UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarter Ended September 30, 2012
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
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):
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 October 31, 2012 was 38,694,058.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2012
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Statements of Assets and Liabilities as of September 30, 2012 (unaudited) and December 31, 2011
Consolidated Statements of Operations for the three and nine months ended September 30, 2012 (unaudited) and September 30, 2011 (unaudited)
Consolidated Statements of Changes in Net Assets for the nine months ended September 30, 2012 (unaudited) and the year ended December 31, 2011
Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 (unaudited) and September 30, 2011 (unaudited)
Consolidated Schedule of Investments as of September 30, 2012 (unaudited)
Consolidated Schedule of Investments as of December 31, 2011
Notes to Consolidated Financial Statements (unaudited)
.
Report of Independent Registered Public Accounting Firm
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
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Signatures
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
(in thousands, except shares)
2012
(unaudited)
2011
Assets
Investments at value:
Companies less than 5% owned (cost: $1,128,982 and $1,062,844 respectively)
Companies 5% to 25% owned (cost: $72,492 and $41,819, respectively)
Companies more than 25% owned (cost: $28,785 and $47,910, respectively)
Total investments (cost: $1,230,259 and $1,152,573, respectively)
Cash and cash equivalents
Interest and dividends receivable
Deferred credit facility costs
Deferred offering costs
Receivable for investments sold
Fee revenue receivable
Unrealized appreciation on foreign exchange contracts and fair value of interest rate caps
Prepaid expenses and other receivables
Total Assets
Liabilities
Revolving credit facilities
Senior secured notes
Term Loan
Payable for investments purchased
Dividend payable
Investment advisory and management fee payable
Performance-based incentive fee payable
Interest payable
Administrative services fee payable
Deferred fee revenue
Other accrued expenses and payables
Total Liabilities
Net Assets
Common stock, par value $0.01 per share, 38,667,196 and 36,608,038 shares issued and outstanding, respectively, 200,000,000 authorized
Paid-in capital in excess of par
Undistributed net investment income
Distributions in excess of net investment income
Accumulated net realized losses
Net unrealized depreciation
Total Net Assets
Number of shares outstanding
Net Asset Value Per Share
See notes to consolidated financial statements.
1
CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
INVESTMENT INCOME:
Interest and dividends:
Other interest and dividend income
Companies 5% to 25% owned
Companies more than 25% owned
Total investment income
EXPENSES:
Investment advisory and management fees
Performance-based incentive fees
Interest and other credit facility expenses
Administrative services fees
Other general and administrative expenses
Total operating expenses
Net investment income before income tax expense
Income tax expense
Net investment income
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS, DERIVATIVES AND FOREIGN CURRENCIES:
Net realized gain (loss):
Investments:
Companies less than 5% owned
Net realized gain (loss) on investments
Foreign currencies & derivatives
Net realized gain (loss) before income taxes
Net realized gain (loss)
Net change in unrealized gain (loss):
Investments
Net change in unrealized gain (loss)
Net realized and unrealized gain (loss) on investments, derivatives and foreign currencies
Net Increase (Decrease) in Net Assets Resulting From Operations
Earnings (Loss) per share
2
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Increase in net assets resulting from operations:
Net realized loss
Net increase in net assets resulting from operations
Dividends and distributions to shareholders:
Capital share transactions:
Common equity offering
Reinvestment of dividends
Total capital share transactions
Net increase (decrease) in net assets
Net assets at beginning of period
Net assets at end of period
3
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands except shares)
Cash Flows from Operating Activities:
Net increase in net assets from operations
Adjustments to reconcile net increase in net assets from operations to net cash (used) provided by operating activities:
Net realized (gain) loss from investments
Net realized (gain) loss from foreign currency exchange
Net change in unrealized (gain) loss on investments
Net change in (gain) loss on derivatives
(Increase) decrease in operating assets:
Purchase of investment securities
Proceeds from disposition of investment securities
Capitalization of payment-in-kind interest
Collections of payment-in-kind interest
Purchase of interest rate cap
Increase (decrease) in operating liabilities:
Net Cash (Used) Provided by Operating Activities
Cash Flows from Financing Activities:
Cash dividends paid
Proceeds from borrowings on senior secured notes
Proceeds from borrowings on revolving/term credit facilities
Repayments of borrowings on revolving/term credit facilities
Net Cash Provided (Used) in Financing Activities
NET INCREASE 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:
Dividends reinvestment
4
CONSOLIDATED SCHEDULE OF INVESTMENTS (unaudited)
September 30, 2012
Description(1)
Industry
Bank Debt/Senior Secured Loans-54.3%
Asurion Corporation(16)
AREP Fifty-Seventh LLC(10)(23)
ARK Real Estate Partners II LP(10)(23)
AviatorCap SII, LLC I(9)
AviatorCap SII, LLC II(9)
AviatorCap SII, LLC III(9)
Direct Buy Inc.(18)
DS Waters of America, Inc.(10)(22)
4% PIK)
(7)
Fulton Holding Corp.
Easy Financial Services, Inc.(19)(24)
Grakon, LLC(11)
Good Sam Enterprise, LLC
Grocery Outlet Inc.(16)
Isotoner Corporation
Interactive Health Solutions, Inc.(16)(17)
MYI Acquiror Corporation(4)(8)(19)
1% PIK)
SMG
Southern Auto Finance Company(19)
SOINT, LLC(9)
Spencer Spirit Holdings, Inc.
T&D Solutions holdings
Transplace Texas, LP(16)
Trident USA Health Services, LLC
USAW 767(9)
ViaWest Inc(16)
1.5% PIK)
Total Bank Debt/Senior Secured Loans
Subordinated Debt/Corporate Notes – 56.4%
Adams Outdoor Advertising
Asurion Holdco(21)
CIBT Solutions
Crosman Corporation
2% PIK)
Earthbound Farm(16)
Alegeus Technologies Holdings Corp.
