-----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, WP9ZjGS1WY14CQriqhwEh62ObEAH6aCK8e8UE9E4ySXs0klEJ0v0opu571/YgCi4 uo0N8CxWNJQnVaVJt2d3iQ== 0001215811-05-000026.txt : 20050331 0001215811-05-000026.hdr.sgml : 20050331 20050331154727 ACCESSION NUMBER: 0001215811-05-000026 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050331 DATE AS OF CHANGE: 20050331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMERICAN MORTGAGE ACCEPTANCE CO CENTRAL INDEX KEY: 0000878774 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 136972380 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: 1934 Act SEC FILE NUMBER: 001-14583 FILM NUMBER: 05720117 BUSINESS ADDRESS: STREET 1: 625 MADISON AVE CITY: NEW YORK STATE: NY ZIP: 10022 BUSINESS PHONE: 2124215333 MAIL ADDRESS: STREET 1: 625 MADISON AVENUE CITY: NEW YORK STATE: NY ZIP: 10022 FORMER COMPANY: FORMER CONFORMED NAME: AMERICAN MORTGAGE INVESTORS TRUST DATE OF NAME CHANGE: 19931013 10-K/A 1 f10ka_march2005-amac.txt SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A AMENDMENT NO. 1 (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ------- EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - ------- EXCHANGE ACT OF 1934 Commission File Number 0-23972 AMERICAN MORTGAGE ACCEPTANCE COMPANY (Exact name of registrant as specified in its charter) Delaware 13-6972380 - ---------------------------------------- ------------------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 625 Madison Avenue, New York, New York 10022 - ---------------------------------------- ------------------------------ (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (212) 317-5700 Securities registered pursuant to Section 12(b) of the Act: Title of each class -------------------------------------------------- Shares of Beneficial Interest, par value $.10 per share Name of each exchange on which registered: -------------------------------------------------- American Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ------ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes X No ----- ------ The approximate aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant as of December 31, 2004 was approximately $140,763,000 based on a price of $17.20 per share, the closing sales price for the Registrant's common shares of beneficial interest on the American Stock Exchange on that date. As of March 1, 2005 there were 8,336,803 outstanding common shares of the Registrant's shares of beneficial interest. DOCUMENTS INCORPORATED BY REFERENCE None EXPLANATORY NOTE This amendment to the Annual Report on Form 10-K/A for the year ended December 31, 2004 of American Mortgage Acceptance Company ("the Company") is being filed to include: (i) a copy of the amendment to the Company's declaration of trust which was approved by shareholders at last year's annual meeting; and (ii) the audited consolidated financial statements of ARCap Investors, LLC ("ARCap") for the years ended December 31, 2004, 2003 and 2002, as required by Rule 3-09 of Regulation S-X. The Company has an investment in ARCap which it accounts for under the equity method of accounting and the financial statements were not available at the time the Company filed its Annual Report on Form 10-K on March 16, 2005. The consent of Ernst & Young LLP, independent registered public accounting firm for ARCap, is also filed as an exhibit hereto. There were no changes made to the Company's Form 10-K for the year ended December 31, 2004. 2 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (c) Exhibits. EXHIBIT NO. EXHIBIT TITLE - ---------- ------------- 3 Amendment to Declaration of Trust* 23(a) Consent of Ernst & Young LLP with respect to incorporation by reference of its report relating to the 2004, 2003 and 2002 consolidated financial statements of ARCap Investors, LLC in the Company's Registration Statement on Form S-3 and Form S-8* 24.1 Power of Attorney (previously filed as part of the Company's filing on Form 10-K on March 16, 2005) 31.1 Chief Executive Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* 31.2 Chief Financial Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* 99. Additional Exhibits 99(a) The 2004 consolidated financial statements of ARCap Investors, LLC which invests primarily in subordinated commercial mortgage-backed securities, as required by Regulation S-X, Rule 3-09* 99(b) The 2003 consolidated financial statements of ARCap Investors, LLC which invests primarily in subordinated commercial