-----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, V/B+bXHpdbS1dIJ9CRSwOVSwbvcpS3XT7GZN6piy623IuWMN1SACpWHhk7O/+tQo XogCBHMju/LxNKkIHMpiJg== 0000950133-99-003460.txt : 19991115 0000950133-99-003460.hdr.sgml : 19991115 ACCESSION NUMBER: 0000950133-99-003460 CONFORMED SUBMISSION TYPE: POS 8C PUBLIC DOCUMENT COUNT: 5 FILED AS OF DATE: 19991112 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: POS 8C SEC ACT: SEC FILE NUMBER: 333-84973 FILM NUMBER: 99746478 BUSINESS ADDRESS: STREET 1: 1666 K ST NW STE 901 CITY: WASHINGTON STATE: DC ZIP: 20006 BUSINESS PHONE: 2023311112 MAIL ADDRESS: STREET 1: 1666 K STREET 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 POS 8C 1 POST-EFFECTIVE AMENDMENT NO.1 TO FORM N-2 1 As filed with the Securities and Exchange Commission on November 10, 1999 REGISTRATION NO. 333-84973 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM N-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 [ ] PRE-EFFECTIVE AMENDMENT NO. [X] POST-EFFECTIVE AMENDMENT NO. 1 ALLIED CAPITAL CORPORATION (Exact Name of Registrant as Specified in Charter) 1919 PENNSYLVANIA AVENUE, N.W. WASHINGTON, D.C. 20006-3434 (202) 331-1112 (Address and Telephone Number, including Area Code, of Principal Executive Offices) WILLIAM L. WALTON, CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER ALLIED CAPITAL CORPORATION 1919 PENNSYLVANIA AVENUE, N.W. WASHINGTON, D.C. 20006-3434 (Name and Address of Agent for Service) Copies of information to: STEVEN B. BOEHM SUTHERLAND ASBILL & BRENNAN LLP 1275 PENNSYLVANIA AVENUE, N.W. WASHINGTON, D.C. 20004-2415 Approximate Date of Proposed Public Offering: From time to time after the effective date of the Registration Statement. If any securities being registered on this form will be offered on a delayed or continuous basis in reliance on Rule 415 under the Securities Act of 1933, other than securities offered in connection with a dividend reinvestment plan, check the following box. [X] THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SECTION 8(a), MAY DETERMINE. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 PROSPECTUS Allied Capital Logo 6,000,000 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 November , 1999 (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 70 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 6,000,000 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 small and middle-market businesses in a variety of industries and in diverse geographic locations, primarily in 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 November , 1999, the last reported sales price for the common stock was . 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. ------------------------ November , 1999 3 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................................................. 12 Use of Proceeds............................................. 12 Price Range of Common Stock and Dividends................... 13 Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 14 Senior Securities........................................... 32 Business.................................................... 36 Portfolio Companies......................................... 47 Determination of Net Asset Value............................ 52 Management.................................................. 53 Taxation.................................................... 59 Certain Government Regulations.............................. 61 Dividend Reinvestment Plan.................................. 63 Description of Capital Stock................................ 64 Plan of Distribution........................................ 68 Legal Matters............................................... 69 Safekeeping, Transfer and Dividend Paying Agent and Registrar................................................. 69 Independent Public Accountants.............................. 69 Table of Contents of Statement of Additional Information.... 70 Index to Financial Statements............................... 71
------------------------ (i) 4 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., 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 12) We provide capital to small and middle-market companies in a variety of different industries and in diverse geographic locations. We have been lending to private growing businesses for over 40 years and have financed thousands of borrowers nationwide. Our lending and investment activity is focused in three areas: - mezzanine finance, - commercial real estate finance, including the purchase of commercial mortgage-backed securities ("CMBS"), and - small business and commercial real estate loans originated for sale under our Allied Capital Express brand name. Our principal loan products include: - subordinated loans with equity features, - commercial mortgage loans, and - 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 in Chicago, San Francisco and New York, and Allied Capital Express offices in Detroit, Atlanta, Philadelphia, Chicago and Greenville, SC. We cen- tralize 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 and in diverse geographic locations, primarily in the United States. THE OFFERING (Page 68) We may offer, from time to time, up to 6,000,000 shares of common stock, par value $0.0001 per share, on terms to be 1 5 determined at the time of offering. Shares 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 12) 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 small and middle-market, private growth companies in accordance with our investment objective, purchase of CMBS, repayment of indebtedness, acquisitions and other general corporate purposes. DIVIDENDS (Page 13) We pay quarterly dividends to shareholders. The amount of our quarterly dividends is determined by the board of directors and is currently based upon our estimate of annual taxable income. DIVIDEND REINVESTMENT PLAN (Page 63) 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 and loans to small and middle-market 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 of our portfolio, changing interest rates, accessing additional capital, fluctuating quarterly results, operating in a regulated environment and assessing Year 2000 problems. 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 65) 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 6 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)................................... 4.8% Interest payments on borrowed funds(5).................. 6.4% ----- Total annual expenses(6)........................... 11.2% =====
- ------------------------- (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 September 30, 1999. (4) "Operating expenses" represent the estimated 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) "Interest payments on borrowed funds" represent estimated interest payments for the year ended December 31, 1999. The Company had outstanding borrowings of $537.9 million at September 30, 1999. This percentage for the year ended December 31, 1998 was 4.2%. See "Risk Factors." (6) "Total annual expenses" is based on estimated expenses for the year ended December 31, 1999. "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 the "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 money. If the "Total annual expenses" percentage were calculated instead as a percentage of consolidated total assets, the "Total annual expenses" percentage for the Company would be 5.7% 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.......... $112 $334 $552 $1,085
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 7 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, 1998, 1997, 1996 and 1995 has been derived from audited financial statements. Financial information for the year ended December 31, 1994 has been derived from the audited financial statements of the individual predecessor companies. 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. Quarterly financial information is derived from unaudited financial data, but in the opinion of management, reflects all adjustments (consisting only of normal recurring adjustments) which are necessary to present fairly the results for such interim periods. Interim results at and for the nine months ended September 30, 1999 are not necessarily indicative of the results that may be expected for the year ending December 31, 1999. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" ON PAGE 14 FOR MORE INFORMATION.
NINE MONTHS ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31, ----------------- ----------------------------------------------- (IN THOUSANDS, 1999 1998 1998 1997 1996 1995 1994 EXCEPT PER SHARE DATA) ------- ------- ------- ------- ------- ------- ------- (UNAUDITED) OPERATING DATA: Interest and related portfolio income: Interest..................... $84,419 $58,428 $79,921 $86,882 $77,541 $61,550 $47,065 Net premiums from loan dispositions............... 9,032 2,913 5,949 7,277 4,241 2,796 2,380 Net gain on securitization of commercial mortgage loans...................... -- 14,812 14,812 -- -- -- -- Investment advisory fees and other income............... 5,411 4,611 6,056 3,246 3,155 4,471 2,710 ------- ------- ------- ------- ------- ------- ------- Total interest and related portfolio income................ 98,862 80,764 106,738 97,405 84,937 68,817 52,155 ------- ------- ------- ------- ------- ------- ------- Expenses: Interest on indebtedness..... 24,173 14,539 20,694 26,952 20,298 12,355 7,486 Salaries and employee benefits................... 11,303 8,254 11,829 10,258 8,774 8,031 6,929 General and administrative... 8,476 8,970 11,921 8,970 8,289 6,888 7,170 Merger....................... -- -- -- 5,159 -- -- -- ------- ------- ------- ------- ------- ------- ------- Total operating expenses.............. 43,952 31,763 44,444 51,339 37,361 27,274 21,585 Formula and cut-off awards(1).................. 5,188 5,532 7,049 -- -- -- -- ------- ------- ------- ------- ------- ------- ------- Portfolio income before net realized and unrealized gains...................... 49,722 43,469 55,245 46,066 47,576 41,543 30,570 ------- ------- ------- ------- ------- ------- ------- Net realized and unrealized gains: Net realized gains........... 16,448 20,001 22,541 10,704 19,155 12,000 6,236 Net unrealized gains (losses)................... 1,475 (437) 1,079 7,209 (7,412) 9,266 (2,244) ------- ------- ------- ------- ------- ------- ------- Total net realized and unrealized gains...... 17,923 19,564 23,620 17,913 11,743 21,266 3,992 ------- ------- ------- ------- ------- ------- ------- Income before minority interests and income taxes............... 67,645 63,033 78,865 63,979 59,319 62,809 34,562 Minority interests............... -- -- -- 1,231 2,427 546 -- Income tax expense............... -- 1,585 787 1,444 1,945 1,784 672 ------- ------- ------- ------- ------- ------- ------- Net increase in net assets resulting from operations...... $67,645 $61,448 $78,078 $61,304 $54,947 $60,479 $33,890 ======= ======= ======= ======= ======= ======= =======
(footnotes appear on next page) 4 8
NINE MONTHS ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31, ----------------- ----------------------------------------------- (IN THOUSANDS, 1999 1998 1998 1997 1996 1995 1994 EXCEPT PER SHARE DATA) ------- ------- ------- ------- ------- ------- ------- (UNAUDITED) PER SHARE: Basic earnings per common share....... $ 1.14 $ 1.19 $ 1.50 $ 1.24 $ 1.19 $ 1.38 $ 0.80 Diluted earnings per common share............................... $ 1.14 $ 1.19 $ 1.50 $ 1.24 $ 1.17 $ 1.37 $ 0.79 Total tax distributions per common share(2)............................ $ 1.20 $ 1.05 $ 1.43 $ 1.71 $ 1.23 $ 1.09 $ 0.94 Weighted average basic common shares outstanding(3)...................... 59,077 51,502 51,941 49,218 46,172 43,697 42,463 Weighted average diluted common shares outstanding(3)...................... 59,239 51,712 51,974 49,251 46,733 44,010 42,737
AT SEPTEMBER 30, AT DECEMBER 31, ---------------- ---------------------------------------------------- (IN THOUSANDS, 1999 1998 1997 1996 1995 1994 EXCEPT PER SHARE DATA) ---------------- -------- -------- -------- -------- -------- (UNAUDITED) BALANCE SHEET DATA: Portfolio at value......... $1,103,653 $800,274 $697,021 $607,368 $528,483 $443,316 Portfolio at cost.......... 1,098,111 796,389 690,720 613,276 526,979 451,078 Total assets............... 1,169,531 856,079 807,775 713,360 605,434 501,817 Total debt outstanding(4)........... 537,850 334,350 347,663 274,997 200,339 130,236 Preferred stock issued to SBA(4)................... 7,000 7,000 7,000 7,000 7,000 7,000 Shareholders' equity....... 593,833 485,117 420,060 402,134 367,192 344,043 Shareholders' equity per common share............. $ 9.58 $ 8.68 $ 8.07 $ 8.34 $ 8.26 $ 8.02 Common shares outstanding at period end(3)......... 61,972 55,919 52,047 48,238 44,479 42,890
NINE MONTHS ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31, ----------------------- ------------------------------------------------------ 1999 1998 1998 1997 1996 1995 1994 (IN THOUSANDS) ---------- ---------- ---------- -------- -------- -------- -------- (UNAUDITED) OTHER DATA: Loan originations.... $ 534,017 $ 349,586 $ 524,530 $364,942 $283,295 $216,175 $215,843 Loan repayments...... 120,563 75,817 138,081 233,005 179,292 111,731 54,097 Loan sales(5)........ 120,871 28,957 81,013 53,912 27,715 29,726 30,160 Total assets managed at period end(6)... 1,435,036 1,106,552 1,143,548 935,720 822,450 702,567 583,817 Realized gains....... 21,606 20,819 25,757 15,804 30,417 16,679 9,144 Realized losses...... (5,158) (818) (3,216) (5,100) (11,262) (4,679) (2,908)
- ------------------------- (1) See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Comparison of Nine Months Ended September 30, 1999 and 1998 and Fiscal Years Ended December 31, 1998, 1997 and 1996." (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 808,348 shares held in the deferred compensation trust at or for the nine months ended September 30, 1999 and 1998, respectively, and 810,456 shares held in the deferred compensation trust at or for the year ended December 31, 1998. (4) See "Senior Securities" on page 32 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, 1998, 1997 and 1996." (6) Total assets managed includes the Company's assets and assets managed on behalf of others. 5 9
1999 1998 1997 --------------------------- ------------------------------------- ------------------------------------- (IN THOUSANDS, QTR 3 QTR 2 QTR 1 QTR 4 QTR 3 QTR 2 QTR 1 QTR 4 QTR 3 QTR 2 QTR 1 EXCEPT PER SHARE DATA) ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- (UNAUDITED) QUARTERLY DATA: Total interest and related portfolio income............... $37,998 $33,186 $27,678 $25,974 $22,546 $21,321 $36,897 $25,984 $25,111 $24,911 $21,399 Portfolio income before realized and unrealized gains.... 19,273 16,619 13,830 11,776 9,401 9,148 24,920 7,910 12,093 14,095 11,968 Net increase in net assets resulting from operations.......... 26,944 22,121 18,580 16,631 14,906 14,476 32,065 13,216 17,146 18,296 12,646 Basic earnings per common share........ 0.44 0.38 0.33 0.31 0.29 0.28 0.62(3) 0.25 0.35 0.37 0.27 Diluted earnings per common share........ 0.44 0.38 0.33 0.31 0.29 0.28 0.61(3) 0.25 0.35 0.37 0.27 Net asset value per common share(1)..... 9.58 9.11 8.98 8.68 8.13 8.14 8.23 8.07 8.42 8.50 8.39 Dividends declared per common share........ 0.40 0.40 0.40 0.38 0.35 0.35 0.35 0.80(2) 0.31 0.30 0.30
- ------------------------- (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 fourth quarter of 1997, the Company declared a quarterly dividend of $0.61 per common share which included $0.34 per common share representing the distribution of shares of Allied Capital Lending Corporation previously held in Allied Capital Corporation's (old) portfolio. The Company also declared an annual extra distribution of $0.02 per common share, and a special distribution of previously undistributed earnings of $0.17 per common share in conjunction with the merger. (3) 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; Seven World Trade Center, New York, New York 10048; and 500 West Madison Street, Chicago, Illinois 60661. 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 10 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. LENDING TO PRIVATE SMALL AND MIDDLE-MARKET COMPANIES INVOLVES A HIGH DEGREE OF RISK. Our portfolio consists primarily of loans to private small and middle-market companies. There is generally no publicly available information about these companies, and we rely on the diligence of our employees and agents to obtain information in connection with the Company's investment decisions. Typically, small businesses depend on the management talents and efforts of one person or a small group of persons for their success. The death, disability or resignation of these persons could have a material adverse impact on such a company. In addition, small businesses frequently have smaller product lines and market shares than their competition. Small companies may be more vulnerable to customer preferences, market conditions and economic downturns and often need substantial additional capital to expand or compete. Small companies may also experience substantial variations in operating results, and frequently have highly leveraged capital structures. Such factors can severely effect the return on, or the recovery of, our investment in such businesses. Loans to small 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 invest in and lend to small and middle-market companies that may have limited financial resources and that may be unable to obtain financing from traditional sources. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by bank lenders. 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. A deterioration in a borrower's financial condition and prospects may be accompanied by deterioration in the collateral for the loan. We also 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 loans and equity securities directly from small companies. Our portfolio of loans and equity securities are and 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 7 11 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. The CMBS tend to react more to changes in interest rates than do higher-rated securities, have a higher risk of default, tend to be less liquid, and may be more difficult to value. OUR PORTFOLIO IS RECORDED AT FAIR VALUE AS DETERMINED BY THE BOARD OF DIRECTORS. There is typically no public market for the loans and equity securities of the companies to which we make loans. As a result, our board of directors estimates the value of these loans and equity securities. Unlike traditional lenders, we do not establish reserves for anticipated loan losses. Instead, 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 and other lenders. Lenders of these senior securities have fixed dollar claims on our consolidated assets which are superior to the claims of our common shareholders. 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. 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 September 30, 1999, the Company's debt as a percentage of total liabilities and shareholders' equity was 46%. 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 September 30, 1999, the Company had $537.9 million of outstanding indebtedness, bearing a weighted annual interest cost, excluding closing costs, of 7.4%. In order for us to cover annual interest payments on indebtedness, we must achieve annual returns of at least 3.4% on our portfolio. 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 8 12 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)........ -46.1% -26.4% -16.6% -6.7% 3.1% 13.0% 32.7%
- ------------------------- (1) The calculation assumes (i) $1,169.5 million in total assets, (ii) an average cost of funds of 7.4%, (iii) $537.9 million in debt outstanding and (iv) $593.8 million of shareholders' equity. CHANGES IN INTEREST RATES MAY AFFECT OUR PROFITABILITY. Because we borrow money to make investments, our income is materially dependent upon the "spread" between the rate at which we borrow funds and the rate at which we loan these funds. In periods of sharply rising interest rates, our cost of funds would increase and could reduce or eliminate the spread. We use a combination of long-term and short-term borrowings to finance our lending activities. 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 we can maintain a positive net interest spread or that a significant change in market interest rates will not have a material adverse effect on our profitability. BECAUSE WE MUST DISTRIBUTE INCOME, WE WILL CONTINUE TO NEED ADDITIONAL CAPITAL. We will continue to need capital to fund investments. Historically, we have borrowed from financial institutions and have issued equity securities. A reduction in the availability of funds from financial institutions could have a material adverse effect on the Company. We must distribute at least 90% of our net operating income other than 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 loan 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 loans, it could have a material adverse effect on the Company's financial condition and our results. In addition, as a 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. Mezzanine loans 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, mezzanine loans will 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. The Company qualifies as a RIC. If we meet certain diversification and distribution requirements, the Company qualifies for pass-through tax treatment. The Company would 9 13 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. 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 purchase or originate loans 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 FROM QUARTER TO QUARTER. The Company's quarterly operating results could fluctuate due to a number of factors. These factors include, among others, the completion of a securitization transaction in a particular calendar quarter, variations in the loan origination volume, variation in timing of loan 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. POTENTIAL YEAR 2000 PROBLEMS MAY ADVERSELY AFFECT OUR BUSINESS. The Year 2000 issue is the result of computer programs and embedded hardware systems having been developed using two digits rather than four to define the applicable year. These computer programs or hardware that have date-sensitive software or embedded chips may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could result in system failures or miscalculations causing disruptions or failure of our operations, including among other things, a temporary inability to transact new business or communicate with our customers. We depend on our computer software programs and operating systems in operating our business. We also depend on the proper functioning of computer systems of third parties, such as service providers and portfolio companies. The failure of any of these systems to appropriately interpret the upcoming calendar Year 2000 could have a material adverse effect on our business and financial condition. All vendors providing critical software and hardware have indicated that their programs and systems are Year 2000 compliant. We have tested most of our critical software applications and the test results 10 14 have indicated the software and systems are Year 2000 compliant. We continue to monitor and test critical software and systems as they are updated. We continue to monitor all of our critical service providers as they work toward Year 2000 compliance. We are not aware of any critical service provider that will not be Year 2000 compliant. However, we cannot assure you that the service providers will be Year 2000 compliant, or that no interruption of business will occur as a result of their non-compliance. We have sent Year 2000 questionnaires to our portfolio companies to assess their awareness and to evaluate their Year 2000 readiness. Based on the responses to the Year 2000 questionnaires that we have received to date, the portfolio companies have represented that they expect to be Year 2000 compliant by December 31, 1999. We will continue to monitor the progress of our portfolio companies that are working toward Year 2000 compliance. However, no assurance can be given that some of the Company's portfolio companies will not suffer material adverse effects from Year 2000 issues, and if such adverse effects impact such companies' ability to repay their loans, our operating results and financial condition could be affected. Throughout 1999, we will continue to address any issues of Year 2000 non- compliance. In addition, we have developed our contingency plan to ensure the continuance of business operations in the event of systems failure in the Year 2000. We cannot assure you that our Year 2000 compliance program will be effective or that our estimates about the cost of completing our program will be accurate. While Allied Capital believes that it is taking the necessary steps to be Year 2000 compliant, it is difficult to fully predict the impact on the Company of non-compliance in any of the above-mentioned areas. Significant non-compliance by the Company, its critical service providers or its portfolio companies could result in a material adverse effect on our financial condition and results from operations. 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. 11 15 THE COMPANY Our company is principally engaged in lending to and investing in private small and middle-market 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 maintain regional offices in Chicago, San Francisco and New York, and Allied Capital Express offices in Detroit, Atlanta, Philadelphia, Chicago and Greenville, SC. 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 small and middle-market 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. 12 16 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 in 1998 and 1999 and for Allied Capital Lending Corporation's stock, the predecessor company to the Company, in 1997. The stock quotations are interdealer quotations and do not include markups, markdowns or commissions. On November , 1999, the last reported closing sale price of the common stock was $ per share.
CLOSING SALE PRICE ------------------ HIGH LOW ------- ------- ALLIED CAPITAL LENDING CORPORATION YEAR ENDED DECEMBER 31, 1997 First Quarter............................. $17.000 $14.875 Second Quarter............................ 16.625 13.875 Third Quarter............................. 16.750 14.500 Fourth Quarter............................ 22.750 15.750 ALLIED CAPITAL CORPORATION 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 ENDING DECEMBER 31, 1999 First Quarter............................. $20.000 $16.750 Second Quarter............................ 24.000 17.031 Third Quarter............................. 23.250 20.500 Fourth Quarter (through November , 1999)..................................
Allied Capital Lending Corporation's common stock historically traded at prices in excess of its net asset value. 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 Company has indicated that it expects to distribute four regular quarterly dividends of $0.40 per share during 1999, for total dividends of $1.60 per share for 1999. The amount of our quarterly dividends is determined by the board of directors and is currently based upon an estimate of annual taxable income. The Company's dividend policy currently is to annually distribute substantially all of its net taxable income, including net capital gains, if any. See "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. 13 17 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: - Mezzanine finance - Commercial real estate finance, including the purchase of CMBS, and - Small business and commercial real estate loans originated for sale under our Allied Capital Express brand name. The Company's earnings depend primarily on the level of interest and related portfolio income and net realized and unrealized gain income 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, the amortization of loan origination points and original issue discount, and the amortization of any market discount arising from purchased loans. The level of interest income is directly related to the balance of the investment portfolio multiplied by the effective 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. The total portfolio at value was $1,103.7 million at September 30, 1999 and $800.3 million, $697.0 million and $607.4 million at December 31, 1998, 1997 and 1996, respectively. During the nine months ended September 30, 1999, the Company invested a total of $534.0 million. After total repayments of $120.6 million, loan sales of $120.9 million and valuation changes, the Company's investment portfolio increased by 38% since December 31, 1998. The portfolio increased approximately 15% for each of the years ended December 31, 1998, 1997 and 1996.
AT AT DECEMBER 31, SEPTEMBER 30, ------------------- ASSET COMPOSITION 1999 1998 1997 1996 ----------------- ------------- ---- ---- ----- Mezzanine Investments................ 47% 46% 25% 27% Commercial Mortgage-Backed Securities*........................ 25% 13% -- -- Commercial Mortgage Loans............ 16% 27% 56% 52% SBA 7(a) Loans....................... 6% 7% 5% 6% Cash and Other Assets................ 6% 7% 14% 15% ---- ---- ---- ---- 100% 100% 100% 100% ==== ==== ==== ====
- ------------------------- * Includes Purchased CMBS totaling 18% and 4% of total assets at September 30, 1999 and December 31, 1998, respectively. 14 18 MEZZANINE Mezzanine loans, debt securities and equity interests were $546.0 million, $388.6 million, $207.7 million and $191.2 million at September 30, 1999 and December 31, 1998, 1997 and 1996, respectively. The effective yield on the mezzanine loans and debt securities was 14.0%, 14.6%, 12.6%, and 13.2% at September 30, 1999 and December 31, 1998, 1997 and 1996, respectively. Mezzanine loan originations and purchases were $237.6 million and $127.2 million for the nine months ended September 30, 1999 and 1998, respectively. Mezzanine loan originations and purchases were $236.0 million, $66.7 million and $66.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. Mezzanine repayments were $86.5 million and $23.9 million for the nine months ended September 30, 1999 and 1998, respectively. Mezzanine repayments and sales were $41.3 million, $64.9 million, and $67.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. COMMERCIAL MORTGAGE-BACKED SECURITIES Commercial mortgage-backed securities (CMBS) were $296.2 million and $113.7 million at September 30, 1999 and December 31, 1998. The portfolio at September 30, 1999 consisted of $213.4 million of purchased CMBS ("Purchased CMBS") and $82.8 million of CMBS retained primarily from a $295 million asset securitization the Company completed on January 30, 1998 ("Residual CMBS"). During the first nine months of 1999, the Company acquired Purchased CMBS with a face value of $373.2 million for a cost of $183.4 million. At September 30, 1999 and December 31, 1998, the estimated yield to maturity on the Purchased CMBS and the Residual CMBS was 14.2% and 9.9%, and 15.0% and 9.7%, respectively. At September 30, 1999 and December 31, 1998, the weighted average yield on the entire CMBS portfolio was 13.0% and 11.2%, respectively. The weighted average loan-to-value and debt service coverage of the loans securing the total CMBS portfolio at September 30, 1999 were 69.9% and 1.4, respectively. Acquisitions of Purchased CMBS have had, and will continue to have, the full scrutiny of the Company's underwriting processes. The Company re-underwrites the majority of the loans securing the bonds, including determining its own assessment of cash flow available for debt service and appraisal value, and visits most of the collateral properties. The Company will continue to bid on similar CMBS offerings as long as we can achieve significant discounts and attractive yields on the purchase of such offerings. However, we will limit our Purchased CMBS acquisitions in order to maintain a balanced portfolio. COMMERCIAL MORTGAGE LOANS Commercial mortgage loans were $185.5 million at September 30, 1999 and $233.2 million, $447.2 million and $373.7 million at December 31, 1998, 1997 and 1996, respectively. The weighted average current stated interest rate on the commercial mortgage loan portfolio at September 30, 1999 was 9.6% and at December 31, 1998, 1997 and 1996 was 9.7%, 9.6% and 10.3%, respectively. The weighted average yield on the commercial mortgage loan portfolio was 9.8% at September 30, 1999 and 10.4%, 11.4% and 13.4% at December 31, 1998, 1997 and 1996, respectively. The effective yield on the commercial mortgage loan portfolio is higher than the stated interest rate due to the amortization of market discount on purchased loans and original issue discount. 15 19 In the first quarter of 1998, the Company reduced its commercial mortgage loan portfolio through the securitization of $295 million in commercial real estate loans. In addition the Company slowed its origination activity in early 1998 due to pricing conditions in the market. The Company has also continued to sell commercial mortgage loans in order to reduce the portfolio. As a result, the commercial mortgage loan portfolio decreased by 20% and 48%, respectively, for the nine months ended September 30, 1999 and the year ended December 31, 1998. In prior years, the Company had been actively expanding its commercial real estate portfolio and as a result the portfolio had increased by 20% and 35% for the years ended December 31, 1997 and 1996, respectively. ALLIED CAPITAL EXPRESS 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 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. A summary of Allied Capital Express loan origination and sale activity for the nine months ended September 30, 1999 and 1998 is as follows:
FOR THE NINE MONTHS ENDED SEPTEMBER 30, -------------------- 1999 1998 -------- --------- (in thousands) Loan Originations: SBA 7(a).................................................. $64,650 $ 39,600 Other..................................................... 48,426 182,700 Loan Sales: SBA 7(a).................................................. 45,075 26,800 Other..................................................... 75,796 --
On a comparative basis, SBA 7(a) loan origination activity has increased due to the opening of new office locations and due to increased emphasis that is being placed on the Allied Capital Express product area. Non-SBA 7(a) loan origination activity has decreased due to the reduction of middle-market commercial real estate lending activity that occurred in 1998 as discussed under "Commercial Mortgage Loans." Allied Capital Express targets small commercial real estate loans that are in many cases originated in conjunction with SBA 7(a) loans. The 1999 and 1998 non-SBA 7(a) activity is not comparable because of the shift from larger real estate loans originated for the portfolio to smaller commercial real estate loans originated primarily for sale. 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. RESULTS OF OPERATIONS COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998 Net increase in net assets resulting from operations (NIA) was $67.6 million, or $1.14 per share, and $61.4 million, or $1.19 per share, for the nine months ended September 30, 1999 and 1998, respectively. 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. The NIA for the nine months ended 16 20 September 30, 1998 also includes a one-time gain of $14.8 million, or $0.28 per share, resulting from a commercial mortgage loan securitization transaction that was completed in January 1998. Total interest and related portfolio income was $98.9 million and $80.8 million for the nine months ended September 30, 1999 and 1998, 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 related portfolio income includes net premiums from loan dispositions, prepayment premiums, and investment advisory fees and other income. 1998 total interest and related portfolio income 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 in the first nine months of 1999 by 50% as compared to the first nine months of 1998. Interest income totaled $84.4 million and $58.4 million for the nine months ended September 30, 1999 and 1998, respectively. Interest income increased $26.0 million or 44% compared to the same period in the prior year. 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 49% to $1,033.6 million at September 30, 1999 from $692.9 million at September 30, 1998. The weighted average yield on the interest bearing investments in the portfolio at September 30, 1999 was 12.5% as compared to 11.8% at September 30, 1998. Net premiums from loan dispositions were $9.0 million and $2.9 million for the nine months ended September 30, 1999 and 1998, respectively. 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 $5.2 million and $2.2 million for the nine months ended September 30, 1999 and 1998, respectively. This premium income results primarily from the premium paid by purchasers of the guaranteed portion of the Company's SBA 7(a) loans sold into the secondary market and the commercial real estate loans sold to third parties, less the origination commissions associated with the loans sold. Prepayment premiums were $3.8 million and $0.7 million for the nine months ended September 30, 1999 and 1998, respectively. While the scheduled maturity of mezzanine and commercial mortgage loans ranges 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. Investment advisory fees and other income were $5.4 million and $4.6 million for the nine months ended September 30, 1999 and 1998, respectively. Investment advisory fees are received from the private funds managed by the Company. Total operating expenses were $44.0 million and $31.8 million for the nine months ended September 30, 1999 and 1998, respectively. Operating expenses include interest on indebtedness, salaries and employee benefits, and general and administrative expenses. The Company's single largest expense is interest on indebtedness, which totaled $24.2 million and $14.5 million for the nine months ended September 30, 1999 and 1998, 17 21 respectively. Interest expense increased $9.6 million, or 66%, compared to the same period in the prior year. The increase is attributable to an increase in borrowings by the Company and its subsidiaries under various credit facilities. The Company's total borrowings were $537.9 million and $361.7 million at September 30, 1999 and 1998, respectively. Average outstanding indebtedness for the nine months ended September 30, 1999 and 1998 was $414.1 million and $252.5 million, respectively. The Company's weighted average interest cost, excluding closing costs, on outstanding borrowings at September 30, 1999 and 1998 was 7.4% and 7.2%, respectively. Salaries and employee benefits totaled $11.3 million and $8.3 million for the nine months ended September 30, 1999 and 1998, respectively. Total employees were 124 and 96 at September 30, 1999 and 1998, respectively. The increase in salaries and employee benefits reflects the increase in total employees, combined with wage increases and the experience level of employees hired. The Company has been an active recruiter throughout 1998 and 1999 for experienced investment and operational personnel, and the Company will continue to actively recruit and hire new professionals in 1999 to support anticipated portfolio growth. General and administrative expenses include the leases for the Company's headquarters in Washington, DC, and its regional offices. General and administrative expenses also include travel costs, stock record expenses, directors' fees, legal and accounting fees and various other expenses. General and administrative expenses totaled $8.5 million and $9.0 million for the nine months ended September 30, 1999 and 1998, respectively. The decrease in general and administrative expenses was partially due to certain post-Merger integration expenses incurred in the first quarter of 1998, totaling $0.2 million. The post- Merger integration expenses included primarily the costs of legal and accounting advice as well as the use of certain outside consultants. The remaining decrease results from the timing of incurring expenses in 1999 and 1998. For the nine months ended September 30, 1999 and 1998, operating expenses excluding interest on indebtedness as a percent of total interest and related portfolio income less interest expense plus net realized and unrealized capital gains was 21% and 20%, respectively. For the years ended December 31, 1998, 1997 and 1996 this ratio was 22%. The formula award and cut-off award totaled $5.2 million and $5.5 million, or $0.09 per share and $0.11 per share, for the nine months ended September 30, 1999 and 1998, respectively. The formula award expense totaled $4.7 million for each of the nine months ended September 30, 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 award remain with the Company over the remaining vesting period, the Company will expense the remaining formula award during 1999 and 2000 in an annual amount of approximately $6.2 million. The cut-off award expense totaled $0.5 million and $0.8 million for the nine months ended September 30, 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 18 22 payable if the award recipient is employed by the Company on a future vesting date. Total cut-off award that will vest in 1999 is estimated at $0.5 million. Net realized gains were $16.4 million and $20.0 million for the nine months ended September 30, 1999 and 1998, respectively. These gains resulted from the sale of equity securities associated with certain mezzanine and commercial mortgage loans and the realization of unamortized discount resulting from the sale and early repayment of mezzanine and commercial mortgage loans, offset by losses on investments. Realized gains totaled $21.6 million and $20.8 million for the nine months ended September 30, 1999 and 1998, respectively. Realized gains during 1999 primarily resulted from transactions involving three portfolio companies, Radio One, Inc. ($10.5 million), COHR, Inc. ($5.3 million), and Precision Industries Co. ($3.3 million). The Company reversed previously recorded unrealized appreciation of $8.3 million when these gains were realized in 1999. Realized losses totaled $5.2 million and $0.8 million for the nine months ended September 30, 1999 and 1998, respectively. Realized losses during 1999 resulted primarily from the liquidation of one portfolio investment, CeraTech Holdings Corporation ($2.5 million). 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 $4.7 million in 1999 when the related losses were realized. The Company recorded net unrealized gains of $1.5 million for the nine months ended September 30, 1999 and net unrealized losses of $0.4 million for the nine months ended September 30, 1998. Net unrealized gains for 1999 and net unrealized losses for 1998 consisted of valuation changes resulting from the Board of Directors' valuation of the Company's assets and the effect of reversals of net unrealized appreciation resulting from net realized gains. At September 30, 1999, net unrealized appreciation in the portfolio totaled $3.9 million, and was composed of unrealized appreciation of $31.8 million resulting primarily from appreciated equity interests in portfolio companies, and unrealized depreciation of $27.9 million resulting primarily from underperforming loan and equity investments in the portfolio. At September 30, 1998, net unrealized appreciation in the portfolio totaled $0.9 million and was composed of unrealized appreciation of $28.0 million and unrealized depreciation of $27.1 million. 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. During 1998, the Company began to grade its commercial mortgage and 7(a) loan portfolios using the same grading system used for its mezzanine loan portfolio, so that the Company's entire portfolio would have a uniform grading system. Prior to this, the commercial real estate portfolio used a different grading system and the 7(a) loan portfolio was not graded. 19 23 At September 30, 1999, the Company's portfolio was graded as follows:
INVESTMENTS PERCENTAGE OF GRADE AT VALUE TOTAL PORTFOLIO ----- ------------- --------------- (IN MILLIONS) 1............................................ $ 114.8 10.4% 2............................................ 916.0 83.0 3............................................ 35.4 3.2 4............................................ 19.4 1.8 5............................................ 18.1 1.6 -------- ----- $1,103.7 100.0% ======== =====
Grade 5 mezzanine investments totaled $11.8 million at value at September 30, 1999, or 1.1%, of the Company's total portfolio based on the valuation of the Board of Directors. The value of these Grade 5 mezzanine investments has been reduced from an aggregate cost of $31.8 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 mezzanine investments at December 31, 1998 totaled $6.4 million at value, or 0.8% of the Company's total portfolio. At September 30, 1999, there were no Grade 5 commercial mortgage loans. Grade 5 commercial mortgage loans at December 31, 1998 totaled $0.1 million at value. Grade 5 SBA 7(a) loans totaled $6.3 million at value at September 30, 1999. The value of these loans has been reduced from an aggregate cost basis of $7.3 million, which includes $4.9 million at cost that is guaranteed by the SBA. Grade 5 SBA 7(a) loans at December 31, 1998 totaled $6.3 million at value. For the total portfolio, loans greater than 120 days delinquent were $28.6 million at value at September 30, 1999, or 2.6% of the total portfolio. Included in this category are loans valued at $18.7 million that are fully secured by real estate. Loans greater than 120 days delinquent generally do not accrue interest. Loans greater than 120 days delinquent at December 31, 1998 were $13.7 million at value, or 1.7% of the total portfolio, which includes $9.9 million that are fully secured by real estate. 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 and realized capital gains, to the extent that such income and gains are distributed to shareholders. The Company's dividend policy currently is to annually distribute substantially all of its net taxable income, including net capital gains, if any. 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. The Company's current regular quarterly dividend was determined based on estimated 1999 taxable income. 20 24 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 to shareholders at least 90% of its investment company taxable ordinary income annually. 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. Certain of the Company's credit facilities limit the Company's ability to declare dividends, should the Company default under certain provisions of the respective credit agreements. The weighted average common shares outstanding used to compute basic earnings per share were 59.1 million and 51.5 million for the nine months ended September 30, 1999 and 1998, 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 59.2 million and 51.7 million for the nine months ended September 30, 1999 and 1998, respectively. COMPARISON OF FISCAL YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 Net increase in net assets resulting from operations (NIA) was $78.1 million, or $1.50 per share, $61.3 million, or $1.24 per share, and $54.9 million, or $1.17 per share, for the years ended December 31, 1998, 1997 and 1996, respectively. 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%, 15% and 14% for 1998, 1997 and 1996, respectively. NIA, excluding the formula and cut-off awards in 1998, as a percentage of average shareholders' equity for 1998 was 18.8%. NIA, excluding Merger expenses, as a percentage of average shareholders' equity for 1997 was 16%. A key element of the Company's post-Merger strategy was to allocate more of its capital resources to the Company's higher yielding mezzanine and 7(a) lending activities and reduce its lower yielding commercial mortgage loan portfolio. As a result, the Company completed a commercial mortgage loan securitization transaction in January 1998, in order to effectively liquidate $223 million of its lower yielding commercial mortgage loans. The Company securitized $295 million in loans and received cash proceeds, net of costs, of $223 million. The Company retained a trust certificate for its residual interest in mortgage securitization (the Residual CMBS) in the loan pool sold, and will receive interest income from this Residual CMBS as well as receive the net spread of the interest earned on the loans sold less the interest paid on the bonds over the life of the bonds (the "Residual Securitization Spread"). The Company accounted for the securitization in accordance with Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." As a result, the Company recorded a gain of $14.8 million, or $0.28 per share, net of the costs of the securitization and the cost of settlement of interest rate swaps. The gain arises from the difference between the carrying amount of the loans and the fair market value of the assets received (i.e., cash, 21 25 Residual Securitization Spread, Residual CMBS and a servicing asset). The Company will continue to earn interest income from the Residual CMBS, and will receive the actual net spread from the portion of the loans sold represented by the bonds issued. As the net spread is received, a portion will be allocated to interest income with the remainder applied to reduce the carrying amount of the Residual Securitization Spread. The Residual CMBS and the Residual Securitization Spread have been and will continue to be valued each quarter using updated prepayment, interest rate and loss estimates. As of December 31, 1998, the mortgage loan pool had an approximate weighted average stated interest rate of 9.4%. The value of the Residual Securitization Spread of $10.7 million was determined based on a constant prepayment rate of 7% and a discount rate of 12%. The value of the Residual CMBS of $70.8 million was determined using a discount rate equal to the average stated interest rate of the underlying mortgage loans. The Company completed the securitization as a means to improve its liquidity for investment in high yielding mezzanine and 7(a) loans. Total interest and related portfolio income was $106.7 million, $97.4 million and $84.9 million for the years ended December 31, 1998, 1997 and 1996, 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 related portfolio income includes premiums from loan sales, prepayment premiums, and advisory fee and other income. Interest income totaled $79.9 million, $86.9 million and $77.5 million for the years ended December 31, 1998, 1997 and 1996, respectively. Interest income decreased 8% and increased 12% for 1998 and 1997, respectively. The decrease and increase in interest income earned results primarily from changes in the amount of loans outstanding during the periods presented. The Company's loan portfolio decreased by 4% to $628.6 million at December 31, 1998 from $655.8 million at December 31, 1997, and the loan portfolio increased by 13% to $655.8 million at December 31, 1997 from $580.9 million at December 31, 1996. During 1998, the Company originated or purchased loans and other investments totaling $524.5 million. This increase was offset by the sale through securitization of $295 million in commercial mortgage loans, whole loan sales of commercial mortgage loans of $44.0 million, and the sale of the guaranteed portion of 7(a) loans totaling $37.0 million. In addition, the Company received loan repayments totaling $138.1 million. The Company's efforts to reduce its lower yielding commercial mortgage loan portfolio in 1998 had the effect of reducing gross interest income in 1998 when compared to 1997. The reduction in this portfolio, however, has increased the overall weighted average yield on the portfolio, and should have the impact of increasing interest income prospectively, as well as increasing the Company's overall return on assets net of interest expense and return on equity capital. The weighted average yield on the total loan portfolio at December 31, 1998 was 12.5%, as compared to 11.7% and 13.1% at December 31, 1997 and 1996, respectively. Net premiums from loan dispositions were $6.0 million, $7.3 million and $4.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. 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 $3.8 million, $3.2 million and $2.6 million for the years ended December 31, 1998, 1997 and 1996, respectively. This premium income results primarily from the sale of the guaranteed portion of the 22 26 Company's SBA 7(a) loans into the secondary market and commercial real estate loans sold to third parties, less the origination costs associated with the loans sold. Prepayment premiums were $2.2 million, $4.1 million and $1.6 million for the years ended December 31, 1998, 1997 and 1996, respectively. Commercial mortgage loan repayments of $154.5 million in 1997 were primarily responsible for the large level of prepayment premiums experienced in 1997. While the scheduled maturity of mezzanine and commercial mortgage loans ranges 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. Investment advisory fees and other income were $6.1 million, $3.2 million and $3.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. Investment advisory fees are received from the private funds managed by the Company. In January 1998, the Company entered into an investment advisory agreement with Kreditanstalt fur Wiederaufbau (KfW), the state-owned public development bank of Germany, to manage a fund of approximately DM 160 million (approximately $95.4 million at December 31, 1998). For its services related to sourcing, structuring, investing, monitoring and disposing of its investments in small, private and medium-sized German businesses, the Company will receive a 3% per annum fee on total committed capital, payable quarterly. The increase in advisory fees and other income in 1998 is primarily the result of the advisory fees earned from KfW of approximately $2.7 million. Total operating expenses were $44.4 million, $51.3 million ($46.2 million without Merger expenses) and $37.4 million for the years ended December 31, 1998, 1997 and 1996, respectively. Operating expenses include interest on indebtedness, salaries and employee benefits, and general and administrative expenses. The Company's single largest expense is interest on indebtedness, which totaled $20.7 million, $27.0 million and $20.