Grakon Holdings LLC Sr(11)
Grakon Holdings LLC Jr(11)
Granite Global Solutions Corp.(3)(18)(19)
Midcap Financial Intermediate Holdings, LLC(16)(19)
ProSieben Sat.1 Media AG(3)(6)(19)
3.5% PIK)
Richelieu Foods, Inc.(15)
1.75% PIK)
Rug Doctor L.P.(20)(16)
(wtd. avg. 17.54%
Weetabix Group(3)(5)(19)
WireCo. Worldgroup Inc.
Total Subordinated Debt/Corporate Notes
5
CONSOLIDATED SCHEDULE OF INVESTMENTS (unaudited) (continued)
Preferred Equity – 16.8%
Senior Preferred 15% Units of DSW GroupHoldings LLC(10)
SODO Corp.(9)(12)
SOCAY Limited(9)(12)(19)
Wyle Laboratories
Total Preferred Equity
Common Equity / Partnership Interests /Warrants – 5.9%
Ark Real Estate Partners LP(10)(11)
Participating Preferred Units of DSW GroupHoldings LLC(10)
Grakon, LLC Warrants(11)
Great American Group Inc.(13)(19)
Great American Group Inc.(14)(19)
Nuveen Investments, Inc.
NXP Semiconductors Netherlands B.V.(3)(19)
Seven West Media Limited(3)(19)
Total Common Equity/PartnershipsInterests / Warrants
Total Investments – 133.4%
Liabilities in Excess of Other Assets – (33.4%)
Net Assets – 100.0%
6
7
Industry Classification
Beverage, Food & Tobacco
Personal, Food & Misc. Services
Banking
Insurance
Healthcare, Education & Childcare
Buildings & Real Estate
Farming & Agriculture
Aerospace & Defense
Building Products
Leisure, Amusement, Entertainment
Retail Stores
Diversified/Conglomerate Service
Personal & Nondurable Consumer Products
Grocery
Healthcare Technology
Machinery
Cargo Transport
Broadcasting & Entertainment
Utilities
Consumer Finance
Finance
Electronics
Home, Office Furnishing & Durable Consumer Products
8
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2011
Bank Debt/Senior Secured Loans – 51.2%
Asurion Corporation(18)
Airvana Network Solutions Inc.
AviatorCap SII, LLC I(10)
AviatorCap SII, LLC II(10)
AviatorCap SII, LLC III(10)
Direct Buy Inc.(20)
Fulton Holding Corp(18)
Grakon, LLC
Grocery Outlet Inc.
Interactive Health Solutions, Inc.(18)(19)
MYI Acquiror Corporation(3)(4)(8)(21)
Roundy’s Supermarkets, Inc. – 2nd Lien(18)
Southern Auto Finance Company(21)
Transplace Texas, LP(18)
USAW 767(10)
ViaWest Inc(18)
Vision Holding Corp.(18)
VPSI, Inc.(17)
Subordinated Debt/Corporate Notes – 67.9%
AMC Entertainment Holdings, Inc.
DSW Group, Inc.
Earthbound Farm(18)
Grakon Holdings LLC Sr
Grakon Holdings LLC Jr
Granite Global Solutions Corp.(3)(16)(21)
Magnolia River, LLC
Midcap Financial Intermediate Holdings, LLC(18)
ProSieben Sat.1 Media AG(3)(6)(21)
Richelieu Foods, Inc.(17)
Rug Doctor L.P.(18)(22)
Shoes For Crews, LLC (17)
Weetabix Group(3)(5)(21)
Preferred Equity – 1.8%
SODO Corp.(10)(13)
SOCAY Limited(10)(13)
9
CONSOLIDATED SCHEDULE OF INVESTMENTS (continued)
Common Equity / Partnership Interests / Warrants – 8.8%
Ark Real Estate Partners LP(9)(11)(12)
Grakon, LLC Warrants
Great American Group Inc.(14)
Great American Group Inc.(15)
National Specialty Alloys, LLC(10)
NXP Semiconductors Netherlands B.V.(3)
Seven West Media Limited
Total Common Equity/Partnerships Interests / Warrants
Total Investments – 129.7%
Liabilities in Excess of OtherAssets – (29.7%)
10
11
Hotels, Motels, Inns and Gaming
Personal Transportation
Mining, Steel, Iron & Nonprecious Metals
Textiles & Leather
Telecommunications
12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Note 1. Organization
Solar Capital Ltd. (“Solar Capital”, “we”, or the “Company”), 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 has elected to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). In February 2010, Solar Capital Ltd. completed its initial public offering.
The Company’s 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. 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, including proportionately with the size of our capital base.
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 subsidiaries, Solar Capital Luxembourg I S.a.r.l., which was incorporated under the laws of the Grand Duchy of Luxembourg on April 26, 2007, and Solar Capital Funding II LLC (“SC Funding”), a Delaware limited liability company formed on December 8, 2010. 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. Certain prior period amounts have been reclassified to conform to current year presentation.
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, 2012.
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 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 (unaudited) (continued)
Valuation methods, among other measures and as applicable, may include comparisons of financial ratios of the portfolio companies that issued such 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 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.
Credit Facilities – The Company has made an irrevocable election to apply the fair value option of accounting to the certain credit facilities and senior secured notes (see Note 6), in accordance with Accounting Standards Codification (“ASC”) 825-10. The Company uses an independent third-party valuation firm to measure their fair values.
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.
