expenses related to establishing the Credit Facility and Senior Unsecured Notes. This weighted average annualized interest cost reflects the average interest cost for all borrowings. The average debt outstanding for the six months ended June 30, 2010 and for the year ended December 31, 2009 were $133,878 and $29,035, respectively. The maximum amounts borrowed on the Credit Facility during the six months ended June 30, 2010 and year ended December 31, 2009 were $172,882 and $122,065, respectively. There was nothing drawn on the Credit Facility as of June 30, 2010 and $88,114 outstanding as of December 31, 2009. At June 30, 2010 and December 31, 2009, the Company was in compliance with all financial and operational covenants required by the Credit Facility and Senior Unsecured Notes.
Note 7. Fair Value
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. GAAP establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:
GAAP fair value measurement guidance classifies the inputs used to measure these fair values into the following hierarchy:
Level 1. Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that the Company has the ability to access (examples include active exchange-traded equity securities, exchange-traded derivatives, and most U.S. Government and agency securities).
Level 2. Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:
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Level 3. Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain of our private debt and equity investments) and long-dated or complex derivatives (including certain equity and currency derivatives).
When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. For example, a Level 3 fair value measurement may include inputs that are observable (Levels 1 and 2) and unobservable (Level 3). Therefore gains and losses for such assets and liabilities categorized within the Level 3 table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following tables do not take into consideration the effect of offsetting Levels 1 and 2 financial instruments entered into by the Company that economically hedge certain exposures to the Level 3 positions.
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets or liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassifications occur.
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis, as of June 30, 2010 and December 31, 2009:
Fair Value Measurements
As of June 30, 2010
Assets:
Subordinated Debt / Corporate Notes
Common Equity / Partnership Interests / Warrants
Liabilities:
Derivative liabilities – forward contracts
As of December 31, 2009
Derivative assets – forward contracts
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The following table provides a summary of the changes in fair value of Level 3 assets and liabilities for the six months ended June 30, 2010 and the year ended December 31, 2009, as well as the portion of gains or losses included in income attributable to unrealized gains or losses related to those assets and liabilities still held at June 30, 2010 and December 31, 2009:
Fair Value Measurements Using Level 3 Inputs
Fair value, January 1, 2010
Total gains or losses included in earnings:
Purchases, sales, issuances, and settlements (net)
Transfers out of Level 3
Fair value, June 30, 2010
Net change in unrealized gain:
The Company had no assets or liabilities measured at fair value on a nonrecurring basis during the period.
Fair value, January 1, 2009
Transfers into Level 3
Fair value, December 31, 2009
Unrealized gains (losses) for the period relating to those Level 3 assets that were still held by the Company at the end of the period:
The Company had no assets or liabilities measured at fair value on a nonrecurring basis during the year.
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Note 9. Stockholders’ Equity
The table below illustrates the effect of certain transactions on our capital accounts for the six months ended June 30, 2010:
Common Stock
Balance at December 31, 2009
Solar Capital Merger(1)
Issuances of common stock(2)
Net increase in stockholders’ equity resulting from operations
Dividends declared ($0.94 per share)
Permanent tax differences
Balance at June 30, 2010
Note 10. Earnings Per Share
The following information sets forth the computation of basic and diluted net increase (decrease) in shareholders’ capital per share resulting from operations for the three and six months ended June 30, 2010 and 2009:
Numerator for basic and diluted earnings per share:
Denominator for basic and diluted weighted average share:
Basic and diluted net increase in share holders’ equity resulting from operations per share:
As required by ASC 260-10, the number of shares used to calculate weighted average shares for use in computations on a per share basis have been decreased retroactively by a factor of approximately 0.4022 for all periods prior to February 9, 2010. This factor represents the effective impact of the reduction in shares resulting from the Merger.