mortgage-backed securities, as required by Regulation S-X, Rule 3-09* 99(c) The 2002 consolidated financial statements of ARCap Investors, LLC which invests primarily in subordinated commercial mortgage-backed securities, as required by Regulation S-X, Rule 3-09* * Filed herewith 3 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN MORTGAGE ACCEPTANCE COMPANY (Registrant) Date: March 31, 2005 By: /s/ Stuart J. Boesky -------------------- Stuart J. Boesky Chairman of the Board of Trustees, President and Chief Executive Officer Date: March 31, 2005 By: /s/ Alan P. Hirmes ------------------ Alan P. Hirmes Managing Trustee and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signature Title Date - -------------------- ------------------------------------- --------------- /s/ Stuart J. Boesky - -------------------- Stuart J. Boesky Chairman of the Board of Trustees, President and Chief Executive Officer March 31, 2005 /s/ Alan P. Hirmes - ------------------ Alan P. Hirmes Managing Trustee and Chief Financial Officer March 31, 2005 * - -------------------- Stanley R. Perla Trustee March 31, 2005 * - -------------------- Richard M. Rosan Trustee March 31, 2005 * - -------------------- Scott M. Mannes Trustee March 31, 2005 * by: /s/ Alan P. Hirmes ------------------ Attorney-in-Fact 4 Exhibit 3 AMENDMENT TO DECLARATION OF TRUST To the Secretary of State of Commonwealth of Massachusetts It is herby stated that: 1. This document constitutes an Amendment to the Second Amended and Restated Declaration of Trust (hereinafter called the "Declaration") of AMERICAN MORTGAGE ACCEPTANCE COMPANY (hereinafter called the "business trust"). 2. The Declaration amended by this document was filed with the Secretary of State of the Commonwealth of Massachusetts on April 6, 1999. 3. The amendment to the Declaration effected by this document is as follows: Deleting the first sentence of Article IV, Section 4.8 in its entirety and restating said sentence in its entirety as follows: "COMPENSATION. Independent Trustees may receive fixed sums, Common Shares in the Trust or other compensation per year and/or per meeting and/or for any service or activity they perform or engage in as Trustees, as determined by resolution of the Board of Trustees. Additionally, Independent Trustees shall be reimbursed for travel expenses and other out-of-pocket disbursements incurred in connection with attending any meetings. Non-Independent Trustees shall not receive any compensation from the Trust. Nothing herein shall be construed to preclude any non-Independent Trustee from serving the Trust in any other capacity as an officer, agent or otherwise, and receiving compensation therefor. Independent Trustees shall not perform any services for the Trust except as Trustees." 4. The amendment herein provided for was authorized in accordance with law. IN WITNESS WHEREOF, the undersigned has executed this amendment this 20th day of August, 2004. By: /s/ Alan P. Hirmes ------------------ Name: Alan P. Hirmes Title: Managing Trustee and Chief Financial Officer 5 Exhibit 23(a) CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in Registration Statement (Form S-3 No. 33-87440 and Form S-8 No. 33-118572) of American Mortgage Acceptance Company and in the related Prospectus of our reports dated March 29, 2005, February 6, 2004 and February 4, 2003, with respect to the consolidated financial statements of ARCap Investors, L.L.C. included in this Annual Report (Form 10-K) for the year ended December 31, 2004. /s/ Ernst & Young LLP Dallas, Texas March 29, 2005 6 Exhibit 31.1 CERTIFICATION I, Stuart J. Boesky, hereby certify that: 1. I have reviewed this annual report on Form 10-K of American Mortgage Acceptance Company; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure the material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals; c) evaluated the effectiveness of the registrant's disclosure controls and procedures presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors or persons performing the equivalent functions: a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 31, 2005 By: /s/ Stuart J. Boesky -------------- -------------------- Stuart J. Boesky Chief Executive Officer 7 Exhibit 31.2 CERTIFICATION I, Alan P. Hirmes, hereby certify that: 1. I have reviewed this annual report on Form 10-K of American Mortgage Acceptance Company; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure the material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals; c) evaluated the effectiveness of the registrant's disclosure controls and procedures presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors or persons performing the equivalent functions: a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 31, 2005 By: /s/ Alan P. Hirmes -------------- ------------------ Alan P. Hirmes Chief Financial Officer 8 Exhibit 32.1 CERTIFICATION PURSUANT TO 18.U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of American Mortgage Acceptance Company (the "Company") on Form 10-K for the year ending December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Stuart J. Boesky, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. By: /s/ Stuart J. Boesky -------------------- Stuart J. Boesky Chief Executive Officer March 31, 2005 A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. 9 Exhibit 32.2 CERTIFICATION PURSUANT TO 18.U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of American Mortgage Acceptance Company (the "Company") on Form 10-K for the year ending December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Alan P. Hirmes, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. By: /s/ Alan P. Hirmes ------------------ Alan P. Hirmes Chief Financial Officer March 31, 2005 A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission 10 EX-99 2 exh_2004arcap-amac.txt Exhibit 99 (a) CONSOLIDATED FINANCIAL STATEMENTS ARCap Investors, L.L.C. and Subsidiaries YEAR ENDED DECEMBER 31, 2004 ARCap Investors, L.L.C. and Subsidiaries Consolidated Financial Statements Year ended December 31, 2004 CONTENTS Report of Independent Auditors.................................................1 Audited Consolidated Financial Statements Consolidated Balance Sheet.................. ..................................2 Consolidated Statement of Operations...........................................3 Consolidated Statement of Members' Equity.... .................................4 Consolidated Statement of Cash Flows.......... ................................5 Notes to Consolidated Financial Statements.....................................7 Report of Independent Auditors The Board of Managers ARCap Investors, L.L.C. We have audited the accompanying consolidated balance sheet of ARCap Investors, L.L.C. and subsidiaries (the Company) as of December 31, 2004, and the related consolidated statements of operations, members' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ARCap Investors, L.L.C. and subsidiaries at December 31, 2004, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP March 29, 2005 ARCap Investors, L.L.C. and Subsidiaries Consolidated Balance Sheet December 31, 2004
ASSETS Investment CMBS securities - available-for-sale, net (NOTE 3) $770,675,611 Investment CMBS securities - trading, net (NOTE 3) 108,393,405 Resecuritization certificates - available-for-sale, net (NOTE 3) 49,440,468 Accrued interest receivable 10,380,330 Deferred borrowing costs, net (NOTES 5 AND 6) 7,881,749 Restricted cash - swaps (NOTES 4 AND 5) 4,768,210 Cash and cash equivalents 13,082,610 Notes receivable - employees (NOTE 11) 952,614 Borrowed investment securities and related interest rate swaps, net (NOTE 4) 512,908 Other assets 2,226,853 ------------ Total assets $968,314,758 ============ LIABILITIES AND MEMBERS' EQUITY Liabilities: Long-term debt (NOTE 5) $370,800,000 Repurchase agreements (NOTE 6) 55,210,918 Deferred compensation (NOTE 12) 16,914,353 CDO swap liability (NOTE 5) 2,817,603 Accrued interest payable 1,970,273 Accrued expenses 1,116,241 ------------ Total liabilities 448,829,388 Commitments and contingencies Minority interest in consolidated entities 316,680,180 Members' equity (NOTE 10): Series A preferred members 108,932,080 Common members 93,873,110 ------------ Total members' equity 202,805,190 ------------ Total liabilities and members' equity $968,314,758 ============
SEE ACCOMPANYING NOTES. 2 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Operations Year ended December 31, 2004
