-----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, ScZEmcDnVF7wjKdyWATNzTeLa3AhTWlJFu13zAPtqr0Sv+CWX0ufKaUPJxThbDg2 TB5R0fT6UVZcWAJ+YgD6XA== 0000950133-00-001454.txt : 20000411 0000950133-00-001454.hdr.sgml : 20000411 ACCESSION NUMBER: 0000950133-00-001454 CONFORMED SUBMISSION TYPE: 497 PUBLIC DOCUMENT COUNT: 1 FILED AS OF DATE: 20000410 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALLIED CAPITAL CORP CENTRAL INDEX KEY: 0000003906 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 521081052 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 497 SEC ACT: SEC FILE NUMBER: 333-33478 FILM NUMBER: 597132 BUSINESS ADDRESS: STREET 1: 1919 PENNSYLVANIA AVENUE NW CITY: WASHINGTON STATE: DC ZIP: 20006 BUSINESS PHONE: 2023311112 MAIL ADDRESS: STREET 1: 1919 PENNSYLVANIA AVENUE NW STREET 2: 1666 K STREET NW CITY: WASHINGTON STATE: DC ZIP: 20006 FORMER COMPANY: FORMER CONFORMED NAME: ALLIED CAPITAL LENDING CORP DATE OF NAME CHANGE: 19931116 FORMER COMPANY: FORMER CONFORMED NAME: ALLIED LENDING CORP DATE OF NAME CHANGE: 19920703 497 1 FILED PURSUANT TO RULE 497 1 Filed Pursuant to Rule 497 Registration Statement No. 333-33478 Allied Capital Logo PROSPECTUS 12,000,000 SHARES ALLIED CAPITAL CORPORATION COMMON STOCK ------------------------ Please read this prospectus, and the accompanying prospectus supplement, if any, before investing, and keep it for future reference. It contains important information about the Company. To learn more about the Company, you may want to look at the Statement of Additional Information dated April 7, 2000 (known as the "SAI"). For a free copy of the SAI, contact us at: Allied Capital Corporation 1919 Pennsylvania Avenue, N.W. Washington, DC 20006 1-888-818-5298 The Company has filed the SAI with the U.S. Securities and Exchange Commission and has incorporated it by reference into this prospectus. The SAI's table of contents appears on page 63 of this prospectus. The Commission maintains an Internet website (http://www.sec.gov) that contains the SAI, material incorporated by reference and other information about the Company. We may offer, from time to time, up to 12,000,000 shares of common stock, par value $0.0001 per share, on terms to be determined at the time of offering. The shares may be offered at prices and on terms to be described in one or more supplements to this prospectus, provided, however, that the offering price per share, less any underwriting commissions or discounts, must equal or exceed the net asset value per share of our common stock. We are an internally managed closed-end management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, as amended. Our investment objective is to achieve current income and capital gains. We seek to achieve our investment objective by investing primarily in private businesses in a variety of industries throughout the United States. No assurances can be given that we will continue to achieve our objective. Our common stock is traded on the Nasdaq National Market under the symbol "ALLC." As of April 7, 2000, the last reported sales price for the common stock was $17.563. YOU SHOULD REVIEW THE INFORMATION INCLUDING THE RISK OF LEVERAGE, SET FORTH UNDER "RISK FACTORS" ON PAGE 7 OF THIS PROSPECTUS BEFORE INVESTING IN COMMON STOCK OF THE COMPANY. ------------------------ NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATIONS TO THE CONTRARY IS A CRIMINAL OFFENSE. ------------------------ April 7, 2000 2 WE HAVE NOT AUTHORIZED ANY DEALER, SALESMAN OR OTHER PERSON TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION OTHER THAN THOSE CONTAINED OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS OR ANY ACCOMPANYING SUPPLEMENT TO THIS PROSPECTUS. YOU MUST NOT RELY UPON ANY INFORMATION OR REPRESENTATION NOT CONTAINED OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS OR THE ACCOMPANYING PROSPECTUS SUPPLEMENT AS IF WE HAD AUTHORIZED IT. THIS PROSPECTUS AND ANY PROSPECTUS SUPPLEMENT DO NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF ANY OFFER TO BUY ANY SECURITY OTHER THAN THE REGISTERED SECURITIES TO WHICH THEY RELATE, NOR DO THEY CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY ANY SECURITIES IN ANY JURISDICTION TO ANY PERSON TO WHOM IT IS UNLAWFUL TO MAKE SUCH AN OFFER OR SOLICITATION IN SUCH JURISDICTION. THE INFORMATION CONTAINED IN THIS PROSPECTUS AND ANY PROSPECTUS SUPPLEMENT IS ACCURATE AS OF THE DATES ON THEIR COVERS. ------------------------ TABLE OF CONTENTS
PAGE ---- Prospectus Summary.......................................... 1 Selected Consolidated Financial Data........................ 4 Risk Factors................................................ 7 The Company................................................. 11 Use of Proceeds............................................. 11 Price Range of Common Stock and Dividends................... 12 Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 13 Senior Securities........................................... 25 Business.................................................... 29 Portfolio Companies......................................... 40 Determination of Net Asset Value............................ 45 Management.................................................. 45 Taxation.................................................... 51 Certain Government Regulations.............................. 53 Dividend Reinvestment Plan.................................. 56 Description of Capital Stock................................ 57 Plan of Distribution........................................ 60 Legal Matters............................................... 62 Safekeeping, Transfer and Dividend Paying Agent and Registrar................................................. 62 Independent Public Accountants.............................. 62 Table of Contents of Statement of Additional Information.... 63 Index to Financial Statements............................... 64
------------------------ (i) 3 PROSPECTUS SUMMARY The following summary contains basic information about this offering. It likely does not contain all the information that is important to an investor. For a more complete understanding of this offering, we encourage you to read this entire document and the documents to which we have referred. Our current business and investment portfolio resulted from the merger of five affiliated companies on December 31, 1997. The companies that merged were Allied Capital Corporation (old), Allied Capital Corporation II, Allied Capital Advisers, Inc. ("Advisers"), Allied Capital Commercial Corporation and Allied Capital Lending Corporation. The five companies are referred to as the predecessor companies. All information in this prospectus, unless otherwise indicated, has been presented as if the predecessor companies had merged as of the beginning of the earliest period presented. In this prospectus or any accompanying prospectus supplement, unless otherwise indicated, the "Company", "ACC", "we", "us" or "our" refer to the post-merger Allied Capital Corporation and its subsidiaries. THE COMPANY (Page 11) We are a lender to and investor in private companies in a variety of different industries throughout the United States. We have been investing in growing businesses for over 40 years and have financed thousands of private companies nationwide. Our lending and investment activity is focused in three areas: - private finance, - commercial real estate finance, including the purchase of commercial mortgage-backed securities ("CMBS"), and - Allied Capital Express, our small business finance group. Our investment portfolio includes: - long-term unsecured loans with equity features, - commercial mortgage-backed securities, - commercial mortgage loans, and - small senior loans, including SBA 7(a) guaranteed loans. We are a value-added full-service lender, and we source loans and investments through our numerous relationships with: - regional and boutique investment banks, - mezzanine and private equity investors, and - other intermediaries, including professional services firms. In order to increase our sourcing and origination activities, we have regional offices nationwide. We centralize our credit approval function and service our loans through an experienced staff of professionals at our headquarters in Washington, DC. Our common stock is quoted on the Nasdaq National Market under the symbol "ALLC." We have an advantageous structure that allows for the "pass-through" of income to our shareholders without the imposition of a corporate level of taxation. See "Taxation." We are an internally managed diversified closed-end management investment company that has elected to be regulated as a business development company ("BDC") under the Investment Company Act of 1940, as amended ("1940 Act"). Our investment objective is to achieve current income and capital gains. We seek to achieve our investment objective by investing in growing businesses in a variety of industries throughout the United States. THE OFFERING (Page 60) We may offer, from time to time, up to 12,000,000 shares of common stock, par value $0.0001 per share, on terms to be determined at the time of offering. Shares 1 4 may be offered at prices and on terms described in one or more supplements to this prospectus, provided, however, that the offering price per share, less any underwriting commissions or discounts, must equal or exceed the net asset value per share of our common stock. We may offer shares directly to one or more purchasers, through agents we designate, or to or through underwriters or dealers. If any agents or underwriters are involved in the sale of shares, their names, and any applicable purchase price, fee, commission or discount, will be described in an accompanying prospectus supplement. We will not sell shares without delivering a prospectus supplement describing the method and terms of the offering of such shares. USE OF PROCEEDS (Page 11) Unless otherwise specified in the prospectus supplement accompanying this prospectus, we intend to use the net proceeds from selling shares for general corporate purposes, which may include investments in private growing companies in accordance with our investment objective, purchase of CMBS, repayment of indebtedness, acquisitions and other general corporate purposes. DIVIDENDS (Page 12) We pay quarterly dividends to shareholders. The amount of our quarterly dividends is determined by the board of directors. DIVIDEND REINVESTMENT PLAN (Page 56) We have adopted an "opt out" dividend reinvestment plan ("DRIP plan"). Under the DRIP plan, if your shares are registered in your name, your dividends will be automatically reinvested in additional shares of common stock unless you "opt out" of the DRIP plan. PRINCIPAL RISK FACTORS (Page 7) Investment in shares of common stock involves certain risks relating to our structure and our investment objective that you should consider before purchasing shares. As a BDC, our consolidated portfolio includes securities primarily issued by privately held companies. These investments may involve a high degree of business and financial risk, and they are generally illiquid. A large number of entities and individuals compete for the same kind of investment opportunities as we do. We borrow funds to make investments in private businesses. As a result, we are exposed to the risks of leverage, which may be considered a speculative investment technique. Borrowings, also known as leverage, magnify the potential for gain and loss on amounts invested and, therefore increase the risks associated with investing in our securities. Also, we are subject to certain risks associated with investing in non-investment grade CMBS, valuing our portfolio, changing interest rates, accessing additional capital, fluctuating quarterly results, and operating in a regulated environment. In addition, the loss of pass-through tax treatment could have a material adverse effect on our total return, if any. CERTAIN ANTI-TAKEOVER PROVISIONS (Page 57) Our charter and bylaws, as well as certain statutory and regulatory requirements, contain certain provisions that may have the effect of discouraging a third party from making an acquisition proposal for the Company. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of common stock the opportunity to realize a premium over the market price for the common stock. 2 5 FEES AND EXPENSES This table describes the various costs and expenses that an investor in the Company will bear directly or indirectly. SHAREHOLDER TRANSACTION EXPENSES Sales load (as a percentage of offering price)(1)....... --% Dividend reinvestment plan fees(2)...................... None ANNUAL EXPENSES (AS A PERCENTAGE OF CONSOLIDATED NET ASSETS ATTRIBUTABLE TO COMMON SHARES)(3) Operating expenses(4)................................... 4.3% Interest payments on borrowed funds(5).................. 5.2% ----- Total annual expenses(6)........................... 9.5% =====
- ------------------------- (1) In the event that shares to which this prospectus relates are sold to or through underwriters, a corresponding prospectus supplement will disclose the applicable sales load. (2) The expenses of the Company's DRIP plan are included in "Operating expenses." The Company has no cash purchase plan. The participants in the DRIP plan will bear a pro rata share of brokerage commissions incurred with respect to open market purchases, if any. See "Dividend Reinvestment Plan." (3) "Consolidated net assets attributable to common shares" equals net assets (i.e., total assets less total liabilities and preferred stock) at December 31, 1999. (4) "Operating expenses" represent all operating expenses of the Company for the year ended December 31, 1999 excluding interest on indebtedness. Operating expenses exclude the formula and cut-off awards. See "Management -- Compensation Plans." (5) The "Interest payments on borrowed funds" percentage is based on interest payments for the year ended December 31, 1999 divided by consolidated net assets attributable to common shares. The Company had outstanding borrowings of $592.9 million at December 31, 1999. See "Risk Factors." (6) "Total annual expenses" as a percentage of consolidated net assets attributable to common shares are higher than the total annual expenses percentage would be for a company that is not leveraged. The Company borrows money to leverage its net assets and increase its total assets. The Securities and Exchange Commission requires that "Total annual expenses" percentage be calculated as a percentage of net assets, rather than the total assets, including assets that have been funded with borrowed monies. If the "Total annual expenses" percentage were calculated instead as a percentage of consolidated total assets, "Total annual expenses" for the Company would be 4.9% of consolidated total assets. EXAMPLE The following example, required by the Securities and Exchange Commission (the "Commission"), demonstrates the projected dollar amount of total cumulative expenses that would be incurred over various periods with respect to a hypothetical investment in the Company. In calculating the following expense amounts, we assumed we would have no additional leverage and that our operating expenses would remain at the levels set forth in the table above. In the event that shares to which this prospectus relates are sold to or through underwriters, a corresponding prospectus supplement will restate this example to reflect the applicable sales load.
1 YEAR 3 YEARS 5 YEARS 10 YEARS ------ ------- ------- -------- You would pay the following expenses on a $1,000 investment, assuming a 5.0% annual return........ $95 $286 $477 $956
Although the example assumes (as required by the Commission) a 5.0% annual return, our performance will vary and may result in a return of greater or less than 5.0%. In addition, while the example assumes reinvestment of all dividends and distributions at net asset value, participants in the DRIP plan may receive shares that we issue at or above net asset value or are purchased by the administrator of the DRIP plan, at the market price in effect at the time, which may be higher than, at, or below net asset value. See "Dividend Reinvestment Plan." THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE EXPENSES, AND THE ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. 3 6 SELECTED CONSOLIDATED FINANCIAL DATA You should read the consolidated financial information below with the Consolidated Financial Statements and Notes thereto included in this prospectus. Financial information for the years ended December 31, 1999, 1998, 1997, 1996 and 1995 has been derived from audited financial statements. The selected financial data reflects the operations of the Company with all periods restated as if the predecessor companies had merged as of the beginning of the earliest period presented. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" ON PAGE 13 FOR MORE INFORMATION.
YEAR ENDED DECEMBER 31, ------------------------------------------------ (IN THOUSANDS, 1999 1998 1997 1996 1995 EXCEPT PER SHARE DATA) -------- ------- ------- ------- ------- OPERATING DATA: Interest and related portfolio income: Interest..................................... $119,772 $79,921 $86,882 $77,541 $61,550 Premiums from loan dispositions.............. 14,284 5,949 7,277 4,241 2,796 Post-merger gain on securitization of commercial mortgage loans.................. -- 14,812 -- -- -- Investment advisory fees and other income.... 7,084 6,056 3,246 3,155 4,471 -------- ------- ------- ------- ------- Total interest and related portfolio income................................ 141,140 106,738 97,405 84,937 68,817 -------- ------- ------- ------- ------- Expenses: Interest..................................... 34,860 20,694 26,952 20,298 12,355 Employee..................................... 16,136 11,829 10,258 8,774 8,031 Administrative............................... 12,350 11,921 8,970 8,289 6,888 Merger....................................... -- -- 5,159 -- -- -------- ------- ------- ------- ------- Total operating expenses................ 63,346 44,444 51,339 37,361 27,274 Formula and cut-off awards(1)................ 6,753 7,049 -- -- -- -------- ------- ------- ------- ------- Portfolio income before net realized and unrealized gains........................... 71,041 55,245 46,066 47,576 41,543 -------- ------- ------- ------- ------- Net realized and unrealized gains: Net realized gains........................... 25,391 22,541 10,704 19,155 12,000 Net unrealized gains (losses)................ 2,138 1,079 7,209 (7,412) 9,266 -------- ------- ------- ------- ------- Total net realized and unrealized gains................................. 27,529 23,620 17,913 11,743 21,266 -------- ------- ------- ------- ------- Income before minority interests and income taxes.......................................... 98,570 78,865 63,979 59,319 62,809 Minority interests............................... -- -- 1,231 2,427 546 Income tax expense............................... -- 787 1,444 1,945 1,784 -------- ------- ------- ------- ------- Net increase in net assets resulting from operations..................................... $ 98,570 $78,078 $61,304 $54,947 $60,479 ======== ======= ======= ======= =======
PER SHARE: Basic earnings per common share................... $ 1.64 $ 1.50 $ 1.24 $ 1.19 $ 1.38 Diluted earnings per common share................. $ 1.64 $ 1.50 $ 1.24 $ 1.17 $ 1.37 Dividends per common share(2)..................... $ 1.60 $ 1.43 $ 1.71 $ 1.23 $ 1.09 Weighted average common shares outstanding - basic(3)........................................ 59,877 51,941 49,218 46,172 43,697 Weighted average common shares outstanding - diluted(3)...................................... 60,044 51,974 49,251 46,733 44,010
(footnotes appear on next page) 4 7
AT DECEMBER 31, -------------------------------------------------------- (IN THOUSANDS, 1999 1998 1997 1996 1995 EXCEPT PER SHARE DATA) ---------- ---------- -------- -------- -------- BALANCE SHEET DATA: Portfolio at value................... $1,228,497 $ 807,119 $703,331 $612,411 $532,311 Portfolio at cost.................... 1,222,901 803,479 697,030 618,319 530,807 Total assets......................... 1,290,038 856,079 807,775 713,360 605,434 Total debt outstanding(4)............ 592,850 334,350 347,663 274,997 200,339 Preferred stock issued to SBA(4)..... 7,000 7,000 7,000 7,000 7,000 Shareholders' equity................. 667,513 491,358 420,060 402,134 367,192 Shareholders' equity per common share (NAV)........................ $ 10.20 $ 8.79 $ 8.07 $ 8.34 $ 8.26 Common shares outstanding at period end(3)............................. 65,414 55,919 52,047 48,238 44,479 OTHER DATA: New portfolio investments............ $ 751,871 $ 524,530 $364,942 $283,295 $216,175 Loan repayments...................... 145,706 138,081 233,005 179,292 111,731 Loan sales(5)........................ 198,368 81,013 53,912 27,715 29,726 Total assets managed at period end(6)............................. 1,577,296 1,143,548 935,720 822,450 702,567 Realized gains....................... 31,536 25,757 15,804 30,417 16,679 Realized losses...................... (6,145) (3,216) (5,100) (11,262) (4,679)
- ------------------------- (1) See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- For the Years Ended December 31, 1999, 1998, and 1997." (2) Distributions are based on taxable income, which differs from income for financial reporting purposes. In 1997, Allied Capital Corporation (old) distributed $0.34 per common share representing the 844,914 shares of Allied Capital Lending Corporation distributed in conjunction with the merger. The distribution resulted in a partial return of capital. Also in conjunction with the merger, the Company distributed $0.17 per common share representing the undistributed earnings of the predecessor companies at December 31, 1997. (3) Excludes 516,779 shares and 810,456 shares held in the deferred compensation trust at or for the year ended December 31, 1999 and 1998, respectively. (4) See "Senior Securities" on page 25 for more information regarding the Company's level of indebtedness. (5) Excludes loans sold through securitization in January 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Comparison of Fiscal Years Ended December 31, 1999, 1998, and 1997." (6) Total assets managed includes the Company's assets and assets managed on behalf of others. 5 8
1999 1998 ------------------------------------- ------------------------------------- (IN THOUSANDS, QTR 4 QTR 3 QTR 2 QTR 1 QTR 4 QTR 3 QTR 2 QTR 1 EXCEPT PER SHARE DATA) ------- ------- ------- ------- ------- ------- ------- ------- QUARTERLY DATA: Total interest and related portfolio income....................... $42,278 $37,998 $33,186 $27,678 $25,974 $22,546 $21,321 $36,897 Portfolio income before realized and unrealized gains........................ 21,319 19,273 16,619 13,830 11,776 9,401 9,148 24,920 Net increase in net assets resulting from operations.... 30,925 26,944 22,121 18,580 16,631 14,906 14,476 32,065 Basic earnings per common share........................ $ 0.49 $ 0.44 $ 0.38 $ 0.33 $ 0.31 $ 0.29 $ 0.28 $ 0.62(2) Diluted earnings per common share........................ 0.49 0.44 0.38 0.33 0.31 0.29 0.28 0.61(2) Net asset value per common share(1)..................... 10.20 9.66 9.17 9.00 8.79 8.22 8.21 8.26 Dividends declared per common share........................ 0.40 0.40 0.40 0.40 0.38 0.35 0.35 0.35
- ------------------------- (1) We determine net asset value per common share as of the last day of the quarter. The net asset values shown are based on outstanding shares at the end of each period, excluding common stock held in the Company's deferred compensation trust. (2) During the first quarter of 1998, the Company recorded a gain from a securitization transaction of $14.8 million or $0.28 per share. WHERE YOU CAN FIND ADDITIONAL INFORMATION We have filed with the Commission a registration statement and related exhibits under the Securities Act of 1933, as amended (the "Securities Act"). The registration statement contains additional information about us and the registered securities being offered by this prospectus. You may inspect the registration statement and the exhibits without charge at the Securities and Exchange Commission at 450 Fifth Street, NW, Washington, DC 20549. You may obtain copies from the Commission at prescribed rates. We file annual, quarterly and special reports, proxy statements and other information with the Commission. You can inspect, without charge, at the public reference facilities of the Commission at 450 Fifth Street, NW, Washington, DC 20549. The Commission also maintains a web site at http://www.sec.gov that contains reports, proxy statements and other information regarding public companies, including our Company. You can also obtain copies of these materials from the public reference section of the Commission at 450 Fifth Street, NW, Washington, DC 20549, at prescribed rates. Please call the Commission at 1-800-SEC-0330 for further information on the public reference room. You can also inspect reports and other information we file at the offices of the Nasdaq Stock Market, 1735 K Street, NW, Washington, DC 20006. 6 9 RISK FACTORS Investing in the Company involves a number of significant risks and other factors relating to the structure and investment objective of the Company. As a result, there can be no assurance that the Company will achieve its investment objective. In addition to the information contained in this prospectus, you should consider carefully the following information before making investments in the shares. INVESTING IN PRIVATE COMPANIES INVOLVES A HIGH DEGREE OF RISK. Our portfolio consists primarily of long-term loans to and investments in private companies. There is generally no publicly available information about these companies, and we rely significantly on the diligence of our employees and agents to obtain information in connection with the Company's investment decisions. In addition, some smaller businesses have narrower product lines and market shares than their competition, and may be more vulnerable to customer preferences, market conditions or economic downturns, which may adversely affect the return on, or the recovery of, our investment in such businesses. Investments in private businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative. OUR BORROWERS MAY DEFAULT ON THEIR PAYMENTS. We primarily invest in and lend to companies that may have limited financial resources and that may be unable to obtain financing from traditional sources. Numerous factors may affect a borrower's ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. Deterioration in a borrower's financial condition and prospects may be accompanied by deterioration in the collateral for the loan. We make unsecured, subordinated loans or invest in equity securities, which may involve a higher degree of repayment risk. OUR PORTFOLIO OF INVESTMENTS IS ILLIQUID. We acquire most of our investments directly from private companies. The majority of the investments in our portfolio will be subject to restrictions on resale or otherwise have no established trading market. The illiquidity of most of our portfolio may adversely affect our ability to dispose of loans and securities at times when it may be advantageous for us to liquidate such investments. WE INVEST IN NON-INVESTMENT GRADE CMBS. The commercial mortgage-backed securities ("CMBS") in which we invest are non-investment grade, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (e.g., "AAA" through "BBB"). Non-investment grade securities usually provide a higher yield than do investment-grade bonds, but with the higher return comes greater risk. Non-investment grade securities are considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not ensured. Therefore, the non-investment grade CMBS tend to be less liquid, may have a higher risk of default and may be more difficult to value. OUR PORTFOLIO IS RECORDED AT FAIR VALUE AS DETERMINED BY THE BOARD OF DIRECTORS. Pursuant to the requirements of the Investment Company Act of 1940 ("1940 Act"), the Board of Directors is required to value each asset quarterly, and we are required to carry our portfolio at fair value as determined by the Board of Directors. Since there is typically no public market for the loans and equity securities of the companies in which we make investments, our Board of Directors estimates the fair value of these loans and equity securities pursuant to a written valuation policy and a consistently applied valuation process. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses; we are instead required by the 1940 Act to specifically value each individual 7 10 investment and record an unrealized loss for an asset that we believe has become impaired. We adjust quarterly the valuation of our portfolio to reflect the Board of Directors' estimate of the current realizable value of each investment in our portfolio. Without a readily ascertainable market value, the estimated value of our portfolio of loans and equity securities may differ significantly from the values that would be placed on the portfolio if there existed a ready market for the loans and equity securities. Any changes in estimated value are recorded in the Company's statement of operations as "Net unrealized gains (losses)." WE BORROW MONEY WHICH MAY INCREASE THE RISK OF INVESTING IN OUR COMPANY. We borrow from, and issue senior debt securities to, banks, insurance companies and other lenders. Lenders of these senior securities have fixed dollar claims on our consolidated assets that are superior to the claims of our common shareholders. Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in our securities. If the value of our consolidated assets increases, then leveraging would cause the net asset value attributable to the Company's common stock to increase more sharply than it would have had we not leveraged. Conversely, if the value of our consolidated assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any increase in our consolidated income in excess of consolidated interest payable on the borrowed funds would cause our net income to increase more than it would without the leverage, while any decrease in our consolidated income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to make common stock dividend payments, and, if asset coverage for a class of senior security representing indebtedness declines to less than 200%, we may be required to sell a portion of our investments when it is disadvantageous to do so. Leverage is generally considered a speculative investment technique. As of December 31, 1999, the Company's asset coverage for indebtedness was 228%. Our ability to achieve our investment objective may depend in part on our continued ability to maintain a leveraged capital structure by borrowing from banks or other lenders on favorable terms. There can be no assurance that we will be able to maintain such leverage. At December 31, 1999, the Company had $592.9 million of outstanding indebtedness, bearing a weighted annual interest cost of 7.9%. In order for us to cover annual interest payments on indebtedness, we must achieve annual returns on our portfolio of at least 3.7%. Illustration. The following table illustrates the effect of leverage on returns from an investment in our common stock assuming various annual returns, net of expenses. The calculations in the table below are hypothetical and actual returns may be higher or lower than those appearing below. ASSUMED RETURN ON THE COMPANY'S PORTFOLIO (NET OF EXPENSES)
-20% -10% -5% 0% 5% 10% 20% ------ ------ ------ ----- ---- ----- ----- Corresponding return to shareholder(1)........ -45.7% -26.4% -16.7% -7.1% 2.6% 12.3% 31.6%
- ------------------------- (1) The calculation assumes (i) $1,290.0 million in total assets, (ii) an average cost of funds of 7.9%, (iii) $592.9 million in debt outstanding and (iv) $667.5 million of shareholders' equity. 8 11 CHANGES IN INTEREST RATES MAY AFFECT OUR COST OF CAPITAL. Because we borrow money to make investments, our income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. In periods of sharply rising interest rates, our cost of funds would increase, which would reduce our portfolio income before net realized and unrealized gains. However, there would be no effect on the return, if any, that could be generated from our equity interests. We use a combination of long-term and short-term borrowings and equity capital to finance our investing activities. Investments originated for sale generally carry variable rates and are financed with short-term variable rate debt. Our long-term fixed-rate investments are financed with long-term fixed-rate debt and equity. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act. There can be no assurance that a significant change in market interest rates will not have a material adverse effect on our portfolio income. BECAUSE WE MUST DISTRIBUTE INCOME, WE WILL CONTINUE TO NEED ADDITIONAL CAPITAL. We will continue to need capital to fund incremental growth in our investments. Historically, we have borrowed from financial institutions and have issued equity securities. A reduction in the availability of funds from financial institutions could limit our ability to grow. We must distribute at least 90% of our taxable net operating income excluding net realized long-term capital gains to our stockholders to maintain our regulated investment company ("RIC") status. As a result such earnings will not be available to fund investment originations. We expect to continue to borrow from financial institutions and sell additional equity securities. If we fail to obtain funds from such sources or from other sources to fund our investments, it could limit our ability to grow, which could have a material adverse effect on the value of the Company's common stock. In addition, as a business development company ("BDC"), we are generally required to maintain a ratio of at least 200% of total assets to total borrowings, which may restrict our ability to borrow in certain circumstances. OUR PORTFOLIO MAY NOT PRODUCE CAPITAL GAINS. Private finance investments are typically structured as debt securities with a relatively high fixed rate of interest and with an equity feature such as conversion rights, warrants or options. As a result, private finance investments generate interest income from the time they are made, and may also produce a realized gain from an accompanying equity feature. We cannot be sure that our portfolio will generate a current return or capital gains. LOSS OF PASS-THROUGH TAX TREATMENT WOULD SUBSTANTIALLY REDUCE NET ASSETS AND INCOME AVAILABLE FOR DIVIDENDS. We have operated the Company so as to qualify to be taxed as a RIC under Subchapter M of the Code. If we meet certain diversification and distribution requirements, the Company qualifies for pass-through tax treatment. The Company would cease to qualify for pass-through tax treatment if it were unable to comply with these requirements, or if it ceased to qualify as a BDC under the 1940 Act. We also could be subject to a 4% excise tax (and, in certain cases, corporate level income tax) if we fail to make certain distributions. If the Company fails to qualify as a RIC, the Company would become subject to federal income tax as if it were an ordinary corporation, which would substantially reduce our net assets and the amount of income available for distribution to our shareholders. WE OPERATE IN A COMPETITIVE MARKET FOR INVESTMENT OPPORTUNITIES. We compete for investments with many other companies and individuals, some of whom have greater resources than we do. Increased competition would make it more difficult for us to 9 12 purchase or originate investments at attractive prices. As a result of this competition, sometimes we may be precluded from making otherwise attractive investments. WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT. We are regulated by the Commission and the SBA. In addition, changes in the laws or regulations that govern BDCs, RICs, real estate investment trusts ("REITs"), SBICs and SBLCs may significantly affect our business. Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations also are subject to change. Any change in the law or regulations that govern our business could have a material impact on the Company or its operations. QUARTERLY RESULTS MAY FLUCTUATE. The Company's quarterly operating results could fluctuate due to a number of factors. These factors include, among others, variations in the investment origination volume, variation in timing of prepayments, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. As a result of these factors, you should not rely on quarterly results to be indicative of the Company's performance in future quarters. DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS INFORMATION CONTAINED OR INCORPORATED BY REFERENCE IN THIS PROSPECTUS, AND THE ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, MAY CONTAIN "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS "MAY," "WILL," "EXPECT," "INTEND," "ANTICIPATE," "ESTIMATE" OR "CONTINUE" OR THE NEGATIVE THEREOF OR OTHER VARIATIONS OR SIMILAR WORDS OR PHRASES. THE MATTERS DESCRIBED IN "RISK FACTORS" AND CERTAIN OTHER FACTORS NOTED THROUGHOUT THIS PROSPECTUS, AND THE ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, AND IN ANY EXHIBITS TO THE REGISTRATION STATEMENT OF WHICH THIS PROSPECTUS, AND THE ACCOMPANYING PROSPECTUS SUPPLEMENT, IF ANY, IS A PART, CONSTITUTE CAUTIONARY STATEMENTS IDENTIFYING IMPORTANT FACTORS WITH RESPECT TO ANY SUCH FORWARD- LOOKING STATEMENTS, INCLUDING CERTAIN RISKS AND UNCERTAINTIES, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD-LOOKING STATEMENTS. 10 13 THE COMPANY Our company is principally engaged in lending to and investing in private and undervalued public companies. The Company is organized in the state of Maryland and is an internally managed closed-end management investment company that has elected to be regulated as a business development company (as defined above, a "BDC") under the 1940 Act. We have two wholly owned subsidiaries that have also elected to be regulated as BDCs. Allied Investment Corporation ("Allied Investment") is licensed by the Small Business Administration ("SBA") as a Small Business Investment Company ("SBIC"). Allied Capital SBLC Corporation ("Allied SBLC") is licensed by the SBA as a Small Business Lending Company ("SBLC") and is a participant in the SBA Section 7(a) Guaranteed Loan Program. In addition, we have a real estate investment trust subsidiary, Allied Capital REIT, Inc. ("Allied REIT"). Our executive offices are located at 1919 Pennsylvania Avenue, NW, Washington, DC 20006 and our telephone number is (202) 331-1112. In addition, we have regional offices throughout the United States. We also have an office in Frankfurt, Germany. USE OF PROCEEDS Unless otherwise specified in the prospectus supplement accompanying this prospectus, we intend to use the net proceeds from selling shares for general corporate purposes, which may include investment in private companies in accordance with our investment objective, purchase of commercial mortgage-backed securities, repayment of indebtedness, acquisitions and other general corporate purposes. We anticipate that substantially all of the net proceeds of any offering of shares will be used, as described above, within six months, but in no event longer than two years. Pending investment, we intend to invest the net proceeds of any offering of shares in time deposits, income-producing securities with maturities of three months or less that are issued or guaranteed by the federal government or an agency of the federal government, and high quality debt securities maturing in one year or less from the time of investment. Our ability to achieve our investment objective may be limited to the extent that the net proceeds of any offering, pending full investment, are held in time deposits and other short-term instruments. 11 14 PRICE RANGE OF COMMON STOCK AND DIVIDENDS Our common stock is traded on the Nasdaq National Market under the symbol "ALLC." The following table lists the high and low closing sales prices for the Company's stock. The stock quotations are interdealer quotations and do not include markups, markdowns or commissions. On April 7, 2000, the last reported closing sale price of the common stock was $17.563 per share.
