-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, UVI1gL/qDngFM5xTIiHA8Ho9mwtG7XKIFS5msflTG0kQuL+w0UHPuGPHqmLIAz+4 /T10bMiR4Hguv27PEErEdw== 0000935069-06-002994.txt : 20061106 0000935069-06-002994.hdr.sgml : 20061106 20061106154124 ACCESSION NUMBER: 0000935069-06-002994 CONFORMED SUBMISSION TYPE: N-CSR PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20060831 FILED AS OF DATE: 20061106 DATE AS OF CHANGE: 20061106 EFFECTIVENESS DATE: 20061106 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HIGHLAND FLOATING RATE FUND CENTRAL INDEX KEY: 0001068200 IRS NUMBER: 364251182 STATE OF INCORPORATION: MA FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: N-CSR SEC ACT: 1940 Act SEC FILE NUMBER: 811-08953 FILM NUMBER: 061190232 BUSINESS ADDRESS: STREET 1: TWO GALLERIA TOWER STREET 2: 13455 NOEL ROAD,SUITE 1300 CITY: DALLAS STATE: TX ZIP: 75240 BUSINESS PHONE: 9726284100 MAIL ADDRESS: STREET 1: TWO GALLERIA TOWER STREET 2: 13455 NOEL ROAD,SUITE 1300 CITY: DALLAS STATE: TX ZIP: 75240 FORMER COMPANY: FORMER CONFORMED NAME: COLUMBIA FLOATING RATE FUND DATE OF NAME CHANGE: 20031107 FORMER COMPANY: FORMER CONFORMED NAME: LIBERTY FLOATING RATE FUND DATE OF NAME CHANGE: 20001212 FORMER COMPANY: FORMER CONFORMED NAME: LIBERTY STEIN ROE ADVISOR FLOATING RATE FUND DATE OF NAME CHANGE: 19991025 N-CSR 1 floatingratencsr.txt FLOATING RATE NCSR UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM N-CSR CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT INVESTMENT COMPANIES Investment Company Act file number 811-08953 ---------------------------- HIGHLAND FLOATING RATE FUND - -------------------------------------------------------------------------------- (Exact name of registrant as specified in charter) 13455 Noel Road, Suite 800 DALLAS, TEXAS 75240 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) James D. Dondero Highland Capital Management, L.P. 13455 Noel Road, Suite 800 DALLAS, TEXAS 75240 - -------------------------------------------------------------------------------- (Name and address of agent for service) registrant's telephone number, including area code: (877) 665-1287 --------------- Date of fiscal year end: AUGUST 31 ---------- Date of reporting period: AUGUST 31, 2006 ---------------- Form N-CSR is to be used by management investment companies to file reports with the Commission not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under Rule 30e-1 under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may use the information provided on Form N-CSR in its regulatory, disclosure review, inspection, and policymaking roles. A registrant is required to disclose the information specified by Form N-CSR, and the Commission will make this information public. A registrant is not required to respond to the collection of information contained in Form N-CSR unless the Form displays a currently valid Office of Management and Budget ("OMB") control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. ss. 3507. ITEM 1. REPORTS TO STOCKHOLDERS. The Report to Shareholders is attached herewith. FLOATING RATE FRONT [GRAPHIC OMITTED] HIGHLAND SHIELD HIGHLAND FLOATING RATE FUND - -------------------------------------------------------------------------------- TABLE OF CONTENTS
Portfolio Manager's Letter ......................................................................... 1 Fund Profile ....................................................................................... 3 Financial Statements ............................................................................... 4 Investment Portfolio ............................................................................ 5 Portfolio Statement of Assets and Liabilities ................................................... 16 Portfolio Statement of Operations ............................................................... 17 Portfolio Statements of Changes in Net Assets ................................................... 18 Portfolio Statement of Cash Flows ............................................................... 19 Portfolio Financial Highlights .................................................................. 20 Fund Statement of Assets and Liabilities ........................................................ 21 Fund Statement of Operations .................................................................... 22 Fund Statements of Changes in Net Assets ........................................................ 23 Fund Financial Highlights ....................................................................... 25 Notes to Financial Statements ................................................................... 29 Report of Independent Registered Public Accounting Firm ............................................ 35 Additional Information ............................................................................. 36 Important Information About This Report ............................................................ 40
Economic and market conditions change frequently. There is no assurance that the trends described in this report will continue or commence. A PROSPECTUS MUST PRECEDE OR ACCOMPANY THIS REPORT. PLEASE READ THE PROSPECTUS CAREFULLY BEFORE YOU INVEST. PORTFOLIO MANAGERS' LETTER - -------------------------------------------------------------------------------- OCTOBER 27, 2006 HIGHLAND FLOATING RATE FUND Dear Shareholders: Highland Floating Rate Fund (the "Fund"), is a non-diversified, closed-end management investment company that seeks to provide a high level of current income consistent with preservation of capital. This annual report for the Fund covers the twelve-month period ended August 31, 2006. In the report, portfolio managers Mark Okada and Joseph Dougherty of Highland Capital Management, L.P. ("Highland") discuss performance, investment process strategy, and outlook. Q: HOW HAS THE FUND PERFORMED? A: For the 12-month period ending August 31, 2006, the Fund (Z share) returned 8.57%. That was greater than the return of the Fund's benchmark, the Credit Suisse ("CS") Leveraged Loan Index, which was 6.36% for the period, and the Lipper Loan Participation Loan Category average, which was 6.46% for the period. During this same time period, the Standard & Poor's 500 Index returned 8.88% and the Lehman Aggregate Bond Index returned 1.71%. So the Fund has done very well relative to both its own benchmark and other traditional asset classes. Within the portfolio there were a number of positions that performed well during the period. The Fund's strongest performers include Mirant Corp. common stock, which was received through the company's bankruptcy in exchange for the loans the Fund had held; Blockbuster Entertainment Corp. Tranche B Term Loan, which is a core position in the Fund; Calpine Corp. Second Lien Term Loan, DS Waters Enterprises, LP Term Loan; and Resorts International Holdings, LLC Second Lien Term Loan. The weakest performers during the period include Nellson Nutraceutical, Inc. Second Lien Term Loan, CamelBak Products, LLC Second Lien Term Loan, American Homepatient, Inc. Secured Promissory Note, Covanta Energy Corp. First Lien Revolver, and Cornerstone Healthcare Group Senior Subordinated Unsecured Notes. Q: WHAT WAS THE INVESTMENT ENVIRONMENT LIKE FOR LEVERAGED LOANS DURING THE PERIOD? A: The investment environment during the twelve months ending August 31, 2006, has generally been beneficial for the leveraged loan markets. As measured by the CS Leveraged Loan Index, the leveraged loan market was up 6.36% over the past twelve months. The credit environment continued to be favorable for the loan markets as the default environment was relatively benign. Default rates have decreased slightly from 1.51% in August, 2005 (by number of loans on a trailing 12-month basis) to 1.36% at the end of August 2006, according to Standard and Poor's Leveraged Commentary & Data ("LCD"). Solid earnings growth and strong liquidity have kept default rates low during the period. Spreads narrowed from 265 basis points at the end of August 2005 to 253 basis points at the end of August 2006, as tracked by the CS Leveraged Loan Index. However, the tightening in spreads was more than offset by an increase in interest rates. Three-month LIBOR increased approximately 150 basis points during the same time period. As a result, the weighted average coupon for leveraged loans increased from 6.34% to 7.98% during the same period, as tracked by the CS Leveraged Loan Index. New issue bank loan volume growth has been dramatic in 2006, totaling $397 billion during the first eight months, which is up from $241 billion during the comparable time period in 2005, according to Prospect News Bank Loan Daily. [GRAPHIC OMITTED] EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC AS FOLLOWS: 8/31/05 3.87 9/30/05 4.07 10/31/05 4.26 11/30/05 4.42 12/31/05 4.54 1/31/06 4.68 2/28/06 4.82 3/31/06 5 4/30/06 5.13 5/31/06 5.24 6/30/06 5.48 7/31/06 5.47 8/31/06 5.4 Source: British Bankers' Association Annual Report | 1 PORTFOLIO MANAGERS' LETTER - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND Q: HOW IS THE FUND CURRENTLY POSITIONED? A: The Fund is approximately 98.5% loans, 0.0% bonds, and 1.5% equities, as a percentage of investments. With regards to diversification, the Fund is currently invested in approximately 43 industries and 334 borrowers. Some of the Fund's core positions include Cricket Communications, Inc., a wireless communications service; Movie Gallery, Inc., a home entertainment specialty retailer; Blockbuster Entertainment Corp., a company providing rentable home entertainment; Resorts International Holdings, Ltd., a gaming company; and Millennium Digital Media Systems, LLC, a broadband services company. The U.S. cable television, real estate development, and utility industries are among the largest exposures in the portfolio. Q: WHAT IS YOUR OUTLOOK? A: We expect the leveraged loan market to perform well during the remainder of 2006. We believe defaults should continue to move up slightly during the remainder of the year, although they should continue to remain below the historical average of 3.09% for the 10-year period ended 2005, as tracked by the CS Leveraged Loan Index. New issue bank loan volume is expected to remain strong for the foreseeable future, driven by jumbo deals. Demand from new collateralized loan obligations will continue to provide ample liquidity in the loan market. The Fed raised rates to 5.25% in June and left rates at that level during the August and September meetings, and we anticipate a stable rate environment in the coming year. Overall, our view is that the economy is healthy, but slowing, and do not expect any material decreases in the credit quality of the portfolio. We thank you for your investment in the Fund. /S/MARK OKADA /S/JOE DOUGHERTY MARK OKADA JOE DOUGHERTY Portfolio Manager Portfolio Manager Mark Okada and Joe Dougherty have been portfolio managers of the Highland Floating Rate Fund since April 15, 2004. Just like any other investment, floating rate loan investments present financial risks. Defaults on the loans in the portfolio could reduce the Fund's net asset value and its distributions, as could nonpayment of scheduled interest and principal. Prepayment of principal by a borrower could mean the Fund's managers have to replace the loan with a lower-yielding security, which could affect the valuation of the portfolio's holdings. The Fund is a continuously offered, closed-end management investment company and provides limited liquidity through a quarterly tender offer for between 5% and 25% of outstanding shares. Each quarter, the Fund's trustees must approve the actual tender. Please read the prospectus carefully for more details. The Fund may invest a high percentage of assets in a limited number of loans, so the default of any individual holdings can have a greater impact on the Fund's net asset value than could a default in a more diversified portfolio. Floating rate loans are not covered by FDIC insurance or other guarantees relating to timely payment of principal and interest. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. The opinions expressed are those of the contributor and are subject to change. Prior investment returns are not indicative of future results. 2 | Annual Report FUND PROFILE - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND - --------------------------------------------- Objective - --------------------------------------------- The Highland Floating Rate Fund (the "Fund") invests all of its investable assets in Highland Floating Rate Limited Liability Company (the "Portfolio"). The Fund and the Portfolio seek a high level of current income consistent with preservation of capital. - --------------------------------------------- Total Net Assets as of August 31, 2006 - --------------------------------------------- $1,736.9 million - --------------------------------------------- Portfolio Data as of August 31, 2006 - --------------------------------------------- The information below provides a snapshot of the Portfolio at the end of the reporting period. The Portfolio is actively managed and the composition of its portfolio will change over time. - -------------------------------------------------- QUALITY BREAKDOWN AS OF 08/31/06 (%) - -------------------------------------------------- Baa 0.0 - -------------------------------------------------- Ba 15.2 - -------------------------------------------------- B 54.0 - -------------------------------------------------- Caa 10.4 - -------------------------------------------------- NR 20.4 - -------------------------------------------------- - -------------------------------------------------- TOP 5 SECTORS AS OF 08/31/06 (%) - -------------------------------------------------- Retail 8.2 - -------------------------------------------------- Cable: US Cable 8.0 - -------------------------------------------------- Utility 6.1 - -------------------------------------------------- Telecommunications 4.6 - -------------------------------------------------- Housing -- Real Estate Development 4.2 - -------------------------------------------------- - -------------------------------------------------------------------------------- TOP 10 HOLDINGS AS OF 08/31/06 (%) - -------------------------------------------------------------------------------- Cricket Communications, Inc. 2.9 - -------------------------------------------------------------------------------- Movie Gallery, Inc. 2.3 - -------------------------------------------------------------------------------- Westgate Investments, LLC 2.2 - -------------------------------------------------------------------------------- Blockbuster Entertainment Corp. 2.1 - -------------------------------------------------------------------------------- Resorts International Holdings Ltd. 1.9 - -------------------------------------------------------------------------------- Millennium Digital Media Systems, LLC 1.9 - -------------------------------------------------------------------------------- Charter Communications Operating LLC 1.9 - -------------------------------------------------------------------------------- Georgia-Pacific Corp. 1.7 - -------------------------------------------------------------------------------- United Air Lines, Inc. 1.7 - -------------------------------------------------------------------------------- CSC Holdings, Inc. 1.5 - -------------------------------------------------------------------------------- Quality is calculated as a percentage of total notes and bonds. Sectors and holdings are calculated as a percentage of net assets. Annual Report | 3 FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND A GUIDE TO UNDERSTANDING THE FUND'S FINANCIAL STATEMENTS
INVESTMENT PORTFOLIO The Investment Portfolio details all of the Portfolio's holdings and their market value as of the last day of the reporting period. Portfolio holdings are organized by type of asset and industry to demonstrate areas of concentration and diversification. STATEMENT OF ASSETS AND LIABILITIES These statements detail the Fund's and the Portfolio's assets, liabilities, net assets and, with respect to the Fund, share price for each share class as of the last day of the reporting period. Net assets are calculated by subtracting all liabilities (including any unpaid expenses) from the total of investment and non-investment assets. The share price for each class is calculated by dividing net assets for that class by the number of shares outstanding in that class as of the last day of the reporting period. STATEMENT OF OPERATIONS These statements detail income earned by the Fund and the Portfolio and the expenses accrued by the Fund during the reporting period. The Statement of Operations also shows any net gain or loss realized on the sales of holdings during the period, as well as any unrealized gains or losses recognized over the period. The total of these results represents net increase or decrease in net assets from operations. STATEMENTS OF CHANGES IN NET ASSETS These statements demonstrate how the Fund's and the Portfolio's net assets were affected by their operating results, distributions to shareholders and shareholder transactions (e.g., subscriptions, redemptions and dividend reinvestments) during the reporting period. The Statement of Changes in Net Assets, with respect to the Fund, also details changes in the number of shares outstanding. STATEMENT OF CASH FLOWS The Statement of Cash Flows reports net cash and foreign currency provided or used by operating, investing and financing activities and the net effect of those flows on cash, foreign currency and cash equivalents during the period. FINANCIAL HIGHLIGHTS The Financial Highlights demonstrate how the Fund's net asset value per share was affected by the Fund's operating results. The Financial Highlights table also discloses the classes' performance and certain key ratios of the Fund and the Portfolio (e.g., class expenses and net investment income as a percentage of average net assets). NOTES TO FINANCIAL STATEMENTS These notes disclose the organizational background of the Fund and the Portfolio, their significant accounting policies (including those surrounding security valuation, income recognition and distributions to shareholders), federal tax information, fees and compensation paid to affiliates and significant risks and contingencies.