Dividend Income: Dividend income on preferred equity securities is recorded as dividend income on an accrual basis to the extent that such amounts are payable by the portfolio company and are expected to be collected. Dividend income on common equity securities is recorded on the record date for private portfolio companies or on the ex-dividend date for publicly traded portfolio companies.
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
14
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 are paid and, in management’s judgment, are likely to remain current.
Fee Revenue Receivable – Fee revenue receivable consists of premium payments owed to the Company at the maturity of certain loans. The premium payments are recorded as a receivable at the inception of the loan and are accreted into interest income over the respective terms of the applicable loans.
Deferred Fee Revenue – Deferred fee revenue represents the unearned portion of premium payments owed to the Company at the maturity of certain loans.
U.S. Federal Income Taxes – The Company has elected 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. Depending on the level of taxable income earned in a given 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 estimates that its current year annual taxable income may be in excess of estimated current year dividend distributions, the Company may accrue an excise tax on estimated excess taxable income as it is earned. For the nine months ended September 30, 2012, $343 was accrued for estimated U.S. Federal excise tax.
Although the Company files federal and state tax returns, its major tax jurisdiction is federal. The Company’s inception-to-date federal tax years remain subject to examination by the Internal Revenue Service. 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.
The Company has formed and used certain taxable subsidiaries to be taxed as a corporation for federal income tax purposes. These taxable subsidiaries allow the Company to hold portfolio companies organized as pass-through entities and still satisfy certain RIC income requirements. The Company does not consolidate the taxable subsidiaries for income tax purposes but recognizes the results of these subsidiaries for financial reporting purposes.
The Company evaluates tax positions taken or expected to be taken in the course of preparing its financial statements to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions not deemed to meet the “more-likely-than-not” threshold are reversed and recorded as a tax benefit or expense in the current year. All penalties and interest associated with income taxes are included in income tax expense. Conclusions regarding tax positions are subject to review and may be adjusted at a later date based on factors including, but not limited to, on-going analyses of tax laws, regulations and interpretations thereof. The Company did not have any uncertain tax positions that met the recognition or measurement criteria of ASC 740-10-25 nor did it have any unrecognized tax benefits as of the periods presented herein.
Capital Accounts – Certain capital accounts including under (over) distributed net investment income, accumulated net realized gain or loss, net unrealized 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.
15
At December 31, 2011, as a result of permanent book-to-tax differences, the Company decreased under (over) distributed net investment income by $4,582, decreased accumulated net realized loss by $8,555, and decreased paid-in capital in excess of par value by $3,973. Aggregate stockholders’ equity was not affected by this reclassification.
Dividends – Dividends and distributions to common stockholders are recorded on the ex-dividend date. Quarterly dividend payments are determined by the Board and are generally based upon taxable earnings estimated by management. Net realized capital gains, if any, are typically 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 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, 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 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. Foreign currency amounts are translated into U.S. dollars on the following basis:
The Company does not isolate that portion of realized and unrealized gains or losses on investments that result from changes in market prices of investments from those that result from fluctuations in foreign exchange rates. Net realized foreign currency gains or losses arise from sales or repayments of foreign denominated investments (recorded in realized gain/loss on investments), maturities or terminations of foreign currency derivatives (recorded in realized gain/loss on derivatives), repayments of foreign denominated liabilities and other transactional gain or loss resulting from fluctuations in foreign exchange rates on amounts received or paid (recorded in realized gain/loss on foreign exchange). Net unrealized foreign exchange gains and losses arise from valuation changes in foreign denominated assets and liabilities, resulting from changes in exchange rates, including unrealized foreign exchange gains and losses on investments (recorded in unrealized gain/loss on investments), foreign currency derivatives (recorded in unrealized gain/loss on derivatives), and all other assets and liabilities (recorded in unrealized gain/loss on foreign exchange).
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 – The Company recognizes derivatives as either assets or liabilities at fair value on its Consolidated Statements of Assets and Liabilities with valuation changes recorded as realized or unrealized gains and losses. The Company currently does not have any formally documented hedges that qualify for hedge accounting treatment.
The Company generally uses foreign exchange forward contracts and/or borrowings on its multicurrency revolving credit facility to minimize foreign currency exchange risks. Changes in the values of the Company’s
16
foreign denominated assets are recorded in current earnings as realized and unrealized gains and losses; likewise, realized and unrealized gains and losses from derivatives and foreign denominated debt are also recorded in current earnings. 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. Fluctuations in market values of assets and liabilities denominated in the same foreign currency offset in earnings, providing a “natural” foreign currency hedge.
The Company may use interest rate caps to create a synthetic “ceiling” on its borrowing rates. An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds an agreed cap rate. Interest payments on the Company’s credit facilities are primarily LIBOR based. By purchasing caps on LIBOR, if LIBOR exceeds the cap rate, the Company will pay a higher interest rate on its credit facilities but receive an offsetting payment from the cap counterparty on the notional amount above the cap rate. Caps have an initial cost. The fair value of interest rate caps is determined using option pricing models that use readily available market inputs.
Deferred Offering Costs – The Company records expenses related to shelf registration statement filings and other applicable offering costs as prepaid assets. These expenses are charged to capital upon utilization, in accordance with ASC 946-20-25.
Receivable for Investments Sold – Receivable for investments sold represents a receivable for investments that have been sold but the proceeds have not been received.
Payable for Investments Purchased – Payable for investments purchased represents a liability for investments that have been purchased but the proceeds have not been paid and any unfunded loan commitments.
Deferred Credit Facility Costs – Deferred credit facility costs are amortized over the life of the related credit facility unless the fair value option was elected in accordance with ASC 825-10.
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 evaluates the need for disclosures and/or adjustments resulting from subsequent events through the date the financial statements were issued.