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. Interest expense decreased 23% for 1998 and increased 33% and 64% for 1997 and 1996, respectively. The increases and decreases are attributable to increases and decreases in borrowings by the Company and its subsidiaries under various credit facilities. Again, the Company's efforts to decrease the commercial mortgage loan portfolio during 1998 had the effect of reducing the overall level of the Company's outstanding borrowings throughout the year. The Company's total borrowings were $334.4 million, $347.7 million and $275.0 million at December 31, 1998, 1997 and 1996, respectively. Total borrowings decreased 4% for 1998 and increased 26% and 37% in 1997 and 1996, respectively. The Company's weighted average interest cost on outstanding borrowings at December 31, 1998, 1997 and 1996 was 7.5%, 7.3% and 7.6%, respectively. Salaries and employee benefits totaled $11.8 million, $10.3 million and $8.8 million for the years ended December 31, 1998, 1997 and 1996, respectively. Total employees were 106, 80 and 66 at December 31, 1998, 1997 and 1996, respectively. The increase in salaries and employee benefits reflects the increase in total employees, combined with wage increases and the experience level of employees hired. The Company was an active recruiter in 1998 for experienced investment and operational personnel and the Company will continue to actively recruit and hire new professionals in 1999 to support anticipated portfolio growth. 23 27 General and administrative expenses include the lease for the Company's headquarters in Washington, DC, leases established in 1997 for the Company's offices in Chicago and San Francisco, leases established in 1998 for the Company's new offices in Atlanta and Detroit, travel costs, stock record expenses, directors' fees, legal and accounting fees and various other expenses. General and administrative expenses totaled $11.9 million, $9.0 million and $8.3 million, respectively, for the years ended December 31, 1998, 1997 and 1996. The increase in general and administrative expenses was partially due to twelve full months of costs associated with the 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. Total operating expenses excluding interest on indebtedness and Merger expenses represented approximately 2.9%, 2.5% and 2.6% of the Company's average assets for the years ended December 31, 1998, 1997 and 1996, respectively. During 1998, the Company began to expense a portion of the formula and cut-off awards that were established in connection with the Merger. Prior to the Merger, each of the predecessor companies had a stock option plan (the "Old Plans"). In preparation for the Merger, the Compensation Committees of the predecessor companies determined that the Old Plans should be terminated upon the Merger, so that the new merged Company would be able to develop a new incentive compensation plan for all officers and directors with a single equity security. The existence of the Old Plans had resulted in certain inequities in option grants among the various officers of the predecessor companies simply because of the differences in the underlying equity securities. To balance stock option awards among the employees, and to account for the deviations caused by the existence of five plans supported by five different publicly traded stocks, the Company developed two special awards to be granted in lieu of options under the Old Plans that would be foregone upon the cancellation of the Old Plans. FORMULA AWARD. The formula award was designed to compensate officers from the point in time when their unvested options would cease to appreciate in value pursuant to the mechanics of the cut-off award (i.e., August 14, 1997) up until the time in which they would be able to receive option awards in the Company after the Merger became effective. In the aggregate, the formula award equaled 6% of the difference between the combined aggregate market capitalizations of the Predecessor Companies as of the close of the market on December 30, 1997, and the combined aggregate market capitalizations of the Predecessor Companies on August 14, 1997. The formula award was designed as a long-term incentive compensation program that would replace canceled stock options and would balance share ownership among key officers for past and prospective service. The terms of the formula award require that the award be contributed to the Company's deferred compensation plan, and be used to purchase shares of the Company in the open market. The formula award vests over a three-year period, on the anniversary date of the Merger, beginning on December 31, 1998. In the aggregate, the market capitalizations of the Predecessor Companies increased by approximately $319 million from August 14, 1997 to December 30, 1997, and the total formula award was computed to be $19.0 million. The total expense recorded as a result of 24 28 the formula awards during 1998 was $6.2 million, or approximately $0.12 per share. Assuming all officers who received a formula award remain with the Company over the remaining vesting period, the Company will expense the remaining formula award during 1999 and 2000 in an annual amount of approximately $6.4 million. CUT-OFF AWARD. The cut-off award established a cut-off dollar amount as of August 14, 1997 (the Merger announcement date) that would be computed for all outstanding, but unvested options that would be canceled as of the date of the Merger. 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 was designed to be equal to the difference between the market prices of the shares of stock underlying the canceled options under the Old Plans at August 14, 1997, less the exercise prices of the options. The cut-off award was computed to be $2.9 million in the aggregate and will be payable for each canceled option as the canceled options would have vested. The cut-off award will only be payable if the award recipient is employed by the Company on a future vesting date. The cut-off award expense totaled $0.8 million, or $0.02 per share, for 1998. Net realized gains were $22.5 million, $10.7 million and $19.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. These gains resulted from the sale of equity securities associated with certain mezzanine and commercial mortgage loans and the realization of unamortized discount resulting from the sale and early repayment of mezzanine and commercial mortgage loans, offset by losses on investments. Realized gains totaled $25.8 million, $15.8 million and $30.4 million for the years ended December 31, 1998, 1997 and 1996, respectively. Realized gains during 1998 primarily resulted from transactions involving ten portfolio companies: ARS ($1.1 million), Calendar Broadcasting ($1.1 million), Arlington Square Associates ($1.9 million), DMI Furniture ($0.6 million), Virginia Beach Associates ($2.4 million), Labor Ready, Inc. ($5.0 million), Broadcast Holdings, Inc. ($1.1 million), Waterview Limited Partnership ($3.0 million), Z-Spanish Radio Network, Inc. ($2.7 million) and El Dorado Communications, Inc. ($0.8 million). Gains resulting from investments in these ten companies totaled $19.7 million. The Company also realized a gain of $4.0 million from the sale of an office building owned by Allied Capital Advisers Inc. prior to the Merger and incurred an income tax liability related to that gain of $0.8 million. Realized gains in 1997 resulted from transactions involving 83 portfolio companies. Realized losses in 1998, 1997 and 1996 totaled $3.3 million, $5.1 million and $11.2 million and represented 0.4%, 0.6% and 1.6% of the Company's total assets, respectively. Realized losses in 1998 resulted primarily from the full or partial liquidation of three portfolio investments: SunStates Refrigerated Services, Inc. ($1.8 million), R-Tex Decoratives Company, Inc. ($0.6 million), and Pines Hotel ($0.3 million). These three investments resulted in realized losses of $2.7 million. Realized losses in 1997 resulted primarily from the full or partial liquidation of four investments: Taco Tico, Inc. ($1.1 million), SunStates Refrigerated Services, Inc. ($0.8 million), Enviroplan, Inc. ($0.8 million), and Vineyard Sycamore Plaza Associates ($0.4 million). Realized losses resulting from these four investments totaled $3.1 million. Realized losses in 1996 included $6.6 million in losses from the liquidation of two portfolio investments. The Company made loans to these two borrowers in the late 1980s and early 1990s, and each borrower encountered significant difficulties during the recession of the early 1990's. Losses realized in 1998, 1997 and 1996 had been recognized in NIA over time as unrealized depreciation when the Company determined that the respective portfolio security's value had become 25 29 impaired. Thus, the Company reversed previously recorded unrealized depreciation totaling $3.6 million, $9.7 million and $7.5 million when the related losses were realized in 1998, 1997 and 1996, respectively. The Company recorded net unrealized gains of $1.1 million and $7.2 million for the years ended December 31, 1998 and 1997, respectively, and net unrealized losses of $7.4 million for the year ended December 31, 1996. Net unrealized gains for 1998 consisted of valuation changes resulting from the Board of Directors' valuation of the Company's assets, the effect of valuation of interest rate swap agreements, and the effect of reversals of net unrealized appreciation resulting from net realized gains. At December 31, 1998, net unrealized appreciation in the portfolio totaled $2.4 million, and was composed of unrealized appreciation of $27.3 million resulting primarily from appreciated equity interests in portfolio companies, and unrealized depreciation of $24.9 million resulting primarily from underperforming loan and equity investments in the portfolio. At December 31, 1997, net unrealized appreciation in the portfolio totaled $1.3 million and was composed of unrealized appreciation of $19.2 million and unrealized depreciation of $17.9 million. At December 31, 1996, net unrealized depreciation in the portfolio totaled $5.9 million. The Company employs a standard grading system for the entire portfolio. Grade 1 is used for those loans from which a capital gain is expected. Grade 2 is used for loans performing in accordance with plan. Grade 3 is used for loans that require closer monitoring; however, no loss of interest or principal is expected. Grade 4 is used for loans for which some loss of contractually due interest is expected, but no loss of principal is expected. Grade 5 is used for loans for which some loss of principal and interest is expected and the loan is written down to net realizable value. During 1998, the Company began to grade its commercial mortgage and 7(a) loan portfolios using the same grading system used for its mezzanine loan portfolio, so that the Company's entire portfolio would have a uniform grading system. Prior to this, the commercial real estate portfolio used a different grading system and the 7(a) loan portfolio was not graded. At December 31, 1998, the Company's portfolio was graded as follows:
INVESTMENTS PERCENTAGE OF AT VALUE TOTAL PORTFOLIO ------------- --------------- (IN MILLIONS) 1............................................ $104.4 13.0% 2............................................ 618.0 77.2 3............................................ 53.2 6.7 4............................................ 11.8 1.5 5............................................ 12.9 1.6 ------ ----- $800.3 100.0% ====== =====
Grade 5 mezzanine investments totaled $6.4 million at value at December 31, 1998, or 0.8% of the Company's total portfolio based on the valuation of the Board of Directors. The value of these Grade 5 investments has been reduced from an aggregate cost of $22.7 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 a substantial amount of the potential exposure when such 26 30 exposure is identified. During 1998, Grade 5 mezzanine investments decreased by $6.5 million from $12.9 million at December 31, 1997. At December 31, 1998, commercial real estate Grade 5 loans totaled $0.1 million at value. The value of these Grade 5 loans approximates cost because of the estimated value of the underlying collateral securing the loans. A Grade 5 classification for a commercial real estate loan prior to the use of the uniform grading system meant that the loan was in workout. Because of the collateral securing these loans, however, few previous Grade 5 loans were ever expected to result in loss of principal. Of the loans included in Grade 5 at December 31, 1997, only one loan totaling $0.3 million at cost was expected to incur any loss of principal, and this loan was valued at $0.2 million. Grade 5 SBA 7(a) loans totaled $6.3 million at value at December 31, 1998, and have been reduced from an aggregate cost basis of $7.9 million. The SBA 7(a) loan portfolio was not graded at December 31, 1997. For the total portfolio, loans greater than 120 days delinquent were $13.7 million at value at December 31, 1998, or 1.7% of the total portfolio. Included in this category are loans valued at $9.9 million that are fully secured by real estate. Loans greater than 120 days delinquent generally do not accrue interest. Loans greater than 120 days delinquent at December 31, 1997, were $20.2 million at value or 2.9% of the total portfolio. The Company incurred income tax expense of $0.8 million for the year ended December 31, 1998, which resulted from the taxation of a net built-in gain realized from the sale of an office building owned by Allied Capital Advisers Inc. prior to the Merger. The Company incurred income tax expense of $1.4 million and $1.9 million, respectively, for the years ended December 31, 1997 and 1996 resulting from the operations of Allied Capital Advisers Inc. 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 and realized capital gains, to the extent that such income and gains are distributed to shareholders. During 1998, 1997 and 1996, the Company or the Predecessor Companies declared dividends to their shareholders representing all of each company's ordinary taxable income, taxable net capital gains, and, in the case of Allied Capital Corporation in 1997, a partial return of capital resulting from the distribution of Allied Capital Corporation's ownership of Allied Capital Lending Corporation's shares. Tax distributions differ from NIA due to timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation, which is not included in taxable income. Total tax distributions declared were $75.1 million, $85.7 million and $57.4 million for 1998, 1997 and 1996, respectively. Tax distributions per share were $1.43, $1.71 and $1.23 for the three years ended December 31, 1998, 1997 and 1996, respectively. The per share distributions for 1997 and 1996 have been exchange adjusted for the Merger and include the exchange-adjusted shares of Allied Capital Advisers Inc. for which no tax distributions had historically been declared or paid. Included in 1997 tax distributions was $18 million, or $0.34 per share, representing a non-cash dividend of the shares of Allied Capital Lending Corporation held in Allied Capital Corporation's portfolio. Allied Capital Corporation declared and paid a dividend equal to 0.107448 shares of Allied Capital Lending Corporation for each share of Allied Capital Corporation held on the record date for such dividend. These shares had a market value of $21.25 per share on December 30, 1997, the distribution date. 27 31 Also included in 1997 tax distributions was a special, one-time dividend equal to $8.8 million, or $0.17 per share, representing all of the retained earnings and profits of the Predecessor Companies at December 31, 1997. The special dividend was declared in conjunction with the Merger in order for the Company to maintain its RIC status. The weighted average common shares outstanding used to compute basic earnings per share were 51.9 million, 49.2 million and 46.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. The increases in the weighted average shares reflect the issuance of new shares, the exercise of employee stock options to purchase shares of the Company and the issuance of shares pursuant to a dividend reinvestment plan. Allied Capital Corporation's ownership of Allied Capital Lending Corporation during the periods presented has been eliminated in consolidation. 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 52.0 million, 49.3 million and 46.7 million for the years ended December 31, 1998, 1997 and 1996, respectively. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES CASH AND CASH EQUIVALENTS At September 30, 1999, the Company had $15.4 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 lines of credit. INDEBTEDNESS The Company had outstanding indebtedness at September 30, 1999 as follows:
ANNUAL PORTFOLIO RETURN TO AMOUNT ANNUAL COVER INTEREST CLASS OUTSTANDING INTEREST RATE(1) PAYMENTS(2) ----- -------------- ---------------- ------------------- (IN THOUSANDS) Debentures and notes payable: Master loan and security agreement.......... $ 34,500 6.40% 0.19% Unsecured long-term notes payable...... 317,000 7.30% 1.98% SBA debentures....... 47,650 8.22% 0.33% OPIC loan............ 5,700 6.57% 0.03% -------- Total debentures and notes payable...... $404,850 7.32% 2.53% ======== Revolving line of credit.................. $133,000 7.69% 0.87% ========
- --------------- (1) The annual interest rate includes the cost of commitment fees and other facility fees. (2) The annual portfolio return to cover interest payments ("Annual Return") is calculated as total estimated 1999 annual interest or dividend payments per class of financing, divided by total assets at September 30, 1999. The total Annual Return needed to cover all classes of financing at September 30, 1999 combined is 3.4%. 28 32 MASTER LOAN AND SECURITY AGREEMENT. The Company had a facility to borrow up to $250 million, of which $100 million was committed, using its commercial mortgage loans as collateral. The agreement generally required interest-only payments with all principal due at maturity. The agreement charged interest at one-month London Inter-Bank Offered Rate ("LIBOR") plus 1.0%. The facility matured on October 7, 1999, and has been extended through October 28, 2000, with a total committed facility up to $100 million. UNSECURED LONG-TERM NOTES PAYABLE. At September 30, 1999, the Company has $317 million in financing through the issuance of unsecured long-term notes with private institutional lenders, primarily insurance companies. The terms of the notes include five- or seven-year maturities, priced at a weighted average rate of 7.3%. The notes require payment of interest only semiannually, and all principal is due upon maturity. The Company is in the process of negotiating terms for additional long term notes totaling approximately $100 million. The Company plans to complete this financing during the fourth quarter of 1999. SBA DEBENTURES. The Company, through its SBIC subsidiary, has debentures totaling $47.7 million payable to the SBA, at interest rates ranging from 6.9% to 9.6% with scheduled maturity dates as follows: 1999 -- $0; 2000 -- $17.3 million; 2001 -- $9.4 million; 2002 -- $0; 2003 -- $0; and $21.0 million thereafter. The debentures require semi-annual interest-only payments with all principal due upon maturity. During 1997, Congress increased the maximum leverage available to an SBIC to $101.0 million, and the Company intends to continue to borrow under the SBIC program as the situation warrants. The Company currently has a commitment from the SBA for an additional $27.0 million of debt. REVOLVING LINE OF CREDIT. The Company has a two-year, $340 million unsecured revolving line of credit which 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) 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. The credit facility also requires an annual facility fee equal to 0.25% of the committed amount, regardless of the amount outstanding under the facility, which is payable quarterly in arrears. EQUITY CAPITAL AND DIVIDENDS During the first nine months of 1999, the Company raised $106.5 million in new equity primarily through the sale of shares from its shelf registration statement. At September 30, 1999, total shareholders' equity had increased to $593.8 million. The Company expects to distribute four regular quarterly dividends of $0.40 per share during 1999, for total dividends of $1.60 per share for 1999. During the first, second and third quarters of 1999, the board of directors declared and the Company paid regular quarterly dividends of $0.40 per share. The Company's dividend policy currently is to annually distribute substantially all of its net taxable income, including net capital gains, if any. The Company's taxable income can differ from its financial reporting income due to differences in the timing of revenue and expense recognition. The Company's current regular dividend was determined based on estimated 1999 taxable income. Dividends for 1998 totaled $1.43 per share. 29 33 FUTURE DEBT OR EQUITY OFFERINGS The Company plans to secure additional debt and equity capital for continued investment in growing businesses. Because the Company is a RIC, it distributes substantially all of 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. The Company plans to maintain a strategy of financing its operations, dividend requirements and future investments with cash from operations, through borrowing 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 and may hedge variable and short-term interest rate exposure through interest rate swaps, Treasury locks and other techniques when appropriate. The Company believes that it has access to capital sufficient to fund its ongoing investment and operating activities, and from which to pay dividends. FINANCIAL OBJECTIVES The Company has set forth certain financial objectives that it intends to use in allocating its resources and in selecting new investment opportunities. Management's goal is to increase NIA annually by 15% to 20% and to result in a ratio of NIA to average shareholders' equity, or return on equity, of 19% to 22%. Management believes that the Company will be able to achieve these goals over the next three to five years. Factors that may impede the achievement of these objectives include those described under "Risk Factors" and also include other factors such as changes in the economy, competitive and market conditions, and future business decisions. YEAR 2000 COMPLIANCE The Company has a Year 2000 compliance committee which is responsible for assessing the Company's Year 2000 readiness and preparing the Company's Year 2000 contingency plan by focusing on three main areas: the Company's information technology ("IT") and other operating systems, critical service providers, and portfolio companies. The committee reports periodically to the board of directors and to executive management. The Company's IT systems consist of third-party software and relatively new hardware systems. All vendors providing critical software and hardware have indicated that their programs and systems are Year 2000 compliant. The Company has tested its critical software applications and the test results have indicated that the software and systems are Year 2000 compliant. In addition to the testing performed by Company personnel, the Company also contracted with its loan accounting software vendor to perform independent validation tests, using the Company's data, to verify that this software will be Year 2000 compliant. The test results revealed that the Company's loan accounting software is currently Year 2000 compliant. Implementation of tested software and IT systems has been completed. The Company currently has service and maintenance contracts with all its critical software vendors, therefore, no additional costs were incurred by the Company for the upgrades needed to become compliant. In addition to our testing prior to Year 2000, all computer software programs and operating systems will be tested again on January 1, 2000 to determine that they are operating normally and that the software programs are accurately processing transactions 30 34 that are date sensitive. If the computer hardware or software does not accurately perform its intended functions, the respective vendors will be contacted immediately and our management information systems group will work with the vendors to correct any problems. In the event that our computer systems are not operational due to specific problems encountered at our headquarters in Washington, DC, we have the option to transfer our operations to our disaster recovery site. In addition, all critical company data will be printed from the computer system prior to January 1, 2000 so that it will be available for use after that date as needed. The second area of focus is the Company's critical service providers. The Company continues to monitor all of its critical service providers as they work toward Year 2000 compliance. The Company is not aware of any critical service provider that will not be Year 2000 compliant. However, the Company cannot give any assurance that the service providers will be Year 2000 compliant and that no interruption of business will occur as a result of their noncompliance. We have communicated with each of our critical service providers to identify contacts and establish contingency plans in the event that they have a business disruption resulting from a Year 2000 problem. The Company has sent Year 2000 questionnaires to its portfolio companies to assess their awareness and to evaluate their Year 2000 readiness. Based on the responses to the Year 2000 questionnaires, the portfolio companies have represented that they expect to be Year 2000 compliant by December 31, 1999. The Company will continue to monitor the progress of its portfolio companies that are working toward Year 2000 compliance. During 1998, the Company began to evaluate each new portfolio company's Year 2000 compliance as part of the due diligence process. No assurance can be given that certain of the Company's portfolio companies will not suffer material adverse effects from Year 2000 issues, and if such adverse effects impact such companies' ability to repay their loans, the Company's operating results and financial condition could be affected. We will be closely monitoring the performance of each of our portfolio companies during the Year 2000 by reviewing their loan payment performance and financial statements. Borrowers will be contacted immediately in the event of non-payment or if their operating results indicate that they may not be able to make required principal and/or interest payments. The Company estimates its operating costs to reach Year 2000 compliance will be approximately $100,000, and these costs are included in the Company's 1999 budget. This includes time allocated to this task by Company personnel and costs incurred in the testing phase. While the Company believes that it is taking the necessary steps to be Year 2000 compliant, it is difficult to fully predict the impact on the Company of non-compliance in any of the above-mentioned areas. Significant non-compliance could result in a material adverse effect on the Company's financial conditions and results from operations. The Company believes that the worst case Year 2000 scenarios may include 1) incurring additional costs to maintain the Company's books and records and to service the Company's investment portfolio, 2) the inability of the Company to access or transfer cash needed to pay its bills or fund new investments, 3) an increase in delinquencies and/or losses due to Year 2000 problems with the Company's portfolio companies, or 4) disruption in the capital markets resulting in a lack of liquidity to the Company. The degree of impact resulting from any of these worst case scenarios cannot be determined at this time. 31 35 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 (as of September 30)... 34,500,000 2,226 -- 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 (as of September 30)... 317,000,000 2,226 -- 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 (as of September 30)... 47,650,000 2,226 -- N/A
32 36
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 (as of September 30)... 5,700,000 2,226 -- 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 (as of September 30)... 133,000,000 2,226 -- 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 (as of September 30)... 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 (as of September 30)... 0 0 -- N/A
33 37
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 (as of September 30)... 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 (as of September 30)... 1,000,000 223 100 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 (as of September 30)... 6,000,000 223 100 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. 34 38 (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. 35 39 BUSINESS We provide capital to small and middle-market companies in a variety of different industries and in diverse geographic locations. We have been lending to growing businesses for over 40 years and have financed thousands of borrowers nationwide. Our lending and investment activity is focused in three areas: - Mezzanine finance - Commercial real estate finance, including the purchase of CMBS, and - Small business and commercial real estate loans originated for sale under our Allied Capital Express brand name. Our investment portfolio consists primarily of subordinated loans with equity features, commercial mortgage loans, commercial mortgage-backed securities, and small senior loans. At September 30, 1999, our investment portfolio totaled $1,103.7 million representing 639 borrower relationships in 40 states and the District of Columbia. The Company's investment objective is to achieve current income and capital gains. 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. THE 1997 MERGER Allied Capital Corporation was formed through the merger, on December 31, 1997, of five affiliated public companies, the "predecessor companies", the oldest of which was founded in 1958. The merger provided numerous benefits and key competitive advantages: - INCREASED SIZE. We are now the largest BDC in the United States and are significantly larger than any of the predecessor companies that merged in terms of total assets, total equity capital and total market capitalization. A larger asset base allows us to make larger investments in growing companies while maintaining portfolio diversity. A larger market capitalization provides our stockholders with better liquidity, and has increased our visibility in the debt and equity capital markets. These improvements have provided the Company with a better foundation for growth. - IMPROVED MIX OF INCOME. We now have a portfolio that produces a higher level of recurring investment income since the five companies merged. In addition, as a single company, we have been able to expand our existing businesses and improve our asset and liability management. - EFFICIENCY. As one company, we now operate more efficiently. We have been able to eliminate redundant processes and expenses, including financial reporting, auditing, and corporate legal fees. - SINGLE ENTITY FOCUSED ON HIGH RETURN INVESTMENTS. We now have one business plan with a single investment goal of generating strong current income and long-term capital gains. We are able to allocate both capital and human resources more effectively to maximize our returns on shareholder equity. - INCREASED COMPETITIVENESS. Because of our increased size, focus, and efficiency, we have become a formidable competitor in the mezzanine finance marketplace. Our increased size has lowered our cost of capital and increased our pricing 36 40 competitiveness. Our increased size has also enabled us to finance larger transactions while maintaining portfolio diversity. Our increased efficiency has enabled us to grow both our sales and investment professional headcount so that we can more aggressively compete in the marketplace. As a result of the merger, we have increased our annual loan originations and improved the credit quality of our portfolio. We also increased our access to capital, particularly our ability to borrow from lenders. During 1998 and 1999, we have increased our credit facilities and obtained unsecured debt financing at a lower cost with more favorable financing terms. In addition, we believe our larger market capitalization has increased our access to equity capital. Greater access to capital at a lower cost has enabled us to price our loans to borrowers more competitively. MEZZANINE FINANCE We provide mezzanine debt and equity financing in private transactions for small and middle-market companies. Our mezzanine finance activities target a market niche between the senior debt financing provided by traditional lenders, such as banks and insurance companies, and the equity capital provided by private equity investors. Our mezzanine financing is generally used to fund growth, leveraged buyouts, note purchases, loan restructurings, acquisitions, recapitalizations, and bridge financings. We generally invest in private companies though, from time to time, we may invest in thinly traded public companies that lack access to public capital and whose securities are generally not marginable. We originate and purchase investments generally ranging in size from $5 million to $25 million. Our mezzanine investments are generally structured as a subordinated loan that carries a relatively high fixed interest rate (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. Our mezzanine investments may also include equity features, such as warrants or options to buy a minority interest in the portfolio company. At September 30, 1999, approximately 97% of the Company's mezzanine investments had fixed interest rates. We seek to generate a return on mezzanine assets ranging from 14% to 20%, including both interest income and capital gains from the sale of our equity interests. Historically, we had structured our mezzanine investments so that approximately one-half of the potential return was earned through current interest payments, and approximately one-half was earned in capital gains, which would arise from the sale of our equity interest in the portfolio company. Since early 1998, we have begun to structure many of our mezzanine investments with more emphasis on current interest, and less emphasis on the potential return from capital gains. Our equity investments, which include warrants, options, and common and preferred stock, generally do not produce a current return, but are held for potential investment appreciation and ultimate capital gains. Generally, our warrants expire five years after the related debt is repaid, and the exercise price is usually nominal. The warrants often include registration rights, which allow us to sell the securities if the portfolio company completes a public offering. In many cases, the warrants 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. 37 41 At September 30, 1999, our mezzanine portfolio had $476.0 million in mezzanine loans and debt securities, and $70.0 million in equity interests, which combined represented 47% of our total assets. The geographic and industry composition of the mezzanine portfolio at September 30, 1999 was as follows:
GEOGRAPHIC REGION ----------------- Mid-Atlantic.................. 26% Midwest....................... 25% Southeast..................... 20% West.......................... 13% Northeast..................... 11% International................. 5% ---- Total.................... 100% ==== INDUSTRY -------- Business services............. 26% Consumer products............. 20% Telecommunications............ 14% Industrial products........... 14% Broadcasting.................. 6% Education..................... 6% Other......................... 14% ---- Total.................... 100% ====
Private mezzanine investment partnerships are our primary competitors in the mezzanine finance business. We believe that we have certain structural and operational advantages when compared to many of these competitors. Our scale of operations, equity capital base, and successful track record as a mezzanine lender has enabled us to borrow long-term capital to leverage our equity and reduce our overall cost of capital. We use our lower cost of capital to price our loans competitively. In addition, the perpetual nature of our corporate structure enables us to be a better long-term partner for our borrowers than traditional mezzanine partnerships, which typically have a limited life. We also believe that high overhead, cumbersome regulatory structures and large size hinder many traditional lenders from lending effectively to our niche of small and middle-market businesses. We hold a portion of our mezzanine 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 to small and middle-market companies for many years, and maintain a commercial mortgage loan portfolio. During 1998, we 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 have combined small real estate lending with our SBA lending activity to form our Allied Capital Express product line, which is discussed below. We continue to seek unique opportunities for commercial mortgage loans for our portfolio when our return objectives can be achieved. These loans are generally priced at higher interest rates and include subordinated real estate loans. Subordinated loans are priced similarly to our mezzanine loans and may be accompanied by an equity interest in the real estate or in the underlying business. 38 42 At September 30, 1999, 80% of the Company's portfolio of commercial mortgage loans carried a fixed interest rate, and 20% carried a floating rate tied to various indices. These loans may require payments of interest only, or they may require level payments of principal and interest calculated to amortize the principal on a 10- to 30-year basis with a balloon payment at maturity. We derive income from the (1) interest charged on the commercial mortgage loan portfolio and (2) amortization of original issue and purchased discounts. The weighted average stated interest rate on the commercial mortgage loan portfolio at September 30, 1999 was 9.6% and the weighted average yield was 9.8%. The effective yield on the mortgage loan portfolio is higher than the stated interest rate due to the amortization of original issue discount and purchased discount. At September 30, 1999, the weighted average loan-to-value for the commercial mortgage loan portfolio was 70.0%. The Company's commercial mortgage loan portfolio totaled approximately $185.5 million at September 30, 1999, or 16% of the Company's total assets. The geographic composition and the property types securing the commercial mortgage loan portfolio at September 30, 1999 were as follows:
GEOGRAPHIC REGION ----------------- Mid-Atlantic.................. 43% Southeast..................... 27% West.......................... 19% Midwest....................... 8% Northeast..................... 3% ---- Total.................... 100% ==== PROPERTY TYPE ------------- Hospitality................... 35% Office........................ 31% Retail........................ 13% Recreation.................... 11% Other......................... 10% ---- Total.................... 100% ====
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. COMMERCIAL MORTGAGE-BACKED SECURITIES. The same pricing pressures that caused us to reduce our origination of commercial mortgage loans for middle-market companies in 1998 created significant liquidity problems for many other real estate lenders who had remained active lenders as pricing declined throughout 1998. Many of these lenders experienced severe valuation decreases in their portfolios and as a result defaulted on their secured credit facilities. This turmoil in the real estate capital markets during the fourth quarter of 1998 created a unique opportunity for our Company to acquire non-investment grade commercial mortgage-backed securities ("Purchased CMBS") at attractive yields. However, we will limit our Purchased CMBS purchasing activity in order to maintain a balanced portfolio. 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, and the loans securing the Purchased CMBS have an average loan- 39 43 to-value of approximately 71.4% and a weighted average cost-to-value of 68.7% at September 30, 1999. 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. They tend to react more to changes in interest rates than do higher-rated securities, have a higher risk of default, tend to be less liquid, 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 that offer the non-investment grade securities, 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 the acquisition of the Purchased CMBS. When we evaluate a CMBS purchase, we use the same underwriting procedures and criteria for the pooled loans as we do for the loans we originate and purchase. These underwriting procedures and criteria are described in detail below. In addition, we believe that the underlying real estate collateral for our Purchased CMBS adequately secures our position. At September 30, 1999, the weighted average loan-to-value ratio for the loans securing our Purchased CMBS portfolio was 71.4% and a weighted average cost-to-value of 68.7%. At September 30, 1999, the Company had $213.4 million in Purchased CMBS, which represented 18.3% of the Company's total assets. The Purchased CMBS portfolio had a weighted average yield to maturity of 14.2%. These securities were all acquired at significant discounts from face. The face amount of these securities at September 30, 1999 was $434.5 million. In addition to our Purchased CMBS portfolio, we maintain in our CMBS portfolio a residual interest resulting primarily from our January 1998 $295 million commercial real estate loan securitization ("the Residual CMBS"). We continue to service all of the loans in the pool. This transaction provided liquidity from our investment portfolio, and allowed us to reinvest the cash proceeds from the commercial real estate loan securitization into higher yielding mezzanine and SBA 7(a) loans. We do not anticipate significant future commercial mortgage loan securitization activity; we intend to gain liquidity from our lower yielding commercial mortgage loans primarily through whole loan sales. At September 30, 1999, the Company had $82.8 million in Residual CMBS, which represented 7.1% of the Company's total assets. The Residual CMBS had a weighted average yield to maturity of 9.7%. The geographic composition and the property types securing the total CMBS portfolio at September 30, 1999 were as follows:
GEOGRAPHIC REGION ----------------- West.......................... 29% Mid-Atlantic.................. 23% Midwest....................... 22% Southeast..................... 21% Northeast..................... 5% ---- Total.................... 100% ==== PROPERTY TYPE ------------- Retail........................ 33% Housing....................... 30% Office........................ 20% Hospitality................... 8% Industrial.................... 8% Other......................... 1% ---- Total.................... 100% ====
40 44 ALLIED CAPITAL EXPRESS We originate small business and commercial real estate loans, primarily for sale, under our brand name of Allied Capital Express. The loans we originate in this program are generally for financings of up to $3 million in size and the loans are sold to banks and other financial institutions. The loans we sell are sold 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 mezzanine finance activity and avoid confusion in the market place. 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. One of our subsidiaries is 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 SBA 7(a) loans are provided to small businesses for the purposes of acquiring 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 SBA 7(a) loan origination activity on loans secured by commercial real estate assets. 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 the Company's SBA 7(a) loan portfolio had variable interest rates as of September 30, 1999. 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. Our post-Merger capital structure has allowed us to lower our pricing on SBA 7(a) loans. As a result, we believe we now compete more effectively in the marketplace, and we have increased our deal flow. We routinely sell the guaranteed portion of our SBA 7(a) loans in the well- established secondary market of banks and other institutional buyers. We earn a premium on the sale of the guaranteed portion of our SBA 7(a) loans. Typically our premiums on guaranteed SBA 7(a) loan sales, net of origination costs, range from 4% to 7.5% of the face amount of each loan sold. This premium income enhances the return on our 25% retained investment in the loan, and our retained portion is not subordinate to the guaranteed portion 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. We continue to service 100% of each loan we originate. 41 45 Our SBA 7(a) loan portfolio totaled $68.9 million at September 30, 1999, or 6% of our total assets. The SBA 7(a) portfolio includes loans to, among others, hotels and motels, automotive shops and gas stations, restaurants, manufacturers, broadcasting and communications companies, service providers, retail shops, and other small businesses. The following tables show our 7(a) loan portfolio by geographic region and industry at September 30, 1999:
GEOGRAPHIC REGION ----------------- Midwest....................... 35% Mid-Atlantic.................. 35% Southeast..................... 15% West.......................... 10% Northeast..................... 5% ---- Total.................... 100% ====
INDUSTRY -------- Retail........................ 40% Hospitality................... 29% Consumer products............. 12% Consumer services............. 5% Business services............. 4% Broadcasting.................. 3% Other......................... 7% ---- Total.................... 100% ====
In addition to SBA 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 SBA 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 institutions. Our range of net premiums on these loan sales is generally between 4% to 7% of the loan balance sold. We believe that there is significant opportunity to originate these small business and commercial real estate loans. The SBA 7(a) program is estimated to provide over $10.5 billion to small businesses on an annual basis. Recently, there has been significant merger and consolidation activity among the major non-bank SBA lenders, and this consolidation has created a market opportunity to expand our Allied Capital Express program. We are currently recruiting additional business development professionals in several markets. Since the first of the year, we have added new business development professionals in Atlanta, Philadelphia, Chicago, Washington, DC and Greenville, SC. We have also increased our loan underwriting and loan closing staffs. We have made significant progress in automating our loan origination process and are actively pursuing an Internet strategy to increase our marketing and business development activities. 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. See "Management's Discussion and Analysis -- Results of Operations." LOAN SOURCING Over the last 18 months, we significantly increased the scope of our sales and marketing activity by opening regional offices in Chicago, San Francisco and New York. We have also opened Allied Capital Express offices in Detroit, Atlanta, Philadelphia, Chicago and Greenville, SC. We have a full-time sales and marketing staff dedicated to identifying and pursuing mezzanine investments, commercial mortgage loans, and 42 46 SBA 7(a) loans. 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 investment opportunities. We have established an extensive network of investment referral relationships over our 40-year history. We are recognized as a pioneer in the mezzanine finance industry, and have developed a reputation in the commercial real estate finance market for our ability to finance complex transactions. ASSET APPROVAL AND UNDERWRITING PROCESS In assessing new investment opportunities, we maintain rigorous credit standards based on our underwriting guidelines, a thorough due diligence process, and a 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. The following table highlights general underwriting criteria for each product type. We use these criteria as general guidelines only, and the characteristics of individual investments may vary significantly depending upon each unique investment opportunity.
MEZZANINE REAL ESTATE/SBA 7(a) LENDING ------------------------------- ------------------------------- INDUSTRY OR Consumer and industrial Office buildings, full service PROPERTY products, business services hotels, manufacturing TYPE (outsourcing), broadcasting, facilities, warehouses, retail telecommunications, education, facilities, convenience stores, and other industries that have gas stations, and other low vulnerability to changes in properties requiring economic cycles specialized underwriting expertise INVESTMENT Stable, growing companies, Amortization, collateral CRITERIA strong cash flow, high returns coverage, cash flow coverage on invested capital, later-stage, strong management LOAN SIZE $5 million to $25 million $0.2 million to $25 million TERM 5 to 10 years 1 to 30 years COLLATERAL Second lien on assets, if First lien on real estate or available equipment, second lien on real estate, personal guarantees
43 47 LOAN UNDERWRITING PROCEDURES AND CRITERIA MEZZANINE FINANCING. We generally require that the companies in which we invest demonstrate strong market position, sales growth, positive cash flow, and profitability. We emphasize the quality of management, and seek experienced entrepreneurs with a management track record and relevant industry experience. We generally seek companies with annual revenues of $20 million to $200 million, cash flow margins of greater than 10% of revenues, operating histories of at least ten years, and seasoned management teams who have significant personal investments at risk in the business. In addition, the business must generate a high return on its invested capital, and must demonstrate a low level of vulnerability to changes in economic cycles. In a typical mezzanine 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 specialist consultant; study the industry and competitive landscape; and conduct numerous reference checks with employees, both current and former, customers, suppliers and competitors. The typical mezzanine financing requires two to three months of diligence and structuring before funding occurs. 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 perform a detailed review of all of the underlying commercial mortgage loans securing the CMBS. We recompute 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 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. We formulate our bid to achieve an effective yield on our investment over a ten-year period to approximate 13.5% to 15%. In computing estimated yield, we assume a 1% loss rate on the entire underlying mortgage pool. We look for an overall weighted average debt service coverage of 1.25 to 1.4, and a loan-to-value ratio of approximately 70%. 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 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 44 48 inspect the property during the due diligence process, and value the property using internally developed valuation analyses. SBA 7(a) LENDING. SBA 7(a) loans made to qualifying small businesses are generally secured by a mortgage 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. The SBA has established certain financial ratios and guidelines that generally govern SBA 7(a) loans. Factors to be considered include the debt service coverage ratio, value of the collateral, and the net worth of the borrower. We generally follow the same underwriting procedures and criteria for SBA 7(a) loans as we do for our commercial real estate loans. CREDIT APPROVAL PROCESS All credit approval is obtained through a committee review process centralized at our headquarters in Washington, DC. For mezzanine and CMBS transactions, all of our lending disciplines are represented on the investment committee, which is comprised of our most senior lenders. For Allied Capital Express transactions, a committee comprised of small business and real estate lenders meet to approve all loans. No one individual has the ability to approve a credit. The asset approval process not only benefits from the experience of the committee members, but also from the experience of our other investment professionals who together with the committee members, on average, have over 14 years of professional experience. This experienced staff of investment professionals underwrites each new loan and subjects each potential investment to a rigorous due diligence process, as is described above. In certain instances where risk/return characteristics warrant and for every transaction larger than $10 million, we require approval from the executive committee of the board of directors in addition to the investment committee. Even after all such approvals are received, due diligence must be successfully completed with final committee approval before funds are disbursed to a new borrower. PORTFOLIO MANAGEMENT LOAN SERVICING: Our staff is responsible for routine loan servicing, which includes: - 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. 45 49 PORTFOLIO MONITORING AND VALUATION: We use a grading system in order to help us monitor our portfolio. The grading system assigns grades to investments from 1 to 5 as follows:
GRADE DESCRIPTION - ----- ----------- 1 Probable capital gain 2 Performing security 3 Close monitoring -- no loss of principal or interest expected 4 Workout -- some loss of interest expected 5 Workout -- some loss of principal expected. Security is valued at net realized value.