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Note 11. Financial Highlights
The following is a schedule of financial highlights for the six months ended June 30, 2010:
Per Share Data:(a)
Net asset value, beginning of period
Net realized and unrealized gain (loss)
Net increase (decrease) in net assets resulting from operations
Effect of dilution
Offering costs
Dividends to shareholders declared
Net asset value, end of period
Total return(c)
Net assets, end of period
Per share market value at end of period
Shares outstanding end of period
Ratio to average net assets
Expenses without incentive fees(b)
Incentive fees
Total expenses
Net investment income without incentive fees (b)
Note 12. New Accounting Pronouncements and Accounting Standards Updates
Fair Value Measurements and Disclosures
In January 2010, the FASB issued an update to ASC 820, Fair Value Measurements and Disclosures Topic, which will require additional disclosures about inputs into valuation techniques, disclosures about significant transfers into or out of Levels 1 and 2, and disaggregation of purchases, sales, issuances, and settlements in the Level 3 rollforward disclosure. The guidance is effective for interim and annual reporting periods beginning after December 15, 2009 except for the disclosures about purchases, sales issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.
Note 13. Related Parties
From July 2006 through approximately the first quarter of 2009, Mr. Gross, the Company’s chairman and chief executive officer, was a partner in Magnetar Capital Partners LP. Mr. Spohler, our chief operating officer together with Solar Capital Partners LLC’s other investment professionals, advised Magnetar Financial LLC (“Magnetar”) on certain investments which coincide with those of Solar Capital. Certain entities affiliated with Magnetar own as of June 30, 2010 and December 31, 2009, either directly or indirectly, approximately 19.61% and 42.84%, respectively, of our outstanding equity.
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SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES
Schedule 12-14
Portfolio Company
Investments Owned Greater than 25%
National Specialty Alloys, LLC
Total Investments Owned Greater than 25%
Investments Owned Greater than 5% and Less than 25%
National Interest Security Corp.
Ark Real Estate Partners LP
Total Investments Owned Greater than 5% and Less than 25%
The table below represents the balance at the beginning of the period, December 31, 2009 and any gross additions and reductions and net unrealized gain (loss) made to such investments as well as the ending fair value as of June 30, 2010.
Gross additions represent increases in the investment from additional investments, payments in kind of interest or dividends.
Gross reductions represent decreases in the investment from sales of investments or repayments.
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Investment Owned Greater than 5% and Less than 25%
The table below represents the balance at the beginning of the period, December 31, 2008 and any gross additions and reductions and net unrealized gain (loss) made to such investments as well as the ending fair value as of December 31, 2009.
505 Capital Partners GP
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The following analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the notes thereto contained elsewhere in this report.
Overview
Solar Capital Ltd. (“Solar Capital”, the “Company” or “we”), a Maryland corporation formed in November 2007, is a closed-end, externally managed, non-diversified management investment company that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). In addition, for tax purposes the Company intends to elect to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”).
On February 9, 2010, Solar Capital Ltd. priced its initial public offering (the “IPO”) selling 5.68 million shares, including the underwriters’ over-allotment, at a price of $18.50 per share. Net of underwriting fees the Company raised a total of $97.7 million and its shares began to trade on the NASDAQ Global Select Market under the ticker “SLRC”. In addition, Solar Capital Ltd. sold 0.60 million shares at $18.50 in a concurrent private placement to management.
Immediately prior to our initial public offering, through a series of transactions Solar Capital LLC merged with and into Solar Capital Ltd., leaving Solar Capital Ltd. as the surviving entity (the “Solar Capital Merger”). Solar Capital Ltd. issued an aggregate of approximately 26.65 million shares of common stock and $125 million in senior unsecured notes (“Senior Unsecured Notes”) to the existing Solar Capital LLC unit holders in connection with the Solar Capital Merger. Solar Capital LLC, a Maryland limited liability company, was formed in February 2007 and conducted a private placement of units of membership interest (“units”) in March 2007. Solar Capital Ltd. had no assets or operations prior to completion of the Solar Capital Merger and as a result, the historical books and records of Solar Capital LLC have become the books and records of the surviving entity.
Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We invest primarily in leveraged middle market companies in the form of senior secured loans, mezzanine loans and equity securities. From time to time, we may also invest in public companies that are thinly traded. Our business model is focused primarily on the direct origination of investments through portfolio companies or their financial sponsors. Our investments generally range between $20 million and $100 million each, although we expect that this investment size will vary proportionately with the size of our capital base. We are managed by Solar Capital Partners LLC. Solar Capital Management LLC provides the administrative services necessary for us to operate.