CLOSING SALE PRICE ------------------ HIGH LOW ------- ------- YEAR ENDED DECEMBER 31, 1998 First Quarter............................. $27.688 $21.000 Second Quarter............................ 29.000 21.750 Third Quarter............................. 24.813 14.938 Fourth Quarter............................ 18.875 12.500 YEAR ENDED DECEMBER 31, 1999 First Quarter............................. $20.250 $16.500 Second Quarter............................ 24.000 17.000 Third Quarter............................. 23.813 20.250 Fourth Quarter............................ 23.125 16.750 YEAR ENDING DECEMBER 31, 2000 First Quarter............................. 19.938 16.000 Second Quarter (through April 7, 2000).... 18.375 16.938
Our common stock continues to trade in excess of net asset value. There can be no assurance, however, that we will maintain a premium to net asset value. We pay quarterly dividends to stockholders. The amount of our quarterly dividends is determined by the board of directors. The Company's board has established a dividend policy for 2000 to review the dividend rate quarterly and to adjust the quarterly dividend rate as the Company's earnings momentum builds. In addition, the board may determine to retain a portion of capital gains during 2000. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Equity Capital and Dividends" and "Taxation." We cannot assure that we will achieve investment results or maintain a tax status that will permit any particular level of dividend payment. Our credit facilities limit our ability to declare dividends if we default under certain provisions. We have adopted an "opt out" dividend reinvestment plan ("DRIP plan"). Under the DRIP plan, if your shares are registered in your name, your dividends will be automatically reinvested in additional shares of common stock unless you "opt out" of the DRIP plan. 12 15 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information contained in this section should be read in conjunction with the Selected Consolidated Financial Data and the Company's Consolidated Financial Statements and Notes thereto. OVERVIEW The Company provides capital to small and middle-market companies in a variety of different industries and in diverse geographic locations. Our lending and investment activity is focused in three areas: - Private finance - Commercial real estate finance, and - Small business finance originated for sale under our Allied Capital Express brand name. The Company's portfolio composition at December 31, 1999, 1998 and 1997 was as follows:
1999 1998 1997 ---- ---- ---- Private Finance............................................. 53% 48% 29% Commercial Real Estate Finance.............................. 42% 44% 64% Small Business Finance...................................... 5% 8% 7%
The Company's earnings depend primarily on the level of interest and related portfolio income and net realized and unrealized gains earned on the Company's investment portfolio after deducting interest paid on borrowed capital and operating expenses. Interest income results from the stated interest rate earned on a loan and the amortization of loan origination points and discounts. The level of interest income is directly related to the balance of the investment portfolio multiplied by the weighted average yield on the portfolio. The Company's ability to generate interest income is dependent on economic, regulatory and competitive factors that influence interest rates and loan originations, and the Company's ability to secure financing for its investment activities. PORTFOLIO AND INVESTMENT ACTIVITY Total portfolio investment activity and yields as of and for the years ended December 31, 1999, 1998 and 1997 were as follows:
1999 1998 1997 -------- ------ ------ (IN MILLIONS) Portfolio at Value........................... $1,228.5 $807.1 $703.3 New Investments.............................. $ 751.9 $524.5 $364.9 Repayments................................... $ 145.7 $138.0 $233.0 Sales........................................ $ 198.4 $304.4 $ 53.9 Yield........................................ 13.0% 12.5% 11.7%
13 16 PRIVATE FINANCE Private finance investment activity and yields as of and for the years ended December 31, 1999, 1998 and 1997 were as follows:
1999 1998 1997 ------ ------ ------ (IN MILLIONS) Portfolio at Value............................. $647.0 $388.6 $204.7 New Investments................................ $346.7 $236.0 $ 66.7 Repayments..................................... $ 87.5 $ 41.3 $ 66.5 Yield.......................................... 14.2% 14.6% 12.6%
The private finance portfolio increased 67% and 90% during the years ended December 31, 1999 and 1998, respectively. The Company's increasing capital base has enabled it to make larger private finance investments, supporting the significant increase in originations in 1999 and 1998. During 1999, the Company originated 27 new private financings with an average investment size of $12.4 million and a weighted average current yield on loans and debt securities of 13.6%. During 1998, the Company originated 22 new private financings with an average investment size of $10.2 million and a weighted average current yield on loans and debt securities of 14.0%. The current yield on the private finance portfolio will fluctuate over time depending on the equity "kicker" or warrants received with each financing. Private finance investments are generally structured such that equity kickers may provide an additional investment return of up to 1,000 basis points. COMMERCIAL REAL ESTATE FINANCE Commercial real estate finance investment activity and yields as of and for the years ended December 31, 1999, 1998 and 1997 were as follows:
1999 1998 1997 ------ ------ ------ (IN MILLIONS) Portfolio at Value............................. $520.0 $355.0 $451.6 New Investments................................ $288.7 $214.6 $249.0 Repayments..................................... $ 51.5 $ 92.5 $154.5 Sales.......................................... $ 86.1 $256.9 $ 0.0 Yield.......................................... 12.3% 10.4% 11.4%
The commercial real estate finance portfolio increased 46.5% and decreased 21.4% for the years ended December 31, 1999 and 1998, respectively. During 1999 and 1998, the Company began to migrate its portfolio from investments in lower yielding commercial real estate loans to higher yielding real estate investments. During 1998, the Company reduced its commercial mortgage loan origination activity for its own portfolio due to declining interest rates and began to sell its loans to other lenders. Then, beginning in the fourth quarter of 1998, the Company began to take advantage of a unique market opportunity to acquire non-investment grade commercial mortgage-backed securities ("CMBS") at significant discounts from the face amount of the bonds. Turmoil in the CMBS market created a lack of liquidity for the traditional buyers of non-investment grade bonds. As a result, yields on these bonds increased to an attractive level for the Company to purchase the securities. The Company opportunistically purchased CMBS during 1999 and will continue to do so during 2000 while maintaining a 14 17 balanced portfolio. The Company believes that CMBS is an attractive asset class because of the yields that can be earned on a security that is fully secured by commercial mortgage loans. The underlying pool of approximately 2,000 loans that are collateral for our CMBS have the following ranges of loan to value ("LTV") and debt service coverage ratios ("DSCR").
LOAN TO VALUE RANGES $ % -------------------- ------------- --- (IN MILLIONS) Less than 60%....................................... $ 978.4 11% 60 - 65%............................................ 560.7 7% 65 - 70%............................................ 1,406.1 16% 70 - 75%............................................ 2,796.7 32% 75 - 80%............................................ 2,777.4 32% Greater than 80%.................................... 180.2 2% -------- --- $8,699.5 100% ======== === Weighted average LTV................................ 70.8%
DEBT SERVICE COVERAGE RATIO RANGES $ % --------------------- ------------- --- (IN MILLIONS) 1.00 - 1.25......................................... $1,968.1 23% 1.26 - 1.50......................................... 4,972.8 57% 1.51 - 1.75......................................... 1,146.4 13% 1.76 - 2.00......................................... 343.2 4% Greater than 2.00................................... 269.0 3% -------- --- $8,699.5 100% ======== === Weighted average DSCR............................... 1.36
The increase in the commercial real estate portfolio during 1999 was primarily due to the purchase of $245.9 million in CMBS with a face value of $507.9 million and a weighted average yield to maturity of 14.6% after assuming a 1% loss rate on the underlying collateral mortgage pool. In addition, the Company sold approximately $86.1 million of commercial mortgage loans with a weighted average yield of approximately 9.5% and redeployed the proceeds into higher yielding assets. The decrease in the commercial real estate portfolio during 1998 was due to the sale through securitization of approximately $295 million in lower yielding commercial mortgage loans, and the sale of whole loans to third parties aggregating approximately $33.5 million. SMALL BUSINESS FINANCE During the second quarter of 1999, the Company combined its commercial real estate loan origination activity with its SBA 7(a) lending activity in order to increase its loans originated for sale business under the Allied Capital Express brand name. Through Allied Capital Express, the Company provides small business and commercial real estate loans up 15 18 to $3 million. The majority of the loans originated in this area are originated for sale, generally at premiums of up to 10% of the loan amount. Allied Capital Express loan activity and yields as of and for the years ended December 31, 1999, 1998 and 1997 were as follows:
1999 1998 1997 ------ ----- ----- (IN MILLIONS) Portfolio at Value............................... $ 61.4 $63.6 $47.1 New Investments.................................. $116.5 $73.9 $49.2 Repayments....................................... $ 6.7 $ 4.2 $12.0 Sales............................................ $112.3 $47.5 $53.9 Yield............................................ 11.5% 11.2% 11.4%
Allied Capital Express loan origination activity for 1999 has increased due to the opening of new regional office locations and from opportunities created by the Internet site launched during 1999. Loans in the Allied Capital Express program are originated for sale; therefore, the increase in loan sales is the result of the increase in originations. In addition, beginning in 1999, the Company began to sell 90% of the unguaranteed portion of SBA 7(a) loans through a structured finance agreement with a commercial paper conduit. In 1999, $36.4 million of unguaranteed portions of SBA 7(a) loans were sold under this facility. Allied Capital Express targets small commercial real estate loans that are, in many cases, originated in conjunction with SBA 7(a) loans. SBA 7(a) loans are originated with variable interest rates priced at spreads ranging from 1.75% to 2.75% over the prime lending rate. 16 19 RESULTS OF OPERATIONS COMPARISON OF THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 The following table summarizes Allied Capital's operating results for the years ended December 31, 1999, 1998 and 1997:
PERCENT PERCENT 1999 1998 CHANGE CHANGE 1998 1997 CHANGE CHANGE -------- -------- -------- ------- -------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) INTEREST AND RELATED PORTFOLIO INCOME Interest............................. $119,772 $79,921 $39,851 50% $79,921 $86,882 $(6,961) (8%) Premiums from loan dispositions...... 14,284 5,949 8,335 140% 5,949 7,277 (1,328) (18%) Post-Merger gain on securitization of commercial mortgage loans.......... -- 14,812 (14,812) (100%) 14,812 -- 14,812 100% Investment advisory fees and other income............................. 7,084 6,056 1,028 17% 6,056 3,246 2,810 87% -------- ------- ------- ----- ------- ------- ------- ----- Total interest and related portfolio income............. 141,140 106,738 34,402 32% 106,738 97,405 9,333 10% -------- ------- ------- ----- ------- ------- ------- ----- EXPENSES Interest............................. 34,860 20,694 14,166 68% 20,694 26,952 (6,258) (23%) Employee............................. 16,136 11,829 4,307 36% 11,829 10,258 1,571 15% Administrative....................... 12,350 11,921 429 4% 11,921 8,970 2,951 33% Merger............................... -- -- -- -- -- 5,159 (5,159) (100%) -------- ------- ------- ----- ------- ------- ------- ----- Total operating expenses....... 63,346 44,444 18,902 43% 44,444 51,339 (6,895) (13%) -------- ------- ------- ----- ------- ------- ------- ----- Formula and cut-off awards........... 6,753 7,049 (296) (4%) 7,049 -- 7,049 100% -------- ------- ------- ----- ------- ------- ------- ----- Portfolio income before net realized and unrealized gains........................ 71,041 55,245 15,796 29% 55,245 46,066 9,179 20% -------- ------- ------- ----- ------- ------- ------- ----- NET REALIZED AND UNREALIZED GAINS Net realized gains................... 25,391 22,541 2,850 13% 22,541 10,704 11,837 111% Net unrealized gains................. 2,138 1,079 1,059 98% 1,079 7,209 (6,130) (85%) -------- ------- ------- ----- ------- ------- ------- ----- Total net realized and unrealized gains............. 27,529 23,620 3,909 17% 23,620 17,913 5,707 32% -------- ------- ------- ----- ------- ------- ------- ----- Income before minority interests and income taxes......................... 98,570 78,865 19,705 25% 78,865 63,979 14,886 23% Minority interests..................... -- -- -- -- -- 1,231 (1,231) (100%) Income tax expense..................... -- 787 (787) (100%) 787 1,444 (657) (45%) -------- ------- ------- ----- ------- ------- ------- ----- Net increase in net assets resulting from operations...................... $ 98,570 $78,078 $20,492 26% $78,078 $61,304 $16,774 27% ======== ======= ======= ===== ======= ======= ======= ===== Diluted earnings per share............. $ 1.64 $ 1.50 $ 0.14 9% $ 1.50 $ 1.24 $ 0.26 21% ======== ======= ======= ===== ======= ======= ======= ===== Weighted average shares outstanding - diluted.............................. 60,044 51,974 8,070 16% 51,974 49,251 2,723 6%
Net increase in net assets resulting from operations (NIA) results from total interest and related portfolio income earned, less total expenses incurred in the operations of the Company, plus net realized and unrealized gains or losses. NIA as a percentage of average shareholders equity, which is also known as return on equity, was 17%, 17% and 15% for the years ended December 31, 1999, 1998 and 1997, respectively. NIA, excluding the formula and cut-off award, in 1999 and 1998 as a percentage of average shareholders' equity was 18.6% and 18.8%, respectively. Total interest and related portfolio income is primarily a function of the level of interest income earned and the balance of portfolio assets. In addition, total interest and 17 20 related portfolio income includes premiums from loan dispositions, prepayment premiums, and investment advisory fees and other income.
1999 1998 1997 ------- ------- ------ (IN MILLIONS, EXCEPT PER SHARE AMOUNTS) Total Interest and Related Portfolio Income..... $141.1 $106.7 $97.4 Per share....................................... $ 2.35 $ 2.05 $1.97
The increase in interest income earned results primarily from continued growth of the Company's investment portfolio and the Company's focus on increasing its overall portfolio yield. The Company's investment portfolio, excluding non-interest bearing equity interests in portfolio companies, increased by 51% to $1,141.2 million at December 31, 1999 from $757.7 million at December 31, 1998, and increased by 14% during 1998 from $666.5 million at December 31, 1997. The weighted average yield on the interest bearing investments in the portfolio at December 31, 1999, 1998 and 1997 was as follows:
1999 1998 1997 ----- ----- ----- Private Finance................................. 14.2% 14.6% 12.6% Commercial Real Estate Finance.................. 12.3% 10.4% 11.4% Small Business Finance.......................... 11.5% 11.2% 11.4% Total Portfolio................................. 13.0% 12.5% 11.7%
Included in net premiums from loan dispositions are premiums from loan sales and premiums received on the early repayment of loans. Premiums from loan sales were $10.5 million, $3.8 million and $3.2 million for the years ended December 31, 1999, 1998 and 1997, respectively. This premium income results primarily from the premium paid by purchasers of loans originated through Allied Capital Express, less the origination commissions associated with the loans sold. In addition to selling the guaranteed portion of the SBA 7(a) loans, in 1999 the Company began to sell 90% of the unguaranteed portion of SBA 7(a) loans through a structured finance agreement with a commercial paper conduit. The 176% increase in premiums from loan sales in 1999 is primarily the result of a significant increase in the sale of the guaranteed SBA 7(a) loans and unguaranteed portions of SBA 7(a) loans. SBA 7(a) loan sales were $93.7 million, $37.0 million and $43.4 million for the years ended December 31, 1999, 1998 and 1997, respectively. Prepayment premiums were $3.8 million, $2.2 million and $4.1 million for the years ended December 31, 1999, 1998 and 1997, respectively. While the scheduled maturities of private finance and commercial real estate loans range from five to ten years, it is not unusual for the Company's borrowers to refinance or pay off their debts to the Company ahead of schedule. Because the Company seeks to finance primarily seasoned, performing companies, such companies at times can secure lower cost financing as their balance sheets strengthen, or as more favorable interest rates become available. Therefore, the Company generally structures its loans to require a prepayment premium for the first three to five years of the loan. Total interest and related portfolio income for 1998 includes a one-time gain on sale of $14.8 million resulting from a commercial mortgage loan securitization transaction that was completed in January 1998. Excluding the 1998 gain on sale, total interest and related portfolio income increased for the year ended December 31, 1999 by 53% as compared to the year ended December 31, 1998. The proceeds of $238.4 million from this transaction were used to repay outstanding debt. 18 21 Our operating expenses include interest, employee and administrative expenses. The Company's single largest expense is interest on indebtedness. The fluctuations in interest expense during 1999, 1998 and 1997 are attributable to changes in the level of borrowings by the Company and its subsidiaries under various notes payable and debentures and revolving credit facilities. The Company's borrowing activity and weighted average interest cost, including fees and closing costs, were as follows:
1999 1998 1997 ------ ------ ------ (IN MILLIONS) Total Outstanding Debt......................... $592.9 $334.4 $347.7 Average Outstanding Debt....................... $461.5 $261.3 $336.8 Weighted Average Cost.......................... 7.9% 7.5% 7.3% BDC Asset Coverage*............................ 228% 273% 243%
- ------------------------- * As a BDC, the Company is generally required to maintain a ratio of 200% of total assets to total borrowings. Employee expenses include salaries and employee benefits. The increase in salaries and employee benefits for the periods presented reflects the increase in total employees, combined with wage increases and the experience level of employees hired. Total employees were 129, 106 and 80 at December 31, 1999, 1998 and 1997, respectively. The Company has been an active recruiter throughout 1999 and 1998 for experienced investment and operational personnel, and the Company will continue to actively recruit and hire new professionals in 2000 to support anticipated portfolio growth. Administrative expenses include the leases for the Company's headquarters in Washington, DC, and its regional offices. Administrative expenses also include travel costs, stock record expenses, directors' fees, legal and accounting fees and various other expenses. The increase in administrative expenses from 1998 to 1999 was primarily the result of increases in costs associated with the new headquarters and four new regional offices. The increase in administrative expenses from 1997 to 1998 was partially the result of twelve full months of costs associated with two new offices that were established in the third and fourth quarters of 1997. In 1997, the Company incurred Merger expenses totaling $5.2 million, which consisted primarily of investment banking fees of $3.1 million, legal fees of $1.0 million and costs associated with the solicitation of proxies of approximately $0.6 million. For the years ended December 31, 1999, 1998 and 1997, employee and administrative costs as a percentage of total interest and related portfolio income less interest expense plus net realized and unrealized capital gains was 21%, 22% and 22%, respectively. The formula and cut-off awards totaled $6.8 million and $7.0 million, or $0.11 per share and $0.14 per share, for the years ended December 31, 1999 and 1998, respectively. The formula award expense totaled $6.2 million for each of the years ended December 31, 1999 and 1998. The formula award was designed as an incentive compensation program that would replace canceled stock options that were canceled as a result of the Company's 1997 Merger and would balance share ownership among key officers. The formula award vests over a three-year period, on the anniversary date of the Merger, beginning on December 31, 1998. Assuming all officers who received a formula 19 22 award remain with the Company over the vesting period, the Company will expense the remaining formula award of approximately $6.2 million during 2000. The cut-off award expense totaled $0.6 million and $0.8 million for the years ended December 31, 1999 and 1998, respectively. The cut-off award was designed to cap the appreciated value in unvested options at the Merger announcement date in order to set the foundation to balance option awards upon the Merger. The cut-off award will only be payable if the award recipient is employed by the Company on a future vesting date. Total cut-off award that will vest in 2000 is estimated at $0.5 million. Net realized gains resulted from the sale of equity securities associated with certain private finance investments and commercial mortgage loans and the realization of unamortized discount resulting from the sale and early repayment of private finance and commercial mortgage loans, offset by losses on investments. Realized gains and losses for the years ended December 31, 1999, 1998 and 1997 were as follows:
1999 1998 1997 ----- ----- ----- (IN MILLIONS) Realized Gains.................................... $31.5 $25.8 $15.8 Realized Losses................................... (6.1) (3.3) (5.1) ----- ----- ----- Net Realized Gains................................ $25.4 $22.5 $10.7 ===== ===== ===== Net Unrealized Gains.............................. $ 2.1 $ 1.1 $ 7.2 ===== ===== =====
Realized gains of $31.5 million during 1999 primarily resulted from transactions involving six portfolio companies, Radio One, Inc. ($10.5 million), COHR, Inc. ($5.3 million), Grant Broadcasting Systems II ($5.1 million), Jack Henry and Associates, Inc. ($3.6 million), Precision Industries Co. ($3.3 million), and Enterprise Software ($0.8 million). The Company reversed previously recorded unrealized appreciation of $14.6 million when gains were realized in 1999. Realized gains in 1998 and 1997 resulted primarily from transactions involving 10 and 6 portfolio companies, respectively. Realized losses in 1999, 1998 and 1997 represented 0.5%, 0.4 % and 0.6% of the Company's total assets, respectively. Realized losses of $6.1 million during 1999 resulted primarily from the liquidation of one portfolio investment, CeraTech Holdings Corporation ($2.5 million). The remaining losses consisted of several losses of less than $0.5 million each. Losses realized in 1999 had been recognized in NIA over time as unrealized depreciation when the Company determined that the respective portfolio security's value had become impaired. Thus, the Company reversed previously recorded unrealized depreciation totaling $5.4 million, $3.6 million and $6.7 million when the related losses were realized in 1999, 1998, and 1997, respectively. Net unrealized gains for 1999, 1998 and 1997 consisted of valuation changes resulting from the Board of Directors' valuation of the Company's assets and the effect of reversals of unrealized appreciation or depreciation resulting from realized gains or losses. At December 31, 1999, net unrealized appreciation in the portfolio totaled $4.5 million and was composed of unrealized appreciation of $32.1 million, resulting primarily from appreciated equity interests in portfolio companies, and unrealized depreciation of $27.6 million resulting primarily from underperforming loan and equity interests in the portfolio. At December 31, 1998 and 1997, net unrealized appreciation in the portfolio totaled $2.4 million and $1.3 million, respectively, and was composed of unrealized appreciation of 20 23 $27.3 million and $19.2 million, and unrealized depreciation of $24.9 million and $17.9 million, respectively. The Company employs a standard grading system for the entire portfolio. Grade 1 is used for those investments from which a capital gain is expected. Grade 2 is used for investments performing in accordance with plan. Grade 3 is used for investments that require closer monitoring; however, no loss of interest or principal is expected. Grade 4 is used for investments for which some loss of contractually due interest is expected, but no loss of principal is expected. Grade 5 is used for investments for which some loss of principal is expected and the investment is written down to net realizable value. At December 31, 1999, the Company's portfolio was graded as follows:
PORTFOLIO PERCENTAGE OF GRADE AT VALUE TOTAL PORTFOLIO - ----- ------------- --------------- (IN MILLIONS) 1........................................... $ 156.0 12.7% 2........................................... 1,002.9 81.7% 3........................................... 22.5 1.8% 4........................................... 32.2 2.6% 5........................................... 14.9 1.2% -------- ------ $1,228.5 100.0% ======== ======
Grade 5 private finance investments totaled $12.6 million at value at December 31, 1999, or 1.0% of the Company's total portfolio based on the valuation of the Board of Directors. The value of these Grade 5 private finance investments has been reduced from an aggregate cost of $31.3 million in order to reflect the Company's estimate of the net realizable value of these investments upon disposition. This reduction in value has been recorded previously as unrealized depreciation over several years in the Company's earnings. The Company continues to follow its historical practices of working with a troubled portfolio company in order to recover the maximum amount of the Company's investment, but records unrealized depreciation for the expected full amount of the potential loss when such exposure is identified. Grade 5 private finance investments at December 31, 1998 and 1997 totaled $6.4 million and $12.9 million at value, or 0.8% and 1.8% of the Company's total portfolio, respectively. At December 31, 1999, the credit quality of the Company's CMBS portfolio remained strong, and delinquencies in the underlying collateral pool were negligible. The yield used to accrue interest on this portfolio assumes a 1% loss rate on the entire underlying collateral mortgage pool. For the total investment portfolio, loans greater than 120 days delinquent were $18.6 million at value at December 31, 1999, or 1.5% of the total portfolio. Included in this category are loans valued at $11.7 million that are fully secured by real estate. Loans greater than 120 days delinquent generally do not accrue interest. In addition, the Company is not accruing interest on a $14.2 million investment that was not yet 120 days delinquent at December 31, 1999, but is expected to be in this category in the first quarter of 2000. Loans greater than 120 days delinquent at December 31, 1998 were $10.4 million at value, or 1.3% of the total portfolio, which included $6.6 million that were fully secured by real estate. 21 24 Because the Company has elected to be taxed as a regulated investment company ("RIC") under Subchapter M of the Code, the Company is not taxed on its investment company taxable income or realized capital gains, to the extent that such income or gains are distributed, or deemed to be distributed, to shareholders. Annual tax distributions may differ from NIA for the fiscal year due to timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation or depreciation, which are not included in taxable income. In order to maintain its RIC status, the Company must, in general, (1) derive at least 90% of its gross income from dividends, interest and gains from the sale of securities; (2) meet investment diversification requirements as defined in the Code; and (3) distribute annually to shareholders at least 90% of its investment company taxable ordinary income. The Company intends to take all steps necessary to continue to meet the RIC qualifications. However, there can be no assurance that the Company will continue to elect or qualify for such treatment in future years. The weighted average common shares outstanding used to compute basic earnings per share were 59.9 million, 51.9 million and 49.2 million for the years ended December 31, 1999, 1998 and 1997, respectively. The increases in the weighted average shares reflect the issuance of new shares and the issuance of shares pursuant to a dividend reinvestment plan. All per share amounts included in management's discussion and analysis have been computed using the weighted average shares used to compute diluted earnings per share, which were 60.0 million, 52.0 million and 49.3 million for the years ended December 31, 1999, 1998 and 1997, respectively. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES CASH AND CASH EQUIVALENTS At December 31, 1999, the Company had $18.2 million in cash and cash equivalents. The Company invests otherwise uninvested cash in U.S. government or agency-issued or guaranteed securities that are backed by the full faith and credit of the United States, or in high quality, short-term repurchase agreements fully collateralized by such securities. The Company's objective is to manage to a low cash balance and fund new originations with its credit facilities. 22 25 DEBT The Company had outstanding debt at December 31, 1999 as follows:
ANNUAL ANNUAL PORTFOLIO AMOUNT INTEREST RETURN TO COVER OUTSTANDING COST(1) INTEREST PAYMENTS(2) ------------- -------- -------------------- (IN MILLIONS) Notes payable and debentures: Unsecured long-term notes payable.... $419.0 7.7% 2.6% SBA debentures....................... 62.7 8.0% 0.4% OPIC loan............................ 5.7 6.6% 0.0% ------ ---- ---- Total notes payable and debentures.................. $487.4 7.7% 3.0% ------ ---- ---- Revolving credit facilities: Revolving line of credit............. $ 82.0 9.3% 0.6% Master loan and security agreement... 23.5 6.9% 0.1% ------ ---- ---- Total revolving credit facilities.................. $105.5 8.8% 0.7% ------ ---- ---- Total debt.................... $592.9 7.9% 3.7% ====== ==== ====
- ------------------------- (1) The annual interest cost includes the cost of commitment fees and other facility fees. (2) The annual portfolio return to cover interest payments is calculated as the December 31, 1999 annualized cost of debt per class of financing divided by total assets at December 31, 1999. UNSECURED LONG-TERM NOTES PAYABLE. The Company has issued long-term debt to private institutional lenders, primarily insurance companies. The notes have five- or seven-year maturities. The notes require payment of interest only semi-annually, and all principal is due upon maturity. SBA DEBENTURES. The Company, through its SBIC subsidiary, has debentures payable to the SBA with terms of ten years. The notes require payment of interest only semi-annually, and all principal is due upon maturity. The Company may borrow up to $101 million from the SBA under the SBIC program. At December 31, 1999, the Company had a commitment from the SBA for an additional $12.0 million of debt, which was borrowed in January 2000. REVOLVING LINE OF CREDIT. The Company has a two-year, $340 million unsecured revolving line of credit that expires in March 2001. This facility may be expanded up to $400 million. At the Company's option, the credit facility bears interest at a rate equal to (i) the one-month London Inter-Bank Offered Rate ("LIBOR") plus 1.25% or (ii) the higher of (a) the NationsBank, N.A. prime rate and (b) the Federal Funds rate plus 0.50%. The credit facility requires monthly payments of interest, and all principal is due upon maturity. In January 2000, the Company increased its unsecured revolving line of credit to $360 million and is currently negotiating to extend the maturity by one year. MASTER LOAN AND SECURITY AGREEMENT. The Company has a facility to borrow up to $100 million using certain commercial mortgage loans as collateral. The agreement generally requires interest-only payments with all principal due at maturity. The agreement charges interest at LIBOR plus 1.0%. The facility matures in October 2000. EQUITY CAPITAL AND DIVIDENDS The Company raises debt and equity capital for continued investment in growing businesses. Because the Company is a RIC, it distributes its income and requires external capital for growth. Because the Company is a business development company, it is limited in the amount of debt capital it may use to fund its growth, since it is generally required to maintain a ratio of 200% of total assets to total borrowings, or approximately 1 to 1 debt to equity capital. 23 26 To support its growth during 1999, the Company raised $168.9 million in new equity capital primarily through the sale of shares from its shelf registration statement. At December 31, 1999, total shareholders' equity had increased to $667.5 million. The Company issues new equity only in cases where attractive investment opportunities have been identified, thus resulting in accretive growth for existing shareholders. The Company's Board has established a dividend policy for 2000 to review the dividend rate quarterly, and to adjust the quarterly dividend rate throughout the year as the Company's earnings momentum builds. In 1999, the Board had established a dividend policy of level quarterly dividends of $0.40 per share, for an annual total distribution of $1.60 per share to approximate annual taxable income. The Board changed its dividend policy for 2000 because of the Company's significant portfolio growth and continued growth in ordinary taxable income. As a result of growth in ordinary taxable income combined with the increased size and diversity of the Company's portfolio and its projected future capital gains, the Company's Board of Directors will continue to evaluate whether to retain or distribute capital gains as they occur. The new policy will allow the Company to continue to distribute some capital gains, but will also allow the Company to retain gains that exceed a normal capital gains distribution level, and therefore avoid any unusual spike in dividends in any one year. The new policy also enables the Board to selectively retain gains to support future growth. The Company plans to maintain a strategy of financing its operations, dividend requirements and future investments with cash from operations, through borrowings under short- or long-term credit facilities, through asset sales, or through obtaining new equity capital. The Company will utilize its short-term credit facilities only as a means to bridge to long-term financing. The Company evaluates its interest rate exposure on an ongoing basis. The Company manages interest rate risk through a diversified borrowing base and a matched-funding policy. A diversified borrowing base consists of short- and long-term debt with a variable or fixed rate. The matched-funding policy states that floating rate assets generally be financed with similar term floating-rate liabilities and fixed-rate assets generally be financed with similar term fixed-rate liabilities. To the extent deemed necessary, the Company may hedge variable and short-term interest rate exposure through interest rate swaps or other techniques. At December 31, 1999, the Company's debt to equity ratio was less than 1 to 1. Approximately 82% of the Company's debt had a fixed interest rate, and the Company's weighted average cost of funds was 7.9% at December 31, 1999. There are no significant maturities of long-term debt until 2003. The Company believes that it has access to capital sufficient to fund its ongoing investment and operating activities, and from which to pay dividends. The "Year 2000 problem" refers to the inability of many computers, computer-based systems, related software, and other electronics to process dates accurately during the Year 2000 and beyond. The Company's Year 2000 readiness plan focused on three main areas: the Company's information technology and other operating systems, critical service providers, and portfolio companies. As of March 1, 2000, we have not experienced any business disruption as a result of the Year 2000 problem. Although Year 2000 problems may not become evident until long after January 1, 2000, based on our Year 2000 readiness and our experience at the end of 1999 and early 2000, we also do not expect significant Year 2000 related business disruptions in the future. 24 27 SENIOR SECURITIES Information about our senior securities is shown in the following tables as of the fiscal year ended December 31, unless otherwise noted. The "--" indicates information which the Commission expressly does not require to be disclosed for certain types of senior securities.