At September 30, 1999 Grade 1 investments totaled $114.8 million, or 10% of the total portfolio at value; Grade 2 investments totaled $916.0 million, or 83% of the total portfolio; Grade 3 investments totaled $35.4 million, or 3% of the total portfolio; Grade 4 investments totaled $19.4 million, or 2% of the total portfolio; and Grade 5 investments totaled $18.1 million or 2% of the total portfolio. As a BDC, the board of directors is required to value the portfolio on a quarterly basis. In valuing each individual investment, we consider the financial performance of each borrower, loan payment histories, indications of potential equity realization events and 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 their 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 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. DELINQUENCIES. 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 investment professionals responsible for special servicing activity for monitoring, collection, and development of a workout plan, if necessary. 46 50 90 DAYS PAST DUE............. Our accounting department reviews loans in conjunction with the investment professional responsible for special servicing to determine whether the loan 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. At September 30, 1999, $28.6 million, or 2.6% of the Company's portfolio at value was 120 days or more past due. Included in this category are loans valued at $18.7 million that are secured by real estate. LOAN LOSSES. We have a history of low levels of loan losses, and have a demonstrated track record of successfully resolving troubled credit situations with minimal loss. The following table shows realized losses in the Company's portfolio over the last five years:
NINE MONTHS ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31, --------------------- ---------------------------------------------------- 1999 1998 1998 1997 1996 1995 1994 ---------- -------- -------- -------- -------- -------- -------- (IN THOUSANDS) Realized Losses...... $ 5,158 $ 818 $ 3,216 $ 5,100 $ 11,262 $ 4,679 $ 2,908 Total Assets..... 1,169,531 815,477 856,079 807,775 713,360 605,434 501,817 Realized Losses/Total Assets............. 0.4% 0.1% 0.4% 0.6% 1.6% 0.8% 0.6%
EMPLOYEES At September 30, 1999, we employed 124 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 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. PORTFOLIO COMPANIES The following is a listing of our portfolio companies in which we had an equity investment at September 30, 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 47 51 general terms of our loans to portfolio companies, see the Consolidated Statement of Investments and Notes thereto at September 30, 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 Product 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 Station 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 Cherry Tree Toys, Inc. ........... Direct Marketer of Common Stock 19.8% 7601 France Avenue South, #225 Woodcrafts Edina, MN 55435 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 Cosmetic Manufacturing............ Cosmetic Manufacturer Options to Purchase 17.5% Resources, LLC Shares 11312 Penrose Street Sun Valley, CA 91352 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
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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) -------------------- ------------------ ------------------- ------------- 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% 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 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. .......... Toilet Seat Convertible Debentures 7.0% 281 Benigno Boulevard Manufacturer Warrants to Purchase 16.0% Bellmawr, NJ 08031 Common Stock Global Communications I, LLC...... Communications and Preferred Stock 60% 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
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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) -------------------- ------------------ ------------------- ------------- 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 Jack Henry & Associates, Inc. .... Commercial Banking Common Stock 0.5% 663 Highway 60 Software Development P.O. Box 807 Monett, MO 65708 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 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
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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) -------------------- ------------------ ------------------- ------------- Nobel Learning Communities, Inc. ............................. Educational Services Series D Convertible 100% 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 Panera Bread Company ............. Restaurant Chain Warrants to Purchase 1.8% 19 Fid Kennedy Avenue Common Stock Boston, MA 02210 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 Quality Software Products Holdings, PLC................... Accounting Software Common Stock 0.1% Talipot House 5th Avenue Developer Gateshead Tyne & Wear, NE110XA UNITED KINGDOM Schwinn/GT........................ Bicycle Manufacturer/ Warrants to Purchase 0.7% 1690 38th Street Distributor Common Stock Boulder, CO 80301 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% 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
51 55
PERCENTAGE NAME AND ADDRESS NATURE OF ITS TITLE OF SECURITIES OF CLASS OF PORTFOLIO COMPANY PRINCIPAL BUSINESS HELD BY THE COMPANY HELD(1) -------------------- ------------------ ------------------- ------------- 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 .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 Common Stock McLean, VA 22102 Centers Vianova Resins GmbH............... Specialty Chemical Warrants to Purchase 0.2% Rheingaustrasse 190 Producer Common Stock D-65203 Weisbaden GERMANY Williams Brothers Lumber Company......................... Builders' Supplies Warrants to Purchase 14.1% 3165 Pleasant Hill Road Common Stock Duluth, GA 30136 Wyo-Tech Acquisition Corporation..................... Vocational School Common Stock 99% 4373 N. 3rd Street Preferred Stock 100% 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. 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. 52 56 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. For our mezzanine and CMBS transactions, our investment decisions are made by an investment committee comprised of the Company's most senior investment professionals. For Allied Capital Express transactions, a committee comprised of small business and real estate lenders meet to approve all loans. Committee approval is required to approve all loan transactions. 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. 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............ 55 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........ 75 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. 53 57 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.............. 39 Managing Director G. Cabell Williams, III ..... 45 Managing Director Penni F. Roll................ 33 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 II from 1996 to 1997. Mr. Walton is the Chairman of Business Mortgage Investors, Inc ("BMI"), and is a director of Nobel Learning Communities, Inc. (a portfolio company). Mr. Walton was Chief Executive Officer of Success Lab, Inc. (children's educational services) from 1993 to 1996, and Chief Executive Officer of Language Odyssey (educational publishing and services) from 1992 to 1996. Mr. Walton was Managing Director of Butler Capital Corporation from 1987 to 1991. Prior to that, Mr. Walton served as the investment advisor to William S. Paley, founder and Chairman of CBS, from 1985 to 1987, and was an investment banker with Lehman Brothers Kuhn Loeb from 1982 to 1985. 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 companies from the later of 1964 or each entity's inception until 1991. Mr. Williams is a director of BMI. 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 was the President, Executive Vice President or Senior Vice President of Advisers from 1984 to 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 BMI and Security Storage Company of Washington, DC, and is a senior advisor to Gilbert Capital, Inc. 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 54 58 Allbrittan Communications Company (owner of television stations). Mr. Hebert is a director of Allnewsco, Inc., the President of Westfield News Advertiser, Inc., 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., Cavanaugh Capital, Inc., Acorn Products, Inc., The Wills Group, Thulman-Eastern Company and Gallagher Fluid Seals, Inc. Robert E. Long is the Managing Director of Goodwyn & Long Investment Management, Inc. Mr. Long has been the President and Chief Executive Officer of Business News Network, Inc. since 1995, 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 trustee of Suburban Hospital from 1991 to 1994, and a trustee of The Audubon Naturalist Society from 1979 to 1985. He has been a director of Franklin National Bank since 1996. 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. John M. Scheurer, Managing Director, has been employed by the Company since 1991. Mr. Scheurer is also President of BMI. Joan M. Sweeney, Managing Director, has been employed by the Company since 1993. Ms. Sweeney is also a Managing Director of BMI. G. Cabell Williams, III, Managing Director, has been employed by the Company since 1981. Mr. Williams is also a Managing Director of BMI. 55 59 Penni F. Roll, Principal and Chief Financial Officer, has been employed by the Company since 1995. Ms. Roll is also Principal and Chief Financial Officer of BMI. Ms. Roll was a Manager at KPMG Peat Marwick, LLP from 1993 to 1995. COMPENSATION PLANS STOCK OPTION PLAN The Company's stock option plan (the "New Plan") is intended to encourage stock ownership in the Company by officers, thus giving them a proprietary interest in the Company's performance. The Company's shareholders approved the New Plan at the Special Meeting of Shareholders of Allied Lending held on November 26, 1997. The principal objective of the Company's compensation committee in awarding stock options to the Chief Executive Officer and other eligible officers of the Company is to align each officer's interests with the success of the Company and the financial interests of its shareholders. The committee believes that the New Plan achieves this objective because it links a portion of each executive's compensation with the performance of the Company's stock and the value delivered to shareholders. The committee grants stock options under the New Plan at a price not less than the prevailing market value, and such options 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 the Company's officers. Historically, when granting stock options, the committee evaluated a number of factors, including the recipient's current stock holdings, years of service, position with the Company, and other factors. The committee has not applied a formula assigning specific weights to any of these factors when making its determination. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, the Company's compensation committee granted a total of 553,921 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. See "Control Persons and Principal Holders of Securities" in the SAI for currently exercisable options granted to certain executive officers. The Company filed an application with the Commission to request approval to grant options under the New Plan to non-officer directors, and on September 8, 1999, the Company received such approval. 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. 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. The New Plan is designed to satisfy the conditions of Section 422 of the Code so that options granted under the New 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. FORMULA AWARD AND CUT-OFF AWARD Prior to the merger, each of the five predecessor companies had a stock option plan (each, an "Old Plan" and collectively, the "Old Plans"). Each predecessor company's compensation committee had granted options under the applicable Old Plan to various 56 60 employees of Advisers, who were also officers of that predecessor company. In preparation for the merger, the Advisers' compensation committee in conjunction with the compensation committees of the other predecessor companies, determined that the five Old Plans should be terminated upon the merger, so that the new merged Company would be able to develop a new plan that would incent all officers and directors with a single equity security. The existence of the Old Plans had resulted in certain inequities in option grants among the various officers of the predecessor companies simply because of the differences in the underlying equity securities. To balance stock option awards among employees, and to account for the deviations caused by the existence of five plans supported by five different publicly traded stocks, two special awards were developed to be granted in lieu of options under the Old Plans that were forgone upon completion of the merger and the cancellation of the Old Plans. FORMULA AWARD. The Formula Award was designed to compensate officers from the point when their unvested options ceased to appreciate in value pursuant to the Cut-Off Award (i.e., August 14, 1997) up until the time in which they are able to receive option awards in the Company after the merger became effective. In the aggregate, the Formula Award equaled six percent (6%) of the difference between the combined aggregate market capitalizations of the predecessor companies as of the close of the market on December 30, 1997, and the combined aggregate market capitalizations of the predecessor companies on August 14, 1997. In total, the combined aggregate market capitalization of the predecessor companies increased by $319 million from August 14, 1997 to December 30, 1997, and the aggregate Formula Award was approximately $19 million. The Formula Award was designed as a long-term incentive compensation program to be a replacement for canceled stock options and to balance share ownership among key officers for past and prospective service. The terms of the Formula Award required that the award be contributed to the Company's deferred compensation plan, as discussed below, and be used to purchase shares of the Company in the open market. The Formula Award vests and accrues equally over a three-year period, on the anniversary of the merger date (December 31, 1997), and vests automatically in the event of a change of control of the Company. If an officer terminates employment with the Company prior to the vesting of any part of the Formula Award, that amount will be forfeited to the Company. Assuming all officers meet the vesting requirement, the Company will accrue the Formula Award over the three-year period in equal amounts of approximately $6.2 million less any forfeitures. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, $4.7 million and $6.2 million, respectively, was expensed for the Formula Award. A table indicating the Formula Award for certain officers, and the related vesting schedule, is contained in the SAI. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, $61,000 and $270,000, respectively, of the Formula Award was forfeited. On January 4, 1999, the trust that holds the deferred compensation plan distributed shares of the Company's common stock with a value of $4,062,000 representing the portion of the Formula Award that vested on December 31, 1998. These shares are held in restricted accounts at a brokerage firm. CUT-OFF AWARD. The Cut-Off Award established a cut-off dollar amount as of the date of the announcement of the merger (August 14, 1997) that was computed for all outstanding, but unvested options that were canceled as of the date of the merger. 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 57 61 the merger. The Cut-Off Award, in the aggregate, was computed to be $2.9 million, and is equal to the difference between the market price of the shares of stock underlying the canceled options under the Old Plans 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. A table indicating the Cut-Off Award for certain officers, and the related vesting schedule, is contained in the SAI. EMPLOYEE STOCK OWNERSHIP PLAN In connection with the merger, the Company adopted an amended and restated Employee Stock Ownership Plan, or ESOP. All eligible employees (i.e., employees with one (1) year of service who are at least 21 years of age) of the Company are eligible participants in the ESOP. Pursuant to this qualified plan, during 1998 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 is made to the deferred compensation plan. The ESOP has used substantially all of these cash contributions to purchase shares of the Company, thus aligning every employee's interest with those of the Company and its shareholders. At September 30, 1999, the ESOP held 0.5% of the outstanding shares of the Company, and the majority of these shares had been allocated to participants' plan accounts. In October 1999, the Board of Directors amended the ESOP in order to begin the process of terminating the ESOP. It is expected that the Company will make a final contribution to each eligible participant's account for 1999. Participants will have the opportunity to roll their respective ESOP balances to the Company's 401(k) plan. See "401(k) Plan." 401(K) PLAN In October 1999, the Company established a 401(k) plan (the "401(k) Plan"), which will 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. In addition, beginning in 2000, the Company expects to contribute to each eligible 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 would be fully vested at the time of contribution. This contribution would replace any contribution to the ESOP. DEFERRED COMPENSATION PLAN Pursuant to the merger, the Company succeeded to the deferred compensation plan of Advisers (the "Deferred Compensation Plan"), and subsequently adopted such plan as amended and restated. The Deferred Compensation Plan is a funded plan that provides for the deferral of compensation by the Company's employees and consultants. Any employee or consultant of the Company is eligible to participate in the plan at such time and for such period as the board of directors designates. 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. 58 62 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 dealers in securities and financial institutions. This summary does not discuss any aspects of foreign, state or local tax laws. 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 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 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, if any, for each taxable year so that it will not incur income and excise taxes on its earnings. In order to qualify as a RIC for federal income tax purposes, the Company must, 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 of one issuer (other than U.S. government securities or securities of other RICs), or of two or more issuers that are controlled by the Company and are engaged in the same or similar or related trades or businesses. The 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 59 63 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 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. Shareholders not subject to tax on income will not be required to pay tax on amounts the Company distributed to them. The Company's distributions of the ordinary income and net short-term capital gain 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. 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 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, 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) 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 60 64 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 focuses on investing in or lending to small private companies and making managerial assistance available to them. A BDC may use capital 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 61 65 continuing basis to any portfolio company that requests it, whether or not difficulties are perceived. 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. 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, government securities 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 of one issuer (other than U.S. government securities), 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. Allied Investment resulted from the merger of the Company's two wholly owned SBIC subsidiaries in July 1998. Pursuant to this merger, the Company's subsidiary that was then named Allied Investment Corporation merged with and into Allied Capital Financial Corporation ("Allied Financial"). Allied Financial then changed its name to Allied Investment Corporation ("Allied Investment"). Prior to the merger, Allied Financial was 62 66 licensed by the SBA as a Specialized Small Business Investment Company ("SSBIC") under 301(d) of the 1958 Act. After the merger, Allied Investment could make SBIC eligible investments in addition to SSBIC eligible investments. 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 eligible to sell preferred stock to the SBA. Allied Investment had received $47.7 million of subordinated debentures and $7.0 million of preferred stock investments from the SBA at September 30, 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 rate of 8.22%. At September 30, 1999, we had an outstanding commitment from the SBA to purchase up to $27.0 million in additional SBIC debentures. We may seek this additional financing during 1999. 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 63 67 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. DESCRIPTION OF CAPITAL STOCK COMMON STOCK The Company is authorized to issue 100,000,000 shares of common stock, par value $0.0001. At November 5, 1999, there were 62,491,777 shares of common stock outstanding and 5,307,073 shares of Common Stock reserved for issuance under the New Plan. The following are the authorized classes of securities of the Company as of November 5, 1999:
(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 61,974,998
- ------------------------- * 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. 64 68 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 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. 65 69 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 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: 66 70 (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. 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 67 71 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 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 68 72 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. 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. 69 73 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-4 Formula Award and Cut-off Award........................ B-4 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 Accounting Services......................................... B-8 Brokerage Allocation and Other Practices.................... B-8 Tax Status.................................................. B-9
70 74 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS INDEX TO FINANCIAL STATEMENTS
PAGE ---- Consolidated Balance Sheet -- September 30, 1999 (unaudited) and December 31, 1998 and 1997............................ F-1 Consolidated Statement of Operations -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and for the Years Ended December 31, 1998, 1997 and 1996.............. F-2 Consolidated Statement of Changes in Net Assets -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and for the Years Ended December 31, 1998, 1997 and 1996...................................................... F-3 Consolidated Statement of Cash Flows -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and for the Years Ended December 31, 1998, 1997 and 1996.............. F-4 Consolidated Statement of Investments -- September 30, 1999 (unaudited) and December 31, 1998......................... F-5 Notes to Consolidated Financial Statements.................. F-16 Report of Independent Public Accountants.................... F-38
71 75 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, DECEMBER 31, ------------- ------------------- 1999 1998 1997 ------------- -------- -------- (IN THOUSANDS, EXCEPT NUMBER OF SHARES) (UNAUDITED) ASSETS Portfolio at value: Mezzanine loans and debt securities (cost: 1999-$495,169; 1998-$354,870; 1997-$181,184)........ $ 476,003 $339,163 $167,842 Commercial mortgage-backed securities (cost: 1999-$297,656; 1998-$115,174; 1997-$0).............. 296,156 113,674 -- Commercial mortgage loans (cost: 1999-$185,128; 1998-$232,745; 1997-$446,114)....................... 185,481 233,186 447,244 Small Business Administration 7(a) loans (cost: 1999-$69,394; 1998-$57,651; 1997-$41,103)........... 68,912 56,285 40,709 Equity interests in portfolio companies (cost: 1999-$43,192; 1998-$27,618; 1997-$20,050)........... 70,031 49,391 39,906 Other portfolio assets (cost: 1999-$7,572; 1998-$8,331; 1997-$2,269)........................... 7,070 8,575 1,320 ---------- -------- -------- Total portfolio at value.......................... 1,103,653 800,274 697,021 ---------- -------- -------- Cash and cash equivalents................................... 15,376 25,075 70,437 U.S. government securities.................................. -- -- 11,091 Other assets................................................ 50,502 30,730 29,226 ---------- -------- -------- Total assets...................................... $1,169,531 $856,079 $807,775 ========== ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Debentures and notes payable.......................... $ 404,850 $239,350 $308,821 Revolving lines of credit............................. 133,000 95,000 38,842 Accounts payable and other liabilities................ 30,848 27,912 23,984 Dividends and distributions payable................... -- 1,700 9,068 ---------- -------- -------- Total liabilities................................. 568,698 363,962 380,715 ---------- -------- -------- Commitments and Contingencies Preferred stock issued to Small Business Administration..... 7,000 7,000 7,000 Shareholders' equity: Common stock, $0.0001 par value, 100,000,000 shares authorized; 62,488,443, 56,729,502 and 52,047,318 issued and outstanding at September 30, 1999, December 31, 1998 and 1997, respectively............ 6 6 5 Additional paid-in capital............................ 637,096 526,824 451,044 Common stock held in deferred compensation trust (516,779 shares and 810,456 shares at September 30, 1999 and December 31, 1998, respectively)........... (13,128) (19,431) -- Notes receivable from sale of common stock............ (27,276) (23,735) (29,611) Net unrealized appreciation on portfolio.............. 3,855 2,380 1,301 Distributions in excess of earnings................... (6,720) (927) (2,679) ---------- -------- -------- Total shareholders' equity........................ 593,833 485,117 420,060 ---------- -------- -------- Total liabilities and shareholders' equity........ $1,169,531 $856,079 $807,775 ========== ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-1 76 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31, ------------------- --------------------------------- 1999 1998 1998 1997 1996 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -------- -------- --------- --------- --------- (UNAUDITED) Interest and related portfolio income: Interest.............................................. $84,419 $58,428 $79,921 $86,882 $77,541 Net premiums from loan dispositions................... 9,032 2,913 5,949 7,277 4,241 Net gain on securitization of commercial mortgage loans............................................... -- 14,812 14,812 -- -- Investment advisory fees and other income............. 5,411 4,611 6,056 3,246 3,155 ------- ------- ------- ------- ------- Total interest and related portfolio income....... 98,862 80,764 106,738 97,405 84,937 ------- ------- ------- ------- ------- Expenses: Interest on indebtedness.............................. 24,173 14,539 20,694 26,952 20,298 Salaries and employee benefits........................ 11,303 8,254 11,829 10,258 8,774 General and administrative............................ 8,476 8,970 11,921 8,970 8,289 Merger................................................ -- -- -- 5,159 -- ------- ------- ------- ------- ------- Total operating expenses.......................... 43,952 31,763 44,444 51,339 37,361 Formula and cut-off awards............................ 5,188 5,532 7,049 -- -- ------- ------- ------- ------- ------- Portfolio income before net realized and unrealized gains... 49,722 43,469 55,245 46,066 47,576 ------- ------- ------- ------- ------- Net realized and unrealized gains: Net realized gains.................................... 16,448 20,001 22,541 10,704 19,155 Net unrealized gains (losses)......................... 1,475 (437) 1,079 7,209 (7,412) ------- ------- ------- ------- ------- Total net realized and unrealized gains........... 17,923 19,564 23,620 17,913 11,743 ------- ------- ------- ------- ------- Income before minority interests and income taxes........... 67,645 63,033 78,865 63,979 59,319 Minority interests.......................................... -- -- -- 1,231 2,427 Income tax expense.......................................... -- 1,585 787 1,444 1,945 ------- ------- ------- ------- ------- Net increase in net assets resulting from operations........ $67,645 $61,448 $78,078 $61,304 $54,947 ======= ======= ======= ======= ======= Basic earnings per common share............................. $ 1.14 $ 1.19 $ 1.50 $ 1.24 $ 1.19 ======= ======= ======= ======= ======= Diluted earnings per common share........................... $ 1.14 $ 1.19 $ 1.50 $ 1.24 $ 1.17 ======= ======= ======= ======= ======= Weighted average common shares outstanding -- basic......... 59,077 51,502 51,941 49,218 46,172 ======= ======= ======= ======= ======= Weighted average common shares outstanding -- diluted....... 59,239 51,712 51,974 49,251 46,733 ======= ======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. F-2 77 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31, ------------------- --------------------------------- 1999 1998 1998 1997 1996 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -------- -------- --------- --------- --------- (UNAUDITED) Operations: Portfolio income before realized and unrealized gains................... $ 49,722 $ 43,469 $ 55,245 $ 46,066 $ 47,576 Net realized gains................... 16,448 20,001 22,541 10,704 19,155 Net unrealized gains (losses)........ 1,475 (437) 1,079 7,209 (7,412) Minority interests and income tax expense............................ -- 1,585 (787) (2,675) (4,372) -------- -------- -------- -------- -------- Net increase in net assets resulting from operations..... 67,645 61,448 78,078 61,304 54,947 -------- -------- -------- -------- -------- Shareholder distributions: Portfolio income..................... (71,800) (54,727) (49,397) (38,751) (39,030) Excess of portfolio income........... -- -- -- (605) (2,533) Net capital gains.................... -- -- (24,976) (15,172) (11,546) Excess of net capital gains.......... -- -- (714) -- -- Return of capital.................... -- -- -- (22,302) (4,289) Undistributed earnings............... -- -- -- (8,848) -- Preferred stock dividend............. (165) (165) (230) (220) (220) -------- -------- -------- -------- -------- Net decrease in net assets resulting from shareholder distributions................. (71,965) (54,892) (75,317) (85,898) (57,618) -------- -------- -------- -------- -------- Capital share transactions: Sale of common stock................. 103,022 -- 69,675 -- 22,365 Net decrease (increase) in notes receivable from sale of common stock.............................. (3,540) 5,711 5,576 (14,120) (8,176) Issuance of common stock upon the exercise of stock options.......... 3,753 222 221 28,426 12,176 Issuance of common stock in lieu of cash distributions................. 3,498 4,097 6,184 26,612 11,986 Purchase of common stock by deferred compensation trust................. -- (19,431) (19,431) -- -- Distribution of common stock by deferred compensation trust........ 6,303 -- -- -- -- Other................................ -- 1,500 71 1,602 (738) -------- -------- -------- -------- -------- Net increase (decrease) in net assets resulting from capital share transactions............ 113,036 (7,901) 62,296 42,520 37,613 -------- -------- -------- -------- -------- Total increase (decrease) in net assets... $108,716 $ (1,345) $ 65,057 $ 17,926 $ 34,942 -------- -------- -------- -------- -------- Net assets at beginning of period......... $485,117 $420,060 $420,060 $402,134 $367,192 -------- -------- -------- -------- -------- Net assets at end of period............... $593,833 $418,715 $485,117 $420,060 $402,134 ======== ======== ======== ======== ======== Net asset value per common share.......... $ 9.58 $ 8.13 $ 8.68 $ 8.07 $ 8.34 ======== ======== ======== ======== ======== Common shares outstanding at end of period.................................. 61,972 51,490 55,919 52,047 48,238 ======== ======== ======== ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-3 78 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31, --------------------- --------------------------------- 1999 1998 1998 1997 1996 (IN THOUSANDS) --------- --------- --------- --------- --------- (UNAUDITED) Cash flows from operating activities: Net increase in net assets resulting from operations................................ $ 67,645 $ 61,448 $ 78,078 $ 61,304 $ 54,947 Adjustments Net unrealized (gains) losses............. (1,475) (286) (1,079) (7,209) 7,412 Net gain on securitization of commercial mortgage loans.......................... -- (14,812) (14,812) -- -- Depreciation and amortization............. 599 523 702 450 393 Amortization of loan discounts and fees... (6,195) (3,237) (6,032) (10,804) (9,027) Deferred income taxes..................... -- -- -- 1,087 (381) Minority interests........................ -- -- -- 1,231 2,427 Changes in other assets and liabilities... (11,518) 6,206 11,998 12,881 (10,606) --------- --------- --------- --------- --------- Net cash provided by operating activities........................... 49,056 49,842 68,855 58,940 45,165 --------- --------- --------- --------- --------- Cash flows from investing activities: Investments in small business concerns...... (534,017) (349,586) (524,530) (364,942) (283,295) Collections of investment principal......... 120,563 75,817 138,081 233,005 179,292 Proceeds from loan sales.................... 120,871 28,957 81,013 53,912 27,715 Proceeds from securitization of commercial mortgage loans............................ -- 223,401 223,401 -- -- Net redemption (purchase) of U.S. government securities................................ -- 11,091 11,091 (10,301) -- Collections of notes receivable from sale of common stock.............................. 212 5,411 5,591 6,534 2,199 Other investing activities.................. (2,738) (1,431) (2,539) (182) 2,635 --------- --------- --------- --------- --------- Net cash (used in) provided by investing activities........................... (295,109) (6,340) (67,892) (81,974) (71,454) --------- --------- --------- --------- --------- Cash flows from financing activities: Sale of common stock........................ 103,079 222 69,896 8,615 24,166 Purchase of common stock by deferred compensation trust........................ -- (19,431) (19,431) -- -- Common dividends and distributions paid..... (70,003) (51,107) (69,536) (58,194) (47,089) Special undistributed earnings distribution paid...................................... -- (8,261) (8,848) -- -- Preferred stock dividends................... (165) (385) (450) (220) (220) Net borrowings under (payments on) debentures and notes payable.............. 165,500 (17,171) (69,471) 78,923 (35,202) Net borrowings under (payments on) revolving lines of credit........................... 38,000 31,158 56,158 (6,257) 110,460 Other financing activities.................. (57) (5,342) (4,643) (1,237) (3,029) --------- --------- --------- --------- --------- Net cash provided by (used in) financing activities........................... 236,354 (70,317) (46,325) 21,630 49,086 --------- --------- --------- --------- --------- Net increase (decrease) in cash and cash equivalents................................. $ (9,699) $ (26,815) $ (45,362) $ (1,404) $ 22,797 Cash and cash equivalents at beginning of period...................................... $ 25,075 $ 70,437 $ 70,437 $ 71,841 $ 49,044 --------- --------- --------- --------- --------- Cash and cash equivalents at end of period.... $ 15,376 $ 43,622 $ 25,075 $ 70,437 $ 71,841 ========= ========= ========= ========= =========
The accompanying notes are an integral part of these consolidated financial statements. F-4 79 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INVESTMENTS
PORTFOLIO COMPANY SEPTEMBER 30, 1999 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------- --------------------------------------------- -------- -------- (UNAUDITED) MEZZANINE LOANS AND DEBT SECURITIES AND EQUITY INTERESTS IN PORTFOLIO COMPANIES ACE Products, Inc. Debt Securities $ 13,171 $ 13,171 - ----------------------------------------------------------------------------------------------------- Acme Paging, L.P. Debt Securities 6,525 6,525 Partnership Interest 1,456 2,100 - ----------------------------------------------------------------------------------------------------- Allied Office Products Debt Securities 9,952 9,952 Warrants -- -- - ----------------------------------------------------------------------------------------------------- American Barbecue & Grill, Inc. Warrants 125 125 - ----------------------------------------------------------------------------------------------------- AMF Bowling, Inc. (1) High Yield Debt 5,479 5,479 - ----------------------------------------------------------------------------------------------------- ASW Holding Corporation Warrants 25 25 - ----------------------------------------------------------------------------------------------------- Aurora Communications Inc. Loans 13,365 13,365 Preferred Stock 1,500 1,500 - ----------------------------------------------------------------------------------------------------- Avborne, Inc. Debt Securities 11,934 11,934 Warrants 1,180 1,180 - ----------------------------------------------------------------------------------------------------- CampGroup, LLC Debt Securities 2,450 2,450 Warrants 220 220 - ----------------------------------------------------------------------------------------------------- Candlewood Hotel Company (1) Preferred Stock (3,250 shares) 3,250 3,250 - ----------------------------------------------------------------------------------------------------- Celebrities, Inc. Debt Securities 318 318 Warrants 12 12 - ----------------------------------------------------------------------------------------------------- Cherry Tree Toys, Inc. Debt Securities 1,610 850 Common Stock (220 shares) 1 -- - ----------------------------------------------------------------------------------------------------- Convenience Corporation of Debt Securities 8,391 2,774 America Series A Preferred Stock (31,521 shares) 334 -- Warrants -- -- - ----------------------------------------------------------------------------------------------------- Cooper Natural Resources, Inc. Debt Securities 3,458 3,458 Warrants -- 1,138 - ----------------------------------------------------------------------------------------------------- CorrFlex Graphics, LLC Loan 5,921 5,921 - ----------------------------------------------------------------------------------------------------- Cosmetic Manufacturing Debt Securities 5,809 5,809 Resources, LLC Options 87 87 - ----------------------------------------------------------------------------------------------------- Coverall North America Loan 9,296 9,296 - ----------------------------------------------------------------------------------------------------- Csabai Canning Factory Rt. Hungarian Quotas (9.2%) 700 -- - ----------------------------------------------------------------------------------------------------- DEH Printed Circuits, Inc. Warrants 250 -- - ----------------------------------------------------------------------------------------------------- DeVlieg-Bullard, Inc. (1) Warrants 350 49 - ----------------------------------------------------------------------------------------------------- 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 -- - -----------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-5 80
PORTFOLIO COMPANY SEPTEMBER 30, 1999 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------- --------------------------------------------- -------- -------- (UNAUDITED) Drilltec Patents & Technologies Loan $ 10,908 $ 8,752 Company, Inc. Debt Securities 426 426 Warrants -- -- - ----------------------------------------------------------------------------------------------------- ECM Enterprises Loan 28 4 - ----------------------------------------------------------------------------------------------------- EDM Consulting, LLC Loans 14 14 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 -- - ----------------------------------------------------------------------------------------------------- Everything Yogurt Loan 8 8 - ----------------------------------------------------------------------------------------------------- Ex Terra Credit Recovery, Inc. Series A Preferred Stock (500 shares) 500 500 Common Stock (2,500 shares) -- -- Warrants -- -- - ----------------------------------------------------------------------------------------------------- Executive Greetings, Inc. Debt Securities 15,736 15,736 Warrants 360 360 - ----------------------------------------------------------------------------------------------------- Fairchild Industrial Products Debt Securities 5,740 5,740 Company Warrants 280 3,628 - ----------------------------------------------------------------------------------------------------- FHM Distributions, Inc. Loans 200 200 - ----------------------------------------------------------------------------------------------------- FTI Consulting, Inc. (1) Debt Securities 11,874 11,874 Warrants 970 970 - ----------------------------------------------------------------------------------------------------- Galaxy American Debt Securities 30,731 30,731 Communications, LLC Warrants -- 750 - ----------------------------------------------------------------------------------------------------- Genesis Worldwide, Inc. (1) Loan 1,328 1,328 Common Stock (41,644 shares) 214 151 - ----------------------------------------------------------------------------------------------------- Genoa Mine Acquisition Loan 242 242 Corporation - ----------------------------------------------------------------------------------------------------- Gibson Guitar Corporation Debt Securities 15,572 15,572 Warrants 525 1,000 - ----------------------------------------------------------------------------------------------------- Ginsey Industries, Inc. Loans 5,000 5,000 Convertible Debentures 500 500 Warrants -- 154 - ----------------------------------------------------------------------------------------------------- Global Communications I, LLC Debt Securities 1,863 1,863 Preferred Stock 5,667 5,667 - ----------------------------------------------------------------------------------------------------- Golden Eagle/Satellite Loans 1,390 840 Archery, LLC Convertible Debentures 2,248 2,008 - ----------------------------------------------------------------------------------------------------- Grant Broadcasting System II Warrants 139 8,500 - ----------------------------------------------------------------------------------------------------- Grant Television, Inc. Debt Securities 9,171 9,171 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Han Hie Loan 504 504 - ----------------------------------------------------------------------------------------------------- Hotelevision, Inc. Preferred Stock (1,000,000 shares) 1,000 1,000 - -----------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-6 81
PORTFOLIO COMPANY SEPTEMBER 30, 1999 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------- --------------------------------------------- -------- -------- (UNAUDITED) Jack Henry & Associates, Inc. (1) Common Stock (90,498 shares) $ 26 $ 3,079 - ----------------------------------------------------------------------------------------------------- Jakel, Inc. Loan 17,938 17,938 - ----------------------------------------------------------------------------------------------------- Jeff & Chris Mufflers, Inc. Loan 62 62 - ----------------------------------------------------------------------------------------------------- JRI Industries, Inc. Debt Securities 2,130 2,130 Warrants 74 74 - ----------------------------------------------------------------------------------------------------- Julius Koch USA, Inc. Debt Securities 3,801 3,801 Warrants 324 4,100 - ----------------------------------------------------------------------------------------------------- Kirker Enterprises, Inc. Warrants 348 3,495 Equity Interest 4 9 - ----------------------------------------------------------------------------------------------------- Kirkland's, Inc. Debt Securities 6,309 6,309 Warrants 96 1,500 - ----------------------------------------------------------------------------------------------------- Kyrus Corporation Debt Securities 7,648 7,648 Warrants 348 348 - ----------------------------------------------------------------------------------------------------- Liberty-Pittsburgh Systems, Inc. Debt Securities 3,430 3,430 Common Stock (64,535 shares) 142 142 - ----------------------------------------------------------------------------------------------------- Lingcomm, Inc. Loan 207 207 - ----------------------------------------------------------------------------------------------------- Liqui-Dri Foods, Inc. Loans 10,782 10,782 - ----------------------------------------------------------------------------------------------------- The Loewen Group, Inc. (1) High Yield Debt 15,150 15,150 - ----------------------------------------------------------------------------------------------------- Love Funding Corporation Series D Preferred Stock (26,000 shares) 359 213 - ----------------------------------------------------------------------------------------------------- Master Plan, Inc. Common Stock (156 shares) 42 3,042 - ----------------------------------------------------------------------------------------------------- May Investments Loan 47 -- - ----------------------------------------------------------------------------------------------------- MedAssets.com, Inc. Loans 3,803 3,803 Series B Convertible Preferred Stock 2,049 2,049 (227,665 shares) Warrants 136 136 - ----------------------------------------------------------------------------------------------------- Meigher Communications, L.P. Loan 2,933 2,933 - ----------------------------------------------------------------------------------------------------- Mid Atlantic Telecom Plus, LLC Loan 10,936 10,936 - ----------------------------------------------------------------------------------------------------- Midview Associates, L.P. Warrants -- -- - ----------------------------------------------------------------------------------------------------- Mihadas Loan 285 285 - ----------------------------------------------------------------------------------------------------- Monitoring Solutions, Inc. Loans 17 17 Debt Securities 1,823 370 Common Stock (33,333 shares) -- -- Warrants -- -- - ----------------------------------------------------------------------------------------------------- Morton Industrial Group (1) Common Stock (5,835 shares) 241 82 - ----------------------------------------------------------------------------------------------------- MVL Group Debt Securities 13,768 13,768 Warrants 849 849 - ----------------------------------------------------------------------------------------------------- NET-Tel Communications, Inc. Debt Securities 9,479 9,479 Series B Convertible Preferred Stock 5,000 5,000 (647 shares) Warrants 500 500 - ----------------------------------------------------------------------------------------------------- New York Donut Corporation Loan 23 23 - -----------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-7 82
PORTFOLIO COMPANY SEPTEMBER 30, 1999 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------- --------------------------------------------- -------- -------- (UNAUDITED) Nobel Learning Communities, Debt Securities $ 9,473 $ 9,473 Inc. (1) Series D Convertible Preferred Stock 2,000 2,000 (265,957 shares) Warrants 575 575 - ----------------------------------------------------------------------------------------------------- Northeast Broadcasting Group, Debt Securities 391 391 L.P. - ----------------------------------------------------------------------------------------------------- Nursefinders, Inc. Debt Securities 10,902 10,902 Warrants 900 900 - ----------------------------------------------------------------------------------------------------- Old Mill Holdings, Inc. Debt Securities 140 -- - ----------------------------------------------------------------------------------------------------- Opinion Research Corporation(1) Debt Securities 13,864 13,864 Warrants 996 996 - ----------------------------------------------------------------------------------------------------- PAL Liberty, Inc. Loan 210 210 - ----------------------------------------------------------------------------------------------------- Panera Bread Company (1) Warrants 227 58 - ----------------------------------------------------------------------------------------------------- Pico Products, Inc. (1) Debt Securities 4,591 2,591 Common Stock (208,000 shares) 59 12 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Polaris Pool Systems, Inc. Debt Securities 7,425 7,425 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Powell Plant Farms, Inc. Loan 14,850 14,850 - ----------------------------------------------------------------------------------------------------- Progressive International Debt Securities 3,937 3,937 Corporation Common Stock (197 shares) 13 13 Preferred Stock (500 shares) 500 500 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Quality Software Products Common Stock (14,000 shares) 133 123 Holdings, PLC (1) - ----------------------------------------------------------------------------------------------------- R.L. Singletary Loan 89 89 - ----------------------------------------------------------------------------------------------------- Schwinn/GT Debt Securities 9,884 9,884 Warrants 395 395 - ----------------------------------------------------------------------------------------------------- Seasonal Expressions, Inc. Series A Preferred Stock (1,000 shares) 993 271 - ----------------------------------------------------------------------------------------------------- Soff-Cut Holdings, Inc. Debt Securities 8,121 8,121 Common Stock (2,000 shares) 200 200 Preferred Stock (300 shares) 300 300 Warrants 446 446 - ----------------------------------------------------------------------------------------------------- Southwest PCS, LP Debt Securities 7,359 7,359 Options -- -- - ----------------------------------------------------------------------------------------------------- Spa Lending Corporation Preferred Stock (28,625 shares) 335 223 Common Stock (6,208 shares) 25 18 - ----------------------------------------------------------------------------------------------------- SunStates Refrigerated Services, Loans 6,130 4,641 Inc. Debt Securities 2,445 676 - ----------------------------------------------------------------------------------------------------- Sydran Food Services II, L.P. Debt Securities 11,666 11,666 Options 266 266 - ----------------------------------------------------------------------------------------------------- Techniplas, Inc. Loan 1,396 1,396 - -----------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-8 83
PORTFOLIO COMPANY SEPTEMBER 30, 1999 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - --------------------------------- --------------------------------------------- -------- -------- (UNAUDITED) Teknekron Infoswitch Corporation Debt Securities $ 14,714 $ 14,714 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Total Foam, Inc. Debt Securities 1,536 147 Common Stock (910 shares) 57 -- - ----------------------------------------------------------------------------------------------------- Tubbs Snowshoe Company, LLC Debt Securities 3,883 3,883 Warrants 54 54 Common Units (2,325 units) 500 500 - ----------------------------------------------------------------------------------------------------- United Pet Group Debt Securities 4,951 4,951 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Unitel, Inc. Debt Securities 3,665 3,665 Warrants 360 1,010 - ----------------------------------------------------------------------------------------------------- Vianova Resins GmbH Debt Securities 1,652 1,652 Warrants -- -- - ----------------------------------------------------------------------------------------------------- Vidon, Inc. Loan 257 257 - ----------------------------------------------------------------------------------------------------- William R. Dye Loan 262 262 - ----------------------------------------------------------------------------------------------------- Williams Brothers Lumber Company Warrants 24 322 - ----------------------------------------------------------------------------------------------------- Wilton Industries, Inc. Loan 12,390 12,390 - ----------------------------------------------------------------------------------------------------- Wyo-Tech Acquisition Debt Securities 15,108 15,108 Corporation Common Stock (99 shares) 100 100 Preferred Stock (100 shares) 3,700 3,700 - ----------------------------------------------------------------------------------------------------- Total mezzanine loans and debt securities and equity interests in portfolio companies (102 investments) $538,361 $546,034 - -----------------------------------------------------------------------------------------------------
SEPTEMBER 30, 1999 INTEREST NUMBER OF ----------------------- RATE RANGES INVESTMENTS COST VALUE ---------------- ----------- ---------- ---------- (UNAUDITED) COMMERCIAL MORTGAGE-BACKED SECURITIES Purchased CMBS 6 $ 213,371 $ 213,371 - -------------------------------------------------------------------------------------------------- Residual CMBS 1 75,808 75,808 - -------------------------------------------------------------------------------------------------- Residual securitization spread 1 8,477 6,977 - -------------------------------------------------------------------------------------------------- Total commercial mortgage-backed securities 8 $ 297,656 $ 296,156 - -------------------------------------------------------------------------------------------------- COMMERCIAL MORTGAGE LOANS Up to 6.99% 6 $ 2,033 $ 2,033 7.00%- 8.99% 19 79,535 79,535 9.00%-10.99% 48 41,774 42,127 11.00%-12.99% 23 48,428 48,428 13.00%-14.99% 4 12,365 12,365 15.00% and above 1 993 993 - -------------------------------------------------------------------------------------------------- Total commercial mortgage loans 101 $ 185,128 $ 185,481 - --------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-9 84
SEPTEMBER 30, 1999 INTEREST NUMBER OF ----------------------- RATE RANGES INVESTMENTS COST VALUE ---------------- ----------- ---------- ---------- (UNAUDITED) SMALL BUSINESS ADMINISTRATION 7(a) LOANS Up to 6.99% 3 $ 113 $ 113 7.00%- 8.99% 5 54 42 9.00%-10.99% 121 31,677 31,989 11.00%-12.99% 287 37,370 36,605 13.00%-14.99% 3 180 163 15.00% and above -- -- -- - -------------------------------------------------------------------------------------------------- Total Small Business Administration 7(a) loans 419 $ 69,394 $ 68,912 - -------------------------------------------------------------------------------------------------- Other portfolio assets 9 $ 7,572 $ 7,070 - -------------------------------------------------------------------------------------------------- Total portfolio at value 639 $1,098,111 $1,103,653 - --------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-10 85 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INVESTMENTS
PORTFOLIO COMPANY DECEMBER 31, 1998 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - ----------------------------- --------------------------------------------------- -------- -------- MEZZANINE LOANS AND DEBT SECURITIES AND EQUITY INTERESTS IN PORTFOLIO COMPANIES Acme Paging, L.P. Debt Securities $ 6,273 $ 6,273 Partnership Interest 1,456 2,600 - ------------------------------------------------------------------------------------------------------- American Barbecue & Grill, Loans 1,475 1,475 Inc. Debt Securities 2,084 2,084 Warrants 125 125 - ------------------------------------------------------------------------------------------------------- AMF Bowling, Inc. (1) High Yield Debt 5,086 5,086 - ------------------------------------------------------------------------------------------------------- Arnold Moving Co., Inc. Loans 570 570 - ------------------------------------------------------------------------------------------------------- ASW Holding Corporation Warrants 25 25 - ------------------------------------------------------------------------------------------------------- Au Bon Pain Co., Inc. (1) Debt Securities 7,427 7,427 Warrants 227 8 - ------------------------------------------------------------------------------------------------------- Avborne, Inc. Debt Securities 12,510 12,510 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Brazos Sportswear, Inc. (1) Common Stock (342,938 shares) 330 -- - ------------------------------------------------------------------------------------------------------- Candlewood Hotel Company (1) Preferred Stock (3,250 shares) 3,250 3,250 - ------------------------------------------------------------------------------------------------------- Celebrities, Inc. Debt Securities 339 339 Warrants 12 12 - ------------------------------------------------------------------------------------------------------- CeraTech Holdings Corporation Debt Securities 1,991 50 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Cherry Tree Toys, Inc. Debt Securities 1,557 1,557 Common Stock (220 shares) 1 -- - ------------------------------------------------------------------------------------------------------- Convenience Corporation of Debt Securities 8,391 2,774 America Series A Preferred Stock (31,521 shares) 334 -- Warrants -- -- - ------------------------------------------------------------------------------------------------------- Cooper Natural Resources, Debt Securities 3,450 3,450 Inc. Warrants -- 1,138 - ------------------------------------------------------------------------------------------------------- CorrFlex Graphics, LLC Loan 5,860 5,860 - ------------------------------------------------------------------------------------------------------- Cosmetic Manufacturing Debt Securities 2,948 2,948 Resources, LLC Options -- -- - ------------------------------------------------------------------------------------------------------- Coverall North America Loan 8,915 8,915 - ------------------------------------------------------------------------------------------------------- Csabai Canning Factory Rt. Hungarian Quotas (9.2%) 700 700 - ------------------------------------------------------------------------------------------------------- DEH Printed Circuits, Inc. Warrants 250 250 - ------------------------------------------------------------------------------------------------------- DeVlieg-Bullard, Inc. (1) Warrants 350 133 - ------------------------------------------------------------------------------------------------------- Directory Investment Common Stock (470 shares) -- 148 Corporation - -------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-11 86
PORTFOLIO COMPANY DECEMBER 31, 1998 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - ----------------------------- --------------------------------------------------- -------- -------- Directory Lending Corporation Series A Common Stock (1,031 shares) $ -- $ -- Series B Common Stock (188 shares) 235 161 Series C Common Stock (292 shares) 656 449 Series A Preferred Stock (214 shares) 307 210 Series B Preferred Stock (175 shares) 931 638 Series C Preferred Stock (58 shares) 58 40 - ------------------------------------------------------------------------------------------------------- Drilltec Patents & Loan 10,020 10,020 Technologies Company, Inc. - ------------------------------------------------------------------------------------------------------- ECM Enterprises Loan 31 4 - ------------------------------------------------------------------------------------------------------- EDM Consulting, LLC Loans 30 30 Debt Securities 1,875 680 Common Stock (100 shares) 250 -- - ------------------------------------------------------------------------------------------------------- El Dorado Communications, Loans 306 306 Inc. - ------------------------------------------------------------------------------------------------------- Enterprise Software, Inc. (1) Debt Securities 14,880 14,880 Common Stock (147,975 shares) 1,176 683 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Eparfin S.A. Loan 29 29 - ------------------------------------------------------------------------------------------------------- Esquire Communications Ltd. Warrants 6 -- (1) - ------------------------------------------------------------------------------------------------------- Everything Yogurt Loan 34 34 - ------------------------------------------------------------------------------------------------------- Ex Terra Credit Recovery, Series A Preferred Stock (500 shares) 497 497 Inc. Common Stock (2,500 shares) 3 3 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Fairchild Industrial Products Debt Securities 5,702 5,702 Company Warrants 280 3,629 - ------------------------------------------------------------------------------------------------------- FHM Distributions, Inc. Loans 200 200 - ------------------------------------------------------------------------------------------------------- Galaxy American Debt Securities 30,703 30,703 Communications, LLC Warrants -- -- - ------------------------------------------------------------------------------------------------------- Gibson Guitar Corporation Debt Securities 15,080 15,080 Warrants 525 1,000 - ------------------------------------------------------------------------------------------------------- Ginsey Industries, Inc. Loans 5,000 5,000 Convertible Debentures 500 500 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Golden Eagle/Satellite Loans 1,390 1,390 Archery, LLC Convertible Debentures 2,248 2,242 - ------------------------------------------------------------------------------------------------------- Grant Broadcasting System II Warrants 139 3,600 - ------------------------------------------------------------------------------------------------------- Grant Television, Inc. Debt Securities 9,154 9,154 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Han Hie Loan 510 510 - ------------------------------------------------------------------------------------------------------- H.B.N. Communications, Inc. Loan 233 233 - ------------------------------------------------------------------------------------------------------- Hotelevision, Inc. Preferred Stock (1,000,000 shares) 1,000 1,000 - ------------------------------------------------------------------------------------------------------- In the Dough, Inc. Loan 2 2 - -------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-12 87
PORTFOLIO COMPANY DECEMBER 31, 1998 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - ----------------------------- --------------------------------------------------- -------- -------- Jack Henry & Associates, Inc. Common Stock (90,438 shares) $ 26 $ 4,193 (1) - ------------------------------------------------------------------------------------------------------- Jeff & Chris Mufflers, Inc. Loan 93 93 - ------------------------------------------------------------------------------------------------------- JRI Industries, Inc. Debt Securities 2,111 2,111 Warrants 74 74 - ------------------------------------------------------------------------------------------------------- Julius Koch USA, Inc. Debt Securities 4,692 4,692 Warrants 324 2,100 - ------------------------------------------------------------------------------------------------------- Kirker Enterprises, Inc. Loans 3,739 3,739 Debt Securities 2,609 2,609 Warrants 348 3,500 Equity Interest 3 3 - ------------------------------------------------------------------------------------------------------- Kirkland's, Inc. Debt Securities 6,283 6,283 Warrants 96 2,850 - ------------------------------------------------------------------------------------------------------- Kyrus Corporation Debt Securities 7,601 7,601 Warrants 348 348 - ------------------------------------------------------------------------------------------------------- KZSF Broadcasting, Inc. Loans 884 884 - ------------------------------------------------------------------------------------------------------- Liberty-Pittsburgh Systems, Debt Securities 3,403 3,403 Inc. Common Stock (64,535 shares) 142 142 - ------------------------------------------------------------------------------------------------------- Lingcomm, Inc. Loan 207 207 - ------------------------------------------------------------------------------------------------------- Liqui-Dri Foods, Inc. Loans 10,291 10,291 - ------------------------------------------------------------------------------------------------------- The Loewen Group, Inc. (1) High Yield Debt 15,002 15,002 - ------------------------------------------------------------------------------------------------------- Love Funding Corporation Series D Preferred Stock (26,000 shares) 359 213 - ------------------------------------------------------------------------------------------------------- May Investments Loan 47 -- - ------------------------------------------------------------------------------------------------------- Meigher Communications, L.P. Loan 2,918 2,918 - ------------------------------------------------------------------------------------------------------- Mid Atlantic Telecom Plus, Loan 10,434 10,434 LLC - ------------------------------------------------------------------------------------------------------- Midview Associates, L.P. Debt Securities 197 197 Options -- -- - ------------------------------------------------------------------------------------------------------- Mihadas Loan 287 287 - ------------------------------------------------------------------------------------------------------- Mill-It Striping, Inc. Common Stock (18 shares) 250 -- - ------------------------------------------------------------------------------------------------------- Monitoring Solutions, Inc. Loans 17 17 Debt Securities 1,823 219 Common Stock (33,333 shares) -- -- Warrants -- -- - ------------------------------------------------------------------------------------------------------- Morton Industrial Group (1) Common Stock (5,835 shares) 241 82 - ------------------------------------------------------------------------------------------------------- New York Donut Corporation Loan 61 61 - ------------------------------------------------------------------------------------------------------- Nobel Learning Communities, Debt Securities 9,419 9,419 Inc. (1) Series D Convertible Preferred Stock (265,957 2,000 2,000 shares) Warrants 575 575 - ------------------------------------------------------------------------------------------------------- Norman's Yogurt, Inc. Loan 8 8 - -------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-13 88
PORTFOLIO COMPANY DECEMBER 31, 1998 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - ----------------------------- --------------------------------------------------- -------- -------- Northeast Broadcasting Group, Debt Securities $ 415 $ 415 L.P. - ------------------------------------------------------------------------------------------------------- Nursefinders, Inc. Debt Securities 10,841 10,841 Warrants 900 900 - ------------------------------------------------------------------------------------------------------- Old Mill Holdings, Inc. Debt Securities 589 140 Warrants 77 -- - ------------------------------------------------------------------------------------------------------- PAL Liberty, Inc. Loan 229 229 - ------------------------------------------------------------------------------------------------------- David Peters Loan 164 55 - ------------------------------------------------------------------------------------------------------- PIATL Holdings, Inc. Loan 31 31 Preferred Stock (276 shares) 160 222 Common Stock (24 shares) -- -- - ------------------------------------------------------------------------------------------------------- Pico Products, Inc. (1) Debt Securities 4,091 4,091 Common Stock (208,000 shares) 59 33 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Precision Industries Co. Debt Securities 9,580 9,580 Common Stock (132,507 shares) 1,050 1,616 - ------------------------------------------------------------------------------------------------------- Progressive International Debt Securities 3,680 3,680 Corporation Preferred Stock (500 shares) 500 500 Warrants -- -- - ------------------------------------------------------------------------------------------------------- Quality Software Products Common Stock (94,479 shares) 901 557 Holdings, PLC (1) - ------------------------------------------------------------------------------------------------------- Radio One of Atlanta, Inc. Loans 2,000 2,000 Debt Securities 9,972 9,972 Common Stock (1,430 shares) -- 3,000 - ------------------------------------------------------------------------------------------------------- Randhawa Brothers Loan 117 117 Enterprises, Inc. - ------------------------------------------------------------------------------------------------------- R.L. Singletary Loan 98 98 - ------------------------------------------------------------------------------------------------------- Schwinn/GT Debt Securities 9,605 9,605 Warrants 395 395 - ------------------------------------------------------------------------------------------------------- Seasonal Expressions, Inc. Series A Preferred Stock (1,000 shares) 993 993 - ------------------------------------------------------------------------------------------------------- Spa Lending Corporation Preferred Stock (28,625 shares) 399 306 Common Stock (6,208 shares) 24 -- - ------------------------------------------------------------------------------------------------------- SunStates Refrigerated Loans 1,830 341 Services, Inc. Debt Securities 2,445 676 - ------------------------------------------------------------------------------------------------------- Sydran Food Services II, L.P. Debt Securities 11,881 11,881 Options -- -- - ------------------------------------------------------------------------------------------------------- Total Foam, Inc. Debt Securities 1,562 106 Common Stock (910 shares) 57 -- - ------------------------------------------------------------------------------------------------------- Unitel, Inc. Debt Securities 3,579 3,579 Warrants 360 360 - ------------------------------------------------------------------------------------------------------- Vianova Resins GmbH Debt Securities 1,812 1,812 Warrants -- -- - -------------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-14 89
PORTFOLIO COMPANY DECEMBER 31, 1998 (IN THOUSANDS, EXCEPT NUMBER ------------------- OF SHARES) INVESTMENT(2) COST VALUE - ----------------------------- --------------------------------------------------- -------- -------- Vidon, Inc. Loan $ 259 $ 259 - ------------------------------------------------------------------------------------------------------- William R. Dye Loan 265 265 - ------------------------------------------------------------------------------------------------------- Williams Brothers Lumber Warrants 24 322 Company - ------------------------------------------------------------------------------------------------------- Wilton Industries, Inc. Loan 12,000 12,000 - ------------------------------------------------------------------------------------------------------- WYCB Acquisition Corporation Loan 3,812 3,812 - ------------------------------------------------------------------------------------------------------- Wyo-Tech Acquisition Debt Securities 15,094 15,094 Corporation Common Stock (99 shares) 100 100 Preferred Stock (100 shares) 3,700 3,700 - ------------------------------------------------------------------------------------------------------- Total mezzanine loans and debt securities and equity interests in portfolio companies (94 investments) $382,488 $388,554 - -------------------------------------------------------------------------------------------------------
DECEMBER 31, 1998 INTEREST NUMBER OF ------------------- RATE RANGES INVESTMENTS COST VALUE ---------------- ----------- -------- -------- COMMERCIAL MORTGAGE-BACKED SECURITIES Purchased CMBS 1 $ 32,221 $ 32,221 - ------------------------------------------------------------------------------------------------ Residual CMBS 1 70,771 70,771 - ------------------------------------------------------------------------------------------------ Residual securitization spread 1 12,182 10,682 - ------------------------------------------------------------------------------------------------ Total commercial mortgage-backed securities 3 $115,174 $113,674 - ------------------------------------------------------------------------------------------------ COMMERCIAL MORTGAGE LOANS Up to 6.99% 3 $ 1,327 $ 1,327 7.00%- 8.99% 43 104,872 104,872 9.00%-10.99% 102 69,635 70,076 11.00%-12.99% 31 44,424 44,424 13.00%-14.99% 4 12,362 12,362 15.00% and above 1 125 125 - ------------------------------------------------------------------------------------------------ Total commercial mortgage loans 184 $232,745 $233,186 - ------------------------------------------------------------------------------------------------ SMALL BUSINESS ADMINISTRATION 7(a) LOANS Up to 6.99% 12 $ 160 $ 115 7.00%- 8.99% 12 134 57 9.00%-10.99% 364 51,925 51,343 11.00%-12.99% 53 5,148 4,592 13.00%-14.99% 5 284 178 15.00% and above -- -- -- - ------------------------------------------------------------------------------------------------ Total Small Business Administration 7(a) loans 446 $ 57,651 $ 56,285 - ------------------------------------------------------------------------------------------------ Other portfolio assets 6 $ 8,331 $ 8,575 - ------------------------------------------------------------------------------------------------ Total portfolio at value 733 $796,389 $800,274 - ------------------------------------------------------------------------------------------------
(1) Public company. (2) Common stock, preferred stock, warrants and equity interests are generally non-income producing and restricted.