In addition, we may invest a portion of our portfolio in other types of investments, which we refer to as opportunistic investments, which are not our primary focus but are intended to enhance our overall returns. These investments may include, but are not limited to, direct investments in public companies that are not thinly traded and securities of leveraged companies located in select countries outside of the United States.
As of June 30, 2010, our long term investments totaled $819.3 million and our net asset value was $728.8 million. Our portfolio was comprised of debt and equity investments in 33 portfolio companies and our income producing assets, which represented 92.4% of our total portfolio, had a weighted average annualized yield on fair value of approximately 14.1%.
Recent Developments
Dividend
On August 3, 2010, our board of directors declared a quarterly dividend of $0.60 per share payable on October 4, 2010 to holders of record as of September 17, 2010. We expect the dividend to be paid from taxable earnings with specific tax characteristics reported to stockholders after the end of the calendar year.
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Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting policies (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following items as critical accounting policies.
Valuation of Portfolio Investments
We conduct the valuation of our assets, pursuant to which our net asset value is determined, at all times consistent with GAAP, and the 1940 Act. Our valuation procedures are set forth in more detail below:
Securities for which market quotations are readily available on an exchange are valued at the closing price on the valuation date. We may also obtain quotes with respect to certain of our investments from pricing services or brokers or dealers in order to value assets. When doing so, we determine whether the quote obtained is sufficient according to GAAP to determine the fair value of the security. If determined adequate, we use the quote obtained.
Securities for which reliable market quotations are not readily available or for which the pricing source does not provide a valuation or methodology or provides a valuation or methodology that, in the judgment of our investment adviser or board of directors, does not represent fair value, shall be valued as follows: (i) each portfolio company or investment is initially valued by the investment professionals responsible for the portfolio investment; (ii) preliminary valuation conclusions are documented and discussed with our senior management; (iii) independent third-party valuation firms engaged by, or on behalf of, the board of directors will conduct independent appraisals and review management’s preliminary valuations and make their own assessment for all material assets; (iv) the board of directors will discuss valuations and determine the fair value of each investment in our portfolio in good faith based on the input of the investment adviser and, where appropriate, the respective third-party valuation firms.
The recommendation of fair value will generally be based on the following factors, as relevant:
the nature and realizable value of any collateral;
the portfolio company’s ability to make payments;
the portfolio company’s earnings and discounted cash flow;
the markets in which the issuer does business; and
comparisons to publicly traded securities.
Securities for which market quotations are not readily available or for which a pricing source is not sufficient may include, but are not limited to, the following:
private placements and restricted securities that do not have an active trading market;
securities whose trading has been suspended or for which market quotes are no longer available;
debt securities that have recently gone into default and for which there is no current market;
securities whose prices are stale;
securities affected by significant events; and
securities that the investment adviser believes were priced incorrectly.
Determination of fair value involves subjective judgments and estimates. Accordingly, the notes to our financial statements express the uncertainty with respect to the possible effect of such valuations, and any change in such valuations, on our financial statements.
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Level 1. Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that the Company has the ability to access (examples include active exchange-traded equity securities and exchange-traded derivatives).
a) Quoted prices for similar assets or liabilities in active markets;
b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently);
c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including foreign exchange forward contracts); and
d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability.
At June 30, 2010 the fair value of investments classified as Level 3 was $665.2 million or 72.6% of total assets. There were no investments transferred into Level 3 during the first or second quarter of 2010. During the second quarter of 2010, two investments with a total market value of $98.0 million were transferred from Level 3 to Level 2 due to the reliability of broker quotes for these assets resulting from increased market liquidity.
Revenue Recognition
Our revenue recognition policies are as follows:
Interest Income: Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as part of interest income. We have loans in our portfolio that contain a PIK provision. PIK interest is accrued at the contractual rates and added to the loan principal on the reset dates. For us to maintain our status as a RIC, substantially all of this income must be paid out to stockholders in the form of dividends, even though we have not collected any cash with respect to PIK securities.
Non-accrual: Loans are placed on non-accrual status when principal or interest payments are past due 30 days or more or when there is reasonable doubt that principal or interest will be collected. Accrued interest is generally reversed when a loan is placed on non-accrual status. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management’s judgment about ultimate collectability of principal. Non-accrual loans are restored to accrual status when past due principal and interest is paid and, in management’s judgment, are likely to remain current.