TOTAL AMOUNT OUTSTANDING INVOLUNTARY EXCLUSIVE OF ASSET LIQUIDATING AVERAGE TREASURY COVERAGE PREFERENCE MARKET VALUE CLASS AND YEAR SECURITIES(1) PER UNIT(2) PER UNIT(3) PER UNIT(4) -------------- ------------- ----------- ----------- -------------- MASTER REPURCHASE AGREEMENT AND MASTER LOAN AND SECURITY AGREEMENT 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 23,210,000 3,695 -- N/A 1995........................ 0 0 -- N/A 1996........................ 85,775,000 2,485 -- N/A 1997........................ 225,821,000 2,215 -- N/A 1998........................ 6,000,000 2,734 -- N/A 1999........................ 23,500,000 2,283 -- N/A UNSECURED LONG-TERM NOTES PAYABLE 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 0 0 -- N/A 1995........................ 0 0 -- N/A 1996........................ 0 0 -- N/A 1997........................ 0 0 -- N/A 1998........................ 180,000,000 2,734 -- N/A 1999........................ 419,000,000 2,283 -- N/A SBA DEBENTURES(5) 1989........................ $ 25,350,000 $4,015 $-- N/A 1990........................ 40,450,000 3,397 -- N/A 1991........................ 49,800,000 3,834 -- N/A 1992........................ 49,800,000 5,789 -- N/A 1993........................ 49,800,000 6,013 -- N/A 1994........................ 54,800,000 3,695 -- N/A 1995........................ 61,300,000 2,868 -- N/A 1996........................ 61,300,000 2,485 -- N/A 1997........................ 54,300,000 2,215 -- N/A 1998........................ 47,650,000 2,734 -- N/A 1999........................ 62,650,000 2,283 -- N/A
25 28
TOTAL AMOUNT OUTSTANDING INVOLUNTARY EXCLUSIVE OF ASSET LIQUIDATING AVERAGE TREASURY COVERAGE PREFERENCE MARKET VALUE CLASS AND YEAR SECURITIES(1) PER UNIT(2) PER UNIT(3) PER UNIT(4) -------------- ------------- ----------- ----------- -------------- OVERSEAS PRIVATE INVESTMENT CORPORATION LOAN 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 0 0 -- N/A 1995........................ 0 0 -- N/A 1996........................ 8,700,000 2,485 -- N/A 1997........................ 8,700,000 2,215 -- N/A 1998........................ 5,700,000 2,734 -- N/A 1999........................ 5,700,000 2,283 -- N/A REVOLVING LINES OF CREDIT 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 32,226,000 3,695 -- N/A 1995........................ 20,414,000 2,868 -- N/A 1996........................ 45,099,000 2,485 -- N/A 1997........................ 38,842,000 2,215 -- N/A 1998........................ 95,000,000 2,734 -- N/A 1999........................ 82,000,000 2,283 -- N/A SENIOR NOTE PAYABLE(6) 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 20,000,000 5,789 -- N/A 1993........................ 20,000,000 6,013 -- N/A 1994........................ 20,000,000 3,695 -- N/A 1995........................ 20,000,000 2,868 -- N/A 1996........................ 20,000,000 2,485 -- N/A 1997........................ 20,000,000 2,215 -- N/A 1998........................ 0 0 -- N/A 1999........................ 0 0 -- N/A BONDS PAYABLE 1989........................ $ 0 $ 0 $-- N/A 1990........................ 0 0 -- N/A 1991........................ 0 0 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 0 0 -- N/A 1995........................ 98,625,000 2,868 -- N/A 1996........................ 54,123,000 2,485 -- N/A 1997........................ 0 0 -- N/A 1998........................ 0 0 -- N/A 1999........................ 0 0 -- N/A
26 29
TOTAL AMOUNT OUTSTANDING INVOLUNTARY EXCLUSIVE OF ASSET LIQUIDATING AVERAGE TREASURY COVERAGE PREFERENCE MARKET VALUE CLASS AND YEAR SECURITIES(1) PER UNIT(2) PER UNIT(3) PER UNIT(4) -------------- ------------- ----------- ----------- -------------- REVERSE REPURCHASE AGREEMENTS(7) 1989........................ $ 29,386,000 $4,015 $ -- N/A 1990........................ 28,361,000 3,397 -- N/A 1991........................ 2,761,000 3,834 -- N/A 1992........................ 0 0 -- N/A 1993........................ 0 0 -- N/A 1994........................ 0 0 -- N/A 1995........................ 0 0 -- N/A 1996........................ 0 0 -- N/A 1997........................ 0 0 -- N/A 1998........................ 0 0 -- N/A 1999........................ 0 0 -- N/A REDEEMABLE CUMULATIVE PREFERRED STOCK(5) 1989........................ $ 0 $ 0 $ 0 N/A 1990........................ 1,000,000 308 100 N/A 1991........................ 1,000,000 338 100 N/A 1992........................ 1,000,000 526 100 N/A 1993........................ 1,000,000 546 100 N/A 1994........................ 1,000,000 351 100 N/A 1995........................ 1,000,000 277 100 N/A 1996........................ 1,000,000 242 100 N/A 1997........................ 1,000,000 217 100 N/A 1998........................ 1,000,000 267 100 N/A 1999........................ 1,000,000 225 100 N/A NON-REDEEMABLE CUMULATIVE PREFERRED STOCK(5) 1989........................ $ 6,000,000 $ 362 $ 100 N/A 1990........................ 6,000,000 308 100 N/A 1991........................ 6,000,000 338 100 N/A 1992........................ 6,000,000 526 100 N/A 1993........................ 6,000,000 546 100 N/A 1994........................ 6,000,000 351 100 N/A 1995........................ 6,000,000 277 100 N/A 1996........................ 6,000,000 242 100 N/A 1997........................ 6,000,000 217 100 N/A 1998........................ 6,000,000 267 100 N/A 1999........................ 6,000,000 225 100 N/A
- ------------------------- (1) Total amount of each class of senior securities outstanding at the end of the period presented. (2) The asset coverage ratio for a class of senior securities representing indebtedness is calculated as the Company's consolidated total assets, less all liabilities and indebtedness not represented by senior securities, divided by senior securities representing indebtedness. This asset coverage ratio is multiplied by $1,000 to determine the Asset Coverage Per Unit. The asset coverage ratio for a class of senior securities that is preferred stock is calculated as the Company's consolidated total assets, less all liabilities and indebtedness not represented by senior securities, divided by senior securities representing indebtedness, plus the involuntary liquidation preference of the preferred stock (see footnote 3). The Asset Coverage Per Unit for preferred stock is expressed in terms of dollar amounts per share. (3) The amount to which such class of senior security would be entitled upon the involuntary liquidation of the issuer in preference to any security junior to it. 27 30 (4) Not applicable, as senior securities are not registered for public trading. (5) Issued by the Company's SBIC subsidiary to the SBA. These categories of senior securities are not subject to the asset coverage requirements of the 1940 Act. See "Certain Government Regulations -- SBA Regulations." (6) The Company was the obligor on $15 million of the senior notes. The Company's SBIC subsidiaries were the obligors on the remaining $5 million, which is not subject to the asset coverage requirements of the 1940 Act. (7) U.S. government agency guaranteed loans sold under agreements to repurchase. The Company was advised by the Staff of the Commission that these reverse repurchase agreements were not considered a class of senior security representing indebtedness and thus were not subject to the asset coverage requirements of the 1940 Act. 28 31 BUSINESS We are principally a lender to and investor in private companies in a variety of different industries and in diverse geographic locations throughout in the United States. We have been investing in growing businesses for over 40 years and have financed thousands of private companies nationwide. Our investment activity is focused in three areas: - Private finance - Commercial real estate finance, including the purchase of CMBS, and - Allied Capital Express -- small business and commercial real estate loans of up to $3 million originated for sale. Our investment portfolio consists primarily of long-term unsecured loans with equity features, commercial mortgage-backed securities, commercial mortgage loans, and small senior loans, including SBA 7(a) guaranteed loans. At December 31, 1999, our investment portfolio totaled $1.2 billion representing 641 borrower relationships in 38 states and the District of Columbia. The Company's investment objective is to achieve current income and capital gains. PRIVATE FINANCE We provide long-term debt and equity financing to private companies nationwide. Our private finance activities target a market niche between the senior debt financing provided by traditional lenders, such as banks, commercial finance companies and insurance companies, and the equity capital provided by private equity investors. Our private financing is generally used to fund growth, buyouts, note purchases, acquisitions, recapitalizations, and bridge financings. We generally invest in private companies though, from time to time, we may invest in undervalued public companies that lack access to public capital and whose securities may not be marginable. We target two types of companies when seeking new investments. The first type of company we seek is a market leader in a stable industry that has demonstrated over many years of operations that it can successfully achieve its business plan and thereby achieve our investment objective. The second type of company we seek is an emerging company in a growing industry that is positioned for significant growth. We have spent over 40 years refining our highly selective investment discipline, which is founded on seeking portfolio companies having key characteristics and targeting specific industries. We originate investments generally ranging in size from $5 million to $30 million, and in 1999 our average investment size was approximately $12.4 million. Our private finance investments are generally structured as an unsecured, subordinated loan that carries a relatively high fixed interest rate (generally 12% to 18%), with interest-only payments in the early years and payments of both principal and interest in the later years, with maturities of five to ten years. Approximately 98% of the investments in the private finance portfolio have fixed rates of interest. Our private finance investments typically include equity features, such as warrants or options to buy a minority interest in the portfolio company. We also make preferred and common equity investments, particularly when we see unique opportunities to profit from the growth of an emerging company. At December 31, 1999, 87% of the private finance portfolio consisted of debt securities, and 13% consisted of equity securities. Our private finance portfolio is geographically diverse, and includes investments in a wide variety of industries, including business services, consumer products, telecommunications, industrial products and broadcasting. 29 32 Capital providers for the finance of private companies can be generally categorized as shown in the diagram below: CAPITAL PROVIDER Banks Commercial Insurance Allied Private Private Finance Companies/ Capital Mezzanine Equity Companies High Yield Funds Funds Market - ----------------------------------------------------------------------------------------------------- PRIMARY Senior, Asset-based Large Unsecured Unsecured Equity BUSINESS short-term lending >$30 million long-term long-term FOCUS debt credits debt with debt with equity equity upside upside - ----------------------------------------------------------------------------------------------------- TYPICAL PRICING LIBOR+ [graphic of arrow stretching between 'LIBOR+' and 30%+ SPECTRUM* '30%+']
- --------------- * Based on market experience of our marketing and investment professionals. Banks are primarily focused on providing senior secured and unsecured short-term debt. They typically do not provide meaningful long-term unsecured loans. Commercial finance companies are primarily focused on providing senior secured long-term debt. The private insurance company and high-yield debt markets are focused primarily on very large financing transactions, typically in excess of the financings we do. We generally do not compete with banks, commercial finance companies, or the insurance company/high yield market. Instead, we compete directly with the private mezzanine sector of the private equity market. Private mezzanine funds are also focused on providing unsecured long-term debt to private companies for the types of transactions discussed above. We believe that we have key structural and operational advantages when compared to private mezzanine funds. Our scale of operations, equity capital base, and successful track record as a private finance investor has enabled us to borrow long-term capital to leverage our returns on our common equity. Therefore, our access to debt capital reduces our total cost of capital. In many cases, a private mezzanine fund is unable to access the debt capital markets, and therefore must achieve an unleveraged equity return for their investors. Our lower cost of capital gives us a pricing advantage when competing for new investments. In addition, the perpetual nature of our corporate structure enables us to be a better long-term partner for our portfolio companies than a traditional mezzanine fund, which typically has a finite life. We estimate that we fund only 2% of all the private finance investments that we review. When assessing a prospective investment, we look for a company that has achieved, or has the potential to achieve, market leadership in a niche, critical mass, and a sustainable cash flow. We also look for companies that, because of their industry and business plan, can demonstrate minimal vulnerability to changes in economic cycles. Since our debt securities are primarily unsecured in nature, we look for companies in industries that are non-cyclical, cash flow intensive, and can demonstrate a high return on their invested capital. We generally do not target companies in industries where businesses tend to be vulnerable to changes in economic cycles, are capital intensive, and have low returns on their invested capital. We generally target and do not target the following industries, 30 33 though we will consider investments in any industry if the prospective company demonstrates unique characteristics that make it an attractive investment opportunity: INDUSTRIES TARGETED NON-CYCLICAL/CASH FLOW INTENSIVE/ HIGH RETURN ON CAPITAL --------------------------------------- Business services Telecommunications Broadcasting Education Healthcare Consumer products Light industrial products INDUSTRIES NOT TARGETED CYCLICAL/CAPITAL INTENSIVE/ LOW RETURN ON CAPITAL --------------------------------------- Heavy manufacturing Natural resources Commodity retail Low value-add distribution Agriculture Transportation Another critical element of our investment discipline is to invest in companies with a significant equity capital base, and a strong private equity sponsor. For example, in 1999, 77% of our private financings were completed in conjunction with private equity firms, which provided capital that is junior to ours. We believe strong equity sponsorship significantly strengthens our position as a long-term lender. A strong equity sponsor provides not only strong equity capital beneath our investment, but also provides a reliable source of additional equity capital if the portfolio company requires additional financing. Private equity sponsors also help us confirm our own due diligence findings when assessing a new investment opportunity, and they provide assistance and leadership to the portfolio company's management team throughout our investment period. The typical private finance structure focuses, first and foremost, on the protection of our investment principal. Our debt instruments generally provide for a contractual interest rate ranging from 12% to 18%, which provides current interest income. The debt instruments also have restrictive covenants that protect our interests in the transaction. The warrants we receive with our debt securities generally require only a minimal cost to exercise, and thus as the portfolio company appreciates in value, we achieve additional investment return from this equity interest. We seek to achieve additional investment returns of up to 1000 basis points from the appreciation and sale of our warrants. Generally, our warrants expire five years after the related debt is repaid. The warrants typically include registration rights, which allow us to sell the securities if the portfolio company completes a public offering. In most cases, the warrants also have a put option that requires that the borrower repurchase our equity position after a specified period of time at a formula price or at its fair market value. Most of the gains we realize from our warrant portfolio arise as a result of the sale of the portfolio company to another business, or through a recapitalization. Historically, we have not been dependent on the public equity markets for the sale of our warrant positions. We hold a portion of our private finance investments in a wholly owned subsidiary, Allied Investment Corporation. Allied Investment is a BDC and is licensed and regulated by the Small Business Administration to operate as a small business investment company ("SBIC"). See "Certain Government Regulations" below for further information about SBIC regulation. COMMERCIAL REAL ESTATE FINANCE COMMERCIAL MORTGAGE LOANS. We have been a commercial real estate lender for many years, and maintain a commercial mortgage loan portfolio. During 1998, we 31 34 significantly reduced our middle-market commercial real estate lending activities, because we believed that the market was under-pricing commercial real estate loans, and that the returns on senior commercial real estate loans were below a level that would result in a fair return on equity for our shareholders. We, however, continue to see a strong demand for small commercial mortgage loans that can be attractively priced for sale to banks and other financial institutions. As a result of this market demand, we combined our small real estate lending with our SBA lending activity to form Allied Capital Express, which is discussed below. We continue to seek unique opportunities for commercial mortgage loans for our portfolio when our risk/return objectives can be achieved. These loans are generally priced at higher fixed interest rates and include subordinated real estate loans. Subordinated loans are priced similarly to our private finance loans and may be accompanied by an equity interest in the real estate or in the underlying business. We derive income from the interest charged on the commercial mortgage loan portfolio through contractual interest and amortization of discounts. We compete with banks, real estate conduits, equity and mortgage real estate investment trusts ("REITs") and other lenders for the commercial mortgage loans we originate for investment. We believe we have earned a reputation in the commercial real estate finance market as a specialist in credits that require more difficult structuring or underwriting techniques, and that we compete successfully in this niche. During 1999, we sold a significant portion of our lower yielding commercial mortgage loan portfolio, and redeployed the proceeds into higher yielding investments. We may continue to sell loans from this portfolio during 2000. COMMERCIAL MORTGAGE-BACKED SECURITIES. The same pricing pressures that caused us to reduce our origination of commercial mortgage loans in 1998 created significant liquidity problems for many other real estate lenders who had remained active lenders as pricing declined throughout 1998. In the fourth quarter of 1998, many of these lenders experienced severe liquidity constraints that caused them to exit the commercial mortgage-backed securities market. This liquidity turmoil in the real estate capital markets created a unique opportunity for us to acquire newly issued, non-investment grade commercial mortgage-backed securities ("Purchased CMBS") at significant discounts from the face amount of the bonds and at attractive yields. As an investor, we believe that Purchased CMBS has attractive risk/return characteristics. The Purchased CMBS in which we invest are non-investment grade, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (i.e., "AAA" through "BBB"), and are sometimes referred to as "junk bonds." Unlike most "junk bonds," which are typically unsecured debt instruments, the non-investment grade Purchased CMBS in which we invest are secured by mortgage loans with real estate collateral. Our Purchased CMBS are fully collateralized by senior mortgage loans on commercial real estate properties where the loans are, on average, supported by a 30% equity investment. We acquire our Purchased CMBS on the initial issuance of the CMBS bond offering, and are able to underwrite and negotiate to purchase the securities at a significant discount from their face amount, generally resulting in an estimated yield to maturity ranging from 13% to 16%. Our negotiated discount and estimated yield to maturity assumes a 1% loss rate on the entire underlying commercial mortgage loan collateral pool, which takes into consideration certain business and economic uncertainties and contingencies. We find the yields for Purchased CMBS very attractive given their collateral protection. 32 35 We believe this risk/return dynamic exists in this market today because there are significant barriers to entry as a non-investment grade CMBS investor. First, non-investment grade CMBS are long-term investments and require long-term investment capital. Our capital structure, which is in excess of 50% equity capital, is well suited for this asset class. Second, when we purchase CMBS on an initial issuance, we re-underwrite every mortgage loan in the underlying collateral pool, and we meet with the issuer to discuss the nature and type of loans we will accept into the pool. We have significant commercial mortgage loan underwriting expertise, both in terms of the number of professionals we employ and the depth of their commercial real estate experience. Access to this type of expertise is another barrier to entry into this market. As a non-investment grade CMBS investor, we recognize that non-investment grade securities have a higher degree of risk than do investment grade bonds. Non-investment grade securities are considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not ensured. They tend to be less liquid, may have a higher risk of default, and may be more difficult to value. We invest in non-investment grade CMBS represented by the "BB" to non-rated tranches of a CMBS issuance. Due to the underlying structure of the CMBS issuances, our CMBS tranches receive principal payments only after the securities that are senior to our securities are repaid. Thus, if losses are incurred in the underlying mortgage loan collateral pool, we would experience these losses. To mitigate this risk, we perform extensive due diligence prior to an investment in Purchased CMBS. When we evaluate a CMBS investment, we use the same underwriting procedures and criteria for the mortgage loans in the collateral pool as we do for all of the loans we originate. These underwriting procedures and criteria are described in detail below. We will only invest in CMBS when we believe, as a result of our underwriting procedures, that the underlying mortgage pool adequately secures our position. Our portfolio of CMBS is secured by more than 2,000 commercial real estate properties located in diverse geographic locations across the United States in a wide variety of property types, including retail, multi-family housing, office, and hospitality. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a summary of the loan to value ratios and debt service coverage ratios of the mortgage loans securing our Purchased CMBS investments. Our Purchased CMBS activity complements our private finance activity because it provides a steady stream of recurring interest income. In order to maintain a balanced investment portfolio, we expect to limit our Purchased CMBS activity on a proportional basis as our private finance portfolio grows. ALLIED CAPITAL EXPRESS We originate small business and commercial real estate loans, primarily for sale, under the brand name "Allied Capital Express." The loans we originate in this program are generally for financings of up to $3 million in size, and may be composed of an SBA 7(a) guaranteed loan and a conventional commercial mortgage loan. These loans are sold to banks and other financial institutions for premiums ranging from 5% to 10% of the loan amount sold. We also may sell these loans for a retained servicing spread that can range from 1% to 5% of the outstanding loan balance for the period that the loan remains outstanding. We began using a separate brand name for these smaller loans in the second quarter of 1999, to distinguish this program from our core private finance activity and avoid confusion in the market place. Allied Capital Express provides a steady stream of 33 36 premium income to the Company with minimal capital employed, and thus complements our other portfolio activities. Many of the loans originated under the Allied Capital Express brand name are through our participation in the SBA's 7(a) Guaranteed Loan Program. The SBA 7(a) program is estimated to provide approximately $10 billion to small businesses on an annual basis. One of our subsidiaries is licensed by the SBA as a Small Business Lending Company ("SBLC") and is one of only fourteen non-bank SBLCs operating in the United States. Under the SBA 7(a) program, we extend senior secured loans that are partially guaranteed by the SBA. Our 7(a) loans are provided to small businesses for the purposes of acquiring a business or real estate, purchasing machinery or equipment, or providing working capital. The loans are secured by a mortgage or other liens on the assets of the borrower, and in all cases the owners of the business must personally guarantee the repayment of the loan. We focus our 7(a) loan origination activity on loans secured by commercial real estate assets. We are a Preferred Lender and we operate in 20 SBA-designated markets throughout the United States. We have Allied Capital Express offices in seven locations. In 1999, we began an initiative to increase the growth and profitability of Allied Capital Express. We developed technology to streamline the closing process and reduce cycle times for transactions. We strengthened our sales force and increased our loan sale network. We also began a process to migrate the application process to the Internet to increase our loan origination activity. We intend to continue with all aspects of this initiative throughout 2000. Our 7(a) loans typically range in size from $250,000 to $1 million. The SBA guarantees 80% of any qualified loan up to $100,000 regardless of maturity, and 75% of any qualified loan over $100,000 regardless of maturity, to a maximum guarantee of $750,000 for any one borrower. SBA regulations define qualified small businesses generally as businesses with (1) no more than $5 million in annual sales or (2) no more than 500 employees. The SBA stipulates that loans used to acquire real estate may have a maximum maturity of 25 years; loans used to purchase machinery and equipment may have a maximum maturity of 15 years; loans used for working capital may have a maximum maturity of seven years. We generally price our 7(a) loans with variable interest rates typically ranging from 1.75% to 2.75% over the prime rate, adjusted monthly. Approximately 98% of this portfolio has variable interest rates. Generally loans are payable in equal monthly installments of principal and interest on the first day of the month following the month in which the loan is funded, until maturity. We routinely sell the guaranteed portion of our 7(a) loans in the well-established secondary market of banks and other institutional buyers. We earn a premium, net of origination costs, on the sale of the guaranteed portion of our 7(a) loans, which typically range from 4% to 7.5% of the face amount of each loan sold. We also may sell these loans for a retained servicing spread that generally ranges from 1% to 5% of the loan balance for the period that the loan remains outstanding. In 1999, we entered into an agreement with a commercial paper conduit to sell up to 90% of the unguaranteed interests in our 7(a) loans. We retain a servicing spread of approximately 3.75% on the unguaranteed interests sold. We continue to service 100% of each 7(a) loan we originate. In addition to 7(a) loans, we originate small commercial real estate loans for sale to banks and other institutional buyers. These loans are often originated in conjunction with 7(a) loans. The small commercial real estate loans generally are priced and structured such that we can receive premiums for the sale of these loans to banks and other financial 34 37 institutions. Our net premium on these loan sales is generally up to 10% of the loan balance sold. INVESTMENT ADVISORY SERVICES We are a registered investment adviser, pursuant to the Investment Advisers Act of 1940, and have certain investment advisory agreements to manage private investment funds. The revenue generated from these agreements is not material to the Company's operations. LOAN SOURCING Over the last two years, we have significantly increased the scope of our sales and marketing activity by opening new regional offices and increasing our sales and marketing staff. To source new investment opportunities, we work with thousands of intermediaries including: - regional and boutique investment banks; - private mezzanine and equity investors; - business and mortgage brokers; - national retail financial services companies; and - banks, law firms and accountants. We believe that our experience and reputation provide a competitive advantage in originating new investments. We have established an extensive network of investment referral relationships over our 41-year history. We are recognized as a pioneer in the private finance industry, and have developed a reputation in the commercial real estate finance market for our ability to finance complex transactions. For Allied Capital Express activities, we continue to build our network of Internet relationships to direct traffic to our web site, AlliedCapitalExpress.com, which we believe will increase our business opportunities. We have entered into a strategic relationship with an online loan broker and plan to enter into similar agreements with other small business portals and online intermediaries throughout 2000. INVESTMENT APPROVAL AND UNDERWRITING PROCEDURES In assessing new investment opportunities, we maintain conservative credit standards based on our underwriting guidelines, a thorough due diligence process, and a centralized credit approval process requiring committee review, all of which are described below. The combination of conservative underwriting standards and our credit-oriented culture has resulted in a record of minimal realized losses. PRIVATE FINANCE. We generally require that the companies in which we invest demonstrate strong market position, sales growth, positive cash flow, and profitability, as discussed above. We emphasize the quality of management, and seek experienced entrepreneurs with a management track record, relevant industry experience and a significant equity stake in the business. In a typical private financing, we thoroughly review, analyze and substantiate, through due diligence, the business plan and operations of the potential portfolio company. We perform financial due diligence, often with assistance of an accounting firm; perform operational due diligence, often with the assistance of an industry consultant; study the industry and competitive landscape; and conduct numerous reference checks with current and former employees, customers, suppliers and competitors. 35 38 The typical private finance transaction requires two to three months of diligence and structuring before funding occurs. Private finance transactions are approved by an investment committee consisting of our most senior private finance professionals and chaired by our Chairman and Chief Executive Officer. The private finance approval process benefits from the experience of the investment committee members and from the experience of our other investment professionals who together with the committee members, on average, have over eleven years of professional experience. For every transaction of $10 million or greater, we also require approval from the executive committee of the board of directors in addition to the investment committee approval. Even after all such approvals are received, due diligence must be successfully completed with final investment committee approval before funds are disbursed to a new portfolio company. PURCHASED CMBS. We receive extensive packages of information regarding the mortgage loans comprising a CMBS pool. We work with the issuer, the investment bank, and the rating agencies in performing our diligence on a CMBS purchase. The typical CMBS purchase takes between two to three months to complete because of the breadth and depth of our diligence procedures. We re-underwrite all of the underlying commercial mortgage loans securing the CMBS. We challenge the estimate of underwriteable cash flow and challenge necessary carve-outs, such as replacement reserves. We study the trends of the industry and geographic location of each property, and independently assess our own estimate of the anticipated cash flow over the period of the loan. Our loan officers physically inspect most of the collateral properties, and assess appraised values based on our own opinion of comparable market values. Based on the findings of our diligence procedures, we may reject certain mortgage loans from inclusion in the pool. We then formulate our negotiated purchase price and discount to achieve an effective yield on our investment over a ten-year period to approximate 13% to 16%. In computing this estimated yield, we assume a 1% loss rate on the entire underlying mortgage pool. CMBS transactions are approved by an investment committee and, because of their size, every CMBS transaction is reviewed and approved by the executive committee of the board of directors. The investment committee for CMBS transactions consists of our most senior commercial real estate professionals and is chaired by our Chairman and Chief Executive Officer. COMMERCIAL REAL ESTATE FINANCE. When we evaluate commercial mortgage loans, we generally receive an initial package of information that typically includes underwriting information that was developed by the borrower. Typical underwriting information that is required from potential borrowers in order to conduct appropriate due diligence includes: financial statements of the borrower, appraisals, rent rolls and lease information, environmental reports, structural and engineering reports, and any other information deemed appropriate under the circumstances. Our underwriting process includes assessing the borrower's estimated earnings and current cash flow coverage, the creditworthiness of the borrower, the net worth and financial strength of the borrower, the estimated current liquidation value of the related mortgaged property, the financial strength of the significant tenants, and any other collateral. We also study trends in the borrower's industry and in real estate values in the borrower's geographic region. Our loan officers inspect the property during the due diligence process, and value the property using internally developed valuation analyses. 36 39 Commercial mortgage loans are approved by an investment committee, which is composed of the Company's most senior commercial real estate finance investment professionals. For loans of $10 million or greater, the executive committee of the board of directors must also approve the transaction, as described above. ALLIED CAPITAL EXPRESS. Loans made to small businesses are generally secured by real estate and other liens on the assets of the borrower and, frequently, by the assets of principals. The entrepreneur must personally guarantee the payment of interest and principal on the loans. We generally follow the same underwriting procedures and criteria for 7(a) loans as we do for our commercial real estate loans, however, in addition to those underwriting standards, the SBA has established certain financial ratios and guidelines that generally govern 7(a) loans. Factors to be considered include the debt service coverage ratio, value of the collateral, and the net worth of the borrower. Allied Capital Express loans require the review and approval of three senior small business lending professionals prior to funding. The small business investment committee periodically ratifies each new investment. PORTFOLIO MANAGEMENT PORTFOLIO DIVERSITY. We monitor the portfolio to maintain both industry and geographic diversity. We currently do not have a policy with respect to "concentrating" (i.e., investing 25% or more of our total assets) in any industry or group of industries and currently our portfolio is not concentrated. We may or may not concentrate in any industry or group of industries in the future. LOAN SERVICING. Our loan servicing staff is responsible for routine loan servicing, which includes: - delinquency monitoring; - payment processing; - borrower inquiries; - escrow analysis and processing; - third-party reporting; and - insurance and tax administration. In addition, our staff is responsible for special servicing activities including delinquency monitoring and collection, workout administration and management of foreclosed assets. 37 40 PORTFOLIO MONITORING AND VALUATION We use a grading system in order to help us monitor the credit quality of our portfolio and the potential for capital gains. The grading system assigns grades to investments from 1 to 5, and the portfolio was graded at December 31, 1999 as follows:
PERCENTAGE PORTFOLIO AT OF TOTAL GRADE DESCRIPTION VALUE PORTFOLIO - ----- ----------- ------------- ---------- (IN MILLIONS) 1 Probable capital gain $ 156.0 12.7% 2 Performing security 1,002.9 81.7% Close monitoring -- no loss of principal or interest 3 expected 22.5 1.8% 4 Workout -- Some loss of interest expected 32.2 2.6% 5 Workout -- Some loss of principal expected 14.9 1.2% -------- ------ $1,228.5 100.0% ======== ======
The 1940 Act requires that the board of directors value each asset in the portfolio on a quarterly basis. We are not permitted to have a general loan loss reserve, but instead must value each specific investment. We have a written valuation policy that governs the valuation of our assets, and we follow a consistent valuation process quarterly. In valuing each individual investment, we consider the financial performance of each portfolio company, loan payment histories, indications of potential equity realization events, current collateral values and determine whether the value of the asset should be increased through unrealized appreciation or decreased through unrealized depreciation. After each investment professional has made his or her determination of value, members of senior management review the valuations. These valuations are then presented to the board of directors for review and approval. As a general rule, we do not value our loans above cost, but loans are subject to depreciation events when the asset is considered impaired. Also as a general rule, equity securities may be assigned appreciation if circumstances warrant. With respect to private equity securities, each investment is valued using industry valuation benchmarks, and then the value is assigned a discount reflecting the illiquid nature of the investments as well as our minority, non-control position. When an external event such as a purchase transaction, public offering, or subsequent equity sale occurs, the pricing indicated by the external event is used to corroborate our private equity valuation. Equity securities in public companies that carry certain restrictions on sale are generally valued at a discount from the public market value of the securities. Restricted and unrestricted publicly traded stocks may also be valued at discounts due to the size of our investment, restrictions on trading or market liquidity concerns. We monitor loan delinquencies weekly. The following outlines the treatment of each delinquency category: 30 Days Past Due Our loan servicing staff monitors loans and contacts borrowers for collection. 60 Days Past Due We generally transfer loans to professionals responsible for special servicing activity for monitoring, collection and development of a workout plan, if necessary. 90 Days Past Due Our accounting department reviews loans in conjunction with the professional responsible for special servicing to determine 38 41 whether the loans should be placed on a non-accrual status or whether a valuation adjustment is required. 120 Days Past Due Generally, we place such loans on non-accrual status and the loan is an active workout. INVESTMENT GAINS AND LOSSES As an investor focused primarily on debt investments, our investment decisions are based on credit dynamics. Our underwriting focuses on the preservation of principal, and we will pursue every available means to recover our capital investment. As a result of this investment discipline and credit culture, we have a history of low levels of loan losses, and have a demonstrated track record of successfully resolving troubled credit situations with minimal losses. In fact, we have historically experienced a loss rate that has averaged less than 1% of total assets annually over the last five, ten and twenty years. Our realized gains from the sale of our equity interests have historically exceeded losses, as is reflected in the chart below.