The accompanying notes are an integral part of these consolidated financial statements. F-15 90 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. MERGER On December 31, 1997, Allied Capital Corporation ("Allied I"), Allied Capital Corporation II ("Allied II"), Allied Capital Commercial Corporation ("Allied Commercial"), and Allied Capital Advisers ("Advisers"), merged with and into Allied Capital Lending Corporation ("Allied Lending") (each a "Predecessor Company" and collectively the "Predecessor Companies") pursuant to an Agreement and Plan of Merger, dated as of August 14, 1997, as amended and restated as of September 19, 1997 in a stock-for-stock exchange (the "Merger"). Immediately following the Merger, Allied Lending changed its name to Allied Capital Corporation ("ACC" or the "Company"). The Merger was treated as a tax-free reorganization under Section 368 (a)(1)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). For federal income tax purposes, the Predecessor Companies carried forward the historical cost basis of their assets and liabilities to the surviving entity (ACC). For financial reporting purposes, the Predecessor Companies also carried forward the historical cost basis of their respective assets and liabilities at the time the Merger was effected. The consolidated financial statements reflect the operations of ACC with the years ended December 31, 1997 and 1996 restated as if the Predecessor Companies had merged as of the beginning of the earliest period presented. Prior to the Merger, Allied I owned approximately 16 percent of Allied Lending's total shares outstanding. These shares were distributed to the Allied I shareholders in a dividend immediately prior to the Merger at a rate of 0.107448 shares of Allied Lending for each share of Allied I held on the record date. For financial reporting purposes, Allied I's ownership of Allied Lending has been eliminated for all periods presented. NOTE 2. 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"). The Company has two wholly owned subsidiaries that have also elected to be regulated as BDCs. Allied Investment Corporation is licensed under the Small Business Investment Act of 1958 as a Small Business Investment Company ("SBIC"). Allied Investment Corporation is the result of the merger of the Company's two wholly owned SBIC subsidiaries in July 1998 whereby Allied Investment Corporation merged with and into Allied Capital Financial Corporation ("Allied Financial"). Allied Financial then changed its name to Allied Investment Corporation ("Allied Investment"). 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 also established a real estate investment trust subsidiary, Allied Capital REIT, Inc. ("Allied REIT"). The Company also has 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" or "ACC." 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, growing businesses in a variety of industries and in diverse geographic locations (primarily in the United States). F-16 91 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements for the periods presented have been restated to include the accounts of the Predecessor Companies for all periods presented. Transaction fees and expenses related to the Merger were expensed in the fourth quarter of 1997. The consolidated financial statements include the accounts of the Company or 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, 1997 and 1996 balances to conform with the 1999 financial statement presentation. VALUATION OF PORTFOLIO INVESTMENTS Portfolio assets are carried at fair value as determined by the Board of Directors under the Company's valuation policy. LOAN AND DEBT SECURITIES The values of loans and debt securities are considered to be amounts which 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. 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 Commercial mortgage-backed securities consist of purchased commercial mortgage-backed securities ("Purchased CMBS"), residual interest in mortgage securitization ("Residual CMBS") and residual securitization spread. PURCHASED CMBS The Purchased CMBS is carried at fair value. The Company recognizes income from Purchased CMBS using the effective interest method, using the anticipated yield over the projected life of the F-17 92 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED investment. Changes in estimated yields are due to revisions in estimates of future credit losses, actual losses incurred and actual 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 carrying amount. RESIDUAL CMBS The Company values its residual interest in securitization and recognizes income using the same accounting policies used for the Purchased CMBS. RESIDUAL SECURITIZATION SPREAD (INTEREST-ONLY STRIP) The residual securitization spread is carried at fair value based on the amortized cost of the residual securitization spread and the estimated future cash flows. The Company recognizes income 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 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. DISTRIBUTIONS TO SHAREHOLDERS Distributions to shareholders are recorded on the record date. FEDERAL AND STATE INCOME TAXES With the exception of Advisers, the Predecessor Companies qualified as regulated investment companies ("RIC") or a real estate investment trust ("REIT"); however, Advisers was a corporation F-18 93 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED 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. The Company and its wholly owned subsidiaries intend to comply with the requirements of the Code that are applicable to RICs and REITs. The Company and its wholly owned subsidiaries intend to distribute annually all of their taxable income to shareholders; therefore, the Company has made no provision for income taxes. 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 4. PORTFOLIO The Company's lending operations are conducted in three primary areas: mezzanine finance, commercial real estate finance, and SBA Section 7(a) guaranteed lending. MEZZANINE FINANCE Mezzanine investments are generally structured as loans that carry a relatively high fixed rate of interest, which may be combined with equity features, such as conversion privileges, warrants or options to purchase a portion of the portfolio company's equity at a nominal price. Such an investment 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 loan maturities and principal amortization schedules vary. Equity investments 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 September 30, 1999, December 31, 1998 and 1997, approximately 97 percent, 98 percent and 98 percent, respectively, of the Company's mezzanine loan portfolio was composed of fixed interest rate loans. The weighted average yield (at value) on the mezzanine portfolio at September 30, 1999, December 31, 1998 and 1997 was 14.0 percent, 14.6 percent, and 12.6 percent, respectively. At September 30, 1999, December 31, 1998 and 1997, mezzanine loans and debt securities with a cost basis of $35,911,000, $20,977,000 and $13,661,000, respectively, were not accruing interest. F-19 94 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. PORTFOLIO, CONTINUED The geographic and industry composition of the mezzanine portfolio at September 30, 1999, December 31, 1998 and 1997 was as follows:
1999 1998 1997 ---- ---- ---- GEOGRAPHIC REGION Mid-Atlantic................................................ 26% 28% 29% Midwest..................................................... 25 27 17 Southeast................................................... 20 23 27 West........................................................ 13 11 13 Northeast................................................... 11 4 8 International............................................... 5 7 6 --- --- --- Total............................................. 100% 100% 100% === === === INDUSTRY Business Services........................................... 26% 11% 7% Consumer Products........................................... 20 25 25 Telecommunications.......................................... 14 14 7 Industrial Products......................................... 14 8 9 Education................................................... 6 8 1 Broadcasting................................................ 6 9 23 Retail...................................................... 4 9 14 Other....................................................... 10 16 14 --- --- --- Total............................................. 100% 100% 100% === === ===
COMMERCIAL MORTGAGE-BACKED SECURITIES In December 1998, the Company purchased $67 million of Purchased Commercial Mortgage-Backed Securities ("Purchased CMBS") for $32 million. For the nine months ended September 30, 1999, the Company purchased for a price of $183.4 million, Purchased CMBS with a face value of $373.2 million. The bonds owned by the Company of non-investment grade and unrated tranches 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. As of September 30, 1999 and December 31, 1998, the estimated yield to maturity on the Purchased CMBS was approximately 14.2 percent and 15.0 percent, respectively. The Company's estimated returns on its Purchased CMBS are 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. As these uncertainties 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. F-20 95 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. PORTFOLIO, CONTINUED On January 30, 1998, the Company in conjunction with Business Mortgage Investors, Inc. ("BMI"), a private REIT managed by the Company, completed a $310 million asset securitization, whereby bonds totaling $239 million were sold in three classes rated "AAA", "AA" and "A" by Standard & Poor's Rating Services and Fitch IBCA, Inc. in a private placement. The three bond classes sold had an aggregate weighted average interest rate of approximately 6.38 percent. To effect the securitization, the Company and BMI sold a pool of 97 commercial mortgage loans totaling $310 million to a special purpose, bankruptcy remote entity which transferred the assets to a trust which issued the bonds. The Company contributed approximately 95%, or $295 million, of the total assets securitized, and received cash proceeds, net of costs of approximately $223 million. The Company retained a trust certificate for its residual interest (the "Residual CMBS") in the loan pool sold, and will receive interest income from this Residual CMBS as well as the net spread of the interest earned on the loans sold less the interest paid on the bonds over the life of the bonds (the "Residual Securitization Spread"). The Company accounted for the securitization in accordance with Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." As a result, 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. The gain arises from the difference between the carrying amount of the loans and the fair market value of the assets received (i.e., cash, Residual Securitization Spread, Residual CMBS and a servicing asset). As of September 30, 1999, the mortgage loan pool had an approximate weighted average stated interest rate of 9.4 percent. 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 Securitization Spread was determined based on a constant prepayment rate of 7 percent and a discount rate of 14 percent. The geographic composition and the property types securing the commercial mortgage-backed securities at September 30, 1999 and December 31, 1998 were as follows:
1999 1998 ---- ---- GEOGRAPHIC REGION West........................................................ 29% 17% Mid-Atlantic................................................ 23 32 Midwest..................................................... 22 19 Southeast................................................... 21 25 Northeast................................................... 5 7 --- --- Total............................................. 100% 100% === === PROPERTY TYPE Retail...................................................... 33% 32% Housing..................................................... 30 13 Office...................................................... 20 21 Hospitality................................................. 8 23 Other....................................................... 9 11 --- --- Total............................................. 100% 100% === ===
F-21 96 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. PORTFOLIO, CONTINUED COMMERCIAL REAL ESTATE FINANCE The commercial mortgage loan portfolio contains loans that were originated by the Company or were purchased from the Resolution Trust Corporation, the Federal Deposit Insurance Corporation and other third party sellers including life insurance companies and banks. At September 30, 1999, December 31, 1998 and 1997, approximately 80 percent and 20 percent, 68 percent and 32 percent, and 73 percent and 27 percent of the Company's commercial mortgage loan portfolio was composed of fixed and adjustable interest rate loans, respectively. The weighted average yield (at value) on the real estate portfolio as of September 30, 1999, December 31, 1998 and 1997 equaled 9.8 percent, 10.4 percent and 11.4 percent, respectively. As of September 30, 1999, December 31, 1998 and 1997, loans with a cost basis of $5,042,000, $5,443,000 and $11,987,000, respectively, were not accruing interest. The geographic composition and the property types securing the commercial mortgage loan portfolio at September 30, 1999, December 31, 1998 and 1997 were as follows:
1999 1998 1997 ---- ---- ---- GEOGRAPHIC REGION Mid-Atlantic................................................ 43% 37% 38% Southeast................................................... 27 26 14 West........................................................ 19 24 18 Midwest..................................................... 8 9 18 Northeast................................................... 3 4 12 --- --- --- Total............................................. 100% 100% 100% === === === PROPERTY TYPE Hospitality................................................. 35% 47% 34% Office...................................................... 31 20 32 Retail...................................................... 13 14 17 Recreation.................................................. 11 7 4 Other....................................................... 10 12 13 --- --- --- Total............................................. 100% 100% 100% === === ===
SBA SECTION 7(a) GUARANTEED LENDING 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 percent of any qualified loan up to $100,000 regardless of maturity, and 75 percent 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 percent to 2.75 percent 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 F-22 97 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4. PORTFOLIO, CONTINUED interest from the date on which the loan was made to its maturity. At September 30, 1999, December 31, 1998 and 1997, approximately 98 percent, 96 percent and 92 percent, respectively of the Company's portfolio of 7(a) loans were variable interest rate loans. As permitted by SBA regulations, the Company sells to investors, without recourse, the guaranteed portion of its loans while retaining the right to service 100 percent of such loans. As of September 30, 1999, December 31, 1998 and 1997, 7(a) loans with a cost basis of $13,133,000, $11,227,000 and $4,346,000, respectively, were not accruing interest. The geographic and industry composition of the SBA 7(a) portfolio at September 30, 1999, December 31, 1998 and 1997 was as follows:
1999 1998 1997 ---- ---- ---- GEOGRAPHIC REGION Midwest..................................................... 35% 34% 36% Mid-Atlantic................................................ 35 29 29 Southeast................................................... 15 16 18 West........................................................ 10 14 7 Northeast................................................... 5 7 10 --- --- --- Total............................................. 100% 100% 100% === === === INDUSTRY Retail...................................................... 40% 41% 37% Hospitality................................................. 29 30 26 Consumer Products........................................... 12 6 7 Consumer Services........................................... 5 6 4 Business Services........................................... 4 4 6 Broadcasting................................................ 3 4 8 Other....................................................... 7 9 12 --- --- --- Total............................................. 100% 100% 100% === === ===
F-23 98 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5. DEBT At September 30, 1999, December 31, 1998 and 1997, the Company had the following credit facilities:
1999 1998 1997 ------------------- ------------------- ------------------- FACILITY AMOUNT FACILITY AMOUNT FACILITY AMOUNT AMOUNT DRAWN AMOUNT DRAWN AMOUNT DRAWN -------- -------- -------- -------- -------- -------- (IN THOUSANDS) Debentures and notes payable: Master loan and security agreement.............. $250,000 $ 34,500 $250,000 $ 6,000 $250,000 $ 23,116 Unsecured long-term notes payable................ 317,000 317,000 180,000 180,000 -- -- SBA debentures........... 74,650 47,650 74,650 47,650 54,300 54,300 OPIC loan................ 5,700 5,700 5,700 5,700 20,000 8,700 Master repurchase agreement.............. -- -- 250,000 -- 250,000 202,705 Senior note payable...... -- -- -- -- 20,000 20,000 -------- -------- -------- -------- -------- -------- Total debentures and notes payable..... 647,350 404,850 760,350 239,350 594,300 308,821 -------- -------- -------- -------- -------- -------- Revolving lines of credit..... 340,000 133,000 200,000 95,000 80,000 38,842 -------- -------- -------- -------- -------- -------- Total Debt.......... $987,350 $537,850 $960,350 $334,350 $674,300 $347,663 ======== ======== ======== ======== ======== ========
MASTER LOAN AND SECURITY AGREEMENT The Company, and BMI, established a facility to borrow up to $250,000,000, of which $100,000,000 is committed, using commercial mortgage loans as collateral under the agreement. The Company pledges commercial mortgage loans as collateral for the facility such that the amount borrowed is approximately equal to 80 percent to 90 percent 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 London Interbank Offer Rate ("LIBOR") plus 1.0 percent, or 6.4 percent, 6.6 percent and 6.7 percent, at September 30, 1999, December 31, 1998 and 1997, respectively. Average debt outstanding, maximum amount borrowed, and weighted average interest rate charged on this facility for the nine months ended September 30, 1999 and for the years ended December 31, 1998 and 1997 were $40,323,000, $21,932,000 and $17,899,000; $84,392,000, $56,000,000 and $23,116,000; and 6.1 percent, 6.5 percent and 6.7 percent; respectively. The agreement matured on October 7, 1999 and the Company, without BMI, extended the facility through October 30, 2000, with a total committed facility up to $100,000,000. UNSECURED LONG-TERM NOTES PAYABLE In June 1998 and May 1999 the Company issued unsecured long-term notes held by private institutional investors. The notes have terms of 5 or 7 years with an aggregate principal balance of $317,000,000. The weighted average interest rate on the notes is 7.3 percent and interest only is payable semi-annually until maturity. The notes may be prepaid in whole or in part together with an interest premium as stipulated in the note agreement. F-24 99 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 5. DEBT, CONTINUED SBA DEBENTURES At September 30, 1999, December 31, 1998 and 1997, the Company had drawn debentures totaling $47,650,000, $47,650,000 and $54,300,000, respectively, payable to the SBA at interest rates ranging from 6.9 percent to 9.6 percent. Scheduled maturity dates are as follows: 1999 -- $0; 2000 -- $17,300,000; 2001 -- $9,350,000; 2002 -- $0; 2003 -- $0; and $21,000,000 thereafter. The debentures require semi-annual interest-only payments with all principal due upon maturity. The SBA debentures are subject to prepayment penalties if paid prior to maturity. OVERSEAS PRIVATE INVESTMENT CORPORATION (OPIC) LOAN The Company has a loan agreement with OPIC to provide financing for international projects involving qualifying U.S. small businesses. Loans under this agreement bear interest at the U.S. Treasury rate plus 0.5 percent for the applicable period of the borrowing, or 6.6 percent, 6.6 percent and 6.8 percent at September 30, 1999, December 31, 1998 and 1997, respectively. In addition, OPIC is entitled to receive from the Company a contingent fee at maturity of the loan equal to 5 percent of the return generated by the OPIC-related investments in excess of 7 percent. There are no required principal payments until the OPIC loans mature in January 2006. REVOLVING LINES 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 LIBOR plus 1.25 percent, or 6.6 percent and 6.9 percent at September 30, 1999 and December 31, 1998, respectively, and requires a commitment fee equal to 0.25 percent of the committed amount. The new line expires in March 2001. The line of credit requires monthly payments of interest and all principal is due upon its expiration. The average debt outstanding on the revolving lines were $83,253,000, $51,904,000 and $30,033,000 for the nine months ended September 30, 1999 and for the years ended December 31, 1998 and 1997, respectively. The maximum amount borrowed under these facilities and the weighted average interest rate for the nine months ended September 30, 1999 and for the years ended December 31, 1998 and 1997 were $174,000,000, $105,000,000 and $45,759,000, and 6.4 percent, 6.8 percent and 8.1 percent, respectively. NOTE 6. INCOME TAXES For the years ended December 31, 1998, 1997 and 1996, the Company's effective tax rate was 1.0 percent, 2.3 percent and 3.5 percent, respectively. The Company incurred no income tax for the nine months ended September 30, 1999. 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 years ended December 31, 1997 and 1996, the Company's income subject to federal and state taxes related to the income generated by the pre-Merger operations of Advisers. The income generated by the other Predecessor Companies is not subject to federal and state income taxes because these companies qualified as regulated investment companies or a real estate investment trust. F-25 100 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7. PREFERRED STOCK Allied Investment has outstanding a total of 60,000 shares of $100 par value, 3 percent cumulative preferred stock and 10,000 shares of $100 par value, 4 percent 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 percent 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 percent redeemable cumulative preferred stock has a required redemption date of June 4, 2005. NOTE 8. SHAREHOLDERS' EQUITY During the nine months ended September 30, 1999, the Company sold 3,803,000 shares of its common stock through underwriters for net proceeds of $73,321,000, after costs of $3,608,000 which included a weighted average discount of 3.8 percent. In addition, the Company sold 1,604,119 shares of its common stock to an institutional investor in three transactions. The net proceeds from the transactions were $29,758,000, after costs of $1,169,000 which included a discount of 3.0 percent. In 1998, the Company sold 3,565,000 shares of its common stock through an underwriter for net proceeds of $56,776,000, after costs of $3,384,000 which included a 5.0 percent fee paid to the underwriter. In 1998, the Company also sold 801,959 shares of its common stock to an institutional investor in two transactions. The net proceeds from the transactions were $12,899,000, after costs of $677,000 which included a weighted average discount of 4.0 percent. In 1996, the Company completed two non-transferable subscription rights offerings to common shareholders. The Company issued 1,433,414 shares of common stock pursuant to these offerings raising net proceeds to the Company of $17,147,000, after costs including a 2.5 percent fee paid to eligible broker/dealers. In 1996, the Company also sold 400,000 shares of its common stock through an underwriter for net proceeds of $5,218,000. 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 sales prices reported for the Company's common stock for the five days on which trading in the shares takes place immediately prior to the dividend payment date. For the nine months ended September 30, 1999 and for the years ended December 31, 1998, 1997 and 1996 the Company issued 169,588, 241,482, 550,971 and 913,206 shares, respectively, at an average price per share of $19.80, $20.35, $15.67 and $13.13, respectively. F-26 101 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. EARNINGS PER COMMON SHARE
PER COMMON INCOME SHARES SHARE AMOUNT -------- ------- ------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 (UNAUDITED) Net increase in net assets resulting from operations... $67,645 Less: Preferred stock dividends (165) ------- Income available to common shareholders................ $67,480 ======= BASIC EARNINGS PER COMMON SHARE........................ 59,077 $1.14 ===== Options outstanding to officers........................ 162 ------ DILUTED EARNINGS PER COMMON SHARE...................... 59,239 $1.14 ====== ===== FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 (UNAUDITED) Net increase in net assets resulting from operations... $61,448 Less: Preferred stock dividends........................ (165) ------- Income available to common shareholders................ $61,283 ======= BASIC EARNINGS PER COMMON SHARE........................ 51,502 $1.19 ===== Options outstanding to officers........................ 210 ------ DILUTED EARNINGS PER COMMON SHARE...................... 51,712 $1.19 ====== ===== 1998 Net increase in net assets resulting from operations... $78,078 Less: Preferred stock dividends........................ (230) ------- Income available to common shareholders................ $77,848 ======= BASIC EARNINGS PER COMMON SHARE........................ 51,941 $1.50 ===== Options outstanding to officers........................ 33 ------ DILUTED EARNINGS PER COMMON SHARE...................... 51,974 $1.50 ====== ===== 1997 Net increase in net assets resulting from operations... $61,304 Less: Preferred stock dividends........................ (220) ------- Income available to common shareholders................ $61,084 ======= BASIC EARNINGS PER COMMON SHARE........................ 49,218 $1.24 ===== Options outstanding to officers........................ 33 ------ DILUTED EARNINGS PER COMMON SHARE...................... 49,251 $1.24 ====== ===== 1996 Net increase in net assets resulting from operations... $54,947 Less: Preferred stock dividends........................ (220) ------- Income available to common shareholders................ $54,727 ======= BASIC EARNINGS PER COMMON SHARE........................ 46,172 $1.19 ===== Options outstanding to officers........................ 561 ------ DILUTED EARNINGS PER COMMON SHARE...................... 46,733 $1.17 ====== =====
Basic earnings per common share was computed by dividing the net increase in net assets resulting from operations, after deducting preferred stock dividends, by the weighted average number of common shares outstanding each period. F-27 102 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. EARNINGS PER COMMON SHARE, CONTINUED Diluted earnings per common share was computed by dividing the net increase in net assets resulting from operations, after deducting preferred stock dividends, by the weighted average number of common shares outstanding plus common shares issuable upon assumed exercise of stock options outstanding each period. NOTE 10. EMPLOYEE STOCK OWNERSHIP PLAN AND DEFERRED COMPENSATION PLAN The Company has an employee stock ownership plan ("ESOP"). Pursuant to the ESOP, the Company is obligated to contribute 5 percent of each eligible participant's total cash compensation for the year to a plan account on the participant's behalf, which vests over a two-year period. ESOP contributions are used to purchase shares of the Company's common stock. As of September 30, 1999, December 31, 1998 and 1997, the ESOP held 299,998 shares, 282,500 shares and 433,047 shares, respectively, of the Company's common stock, the majority 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, 1998, 1997, and 1996 was $489,000, $351,000 and $1,018,000, respectively, net of forfeitures of $4,000, $0 and $36,000, respectively. In October 1999, the Board of Directors amended the ESOP in order to begin the process of terminating the ESOP. It is expected that the Company will make a final contribution to each eligible participant's account for 1999. Participants will have the opportunity to roll their respective ESOP balances to the Company's 401(k) plan. 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 percent vested and non-forfeitable except for amounts credited to participants' accounts related to the Formula Award (see Note 12). 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. NOTE 11. 401(k) PLAN In October 1999, the Company established a 401(k) plan, which will 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. In addition, beginning in 2000, the Company expects to contribute to each eligible participant 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 would be fully vested at the time of contribution. This contribution would replace any contribution to the ESOP. NOTE 12. 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 F-28 103 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12. STOCK OPTION PLAN, CONTINUED at a special meeting of shareholders on November 26, 1997, the Company's shareholders approved a new stock option plan ("ACC Plan") for the Company to be effected post-Merger. THE ACC PLAN The purpose of the ACC 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 11 percent of the outstanding shares as of December 31, 1998. 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. If an optionee dies or becomes totally and permanently disabled before expiration of the options without fully exercising them, he or she or the executors or administrators or legatees or distributees of the estate shall, as may be provided at the time of the grant, have the right, within one year after the optionee's death or total and permanent disability, to exercise the options in whole or in part before the expiration of their term. 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. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, the Company's compensation committee granted a total of 553,921 options and 5,189,944 options, respectively, to officers and non-officer directors of the Company under the ACC Plan. The options awarded to officers were generally non-qualified stock options that vest over a five-year period from the grant date. The stock options have been granted at the market price on the date of grant with a weighted average exercise price equal to $20.33 per share. At September 30, 1999, options for 1,460,111 shares were vested. 191,135 options were exercised and 149,611 options were cancelled during the nine months ended September 30, 1999. Options were exercised for 10,408 shares, and options were canceled for 65,638 shares during the year ended December 31, 1998. OLD PLAN ACTIVITY During 1997 and 1996, the Predecessor Companies granted 1,474,000 and 866,000 options, respectively, 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 and 1,051,000 during 1997 and 1996, respectively. 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. As of September 30, 1999 and December 31, 1998, 1997 and 1996, the Company had outstanding loans to officers of $27,276,000, $23,735,000, $29,611,000 and $15,491,000, respectively. Officers with outstanding loans repaid principal of $255,000, $5,591,000, $6,534,000, and $2,199,000 for the nine months ended September 30, 1999 and for the years ended December 31, 1998, 1997 and 1996, respectively. The F-29 104 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 12. STOCK OPTION PLAN, CONTINUED Company recognized interest income from these loans of $1,115,000, $1,600,000, $1,031,000 and $529,000, respectively, during these same periods. 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:
FOR THE YEARS ENDED DECEMBER 31, ----------------------------------------- 1998 1997 1996 --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net increase in net assets resulting from operations: As reported.......................................... $78,078 $61,304 $54,947 Pro forma............................................ $72,684 $60,656 $53,372 Basic earnings per common share: As reported.......................................... $ 1.50 $ 1.24 $ 1.19 Pro forma............................................ $ 1.39 $ 1.23 $ 1.16 Diluted earnings per common share: As reported.......................................... $ 1.50 $ 1.24 $ 1.17 Pro forma............................................ $ 1.39 $ 1.23 $ 1.14
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. NOTE 13. FORMULA AWARD AND CUT-OFF AWARD 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 percent 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 10) 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 will be expensed in each year in which it vests. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, $4,681,000 and $6,242,000, respectively was expensed as a result of the Formula Award. 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 F-30 105 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13. FORMULA AWARD AND CUT-OFF AWARD, CONTINUED Company stock is retired. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, $61,000 and $270,000, respectively, of the Formula Award was forfeited. On January 4, 1999, the Company distributed shares of the Company's common stock with a value of $4,062,000 representing the portion of the Formula Award that vested on December 31, 1998. 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 is computed for each unvested option as of the Merger date. The Cut-off Award is 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 is 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 approximates $2.9 million in the aggregate and is expensed as the Cut-off Award vests. For the nine months ended September 30, 1999 and for the year ended December 31, 1998, $507,000 and $807,000, respectively, of the Cut-off Award vested. F-31 106 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14. DIVIDENDS AND DISTRIBUTIONS The Company's Board of Directors declared and the Company paid a $1.20 per common share dividend, or $71,800,000, for the nine months ended September 30, 1999. For the years ended December 31, 1998, 1997 and 1996, the Company declared the following distributions:
1998 1997 1996 --------------- --------------- --------------- TOTAL TOTAL TOTAL TOTAL PER TOTAL PER TOTAL PER AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE ------- ----- ------- ----- ------- ----- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) First quarter............................ $18,025 $0.35 $14,347 $0.30 $11,158 $0.25 Second quarter........................... 17,966 0.35 14,795 0.30 11,911 0.26 Third quarter............................ 17,976 0.35 15,548 0.31 12,743 0.27 Fourth quarter........................... 19,444 0.35 31,022 0.61 13,678 0.29 Annual extra distribution................ 1,676 0.03 1,118 0.02 7,908 0.16 Special undistributed earnings distribution........................... -- -- 8,848 0.17 -- -- ------- ----- ------- ----- ------- ----- Total distributions to common shareholders........................... $75,087 $1.43 $85,678 $1.71 $57,398 $1.23 ======= ===== ======= ===== ======= =====
For income tax purposes, distributions for 1998, 1997 and 1996 were comprised of the following:
1998 1997 1996 --------------- --------------- --------------- TOTAL TOTAL TOTAL TOTAL PER TOTAL PER TOTAL PER AMOUNT SHARE AMOUNT SHARE AMOUNT SHARE ------- ----- ------- ----- ------- ----- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Ordinary income.......................... $49,397 $0.94 $39,356 $0.79 $41,563 $0.89 Long-term capital gains.................. 25,690 0.49 31,037 0.62 15,835 0.34 Return of capital (tax).................. -- -- 6,437 0.13 -- -- ------- ----- ------- ----- ------- ----- Total distributions before special distribution........................... 75,087 1.43 76,830 1.54 57,398 1.23 ------- ----- ------- ----- ------- ----- Special undistributed earnings distribution........................... -- -- 8,848 0.17 -- -- Total distributions to common shareholders........................... $75,087 $1.43 $85,678 $1.71 $57,398 $1.23 ======= ===== ======= ===== ======= =====
F-32 107 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14. DIVIDENDS AND DISTRIBUTIONS, CONTINUED The following table summarizes the differences between financial statement net income and taxable income for the years ended December 31, 1998, 1997 and 1996:
1998 1997 1996 ------- ------- ------- (IN THOUSANDS) Financial statement net income.............................. $78,078 $61,304 $54,947 Adjustments: Net unrealized (gains) losses.......................... (1,079) (7,209) 7,412 Amortization of discount............................... 2,207 (1,124) (2,779) Net gain on securitization of commercial mortgage loans................................................ (14,812) -- -- Interest income from securitized commercial mortgage loans................................................ 4,910 -- -- Gains from disposition of portfolio assets............. 1,177 17,890 874 Expenses not deductible for tax: Merger expenses................................... -- 5,159 -- Formula award..................................... 6,242 -- -- Other............................................. 1,393 853 2,306 Other.................................................. (3,029) (9,050) (1,372) Income tax expense..................................... -- 1,444 1,945 ------- ------- ------- Taxable income.............................................. $75,087 $69,267 $63,333 ======= ======= =======
NOTE 15. 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 September 30, 1999 and December 31, 1998 and 1997, cash and cash equivalents consisted of the following:
SEPTEMBER 30, 1999 1998 1997 ------------- ------- -------- (UNAUDITED) (IN THOUSANDS) Cash and cash equivalents..................... $22,455 $31,833 $76,791 Less escrows held............................. (7,079) (6,758) (6,354) ------- ------- ------- Total......................................... $15,376 $25,075 $70,437 ======= ======= =======
NOTE 16. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION For the nine months ended September 30, 1999 and for the years ended December 31, 1998, 1997 and 1996, the Company paid $16,707,000, $21,708,000, $26,874,000 and $21,391,000, respectively, for interest and income taxes. During 1999, 1998, 1997 and 1996, the Company's non-cash financing activities totaled $7,250,000, $6,237,000, $48,207,000 and $22,361,000, respectively, related primarily to common stock issuances resulting from stock option exercises and dividend reinvestment shares issued. During 1999, 1998, 1997 and 1996, the Company's non-cash investing activities totaled $2,226,000, $1,265,000, $12,022,000 and $2,004,000, respectively. F-33 108 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 17. SELECTED QUARTERLY DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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
1997 ------------------------------------- QTR 1 QTR 2 QTR 3 QTR 4 ------- ------- ------- ------- Total interest and related portfolio income............. $21,399 $24,911 $25,111 $25,984 Portfolio income before realized and unrealized gains... $11,968 $14,095 $12,093 $ 7,910 Net increase in net assets resulting from operations.... $12,646 $18,296 $17,146 $13,216 Basic earnings per common share......................... $ 0.27 $ 0.37 $ 0.35 $ 0.25 Diluted earnings per common share....................... $ 0.27 $ 0.37 $ 0.35 $ 0.25
F-34 109 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING BALANCE SHEET
DECEMBER 31, 1998 ------------------------------------------------------------------------ ALLIED ALLIED CONSOLIDATED ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL -------- ---------- ------- -------- ------------ ------------ (IN THOUSANDS) ASSETS Portfolio at value: Mezzanine loans and debt securities..... $264,968 $ 74,195 $ -- $ -- $ -- $339,163 Commercial mortgage loans............... 206,463 -- -- 26,723 -- 233,186 Commercial mortgage-backed securities... 32,221 -- -- 81,453 -- 113,674 Small Business Administration 7(a) loans................................. -- -- 56,285 -- -- 56,285 Equity interests in portfolio companies............................. 27,641 21,750 -- -- -- 49,391 Investments in subsidiaries............. 159,945 -- -- (335) (159,610) -- Other portfolio assets.................. 277 -- 50 8,248 -- 8,575 -------- -------- ------- -------- --------- -------- Total portfolio at value............ 691,515 95,945 56,335 116,089 (159,610) 800,274 -------- -------- ------- -------- --------- -------- Cash and cash equivalents.................... 5,308 15,068 2,776 1,923 -- 25,075 Intercompany notes and receivables........... 90,194 1,824 90 -- (92,108) -- Other assets................................. 16,822 1,932 9,360 2,734 (118) 30,730 -------- -------- ------- -------- --------- -------- Total assets........................ $803,839 $114,769 $68,561 $120,746 $(251,836) $856,079 ======== ======== ======= ======== ========= ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Debentures and notes payable............ $191,700 $ 47,650 $ -- $ -- $ -- $239,350 Revolving lines of credit............... 95,000 -- -- -- -- 95,000 Accounts payable and other liabilities........................... 25,003 858 1,655 396 -- 27,912 Dividends and distributions payable..... 1,700 5,085 5,594 -- (10,679) 1,700 Intercompany notes and payables......... 5,319 98 46,116 30,001 (81,534) -- -------- -------- ------- -------- --------- -------- 318,722 53,691 53,365 30,397 (92,213) 363,962 -------- -------- ------- -------- --------- -------- Commitments and contingencies Preferred stock issued to Small Business Administration............................. -- 7,000 -- -- -- 7,000 Shareholders' equity: Common stock............................ 6 -- -- 1 (1) 6 Additional paid-in capital.............. 526,824 38,604 17,563 82,294 (138,461) 526,824 Common stock held in deferred compensation trust.................... (19,431) -- -- -- -- (19,431) Notes receivable from sale of common stock................................. (23,735) -- -- -- -- (23,735) Net unrealized appreciation (depreciation) on portfolio........... 2,380 1,486 (2,072) (1,503) 2,089 2,380 Undistributed (distributions in excess of) earnings.......................... (927) 13,988 (295) 9,557 (23,250) (927) -------- -------- ------- -------- --------- -------- Total shareholders' equity.......... 485,117 54,078 15,196 90,349 (159,623) 485,117 -------- -------- ------- -------- --------- -------- Total liabilities and shareholders' equity............................ $803,839 $114,769 $68,561 $120,746 $(251,836) $856,079 ======== ======== ======= ======== ========= ========
The accompanying notes are an integral part of these consolidated financial statements. F-35 110 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1998 ----------------------------------------------------------------------- ALLIED ALLIED CONSOLIDATED ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL -------- ---------- ------- ------- ------------ ------------ (IN THOUSANDS) Interest and related portfolio income: Interest.................. $ 51,247 $11,836 $ 6,257 $10,581 $ -- $ 79,921 Intercompany interest income.................. 4,846 -- -- -- (4,846) -- Net premiums from loan dispositions............ 2,920 240 2,789 -- -- 5,949 Net gain on securitization of commercial mortgage loans................... -- -- -- 14,812 -- 14,812 Income from investments in wholly owned subsidiaries............ 48,873 -- -- -- (48,873) -- Investment advisory fees and other income........ 4,343 9 837 867 -- 6,056 -------- ------- ------- ------- -------- -------- Total interest and related portfolio income.............. 112,229 12,085 9,883 26,260 (53,719) 106,738 -------- ------- ------- ------- -------- -------- Expenses: Interest on indebtedness............ 15,092 4,651 711 240 -- 20,694 Intercompany interest on indebtedness............ -- 503 2,693 1,643 (4,839) -- Salaries and employee benefits................ 11,829 -- -- -- -- 11,829 General and administrative.......... 9,417 437 944 1,123 -- 11,921 -------- ------- ------- ------- -------- -------- Total operating expenses............ 36,338 5,591 4,348 3,006 (4,839) 44,444 -------- ------- ------- ------- -------- -------- Formula and cut-off awards.................. 7,049 -- -- -- -- 7,049 -------- ------- ------- ------- -------- -------- Portfolio income before realized and unrealized gains (losses)...................... 68,842 6,494 5,535 23,254 (48,880) 55,245 -------- ------- ------- ------- -------- -------- Net realized and unrealized gains: Net realized gains (losses)................ 8,156 10,407 (39) 4,017 -- 22,541 Net unrealized gains (losses)................ 956 (3,502) (1,679) (1,377) 6,681 1,079 -------- ------- ------- ------- -------- -------- Total net realized and unrealized gains (losses)............ 9,112 6,905 (1,718) 2,640 6,681 23,620 -------- ------- ------- ------- -------- -------- Income before minority interests and income taxes.............. 77,954 13,399 3,817 25,894 (42,199) 78,865 -------- ------- ------- ------- -------- -------- Minority interests.............. -- -- -- -- -- -- Income tax expense.............. -- -- -- 787 -- 787 -------- ------- ------- ------- -------- -------- Net increase in net assets resulting from operations..... $ 77,954 $13,399 $ 3,817 $25,107 $(42,199) $ 78,078 ======== ======= ======= ======= ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-36 111 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 1998 -------------------------------------------------------------------------- ALLIED ALLIED CONSOLIDATED ACC INVESTMENT SBLC OTHERS ELIMINATIONS TOTAL --------- ---------- -------- -------- ------------ ------------ (IN THOUSANDS) Cash flows from operating activities: Net increase in net assets resulting from operations..................... $ 77,954 $ 13,399 $ 3,817 $ 25,107 $(42,199) $ 78,078 Adjustments Net unrealized (gains) losses....... (956) 3,502 1,679 1,377 (6,681) (1,079) Net gain on securitization of commercial mortgage loans......... -- -- -- (14,812) -- (14,812) Depreciation and amortization....... 702 -- -- -- -- 702 Amortization of loan discounts and fees.............................. (4,741) (583) (708) -- -- (6,032) Changes in other assets and liabilities....................... 3,267 908 (2,329) 10,152 -- 11,998 --------- -------- -------- -------- -------- --------- Net cash provided by operating activities...................... 76,226 17,226 2,459 21,824 (48,880) 68,855 --------- -------- -------- -------- -------- --------- Cash flows from investing activities: Investments in small business concerns.......................... (426,797) (18,870) (57,725) (25,333) 4,195 (524,530) Collections of investment principal......................... 112,535 21,210 4,183 153 -- 138,081 Proceeds from loan sales............ 44,063 -- 36,950 -- -- 81,013 Proceeds from securitization of commercial mortgage loans......... 223,401 -- -- -- -- 223,401 Net (purchase) redemption of U.S. government securities............. -- 11,091 -- -- -- 11,091 Collections (advances) under intercompany notes................ (42,170) (19,756) 34,458 27,468 -- -- Collections of notes receivable from sale of common stock.............. 5,591 -- -- -- -- 5,591 Other investing activities.......... (2,539) -- -- -- -- (2,539) --------- -------- -------- -------- -------- --------- Net cash (used in) provided by investing activities............ (85,916) (6,325) 17,866 2,288 4,195 (67,892) --------- -------- -------- -------- -------- --------- Cash flows from financing activities: Sale of common stock................ 69,896 -- -- -- -- 69,896 Purchase of common stock by deferred compensation trust................ (19,431) -- -- -- -- (19,431) Purchase of common stock of subsidiaries...................... (5,000) -- 5,000 -- -- -- Common dividends and distributions paid.............................. (69,536) -- -- -- -- (69,536) Special undistributed earnings distribution paid................. (8,848) -- -- -- -- (8,848) Dividends paid to parent company.... -- (22,204) (5,594) (16,887) 44,685 -- Preferred stock dividends........... -- (450) -- -- -- (450) Net payments on debentures and notes payable........................... (53,871) (15,600) -- -- -- (69,471) Net borrowings under revolving lines of credit......................... 74,706 -- (18,548) -- -- 56,158 Other financing activities.......... 1,124 -- -- (5,767) -- (4,643) --------- -------- -------- -------- -------- --------- Net cash used in financing activities...................... (10,960) (38,254) (19,142) (22,654) 44,685 (46,325) --------- -------- -------- -------- -------- --------- Net (decrease) increase in cash and cash equivalents............................. (20,650) (27,353) 1,183 1,458 -- (45,362) --------- -------- -------- -------- -------- --------- Cash and cash equivalents at beginning of year.................................... 25,958 42,421 1,593 465 -- 70,437 --------- -------- -------- -------- -------- --------- Cash and cash equivalents at end of year.................................... $ 5,308 $ 15,068 $ 2,776 $ 1,923 $ -- $ 25,075 ========= ======== ======== ======== ======== =========
The accompanying notes are an integral part of these consolidated financial statements. F-37 112 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, 1998 and 1997, including the consolidated statement of investments as of December 31, 1998, 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, 1998. 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. 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, 1998 and 1997, 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. As discussed in Note 3, the consolidated financial statements include investments valued at $800,274,000 as of December 31, 1998 and $697,021,000 as of December 31, 1997, (93 percent and 86 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. 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 Anderson Vienna, Virginia February 18, 1999 F-38 113 ALLIED CAPITAL CORPORATION STATEMENT OF ADDITIONAL INFORMATION NOVEMBER , 1999 ------------------------- This Statement of Additional Information ("SAI") is not a prospectus, and should be read in conjunction with the prospectus dated November , 1999 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;12;36 Investment Objective and Policies........................... B-2 1;12;36 Management.................................................. B-2 53 Compensation of Executive Officers and Directors....... B-2 56 Compensation of Directors.............................. B-3 56 Stock Option Awards.................................... B-4 56 Formula Award and Cut-Off Award........................ B-4 56 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 53 Safekeeping, Transfer and Dividend Paying Agent and Registrar................................................. B-8 69 Accounting Services......................................... B-8 69 Brokerage Allocation and Other Practices.................... B-8 N/A Tax Status.................................................. B-9 59
------------------------- B-1 114 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 and in diverse geographic locations primarily in the United States. We focus on investments in three primary areas: mezzanine finance, commercial real estate finance and SBA 7(a) lending. Our investment portfolio consists primarily of small and middle-market subordinated loans with equity features, small and middle-market commercial mortgage loans, commercial mortgage-backed securities, and small senior loans. At September 30, 1999, our investment portfolio totaled $1,103.7 million. 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, 1998, to the directors and the three highest paid executive officers of the Company (collectively, the "Compensated Persons"). B-2 115 COMPENSATION TABLE
PENSION OR AGGREGATE SECURITIES RETIREMENT BENEFITS DIRECTORS FEES COMPENSATION FROM UNDERLYING ACCRUED AS PART OF PAID BY THE NAME AND POSITION THE COMPANY(1) OPTIONS/SARS(4) COMPANY EXPENSES COMPANY(5) ----------------- ----------------- --------------- ------------------- -------------- William L. Walton, Chairman and Chief Executive Officer(2)*.................. $2,158,599 754,188 $ -- $17,667 Joan M. Sweeney, Managing Director(2).......................... 1,178,920 374,275 -- 0 G. Cabell Williams III, Managing Director(2).......................... 896,873 278,403 -- 0 Brooks H. Browne, Director............. 10,500 -- -- 10,500 John D. Firestone, Director............ 11,500 -- -- 11,500 Anthony T. Garcia, Director............ 12,500 -- -- 12,500 Lawrence I. Hebert, Director........... 8,500 -- -- 8,500 John I. Leahy, Director................ 17,167 -- -- 17,167 Robert E. Long, Director............... 18,667 -- -- 18,667 Warren K. Montouri, Director........... 15,667 -- -- 15,667 Guy T. Steuart II, Director............ 11,000 -- -- 11,000 T. Murray Toomey, Director............. 7,500 -- -- 7,500 Laura W. van Roijen, Director.......... 8,500 -- -- 8,500 George C. Williams, Jr. Director, Chairman Emeritus(3)*................ 626,206 151,395 -- 18,167
- ------------------------- * Interested persons of the Company, as defined in the 1940 Act. (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 for 1998 as to the aggregate compensation of the three highest paid executive officers of the Company.