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Portfolio Investments
At June 30, 2010, we had investments in securities of 33 portfolio companies with a total fair value of approximately $819.3 million compared to investments in securities of 36 portfolio companies with a total fair value of approximately $863.1 million at December 31, 2009. At June 30, 2010, we had investments in debt and preferred securities of 27 portfolio companies, totaling approximately $771.0 million, and equity investments in 9 portfolio companies, totaling approximately $48.3 million. At December 31, 2009, we had investments in debt and preferred securities of 31 portfolio companies, totaling approximately $805.5 million, and equity investments in 10 portfolio companies, totaling approximately $57.6 million.
During the three months ended June 30, 2010, we originated approximately $74.9 million of investments in three new and one existing portfolio company. We also received principal repayments of approximately $85.7 million and sold securities in one portfolio company for approximately $2.9 million. During the three months ended June 30, 2009, we invested approximately $91.3 million in three existing and two new portfolio companies, had approximately $27.8 million in principal repayments in five portfolio companies, and sold securities in six portfolio companies for approximately $12.6 million.
During the six months ended June 30, 2010, we originated approximately $109.6 million of investments in four new and one existing portfolio company. We also received principal repayments of approximately $180.8 million and sold securities in four portfolio companies for approximately $23.5 million. During the six months ended June 30, 2009, we invested approximately $93.7 million in four existing and two new portfolio companies, had approximately $28.0 million in principal repayments in five portfolio companies, and sold securities in seven portfolio companies for approximately $21.5 million.
For the three months ended June 30, 2010 we had net unrealized and realized gains on 18 portfolio company investments totaling approximately $9.3 million, which was offset by net unrealized and realized losses on 16 portfolio company investments totaling approximately $13.5 million. For the three months ended June 30, 2009 we had net unrealized and realized gains on 27 portfolio company investments totaling approximately $70.2 million, which was offset by net unrealized and realized losses on 13 portfolio company investments totaling approximately $38.7 million.
For the six months ended June 30, 2010 we had net unrealized and realized gains on 27 portfolio company investments totaling approximately $44.5 million, which was offset by net unrealized and realized losses on 11 portfolio company investments totaling approximately $11.5 million. For the six months ended June 30, 2009 we had net unrealized and realized gains on 27 portfolio company investments totaling approximately $83.7 million, which was offset by net unrealized and realized losses on 16 portfolio company investments totaling approximately $97.5 million.
The following table shows the fair value of our portfolio of investments by asset class as of June 30, 2010 and December 31, 2009:
(in thousands)
As of June 30, 2010, the weighted average yield on income producing investments in our portfolio was approximately 14.1%, compared to 14.8% at December 31, 2009. The decrease in yield during the first six months of 2010 was primarily due to the increase in fair value and repayment of assets since December 2009.
As of June 30, 2010, there was one investment on non-accrual status with a market value of zero. In addition we had two assets, with a total market value of $14.1 million, that were performing but cash interest payments have been applied as principal payments (“cost-recovery assets”), rather than being included in interest income because management believes, at this time, it is unlikely there will be full repayment of principal. Of the non-accrual assets at December 31, 2009, assets of two portfolio companies were sold prior to the IPO and the third was exchanged for equity of the portfolio company in a restructuring.
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Results of Operations for the Quarter Ended June 30, 2010 compared to the Quarter Ended June 30, 2009
Revenue
Investment income
The increase in investment income for the three months ended June 30, 2010 compared to the three months ended June 30, 2009 was primarily due to prepayment premiums and the accelerated amortization of fees resulting from debt assets repaying during the second quarter of 2010, partially offset by a lower average invested balance, lower average LIBOR rates, and interest not recognized on non-accrual and cost-recovery assets. Three month LIBOR rates fell below 0.25% preceding the second quarter of 2010 compared to 1.22% heading into the second quarter of 2009.
Expenses
The performance-based incentive fee, which is calculated as a percentage of net investment income above a certain hurdle rate, was higher for the three months ended June 30, 2010 primarily due to higher investment income, partially offset by increased interest and other credit facility expenses. Investment advisory and management fees, which are calculated based on average gross assets, were lower during the three months ended June 30, 2010 primarily due to lower average gross assets during the second quarter of 2010 compared to the second quarter of 2009.