4 | Annual Report INVESTMENT PORTFOLIO - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (A) - 87.5% AEROSPACE - AEROSPACE/DEFENSE - 2.0% AWAS Capital, Inc. 14,360,119 First Priority Term Loan, 7.25%, 03/15/13 ................................. 14,072,917 7,840,430 Second Priority Term Loan, 11.50%, 03/15/13 ................................ 7,879,632 7,939,983 DeCrane Aircraft Holdings, Inc. First Lien Term Loan, 9.76%, 03/31/08 ................................. 7,964,756 1,990,000 IAP Worldwide Services, Inc. First Lien Term Loan, 8.50%, 12/30/12 ................................. 2,003,691 2,957,647 Vought Aircraft Industries, Inc. Term Loan, 8.00%, 12/22/11 ...................... 2,981,663 ------------- 34,902,659 ------------- AEROSPACE - AIRLINES - 3.0% Continental Airlines, Inc. 1,714,286 Tranche A-1 Term Loan, 8.61%, 06/01/11 ................................. 1,735,714 4,285,714 Tranche A-2 Term Loan, 8.61%, 06/01/11 ................................. 4,339,285 4,000,000 Northwest Airlines Inc. Term Loan DIP, 08/21/08 (b) ..................... 4,007,520 United Air Lines, Inc. 3,482,500 Delayed Draw Tranche B Term Loan, 9.08%, 02/01/12 ................................. 3,539,091 24,377,500 Tranche B Term Loan, 9.25%, 02/01/12 ................................. 24,761,446 12,500,000 U S Airways, Inc. Term Loan, 9.00%, 03/31/11 ...................... 12,586,000 ------------- 50,969,056 ------------- BROADCASTING - 3.9% 4,403,571 CMP Susquehanna Corp. Term Loan, 7.31%, 05/05/13 ...................... 4,418,719 Millennium Digital Media Systems, LLC 27,288,787 Facility B Term Loan, 9.49%, 06/30/11 ................................. 27,288,787 141,685 Revolver, 06/30/11 (b) (c) ...................... 141,685 1,037,839 Term Facility, 06/30/11 (b) ..................... 1,037,839 NEP Supershooters LP 1,388,202 First Lien Term A Loan, 9.49%, 02/03/11 ................................. 1,403,820 1,043,977 Second Lien Term Loan, 13.50%, 08/03/11 ................................ 1,059,637 NextMedia Operating, Inc 1,221,538 Delay Draw Term Loan, 7.41%, 11/15/12 ................................. 1,216,958 2,748,462 Initial First Lien Term Loan, 7.33%, 11/15/12 ................................. 2,739,309 11,000,000 Paxson Communications Corp. First Lien Term Loan, 8.76%, 01/15/12 ................................. 11,178,750 17,395,716 Young Broadcasting, Inc. Term Loan, 8.00%, 11/03/12 ...................... 17,312,217 ------------- 67,797,721 ------------- CABLE - INTERNATIONAL CABLE - 1.7% 1,861,010 Bragg Communications, Inc. (Canada) Term Loan B, 7.33%, 08/31/11 .................... 1,865,662 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- CABLE - INTERNATIONAL CABLE (CONTINUED) Kabel Baden-Wurttemburg GmbH & Co. (Germany) 750,000 Term B Facility, 06/30/14 (b) ................... 751,875 750,000 Term C Facility, 06/30/15 (b) ................... 755,625 8,000,000 NTL Inc. (United Kingdom) B4 Facility, 01/10/13 (b) ....................... 8,040,000 2,887,500 Puerto Rico Cable Acquisition Co., Inc. (Puerto Rico) First Lien Term Loan, 8.50%, 07/28/11 ................................. 2,901,938 San Juan Cable, LLC (Puerto Rico) 2,487,500 First Lien Term Loan, 7.27%, 10/31/12 ................................. 2,492,674 2,500,000 Second Lien Term Loan, 10.77%, 10/31/13 ................................ 2,543,750 UPC Broadband Holding BV (Netherlands) 5,721,250 Facility J2, 7.64%, 03/31/13 (b) ................ 5,725,255 4,721,250 Facility K2, 03/31/13 (b) ....................... 4,722,761 ------------- 29,799,540 ------------- CABLE - US CABLE - 8.1% Century Cable Holdings LLC 7,500,000 Discretionary Term Loan, 10.25%, 12/31/09 ................................ 7,273,200 2,500,000 Revolver, 9.25%, 03/31/09 ....................... 2,404,700 15,000,000 Term Loan, 10.25%, 06/30/09 ..................... 14,643,750 Cequel Communications LLC 5,000,000 Bridge Term Loan, 10.49%, 10/30/07 ................................ 5,018,750 3,000,000 First Lien Term Loan B, 7.74%, 11/05/13 ................................. 2,969,370 2,000,000 Second Lien Tranche A Term Loan, 10.00%, 05/01/14 ................................ 1,940,000 Charter Communications Operating LLC 29,717,804 Term Loan, 8.13%, 04/28/13 ...................... 29,829,542 1,994,924 Tranche B Term Loan, 8.13%, 04/07/11 ................................. 1,998,435 24,937,500 CSC Holdings, Inc. Incremental Term Loan, 7.13%, 03/29/13 ................................. 24,828,274 14,087,500 Hilton Head Communications LP Revolver, 8.25%, 09/30/07 ....................... 13,492,303 5,083,244 Knology, Inc. Second Lien Term Loan, 15.49%, 06/29/11 ................................ 5,947,395 3,270,000 Mediacom Broadband Group Tranche A Term Loan, 6.57%, 03/31/10 ................................. 3,229,485 1,000,000 Mediacom Illinois, LLC Tranche C Term Loan , 7.05%, 01/31/15 ................................. 999,500 Northland Cable Television, Inc. 4,975,000 First Lien Term Loan B, 9.47%, 12/22/12 ................................. 4,987,438 4,000,000 Second Lien Term Loan, 13.49%, 06/22/13 ................................ 4,000,000 Olympus Cable Holdings LLC 11,500,000 Term Loan A, 9.50%, 06/30/10 .................... 11,066,450 1,000,000 Term Loan B, 10.25%, 09/30/10 ................... 970,200 See accompanying Notes to Financial Statements. | 5 INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) CABLE - US CABLE (CONTINUED) WideOpenWest Finance LLC 3,000,000 First Lien Term Loan, 7.71%, 05/01/13 ................................. 3,004,020 1,000,000 Second Lien Term Loan, 10.23%, 05/01/14 ................................ 1,009,620 ------------- 139,612,432 ------------- CHEMICALS - COMMODITY & FERTILIZER - 0.4% 5,264,342 Celenese Dollar Term Loan B, 7.50%, 04/06/11 ................................. 5,296,139 Ferro Corp. 138,889 Term Loan, 8.58%, 06/06/12 (c) .................. 138,542 972,222 Term Loan, 8.65%, 06/06/12 ...................... 969,791 277,778 Term Loan, 8.74%, 06/06/12 ...................... 277,083 75,097 Huntsman International LLC Term B Dollar Loan, 7.08%, 08/16/12 ................................. 75,016 ------------- 6,756,571 ------------- CHEMICALS - SPECIALTY CHEMICALS - 1.8% 1,995,000 AGY Holding Corp. First Lien Term Loan, 8.25%, 04/07/12 ................................. 2,008,725 Brenntag Holding GMBH & Co. (Germany) 589,091 Acquisition Facility, 8.08%, 01/17/14 ................................. 593,509 2,410,909 Facility B2 Term Loan, 8.08%, 01/17/14 ................................. 2,438,032 Ineos U S Finance LLC 2,000,000 Term Loan A4, 7.34%, 12/14/12 ................... 1,998,280 5,750,000 Term Loan B2, 7.34%, 12/14/13 ................... 5,807,500 5,750,000 Term Loan C2, 7.34%, 12/14/14 ................... 5,818,310 1,717,273 Innophos, Inc. Tranche B Term Loan, 7.67%, 08/13/10 ................................. 1,723,712 2,493,750 ISP Chemco, Inc. Term Loan, 7.46%, 02/16/13 ...................... 2,496,194 3,992,660 Kraton Polymers Group of Cos. Term Loan, 7.38%, 12/23/10 ...................... 3,997,691 3,000,000 Panda Hereford Ethanol, L.P. Tranche A Term Loan, 9.14%, 07/28/13 ................................. 2,992,500 1,970,000 Rockwood Specialties Group, Inc. Tranche E Term Loan, 7.49%, 07/30/12 ................................. 1,985,051 ------------- 31,859,504 ------------- CONSUMER DURABLES - 0.4% 3,000,000 Fender Musical Instruments Corp. Second Lien Term Loan, 11.12%, 09/30/12 ................................ 3,045,000 3,000,000 Rexair LLC Additional Term Facility, 9.78%, 06/30/10 ................................. 3,007,500 ------------- 6,052,500 ------------- CONSUMER NON-DURABLES - 3.5% 1,995,000 Amscan Holdings Term Loan B, 8.64%, 12/23/12 .................... 2,006,212 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- CONSUMER NON-DURABLES (CONTINUED) 2,000,000 Camelbak Products, Inc. Second Lien Term Loan, 12.96%, 02/04/12 ................................ 1,610,000 18,981,423 DS Waters Enterprises LP Term Loan, 9.39%, 11/07/09 ...................... 18,874,747 Eastman Kodak Co. 10,497,992 Term B-1 Advance, 7.71%, 10/18/12 ................................. 10,506,391 2,411,765 Term B-2 Advance Delayed Draw, 7.71%, 10/18/12 ................... 2,412,536 Hanesbrands, Inc. 2,000,000 Second Lien Facility, 03/05/14 (b) .............. 2,036,240 3,000,000 Term Loan B, 09/05/13 (b) ....................... 3,027,360 1,710,625 Hillman Group, Inc. Term Loan B, 8.50%, 03/31/11 .................... 1,724,515 952,915 Jarden Corp. Term Loan B1, 7.50%, 01/24/12 ................... 954,707 1,000,000 MD Beauty, Inc. Second Lien Term Loan, 12.33%, 02/18/13 ................................ 1,007,500 860,080 Polaroid Corp. Term Loan, 14.00%, 04/27/11 ..................... 862,231 Prestige Brands Holdings, Inc. 106,536 Term Loan B Add-On, 7.66%, 04/06/11 ................................. 107,069 1,955,000 Tranche B Term Loan, 7.72%, 04/06/11 ................................. 1,964,775 2,875,000 Revlon Consumer Products Corp. Term Loan, 11.47%, 07/09/10 ..................... 2,957,656 871,066 Solo Cup Co. Term B1 Loan, 7.84%, 02/27/11 ................... 873,714 1,977,440 Spectrum Brands U. S. Dollar Term Loan B, 8.40%, 02/07/12 ................................. 1,981,157 UCG Paper Crafts, Inc. 400,000 First Lien Synthetic Facility, 5.23%, 02/17/13 ................................. 401,000 1,596,000 First Lien Term Facility, 8.58%, 02/17/13 ................................. 1,599,990 1,995,000 Second Lien Term Loan, 12.83%, 08/17/13 ................................ 2,002,481 3,750,000 VJCS Acquisition, Inc. Term B Facility, 7.80%, 07/19/13 ................ 3,750,000 ------------- 60,660,281 ------------- DIVERSIFIED MEDIA - 3.7% 2,854,861 Adams Outdoor Advertising LP Term Loan, 7.27%, 10/15/11 ...................... 2,862,597 5,210,821 American Lawyer Media Holdings, Inc. First Lien Term Loan, 8.00%, 03/05/10 ................................. 5,209,154 377,778 Black Press Group Ltd. (Canada) Term B-2 Tranche Loan, 7.71%, 08/01/13 ................................. 380,139 622,222 Black Press U S Partnership Term B-1 Tranche Loan, 7.50%, 08/01/13 ................................. 626,111 2,977,273 Cygnus Business Media Term Loan B, 10.01%, 07/13/09 ................... 2,962,386 1,363,334 Day International, Inc. First Lien U S Term Loan, 8.12%, 12/05/12 ................................. 1,376,967 2,458,333 Deluxe Canada Holdings, Inc. (Canada) First Lien Tranche C Term Loan, 9.25%, 01/28/11 ................................. 2,482,917 6 | See accompanying Notes to Financial Statements. INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) DIVERSIFIED MEDIA (CONTINUED) Endurance Business Media, Inc. 2,000,000 First Lien Term Loan, 8.08%, 07/24/13 ................................. 2,009,380 2,000,000 First Lien Term Loan, 8.08%, 01/24/14 ................................. 2,015,000 5,500,000 HIT Entertainment PLC (United Kingdom) Second Lien Term Loan, 10.95%, 02/26/13 ................................ 5,551,590 2,985,000 Merrill Communications LLC Combined Term Loan, 7.65%, 05/15/11 ................................. 3,003,656 9,481,238 Metro-Goldwyn-Mayer Holdings II, Inc./LOC Acquisition Co. Tranche B Term Loan, 8.75%, 04/08/12 ................................. 9,450,898 North American Membership Group, Inc. 987,500 First Lien Tranche B Term Loan, 8.75%, 05/19/11 ................................. 985,031 3,000,000 Second Lien Term Loan, 13.00%, 11/18/11 ................................ 2,985,000 1,985,003 PBI Media, Inc. First Lien Term Loan, 7.74%, 09/30/12 ................................. 1,983,772 1,552,834 Six Flags Theme Parks, Inc. Tranche B Term Loan, 8.73%, 06/30/09 ................................. 1,576,453 Springer Science+Business Media S.A. (Germany) 562,496 Tranche B-2, 07/05/13 (b) ....................... 570,332 562,496 Tranche C-2, 07/05/14 (b) ....................... 570,349 338,124 USD Tranche B-2 Add On, 07/05/13 (b) .................................... 342,493 338,124 USD Tranche C-2 Add On, 07/05/14 (b) .................................... 343,619 366,301 USD Tranche E-2 Add On, 07/05/14 (b) .................................... 372,254 2,470,690 VISANT Corp. Tranche C Term Loan, 7.07%, 12/21/11 ................................. 2,486,428 8,000,000 VNU Inc./Nielsen Finance LLC Dollar Term Loan, 08/09/13 (b) .................. 7,972,480 2,403,116 Warner Music Group Term Loan, 7.39%, 02/28/11 ...................... 2,414,964 4,000,000 Yell Group Plc (United Kingdom) Facility B1 (USD), 10/27/12 (b) ................. 4,019,160 ------------- 64,553,130 ------------- ENERGY - EXPLORATION & PRODUCTION - 1.0% 4,466,250 Cheniere LNG Holdings LLC Term Loan, 8.25%, 08/31/12 ...................... 4,502,516 Targa Resources, Inc. 2,000,000 Asset Bridge Term Loan, 7.58%, 10/31/07 ................................. 2,002,920 967,742 Synthetic Term Loan, 5.37%, 10/31/12 ................................. 968,952 4,002,016 Term Loan, 7.65%, 10/31/12 ...................... 4,017,664 6,000,000 TARH E&P Holdings, LP Second Lien Term Loan, 11.68%, 11/15/10 ................................ 6,045,000 ------------- 17,537,052 ------------- PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- ENERGY - OTHER ENERGY - 1.6% 1,777,778 Alon USA Energy, Inc. Paramount Facility, 7.91%, 06/22/13 ................................. 1,796,658 4,455,000 Carrizo Oil & Gas, Inc. Second Lien Term Loan, 11.50%, 07/21/10 ................................ 4,555,238 8,000,000 Coffeyville Resources LLC Second Lien Term Loan, 12.13%, 06/24/13 ................................ 8,266,720 2,000,000 Global Petroleum, Inc. (SPI Petroleum) Term Loan, 07/26/13 (b) ......................... 2,005,000 7,000,000 Helix Energy Solutions Group, Inc. Term Loan, 7.51%, 07/01/13 ...................... 7,008,750 3,000,000 Nordic Biofuels of Ravenna, LLC First Lien Term Loan, 9.75%, 04/30/13 ................................. 3,060,000 364,404 SemCrude LP U S Term Loan, 7.62%, 03/16/11 .................. 366,000 ------------- 27,058,366 ------------- ENERGY - REFINING - 0.3% 3,000,000 Energy Transfer Equity LP Term Loan, 7.50%, 02/08/12 ...................... 3,011,250 2,500,000 J Ray McDermott SA (Panama) Synthetic Facility, 7.77%, 06/06/12 ................................. 2,506,250 ------------- 5,517,500 ------------- ENERGY - SERVICE & EQUIPMENT - 0.1% 2,500,000 Vetco International Holdings, Inc. (DE) (United Kingdom) Second Lien Term D Loan, 01/12/14 (b) .................................... 2,553,126 ------------- FINANCIAL - 1.8% 2,000,000 American Wholesale Insurance Group, Inc. Second Lien Term Loan B, 12.75%, 04/27/12 ................................ 2,005,000 2,887,500 Arias Acquisitions, Inc. Term Loan, 9.25%, 07/26/11 ...................... 2,800,875 Checksmart Financial Co. 1,995,000 First Lien Tranche B Term Loan, 8.06%, 05/01/12 ................................. 1,995,000 2,500,000 Second Lien Term Loan, 10.80%, 05/01/13 ................................ 2,531,250 4,442,547 Conseco, Inc.Term Loan, 7.08%, 06/22/10 ................................. 4,446,279 4,666,667 Crump Group, Inc. Tranche B Term Loan, 8.11%, 12/19/12 ................................. 4,672,500 Flatiron Re Ltd. (Bermuda) 3,705,263 Closing Date Term Loan, 9.76%, 12/29/10 ................................. 3,705,263 1,794,737 Delayed Draw Term Loan, 9.75%, 12/29/10 ................................. 1,794,737 956,731 FleetCor Technologies, Inc. Term Loan, 8.91%, 06/30/11 ...................... 956,731 2,992,500 IPayment, Inc. Term Facility, 7.72%, 05/10/13 .................. 2,994,355 992,506 LPL Holdings, Inc. Tranche B Term Loan, 8.67%, 06/28/13 ................................. 1,004,754 See accompanying Notes to Financial Statements. | 7 INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) FINANCIAL (CONTINUED) NASDAQ Stock Market, Inc. (The) 1,869,720 Tranche B Term Loan, 6.97%, 04/18/12 ................................. 1,870,599 1,083,833 Tranche C Term Loan , 7.07%, 04/18/12 ................................. 1,084,516 ------------- 31,861,859 ------------- FOOD AND DRUG - 1.4% 963,768 Bi-Lo LLC Term Loan, 9.43%, 07/01/11 ...................... 976,413 4,000,000 CTI Food Holdings Co. LLC Second Lien Secured Term Loan, 11.50%, 06/02/12 ................................ 4,065,000 1,364,399 Duloxetine Royalty Sub (Cayman Islands) Term Loan, 10.01%, 10/18/13 ..................... 1,374,632 7,877,716 Jean Coutu Group, Inc. Term Loan B, 8.00%, 07/30/11 .................... 7,905,761 4,552,349 Michael Foods, Inc. Term Loan B-1, 7.51%, 11/21/10 .................. 4,587,037 971,429 Nash Finch Co. Initial Term Loan, 7.63%, 11/12/10 ................................. 975,071 4,879,919 Nellson Nutraceutical, Inc. Second Lien Term Loan, 04/04/10 (d) .................................... 1,716,121 1,000,000 Sturm Foods, Inc. First Lien Term Loan, 7.75%, 05/26/11 ................................. 1,003,750 1,496,250 Supervalu Inc. Term Loan B, 7.06%, 06/02/12 .................... 1,496,250 ------------- 24,100,035 ------------- FOOD/TOBACCO - BEVERAGES & BOTTLING - 0.4% 769,635 AFC Enterprises, Inc. Tranche B Term Loan, 7.75%, 05/09/11 ................................. 772,036 3,300,000 National Distributing Co., Inc. Second Lien Term Loan, 11.83%, 06/01/10 ................................ 3,308,250 1,995,000 Nutro Products, Inc. Term Facility, 7.27%, 04/26/13 .................. 1,998,751 1,209,011 Sunny Delight Beverages Co. First Lien Term Loan, 11.47%, 08/20/10 ................................ 1,207,875 ------------- 7,286,912 ------------- FOOD/TOBACCO - FOOD/TOBACCO PRODUCERS - 1.3% Dole Food Co., Inc. 558,351 Credit Linked Deposit, 5.37%, 04/12/13 ................................. 549,451 1,253,149 Tranche B Term Loan, 7.52%, 04/12/13 ................................. 1,235,479 4,177,163 Tranche C Term Loan, 7.54%, 04/04/13 ................................. 4,110,579 Gate Gourmet Borrower LLC 886,678 Dollar Term Loan First Lien, 8.25%, 03/09/12 ................................. 888,894 111,100 First Lien Letter of Credit, 8.25%, 12/31/10 ................................. 112,350 9,539,590 Merisant Co. Tranche B Term Loan, 8.74%, 01/11/10 ................................. 9,491,892 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- FOOD/TOBACCO - FOOD/TOBACCO PRODUCERS (CONTINUED) 3,935,893 Michelina'sTerm Loan, 8.31%, 04/02/11 ............ 3,967,852 2,878,284 Pinnacle Foods Group Inc. New Term Loan, 7.48%, 11/25/10 ................................. 2,881,882 ------------- 23,238,379 ------------- FOOD/TOBACCO - RESTAURANTS - 0.7% 2,684,331 Buffets, Inc. Term Loan, 8.99%, 06/28/09 ...................... 2,704,463 1,529,920 Caribbean Restaurant LLC Tranche B Term Loan, 8.08%, 06/30/09 ................................. 1,547,131 El Pollo Loco, Inc. 2,000,000 Term Loan, 06/01/13 (b) ......................... 2,005,840 1,990,000 Term Loan, 8.40%, 11/18/11 ...................... 1,995,811 1,481,250 Garden Fresh Restaurant Corp. First Lien Term Loan B, 8.76%, 06/22/11 ................................. 1,484,953 975,313 New World Restaurant Group, Inc. First Lien Term Loan, 8.47%, 03/31/11 ................................. 980,189 1,375,000 NPC International, Inc. Term Loan, 7.14%, 05/03/13 ...................... 1,368,978 ------------- 12,087,365 ------------- FOREST PRODUCTS - PACKAGING - 2.3% 1,644,151 Berry Plastics Corp. Term Loan, 7.08%, 12/02/11 ...................... 1,644,497 Georgia-Pacific Corp. 17,400,031 First Lien Term B, 7.35%, 02/14/13 ................................. 17,434,831 11,000,000 Second Lien Term Loan, 8.30%, 02/14/14 ................................. 11,114,840 7,387,500 Graham Packaging Co. Term Loan B, 7.75%, 10/07/11 .................... 7,413,947 2,000,000 JSG Acquisitions (Smurfit Kappa) (Ireland) B1 Term Loan Facility, 8.38%, 12/01/13 ................................. 2,010,640 ------------- 39,618,755 ------------- FOREST PRODUCTS - PAPER - 0.5% 2,934,147 Appleton Papers, Inc. Term Loan, 7.67%, 06/11/10 ...................... 2,946,998 2,621,875 Graphic Packaging International, Inc. Tranche C Term Loan, 7.92%, 08/09/10 ................................. 2,648,329 2,322,346 NewPage Corp. Term Loan, 8.50%, 05/02/11 ...................... 2,338,324 ------------- 7,933,651 ------------- GAMING/LEISURE - GAMING - 3.6% 2,971,125 CCM Merger, Inc./MotorCity Casino Term Loan B, 7.45%, 04/25/12 .................... 2,967,857 2,000,000 Copa Casino of Mississippi, LLC Term Loan, 10.42%, 06/14/12 ..................... 2,005,000 3,910,450 Green Valley Ranch Gaming LLC Term Loan, 7.50%, 12/22/10 ...................... 