VESTED DEFERRED FORMULA CUT-OFF ESOP COMPENSATION DIRECTORS SALARY BONUS AWARD AWARD CONTRIBUTION CONTRIBUTION FEES -------- -------- ---------- -------- ------------ ------------ --------- Mr. Walton............ $351,517 $525,000 $1,056,683 $170,156 $8,000 $29,576 $17,667 Ms. Sweeney........... 222,191 275,000 619,154 38,965 8,000 15,610 -- G. Cabell Williams III................. 225,327 275,000 287,523 88,257 8,000 12,766 --
The Formula Award, which totaled approximately $19 million in the aggregate, 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 1998 for financial reporting purposes for Mr. Walton, Ms. Sweeney and Mr. Williams 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, 1999, the first vested installment of the Formula Award was generally distributed to participants at the market value of the Company's common stock on that day. The distribution amount for Mr. Walton, Ms. Sweeney and Mr. Williams was $1,056,683, $619,154 and $287,523, respectively. The Company 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, will be paid to individuals on the respective vesting date of any options under the Old Plans which were canceled in connection with the merger. See "-- Cut-Off Award and Formula Award." (3) In addition to director's fees, Mr. Williams received $144,000 in consulting fees, $32,686 in Cut-Off Award and $431,353 in vested Formula Award. The amount of the Formula Award expensed in 1998 for Mr. Williams was $601,068. (4) See "Stock Option Awards" for terms of options granted in 1998. The Company does not maintain a restricted stock plan or a long-term incentive plan. (5) Consists only of directors' fees paid by the Company during 1998. Such fees are also included in the column titled "Aggregate Compensation from the Company." COMPENSATION OF DIRECTORS During the first quarter of 1998, each director received a fee of $1,000 for each meeting of the board of directors or any separate committee meeting attended, and $500 for each committee meeting attended on the same day as a board of directors meeting. Beginning in April 1998, each director received $1,000 for each board or committee meeting attended, except with respect to the members B-3 116 of the executive committee, who each received an annual retainer of $10,000 in lieu of fees paid for each executive committee meeting attended. For 1998, this annual retainer was prorated. Non-officer directors are eligible for stock option awards under the Company's current stock option plan pursuant to an exemptive order from the Commission, which was granted on September 8, 1999. On that date, each incumbent director received options to purchase 10,000 shares, and will receive options to purchase 5,000 shares each year thereafter. See "-- Stock Option Awards" and "Management -- Compensation Plans -- Stock Option Plan" in the prospectus. STOCK OPTION AWARDS The following table sets forth the details relating to option grants in 1998 to the Company's Compensated Persons and the potential realizable value of each grant, as prescribed to be calculated by the Commission. OPTION GRANTS DURING 1998
POTENTIAL REALIZABLE VALUE AT ASSUMED ANNUAL NUMBER OF PERCENT RATES OF SECURITIES OF TOTAL EXERCISE STOCK APPRECIATION UNDERLYING OPTIONS PRICE OVER 10-YEAR TERM(3) OPTIONS GRANTED PER EXPIRATION ------------------------ NAME GRANTED(1) IN 1998(2) SHARE DATE 5% 10% ---- ---------- ---------- -------- ---------- ---------- ----------- William L. Walton......... 659,188 12.7% $21.375 1/8/08 $8,861,216 $22,456,060 95,000 1.8 $17.875 12/8/08 $1,067,942 $ 2,706,374 Joan M. Sweeney........... 319,275 6.2 $21.375 1/8/08 $4,291,893 $10,876,500 55,000 1.1 $17.875 12/8/08 $ 618,282 $ 1,566,848 G. Cabell Williams III.... 223,403 4.3 $21.375 1/8/08 $3,003,122 $ 7,610,501 55,000 1.1 $17.875 12/8/08 $ 618,282 $ 1,566,848 George C. Williams, Jr. .................... 141,395 2.7 $21.375 1/8/08 $1,900,720 $ 4,816,797 10,000 0.2 $17.875 12/8/08 $ 112,415 $ 284,881
- ------------------------- (1) Options granted in 1998 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. (2) In 1998, the Company granted options to purchase a total of 5,189,944 shares. (3) Potential realizable value is calculated on 1998 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. FORMULA AWARD AND CUT-OFF AWARD As discussed in the prospectus, prior to the merger options had been granted under the Old Plans to various employees of Advisers, who were also officers of the predecessor companies. In preparation for the merger, the compensation committee of Advisers, in conjunction with the compensation committee of the other predecessor companies, determined that the five Old Plans should be terminated upon the merger, so that the new merged Company would be able to develop a new plan that would incent all officers and directors with a single equity security. The existence of the Old Plans had resulted in certain inequities in option grants among the various officers of the predecessor companies simply because of the differences in the underlying equity securities. To balance stock option awards among employees, and to account for the deviations caused by the existence of five plans by five different publicly traded stocks, two special awards were developed to be granted in lieu of options under the Old Plans that were foregone upon the merger and the cancellation of the Old Plans. B-4 117 Formula Award. The Formula Award was designed to compensate officers from the point when their unvested options ceased to appreciate in value pursuant to the Cut-Off Award (i.e., August 14, 1997) up until the time at which they would be able to receive option awards in the Company after the merger became effective. In the aggregate, the Formula Award equaled six percent (6%) of the difference between the combined aggregate market capitalizations of the predecessor companies as of the close of the market on December 30, 1997, and the combined aggregate market capitalizations of the predecessor companies on August 14, 1997. In total, the combined aggregate market capitalization of the predecessor companies increased by $319 million from August 14, 1997 to December 30, 1997, and the aggregate Formula Award was approximately $19 million. The Formula Award was designed as a long-term incentive compensation program to be a replacement for canceled stock options and to balance share ownership among key officers for past and prospective service. The terms of the Formula Award required that the award be contributed to the Company's deferred compensation plan, and be used to purchase shares of the Company in the open market. The Formula Award vests and accrues equally over a three-year period, on the anniversary of the merger date (December 31, 1997), and vests automatically in the event of a change of control of the Company. If an officer terminates employment with the Company prior to the vesting of any part of the Formula Award, that amount will be forfeited to the Company. Assuming all officers meet the vesting requirement, the Company will accrue the Formula Award over the three-year period in equal amounts of approximately $6.4 million, less any forfeitures. For the year ended December 31, 1998, $6.2 million, net of forfeitures of $0.3 million, was expensed for the Formula Award. The following table indicates the Formula Award for each Compensated Person, and the related vesting schedule.
FORMULA AWARD RECIPIENT 1998 1999 2000 ----------------------- ---------- ---------- ---------- William L. Walton..................................... $1,472,451 $1,472,451 $1,472,451 Joan M. Sweeney....................................... 862,761 862,761 862,761 G. Cabell Williams III................................ 400,664 400,664 400,664 George C. Williams, Jr................................ 601,068 601,068 601,068
On January 4, 1999, the portion of the Formula Award that vested on December 31, 1998 was generally distributed to participants in the form of shares of the Company's common stock. These shares are held in restricted accounts at a brokerage firm. Cut-Off Award. The Cut-Off Award established a cut-off dollar amount as of the date of the announcement of the merger (August 14, 1997) that was computed for all outstanding, but unvested options that were canceled as of the date of the merger. The Cut-Off Award was designed to cap the appreciated value in unvested options as of 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 is equal to the difference between the market price of the shares of stock underlying the canceled options under the Old Plans at August 14, 1997, less the exercise prices of the options. The Cut-Off Award is payable for each canceled option as the canceled options would have vested and will vest automatically in the event of a change of control. The Cut-Off Award is only payable if the award recipient is employed by the Company on the future vesting date. The B-5 118 following table indicates the Cut-Off Award for each Compensated Person, and the related vesting schedule.
CUT-OFF AWARD RECIPIENT 1998 1999 2000 2001 2002 - ---------------------------------------------- -------- -------- -------- ------- ------- William L. Walton............................. $170,157 $170,157 $170,157 $ 0 $ 0 Joan M. Sweeney............................... 38,964 37,678 36,602 2,026 0 G. Cabell Williams III........................ 88,257 46,802 39,677 21,152 18,916 George C. Williams, Jr........................ 32,686 4,688 52,373 0 0
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 of the board of directors as the board of directors may from time to time grant to it, except where action by the board of directors is required by statute, an order of the Commission or the Company's charter or bylaws. In addition, the Executive Committee is authorized to approve all investments over $10 million, or any investment that possesses unusual risk/reward characteristics. The Executive Committee consists of Messrs. Walton, Leahy, Long, Montouri, and Williams. The Executive Committee met sixteen times during 1998. 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 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 1998. 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 four times during 1998. The Nominating Committee recommends candidates for election as directors. The Nominating Committee consists of Messrs. Walton, Hebert, Toomey and Steuart, and Ms. van Roijen. The Nominating Committee met once in 1998. B-6 119 CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES As of November 5, 1999, 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, at November 5, 1999, the beneficial ownership of the shareholders owning 5% or more of the common stock outstanding as well as 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.
NAME OF NUMBER OF SHARES PERCENTAGE OF BENEFICIAL OWNER OWNED BENEFICIALLY CLASS (1) - ------------------------------------------------------ ------------------ ------------- Wallace R. Weitz and Company 1125 South 103rd Street Omaha, NE 68124 3,167,000 5.1% DIRECTORS: William L. Walton................................... 812,952(2,3) 1.3% Brooks H. Browne.................................... 50,168 * John D. Firestone................................... 30,876 * Anthony T. Garcia................................... 62,507 * Lawrence I. Hebert.................................. 26,800 * John I. Leahy....................................... 26,818 * Robert E. Long...................................... 19,796 * Warren K. Montouri.................................. 216,182 * Guy T. Steuart II................................... 328,180(4) * T. Murray Toomey, Esq. ............................. 42,666(5) * Laura W. van Roijen................................. 38,412 * George C. Williams, Jr.............................. 381,944 * EXECUTIVE OFFICERS: Philip A. McNeill................................... 197,741(2) * Penni F. Roll....................................... 73,721(2) * John M. Scheurer.................................... 372,294(2) * Joan M. Sweeney..................................... 321,409(2) * G. Cabell Williams III.............................. 749,514(2,3) 1.2% All directors and executive officers as a group (17 in number)................................... 3,390,301(6) 5.5%
- ------------------------- * Less than 1% (1) Based on a total of 62,491,777 shares of the Company's common stock issued and outstanding on November 5, 1999 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. (2) Share ownership for the following directors and executive officers includes:
OPTIONS EXERCISABLE ALLOCATED OWNED WITHIN 60 DAYS TO ESOP DIRECTLY OF NOV. 5, 1999 ACCOUNT -------- --------------- --------- Mr. Walton.................................................. 277,400 235,564 874 Mr. Williams, Jr............................................ 284,346 97,598 -- Mr. McNeill................................................. 112,337 118,344 8,727 Ms. Roll.................................................... 49,884 24,551 3,453 Mr. Scheurer................................................ 235,267 124,043 22,151 Ms. Sweeney................................................. 196,355 124,759 9,462 Mr. Williams III............................................ 365,998 92,802 69,675
In addition, the beneficial ownership of each non-officer director includes exercisable options to purchase 10,000 shares. (3) Includes 299,988 shares held by the ESOP, of which Messrs. Walton and Williams III are co-trustees. Participants in the ESOP may direct the voting of these shares; however, if a participant does not direct the voting, the co-trustees of the ESOP will vote the shares on behalf of the participants. Messrs. Walton and Williams III disclaim beneficial ownership of such shares. As of November 5, 1999, substantially all shares held in the ESOP had been allocated. B-7 120 (4) Includes 276,691 shares held by a corporation for which Mr. Steuart serves as an executive officer. (5) Shares are held by a trust for the benefit of Mr. Toomey and his wife. (6) Includes a total of 917,661 shares underlying stock options exercisable within 60 days of November 5, 1999, which are assumed to be outstanding for the purpose of calculating the group's percentage ownership, and 299,988 shares held by the ESOP. 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 88 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 36 other professional employees and staff. For our mezzanine and CMBS transactions, our investment decisions are made by an investment committee, which is composed of senior investment professionals of the Company. For Allied Capital Express transactions, a committee comprised of small business and real estate lenders meet to approve all loans. 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. ACCOUNTING SERVICES Arthur Andersen LLP ("Andersen") has served as the independent accountant to the Company since December 31, 1997. Prior to the year ended December 31, 1997, Allied Lending's financial statements were audited by Matthews, Carter and Boyce, P.C., or its predecessor ("Matthews"). On December 12, 1997, Matthews resigned, effective upon the consummation of the merger, and Andersen was engaged and continues as the independent accountants of the Company. The decision to change accountants was recommended by the Company's Audit Committee and was approved by the board of directors of the Company. For the year ended December 31, 1996, and up to the date of resignation of Matthews, there were no disagreements with Matthews on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure which, if not resolved to the satisfaction of Matthews, would have caused it to make reference to the subject matter of the disagreement in connection with its report. The independent accountants' report on the 1996 financial statements did not contain an adverse opinion or a disclaimer of opinion, and was not qualified or modified as to uncertainty, audit scope or accounting principles. Each of Andersen and Matthews has advised the Company that neither it nor any present member or associate of the relevant firm has any financial interest, direct or indirect, in the Company or its subsidiaries. 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-8 121 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 and financial institutions. This summary does not discuss any aspects of foreign, state or local tax laws. 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 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 and 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 of one issuer (other than U.S. government securities or securities of other RICs) 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 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. B-9 122 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 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 or 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. 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 B-10 123 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) 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. 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. B-11 124 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"). Among other things, the Final Withholding Regulations may require Non-U.S. Stockholders to furnish new certification of their foreign status not later than December 31, 1999. Prospective 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-12 125 PART C OTHER INFORMATION ITEM 24. FINANCIAL STATEMENTS AND EXHIBITS 1. FINANCIAL STATEMENTS. The following financial statements of Allied Capital Corporation (the "Company" or the "Registrant") are included in this registration statement in "Part A: Information Required in a Prospectus":
PAGE ---- Consolidated Balance Sheet -- September 30, 1999 (unaudited) and December 31, 1998 and 1997.............................. F-1 Consolidated Statement of Operations -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and for the Years Ended December 31, 1998, 1997 and 1996.............. F-2 Consolidated Statement of Changes in Net Assets -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and For the Years Ended December 31, 1998, 1997 and 1996...................................................... F-3 Consolidated Statement of Cash Flows -- For the Nine Months Ended September 30, 1999 and 1998 (unaudited) and for the Years Ended December 31, 1998, 1997 and 1996.............. F-4 Consolidated Statement of Investments -- September 30, 1999 (unaudited) and December 31, 1998......................... F-5 Notes to Consolidated Financial Statements.................. F-16 Report of Independent Public Accountants.................... F-38
2. EXHIBITS
EXHIBIT NUMBER DESCRIPTION - ------- ----------- a.1(1) Articles of Amendment and Restatement of the Articles of Incorporation. a.2(2) Articles of Merger. b.(3) Bylaws. c. Not applicable. d.(6) Specimen certificate of the Company's Common Stock, par value $0.0001, the rights of holders of which are defined in Exhibits a.1, a.2 and b. e.(3) Dividend Reinvestment Plan. f.1(4) Form of debenture between certain subsidiaries of ACC and the U.S. Small Business Administration. f.2.a(11) Credit Agreement dated as of March 9, 1999 between the Company, as borrower, each of the financial institutions initially a signatory thereto, as Lenders, and Nationsbank, N.A., as administrative agent, Nationsbanc Montgomery Securities LLC, as sole lead arranger and sole book manager, First Union National Bank, as syndication agent, BankBoston, N.A., as documentation agent, Riggs Bank, N.A., as managing agent, and Chevy Chase Bank, F.S.B. and Credit Lyonnais New York Branch, as co-agents. f.2.b(12) First Amendment to Credit Agreement dated May 7, 1999. f.3(7) Note Agreement dated as of April 30, 1998. f.4(5) Loan Agreement between Allied I and Overseas Private Investment Corporation, dated April 10, 1995. Letter dated December 11, 1997 evidencing assignment of Loan Agreement from Allied I to the Company. f.5(12) Note Agreement dated as of May 1, 1999. f.6* Second Amended and Restated Master Loan & Security Agreement dated October 28, 1999 between the Company and Morgan Stanley Mortgage Capital, Inc.
C-1 126
EXHIBIT NUMBER DESCRIPTION - ------- ----------- f.7.a(6) Sale and Servicing Agreement dated, as of January 1, 1998, among Allied Capital CMT, Inc., Allied Capital Commercial Mortgage Trust 1998-1 and Allied Capital Corporation and LaSalle National Bank and ABN AMRO Bank N.V. f.7.b(6) Indenture dated as of January 1, 1998, between the Allied Capital Commercial Mortgage Trust 1998-1 and LaSalle National Bank. f.7.c(6) Amended and Restated Trust Agreement, dated January 1, 1998 between Allied Capital CMT, LaSalle National Bank Inc. and Wilmington Trust Company. f.7.d(6) Guaranty dated as of January 1, 1998 by the Company. g. Not applicable. h.1(13) Form of Underwriting Agreement, if applicable. i.1(3) Employee Stock Ownership Plan, as amended on December 31, 1997. i.1a(7) First Amendment to the Allied Capital Corporation Employee Stock Ownership Plan dated April 30, 1998. i.1b* Termination Amendment to the Allied Capital Employee Stock Ownership Plan effective December 31, 1999. i.2(10) Amended and Restated Deferred Compensation Plan dated December 30, 1998. i.3(9) Stock Option Plan. i.4 Description of Formula Award and Cut-Off Award Arrangements. A discussion of the Formula and Cut-off Awards is set forth on pages 56 through 58 of the Prospectus to the Registration Statement and pages B-4 through B-6 of the SAI. i.5(14) Allied Capital 401(k) Plan dated September 1, 1999. j.1(6) Form of Custody Agreement with Riggs Bank N.A. with respect to safekeeping. j.2(6) Form of Custody Agreement with LaSalle National Bank. l.* Opinion of counsel and consent to its use. m. Not applicable. n.1* Consent of Arthur Andersen LLP, independent public accountants. n.2* Consent of Sutherland Asbill & Brennan LLP (included in Exhibit l). o. Not applicable. p. Not applicable. q. Not applicable.
- ------------------------- * Filed herewith. (1) Incorporated by reference to exhibit 3(i) filed with Allied Lending's Annual Report on Form 10-K for the year ended December 31, 1996. (2) Incorporated by reference from Appendix B to the Company's registration statement on Form N-14 filed on September 26, 1997 (File No. 333-36459). (3) Incorporated by reference to the exhibit of the same name filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1997. (4) Incorporated by reference to the exhibit of the same name filed with Allied I's Annual Report on Form 10-K for the year ended December 31, 1996. (5) Incorporated by reference to the exhibit f.7 filed with Allied I's Pre-Effective Amendment No. 2 to the registration statement on Form N-2 on January 24, 1996 (File No. 33-64629). Assignment to the Company is incorporated by reference to Exhibit 10.3 of the Company's Annual Report on Form 10-K for the year ended December 31, 1997. (6) Incorporated by reference to the exhibit of the same name to the Company's registration statement on Form N-2 filed on the Company's behalf with the Commission on May 5, 1998 (File No. 333-51899). (7) Incorporated by reference to the exhibit of same name filed with the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1998. (8) Incorporated by reference to the exhibit of the same name filed with the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1998. (9) Incorporated by reference to Exhibit 4 of the Allied Capital Corporation Stock Option Plan registration statement on Form S-8, filed on behalf of such Plan on February 3, 1998 (File No. 333-45525).
C-2 127 (10) Incorporated by reference to the exhibit of the same name filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1998. (11) Incorporated by reference to Exhibit f.2.a with the Company's registration statement on Form N-2 (File No. 333-75161) filed on March 26, 1999. (12) Incorporated by reference to the exhibit of the same name filed with the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1999. (13) Incorporated by reference to Exhibit h.1 filed with this registration statement (File No. 333-84973). (14) Incorporated by reference to Exhibit 4.4 of the Allied Capital 401(k) Plan registration statement on Form S-8, filed on behalf of such Plan on October 8, 1999 (File No. 333-88681).
ITEM 25. MARKETING ARRANGEMENTS The information contained under the heading "Plan of Distribution" on page 65 of the prospectus is incorporated herein by reference, and any information concerning any underwriters will be contained in the accompanying prospectus supplement, if any. ITEM 26. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION Commission registration fee*................................ $ 19,532 NASD filing fee*............................................ $ 7,526 Nasdaq National Market Additional Listing Fee*.............. $ 80,000 Accounting fees and expenses................................ $100,000 Legal fees and expenses..................................... $300,000 Printing and engraving...................................... $250,000 Miscellaneous fees and expenses............................. $ 2,942 -------- Total.................................................. $760,000 ========
- ------------------------- * Estimated for filing purposes. All of the expenses set forth above shall be borne by the Company. ITEM 27. PERSONS CONTROLLED BY OR UNDER COMMON CONTROL Direct Subsidiaries The following list sets forth each of the Company's subsidiaries, the state or country under whose laws the subsidiary is organized, and the percentage of voting securities or membership interests owned by the Company in such subsidiary: Allied Investment Corporation (Maryland).................... 100% Allied Capital SBLC Corporation (Maryland).................. 100% Allied Capital REIT, Inc. ("Allied REIT") (Maryland)........ 100% Allied Capital Holdings LLC (Delaware)...................... 100% Allied Capital Beteiligungsberatung GmbH (Germany).......... 100%
Each of the Company's subsidiaries are consolidated with the Company for financial reporting purposes, except as noted below. Indirect Subsidiaries The Company indirectly controls the entities set forth below through Allied REIT. Allied REIT owns either all of the membership interests (in the case of a limited liability company, "LLC") or all of the outstanding voting stock (in the case of a corporation) of each entity. The following list sets C-3 128 forth each of Allied REIT's subsidiaries, the state under whose laws the subsidiary is organized, and the percentage of voting securities or membership interests owned by Allied REIT of such subsidiary: Allied Capital Property LLC (Delaware)...................... 100% Allied Capital Equity LLC (Delaware)........................ 100% 9586 I-25 East Frontage Road, Longmont, CO 80504 LLC (Delaware)................................................ 100% 8930 Stanford Boulevard LLC (Delaware)...................... 100% Allied Capital CMT, Inc. (Delaware)......................... 100%
Allied REIT also indirectly owns Allied Capital Commercial Mortgage Trust 1998-1, a Delaware business trust that is wholly owned by Allied Capital CMT, Inc. ("CMT"). Each subsidiary of Allied REIT and CMT is not required to maintain financial and other reports required under the Securities Act because each does not have a class of securities registered under the Securities Act. The Company indirectly controls Allied Capital SBLC Holdings LLC (Delaware) through Allied Capital SBLC Corporation, which owns 100% of the membership interests. The Company indirectly controls Allied Investment Holdings LLC (Delaware) through Allied Investment Corporation, which owns 100% of the membership interests. Other Entities Deemed to be Controlled by the Company The Company provides investment advisory services to the certain entities and therefore may be deemed to control such entities and their respective subsidiaries. The following list sets forth each such entity and its respective subsidiaries and the state under whose laws the entity or subsidiary is organized: Allied Capital Germany Fund LLC (Delaware)(1, 2) Allied Capital Syndication LLC (Delaware)(2) Business Mortgage Investors, Inc. (Maryland)(1) Wholly owned subsidiaries of Business Mortgage Investors, Inc.: BMI Holdings, Inc. (Maryland) BMI Funding, Inc. (Delaware) Indirect subsidiary of Business Mortgage Investors, Inc. BMI Funding LLC (Delaware), of which BMI Funding, Inc. owns substantially all membership interests The Company has also established certain limited purpose entities in order to facilitate certain portfolio transactions. - ------------------------- (1) By so including these entities herein, the Registrant does not concede that it controls such entities. (2) Subsidiary does not consolidate for financial reporting purposes. ITEM 28. NUMBER OF HOLDERS OF SECURITIES The following table sets forth the approximate number of record holders of the Company's Common Stock at November 5, 1999.
NUMBER OF TITLE OF CLASS RECORD HOLDERS -------------- -------------- Common Stock, $0.0001 par value........................... 4,500
C-4 129 ITEM 29. INDEMNIFICATION The Annotated Code of Maryland, Corporations and Associations (the "Maryland Law"), Section 2-418 provides that a Maryland corporation may indemnify any director of the corporation and any person who, while a director of the corporation, is or was serving at the request of the corporation as a director, officer, partner, trustee, employee, or agent of another foreign or domestic corporation, partnership, joint venture, trust, other enterprise or employee benefit plan, made a party to any proceeding by reason of service in that capacity unless it is established that the act or omission of the director was material to the matter giving rise to the proceeding and was committed in bad faith or was the result of active and deliberate dishonesty; or the director actually received an improper personal benefit in money, property or services; or, in the case of any criminal proceeding, the director had reasonable cause to believe that the act or omission was unlawful. Indemnification may be made against judgments, penalties, fines, settlements, and reasonable expenses actually incurred by the director in connection with the proceeding, but if the proceeding was one by or in the right of the corporation, indemnification may not be made in respect of any proceeding in which the director shall have been adjudged to be liable to the corporation. Such indemnification may not be made unless authorized for a specific proceeding after a determination has been made, in the manner prescribed by the law, that indemnification is permissible in the circumstances because the director has met the applicable standard of conduct. On the other hand, the director must be indemnified for expenses if he or she has been successful in the defense of the proceeding or as otherwise ordered by a court. The law also prescribes the circumstances under which the corporation may advance expenses to, or obtain insurance or similar cover for, directors. The law also provides for comparable indemnification for corporate officers and agents. The Articles of Incorporation of the Company provide that its directors and officers shall, and its agents in the discretion of the board of directors may, be indemnified to the fullest extent permitted from time to time by the laws of Maryland (with such power to indemnify officers and directors limited to the scope provided for in Section 2-418 as currently in force), provided, however, that such indemnification is limited by the Investment Company Act of 1940 or by any valid rule, regulation or order of the Securities and Exchange Commission thereunder. The Company's Bylaws, however, provide that the Company may not indemnify any director or officer against liability to the Company or its security holders to which he or she might otherwise be subject by reason of such person's willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of his or her office unless a determination is made by final decision of a court, by vote of a majority of a quorum of directors who are disinterested, non-party directors or by independent legal counsel that the liability for which indemnification is sought did not arise out of such disabling conduct. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Company pursuant to the provisions described above, or otherwise, the Company has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Company of expenses incurred or paid by a director, officer or controlling person in the successful defense of an action, suit or proceeding) is asserted by a director, officer or controlling person in connection with the securities being registered, the Company will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of the court of the issue. The Company carries liability insurance for the benefit of its directors and officers on a claims-made basis of up to $10,000,000, subject to a $250,000 retention and the other terms thereof. C-5 130 The Agreement and Plan of Merger (the "Merger Agreement") by and among Advisers, Allied I, Allied II, Allied Lending and Allied Commercial provides that, from and after consummation of the Merger the Company shall indemnify any person who at the date of the Merger Agreement, or had been at any time prior to such date or who becomes prior to the effective time of the merger, an officer or director of Allied I, Allied II, Allied Commercial or Advisers, or any of their respective subsidiaries, from any and all liabilities resulting from their acts and omissions prior to the effective time of the merger to the full extent permitted by Maryland Law and the 1940 Act, including but not limited to acts and omissions arising out of or pertaining to the merger, and shall maintain in effect for at least 72 months directors' and officers' liability insurance policies with respect to matters occurring prior to the effective time of the merger. ITEM 30. BUSINESS AND OTHER CONNECTIONS OF INVESTMENT ADVISER Not applicable. ITEM 31. LOCATION OF ACCOUNTS AND RECORDS The Company maintains at its principal office physical possession of each account, book or other document required to be maintained by Section 31(a) of the 1940 Act and the rules thereunder. ITEM 32. MANAGEMENT SERVICES Not applicable. ITEM 33. UNDERTAKINGS The Registrant hereby undertakes: (1) to suspend the offering of shares until the prospectus is amended if subsequent to the effective date of this Registration Statement, its net asset value declines more than ten percent from its net asset value as of the effective date of this Registration Statement; (2) to file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) to include any prospectus required by Section 10(a)(3) of the Securities Act of 1933; (ii) to reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) under the Securities Act of 1933 if, in the aggregate, the changes in volume and price represent no more than a 20% change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement; and (iii) to include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement. C-6 131 (3) that, for the purpose of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this Registration Statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant under Rule 497(h) under the Securities Act of 1933 shall be deemed to be part of this Registration Statement as of the time it was declared effective; (4) to remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering; (5) that, for the purpose of determining any liability under the Securities Act of 1933, each post effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of the securities at that time shall be deemed to be the initial bona fide offering thereof; and (6) to send by first class mail or other means designed to ensure equally prompt delivery, within two business days of receipt of a written or oral request, any Statement of Additional Information. Subject to the terms and conditions of Section 15(d) of the Securities Exchange Act of 1934, the registrant hereby undertakes to file with the Securities and Exchange Commission such supplementary and periodic information, documents and reports as may be prescribed by any rule or regulation of the Commission heretofore or hereafter duly adopted pursuant to authority conferred in that section. Insofar as indemnification for liability arising under the Securities Act may be permitted to directors, officers and controlling persons of the registrant pursuant to the provisions of its charter and bylaws permitting indemnification, or otherwise, the registrant has been advised that in the opinion of the Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. C-7 132 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Washington, in the District of Columbia, on the 10th day of November, 1999. ALLIED CAPITAL CORPORATION By: /s/ William L. Walton ---------------------------------------- William L. Walton Chief Executive Officer and President Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities indicated on November 10, 1999.
SIGNATURE TITLE --------- ----- /s/ WILLIAM L. WALTON Chairman of the Board, Chief Executive Officer, and - --------------------------------------------- President William L. Walton * Director - --------------------------------------------- Brooks H. Browne * Director - --------------------------------------------- John D. Firestone * Director - --------------------------------------------- Anthony T. Garcia * Director - --------------------------------------------- Lawrence I. Hebert * Director - --------------------------------------------- John I. Leahy * Director - --------------------------------------------- Robert E. Long * Director - --------------------------------------------- Warren K. Montouri * Director - --------------------------------------------- Guy T. Steuart II * Director - --------------------------------------------- T. Murray Toomey * Director - --------------------------------------------- Laura W. van Roijen
133
SIGNATURE TITLE --------- ----- * Director - --------------------------------------------- George C. Williams /s/ PENNI F. ROLL Executive Vice President and Chief Financial - --------------------------------------------- Officer (Principal Financial and Accounting Penni F. Roll Officer)
* Signed by William L. Walton pursuant to a power of attorney signed by the individual and filed with this registration statement on August 11, 1999. 134 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION - --------------- ----------- Ex - 99.2f.6 Second Amended and Restated Master Loan & Security Agreement Ex - 99.2i.1b Termination Amendment to ESOP Ex - 99.2n.1 Consent of Arthur Andersen LLP, independent public accountants Ex - 99.21 Opinion of counsel and consent to its use
EX-99.2F.6 2 2ND AMENDED + RESTATED MASTER LOAN & SECURITY AGMT 1 EXHIBIT 99.2f.6 EXECUTION COPY SECOND AMENDED AND RESTATED MASTER LOAN AND SECURITY AGREEMENT _____________________________ DATED AS OF OCTOBER 28, 1999 ______________________________ ALLIED CAPITAL CORPORATION, AS BORROWER AND MORGAN STANLEY MORTGAGE CAPITAL INC. AS LENDER 2 TABLE OF CONTENTS
Page ---- SECTION 1. DEFINITIONS AND ACCOUNTING MATTERS. ----------------------------------- 1.01 Certain Defined Terms. ......................................................................... 1 ---------------------------- 1.02 Accounting Terms and Determinations. ........................................................... 10 ------------------------------------------ SECTION 2. LOANS, NOTE AND PREPAYMENTS. ---------------------------- 2.01 Loans. ......................................................................................... 11 ------------ 2.02 Notes. ......................................................................................... 11 ------------ 2.03 Procedure for Borrowing. ....................................................................... 11 ------------------------------ 2.04 Limitation on Types of Loans; Illegality. ...................................................... 12 ----------------------------------------------- 2.05 Repayment of Loans; Interest. .................................................................. 13 ----------------------------------- 2.06 Mandatory Prepayments or Pledge. ............................................................... 13 -------------------------------------- 2.07 Indemnity. ..................................................................................... 13 ---------------- 2.08 Extension of Termination Date. ................................................................. 14 ------------------------------------ SECTION 3. PAYMENTS; COMPUTATIONS; ETC. ---------------------------- 3.01 Payments. ...................................................................................... 14 --------------- 3.02 Computations. .................................................................................. 14 ------------------- 3.03 Requirements of Law. ........................................................................... 14 -------------------------- 3.04 Facility Fee; Exit Fee. ........................................................................ 15 ----------------------------- SECTION 4. COLLATERAL SECURITY. -------------------- 4.01 Collateral; Security Interest. ................................................................. 16 ------------------------------------ 4.02 Further Documentation.. ........................................................................ 17 ---------------------------- 4.03 Changes in Locations, Name, etc.. .............................................................. 17 -------------------------------------- 4.04 Lender's Appointment as Attorney-in-Fact. ...................................................... 18 ----------------------------------------------- 4.05 Performance by Lender of Borrower's Obligations. ............................................... 19 ------------------------------------------------------ 4.06 Proceeds.. ..................................................................................... 19 --------------- 4.07 Remedies. ...................................................................................... 19 --------------- 4.08 Limitation on Duties Regarding Preservation of Collateral. ..................................... 20 ---------------------------------------------------------------- 4.09 Powers Coupled with an Interest. ............................................................... 21 -------------------------------------- 4.10 Release of Security Interest.. ................................................................. 21 ----------------------------------- SECTION 5. CONDITIONS PRECEDENT. --------------------- 5.01 Initial Loan. .................................................................................. 21 ------------------- 5.02 Initial and Subsequent Loans. .................................................................. 22 ----------------------------------- SECTION 6. REPRESENTATIONS AND WARRANTIES. ------------------------------- 6.01 Existence. ..................................................................................... 23 ---------------- 6.02 Financial Condition. ........................................................................... 24 -------------------------- 6.03 Litigation. .................................................................................... 24 ----------------- 6.04 No Breach.. .................................................................................... 24 ---------------- 6.05 Action. ........................................................................................ 25 -------------
-i- 3 6.06 Approvals. ..................................................................................... 25 ---------------- 6.07 Margin Regulations. ............................................................................ 25 ------------------------- 6.08 Taxes. ......................................................................................... 25 ------------ 6.09 Investment Company Act.. ....................................................................... 25 ----------------------------- 6.10 Collateral; Collateral Security. ............................................................... 25 -------------------------------------- 6.11 Chief Executive Office. ........................................................................ 26 ----------------------------- 6.12 Location of Books and Records.. ................................................................ 26 ------------------------------------ 6.13 Hedging. ....................................................................................... 26 -------------- 6.14 True and Complete Disclosure. .................................................................. 26 ----------------------------------- 6.15 Consolidated Shareholders' Equity. ............................................................. 27 ---------------------------------------- 6.16 ERISA. ......................................................................................... 27 ------------ 6.17 Material Subsidiaries. ......................................................................... 27 ---------------------------- SECTION 7. COVENANTS OF THE BORROWER. -------------------------- 7.01 Financial Statements. .......................................................................... 27 --------------------------- 7.02 Litigation. .................................................................................... 28 ----------------- 7.03 Existence, etc. ................................................................................ 28 --------------------- 7.04 Prohibition of Fundamental Changes. ............................................................ 29 ----------------------------------------- 7.05 Borrowing Base Deficiency. ..................................................................... 29 -------------------------------- 7.06 Notices. ....................................................................................... 29 -------------- 7.07 Hedging. ....................................................................................... 29 -------------- 7.08 Reports. ....................................................................................... 30 -------------- 7.09 Underwriting Guidelines. ....................................................................... 30 ------------------------------ 7.10 Transactions with Affiliates. .................................................................. 30 ----------------------------------- 7.11 Limitation on Liens. ........................................................................... 30 -------------------------- 7.12 Limitation on Distributions. ................................................................... 30 ---------------------------------- 7.13 Consolidated Shareholders' Equity. ............................................................. 31 ---------------------------------------- 7.14 Maintenance of Ratio of Total Indebtedness to Consolidated Shareholders' Equity. ............... 31 -------------------------------------------------------------------------------------- 7.15 Maintenance of Profitability. .................................................................. 31 ----------------------------------- 7.16 Servicing Tape.. ............................................................................... 31 --------------------- 7.17 Interest Rate Protection Agreements. ........................................................... 31 ------------------------------------------ 7.18 Required Filings. .............................................................................. 31 ----------------------- 7.19 No Adverse Selection. .......................................................................... 31 --------------------------- 7.20 Computer Systems. .............................................................................. 31 ----------------------- 7.21 ERISA.. ........................................................................................ 31 ------------ 7.22 Remittance of Prepayments. ..................................................................... 31 -------------------------------- 7.23 Lender's Right to Purchase. .................................................................... 31 --------------------------------- 7.24 Securitizations. ............................................................................... 32 ---------------------- 7.25 Material Subsidiaries. ......................................................................... 32 ----------------------------
-ii- 4 SECTION 8. EVENTS OF DEFAULT. ------------------ SECTION 9. REMEDIES UPON DEFAULT. ---------------------- SECTION 10. NO DUTY OF LENDER. ------------------ SECTION 11. MISCELLANEOUS. -------------- 11.01 Waiver. ........................................................................................ 35 ----------- 11.02 Notices. ....................................................................................... 35 ------------ 11.03 Indemnification and Expenses. .................................................................. 35 --------------------------------- 11.04 Amendments. .................................................................................... 36 --------------- 11.05 Successors and Assigns. ........................................................................ 36 --------------------------- 11.06 Survival.. ..................................................................................... 36 ------------- 11.07 Captions. ...................................................................................... 37 ------------- 11.08 Counterparts. .................................................................................. 37 ----------------- 11.09 Loan Agreement Constitutes Security Agreement; Governing Law. .................................. 37 ----------------------------------------------------------------- 11.10 SUBMISSION TO JURISDICTION; WAIVERS. ........................................................... 37 ---------------------------------------- 11.11 WAIVER OF JURY TRIAL. .......................................................................... 37 ------------------------- 11.12 Acknowledgments. ............................................................................... 38 -------------------- 11.13 Hypothecation or Pledge of Loans. .............................................................. 38 ------------------------------------- 11.14 Servicing. ..................................................................................... 38 -------------- 11.15 Periodic Due Diligence Review. ................................................................. 39 ---------------------------------- 11.16 Set-Off. ....................................................................................... 40 ------------ 11.17 Intent. ........................................................................................ 40 -----------