Interest and other credit facility expenses for the three months ended June 30, 2010 were higher than the comparable period in 2009 primarily due to higher average debt balances outstanding, higher loan fee amortization expenses and higher unused facility fees.
Administrative service fees were lower during the second quarter of 2010 because the second quarter of 2009 included costs related to pre-IPO private fund administration and reporting. Other general and administrative expenses were higher during the second quarter of 2010 due to increased post-IPO insurance costs and bank custody fees.
Net Realized and Unrealized Gains and Losses
Net realized (loss) on investments
Net realized gain (loss) on forward contracts
Net realized (loss) on foreign currency exchange
Net unrealized gain (loss) on forward contracts
Net unrealized gain (loss) on foreign currency exchange
Total realized and unrealized gain
Total realized and unrealized gain was $1.3 million for the second quarter of 2010 compared to $17.9 million for the same period in 2009. The combined net gain during the second quarter of 2010 was primarily due to continued credit improvement in the portfolio as well as realizations in excess of prior valuations. The net gain during the second quarter of 2009 was primarily due to certain asset valuations that were beginning to recover from technical recession lows. We analyze this section on a combined basis because offsets may exist in the individual line items due to foreign exchange fluctuations and movements from unrealized to realized.
Our investments denominated in Euro, British Pounds and Australian dollars are converted into U.S. dollars at the balance sheet date, and as such, we are exposed to movements in exchange rates. To limit our exposure to movements in foreign currency exchange rates we enter into foreign exchange forward contracts or borrow in foreign currencies under our multi-currency revolving credit facility. For the second quarter of 2010 the total net realized and unrealized gain on forward contracts and foreign currency exchange was $5.5 million compared to a loss of $13.8 million for the same line items in the second quarter of 2009. This was due to the strengthening of the U.S. dollar during the first quarter 2010 compared to weakening during the same period in 2009.
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Results of Operations for the Six Months Ended June 30, 2010 compared to the Six Months Ended June 30, 2009
The increase in investment income for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 was primarily due to prepayment premiums and the accelerated amortization of fees resulting from debt assets repaying during the first half of 2010, partially offset by a lower average invested balance and lower average LIBOR rates, and interest not recognized on non-accrual and cost-recovery assets. Three month LIBOR rates fell below 0.25% preceding the first quarter of 2010 compared to rates near 1.5% heading into the first quarter of 2009.
The performance-based incentive fee was higher for the six months ended June 30, 2010 primarily due to higher investment income resulting from prepayment premiums received and accelerated amortization of fees as a result of debt assets repaying before maturity. Investment advisory and management fees, which are calculated based on average gross assets, were higher during the six months ended June 30, 2010 compared to the same period in 2009 due to higher average gross assets during the six months ended June 30, 2010 compared to the same period in 2009.
Interest and other credit facility expenses were higher for the six months ended June 30, 2010 primarily due to higher average debt balances outstanding during the period, including the newly issued Senior Unsecured Notes, higher loan fee amortization expenses, related to the establishment of the Senior Unsecured Notes and credit facility amendments, and higher unused facility fees.
Administrative service fees were lower during the first half of 2010 because the first half of 2009 included costs related to pre-IPO private fund administration and reporting. Other general and administrative expenses were higher during the first half of 2010 due to increased post-IPO insurance costs and bank custody fees.
Net realized gain (loss) on foreign currency exchange
Net unrealized gain on investments
Net unrealized (loss) on forward contracts
Total realized and unrealized gain (loss)
The combination of the net realized and unrealized gains or losses resulted in a net gain of $42.2 million for the six months ended June 30, 2010 compared to a net loss of $24.8 million for the same period in 2009. The net gain for the six months ended June 30, 2010 was primarily due to increases in the fair value of our portfolio assets during the period as well as realizations in excess of prior valuations. The net increase in the fair value of our portfolio assets was primarily due to continued credit improvement in the portfolio, the tightening of credit spreads in the high yield market and portfolio realizations. The net loss during the six months ended June 30, 2009 was primarily due to overall weakening in the economy during the period resulting in lower portfolio asset values. We analyze this section on a combined basis because offsets may exist in the individual line items due to foreign exchange fluctuations and movements from unrealized to realized.