3,915,338 2,000,000 Lakes Gaming and Resorts, LLC Term Loan, 11.69%, 06/21/10 ..................... 1,990,000 8 | See accompanying Notes to Financial Statements. INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) GAMING/LEISURE - GAMING (CONTINUED) OpBiz LLC 11,416,401 Term Loan A, 8.51%, 08/31/10 .................... 11,069,114 14,181 Term Loan B, 9.51%, 08/31/10 .................... 13,774 Resorts International Holdings Ltd. 17,333,264 Second Lien Term Loan, 16.50%, 04/26/13 ................................ 18,080,848 14,061,509 Term Loan B, 9.50%, 04/26/12 .................... 14,156,001 6,000,000 VML U S Finance LLC Term B Funded Project Loan, 8.20%, 05/25/13 ................................. 6,027,480 2,000,000 Wynn Las Vegas LLC Term Loan B, 7.21%, 08/15/13 .................... 2,007,080 ------------- 62,232,492 ------------- GAMING/LEISURE - OTHER LEISURE - 1.8% 3,162,010 AMF Bowling Worldwide, Inc. Term Loan B, 8.34%, 08/27/09 .................... 3,191,670 2,325,000 BRE/ESA MEZZ 5 LLC Mezzanine D Loan, 8.58%, 07/11/08 ................................. 2,325,000 12,675,000 BRE/Homestead MEZZ 4 LLC Mezzanine D Loan, 8.58%, 07/11/08 ................................. 12,675,000 Fontainebleu Florida Hotel LLC 3,000,000 Tranche A Term Loan, 8.15%, 05/11/08 ................................. 3,000,000 2,000,000 Tranche B Term Loan, 8.15%, 05/11/08 ................................. 2,000,000 992,500 Kuilima Resort Co. First Lien Term Loan, 8.08%, 09/30/10 ................................. 985,056 2,000,000 Riverside Casino & Golf Resort LLC Term Loan, 9.44%, 11/30/11 ...................... 2,005,000 2,231,241 Trump Entertainment Resorts, Inc. Term Loan B-1, 7.17%, 05/20/12 .................. 2,245,186 1,960,000 Wallace Theaters First Lien Term Loan, 8.75%, 07/31/09 ................................. 1,973,485 ------------- 30,400,397 ------------- HEALTHCARE - ACUTE CARE - 0.6% 3,541,409 Alliance Imaging, Inc. Tranche C1 Term Loan, 7.98%, 12/29/11 ................................. 3,555,433 1,995,000 Ameripath, Inc. Tranceh B Term Loan, 7.39%, 10/31/12 ................................. 1,996,237 1,019,361 Cornerstone Healthcare Group Holding, Inc. Senior Subordinated Unsecured Notes, 14.00%, 07/15/12 (i) ............................ 815,489 3,595,520 DaVita, Inc. Tranche B Term Loan, 7.47%, 10/05/12 ................................. 3,610,765 ------------- 9,977,924 ------------- HEALTHCARE - ALTERNATE SITE SERVICES - 1.5% 1,442,482 American HomePatient, Inc. Secured Promissory Note, 6.79%, 08/01/09 (i) ............................. 1,442,482 1,989,377 American Medical Response, Inc. Term Loan, 7.28%, 02/10/12 ...................... 1,993,733 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- HEALTHCARE - ALTERNATE SITE SERVICES (CONTINUED) 1,995,000 CRC Health Corp. New Term Loan, 7.75%, 02/06/13 .................. 1,997,494 FHC Health Systems, Inc. 1,300,000 Delayed Draw Term Loan, 13.23%, 10/31/06 ................................ 1,345,500 1,857,143 Initial Term Loan, 11.23%, 10/31/06 ................................ 1,922,143 6,500,000 Third Lien Term Loan, 14.23%, 02/09/11 ................................ 6,760,000 4,466,250 Renal Advantage, Inc. Tranche B Term Loan, 7.84%, 10/06/12 ................................. 4,491,350 1,980,000 Skilled Healthcare LLC First Lien Term Loan, 7.78%, 06/15/12 ................................. 2,002,275 474,603 Sunrise Medical Holdings, Inc. Term Loan B-1, 8.63%, 05/13/10 .................. 475,196 839,908 VWR International, Inc. Tranche B Dollar Term Loan, 7.77%, 04/07/11 ................................. 842,277 1,960,000 WellCare Health Plans, Inc. Term Loan, 7.63%, 05/13/09 ...................... 1,967,350 ------------- 25,239,800 ------------- HEALTHCARE - MEDICAL PRODUCTS - 3.2% 2,000,000 American Medical Systems, Inc. Term Loan, 7.81%, 07/20/12 ...................... 2,007,500 Carl Zeiss TopCo GmbH/US Newco 375,000 Term B U S Dollar Loan, 7.86%, 05/04/13 ................................. 376,406 375,000 Term C U S Dollar Loan, 7.86%, 05/04/14 ................................. 376,406 CCS Medical, Inc. 4,447,519 First Lien Term Loan, 09/30/12 (b) .............. 4,319,652 2,250,000 Second Lien Term Loan, 13.50%, 03/30/13 ................................ 2,109,375 1,975,000 CompBenefits Corp. Tranche B Term Loan, 8.54%, 04/12/12 ................................. 1,988,588 1,110,920 Encore Medical IHC, Inc. Term Loan, 8.34%, 10/04/10 ...................... 1,115,086 1,000,000 Golden Gate National Senior Care LLC Second Lien Term Loan, 12.96%, 09/14/11 ................................ 1,017,500 3,500,000 Hanger Orthopedic Group, Inc. Tranche B Term Loan, 8.00%, 09/30/09 ................................. 3,517,500 13,500,000 HealthSouth Corp. Term Loan B, 8.52%, 03/10/13 .................... 13,565,880 2,028,269 Matria Healthcare, Inc. First Lien Tranche B Term Loan, 7.71%, 01/19/12 ................................. 2,030,805 MMM Holding, Inc./NAMM (Puerto Rico) Holdings, Inc. 1,486,835 PHMC Acquisition Term Loan, 7.75%, 08/10/11 ................................. 1,490,552 2,513,165 Term Loan, 7.75%, 08/22/11 ...................... 2,519,448 8,500,000 National Renal Institutes, Inc. Term Facility, 7.63%, 03/31/13 .................. 8,518,615 2,411,831 Reliant Pharmaceuticals, Inc. First Lien Term Loan, 15.00%, 06/30/08 .......... 2,435,949 See accompanying Notes to Financial Statements. | 9 INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) HEALTHCARE - MEDICAL PRODUCTS (CONTINUED) Warner Chilcott Co., Inc. (Puerto Rico) 165,887 Dovobet Delayed Draw Term Loan, 7.93%, 01/18/12 ................................. 166,751 829,363 Dovonex Delayed Draw Term Loan, 7.80%, 01/18/12 ................................. 831,437 4,416,667 Tranche B Acquisition Date Term Loan, 7.79%, 01/18/12 ...................... 4,430,447 1,779,701 Warner Chilcott Corp. Tranche C Acquisition Date Term Loan, 7.61%, 01/18/12 ...................... 1,791,376 822,172 Warner Chilcott Holdings Co. III, Ltd. (Bermuda) Tranche D Acquisition Date Term Loan, 7.61%, 01/18/12 ...................... 827,565 ------------- 55,436,838 ------------- HOUSING - BUILDING MATERIALS - 1.2% 1,335,882 Atrium Cos., Inc. Closing Date Term Facility, 8.22%, 06/21/12 ................................. 1,295,806 995,556 Contech Construction Products New Term Loan, 7.44%, 01/31/13 .................. 998,662 1,890,397 Custom Building Products, Inc. First Lien Term Loan, 7.75%, 10/20/11 ................................. 1,902,609 1,775,667 DESA LLC Term Loan, 11.23%, 11/26/11 ..................... 1,779,005 5,000,000 Edge Las Vegas Development LLC Second Lien Term Loan, 8.65%, 06/01/07 ................................. 5,025,000 1,950,151 Nortek Holdings, Inc. Term Loan, 7.36%, 08/27/11 ...................... 1,956,040 807,256 PGT Industries, Inc. First Lien Tranche A-2 Term Loan, 8.41%, 02/14/12 ................................. 810,283 1,488,750 Pivotal Group Promotory First Lien Term Loan, 8.08%, 08/31/10 ................................. 1,472,002 Ply Gem Industries, Inc. 140,273 Canadian Term Loan, 7.65%, 08/15/11 ................................. 139,308 2,104,102 U S Term Loan, 7.65%, 08/15/11 .................. 2,089,625 1,000,000 Standard Pacific Corp. Term Loan B, 6.93%, 05/05/13 .................... 986,250 987,500 Stile Acquisition Corp. (Canada) Canadian Term Loan, 7.49%, 04/06/13 ................................. 970,219 987,500 Stile U S Acquisition Corp. U S Term Loan, 7.49%, 04/06/13 .................. 972,628 ------------- 20,397,437 ------------- HOUSING - REAL ESTATE DEVELOPMENT - 4.4% 6,000,000 Edge Star Partners LLC First Lien Term Loan, 8.65%, 11/18/06 ................................. 6,026,280 2,143,382 Giraffe Intermediate, LLC Mezzanine Note A-1, 7.12%, 08/09/07 ................................. 2,143,382 4,096,212 Lake at Las Vegas Joint Venture First Lien Term Loan, 8.25%, 11/01/09 ................................. 4,099,285 3,980,000 LBREP/L-Suncal Master I LLC First Lien, 8.74%, 01/18/10 ..................... 4,007,382 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- HOUSING - REAL ESTATE DEVELOPMENT (CONTINUED) 11,000,000 LNR Property Corp. Initial Tranche B Term Loan, 8.22%, 07/12/11 ................................. 11,091,740 Morningside Assisted Living 1,996,280 Mezzanine Loan, 12.63%, 10/12/08 ................................ 1,996,280 1,497,210 Senior Mortgage Loan, 8.38%, 10/12/08 ................................. 1,497,210 606,618 MPO Intermediate LLC Mezzanine Note A-1, 7.12%, 08/09/07 ................................. 606,618 2,493,750 November 2005 Land Investors, LLC First Lien Term Loan, 8.25%, 05/09/11 ................................. 2,499,984 3,960,000 Palmdale Hills Property LLC First Lien Term Loan, 8.26%, 05/19/10 ................................. 3,920,400 2,000,000 Shea Capital I, LLC Facility B, 7.49%, 10/27/11 ..................... 1,986,240 Spanish Peaks Holdings LLC 751,997 Tranche A Credit-Linked Deposit, 5.40%, 08/10/11 ................................. 742,597 1,615,009 Tranche B Term Loan, 7.82%, 08/10/11 ................................. 1,596,841 Tamarack Resort LLC 1,400,000 Tranche A Credit-Linked Deposit, 8.75%, 05/19/11 ................................. 1,400,000 2,094,750 Tranche B Term Loan, 8.75%, 05/19/11 ................................. 2,094,750 5,500,000 TE/TOUSA Mezzanine LLC Senior Mezzanine Loan, 10.75%, 08/01/09 ................................ 5,513,750 16,350,000 Westgate Investments, LLC Second Lien Term Loan, 07/15/10 (b) .................................... 16,350,000 4,000,000 Weststate Land Partners LLC First Lien Term Loan, 8.65%, 05/01/07 ................................. 4,010,000 4,000,000 Woodlands Commercial Properties Co. LP Bridge Loan, 8.26%, 02/28/08 .................... 4,005,000 ------------- 75,587,739 ------------- INFORMATION TECHNOLOGY - 2.9% 1,000,000 Aspect Software, Inc. Second Lien Term Loan, 12.56%, 07/05/12 ................................ 997,500 1,975,000 Billing Services Group North America, Inc.U S Term Loan, 8.12%, 05/05/12 ..... 1,977,469 480,286 Bridge Information Systems, Inc. Multidraw Term Loan, 07/07/13 (d) (e) ................................ 36,021 6,000,000 Comsys Information Services Second Lien Term Loan, 13.04%, 10/31/10 ................................ 6,015,000 997,500 Data Transmission Network Corp. First Lien Tranche B Term Loan, 8.43%, 03/10/13 ................................. 1,002,488 997,490 Deltek Systems, Inc. Term Loan, 7.75%, 04/22/11 ...................... 1,004,971 409,858 Fidelity National Information Services, Inc.Term Loan B, 7.08%, 03/09/13 ...... 411,378 10 | See accompanying Notes to Financial Statements. INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) INFORMATION TECHNOLOGY (CONTINUED) 2,000,000 GXS Corp. Second Lien Term Loan, 14.51%, 12/20/11 ................................ 2,010,000 Infor Enterprise Solutions Holdings, Inc. (Luxembourg) 3,428,571 Delayed Draw Term Loan, 9.08%, 07/28/12 ................................. 3,456,411 6,571,429 Initial U S Term Facility, 9.08%, 07/28/12 ................................. 6,604,286 892,562 Infor Global Solutions European Finance S.A.R.L.First Lien LUX Term Loan, 04/18/11 (b) .................................... 903,719 1,912,924 IPC Acquisition Corp. First Lien Tranche B Term Loan, 8.03%, 08/05/11 ................................. 1,922,489 409,091 Magellan Holdings, Inc. First Lien U S Term Loan, 04/18/11 (b) .................................... 411,136 6,905,242 ON Semiconductor Corp. Term Loan H, 7.75%, 12/15/11 .................... 6,944,050 2,212,644 Per-Se Technologies, Inc. Term Loan, 7.67%, 01/06/13 ...................... 2,220,941 12,375,000 SunGard Data Systems, Inc. U S Term Loan, 8.00%, 02/11/13 .................. 12,471,896 2,000,000 Transfirst Holdings, Inc. Second Lien Term Loan, 13.00%, 08/15/13 ................................ 2,020,000 ------------- 50,409,755 ------------- MANUFACTURING - 1.2% 1,412,101 AIRXCEL, Inc. First Lien Term Loan, 8.38%, 08/31/12 ................................. 1,419,162 928,301 Blount International, Inc. U S Term Loan B, 7.21%, 08/09/10 ................................. 933,518 1,496,974 Coinmach Corp. Tranche B-1 Term Loan, 7.91%, 12/16/12 ................................. 1,508,680 1,500,000 Dundee Holdco Ltd. (United Kingdom) U S Term Loan B1, 8.08%, 02/17/14 ................................. 1,503,750 828,947 Euramax International Holdings B.V. Second Lien European Term Loan, 12.49%, 06/29/13 ................................ 822,730 Euramax International, Inc. 2,062,482 First Lien Domestic Term Loan, 8.06%, 06/29/12 ................................. 2,078,466 1,671,053 Second Lien Domestic Term Loan, 12.49%, 06/29/13 ................................ 1,682,549 2,000,000 Georgia Gulf Corp. Term Loan, 09/01/13 (b) ......................... 2,010,500 3,411,288 Mueller Group LLC Term Loan, 7.50%, 10/03/12 ...................... 3,436,463 1,773,784 Polypore, Inc. U S Term Loan, 8.33%, 11/12/11 .................. 1,789,304 3,000,000 Sensata Technology BV/Sensata Technology Finance Co. (Netherlands) U S Term Loan, 7.24%, 04/27/13 .................. 2,984,220 ------------- 20,169,342 ------------- PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- MINERALS - OTHER METALS/MINERALS - 1.1% 2,487,500 Alpha Natural Resources LLC Tranche B Term Loan, 7.25%, 10/26/12 ................................. 2,485,958 5,000,000 Kaiser Aluminum & Chemical Second Lien Term Loan, 9.70%, 04/24/11 ................................. 5,025,000 8,135,320 Murray Energy Corp. Tranche B Term Loan, 8.40%, 01/28/10 ................................. 8,216,674 800,000 Oglebay Norton Co. Tranche B Term Loan, 7.90%, 07/31/12 ................................. 806,000 2,992,500 Universal Buildings Products, Inc. Term Loan, 8.96%, 04/28/12 ...................... 3,022,425 ------------- 19,556,057 ------------- METALS/MINERALS - STEEL - 0.3% 2,974,975 CII Carbon LLC Term Loan B, 7.50%, 08/23/12 .................... 2,978,694 Novelis, Inc. (Canada) 641,436 Canadian Term Loan, 7.72%, 01/07/12 ............. 644,842 1,114,073 U S Term Loan, 7.72%, 01/07/12 .................. 1,121,503 833,333 Standard Steel, LLC Initial Term Loan, 8.09%, 06/30/12 .............. 839,583 ------------- 5,584,622 ------------- RETAIL - 7.2% 34,926,365 Blockbuster Entertainment Corp. Tranche B Term Loan, 8.97%, 08/20/11 ................................. 35,029,048 8,961,250 Burlington Coat Factory Warehouse Corp. Term Loan, 05/28/13 (b) ......................... 8,763,117 2,955,094 Dollarama Group LP (Canada) Term Loan B, 7.49%, 11/18/11 .................... 2,964,314 2,493,225 Eddie Bauer, Inc. Term Loan, 9.58%, 06/21/11 ...................... 2,495,095 3,445,269 Harbor Freight Tools USA Term Loan, 7.18%, 07/15/10 ...................... 3,449,576 25,541,353 Home Interiors & Gifts, Inc. Initial Term Loan, 10.39%, 03/31/11 ................................ 22,093,271 Movie Gallery, Inc. 351,810 Term Loan A, 10.50%, 04/27/11 ................... 335,321 40,409,656 Term Loan B, 04/27/11 (b) ....................... 38,409,378 4,984,177 Neiman Marcus Group, Inc. (The) Term Loan, 7.77%, 04/06/13 ...................... 5,029,234 4,000,000 Toys "R" Us Tranche B Term Loan, 9.64%, 07/19/12 ................................. 4,070,800 1,000,000 TRU 2005 Holding Co. I, Ltd Term Loan, 8.40%, 12/09/08 ...................... 998,340 ------------- 123,637,494 ------------- SERVICE - ENVIRONMENTAL SERVICES - 1.1% 2,187,500 Alliance Laundry Systems LLC Term Loan, 7.62%, 01/27/12 ...................... 2,202,550 Allied Waste North America, Inc. 2,725,219 Term Loan, 7.23%, 01/15/12 ...................... 2,722,767 1,058,147 Tranche A Credit Linked Deposit, 5.37%, 01/15/12 ................................. 1,057,491 3,353,100 Audio Visual Services Corp. Term Loan, 8.00%, 05/18/11 ...................... 3,369,866 See accompanying Notes to Financial Statements. | 11 INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- SENIOR LOAN NOTES (CONTINUED) SERVICE - ENVIRONMENTAL SERVICES (CONTINUED) 603,774 Duratek, Inc. Term Loan B, 7.76%, 06/07/13 .................... 608,676 EnergySolutions, LLC 62,893 Synthetic Letter of Credit, 7.58%, 06/07/13 ................................. 63,404 1,333,333 Term Loan, 7.76%, 09/30/11 ...................... 1,345,280 877,273 La Petite Academy, Inc. Closing Date Term Loan, 8.33%, 08/16/12 ................................. 881,659 Safety-Kleen Systems, Inc. 1,322,034 Synthetic Letter of Credit, 08/02/13 (b) .................................... 1,326,159 4,677,966 Term B Loan, 08/02/13 (b) ....................... 4,692,561 ------------- 18,270,413 ------------- SERVICE - OTHER SERVICES - 1.3% 3,833,333 Brickman Group Holdings, Inc. Term Loan, 10.52%, 11/15/09 ..................... 3,823,750 4,000,000 Education Management LLC Tranche B Term Loan, 8.06%, 06/01/13 ................................. 4,023,760 Koosharem Corp. 3,000,000 First Lien Term Loan, 11.75%, 06/30/12 ................................ 2,992,500 1,000,000 Second Lien Term Loan, 15.75%, 06/30/13 ................................ 987,500 3,000,000 NES Rentals Holdings, Inc. Second Lien Permanent Term Loan, 12.13%, 07/20/13 ................................ 3,030,000 United Rentals, Inc. 7,348,399 Initial Term Loan, 7.33%, 02/14/11 ................................. 7,374,412 336,842 Tranche B Credit-Linked Deposit, 4.86%, 02/14/11 ................................. 336,842 ------------- 22,568,764 ------------- TELECOMMUNICATIONS - 1.9% 4,000,000 Crown Castle Operating Co. Term Loan, 7.65%, 06/01/14 ...................... 4,026,480 1,000,000 Gabriel Communications Finance Co. Term Loan B, 10.34%, 05/12/12 ................... 1,005,620 12,000,000 Intelsat Corp. Tranche B-2 Term Loan, 8.01%, 01/03/14 .......... 12,091,920 1,485,811 IWL Communications, Inc. First Lien Tranche B Term Loan, 9.01%, 01/31/12 ................................. 1,465,381 5,000,000 Level 3 Financing, Inc. Term Loan, 8.41%, 12/01/11 ...................... 5,034,400 5,000,000 Sorenson Communications, Inc. Tranche B Term Loan, 8.33%, 08/16/13 ................................. 5,021,900 750,000 Stratos Global Corp./Stratos Funding LP (Canada) Term B Facility, 8.25%, 02/13/12 ................ 748,590 3,000,000 Windstream Corp. Tranche B Term Loan, 7.26%, 07/17/13 ............ 3,016,860 ------------- 32,411,151 ------------- PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- TELECOMMUNICATIONS - CLEC - 0.3% 4,937,500 Consolidated Communications, Inc. Term Loan D, 7.44%, 10/14/11 .................... 4,931,328 ------------- TELECOMMUNICATIONS - DATA/INTERNET - 0.1% 1,000,000 Pine Tree Holdings/Country Road Communications, Inc. Second Lien Tranche B Term Loan, 13.30%, 07/15/13 ................................ 1,015,000 TELECOMMUNICATIONS - FIBER/LONG DISTANCE - 0.8% 5,000,000 FairPoint Communications, Inc. Replacement B Term Loan, 7.25%, 02/08/12 ................................. 4,970,300 997,778 Hawaiian Telcom Communications Tranche B Term Loan, 7.75%, 10/31/12 ................................. 1,001,250 7,000,000 Qwest Corp. Tranche B Term Loan, 6.95%, 06/30/10 (i) ............................. 7,044,590 1,000,000 WestCom Corp. Second Lien Term Loan, 12.54%, 06/17/11 ................................ 1,006,880 ------------- 14,023,020 ------------- TRANSPORTATION - AUTO - 4.2% 3,891,897 Carey International, Inc. Second Lien Term Loan, 17.20%, 05/10/12 ................................ 3,882,167 16,000,000 Dana Corp. DIP Term Loan, 7.65%, 04/13/08 .................. 16,016,640 Delphi Corp. 16,903,133 Term Loan, 13.75%, 06/14/11 ..................... 17,529,056 1,500,000 Tranche B DIP Term Loan, 8.13%, 10/08/07 ................................. 1,528,740 4,500,000 Environmental Systems Products Holdings Second Lien Term Loan, 15.41%, 12/12/10 ................................ 4,590,000 Federal-Mogul Corp. 2,500,000 DIP Term Loan, 7.50%, 12/09/06 .................. 2,509,375 1,270,249 Supplemental Revolver, 9.08%, 12/09/06 (c) ............................. 1,275,012 1,048,750 Tranche C Term Loan, 9.08%, 12/09/06 ................................. 1,051,372 2,000,000 Gleason Works (The) Second Lien Term Loan, 10.97%, 12/30/13 ................................ 2,030,000 4,500,000 Goodyear Tire & Rubber Co. Third Lien Term Loan, 8.70%, 03/01/11 ................................. 4,556,250 838,635 Insurance Auto Auctions, Inc. Term Loan, 8.37%, 05/19/12 (c) .................. 843,348 5,124,728 Key Plastics LLC Term Loan B, 8.84%, 06/29/10 .................... 