SCHEDULES SCHEDULE 1 Representations and Warranties re: Mortgage Loans SCHEDULE 2 Filing Jurisdictions and Offices SCHEDULE 3 List of Material Subsidiaries EXHIBITS EXHIBIT A Form of Second Amended and Restated Promissory Note EXHIBIT B Second Amended and Restated Custodial Agreement EXHIBIT C Opinion of Counsel to Borrower EXHIBIT D Form of Request for Borrowing EXHIBIT E-1 Form of Borrower's Release Letter EXHIBIT E-2 Form of Warehouse Lender's Release Letter EXHIBIT F Underwriting Guidelines EXHIBIT G Form of Servicer Notice -iii- 5 SECOND AMENDED AND RESTATED MASTER LOAN AND SECURITY AGREEMENT SECOND AMENDED AND RESTATED MASTER LOAN AND SECURITY AGREEMENT, dated as of October 28, 1999, among ALLIED CAPITAL CORPORATION, a Maryland corporation successor by merger to Allied Capital Commercial Corporation (the "Borrower") and MORGAN STANLEY MORTGAGE CAPITAL INC., a New York corporation (the "Lender"). RECITALS WHEREAS, the Borrower and the Lender entered into an Amended and Restated Master Loan and Security Agreement, dated October 7, 1998 (the "Existing Agreement"); WHEREAS, the Borrower has requested that the Lender from time to time make revolving credit loans to them on a committed basis to finance certain multifamily and commercial mortgage loans owned by the Borrower, and the Lender is prepared to make such loans upon the terms and conditions hereof; WHEREAS, the Lender and the Borrower desire to amend and restate the Existing Agreement to provide terms and conditions under which the Lender is prepared to make further revolving credit loans to the Borrower from and after the date hereof. NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree that the Existing Agreement is amended and restated in its entirety as follows: Section 1. Definitions and Accounting Matters. 1.01 Certain Defined Terms. As used herein, the following terms shall have the following meanings (all terms defined in this Section 1.01 or in other provisions of this Loan Agreement in the singular to have the same meanings when used in the plural and vice versa): "Affiliate" shall mean with respect to any Person, any "affiliate" of such Person as such term is defined in the United States Bankruptcy Code. "Applicable Collateral Percentage" shall mean (a) with respect to all Eligible Mortgage Loans that can be readily deposited in a Standard Securitization Transaction, 85% to 88%, as determined by the Lender, and (b) with respect to Other Eligible Mortgage Loans, such percentage as is acceptable to the Lender in its sole discretion. "Applicable Margin" shall mean (a) with respect to Eligible Mortgage Loans other than Other Eligible Mortgage Loans, 100 basis points (1%), and (b) with respect to Other Eligible Mortgage Loans, such margin as is acceptable to the Lender in its sole discretion. 6 "Bailee Agreement" shall mean a Bailee Agreement, among the Borrower, the Lender and a Settlement Agent, in form and substance acceptable to the Lender. "Bankruptcy Code" shall mean the United States Bankruptcy Code of 1978, as amended from time to time. "Borrower" shall have the meaning provided in the heading hereof. "Borrowing Base" shall mean the aggregate Collateral Value of all Eligible Mortgage Loans. "Borrowing Base Deficiency" shall have the meaning provided in Section 2.06 hereof. "Business Day" shall mean any day other than (i) a Saturday or Sunday or (ii) a day on which the New York Stock Exchange, the Federal Reserve Bank of New York or the Custodian is authorized or obligated by law or executive order to be closed. "Business Development Company" shall mean an investment company that has elected to be regulated as a 'business development company' under the 1940 Act. "Capital Lease Obligations" shall mean, for any Person, all obligations of such Person to pay rent or other amounts under a lease of (or other agreement conveying the right to use) Property to the extent such obligations are required to be classified and accounted for as a capital lease on a balance sheet of such Person under GAAP, and, for purposes of this Loan Agreement, the amount of such obligations shall be the capitalized amount thereof, determined in accordance with GAAP. "Code" shall mean the Internal Revenue Code of 1986, as amended from time to time. "Collateral" shall have the meaning provided in Section 4.01(b) hereof. "Collateral Value" shall mean, with respect to each Eligible Mortgage Loan, the lesser of (a) the Applicable Collateral Percentage of the Market Value of such Mortgage Loan, and (b) the outstanding principal balance of such Mortgage Loan; provided, that: (i) the Collateral Value shall be deemed to be zero with respect to each Eligible Mortgage Loan (1) in respect of which there is a breach of a representation and warranty set forth on Schedule 1 (assuming each representation and warranty is made as of the date Collateral Value is determined), (2) in respect of which there is a delinquency in the payment of principal and/or interest which continues for a period 30 days or more (without regard to any applicable grace periods), (3) which is an Eligible Mortgage Loan which remains pledged to the Lender hereunder later than 270 days after the date on which it is first included in the Collateral (other than Outstanding Mortgage Loans) or (4) which has been released from the possession of the Custodian under the Custodial Agreement to the Borrower for a period in excess of 14 days; or (5) a Table-Funded Mortgage Loan for which the Custodian has failed to receive the original -2- 7 Mortgage Loan Documents by 10:00 a.m., New York time on the fourth Business Day following the applicable Funding Date; and (ii) the aggregate Collateral Value of Eligible Mortgage Loans which are Table-Funded Mortgage Loans may not exceed $30,000,000, unless otherwise approved by the Lender in its sole discretion. "Consolidated Shareholders' Equity" shall mean, as of the date of determination thereof, the total shareholders' equity of the Borrower and its Consolidated Subsidiaries as the same would be required to appear on a consolidated balance sheet of the Borrower and its Consolidated Subsidiaries prepared as of such date in accordance with GAAP, including, in any case, common stock of the Borrower (valued at cost) held in the Allied Capital Corporation Deferred Compensation Trust and Permitted Preferred Stock of the Borrower and its Consolidated Subsidiaries but excluding any stock, common or preferred, not both issued and outstanding. "Consolidated Subsidiaries" shall mean any Subsidiary which is required to be consolidated on financial statements of the Borrower prepared accordance with GAAP. "Custodial Agreement" shall mean the Second Amended and Restated Custodial Agreement, dated as of the date hereof, among the Borrower, the Custodian and the Lender, substantially in the form of Exhibit B hereto, as the same shall be modified and supplemented and in effect from time to time. "Custodian" shall mean LaSalle National Bank, as custodian under the Custodial Agreement, and its successors and permitted assigns thereunder. "Default" shall mean an Event of Default or an event that with notice or lapse of time or both would become an Event of Default. "Dollars" and "$" shall mean lawful money of the United States of America. "Due Diligence Review" shall mean the performance by the Lender of any or all of the reviews permitted under Section 11.15 hereof with respect to any or all of the Mortgage Loans, as desired by the Lender from time to time. "Effective Date" shall mean the date upon which the conditions precedent set forth in Section 5.01 shall have been satisfied. "Eligible Mortgage Loans" shall mean (a) any Mortgage Loan secured by a first mortgage lien on a retail, office, hotel or other commercial property or (b) any Mortgage Loan secured by a first mortgage lien on a five-or-more family residential property; provided, however, that, in each case, with respect to each Mortgage Loan either (A)(i) the representations and warranties in Section 6.10 and Part I of Schedule 1 hereof are correct in all material respects (ii) each Mortgage Loan is underwritten in accordance with the Borrower's Underwriting Guidelines and (iii) each Mortgage Loan is eligible for inclusion in a Standard Securitization Transaction or (B) such Mortgage Loan is an Other Eligible Mortgage Loan; provided that, in no event shall any Mortgage Loan the pledge of which under this Loan Agreement constitutes a -3- 8 pledge of a security under the 1934 Act or the foreclosure upon which would constitute the acquisition of a security under the 1934 Act or the sale of which would constitute the sale of a security under the 1934 Act (without in any way affecting the characterization of such Mortgage Loan under the 1940 Act) be considered an Eligible Mortgage Loan for purposes hereof. "Equity Issuance" shall mean any issuance or sale by a Person of its capital stock or other similar equity security, or any warrants, options or similar rights to acquire, or securities convertible into or exchangeable for, such capital stock or other similar equity security. "ERISA" shall mean the Employee Retirement Income Security Act of 1974, as amended from time to time. "ERISA Affiliate" shall mean any corporation or trade or business that is a member of any group of organizations (i) described in Section 414(b) or (c) of the Code of which the Borrower is a member and (ii) solely for purposes of potential liability under Section 302(c)(11) of ERISA and Section 412(c)(11) of the Code and the lien created under Section 302(f) of ERISA and Section 412(n) of the Code, described in Section 414(m) or (o) of the Code of which the Borrower is a member. "Eurodollar Rate" shall mean with respect to each day during each Interest Period pertaining to such Loan, the rate per annum equal to the rate appearing at page 5 of the Telerate Screen, on the first day of such Interest Period, for the one-month term corresponding to such Interest Period, and if such rate shall not be so quoted, the rate per annum at which the Lender is offered Dollar deposits at or about 10:00 A.M., New York City time, on the first day of such Interest Period, by prime banks in the interbank eurodollar market where the eurodollar and foreign currency and exchange operations in respect of its Loans are then being conducted for delivery on the first day of such Interest Period for the number of days comprised therein and in an amount comparable to the amount of the Loans to be outstanding during such Interest Period. "Event of Default" shall have the meaning set forth in Section 8 hereof. "Exit Fee" shall have the meaning set forth in Section 3.04(b). "Federal Funds Rate" shall mean, for any day, the weighted average of the rates on overnight federal funds transactions with members of the Federal Reserve System arranged by federal funds brokers, as published on the next succeeding Business Day by the Federal Reserve Bank of New York, or, if such rate is not so published for any day which is a Business Day, the average of the quotations for the day of such transactions received by the Lender from three federal funds brokers of recognized standing selected by it. "Funding Date" shall mean the date on which a Loan is made hereunder. "GAAP" shall mean generally accepted accounting principles as in effect from time to time in the United States. "Governmental Authority" shall mean any nation or government, any state or other political subdivision thereof, any entity exercising executive, legislative, judicial, -4- 9 regulatory or administrative functions of or pertaining to government and any court or arbitrator having jurisdiction over the Borrower, any of its Subsidiaries, or any of its properties. "Guarantee" shall mean, as to any Person, any obligation of such Person directly or indirectly guaranteeing any Indebtedness of any other Person or in any manner providing for the payment of any Indebtedness of any other Person or otherwise protecting the holder of such Indebtedness against loss (whether by virtue of partnership arrangements, by agreement to keep-well, to purchase assets, goods, securities or services, or to take-or-pay or otherwise); provided that the term "Guarantee" shall not include (i) endorsements for collection or deposit in the ordinary course of business, or (ii) obligations to make servicing advances for delinquent taxes and insurance or other obligations in respect of a Mortgaged Property, to the extent required by the Lender. The amount of any Guarantee of a Person shall be deemed to be an amount equal to the stated or determinable amount of the primary obligation in respect of which such Guarantee is made or, if not stated or determinable, the maximum reasonably anticipated liability in respect thereof as determined by such Person in good faith. The terms "Guarantee" and "Guaranteed" used as verbs shall have correlative meanings. "Indebtedness" shall mean, for any Person: (a) obligations created, issued or incurred by such Person for borrowed money (whether by loan, the issuance and sale of debt securities or the sale of Property to another Person subject to an understanding or agreement, contingent or otherwise, to repurchase such Property from such Person); (b) obligations of such Person to pay the deferred purchase or acquisition price of Property or services, other than trade accounts payable (other than for borrowed money) arising, and accrued expenses incurred, in the ordinary course of business so long as such trade accounts payable are payable within 90 days of the date the respective goods are delivered or the respective services are rendered; (c) Indebtedness of others secured by a Lien on the Property of such Person, other than the respective Indebtedness so secured that has not been assumed by such Person; (d) obligations (contingent or otherwise) of such Person in respect of letters of credit or similar instruments issued or accepted by banks and other financial institutions for account of such Person; (e) Capital Lease Obligations of such Person; (f) obligations of such Person under repurchase agreements, sale/buy-back agreements or like arrangements; (g) Indebtedness of others Guaranteed by such Person; (h) all obligations of such Person incurred in connection with the acquisition or carrying of fixed assets by such Person; and (i) Indebtedness of general partnerships of which such Person is a general partner. "Interest Period" shall mean, with respect to any Loan, (a) initially, the period commencing on the applicable Funding Date to but excluding the first Payment Date; and (b) thereafter, each period commencing on a Payment Date to but excluding the next Payment Date; provided that, notwithstanding the foregoing, (i) an Interest Period may be for a term of fewer days as mutually agreed upon between the Borrower and the Lender and (ii) no Interest Period may end after the Termination Date. "Interest Rate Protection Agreement" shall mean, any interest rate swap, cap or collar agreement or similar arrangements providing for protection against fluctuations in interest rates or the exchange of nominal interest obligations, either generally or under specific contingencies, entered into by the Borrower and reasonably acceptable to the Lender. -5- 10 "Lender" shall have the meaning provided in the heading hereto. "Lien" shall mean any mortgage, lien, pledge, charge, security interest or similar encumbrance. "Loan" shall have the meaning provided in Section 2.01(a) hereof. "Loan Agreement" shall mean this Second Amended and Restated Master Loan and Security Agreement, as the same may be amended, supplemented or otherwise modified from time to time. "Loan Documents" shall mean, collectively, this Loan Agreement, the Note and the Custodial Agreement. "Market Value" shall mean, as of any date in respect of an Eligible Mortgage Loan, the price at which such Eligible Mortgage Loan could readily be sold as determined in good faith by the Lender, which price may be determined to be zero. The Lender's determination of Market Value shall be conclusive upon the parties absent manifest error on the part of the Lender. "Material Adverse Effect" shall mean a material adverse effect on (a) the Property, business, operations, financial condition or prospects of the Borrower, (b) the status of the Borrower as a Business Development Company or the Borrower's compliance with the 1940 Act, (c) the ability of the Borrower to perform its obligations under any of the Loan Documents to which it is a party, (d) the validity or enforceability of any of the Loan Documents, (e) the rights and remedies of the Lender under any of the Loan Documents, (f) the timely payment of the principal of or interest on the Loans or other amounts payable in connection therewith or (g) the Collateral. "Maximum Credit" shall mean $100,000,000. "Material Subsidiary" shall mean, as of the date of any determination thereof, any Subsidiary which has total assets having a value (determined in accordance with the market valuation method pursuant to GAAP) greater than or equal to $20,000,000. "Mortgage" shall mean the mortgage, deed of trust or other instrument securing a Mortgage Note, which creates a first lien on the fee in real property securing the Mortgage Note and the assignment of rents and leases related thereto. "Mortgage File" shall have the meaning assigned thereto in the Custodial Agreement. "Mortgage Loan" shall mean a mortgage loan which the Custodian has been instructed to hold for the Lender pursuant to the Custodial Agreement, and which Mortgage Loan includes, without limitation, (i) a Mortgage Note and related Mortgage and (ii) all right, title and interest of the Borrower in and to the Mortgaged Property covered by such Mortgage. -6- 11 "Mortgage Loan Documents" shall mean, with respect to a Mortgage Loan, the documents comprising the Mortgage File for such Mortgage Loan. "Mortgage Loan Schedule" shall have the meaning assigned thereto in the Custodial Agreement. "Mortgage Loan Schedule and Exception Report" shall mean the mortgage loan Schedule and exception report prepared by the Custodian pursuant to the Custodial Agreement. "Mortgage Loan Tape" shall mean a computer-readable magnetic tape with respect to each Mortgage Loan, to be delivered by the Borrower to the Lender pursuant to Section 2.03(a) hereof, containing tape fields set forth in Annex 1 to the Custodial Agreement. "Mortgage Note" shall mean the original executed promissory note or other evidence of the indebtedness of a mortgagor/borrower with respect to a Mortgage Loan. "Mortgaged Property" shall mean the real property (including all improvements, buildings, fixtures, building equipment and personal property thereon and all additions, alterations and replacements made at any time with respect to the foregoing) and all other collateral securing repayment of the debt evidenced by a Mortgage Note. "Mortgagor" shall mean the obligor on a Mortgage Note. "MS & Co." shall mean Morgan Stanley & Co. Incorporated, a registered broker-dealer. "Multiemployer Plan" shall mean a multiemployer plan defined as such in Section 3(37) of ERISA to which contributions have been or are required to be made by the Borrower or any ERISA Affiliate and that is covered by Title IV of ERISA. "Net Income" shall mean, for any period, the net income of the Borrower for such period as determined in accordance with GAAP. "Net Proceeds" shall mean, with respect to an Equity Issuance by a Person, the aggregate amount of all cash received by such Person in respect of such Equity Issuance net of investment banking fees, legal fees, accountants fees, underwriting discounts and commissions and other customary fees and expenses actually incurred by such Person in connection with such Equity Issuance. "1940 Act" shall mean the Investment Company Act of 1940, as amended. "1934 Act" shall mean the Securities and Exchange Act of 1934, as amended. "Note" shall have the meaning provided in Section 2.02(a) hereof. "Other Eligible Mortgage Loans" shall mean each Mortgage Loan that does not satisfy the requirements of clause (b)(A) in the definition of Eligible Mortgage Loans but that is -7- 12 otherwise expressly approved as an Eligible Mortgage Loan by the Lender in writing in its sole discretion. "Other Relevant Subsidiary" shall mean any Subsidiary, individually or together with other Subsidiaries, the occurrence of any of the events described in Section 8 hereof, with respect to which could reasonably be expected to have a Material Adverse Effect. "Outstanding Mortgage Loan" shall mean a Mortgage Loan pledged to the Lender prior to the date hereof which remains pledged to the Lender on the date hereof. "Payment Date" shall mean (a) the first Business day of each calendar month, commencing with the first Business Day of the month following the month in which the first Funding Date occurs, and (b) the Termination Date. "PBGC" shall mean the Pension Benefit Guaranty Corporation or any entity succeeding to any or all of its functions under ERISA. "Person" shall mean any individual, corporation, company, voluntary association, partnership, joint venture, limited liability company, trust, unincorporated association or government (or any agency, instrumentality or political subdivision thereof). "Permitted Preferred Stock" shall mean (i) preferred stock that is issued from time to time by a Subsidiary to the United States Small Business Administration having an aggregate stated value not exceeding $7,000,000 at any one time outstanding, or (ii) preferred stock that is issued from time to time by a Subsidiary for the purpose of qualifying such Subsidiary as a real estate investment trust under Section 856 through 860 of the Internal Revenue Code and having an aggregate stated value not exceeding $500,000 at any one time outstanding, provided that in any event Permitted Preferred Stock shall not include any Voting Stock. "Plan" shall mean an employee benefit or other plan established or maintained by the Borrower or any ERISA Affiliate and covered by Title IV of ERISA, other than a Multiemployer Plan. "Prepayment" shall mean for any Mortgage Loan, any unScheduled payment of principal due thereunder. "Post-Default Rate" shall mean, in respect of any principal of any Loan or any other amount under this Loan Agreement, the Note or any other Loan Document that is not paid when due to the Lender (whether at stated maturity, by acceleration, by optional or mandatory prepayment or otherwise), a rate per annum during the period from and including the due date to but excluding the date on which such amount is paid in full equal to 2% per annum plus the Prime Rate. "Prime Rate" shall mean the prime rate announced to be in effect from time to time, as published as the average rate in The Wall Street Journal. "Property" shall mean any right or interest in or to property of any kind whatsoever, whether real, personal or mixed and whether tangible or intangible. -8- 13 "Regulations T, U and X" shall mean Regulations T, U and X of the Board of Governors of the Federal Reserve System (or any successor), as the same may be modified and supplemented and in effect from time to time. "Requirement of Law" shall mean as to any Person, the certificate of incorporation and by- laws or other organizational or governing documents of such Person, and any law, treaty, rule or regulation or determination of an arbitrator or a court or other Governmental Authority, in each case applicable to or binding upon such Person or any of its property or to which such Person or any of its property is subject. "Responsible Officer" shall mean, as to any Person, the chief executive officer, managing director or treasurer, or with respect to financial matters, the chief financial officer of such Person. "Secured Obligations" shall have the meaning provided in Section 4.01(c) hereof. "Servicer" shall have the meaning provided in Section 11.14(c) hereof. "Servicing Agreement" shall have the meaning provided in Section 11.14(c) hereof. "Servicing Records" shall have the meaning provided in Section 11.14(b) hereof. "Settlement Agent" shall mean, with respect to any Loan, the entity approved by the Lender, in its sole good-faith discretion (which may be a title company, escrow company or attorney in accordance with local law and practice in the jurisdiction where the related Table-Funded Mortgage Loan is being originated) to which the proceeds of such Loan are to be wired pursuant to the instructions of the Lender. "Standard Securitization Transaction" shall mean a securitization transaction backed by Mortgage Loans underwritten or placed on behalf of the Borrower which transaction has received an investment grade rating from any nationally-recognized rating agency and otherwise conforms to the current standards of institutional securitization applicable to mortgage loans substantially similar in nature to the Mortgage Loans. "Subsidiary" shall mean, with respect to any Person, any corporation, partnership or other entity of which at least a majority of the securities or other ownership interests having by the terms thereof ordinary voting power to elect a majority of the board of directors or other persons performing similar functions of such corporation, partnership or other entity (irrespective of whether or not at the time securities or other ownership interests of any other class or classes of such corporation, partnership or other entity shall have or might have voting power by reason of the happening of any contingency) is at the time directly or indirectly owned or controlled by such Person or one or more Subsidiaries of such Person or by such Person and one or more Subsidiaries of such Person Notwithstanding the foregoing, the term "Subsidiary," when used with respect to the Borrower, shall not include any Person if the securities or other ownership interests of such Person held by the Borrower (directly or through one or more Subsidiaries of the Borrower) would be required under GAAP to be accounted for on a consolidated balance sheet of the Borrower as portfolio investments. -9- 14 "System" shall mean all hardware or software, or any system consisting of one or more thereof, including, without limitation, any and all enhancements, upgrades, customizations, modifications, maintenance and the like utilized by any Person for the benefit of such Person to perform its obligations and to administer and track, store, process, provide, and where appropriate, insert, true and accurate dates and calculations for dates and spans with respect to the Mortgage Loans. "Table-Funded Mortgage Loan" shall mean a Mortgage Loan which is pledged to the Lender simultaneously with the origination thereof by the Borrower, which origination is financed in part or in whole with proceeds of Loans advanced directly to a Settlement Agent and which Table-Funded Mortgage Loan is held by the Settlement Agent pursuant to a Bailee Agreement. "Termination Date" shall mean October 27, 2000 or such earlier date on which this Loan Agreement shall terminate in accordance with the provisions hereof or by operation of law provided that such Termination Date may be extended from time to time pursuant to Section 2.08 hereof. "Test Period" shall have the meaning provided in Section 7.15 hereof. "Total Indebtedness" shall mean, for any period, the aggregate Indebtedness of the Borrower and its Consolidated Subsidiaries during such period, determined on a consolidated basis in accordance with GAAP less the amount of any nonspecific balance sheet reserves also maintained in accordance with GAAP. "Underwriting Guidelines" shall mean the underwriting guidelines attached as Exhibit F hereto. "Uniform Commercial Code" shall mean the Uniform Commercial Code as in effect on the date hereof in the State of New York; provided that if by reason of mandatory provisions of law, the perfection or the effect of perfection or non-perfection of the security interest in any Collateral is governed by the Uniform Commercial Code as in effect in a jurisdiction other than New York, "Uniform Commercial Code" shall mean the Uniform Commercial Code as in effect in such other jurisdiction for purposes of the provisions hereof relating to such perfection or effect of perfection or non-perfection. "Voting Stock" shall mean securities of any class or classes, the holders of which are ordinarily, in the absence of contingencies, entitled to elect a majority of the corporate directors (or persons performing similar functions). "Year 2000 Compliant" shall mean the ability of a System to continue its normal functions including and following January 1, 2000 and the ability of such System to support its continued normal usage such that neither the performance nor the correct functioning of such System will be affected by the approach, and passing into, the year 2000. 1.02 Accounting Terms and Determinations. Except as otherwise expressly provided herein, all accounting terms used herein shall be interpreted, and all financial -10- 15 statements and certificates and reports as to financial matters required to be delivered to the Lender hereunder shall be prepared, in accordance with GAAP. Section 2. Loans, Note and Prepayments. 2.01 Loans. (a) Subject to the fulfillment of the conditions precedent set forth in Sections 5.01 and 5.02 hereof, and provided that no Default shall have occurred and be continuing hereunder, the Lender agrees, from time to time, on the terms and conditions of this Loan Agreement, to make loans (individually, a "Loan" and, collectively, the "Loans") to the Borrower in Dollars, from and including the Effective Date to and including the Termination Date in an aggregate principal amount at any one time outstanding up to but not exceeding the Maximum Credit as in effect from time to time. (b) Subject to the terms and conditions of this Loan Agreement, during such period the Borrower may borrow, repay and reborrow hereunder; provided that, notwithstanding the foregoing, the Lender shall have no obligation to make Loans to the Borrower in excess of the then current Maximum Credit and, in the event the obligation of the Lender to make Loans to the Borrower is terminated as permitted hereunder, the Lender shall have no further obligation to make additional Loans hereunder. (c) In no event shall a Loan be made when any Default or Event of Default has occurred and is continuing. 2.02 Notes. (a) The Loans made by the Lender shall be evidenced by a single second amended and restated promissory note of the Borrower substantially in the form of Exhibit A hereto (the "Note"), dated August 21, 1997, as amended and restated as of the date hereof, payable to the Lender in a principal amount equal to the amount of the Maximum Credit as originally in effect and otherwise duly completed. The Lender shall have the right to have its Note subdivided, by exchange for promissory notes of lesser denominations or otherwise. (b) The date, amount and interest rate of each Loan made by the Lender to the Borrower, and each payment made on account of the principal thereof, shall be recorded by the Lender on its books and, prior to any transfer of the Note, endorsed by the Lender on the Schedule attached to the Note or any continuation thereof; provided that the failure of the Lender to make any such recordation or endorsement shall not affect the obligations of the Borrower to make a payment when due of any amount owing hereunder or under the Note in respect of the Loans. 2.03 Procedure for Borrowing. (a) The Borrower may request a borrowing hereunder, on any Business Day during the period from and including the Effective Date to and including the Termination Date, by delivering to the Lender, with a copy to the Custodian, a written request for borrowing, substantially in the form of Exhibit D attached hereto, which request must be received by the -11- 16 Lender prior to 11:00 a.m., New York City time, one (l) Business Day prior to the requested Funding Date. Such request for borrowing shall (i) attach a Schedule identifying the Eligible Mortgage Loans that the Borrower proposes to pledge to the Lender and to be included in the Borrowing Base in connection with such borrowing, (ii) specify the requested Funding Date and the requested Loan amount, (iii) include a Mortgage Loan Tape containing information with respect to the Eligible Mortgage Loans that the Borrower proposes to pledge to the Lender and to be included in the Borrowing Base in connection with such borrowing, which Mortgage Loan Tape shall specify any deviations from the Underwriting Guidelines and Schedule 1 of this Loan Agreement, and (iv) attach an officer's certificate signed by a Responsible Officer of the Borrower as required by Section 5.02(b) hereof. (b) Upon the Borrower's request for a borrowing pursuant to Section 2.03(a), the Lender shall, assuming all conditions precedent set forth in Section 5.01 and 5.02 have been met and provided no Default shall have occurred and be continuing, make a Loan to the Borrower on the requested Funding Date, in the amount so requested. (c) The requesting Borrower shall release to the Custodian no later than 12:00 p.m., New York City time, one (1) Business Day prior to the requested Funding Date, the Mortgage File pertaining to each Eligible Mortgage Loan to be pledged to the Lender and included in the Borrowing Base on such requested Funding Date, in accordance with the terms and conditions of the Custodial Agreement. (d) Pursuant to the Custodial Agreement, the Custodian shall deliver to the Lender and the Borrower, no later than 11:00 a.m. on a Funding Date, a Trust Receipt (as defined in the Custodial Agreement) in respect of all Eligible Mortgage Loans (other than a Table-Funded Mortgage Loan) pledged to the Lender on such Funding Date, and a Mortgage Loan Schedule and Exception Report. Subject to Section 5 hereof, such borrowing will then be made available to the Borrower by the Lender transferring, via wire transfer, with respect to Loans secured by Mortgage Loans other than Table-Funded Mortgage Loans, to the following account of the Borrower: Bank of America ABA 052-001633 Acct # 391-897-3064, and, with respect to Loans secured by Table-Funded Mortgage Loans, to the Settlement Agent in accordance with the Borrower's instructions. 2.04 Limitation on Types of Loans; Illegality. Anything herein to the contrary notwithstanding, if, on or prior to the determination of any Eurodollar Rate: (a) the Lender determines, which determination shall be conclusive, that quotations of interest rates for the relevant deposits referred to in the definition of "Eurodollar Rate" in Section 1.01 hereof are not being provided in the relevant amounts or for the relevant maturities for purposes of determining rates of interest for Loans as provided herein; or (b) the Lender determines, which determination shall be conclusive, that the relevant rate of interest referred to in the definition of "Eurodollar Rate" in Section 1.01 hereof upon the basis of which the rate of interest for Loans is to be determined is not likely adequately to cover the cost to the Lender of making or maintaining Loans; or -12- 17 (c) it becomes unlawful for the Lender to honor its obligation to make or maintain Loans hereunder using a Eurodollar Rate; then the Lender shall give the Borrower prompt notice thereof and, so long as such condition remains in effect, the Lender shall be under no obligation to make additional Loans (provided that the Borrower and the Lender will use their best efforts to mutually agree upon an interest rate for future Loans, and upon such agreement, the Lender shall be obligated to make such additional Loans hereunder bearing such interest rate), and the Borrower shall at Borrower's option, either prepay all such Loans as may be outstanding, without penalty or premium, or pay interest on such Loans at a rate per annum equal to the Federal Funds Rate plus 1.5%. 2.05 Repayment of Loans; Interest. (a) The Borrower hereby promises to repay in full on the Termination Date the then aggregate outstanding principal amount of the Loans. Prepayments on one or more of the Mortgage Loans may occur at any time and from time to time without penalty or premium. (b) The Borrower hereby promises to pay to the Lender interest on the unpaid principal amount of each Loan for the period from and including the date of such Loan to but excluding the date such Loan shall be paid in full, at a rate per annum equal to the Eurodollar Rate plus the Applicable Margin. Notwithstanding the foregoing, the Borrower hereby promises to pay to the Lender interest at the applicable Post-Default Rate on any principal of any Loan and on any other amount payable by the Borrower hereunder or under the Note that shall not be paid in full when due (whether at stated maturity, by acceleration or by mandatory prepayment or otherwise) for the period from and including the due date thereof to but excluding the date the same is paid in full. Accrued interest on each Loan shall be payable on each Payment Date, except that interest payable at the Post-Default Rate shall accrue daily and shall be payable upon such accrual. Promptly after the determination of any interest rate provided for herein or any change therein, the Lender shall give notice thereof to the Borrower. (c) It is understood and agreed that, unless and until a Default shall have occurred and be continuing, the Borrower shall be entitled to the proceeds of the Mortgage Loans, including interest and principal payments thereunder and proceeds from the sale thereof, pledged to the Lender hereunder. 2.06 Mandatory Prepayments or Pledge. If at any time the aggregate outstanding principal amount of Loans exceeds the Borrowing Base (a "Borrowing Base Deficiency"), as determined by the Lender and notified to the Borrower on any Business Day, the Borrower shall no later than one (1) Business Day after receipt of such notice, either prepay the Loans in part or in whole or pledge additional Eligible Mortgage Loans (which Collateral shall be in all respects acceptable to the Lender) to the Lender, such that after giving effect to such prepayment or pledge the aggregate outstanding principal amount of the Loans does not exceed the Borrowing Base. 2.07 Indemnity. If the Borrower makes a prepayment of the Loans on any day which is not a Payment Date, the Borrower shall indemnify the Lender and hold the Lender -13- 18 harmless from any actual loss or expense which the Lender may sustain or incur arising from the reemployment of funds obtained by the Lender to maintain the Loans hereunder or from fees payable to terminate the deposits from which such funds were obtained. This Section 2.07 shall survive termination of this Agreement and payment of the Note. 2.08 Extension of Termination Date. At the request of the Borrower made at least thirty (30) days, but in no event earlier than ninety (90) days, prior to the then current Termination Date, the Lender may in its sole discretion extend the Termination Date for a period to be determined by Lender in its sole discretion by giving written notice of such extension to the Borrower no later than twenty (20) days, but in no event earlier than thirty (30) days, prior to the then current Termination Date. Any failure by the Lender to deliver such notice of extension shall be deemed to be the Lender's determination not to extend the then current Termination Date. Section 3. Payments; Computations; Etc. 3.01 Payments. (a) Except to the extent otherwise provided herein, all payments of principal, interest and other amounts to be made by the Borrower under this Loan Agreement and the Note, shall be made in Dollars, in immediately available funds, without deduction, set-off or counterclaim, to the Lender at the following account maintained by the Lender: Account No. 40615114, for the account of MSMCI, Citibank, N.A., ABA No. 021000089, Attn: Whole Loan Operations not later than 1:00 p.m., New York City time, on the date on which such payment shall become due (and each such payment made after such time on such due date shall be deemed to have been made on the next succeeding Business Day). The Borrower acknowledges that it has no rights of withdrawal from the foregoing account. (b) Except to the extent otherwise expressly provided herein, if the due date of any payment under this Loan Agreement or the Note would otherwise fall on a day that is not a Business Day, such date shall be extended to the next succeeding Business Day, and interest shall be payable for any principal so extended for the period of such extension. 3.02 Computations. Interest on the Loans shall be computed on the basis of a 360-day year for the actual days elapsed (including the first day but excluding the last day) occurring in the period for which payable. 3.03 Requirements of Law. (a) If any Requirement of Law enacted and in effect after the date of this Agreement (other than with respect to any amendment made to the Lender's certificate of incorporation and by-laws or other organizational or governing documents) or any change in the interpretation or application thereof or compliance by the Lender with any request or directive (whether or not having the force of law) from any central bank or other Governmental Authority made subsequent to the date hereof: -14- 19 (i) shall subject the Lender to any tax of any kind whatsoever with respect to this Loan Agreement, the Note or any Loan made by it (excluding net income taxes) or change the basis of taxation of payments to the Lender in respect thereof; (ii) shall impose, modify or hold applicable any reserve, special deposit, compulsory Loan or similar requirement against assets held by, deposits or other liabilities in or for the account of, advances, Loans or other extensions of credit by, or any other acquisition of funds by, any office of the Lender which is not otherwise included in the determination of the Eurodollar Rate hereunder; (iii) shall impose on the Lender any other condition; and the result of any of the foregoing is to increase the cost to the Lender, by an amount which the Lender deems to be material, of making, continuing or maintaining any Loan or to reduce any amount due or owing hereunder in respect thereof, then, in any such case, the Borrower shall promptly pay the Lender such additional amount or amounts as will compensate the Lender for such increased cost or reduced amount receivable. (b) If the Lender shall have determined that the adoption of or any change in any Requirement of Law (other than with respect to any amendment made to the Lender's certificate of incorporation and by-laws or other organizational or governing documents) regarding capital adequacy or in the interpretation or application thereof or compliance by the Lender or any corporation controlling the Lender with any request or directive regarding capital adequacy (whether or not having the force of law) from any Governmental Authority made subsequent to the date hereof shall have the effect of reducing the rate of return on the Lender's or such corporation's capital as a consequence of its obligations hereunder to a level below that which the Lender or such corporation could have achieved but for such adoption, change or compliance (taking into consideration the Lender's or such corporation's policies with respect to capital adequacy) by an amount deemed by the Lender to be material, then from time to time, the Borrower shall promptly pay to the Lender such additional amount or amounts as will compensate the Lender for such reduction. (c) If the Lender becomes entitled to claim any additional amounts pursuant to this Section, it shall promptly notify the Borrower of the event by reason of which it has become so entitled. A certificate as to any additional amounts payable pursuant to this Section submitted by the Lender to the Borrower shall be conclusive in the absence of manifest error. 3.04 Facility Fee; Exit Fee. (a) The Borrower agrees to pay to the Lender on or prior to the Effective Date a facility fee equal to 12.5 basis points (0.125%) per annum of the Maximum Credit, such payment to be made in Dollars, in immediately available funds, without deduction, set-off or counterclaim, to the Lender at the account set forth in Section 3.01(a) hereof. In the event that the Lender fails to make a Loan to the Borrower due solely to any of the circumstances set forth in Section 5.02(i)(i), (ii) or (iii) or 5.02(j) hereof, then, upon request of the Borrower, the Lender shall refund to the Borrower that portion of the facility fee paid pursuant to this Section 3.04(a), pro-rated over the number of days (notwithstanding any extension of the Termination Date -15- 20 pursuant to Section 2.08 hereof such amount shall be calculated based upon the original term of this Loan Agreement) during which the Lender fails to make Loans requested by the Borrower solely because of the circumstances set forth in Section 5.02(i)(i), (ii) or (iii) or 5.02(j) hereof. (b) The Borrower agrees to pay to the Lender an exit fee equal to 0.5% of the Disposition Amount upon Disposition of such Mortgage Loans, as of the date on which any such pledged Mortgage Loans are no longer pledged to the Lender hereunder (the "Exit Fee"), each such payment to be made in Dollars, in immediately available funds, without deduction, set-off or counterclaim, to the Lender at the account set forth in Section 3.01(a) hereof. Without limiting the generality of the foregoing, any Exit Fee for any Disposition shall accrue and be payable as a condition to release by the Lender of its Lien on the applicable Mortgage Loans that are subject to such Disposition. For purposes of this Section, a "Disposition" shall mean any of the following: (i) the sale or securitization of Mortgage Loans pledged to the Lender hereunder; (ii) termination of this Loan Agreement for any reason whatsoever (provided that, in the event the Lender shall fail to extend the Termination Date pursuant to a request by the Borrower pursuant to Section 2.08 hereof, or in the event the Borrower shall terminate this Loan Agreement because of the Lender's failure to make a loan pursuant to Section 5.02(i)(i), (ii) or (iii) or Section 5.02(j), any Exit Fee which would otherwise be due solely as a result of the occurrence of the Termination Date hereunder (and absent any Event of Default hereunder) shall be deemed waived by the Lender); or (iii) the release of any or all of the Mortgage Loans from the Lien of the Lender hereunder. For purposes of this Section, the "Disposition Amount" shall equal: (y) with respect to a Disposition pursuant to clauses (i) and (ii) above, the outstanding principal balance of the Loan secured by Mortgage Loans pledged to the Lender hereunder, and (z) with respect to a Disposition pursuant to clause (iii) above, the Collateral Value attributable to the Mortgage Loans so released. Section 4. Collateral Security. 4.01 Collateral; Security Interest. (a) Pursuant to the Custodial Agreement, the Custodian shall hold the Mortgage Loan Documents as exclusive bailee and agent for the Lender pursuant to terms of the Custodial Agreement and shall deliver to the Lender Trust Receipts (as defined in the Custodial Agreement) each to the effect that it has reviewed such Mortgage Loan Documents in the manner and to the extent required by the Custodial Agreement and identifying any deficiencies in such Mortgage Loan Documents as so reviewed. (b) All of the Borrower's right, title and interest in, to and under each of the following items of property, whether now owned or hereafter acquired, now existing or hereafter created and wherever located, is hereinafter referred to as the "Collateral": (i) all Mortgage Loans; (ii) all Mortgage Loan Documents, including without limitation all promissory notes, and all Servicing Records (as defined in Section 11.14(b) below), servicing agreements and any other collateral pledged or otherwise relating to such Mortgage Loans, together with all files, documents, instruments, surveys, certificates, -16- 21 correspondence, appraisals, accounting records and other books and records relating thereto; (iii) all mortgage guaranties and insurance (issued by governmental agencies or otherwise) and any mortgage insurance certificate or other document evidencing such mortgage guaranties or insurance relating to any Mortgage Loan and all claims and payments thereunder; (iv) all other insurance policies and insurance proceeds relating to any Mortgage Loan or the related Mortgaged Property; (v) all Interest Rate Protection Agreements between the Borrower and the Lender or any Affiliate of the Lender, relating to or constituting any and all of the foregoing; (vi) all collateral, however defined, under any other agreement between the Borrower or any of its Affiliates on the one hand and the Lender or any of its Affiliates on the other hand; (vii) all "general intangibles" as defined in the Uniform Commercial Code relating to or constituting any and all of the foregoing; and (viii) any and all replacements, substitutions, distributions on or proceeds of any and all of the foregoing. (c) The Borrower hereby assigns, pledges and grants a security interest in all of its right, title and interest in, to and under the Collateral to the Lender to secure the repayment of principal of and interest on all Loans and all other amounts owing to the Lender hereunder, under the Note and under the other Loan Documents (collectively, the "Secured Obligations"). The Borrower agrees to mark its computer records and tapes to evidence the interests granted to the Lender hereunder. 4.02 Further Documentation. At any time and from time to time, upon the written request of the Lender, and at the sole expense of the Borrower, the Borrower will promptly and duly execute and deliver, or will promptly cause to be executed and delivered, such further instruments and documents and take such further action as the Lender may reasonably request for the purpose of obtaining or preserving the full benefits of this Loan Agreement and of the rights and powers herein granted, including, without limitation, the filing of any financing or continuation statements under the Uniform Commercial Code in effect in any jurisdiction with respect to the Liens created hereby. The Borrower also hereby authorizes the Lender to file any such financing or continuation statement without the signature of the Borrower to the extent permitted by applicable law. A carbon, photographic or other reproduction of this Loan Agreement shall be sufficient as a financing statement for filing in any jurisdiction. 4.03 Changes in Locations, Name, etc. The Borrower shall not (a) change the location of its chief executive office/chief place of business from that specified in Section 6 hereof or (b) change its name, identity or corporate structure (or the equivalent) or change the location where it maintains its records with respect to the Collateral unless it shall have given the -17- 22 Lender at least 30 days prior written notice thereof and shall have delivered to the Lender all Uniform Commercial Code financing statements and amendments thereto as the Lender shall request and taken all other actions deemed necessary by the Lender to continue its perfected status in the Collateral with the same or better priority. 4.04 Lender's Appointment as Attorney-in-Fact. (a) The Borrower hereby irrevocably constitutes and appoints the Lender and any officer or agent thereof, with full power of substitution, as its true and lawful attorney-in-fact with full irrevocable power and authority in the place and stead of the Borrower and in the name of the Borrower or in its own name, from time to time during the continuance of a Default in the Lender's discretion, for the purpose of carrying out the terms of this Loan Agreement, to take any and all appropriate action and to execute any and all documents and instruments which may be necessary or desirable to accomplish the purposes of this Loan Agreement, and, without limiting the generality of the foregoing, the Borrower hereby gives the Lender the power and right, on behalf of the Borrower, without assent by, but with notice to, the Borrower, if an Event of Default shall have occurred and be continuing, to do the following: (i) in the name of the Borrower or its own name, or otherwise, to take possession of and endorse and collect any checks, drafts, notes, acceptances or other instruments for the payment of moneys due under any mortgage insurance or with respect to any other Collateral and to file any claim or to take any other action or proceeding in any court of law or equity or otherwise deemed appropriate by the Lender for the purpose of collecting any and all such moneys due under any such mortgage insurance or with respect to any other Collateral whenever payable; (ii) to pay or discharge taxes and Liens levied or placed on or threatened against the Collateral; and (iii) (A) to direct any party liable for any payment under any Collateral to make payment of any and all moneys due or to become due thereunder directly to the Lender or as the Lender shall direct; (B) to ask or demand for, collect, receive payment of and receipt for, any and all moneys, claims and other amounts due or to become due at any time in respect of or arising out of any Collateral; (C) to sign and endorse any invoices, assignments, verifications, notices and other documents in connection with any of the Collateral; (D) to commence and prosecute any suits, actions or proceedings at law or in equity in any court of competent jurisdiction to collect the Collateral or any portion thereof and to enforce any other right in respect of any Collateral; (E) to defend any suit, action or proceeding brought against the Borrower with respect to any Collateral; (F) to settle, compromise or adjust any suit, action or proceeding described in clause (E) above and, in connection therewith, to give such discharges or releases as the Lender may deem appropriate; and (G) generally, to sell, transfer, pledge and make any agreement with respect to or otherwise deal with any of the Collateral as fully and completely as though the Lender were the absolute owner thereof for all purposes, and to do, at the Lender's option and the Borrower's expense, at any time, and from time to time, all acts and things which the Lender deems necessary to protect, preserve or realize upon the Collateral and -18- 23 the Lender's Liens thereon and to effect the intent of this Loan Agreement, all as fully and effectively as the Borrower might do. The Borrower hereby ratifies all that said attorneys shall lawfully do or cause to be done by virtue hereof. This power of attorney is a power coupled with an interest and shall be irrevocable. (b) The Borrower also authorizes the Lender, at any time and from time to time, to execute, in connection with any sale provided for in Section 4.07 hereof, any endorsements, assignments or other instruments of conveyance or transfer with respect to the Collateral. (c) The powers conferred on the Lender are solely to protect the Lender's interests in the Collateral and shall not impose any duty upon the Lender to exercise any such powers. The Lender shall be accountable only for amounts that it actually receives as a result of the exercise of such powers, and neither the Lender nor any of its officers, directors, or employees shall be responsible to the Borrower for any act or failure to act hereunder, except for its own gross negligence or willful misconduct. 4.05 Performance by Lender of Borrower's Obligations. If the Borrower fails to perform or comply with any of its agreements contained in the Loan Documents, concurrently with providing notice to the Borrower, the Lender may itself perform or comply, or otherwise cause performance or compliance, with such agreement, the expenses of the Lender incurred in connection with such performance or compliance, together with interest thereon at a rate per annum equal to the Post-Default Rate, shall be payable, subject to Section 11.18 hereof, by the Borrower to the Lender on demand and shall constitute Secured Obligations. 4.06 Proceeds. If an Event of Default shall occur and be continuing, (a) all proceeds of Collateral received by the Borrower consisting of cash, checks and other near-cash items shall be held by the Borrower in trust for the Lender, segregated from other funds of the Borrower, and shall forthwith upon receipt by the Borrower be turned over to the Lender in the exact form received by the Borrower (duly endorsed by the Borrower to the Lender, if required) and (b) any and all such proceeds received by the Lender (whether from the Borrower or otherwise) may, in the sole discretion of the Lender, be held by the Lender as collateral security for, and/or then or at any time thereafter may be applied by the Lender against, the Secured Obligations (whether matured or unmatured), such application to be in such order as the Lender shall elect. Any balance of such proceeds remaining after the Secured Obligations shall have been paid in full and this Loan Agreement shall have been terminated shall be paid over to the Borrower or to whomsoever may be lawfully entitled to receive the same. For purposes hereof, proceeds shall include, but not be limited to, all principal and interest payments, all prepayments and payoffs, insurance claims, condemnation awards, sale proceeds, real estate owned rents and any other income and all other amounts received with respect to the Collateral. 4.07 Remedies. If an Event of Default shall occur and be continuing, the Lender may, at its option, enter into one or more Interest Rate Protection Agreements covering all or a portion of the Mortgage Loans pledged to the Lender hereunder, and the Borrower shall be responsible for all damages, judgments, costs and expenses of any kind which may be -19- 24 imposed on, incurred by or asserted against the Lender relating to or arising out of such Interest Rate Protection Agreements including without limitation any losses resulting from such Interest Rate Protection Agreements. If an Event of Default shall occur and be continuing, the Lender may exercise, in addition to all other rights and remedies granted to it in this Loan Agreement and in any other instrument or agreement securing, evidencing or relating to the Secured Obligations, all rights and remedies of a secured party under the Uniform Commercial Code. Without limiting the generality of the foregoing, the Lender without demand of performance or other demand, presentment, protest, advertisement or notice of any kind (except any notice required by law referred to below) to or upon the Borrower or any other Person (each and all of which demands, presentments, protests, advertisements and notices are hereby waived), may in such circumstances forthwith collect, receive, appropriate and realize upon the Collateral, or any part thereof, and/or may forthwith sell, lease, assign, give option or options to purchase, or otherwise dispose of and deliver the Collateral or any part thereof (or contract to do any of the foregoing), in one or more parcels or as an entirety at public or private sale or sales, at any exchange, broker's board or office of the Lender or elsewhere upon such terms and conditions as it may deem advisable and at such prices as it may deem best, for cash or on credit or for future delivery without assumption of any credit risk. The Lender shall have the right upon any such public sale or sales, and, to the extent permitted by law, upon any such private sale or sales, to purchase the whole or any part of the Collateral so sold, free of any right or equity of redemption in the Borrower, which right or equity is hereby waived or released. The Borrower further agrees, at the Lender's request, to assemble the Collateral and make it available to the Lender at places which the Lender shall reasonably select, whether at the Borrower's premises or elsewhere. The Lender shall apply the net proceeds of any such collection, recovery, receipt, appropriation, realization or sale, after deducting all reasonable costs and expenses incurred therein or incidental to the care or safekeeping of any of the Collateral or in any way relating to the Collateral or the rights of the Lender hereunder, including without limitation reasonable attorneys' fees and disbursements, to the payment in whole or in part of the Secured Obligations, in such order as the Lender may elect, and only after such application and after the payment by the Lender of any other amount required or permitted by any provision of law, including without limitation Section 9-504(1)(c) of the Uniform Commercial Code, need the Lender account for the surplus, if any, to the Borrower. To the extent permitted by applicable law, the Borrower waives all claims, damages and demands it may acquire against the Lender arising out of the exercise by the Lender of any of its rights hereunder, other than those claims, damages and demands arising from the gross negligence or willful misconduct of the Lender. If any notice of a proposed sale or other disposition of Collateral shall be required by law, such notice shall be deemed reasonable and proper if given at least 10 days before such sale or other disposition. The Borrower shall remain liable for any deficiency (plus accrued interest thereon as contemplated pursuant to Section 2.05(b) hereof) if the proceeds of any sale or other disposition of the Collateral are insufficient to pay the Secured Obligations and the fees and disbursements of any attorneys employed by the Lender to collect such deficiency. 4.08 Limitation on Duties Regarding Preservation of Collateral. The Lender's duty with respect to the custody, safekeeping and physical preservation of the Collateral in its possession, under Section 9-207 of the Uniform Commercial Code or otherwise, shall be to deal with it in the same manner as the Lender deals with similar property for its own account. Neither the Lender nor any of its directors, officers or employees shall be liable for failure to demand, collect or realize upon all or any part of the Collateral or for any delay in doing so or shall be -20- 25 under any obligation to sell or otherwise dispose of any Collateral upon the request of the Borrower or otherwise. 4.09 Powers Coupled with an Interest. All authorizations and agencies herein contained with respect to the Collateral are irrevocable and powers coupled with an interest. 4.10 Release of Security Interest. Upon termination of this Loan Agreement and repayment to the Lender of all Secured Obligations and the performance of all obligations under the Loan Documents the Lender shall release its security interest in any remaining Collateral. Section 5. Conditions Precedent. 5.01 Initial Loan. The obligation of the Lender to make its initial Loan hereunder is subject to the satisfaction, immediately prior to or concurrently with the making of such Loan, of the condition precedent that the Lender shall have received all of the following, each of which shall be reasonably satisfactory to the Lender and its counsel in form and substance: (a) Loan Documents. (i) Note. The Note, duly completed and executed; and (ii) Custodial Agreement. The Custodial Agreement, duly executed and delivered by the Borrower and the Custodian. In addition, the Borrower shall have taken such other action as the Lender shall have requested in order to perfect the security interests created pursuant to the Loan Agreement; (b) Organizational Documents. A good standing certificate and certified copies of the charter and by-laws (or equivalent documents) of the Borrower and of all corporate or other authority for the Borrower with respect to the execution, delivery and performance of the Loan Documents and each other document to be delivered by the Borrower from time to time in connection herewith (and the Lender may conclusively rely on such certificate until it receives notice in writing from the Borrower to the contrary); (c) Legal Opinion. A legal opinion of outside counsel to the Borrower, substantially in the form attached hereto as Exhibit C; (d) Trust Receipt and Mortgage Loan Schedule and Exception Report. A Trust Receipt, substantially in the form of Annex 2 of the Custodial Agreement and Mortgage Loan Schedule and Exception Report, dated the Effective Date, from the Custodian, duly completed, with a Mortgage Loan Schedule and Exception Report attached thereto; (e) Servicing Agreement(s). Any Servicing Agreement, certified as a true, correct and complete copy of the original, with the letter of the applicable Servicer consenting to termination of such Servicing Agreement upon the occurrence of an Event of Default attached; and -21- 26 (f) Other Documents. Such other documents as the Lender may reasonably request. 