Revenues: Interest income - CMBS $ 114,060,310 Other income 8,610,417 ------------- 122,670,727 Expenses: Interest - long-term debt and repurchase agreements 38,777,544 Interest - borrowed investment securities and related interest rate swaps, net 2,094,055 Salaries and employee benefits 12,304,902 General and administrative 4,212,225 Financing fee 885,000 ------------- 58,273,726 ------------- Net margin on CMBS and other income 64,397,001 Other revenue (expense): Accretion of purchase discounts 6,326,788 Gain on investment securities, net (NOTE 8) 73,944,381 Realized gain on hedging instrument (NOTE 5) 1,665,000 Deferred compensation expense (NOTE 12) (13,774,109) Loss on early extinguishment of debt (NOTES 5 AND 7) (33,371,544) ------------- 34,790,516 ------------- Income before minority interest 99,187,517 Minority interest (34,681,048) ------------- Net income 64,506,469 Other comprehensive income (loss) (NOTE 10): Unrealized gain on available-for-sale securities, net of minority interest of $50,478,765 18,880,916 Unrealized loss on swap liability, net of minority interest of $(1,911,900) (78,108) Realized gain on hedging instrument - swap, net of minority interest of $1,683,874 495,478 ------------- 19,298,286 ------------- Comprehensive income $ 83,804,755 =============
SEE ACCOMPANYING NOTES. 3 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Members' Equity
SERIES A COMMON PREFERRED MEMBERS MEMBERS TOTAL ------------------------------------------------ BALANCE AT JANUARY 1, 2004 $ 67,367,415 $ 142,198,741 $ 209,566,156 Costs to raise capital of consolidated subsidiaries (3,954,961) (4,382,475) (8,337,436) Distributions (13,340,365) (17,400,000) (30,740,365) Net income 39,785,587 24,720,882 64,506,469 Other comprehensive income 9,102,582 10,195,704 19,298,286 Redemption of members' equity (21,005,765) (30,482,155) (51,487,920) Conversion of members' equity 15,918,617 (15,918,617) -- ------------------------------------------------ BALANCE AT DECEMBER 31, 2004 $ 93,873,110 $ 108,932,080 $ 202,805,190 ================================================
SEE ACCOMPANYING NOTES. 4 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Cash Flows Year ended December 31, 2004
OPERATING ACTIVITIES Net income $ 64,506,469 Adjustments to reconcile net income to net cash provided by operating activities: Gain on investment securities, net (73,944,381) Loss on early extinguishment of debt 33,371,544 Accretion of purchase discounts (6,326,788) Deferred compensation expense 13,774,109 Realized gain on hedging instrument (1,665,000) Amortization of deferred borrowing costs 1,976,106 Amortization of realized gain on hedging instrument - swap in other comprehensive income (loss) (270,648) Minority interest 34,681,048 Changes in operating assets and liabilities: Investment CMBS securities - trading 26,337,070 Accrued interest receivable 1,053,078 Restricted cash - swaps (392,099) Notes receivable - employees (815,550) Borrowed investment securities and related interest rate swaps, net (1,925,160) Other assets (21,147) Accrued interest payable (869,563) Accrued expenses 130,721 ------------- Net cash provided by operating activities 89,599,809 INVESTING ACTIVITIES Proceeds from sale of investment CMBS securities - available-for-sale, net 210,814,876 Proceeds from realized gain on hedging instrument 1,665,000 ------------- Net cash provided by investing activities 212,479,876 FINANCING ACTIVITIES Retirement of long-term debt (266,000,000) Proceeds from the issuance of long-term debt 175,000,000 Payments of repurchase agreements (107,800,082) Payment of prepayment premiums in connection with extinguishment of debt (29,491,191) Redemption of members' equity (51,487,920) Distributions to members (30,740,365) Capital contributions from (returns of capital to) minority interest holders, net 60,370,585 Operating distributions to minority interest holders (31,029,539) Costs to raise capital of consolidated subsidiaries (8,337,436) Costs to raise capital of minority interest holders (182,005) Payments for deferred borrowing costs (4,406,253) Proceeds from realized gain on hedging instrument - swap in other comprehensive income (loss) 2,450,000 ------------- Net cash used in financing activities (291,654,206) ------------- Net change in cash and cash equivalents 10,425,479 Cash and cash equivalents at beginning of year 2,657,131 ------------- Cash and cash equivalents at end of year $ 13,082,610 =============
5 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Cash Flows (continued) Year ended December 31, 2004
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash payments for interest on long-term debt and repurchase agreements $36,850,542 =========== SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Investment CMBS securities exchanged for the following: Resecuritization certificates $41,981,514 =========== Other assets $ 1,135,345 ===========