Note 3. Investments
Investments consisted of the following as of September 30, 2012 and December 31, 2011:
Bank Debt/Senior Secured Loans
Subordinated Debt/Corporate Notes
Preferred Equity
Common Equity/Partnership Interests/Warrants
Total
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As of September 30, 2012, the Company had two non-accrual assets with a total market value of $20,725. As of December 31, 2011, there was one non-accrual asset with a market value of $5,875.
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. 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 equals 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 adviser. For financial statement presentation purposes, a fee is accrued to include unrealized capital appreciation. No accrual was required for the capital gains based incentive fee for the nine months ended September 30, 2012 or for the year ended December 31, 2011.
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.
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Note 5. Derivatives
The Company is exposed to interest rate risk both as a lender and a borrower. The Company’s borrowing facilities and term loan bear interest at a floating rate, which means that rising interest rates would increase our cost of borrowing. To partially mitigate this risk, in 2011, the Company purchased two interest rate cap contracts, which effectively limit the interest rate payable on $150 million of LIBOR based borrowings. The following table highlights the outstanding interest rate caps:
Index Rate
3 Month Libor
The Company is also exposed to foreign exchange risk through its investments denominated in foreign currencies. The Company attempts to mitigate this risk through the use of foreign currency forward contracts and/or borrowing in local currencies. As an investment company, all changes in the fair value of assets, including changes caused by foreign currency fluctuation, flow through current earnings.
As of September 30, 2012, there were no open forward foreign currency contracts outstanding. As of December 31, 2011, there were two open forward foreign currency contracts entered into with SunTrust, one selling 966 Euro and the other selling 12,989 GBP, for USD values of $1,295 and $20,308 at December 31, 2011, respectively. Unrealized appreciation as of December 31, 2011 totaled $180, or $44 and $136, respectively, for the Euro and GBP foreign currency forward contracts.
The Company had no derivatives designated as hedging instruments at September 30, 2012 and December 31, 2011.
Note 6. Borrowing Facilities and Senior Secured Notes
Senior Secured Credit Facility – In June 2012, Solar Capital Ltd. entered into a $485 million Senior Secured Credit Facility comprised of $450 million of multi-currency revolving credit and a $35 million term loan. In August 2012, the Company added $40 million under the Facility’s accordion feature split $25 million in USD revolving credit commitments and $15 million in a term loan. Borrowings bear interest at a rate per annum equal to LIBOR plus 2.50% or the alternate base rate plus 1.50%. The Facility has no LIBOR floor requirement. Citibank N.A. acted as Administrative Agent, JPMorgan Chase Bank, N.A. acted as Syndication Agent, and SunTrust Bank acted as Documentation Agent for the Facility. The Facility matures in July 2016 and includes a ratable amortization in the fourth year. At September 30, 2012, total outstanding USD equivalent borrowings under the Facility were $135,907.
The Facility may be increased up to $800 million with new or existing lenders. The Facility also contains certain customary affirmative and negative covenants and events of default. In addition, the Facility contains certain financial covenants that among other things, requires the Company to maintain a minimum shareholder’s equity and a minimum asset coverage ratio. The Company will pay the issuers of the term loans quarterly in arrears a commitment fee at the rate of 0.25% per annum on the average daily outstanding balance.
In conjunction with the establishment of the Facility, the predecessor facility and a term loan was retired, resulting in $2,295 of non-recurring charges to expense unamortized costs.
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At September 30, 2012, the Company had outstanding non-USD borrowings on the revolving portion of the Facility. Unrealized appreciation (depreciation) on these outstanding borrowings is indicated in the table below:
Foreign Currency
British Pound
Euro
Canadian Dollar
Senior Secured Notes – On May 10, 2012, the Company closed a private offering of $75,000 of Senior Secured Notes (“Private Notes”) with a fixed interest rate of 5.875% and a maturity date of May 10, 2017. Interest on the Private Notes is due semi-annually on May 10th and November 10th. The Private Notes were issued in a private placement only to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended.
Senior Secured Loan Facility – On December 17, 2010, Solar Capital Ltd. entered into a $100 million senior secured credit facility (the “$100 Million Facility”) with Wells Fargo Securities LLC, as administrative agent. Solar Capital entered into (i) a Purchase and Sale Agreement (the “Purchase and Sale Agreement”) with SC Funding, pursuant to which Solar Capital will sell to SC Funding certain loans that it has originated or acquired, or will originate or acquire (the “Loans”) from time to time; (ii) a Loan and Servicing Agreement (the “Loan and Servicing Agreement” and, together with the Purchase and Sale Agreement, the “Agreements”) with SC Funding as borrower; and (iii) various supporting documentation. The $100 Million Facility is secured by all of the assets held by SC Funding. The $100 Million Facility, among other things, matures on December 17, 2015 and bears interest based on LIBOR plus 2.75%. Under the Agreements, Solar Capital and SC Funding, as applicable, are required to comply with various covenants, reporting requirements and other customary requirements for similar credit facilities. The Purchase and Sale Agreement includes usual and customary events of default for credit facilities of this nature.
The Company has made an irrevocable election to apply the fair value option of accounting to the Facility and the Private Notes in accordance with ASC 825-10. Accounting for the Facility and the Private Notes at fair value will better align the measurement methodologies of assets and liabilities, which may mitigate certain earnings volatility. As a result of this election, $3,881 and $1,128 of costs related to the establishment of the Facility and the Private Notes, respectively, were expensed as incurred, rather than being deferred and amortized over the life of the obligation. ASC 825-10 requires entities to record the fair value of the selected assets and liabilities on the face of the Consolidated Statements of Assets and Liabilities and changes in fair value of the Facility and the Private Notes are reported in the Consolidated Statements of Operations. For the three and nine months ended September 30, 2012, the Facility and the Private Notes had no net change in price as a percentage of par but recognizes unrealized (appreciation) depreciation on non-USD borrowings due to changes in foreign exchange rates as noted in the table above.