Our investments denominated in Euro, British Pounds and Australian dollars are converted into U.S. dollars at the balance sheet date, and as such, we are exposed to movements in exchange rates. To limit our exposure to movements in foreign currency exchange rates we enter into foreign exchange forward contracts or borrow in foreign currencies under our multi-currency revolving credit facility. For the six months ended June 30, 2010 the total net realized and unrealized gain on forward contracts and foreign currency exchange was $9.2 million compared to a loss of $10.9 million for the same line items for the six months ended June 30, 2009. This is due to a greater relative strengthening of the U.S. dollar during the six months ended June 30, 2010 compared to the same period in 2009.
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Liquidity and Capital Resources
The Company’s liquidity is generated and generally available through its multi-currency $355 million revolving credit facility maturing in February 2013, from cash flows from operations, investment sales of liquid assets, repayments of senior and subordinated loans, income earned on investments and cash equivalents, and we expect through periodic follow-on equity offerings. On February 9, 2010, Solar Capital Ltd. priced its initial public offering selling 5.68 million shares, including the underwriters over-allotment, at a price of $18.50 per share. Net of underwriting fees the Company raised a total of $97.7 million and its shares began to trade on the NASDAQ Global Select Market under the ticker “SLRC”. In addition, Solar Capital Ltd. sold 0.60 million shares at $18.50 in a concurrent private placement to management. The primary use of our liquidity is expected to be for repayment of indebtedness, investments in portfolio companies, cash distributions to our shareholders or for other general corporate purposes.
At June 30, 2010 and December 31, 2009, we had cash and cash equivalents of approximately $68.8 million and $5.7 million, respectively. Cash provided by operating activities for the six months ended June 30, 2010 and 2009 was approximately $125.6 million and $16.5 million, respectively. We expect that all current liquidity needs will be met with cash flows from operations and other activities.
Credit Facility and Senior Unsecured Notes
Credit Facility. On February 12, 2010, Solar Capital Ltd. amended and restated Solar Capital LLC’s $250 million Senior Secured Revolving Credit Facility (the “Credit Facility”), extending the maturity to February 2013 and increasing the total commitments under the facility to $270 million. Per the amended agreement, borrowings bear interest at a rate per annum equal to the base rate plus 3.25% or the alternate base rate plus 2.25%. The commitment fee on unused balances is 0.375%. The amendment also reduced the advance rates permitted on certain asset types and placed limitations on the secured borrowing amount. On May 26, 2010, the Credit Facility was amended to remove the limitations on the secured borrowing and increase the advance rates permitted on certain asset types. Total commitments under the Credit Facility have been increased to $355 million as a result of the addition of two new lenders on May 12, 2010 and June 23, 2010. The facility size may be increased up to $600 million with additional new lenders or the increase in commitments of current lenders. The Credit Facility contains certain customary affirmative and negative covenants and events of default, including the occurrence of a change of control. In addition, the Credit Facility contains certain financial covenants that among other things, requires the Company to maintain a minimum shareholder’s equity and a minimum debt to total assets ratio.
Senior Unsecured Notes. In February 2010, as a component of the Solar Capital Merger, Solar Capital Ltd. issued $125 million of Senior Unsecured Notes. The Senior Unsecured Notes mature in February 2014 and have a coupon of 8.75%, payable quarterly in cash beginning May 1, 2010. The Senior Unsecured Notes are redeemable at any time, in whole or in part, at a price of 100% of their principal amount, plus accrued and unpaid interest to the date of redemption. Further, we must use the net cash proceeds from the issuance of any other senior notes either to redeem or make an offer to purchase the outstanding Senior Unsecured Notes at a price of 100% of their principal amount, plus accrued and unpaid interest to the date of redemption. The Senior Unsecured Notes subject us to customary covenants, including, among other things, (i) a requirement to maintain an “asset coverage ratio” of at least 2.00 to 1.00; (ii) a requirement that in the event of a “change of control” (as defined in the agreement governing the Senior Unsecured Notes) we will be required to offer to repurchase the Senior Unsecured Notes at a price of 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase; and (iii) a restriction on incurring any debt on a junior lien basis, or any debt that is contractually subordinated in right of payment to any other debt unless it is also subordinated to the Senior Unsecured Notes on substantially identical terms. The agreement under which the Senior Unsecured Notes have been issued contains customary events of default.