5,172,798 5,000,000 Lear Corp. First Lien Term Loan B, 7.97%, 04/25/12 ................................. 4,952,200 2,689,231 Stanadyne Corp. Term Loan, 8.90%, 08/02/10 ...................... 2,702,677 12 | See accompanying Notes to Financial Statements. INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- TRANSPORTATION - AUTO (CONTINUED) Tenneco Automotive, Inc. 1,779,338 Tranche B Term Loan, 7.40%, 12/12/10 ................................. 1,794,925 781,632 Tranche B-1 Credit Linked Deposit, 7.40%, 12/12/10 ................................. 787,494 2,000,000 Vanguard Car Rental USA Holding, Inc. Term Loan, 8.32%, 06/14/13 ...................... 2,004,760 ------------- 73,226,814 ------------- TRANSPORTATION - LAND - 0.6% Quality Distribution, Inc. 1,427,481 Synthetic Letters of Credit, 5.40%, 11/13/09 ................................. 1,434,618 2,701,353 Term Loan, 8.33%, 11/13/09 (e) .................. 2,714,859 4,352,584 Term Loan, 8.33%, 11/13/09 ...................... 4,374,347 1,000,000 SIRVA Worldwide, Inc. Tranche B Term Loan, 11.40%, 12/01/10 ................................ 958,340 ------------- 9,482,164 ------------- UTILITIES - 4.3% Boston Generating LLC 1,408,312 First Lien Series A Term Advance, 8.75%, 12/15/10 ................................. 1,436,478 80,438 First Lien Series B Term Advance, 8.75%, 09/30/10 ................................. 81,826 1,940,000 Calpine Construction Finance Co., LP First Lien Term Loan, 11.40%, 08/26/09 ................................ 2,053,160 Calpine Corp. 1,436,113 First Lien DIP Revolver, 7.75%, 12/20/07 ................................. 1,444,730 233,749 Second Lien Term Loan, 10.35%, 07/16/07 (d) ............................ 237,400 9,750,000 Second Lien Term Loan B, 10.35%, 07/16/07 ................................ 9,902,295 CenterPoint Energy, Inc. 3,965,025 Term Loan, 7.66%, 04/30/10 ...................... 3,970,417 1,309,789 Term Loan, 7.71%, 04/30/10 ...................... 1,311,571 Coleto Creek Power, LP 5,000,000 Second Lein Term Loan, 06/28/13 (b) .................................... 4,700,000 318,471 Synthetic Facility, 8.26%, 06/28/13 ............. 316,879 4,681,529 Term Loan, 8.20%, 06/28/13 ...................... 4,658,121 1,500,000 Covanta Energy Corp. Delayed Draw Term Loan, 7.75%, 06/30/12 ................................. 1,511,250 2,000,000 El Paso Corp. Deposit Loan, 07/31/11 (b) ...................... 2,011,240 4,000,000 GBGH, LLC (U S Energy) First Lien Term Loan, 10.94%, 08/07/13 ................................ 4,010,000 KGen, LLC 1,975,000 Tranche A Term Loan, 8.12%, 08/05/11 ................................. 1,975,000 36,217 Tranche B Term Loan, 14.50%, 08/05/11 ................................ 37,213 500,000 La Paloma Generating Co. LLC Second Lien Term Loan, 9.00%, 08/16/13 ................................. 503,960 PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- UTILITIES (CONTINUED) LSP General Finance Co. LLC 119,545 First Lien Delayed Draw Term Loan, 9.00%, 05/04/13 ................................. 120,143 2,878,788 First Lien Term Loan B, 7.25%, 05/04/13 ................................. 2,875,218 NATG Holdings LLC 570,221 Credit Linked Certificate of Deposit, 01/23/09 (d) .................................... 496,093 1,001,749 Term Loan A, 01/23/09 (d) ....................... 177,810 733,455 Term Loan B1, 01/23/10 (d) ...................... 132,022 72,363 Term Loan B2, 01/23/10 (d) ...................... 62,956 NRG Energy, Inc. 2,413,620 Credit Linked Certificate of Deposit, 7.50%, 02/02/13 ................................. 2,423,226 6,569,914 Term Loan, 7.33%, 02/01/13 ...................... 6,607,231 4,470,594 Plum Point Energy Associates, LLC Second Lien Term Loan, 10.75%, 09/14/14 ................................ 4,431,476 2,000,000 Primary Energy Operations LLC Term Loan, 8.15%, 08/24/09 ...................... 2,005,640 4,518,016 Riverside Energy Center LLC Term Loan, 9.74%, 06/24/11 ...................... 4,642,262 Rocky Mountain Energy Center LLC 361,073 Credit Linked Certificate of Deposit, 5.39%, 06/24/11 ................................. 371,906 3,121,434 Term Loan, 9.74%, 06/24/11 ...................... 3,207,273 TECO Panda Generating Co. - Gila River Power Station 485,932 Project Letter of Credit, 06/01/12 (b) .......... 561,252 1,332,395 Tranche A Term Loan, 06/01/12 (b) ............... 1,525,593 1,285,370 Tranche B Term Loan, 06/01/20 (b) ............... 1,497,456 31,350 Working Capital, 06/01/12 (b) ................... 36,523 TECO Panda- Union Power Partners, L.P. 141,077 Project Letter of Credit, 06/01/12 (b) .......... 164,355 783,762 Tranche A Term Loan, 06/01/12 (b) ............... 897,408 752,412 Tranche B Term Loan, 06/01/20 (b) ............... 876,559 62,701 Working Capital, 06/01/12 (b) ................... 73,047 Thermal North America, Inc. 1,000,000 Credit Linked Certificate of Deposit, 7.16%, 10/12/13 ................................. 997,500 912,955 Term Loan, 7.25%, 10/12/13 ...................... 911,814 ------------- 75,256,303 ------------- WIRELESS - CELLULAR/PCS - 4.0% 2,940,000 Cellular South, Inc. Term Loan, 7.25%, 05/04/11 ...................... 2,942,764 3,822,500 Centennial Cellular Operating Co. (Puerto Rico) Term Loan, 7.69%, 02/09/11 ...................... 3,846,391 38,500,000 Cricket Communications, Inc. Term B Facility, 8.25%, 06/16/13 ................ 38,856,125 1,500,000 Maritime Telecommunications Network, Inc. First Lien Term Loan, 8.19%, 05/11/12 ................................. 1,507,500 MetroPCS, Inc. 9,850,000 First Lien Tranche B Term Loan, 10.44%, 05/27/11 ................................ 10,096,250 10,800,000 Second Lien Term Loan, 12.94%, 05/27/12 ................................ 11,385,036 ------------- 68,634,066 ------------- Total Senior Loan Notes (Cost $1,508,383,681) ........................... 1,510,205,314 ------------- See accompanying Notes to Financial Statements. | 13 INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- FOREIGN DENOMINATED SENIOR LOAN NOTES (A) - 6.5% DENMARK - 0.6% EUR Nordic Telephone Co. Holdings APS 3,750,000 Euro Facility B2, 5.54%, 04/10/14 ................................. 4,853,562 3,750,000 Euro Facility C2, 5.54%, 04/10/15 ................................. 4,859,611 ------------- 9,713,173 ------------- FRANCE- 0.8% EUR Ypso Holding SA 2,106,147 Eur B (Acq) 1 Facility, 5.61%, 06/15/14 ................................. 2,674,080 3,436,345 Eur B (Acq) 2 Facility, 5.61%, 06/15/14 ................................. 4,362,973 5,457,508 Eur B (Recap) 1 Facility, 5.61%, 06/15/14 ................................. 6,929,153 ------------- 13,966,206 ------------- GERMANY - 1.2% EUR 16,900,000 P7S1 Holding II S.A.R.L - GMP Facility B, 7.07%, 07/08/11 ..................... 21,599,083 ------------- ITALY - 0.8% EUR Prysmian Cables & Systems, Inc. 1,923,077 Second Lien Term Loan, 9.94%, 01/20/15 ................................. 2,526,251 875,000 Euro Term Loan B, 5.57%, 08/04/12 ................................. 1,127,458 875,000 Euro Term Loan C2, 5.57%, 08/04/12 ................................. 1,128,679 576,923 Second Lien Tranche C Term Loan, 9.94%, 01/20/15 ................................. 757,875 Wind Telecomunicazione S.p.A. 3,500,000 A1 Term Loan Facility, 5.38%, 05/26/12 ................................. 4,476,140 1,750,000 B1 Term Loan Facility, 5.63%, 05/26/13 ................................. 2,250,122 1,750,000 C1 Term Loan Facility, 5.63%, 05/26/14 ................................. 2,254,781 ------------- 14,521,306 ------------- NETHERLANDS - 0.2% EUR YBR Acquisition B.V. 806,733 Facility B2 Term Loan, 6.24%, 06/30/13 ................................. 1,047,611 1,250,000 Facility C2 Term Loan, 5.74%, 06/30/14 ................................. 1,626,174 ------------- 2,673,785 ------------- SWITZERLAND - 0.1% EUR 1,262,063 Merisant Co. Tranche A (Euro) Term Loan, 6.40%, 01/11/09 ................................. 1,565,018 ------------- PRINCIPAL AMOUNT ($) VALUE ($) - ------------------- --------- UNITED KINGDOM - 2.8% GBP 869,822 Eggborough Power Ltd. Term Loan, 03/31/22 (b) ......................... 5,534,417 926,518 Invensys International Holdings Ltd. GBP Bonding Facility B, 7.04%, 12/15/10 ................................. 1,777,799 3,000,000 NTL Inc. A Facility, 03/03/11 (b) ........................ 5,625,998 1,750,000 NTL Investment Holdings Ltd. GBP Tranche C Term Loan, 7.64%, 03/03/13 ................................. 3,349,573 Peacock Group (The) 2,250,000 Facility B, 7.44%, 10/30/13 ..................... 4,306,593 2,250,000 Facility C, 7.44%, 10/30/14 ..................... 4,306,593 3,022,959 PlayPower, Inc. Add-on Term Loan, 7.75%, 12/18/09 ................................. 5,750,131 1,392,327 SunGard U K Holdings Ltd. U K Term Loan, 7.22%, 02/11/13 .................. 2,674,903 2,824,639 Teesside Power Ltd. Term Loan, 5.51%, 04/01/08 ...................... 5,446,773 Trinitybrook PLC 2,500,000 Term Loan B1, 7.66%, 07/31/13 ................... 4,766,986 2,500,000 Term Loan C1, 7.66%, 07/31/14 ................... 4,785,817 ------------- 48,325,583 ------------- Total Foreign Denominated Senior Loan Notes (Cost $108,867,712) ........................... 112,364,154 ------------- CORPORATE NOTES AND BONDS (I) - 0.0% TRANSPORTATION - AUTO - 0.0% Key Plastics Holdings, Inc. 72,552 Junior Secured Subordinated Notes, 18.32%, 04/26/07 (f) ..................... 67,292 101,433 Senior Secured Subordinated Notes, 7.00%, 04/26/07 (f) ...................... 93,906 ------------- 161,198 ------------- Total Corporate Notes and Bonds (Cost $165,136) ............................... 161,198 ------------- SHARES ------- COMMON STOCKS (G) - 1.4% MANUFACTURING - 0.0% 12 GenTek, Inc., B Shares ........................... 359 ------------- TELECOMMUNICATIONS/COMBINATION - 0.0% 1,756 Eningen Realty (f) ............................... 0 ------------- TRANSPORTATION - AUTO - 0.0% 3,445 Environmental Systems Products Holdings (f) .................................... 0 ------------- UTILITIES - 1.2% 12,470 CenterPoint Energy, Inc. ......................... 167,846 731,628 Mirant Corp. ..................................... 21,195,263 322,876 NATG Holdings LLC (f) 0 ------------- 21,363,109 ------------- 14 | See accompanying Notes to Financial Statements. INVESTMENT PORTFOLIO (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY SHARES VALUE ($) ------ --------- COMMON STOCKS (CONTINUED) WIRELESS - CELLULAR/PCS - 0.2% 76,137 Leap Wireless International, Inc. ................ 3,522,098 ------------- Total Common Stocks (Cost $22,921,785) ............................ 24,885,566 ------------- PREFERRED STOCKS - 0.0% MANUFACTURING - 0.0% 14,382 Superior Telecom, Inc., Series A ................. 11,506 ------------- TRANSPORTATION - AUTO - 0.0% 13 Key Plastics Holdings, Inc. (f) .................. 0 ------------- Total Preferred Stocks (Cost $14,382) ................................ 11,506 ------------- UNITS ------- WARRANTS - 0.0% GAMING/LEISURE - GAMING - 0.0% 23,070 OpBiz LLC, expires 08/31/10 (f) .................. 0 25 OpBiz LLC, expires 08/31/10 (f) .................. 0 ------------- 0 ------------- Total Warrants (Cost $0) ..................................... 0 ------------- CLAIMS (H) - 0.0% UTILITIES - 0.0% 17,500,000 Mirant Corp. ..................................... 218,750 ------------- Total Claims (Cost $2) ..................................... 218,750 ------------- TOTAL INVESTMENTS - 95.4% ...................................... 1,647,846,488 ------------- (cost of $1,640,352,698) (j) OTHER ASSETS & LIABILITIES, NET - 4.6% ......................... 78,965,740 ------------- NET ASSETS - 100.0% ............................................ 1,726,812,228 ============= - ------------------- (a) Senior loans in which the Fund invests generally pay interest at rates which are periodically predetermined by reference to a base lending rate plus a premium. (Unless otherwise identified by footnote (i), all senior loans carry a variable rate interest.) These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Inter-Bank Offered Rate ("LIBOR") or (iii) the certificate of deposit rate. Rate shown represents the weighted average rate at August 31, 2006. Senior loans, while exempt from registration under the Security Act of 1933, as amended, contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturities shown. (b) All or a portion of these positions have not settled. Contract rates do not take effect until settlement date. (c) Senior Loan Notes have additional unfunded loan commitments. See Note 9. (d) These issuers are in default of certain debt covenants. Income is not being accrued. (e) Loans held on participation. (f) Represents fair value as determined in good faith under the direction of the Board of Trustees. (g) Non-income producing security. (h) Security is the result of company restructuring that will be converted into equity upon the completion of court proceedings. (i) Fixed rate senior loans or corporate notes. (j) Cost for Federal income tax purposes is $1,640,586,863. CLEC Competitive Local Exchange Carrier DIP Debtor in Possession EUR Euro Currency GBP Great Britain Pound FOREIGN DENOMINATED SENIOR LOAN NOTES INDUSTRY CONCENTRATION TABLE (% of Total Net Assets) Broadcasting ........................ 1.2% Cable - International Cable ......... 1.3% Telecommunications .................. 1.1% Retail .............................. 1.1% Manufacturing ....................... 0.8% Utilities ........................... 0.6% Diversified Media ................... 0.2% Information Technology .............. 0.1% Food/Tobacco-Food/Tobacco Producers . 0.1% ------ Total ............................... 6.5% ====== See accompanying Notes to Financial Statements. | 15 STATEMENT OF ASSETS AND LIABILITIES - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY
($) - ---------------------------------------------------------------------------------------------------------------------- ASSETS: Investments: Investments, at value (Cost $1,640,352,698) ..................................................... 1,647,846,488 Cash ............................................................................................ 143,669,324 Foreign currency (Cost $12,720,150) ............................................................. 12,903,597 Receivable for: Investments sold ............................................................................. 18,903,318 Dividend, interest and fees .................................................................. 18,017,424 Other assets .................................................................................... 69,969 --------------- Total assets .............................................................................. 1,841,410,120 LIABILITIES: Deferred facility fees (Note 2) ................................................................. 5,300 Net discount and unrealized appreciation on unfunded transactions (Note 9) ...................... 413,771 Payable for: Investments purchased ........................................................................ 113,116,986 Investment advisory fee (Note 4) ............................................................. 610,434 Trustees' fees (Note 4) ...................................................................... 3,333 Accrued expenses and other liabilities .......................................................... 448,068 --------------- Total liabilities ......................................................................... 114,597,892 --------------- NET ASSETS ......................................................................................... 1,726,812,228 ===============
16 | See accompanying Notes to Financial Statements.
STATEMENT OF OPERATIONS - -------------------------------------------------------------------------------------------------- FOR THE YEAR ENDED AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY ($) - ---------------------------------------------------------------------------------------------------------------------- INVESTMENT INCOME Interest ........................................................................................ 111,966,111 Dividends ....................................................................................... 1,366 Facility and other fees ......................................................................... 79,535 --------------- Total investment income ................................................................... 112,047,012 EXPENSES Investment advisory fee (Note 4) ................................................................ 5,902,860 Accounting services fee ......................................................................... 382,299 Professional fees ............................................................................... 119,554 Trustees' fees (Note 4) ......................................................................... 20,000 Custody fee ..................................................................................... 155,078 Reports to shareholders ......................................................................... 9,462 Texas franchise expense ......................................................................... 324,610 Other expenses .................................................................................. 29,858 --------------- Total operating expenses .................................................................. 6,943,721 Interest expense (Note 8) ....................................................................... 157,549 Facility expense ................................................................................ 414,842 -------------- Net expenses .............................................................................. 7,516,112 --------------- Net investment income ........................................................................... 104,530,900 --------------- NET REALIZED AND UNREALIZED GAIN ON INVESTMENTS Net realized gain on investments ................................................................ 10,268,462 Net realized gain on foreign currency transactions .............................................. 2,095,294 Net change in unrealized depreciation on investments ............................................ (457,119) Net change in unrealized depreciation on unfunded transactions (Note 9) ......................... (165,556) Net change in unrealized depreciation on translation of assets and liabilities denominated in foreign currency .............................................................................. (658,726) --------------- Net realized and unrealized gain ................................................................ 11,082,355 -------------- Net increase in net assets from operations ...................................................... 115,613,255 ==============
See accompanying Notes to Financial Statements. | 17
STATEMENTS OF CHANGES IN NET ASSETS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY YEARS ENDED AUGUST 31, 2006 2005 ($) ($) ---------------- --------------- INCREASE IN NET ASSETS: OPERATIONS Net investment income ......................................................... 104,530,900 55,342,478 Net realized gain (loss) on investments and unfunded transactions and foreign currency transactions .............................................. 12,363,756 (155,500) Net change in unrealized appreciation (depreciation) on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency ........................................................... (1,281,401) 7,371,115 ---------------- -------------- Net increase from operations ............................................... 115,613,255 62,558,093 ---------------- -------------- TRANSACTIONS IN INVESTOR'S BENEFICIAL INTEREST Contributions ................................................................. 817,426,901 401,269,018 Withdrawals ................................................................... (345,645,810) (220,779,725) ---------------- -------------- Net increase from transactions in investor's beneficial interest ........... 471,781,091 180,489,293 ---------------- -------------- Total increase in net assets ............................................... 587,394,346 243,047,386 NET ASSETS Beginning of period ........................................................... 1,139,417,882 896,370,496 ---------------- -------------- End of period ................................................................. 1,726,812,228 1,139,417,882 ================ ==============
18 | See accompanying Notes to Financial Statements.