The weighted average annualized interest cost for all borrowings for the nine months ended September 30, 2012 and 2011 was 4.74% and 3.53%, respectively. These costs are exclusive of commitment fees and for other prepaid expenses, if any, related to establishing the Facility, the Private Notes, and the $100 Million Credit Facility (collectively the “Credit Facilities.”) This weighted average annualized interest cost reflects the average
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interest cost for all outstanding borrowings. For the nine months ended September 30, 2012 and 2011, average debt outstanding was $184,061 and $117,092, respectively. The maximum amounts borrowed on the Credit Facilities during the nine months ended September 30, 2012 and 2011 was $279,327 and $435,356, respectively. There was $248,362 drawn on the Credit Facilities as of September 30, 2012 and $236,355 as of December 31, 2011. At September 30, 2012 and December 31, 2011, the Company was in compliance with all financial and operational covenants required by the Credit Facilities.
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:
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:
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.
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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 tables present the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011:
Fair Value Measurements
As of September 30, 2012
Assets:
Subordinated Debt / Corporate Notes
Common Equity / Partnership Interests / Warrants
Derivative assets – interest rate caps contracts
Liabilities:
The Facility and Private Notes
As of December 31, 2011
Derivative assets – interest rate cap
Derivative assets – forward contracts
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The tables below provide a summary of the changes in fair value of Level 3 assets and liabilities for the nine months ended September 30, 2012 and the year ended December 31, 2011, 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 September 30, 2012 and December 31, 2011:
Fair Value Measurements Using Level 3 Inputs
Fair value, December 31, 2011
Total gains or losses included in earnings:
Proceeds from dispositions of investment securities
Transfers in/out of Level 3
Fair value, September 30, 2012
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:
During the nine months ended September 30, 2012, there were no transfers in and out of Levels 1 and 2.
Fair value, December 31, 2010
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During 2011, one investment with a fair value of $41,065 was transferred from Level 3 to Level 2 as a result of an increase in the availability and reliability of third party market quotes for this investment. During 2011, one asset with a fair value of $9,900 was transferred from Level 2 to Level 1 when trading restrictions expired on a publicly traded equity investment.
The following table shows a reconciliation of the beginning and ending balances for fair valued liabilities measured using significant unobservable inputs (Level 3) for the nine months ended September 30, 2012:
Beginning fair value
Total unrealized appreciation
Borrowings
Repayments
Ending fair value
The Company has made an irrevocable election to apply the fair value option of accounting to the Facility and the Private Notes, in accordance with ASC 825-10. On September 30, 2012, there were borrowings of $135,907 and $75,000, respectively, on the Facility and the Private Notes. For the three and nine months ended September 30, 2012, the Facility and the Private Notes had no net change in unrealized (appreciation) depreciation. The Company used an independent third-party valuation firm to measure the fair value of the Facility and Private Notes.
The Company typically determines the fair value of its performing debt investments utilizing a yield analysis. In a yield analysis, a price is ascribed for each investment based upon an assessment of current and expected market yields for similar investments and risk profiles. Additional consideration is given to current contractual interest rates, relative maturities and other key terms and risks associated with an investment. Among other factors, a significant determinant of risk is the amount of leverage used by the portfolio company relative to the total enterprise value of the company, and the rights and remedies of our investment within each portfolio company.
Significant unobservable quantitative inputs typically used in the fair value measurement of the Company’s Level 3 assets and liabilities primarily reflect current market yields, including indices, and readily available quotes from brokers, dealers, and pricing services as indicated by comparable assets and liabilities, as well as enterprise values and EBITDA multiples of similar companies, and comparable market transactions for equity securities.
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Quantitative information about the Company’s Level 3 asset and liability fair value measurements as of September 30, 2012 is summarized in the table below:
Quantitative Information about Level 3 Fair Value Measurements
Senior Secured / Bank Debt
Subordinated Debt / Corporate Note
Common Equity
The Facility
Private Notes
Significant increases or decreases in any of the above unobservable inputs in isolation, including unobservable inputs used in deriving bid-ask spreads, if applicable, would result in a significantly lower or higher fair value measurement for such assets and liabilities.
Note 8. Earnings Per Share
The following information sets forth the computation of basic and diluted earnings (loss) per share, pursuant to ASC 260-10, for the three and nine months ended September 30, 2012 and 2011, respectively:
Numerator for basic and diluted increase in net assets per share:
Denominator for basic and diluted weighted average share:
Basic and diluted earnings (loss) per share:
Note 9. Taxation
We did not have any uncertain tax positions that met the recognition or measurement criteria of ASC 740-10-25, Income Taxes, nor did we have any unrecognized tax benefits as of the periods presented herein. Although we file federal and state tax returns, our major tax jurisdiction is federal. Our inception-to-date federal tax years remain subject to examination by the Internal Revenue Service.
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Note 10. Financial Highlights
The following is a schedule of financial highlights for the nine months ended September 30, 2012 and for the year ended December 31, 2011:
Per Share Data:(a)
Net asset value, beginning of year
Net realized and unrealized gain (loss)
Dividends to shareholders
Effect of dilution
Net asset value, end of period
Total return(b)
Net assets, end of period
Per share market value at end of period
Shares outstanding end of period
Ratio to average net assets:(c)
Expenses without incentive fees
Incentive fees
Total expenses
Portfolio turnover ratio
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SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES (unaudited)
Schedule 12-14
Portfolio Company
Investments Owned Greater than 25%
AviatorCap SII, LLC I
AviatorCap SII, LLC II
AviatorCap SII, LLC III
USAW 767
SODO Corp.