Certain covenants may restrict our business activities, including limitations that could hinder our ability to finance additional loans and investments or to make the distributions required to maintain our status as a RIC under Subchapter M of the Code.
Contractual Obligations
A summary of our significant contractual payment obligations as of June 30, 2010:
(in millions)
Senior secured revolving credit facility(1)
Senior Unsecured Notes
We have certain commitments pursuant to our Investment Advisory and Management Agreement entered into with Solar Capital Partners, LLC (“Solar Capital Partners”). We have agreed to pay a fee for investment advisory and management services consisting of two components—a base management fee and an incentive fee. Payments under the Investment Advisory and Management Agreement are equal to (1) a percentage of the value of our average gross assets and (2) a two-part incentive fee. We have also entered into a contract with Solar Capital Management LLC, (“Solar Capital Management”) to serve as our administrator. Payments under the Administration Agreement are equal to an amount based upon our allocable portion of Solar Capital Management’s overhead in performing its obligation under the agreement, including rent, fees, and other expenses inclusive of our allocable portion of the compensation of our chief financial officer and any administrative staff.
Off-Balance Sheet Arrangements
In the normal course of our business, we trade various financial instruments and may enter into various investment activities with off-balance sheet risk, which include forward foreign currency contracts. Generally, these financial instruments represent future commitments to purchase or sell other financial instruments at specific terms at future dates. These financial instruments contain varying degrees of off-balance sheet risk whereby changes in the market value or our satisfaction of the obligations may exceed the amount recognized in our Consolidated Statements of Assets and Liabilities.
Borrowings
We had borrowings of $125.0 million and $88.1 million outstanding as of June 30, 2010 and December 31, 2009, respectively.
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Distributions and Dividends
On August 3, 2010, our board of directors declared a quarterly dividend of $0.60 per share payable on October 4, 2010 to holders of record as of September 17, 2010. For the three and six months ended June 30, 2010, declared dividends to stockholders totaled $0.60 per share or $19.8 million and $0.94 per share or $31.0 million, respectively. The $0.34 dividend declared during the first quarter of 2010 was a $0.60 dividend prorated for the number of days that remained in the quarter after our initial public offering. Tax characteristics of all dividends will be reported to shareholders on Form 1099 after the end of the calendar year. Our quarterly dividends, if any, will be determined by our board of directors.
We intend to elect to be taxed as a RIC under Subchapter M of the Code. To maintain our RIC status, we must distribute at least 90% of our ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, out of the assets legally available for distribution. In addition, although we currently intend to distribute net realized capital gains (net long-term capital gains in excess of short-term capital losses), if any, at least annually, out of the assets legally available for such distributions, we may in the future decide to retain such capital gains for investment.
We maintain an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a dividend, then stockholders’ cash dividends will be automatically reinvested in additional shares of our common stock, unless they specifically “opt out” of the dividend reinvestment plan so as to receive cash dividends.
Related Parties
We have entered into a number of business relationships with affiliated or related parties, including the following:
We have entered into an Investment Advisory and Management Agreement with Solar Capital Partners. Mr. Gross, our chairman and chief executive officer, is the managing member and a senior investment professional of, and has financial and controlling interests in, Solar Capital Partners. In addition, Mr. Spohler, our chief operating officer is a partner and a senior investment professional of, and has financial interests in, Solar Capital Partners.
Solar Capital Management provides us with the office facilities and administrative services necessary to conduct day-to-day operations pursuant to our Administration Agreement. We reimburse Solar Capital Management for the allocable portion of overhead and other expenses incurred by it in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions, and the compensation of our chief compliance officer, our chief financial officer and any administrative support staff. Solar Capital Partners, our investment adviser, is the sole member of and controls Solar Capital Management.
We have entered into a license agreement with Solar Capital Partners, pursuant to which Solar Capital Partners has granted us a non-exclusive, royalty-free license to use the name “Solar Capital.”
Certain entities affiliated with Magnetar Financial LLC own as of August 3, 2010, approximately 19.61% of our outstanding shares of common stock.