STATEMENT OF CASH FLOWS - -------------------------------------------------------------------------------- FOR THE YEAR ENDED AUGUST 31, 2006 HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY ($) - ---------------------------------------------------------------------------------------------------------------------- CASH FLOWS USED FOR OPERATING ACTIVITIES Net investment income ........................................................................... 104,530,900 ADJUSTMENTS TO RECONCILE NET INVESTMENT INCOME TO NET CASH USED FOR OPERATING ACTIVITIES Purchase of investments securities .............................................................. (1,381,878,263) Proceeds from disposition of investment securities .............................................. 866,663,888 Increase in dividends, interest and fees receivable ............................................. (10,160,876) Increase in receivable for investments sold ..................................................... (11,755,437) Increase in other assets ........................................................................ (65,784) Decrease in deferred facility fees .............................................................. (73,293) Net amortization of premium (discount) .......................................................... (1,971,439) Increase in payable for investments purchased ................................................... 20,414,570 Increase in payables to related parties ......................................................... 191,712 Increase in mark-to-market on realized and unrealized gain (loss) on foreign currency ........... 1,436,568 Increase in other liabilities ................................................................... 240,576 --------------- Net cash and foreign currency flow from operating activities .............................. (412,426,878) CASH FLOWS PROVIDED BY FINANCING ACTIVITIES Proceeds from capital contributions ............................................................. 817,426,901 Payment of capital withdrawals .................................................................. (345,645,810) --------------- Net cash flow provided by financing activities ............................................ 471,781,091 --------------- Net increase in cash and foreign currency ................................................. 59,354,213 CASH AND FOREIGN CURRENCY Beginning of the period ......................................................................... 97,218,708 --------------- End of the period ............................................................................... 156,572,921 ===============
See accompanying Notes to Financial Statements. | 19 FINANCIAL HIGHLIGHTS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE LIMITED LIABILITY COMPANY SELECTED DATA FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD IS AS FOLLOWS:
- ------------------------------------------------------------------------------------------------------------------------------------ YEAR ENDED AUGUST 31, ------------------------------------------------------------------------------ 2006 2005 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ RATIOS TO AVERAGE NET ASSETS/ SUPPLEMENTAL DATA Total return 8.72% 6.54% 10.39% 11.68%(a) (2.20)% Operating expenses 0.52% 0.51%(b) 0.52%(b) 0.57%(b) 0.55%(b) Interest expense and facility expense 0.04% 0.05% --%(c) --%(c) 0.03% Net expenses 0.56% 0.56%(b) 0.52%(b) 0.57%(b) 0.58%(b) Net investment income 7.74% 5.69%(b) 4.45%(b) 5.96%(b) 6.42%(b)(d) Portfolio turnover rate 64% 75% 97% 75% 70% - ---------------------------------------------------- (a) Total return includes a voluntary reimbursement by the Portfolio's Investment Adviser for a realized investment loss on an investment not meeting the Portfolio's investment restrictions. This reimbursement had an impact of less than 0.01% on the Portfolio's return. (b) The benefits derived from custody credits and directed brokerage arrangements, if applicable, had an impact of less than 0.01%. (c) Rounds to less than 0.01%. (d) Effective September 1, 2001, the Portfolio adopted the provisions of the AICPA Audit and Accounting Guide for Investment Companies and began amortizing and accreting premiums and discounts on debt securities. The effect of this change for the year ended August 31, 2002, was to increase the ratio of net investment income to average net assets from 6.41% to 6.42%. Ratios and supplemental data for the periods prior to August 31, 2002 have not been restated to reflect this change in presentation.
20 | See accompanying Notes to Financial Statements. STATEMENT OF ASSETS AND LIABILITIES - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND
($) - ---------------------------------------------------------------------------------------------------------------------- ASSETS: Investments: Investments in Portfolio ........................................................................ 1,726,812,228 Receivable for: Fund shares sold ............................................................................. 11,321,089 --------------- Total assets .............................................................................. 1,738,133,317 LIABILITIES: Payable for: Distributions ................................................................................ 6,909 Administration fee (Note 4) .................................................................. 269,785 Trustees' fees (Note 4) ...................................................................... 13,333 Distribution and service fees (Note 4) ....................................................... 732,840 Accrued expenses and other liabilities .......................................................... 173,226 --------------- Total liabilities ......................................................................... 1,196,093 --------------- NET ASSETS ......................................................................................... 1,736,937,224 =============== COMPOSITION OF NET ASSETS Paid-in capital ................................................................................. 1,733,087,057 Undistributed net investment income ............................................................. 2,499,928 Accumulated net realized loss on investments and foreign currency transactions allocated from Portfolio .................................................................................... (5,639,590) Net unrealized appreciation on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency allocated from Portfolio ..................... 6,989,829 --------------- NET ASSETS ......................................................................................... 1,736,937,224 =============== CLASS A Net assets ...................................................................................... 732,766,828 Shares outstanding (unlimited authorization) .................................................... 73,609,935 Net asset value per share (Net assets/Shares outstanding) ...................................... 9.95(a) Maximum offering price per share (100 / 96.50 of $9.95) ......................................... 10.31(b) CLASS B Net assets ...................................................................................... 150,921,879 Shares outstanding (unlimited authorization) .................................................... 15,167,733 Net asset value and offering price per share (Net assets/Shares outstanding) ................... 9.95(a) CLASS C Net assets ...................................................................................... 627,964,295 Shares outstanding (unlimited authorization) .................................................... 63,109,247 Net asset value and offering price per share (Net assets/Shares outstanding) ................... 9.95(a) CLASS Z Net assets ...................................................................................... 225,284,222 Shares outstanding (unlimited shares authorized) ................................................ 22,641,661 Net asset value, offering and redemption price per share (Net assets/Shares outstanding) ........ 9.95 - ---------------------------------------------------- (a) Redemption price per share is equal to net asset value less any applicable contingent deferred sales charge. (b) On sales of $100,000 or more, the offering price is reduced.
See accompanying Notes to Financial Statements. | 21 STATEMENT OF OPERATIONS - -------------------------------------------------------------------------------- FOR THE YEAR ENDED AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND
($) - ---------------------------------------------------------------------------------------------------------------------- INVESTMENT INCOME ALLOCATED FROM PORTFOLIO (NOTE 1) Interest ........................................................................................ 110,894,171 Dividends ....................................................................................... 1,339 Facility and other fees ......................................................................... 76,996 --------------- Total investment income allocated from Portfolio .......................................... 110,972,506 EXPENSES Total operating expenses allocated from Portfolio (Note 1) ...................................... 6,543,885 Administration fee (Note 4) ..................................................................... 2,674,362 Distribution fee (Note 4): Class A ...................................................................................... 515,756 Class B ...................................................................................... 710,019 Class C ...................................................................................... 2,806,591 Service fee (Note 4): Class A ...................................................................................... 1,289,391 Class B ...................................................................................... 394,455 Class C ...................................................................................... 1,169,413 Transfer agent fee .............................................................................. 704,419 Professional fees ............................................................................... 73,175 Accounting services fee ......................................................................... 12,600 Trustees' fees (Note 4) ......................................................................... 77,750 Custody fee ..................................................................................... 1,200 Registration fees ............................................................................... 82,000 Reports to shareholders ......................................................................... 392,698 Texas franchise expense allocated from Portfolio (Note 1) ....................................... 319,893 Other expenses .................................................................................. 268,923 --------------- Total operating expenses .................................................................. 18,036,530 --------------- Interest expenses allocated from Portfolio (Note 8) ............................................. 153,221 Facility expense allocated from Portfolio ....................................................... 411,423 --------------- Total expenses ............................................................................ 18,601,174 Fees and expenses waived or reimbursed by Investment Adviser (Note 4) ........................... (152,715) --------------- Net expenses .............................................................................. 18,448,459 --------------- Net investment income ........................................................................... 92,524,047 --------------- NET REALIZED AND UNREALIZED GAIN ON INVESTMENTS ALLOCATED FROM PORTFOLIO (NOTE 1) Net realized gain on investments ................................................................ 9,977,179 Net realized gain on foreign currency transactions .............................................. 2,099,783 Net change in unrealized depreciation on investments ............................................ (44,817) Net change in unrealized depreciation on unfunded transactions .................................. (163,207) Net change in unrealized depreciation on translation of assets and liabilities denominated in foreign currency .......................................................................... (643,179) --------------- Net realized and unrealized gain ................................................................ 11,225,759 --------------- Net increase in net assets ...................................................................... 103,749,806 ===============
22 | See accompanying Notes to Financial Statements. STATEMENTS OF CHANGES IN NET ASSETS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND
YEARS ENDED AUGUST 31, 2006 2005 ($) ($) ---------------- --------------- INCREASE IN NET ASSETS: OPERATIONS Net investment income ................................................................ 92,524,047 44,426,514 Net realized gain (loss) on investments and foreign currency transactions allocated from Portfolio ................................................................... 12,076,962 (177,535) Net change in unrealized appreciation (depreciation) on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency allocated from Portfolio ................................................. (851,203) 7,005,353 --------------- -------------- Net increase from operations ...................................................... 103,749,806 51,254,332 --------------- -------------- DISTRIBUTIONS DECLARED TO SHAREHOLDERS From net investment income: Class A ........................................................................... (36,949,931) (13,226,644) Class B ........................................................................... (10,607,992) (8,228,190) Class C ........................................................................... (31,033,409) (13,491,196) Class Z ........................................................................... (14,588,702) (8,949,145) --------------- -------------- Total distributions declared to shareholders ...................................... (93,180,034) (43,895,175) --------------- -------------- SHARE TRANSACTIONS Class A Subscriptions ..................................................................... 460,060,712 194,284,743 Distributions reinvested .......................................................... 17,848,900 8,414,712 Redemptions ....................................................................... (105,237,595) (71,078,183) --------------- -------------- Net increase ...................................................................... 372,672,017 131,621,272 Class B Subscriptions ..................................................................... 370,397 5,874,003 Distributions reinvested .......................................................... 6,226,923 4,892,459 Redemptions ....................................................................... (26,685,543) (33,620,192) --------------- -------------- Net decrease ...................................................................... (20,088,223) (22,853,730) Class C Subscriptions ..................................................................... 307,867,391 152,460,394 Distributions reinvested .......................................................... 15,573,084 8,018,612 Redemptions ....................................................................... (66,041,445) (74,887,937) --------------- -------------- Net increase ...................................................................... 257,399,030 85,591,069 Class Z Subscriptions ..................................................................... 88,139,842 97,758,278 Distributions reinvested .......................................................... 5,020,371 2,265,809 Redemptions ....................................................................... (61,876,293) (48,412,070) --------------- -------------- Net increase ...................................................................... 31,283,920 51,612,017 --------------- -------------- Net increase from share transactions .............................................. 641,266,744 245,970,628 --------------- -------------- Total increase in net assets ...................................................... 651,836,516 253,329,785 --------------- -------------- NET ASSETS Beginning of period .................................................................. 1,085,100,708 831,770,923 End of period (including undistributed net investment income of $2,499,928 and $633,282, respectively) ......................................... 1,736,937,224 1,085,100,708 =============== ==============
See accompanying Notes to Financial Statements. | 23 STATEMENTS OF CHANGES IN NET ASSETS (CONTINUED) - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND
YEARS ENDED AUGUST 31, 2006 2005 ($) ($) ---------------- --------------- CHANGE IN SHARES Class A Subscriptions ..................................................................... 46,389,131 19,770,029 Issued for distributions reinvested ............................................... 1,799,527 856,198 Redemptions ....................................................................... (10,621,709) (7,239,210) --------------- -------------- Net increase ...................................................................... 37,566,949 13,387,017 Class B Subscriptions ..................................................................... 37,376 597,890 Issued for distributions reinvested ............................................... 628,285 497,995 Redemptions ....................................................................... (2,694,070) (3,425,945) --------------- -------------- Net decrease ...................................................................... (2,028,409) (2,330,060) Class C Subscriptions ..................................................................... 31,050,062 15,517,260 Issued for distributions reinvested ............................................... 1,570,587 816,243 Redemptions ....................................................................... (6,667,761) (7,624,801) --------------- -------------- Net increase ...................................................................... 25,952,888 8,708,702 Class Z Subscriptions ..................................................................... 8,891,919 9,948,182 Issued for distributions reinvested ............................................... 506,341 230,667 Redemptions ....................................................................... (6,252,836) (4,924,398) --------------- -------------- Net increase ...................................................................... 3,145,424 5,254,451
24 | See accompanying Notes to Financial Statements. FINANCIAL HIGHLIGHTS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND SELECTED DATA FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD IS AS FOLLOWS:
YEAR ENDED AUGUST 31, ------------------------------------------------------------------------------ CLASS A SHARES 2006 2005 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF PERIOD $ 9.88 $ 9.80 $ 9.29 $ 8.83 $ 9.62 - ------------------------------------------------------------------------------------------------------------------------------------ INCOME FROM INVESTMENT OPERATIONS: Net investment income(a) 0.70 0.49 0.37 0.48 0.54(b) Net realized and unrealized gain (loss) allocated from Portfolio(a) 0.07 0.08 0.52 0.46 (0.79)(b) -------- -------- -------- ------ -------- Total from investment operations 0.77 0.57 0.89 0.94 (0.25) - ------------------------------------------------------------------------------------------------------------------------------------ LESS DISTRIBUTIONS DECLARED TO SHAREHOLDERS: From net investment income (0.70) (0.49) (0.38) (0.48) (0.54) From net realized gains -- -- -- -- --(c) -------- -------- -------- ------- -------- Total distributions declared to shareholders (0.70) (0.49) (0.38) (0.48) (0.54) - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF PERIOD $ 9.95 $ 9.88 $ 9.80 $ 9.29 $ 8.83 Total return(d) 8.18% 5.93% 9.65% 11.03%(e) (2.67)% - ------------------------------------------------------------------------------------------------------------------------------------ RATIOS TO AVERAGE NET ASSETS/ SUPPLEMENTAL DATA: Net operating expenses 1.17% 1.15% 1.15% 1.15% 1.15% Interest expense & facility expense allocated from Portfolio 0.04% 0.05% --%(f) --%(f) 0.03% Net expenses(g) 1.21% 1.20% 1.15% 1.15% 1.18% Net investment income 7.08% 5.05% 3.78% 5.39% 5.83%(b) Waiver/reimbursement 0.01% 0.08% 0.17% 0.28% 0.28% Net assets, end of period (000's) $732,767 $355,998 $222,032 $97,924 $108,583 - ---------------------------------------------------- (a) Per share data was calculated using average shares outstanding during the period. (b) Effective September 1, 2001, the Fund adopted the provisions of the AICPA Audit and Accounting Guide for Investment Companies and began amortizing and accreting premium and discount on all debt securities. The effect of this change for the year ended August 31, 2002, on the net investment income and net realized and unrealized loss per share was less than $0.01, and increased the ratio of net investment income to average net assets from 5.82% to 5.83%. Per share data and ratios for periods prior to August 31, 2002 have not been restated to reflect this change in presentation. (c) Rounds to less than $0.01. (d) Total return is at net asset value assuming all distributions reinvested and no initial sales charge or CDSC. Had the Portfolio's investment adviser not waived or reimbursed a portion of expenses, total return would have been reduced. (e) Total return includes a voluntary reimbursement by the Portfolio's investment adviser for a realized investment loss on an investment not meeting the Portfolio's investment restrictions. This reimbursement had an impact of less than 0.01% on the Fund's Class A Shares return. (f) Rounds to less than 0.01%. (g) Net expense ratio has been calculated after applying any waiver/reimbursement.
See accompanying Notes to Financial Statements. | 25 FINANCIAL HIGHLIGHTS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND SELECTED DATA FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD IS AS FOLLOWS:
YEAR ENDED AUGUST 31, ------------------------------------------------------------------------------ CLASS B SHARES 2006 2005 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF PERIOD $ 9.87 $ 9.80 $ 9.29 $ 8.83 $ 9.62 - ------------------------------------------------------------------------------------------------------------------------------------ INCOME FROM INVESTMENT OPERATIONS: Net investment income(a) 0.67 0.46 0.34 0.45 0.51(b) Net realized and unrealized gain (loss) allocated from Portfolio(a) 0.08 0.06 0.51 0.46 (0.79)(b) -------- -------- -------- -------- -------- Total from investment operations 0.75 0.52 0.85 0.91 (0.28) - ------------------------------------------------------------------------------------------------------------------------------------ LESS DISTRIBUTIONS DECLARED TO SHAREHOLDERS: From net investment income (0.67) (0.45) (0.34) (0.45) (0.51) From net realized gains -- -- -- -- --(c) -------- -------- -------- -------- -------- Total distributions declared to shareholders (0.67) (0.45) (0.34) (0.45) (0.51) - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF PERIOD $ 9.95 $ 9.87 $ 9.80 $ 9.29 $ 8.83 Total return(d) 7.82% 5.46% 9.27% 10.65%(e) (3.02)% - ------------------------------------------------------------------------------------------------------------------------------------ RATIOS TO AVERAGE NET ASSETS/ SUPPLEMENTAL DATA: Net operating expenses 1.52% 1.50% 1.50% 1.50% 1.50% Interest expense & facility expense allocated from Portfolio 0.04% 0.05% --%(f) --%(f) 0.03% Net expenses(g) 1.56% 1.55% 1.50% 1.50% 1.53% Net investment income 6.73% 4.70% 3.51% 5.05% 5.48%(b) Waiver/reimbursement 0.01% 0.08% 0.17% 0.28% 0.28% Net assets, end of period (000's) $150,922 $169,780 $191,365 $163,448 $174,707 - ---------------------------------------------------- (a) Per share data was calculated using average shares outstanding during the period. (b) Effective September 1, 2001, the Fund adopted the provisions of the AICPA Audit and Accounting Guide for Investment Companies and began amortizing and accreting premium and discount on all debt securities. The effect of this change for the year ended August 31, 2002, on the net investment income and net realized and unrealized loss per share was less than $0.01, and increased the ratio of net investment income to average net assets from 5.47% to 5.48%. Per share data and ratios for periods prior to August 31, 2002 have not been restated to reflect this change in presentation. (c) Rounds to less than $0.01. (d) Total return is at net asset value assuming all distributions reinvested and no CDSC. Had the Portfolio's investment adviser not waived or reimbursed a portion of expenses, total return would have been reduced. (e) Total return includes a voluntary reimbursement by the Portfolio's investment adviser for a realized investment loss on an investment not meeting the Portfolio's investment restrictions. This reimbursement had an impact of less than 0.01% on the Fund's Class B Shares return. (f) Rounds to less than 0.01%. (g) Net expense ratio has been calculated after applying any waiver/reimbursement.