SOCAY Corp.
SOINT, LLC
Total Investments Owned Greater than 25%
Investments Owned Greater than 5% and Less than 25%
Ark Real Estate Partners LP
AREP Fifty-Seventh LLC
ARK Real Estate Partners II LP
DS Waters of America, Inc.
Senior Preferred 15% Units of DSW Group Holdings LLC
Participating Preferred Units of DSW Group Holdings LLC
Total Investments Owned Greater than 5% and Less than 25%
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SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES (unaudited) (continued)
The table below represents the balance at the beginning of the year, December 31, 2011 and any gross additions and reductions and net unrealized gain (loss) made to such investments as well as the ending fair value as of September 30, 2012.
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.
National Specialty Alloys, LLC
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The table below represents the balance at the beginning of the year, December 31, 2010 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, 2011.
Gross additions represent increases in the investment from additional investments, amortization and payments in kind of interest or dividends.
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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 September 30, 2012, and the consolidated statements of operations for the three and nine-month periods ended September 30, 2012 and 2011, the consolidated statement of changes in net assets for the nine-month period ended September 30, 2012 and consolidated statements of cash flows for the nine-month periods ended September 30, 2012 and 2011. These consolidated financial statements 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 Ltd. as of December 31, 2011, and the related consolidated statement of changes in net assets for the year ended December 31, 2011 and we expressed an unqualified opinion on them in our report dated February 22, 2012.
/s/ KPMG LLP
New York, New York
November 1, 2012
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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”, 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 we have elected to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). In February 2010, we completed our initial public offering and a concurrent private offering of shares to management.
We invest primarily in U.S. middle market companies, where we believe the supply of primary capital is limited and the investment opportunities are most attractive. 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 September 30, 2012, our investments totaled $1.17 billion and our net asset value was $877.6 million. Our portfolio was comprised of debt and equity investments in 41 portfolio companies and our income producing assets, which represented 93.8% of our total portfolio at fair value, had a weighted average annualized yield on a fair value basis of approximately 13.9%.
Recent Developments
Dividend
On November 1, 2012, our board of directors declared a quarterly dividend of $0.60 per share payable on January 3, 2013 to holders of record as of December 20, 2012. We expect the dividend to be paid from taxable earnings with specific tax characteristics reported to stockholders after the end of the calendar year.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with 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.
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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 day of valuation. 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 reliable, 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 including credit risk;
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; 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.
GAAP fair value measurement guidance classifies the inputs used to measure these fair values into the following hierarchy:
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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.
Derivative assets – interest rate caps
At September 30, 2012, the fair value of investments classified as Level 3 was approximately $1,108 million or 92.3% of total assets. There were no investments transferred in or out of Level 3 during the 3rd quarter of 2012.
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.
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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.
Payment-in-Kind Interest
We have investments in our portfolio which contain a PIK interest provision. Over time, PIK interest increases the principal balance of the investment, but is recorded as interest income. 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 currently collected cash with respect to the PIK interest.
New Accounting Pronouncements and Accounting Standards Updates
In May 2011, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). ASU 2011-04 was issued concurrently with International Financial Reporting Standards No. 13 (“IFRS 13”), Fair Value Measurements, to provide largely identical guidance about fair value measurement and disclosure requirements as is currently required under ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820). The new standards did not extend the use of fair value but, rather, provided guidance about how fair value should be applied where it already is required or permitted under IFRS or GAAP. For GAAP, most of the changes were clarifications of existing guidance or wording changes to align with IFRS 13. ASU 2011-04 eliminated the concepts of in-use and in-exchange when measuring fair value of all financial instruments. For Level 3 fair value measurements, the ASU requires that our disclosure include quantitative information about significant unobservable inputs, a qualitative discussion about the sensitivity of the fair value measurement to changes in the unobservable inputs and the interrelationship between inputs, and a description of our valuation process. Public companies were required to apply ASU 2011-04 prospectively for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 did not have a significant impact on the Company’s financial statements or its disclosures.
Portfolio Investments
The total value of our investments was approximately $1.17 billion and $1.05 billion at September 30, 2012 and December 31, 2011, respectively. During the three months ended September 30, 2012, we invested approximately $27.2 million in two new portfolio companies and $0.2 million in one existing portfolio company. During the nine months ended September 30, 2012, we originated approximately $191.8 million of investments in seven new portfolio companies and approximately $89.9 million was invested in six existing portfolio companies.
In certain instances, we receive payments on our debt investments based on scheduled amortization of the outstanding balances. In addition, we may receive repayments of certain debt investments prior to their scheduled maturity date. The frequency or volume of these repayments may fluctuate significantly from period to period. Our portfolio activity may also reflect sales of securities. For the three months ended September 30, 2012, we had approximately $64.5 million in debt investments repaid as well as $7.0 million of investments sold. For the nine months ended September 30, 2012, we had approximately $176.7 million in debt investments repaid and sales of securities of approximately $36.4 million.
At September 30, 2012, we had investments in 41 portfolio companies that include debt and preferred securities in 37 portfolio companies, totaling approximately $1.12 billion, and equity investments in seven portfolio companies totaling approximately $51.7 million. At December 31, 2011, we had investments in 42 portfolio companies that include debt and preferred securities of 36 portfolio companies, totaling approximately $973.9 million, and equity investments in seven portfolio companies totaling approximately $71.1 million.
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The following table shows the fair value of our portfolio of investments by asset class as of September 30, 2012 and December 31, 2011 (in thousands):
As of September 30, 2012 and December 31, 2011, the weighted average yield on income producing investments in our portfolio based on fair market value was approximately 13.9% and 14.2%, respectively. The weighted average yield on income producing investments in our portfolio based on cost was approximately 13.9% and 13.2%, respectively.