5.02 Initial and Subsequent Loans. The making of each Loan to the Borrower (including the initial Loan) on any Business Day is subject to the satisfaction of the following further conditions precedent, both immediately prior to the making of such Loan and also after giving effect thereto and to the intended use thereof: (a) no Default or Event of Default shall have occurred and be continuing; (b) both immediately prior to the making of such Loan and also after giving effect thereto and to the intended use thereof, the representations and warranties made by the Borrower in Section 6 hereof, and elsewhere in each of the Loan Documents, shall be true, correct and complete on and as of the date of the making of such Loan in all material respects (in the case of the representations and warranties in Section 6.10 and Schedule 1, solely with respect to Mortgage Loans included in the Borrowing Base) with the same force and effect as if made on and as of such date (or, if any such representation or warranty is expressly stated to have been made as of a specific date, as of such specific date). The Lender shall have received an officer's certificate signed by a Responsible Officer of the Borrower certifying as to the truth, accuracy and completeness of the above, which certificate shall specifically include a statement that the Borrower is in compliance with all governmental licenses and authorizations and is qualified to do business and in good standing in all required jurisdictions and that such borrowing does not violate restrictions imposed upon the Borrower as a Business Development Company or otherwise. (c) the aggregate outstanding principal amount of the Loans shall not exceed the Borrowing Base; (d) subject to the Lender's right to perform one or more Due Diligence Reviews pursuant to Section 11.15 hereof, the Lender shall have completed its Due Diligence Review of the Mortgage Loan Documents for each Loan and such other documents, records, agreements, instruments, mortgaged properties or information relating to such Loans as the Lender in its sole discretion deems appropriate to review and such review shall be satisfactory to the Lender in its sole discretion; (e) the Lender shall have received from the Custodian a Mortgage Loan Schedule with exceptions as are acceptable to the Lender in its sole discretion in respect of Eligible Mortgage Loans to be pledged hereunder on such Business Day; (f) Bailee Agreement. A Bailee Agreement in respect of Table-Funded Mortgage Loans to be pledged to hereunder on such Business Day, duly executed by the parties thereto; (g) the Lender shall have received from the Borrower a Warehouse Lender's Release Letter substantially in the form of Exhibit E-2 hereto (or such other form acceptable to the Lender) or a Seller's Release Letter substantially in the form of Exhibit E-1 hereto (or such other form acceptable to the Lender) covering each Mortgage Loan to be pledged to the Lender; -22- 27 (h) the Consolidated Shareholders' Equity is not equal to or less than $475,000,000; (i) none of the following shall have occurred and/or be continuing: (i) an event or events shall have occurred resulting in the effective absence of a "repo market" or comparable "lending market" for financing debt obligations secured by mortgage loans or securities (or reasonably expected to be) or an event or events shall have occurred resulting in the Lender not being able to finance any Mortgage Loans through the "repo market" or "lending market" with traditional counterparties at rates which would have been reasonable prior to the occurrence of such event or events; (ii) an event or events shall have occurred resulting in the effective absence of a "securities market" for securities backed by mortgage loans (or reasonably expected to be) or an event or events shall have occurred resulting in the Lender not being able to sell securities backed by mortgage loans at prices which would have been reasonable prior to such event or events; or (iii) there shall have occurred a material adverse change in the financial condition of the Lender which effects (or can reasonably be expected to effect) materially and adversely the ability of the Lender to fund its obligations under this Loan Agreement; (iv) there shall have occurred any action, suit, arbitration, investigation (including, without limitation, any of the foregoing which are pending or threatened) or other legal or arbitrable proceeding affecting the Borrower or affecting any of the Property of any of them before any Governmental Authority (i) as to which individually or in the aggregate there is a reasonable likelihood of an adverse decision which would be reasonably likely to have a material adverse effect on its Property, business or financial condition or prospects or, (ii) makes a claim or claims in an aggregate amount greater than $5,000,000.00, (ii) which, individually or in the aggregate, if adversely determined, could be reasonably likely to have a Material Adverse Effect, or (iii) which requires filing with the Securities and Exchange Commission in accordance with the 1934 Act or any rules thereunder. (j) Morgan Stanley Dean Witter & Co.'s corporate bond rating as calculated by S&P or Moody's has not been lowered or downgraded to a rating below A- as indicated by S&P or below A3 as indicated by Moody's. Each request for a borrowing by the Borrower hereunder shall constitute a certification by the Borrower that all the conditions set forth in this Section 5 (other than Sections 5.02(d), 5.02(i)(i), (ii) and (iii) and 5.02(j)) have been satisfied (both as of the date of such notice, request or confirmation and as of the date of such borrowing). Section 6. Representations and Warranties. The Borrower represents and warrants to the Lender that throughout the term of this Loan Agreement: 6.01 Existence. The Borrower (a) is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction of its organization, (b) has all -23- 28 requisite corporate or other power, and has all governmental licenses, authorizations, consents and approvals necessary to own its assets and carry on its business as now being or as proposed to be conducted, except where the lack of such licenses, authorizations, consents and approvals would not be reasonably likely to have a material adverse effect on its Property, business or financial condition or prospects; and (c) is qualified to do business and is in good standing in all other jurisdictions in which the nature of the business conducted by it makes such qualification necessary, except where failure so to qualify would not be reasonably likely (either individually or in the aggregate) to have a Material Adverse Effect. 6.02 Financial Condition. The Borrower has heretofore furnished to the Lender a copy of (a) the consolidated balance sheets of the Borrower and its consolidated Subsidiaries for the first two quarterly fiscal periods of the fiscal year of the Borrower ended December 31, 1999 and the related consolidated statements of operations and changes in net assets and of cash flows for the Borrower and its consolidated Subsidiaries for such quarterly fiscal periods, setting forth in each case in comparative form the figures for the previous year, (b) the consolidated balance sheets of the Borrower and its consolidated Subsidiaries for the 1998 fiscal year and the related consolidated statements of operations and changes in net assets and of cash flows for the Borrower and its consolidated Subsidiaries for such fiscal year, setting forth in each case in comparative form the figures for the previous year, with the opinion thereon of Arthur Andersen LLP. All such financial statements are complete and correct and fairly present, in all material respects, the consolidated financial condition of the Borrower and its consolidated Subsidiaries and the consolidated results of its operations as at such dates and for such fiscal periods, all in accordance with GAAP applied on a consistent basis. Since June 30, 1999, there has been no material adverse change in the consolidated business, operations or financial condition of the Borrower from that set forth in said financial statements. 6.03 Litigation. There are no actions, suits, arbitrations, investigations (including, without limitation, any of the foregoing which are pending or threatened) or other legal or arbitrable proceedings affecting the Borrower or any of its Subsidiaries or affecting any of the Property of any of them before any Governmental Authority that (i) questions or challenges the validity or enforceability of any of the Loan Documents or performance by the Borrower of its obligations thereunder, (ii) as to which individually or in the aggregate there is a reasonable likelihood of an adverse decision which would be reasonably likely to have a material adverse effect on its Property, business or financial condition or prospects, (iii) makes a claim or claims in an aggregate amount greater than $5,000,000.00, (iv) which, individually or in the aggregate, if adversely determined, could be reasonably likely to have a Material Adverse Effect, or (v) which requires filing with the Securities and Exchange Commission in accordance with the 1934 Act or any rules thereunder. 6.04 No Breach. Neither (a) the execution and delivery of the Loan Documents nor (b) the consummation of the transactions therein contemplated in compliance with the terms and provisions thereof will conflict with or result in a breach of the charter or by-laws of the Borrower, or any applicable law, rule or regulation, or any order, writ, injunction or decree of any Governmental Authority, including the Investment Company Act of 1940, or any Servicing Agreement or other material agreement or instrument to which the Borrower is a party or by which the Borrower or any of its Property is bound or to which it is subject, or constitute a default under any such material agreement or instrument or result in the creation or imposition of -24- 29 any Lien (except for the Liens created pursuant to this Loan Agreement) upon any Property of the Borrower pursuant to the terms of any such agreement or instrument. 6.05 Action. The Borrower has all necessary corporate or other power, authority and legal right to execute, deliver and perform its obligations under each of the Loan Documents; the execution, delivery and performance by the Borrower of each of the Loan Documents have been duly authorized by all necessary corporate or other action on its part; and each Loan Document has been duly and validly executed and delivered by the Borrower and constitutes a legal, valid and binding obligation of the Borrower, enforceable against the Borrower in accordance with its terms subject to bankruptcy laws and other similar laws of general application affecting rights of creditors and subject to the rules of equity including those respecting the availability of specific performance. 6.06 Approvals. No authorizations, approvals or consents of, and no filings or registrations with, any Governmental Authority or any securities exchange are necessary for the execution, delivery or performance by the Borrower of the Loan Documents or for the legality, validity or enforceability thereof, except for filings and recordings in respect of the Liens created pursuant to this Loan Agreement. 6.07 Margin Regulations. Neither the making of any Loan hereunder, nor the use of the proceeds thereof, will violate or be inconsistent with the provisions of Regulations T, U or X. 6.08 Taxes. The Borrower and each of its Subsidiaries has filed all Federal income tax returns and all other material tax returns or necessary extensions that are required to be filed by any of them and have paid all taxes due pursuant to such returns or pursuant to any assessment received by any of them, except for any such taxes as are being appropriately contested in good faith by appropriate proceedings diligently conducted and with respect to which adequate reserves have been provided. The charges, accruals and reserves on the books of the Borrower and its Subsidiaries in respect of taxes and other governmental charges are, in the opinion of the Borrower, adequate. 6.09 Investment Company Act. The Borrower has elected to be regulated as a Business Development Company under the 1940 Act. The execution, delivery and performance by the Borrower of this Agreement and the other Loan Documents and each borrowing by the Borrower hereunder do not and will not violate or conflict with, or require any consent of any Governmental Authority under, the 1940 Act. 6.10 Collateral; Collateral Security. (a) The Borrower has not assigned, pledged, nor otherwise conveyed or encumbered any Mortgage Loan or other Collateral to any other Person, and immediately prior to the pledge of such Mortgage Loan or any other Collateral to the Lender, the Borrower was the sole owner of such Mortgage Loan or such other Collateral and had good and marketable title thereto, free and clear of all Liens, in each case except for Liens to be released simultaneously with the Liens granted in favor of the Lender hereunder. No Mortgage Loan pledged to the Lender hereunder was acquired (by purchase or otherwise) by the Borrower from an Affiliate of -25- 30 the Borrower, or such other acquisition approved in writing by the Lender at the Lender's sole discretion. (b) The provisions of this Loan Agreement are effective to create in favor of the Lender a valid security interest in all right, title and interest of the Borrower in, to and under the Collateral. (c) Upon receipt by the Custodian of each Mortgage Note, endorsed in blank by a duly authorized officer of the Borrower, the Lender shall have a fully perfected first priority security interest therein, in the Mortgage Loan evidenced thereby and in the Borrower's interest in the related Mortgaged Property. (d) Upon the filing of financing statements on Form UCC-1 naming the Lender as "Secured Party" and the Borrower as "Debtor", and describing the Collateral, in the jurisdictions and recording offices listed on Schedule 2 attached hereto, the security interests granted hereunder in the Collateral will constitute fully perfected first priority security interests under the Uniform Commercial Code in all right, title and interest of the Borrower in, to and under such Collateral which can be perfected by filing under the Uniform Commercial Code. 6.11 Chief Executive Office. The Borrower's chief executive office on the Effective Date, and during the four months immediately preceding the Effective Date, the Borrower's chief executive office, is, and has been, located at 1919 Pennsylvania Avenue, N.W., Washington, D.C. 20006. On the Effective Date, the Borrower's jurisdiction of organization is the State of Maryland. 6.12 Location of Books and Records. The location where the Borrower keeps its books and records, including all computer tapes and records relating to the Collateral is its chief executive office. 6.13 Hedging. The Borrower shall enter into Interest Rate Protection Agreements pursuant to the Borrower's variable rate debt having terms with respect to protection against fluctuations in interest rates pursuant to the Borrower's policies and procedures reasonably acceptable to the Lender. 6.14 True and Complete Disclosure. The information, reports, financial statements, exhibits and Schedules furnished in writing by or on behalf of the Borrower to the Lender in connection with the negotiation, preparation or delivery of this Loan Agreement and the other Loan Documents or included herein or therein or delivered pursuant hereto or thereto, when taken as a whole, do not contain any untrue statement of material fact or omit to state any material fact necessary to make the statements herein or therein, in light of the circumstances under which they were made, not misleading. All written information furnished after the date hereof by or on behalf of the Borrower to the Lender in connection with this Loan Agreement and the other Loan Documents and the transactions contemplated hereby and thereby will be true, complete and accurate in every material respect, or (in the case of projections) based on reasonable estimates, on the date as of which such information is stated or certified. There is no fact known to a Responsible Officer of the Borrower, after due inquiry, that could reasonably be expected to have a Material Adverse Effect that has not been disclosed herein, in the other Loan -26- 31 Documents or in a report, financial statement, exhibit, Schedule, disclosure letter or other writing furnished to the Lender for use in connection with the transactions contemplated hereby or thereby. 6.15 Consolidated Shareholders' Equity. On the Effective Date, the Consolidated Shareholders' Equity is not less than $542,000,000. 6.16 ERISA. The Borrower has not established nor contributed to a Plan or Multiemployer Plan. 6.17 Material Subsidiaries. As of the Effective Date, the Material Subsidiaries of the Borrower are listed on Schedule 3 hereto. Section 7. Covenants of the Borrower. The Borrower covenants and agrees with the Lender that, so long as any Loan is outstanding and until payment in full of all Secured Obligations: 7.01 Financial Statements. The Borrower shall deliver to the Lender: (a) as soon as available and in any event within 45 days after the end of each of the first three quarterly fiscal periods of each fiscal year of the Borrower, the unaudited consolidated balance sheets of the Borrower and its consolidated Subsidiaries as at the end of such period and the related unaudited consolidated statements of operations and changes in net assets and of cash flows for the Borrower and its consolidated Subsidiaries for such period and the portion of the fiscal year through the end of such period, setting forth in each case in comparative form the figures for the previous year, accompanied by a certificate of a Responsible Officer of the Borrower, which certificate shall state that said consolidated financial statements fairly present the consolidated financial condition and results of operations of the Borrower and its consolidated Subsidiaries in accordance with GAAP, consistently applied, as at the end of, and for, such period (subject to normal year-end audit adjustments); (b) as soon as available and in any event within 120 days after the end of each fiscal year of the Borrower, the consolidated balance sheets of the Borrower as at the end of such fiscal year and the related consolidated statements of operations and changes in net assets and of cash flows for the Borrower for such year, setting forth in each case in comparative form the figures for the previous year, accompanied by an opinion thereon of independent certified public accountants of recognized national standing, which opinion shall not be qualified as to scope of audit or going concern and shall state that said consolidated financial statements fairly present the consolidated financial condition and results of operations of the Borrower and its consolidated Subsidiaries as at the end of, and for, such fiscal year in accordance with GAAP; (c) from time to time such other information regarding the financial condition, operations, or business of the Borrower as the Lender may reasonably request; and The Borrower will furnish to the Lender, at the time it furnishes each set of financial statements pursuant to paragraphs (a) and (b) above, a certificate of a Responsible Officer of the Borrower to the effect that, to the best of such Responsible Officer's knowledge, the Borrower during such fiscal period or year has observed or performed all of its covenants and other agreements, and -27- 32 satisfied every condition, contained in this Loan Agreement and the other Loan Documents to be observed, performed or satisfied by it, and that such Responsible Officer has obtained no knowledge of any Default or Event of Default except as specified in such certificate (and, if any Default or Event of Default has occurred and is continuing, describing the same in reasonable detail and describing the action the Borrower has taken or proposes to take with respect thereto). 7.02 Litigation. The Borrower will, promptly, and in any event within 10 days after service of process on any of the following, give to the Lender notice of all litigation, actions, suits, arbitrations, investigations (including, without limitation, any of the foregoing which are pending or threatened) or other legal or arbitrable proceedings affecting the Borrower or any of its Subsidiaries or affecting any of the Property of any of them before any Governmental Authority that (i) questions or challenges the validity or enforceability of any of the Loan Documents or performance by the Borrower of its obligations thereunder, (ii) as to which individually or in the aggregate there is a reasonable likelihood of an adverse decision which would be reasonably likely to have a material adverse effect on its Property, business or financial condition or prospects, (iii) which makes a claim or claims in an aggregate amount greater than $5,000,000.00, (iv) which, individually or in the aggregate, if adversely determined, could be reasonably likely to have a Material Adverse Effect, or (v) which requires filing with the Securities and Exchange Commission in accordance with the 1934 Act and any rules thereunder. 7.03 Existence, etc. The Borrower will: (a) preserve and maintain its legal existence and all of its material rights, privileges, licenses and franchises including the Borrower's election to be regulated as a Business Development Company, (provided that nothing in this Section 7.03(a) shall prohibit any transaction expressly permitted under Section 7.04 hereof); (b) comply with the requirements of all applicable laws, rules, regulations and orders of Governmental Authorities (including, without limitation, all environmental laws) if failure to comply with such requirements would be reasonably likely (either individually or in the aggregate) to have a material adverse effect on its Property, business or financial condition, or prospects; (c) keep adequate records and books of account, in which complete entries will be made in accordance with GAAP consistently applied; (d) not move its chief executive office from the address referred to in Section 6.11 or change its jurisdiction of organization from the jurisdiction referred to in Section 6.11 unless it shall have provided the Lender 30 days' prior written notice of such change; (e) pay and discharge all taxes, assessments and governmental charges or levies imposed on it or on its income or profits or on any of its Property prior to the date on which penalties attach thereto, except for any such tax, assessment, charge or levy the payment of which is being contested in good faith and by proper proceedings and against which adequate reserves are being maintained; and -28- 33 (f) permit representatives of the Lender, during normal business hours and upon reasonable advance notice, to examine, copy and make extracts from its books and records, to inspect any of its Properties, and to discuss its business and affairs with its officers, all to the extent reasonably requested by the Lender. 7.04 Prohibition of Fundamental Changes. The Borrower shall not enter into any transaction of merger or consolidation or amalgamation, or liquidate, wind up or dissolve itself (or suffer any liquidation, winding up or dissolution) or sell all or substantially all of its assets; provided, that the Borrower may merge or consolidate with (a) any wholly owned subsidiary of the Borrower, or (b) any other Person if the Borrower is the surviving corporation; and provided further, that if after giving effect thereto, no Default would exist hereunder. 7.05 Borrowing Base Deficiency. If at any time there exists a Borrowing Base Deficiency the Borrower shall cure same in accordance with Section 2.06 hereof. 7.06 Notices. The Borrower shall give notice to the Lender: (a) promptly upon receipt of notice or knowledge of the occurrence of any Default or Event of Default; (b) with respect to any Mortgage Loan pledged to the Lender hereunder, within one Business Day of receipt of any principal prepayment other than Scheduled payments (in full or partial) of such pledged Mortgage Loan; (c) with respect to any Mortgage Loan pledged to the Lender hereunder, immediately upon receipt of notice or knowledge that the underlying Mortgaged Property has been damaged by waste, fire, earthquake or earth movement, windstorm, flood, tornado or other casualty, or otherwise damaged so as to affect adversely the Collateral Value of such pledged Mortgage Loan; and (d) promptly upon receipt of notice or knowledge of (i) any default related to any Collateral, (ii) any Lien or security interest (other than security interests created hereby or by the other Loan Documents) on, or claim asserted against, any of the Collateral or (iii) any event or change in circumstances which could reasonably be expected to have a material adverse effect on the Property, business or financial condition or prospects of the Borrower. (e) promptly upon receipt of notice or knowledge that The Borrower may not be in compliance with the requirements of the 1940 Act for a Business Development Company. Each notice pursuant to this Section shall be accompanied by a statement of a Responsible Officer of the Borrower setting forth details of the occurrence referred to therein and stating what action the Borrower has taken or proposes to take with respect thereto. 7.07 Hedging. The Borrower shall at all times maintain Interest Rate Protection Agreements, pursuant to the Borrower's variable rate debt having terms with respect to protection against fluctuations in interest rates pursuant to the Borrower's policies and procedures reasonably acceptable to the Lender. The Borrower shall deliver to the Lender -29- 34 quarterly (unless requested more frequently by the Lender) a written summary of the notional amount of all outstanding Interest Rate Protection Agreements. 7.08 Reports. The Borrower shall provide the Lender with a quarterly report, which report shall include, among other items, a summary of the Borrower's delinquency and loss experience with respect to mortgage loans held by the Borrower, plus any such additional reports as the Lender may reasonably request with respect to the Borrower's or any Servicer's servicing portfolio or pending originations of mortgage loans. The Borrower shall provide the Lender with information, promptly upon the Borrower's receipt, with respect to each Mortgaged Property related to each Mortgage Loan pledged to the Lender hereunder, including without limitation, the operating statements, rent roll (if applicable and which may be provided on a quarterly basis if not available on a monthly basis) and occupancy status of such Mortgaged Property and property level information. 7.09 Underwriting Guidelines. Without the prior written consent of the Lender, the Borrower shall not amend materially nor otherwise modify materially the Underwriting Guidelines. Notwithstanding the preceding sentence, in the event that the Borrower makes any amendment or modification to its Underwriting Guidelines, the Borrower shall promptly deliver to the Lender a complete copy of the amended or modified Underwriting Guidelines. 7.10 Transactions with Affiliates. The Borrower will not enter into any transaction, including without limitation any purchase, sale, lease or exchange of property or the rendering of any service, with any Affiliate unless such transaction is (a) otherwise permitted under this Loan Agreement, (b) in the ordinary course of the Borrower's business and (c) upon fair and reasonable terms no less favorable to the Borrower than it would obtain in a comparable arm's length transaction with a Person which is not an Affiliate, or make a payment that is not otherwise permitted by this Section 7.10 to any Affiliate. In no event shall the Borrower pledge to the Lender hereunder any Mortgage Loan acquired by the Borrower from an Affiliate of the Borrower other than an acquisition approved in writing by the Lender at the Lender's sole discretion. 7.11 Limitation on Liens. The Borrower will defend the Collateral against, and will take such other action as is necessary to remove, any Lien, security interest or claim on or to the Collateral, other than the security interests created under this Loan Agreement, and the Borrower will defend the right, title and interest of the Lender in and to any of the Collateral against the claims and demands of all persons whomsoever. 7.12 Limitation on Distributions. After the occurrence and during the continuation of any Event of Default under Section 8(a), (b), (f), (g) or (h), or clause (i) or (ii) of (k) hereof, the Borrower shall not make any payment on account of, or set apart assets for, a sinking or other analogous fund for the purchase, redemption, defeasance, retirement or other acquisition of any equity or partnership interest of the Borrower, whether now or hereafter outstanding, or make any other distribution in respect of any of the foregoing or to any shareholder or equity owner of the Borrower in its capacity as such, either directly or indirectly, whether in cash or property or in obligations of the Borrower or any of its consolidated Subsidiaries. -30- 35 7.13 Consolidated Shareholders' Equity. The Borrower shall not permit the Consolidated Shareholders' Equity to be less than (i) $425,000,000 plus (ii) 75% of the Net Proceeds of all Equity Issuances effected by the Borrower or any of its Subsidiaries at any time subsequent to the date hereof (excluding the Net Proceeds of any Equity Issuance by a Subsidiary to Subsidiaries or to the Borrower). 7.14 Maintenance of Ratio of Total Indebtedness to Consolidated Shareholders' Equity. The Borrower shall not permit the ratio of Total Indebtedness with respect to recourse obligations to Consolidated Shareholders' Equity at any time to be greater than 3:1. 7.15 Maintenance of Profitability. The Borrower shall not permit, for any period of two consecutive fiscal quarters (each such period, a "Test Period"), Net Income for such Test Period, before income taxes for such Test Period and distributions made during such Test Period, to be less than $1.00. 7.16 Servicing Tape. The Borrower shall provide to the Lender on the twelfth (12th) Business Day of each month a computer readable file containing servicing information, including without limitation those fields specified by the Lender from time to time, on a loan-by-loan basis and in the aggregate, with respect to the Mortgage Loans serviced hereunder by the Borrower or any Servicer. 7.17 Interest Rate Protection Agreements. The Borrower shall not pledge, hypothecate, encumber or permit any Lien to exist on any Interest Rate Protection Agreement, except with respect to those Interest Rate Protection Agreements between the Borrower and the Lender or any Affiliate of the Lender. 7.18 Required Filings. The Borrower shall promptly provide the Lender with copies of all documents which the Borrower or any Subsidiary of the Borrower is required to file with the Securities and Exchange Commission in accordance with the 1934 Act or any rules thereunder. 7.19 No Adverse Selection. The Borrower has not selected the Collateral in a manner so as to adversely affect the Lender's interests. 7.20 Computer Systems. The Borrower shall take all action necessary to assure that its System shall reasonably be expected to be Year 2000 Compliant. 7.21 ERISA. The Borrower shall not establish nor contribute to a Plan or Multiemployer Plan. 7.22 Remittance of Prepayments. The Borrower shall remit, with sufficient detail to enable the Lender to appropriately identify the Mortgage Loan to which any amount remitted applies, to the Lender on each Thursday (or the next Business Day if such Thursday is not a Business Day) all Prepayments that the Borrower has received during the previous week. 7.23 Lender's Right to Purchase. Prior to any whole loan sale of any Mortgage Loan to a bona-fide third party purchaser, the Borrower shall first provide the Lender with the opportunity to submit a bid on said Mortgage Loans. -31- 36 7.24 Securitizations. The Borrower agrees that MS&Co. shall retain the exclusive option to act as sole lead underwriter or sole lead placement agent in connection with the consummation of the next securitization of any Mortgage Loans by the Borrower or any of the Borrower's Subsidiaries following the Effective Date. 7.25 Material Subsidiaries. The Borrower shall immediately notify the Lender upon any present of future Subsidiary of the Borrower becoming a Material Subsidiary by delivering a revised Schedule 3 hereto. Section 8. Events of Default. Each of the following events shall constitute an event of default (an "Event of Default") hereunder: (a) the Borrower shall default in the payment of any principal of or interest on any Loan when due (whether at stated maturity, upon acceleration or at mandatory or optional prepayment); or (b) the Borrower shall default in the payment of any other amount payable by it hereunder or under any other Loan Document after notification by the Lender of such default, and such default shall have continued unremedied for five Business Days; or (c) any representation, warranty or certification made or deemed made herein or in any other Loan Document by the Borrower or any certificate furnished to the Lender pursuant to the provisions hereof or thereof shall prove to have been false or misleading in any material respect as of the time made or furnished other than the representations and warranties set forth in Schedule 1, which shall be considered solely for the purpose of determining the Collateral Value of the Mortgage Loans; unless (i) the Borrower shall have made any such representations and warranties with knowledge that they were materially false or misleading at the time made, or (ii) any such representations and warranties have been determined by the Lender in its sole discretion to be materially false or misleading on a regular basis); or (d) the Borrower shall fail to comply with the requirements of Section 7.03(a), Section 7.04, Section 7.05, Section 7.06, or any of Sections 7.09 through 7.22 or Section 7.25 hereof; or the Borrower shall otherwise fail to comply with the requirements of Section 7.03 hereof and such default shall continue unremedied for a period of five Business Days; or the Borrower shall fail to observe or perform any other covenant or agreement contained in this Loan Agreement or any other Loan Document and such failure to observe or perform shall continue unremedied for a period of seven Business Days; or (e) a final judgment or judgments for the payment of money in excess of $20,000,000 in the aggregate shall be rendered against the Borrower or any of its Subsidiaries by one or more courts, administrative tribunals or other bodies having jurisdiction and the same shall not be satisfied, discharged (or provision shall not be made for such discharge) or bonded, or a stay of execution thereof shall not be procured, within 60 days from the date of entry thereof, and the Borrower or any such Subsidiary shall not, within said period of 60 days, or such longer period during which execution of the same shall have been stayed or bonded, appeal therefrom and cause the execution thereof to be stayed during such appeal; or -32- 37 (f) the Borrower shall admit in writing its inability to pay its debts as such debts become due; or (g) the Borrower or any of its Material Subsidiaries or any of its Other Relevant Subsidiaries shall (i) apply for or consent to the appointment of, or the taking of possession by, a receiver, custodian, trustee, examiner or liquidator or the like of itself or of all or a substantial part of its property, (ii) make a general assignment for the benefit of its creditors, (iii) commence a voluntary case under the Bankruptcy Code, (iv) file a petition seeking to take advantage of any other law relating to bankruptcy, insolvency, reorganization, liquidation, dissolution, arrangement or winding-up, or composition or readjustment of debts, (v) fail to controvert in a timely and appropriate manner, or acquiesce in writing to, any petition filed against it in an involuntary case under the Bankruptcy Code or (vi) take any corporate or other action for the purpose of effecting any of the foregoing; or (h) a proceeding or case shall be commenced, without the application or consent of the Borrower or any of its Material Subsidiaries or any of its Other Relevant Subsidiaries, in any court of competent jurisdiction, seeking (i) its reorganization, liquidation, dissolution, arrangement or winding-up, or the composition or readjustment of its debts, (ii) the appointment of, or the taking of possession by, a receiver, custodian, trustee, examiner, liquidator or the like of the Borrower or any such Material Subsidiary or Other Relevant Subsidiary or of all or any substantial part of its property, or (iii) similar relief in respect of the Borrower or any such Material Subsidiary or Other Relevant Subsidiary under any law relating to bankruptcy, insolvency, reorganization, liquidation, dissolution, arrangement or winding-up, or composition or adjustment of debts, and such proceeding or case shall continue undismissed, or an order, judgment or decree approving or ordering any of the foregoing shall be entered and continue unstayed and in effect, for a period of 60 or more days; or an order for relief against the Borrower or any such Material Subsidiary or Other Relevant Subsidiary shall be entered in an involuntary case under the Bankruptcy Code; or (i) the Custodial Agreement or any Loan Document shall for whatever reason be terminated or cease to be in full force and effect, or the enforceability thereof shall be contested by the Borrower; (j) the Borrower shall grant, or suffer to exist, any Lien on any Collateral except the Liens contemplated hereby; or the Liens contemplated hereby shall cease to be first priority perfected Liens on the Collateral in favor of the Lender or shall be Liens in favor of any Person other than the Lender; (k) (i) the Borrower or any of the Borrower's Subsidiaries shall fail to pay when due and payable the principal of, or interest on, any Indebtedness (other than the Loans) having an aggregate outstanding principal amount of $5,000,000 or more, (ii) the maturity of any Indebtedness (other than the Loans) of the Borrower or any of the Borrower's Subsidiaries having an aggregate outstanding principal amount of $5,000,000 or more shall have (x) been accelerated in accordance with the provisions of any indenture, contract or instrument evidencing, providing for the creation of or otherwise concerning such Indebtedness or (y) been required to be prepaid prior to the stated maturity thereof; or (iii) any other event shall have occurred and be continuing with respect to any Indebtedness (other than the Loans) of the -33- 38 Borrower or any of the Borrower's Subsidiaries having an aggregate outstanding principal amount of $5,000,000 or more which, with or without the passage of time, the giving of notice, or otherwise, would permit any holder or holders of such Indebtedness, any trustee or agent acting on behalf of such holder or holders or any other Person, to accelerate the maturity of any such Indebtedness or require any such Indebtedness to be prepaid prior to its stated maturity; or (l) any materially adverse change in the Property, business, financial condition or prospects of the Borrower or any of the Borrower's Material Subsidiaries or Other Related Subsidiaries shall occur, in each case as determined by the Lender in its sole discretion, or any other condition shall exist which, in the Lender's sole discretion, constitutes a material impairment of the Borrower's ability to perform its obligations under this Loan Agreement, the Note or any other Loan Document; or (m) the discovery by the Lender of a condition or event which existed at or prior to the execution hereof and which the Lender, in its sole discretion, determines materially and adversely affects; (i) the condition (financial or otherwise) of the Borrower, any of its Affiliates; or (ii) the ability of either the Borrower or the Lender to fulfill its respective obligations under this Loan Agreement. Section 9. Remedies Upon Default. (a) An Event of Default shall be deemed to be continuing unless expressly waived by the Lender in writing. Upon the occurrence of one or more Events of Default hereunder, the Lender's obligation to make additional Loans to the Borrower shall automatically terminate without further action by any Person. Upon the occurrence of one or more Events of Default other than those referred to in Section 8(g) or (h), the Lender may immediately declare the principal amount of the Loans then outstanding under the Note to be immediately due and payable, together with all interest thereon and fees and expenses accruing under this Loan Agreement. Upon the occurrence of an Event of Default referred to in Sections 8(g) or (h), such amounts shall immediately and automatically become due and payable without any further action by any Person. Upon such declaration or such automatic acceleration, the balance then outstanding on the Note shall become immediately due and payable, without presentment, demand, protest or other formalities of any kind, all of which are hereby expressly waived by the Borrower. (b) Upon the occurrence of one or more Events of Default, the Lender shall have the right to obtain physical possession of the Servicing Records and all other files of the Borrower relating to the Collateral and all documents relating to the Collateral which are then or may thereafter come in to the possession of the Borrower or any third party acting for the Borrower and the Borrower shall deliver to the Lender such assignments as the Lender shall request. The Lender shall be entitled to specific performance of all agreements of the Borrower contained in this Loan Agreement. -34- 39 Section 10. No Duty of Lender. The powers conferred on the Lender hereunder are solely to protect the Lender's interests in the Collateral and shall not impose any duty upon it to exercise any such powers. The Lender shall be accountable only for amounts that it actually receives as a result of the exercise of such powers, and neither it nor any of its officers, directors, employees or agents shall be responsible to the Borrower for any act or failure to act hereunder, except for its or its own gross negligence or willful misconduct. Section 11. Miscellaneous. 11.01 Waiver. No failure on the part of the Lender to exercise and no delay in exercising, and no course of dealing with respect to, any right, power or privilege under any Loan Document shall operate as a waiver thereof, nor shall any single or partial exercise of any right, power or privilege under any Loan Document preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The remedies provided herein are cumulative and not exclusive of any remedies provided by law. 11.02 Notices. Except as otherwise expressly permitted by this Loan Agreement, all notices, requests and other communications provided for herein and under the Custodial Agreement (including without limitation any modifications of, or waivers, requests or consents under, this Loan Agreement) shall be given or made in writing (including without limitation by telex or telecopy) delivered to the intended recipient at the "Address for Notices" specified below its name on the signature pages hereof or thereof); or, as to any party, at such other address as shall be designated by such party in a written notice to each other party provided, that a copy of all notices given under Section 7.01 shall simultaneously be delivered to Credit Department, Morgan Stanley Dean Witter, 1221 Avenue of the Americas, 35th Floor, New York, New York 10036; Attention: Patrick Romaine. Except as otherwise provided in this Loan Agreement and except for notices given under Section 2 (which shall be effective only on receipt), all such communications shall be deemed to have been duly given when transmitted by telex or telecopy or personally delivered or, in the case of a mailed notice, upon receipt, in each case given or addressed as aforesaid. 11.03 Indemnification and Expenses. (a) The Borrower agrees to hold the Lender, and its Affiliates and their officers, directors, employees, agents and advisors (each an "Indemnified Party") harmless from and indemnify any Indemnified Party against all liabilities, losses, damages, judgments, costs and expenses of any kind which may be imposed on, incurred by or asserted against such Indemnified Party (collectively, the "Costs") relating to or arising out of this Loan Agreement, the Note, any other Loan Document or any transaction contemplated hereby or thereby, or any amendment, supplement or modification of, or any waiver or consent under or in respect of, this Loan Agreement, the Note, any other Loan Document or any transaction contemplated hereby or thereby, that, in each case, results from anything other than any Indemnified Party's gross negligence or willful misconduct. Without limiting the generality of the foregoing, the Borrower agrees to hold any Indemnified Party harmless from and indemnify such Indemnified Party against all Costs with respect to (i) Table-Funded Mortgage Loans relating to or arising out of any breach, violation or alleged breach or violation of any consumer credit laws, including without limitation the Truth in Lending Act and/or the Real Estate Settlement Procedures Act -35- 40 and (ii) all Mortgage Loans relating to or arising out of any violation or alleged violation of any environmental law, rule or regulation that, in each case, results from anything other than such Indemnified Party's gross negligence or willful misconduct. In any suit, proceeding or action brought by an Indemnified Party in connection with any Mortgage Loan for any sum owing thereunder, or to enforce any provisions of any Mortgage Loan, the Borrower will save, indemnify and hold such Indemnified Party harmless from and against all expense, loss or damage suffered by reason of any defense, set-off, counterclaim, recoupment or reduction or liability whatsoever of the account debtor or obligor thereunder, arising out of a breach by the Borrower of any obligation thereunder or arising out of any other agreement, indebtedness or liability at any time owing to or in favor of such account debtor or obligor or its successors from the Borrower. The Borrower also agrees to reimburse an Indemnified Party as and when billed by such Indemnified Party for all such Indemnified Party's costs and expenses incurred in connection with the enforcement or the preservation of such Indemnified Party's rights under this Loan Agreement, the Note, any other Loan Document or any transaction contemplated hereby or thereby, including without limitation the reasonable fees and disbursements of its counsel. The Borrower hereby acknowledges that, notwithstanding the fact that the Note is secured by the Collateral, the obligation of the Borrower under the Note is a recourse obligation of the Borrower. (b) The Borrower agrees to pay as and when billed by the Lender all of the out-of-pocket costs and expenses incurred by the Lender in connection with the development, preparation and execution of, and any amendment, supplement or modification to, this Loan Agreement, the Note, any other Loan Document or any other documents prepared in connection herewith or therewith. The Borrower agrees to pay as and when billed by the Lender all of the out-of-pocket costs and expenses incurred in connection with the consummation and administration of the transactions contemplated hereby and thereby including without limitation all the reasonable fees, disbursements and expenses of counsel to the Lender, not to exceed $25,000, which amount shall be deducted from the first Loan disbursement. 11.04 Amendments. Except as otherwise expressly provided in this Loan Agreement, any provision of this Loan Agreement may be modified or supplemented only by an instrument in writing signed by the Borrower and the Lender and any provision of this Loan Agreement may be waived by the Lender. 11.05 Successors and Assigns. This Loan Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and permitted assigns. 11.06 Survival. The obligations of the Borrower under Sections 3.03, 3.04 and 11.03 hereof shall survive the repayment of the Loans and the termination of this Loan Agreement. In addition, each representation and warranty made or deemed to be made by a request for a borrowing, herein or pursuant hereto shall survive the making of such representation and warranty, and the Lender shall not be deemed to have waived, by reason of making any Loan, any Default that may arise because any such representation or warranty shall have proved to be false or misleading, notwithstanding that the Lender may have had notice or knowledge or reason to believe that such representation or warranty was false or misleading at the time such Loan was made. -36- 41 11.07 Captions. The table of contents and captions and section headings appearing herein are included solely for convenience of reference and are not intended to affect the interpretation of any provision of this Loan Agreement. 11.08 Counterparts. This Loan Agreement may be executed in any number of counterparts, all of which taken together shall constitute one and the same instrument, and any of the parties hereto may execute this Loan Agreement by signing any such counterpart. 11.09 Loan Agreement Constitutes Security Agreement; Governing Law. This Loan Agreement shall be governed by New York law without reference to choice of law doctrine, and shall constitute a security agreement within the meaning of the Uniform Commercial Code. 11.10 SUBMISSION TO JURISDICTION; WAIVERS. LENDER AND THE BORROWER HEREBY IRREVOCABLY AND UNCONDITIONALLY: (a) SUBMITS FOR ITSELF AND ITS PROPERTY IN ANY LEGAL ACTION OR PROCEEDING RELATING TO THIS LOAN AGREEMENT, THE NOTE AND THE OTHER LOAN DOCUMENTS, OR FOR RECOGNITION AND ENFORCEMENT OF ANY JUDGMENT IN RESPECT THEREOF, TO THE NON-EXCLUSIVE GENERAL JURISDICTION OF THE COURTS OF THE STATE OF NEW YORK, THE FEDERAL COURTS OF THE UNITED STATES OF AMERICA FOR THE SOUTHERN DISTRICT OF NEW YORK, AND APPELLATE COURTS FROM ANY THEREOF; (b) CONSENTS THAT ANY SUCH ACTION OR PROCEEDING MAY BE BROUGHT IN SUCH COURTS AND, TO THE EXTENT PERMITTED BY LAW, WAIVES ANY OBJECTION THAT IT MAY NOW OR HEREAFTER HAVE TO THE VENUE OF ANY SUCH ACTION OR PROCEEDING IN ANY SUCH COURT OR THAT SUCH ACTION OR PROCEEDING WAS BROUGHT IN AN INCONVENIENT COURT AND AGREES NOT TO PLEAD OR CLAIM THE SAME; (c) AGREES THAT SERVICE OF PROCESS IN ANY SUCH ACTION OR PROCEEDING MAY BE EFFECTED BY MAILING A COPY THEREOF BY REGISTERED OR CERTIFIED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL), POSTAGE PREPAID, TO ITS ADDRESS SET FORTH UNDER ITS SIGNATURE BELOW OR AT SUCH OTHER ADDRESS OF WHICH THE LENDER SHALL HAVE BEEN NOTIFIED; AND (d) AGREES THAT NOTHING HEREIN SHALL AFFECT THE RIGHT TO EFFECT SERVICE OF PROCESS IN ANY OTHER MANNER PERMITTED BY LAW OR SHALL LIMIT THE RIGHT TO SUE IN ANY OTHER JURISDICTION. 11.11 WAIVER OF JURY TRIAL. EACH OF THE BORROWER AND THE LENDER HEREBY IRREVOCABLY WAIVES, TO THE FULLEST EXTENT PERMITTED BY APPLICABLE LAW, ANY AND ALL RIGHT TO TRIAL BY JURY IN ANY LEGAL PROCEEDING ARISING OUT OF OR RELATING TO THIS LOAN -37- 42 AGREEMENT, ANY OTHER LOAN DOCUMENT OR THE TRANSACTIONS CONTEMPLATED HEREBY OR THEREBY. 11.12 Acknowledgments. The Borrower hereby acknowledges that: (a) it has been advised by counsel in the negotiation, execution and delivery of this Loan Agreement, the Note and the other Loan Documents; (b) the Lender has no fiduciary relationship to the Borrower, and the relationship between the Borrower and the Lender is solely that of debtor and creditor; and (c) no joint venture exists between the Lender and the Borrower. 11.13 Hypothecation or Pledge of Loans. The Lender shall have free and unrestricted use of all Collateral and nothing in this Loan Agreement shall preclude the Lender from engaging in repurchase transactions with the Collateral or otherwise pledging, repledging, transferring, hypothecating, or rehypothecating the Collateral. Nothing contained in this Loan Agreement shall obligate the Lender to segregate any Collateral delivered to the Lender by the Borrower, however the Lender shall be obligated to deliver the Collateral back to the Borrower in accordance with, and subject to, the provisions of this Loan Agreement. 11.14 Servicing. (a) The Borrower covenants to maintain or cause the servicing of the Mortgage Loans to be maintained in conformity with accepted and prudent servicing practices in the industry for the same type of mortgage loans as the Mortgage Loans and in a manner at least equal in quality to the servicing the Borrower provides for mortgage loans which it owns. In the event that the preceding language is interpreted as constituting one or more servicing contracts, each such servicing contract shall terminate automatically upon the earliest of (i) an Event of Default, (ii) the date on which all the Secured Obligations have been paid in full or (iii) the transfer of servicing approved by the Borrower. (b) If the Mortgage Loans are serviced by the Borrower, (i) the Borrower agrees that the Lender is the collateral assignee of all servicing records, including but not limited to any and all servicing agreements, files, documents, records, data bases, computer tapes, copies of computer tapes, proof of insurance coverage, insurance policies, appraisals, other closing documentation, payment history records, and any other records relating to or evidencing the servicing of Mortgage Loans (the "Servicing Records"), and (ii) the Borrower grants the Lender a security interest in all servicing fees and rights relating to the Mortgage Loans and all Servicing Records to secure the obligation of the Borrower or its designee to service in conformity with this Section and any other obligation of the Borrower to the Lender. The Borrower covenants to safeguard such Servicing Records and to deliver them promptly to the Lender or its designee (including the Custodian) at the Lender's request. (c) If the Mortgage Loans are serviced by a third party servicer (the "Servicer"), the Borrower (i) shall provide a copy of the servicing agreement to the Lender, which shall be in form and substance acceptable to the Lender (the "Servicing Agreement"); (ii) shall provide a Servicer Notice to the Servicer substantially in the form of Exhibit G hereto, and -38- 43 (ii) hereby irrevocably assigns to the Lender and the Lender's successors and assigns all right, title, interest of the Borrower in, to and under, and the benefits of, any Servicing Agreement with respect to the Mortgage Loans. Any successor to the Servicer shall be approved in writing by the Lender prior to such successor's assumption of servicing obligations with respect to the Mortgage Loans. (d) If the servicer of the Mortgage Loans is the Borrower or the Servicer is an Affiliate of the Borrower, the Borrower shall provide to the Lender a letter from the Borrower or the Servicer, as the case may be, to the effect that upon the occurrence of an Event of Default the Lender may terminate any Servicing Agreement and transfer servicing to its designee, at no cost or expense to the Lender, it being agreed that the Borrower will pay any and all fees required to terminate the Servicing Agreement and to effectuate the transfer of servicing to the designee of the Lender. (e) After the Funding Date, until the pledge of any Mortgage Loan is relinquished by the Custodian, the Borrower will have no right to modify or alter the terms of such Mortgage Loan and the Borrower will have no obligation or right to repossess such Mortgage Loan or substitute another Mortgage Loan, except as provided in the Custodial Agreement. (f) In the event the Borrower or its Affiliate is servicing the Mortgage Loans, the Borrower shall permit the Lender to inspect the Borrower's or its Affiliate's servicing facilities, as the case may be, for the purpose of satisfying the Lender that the Borrower or its Affiliate, as the case may be, has the ability to service the Mortgage Loans as provided in this Loan Agreement. (g) The Borrower shall ensure that the Servicer shall take all action necessary to assure that the Servicer's System shall reasonably be expected to be Year 2000 Compliant. 11.15 Periodic Due Diligence Review. The Borrower acknowledges that the Lender has the right to perform continuing due diligence reviews with respect to the Mortgage Loans, for purposes of verifying compliance with the representations, warranties and specifications made hereunder, or otherwise, and the Borrower agrees that upon reasonable (but no less than five Business Days prior notice, unless a Default shall have occurred, in which case no notice shall be required) to the Borrower, the Lender or its authorized representatives will be permitted during normal business hours to examine, inspect, and make copies and extracts of, the Mortgage Files and any and all documents, records, agreements, instruments or information relating to such Mortgage Loans in the possession or under the control of the Borrower and/or the Custodian. The Borrower also shall make available to the Lender, on a reasonable basis, a knowledgeable financial or accounting officer for the purpose of answering questions respecting the Mortgage Files and the Mortgage Loans. Without limiting the generality of the foregoing, the Borrower acknowledges that the Lender may make Loans to the Borrower based solely upon the information provided by the Borrower to the Lender in the Mortgage Loan Tape and the representations, warranties and covenants contained herein, and that the Lender, at its option, has the right at any time to conduct a partial or complete due diligence review on some or all of the Mortgage Loans securing such Loan, including without limitation ordering new credit reports and new appraisals on the related Mortgaged Properties and otherwise re-generating the -39- 44 information used to originate such Mortgage Loan. The Lender may underwrite such Mortgage Loans itself or engage a mutually agreed upon third party underwriter to perform such underwriting. The Borrower agrees to cooperate with the Lender and any third party underwriter in connection with such underwriting, including, but not limited to, providing the Lender and any third party underwriter with access to any and all documents, records, agreements, instruments or information relating to such Mortgage Loans in the possession, or under the control, of the Borrower. The Borrower further agrees that if a Default shall have occurred, the Borrower shall reimburse the Lender for any and all out-of-pocket costs and expenses incurred by the Lender in connection with the Lender's activities pursuant to this Section 11.15 performed following such Default. 11.16 Set-Off. In addition to any rights and remedies of the Lender provided by this Loan Agreement and by law, the Lender shall have the right, without prior notice to the Borrower, any such notice being expressly waived by the Borrower to the extent permitted by applicable law, upon any amount becoming due and payable by the Borrower hereunder (whether at the stated maturity, by acceleration or otherwise) to set-off and appropriate and apply against such amount any and all deposits (general or special, time or demand, provisional or final), in any currency, and any other credits, indebtedness or claims, in any currency, in each case whether direct or indirect, absolute or contingent, matured or unmatured, at any time held or owing by the Lender or any Affiliate thereof to or for the credit or the account of the Borrower. The Lender agrees promptly to notify the Borrower after any such set-off and application made by the Lender; provided that the failure to give such notice shall not affect the validity of such set-off and application. 