Solar Capital Partners and its affiliates may also manage other funds in the future that may have investment mandates that are similar, in whole and in part, with ours. Solar Capital Partners and its affiliates may determine that an investment is appropriate for us and for one or more of those other funds. In such event, depending on the availability of such investment and other appropriate factors, Solar Capital Partners or its affiliates may determine that we should invest side-by-side with one or more other funds. Any such investments will be made only to the extent permitted by applicable law and interpretive positions of the SEC and its staff, and consistent with Solar Capital Partners’ allocation procedures. In addition, we have adopted a formal code of ethics that governs the conduct of our officers and directors. Our officers and directors also remain subject to the duties imposed by both the 1940 Act and the Maryland General Corporation Law.
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We are subject to financial market risks, including changes in interest rates. During the three months ended June 30, 2010, certain of the loans in our portfolio had floating interest rates. Interest rates on these loans are typically based on floating LIBOR and reset to current market rates every one to six months. As we increase our investments in mezzanine and other subordinated loans we expect that our portfolio will have an increased percentage of fixed rate assets. A change in interest rates would not have a material effect on our net investment income. However, we may hedge against interest rate fluctuations from time-to-time by using standard hedging instruments such as futures, options and forward contracts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of higher interest rates with respect to our portfolio of investments. During the three months ended June 30, 2010, we did not engage in interest rate hedging activities.
The following table quantifies the potential changes in interest income net of interest expense should interest rates increase by 100 or 200 basis points or decrease by 25 basis points. Investment income is calculated as revenue from loans and other lending investments held at June 30, 2010 and interest expense is calculated based on our borrowings of $125 million on the fixed rate Senior Unsecured Notes as of June 30, 2010. We had no outstanding borrowings under the floating rate Credit Facility as of June 30, 2010 and therefore the interest expense calculations below do not change with the hypothetical changes in interest rates. The base interest rate case assumes the rates on our portfolio investments remain as they were on June 30, 2010. All of the hypothetical calculations are based on a model of our portfolio for the twelve months subsequent to June 30, 2010 and assume no change to any input other than the underlying base interest rates.
Actual results could differ significantly from those estimated in the table.
Change in Interest Rates
-25 Basis Points
Base Interest Rate
+100 Basis Points
+200 Basis Points
We have exposure to foreign currencies (Euro, British Pounds and Australian dollars) through various investments. These investments are converted into U.S. dollars at the balance sheet date, exposing us to movements in exchange rates. To limit our exposure to fluctuations in exchange rates, we enter into foreign exchange forward contracts or borrow in those currencies under our multi-currency revolving credit facility. Our foreign currency exchange contracts are short term contracts that are continuously rolled forward to hedge the longer term portfolio investments. The table below presents our exchange rate sensitive assets and liabilities as of June 30, 2010:
Portfolio Investments (Long) (unaudited)
Par Amount, Fair Value for Equity (in Currency in millions)
Par Amount, Fair Value for Equity ($ in millions)
Fair Value ($ in millions)
Forward Contracts (Short) (unaudited)
Notional Amount (in Currency in millions)
Contractual Exchange Rate
Contract Amount ($ in millions)
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(a) Evaluation of Disclosure Controls and Procedures
As of June 30, 2010 (the end of the period covered by this report), we, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the 1934 Act). Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective and provided reasonable assurance that information required to be disclosed in our periodic SEC filings is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. However, in evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of such possible controls and procedures.
(b) Changes in Internal Controls Over Financial Reporting
Management has not identified any change in the Company’s internal control over financing reporting that occurred during the second quarter of 2010 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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We, Solar Capital Management, LLC and Solar Capital Partners, LLC are not currently subject to any material pending legal proceedings threatened against us. From time to time, we may be a party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our business, financial condition or results of operations.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009, which could materially affect our business, financial condition and/or operating results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition and/or operating results. There have been no material changes during the six months ended June 30, 2010 to the risk factors discussed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2009.
While we did not engage in unregistered sales of equity securities during the three months ended June 30, 2010, we issued a total of 102,384 shares of common stock under the dividend reinvestment plan. This issuance was not subject to the registration requirements under the Securities Act of 1933. The aggregate valuation price for the shares of common stock issued under the dividend reinvestment plan was approximately $22.34 per share.
None.
[Intentionally left blank]
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(a) Exhibits
The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC:
ExhibitNumber
Description
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 3, 2010.
/s/ MICHAEL S. GROSS
/s/ NICHOLASRADESCA
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