Results of Operations for the Three and Nine Months Ended September 30, 2012 compared to the Three and Nine Months Ended September 30, 2011
Investment Income
For the three and nine months ended September 30, 2012, gross investment income totaled $40.6 million and $111.8 million, respectively. For the three and nine months ended September 30, 2011, gross investment income totaled $35.3 million and $102.9 million, respectively. The increase in gross investment income for the three and nine months ended September 30, 2012 as compared to the three and nine months ended September 30, 2011 was primarily due to a larger average earning asset base partially offset by a slightly lower weighted average yield on the comparative portfolios.
Expenses
Total expenses, including income taxes, totaled $18.4 million and $54.0 million, respectively, for the three and nine months ended September 30, 2012, of which $11.6 million and $31.5 million, respectively, were base management fees and performance-based incentive fees and $3.5 million and $15.2 million, respectively, were interest and other debt expenses. Administrative services and other general and administrative expenses totaled $3.2 million and $7.0 million, respectively, for the three and nine months ended September 30, 2012. Total expenses, including income taxes, totaled $14.6 million and $41.7 million, respectively, for the three and nine months ended September 30, 2011, of which $10.5 million and $30.6 million, respectively, were base management fees and performance -based incentive fees and $2.2 million and $6.2 million, respectively, were interest and other debt expenses. Administrative services and other general and administrative expenses totaled $1.6 million and $4.1 million, respectively, for the three and nine months ended September 30, 2011. Expenses consist of base investment advisory and management fees, insurance expenses, administrative services fees, legal fees, directors’ fees, audit and tax services expenses, and other general and administrative expenses. The increase in expenses from the September 2012 periods to the September 2011 periods was primarily due to an increase in interest and related expenses associated with the establishment of a new credit facility and the issuance of private notes, together with a larger average outstanding debt balance relative to comparative periods. In addition, higher administrative services and other general and administrative expenses were primarily related to higher legal, insurance and tax services expense.
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Net Investment Income
The Company’s net investment income totaled $22.3 million and $57.7 million, or $0.60 and $1.57, on a per average share basis, respectively, for the three and nine months ended September 30, 2012. The Company’s net investment income totaled $20.7 million and $61.2 million, or $0.57 and $1.68 on a per average share basis, respectively, for the three and nine months ended September 30, 2011.
Net Realized Gains (Losses)
Net realized gains (losses) for the three and nine months ended September 30, 2012 were $0.4 million and ($9.6) million, respectively. For the three and nine months ended September 30, 2011, net realized gains (losses) totaled $2.1 million and ($2.3) million, respectively. Net realized gains were not significant for the three months ended September 30, 2012 but net realized losses for the nine month period ended September 30, 2012 were primarily derived from the recapitalization of our investment in DSW Group. Realized losses incurred upon the exit of this investment reversed out previously reported unrealized losses. Net realized gains and net realized losses for the three and nine months ended September 30, 2011, respectively, were primarily derived from selected exits of outperforming and underperforming investments.
Net Unrealized Appreciation (Depreciation) on Investments, Foreign Currencies and Derivatives
For the three and nine months ended September 30, 2012, the net change in unrealized appreciation (depreciation) on the Company’s investments, cash equivalents, foreign currencies and other assets and liabilities totaled $7.6 million and $44.4 million, respectively. For the three and nine months ended September 30, 2011, the net change in unrealized appreciation (depreciation) on the Company’s investments, cash equivalents, foreign currencies and other assets and liabilities totaled ($74.8) million and ($49.4) million, respectively. For the three and nine months ended September 30, 2012, unrealized appreciation was derived from a general tightening of credit spreads and modestly improved overall health of the investment portfolio. For the three and nine months ended September 30, 2011, unrealized depreciation was derived from a temporary spike in credit spreads and generally weaker market conditions during the period.
For the three and nine months ended September 30, 2012, the Company had a net increase in net assets resulting from operations of $30.2 million and $92.5 million, respectively. For the three months ended September 30, 2011, the Company had a net decrease in net assets resulting from operations of $51.9 million. For the nine months ended September 30, 2011, the Company had a net increase in net assets resulting from operations of $9.5 million. For the three and nine months ended September 30, 2012 earnings per average share were $0.82 and $2.52, respectively. Losses per average share were $1.42 for the three months ended September 30, 2011. For the nine months ended September 30, 2011, earnings per average share totaled $0.26.
Liquidity and Capital Resources
The Company’s liquidity and capital resources are generated and generally available through its $525 million credit facility maturing in July 2016 (the “Facility”) and a $100 million credit facility maturing in December 2015, through cash flows from operations, investment sales, repayments of senior and subordinated loans, income earned on investments and cash equivalents, and we expect periodic follow-on equity and/or debt offerings. We may from time to time issue such securities in either public or private offerings. The issuance of debt or equity securities will depend on future market conditions, funding needs and other factors and there can be no assurance that any such issuance will occur or be successful. The primary use of existing funds and any funds raised in the future is expected to be for investments in portfolio companies, repayment of indebtedness, cash distributions to our shareholders, or for other general corporate purposes.
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On August 23, 2012, the Company entered into its most recent follow-on public equity offering of 2.0 million shares of common stock at $22.51 per share raising approximately $45.0 million in proceeds. In the future, the Company may raise additional equity or debt capital, among other considerations.
At September 30, 2012 and December 31, 2011, we had cash and cash equivalents of approximately $13.0 million and $11.8 million, respectively. Cash (used) and provided by operating activities for the nine months ended September 30, 2012 and 2011 was approximately ($15.7) million and $30.9 million, respectively. We expect that all current liquidity needs will be met with cash flows from operations and other activities.