1999 1998 1997 1996 1995 ---------- -------- -------- -------- -------- Realized gains................. $ 31,536 $ 25,757 $ 15,804 $ 30,417 $ 16,679 Realized losses................ $ (6,145) $ (3,216) $ (5,100) $(11,262) $ (4,679) Net realized gains............. $ 25,391 $ 22,541 $ 10,704 $ 19,155 $ 12,000 Total assets................... $1,290,038 $856,079 $807,775 $713,360 $605,434 Realized losses/Total assets... 0.5% 0.4% 0.6% 1.6% 0.8%
EMPLOYEES At December 31, 1999, we employed 129 individuals including investment professionals, operations professionals and administrative staff. The majority of these individuals are located in the Washington, DC office. We believe that our relations with our employees are excellent. LEGAL PROCEEDINGS We are a party to certain lawsuits in the normal course of our business. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations. 39 42 PORTFOLIO COMPANIES The following is a listing of our portfolio companies in which we had an equity investment at December 31, 1999. We make available significant managerial assistance to our portfolio companies. Other than loans to the portfolio company, our only relationship with each portfolio company is our investment. For information relating to the amount and general terms of our loans to portfolio companies, see the Consolidated Statement of Investments and Notes thereto at December 31, 1999 at pages F-5 to F-10.
PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- Acme Paging, L.P. ................ Paging Services Partnership Interests 1.8% 1336 Basswood, Suite F Schaumburg, IL 60173 Allied Office Products............ Office Products Warrants to Purchase 2.1% 75 Route 17 South Retailer Common Stock Hasbrouck Heights, NJ 07604 American Barbecue & Grill, Inc. ........................... Restaurant Chain Warrants to Purchase 17.3% 7300 W. 110th Street, Suite 570 Common Stock Overland Park, KS 66210 ASW Holding Corporation........... Steel Wool Manufacturer Warrants to Purchase 5.0% 2825 W. 31st Street Common Stock Chicago, IL 60623 Aurora Communications, LLC........ Radio Stations Redeemable Preferred 3.3% 3 Stamford Landing, Suite 210 Stock 46 Southfield Avenue Stamford, CT 06902 Avborne, Inc. .................... Aviation Services Warrants to Purchase 2.5% c/o Trivest, Inc. Company Common Stock 2665 S. Bayshore Dr., Suite 800 Miami, FL 33133-5462 CampGroup, LLC.................... Recreational Camp Warrants to Purchase 2.6% 4 New King Street Operator Common Stock White Plains, NY 10604 Candlewood Hotel Company.......... Extended Stay Series A Convertible 5.3% 9342 East Central Facilities Preferred Stock Wichita, KS 67206 Celebrities, Inc. ................ Radio Stations Warrants to Purchase 25.0% 408-412 W. Oakland Park Common Stock Boulevard Ft. Lauderdale, FL 33311-1712 Convenience Corporation of America......................... Convenience Store Chain Series A Preferred Stock 10.0% 711 N. 108th Court Warrants to Purchase 4.5% Omaha, NE 68154 Common Stock Cooper Natural Resources, Inc. ... Sodium Sulfate Producer Warrants to Purchase 25.3% P.O. Box 1477 Common Stock Seagraves, TX 79360 Corrflex Graphics, LLC............ Packaging Manufacturer Warrants to Purchase 4.8% P.O. Box 1337 Common Stock Monroe, NC 28110 Options to Purchase 1.0% Common Stock Cosmetic Manufacturing............ Cosmetic Manufacturer Options to Purchase 17.5% Resources, LLC Shares 11312 Penrose Street Sun Valley, CA 91352
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PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- Csabai Canning Factory Rt. ....... Food Processing Hungarian Quotas 9.2% 5600 Bekescasba Bekis: vt 52-54 Hungary DEH Printed Circuits, Inc. ....... Circuit Board Warrants to Purchase 12.5% 840 Church Road Manufacturer Common Stock Elgin, IL 60123 DeVlieg-Bullard, Inc. ............ Tool Manufacturer Warrants to Purchase 1.7% One Gorham Island Common Stock Westport, CT 06680 Directory Investment Corporation..................... Telephone Directories Common Stock 50.0% 1919 Pennsylvania Avenue, N.W. Washington, DC 20006 Directory Lending Corporation..... Telephone Directories Common Stock 50.0% 1919 Pennsylvania Avenue, N.W. Washington, DC 20006 Drilltec Patents & Technologies Company, Inc.................... Drill Pipe Packager Warrants to Purchase 15.0% 10875 Kempwood Drive, Suite 2 Common Stock Houston, TX 77043 EDM Consulting, LLC............... Environmental Common Stock 25.0% 14 Macopin Avenue Consulting Montclair, NJ 07043 Esquire Communications Ltd. ...... Court Reporting Warrants to Purchase 3.0% 216 E. 45th Street, 8th floor Services Common Stock New York, NY 10017 ExTerra Credit Recovery, Inc. .... Consumer Finance Preferred Stock 0.9% 35 Lennon Lane, Suite 200 Common Stock 0.7% Walnut Creek, CA 94598 Warrants to Purchase 0.7% Common Stock Executive Greetings, Inc. ........ Personalized Business Warrants to Purchase 1.5% 120 Industrial Park Access Road Products Common Stock New Hartford, CT 06057 Fairchild Industrial Products Company......................... Industrial Controls Warrants to Purchase 21.5% 3920 Westpoint Boulevard Manufacturer Common Stock Winston-Salem, NC 27013 FTI Consulting, Inc. ............. Litigation Support Warrants to Purchase 5.0% 2021 Research Drive Services Common Stock Annapolis, MD 21401 Galaxy American Communications, LLC............................. Cable Television Warrants to Purchase 6.0% 1220 N. Main Street Operator Common Stock Sikeston, MO 63801 Garden Ridge Corporation.......... Home Decor Retailer Series A Preferred Stock 2.6% 650 Madison Avenue Common Stock 4.7% New York, NY 10022 Genesis Worldwide, Inc. .......... Manufacturers of Common Stock 1.1% 2600 Kettering Tower Metal Working P.O. Box 668 Machinery Dayton, OH 45423 Gibson Guitar Corporation ........ Guitar Manufacturer Warrants to Purchase 3.0% 1818 Elm Hill Pike Common Stock Nashville, TN 37210 Ginsey Industries, Inc. .......... Bathroom Accessories Convertible Debentures 7.0% 281 Benigno Boulevard Manufacturer Warrants to Purchase 16.0% Bellmawr, NJ 08031 Common Stock
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PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- Global Communications I, LLC...... Communications and Preferred Stock 60.0% 201 East 69th Street Media Businesses New York, NY 10021 Golden Eagle/Satellite Archery, LLC.................... Sporting Equipment Convertible Debentures 26.9% 1733 Gunn Highway Manufacturer Odessa, FL 33556 Grant Broadcasting System II...... Television Stations Warrants to Purchase 40.0% 919 Middle River Drive, Common Stock Suite 409 Warrants to Purchase 40.0% Ft. Lauderdale, FL 33304 Common Stock in Affiliate Company Grant Television, Inc. ........... Television Stations Warrants to Purchase 20.0% (See Grant Broadcasting System II) Common Stock Hotelevision, Inc. ............... Hotel Cable-TV Preferred Stock 14.2% 599 Lexington Avenue Network Suite 2300 New York, NY 10022 Icon International, Inc. ......... Corporate Barter Series A Preferred Stock 2.1% 281 Tressor Boulevard Services Series B Preferred Stock 1.8% 8th Floor Stamford, CT 06901 J3 Technology Services Corporation..................... Information Technology Warrants to Purchase 4.0% 5825 Glenridge Drive Services Provider Common Stock Building II, Suite 107 Atlanta, GA 30328 JRI Industries, Inc. ............. Machinery Manufacturer Warrants to Purchase 7.5% 2958 East Division Common Stock Springfield, MO 65803 Julius Koch USA, Inc. ............ Cord Manufacturer Warrants to Purchase 45.0% 387 Church Street Common Stock New Bedford, MA 02745 Kirker Enterprises, Inc. ......... Nail Enamel Warrants to Purchase 22.5% 55 East 6th Street Manufacturer Common Stock Paterson, NJ 07524 Equity Interest in 5.0% Affiliate Company Kirkland's, Inc. ................. Home Furnishing Warrants to Purchase 5.0% P.O. Box 7222 Retailer Common Stock Jackson, TN 38308-7222 Kyrus Corporation................. Value-Added Reseller, Warrants to Purchase 8.0% 25 Westridge Market Place Computer Systems Common Stock Chandler, NC 28715 Liberty-Pittsburgh Systems, Inc. ........................... Business Forms Printing Common Stock 20.0% 265 Executive Drive Plainview, NY 11803 Love Funding Corporation.......... Mortgage Services Series D Preferred Stock 26.0% 1220 19th Street, NW, Suite 801 Washington, DC 20036 Master Plan, Inc. ................ Healthcare Outsourcing Common Stock 15.6% 21540 Plummer Street Chatsworth, CA 91311 Med Assets.com, Inc. ............. Healthcare Outsourcing Series B Convertible 8.5% 21540 Plummer Street Preferred Stock Chatsworth, CA 91311 Warrants to Purchase 5.3% Preferred Stock
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PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- Midview Associates, L.P. ......... Residential Land Options to purchase 35.0% 2 Eaton Street, Suite 1101 Development partnership interests Hampton, VA 23669 Monitoring Solutions, Inc. ....... Air Emissions Common Stock 25.0% 4303 South High School Road Monitoring Warrants to Purchase 40.0% Indianapolis, IN 46241 Common Stock Morton Industrial Group........... Friction Materials Common Stock 0.2% 5305 Oakbrook Parkway Manufacturer Norcross, GA 30093 MVL Group......................... Market Research Warrants to Purchase 8.0% 1061 E. Indiantown Road Service Common Stock Suite 300 Jupiter, FL 33477 NET-Tel Communications, Inc. ..... Integrated Series B Convertible 2.5% 1023 31st Street, N.W. Communications Preferred Stock Washington, DC 20007 Provider Warrants to Purchase 1.8% Common Stock Nobel Learning Communities, Inc. ........................... Educational Services Series D Convertible 100.0% 1400 N. Providence Road, Preferred Stock Suite 3055 Warrants to Purchase 13.1% Media, PA 19063 Common Stock Nursefinders, Inc. ............... Home Healthcare Warrants to Purchase 3.5% 1200 Copeland Road, Suite 200 Providers Common Stock Arlington, TX 76011 Opinion Research Corporation...... Corporate Marketing Warrants to Purchase 8.0% P.O. Box 183 Research Firm Common Stock Princeton, NJ 08542 Outsource Partners, Inc. ......... Outsourced Facility Warrants to Purchase 4.0% 200 Mansell Court East Services Provider Common Stock Suite 500 Preferred Stock 4.0% Roswell, GA 30076 Panera Bread Company ............. Restaurant Chain Warrants to Purchase 1.8% 19 Fid Kennedy Avenue Common Stock Boston, MA 02210 Physician Specialty Corporation... Physician Management Redeemable Preferred 1.4% 1150 Lake Hearn Drive Services Provider Stock Atlanta, GA 30342 Convertible Preferred 0.3% Stock Warrants to Purchase 1.9% Common Stock Pico Products, Inc. .............. Satellite/Television Common Stock 5.0% 12500 Foothill Boulevard Component Warrants to Purchase 15.0% Lakeview Terr., CA 91342 Manufacturer Common Stock Polaris Pool Systems, Inc. ....... Pool Cleaner Warrants to Purchase 2.3% P.O. Box 1149 Manufacturer Common Stock San Marcos, CA 92079-1149 Progressive International Corporation .................... Retail Kitchenware Common Stock 0.0% 6111 S. 228th Street Redeemable Preferred 6.2% P.O. Box 97045 Stock Kent, WA 98064 Warrants to Purchase 8.0% Common Stock Schwinn/GT........................ Bicycle Manufacturer/ Warrants to Purchase 0.7% 1690 38th Street Distributor Common Stock Boulder, CO 80301
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PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- Seasonal Expressions, Inc......... Decorative Ribbon Series A Preferred Stock 100.0% 230 5th Avenue, Suite 1007 Manufacturer New York, NY 10001 Soff-Cut Holdings, Inc............ Concrete Sawing Common Stock 2.7% 1112 Olympic Drive Equipment Manufacturer Series A Preferred Stock 4.0% Corona, CA 91719 Warrants to Purchase 6.7% Common Stock Southwest PCS, LP................. Wireless Telephone Options to Purchase 6.0% 5 North McCormick Carrier Common Stock Oklahoma City, OK 73127 Spa Lending Corporation........... Health Spas Series A Preferred Stock 100.0% 1919 Pennsylvania Avenue, N.W. Series B Preferred Stock 68.4% Washington, DC 20006 Series C Preferred Stock 46.3% Common Stock 62.1% Sure-Tel, Inc. ................... Telephone Services Series A Convertible 9.3% 5 North McCormick Company Redeemable Preferred Oklahoma City, OK 73127 Stock Warrants to Purchase 11.6% Common Stock Options 1.9% Sydran Food Services II, LP. Operator of Fast Options to Purchase 2.5% Bishop Ranch 8 Food Restaurants Common Stock 3000 Executive Parkway Ste. 515 San Ramon, CA 94583-4254 Teknekron Infoswitch Corporation..................... Telecommunications Warrants to Purchase 5.5% 4425 Cambridge Road Software Provider Common Stock Fort Worth, TX 76155-2692 Total Foam, Inc. ................. Packaging Systems Common Stock 49.0% P.O. Box 688 Ridgefield, CT 06877 Tubbs Snowshoe Company, LLC. ..... Snowshoe Manufacturer Warrants to Purchase 8.4% 52 River Road Common Units Stowe, VT 05672 Common Units of 6.4% Affiliate Company United Pet Group, Inc. ........... Manufacturer of Pet Warrants to Purchase 0.8% 125 High Street Supply Products Common Stock Boston, MA 02110 Unitel, Inc. ..................... Operator of Call Warrants to Purchase 8.0% 8300 Greensboro Drive, 6th Floor Service Centers Common Stock McLean, VA 22102 Williams Brothers Lumber Company......................... Builders' Supplies Warrants to Purchase 14.1% 3165 Pleasant Hill Road Common Stock Duluth, GA 30136 Woodstream Corporation............ Pest Control Equity Interest 12.6% 69 North Locust Street Manufacturer Warrants to Purchase 7.2% Lititz, PA 17543 Common Stock Wyo-Tech Acquisition Corporation..................... Vocational School Common Stock 99.0% 4373 N. 3rd Street Preferred Stock 100.0% Laramie, WY 82072
- --------------- (1) Percentages shown for warrants and options held represent the percentage of class of security we may own, on a fully diluted basis, assuming we exercise our warrants or options. 44 47 DETERMINATION OF NET ASSET VALUE We determine the net asset value per share of our common stock quarterly. The net asset value per share is equal to the value of our total assets minus liabilities and preferred stock divided by the total number of common shares outstanding. Portfolio assets are carried at fair value as determined by the board of directors under our valuation policy. As a general rule, we do not value the Company's loans above cost, but loans are subject to depreciation events when the asset is considered impaired. Also as a general rule, equity securities may be assigned appreciation if circumstances warrant. With respect to private equity securities, each investment is valued using industry valuation benchmarks, and then the value is assigned a discount reflecting the illiquid nature of the investment as well as our minority, non-control position. When an external event such as a purchase transaction, public offering, or subsequent equity sale occurs, the pricing indicated by the external event is used to corroborate our private equity valuation. Equity securities in public companies that carry certain restrictions on sale are generally valued at a discount from the public market value of the securities. Restricted and unrestricted publicly traded stocks may also be valued at discounts, due to the size of our investment or market liquidity concerns. Determination of fair value involves subjective judgments that cannot be substantiated by auditing procedures. Accordingly, under current standards, the accountants' opinion on the Company's financial statements in our annual report refers to the uncertainty with respect to the possible effect on the financial statements of such valuation. MANAGEMENT The board of directors supervises the management of our Company. The responsibilities of each director include, among other things, the oversight of the loan approval process, the quarterly valuation of our assets, and oversight of our financing arrangements. The board of directors maintains an Executive Committee, Audit Committee, Compensation Committee, and Nominating Committee, and may establish additional committees in the future. All of the Company's directors also serve as directors of its subsidiaries. Our investment decisions in each business area are made by investment committees comprised of the Company's most senior investment professionals. No one person is primarily responsible for making recommendations to a committee. The Company is internally managed and our investment professionals manage our portfolio and the portfolios of companies for which we serve as investment adviser. These investment professionals have extensive experience in managing investments in private growing businesses in a variety of industries and in diverse geographic locations, and are familiar with our approach of lending and investing. Because the Company is internally managed, we pay no investment advisory fees, but instead we pay the operating costs associated with employing investment management professionals. STRUCTURE OF BOARD OF DIRECTORS The Company's board of directors is classified into three approximately equal classes with three-year terms, with only one of the three classes expiring each year. Directors serve until their successors are elected and qualified. 45 48 DIRECTORS Information regarding the board of directors is as follows:
DIRECTOR EXPIRATION NAME AGE POSITION SINCE(1) OF TERM - ---- --- -------- -------- ---------- William L. Walton*........... 50 Chairman, Chief Executive Officer and President 1986 2001 George C. Williams, Jr.*..... 73 Chairman Emeritus 1964 2001 Brooks H. Browne............. 50 Director 1990 2001 John D. Firestone............ 56 Director 1993 2002 Anthony T. Garcia............ 43 Director 1991 2002 Lawrence I. Hebert........... 53 Director 1989 2002 John I. Leahy................ 69 Director 1994 2000 Robert E. Long............... 68 Director 1972 2001 Warren K. Montouri........... 70 Director 1986 2000 Guy T. Steuart II............ 68 Director 1984 2000 T. Murray Toomey, Esq........ 76 Director 1959 2000 Laura W. van Roijen.......... 47 Director 1992 2002
- --------------- * Interested persons of the Company, as defined in the 1940 Act. (1) Includes service as a director of any of the predecessor companies. EXECUTIVE OFFICERS Information regarding the Company's executive officers is as follows:
NAME AGE POSITION ---- --- -------- William L. Walton............ 50 Chairman, Chief Executive Officer and President Philip A. McNeill............ 40 Managing Director John M. Scheurer............. 47 Managing Director Joan M. Sweeney.............. 40 Managing Director G. Cabell Williams, III ..... 45 Managing Director Penni F. Roll................ 34 Principal and Chief Financial Officer
BIOGRAPHICAL INFORMATION DIRECTORS William L. Walton has been the Chairman, Chief Executive Officer and President of the Company since 1997. Mr. Walton was President of Allied Capital Corporation II from 1996 to 1997. Mr. Walton is a director of Nobel Learning Communities, Inc. (a portfolio company) and Riggs National Corporation. Mr. Walton was co-founder and CEO of Success Lab, Inc. (children's educational services) from 1993 to 1996, and founder and CEO of Language Odyssey (educational publishing and services) from 1992 to 1996. Mr. Walton was Managing Director of Butler Capital Corporation from 1987 to 1991. George C. Williams, Jr. is Chairman Emeritus of the Company. Mr. Williams was an officer of the predecessor companies from the later of 1959 or the inception of the relevant entity and President or Chairman and Chief Executive Officer of the predecessor 46 49 companies from the later of 1964 or each entity's inception until 1991. Mr. Williams is the father of G. Cabell Williams III, an executive officer of the Company. Brooks H. Browne has been the President of Environmental Enterprises Assistance Fund since 1993. Mr. Browne is a director of SEAF, Corporation Financiera Ambiental (Panama), Empresas Ambientales de Centro America (Costa Rica) and Yayasan Bina Usaha Lingkungan (Indonesia) (environmental nonprofit or investment funds). John D. Firestone has been a Partner of Secor Group (venture capital) since 1978. Mr. Firestone is a director of Business Mortgage Investors, Inc., Security Storage Company of Washington, DC, Bryn Mawr Bank Corporation and the National Organization on Disability. Mr. Firestone is an Advisory Board member of GeoPortals.com. Anthony T. Garcia has been General Manager of Breen Capital Group (investor in tax liens) since 1997. Mr. Garcia was a Senior Vice President of Lehman Brothers Inc. from 1985 to 1996. Lawrence I. Hebert has been a director of Riggs National Corporation since 1988. He also serves as a director of Riggs Investment Management Corporation and Riggs Bank Europe Limited (indirect subsidiaries of Riggs National Corporation). Mr. Hebert is the President and a director of Perpetual Corporation (owner of Allbritton Communications Company and Allnewsco, Inc.) and the Chairman and Chief Executive Officer of Allbritton Communications Company (owner of television stations). Mr. Hebert is a director of Allnewsco, Inc. (news programming service), the President of Westfield News Advertiser, Inc. (owner of a television station and newspapers), and a trustee of The Allbritton Foundation. Mr. Hebert was Vice President of University Bancshares, Inc. (a Texas bank holding company) from 1975 to 1997. John I. Leahy has been the President of Management and Marketing Associates (a management consulting firm) since 1986. Mr. Leahy was the President and Group Executive Officer, Western Hemisphere of Black & Decker Corporation from 1982 to 1985. Mr. Leahy is a director of Kar Kraft Systems, Inc., The Wills Group and Chairman of Gallagher Fluid Seals, Inc. Mr. Leahy is a trustee of St. Mary's Seminary & University and Trustee Emeritus of Loyola College Sellinger School of Business. Robert E. Long is the Managing Director of Goodwyn, Long & Black Investment Management, Inc. and has been the Chairman and Chief Executive Officer of Emerald City Radio Partners, LLC since 1997. Mr. Long has been the President and Chief Executive Officer of Business News Network, Inc. from 1995 to 1998, was the Chairman and Chief Executive Officer of Southern Starr Broadcasting Group, Inc. from 1991 to 1995, and a director and the President of Potomac Asset Management, Inc. from 1983 to 1991. Mr. Long is a director of Ambase Inc., AHL Shipping Company, Inc., CSC Scientific, Inc., and Global Travel, Inc. Warren K. Montouri has been a Partner of Montouri & Roberson (real estate investment firm) since 1980. Mr. Montouri was a director of C&S/Sovran Bank from 1970 to 1990, a director of Sovran Financial Corporation from 1989 to 1990, a director of NationsBank, N.A. from 1990 to 1996, a director of BB&T Bank (formerly Franklin National Bank) since 1996, a trustee of Suburban Hospital from 1991 to 1994, and a trustee of The Audubon Naturalist Society from 1979 to 1985. 47 50 Guy T. Steuart II has been a director and President of Steuart Investment Company (manages, operates, and leases real and personal property and holds stock in operating subsidiaries engaged in various businesses) since 1960. Mr. Steuart is Trustee Emeritus of Washington and Lee University. T. Murray Toomey, Esq. has been an attorney at law since 1949. Mr. Toomey is a director of The National Capital Bank of Washington and Federal Center Plaza Corporation. He is also a trustee of The Catholic University of America. Laura W. van Roijen has been a private real estate investor since 1992. Ms. van Roijen was the Chairman of CWV & Associates (RTC qualified contracting firm) from 1991 to 1994, a director and the Treasurer of Black Possum Inc. (retail concern) from 1994 to 1996, the President of Volta Place, Inc. (real estate advisory firm) from 1991 to 1994, and Vice President (from 1986 to 1991) and Market Director (from 1989 to 1991) of Citicorp Real Estate, Inc. EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS Philip A. McNeill, Managing Director, has been employed by the Company since 1993 and is responsible for co-managing the Company's private finance group. Before joining the Company, he served as a vice president of M&T Capital Corporation. Prior to entering the private finance industry, he was founding director of Western Oklahoma National Bank, and structured and managed numerous privately negotiated investments. John M. Scheurer, Managing Director, has been employed by the Company since 1991 and manages the Company's real estate finance group. He has more than 22 years of experience in commercial finance and real estate lending and management. Prior to joining the Company, Mr. Scheurer worked in various capacities with Capital Recovery Advisors, Inc. and First American Bank. He also started his own company, The Scheurer Company, and co-founded Hunter & Associates, a major leasing and consulting real estate firm in the Washington, DC area. Joan M. Sweeney, Managing Director, has been employed by the Company since 1993. Ms. Sweeney oversees all company operations and is responsible for strategic planning, financial management, information technology, marketing, investor relations, and all regulatory compliance. Ms. Sweeney also has direct responsibility for the Company's small business lending operations through Allied Capital Express. Prior to joining the Company, Ms. Sweeney spent ten years of her career consulting with private and small public companies at both Ernst & Young and Coopers & Lybrand. Ms. Sweeney was a member of the SEC Division of Enforcement in the late 1980s. G. Cabell Williams, III, Managing Director, has been employed by the Company since 1981 and is responsible for co-managing the operations of the Company's private finance group. He has over 19 years of private finance experience, and has structured numerous types of private debt and equity finance transactions. Mr. Williams has served in many capacities during his tenure with the Company. Penni F. Roll, Principal and Chief Financial Officer, has been employed by the Company since 1995. Ms. Roll is responsible for the Company's financial management and reporting, accounting, loan servicing, special servicing, portfolio monitoring and regulatory compliance activities. Prior to joining the Company, she spent seven years in the financial services practice at KPMG Peat Marwick, including serving as a Manager from 1993 to 1995. 48 51 COMPENSATION PLANS STOCK OPTION PLAN The Company's stock option plan (the "Stock Option Plan") is intended to encourage stock ownership in the Company by officers, thus giving them a proprietary interest in the Company's performance. The Stock Option Plan was approved by shareholders at the Special Meeting of Shareholders on November 26, 1997. The Committee's principal objective in awarding stock options to the eligible officers of the Company is to align each optionee's interests with the success of the Company and the financial interests of its stockholders by linking a portion of such optionee's compensation with the performance of the Company's stock and the value delivered to stockholders. Stock options are granted under the Stock Option Plan at a price not less than the prevailing market value and will have value only if the Company's stock price increases. The Committee determines the amount and features of the stock options, if any, to be awarded to optionees. The Committee evaluates a number of criteria, including the past service of each such optionee to the Company, the present and potential contributions of such optionee to the success of the Company and such other factors as the Committee shall deem relevant in connection with accomplishing the purposes of the Stock Option Plan, including the recipient's current stock holdings, years of service, position with the Company and other factors. The Committee does not apply a formula assigning specific weights to any of these factors when making its determination. The Committee awards stock options on a subjective basis and such awards depend in each case on the performance of the officer under consideration. For the years ended December 31, 1999 and 1998, the Company's compensation committee granted a total of 1,287,736 and 5,189,944 options, respectively, to certain officers and non-officer directors of the Company. These options generally vest over a five-year period except that grants to non-officer directors vest immediately. See "Control Persons and Principal Holders of Securities" in the SAI for currently exercisable options granted to certain executive officers and non-officer directors. On September 8, 1999, the Company received approval from the Commission to grant options under the Stock Option Plan to non-officer directors. On that date, each incumbent non-officer director received options to purchase 10,000 shares, and pursuant to the Commission order, each will receive options to purchase 5,000 shares each year thereafter on the date of the annual meeting. New directors will receive options to purchase 10,000 shares upon election to the board, and options to purchase 5,000 shares each year thereafter on the date of the annual meeting. The Stock Option Plan is designed to satisfy the conditions of Section 422 of the Code so that options granted under the Stock Option Plan may qualify as "incentive stock options." To qualify as "incentive stock options," options may not become exercisable for the first time in any year if the number of incentive options first exercisable in that year multiplied by the exercise price exceeds $100,000. The Board of Directors has submitted an amended Stock Option Plan to increase the authorized shares under the plan as well as certain other administrative changes to stockholders to be voted on at the Annual Meeting of Stockholders to be held on May 9, 2000. 49 52 FORMULA AWARD AND CUT-OFF AWARD FORMULA AWARD. The Formula Award was designed as an incentive compensation program that would replace stock options of the predecessor companies that were cancelled as a result of the Company's 1997 merger, and would balance share ownership among key officers. Assuming all officers meet the vesting requirement, the Company would accrue the Formula Award in equal amounts of approximately $6.4 million, over the three-year period on the anniversary of the merger date (December 31) in 1998, 1999 and 2000, and will vest automatically in the event of a change of control of the Company. The Formula Award expense for 1999 totaled $6.2 million. If an officer terminates employment with the Company prior to the vesting of any part of the Formula Award, that amount is forfeited to the Company. The terms of the Formula Award require that the award be contributed to the Company's deferred compensation plan, and used to purchase shares of the Company in the open market. See "Deferred Compensation Plan." The amount of the Formula Awards received by certain executive officers in 1999 is provided in the SAI. On January 3, 2000, the trust that holds the deferred compensation plan distributed shares of the Company's common stock with a value of $4,274,000 representing the portion of the Formula Award that vested on December 31, 1999. These shares are held in restricted accounts at a brokerage firm. CUT-OFF AWARD. The Cut-Off Award was designed to cap the appreciated value in unvested options at the merger announcement date in order to set the foundation to balance option awards upon the merger. The Cut-Off Award, in the aggregate, was computed to be $2.9 million, and was equal to the difference between the market price of the shares of stock underlying the canceled options under the old plans of the predecessor companies at August 14, 1997, less the exercise prices of the options. The Cut-Off Award is payable for each canceled option as the canceled option would have vested, and vests automatically in the event of a change of control. The Cut-Off Award is payable only if the award recipient is employed by the Company on the future vesting date. The Cut-Off Award expense for 1999 totaled $0.6 million. The amount of the Cut-Off Award received by certain executive officers in 1999 is provided in the SAI. EMPLOYEE STOCK OWNERSHIP PLAN AND 401(K) PLAN Until December 31, 1999, the Company maintained an Employee Stock Ownership Plan (the "ESOP"). All eligible employees (i.e., employees with one (1) year of service who are at least 21 years of age) of the Company were eligible participants in the ESOP. Pursuant to this qualified plan, during 1999 the Company contributed 5% of each eligible participant's total cash compensation for the year (up to $160,000) to a plan account on the participant's behalf, which fully vests over a two-year period. The contribution with respect to compensation in excess of $160,000 was made to the deferred compensation plan. The ESOP used substantially all of these cash contributions to purchase shares of the Company. At December 31, 1999, the ESOP held 0.4% of the outstanding shares of the Company, and all of these shares had been allocated to participants' plan accounts. On December 31, 1999 the ESOP was terminated. In October 1999, the Company established a 401(K) plan (the "401(K) Plan"), to replace the existing ESOP. All employees who are at least 21 years of age have the opportunity to contribute pre-tax salary deferrals into the 401(K) Plan up to $10,500, and to direct the investment of these contributions. The 401(K) Plan allows eligible participants to invest in shares of the Company's common stock among other investment options. In addition, beginning in 2000, the Company expects to contribute to each eligible 50 53 participant (i.e., employees with one (1) year of service), 5% of each participant's total cash compensation for the year, up to $170,000, to each participant's plan account on the participant's behalf, which fully vests at the time of contribution. The contribution with respect to compensation in excess of $170,000 is made to the Deferred Compensation Plan. Generally, participants, including the executive officers, transferred the balance of their ESOP account, including shares of the Company, into the 401(K) Plan on March 16, 2000. On March 22, 2000, the 401(K) Plan held 0.4% of the outstanding shares of the Company. DEFERRED COMPENSATION PLAN The Company maintains a deferred compensation plan (the "Deferred Compensation Plan"). The Deferred Compensation Plan is a funded plan that provides for the deferral of compensation by employees and consultants of the Company. Any employee or consultant of the Company is eligible to participate in the plan at such time and for such period as designated by the board of directors. The Deferred Compensation Plan is administered through a trust, and the Company funds this plan through cash contributions. The Deferred Compensation Plan holds the unvested shares of the Company's common stock purchased in connection with the Formula Award. TAXATION The following discussion is a general summary of the material federal income tax considerations applicable to the Company and to an investment in the common stock and does not purport to be a complete description of the income tax considerations applicable to such an investment. The discussion is based upon the Code, Treasury Regulations, and administrative and judicial interpretations each as of the date of this prospectus and, all of which are subject to change. You should consult your own tax advisor with respect to tax considerations which pertain to your purchase of common stock. This summary assumes that the investors in the Company hold shares as capital assets. This summary does not discuss all aspects of federal income taxation relevant to holders of the common stock in light of particular circumstances, or to certain types of holders subject to special treatment under federal income tax laws, including pension plans and trusts, dealers in securities and financial institutions. This summary does not discuss any aspects of foreign, state or local tax laws. It also does not discuss the special treatment under federal tax laws that could result if the Company invested in tax-exempt obligations or certain other investment assets. TAXATION AS A RIC The Company intends to be treated for tax purposes as a "regulated investment company" or "RIC" within the meaning of Section 851 of the Code. If the Company qualifies as a RIC and distributes to its shareholders in a timely manner at least 90% of its "investment company taxable income," as defined in the Code (the "90% Distribution Requirement"), each year, it will not be subject to federal income tax on the portion of its taxable income and gains it distributes (as defined in Section 1222(ii) of the Code) to shareholders. In addition, if a RIC distributes in a timely manner (or treats as "deemed distributed") 98% of its capital gain net income for each one year period ending on December 31 (pursuant to Section 4982(e)(4)(A) of the Code), and distributes 98% of its ordinary income for each calendar year, it will not be subject to the 4% nondeductible 51 54 federal excise tax on certain undistributed income of RICs. The Company generally endeavors to distribute to shareholders all of its investment company taxable income and its net capital gain (as defined in Section 1222(ii) of the Code), if any, for each taxable year so that it will not incur income or excise taxes on its earnings. In order to qualify as a RIC for federal income tax purposes, the Company must generally, among other things: (1) continue to qualify as a BDC under the 1940 Act; (2) derive in each taxable year at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities or other income derived with respect to its business of investing in such stock or securities; and (3) diversify its holdings so that at the end of each quarter of the taxable year (a) at least 50% of the value of its assets consists of cash, cash items, U.S. government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the Company's assets or 10% of the outstanding voting securities of the issuer, and (b) no more than 25% of the value of the Company's assets are invested in securities (other than U.S. government securities or securities of other RICs) of one issuer, or of two or more issuers that are controlled by the Company and are engaged in the same or similar or related trades or businesses. The failure of one or more of the Company's subsidiaries to continue to qualify as RICs could adversely affect the Company's ability to satisfy foregoing diversification requirements. If the Company fails to satisfy the 90% Distribution Requirement or otherwise fails to qualify as a RIC in any taxable year, it will be subject to tax in that year on all of its taxable income, regardless of whether it makes any distribution to its shareholders. In that case, all of the Company's distributions to its shareholders will be characterized as ordinary income (to the extent of the Company's current and accumulated earnings and profits). In contrast, as is explained below, if the Company qualifies as a RIC, a portion of its distributions or deemed distributions may be characterized as long-term capital gain in the hands of shareholders. TAXATION OF SHAREHOLDERS Distributions of the Company generally are taxable to shareholders as ordinary income or capital gains. Shareholders receive notification from the Company at the end of each year as to the amount and nature of the income or gains distributed to them for that year. The distributions from the Company to a particular shareholder may be subject to the alternative minimum tax under the provisions of the Code. The Company's distributions of ordinary income and net short-term capital gain (as defined in Section 1222(5) of the Code) generally are taxable to shareholders as ordinary income. Distributions of net capital gain, if any, that the Company designates as capital gain dividends generally are taxable to shareholders as long-term capital gain, regardless