11.17 Intent. The parties recognize that each Loan is a "securities contract" as that term is defined in Section 741 of Title 11 of the United States Code, as amended. [SIGNATURE PAGE FOLLOWS] -40- 45 IN WITNESS WHEREOF, the parties hereto have caused this Loan Agreement to be duly executed and delivered as of the day and year first above written. BORROWER ALLIED CAPITAL CORPORATION By /s/ KELLY A. ANDERSON ----------------------- Name: Kelly A. Anderson Title: Executive Vice President, Treasurer Address for Notices: 1919 Pennsylvania Avenue, N.W. Washington, D.C. 20006 Attention: Ms. Kelly A. Anderson Telecopier No.: (202) 659-2053 Telephone No: (202) 973-6328 LENDER MORGAN STANLEY MORTGAGE CAPITAL INC. By /s/ MARC FLAMINO ----------------- Name: Marc Flamino Title: Vice President Address for Notices: 1585 Broadway New York, New York 10036 Attention: Mr. Andy Neuberger Telecopier No.: 212-761-0093 Telephone No.: 212-761-2408 -41- 46 SCHEDULE 1 REPRESENTATIONS AND WARRANTIES RE: MORTGAGE LOANS Part I. Eligible Mortgage Loans As to each Eligible Mortgage Loan included in the Borrowing Base on a Funding Date (and the related Mortgage, Mortgage Note, Assignment of Mortgage and Mortgaged Property), the Borrower shall be deemed to make the following representations and warranties to the Lender as of such date and as of each date Collateral Value is determined (certain defined terms used herein and not otherwise defined in the Loan Agreement appearing in Part III to this Schedule 1, except as otherwise set forth on an Officer's Certificate (as defined in the Custodial Agreement) delivered on or prior to Funding Date or otherwise disclosed in writing to the Lender. (a) Mortgage Loans as Described. The information set forth in the Mortgage Loan Schedule with respect to the Mortgage Loan is complete, true and correct in all material respects. (b) No Outstanding Charges. There are no material defaults in complying with the terms of the Mortgage securing the Mortgage Loan, and to the best of the Borrower's knowledge, all taxes, governmental assessments, required insurance premiums, water, sewer and municipal charges, leasehold payments or ground rents which previously became due and owing have been paid. Neither the Borrower nor to the best of the Borrower's knowledge, the Qualified Originator from which the Borrower acquired the Mortgage Loan has advanced funds, or induced, solicited or knowingly received any advance of funds by a party other than the Mortgagor, directly or indirectly, for the payment of any amount required under the Mortgage Loan, except for interest accruing from the date of the Mortgage Note or date of disbursement of the proceeds of the Mortgage Loan, whichever is earlier, to the day which precedes by one month the Due Date of the first installment of principal and interest thereunder. (c) Original Terms Unmodified. The terms of the Mortgage Note and Mortgage have not been impaired, waived, altered or modified in any respect, from the date of origination except by a written instrument which has been recorded, if necessary to protect the interests of the Lender, and which has been delivered to the Custodian and the terms of which are reflected in the Mortgage Loan Schedule. The substance of any such waiver, alteration or modification has been approved by the title insurer, to the extent required, and its terms are reflected on the Mortgage Loan Schedule. No Mortgagor in respect of the Mortgage Loan has been released, in whole or in part, except in connection with an assumption agreement approved by the title insurer, to the extent required, and which assumption agreement is part of the Mortgage File delivered to the Custodian and the terms of which are reflected in the Mortgage Loan Schedule (to the extent such terms affect the information on the Mortgage Loan Schedule). (d) No Defenses. To the best of the Borrower's knowledge, the Mortgage Loan is not subject to any right of rescission, set-off, counterclaim or defense, including without limitation the defense of usury, nor will the operation of any of the terms of the Mortgage Note or the Schedule 1, Page 1 47 Mortgage, or the exercise of any right thereunder, render either the Mortgage Note or the Mortgage unenforceable, in whole or in part and no such right of rescission, set-off, counterclaim or defense has been asserted with respect thereto. The Borrower has no knowledge nor has it received any notice that any Mortgagor in respect of the Mortgage Loan is a debtor in any state or federal bankruptcy or insolvency proceeding. (e) Hazard Insurance. The Mortgaged Property is insured by a fire and extended perils insurance policy, issued by a Qualified Insurer, and such other hazards as are customary in the area where the Mortgaged Property is located, and to the extent required by the Borrower as of the date of origination consistent with the Underwriting Guidelines, against earthquake and other risks insured against by Persons operating like properties in the locality of the Mortgaged Property, in an amount not less than the greatest of (i) 100% of the replacement cost of all improvements to the Mortgaged Property, (ii) the outstanding principal balance of the Mortgage Loan, or (iii) the amount necessary to avoid the operation of any co- insurance provisions with respect to the Mortgaged Property, and consistent with the amount that would have been required as of the date of origination in accordance with the Underwriting Guidelines. If any portion of the Mortgaged Property is in an area identified by any federal Governmental Authority as having special flood hazards, and flood insurance is available, a flood insurance policy meeting the current guidelines of the Federal Insurance Administration is in effect with a generally acceptable insurance carrier, in an amount representing coverage not less than the lesser of (1) the full insurable value of the Mortgaged Property, and (2) the maximum amount of insurance available under the Flood Disaster Protection Act of 1973, as amended. All such insurance policies (collectively, the "hazard insurance policy") contain a standard mortgagee clause naming the Borrower, its successors and assigns (including without limitation, subsequent owners of the Mortgage Loan), as mortgagee, and may not be reduced, terminated or canceled without 30 days' prior written notice to the mortgagee. No such notice has been received by the Borrower. All premiums on such insurance policy have been paid. The related Mortgage obligates the Mortgagor to maintain all such insurance and, at such Mortgagor's failure to do so, authorizes the mortgagee to maintain such insurance at the Mortgagor's cost and expense and to seek reimbursement therefor from such Mortgagor. Where required by state law or regulation, the Mortgagor has been given an opportunity to choose the carrier of the required hazard insurance, provided the policy is not a "master" or "blanket" hazard insurance policy covering a condominium, or any hazard insurance policy covering the common facilities of a planned unit development. To the best of the Borrower's knowledge, the hazard insurance policy is the valid and binding obligation of the insurer and is in full force and effect. The Borrower has not engaged in, and to the best of the Borrower's knowledge, the Mortgagor has not engaged in, any act or omission which would impair the coverage of any such policy, the benefits of the endorsement provided for herein, or the validity and binding effect of either including, without limitation, no unlawful fee, commission, kickback or other unlawful compensation or value of any kind has been or will be received, retained or realized by any attorney, firm or other Person, and no such unlawful items have been received, retained or realized by the Borrower. The Mortgagor maintains (A) rental continuation coverage sufficient to protect against loss for a period of up to 12 months, under a policy issued by a Qualified Insurer and (B) ordinance or law coverage if applicable under the terms and conditions of the Underwriting Guidelines. (f) Compliance with Applicable Laws. With respect to Mortgage Loans originated by the Borrower, and to the best of the Borrower's knowledge with respect to Mortgage Loans acquired by the Borrower, (i) any and all requirements of any federal, state or Schedule 1, Page 2 48 local law including, without limitation, usury, or disclosure laws applicable to the Mortgage Loan have been complied with, and (ii) the consummation of the transactions contemplated hereby will not involve the violation of any such laws or regulations, and the Borrower shall maintain or shall cause its agent to maintain in its possession, available for the inspection of the Lender, and shall deliver to the Lender, upon demand, evidence of compliance with all such requirements. (g) No Satisfaction of Mortgage. The Mortgage has not been satisfied, canceled, subordinated or rescinded, in whole or in part, and the Mortgaged Property has not been released from the lien of the Mortgage, in whole or in part, nor has any instrument been executed that would effect any such release, cancellation, subordination or rescission. (h) Location and Type of Mortgaged Property. The Mortgaged Property is located in an Acceptable State as identified in the Mortgage Loan Schedule and consists of real property upon which is located one or more commercial or multifamily structures; provided, however, that any commercial or multifamily property shall conform with the Underwriting Guidelines. The Mortgaged Property is being used for the purpose set forth in the Mortgagor's loan application, unless otherwise notified by the Mortgagor. (i) Valid First Lien. The Mortgage is a valid, subsisting, enforceable and perfected first lien on the real property included in the Mortgaged Property, including all buildings on the Mortgaged Property and all installations and mechanical, electrical, plumbing, heating and air conditioning systems located in or annexed to such buildings, and all additions, alterations and replacements made at any time with respect to the foregoing. The lien of the Mortgage is subject only to: (1) the lien of current real property taxes and assessments not yet due and payable; (2) covenants, conditions and restrictions, rights of way, easements and other matters of the public record as of the date of recording acceptable to prudent mortgage lending institutions generally and specifically referred to in the lender's title insurance policy delivered to the originator of the Mortgage Loan and (a) referred to or otherwise considered in the appraisal made for the originator of the Mortgage Loan or (b) which do not materially and adversely affect the Appraised Value of the Mortgaged Property set forth in such appraisal; and (3) other matters to which like properties are commonly subject which do not materially interfere with the benefits of the security intended to be provided by the Mortgage or the use, enjoyment, value or marketability of the related Mortgaged Property. Any security agreement, chattel mortgage or equivalent document related to and delivered in connection with the Mortgage Loan establishes and creates a valid, subsisting and enforceable first lien and first priority security interest on the property described therein and the Borrower has full right to pledge and assign the same to the Lender. The Mortgaged Property was not, as of the date of origination of the Mortgage Loan, subject to a mortgage, deed of trust, deed to secure debt or other security instrument creating a lien subordinate to the lien of the Mortgage. (j) Validity of Mortgage Documents. The Mortgage Note and the Mortgage and any other agreement executed and delivered by a Mortgagor or guarantor, if applicable, in connection with a Mortgage Loan are genuine, and each is the legal, valid and binding obligation of the maker thereof enforceable in accordance with its terms subject to bankruptcy laws and other similar laws of general application affecting rights of creditors and subject to the Schedule 1, Page 3 49 application of the rules of equity, including those respecting the availability of specific performance. (k) Full Disbursement of Proceeds. The Mortgage Loan has been closed and the proceeds of the Mortgage Loan have been fully disbursed and there is no further requirement for future advances thereunder, and either (i) any and all requirements as to completion of any on-site or off-site improvement and as to disbursements of any escrow funds therefor have been complied with or (ii) an escrow of funds for the completion of any on-site or off-site improvements has been established in an amount sufficient to make all repairs required by the Qualified Originator to the Mortgaged Property. All costs, fees and expenses incurred in making or closing the Mortgage Loan and the recording of the Mortgage were paid, and the Mortgagor is not entitled to any refund of any amounts paid or due under the Mortgage Note or Mortgage. To the best of the Borrower's knowledge, all costs, fees and expenses incurred in making or closing the Mortgage Loan and the recording of the Mortgage were paid, and the Mortgagor is not entitled to any refund of any amounts paid or due under the Mortgage Note or Mortgage. (l) Ownership. The Borrower is the sole owner and holder of the Mortgage Loan. The Mortgage Loan is not assigned or pledged, and the Borrower has good, indefeasible and marketable title thereto, and has full right to transfer, pledge and assign the Mortgage Loan to the Lender free and clear of any encumbrance, equity, participation interest, lien, pledge, charge, claim or security interest, and has full right and authority subject to no interest or participation of, or agreement with, any other party, to assign, transfer and pledge each Mortgage Loan pursuant to this Loan Agreement and following the pledge of each Mortgage Loan, the Lender will hold such Mortgage Loan free and clear of any encumbrance, equity, participation interest, lien, pledge, charge, claim or security interest except any such security interest created pursuant to the terms of this Loan Agreement. (m) Doing Business. To the best of the Borrower's knowledge, all parties which have had any interest in the Mortgage Loan, whether as mortgagee, assignee, pledgee or otherwise, are (or, during the period in which they held and disposed of such interest, were) (i) in compliance with any and all applicable licensing requirements of the laws of the state wherein the Mortgaged Property is located, and (ii) either (A) organized under the laws of such state, (B) qualified to do business in such state, (C) a federal savings and loan association, a savings bank or a national bank having a principal office in such state, or (D) not doing business in such state. (n) Loan-to-Value Ratio and Debt Service Ratio. The Loan-to-Value Ratio for the Mortgage Loan is not greater than that set forth in the Underwriting Guidelines. The Debt Service Ratio for the Mortgage Loan is not less than that set forth in the Underwriting Guidelines. (o) Title Insurance. The Mortgage Loan is covered by either (i) an attorney's opinion of title and abstract of title, the form and substance of which is acceptable to prudent mortgage lending institutions making mortgage loans in the area wherein the Mortgaged Property is located or (ii) an ALTA lender's title insurance policy or other generally acceptable form of policy or insurance and each such title insurance policy is issued by a title insurer qualified to do business in the jurisdiction where the Mortgaged Property is located, insuring the Schedule 1, Page 4 50 Borrower, its successors and assigns, as to the first priority lien of the Mortgage in the original principal amount of the Mortgage Loan, subject only to the exceptions contained in clauses (1), (2) and (3) of paragraph (i) of this Schedule 1. Where required by state law or regulation, the Mortgagor has been given the opportunity to choose the carrier of the required mortgage title insurance. Additionally, such lender's title insurance policy affirmatively insures ingress and egress and against encroachments by or upon the Mortgaged Property or any interest therein. The title policy does not contain any special exceptions (other than the standard exclusions) for zoning and uses and has been marked to delete the standard survey exception or to replace the standard survey exception with a specific survey reading. The Borrower, its successors and assigns, are the sole insureds of such lender's title insurance policy, and such lender's title insurance policy is valid and remains in full force and effect and will be in force and effect upon the consummation of the transactions contemplated by this Loan Agreement. No claims have been made under such lender's title insurance policy. The title policy has been marked to delete the intervening lien exception and all premiums for such policy, including any premiums for endorsements and special endorsements, have been paid. (p) No Defaults. To the best of the Borrower's knowledge, there is no default, breach, violation or event of acceleration existing under the Mortgage or the Mortgage Note and no event has occurred which, with the passage of time or with notice and the expiration of any grace or cure period, to the best of the Borrower's knowledge, would constitute a default, breach, violation or event of acceleration, and neither the Borrower nor its predecessors have waived any default, breach, violation or event of acceleration. (q) No Mechanics' Liens. To the best of the Borrower's knowledge, there are no mechanics' or similar liens or claims which have been filed for work, labor or material (and no rights are outstanding that under the law could give rise to such liens) affecting the Mortgaged Property which are or may be liens prior to, or equal or coordinate with, the lien of the Mortgage. (r) Location of Improvements; No Encroachments. To the best of the Borrower's knowledge, all improvements which were considered in determining the Appraised Value of the Mortgaged Property lie wholly within the boundaries and building restriction lines of the Mortgaged Property, and no improvements on adjoining properties encroach upon the Mortgaged Property or the Lender's title insurance policy referenced in (o) above affirmatively insures such encroachments. To the best of the Borrower's knowledge, no improvement located on or being part of the Mortgaged Property is in violation of any applicable zoning and building law, ordinance or regulation. (s) Origination; Payment Terms. Principal payments on the Mortgage Loan commenced no more than 60 days after funds were disbursed in connection with the Mortgage Loan. The Mortgage Note is payable monthly with interest calculated and payable in arrears, sufficient to amortize the Mortgage Loan fully by the stated maturity date, or otherwise providing for a balloon payment in accordance with the Underwriting Guidelines over an original term of not more than 30 years from commencement of amortization. (t) Customary Provisions. The Mortgage Note has a stated maturity. The Mortgage contains customary and enforceable provisions such as to render the rights and remedies of the holder thereof adequate for the realization against the Mortgaged Property of the Schedule 1, Page 5 51 benefits of the security provided thereby, including, (i) in the case of a Mortgage designated as a deed of trust, by trustee's sale, and (ii) otherwise by power of sale or judicial foreclosure. The Mortgage or the laws of the applicable state in which the Mortgaged Property is located provides for the appointment of a receiver for rents in the event of an institution of foreclosure proceedings, or allows the Mortgagee to enter into possession to collect rents to the extent permitted by applicable law. (u) Conformance with Underwriting Guidelines. The Mortgage Loan was underwritten in accordance with the Underwriting Guidelines. (v) Occupancy of the Mortgaged Property. To the best of the Borrower's knowledge, as of the Funding Date the Mortgaged Property is lawfully occupied under applicable law. To the best of the Borrower's knowledge, all inspections, licenses and certificates required to be made or issued with respect to all occupied portions of the Mortgaged Property and, with respect to the use and occupancy of the same, including but not limited to, certificates of occupancy and fire underwriting certificates, have been made or obtained from the appropriate authorities. To the best of the Borrower's knowledge, the Borrower has not received notification from any governmental authority that the Mortgaged Property is in material non-compliance with such laws or regulations, is being used, operated or occupied unlawfully or has failed to have or obtain such inspection, licenses or certificates, as the case may be. The Borrower has not received notice of any violation or failure to conform with any such law, ordinance, regulation, standard, license or certificate. (w) Deeds of Trust. In the event the Mortgage constitutes a deed of trust, a trustee, authorized and duly qualified under applicable law to serve as such has been properly designated and currently so serves and is named in the Mortgage, and no fees or expenses are or will become payable by the Custodian or the Lender to the trustee under the deed of trust, except in connection with a trustee's sale after default by the Mortgagor. (x) Delivery of Mortgage Documents. The Mortgage Note, the Mortgage, the Assignment of Mortgage and any other documents required to be delivered under the Custodial Agreement for each Mortgage Loan have been delivered to the Custodian. The Borrower or its agent is in possession of a complete, true and accurate Mortgage File in compliance with the Custodial Agreement, except for such documents the originals of which have been delivered to the Custodian. (y) Transfer of Mortgage Loans. The Assignment of Mortgage is in recordable form and is acceptable for recording under the laws of the jurisdiction in which the Mortgaged Property is located. (z) No Buydown Provisions; No Graduated Payments or Contingent Interests. The Mortgage Loan does not contain provisions pursuant to which Monthly Payments are paid or partially paid with funds deposited in any separate account established by the Borrower, the Mortgagor, or anyone on behalf of the Mortgagor, or paid by any source other than the Mortgagor nor does it contain any other similar provisions which may constitute a "buydown" provision. The Mortgage Loan is not a graduated payment mortgage loan and the Mortgage Loan does not have a shared appreciation or other contingent interest feature. Schedule 1, Page 6 52 (aa) Mortgaged Property Undamaged. To the best of the Borrower's knowledge, the Mortgaged Property is undamaged by waste, fire, earthquake or earth movement, windstorm, flood, tornado or other casualty so as to affect materially and adversely the value of the Mortgaged Property as security for the Mortgage Loan or the use for which the premises were intended and each Mortgaged Property is in good repair. To the best of the Borrower's knowledge, there have not been any condemnation proceedings commenced with respect to the Mortgaged Property and the Borrower has no knowledge of any such proceedings. (bb) Collection Practices; Escrow Deposits. The origination and collection practices used by the originator, each servicer of the Mortgage Loan and the Borrower with respect to the Mortgage Loan have been in all material respects in compliance with Accepted Servicing Practices, applicable laws and regulations, and have been in all material respects legal. With respect to escrow deposits and Escrow Payments, all such payments are in the possession of, or under the control of, the Borrower and there exist no deficiencies in connection therewith for which customary arrangements for repayment thereof have not been made. All Escrow Payments have been collected in full compliance with state and federal law. (cc) Other Insurance Policies. To the best of the Borrower's knowledge, no action, inaction or event has occurred and no state of facts exists or has existed that has resulted or will result in the exclusion from, denial of, or defense to coverage under any applicable special hazard insurance policy or bankruptcy bond, irrespective of the cause of such failure of coverage. In connection with the placement of any such insurance, no commission, fee, or other compensation has been or will be received by the Borrower or by any officer, director, or employee of the Borrower or any designee of the Borrower or any corporation in which the Borrower or any officer, director, or employee had a financial interest at the time of placement of such insurance. (dd) Appraisal. The Mortgage File contains an appraisal of the related Mortgaged Property signed (to the best of the Borrower's knowledge, prior to the date a commitment to fund such Mortgage Loan becomes binding) by a qualified appraiser, duly appointed by the Borrower, who had no interest, direct or indirect in the Mortgaged Property or in any loan made on the security thereof, and whose compensation is not affected by the approval or disapproval of the Mortgage Loan. (ee) Capitalization of Interest. The Mortgage Note does not by its terms provide for the capitalization or forbearance of interest; provided that the Mortgage Note may have been restructured, and at the time of such restructuring, outstanding interest may have been capitalized. (ff) No Equity Participation. No document relating to the Mortgage Loan provides for any contingent or additional interest in the form of participation in the cash flow of the Mortgaged Property or a sharing in the appreciation of the value of the Mortgaged Property. The indebtedness evidenced by the Mortgage Note is not convertible to an ownership interest in the Mortgaged Property or the Mortgagor and the Borrower has not financed nor does it own directly or indirectly, any equity of any form in the Mortgaged Property or the Mortgagor. Schedule 1, Page 7 53 (gg) Proceeds of Mortgage Loan. Except as expressly previously disclosed to the Lender, the proceeds of the Mortgage Loan have not been and shall not be used to satisfy, in whole or in part, any debt owed or owing by the Mortgagor to the Borrower or any Affiliate or correspondent of the Borrower except in each case, fees and expenses incurred in the origination of the Mortgage Loan. (hh) Withdrawn Mortgage Loans. If the Mortgage Loan has been released to the Borrower pursuant to a Request for Release and Receipt as permitted under Section 5 of the Custodial Agreement, then, the promissory note relating to the Mortgage Loan was returned to the Custodian within 10 days of release (or if such tenth day is not a Business Day, the next succeeding Business Day). (ii) No Exception. The Custodian has not noted any material exceptions on an Exception Report (as defined in the Custodial Agreement) with respect to the Mortgage Loan which would materially adversely affect the Mortgage Loan or the Lender's security interest, granted by the Borrower, in the Mortgage Loan. (jj) Qualified Originator. The Mortgage Loan has been originated by, and, if applicable, purchased by the Borrower from, a Qualified Originator. (kk) Title Survey; Improvements. To the best of the Borrower's knowledge, the Mortgage File includes a title survey, certified to the Borrower or the Qualified Originator, its successors and assigns, and the title insurance company, in accordance with most recent minimum standards for title surveys as determined by the American Land Title Association, with the signature and seal of a licensed engineer or surveyor affixed thereto. (ll) Inspection. The Borrower or the Qualified Originator or its agents, has inspected or has caused to be inspected each related Mortgaged Property in connection with the origination thereof no earlier than six months prior to the related Funding Date. (mm) Access Routes. To the best of the Borrower's knowledge, at the time of origination, the Mortgaged Property was (i) contiguous to a physically open, dedicated all-weather public street, (ii) had all necessary permits and approvals for ingress and egress, (iii) was adequately serviced by public or private water, public or private sewer systems and utilities, and (iv) was on a separate tax parcel, separate and apart from any other property owned by the Mortgagor or any other Person. (nn) Mortgagor is Landlord under Leases. Each Mortgagor is the owner and holder of the landlord's interest under any lease for use and occupancy of all or any portion of the related Mortgaged Property. Neither the Borrower nor, to the best of the Borrower's knowledge, the Mortgagor, has made any assignments of the landlord's interest in any such lease or any portion of the rents, additional rents, charges, issues or profits due and payable or to become due and payable under any such lease (other than an assignment in favor of the Borrower or in favor of the Lender) which assignments are presently outstanding. The assignment of leases and/or rents and any security agreement, chattel mortgage or equivalent document related to and delivered in connection with the Mortgage Loan establishes and creates a valid and enforceable first lien or first priority security interest on the leases affecting the Mortgaged Schedule 1, Page 8 54 Property except as enforceability may be limited by bankruptcy or other laws affecting creditor's rights generally or by the application of the rules of equity. (oo) Mortgaged Property Leased to Tenants. To the best of the Borrower's knowledge as to each Mortgage Loan secured by Mortgaged Property which is leased to tenants: (i) the Mortgaged Property is not subject to any leases other than the leases described in the rent roll contained in the Servicing File (hereinafter referred to as the "Leases"), and such rent roll is accurate and complete in all material respects, including description of the rent and term. (ii) no Person has any possessory interest in the Mortgaged Property or right to occupy the same except under and pursuant to the provisions of the Leases and except those possessory interests set forth in clauses (2) and (3) of paragraph (i) of this Schedule 1, Part I, (iii) each Lease of all or any portion of the Mortgaged Property is subordinate to the Mortgage, unless otherwise approved by the Borrower; (iv) with respect to any Lease having the benefit of a non-disturbance or similar recognition agreement, there are no circumstances or conditions with respect to the Mortgage, the Mortgaged Property, and Mortgagor, any tenant (alone or considered with other tenants) of the Mortgaged Property, or the Mortgagor's or any tenant's credit standing that would cause prudent mortgage lenders making loans similar to the Mortgage Loan in the area in which the Mortgaged Property is located to refuse to grant such non-disturbance or similar recognition agreement; are no recorded assignments of the Leases or of any portion of the rents, additional rents, charges, issues or profits due and payable or to become due and payable thereunder (hereinafter collectively referred to as the "Rents") to anyone other than the Mortgagor or a mortgagee which are now outstanding; (v) no Leases contain any option to purchase, any right of first refusal to lease or purchase, any express right to terminate the Lease or vacate the premises prior to expiration of the lease term, or any express right to abate or defer rent or any other similar provisions which materially adversely affect the Mortgaged Property or which might materially, adversely affect the rights of any holder of the Mortgage Loan; (vi) of the Leases are in full force and effect and have not been modified or amended other than by documents contained in the Servicing File, and the Servicing File contains true and complete copies of the Leases; (vii) The Mortgagor has certified that all rents due and payable under the Leases have been paid in full and no such rents have been paid more than one month in advance of the Due Date; and (viii) the Mortgagor has certified that neither the Mortgagor (landlord) nor any tenant under the Leases is in default under any of the terms, covenants or provisions of the Leases and the Borrower knows of no event which, but for the passage of time or the giving of notice or both, would constitute an event of default under any of the Leases. (pp) Organization. If not an individual, to the best of the Borrower's knowledge, the Mortgagor has been duly organized and is validly existing and in good standing under the laws of the jurisdiction of its formation. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor has requisite power and authority to (i) own its properties, (ii) transact the business in which it is now engaged, (iii) execute and deliver the Mortgage Note, the Mortgage and the other Mortgage and the other Mortgage Loan Documents and (iv) consummate the transactions contemplated hereby and thereby. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is duly qualified to do business and is in good standing in the jurisdiction where it is required to be so qualified in connection with the ownership, maintenance, management and operation of the Mortgaged Property. The Mortgagor has represented, warranted and covenanted that it shall (1) own no assets, and will not engage in any Schedule 1, Page 9 55 business, other than ownership, operation and management of its respective Mortgaged Property except as Scheduled and identified to the Lender (2) not enter into any contract or agreement with any affiliate except upon terms and conditions that are intrinsically fair and substantially similar to those that would be available on an arms-length basis with persons other than such affiliate; (3) not incur any indebtedness or obligation, secured or unsecured, direct or indirect, absolute or contingent (including guaranteeing any obligation), other than pursuant to the Mortgage Loan Document and other known liens or other trade payables; (4) not make any loans or advances to any third party, and shall not acquire obligations or securities of its affiliates; (5) pay its debts and liabilities (including, as applicable, shared personnel and overhead expenses) only from its own assets; (6) comply with the provisions of its organizational documents; (7) do all things necessary to observe organizational formalities and to preserve its existence, and will not amend, modify or otherwise change its organizational documents, or suffer same to be amended, modified or otherwise changed, without the prior written consent of the Lender; (8) maintain all of its books, records, financial statements and bank accounts separate from those of its Affiliates; (9) be, and at all times will hold itself out to the public as, a legal entity separate and distinct from any other entity (including any affiliate), shall correct any known misunderstanding regarding its status as a separate entity, shall conduct business in its own name, shall not identify itself or any of its affiliates as a division or part of the other and shall maintain and utilize separate stationery, invoices and checks; (10) maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character and in light of its contemplated business operations; (11) not engage in or suffer any change of ownership, dissolution, winding up, liquidation, consolidation or merger in whole or in part; (12) not commingle its funds or other assets with those of any affiliate or any other Person; (13) maintain its assets in such a manner that it will not be costly or difficult to segregate, ascertain or identify its individual assets from those of any affiliate or any other person; and (14) not and will not hold itself out to be responsible for the debts or obligations of any other Person. (qq) Mortgagor Properly Licensed and in Compliance With Terms of Mortgage Loan Documents. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, (i) the Mortgagor was at the time of origination in possession of all licenses, permits and other authorizations necessary and required by applicable law for the conduct of its business; (ii) all such licenses, permits and authorizations are valid and in full force and effect and (iii) all material conditions on the Mortgagor's part to be fulfilled under the terms of any lease of the Mortgaged Property have been satisfied. (rr) No Conflicts. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, (i) the execution, delivery and performance of the Mortgage Note, the Mortgage, and the other Mortgage Loan Documents by the Mortgagor do not conflict with or constitute a default under, or result in the creation or imposition of any lien (other than pursuant to the Mortgage Loan Documents) mortgage, deed of trust, loan agreement, partnership agreement, or other agreement or instrument to which the Mortgagor is a party or to which the Mortgaged Property is subject, nor will such action result in any violation of the provisions of any statute or any jurisdiction over the Mortgagor or the Mortgaged Property, and (ii) any qualification of or with any Governmental Authority required for the execution, deliver, and performance by the Mortgagor of the Mortgage Note, the Mortgage, or the other Mortgage Loan Documents has been obtained as is in full force and effect. Schedule 1, Page 10 56 (ss) Litigation. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, there are no actions, suits, or proceedings at law or in equity by or before any Governmental Authority now pending or threatened against or affecting the Mortgagor or the Mortgaged Property, which actions, suits or proceedings, if determined against the Mortgagor or the Mortgaged Property, might materially adversely affect the condition (financial or otherwise) or business of the Mortgagor or the condition or ownership of the Mortgaged Property. (tt) No Violation of Environmental Laws. To the best of the Borrower's knowledge, there is no pending action or proceeding directly involving the Mortgaged Property in which compliance with any environmental law, rule or regulation is an issue; and to the best of the Borrower's knowledge, nothing further remains to be done to satisfy in full all requirements of each such law, rule or regulation constituting a prerequisite to use and enjoyment of said property. (uu) Agreements. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is not a party to any agreement or instrument or subject to any restriction which might adversely affect the Mortgagor. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is not in default in any material respect in the performance, observance, or fulfillment of any of the obligations, covenants or conditions contained in any agreement or instrument to which it is a party or by which the Mortgagor or the Mortgaged Property is bound. (vv) No Bankruptcy Filing. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is not contemplating either the filing of a petition by it under any state or federal bankruptcy or insolvency laws or the liquidation of all or a major portion of the Mortgagor's assets or the Mortgaged Property. (ww) Full and Accurate Disclosure. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, no statement of fact made by the Mortgagor in the Mortgage Loan Documents contains any untrue statement of a material fact or omits to state any material fact necessary to make statements contained herein or therein not misleading. (xx) No Plan Assets. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is not an "employee benefit plan," as defined in Sections 3 (3) of ERISA, subject to Title I of ERISA, and none of the assets of the Mortgagor constitutes or will constitute "plan assets" of one or more such plans within the meaning of 29 C.F.R. Section 2510.3-101. (yy) Compliance. To the best of the Borrower's knowledge, the Mortgagor and the Mortgaged Property and the use thereof comply in all material respects with all applicable legal requirements, including, without limitation, parking requirements. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgagor is not in default or violation of any order, writ, injunction, decree or demand of any Governmental Authority, the violation of which might materially adversely affect the condition (financial or otherwise) or business of the Mortgagor. Schedule 1, Page 11 57 (zz) Contracts. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, there are no material contracts (other than management contracts) affecting the Mortgaged Property that are not terminable on one month's notice or less without cause and without penalty or premium. (aaa) Financial Information. To the best of the Borrower's knowledge, based upon the Mortgagor's representations and warranties, all financial data, including, without limitation the statements of cash flow and income and operating expense, that have been delivered to the Qualified Originator (i) are true, complete, and correct in all material respects, and (ii) accurately represent the financial condition of the Mortgaged Property and the persons covered thereby as of the date of such reports. (bbb) Not a Foreign Person. To the best of the Borrower's knowledge based upon the Mortgagor's representations and warranties, the Mortgagor is not a "foreign person" within the meaning of Section 1445(f)(3) of the Code. (ccc) Separate Lots. To the best of the Borrower's knowledge based on the Mortgagor's representations and warranties, the Mortgaged Property is not assessed jointly with any other real property constituting a separate tax lot or with any other real property constituting a separate tax lot or with any personal property not constituting part of such Mortgaged Property such that the lien of any taxes which may be levied against such personal property shall be assessed or levied or charged as a lien on the Mortgaged Property. (ddd) Assessments. To the best of the Borrower's knowledge based upon the Mortgagor's representations and warranties, there are no pending or proposed special or other assessments for public improvements or otherwise affecting the Mortgaged Property, nor to the best of the Borrower's knowledge based upon the Mortgagor's representations and warranties are there any contemplated improvements to the Mortgaged Property that may result in such special or other assessments. (eee) Mortgage Submitted for Recordation. The Mortgage either has been or will promptly be submitted for recordation in the appropriate governmental recording office of the jurisdiction where the Mortgaged Property is located. (fff) The Ground Lease. To the best of the Borrower's knowledge based upon the Mortgagor's representations and warranties with respect to each ground lease to which the Mortgaged Property is subject (a "Ground Lease"): (i) the Mortgagor is the owner of a valid and subsisting interest as tenant under the Ground Lease; (ii) the Ground Lease is unmodified and not supplemented by any writing or otherwise (other than as disclosed in the Servicing File) and is in full force and effect; (iii) all rent, additional rent and other charges reserved therein have been paid to the extent they are payable to the date hereof; (iv) the Mortgagor enjoys the quiet and peaceful possession of the estate demised thereby, subject to any sublease; (v) the Mortgagor is not in default under any of the terms thereof and there are no circumstances which, with the passage of time or the giving of notice or both, would constitute an event of default thereunder; (vii) the lessor under the Ground Lease is not in default under any of the terms or provisions thereof on the part of the lessor to be observed or performed; (vii) the lessor under the Ground Lease has satisfied all of its repair or construction obligations, if any, to date pursuant to the Schedule 1, Page 12 58 terms of the Ground Lease; and (ix) the execution, delivery and performance of the Mortgage do not require the consent (other than those consents which have been obtained and are in full force and effect) under, and will not contravene any provision of or cause a default under, the Ground Lease. (ggg) Table-Funded Mortgage Loans. With respect to each Mortgage Loan that is a Table-Funded Mortgage Loan, the Settlement Agent has entered into a Bailee Agreement agreeing to hold the related Mortgage Loan Documents as agent and bailee for the Lender and to promptly forward such Mortgage Loan Documents to the Custodian for receipt by the fourth (4th) Business Day following the applicable Funding Date. Schedule 1, Page 13 59 Part II. Eligible Commercial Mortgage Loans that are Secured by Hotels As to each Eligible Commercial Mortgage Loan secured by a Hotel included in the Borrowing Base on a Funding Date (and the related Mortgage, Mortgage Note, Assignment of Mortgage and Mortgaged Property), the Borrower shall be deemed to make the following representations and warranties to the Lender as of such date (certain defined terms used herein and not otherwise defined in the Agreement appearing in Part III to this Schedule 1, except as otherwise set forth on an Officer's Certificate (as defined in the Custodial Agreement) delivered on or prior to Funding Date or otherwise disclosed in writing to the Lender. (a) To the best of the Borrower's knowledge, the Franchise Agreement, if any, is in full force and effect and there is no default, breach or violation existing thereunder by any party thereto and no event (other than payments due but not yet delinquent) which, with the passage of time or with notice and the expiration of any grace or cure period would constitute a default, breach or violation by any party thereunder; (b) To the best of the Borrower's knowledge, the Management Agreement, if any, is in full force and effect and there is no default, breach or violation existing thereunder by any party thereto and no event (other than payments due but not yet delinquent) which, with the passage of time or with notice and the expiration of any grace or cure period would constitute a default, breach or violation by any party thereunder; (c) To the best of the Borrower's knowledge, the Mortgagor owns/and or possesses, and holds free from burdensome restrictions or known conflicts with the rights of others, all material licenses, registrations, permits, certificates, authorizations and approvals necessary for the operation of the Mortgaged Property as a Hotel; and (d) Neither the execution and delivery of the Mortgage Loan Documents, the Mortgagor's performance thereunder, the recordation of the Mortgage, will materially and adversely affect (x) the Mortgagor's rights under either the Franchise Agreement, if any, or the Management Agreement, if any, or (y) the licenses, registration, permits, certificates, authorizations and approvals necessary for the operation of the Hotel; provided, however, in the case of clause (y) the Borrower's knowledge is limited to the Borrower's actual knowledge based on (1) a review of such items and (2) reliance on an opinion of counsel from the Mortgagor's counsel. Schedule 1, Page 14 60 Part III. Defined Terms In addition to terms defined elsewhere in the Loan Agreement, the following terms shall have the following meanings when used in this Schedule 1: "Acceptable State" shall mean any state for which approval has not been revoked by the Lender in its sole discretion, any such notice of revocation to be given no later than 10 Business Days prior to its intended effective date. "Accepted Servicing Practices" shall mean, with respect to any Mortgage Loan, those mortgage servicing practices of prudent mortgage lending institutions which service mortgage loans of the same type as such Mortgage Loans in the jurisdiction where the related Mortgaged Property is located. "ALTA" means the American Land Title Association. "Appraised Value" shall mean the value set forth in an appraisal made in connection with the origination of the related Mortgage Loan as the value of the Mortgaged Property. "Assignment of Mortgage" shall mean an assignment of the Mortgage, notice of transfer or equivalent instrument in recordable form, sufficient under the laws of the jurisdiction wherein the related Mortgaged Property is located to reflect the transfer of the Mortgage. "Best's" means Best's Key Rating Guide, as the same shall be amended from time to time. "Cut-off Date" means the first day of the month in which the related Funding Date occurs. "Debt Service Ratio" means as of any date of determination and for any period, the applicable "Debt Service Coverage" ratio determined in accordance with, and defined in, the Underwriting Guidelines. "Due Date" means the day of the month on which the Monthly Payment is due on a Mortgage Loan, exclusive of any days of grace. "Escrow Payments" means with respect to any Mortgage Loan, the amounts constituting ground rents, taxes, assessments, water rates, sewer rents, municipal charges, mortgage insurance premiums, fire and hazard insurance premiums, condominium charges, and any other payments required to be escrowed by the Mortgagor with the mortgagee pursuant to the Mortgage or any other document. "Freddie Mac" means Freddie Mac, or any successor thereto. "Fannie Mae" means Fannie Mae, or any successor thereto. Schedule 1, Page 15 61 "Gross Margin" means with respect to each adjustable rate Mortgage Loan, the fixed percentage amount set forth in the related Mortgage Note. "Ground Lease" means a lease for all or any portion of the real property comprising the Mortgaged Property, the lessee's interest in which is held by the Mortgagor of the related Mortgage Loan. "Ground Lessee" shall mean the ground lessee under a Ground Lease. "Hotel" shall mean a real estate development owned by the Mortgagor or for which the Mortgagor is a Ground Lessee, which constitutes a full operational hotel or motel, including all land, amenities and improvements, with individual rooms principally for short-term rental to tenants occupying same, as more particularly described in the Underwriting Guidelines. "Index" means with respect to each adjustable rate Mortgage Loan, the index set forth in the related Mortgage Note for the purpose of calculating the interest rate thereon. "Insurance Proceeds" means with respect to each Mortgage Loan, proceeds of insurance policies insuring the Mortgage Loan or the related Mortgaged Property. "Interest Rate Adjustment Date" means with respect to each adjustable rate Mortgage Loan, the date, specified in the related Mortgage Note and the Mortgage Loan Schedule, on which the Mortgage Interest Rate is adjusted. "Loan-to-Value Ratio" or "LTV" means with respect to any Mortgage Loan, the ratio of the original outstanding principal amount of the Mortgage Loan to the lesser of (a) the Appraised Value of the Mortgaged Property at origination or (b) if the Mortgaged Property was purchased within 12 months of the origination of the Mortgage Loan, the purchase price of the Mortgaged Property. "Monthly Payment" means the Scheduled monthly payment of principal and interest on a Mortgage Loan as adjusted in accordance with changes in the Mortgage Interest Rate pursuant to the provisions of the Mortgage Note for an adjustable rate Mortgage Loan. "Mortgage Interest Rate" means the annual rate of interest borne on a Mortgage Note, which shall be adjusted from time to time with respect to adjustable rate Mortgage Loans. "Mortgage Interest Rate Cap" means with respect to an adjustable rate Mortgage Loan, the limit on each Mortgage Interest Rate adjustment as set forth in the related Mortgage Note. "Mortgagee" means the Borrower or any subsequent holder of a Mortgage Loan. "Origination Date" shall mean, with respect to each Mortgage Loan, the date of the Mortgage Note relating to such Mortgage Loan, unless such information is not provided by the Borrower with respect to such Mortgage Loan, in which case the Origination Date shall be deemed to be the date that is 40 days prior to the date of the first payment under the Mortgage Note relating to such Mortgage Loan. Schedule 1, Page 16 62 "PMI Policy" or "Primary Insurance Policy" means a policy of primary mortgage guaranty insurance issued by a Qualified Insurer. "Qualified Insurer" means an insurance company duly qualified as such under the laws of the states in which the Mortgaged Property is located, duly authorized and licensed in such states to transact the applicable insurance business and to write the insurance provided, and approved as an insurer by Fannie Mae and Freddie Mac and whose claims paying ability is rated in the two highest rating categories by any of the rating agencies with respect to primary mortgage insurance and in the two highest rating categories by Best's with respect to hazard and flood insurance. "Qualified Originator" means an originator of Mortgage Loans reasonably acceptable to the Lender. "Servicing File" means with respect to each Mortgage Loan, the file retained by the Borrower consisting of originals of all documents in the Mortgage File which are not delivered to a Custodian and copies of the Mortgage Loan Documents set forth in Section 2 of the Custodial Agreement. Schedule 1, Page 17 EX-99.2I.1B 3 TERMINATION AMENDMENT TO ESOP 1 EXHIBIT 99.2i.1b TERMINATION AMENDMENT TO THE ALLIED EMPLOYEE STOCK OWNERSHIP PLAN AND TRUST AGREEMENT Allied Capital Corporation, having adopted the Allied Employee Stock Ownership Plan and Trust Agreement (the "Plan"), effective as of January 1, 1998, having reserved to itself in Section 9.2 of the Plan the right to terminate the Plan at any time, hereby terminates the Plan effective as of December 31, 1999 (the "Termination Date") and provides for the distribution of each Participant's account balance upon the terms and conditions set forth in this Termination Amendment: 1. The Plan is hereby terminated effective as of the Termination Date. 2. The Trustee is hereby authorized and instructed by the Plan Administrator to distribute, in accordance with Plan Article VII, to each Participant his account balance as soon as administratively feasible. 3. Upon the distribution of all Participants' account balances, all liabilities of the Plan to Participants shall cease and the Trust Fund maintained pursuant to the Plan shall thereupon terminate and dissolve. 4. Allied Capital Corporation hereby reserves the right to further amend the Plan and to amend the provisions of this Termination Amendment. IN WITNESS WHEREOF, this instrument is duly executed this 21st day of October, 1999. By: /s/ KELLY A. ANDERSON -------------------------------------------- Kelly A. Anderson, Executive Vice President and Treasurer Attest: /s/ SUZANNE V. SPARROW - ----------------------------- Suzanne V. Sparrow, Secretary EX-99.2N.1 4 CONSENT OF ARTHUR ANDERSEN LLP 1 EXHIBIT EX-99.2n.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the use of our report dated February 18, 1999, and to all references to our Firm included in or made part of this registration statement. /s/ Arthur Andersen LLP Vienna, Virginia November 10, 1999 EX-99.2L 5 OPINION OF COUNSEL AND CONSENT TO ITS USE 1 EXHIBIT EX-99.2L Sutherland Asbill & Brennan LLP 1275 Pennsylvania Avenue, N.W. Washington, D.C. 20004 November 10, 1999 STEVEN B. BOEHM DIRECT LINE: (202) 383-0176 Internet: sboehm@sablaw.com Allied Capital Corporation 1919 Pennsylvania Avenue, N.W. 3rd Floor Washington, D.C. 20006 Ladies and Gentlemen: We have acted as counsel to Allied Capital Corporation, a Maryland corporation (the "Company") in connection with the offering from time to time by the Company of up to 6,000,000 shares of the Company's common stock, par value $0.0001 per share (the "Shares"). Such offering is the subject of a registration statement on Form N-2, under the Securities Act of 1933, as amended (the "Act") filed by the Company on August 11, 1999, as amended by post-effective amendment number one to the registration statement (the "registration statement") being filed by the Company with the Commission. The Registration Statement provides that the Shares may be offered in amounts, at prices, and on terms to be set forth in one or more supplements (each a "Prospectus Supplement") to the final prospectus (the "Prospectus"). We have participated in the preparation of the Registration Statement and have examined originals or copies, certified or otherwise identified to our satisfaction by public officials or officers of the Company as authentic copies of originals, of (i) the Company's charter (the "Charter") and its bylaws ("the Bylaws"), (ii) resolutions of the board of directors of the Company relating to the authorization of the preparation and filing of the Registration Statement and approving the offer and the issuance of the Shares, and (iii) such other documents as in our judgment were necessary to enable us to render the opinions expressed below. In our review and examination of all such documents, we have assumed the legal capacity of all natural persons, the genuineness of all signatures, the authenticity of all documents and records submitted to us as originals, and the conformity with authentic originals of all documents and records submitted to us as copies. To the extent we have deemed appropriate, we have relied upon certificates of public officials and certificates and statements of corporate officers of the Company as to certain factual matters. We assume that prior to the issuance of any Shares there will exist, under the Charter of the Company, the requisite number of authorized but unissued shares of common stock of the Company. In addition, we assume that underwriting agreements for the offerings of the Shares (an "Underwriting Agreement") will be valid and legally binding agreements that conform to the description thereof set forth in the applicable Prospectus Supplement. 2 Allied Capital Corporation November 10, 1999 Page 2 We assume that the issuance, sale and amount of the Shares to be offered from time to time will be authorized and determined by proper action of the Board of Directors of the Company in accordance with the parameters described in the Registration Statement (each, a "Board Action") and in accordance with the Company's Charter and Bylaws and with applicable Maryland law. This opinion is limited to the laws of the State of Maryland, and we express no opinion with respect to the laws of any other jurisdiction. The opinions expressed in this letter are based on our review of the General Corporation Law of Maryland. Based upon and subject to the foregoing and our investigation of such matters of law as we have considered advisable, we are of the opinion that: 1. The Company is a corporation duly incorporated and existing under the laws of the State of Maryland. 2. Upon due authorization by Board Action of the issuance of the Shares, and upon the consummation of the sale of Shares and the payment of the consideration therefor in accordance with the terms and provisions of such Board Action, the Registration Statement (as declared effective under the Act), the Prospectus or the applicable Prospectus Supplement and, if applicable, an Underwriting Agreement, the Shares will be duly authorized, validly issued, fully paid and nonassessable. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement and to the reference to our firm in the "Legal Matters" section of the prospectus included in the Registration Statement. We do not admit by giving this consent that we are in the category of persons whose consent is required under Section 7 of the Securities Act of 1933, as amended. Very truly yours, Sutherland Asbill & Brennan LLP By: /s/ Steven B. Boehm --------------------- Steven B. Boehm SSB/gth -----END PRIVACY-ENHANCED MESSAGE-----