26 | See accompanying Notes to Financial Statements. FINANCIAL HIGHLIGHTS HIGHLAND FLOATING RATE FUND SELECTED DATA FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD IS AS FOLLOWS:
YEAR ENDED AUGUST 31, ------------------------------------------------------------------------------ CLASS C SHARES 2006 2005 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF PERIOD $ 9.87 $ 9.80 $ 9.29 $ 8.83 $ 9.62 - ------------------------------------------------------------------------------------------------------------------------------------ INCOME FROM INVESTMENT OPERATIONS: Net investment income(a) 0.65 0.45 0.32 0.44 0.50(b) Net realized and unrealized gain (loss) allocated from Portfolio(a) 0.08 0.06 0.52 0.46 (0.79)(b) -------- -------- -------- -------- -------- Total from investment operations 0.73 0.51 0.84 0.90 (0.29) - ------------------------------------------------------------------------------------------------------------------------------------ LESS DISTRIBUTIONS DECLARED TO SHAREHOLDERS: From net investment income (0.65) (0.44) (0.33) (0.44) (0.50) From net realized gains -- -- -- -- --(c) -------- -------- -------- -------- -------- Total distributions declared to shareholders (0.65) (0.44) (0.33) (0.44) (0.50) - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF PERIOD $ 9.95 $ 9.87 $ 9.80 $ 9.29 $ 8.83 Total return(d) 7.65% 5.30% 9.10% 10.48%(e) (3.16)% - ------------------------------------------------------------------------------------------------------------------------------------ RATIOS TO AVERAGE NET ASSETS/ SUPPLEMENTAL DATA: Net operating expenses 1.67% 1.65% 1.65% 1.65% 1.65% Interest expense & facility expense allocated from Portfolio 0.04% 0.05% --%(f) --%(f) 0.03% Net expenses(g) 1.71% 1.70% 1.65% 1.65% 1.68% Net investment income 6.58% 4.55% 3.28% 4.88% 5.33%(b) Waiver/reimbursement 0.01% 0.08% 0.17% 0.28% 0.28% Net assets, end of period (000's) $627,964 $366,841 $278,797 $132,656 $137,098 - ---------------------------------------------------- (a) Per share data was calculated using average shares outstanding during the period. (b) Effective September 1, 2001, the Fund adopted the provisions of the AICPA Audit and Accounting Guide for Investment Companies and began amortizing and accreting premium and discount on all debt securities. The effect of this change for the year ended August 31, 2002, on the net investment income and net realized and unrealized loss per share was less than $0.01, and increased the ratio of net investment income to average net assets from 5.32% to 5.33%. Per share data and ratios for periods prior to August 31, 2002 have not been restated to reflect this change in presentation. (c) Rounds to less than $0.01. (d) Total return is at net asset value assuming all distributions reinvested and no CDSC. Had the Portfolio's investment adviser not waived or reimbursed a portion of expenses, total return would have been reduced. (e) Total return includes a voluntary reimbursement by the Portfolio's investment adviser for a realized investment loss on an investment not meeting the Portfolio's investment restrictions. This reimbursement had an impact of less than 0.01% on the Fund's Class C Shares return. (f) Rounds to less than 0.01%. (g) Net expense ratio has been calculated after applying any waiver/reimbursement.
See accompanying Notes to Financial Statements. | 27 FINANCIAL HIGHLIGHTS - -------------------------------------------------------------------------------- HIGHLAND FLOATING RATE FUND SELECTED DATA FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD IS AS FOLLOWS:
YEAR ENDED AUGUST 31, ------------------------------------------------------------------------------ CLASS Z SHARES 2006 2005 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF PERIOD $ 9.87 $ 9.80 $ 9.29 $ 8.83 $ 9.62 - ------------------------------------------------------------------------------------------------------------------------------------ INCOME FROM INVESTMENT OPERATIONS: Net investment income(a) 0.74 0.53 0.40 0.50 0.57(b) Net realized and unrealized gain (loss) allocated from Portfolio(a) 0.08 0.06 0.52 0.47 (0.78)(b) -------- -------- -------- -------- -------- Total from investment operations 0.82 0.59 0.92 0.97 (0.21) - ------------------------------------------------------------------------------------------------------------------------------------ LESS DISTRIBUTIONS DECLARED TO SHAREHOLDERS: From net investment income (0.74) (0.52) (0.41) (0.51) (0.58) From net realized gains -- -- -- -- --(c) -------- -------- -------- -------- -------- Total distributions declared to shareholders (0.74) (0.52) (0.41) (0.51) (0.58) - ------------------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF PERIOD $ 9.95 $ 9.87 $ 9.80 $ 9.29 $ 8.83 Total return (d) 8.57% 6.20% 10.03% 11.42%(e) (2.33)% - ------------------------------------------------------------------------------------------------------------------------------------ RATIOS TO AVERAGE NET ASSETS/ SUPPLEMENTAL DATA: Net operating expenses 0.82% 0.80% 0.80% 0.80% 0.80% Interest expense & facility expense allocated from Portfolio 0.04% 0.05% --%(f) --%(f) 0.03% Net expenses(g) 0.86% 0.85% 0.80% 0.80% 0.83% Net investment income 7.43% 5.40% 4.12% 5.53% 6.18%(b) Waiver/reimbursement 0.01% 0.08% 0.17% 0.28% 0.28% Net assets, end of period (000's) $225,284 $192,482 $139,577 $ 31,055 $ 13,236 - ---------------------------------------------------- (a) Per share data was calculated using average shares outstanding during the period. (b) Effective September 1, 2001, the Fund adopted the provisions of the AICPA Audit and Accounting Guide for Investment Companies and began amortizing and accreting premium and discount on all debt securities. The effect of this change for the year ended August 31, 2002, on the net investment income and net realized and unrealized loss per share was less than $0.01, and increased the ratio of net investment income to average net assets from 6.17% to 6.18%. Per share data and ratios for periods prior to August 31, 2002 have not been restated to reflect this change in presentation. (c) Rounds to less than $0.01. (d) Total return is at net asset value assuming all distributions reinvested. Had the Portfolio's investment adviser not waived or reimbursed a portion of expenses, total return would have been reduced. (e) Total return includes a voluntary reimbursement by the Portfolio's investment adviser for a realized investment loss on an investment not meeting the Portfolio's investment restrictions. This reimbursement had an impact of less than 0.01% on the Fund's Class Z Shares return. (f) Rounds to less than 0.01%. (g) Net expense ratio has been calculated after applying any waiver/reimbursement.
28 | See accompanying Notes to Financial Statements. NOTES TO FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND NOTE 1. ORGANIZATION Highland Floating Rate Fund (the "Fund") is a Massachusetts business trust registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as a non-diversified, closed-end management investment company. INVESTMENT OBJECTIVE The Fund invests all of its investable assets in Highland Floating Rate Limited Liability Company (the "Portfolio"). The Portfolio seeks a high level of current income consistent with preservation of capital. THE PORTFOLIO The Portfolio is registered under the 1940 Act as a non-diversified, closed-end management investment company and is organized as a Delaware limited liability company. The Portfolio allocates income, expenses and realized and unrealized gains and losses to each investor on a daily basis, based on methods in compliance with the Internal Revenue Code of 1986, as amended (the "Code"). Prior to May 5, 2006, the Fund and Highland Institutional Floating Rate Income Fund (the "Institutional Fund") were the sole investors in the Portfolio. On May 5, 2006, the Institutional Fund liquidated and the Fund became the sole investor in the Portfolio. At August 31, 2006, the Fund was the sole investor in the Portfolio. FUND SHARES The Fund may issue an unlimited number of shares and continuously offers three classes of shares: Class A, Class C and Class Z. Certain share classes have their own sales charge and bear class specific expenses, which include distribution fees and service fees. On March 3, 2005, the Board of Trustees of the Fund approved the closing of the Fund's Class B shares to purchases by new and existing shareholders. The Fund discontinued selling Class B shares to new and existing investors following the close of business on May 2, 2005, although existing investors may still reinvest distributions in Class B shares. Class A shares are subject to a maximum front-end sales charge of 3.50% based on the amount of initial investment. Class A shares purchased without an initial sales charge by accounts aggregating $1 million and greater at the time of purchase are subject to a 1.00% contingent deferred sales charge ("CDSC") on shares sold within eighteen months. Class B shares are subject to a maximum CDSC of 3.25% based upon the holding period after purchase. Class B shares will convert to Class A shares eight years after purchase. Please read the Fund's prospectus for additional details on the Class B CDSC. Class C shares are subject to a 1.00% CDSC on shares sold within one year after purchase. Class Z shares are not subject to a sales charge. There are certain restrictions on the purchase of Class Z shares, as described in the Fund's prospectus. NOTE 2. SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The following is a summary of significant accounting policies consistently followed by the Portfolio and the Fund in the preparation of their financial statements. SECURITY VALUATION The value of the Fund's assets is based on its proportionate share of the current market value of the Portfolio's net assets. For securities with readily available market quotations, the Portfolio uses those quotations for pricing. Securities without a sale price or bid and ask quotations on the valuation day will be priced by an independent pricing service. When portfolio securities are traded on the relevant day of valuation, the valuation will be the last reported sale price on that day. If there are no such sales on that day, the security will be valued at the mean between the most recently quoted bid and asked prices from principal market makers. If securities do not have readily available market quotations or pricing service prices, including circumstances under which such are determined not to be accurate or current (including when events materially affect the value of securities occurring between the time when market price is determined and calculation of the Portfolio's net asset value), such securities are valued at their fair value, as determined in good faith by the Investment Adviser in accordance with procedures established by the Portfolio's Board of Trustees. In these cases, the Portfolio's net asset value will reflect the affected portfolio securities' value as determined in the judgment of the Board of Trustees or its designee instead of being determined by the market. Using a fair value pricing methodology to price securities may result in a value that is different from a security's most Annual Report | 29 NOTES TO FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND recent sale price and from the prices used by other investment companies to calculate their net asset values. There can be no assurance that the Portfolio's valuation of a security will not differ from the amount that it realizes upon the sale of such security. SECURITY TRANSACTIONS Security transactions are accounted for on the trade date. Costs and gains (losses) are determined based upon the specific identification method for both financial statement and federal income tax purposes. FOREIGN CURRENCY Foreign currencies, investments and other assets and liabilities are translated into U.S. dollars at the exchange rates using the current 4:00 p.m. London Time Spot Rate. Fluctuations in the value of the foreign currencies and other assets and liabilities resulting from changes in exchange rates, between trade and settlement dates on securities transactions and between the accrual and payment dates on dividends, interest income and foreign withholding taxes, are recorded as unrealized foreign currency gains (losses). Realized gains (losses) and unrealized appreciation (depreciation) on investment securities and income and expenses are translated on the respective dates of such transactions. The effect of changes in foreign currency exchange rates on investments in securities are not segregated in the statement of operations from the effects of changes in market prices of those securities, but are included with the net realized and unrealized gain or loss on investment securities. REPURCHASE AGREEMENTS The Portfolio may engage in repurchase agreement transactions with institutions that the Portfolio's investment adviser has determined are creditworthy. The Portfolio, through its custodian, receives delivery of underlying securities collateralizing a repurchase agreement. Collateral is at least equal, at all times, to the value of the repurchase obligation including interest. A repurchase agreement transaction involves certain risks in the event of default or insolvency of the counterparty. These risks include possible delays or restrictions upon the Portfolio's ability to dispose of the underlying securities and a possible decline in the value of the underlying securities during the period while the Portfolio seeks to assert its rights. INCOME RECOGNITION Interest income is recorded on the accrual basis and includes accretion of discounts and amortization of premiums, if any. As of April 2004, facility fees received are recorded as a reduction of cost to the loan and amortized through the maturity of the loan. Prior to April 2004, facility fees received were treated as deferred revenue and amortized over two years. Unamortized facility fees are reflected as deferred fees on the Statement of Assets and Liabilities. DETERMINATION OF CLASS NET ASSET VALUES All income, expenses (other than distribution fees and service fees, which are class-specific expenses, as shown on the Statement of Operations) and realized and unrealized gains (losses) are allocated to each class of the Fund on a daily basis for purposes of determining the net asset value of each class. Income and expenses are allocated to each class based on the settled shares method, while realized and unrealized gains (losses) are allocated based on the relative net assets of each class. FEDERAL INCOME TAX STATUS The Fund intends to qualify each year as a "Regulated Investment Company" under Subchapter M of the Code and will distribute substantially all of its taxable income and gains, if any, for its tax year, and as such will not be subject to federal income taxes. In addition, the Portfolio is treated as a partnership for federal income tax purposes and all of its income is allocated to its owners based on methods in compliance with the Internal Revenue Service. Therefore, no federal income tax provision is recorded. The Fund is the sole member of the Portfolio. For federal income tax purposes, the Portfolio is a disregarded entity. DISTRIBUTIONS TO SHAREHOLDERS Dividends from net investment income are declared by the Fund daily and paid monthly. Net realized capital gains, if any, are distributed at least annually. STATEMENT OF CASH FLOWS Information on financial transactions which have been settled through the receipt or disbursement of cash are presented in the Statement of Cash Flows. The cash and foreign currency amount shown in the Statement of Cash Flows is the amount included within the Portfolio's Statement of Assets and Liabilities and includes cash on hand at its custodian bank and sub-custodian bank, respectively, and does not include any short-term investments. 30 | Annual Report NOTES TO FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND ADDITIONAL ACCOUNTING STANDARDS On July 13, 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48 "Accounting for Uncertainty in Income Taxes" ("FIN 48"). FIN 48 provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the financial statements. FIN 48 requires the evaluation of tax positions taken in the course of preparing the Fund's tax returns to determine whether the tax positions are "more-likely-than-not" of being sustained by the applicable tax authority. Tax benefits of positions not deemed to meet the more-likely-than-not threshold would be booked as a tax expense in the current year and recognized as: a liability for unrecognized tax benefits; a reduction of an income tax refund receivable; a reduction of deferred tax asset; an increase in deferred tax liability; or a combination thereof. Adoption of FIN 48 is required for fiscal years beginning after December 15, 2006. At this time, management is evaluating the implications of FIN 48 and its impact in the financial statements has not yet been determined. NOTE 3. FEDERAL TAX INFORMATION The timing and character of income and capital gain distributions are determined in accordance with Federal income tax regulations, which may differ from GAAP. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Reclassifications are made to the Fund's capital accounts for permanent tax differences to reflect income and gains available for distribution (or available capital loss carryforwards) under income tax regulations. For the year ended August 31, 2006, permanent differences resulting from differing treatments for discount accretion/premium amortization on debt securities, bond bifurcation, unreversed wash sales and section 988 gain (loss) were identified and reclassified among the components of the Fund's net assets as follows: Overdistributed Accumulated Net Net Investment Realized Gain Paid-In Income (Loss) Capital - ------------------------------------------------------------------- $2,522,633 $(2,543,750) $21,117 - ------------------------------------------------------------------- The tax character of distributions paid during the years ended August 31, 2006 and August 31, 2005 was as follows: 2006 2005 - -------------------------------------------------------------- Distributions paid from: - -------------------------------------------------------------- Ordinary income* $93,180,034 $43,895,175 - -------------------------------------------------------------- Long-term capital gains -- -- - -------------------------------------------------------------- * For tax purposes, short-term capital gains distributions, if any, are considered ordinary income distributions. As of August 31, 2006, the most recent tax year end, the components of distributable earnings on a tax basis were as follows: Undistributed Undistributed Ordinary Long-Term Net Unrealized Income Capital Gains Appreciation* - ----------------------------------------------------------------- $2,956,459 $-- $7,443,072 - ----------------------------------------------------------------- * The differences between book-basis and tax-basis net unrealized appreciation/depreciation are primarily due to deferral of losses from wash sales, premium amortization and Section 732 adjustments. Portfolio unrealized appreciation and depreciation at August 31, 2006, based on cost of investments for federal income tax purposes, and excluding any unrealized appreciation and depreciation from changes in the value of other assets and liabilities resulting from changes in exchange rates, was: Unrealized appreciation $ 20,722,102 Unrealized depreciation (13,462,477) ------------ Net unrealized appreciation $ 7,259,625 ============ The following capital loss carryforwards may be available to reduce taxable income arising from future net realized gains on investments, if any, to the extent permitted by the Code: Year of Capital Loss Expiration Carryforward - ------------------------------------------------------------- 2011 $2,282,275 - ------------------------------------------------------------- 2012 3,291,779 - ------------------------------------------------------------- Total $5,574,054 - ------------------------------------------------------------- Annual Report | 31 NOTES TO FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND 4. ADVISORY, ADMINISTRATION, SERVICE AND DISTRIBUTION, AND TRUSTEE FEES INVESTMENT ADVISORY FEE Highland Capital Management, L.P. ("Highland" or the "Investment Adviser") is the investment adviser to the Portfolio. Highland receives a monthly investment advisory fee from the Portfolio based on the Portfolio's average daily net assets at the following annual rates: - --------------------------------------------------------------- Average Daily Net Assets Annual Fee Rate - --------------------------------------------------------------- First $1billion 0.45% - --------------------------------------------------------------- Next $1billion 0.40% - --------------------------------------------------------------- Over $2 billion 0.35% - --------------------------------------------------------------- For the year ended August 31, 2006, the Portfolio's effective investment advisory fee rate was 0.44%. At an in-person Board meeting held on May 19, 2006, the Fund's Board, including the members of the Board who are not "interested persons" (as defined in the 1940 Act) of the Fund (the "Independent Trustees"), unanimously approved both the continuation of the current advisory agreement between the Portfolio and Highland (the "Current Advisory Agreement") and a new advisory agreement between the Portfolio and Highland (the "New Advisory Agreement") to be submitted to shareholders. The New Advisory Agreement would provide for a monthly advisory fee, computed and accrued daily, based on an annual rate of 0.65% of the average daily net assets of the Portfolio for the first one billion dollars ($1,000,000,000), 0.60% of the average daily net of the Portfolio for the next one billion dollars ($1,000,000,000), and 0.55% of the average daily net assets of the Portfolio over two billion dollars ($2,000,000,000). Prior to May 5, 2006, Highland also provided portfolio management services to another feeder fund, the Institutional Fund, via the Institutional Fund's investment in the Portfolio. The Institutional Fund was liquidated as of May 5, 2006. The Fund's management believes that it would be in the best interests of the Fund's shareholders for the Fund to terminate the Portfolio by exchanging all of its shares in the Portfolio for all of the assets of the Portfolio and investing directly in securities. Once the Fund withdraws from the Portfolio, the Portfolio will be dissolved. At that time, the Fund would adopt an investment advisory agreement with Highland with the same terms and fee arrangements as the New Advisory Agreement that is between Highland and the Portfolio. If shareholders approve the New Advisory Agreement, such approval will also constitute approval of a direct advisory agreement between the Fund and Highland. ADMINISTRATION FEES Highland provides administrative services to the Portfolio and the Fund for a monthly administration fee at the annual rate of 0.20% of the Fund's average daily net assets. The Fund, but not the Portfolio, pays Highland for these services. Under separate sub-administration agreements, Highland has delegated certain administrative functions to PFPC Inc. ("PFPC"). Highland pays PFPC directly for these services. SERVICE AND DISTRIBUTION FEES PFPC Distributors, Inc. (the "Distributor") serves as the principal underwriter and distributor of the Fund's shares. The Distributor is paid a CDSC on certain redemptions of Class A, Class B and Class C Shares. For the year ended August 31, 2006, the Distributor received $23,378, $157,249 and $72,807 of CDSC on Class A, Class B and Class C share redemptions, respectively. The Fund has adopted a plan pursuant to Rule 12b-1 under the 1940 Act (the "Plan"), which requires the payment of a monthly service fee to the Distributor at the annual rate not to exceed 0.25% of the average daily net assets attributable to Class A, Class B and Class C shares of the Fund. The Plan also requires the payment of a monthly distribution fee to the Distributor on an annual basis not to exceed 0.10%, 0.45% and 0.60% of the average daily net assets attributable to Class A, Class B and Class C shares, respectively. The