of the length of time a shareholder has held the shares. All distributions are taxable, whether invested in additional shares or received in cash. Dividends that the Company declares and are payable to shareholders of record in October, November or December of a given year that are paid during the following January, will be treated as having been received by shareholders on December 31 of the year of declaration. At the Company's option, the Company may elect to retain some or all of its net capital gains for a tax year, but designate the retained amount as a deemed distribution to its shareholders. In that case, among other consequences, the Company will pay tax on the retained amount on behalf of the shareholders, the shareholders will include the deemed distribution in income, and the 52 55 shareholders will obtain a tax credit for the tax paid by the Company. In the event the Company chooses this option, it must provide written notice to the shareholders prior to the expiration of 60 days after the close of the relevant tax year. If certain conditions are met, the Company's ordinary income dividends to its corporate shareholders may qualify for the dividends received deduction to the extent that the Company receives qualifying dividend income during the taxable year. Capital gain dividends distributed by the Company are not eligible for the dividends received deduction. In general, any gain or loss realized upon a taxable disposition of shares of the Company, or upon receipt of a liquidating distribution, will be treated as capital gain or loss. If gain is realized, it will be subject to taxation at various tax rates depending on the length of time the taxpayer has held such shares and other factors. The gain or loss will be short-term capital gain or loss if the shares have been held for one year or less. If a shareholder has received any capital gain dividends or deemed dividends with respect to such shares, any loss realized upon a taxable disposition of shares treated under the Code as having been held for six months or less, to the extent of such capital gain dividends or deemed dividends, will be treated as a long-term capital loss. All or a portion of any loss realized upon a taxable disposition of shares of the Company may be disallowed if other shares of the Company are purchased (under a DRIP plan or otherwise) within 30 days before or after the disposition. A shareholder that is not a "United States person" within the meaning of the Code (a "Non-U.S. shareholder") generally will be subject to a withholding tax of 30% (or lower applicable treaty rate) on dividends from the Company (other than capital gain dividends or deemed dividends) that are not "effectively connected" with a United States trade or business carried on by such shareholder. Accordingly, investment in the Company is likely to be appropriate for a Non-U.S. shareholder only if such person can utilize a foreign tax credit or corresponding tax benefit in respect of such United States withholding tax. Non-effectively connected capital gain dividends and gains realized from the sale of Shares will not be subject to United States federal income tax in the case of (i) a Non-U.S. shareholder that is a corporation and (ii) a Non-U.S. shareholder that is not present in the United States for more than 182 days during the taxable year (assuming that certain other conditions are met). See "Tax Status -- Non-U.S. Stockholders" in the SAI. Prospective foreign investors should consult their U.S. tax advisors concerning the tax consequences to them of an investment in shares. The Company is required to withhold and remit to the Internal Revenue Service (the "IRS") 31% of the dividends paid to any shareholder who (i) fails to furnish the Company with a certified taxpayer identification number; (ii) has underreported dividend or interest income to the IRS; or (iii) fails to certify to the Company that he, she or it is not subject to backup withholding. CERTAIN GOVERNMENT REGULATIONS We operate in a highly regulated environment. The following discussion generally summarizes certain regulations. BUSINESS DEVELOPMENT COMPANY ("BDC"). A business development company is defined and regulated by the Investment Company Act of 1940. It is a unique kind of investment company that primarily focuses on investing in or lending to small private companies and making managerial assistance available to them. A BDC may use capital 53 56 provided by public shareholders and from other sources to invest in long-term, private investments in growing small businesses. A BDC provides shareholders the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits, if any, of investing in privately owned growth companies. As a BDC, we may not acquire any asset other than "Qualifying Assets" unless, at the time we make the acquisition, our Qualifying Assets represent at least 70% of the value of our total assets (the "70% test"). The principal categories of Qualifying Assets relevant to our business are: (1) Securities purchased in transactions not involving any public offering, the issuer of which is an eligible portfolio company. An eligible portfolio company is defined to include any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than an SBIC wholly owned by a BDC (our investments in Allied Investment, Allied SBLC and certain other subsidiaries generally are Qualifying Assets), and (c) does not have any class of publicly traded securities with respect to which a broker may extend margin credit; (2) Securities received in exchange for or distributed with respect to securities described in (1) above or pursuant to the exercise of options, warrants, or rights relating to such securities; and (3) Cash, cash items, government securities, or high quality debt securities (within the meaning of the 1940 Act), maturing in one year or less from the time of investment. To include certain securities described above as Qualifying Assets for the purpose of the 70% test, a BDC must make available to the issuer of those securities significant managerial assistance such as providing significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company, or making loans to a portfolio company. We will provide managerial assistance on a continuing basis to any portfolio company that requests it, whether or not difficulties are perceived. We maintain a code of ethics that establishes procedures for personal investing and restricts certain transactions by persons covered by the code. As a BDC, the Company is entitled to issue senior securities in the form of stock or senior securities representing indebtedness, as long as each class of senior security has an asset coverage of at least 200% immediately after each such issuance. This limitation is not applicable to borrowings by our SBIC or SBLC subsidiaries, and therefore any borrowings by these subsidiaries are not included in this asset coverage test. See "Risk Factors." We may not change the nature of our business so as to cease to be, or withdraw our election as, a BDC unless authorized by vote of a "majority of the outstanding voting securities," as defined in the 1940 Act, of our shares. Since we made our BDC election, we have not made any substantial change in the nature of our business. REGULATED INVESTMENT COMPANY ("RIC"). Our status as a RIC enables us to avoid the cost of federal and state taxation, and as a result achieve pre-tax investment returns. We believe that this tax advantage enables us to achieve strong equity returns without having to aggressively leverage our balance sheet. 54 57 In order to qualify as a RIC, the Company must, among other things: (1) Derive at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities or other income derived with respect to its business of investing in such stock or securities. (2) Diversify its holdings so that (a) at least 50% of the value of the Company's assets consists of cash, cash items, U.S. government securities, securities of other RICs and other securities if such other securities of any one issuer do not represent more than 5% of the Company's assets and 10% of the outstanding voting securities of the issuer, and (b) no more than 25% of the value of the Company's assets are invested in securities (other than U.S. government securities) of one issuer, or of two or more issuers that are controlled by the Company. (3) Distribute at least 90% of its "investment company taxable income" each tax year to its shareholders. In addition, if a RIC distributes in a timely manner (or treats as "deemed distributed") 98% of its capital gain net income for each one year period ending on December 31 and distributes 98% of its ordinary income for each calendar year, it will not be subject to the 4% nondeductible federal excise tax on certain undistributed income of RICs. SBA REGULATIONS. Allied Investment is an SBIC and Allied SBLC is an SBLC. SBIC REGULATIONS. Allied Investment, a wholly owned subsidiary of the Company, is licensed by the SBA as an SBIC under Section 301(c) of the Small Business Investment Act of 1958, as amended (the "1958 Act"), and has elected to be regulated as a BDC. SBICs are authorized to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the most recent two fiscal years. In addition, an SBIC must devote 20% of its investment activity to "smaller" concerns as defined by the SBA. A smaller concern is one that has a net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the most recent two fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses, and provide them with consulting and advisory services. Allied Investment provides long-term loans to qualifying small businesses; equity investments and consulting and advisory services are typically provided only in connection with such loans. Allied Investment is periodically examined and audited by the SBA staff to determine its compliance with SBIC regulations. Allied Investment has the opportunity to sell to the SBA subordinated debentures with a maturity of up to ten years, up to an aggregate principal amount of $101 million. This limit generally applies to all financial assistance provided by the SBA to any licensee and its "associates," as that term is defined in SBA regulations. Historically, an SBIC was also 55 58 eligible to sell preferred stock to the SBA. Allied Investment had received $62.7 million of subordinated debentures and $7.0 million of preferred stock investments from the SBA at December 31, 1999; as a result of the $101 million limit, the Company is limited on its ability to apply for additional financing from the SBA. Interest rates on the SBA debentures currently outstanding have a weighted average interest cost of 8.0%. At December 31, 1999, we had an outstanding commitment from the SBA to purchase up to $12.0 million in additional SBIC debentures, which was borrowed in January 2000. SBLC REGULATIONS. Allied SBLC is licensed to operate as an SBLC and is periodically examined and audited by the SBA staff for purposes of determining compliance with SBA regulations, including its participation in the Preferred Lenders Program. See SBA 7(a) Lending, above. DIVIDEND REINVESTMENT PLAN We have adopted an "opt out" dividend reinvestment plan ("DRIP plan"). Under the DRIP plan, if you own shares registered in your own name, our transfer agent, acting as reinvestment plan agent, will automatically reinvest any dividend in additional shares of common stock. Shareholders may change enrollment status in the DRIP plan at any time by contacting either the plan agent or the Company. A shareholder's ability to participate in a DRIP plan may be limited according to how the shares are registered. A nominee may preclude beneficial owners holding shares in street name from participating in the DRIP plan. Shareholders who wish to participate in a DRIP plan may need to register their shares in their own name. Shareholders will be informed of their right to opt out of the DRIP plan in the Company's annual and quarterly reports to shareholders. Shareholders who hold shares in the name of a nominee should contact the nominee for details. All distributions to investors who do not participate (or whose nominee elects not to participate) in the DRIP plan will be paid by check mailed directly, or through the nominee, to the record holder by or under the discretion of the plan agent. The plan agent is American Stock Transfer and Trust Company, 40 Wall Street, New York, New York 10005. Their telephone number is 800-937-5449. Under the DRIP plan, we may issue new shares unless the market price of the outstanding shares is less than 110% of the last reported net asset value. Alternatively, the plan agent may buy shares in the market. We value newly issued shares for the DRIP plan at the average of the reported last sale prices of the outstanding shares on the last five trading days prior to the payment date of the distribution, but not less than 95% of the opening bid price on such date. The price in the case of shares bought in the market will be the average actual cost of such shares, including any brokerage commissions. There are no other fees charged to shareholders in connection with the DRIP plan. Any distributions reinvested under the plan will nevertheless remain taxable to the shareholders. 56 59 DESCRIPTION OF CAPITAL STOCK COMMON STOCK The Company is authorized to issue 100,000,000 shares of common stock, par value $0.0001. At March 24, 2000, there were 68,628,044 shares of common stock outstanding and 5,506,837 shares of Common Stock reserved for issuance under the Stock Option Plan. The following are the authorized classes of securities of the Company as of March 24, 2000:
(4) (3) AMOUNT AMOUNT HELD OUTSTANDING (2) BY COMPANY EXCLUSIVE OF (1) AMOUNT OR FOR ITS AMOUNTS SHOWN TITLE OF CLASS AUTHORIZED ACCOUNT* UNDER(3) -------------- ----------- ----------- ------------- Allied Capital Corporation........ Common Stock 100,000,000 516,779 68,111,265
- ------------------------- * Represents shares of the Company held in a trust for the Deferred Compensation Plan. See "Management -- Compensation Plans." All shares of common stock have equal rights as to earnings, assets, dividends, and voting privileges and all outstanding shares of common stock are fully paid and non-assessable. Our common stock has no preemptive, conversion, or redemption rights and are freely transferable. In the event of liquidation, each share of common stock is entitled to its proportion of our assets after debts and expenses. Each share is entitled to one vote and does not have cumulative voting rights, which means that holders of a majority of the shares, if they so choose, could elect all of the directors, and holders of less than a majority of the shares would, in that case, be unable to elect any director. All shares offered hereby will be, when issued and paid for, fully paid and non-assessable. The board of directors may classify and reclassify any unissued shares of capital stock of the Company by setting or changing in one or more respects the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications, terms or conditions or redemption or other rights of such shares of capital stock. LIMITATION ON LIABILITY OF DIRECTORS The Company has adopted provisions in its charter and bylaws limiting the liability of directors and officers of the Company for monetary damages. The effect of these provisions in the charter and bylaws is to eliminate the rights of the Company and its shareholders (through shareholders' derivative suits on behalf of the Company) to recover monetary damages against a director or officers for breach of the fiduciary duty of care as a director or officer (including breaches resulting from negligent or grossly negligent behavior) except in certain limited situations. These provisions do not limit or eliminate the rights of the Company or any shareholder to seek non-monetary relief such as an injunction or rescission in the event of a breach of a director's or officer's duty of care. These provisions will not alter the liability of directors or officers under federal securities laws. CERTAIN ANTI-TAKEOVER PROVISIONS The charter and bylaws of the Company and certain statutory and regulatory requirements contain certain provisions that could make more difficult the acquisition of 57 60 the Company by means of a tender offer, a proxy contest or otherwise. These provisions are expected to discourage certain types of coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of the Company to negotiate first with the board of directors. We believe that the benefits of these provisions outweigh the potential disadvantages of discouraging such proposals because, among other things, negotiation of such proposals might result in an improvement of their terms. The description set forth below is intended as a summary only and is qualified in its entirety by reference to the charter and the bylaws. CLASSIFIED BOARD OF DIRECTORS The charter provides for the board of directors to be divided into three classes of directors serving staggered three-year terms, with each class to consist as nearly as possible of one-third of the directors then elected to the board. A classified board may render more difficult a change in control of the Company or removal of incumbent management. We believe, however, that the longer time required to elect a majority of a classified board of directors helps to ensure continuity and stability of the Company's management and policies. ISSUANCE OF PREFERRED STOCK The board of directors of the Company, without shareholder approval, has the authority to reclassify common stock as preferred stock and to issue preferred stock. Such stock could be issued with voting, conversion or other rights designed to have an anti-takeover effect. MARYLAND CORPORATE LAW The Company is subject to the Maryland Business Combination Statute and the Control Share Acquisition Statute, as defined below. The partial summary of the foregoing statutes contained in this prospectus is not intended to be complete and reference is made to the full text of such states for their entire terms. BUSINESS COMBINATION STATUTE. Certain provisions of the Maryland Law establish special requirements with respect to "business combinations" between Maryland corporations and "interested shareholders" unless exemptions are applicable (the "Business Combination Statute"). Among other things, the Business Combination Statute prohibits for a period of five years a merger or other specified transactions between a company and an interested shareholder and requires a super majority vote for such transactions after the end of such five-year period. "Interested shareholders" are all persons owning beneficially, directly or indirectly, 10% or more of the outstanding voting stock of a Maryland corporation. "Business combinations" include certain mergers or similar transactions subject to a statutory vote and additional transactions involving transfer of assets or securities in specified amounts to interested shareholders or their affiliates. Unless an exemption is available, a "business combination" may not be consummated between a Maryland corporation and an interested shareholder or its affiliates for a period of five years after the date on which the shareholder first became an interested shareholder and thereafter may not be consummated unless recommended by the board of directors of the Maryland corporation and approved by the affirmative vote of at least 80% of the votes 58 61 entitled to be cast by all holders of outstanding shares of voting stock and 66 2/3% of the votes entitled to be cast by all holders of outstanding shares of voting stock other than the interested shareholder or its affiliates or associates, unless, among other things, the corporation's shareholders receive a minimum price (as defined in the Business Combination Statute) for their shares and the consideration is received in cash or in the same form as previously paid by the interested shareholder for its shares. A business combination with an interested shareholder which is approved by the board of directors of a Maryland corporation at any time before an interested shareholder first becomes an interested shareholder is not subject to the five-year moratorium or special voting requirements. An amendment to a Maryland corporation charter electing not to be subject to the foregoing requirements must be approved by the affirmative vote of at least 80% of the votes entitled to be cast by all holders of outstanding shares of voting stock and 66 2/3% of the votes entitled to be cast by holders of outstanding shares of voting stock who are not interested shareholders. Any such amendment is not effective until 18 months after the vote of shareholders and does not apply to any business combination of a corporation with a shareholder who became an interested shareholder on or prior to the date of such vote. CONTROL SHARE ACQUISITION STATUTE. The Maryland Law imposes limitations on the voting rights of shares acquired in a "control share acquisition." The control share statute defines a "control share acquisition" to mean the acquisition, directly or indirectly, of "control shares" subject to certain exceptions. "Control shares" of a Maryland corporation are defined to be voting shares of stock which, if aggregated with all other shares of stock previously acquired by the acquiror, would entitle the acquiror to exercise voting power in electing directors with one of the following ranges of voting power: (1) one-fifth or more but not less than one-third; (2) one-third or more but less than a majority; or (3) a majority of all voting power. Control shares do not include shares which the acquiring person is entitled to vote as a result of having previously obtained shareholder approval. Control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast by shareholders in the election of directors, excluding shares of stock as to which the acquiring person, officers of the corporation and directors of the corporation who are employees of the corporation are entitled to exercise or direct the exercise of the voting power of the shares in the election of the directors. The control share statute also requires Maryland corporations to hold a special meeting at the request of an actual or proposed control share acquiror generally within 50 days after a request is made with the submission of an "acquiring person statement," but only if the acquiring person: (1) gives a written undertaking and, if required by the directors of the issuing corporation, posts a bond for the cost of the meeting; and (2) submits definitive financing agreements for the acquisition of the control shares to the extent that financing is not provided by the acquiring person. 59 62 In addition, unless the issuing corporation's charter or bylaws provide otherwise, the control share statute provides that the issuing corporation, within certain time limitations, shall have the right to redeem control shares (except those for which voting rights have previously been approved) for "fair value" as determined pursuant to the control share statue in the event: (1) there is a shareholder vote and the grant of voting rights is not approved; or (2) an "acquiring person statement" is not delivered to the target within 10 days following a control share acquisition. Moreover, unless the issuing corporation's charter or bylaws provide otherwise, the control share statute provides that if, before a control share acquisition occurs, voting rights are accorded to control shares which result in the acquiring person having majority voting power, then all shareholders other than the acquiring person have appraisal rights as provided under the Maryland Law. An acquisition of shares may be exempted from the control share statute provided that a charter or bylaw provision is adopted for such purpose prior to the control share acquisition by any person with respect to the Company. The control share acquisition statute does not apply to shares acquired in a merger, consolidation or share exchange to which the corporation is a party. REGULATORY RESTRICTIONS Allied Investment is an SBIC and Allied SBLC is an SBLC, and both are wholly owned subsidiaries of the Company. The SBA prohibits, without prior SBA approval, a "change of control" or transfers which would result in any person (or group of persons acting in concert) owning 10% or more of any class of capital stock of an SBIC. A "change of control" is any event which would result in a transfer of the power, direct or indirect, to direct the management and policies of an SBIC or SBLC, whether through ownership, contractual arrangements or otherwise. PLAN OF DISTRIBUTION We may sell shares through underwriters or dealers, directly to one or more purchasers, through agents or through a combination of any such methods of sale. Any underwriter or agent involved in the offer and sale of shares will be named in the applicable prospectus supplement. The distribution of shares may be effected from time to time in one or more transactions at a fixed price or prices, which may be changed, at prevailing market prices at the time of sale, at prices related to such prevailing market prices, or at negotiated prices, provided, however, that the offering price per share, less any commissions or discounts, must equal or exceed the net asset value ("NAV") per share of our common stock. In connection with the sale of shares, underwriters or agents may receive compensation from the Company or from purchasers of shares, for whom they may act as agents, in the form of discounts, concessions or commissions. Underwriters may sell shares to or through dealers and such dealers may receive compensation in the form of discounts, concessions or commissions from the underwriters and/or commissions from the purchasers for whom they may act as agents. Underwriters, dealers and agents that participate in the distribution of shares may be deemed to be underwriters under the Securities Act, and any 60 63 discounts and commissions they receive from the Company and any profit realized by them on the resale of shares may be deemed to be underwriting discounts and commissions under the Securities Act. Any such underwriter or agent will be identified and any such compensation received from the Company will be described in the applicable prospectus supplement. Any shares sold pursuant to a prospectus supplement will be quoted on the Nasdaq National Market, or another exchange on which the shares are traded. Under agreements into which the Company may enter, underwriters, dealers and agents who participate in the distribution of shares may be entitled to indemnification by the Company against certain liabilities, including liabilities under the Securities Act. Underwriters, dealers and agents may engage in transactions with, or perform services for, the Company in the ordinary course of business. If so indicated in the applicable prospectus supplement, the Company will authorize underwriters or other persons acting as the Company's agents to solicit offers by certain institutions to purchase shares from the Company pursuant to contracts providing for payment and delivery on a future date. Institutions with which such contracts may be made include commercial and savings banks, insurance companies, pension funds, investment companies, educational and charitable institutions and others, but in all cases such institutions must be approved by the Company. The obligations of any purchaser under any such contract will be subject to the condition that the purchase of shares shall not at the time of delivery be prohibited under the laws of the jurisdiction to which such purchaser is subject. The underwriters and such other agents will not have any responsibility in respect of the validity or performance of such contracts. Such contracts will be subject only to those conditions set forth in the prospectus supplement, and the prospectus supplement will set forth the commission payable for solicitation of such contracts. In order to comply with the securities laws of certain states, if applicable, shares offered hereby will be sold in such jurisdictions only through registered or licensed brokers or dealers. In addition, in certain states, the shares may not be sold unless they have been registered or qualified for sale in the applicable state or an exemption from the registration or qualification requirement is available and is complied with. 61 64 LEGAL MATTERS Certain legal matters with respect to the validity of the shares of common stock offered hereby will be passed upon for the Company by Sutherland Asbill & Brennan LLP, Washington, D.C. Certain legal matters will be passed upon for underwriters, if any, by the counsel named in the prospectus supplement. SAFEKEEPING, TRANSFER AND DIVIDEND PAYING AGENT AND REGISTRAR The Company's and its subsidiaries' investments are held in safekeeping by Riggs Bank, N.A. at 808 17th Street, N.W., Washington, D.C. 20006. LaSalle National Bank, located at 25 Northwest Point Boulevard, Suite 800, Elk Grove Village, Illinois 60007, serves as trustee with respect to assets of the Company held for securitization purposes. American Stock Transfer and Trust Company, 40 Wall Street, 46th Floor, New York, New York 10005 acts as the Company's transfer, dividend paying and reinvestment plan agent and registrar. INDEPENDENT PUBLIC ACCOUNTANTS The financial statements included in this prospectus and elsewhere in the registration statement to the extent and for the periods indicated in their report have been audited by Arthur Andersen LLP, independent public accountants, and is included herein in reliance upon the authority of said firm as experts in giving said report. 62 65 TABLE OF CONTENTS OF STATEMENT OF ADDITIONAL INFORMATION General Information and History............................. B-2 Investment Objective and Policies........................... B-2 Management.................................................. B-2 Compensation of Executive Officers and Directors....... B-2 Compensation of Directors.............................. B-3 Stock Option Awards.................................... B-3 Formula Award and Cut-off Award........................ B-6 Committees of the Board of Directors................... B-6 Control Persons and Principal Holders of Securities......... B-7 Investment Advisory Services................................ B-8 Safekeeping, Transfer and Dividend Paying Agent and Registrar................................................. B-8 Brokerage Allocation and Other Practices.................... B-8 Tax Status.................................................. B-9
63 66 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS INDEX TO FINANCIAL STATEMENTS
PAGE ---- Consolidated Balance Sheet -- December 31, 1999 and 1998.... F-1 Consolidated Statement of Operations -- For the Years Ended December 31, 1999, 1998 and 1997.................................................. F-2 Consolidated Statement of Changes in Net Assets -- For the Years Ended December 31, 1999, 1998 and 1997.............. F-3 Consolidated Statement of Cash Flows -- For the Years Ended December 31, 1999, 1998 and 1997.................................................. F-4 Consolidated Statement of Investments -- December 31, 1999...................................................... F-5 Notes to Consolidated Financial Statements.................. F-11 Report of Independent Public Accountants.................... F-32
64 67 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET
DECEMBER 31, --------------------- 1999 1998 (IN THOUSANDS, EXCEPT NUMBER OF SHARE AMOUNTS) ---------- -------- ASSETS Portfolio at value: Private finance (cost: 1999-$639,171; 1998-$382,488)....................................... $ 647,040 $388,554 Commercial real estate finance (cost: 1999-$522,022; 1998-$356,039)....................................... 520,029 354,980 Small business finance (cost: 1999-$61,708; 1998-$64,952)........................................ 61,428 63,585 ---------- -------- Total portfolio at value.......................... 1,228,497 807,119 ---------- -------- Cash and cash equivalents................................... 18,155 25,075 Other assets................................................ 43,386 23,885 ---------- -------- Total assets...................................... $1,290,038 $856,079 ========== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Notes payable and debentures.......................... $ 487,350 $233,350 Revolving credit facilities........................... 105,500 101,000 Accounts payable and other liabilities................ 22,675 21,671 Dividends and distributions payable................... -- 1,700 ---------- -------- Total liabilities................................. 615,525 357,721 ---------- -------- Commitments and Contingencies Preferred stock............................................. 7,000 7,000 Shareholders' equity: Common stock, $0.0001 par value, 100,000,000 shares authorized; 65,930,360 and 56,729,502 issued and outstanding at December 31, 1999 and 1998, respectively......................................... 6 6 Additional paid-in capital............................ 699,149 526,824 Common stock held in deferred compensation trust (516,779 shares and 810,456 shares at December 31, 1999 and 1998, respectively)......................... (6,218) (13,190) Notes receivable from sale of common stock............ (29,461) (23,735) Net unrealized appreciation on portfolio.............. 4,517 2,380 Distributions in excess of earnings................... (480) (927) ---------- -------- Total shareholders' equity........................ 667,513 491,358 ---------- -------- Total liabilities and shareholders' equity........ $1,290,038 $856,079 ========== ========
The accompanying notes are an integral part of these consolidated financial statements. F-1 68 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 1999 1998 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) --------- --------- --------- Interest and related portfolio income: Interest.............................................. $119,772 $ 79,921 $86,882 Premiums from loan dispositions....................... 14,284 5,949 7,277 Post-Merger gain on securitization of commercial mortgage loans...................................... -- 14,812 -- Investment advisory fees and other income............. 7,084 6,056 3,246 -------- -------- ------- Total interest and related portfolio income....... 141,140 106,738 97,405 -------- -------- ------- Expenses: Interest.............................................. 34,860 20,694 26,952 Employee.............................................. 16,136 11,829 10,258 Administrative........................................ 12,350 11,921 8,970 Merger................................................ -- -- 5,159 -------- -------- ------- Total operating expenses.......................... 63,346 44,444 51,339 -------- -------- ------- Formula and cut-off awards............................ 6,753 7,049 -- -------- -------- ------- Portfolio income before net realized and unrealized gains... 71,041 55,245 46,066 -------- -------- ------- Net realized and unrealized gains: Net realized gains.................................... 25,391 22,541 10,704 Net unrealized gains.................................. 2,138 1,079 7,209 -------- -------- ------- Total net realized and unrealized gains........... 27,529 23,620 17,913 -------- -------- ------- Income before minority interests and income taxes........... 98,570 78,865 63,979 -------- -------- ------- Minority interests.......................................... -- -- 1,231 Income tax expense.......................................... -- 787 1,444 -------- -------- ------- Net increase in net assets resulting from operations........ $ 98,570 $ 78,078 $61,304 ======== ======== ======= Basic earnings per common share............................. $ 1.64 $ 1.50 $ 1.24 ======== ======== ======= Diluted earnings per common share........................... $ 1.64 $ 1.50 $ 1.24 ======== ======== ======= Weighted average common shares outstanding -- basic......... 59,877 51,941 49,218 ======== ======== ======= Weighted average common shares outstanding -- diluted....... 60,044 51,974 49,251 ======== ======== =======
The accompanying notes are an integral part of these consolidated financial statements. F-2 69 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 1999 1998 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) --------- --------- --------- Operations: Portfolio income before realized and unrealized gains................................................ $ 71,041 $ 55,245 $ 46,066 Net realized gains..................................... 25,391 22,541 10,704 Net unrealized gains................................... 2,138 1,079 7,209 Minority interests and income tax expense.............. -- (787) (2,675) -------- -------- -------- Net increase in net assets resulting from operations...................................... 98,570 78,078 61,304 -------- -------- -------- Shareholder distributions: Common stock dividends................................. (97,941) (75,087) (85,678) Preferred stock dividends.............................. (230) (230) (220) -------- -------- -------- Net decrease in net assets resulting from shareholder distributions....................... (98,171) (75,317) (85,898) -------- -------- -------- Capital share transactions: Sale of common stock................................... 164,269 69,675 -- Net (increase) decrease in notes receivable from sale of common stock...................................... (5,725) 5,576 (14,120) Issuance of common stock upon the exercise of stock options.............................................. 5,920 221 28,426 Issuance of common stock in lieu of cash distributions........................................ 4,610 6,184 26,612 Net decrease (increase) in common stock held in deferred compensation trust.......................... 6,972 (13,190) -- Other.................................................. (290) 71 1,602 -------- -------- -------- Net increase in net assets resulting from capital share transactions.............................. 175,756 68,537 42,520 -------- -------- -------- Total increase in net assets...................... $176,155 $ 71,298 $ 17,926 ======== ======== ======== Net assets at beginning of year............................. $491,358 $420,060 $402,134 -------- -------- -------- Net assets at end of year................................... $667,513 $491,358 $420,060 -------- -------- -------- Net asset value per common share............................ $ 10.20 $ 8.79 $ 8.07 -------- -------- -------- Common shares outstanding at end of year.................... 65,414 55,919 52,047 ======== ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-3 70 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 1999 1998 1997 (IN THOUSANDS) --------- --------- --------- Cash flows from operating activities: Net increase in net assets resulting from operations..... $ 98,570 $ 78,078 $ 61,304 Adjustments Net unrealized gains.................................. (2,138) (1,079) (7,209) Post-Merger gain on securitization of commercial mortgages........................................... -- (14,812) -- Depreciation and amortization......................... 788 702 450 Amortization of loan discounts and fees............... (10,674) (6,032) (10,804) Deferred income taxes................................. -- -- 1,087 Minority interests.................................... -- -- 1,231 Changes in other assets and liabilities............... (8,712) 11,998 12,881 --------- --------- --------- Net cash provided by operating activities........... 77,834 68,855 58,940 --------- --------- --------- Cash flows from investing activities: Portfolio investments.................................... (751,871) (524,530) (364,942) Repayments of investment principal....................... 145,706 138,081 233,005 Proceeds from loan sales................................. 198,368 81,013 53,912 Proceeds from securitization of commercial mortgages..... -- 223,401 -- Net redemption (purchase) of U.S. government securities............................................ -- 11,091 (10,301) Collections of notes receivable from sale of common stock................................................. 195 5,591 6,534 Other investing activities............................... (1,754) (2,539) (182) --------- --------- --------- Net cash used in investing activities............... (409,356) (67,892) (81,974) --------- --------- --------- Cash flows from financing activities: Sale of common stock..................................... 164,269 69,896 8,615 Purchase of common stock by deferred compensation trust................................................. -- (19,431) -- Common dividends and distributions paid.................. (95,031) (69,536) (58,194) Special undistributed earnings distribution paid......... -- (8,848) -- Preferred stock dividends paid........................... (230) (450) (220) Net borrowings under (payments on) notes payable and debentures............................................ 254,000 (69,471) 78,923 Net borrowings under (payments on) revolving lines of credit................................................ 4,500 56,158 (6,257) Other financing activities............................... (2,906) (4,643) (1,237) --------- --------- --------- Net cash provided by (used in) financing activities....................................... 324,602 (46,325) 21,630 --------- --------- --------- Net decrease in cash and cash equivalents.................. $ (6,920) $ (45,362) $ (1,404) --------- --------- --------- Cash and cash equivalents at beginning of year............. $ 25,075 $ 70,437 $ 71,841 --------- --------- --------- Cash and cash equivalents at end of year................... $ 18,155 $ 25,075 $ 70,437 ========= ========= =========