SEE ACCOMPANYING NOTES. 6 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2004 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES ORGANIZATION ARCap Investors, L.L.C. (the Company) was incorporated in January 1999 and commenced operations on March 17, 1999. The Company was organized to invest primarily in subordinate commercial mortgage-backed securities (CMBS). PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of: - The Company. - ARCap REIT, Inc. (ARCap REIT), a majority-owned subsidiary of the Company. - ARCap Resecuritization Corporation (ARCap Resecuritization), a wholly owned subsidiary of ARCap REIT. ARCap Resecuritization owned all the residual interest in Commercial Resecuritization Trust 2001 ABC-2 (the 2001-ABC2 Trust) and Commercial Resecuritization Trust 2003-ABC3 (the 2003-ABC3 Trust). ARCap Resecuritization was merged into ARCap REIT in December 2004. - ARCap High Yield CMBS Fund, L.L.C. (the High Yield Fund), of which ARCap REIT owns an approximate 23% controlling interest. The High Yield Fund owns approximately 60% of ARCap CMBS Fund REIT, Inc. (the Fund REIT). ARCap 2003-1 Resecuritization, Inc. (2003-1 Resecuritization), a wholly owned subsidiary of the Fund REIT, owns all of the equity interest in ARCap 2003-1 Resecuritization Trust (the 2003-1 Trust). ARCap 2004-1 Resecuritization, Inc. (2004-1 Resecuritization), a wholly owned subsidiary of the Fund REIT, owns all of the equity interest in ARCap 2004-1 Resecuritization Trust (the 2004-1 Trust). - ARCap Diversified Risk CMBS Fund, L.L.C. (the Diversified Risk Fund), of which ARCap REIT owns an approximate 1% controlling interest. The Diversified Risk Fund owns approximately 40% of the Fund REIT. - ARCap Servicing, Inc., a taxable REIT subsidiary wholly owned by ARCap REIT. - ARCap 2004-RR3 Resecuritization, Inc. (2004-RR3), a wholly owned subsidiary of ARCap REIT. - ARCap Fund Management, L.L.C. (AFM), of which ARCap REIT owns an approximate 78.5% controlling interest. AFM owns a 5% controlling interest in ARCap High Yield CMBS Fund II, L.L.C. (the High Yield Fund II), which, in turn, owns approximately 51% of the equity interest in ARCap CMBS Fund II REIT, Inc. (the Fund II REIT). AFM owns a 5% controlling interest in ARCap Diversified Risk CMBS Fund II, L.L.C. (the Diversified Risk Fund II), which owns approximately 49% of the Fund II REIT. Minority interests primarily represent outside members' approximate 77% ownership in the High Yield Fund, outside members' approximate 99% ownership in the Diversified Risk Fund, outside members' 95% ownership in both the High Yield Fund II and the Diversified Risk Fund II, $109,000 of 12.5% preferred stock issued by Fund II REIT, and ARCap Fund Investments, L.L.C.'s (AFI) approximate 21.5% ownership in AFM. The Company has consolidated the High Yield Fund, Diversified Risk Fund, and AFM as it exercises control (through ARCap REIT, which acts as the Managing Member of both funds and AFM in accordance with the 7 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (CONTINUED) terms of the respective LLC agreements) over the operations of these entities. The Company records minority interest expense (income) that reflects the portion of the earnings (losses) of the operations which is applicable to the minority interest members. As the Managing Member of both the High Yield Fund and the Diversified Risk Fund, ARCap REIT is entitled to a 20% promote allocation in the event the funds achieve a specified investment return. Similarly, as the Managing Member of both the High Yield Fund II and the Diversified Risk Fund II, AFM is entitled to a 20% promote allocation in the event those funds achieve a specified investment return. Accordingly, minority interest expense may not equal the earnings of each of the Funds times the respective outside members' ownership percentages. Separate books of accounts are maintained for ARCap REIT, ARCap Resecuritization, the 2001-ABC2 Trust, the High Yield Fund, the Fund REIT, 2003-1 Resecuritization, the 2003-1 Trust, 2004-1 Resecuritization, the 2004-1 Trust, the Diversified Risk Fund, ARCap Servicing, Inc., 2004-RR3, AFM, the High Yield Fund II, the Fund II REIT, the Diversified Risk Fund II, and AFI and are reflected in the accompanying consolidated financial statements of the Company. All material intercompany transactions and account balances have been eliminated in consolidation. VARIABLE INTEREST ENTITIES In December 2003, the Financial Accounting Standards Board (FASB) issued a revised version of FASB Interpretation No. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES (FIN 46R). FIN 46R addresses the application of Accounting Research Bulletin No. 51, CONSOLIDATED FINANCIAL STATEMENTS, to certain entities in which voting rights are not effective in identifying an investor with a controlling financial interest. An entity is subject to consolidation under FIN 46R if the investors either do not have sufficient equity at risk for the entity to finance it activities without additional subordinated financial support, are unable to direct the entity's activities, or are not exposed to the entity's losses or entitled to its residual returns (variable interest entities or VIEs). Variable interest entities within the scope of FIN 46R are required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity's expected losses, of its expected returns, or both. The Company's ownership of the subordinated classes of CMBS from a single issuer gives it the right to control the foreclosure/workout process on the underlying loans (Controlling Class CMBS). FIN 46R provides certain scope exceptions, one of which provides that an enterprise that holds a variable interest in a qualifying special-purpose entity (QSPE) does not consolidate that entity unless that enterprise has the unilateral ability to cause the entity to liquidate. SFAS No. 140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, provides the requirements for an entity to be considered a QSPE. To maintain the QSPE exception, the trust must continue to meet the QSPE criteria both initially and in subsequent periods. A trust's QSPE status can be impacted in future periods by activities by its transferor(s) or other involved parties, including the manner in which certain servicing activities are performed. To the extent its CMBS investments were issued by a trust that meets the requirements to be considered a QSPE, the Company records the investments at the purchase price paid. To the extent the underlying trusts are not QSPEs, the Company follows the guidance set forth in FIN 46R as the trusts would be considered VIEs. The Company has analyzed the governing pooling and servicing agreements for each of its subordinated class CMBS and believes that the terms are industry standard and are consistent with the QSPE criteria. However, given uncertainty with 8 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (CONTINUED) respect to QSPE treatment due to ongoing review by the accounting profession (including the FASB's project to amend SFAS 140), possible actions by various parties involved with QSPE, as discussed above, as well as varying and evolving interpretations of the QSPE criteria under SFAS 140, the Company has also analyzed the investments as if the trusts are not qualifying. Using the fair value approach permitted under FIN 46R to compute expected losses and expected residual returns, the Company has concluded that it would not be the primary beneficiary of any of the underlying trusts. INVESTMENT SECURITIES The Company's investment security transactions are recorded on the trade date for existing securities and the settlement date for to-be-issued securities. In October 2003, the 2001-ABC2 Trust reclassified CMBS with a fair value of approximately $386,000,000 from trading to available-for-sale in connection with the creation of the 2003-ABC3 Trust (see Note 5). The reclassification effectively established a new basis for financial reporting for the related CMBS at the date of transfer. In April 2004, the Fund REIT reclassified 33 CMBS securities with a fair value of approximately $109,000,000 from trading to available-for-sale in connection with the resecuritization of 66 CMBS securities and the issuance of a collateralized debt obligation (2004-1 CDO) (see Note 5). In August 2003, the Fund REIT reclassified CMBS with a fair value of approximately $260,000,000 from trading to available-for-sale in connection with the resecuritization of 64 CMBS securities and the issuance of a collateralized debt obligation (2003-1 CDO) (see Note 5). The reclassifications effectively established a new basis for financial reporting for the related CMBS at the date of transfer. CMBS and resecuritization certificates classified as available-for-sale are securities that the Company considers for possible sales or other dispositions prior to the maturity of the securities. Available-for-sale securities