Credit Facilities and Senior Secured Notes – In June 2012, Solar Capital Ltd. entered into a $485 million Senior Secured Credit Facility comprised of $450 million of multi-currency revolving credit and a $35 million term loan. In August 2012, the Company added $40 million under the Facility’s accordion feature split $25 million in revolving credit commitments and $15 million in a term loan. Borrowings bear interest at a rate per annum equal to the base rate plus 2.50% or the alternate base rate plus 1.50% and has no LIBOR floor requirement. The increased $525 Million Facility matures in July 2016 and includes a ratable amortization in the fourth year. With additional new lenders or the increase in commitments of current lenders, the Facility may be increased up to $800 million. The Facility contains certain customary affirmative and negative covenants and events of default. In addition, the Facility contains certain financial covenants that among other things, requires the Company to maintain a minimum shareholder’s equity and a minimum asset coverage ratio. The Company will also pay issuers of term loans quarterly in arrears a commitment fee at the rate of 0.25% per annum on the average daily outstanding balance. In conjunction with the establishment of the Facility, a predecessor facility and term loan were retired.
On May 10, 2012, the Company closed a private offering of $75,000 of Senior Secured Notes (“Private Notes”) with a fixed interest rate of 5.875% and a maturity date of May 10, 2017. Interest on the Private Notes is due semi-annually on May 10th and November 10th. The Private Notes were issued in a private placement only to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended.
On December 17, 2010, we established the $100 Million Facility with Wells Fargo Securities, LLC acting as administrative agent. In connection with the $100 Million Facility, our wholly-owned financing subsidiary, Solar Capital Funding II, LLC (“SC Funding”), as borrower, entered into a Loan and Servicing Agreement whereby we transferred certain loans we have originated or acquired or will originate or acquire from time to time to SC Funding via a Purchase and Sale Agreement. The $100 Million Facility, as amended, among other things, matures on December 17, 2015 and generally bears interest based on LIBOR plus 2.75%. The $100 Million Facility is secured by all of the assets held by SC Funding. Under the $100 Million Facility, Solar and SC Funding, as applicable, have made certain customary representations and warranties, and are required to comply with various covenants, reporting requirements and other customary requirements for similar credit facilities. The $100 Million Facility includes usual and customary events of default for credit facilities of this nature.
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 is as follows as of September 30, 2012:
(in millions)
Senior secured revolving credit facilities(1)
Senior Secured Notes
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We have certain commitments pursuant to our Investment Advisory and Management Agreement entered into with Solar Capital Partners, LLC. 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 to serve as our administrator. Payments under the Administration Agreement are equal to an amount based upon our allocable portion of Solar Capital Management, LLC’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 its 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 Statement of Assets and Liabilities.
Distributions and Dividends
The following table reflects the cash distributions, including dividends and returns of capital, if any, per share that we have declared on our common stock since our initial public offering:
Date Declared
Fiscal 2012
July 31, 2012
May 1, 2012
February 22, 2012
Total 2012
Fiscal 2011
November 1, 2011
August 2, 2011
May 2, 2011
March 1, 2011
Total 2011
Fiscal 2010
November 2, 2010
August 3, 2010
May 4, 2010
January 26, 2010
Total 2010
Tax characteristics of all dividends will be reported to shareholders on Form 1099 after the end of each calendar year. Future quarterly dividends, if any, will be determined by our board of directors.
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We have elected 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, LLC. 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, LLC. 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, LLC.
Solar Capital Management, LLC 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, LLC 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, LLC, our Investment Adviser, is the sole member of and controls Solar Capital Management, LLC.
We have entered into a license agreement with Solar Capital Partners, LLC, pursuant to which Solar Capital Partners, LLC has granted us a non-exclusive, royalty-free license to use the name “Solar Capital.”
Solar Capital Partners, LLC 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. For example, Solar Capital Partners, LLC presently serves as investment adviser to Solar Senior Capital Ltd., a publicly traded BDC, which to focuses on investing primarily in senior secured loans, including first lien, unitranche and second lien debt instruments. In addition, Michael S. Gross, our chairman and chief executive officer, Bruce Spohler, our chief operating officer, and Richard Peteka, our chief financial officer, serve in similar capacities for Solar Senior Capital Ltd.
Solar Capital Partners, LLC 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, LLC 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, LLC’s 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 nine months ended September 30, 2012, certain of the loans in our portfolio had floating interest rates and our credit facilities also incur floating rate interest. Interest rates on these loans are typically based on floating LIBOR and reset to current market rates every one to six months. A moderate 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, swaps, caps 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 2011, we purchased two 1.00% LIBOR caps on a total of $150 million of notional for 3 years. If during the three year contract period LIBOR exceeds 1.00%, we will receive payments from the counterparty equal to the difference between LIBOR and 1.00% on $150 million. The cost of the caps was approximately $2.9 million.
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 September 30, 2012. Interest expense is calculated separately for each of our borrowings. For our credit facilities, we use the balance and interest rate as of September 30, 2012 and adjust the interest rate based on the hypothetical changes below. The base interest rate case assumes the rates on our portfolio investments remain as they were on September 30, 2012. All of the hypothetical calculations are based on a model of our portfolio for the twelve months subsequent to September 30, 2012 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
(a) Evaluation of Disclosure Controls and Procedures
As of September 30, 2012 (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 Securities Act of 1934, as amended. 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 Securities and Exchange Commission (“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 third quarter of 2012 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, 2011, 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 to the risk factors during the nine months ended September 30, 2012 discussed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2011.
We did not engage in unregistered sales of equity securities during the quarter ended September 30, 2012.
None
Not applicable.
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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:
Exhibit
Number
Description
42
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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 November 1, 2012.
By:
/s/ MICHAEL S. GROSS
/s/ RICHARD L. PETEKA
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