The accompanying notes are an integral part of these consolidated financial statements. F-4 71 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INVESTMENTS
PRIVATE FINANCE DECEMBER 31, 1999 PORTFOLIO COMPANY ------------------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------------- --------------------------------------------- -------- -------- ACE Products, Inc. Debt Securities $ 13,386 $ 13,386 - ----------------------------------------------------------------------------------------------------------- Acme Paging, L.P. Debt Securities 6,618 6,618 Partnership Interest 1,456 2,100 - ----------------------------------------------------------------------------------------------------------- Allied Office Products Debt Securities 9,905 9,905 Warrants -- -- - ----------------------------------------------------------------------------------------------------------- American Barbecue & Grill, Inc. Warrants 125 125 - ----------------------------------------------------------------------------------------------------------- ASW Holding Corporation Warrants 25 25 - ----------------------------------------------------------------------------------------------------------- Aurora Communications, LLC Loans 13,370 13,370 Equity Interest 1,500 1,500 - ----------------------------------------------------------------------------------------------------------- Avborne, Inc. Debt Securities 11,959 11,959 Warrants 1,180 1,180 - ----------------------------------------------------------------------------------------------------------- Bakery Chef, Inc. Loans 10,967 10,967 - ----------------------------------------------------------------------------------------------------------- CampGroup, LLC Debt Securities 2,491 2,491 Warrants 220 220 - ----------------------------------------------------------------------------------------------------------- Candlewood Hotel Company (1) Preferred Stock (3,250 shares) 3,250 3,250 - ----------------------------------------------------------------------------------------------------------- Celebrities, Inc. Loan 310 310 Warrants 12 212 - ----------------------------------------------------------------------------------------------------------- Convenience Corporation of America Debt Securities 8,355 2,738 Series A Preferred Stock (31,521 shares) 334 -- Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Cooper Natural Resources, Inc. Debt Securities 3,460 3,460 Warrants -- 538 - ----------------------------------------------------------------------------------------------------------- CorrFlex Graphics, LLC Loan 6,957 6,957 Debt Securities 4,942 4,942 Warrants -- -- Options -- -- - ----------------------------------------------------------------------------------------------------------- Cosmetic Manufacturing Debt Securities 5,817 5,817 Resources, LLC Options 87 87 - ----------------------------------------------------------------------------------------------------------- Coverall North America Loan 9,298 9,298 - ----------------------------------------------------------------------------------------------------------- Csabai Canning Factory Rt. Hungarian Quotas (9.2%) 700 -- - ----------------------------------------------------------------------------------------------------------- DEH Printed Circuits, Inc. Warrants 250 -- - ----------------------------------------------------------------------------------------------------------- DeVlieg-Bullard, Inc. (1) Warrants 350 29 - ----------------------------------------------------------------------------------------------------------- Directory Investment Corporation Common Stock (470 shares) -- -- - ----------------------------------------------------------------------------------------------------------- Directory Lending Corporation Series A Common Stock (34 shares) -- -- Series B Common Stock (6 shares) 8 -- Series C Common Stock (10 shares) 22 -- - ----------------------------------------------------------------------------------------------------------- Drilltec Patents & Technologies Loan 10,911 8,755 Company, Inc. Debt Securities 786 786 Warrants -- -- - -----------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-5 72
PRIVATE FINANCE DECEMBER 31, 1999 PORTFOLIO COMPANY ------------------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------------- --------------------------------------------- -------- -------- EDM Consulting, LLC Debt Securities $ 1,875 $ 343 Common Stock (100 shares) 250 -- - ----------------------------------------------------------------------------------------------------------- El Dorado Communications, Inc. Loans 306 306 - ----------------------------------------------------------------------------------------------------------- Eparfin S.A. Loan 29 29 - ----------------------------------------------------------------------------------------------------------- Esquire Communications Ltd. (1) Warrants 6 -- - ----------------------------------------------------------------------------------------------------------- Ex Terra Credit Recovery, Inc. Series A Preferred Stock (500 shares) 500 500 Common Stock (2,500 shares) -- -- Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Executive Greetings, Inc. Debt Securities 15,825 15,825 Warrants 360 360 - ----------------------------------------------------------------------------------------------------------- Fairchild Industrial Products Company Debt Securities 5,753 5,753 Warrants 280 3,628 - ----------------------------------------------------------------------------------------------------------- FTI Consulting, Inc. (1) Debt Securities 12,053 12,053 Warrants 970 970 - ----------------------------------------------------------------------------------------------------------- Galaxy American Debt Securities 30,740 30,740 Communications, LLC Options -- 750 - ----------------------------------------------------------------------------------------------------------- Garden Ridge Corporation Debt Securities 26,537 26,537 Preferred Stock (1,130 shares) 1,130 1,130 Common Stock (471 shares) 613 613 - ----------------------------------------------------------------------------------------------------------- Genesis Worldwide, Inc. (1) Loan 1,328 1,328 Common Stock (41,644 shares) 214 81 - ----------------------------------------------------------------------------------------------------------- Genoa Mine Acquisition Corporation Loan 108 108 - ----------------------------------------------------------------------------------------------------------- Gibson Guitar Corporation Debt Securities 15,742 15,742 Warrants 525 1,000 - ----------------------------------------------------------------------------------------------------------- Ginsey Industries, Inc. Loans 5,000 5,000 Convertible Debentures 500 500 Warrants -- 154 - ----------------------------------------------------------------------------------------------------------- Global Communications, LLC Loans 2,526 2,526 Debt Securities 1,733 1,733 Equity Interest 6,867 6,867 Options 1,639 1,639 - ----------------------------------------------------------------------------------------------------------- Golden Eagle/Satellite Loans 1,390 840 Archery, LLC Convertible Debentures 2,248 2,008 - ----------------------------------------------------------------------------------------------------------- Grant Broadcasting Systems II Debt Securities 5,200 5,200 Warrants 87 5,226 - ----------------------------------------------------------------------------------------------------------- Grant Television, Inc. Debt Securities 9,177 9,177 Warrants -- 2,500 - ----------------------------------------------------------------------------------------------------------- Hotelevision, Inc. Preferred Stock (1,000,000 shares) 1,000 1,000 - ----------------------------------------------------------------------------------------------------------- Icon International, Inc. Series A Preferred Stock (13,720 shares) 1,334 1,334 Series B Preferred Stock (11,987 shares) 1,166 1,166 - ----------------------------------------------------------------------------------------------------------- J3 Technology Services Corporation Debt Securities 7,841 7,841 Warrants -- -- - -----------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-6 73
PRIVATE FINANCE DECEMBER 31, 1999 PORTFOLIO COMPANY ------------------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------------- --------------------------------------------- -------- -------- Jakel, Inc. Loan $ 18,174 $ 18,174 - ----------------------------------------------------------------------------------------------------------- JRI Industries, Inc. Debt Securities 2,134 2,134 Warrants 74 74 - ----------------------------------------------------------------------------------------------------------- Julius Koch USA, Inc. Debt Securities 3,502 3,502 Warrants 324 4,100 - ----------------------------------------------------------------------------------------------------------- Kirker Enterprises, Inc. Warrants 348 3,495 Equity Interest 4 9 - ----------------------------------------------------------------------------------------------------------- Kirkland's, Inc. Debt Securities 6,318 6,318 Warrants 96 600 - ----------------------------------------------------------------------------------------------------------- Kyrus Corporation Debt Securities 7,665 7,665 Warrants 348 348 - ----------------------------------------------------------------------------------------------------------- Liberty-Pittsburgh Systems, Inc. Debt Securities 3,439 3,439 Common Stock (64,535 shares) 142 142 - ----------------------------------------------------------------------------------------------------------- The Loewen Group, Inc. (1) High-Yield Senior Secured Debt 15,150 14,150 - ----------------------------------------------------------------------------------------------------------- Love Funding Corporation Series D Preferred Stock (26,000 shares) 359 213 - ----------------------------------------------------------------------------------------------------------- Master Plan, Inc. Common Stock (156 shares) 42 3,042 - ----------------------------------------------------------------------------------------------------------- MedAssets.com, Inc. Debt Securities 3,793 3,793 Series B Convertible Preferred Stock (227,665 shares) 2,049 2,049 Warrants 136 136 - ----------------------------------------------------------------------------------------------------------- Meigher Communications, L.P. Loan 2,938 2,938 - ----------------------------------------------------------------------------------------------------------- Mid Atlantic Telecom Plus, LLC Loan 11,109 11,109 - ----------------------------------------------------------------------------------------------------------- Midview Associates, L.P. Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Monitoring Solutions, Inc. Loans 7 7 Debt Securities 1,823 243 Common Stock (33,333 shares) -- -- Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Morton Industrial Group (1) Common Stock (5,835 shares) 241 20 - ----------------------------------------------------------------------------------------------------------- MVL Group Debt Securities 13,989 13,989 Warrants 651 651 - ----------------------------------------------------------------------------------------------------------- Net-Tel Communications, Inc. Debt Securities 9,426 9,426 Series B Convertible Preferred Stock (647 shares) 5,000 5,000 Warrants 500 500 - ----------------------------------------------------------------------------------------------------------- Nobel Learning Communities, Debt Securities 9,492 9,492 Inc. (1) Series D Convertible Preferred Stock (265,957 shares) 2,000 2,000 Warrants 575 575 - ----------------------------------------------------------------------------------------------------------- Northeast Broadcasting Group, L.P. Debt Securities 384 384 - ----------------------------------------------------------------------------------------------------------- Nursefinders, Inc. Debt Securities 10,922 10,922 Warrants 900 900 - -----------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-7 74
PRIVATE FINANCE DECEMBER 31, 1999 PORTFOLIO COMPANY ------------------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------------- --------------------------------------------- -------- -------- Old Mill Holdings, Inc. Debt Securities $ 140 -- - ----------------------------------------------------------------------------------------------------------- Opinion Research Corporation (1) Debt Securities 13,896 $ 13,896 Warrants 996 996 - ----------------------------------------------------------------------------------------------------------- Outsource Partners, Inc. Debt Securities 23,802 23,802 Warrants 826 826 - ----------------------------------------------------------------------------------------------------------- Panera Bread Company (1) Warrants 227 271 - ----------------------------------------------------------------------------------------------------------- Physician Specialty Corporation Debt Securities 14,388 14,388 Redeemable Preferred Stock (850 shares) 850 850 Convertible Preferred Stock (97,411 shares) 150 150 Warrants 476 476 - ----------------------------------------------------------------------------------------------------------- Pico Products, Inc. (1) Loan 1,300 1,300 Debt Securities 4,591 2,591 Common Stock (208,000 shares) 59 3 Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Polaris Pool Systems, Inc. Debt Securities 6,395 6,395 Warrants 1,050 1,050 - ----------------------------------------------------------------------------------------------------------- Powell Plant Farms, Inc. Loan 15,031 15,031 - ----------------------------------------------------------------------------------------------------------- Progressive International Corporation Debt Securities 3,940 3,940 Preferred Stock (500 shares) 500 500 Common Stock (197 shares) 13 13 Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Schwinn/GT Debt Securities 9,978 9,978 Warrants 395 395 - ----------------------------------------------------------------------------------------------------------- Seasonal Expressions, Inc. Series A Preferred Stock (1,000 shares) 993 136 - ----------------------------------------------------------------------------------------------------------- Soff-Cut Holdings, Inc. Debt Securities 8,140 8,140 Warrants 446 446 Preferred Stock (300 shares) 300 300 Common Stock (2,000 shares) 200 200 - ----------------------------------------------------------------------------------------------------------- Southwest PCS, L.P. Debt Securities 6,364 6,364 Options 1,000 2,000 - ----------------------------------------------------------------------------------------------------------- Spa Lending Corporation Preferred Stock (28,625 shares) 469 360 Common Stock (6,208 shares) 25 18 - ----------------------------------------------------------------------------------------------------------- SunStates Refrigerated Services, Inc. Loans 6,130 4,641 Debt Securities 2,445 1,316 - ----------------------------------------------------------------------------------------------------------- Sure-Tel, Inc. Preferred Stock (1,116,902 shares) 3,108 3,108 Warrants 662 662 Options -- -- - ----------------------------------------------------------------------------------------------------------- Sydran Food Services II, L.P. Debt Securities 11,674 11,674 Options 266 266 - ----------------------------------------------------------------------------------------------------------- Teknekron Infoswitch Corporation Debt Securities 13,863 13,863 Warrants 900 900 - -----------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-8 75
PRIVATE FINANCE DECEMBER 31, 1999 PORTFOLIO COMPANY ------------------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------------- --------------------------------------------- -------- -------- Total Foam, Inc. Debt Securities $ 1,528 $ 135 Common Stock (910 shares) 57 -- - ----------------------------------------------------------------------------------------------------------- Tubbs Snowshoe Company, LLC Debt Securities 3,886 3,886 Warrants 54 54 Equity Interests 500 500 - ----------------------------------------------------------------------------------------------------------- United Pet Group Debt Securities 4,938 4,938 Warrants 15 15 - ----------------------------------------------------------------------------------------------------------- Unitel, Inc. Debt Securities 3,694 3,694 Warrants 360 1,010 - ----------------------------------------------------------------------------------------------------------- Wildwood Designs, Inc. Loan 1,167 1,167 - ----------------------------------------------------------------------------------------------------------- Williams Brothers Lumber Company Warrants 24 322 - ----------------------------------------------------------------------------------------------------------- Wilton Industries, Inc. Loan 12,390 12,390 - ----------------------------------------------------------------------------------------------------------- Woodstream Corporation Debt Securities 8,000 8,000 Equity Interests 1,700 1,700 Warrants -- -- - ----------------------------------------------------------------------------------------------------------- Wyo-Tech Acquisition Corporation Debt Securities 15,113 15,113 Preferred Stock (100 shares) 3,700 3,700 Common Stock (99 shares) 100 4,100 - ----------------------------------------------------------------------------------------------------------- Total private finance (91 investments) $639,171 $647,040 - -----------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants, options and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-9 76
DECEMBER 31, 1999 INTEREST NUMBER OF ------------------- (IN THOUSANDS, EXCEPT NUMBER OF LOANS) RATE RANGES LOANS COST VALUE - ------------------------------------------- ---------------- --------- -------- -------- COMMERCIAL REAL ESTATE FINANCE Commercial Mortgage Loans Up to 6.99% 5 $ 1,422 $ 1,422 7.00%- 8.99% 15 71,619 71,595 9.00%-10.99% 41 39,415 39,623 11.00%-12.99% 30 25,016 25,175 13.00%-14.99% 12 15,207 15,230 15.00% and above 3 1,088 1,064 - ----------------------------------------------------------------------------------------------- Total commercial mortgage loans 106 153,767 154,109 - -----------------------------------------------------------------------------------------------
STATED INTEREST FACE -------- ---- Purchased CMBS Mortgage Capital Funding, Series 1998-MC3 5.5% $ 61,302 $ 29,141 $ 29,141 Morgan Stanley Capital I, Series 1999-RM1 6.4% 71,640 35,453 35,453 COMM 1999-1 5.7% 105,010 54,166 54,166 Morgan Stanley Capital I, Series 1999-FNV1 6.1% 49,486 24,505 24,505 DLJ Commercial Mortgage Trust 1999-CG2 6.1% 96,622 44,288 44,288 Commercial Mortgage Acceptance Corp., Series 1999-C1 6.8% 50,449 28,115 28,115 LB Commercial Mortgage Trust, Series 1999-C2 6.7% 42,391 20,054 20,054 Chase Commercial Mortgage Securities Corp., Series 1999-2 6.5% 43,046 20,121 20,121 FUNB CMT, Series 1999-C4 6.5% 49,288 21,851 21,851 - -------------------------------------------------------------------------------------------------- Total purchased CMBS $569,234 $ 277,694 $ 277,694 - -------------------------------------------------------------------------------------------------- Residual CMBS 76,374 76,374 Residual Interest Spread 6,882 5,382 Real Estate Owned 7,305 6,470 - -------------------------------------------------------------------------------------------------- Total commercial real estate finance $ 522,022 $ 520,029 - -------------------------------------------------------------------------------------------------- Small business finance $ 61,708 $ 61,428 - -------------------------------------------------------------------------------------------------- Total portfolio at value $1,222,901 $1,228,497 - --------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements. F-10 77 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ORGANIZATION Allied Capital Corporation, a Maryland corporation, is a closed-end management investment company that has elected to be regulated as a business development company ("BDC") under the Investment Company Act of 1940 ("1940 Act"). Allied Capital Corporation has two wholly owned subsidiaries that have also elected to be regulated as BDCs. Allied Investment Corporation ("Allied Investment") is licensed under the Small Business Investment Act of 1958 as a Small Business Investment Company ("SBIC"). Allied Capital SBLC Corporation ("Allied SBLC") is licensed by the Small Business Administration ("SBA") as a Small Business Lending Company and is a participant in the SBA Section 7(a) Guaranteed Loan Program. In addition, the Company has a real estate investment trust subsidiary, Allied Capital REIT, Inc. ("Allied REIT") and several single- member limited liability companies established primarily to hold real estate properties. Allied Capital Corporation and its subsidiaries, collectively, are hereinafter referred to as the "Company." The investment objective of the Company is to achieve current income and capital gains. In order to achieve this objective, the Company invests primarily in private, small and middle-market companies in a variety of industries and in diverse geographic locations in the United States. On December 31, 1997, Allied Capital Corporation, Allied Capital Corporation II, Allied Capital Commercial Corporation, and Allied Capital Advisers ("Advisers") merged with and into Allied Capital Lending Corporation ("Allied Lending") (each a "Predecessor Company" and collectively the "Predecessor Companies") in a stock-for-stock exchange (the "Merger"). Immediately following the Merger, Allied Lending changed its name to Allied Capital Corporation. The consolidated financial statements reflect the operations of the Company, with the year ended December 31, 1997 restated as if the Predecessor Companies had merged as of the beginning of the year. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and its wholly owned or majority owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to the 1998 and 1997 balances to conform with the 1999 financial statement presentation. The consolidated financial statements for 1997 and prior periods have been restated to include the accounts of the Predecessor Companies. Transaction fees and expenses related to the Merger were expensed in the fourth quarter of 1997. VALUATION OF PORTFOLIO INVESTMENTS Portfolio assets are carried at fair value as determined by the Board of Directors under the Company's valuation policy. F-11 78 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED LOANS AND DEBT SECURITIES The values of loans and debt securities are considered to be amounts that could be realized in the normal course of business, which generally anticipates the Company holding the loan to maturity and realizing the face value of the loan. For loans and debt securities, value normally corresponds to cost unless the borrower's condition or external factors lead to a determination of value at a lower amount. Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. Loan origination fees, original issue discount and market discount are amortized into interest income using the effective interest method. Yields on loans and debt securities are computed on these investments at value. EQUITY SECURITIES Equity interests in portfolio companies for which there is no public market are valued based on various factors including a history of positive cash flow from operations, the market value of comparable publicly traded companies, and other pertinent factors such as recent offers to purchase a portfolio company's securities or other liquidation events. The determined values are generally discounted to account for liquidity issues and minority control positions. The Company's equity interests in public companies that carry certain restrictions on sale are typically valued at a discount from the public market value of the security at the balance sheet date. Restricted and unrestricted publicly traded stocks may also be valued at a discount due to the investment size or market liquidity concerns. COMMERCIAL MORTGAGE-BACKED SECURITIES ("CMBS") CMBS consists of purchased commercial mortgage-backed securities ("Purchased CMBS"), residual interest in a mortgage securitization ("Residual CMBS") and residual interest spread. PURCHASED CMBS The Purchased CMBS is carried at fair value. The Company recognizes income from the amortization of original issue discount using the effective interest method, using the anticipated yield over the projected life of the investment. Yields are revised when there are changes in estimates of future credit losses, actual losses incurred, and actual and estimated prepayment speeds. Changes in estimated yield are currently recognized as an adjustment to the estimated yield over the remaining life of the Purchased CMBS. The Company recognizes unrealized depreciation on its Purchased CMBS whenever it determines that the value of its Purchased CMBS is less than the cost basis. RESIDUAL CMBS The Company values its residual interest in securitization and recognizes income using the same accounting policies used for the Purchased CMBS. F-12 79 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED RESIDUAL INTEREST SPREAD Residual interest spread is carried at fair value based on discounted estimated future cash flows. The Company recognizes income from the residual interest spread using the effective interest method. At each reporting date, the effective yield is recalculated and used to recognize income until the next reporting date. NET REALIZED AND UNREALIZED GAINS Realized gains or losses are measured by the difference between the net proceeds from the sale and the cost basis of the investment without regard to unrealized gains or losses previously recognized, and include investments charged off during the year, net of recoveries. Unrealized gains or losses reflect the change in portfolio investment values during the reporting period. DEFERRED FINANCING COSTS Financing costs are based on actual costs incurred in obtaining financing and are deferred and amortized as part of interest expense over the term of the related debt instrument. DERIVATIVE FINANCIAL INSTRUMENTS The Company may or may not use derivative financial instruments to reduce interest rate risk. The Company has established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. The Company does not hold or issue derivative financial instruments for trading purposes. CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash in banks and all highly liquid investments with original maturities of three months or less. DIVIDENDS TO SHAREHOLDERS Dividends to shareholders are recorded on the record date. FEDERAL AND STATE INCOME TAXES The Company and its wholly owned subsidiaries intend to comply with the requirements of the Internal Revenue Code ("Code") that are applicable to regulated investment companies ("RIC") and real estate investment trusts ("REIT"). The Company and its wholly owned subsidiaries intend to annually distribute or retain through a deemed distribution all of their taxable income to shareholders; therefore, the Company has made no provision for income taxes. With the exception of Advisers, the Predecessor Companies qualified as a RIC or a REIT; however, Advisers was a corporation subject to federal and state income taxes. Income tax expense reported on the consolidated statement of operations relates to the operations of Advisers for all periods presented. F-13 80 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED PER SHARE INFORMATION Basic earnings per share is calculated using the weighted average number of shares outstanding for the period presented. Diluted earnings per share reflects the potential dilution that could occur if options to issue common stock were exercised into common stock. Earnings per share is computed after subtracting dividends on preferred shares. USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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 these estimates. NOTE 3. PORTFOLIO The Company's investment operations are conducted in three primary areas: private finance, commercial real estate finance, and small business finance. PRIVATE FINANCE At December 31, 1999 and 1998, the private finance portfolio consisted of the following:
1999 1998 --------------------------- --------------------------- COST VALUE YIELD COST VALUE YIELD (IN THOUSANDS) -------- -------- ----- -------- -------- ----- Loans and debt securities............... $578,570 $559,746 14.2% $354,870 $339,163 14.6% Equity interests........................ 60,601 87,294 27,618 49,391 -------- -------- -------- -------- Total......................... $639,171 $647,040 $382,488 $388,554 ======== ======== ======== ========
Private finance investments are generally structured as loans and debt securities that carry a relatively high fixed rate of interest, which may be combined with equity features, such as conversion privileges, or warrants or options to purchase a portion of the portfolio company's equity at a nominal price. Debt securities would typically have a maturity of five to ten years, with interest-only payments in the early years and payments of both principal and interest in the later years, although debt maturities and principal amortization schedules vary. Equity interests consist primarily of securities issued by privately owned companies and may be subject to restrictions on their resale or otherwise illiquid. Equity securities generally do not produce a current return, but are held for investment appreciation and ultimate gain on sale. At December 31, 1999 and 1998, approximately 98% of the Company's private finance loan portfolio was composed of fixed interest rate loans. At December 31, 1999 and 1998, loans and debt securities with a value of $34,560,000 and $5,459,000, respectively, were not accruing interest. F-14 81 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. PORTFOLIO, CONTINUED The geographic and industry compositions of the private finance portfolio at December 31, 1999 and 1998 were as follows:
1999 1998 ---- ---- GEOGRAPHIC REGION Southeast................................................... 27% 23% Midwest..................................................... 26 27 Mid-Atlantic................................................ 23 28 West........................................................ 11 11 Northeast................................................... 9 4 International............................................... 4 7 --- --- Total............................................. 100% 100% === === INDUSTRY Business Services........................................... 32% 15% Consumer Products........................................... 19 25 Telecommunications.......................................... 13 14 Industrial Products......................................... 11 8 Retail...................................................... 8 9 Broadcasting................................................ 6 9 Education................................................... 5 8 Other....................................................... 6 12 --- --- Total............................................. 100% 100% === ===
COMMERCIAL REAL ESTATE FINANCE At December 31, 1999 and 1998, the commercial real estate finance portfolio consisted of the following:
1999 1998 --------------------------- --------------------------- COST VALUE YIELD COST VALUE YIELD (IN THOUSANDS) -------- -------- ----- -------- -------- ----- Loans........................... $153,767 $154,109 9.4% $232,745 $233,186 10.4% CMBS............................ 360,950 359,450 13.5% 115,174 113,674 11.2% REO............................. 7,305 6,470 8,120 8,120 -------- -------- -------- -------- Total................. $522,022 $520,029 $356,039 $354,980 ======== ======== ======== ========
LOANS The commercial mortgage loan portfolio contains loans that were originated by the Company or were purchased from third-party sellers. At December 31, 1999 and 1998, approximately 81% and 19%, and 68% and 32% of the Company's commercial mortgage loan portfolio was composed of fixed and adjustable interest rate F-15 82 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. PORTFOLIO, CONTINUED loans, respectively. As of December 31, 1999 and 1998, loans with a value of $8,334,000 and $5,436,000, respectively, were not accruing interest. The geographic composition and the property types securing the commercial mortgage loan portfolio at December 31, 1999 and 1998 were as follows:
1999 1998 ---- ---- GEOGRAPHIC REGION Mid-Atlantic................................................ 32% 37% Southeast................................................... 31 26 West........................................................ 25 24 Midwest..................................................... 9 9 Northeast................................................... 3 4 --- --- Total............................................. 100% 100% === === PROPERTY TYPE Hospitality................................................. 42% 47% Office...................................................... 24 20 Retail...................................................... 11 14 Recreation.................................................. 8 7 Other....................................................... 15 12 --- --- Total............................................. 100% 100% === ===
CMBS At December 31,1999 and 1998, the CMBS portfolio consisted of the following:
1999 1998 ------------------- ------------------- COST VALUE COST VALUE (IN THOUSANDS) -------- -------- -------- -------- Purchased CMBS.............................. $277,694 $277,694 $ 32,221 $ 32,221 Residual CMBS............................... 76,374 76,374 70,771 70,771 Residual interest spread.................... 6,882 5,382 12,182 10,682 -------- -------- -------- -------- Total............................. $360,950 $359,450 $115,174 $113,674 ======== ======== ======== ========
PURCHASED CMBS. The Company has Purchased CMBS bonds with a face amount of $569,234,000 and a cost of $277,694,000, with the difference representing original issue discount. As of December 31, 1999 and 1998, the estimated yield to maturity on the Purchased CMBS was approximately 14.6% and 15%, respectively. The Company's yield on its Purchased CMBS is based upon a number of assumptions that are subject to certain business and economic uncertainties and contingencies. Examples include the timing and magnitude of credit losses on the mortgage loans underlying the Purchased CMBS that are a result of the general condition of the real estate market (including competition for tenants and their related credit quality) and changes in market rental rates. At December 31, 1999 and 1998, the yield on the Purchased CMBS portfolio was computed assuming a 1% loss estimate for its entire underlying collateral mortgage pool. As these uncertainties F-16 83 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. PORTFOLIO, CONTINUED and contingencies are difficult to predict and are subject to future events which may alter these assumptions, no assurance can be given that the anticipated yields to maturity will be achieved. The non-investment grade and unrated tranches of the Purchased CMBS bonds are junior in priority for payment of principal to the more senior tranches of the related commercial securitization. Cash flow from the underlying mortgages generally is allocated first to the senior tranches, with the most senior tranches having a priority right to the cash flow. Then, any remaining cash flow is allocated, generally, among the other tranches in order of their relative seniority. To the extent there are defaults and unrecoverable losses on the underlying mortgages resulting in reduced cash flows, the subordinate tranche will bear this loss first. The underlying rating classes of the Purchased CMBS is as follows:
1999 1998 --------------------- -------------------- PERCENTAGE PERCENTAGE VALUE OF TOTAL VALUE OF TOTAL (IN THOUSANDS) -------- ---------- ------- ---------- BB........................................... $ 41,091 14.8% $ 4,109 12.8% BB-.......................................... 46,692 16.8 4,269 13.2 B+........................................... 41,765 15.0 -- -- B............................................ 64,830 23.4 13,133 40.8 B-........................................... 40,995 14.8 4,711 14.6 CCC.......................................... 6,506 2.3 -- -- Unrated...................................... 35,815 12.9 5,999 18.6 -------- ----- ------- ----- Total.............................. $277,694 100.0% $32,221 100.0% ======== ===== ======= =====
RESIDUAL CMBS AND RESIDUAL INTEREST SPREAD. The Residual CMBS primarily consists of a retained interest from a post-Merger asset securitization whereby bonds were sold in three classes rated "AAA," "AA" and "A." The Company sold $295 million of loans, and received cash proceeds, net of costs, of approximately $223 million. The Company retained a trust certificate for its residual interest in the loan pool sold, and will receive interest income from this Residual CMBS as well as the Residual Interest Spread from the interest earned on the loans sold less the interest paid on the bonds over the life of the bonds. As a result of this securitization, the Company recorded a gain of $14.8 million, net of the costs of the securitization and the cost of settlement of interest rate swaps. As of December 31, 1999 and 1998, the mortgage loan pool had an approximate weighted average stated interest rate of 9.3% and 9.4%, respectively. The three bond classes sold had an aggregate weighted average interest rate of 6.5% and 6.4% as of December 31, 1999 and 1998, respectively. The value of the Residual CMBS was determined using a discount rate equal to the average interest rate of the underlying mortgage loans. The value of the residual interest spread was determined based on a constant prepayment rate of 7% and a discount rate of 14%. F-17 84 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. PORTFOLIO, CONTINUED The geographic composition and the property types of the underlying mortgage loan pools securing the CMBS at December 31, 1999 and 1998 were as follows:
1999 1998 ---- ---- GEOGRAPHIC REGION West........................................................ 32% 18% Mid-Atlantic................................................ 23 32 Midwest..................................................... 21 20 Southeast................................................... 20 24 Northeast................................................... 4 6 --- --- Total............................................. 100% 100% === === PROPERTY TYPE Retail...................................................... 33% 32% Housing..................................................... 29 13 Office...................................................... 20 21 Hospitality................................................. 9 23 Other....................................................... 9 11 --- --- Total............................................. 100% 100% === ===
SMALL BUSINESS FINANCE At December 31, 1999 and 1998, the small business finance portfolio consisted of the following:
1999 1998 ----------------- ----------------- COST VALUE COST VALUE ------- ------- ------- ------- (IN THOUSANDS) 7(a) loans...................................... $43,246 $43,000 $57,652 $56,285 Residual interest in loans sold................. 4,036 4,036 -- -- Residual interest spread........................ 14,046 14,046 7,250 7,250 REO............................................. 380 346 50 50 ------- ------- ------- ------- Total................................. $61,708 $61,428 $64,952 $63,585 ======= ======= ======= =======
The Company, through its wholly owned subsidiary, Allied SBLC, participates in the SBA's Section 7(a) Guaranteed Loan Program ("7(a) loans"). Pursuant to Section 7(a) of the Small Business Act of 1958, the SBA will guarantee 80% of any qualified loan up to $100,000 regardless of maturity, and 75% of any such loan over $100,000 regardless of maturity, to a maximum guarantee of $750,000 for any one borrower. SBA regulations define qualified small businesses generally as businesses with no more than $5 million in annual sales or no more than 500 employees. The Company charges interest on the 7(a) loans at a variable rate, typically 1.75% to 2.75% above the prime rate, as published in The Wall Street Journal or other financial newspaper, adjusted monthly. All loans are payable in equal monthly installments of principal and interest from the date on which the loan was made to its maturity. F-18 85 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. PORTFOLIO, CONTINUED As permitted by SBA regulations, the Company sells to investors, without recourse, 100% of the guaranteed portion of its 7(a) loans while retaining the right to service 100% of such loans. Additionally, the Company sells up to a 90% interest in the unguaranteed portion of its 7(a) loans through a structured finance agreement with a commercial paper conduit. In 1999, the Company sold $36,387,000 of the unguaranteed portion of 7(a) loans into the facility. The Company received $35,500,000 in proceeds and retained a subordinated interest valued at $4,036,000. The Company recognized a premium from the loan sale of $4,106,000, which includes the value of the retained residual interest spread. As of December 31, 1999 and 1998, 7(a) loans with a value of $5,562,000 and $5,806,000, respectively, were not accruing interest. As of December 31,1999 and 1998, 7(a) loans include a balance of $7,667,000 and $3,229,000, respectively, that is guaranteed by the SBA. NOTE 4. DEBT At December 31, 1999 and 1998, the Company had the following debt:
1999 1998 ------------------- ------------------- FACILITY AMOUNT FACILITY AMOUNT AMOUNT DRAWN AMOUNT DRAWN -------- -------- -------- -------- (IN THOUSANDS) Notes payable and debentures: Unsecured long-term notes payable......... $419,000 $419,000 $180,000 $180,000 SBA debentures............................ 74,650 62,650 74,650 47,650 OPIC loan................................. 5,700 5,700 5,700 5,700 -------- -------- -------- -------- Total notes payable and debentures...................... 499,350 487,350 260,350 233,350 ======== ======== ======== ======== Revolving credit facilities: Revolving line of credit.................. 340,000 82,000 200,000 95,000 Master loan and security agreement........ 100,000 23,500 250,000 6,000 -------- -------- -------- -------- Total revolving credit facilities...................... 440,000 105,500 450,000 101,000 -------- -------- -------- -------- Total..................................... $939,350 $592,850 $710,350 $334,350 ======== ======== ======== ========
NOTES PAYABLE AND DEBENTURES UNSECURED LONG-TERM NOTES PAYABLE. In June 1998, May 1999 and November 1999, the Company issued unsecured long-term notes to private institutional investors. The notes require semi-annual interest payments until maturity and have terms of five or seven years. The weighted average interest rate on the notes was 7.6% and 7.2% at December 31, 1999 and 1998, respectively. The notes may be prepaid in whole or in part together with an interest premium, as stipulated in the note agreement. SBA DEBENTURES. At December 31, 1999 and 1998, the Company had debentures payable to the SBA with terms of ten years and at interest rates ranging from 6.6% to 9.6%. The debentures require F-19 86 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. DEBT, CONTINUED semi-annual interest-only payments with all principal due upon maturity. The SBA debentures are subject to prepayment penalties if paid prior to maturity. Scheduled future maturities of notes payable and debentures at December 31, 1999 are as follows:
YEAR AMOUNT MATURING ---- --------------- (IN THOUSANDS) 2000........................................................ $ 17,300 2001........................................................ 9,350 2002........................................................ -- 2003........................................................ 140,000 2004........................................................ 221,000 Thereafter.................................................. 99,700 -------- Total............................................. $487,350 ========
REVOLVING CREDIT FACILITIES REVOLVING LINE OF CREDIT. In May 1999, the Company increased its unsecured revolving line of credit to $340,000,000 from $315,000,000. The facility bears interest at the London Interbank Offer Rate ("LIBOR") plus 1.25% and adjusts at the beginning of each new interest period, usually every thirty days. The interest rates were 7.7% and 6.9% at December 31, 1999 and December 31, 1998, respectively, and the facility requires a commitment fee equal to 0.25% of the committed amount. The new line expires in March 2001. The line of credit requires monthly interest payments and all principal is due upon its expiration. In January 2000, the Company increased its unsecured revolving line of credit to $360,000,000. MASTER LOAN AND SECURITY AGREEMENT. The Company has a facility to borrow up to $100,000,000, using certain commercial mortgage loans as collateral. The Company pledges commercial mortgage loans as collateral for the facility such that the amount borrowed is approximately equal to 80% of the value of the collateral pledged. The agreement generally requires interest-only payments with all principal due at maturity. Principal may be repaid at any time without penalty. The agreement bears interest at the one-month LIBOR plus 1.0%, and adjusts daily, or 6.8% and 6.6% at December 31, 1999 and 1998, respectively. The agreement matures on October 27, 2000. The average debt outstanding on the revolving credit facilities was $123,860,000 and $73,836,000 for the years ended December 31, 1999 and 1998, respectively. The maximum amount borrowed under these facilities and the weighted average interest rate for the years ended December 31, 1999 and 1998, were $199,392,000 and $135,000,000, and 6.5% and 6.7%, respectively. NOTE 5. INCOME TAXES For the years ended December 31, 1999, 1998 and 1997, the Company's effective tax rate was 0.0%, 1.0% and 2.3%, respectively. F-20 87 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5. INCOME TAXES, CONTINUED For the year ended December 31, 1998, the Company incurred income tax expense of $787,000, which resulted from the realization of a taxable net built-in gain associated with property owned by Advisers prior to the Merger. For the year ended December 31, 1997, the Company's income was subject to federal and state taxes related to the income generated by the pre-Merger operations of Advisers. NOTE 6. PREFERRED STOCK Allied Investment has outstanding a total of 60,000 shares of $100 par value, 3% cumulative preferred stock and 10,000 shares of $100 par value, 4% redeemable cumulative preferred stock issued to the SBA pursuant to Section 303(c) of the Small Business Investment Act of 1958, as amended. The 3% cumulative preferred stock does not have a required redemption date. Allied Investment has the option to redeem in whole or in part the preferred stock by paying the SBA the par value of such securities and any dividends accumulated and unpaid to the date of redemption. The 4% redeemable cumulative preferred stock has a required redemption date in June 2005. NOTE 7. SHAREHOLDERS' EQUITY Sale of common stock in 1999 and 1998 was as follows:
1999 1998 (IN THOUSANDS) -------- ------- Number of common shares..................................... 8,659 4,367 Gross proceeds.............................................. $172,539 $73,736 Less costs including underwriting fees...................... (8,270) (4,061) -------- ------- Net proceeds.............................................. $164,269 $69,675 ======== =======
The Company has a dividend reinvestment plan, whereby the Company may buy shares of its common stock in the open market or issue new shares in order to satisfy dividend reinvestment requests. If the Company issues new shares, the issue price is equal to the average of the closing sale prices reported for the Company's common stock for the five consecutive days immediately prior to the dividend payment date. Dividend reinvestment plan activity for 1999, 1998 and 1997 was as follows:
1999 1998 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------ ------ ------ Shares issued............................................... 233 241 551 Average price per share..................................... $19.43 $20.35 $15.67
F-21 88 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8. EARNINGS PER COMMON SHARE
1999 1998 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------- ------- ------- Net increase in net assets resulting from operations........ $98,570 $78,078 $61,304 Less preferred stock dividends.............................. (230) (230) (220) ------- ------- ------- Income available to common shareholders..................... $98,340 $77,848 $61,084 ======= ======= ======= Basic shares outstanding.................................... 59,877 51,941 49,218 Options outstanding to officers............................. 167 33 33 ------- ------- ------- Diluted shares outstanding.................................. 60,044 51,974 49,251 ======= ======= ======= BASIC EARNINGS PER COMMON SHARE............................. $ 1.64 $ 1.50 $ 1.24 ======= ======= ======= DILUTED EARNINGS PER COMMON SHARE........................... $ 1.64 $ 1.50 $ 1.24 ======= ======= =======
NOTE 9. EMPLOYEE STOCK OWNERSHIP PLAN, 401(k) PLAN AND DEFERRED COMPENSATION PLAN The Company had an employee stock ownership plan ("ESOP"). Pursuant to the ESOP, the Company was obligated to contribute 5% of each eligible participant's total cash compensation for the year to a plan account on the participant's behalf, which vested over a two-year period. ESOP contributions were used to purchase shares of the Company's common stock. As of December 31, 1999 and 1998, the ESOP held 303,210 shares and 282,500 shares, respectively, of the Company's common stock, all of which had been allocated to participants' accounts. The plan is funded annually and the total ESOP contribution expense for the years ended December 31, 1999, 1998, and 1997 was $641,000, $489,000 and $351,000, respectively, net of forfeitures of $4,100, $4,000, and $0, respectively. In 1999, the Company established a 401(k) plan (see below) and elected to terminate the ESOP Plan in 2000. During 2000, the ESOP assets will be transferred into the 401(k) plan. The Company has a 401(k) retirement investment plan, which is open to all of its employees. The employees may elect voluntary wage deferrals ranging from 0% to 15% of taxable compensation for the year. In 2000, the Company will begin making contributions to the 401(k) plan under the same terms that ESOP contributions were made. The Company also has a deferred compensation plan (the "DC Plan"). Eligible participants in the DC Plan may elect to defer some of their compensation and have such compensation credited to a participant account. All amounts credited to a participant's account shall be credited solely for purposes of accounting and computation and remain assets of the Company and subject to the claims of the Company's general creditors. Amounts credited to participants under the DC Plan are at all times 100% vested and non-forfeitable except for amounts credited to participants' accounts related to the Formula Award (see Note 11). A participant's account shall become distributable upon his or her separation from service, retirement, disability, death or at a future determined date. All DC Plan accounts will be distributed in the event of a change of control of the Company or in the event of the Company's insolvency. Amounts deferred by participants under the DC Plan are funded to a trust, the trustee of which administers the DC Plan on behalf of the Company. F-22 89 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10. STOCK OPTION PLAN In conjunction with the Merger, all stock option plans that existed for Allied Lending and the Predecessor Companies before the Merger ("Old Plans") were cancelled on December 31, 1997, and at a special meeting of shareholders on November 26, 1997, the Company's shareholders approved a new stock option plan ("Option Plan") for the Company to be effected post-Merger. THE OPTION PLAN The purpose of the Option Plan is to provide officers and non-officer directors of the Company with additional incentives. Options may be granted from time to time on up to 6,250,000 shares, which represents approximately 10% of the outstanding shares as of December 31, 1999. Options are exercisable at a price equal to the fair market value of the shares on the day the option is granted. Each option states the period or periods of time within which the option may be exercised by the optionee, which may not exceed ten years from the date the option is granted. All rights to exercise options terminate 60 days after an optionee ceases to be (i) a non-officer director, (ii) both an officer and a director, if such optionee serves in both capacities, or (iii) an officer (if such officer is not also a director) of the Company for any cause other than death or total and permanent disability. In the event of a change of control of the Company, all outstanding options will become fully vested and exercisable as of the change of control. Information with respect to options granted, exercised and forfeited under the Option Plan for the years ended December 31, 1999 and 1998 is as follows:
WEIGHTED AVERAGE OPTION PRICE SHARES PER SHARE ------ ------------ (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Options outstanding at January 1, 1998...................... -- $ -- Granted..................................................... 5,190 20.16 Exercised................................................... (10) 21.38 Forfeited................................................... (66) 21.38 ----- ------ Options outstanding at December 31, 1998.................... 5,114 $20.14 Granted..................................................... 1,288 19.75 Exercised................................................... (318) 19.07 Forfeited................................................... (195) 20.00 ----- ------ Options outstanding at December 31, 1999.................... 5,889 $20.12 ===== ======
OLD PLAN ACTIVITY During 1997, the Predecessor Companies granted 1,474,000 options under the Old Plans at exercise prices ranging from $9.53 to $22.58 per share. Total shares issued pursuant to the exercise of stock options totaled 2,395,000 during 1997. F-23 90 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10. STOCK OPTION PLAN, CONTINUED NOTES RECEIVABLE FROM THE SALE OF COMMON STOCK The Company provides loans to officers for the exercise of options. The loans have varying terms not exceeding ten years, bear interest at the applicable federal interest rate in effect at the date of issue and have been recorded as a reduction to shareholders' equity. For the years ended December 31, 1999, 1998 and 1997, the Company had outstanding loans to officers of $29,461,000, $23,735,000, and $29,611,000, respectively. Officers with outstanding loans repaid principal of $195,000, $5,591,000, and $6,534,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The Company recognized interest income from these loans of $1,539,000, $1,600,000, and $1,031,000, respectively, during these same periods. The following table summarizes information about stock options outstanding at December 31, 1999:
TOTAL WEIGHTED AVERAGE TOTAL RANGE OF NUMBER REMAINING WEIGHTED NUMBER WEIGHTED EXERCISE OUTSTANDING CONTRACTUAL LIFE AVERAGE EXERCISABLE AVERAGE PRICES AT 12/31/99 (YEARS) EXERCISE PRICE AT 12/31/99 EXERCISE PRICE -------- ----------- ---------------- -------------- ------------ -------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND YEARS) $15.19-$17.75.......... 774 9.75 $17.25 154 $16.92 $17.88................. 1,196 8.94 $17.88 265 $17.88 $18.50-$19.94.......... 238 9.26 $19.55 55 $19.50 $21.38................. 3,157 8.02 $21.38 1,045 $21.38 $22.00-$22.50.......... 524 9.65 $22.16 170 $22.11 ----- ---- ------ ----- ------ $15.19-$22.50.......... 5,889 8.63 $20.12 1,689 $20.43 ===== ==== ====== ===== ======
The Company accounts for its stock options as required by the Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees," and no compensation cost has been recognized. Had compensation cost for the plan been determined consistent with SFAS No. 123 "Accounting for Stock Based Compensation," the Company's net increase in net assets resulting from operations and basic and diluted earnings per common share would have been reduced to the following pro forma amounts:
1999 1998 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------- ------- ------- Net increase in net assets resulting from operations: As reported.................................. $98,570 $78,078 $61,304 Pro forma.................................... $94,510 $72,684 $60,656 Basic earnings per common share: As reported.................................. $1.64 $1.50 $1.24 Pro forma.................................... $1.58 $1.39 $1.23 Diluted earnings per common share: As reported.................................. $1.64 $1.50 $1.24 Pro forma.................................... $1.57 $1.39 $1.23
Pro forma expenses are based on the underlying value of the options granted by the Company and the Predecessor Companies. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, with the following weighted average assumptions for F-24 91 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10. STOCK OPTION PLAN, CONTINUED grants: risk-free interest rate of 5.9%, 5.7% and 5.0% for 1999, 1998 and 1997, respectively; expected life of approximately five years for all options granted; expected volatility of 37%, 35% and 35% for 1999, 1998 and 1997, respectively. NOTE 11. CUT-OFF AWARD AND FORMULA AWARD The Predecessor Companies' existing stock option plans were canceled and the Company established a cut-off dollar amount for all existing, but unvested options as of the date of the Merger (the "Cut-off Award"). The Cut-off Award was computed for each unvested option as of the Merger date. The Cut-off Award was equal to the difference between the market price on August 14, 1997 (the Merger announcement date) of the shares of stock underlying the option less the exercise price of the option. The Cut-off Award was payable for each unvested option upon the future vesting date of that option. The Cut-off Award was designed to cap the appreciated value in unvested options at the Merger announcement date, in order to set the foundation to balance option awards upon the Merger. The Cut-off Award approximated $2.9 million in the aggregate and has been expensed as the Cut-off Award vests. For the years ended December 31, 1999 and 1998, $532,000 and $807,000, respectively, of the Cut-off Award vested. The Formula Award was established to compensate employees from the point when their unvested options would cease to appreciate in value (the Merger announcement date), up until the time at which they would be able to receive option awards in ACC post-merger. In the aggregate, the Formula Award equaled 6% of the difference between an amount equal to the combined aggregated market capitalizations of the Predecessor Companies as of the close of the market on the day before the Merger date (December 30, 1997), less an amount equal to the combined aggregate market capitalizations of Allied Lending and the Predecessor Companies as of the close of the market on the Merger announcement date. Advisers' compensation committee allocated the Formula Award to individual officers on December 30, 1997. The amount of the Formula Award as computed at December 30, 1997 was $18,994,000. This amount was contributed to the Company's deferred compensation trust under the DC Plan (see Note 9) and was used to purchase shares of the Company's stock (included in common stock held in deferred compensation trust). The Formula Award vests equally in three installments on December 31, 1998, 1999 and 2000; provided, however, that such Formula Award vests immediately upon a change in control of the Company. The Formula Award has been expensed in each year in which it vests. For the years ended December 31, 1999 and 1998, $6,221,000 and $6,241,000, respectively, was expensed as a result of the Formula Award. At December 31, 1999 and 1998, the liability related to the Formula Award was $6,221,000 and $6,241,000, respectively, and has been included in common stock held in deferred compensation trust. Vested Formula Awards are distributable to recipients at the Company's discretion, however, sale of the Company's stock by the recipients is restricted. Unvested Formula Awards are forfeited upon a recipient's separation from service and the related Company stock is retired. During 1999 and 1998, $61,000 and $270,000, respectively, of the Formula Award was forfeited. On January 3, 2000 and January 4, 1999, the Company distributed shares of the Company's common stock with a value of $4,274,000 and $4,062,000, respectively, representing the portion of the Formula Award that vested during the previous year. F-25 92 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12. DIVIDENDS AND DISTRIBUTIONS For the years ended December 31, 1999, 1998 and 1997, the Company declared the following distributions:
1999 1998 1997 ------------------- ------------------- ------------------- TOTAL TOTAL PER TOTAL TOTAL PER TOTAL TOTAL PER AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE ------- --------- ------- --------- ------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) First quarter......................... $23,286 $0.40 $18,025 $0.35 $14,347 $0.30 Second quarter........................ 23,746 0.40 17,966 0.35 14,795 0.30 Third quarter......................... 24,768 0.40 17,976 0.35 15,548 0.31 Fourth quarter........................ 26,141 0.40 19,444 0.35 31,022 0.61 Annual extra distribution............. -- -- 1,676 0.03 1,118 0.02 Special undistributed earnings distribution........................ -- -- -- -- 8,848 0.17 ------- ----- ------- ----- ------- ----- Total distributions to common shareholders........................ $97,941 $1.60 $75,087 $1.43 $85,678 $1.71 ======= ===== ======= ===== ======= =====
For income tax purposes, distributions for 1999, 1998 and 1997 were composed of the following:
1999 1998 1997 ------------------- ------------------- ------------------- TOTAL TOTAL PER TOTAL TOTAL PER TOTAL TOTAL PER AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE ------- --------- ------- --------- ------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Ordinary income....................... $76,948 $1.26 $49,397 $0.94 $39,356 $0.79 Long-term capital gains............... 20,993 0.34 25,690 0.49 31,037 0.62 Return of capital (tax)............... -- -- -- -- 6,437 0.13 ------- ----- ------- ----- ------- ----- Total distributions before special distribution........................ 97,941 1.60 75,087 1.43 76,830 1.54 Special undistributed earnings distribution........................ -- -- -- 8,848 0.17 ------- ----- ------- ----- ------- ----- Total distributions to common shareholders........................ $97,941 $1.60 $75,087 $1.43 $85,678 $1.71 ======= ===== ======= ===== ======= =====
F-26 93 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12. DIVIDENDS AND DISTRIBUTIONS, CONTINUED The following table summarizes the differences between financial statement net income and taxable income for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 -------- -------- -------- (IN THOUSANDS) Financial statement net income............................ $98,570 $78,078 $61,304 Adjustments: Net unrealized gains................................. (2,138) (1,079) (7,209) Amortization of discount............................. 129 2,207 (1,124) Post-Merger gain on securitization of commercial mortgage loans..................................... -- (14,812) -- Interest income from securitized commercial mortgage loans.............................................. 4,640 4,910 -- Gains from disposition of portfolio assets........... (4,547) 1,177 17,890 Expenses not deductible for tax: Merger expenses................................. -- -- 5,159 Formula award................................... 2,158 6,242 -- Other........................................... 1,053 1,393 853 Other................................................ (1,492) (3,816) (9,050) Income tax expense................................... -- 787 1,444 ------- ------- ------- Taxable income............................................ $98,373 $75,087 $69,267 ======= ======= =======
NOTE 13. CONCENTRATIONS OF CREDIT RISK The Company places its cash with financial institutions and, at times, cash held in checking accounts in financial institutions may be in excess of the Federal Deposit Insurance Corporation insured limit. At December 31, 1999 and 1998, cash and cash equivalents consisted of the following:
1999 1998 -------- -------- (IN THOUSANDS) Cash and cash equivalents................................... $24,419 $31,833 Less escrows held........................................... (6,264) (6,758) ------- ------- Total cash and cash equivalents................... $18,155 $25,075 ======= =======
NOTE 14. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION During 1999, 1998 and 1997, the Company paid $21,092,000, $21,708,000 and $26,874,000, respectively, for interest and income taxes. During 1999, 1998 and 1997, the Company's non-cash financing activities totaled $10,241,000, $6,237,000 and $48,207,000, respectively, related primarily to common stock issuance resulting from stock option exercises and dividend reinvestment shares issued. During 1999, 1998 and 1997, the Company's non-cash investing activities totaled $19,320,000, $1,265,000 and $12,022,000, respectively. F-27 94 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 15. SELECTED QUARTERLY DATA (UNAUDITED)
1999 ------------------------------------- QTR 1 QTR 2 QTR 3 QTR 4 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------- ------- ------- ------- Total interest and related portfolio income............. $27,678 $33,186 $37,998 $42,278 Portfolio income before realized and unrealized gains... $13,830 $16,619 $19,273 $21,319 Net increase in net assets resulting from operations.... $18,580 $22,121 $26,944 $30,925 Basic earnings per common share......................... $ 0.33 $ 0.38 $ 0.44 $ 0.49 Diluted earnings per common share....................... $ 0.33 $ 0.38 $ 0.44 $ 0.49
1998 ------------------------------------- QTR 1 QTR 2 QTR 3 QTR 4 ------- ------- ------- ------- Total interest and related portfolio income............. $36,897 $21,321 $22,546 $25,974 Portfolio income before realized and unrealized gains... $24,920 $ 9,148 $ 9,401 $11,776 Net increase in net assets resulting from operations.... $32,065 $14,476 $14,906 $16,631 Basic earnings per common share......................... $ 0.62 $ 0.28 $ 0.29 $ 0.31 Diluted earnings per common share....................... $ 0.61 $ 0.28 $ 0.29 $ 0.31
F-28 95 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING BALANCE SHEET
DECEMBER 31, 1999 ------------------------------------------------------------------------- ALLIED ALLIED ALLIED CONSOLIDATED CAPITAL INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL ---------- ---------- ------- ------- ------------ ------------ (IN THOUSANDS) ASSETS Portfolio at value: Private finance.................... $ 513,835 $133,205 $ -- $ -- $ -- $ 647,040 Commercial real estate finance..... 422,514 4,530 -- 92,985 -- 520,029 Small business finance............. -- -- 61,428 -- -- 61,428 Investments in subsidiaries........ 162,161 -- -- -- (162,161) -- ---------- -------- ------- ------- --------- ---------- Total portfolio at value...... 1,098,510 137,735 61,428 92,985 (162,161) 1,228,497 ---------- -------- ------- ------- --------- ---------- Cash and cash equivalents.............. 10,198 3,361 2,256 2,340 -- 18,155 Intercompany notes and receivables..... 77,748 682 618 4 (79,052) -- Other assets........................... 35,113 2,771 4,299 1,203 -- 43,386 ---------- -------- ------- ------- --------- ---------- Total assets.................. $1,221,569 $144,549 $68,601 $96,532 $(241,213) $1,290,038 ========== ======== ======= ======= ========= ========== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Notes payable and debentures....... $ 424,700 $ 62,650 $ -- $ -- $ -- $ 487,350 Revolving credit facilities........ 105,500 -- -- -- -- 105,500 Accounts payable and other liabilities...................... 19,476 794 2,202 203 -- 22,675 Dividends and distributions payable.......................... -- 6,131 7,791 3,861 (17,783) -- Intercompany notes and payables.... 4,380 9,500 38,664 8,726 (61,270) -- ---------- -------- ------- ------- --------- ---------- Total liabilities............. 554,056 79,075 48,657 12,790 (79,053) 615,525 ---------- -------- ------- ------- --------- ---------- Commitments and Contingencies Preferred stock........................ -- 7,000 -- -- -- 7,000 Shareholders' Equity: Common stock....................... 6 -- -- 1 (1) 6 Additional paid-in capital......... 699,149 36,673 17,643 81,129 (135,445) 699,149 Common stock held in deferred compensation trust............... (6,218) -- -- -- -- (6,218) Notes receivable from sale of common stock..................... (29,461) -- -- -- -- (29,461) Net unrealized appreciation (depreciation) on portfolio...... 4,517 2,056 (970) (2,415) 1,329 4,517 Undistributed (distributions in excess of) earnings.............. (480) 19,745 3,271 5,027 (28,043) (480) ---------- -------- ------- ------- --------- ---------- Total shareholders' equity.... 667,513 58,474 19,944 83,742 (162,160) 667,513 ---------- -------- ------- ------- --------- ---------- Total liabilities and shareholders' equity........ $1,221,569 $144,549 $68,601 $96,532 $(241,213) $1,290,038 ========== ======== ======= ======= ========= ==========
The accompanying notes are an integral part of these consolidating financial statements. F-29 96 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1999 ----------------------------------------------------------------------- ALLIED ALLIED ALLIED CONSOLIDATED CAPITAL INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL -------- ---------- ------- ------- ------------ ------------ (IN THOUSANDS) Interest and Related Portfolio Income Interest................... $ 91,863 $11,465 $ 7,931 $ 8,513 $ -- $119,772 Intercompany interest...... 6,237 -- -- -- (6,237) -- Premiums from loan dispositions............. 4,525 40 9,719 -- -- 14,284 Income from investments in wholly owned subsidiaries............. 34,761 -- -- -- (34,761) -- Investment advisory fees and other income......... 6,574 423 318 (231) -- 7,084 -------- ------- ------- ------- -------- -------- Total interest and related portfolio income.............. 143,960 11,928 17,968 8,282 (40,998) 141,140 -------- ------- ------- ------- -------- -------- Expenses Interest................... 30,765 4,074 6 15 -- 34,860 Intercompany interest...... -- 285 4,648 1,304 (6,237) -- Employee................... 16,136 -- -- -- -- 16,136 Administrative............. 11,000 56 878 416 -- 12,350 -------- ------- ------- ------- -------- -------- Total operating expenses............ 57,901 4,415 5,532 1,735 (6,237) 63,346 -------- ------- ------- ------- -------- -------- Formula and cut-off awards................... 6,753 -- -- -- -- 6,753 -------- ------- ------- ------- -------- -------- Portfolio income before net realized and unrealized gains......................... 79,306 7,513 12,436 6,547 (34,761) 71,041 -------- ------- ------- ------- -------- -------- Net Realized and Unrealized Gains Net realized gains (losses)................. 17,126 9,667 (1,000) (402) -- 25,391 Net unrealized gains (losses)................. 2,138 593 1,104 (915) (782) 2,138 -------- ------- ------- ------- -------- -------- Total net realized and unrealized gains (losses)............ 19,264 10,260 104 (1,317) (782) 27,529 -------- ------- ------- ------- -------- -------- Net increase in net assets resulting from operations..... $ 98,570 $17,773 $12,540 $ 5,230 $(35,543) $ 98,570 ======== ======= ======= ======= ======== ========
The accompanying notes are an integral part of these consolidating financial statements. F-30 97 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 1999 -------------------------------------------------------------------------- ALLIED ALLIED ALLIED CONSOLIDATED CAPITAL INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL --------- ---------- -------- -------- ------------ ------------ (IN THOUSANDS) Cash Flows from Operating Activities Net increase in net assets resulting from operations.... $ 98,570 $ 17,773 $ 12,540 $ 5,230 $(35,543) $ 98,570 Adjustments Net unrealized (gains) losses.................... (2,138) (593) (1,104) 915 782 (2,138) Depreciation and amortization.............. 788 -- -- -- -- 788 Amortization of loan discounts and fees........ (9,079) (761) (834) -- -- (10,674) Changes in other assets and liabilities............... (8,344) (64) (1,642) 1,338 -- (8,712) --------- -------- -------- -------- -------- --------- Net cash provided by operating activities.... 79,797 16,355 8,960 7,483 (34,761) 77,834 --------- -------- -------- -------- -------- --------- Cash Flows from Investing Activities Portfolio investments........ (596,725) (67,022) (88,124) -- -- (751,871) Repayments of investment principal................. 91,851 26,012 6,719 21,124 -- 145,706 Proceeds from loan sales..... 104,706 -- 93,662 -- -- 198,368 Net change in intercompany investments............... 10,389 9,705 (7,980) (21,280) 9,166 -- Collections of notes receivable from sale of common stock.............. 195 -- -- -- -- 195 Other investing activities... 4,805 574 (8,198) 1,065 -- (1,754) --------- -------- -------- -------- -------- --------- Net cash (used in) provided by investing activities.............. (384,779) (30,731) (3,921) 909 9,166 (409,356) --------- -------- -------- -------- -------- --------- Cash Flows from Financing Activities Sale of common stock......... 164,269 -- -- -- -- 164,269 Common dividends and distributions paid........ (95,031) -- -- -- -- (95,031) Dividends paid to parent company................... -- (12,111) (5,559) (7,925) 25,595 -- Preferred stock dividends paid...................... 40 (220) -- (50) -- (230) Net borrowings under notes payable and debentures.... 239,000 15,000 -- -- -- 254,000 Net borrowings under revolving lines of credit.................... 4,500 -- -- -- -- 4,500 Other financing activities... (2,906) -- -- -- -- (2,906) --------- -------- -------- -------- -------- --------- Net cash provided by (used in) financing activities.............. 309,872 2,669 (5,559) (7,975) 25,595 324,602 --------- -------- -------- -------- -------- --------- Net increase (decrease) in cash and cash equivalents................. $ 4,890 $(11,707) $ (520) $ 417 $ -- $ (6,920) --------- -------- -------- -------- -------- --------- Cash and cash equivalents at beginning of year................ $ 5,308 $ 15,068 $ 2,776 $ 1,923 $ -- $ 25,075 --------- -------- -------- -------- -------- --------- Cash and cash equivalents at end of year............................. $ 10,198 $ 3,361 $ 2,256 $ 2,340 $ -- $ 18,155 ========= ======== ======== ======== ======== =========
The accompanying notes are an integral part of these consolidated financial statements. F-31 98 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF ALLIED CAPITAL CORPORATION AND SUBSIDIARIES: We have audited the consolidated balance sheet of Allied Capital Corporation and subsidiaries as of December 31, 1999 and 1998, including the consolidated statement of investments as of December 31, 1999, and the related consolidated statements of operations, changes in net assets and cash flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements and supplementary consolidating financial information referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and supplementary consolidating financial information referred to below based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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. These procedures included physical counts of investments. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 3, the consolidated financial statements include investments valued at $1,228,497,000 as of December 31, 1999 and $807,119,000 as of December 31, 1998, (95 percent and 94 percent, respectively, of total assets) whose values have been estimated by the board of directors in the absence of readily ascertainable market values. We have reviewed the procedures used by the board of directors in arriving at its estimate of value of such investments and have inspected the underlying documentation, and in the circumstances we believe the procedures are reasonable and the documentation appropriate. However, because of the inherent uncertainty of valuation, the board of directors' estimate of values may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Allied Capital Corporation and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations, changes in net assets and cash flows for each of the three years in the period then ended in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The supplementary consolidating balance sheet and related consolidating statements of operations and cash flows are presented for purposes of additional analysis and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic consolidated financial statements and in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP Vienna, Virginia February 14, 2000 F-32 99 ALLIED CAPITAL CORPORATION STATEMENT OF ADDITIONAL INFORMATION APRIL 7, 2000 ------------------------- This Statement of Additional Information ("SAI") is not a prospectus, and should be read in conjunction with the prospectus dated April 7, 2000 relating to this offering and the accompanying prospectus supplement, if any. You can obtain a copy of the prospectus by calling Allied Capital Corporation at 1-888-818-5298 and asking for Investor Relations. Terms not defined herein have the same meaning as given to them in the prospectus. TABLE OF CONTENTS