CDSC and the fees received from the Plan are used principally as repayment for amounts paid to dealers who sold such shares. EXPENSE LIMITS AND FEE REIMBURSEMENTS Prior to June 12, 2006, Highland had voluntarily agreed to waive fees and reimburse certain expenses to the extent that total expenses (inclusive of allocated Portfolio expenses but exclusive of distribution and service fees, brokerage commissions, interest, facility expense, taxes and extraordinary expenses, if any) exceeded 0.80% annually of the Fund's average daily net assets. This arrangement may be reinstated by Highland at any time. FEES PAID TO OFFICERS AND TRUSTEES The Fund pays no compensation to its one interested Trustee or to any of its other officers, all of whom are employees of Highland. Trustees who are not "interested persons" (as defined in the 1940 Act) of the Portfolio and the Fund each receive an annual retainer fee of $25,000 for services provided as Trustees of the Portfolio and the Fund. The Fund and the 32 | Annual Report NOTES TO FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND Institutional Fund paid $20,000 of this fee (allocated based on their relative net assets). As of May 5, 2006, when the Institutional Fund liquidated, the Fund became responsible for sole payment of that fee. The remaining $5,000 is paid by the Portfolio. NOTE 5. PORTFOLIO INFORMATION For the year ended August 31, 2006, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were $1,381,878,263 and $866,663,888, respectively. NOTE 6. PERIODIC REPURCHASE OFFERS The Fund has adopted a fundamental policy to offer each calendar quarter to repurchase a specified percentage (between 5% and 25%) of the shares then outstanding at the Fund's net asset value ("Repurchase Offers"). Repurchase Offers are scheduled to occur on or about the 15th day (or the next business day if the 15th is not a business day) in the months of March, June, September, and December. It is anticipated that normally the date on which the repurchase price of shares will be determined (the "Repurchase Pricing Date") will be the same date as the deadline for shareholders to provide their repurchase requests to the Distributor (the "Repurchase Request Deadline"), and if so, the Repurchase Request Deadline will be set for a time no later than the close of regular trading on the New York Stock Exchange on such date. The Repurchase Pricing Date will occur no later than the 14th day after the Repurchase Request Deadline, or the next business day if the 14th day is not a business day. Repurchase proceeds will be paid to shareholders no later than seven days after the Repurchase Pricing Date. For the year ended August 31, 2006, there were four Repurchase Offers. For each Repurchase Offer, the Fund offered to repurchase 10% of its shares. In the September 2005, December 2005 , March 2006 and June 2006 Repurchase Offers, 4.65%, 6.38%, 3.98% and 4.78%, respectively, of shares outstanding were repurchased. NOTE 7. SENIOR LOAN PARTICIPATION COMMITMENTS The Portfolio invests at least 80% of its net assets (plus any borrowings for investment purposes) in adjustable rate senior loans ("Senior Loans") the interest rates of which float or vary periodically based upon a benchmark indicator of prevailing interest rates to domestic foreign corporations, partnerships and other entities ("Borrowers"). If the lead lender in a typical lending syndicate becomes insolvent, enters FDIC receivership or, if not FDIC insured, enters into bankruptcy, the Portfolio may incur certain costs and delays in receiving payment or may suffer a loss of principal and/or interest. When the Portfolio purchases a participation of a Senior Loan interest, the Portfolio typically enters into a contractual agreement with the lender or other third party selling the participation, not with the borrower directly. As such, the Portfolio assumes the credit risk of the Borrower, selling participant or other persons interpositioned between the Portfolio and the Borrower. The ability of Borrowers to meet their obligations may be affected by economic developments in a specific industry. At August 31, 2006, the following sets forth the selling participants with respect to interests in Senior Loans purchased by the Portfolio on a participation basis. Principal Selling Participant Amount Value - -------------------------------------------------------------------------------- Goldman Sachs: Bridge Information Systems, Inc. Multidraw Term Loan $ 480,286 $ 36,021 - -------------------------------------------------------------------------------- CS: Quality Distributions, Inc. Term Loan 2,701,353 2,714,859 - -------------------------------------------------------------------------------- NOTE 8. LINE OF CREDIT On September 13, 2004, the Portfolio entered into a $150,000,000 credit facility, which was amended on September 12, 2005 to $200,000,000, used for temporary or emergency purposes to facilitate portfolio liquidity. Interest is charged to the Portfolio based on its borrowings. In addition, the Portfolio has agreed to pay facility expenses on the unutilized line of credit, which are included on the Statement of Operations. For the year ended August 31, 2006, the average daily loan balance outstanding on days where borrowings existed was $37,736,842 at a weighted average interest rate of 6.85%. Interest expense allocated to the Fund of $153,221 was paid for use of the line of credit and is included on the Statement of Operations. Annual Report | 33 NOTES TO FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND 9. UNFUNDED LOAN COMMITMENTS As of August 31, 2006, the Portfolio had unfunded loan commitments of $28,163,342, which could be extended at the option of the Borrower, pursuant to the following loan agreements: - ------------------------------------------------------------- Unfunded Loan Borrower Commitment - ------------------------------------------------------------- Alon USA Energy, Inc. $ 222,222 - ------------------------------------------------------------- Atrium Co., Inc. 164,118 - ------------------------------------------------------------- Centennial Cellular Operating Co. 2,250,000 - ------------------------------------------------------------- Covanta Energy Corp. 1,000,000 - ------------------------------------------------------------- Cricket Communications, Inc. 6,500,000 - ------------------------------------------------------------- DeCrane Aircraft Holdings, Inc. 1,000,000 - ------------------------------------------------------------- Federal-Mogul Corp. 102,746 - ------------------------------------------------------------- Ferro Corp. 1,111,111 - ------------------------------------------------------------- Infor Global Solutions European Finance S.A.R. L. 2,250,000 - ------------------------------------------------------------- Insurance Auto Auctions, Inc. 43,007 - ------------------------------------------------------------- Interstate Bakeries Corp. 4,117,132 - ------------------------------------------------------------- La Petite Academy, Inc. 1,122,727 - ------------------------------------------------------------- LSP General Finance Co. LLC 1,666 - ------------------------------------------------------------- Millennium Digital Media Systems, LLC 3,680,705 - ------------------------------------------------------------- Oglebay Norton Co. 200,000 - ------------------------------------------------------------- Standard Steel, LLC 166,667 - ------------------------------------------------------------- Trump Entertainment Resorts, Inc. 2,231,241 - ------------------------------------------------------------- VML US Finance LLC 2,000,000 - ------------------------------------------------------------- $ 28,163,342 ================= - ------------------------------------------------------------- The net discount in unrealized gain (loss) on the unfunded commitments is recorded as a liability on the Statement of Assets and Liabilities. The change in unrealized gain (loss) is recorded on the Statement of Operations. NOTE 10. DISCLOSURE OF SIGNIFICANT RISKS AND CONTINGENCIES INDUSTRY FOCUS The Portfolio may focus its investments in certain industries, subjecting it to greater risk than a Portfolio that is more diversified. NON-PAYMENT RISK Senior Loans, like other corporate debt obligations, are subject to the risk of non-payment of scheduled interest and/or principal. Non-payment would result in a reduction of income to the Portfolio, a reduction in the value of the Senior Loan experiencing non-payment and a potential decrease in the net asset value of the Fund. CREDIT RISK Securities rated below investment grade are commonly referred to as high-yield, high risk or "junk debt." They are regarded as predominantly speculative with respect to the issuing company's continuing ability to meet principal and/or interest payments. Investments in high-yield Senior Loans may result in greater net asset value fluctuation than if the Portfolio did not make such investments. CURRENCY RISK A portion of the Fund's assets may be quoted or denominated in non-U.S. currencies. These securities may be adversely affected by fluctuations in relative currency exchange rates and by exchange control regulations. The Fund's investment performance may be negatively affected by a devaluation of a currency in which the Fund's investments are quoted or denominated. Further, the Fund's investment performance may be significantly affected, either positively or negatively, by currency exchange rates because the U.S. dollar value of securities quoted or denominated in another currency will increase or decrease in response to changes in the value of such currency in relation to the U.S. dollar. FOREIGN SECURITIES Investments in foreign securities may involve special risks compared to investing in securities of U.S. issuers. These risks are more pronounced to the extent that the Portfolio invests a significant portion of its non-U.S. investment in one region or in the securities of emerging market issuers. These risks may include (i) less information about non-U.S. issuers or markets being available due to less rigorous disclosure, accounting standards or regulatory requirements; (ii) many non-U.S. markets are smaller, less liquid and more volatile and Highland may not be able to sell the Portfolio's securities at times, in amounts and at prices it considers reasonable; (iii) the economies of non-U.S. markets may grow at slower rates than expected or may experience a downturn or recession; and (iv) withholdings and other non-U.S. taxes may decrease the Fund's returns. NOTE 11. SUBSEQUENT EVENT At a meeting held on September 8, 2006, the Board of Trustees approved an increase of $50 million in the amount of the Fund's credit facility (resulting in a total credit facility of $250 million) and an amendment to change the maturity date of the credit agreement underlying such credit facility to September 2, 2007. 34 | Annual Report REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - -------------------------------------------------------------------------------- TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF HIGHLAND FLOATING RATE FUND: In our opinion, the accompanying statements of assets and liabilities, including the investment portfolios, and the related statements of operations and of changes in net assets and of cash flows and the financial highlights present fairly, in all material respects, the financial position of Highland Floating Rate Fund (the "Fund") and Highland Floating Rate Limited Liability Company (the "Portfolio") at August 31, 2006, and the results of each of their operations for the year then ended, the changes in each of their net assets, the Portfolio's cash flows and each of these financial highlights for the periods indicated in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's and the Portfolio's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of investments at August 31, 2006 by correspondence with the custodian and the banks with whom the Fund owns participations in loans, provide a reasonable basis for our opinion. PricewaterhouseCoopers LLP Dallas, Texas October 27, 2006 Annual Report | 35 ADDITIONAL INFORMATION (UNAUDITED) - -------------------------------------------------------------------------------- APPROVAL OF INVESTMENT ADVISORY CONTRACTS HIGHLAND FLOATING RATE FUND To assist the Board with its consideration of the continuation of the Current Advisory Agreement and the submission of the New Advisory Agreement to shareholders, the Board requested, through Fund counsel and its independent legal counsel, and received from Highland, various written materials, including: (1) information confirming the financial soundness of Highland; (2) information on the advisory and marketing personnel of Highland, including compensation arrangements; (3) information on the internal compliance procedures of Highland; (4) comparative information showing how the Fund's proposed fee schedule and anticipated operating expenses compare to (i) other registered investment companies that follow investment strategies similar to those of the Fund, and (ii) other private and registered pooled investment vehicles or accounts managed by Highland, as well as the performance of such vehicles and accounts; (5) information regarding brokerage and portfolio transactions; and (6) information on any legal proceedings or regulatory audits or investigations affecting Highland. The Independent Trustees, assisted by their independent legal counsel, met in executive session to discuss the terms of the Current Advisory Agreement and the New Advisory Agreement (together, the "Agreements"). The Independent Trustees reviewed various factors discussed in independent counsel's legal memorandum, detailed information provided by Highland and other relevant information and factors including the following: THE NATURE, EXTENT, AND QUALITY OF THE SERVICES TO BE PROVIDED BY HIGHLAND The Independent Trustees considered the portfolio management services provided by Highland and the activities related to portfolio management, including use of technology, research capabilities, and investment management staff. They discussed the experience and qualifications of the personnel who provide advisory services, including the background and experience of the members of the portfolio management team. The Independent Trustees reviewed the management structure, assets under management and investment philosophies and processes of Highland. They also reviewed and discussed Highland's compliance policies and procedures. The Independent Trustees concluded that Highland had the quality and depth of personnel and investment methods essential to performing its duties under the Agreements and that the nature of such advisory services is satisfactory. HIGHLAND'S HISTORICAL PERFORMANCE IN MANAGING THE FUND The Independent Managers/Trustees reviewed Highland's historical performance in managing the Fund as provided by Lipper. They noted that the Fund is consistently outperforming its benchmark, the Credit Suisse Leverage Loan Index, as well as both its peers that employ leverage and those who do not employ leverage. During the 12 months ended March 31, 2006, the Fund's Class Z shares earned a return of 7.61%, which represents a 22.94% incremental return or 142 basis points more than its benchmark. Additionally, In Lipper's Annualized Rate of Return categories, all of the Fund's share classes were ranked in the Top 5 for the 5-Year and Since Inception Total Return sets, and the top 6 for the 3-Year Total Return set. The Independent Trustees were satisfied with Highland's historical performance in managing the Fund. THE INVESTMENT PERFORMANCE OF OTHER ACCOUNTS OR FUNDS MANAGED BY HIGHLAND The Independent Managers/Trustees reviewed the performance of Highland for accounts or funds that are similar to the Fund compared with other investment companies of similar investment objectives and size. They reviewed the performance of Highland Floating Rate Advantage Fund ("ADV") and noted that since Highland has become ADV's investment adviser, ADV outperformed its benchmark, the Credit Suisse Leveraged Loan Index, by 231 basis points per year on an annualized basis. Furthermore, when compared to its peer group, all of ADV's share classes have been the top performing share classes of any peer, in the categories Year-to-Date Total Return, 1-year Total Return, Total Return since 4/15/04, as well as the Annualized Total Rates of Return in 3-Year, 5-Year, since 4/15/04, and Since Inception time frames. Moreover, during the past 12 months ADV's Class Z Shares earned a return of 9.37%, which represents outperformance of 51.37% or 318 basis points compared to its benchmark, which returned 6.19%. The Independent Mangers/Trustees were satisfied with Highland's overall performance records. THE COSTS OF THE SERVICES TO BE PROVIDED BY HIGHLAND AND THE PROFITS TO BE REALIZED BY HIGHLAND AND ITS AFFILIATES FROM THE RELATIONSHIP WITH THE FUND The Independent Trustees also gave substantial consideration to the fees payable under the New Advisory Agreement, including: (i) the basis points to be paid to Highland; (ii) the anticipated expenses Highland would incur in providing advisory services; and (iii) a comparison of the fees payable to Highland under the Agreements to fees paid to Highland by other trusts and to investment advisers serving other investment companies with similar investment programs to that of the Fund. After such review, the Independent Trustees determined that the anticipated profitability rates to Highland with respect to the Agreements were fair and reasonable. 36 | Annual Report ADDITIONAL INFORMATION (UNAUDITED) (CONTINUED) - -------------------------------------------------------------------------------- APPROVAL OF INVESTMENT ADVISORY CONTRACTS HIGHLAND FLOATING RATE FUND THE EXTENT TO WHICH ECONOMIES OF SCALE WOULD BE REALIZED AS THE FUND GROWS AND WHETHER FEE LEVELS REFLECT THESE ECONOMIES OF SCALE FOR THE BENEFIT OF SHAREHOLDERS The Independent Trustees considered the effective fees under the Agreements, as a percentage of assets at different asset levels, and possible economies of scale to Highland. They considered the anticipated asset levels of the Fund, the information provided by Highland relating to its estimated costs, and information comparing the fee rate to be charged by Highland with fee rates charged by other unaffiliated investment advisers to their clients. They also considered Highland's willingness to add a voluntary "other expenses" cap if shareholders approve the New Advisory Agreement. The Independent Trustees concluded that the fee structures are reasonable and appropriately would result in a sharing of economies of scale in the current environment in view of the information provided by Highland. In determining whether to approve the Agreements, the Independent Trustees concluded that, based on the materials presented to them and the conversations the Board had with representatives of Highland, the Fund's auditors, the Fund's counsel and counsel to the Independent Trustees, continuation of the Current Advisory Agreement and submission of the New Advisory Agreement to shareholders would be in the best interests of shareholders. The Independent Trustees determined that the advisory fee rates under the Agreements are fair and reasonable, in light of the excellent performance of the Fund during the period Highland has served as the investment adviser and in view of the fact that the advisory fee rates for the Fund are substantially below the average advisory/management fee rate in the Fund's Lipper peer groups. Annual Report | 37 ADDITIONAL INFORMATION (UNAUDITED) (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND TRUSTEES AND OFFICERS The Trustees and officers serve terms of indefinite duration. The names, addresses and ages of the Trustees and officers of the Fund, the year each was first elected or appointed to office, their principal business occupations during at least the last five years, the number of portfolios overseen by each Trustee and other directorships they hold are shown below. Each officer listed below serves as an officer of each Fund in the Highland Funds Complex.
YEAR FIRST PRINCIPAL NUMBER OF PORTFOLIOS ELECTED OR OCCUPATION(S) IN HIGHLAND FUNDS OTHER NAME, ADDRESS, POSITION APPOINTED DURING PAST COMPLEX OVERSEEN DIRECTORSHIPS AND AGE WITH FUND TO OFFICE FIVE YEARS BY TRUSTEE 1 HELD INDEPENDENT TRUSTEES Timothy K. Hui Trustee 2004 Assistant Provost for Graduate 8 None (Age 58) Education since July 2004; c/o Highland Capital Assistant Management, L.P. Provost for Educational 13455 Noel Road, Resources, July 2001 to June Suite 800 2004, Philadelphia Biblical Dallas, TX 75240 University Scott F. Kavanaugh Trustee 2004 Private Investor; Executive at 8 None (Age 45) Provident Funding Mortgage c/o Highland Capital Corporation, February 2003 to Management, L.P. July 2003; Executive Vice 13455 Noel Road, President, Director and Suite 800 Treasurer, Commercial Capital Dallas, TX 75240 Bank, January 2000 to February 2003; Managing Principal and Chief Operating Officer, Financial Institutional Partners Mortgage Company and the Managing Principal and President of Financial Institutional Partners, LLC, (an investment banking firm), April 1998 to February 2003. James F. Leary Trustee 2004 Managing Director, Benefit 8 Board Member of (Age 76) Capital Southwest, Inc., Capstone Asset c/o Highland Capital (a financial consulting firm) Management Management, L.P. since January 1999. Group of Mutual 13455 Noel Road, Funds. Suite 800 Dallas, TX 75240 Bryan A. Ward Trustee 2004 Senior Manager, Accenture, 8 None (Age 51) LLP since January 2002; c/o Highland Capital Special Projects Advisor, Management, L.P. Accenture, LLP with focus on 13455 Noel Road, the oil and gas industry, Suite 800 September 1998 to December Dallas, TX 75240 2001.
38 | Annual Report ADDITIONAL INFORMATION (UNAUDITED) (CONTINUED) - -------------------------------------------------------------------------------- AUGUST 31, 2006 HIGHLAND FLOATING RATE FUND TRUSTEES AND OFFICERS
YEAR FIRST PRINCIPAL NUMBER OF PORTFOLIOS ELECTED OR OCCUPATION(S) IN HIGHLAND FUNDS OTHER NAME, ADDRESS, POSITION APPOINTED DURING PAST COMPLEX OVERSEEN DIRECTORSHIPS AND AGE WITH FUND TO OFFICE FIVE YEARS BY TRUSTEE 1 HELD INTERESTED TRUSTEE 2 R. Joseph Dougherty Trustee and 2004 Portfolio Manager of 8 N/A (Age 36) Senior Vice Highland since 2000. c/o Highland Capital President Management, L.P. 13455 Noel Road, Suite 800 Dallas, TX 75240 OFFICERS (3) James D. Dondero President 2004 President and Managing N/A N/A (Age 44) Partner of Highland; President c/o Highland Capital and Director of Strand Advisors, Management, L.P. Inc., the general partner of the 13455 Noel Road, Adviser. Suite 800 Dallas, TX 75240 Mark Okada Executive Vice 2004 Chief Investment Officer of N/A N/A (Age 44) President Highland since March 1993; c/o Highland Capital Officer of Strand Advisors, Management, L.P. Inc., the general partner of the 13455 Noel Road, Adviser. Suite 800 Dallas, TX 75240 M. Jason Blackburn Secretary and 2004 Assistant Controller of N/A N/A (Age 30) Treasurer Highland since November c/o Highland Capital 2001; Accountant, KPMG LLP, Management, L.P. September 1999 to October 13455 Noel Road, 2001. Suite 800 Dallas, TX 75240 Michael S. Minces Chief Compliance 2004 Associate, Akin Gump N/A N/A (Age 32) Officer Strauss Hauer & Feld LLP c/o Highland Capital (law firm), October 2003 to Management, L.P. August 2004; Associate, 13455 Noel Road, Skadden, Arps, Slate, Suite 800 Meagher & Flom LLP (law Dallas, TX 75240 firm), October 2000 to March 2003. Previously, he attended The University of Texas at Austin School of Law. 1 The Highland Fund Complex consists of the following Funds: Highland Floating Rate Limited Liability Company, Highland Floating Rate Fund, Highland Floating Rate Advantage Fund, Highland Corporate Opportunities Fund, Restoration Opportunities Fund, Highland Credit Strategies Fund, Prospect Street(R) High Income Portfolio Inc., Prospect Street(R) Income Shares Inc. and Highland Equity Opportunities Fund. 2 Mr. Dougherty is deemed to be an "interested person" of the Fund under the 1940 Act because of his position with Highland. 3 Each officer also serves in the same capacity for each Fund in the Highland Fund Complex.