PAGE IN THE LOCATION STATEMENT OF RELATED OF ADDITIONAL DISCLOSURE IN INFORMATION THE PROSPECTUS ------------- -------------- General Information and History............................. B-2 1;11;29 Investment Objective and Policies........................... B-2 1;11;29 Management.................................................. B-2 45 Compensation of Executive Officers and Directors....... B-2 49 Compensation of Directors.............................. B-3 49 Stock Option Awards.................................... B-3 49 Formula Award and Cut-Off Award........................ B-6 50 Committees of the Board of Directors................... B-6 N/A Control Persons and Principal Holders of Securities......... B-7 N/A Investment Advisory Services................................ B-8 35;45 Safekeeping, Transfer and Dividend Paying Agent and Registrar................................................. B-8 62 Brokerage Allocation and Other Practices.................... B-8 N/A Tax Status.................................................. B-9 51
------------------------- B-1 100 GENERAL INFORMATION AND HISTORY This SAI contains information with respect to Allied Capital Corporation (the "Company"). The Company changed its name from "Allied Capital Lending Corporation" to "Allied Capital Corporation," effective upon the merger, which was consummated on December 31, 1997. The Company is a registered investment adviser. The Company was initially organized as a corporation in the District of Columbia in 1976 and was reincorporated in the state of Maryland in 1990. INVESTMENT OBJECTIVE AND POLICIES The investment objective of the Company is to achieve current income and capital gains. The Company seeks to achieve its investment objective by lending to and investing primarily in private, growing businesses in a variety of industries throughout the United States. We focus on investments in three primary areas: private finance, commercial real estate finance and small business finance. Our investment portfolio consists primarily of long-term unsecured loans with equity features, commercial mortgage-backed securities, commercial mortgage loans, and small senior loans including SBA 7(a) guaranteed loans. At December 31, 1999, our investment portfolio totaled $1.2 billion. A discussion of the selected financial data, supplementary financial information and management's discussion and analysis of financial condition and results of operations is included in the prospectus. In addition to its core lending business, the Company also provides advisory services to private investment funds. MANAGEMENT COMPENSATION OF EXECUTIVE OFFICERS AND DIRECTORS Under Commission rules applicable to BDCs, we are required to set forth certain information regarding the compensation of certain executive officers and directors. The following table sets forth compensation paid by the Company in all capacities during the year ended December 31, 1999 to the directors and the three highest paid executive officers of the Company (collectively, the "Compensated Persons"). COMPENSATION TABLE
PENSION OR RETIREMENT BENEFITS AGGREGATE SECURITIES ACCRUED AS DIRECTORS COMPENSATION UNDERLYING PART OF FEES PAID FROM THE OPTIONS/ COMPANY BY THE NAME AND POSITION COMPANY (1) SARS(4) EXPENSES COMPANY ----------------- ------------ ---------- ---------- ---------- William L. Walton, Chairman and CEO(2).................... $2,326,190 96,555 -- -- Joan M. Sweeney, Managing Director(2)..................... 1,282,793 75,511 -- -- G. Cabell Williams III, Managing Director(2).............. 931,890 21,324 -- -- Brooks H. Browne, Director................................ 15,000 10,000 -- $15,000 John D. Firestone, Director............................... 10,000 10,000 -- 10,000 Anthony T. Garcia, Director............................... 13,000 10,000 -- 13,000 Lawrence I. Hebert, Director.............................. 6,000 10,000 -- 6,000 John I. Leahy, Director................................... 19,000 10,000 -- 19,000 Robert E. Long, Director.................................. 23,000 10,000 -- 23,000 Warren K. Montouri, Director.............................. 17,000 10,000 -- 17,000 Guy T. Steuart II, Director............................... 7,000 10,000 -- 7,000 T. Murray Toomey, Director................................ 7,000 10,000 -- 7,000 Laura W. van Roijen, Director............................. 7,000 10,000 -- 7,000 George C. Williams, Jr., Director, Chairman Emeritus(3)... 609,544 -- -- 17,000
- ------------------------- B-2 101 (1) There were no perquisites paid by the Company in excess of the lesser of $50,000 or 10% of the Compensated Person's total salary and bonus for the year. (2) The following table provides detail as to aggregate compensation for 1999 as to the three highest paid executive officers of the Company:
VESTED DEFERRED FORMULA CUT-OFF ESOP COMPENSATION SALARY BONUS AWARD AWARD CONTRIBUTION CONTRIBUTION -------- -------- ---------- -------- ------------ ------------ Mr. Walton.................... $410,014 $577,500 $1,121,769 $170,156 $8,000 $38,751 Ms. Sweeney................... 258,651 302,500 657,291 37,679 8,000 18,672 Mr. Williams III.............. 251,102 302,500 305,233 46,802 8,000 18,253
The Formula Award, which was granted in connection with the merger, totaled approximately $19 million in the aggregate at the time of grant, vests in three equal installments on December 31, 1998, 1999, and 2000, and will be expensed for financial reporting purposes similarly. The amount of the Formula Award expensed in 1999 for financial reporting purposes for Mr. Walton, Ms. Sweeney and Mr. Williams III was $1,472,451, $862,761 and $400,664, respectively. The amount expensed was based on the value of the Formula Award contribution to the deferred compensation plan in January 1998. On January 4, 2000, the second vested installment of the Formula Award was generally distributed to participants in the form of shares at the market value of the Company's common stock on that day. The value of the distribution for Mr. Walton, Ms. Sweeney and Mr. Williams III was $1,121,769, $657,291, and $305,233, respectively. The deferred compensation plan trust distributed the vested shares to brokerage accounts for the participants that restrict the sale of the vested shares. The Cut-Off Award, which totaled $2.9 million in the aggregate, is paid to individuals on the respective vesting date of any options granted under the predecessor company option plans that were canceled in connection with the merger. See "Formula Award and Cut-Off Award." (3) In addition to director's fees, Mr. Williams received $144,000 in consulting fees, $4,688 in Cut-Off Award and $443,856 in vested Formula Award. The amount of the Formula Award expensed in 1999 with respect to Mr. Williams' award was $601,068. (4) See "Stock Option Awards" for terms of options granted in 1999. The Company does not maintain a restricted stock plan or a long-term incentive plan. COMPENSATION OF DIRECTORS During 1999, each director received $1,000 for each Board of Directors or committee meeting attended, except with respect to the members of the Executive Committee, who each received an annual retainer of $10,000 in lieu of fees paid for each Executive Committee meeting attended. Non-officer directors are eligible for stock option awards under the Company's Stock Option Plan pursuant to an exemptive order from the Commission. The terms of the order, which was granted in September 1999, provided for a one-time grant of 10,000 options to each non-officer director on the date that the order was issued, or on the date that any new director is elected to the Board. Thereafter, each non-officer director will receive 5,000 options each year on the date of the annual meeting of stockholders at the fair market value on the date of grant. See "Stock Option Plan." STOCK OPTION AWARDS The following table sets forth the details relating to option grants in 1999 to Compensated Persons under the Company's Stock Option Plan, and the potential realizable value of each grant, as prescribed to be calculated by the Commission. See "Stock Option Plan" in the Prospectus. B-3 102 OPTION GRANTS DURING 1999
POTENTIAL REALIZABLE VALUE AT ASSUMED NUMBER OF ANNUAL RATES SECURITIES PERCENT OF OF STOCK APPRECIATION UNDERLYING TOTAL OPTIONS EXERCISE OVER 10-YEAR TERM(3) OPTIONS GRANTED PRICE PER EXPIRATION ----------------------- NAME GRANTED(1) IN 1999(2) SHARE DATE 5% 10% - ---- ---------- ------------- --------- ---------- ---------- ---------- William L. Walton......................... 96,555 7.50% $17.75 12/30/09 $1,077,832 $2,731,438 Joan M. Sweeney........................... 75,511 5.90% 17.75 12/30/09 842,920 2,136,125 G. Cabell Williams III.................... 21,324 1.70% 17.75 12/30/09 238,037 603,233 Brooks H. Browne.......................... 10,000 0.78% 22.06 09/08/09 138,753 351,627 John D. Firestone......................... 10,000 0.78% 22.06 09/08/09 138,753 351,627 Anthony T. Garcia......................... 10,000 0.78% 22.06 09/08/09 138,753 351,627 Lawrence I. Hebert........................ 10,000 0.78% 22.06 09/08/09 138,753 351,627 John I. Leahy............................. 10,000 0.78% 22.06 09/08/09 138,753 351,627 Robert E. Long............................ 10,000 0.78% 22.06 09/08/09 138,753 351,627 Warren K. Montouri........................ 10,000 0.78% 22.06 09/08/09 138,753 351,627 Guy T. Steuart II......................... 10,000 0.78% 22.06 09/08/09 138,753 351,627 T. Murray Toomey.......................... 10,000 0.78% 22.06 09/08/09 138,753 351,627 Laura W. van Roijen....................... 10,000 0.78% 22.06 09/08/09 138,753 351,627
- --------------- (1) Options granted to officers in 1999 generally vest in six equal installments beginning on the date of grant, with full vesting occurring on the fifth anniversary of the grant date or change of control of the Company. Options granted to non-officer directors vest immediately. (2) In 1999, the Company granted options to purchase a total of 1,287,736 shares. (3) Potential realizable value is calculated on 1999 options granted, and is net of the option exercise price but before any tax liabilities that may be incurred. These amounts represent certain assumed rates of appreciation, as mandated by the Commission. Actual gains, if any, or stock option exercises are dependent on the future performance of the shares, overall market conditions, and the continued employment by the Company of the option holder. The potential realizable value will not necessarily be realized. B-4 103 The following table sets forth the details of option exercises by Compensated Persons during 1999 and the values of those unexercised options at December 31, 1999. OPTION EXERCISES AND YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED IN-THE- UNDERLYING UNEXERCISED MONEY OPTIONS SHARES OPTIONS AS OF 12/31/99 AS OF 12/31/99(2) ACQUIRED ON VALUE --------------------------- ----------------------------- NAME EXERCISE REALIZED(1) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE ---- ----------- ----------- ----------- ------------- ------------ -------------- William L. Walton......... 15,834 $55,419 251,657 583,252 $15,996 $73,040 Joan M. Sweeney........... 0 0 137,345 312,441 15,116 51,486 G. Cabell Williams III.... 0 0 96,356 203,371 10,031 26,064 George C. Williams, Jr. .................... 0 0 97,598 53,797 1,460 2,920 Brooks H. Browne.......... 0 0 10,000 0 0 0 John D. Firestone......... 0 0 10,000 0 0 0 Anthony T. Garcia......... 0 0 10,000 0 0 0 Lawrence I. Hebert........ 0 0 10,000 0 0 0 John I. Leahy............. 0 0 10,000 0 0 0 Robert E. Long............ 0 0 10,000 0 0 0 Warren K. Montouri........ 0 0 10,000 0 0 0 Guy T. Steuart II......... 0 0 10,000 0 0 0 T. Murray Toomey.......... 0 0 10,000 0 0 0 Laura W. van Roijen....... 0 0 10,000 0 0 0
- ------------------------- (1) Value realized is calculated as the closing market price on the date of exercise, net of option exercise price, but before any tax liabilities or transaction costs. This is the deemed market value, which may actually be realized only if the shares are sold at that price. (2) Value of unexercised options is calculated as the closing market price on December 31, 1999 ($18.31), net of the option exercise price, but before any tax liabilities or transaction costs. "In-the-Money Options" are options with an exercise price that is less than the market price as of December 31, 1999. B-5 104 FORMULA AWARD AND CUT-OFF AWARD Formula Award. The Formula Award was designed as an incentive compensation program that would replace stock options of the predecessor companies that were cancelled as a result of the Company's 1997 merger, and would balance share ownership among key officers. Assuming all officers meet the vesting requirement, the Company would accrue the Formula Award in equal amounts of approximately $6.4 million, over the three-year period on the anniversary of the merger date (December 31) in 1998, 1999 and 2000, and will vest automatically in the event of a change of control of the Company. The Formula Award expense for 1999 totaled $6.2 million for 1999. The amount of the Formula Award to be expensed in 2000 for financial reporting purposes for Mr. Walton, Ms. Sweeney and Mr. Williams III will be $1,472,451, $862,761 and $400,664, respectively. If an officer terminates employment with the Company prior to the vesting of any part of the Formula Award, that amount is forfeited to the Company. The terms of the Formula Award require that the award be contributed to the Company's deferred compensation plan, and used to purchase shares of the Company in the open market. See "Deferred Compensation Plan." Cut-Off Award. The Cut-Off Award was designed to cap the appreciated value in unvested options at the merger announcement date in order to set the foundation to balance option awards upon the merger on December 31, 1997. As of December 31, 1997, the Cut-Off Award in the aggregate was computed to be $2.9 million. The Cut-Off Award is payable for each canceled option as the canceled options would have vested and vests automatically in the event of a change of control. The Cut-Off Award is payable if the award recipient is employed by the Company on the future vesting date. The Cut-Off Award expense for 1999 totaled $0.6 million. The amount paid to the Compensated Persons in 1999 is set forth above. COMMITTEES OF THE BOARD OF DIRECTORS The Company's board of directors has established an Executive Committee, an Audit Committee, a Nominating Committee and a Compensation Committee. The Executive Committee has and may exercise those rights, powers and authority that the Board of Directors from time to time grants to it, except where action by the full Board is required by statute, an order of the Securities and Exchange Commission (the "Commission") or the Company's charter or bylaws. The Executive Committee also reviews and approves all investments of $10 million or more. The Executive Committee consists of Messrs. Walton, Leahy, Long, Montouri, and Williams. The Executive Committee met 27 times during 1999. The Audit Committee recommends the selection of independent public accountants for the Company, reviews with such independent public accountants the planning, scope and results of their audit of the Company's financial statements and the fees for services performed, reviews with the independent public accountants the adequacy of internal control systems, reviews the Company's annual financial statements and receives the Company's audit reports and financial statements. The Audit Committee consists of Messrs. Browne, Leahy and Steuart. The Audit Committee met twice during 1999. The Compensation Committee determines the compensation for the Company's executive officers and the amount of salary and bonus to be included in the compensation package for each of the Company's officers and employees. In addition, the Compensation Committee approves stock option grants for the Company's officers under the Company's Stock Option Plan. The Compensation Committee consists of Messrs. Browne, Long, Firestone, and Garcia. The Compensation Committee met six times during 1999. The Nominating Committee recommends candidates for election as directors to the Board of Directors. The Nominating Committee consists of Messrs. Walton, Hebert, Toomey and Steuart, and Ms. van Roijen. The Nominating Committee did not meet during 1999. The full Board of Directors nominated directors for election in 1999. B-6 105 CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES As of March 24, 2000, there were no persons that owned 25% or more of the Company's outstanding voting securities, and no person would be deemed to control the Company, as such term is defined in the 1940 Act. The following table sets forth, as of March 24, 2000, each current director, the Chief Executive Officer, the Company's executive officers, and the executive officers and directors as a group. The address for each director and executive officer is 1919 Pennsylvania Avenue, NW, Washington, DC 20006. Unless otherwise indicated, the Company believes that each beneficial owner set forth in the table has sole voting and investment power. The Company is not aware of any shareholder that beneficially owns more than 5% of the Company's outstanding shares.
NUMBER OF SHARES NAME OF OWNED PERCENTAGE BENEFICIAL OWNER BENEFICIALLY OF CLASS 1 - ---------------- ------------ ---------- DIRECTORS: William L. Walton........................................... 975,483(2,4) 1.4% Brooks H. Browne............................................ 53,214(3) * John D. Firestone........................................... 36,329(3) * Anthony T. Garcia........................................... 68,112(3) * Lawrence I. Hebert.......................................... 26,800(3) * John I. Leahy (7)........................................... 26,818(3) * Robert E. Long.............................................. 19,796(3) * Warren K. Montouri (7)...................................... 236,182(3) * Guy T. Steuart II (7)....................................... 328,180(3,5) * T. Murray Toomey, Esq. (7).................................. 42,666(3,6) * Laura W. van Roijen......................................... 38,412(3) * George C. Williams, Jr...................................... 432,475(2) * EXECUTIVE OFFICERS: Philip A. McNeill........................................... 269,186(2) * Penni F. Roll............................................... 88,115(2) * John M. Scheurer............................................ 460,494(2) * Joan M. Sweeney............................................. 436,347(2) * G. Cabell Williams III...................................... 781,560(2,4) 1.1% All directors and executive officers as a group (17 in number)................................................... 4,010,460(7) 5.7%
- --------------- * Less than 1% (1) Based on a total of 68,628,044 shares of the Company's common stock issued and outstanding on March 22, 2000 and shares of the Company's common stock issuable upon the exercise of immediately exercisable stock options held by each individual executive officer and non-officer director. The beneficial ownership of each non-officer director includes exercisable options to purchase 10,000 shares. B-7 106 (2) Share ownership for the following directors and executive officers includes:
OPTIONS EXERCISABLE ALLOCATED TO OWNED WITHIN 60 DAYS 401(K) PLAN DIRECTLY OF MARCH 24, 2000 ACCOUNT -------- ----------------- ------------ William L. Walton...................................... 348,657 361,522 957 George C. Williams, Jr................................. 287,746 144,729 0 Philip A,. McNeill..................................... 182,022 78,297 8,867 Penni F. Roll.......................................... 51,576 32,984 3,555 John M. Scheurer....................................... 251,917 186,200 22,377 Joan M. Sweeney........................................ 236,183 190,558 9,606 G. Cabell Williams, III................................ 382,666 133,590 70,208
(3) Beneficial ownership includes exercisable options to purchase 10,000 shares. (4) Includes 265,304 shares held by the 401(K) Plan, of which Messrs. Walton and Williams III are co-trustees, who have the power to vote the shares on behalf of the participants. Messrs. Walton and Williams III disclaim beneficial ownership of such shares. (5) Includes 276,691 shares held by a corporation for which Mr. Steuart II serves as an executive officer. (6) Shares are held by a trust for the benefit of Mr. Toomey and his wife. (7) Includes a total of 1,127,880 shares underlying stock options exercisable within 60 days of March 22, 2000, which are assumed to be outstanding for the purpose of calculating the group's percentage ownership, and 265,304 shares held by the 401(K) Plan. INVESTMENT ADVISORY SERVICES The Company is internally managed and therefore has not entered into any advisory agreement with, nor pays advisory fees to, an outside investment adviser. The Company is a registered investment adviser under the Advisers Act and provides advisory services to other entities. The Company currently has 75 investment and other portfolio management professionals, who manage the investments of the Company as well as the investments of other managed entities, as well as 20 other professional employees and 34 staff. Our investment decisions in each business area are made by investment committees, comprised of the Company's most senior investment professionals. In addition, in certain instances where risk/return characteristics warrant and for every transaction larger than $10 million, the executive committee of the board of directors must also approve the transaction. See "Management" in the prospectus. SAFEKEEPING, TRANSFER AND DIVIDEND PAYING AGENT AND REGISTRAR The investments of the Company and its subsidiaries are held in safekeeping by Riggs Bank N.A. ("Riggs") at 808 17th Street, N.W., Washington, D.C. 20006. LaSalle National Bank, located at 25 Northwest Point Boulevard, Suite 800, Elk Grove Village, Illinois 60007, serves as the trustee and custodian with respect to assets of the Company held for securitization purposes. American Stock Transfer & Trust Company, 40 Wall Street, 46th Floor, New York, New York 10005 acts as the Company's transfer, dividend paying and reinvestment plan agent and registrar. BROKERAGE ALLOCATION AND OTHER PRACTICES Since the Company generally acquires and disposes of its investments in privately negotiated transactions, it infrequently uses brokers in the normal course of business. B-8 107 TAX STATUS The following discussion is a general summary of the material federal income tax considerations applicable to the Company and to an investment in the common stock and does not purport to be a complete description of the income tax considerations applicable to such an investment. The discussion is based upon the Code, Treasury Regulations, and administrative and judicial interpretations, each as of the date of this SAI and all of which are subject to change. You should consult your own tax advisor with respect to tax considerations which pertain to your purchase of common stock. This summary assumes that the investors in the Company hold shares as capital assets. This summary does not discuss all aspects of federal income taxation relevant to holders of the common stock in light of particular circumstances, or to certain types of holders subject to special treatment under federal income tax laws, including dealers in securities, pension plans and trusts and financial institutions. This summary does not discuss any aspects of foreign, state or local tax laws. It does not discuss the special treatment under federal income tax laws that could result if the Company invested in tax-exempt securities or certain other investment assets. The Company. The Company has elected for each taxable year to be treated as a "regulated investment company" or "RIC" under Subchapter M of the Code and intends to continue to maintain that status. If the Company qualifies as a RIC and distributes to stockholders in a timely manner at least 90% of its "investment company taxable income," as defined in the Code (i.e., net investment income, including accrued original issue discount, and net short-term capital gains) (the "90% Distribution Requirement") each year, it will not be subject to federal income tax on the portion of its investment company taxable income and net capital gains (net long-term capital gain in excess of net short-term capital loss) it distributes (or treats as "deemed distributed") to stockholders. In addition, if the Company distributes in a timely manner 98% of its capital gain net income for each one-year period ending on December 31, and distributes 98% of its net ordinary income for each calendar year (as well as any income not distributed in prior years), it will not be subject to the 4% nondeductible federal excise tax imposed with respect to certain undistributed income of RICs. The Company generally endeavors to distribute to stockholders all of its investment company taxable income and its net capital gain, if any, for each taxable year so that such Company will not incur income or excise taxes on its earnings. In order to qualify as a RIC for federal income tax purposes, the Company must, among other things: (a) continue to qualify as a BDC under the 1940 Act, (b) derive in each taxable year at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities, or other income derived with respect to its business of investing in such stock or securities (the "90% Income Test"); and (c) diversify its holdings so that at the end of each quarter of the taxable year (i) at least 50% of the value of the Company's assets consists of cash, cash items, U.S. government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the Company's assets or 10% of the outstanding voting securities of the issuer, and (ii) no more than 25% of the value of the Company's assets is invested in the securities (other than U.S. government securities or securities of other RICs) of one issuer or of two or more issuers that are controlled (as determined under applicable Code rules) by the Company and are engaged in the same or similar or related trades or businesses. The failure of one or more of the Company's subsidiaries to continue to qualify as RICs could adversely affect the Company's ability to satisfy the foregoing diversification requirements. If the Company acquires or is deemed to have acquired debt obligations that were issued originally at a discount or that otherwise are treated under applicable tax rules as having original issue discount, it must include in income each year a portion of the original issue discount that accrues B-9 108 over the life of the obligation regardless of whether cash representing such income is received by the relevant entity in the same taxable year and to make distributions accordingly. Although it does not presently expect to do so, the Company is authorized to borrow funds and to sell assets in order to satisfy distribution requirements. However, under the 1940 Act, the Company is not permitted to make distributions to stockholders while the Company's debt obligations and other senior securities are outstanding unless certain "asset coverage" tests are met. Moreover, the Company's ability to dispose of assets to meet its distribution requirements may be limited by other requirements relating to its status as a RIC, including the diversification requirements. If the Company disposes of assets in order to meet distribution requirements, the Company may make such dispositions at times which, from an investment standpoint, are not advantageous. If the Company fails to satisfy the 90% Distribution Requirement or otherwise fails to qualify as a RIC in any taxable year, it will be subject to tax in that year on all of its taxable income, regardless of whether it makes any distributions to its stockholders. In that case, all of the Company's distributions to its stockholders will be characterized as ordinary income (to the extent of the Company's current and accumulated earnings and profits). In contrast, as is explained below, if the Company qualifies as a RIC, a portion of its distributions or deemed distributions may be characterized as long-term capital gain in the hands of stockholders. U.S. Stockholders. Other than distributions properly designated as "capital gain dividends" as is described below, dividends to U.S. Stockholders (as defined below) of the investment company taxable income of the Company will be taxable as ordinary income to stockholders to the extent of the Company's current or accumulated earnings and profits, whether paid in cash or reinvested in additional shares. A "U.S. Stockholder" is a stockholder who is (i) a citizen or resident of the United States, (ii) a corporation, partnership or other entity created in or organized under the laws of the United States or any political subdivision thereof, (iii) an estate, the income of which is subject to United States federal income taxation regardless of its source, or (iv) a trust subject to the supervision of a court within the United States and the control of a United States person. Distributions of the Company's net capital gain properly designated by the Company as "capital gain dividends" will be taxable to stockholders as a long-term capital gain regardless of the stockholder's holding period for his or her shares. Distributions in excess of the Company's earnings and profits will first reduce the adjusted tax basis of the stockholder's shares and, after the adjusted basis is reduced to zero, will constitute capital gains to the stockholder. For a summary of the tax rates applicable to capital gains, including capital gains dividends, see discussion below. To the extent that the Company retains any net capital gain, it may designate such retained gain as "deemed distributions" and pay a tax thereon for the benefit of its stockholders. In that event, the stockholders will be required to report their share of retained net capital gain on their tax returns as if it had been distributed to them and report a credit, or claim a refund for the tax paid thereon by the Company. The amount of the deemed distribution net of such tax will be added to the stockholder's cost basis for his or her shares. Since the Company expects to pay tax on net capital gain at its regular corporate capital gain tax rate, and since that rate is in excess of the maximum rate currently payable by individuals on net capital gain, the amount of tax that individual stockholders will be treated as having paid will exceed the amount of tax that such stockholders would be required to pay on net capital gain. Stockholders who are not subject to federal income tax or tax on capital gains should be able to file a Form 990T or an income tax return on the appropriate form that allows them to recover the taxes paid on their behalf. Any dividend declared by the Company in October, November, or December of any calendar year, payable to stockholders of record on a specified date in such a month and actually paid during January of the following year, will be treated as if it had been received by the stockholders on December 31 of the year in which the dividend was declared. B-10 109 You should consider the tax implications of buying shares just prior to a distribution. Even if the price of the shares includes the amount of the forthcoming distribution, you may be taxed upon receipt of the distribution and will not be entitled to offset the distribution against the tax basis in your shares. You may recognize taxable gain or loss if you sell or exchange your shares. Any gain arising from (or, in the case of distributions in excess of earnings and profits, treated as arising from) the sale or exchange of shares generally will be a capital gain or loss. This capital gain or loss normally will be treated as a long-term capital gain or loss if you have held your shares for more than one year; otherwise, it will be classified as short-term capital gain or loss. However, any capital loss arising from the sale or exchange of shares held for six months or less will be treated as a long-term capital loss to the extent of the amount of capital gain dividends received with respect to such shares and, for this purpose, the special rules of Section 246(c)(3) and (4) of the Code generally apply in determining the holding period of shares. It is unclear how any such long-term capital loss offsets capital gains taxable at different rates. All or a portion of any loss realized upon a taxable disposition of shares of the Company may be disallowed if other shares of the Company are purchased (under a DRIP plan or otherwise) within 30 days before or after the disposition. In general, net capital gain derived from an investment in the Company (the excess of net long-term capital gain over net short-term capital loss) of non-corporate taxpayers currently is subject to a maximum federal income tax rate of 20% (subject to reduction in certain situations) while other income may be taxed at rates as high as 39.6%. Capital gains derived from the disposition of assets held for more than one year generally are subject to federal income tax at the rate of 20%. Corporate taxpayers currently are subject to federal income tax on net capital gain at the maximum 35% rate also applied to ordinary income. Tax rates imposed by states and local jurisdictions on capital gain and ordinary income may differ. The Company will send to each of its stockholders, as promptly as possible after the end of each fiscal year, a notice detailing, on a per share and per distribution basis, the amounts includible in such stockholder's taxable income for such year as ordinary income and as long-term capital gain. In addition, the federal tax status of each year's distributions generally will be reported to the IRS. Distributions may also be subject to additional state, local, and foreign taxes depending on a stockholder's particular situation. The Company's ordinary income dividends to its corporate shareholders may, if certain conditions are met, qualify for the dividends received deduction to the extent that the Company has received qualifying dividend income during the taxable year; capital gain dividends distributed by the Company are not eligible for the dividends received deduction. Non-U.S. Stockholders. A Stockholder that is not a U.S. Stockholder (a "Non-U.S. Stockholder") generally is subject to withholding of United States federal income tax at a 30% rate (or lower applicable treaty rate) on dividends from the Company (other than capital gain dividends or deemed dividends) that are not "effectively connected" with a United States trade or business carried on by such stockholder. Accordingly, investment in the Company is likely to be appropriate for a Non-U.S. Stockholder only if such person can utilize a foreign tax credit or corresponding tax benefit in respect of such United States withholding tax. Non-effectively connected capital gain dividends and gains realized from the sale of stock will not be subject to United States federal income tax in the case of (i) a Non-U.S. Stockholder that is a corporation and (ii) a Non-U.S. Stockholder that is not present in the United States for more than 182 days during the taxable year (assuming that certain other conditions are met). However, certain Non-U.S. Stockholders may nonetheless be subject to backup withholding on capital gain dividends and gross proceeds paid to them upon the sale of their stock. See "Backup Withholding" below. B-11 110 If income from the Company or gains realized from the sale of stock are effectively connected with a Non-U.S. Stockholder's United States trade or business, then such amounts will be subject to United States federal income tax at the tax rates applicable to United States persons. Non-U.S. Stockholders that are corporations may be also subject to an additional "branch profits tax" with respect to income from the Company that is effectively connected with a United States trade or business. The United States Treasury Department recently issued Treasury regulations generally effective for payments made after December 31, 1999 concerning the withholding of tax and information reporting for certain amounts paid to nonresident alien individuals and foreign corporations (the "Final Withholding Regulations"). Investors should consult their tax advisors concerning the applicability and effect of the Final Withholding Regulations on an investment in stock. The tax consequences to a Non-U.S. Stockholder entitled to claim the benefits of an applicable tax treaty may be different from those described in this section. An applicable tax treaty may reduce the rate or the scope of U.S. taxation imposed on the income of an eligible Non-U.S. Stockholder. Non-U.S. Stockholders may be required to provide appropriate documentation to establish their entitlement to the benefits of such a treaty. Foreign investors are advised to consult their tax advisors with respect to the tax implications of purchasing, holding and disposing of stock. Backup Withholding. The Company may be required to withhold United States federal income tax at a rate of 31% ("backup withholding") from dividends and redemption proceeds paid to non-corporate stockholders. This tax may be withheld from dividends if (i) the stockholder fails to furnish the Company with its correct taxpayer identification number, (ii) the IRS notifies the Company that the stockholder has failed to properly report certain interest and dividend income to the IRS and to respond to notices to that effect or (iii) when required to do so, the stockholder fails to certify that he or she is not subject to backup withholding. Redemption proceeds may be subject to withholding under the circumstances described in (i) above. The Company may be required to report annually to the IRS and to each Non-U.S. Stockholder the amount of dividends paid to such stockholder and the amount, if any, of tax withheld pursuant to the backup withholding rules with respect to such dividends. This information may also be made available to the tax authorities in the Non-U.S. Stockholder's country of residence. Backup withholding is not an additional tax. Any amounts withheld under the backup withholding rules from payments made to a stockholder may be refunded or credited against such stockholder's United States federal income tax liability, if any, provided that the required information is furnished to the IRS. YOU SHOULD CONSULT YOUR OWN TAX ADVISOR WITH RESPECT TO THE PARTICULAR TAX CONSEQUENCES TO THEM OF AN INVESTMENT IN THE COMPANY, INCLUDING THE POSSIBLE EFFECT OF ANY PENDING LEGISLATION OR PROPOSED REGULATION. B-12 -----END PRIVACY-ENHANCED MESSAGE-----