Annual Report | 39 IMPORTANT INFORMATION ABOUT THIS REPORT - -------------------------------------------------------------------------------- TRANSFER AGENT PFPC Inc. 101 Sabin Street Pawtucket, RI 02860 Distributor PFPC Distributors, Inc. 760 Moore Road King of Prussia, PA 19406 Investment Adviser Highland Capital Management, L.P. 13455 Noel Road, Suite 800 Dallas, TX 75240 INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM PricewaterhouseCoopers LLP 125 High Street Boston, MA 02110 The Fund mails one shareholder report to each shareholder address. If you would like more than one report, please call shareholder services at 1-877-665-1287 and additional reports will be sent to you. This report has been prepared for shareholders of Highland Floating Rate Fund. A description of the policies and procedures that the Fund uses to determine how to vote proxies relating to its portfolio securities, and the Fund's proxy voting record for the most recent 12-month period ended June 30, are available (i) without charge, upon request, by calling 1-877-665-1287 and (ii) on the Securities and Exchange Commission's website at http://www.sec.gov. The Fund files its complete schedule of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year on Form N-Q. The Fund's Forms N-Q are available on the Commission's website at http://www.sec.gov and also may be reviewed and copied at the Commission's Public Reference Room in Washington, DC. Information on the Public Reference Room may be obtained by calling 1-800-SEC-0330. The Statement of Additional Information includes information about Fund Trustees and is available upon request without charge by calling 1-877-665-1287. 40 | Annual Report THIS PAGE LEFT BLANK INTENTIONALLY. FLOATING RATE BACK ITEM 2. CODE OF ETHICS. (a) The registrant, as of the end of the period covered by this report, has adopted a code of ethics that applies to the registrant's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. (b) Not applicable. (c) There have been no amendments, during the period covered by this report, to a provision of the code of ethics that applies to the registrant's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. (d) The registrant has not granted any waiver, including any implicit waiver, from a provision of the code of ethics that applies to the registrant's principal executive officer, principal financial officer, principal accounting officer or controller. (e) Not applicable. (f) The registrant's code of ethics is incorporated by reference to Exhibit (a)(1) to the registrant's Form N-CSR filed with the Securities and Exchange Commission on November 9, 2004 (Accession No. 0001047469-04-033535). ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT. The Registrant's Board of Trustees (the "Board") has determined that James Leary, a member of the Audit Committee of the Board, is an audit committee financial expert as defined by the Securities and Exchange Commission (the "SEC"). Mr. Leary is "independent" as defined by the SEC for purposes of audit committee financial expert determinations. ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES. AUDIT FEES (a) The aggregate fees billed for each of the last two fiscal years for professional services rendered by the principal accountant for the audit of the registrant's annual financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those fiscal years are $12,000 for 2006 and $11,850 for 2005. AUDIT-RELATED FEES (b) The aggregate fees billed in each of the last two fiscal years for assurance and related services by the principal accountant that are reasonably related to the performance of the audit of the registrant's financial statements and are not reported under paragraph (a) of this Item are $4,500 for 2006 and $5,000 for 2005. The nature of the services related to agreed-upon procedures, performed on the Fund's semi-annual financial statements. TAX FEES (c) The aggregate fees billed in each of the last two fiscal years for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning are $3,700 for 2006 and $3,700 for 2005. The nature of the services related to assistance on the Fund's tax returns and excise tax calculations. ALL OTHER FEES (d) The aggregate fees billed in each of the last two fiscal years for products and services provided by the principal accountant, other than the services reported in paragraphs (a) through (c) of this Item are $0 for 2006 and $0 for 2005. (e)(1) Disclose the audit committee's pre-approval policies and procedures described in paragraph (c)(7) of Rule 2-01 of Regulation S-X. The Audit Committee shall: (a) have direct responsibility for the appointment, compensation, retention and oversight of the Fund's independent auditors and, in connection therewith, to review and evaluate matters potentially affecting the independence and capabilities of the auditors; and (b) review and pre-approve (including associated fees) all audit and other services to be provided by the independent auditors to the Fund and all non-audit services to be provided by the independent auditors to the Fund's investment adviser or any entity controlling, controlled by or under common control with the investment adviser (an "Adviser Affiliate") that provides ongoing services to the Fund, if the engagement relates directly to the operations and financial reporting of the Fund; and (c) establish, to the extent permitted by law and deemed appropriate by the Audit Committee, detailed pre-approval policies and procedures for such services; and (d) consider whether the independent auditors' provision of any non-audit services to the Fund, the Fund's investment adviser or an Adviser Affiliate not pre-approved by the Audit Committee are compatible with maintaining the independence of the independent auditors. (e)(2) The percentage of services described in each of paragraphs (b) through (d) of this Item that were approved by the audit committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X are as follows: (b) 100% (c) 100% (d) N/A (f) The percentage of hours expended on the principal accountant's engagement to audit the registrant's financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountant's full-time, permanent employees was less than fifty percent. (g) The aggregate non-audit fees billed by the registrant's accountant for services rendered to the registrant, and rendered to the registrant's investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the adviser that provides ongoing services to the registrant for each of the last two fiscal years of the registrant was $81,000 for 2006 and $85,252 for 2005. (h) The registrant's audit committee of the board of directors has considered whether the provision of non-audit services that were rendered to the registrant's investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the investment adviser that provides ongoing services to the registrant that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-X is compatible with maintaining the principal accountant's independence. ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS. Not applicable. ITEM 6. SCHEDULE OF INVESTMENTS. Schedule of Investments in securities of unaffiliated issuers as of the close of the reporting period is included as part of the report to shareholders filed under Item 1 of this form. ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END MANAGEMENT INVESTMENT COMPANIES. The Adviser has adopted proxy voting guidelines (the "Guidelines") that provide as follows: o The Adviser votes proxies in respect of a client's securities in the client's best economic interests and without regard to the interests of the Adviser or any other client of the Adviser. o Unless the Adviser's Proxy Voting Committee (the "Committee") otherwise determines (and documents the basis for its decision) or as otherwise provided below, the Adviser votes proxies in a manner consistent with the Guidelines. o To avoid material conflicts of interest, the Adviser applies the Guidelines in an objective and consistent manner across client accounts. Where a material conflict of interest has been identified and the matter is covered by the Guidelines, the Committee votes in accordance with the Guidelines. For clients that are registered investment companies, where a conflict of interest has been identified and the matter is not covered in the Guidelines, the Adviser will disclose the conflict and the Committee's determination of the manner in which to vote to the Fund's Board. For clients that are not investment companies, where a conflict of interest has been identified and the matter is not covered in the Guidelines, the Committee will disclose the conflict to the client and advise the client that its securities will be voted only upon the client's written direction. o The Adviser also may determine not to vote proxies in respect of securities of any issuer if it determines it would be in its clients' overall best interests not to vote. The Adviser's Guidelines address how it will vote proxies on particular types of matters such as changes in corporate government structures, adoption of options plans and anti-takeover proposals. For example, the Adviser generally will: o support management in most elections for directors, unless the board gives evidence of acting contrary to the best economic interests of shareholders; o support option plans, if it believes that they provide for their administration by disinterested parties and provide incentive to directors, managers and other employees by aligning their economic interests with those of the shareholders while limiting the transfer of wealth out of the company; and o oppose anti-takeover proposals unless they are structured in such a way that they give shareholders the ultimate decision on any proposal or offer. ITEM 8. PORTFOLIO MANAGERS OF CLOSED-END MANAGEMENT INVESTMENT COMPANIES. The Fund's portfolio is managed by a portfolio management team. The members of the team who are primarily responsible for the day-to-day management of the Fund's portfolio are R. Joseph Dougherty and Mark Okada. Mr. Dougherty is a Portfolio Manager at Highland and heads Highland's retail funds effort. In this capacity, Mr. Dougherty oversees investment decisions for the retail funds, alongside several other portfolio managers, and manages the team dedicated to their day-to-day administration. He also serves as a Director, Chairman and Senior Vice President of Prospect Street(R) High Income Portfolio Inc. ("PHY") and Prospect Street(R) Income Shares Inc. ("CNN"). Prior to his current duties, Mr. Dougherty served as Portfolio Analyst for Highland from 1998 to 1999. As a Portfolio Analyst, Mr. Dougherty also helped follow companies within the chemical, retail, supermarket and restaurant sectors. Prior to joining Highland, Mr. Dougherty served as an Investment Analyst with Sandera Capital Management from 1997 to 1998. Formerly, he was a Business Development Manager at Akzo Nobel from 1994 to 1996 and a Senior Accountant at Deloitte and Touche, LLP from 1992 to 1994. He received a BS in Accounting from Villanova University and an MBA from Southern Methodist University. Mr. Dougherty is a Chartered Financial Analyst and a Certified Public Accountant. Mr. Okada has been Executive Vice President of Highland since March 1993 and is Executive Vice President of PHY and CNN. From July 1990 to March 1993, Mr. Okada was Manager-Fixed Income for Protective Asset Management Company, where his responsibilities included management and administration of approximately $1.3 billion in bank loan purchases, credit evaluation of fixed-income assets and quantitative analysis for special projects. Prior to July 1990, Mr. Okada was employed by Hibernia National Bank, where he most recently served as Vice President and Section Head of the Capital Markets Group and was responsible for a portfolio of $1 billion in highly leveraged transactions. Prior thereto, he was a management trainee for Mitsui Manufacturers Bank. Mr. Okada graduated with honors from UCLA with a B.S. in Economics and a B.S. in Psychology in 1984. Mr. Okada is a Chartered Financial Analyst, and is a member of the Dallas Society of Security Analysts. The following tables provide information about funds and accounts, other than the Fund, for which the Fund's portfolio managers are primarily responsible for the day-to-day portfolio management as of August 31, 2006.
R. JOSEPH DOUGHERTY - --------------------------------------------------------------------------------------------------------------------- Total Assets with Total # of Accounts Managed Performance-Based # of Accounts Total Assets with Performance-Based Advisory Fee TYPE OF ACCOUNTS MANAGED (MILLIONS) ADVISORY FEE (MILLIONS) ---------------- ------- ---------- ------------ ---------- - --------------------------------------------------------------------------------------------------------------------- Registered Investment 7 $3,800 - - Companies: - --------------------------------------------------------------------------------------------------------------------- Other Pooled Investment 1 $276 - - Vehicles: - --------------------------------------------------------------------------------------------------------------------- Other Accounts: - - - - - ---------------------------------------------------------------------------------------------------------------------
MARK OKADA - --------------------------------------------------------------------------------------------------------------------- Total Assets with Total # of Accounts Managed Performance-Based # of Accounts Total Assets with Performance-Based Advisory Fee TYPE OF ACCOUNTS MANAGED (MILLIONS) ADVISORY FEE (MILLIONS) ---------------- ------- ---------- ------------ ---------- - --------------------------------------------------------------------------------------------------------------------- Registered Investment 8 $4,710 - - Companies: - --------------------------------------------------------------------------------------------------------------------- Other Pooled Investment 37 $18,538 31 $16,578 Vehicles: - --------------------------------------------------------------------------------------------------------------------- Other Accounts: - - - - - ---------------------------------------------------------------------------------------------------------------------
CONFLICTS OF INTERESTS. The Adviser has built a professional working environment, a firm-wide compliance culture and compliance procedures and systems designed to protect against potential incentives that may favor one account over another. Highland has adopted policies and procedures that address the allocation of investment opportunities, execution of portfolio transactions, personal trading by employees and other potential conflicts of interest that are designed to ensure that all client accounts are treated equitably over time. Nevertheless, the Adviser furnishes advisory services to numerous clients in addition to the Fund, and the Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts (including accounts that are hedge funds or have performance or higher fees paid to the Adviser or in which portfolio managers have a personal interest in the receipt of such fees) that may be the same as or different from those made to the Fund. In addition, the Adviser, its affiliates and any of their partners, directors, officers, stockholders or employees may or may not have an interest in the securities whose purchase and sale the Adviser recommends to the Fund. Actions with respect to securities of the same kind may be the same as or different from the action that the Adviser, or any of its affiliates, or any of their partners, directors, officers, stockholders or employees or any member of their families may take with respect to the same securities. Moreover, the Adviser may refrain from rendering any advice or services concerning securities of companies of which any of the Adviser's (or its affiliates') partners, directors, officers or employees are directors or officers, or companies as to which the Adviser or any of its affiliates or the partners, directors, officers and employees of any of them has any substantial economic interest or possesses material non-public information. In addition to its various policies and procedures designed to address these issues, the Adviser includes disclosure regarding these matters to its clients in both its Form ADV and investment advisory agreements. The Adviser, its affiliates or their partners, directors, officers and employees similarly serve or may similarly serve other entities that operate in the same or related lines of business. Accordingly, these individuals may have obligations to investors in those entities or funds or to other clients, the fulfillment of which might not be in the best interests of the Fund. As a result, the Adviser will face conflicts in the allocation of investment opportunities to the Fund and other funds and clients. In order to enable such affiliates to fulfill their fiduciary duties to each of the clients for which they have responsibility, the Adviser will endeavor to allocate investment opportunities in a fair and equitable manner which may, subject to applicable regulatory constraints, involve pro rata co-investment by the Fund and such other clients or may involve a rotation of opportunities among the Fund and such other clients. While the Adviser does not believe there will be frequent conflicts of interest, if any, the Adviser and its affiliates have both subjective and objective procedures and policies in place designed to manage the potential conflicts of interest between the Adviser's fiduciary obligations to the Fund and their similar fiduciary obligations to other clients so that, for example, investment opportunities are allocated in a fair and equitable manner among the Fund and such other clients. An investment opportunity that is suitable for multiple clients of the Adviser and its affiliates may not be capable of being shared among some or all of such clients due to the limited scale of the opportunity or other factors, including regulatory restrictions imposed by the 1940 Act. There can be no assurance that the Adviser's or its affiliates' efforts to allocate any particular investment opportunity fairly among all clients for whom such opportunity is appropriate will result in an allocation of all or part of such opportunity to the Fund. Not all conflicts of interest can be expected to be resolved in favor of the Fund. The Adviser expects to apply to the SEC for exemptive relief to enable the Fund and registered investment companies advised by the Adviser to co-invest with other accounts and funds managed by the Adviser and its affiliates in certain privately-placed securities and other situations. There are no assurances that the Adviser will receive the requested relief. If such relief is not obtained and until it is obtained, the Adviser may be required to allocate some investments solely to any of the Fund, a registered fund, or another account or fund advised by the Adviser or its affiliates. This restriction could preclude the Fund from investing in certain securities it would otherwise be interested in and could adversely affect the speed at which the Fund is able to invest its assets and, consequently, the performance of the Fund. DESCRIPTION OF COMPENSATION. Highland's financial arrangements with its portfolio managers, its competitive compensation and its career path emphasis at all levels reflect the value senior management places on key resources. Compensation may include a variety of components and may vary from year to year based on a number of factors including the relative performance of a portfolio managers underlying account, the combined performance of the portfolio managers underlying accounts, and the relative performance of the portfolio managers underlying accounts measured against other employees. The principal components of compensation include a base salary, a discretionary bonus, various retirement benefits and one or more of the incentive compensation programs established by Highland such as the Option It Plan and the Long-Term Incentive Plan. Base compensation. Generally, portfolio managers receive base compensation based on their seniority and/or their position with the firm, which may include the amount of assets supervised and other management roles within the firm. Discretionary compensation. In addition to base compensation, portfolio managers may receive discretionary compensation, which can be a substantial portion of total compensation. Discretionary compensation can include a discretionary cash bonus as well as one or more of the following: Option It Plan. The purpose of the Plan is to attract and retain the highest quality employees for positions of substantial responsibility, and to provide additional incentives to a select group of management or highly compensated employees of the Fund so as to promote the success of the Fund. Long Term Incentive Plan. The purpose of the Plan is to create positive morale and teamwork, to attract and retain key talent, and to encourage the achievement of common goals. The Plan seeks to reward participating employees based on the increased value of Highland through the use of Long-term Incentive Units. Senior portfolio managers who perform additional management functions may receive additional compensation in these other capacities. Compensation is structured such that key professionals benefit from remaining with the firm. OWNERSHIP OF SECURITIES. The following table sets forth the dollar range of equity securities beneficially owned by each portfolio manager in the Fund as of August 31, 2006. - -------------------------------------------------------------------------------- NAME OF PORTFOLIO MANAGER DOLLAR RANGES OF EQUITY SECURITIES BENEFICIALLY OWNED BY PORTFOLIO MANAGER - -------------------------------------------------------------------------------- R. Joseph Dougherty $10,001 - $50,000 - -------------------------------------------------------------------------------- Mark Okada $10,001 - $50,000 - -------------------------------------------------------------------------------- ITEM 9. PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT INVESTMENT COMPANY AND AFFILIATED PURCHASERS. Not applicable. ITEM 10. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There have been no material changes to the procedures by which the shareholders may recommend nominees to the registrant's board of directors, where those changes were implemented after the registrant last provided disclosure in response to the requirements of Item 7(d)(2)(ii)(G) of Schedule 14A (17 CFR 240.14a-101), or this Item. ITEM 11. CONTROLS AND PROCEDURES. (a) The registrant's principal executive and principal financial officers, or persons performing similar functions, have concluded that the registrant's disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940, as amended (the "1940 Act") (17 CFR 270.30a-3(c))) are effective, as of a date within 90 days of the filing date of the report that includes the disclosure required by this paragraph, based on their evaluation of these controls and procedures required by Rule 30a-3(b) under the 1940 Act (17 CFR 270.30a-3(b)) and Rules 13a-15(b) or 15d-15(b) under the Securities Exchange Act of 1934, as amended (17 CFR 240.13a-15(b) or 240.15d-15(b)). (b) There were no changes in the registrant's internal control over financial reporting (as defined in Rule 30a-3(d) under the 1940 Act (17 CFR 270.30a-3(d)) that occurred during the registrant's second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. ITEM 12. EXHIBITS. (a)(1) Not applicable. (a)(2) Certifications pursuant to Rule 30a-2(a) under the 1940 Act and Section 302 of the Sarbanes-Oxley Act of 2002 are attached hereto. (a)(3) Not applicable. (b) Certifications pursuant to Rule 30a-2(b) under the 1940 Act and Section 906 of the Sarbanes-Oxley Act of 2002 are attached hereto. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. (registrant) HIGHLAND FLOATING RATE FUND By (Signature and Title)* /S/ JAMES D. DONDERO ------------------------------------------------------- James D. Dondero, Chief Executive Officer (principal executive officer) Date NOVEMBER 6, 2006 ---------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By (Signature and Title)* /S/ JAMES D. DONDERO ------------------------------------------------------- James D. Dondero, Chief Executive Officer (principal executive officer) Date NOVEMBER 6, 2006 ---------------------------------------------------------------------------- By (Signature and Title)* /S/ M. JASON BLACKBURN ------------------------------------------------------- M. Jason Blackburn, Chief Financial Officer (principal financial officer) Date NOVEMBER 6, 2006 ---------------------------------------------------------------------------- * Print the name and title of each signing officer under his or her signature. EX-99.CERT 2 certs302.txt 302 CERTS CERTIFICATION PURSUANT TO RULE 30A-2(A) UNDER THE 1940 ACT AND SECTION 302 OF THE SARBANES-OXLEY ACT I, James D. Dondero, certify that: 1. I have reviewed this report on Form N-CSR of Highland Floating Rate Fund; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: NOVEMBER 6, 2006 /S/ JAMES D. DONDERO ------------------------ ----------------------------------------- James D. Dondero, Chief Executive Officer (principal executive officer) CERTIFICATION PURSUANT TO RULE 30A-2(A) UNDER THE 1940 ACT AND SECTION 302 OF THE SARBANES-OXLEY ACT I, M. Jason Blackburn, certify that: 1. I have reviewed this report on Form N-CSR of Highland Floating Rate Fund; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: NOVEMBER 6, 2006 /S/ M. JASON BLACKBURN -------------------- ------------------------------------------- M. Jason Blackburn, Chief Financial Officer (principal financial officer) EX-99.906CERT 3 cert906.txt 906 CERT CERTIFICATION PURSUANT TO RULE 30A-2(B) UNDER THE 1940 ACT AND SECTION 906 OF THE SARBANES-OXLEY ACT I, James D. Dondero, Chief Executive Officer of Highland Floating Rate Fund (the "Registrant"), certify that: 1. The Form N-CSR of the Registrant (the "Report") fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Date: NOVEMBER 6, 2006 /S/ JAMES D. DONDERO ------------------------ ----------------------------------------- James D. Dondero, Chief Executive Officer (principal executive officer) I, M. Jason Blackburn, Chief Financial Officer of Highland Floating Rate Fund (the "Registrant"), certify that: 1. The Form N-CSR of the Registrant (the "Report") fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. Date: NOVEMBER 6, 2006 /S/ M. JASON BLACKBURN ------------------------ ------------------------------------------- M. Jason Blackburn, Chief Financial Officer (principal financial officer) -----END PRIVACY-ENHANCED MESSAGE-----