are carried at their estimated fair value with unrealized gains and losses reported in other comprehensive income (loss) as a separate component of members' equity. The Company evaluates unrealized losses on its available-for-sale securities to determine if such declines in fair value are other than temporary. In the event a decline in the fair value of an available-for-sale security is deemed other than temporary, the decline in fair value would be recorded as an impairment to the security and charged through earnings rather than as a component of other comprehensive income (loss). Approximately $22,228,000 of other than temporary impairments has been recognized for the year ended December 31, 2004. The Company's CMBS that are designated as trading assets represent securities the Company is holding for possible sales or other dispositions in the near term. Such securities are carried at their estimated fair value, with unrealized gains or losses included in earnings. The fair value of the Company's portfolio of CMBS and resecuritization certificates is generally estimated by management based on market prices provided by certain dealers who make a market in these financial instruments. The market for the Company's CMBS and resecuritization certificates may lack liquidity and have limited market volume. Accordingly, the fair values reported reflect estimates and may not necessarily be indicative of the amounts that the Company could realize in a current market exchange. The yield to maturity on the Company's CMBS and resecuritization certificates depends on, among other things, the rate and timing of principal payments, the pass-through rate, and interest rate fluctuations. The subordinate CMBS interests and resecuritization certificates owned by the Company provide credit support to the more senior interests of the related commercial securitization. 9 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (CONTINUED) Cash flow from the mortgages underlying the CMBS interests and resecuritization certificates generally is allocated first to the senior interests, with the most senior interest having a priority entitlement to cash flow. Remaining cash flow is allocated generally among the other CMBS interests and resecuritization certificates in order of their relative seniority. To the extent that there are defaults and unrecoverable losses on the underlying mortgages that result in reduced cash flows, the most subordinate CMBS interest and resecuritization certificate will bear this loss first. To the extent that there are losses in excess of the most subordinate interest's or certificate's stated entitlement to principal and interest, then the remaining CMBS interests and resecuritization certificates will bear such losses in order of their relative subordination. REVENUE RECOGNITION Interest income and servicing fees are recognized as earned. Accretion of discounts is computed using the effective-interest method over the expected life of the securities based on management's estimates regarding the timing and amount of cash flows from the underlying collateral. The timing and amount of actual cash flows may differ from these estimates. DERIVATIVE FINANCIAL INSTRUMENTS Derivative financial instruments are utilized by the Company to reduce interest rate risk. The Company utilizes interest rate swaps and cap and floor agreements as a means of hedging the potential financial statement impact of changes in the fair value of its portfolio of CMBS and variable rate long-term debt due to changes in interest rates. Risks in these contracts arise from the movements in interest rates and from the possible inability of counterparties to meet the terms of their contracts. The Company carries its derivative financial instruments at fair value. If the cash flow hedge qualifies for "hedge accounting" under Statement of Financial Accounting Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (SFAS No. 133), the unrealized gain or loss is included in other comprehensive income (loss). Otherwise, the change in the value of the hedge is included in earnings. For derivative financial instruments which otherwise qualify for hedge accounting, any gains or losses representing the amount of the hedge's ineffectiveness are appropriately included in earnings. RESALE AND REPURCHASE AGREEMENTS Transactions involving purchases of securities under agreements to resell (reverse repurchase agreements or reverse repos) or sales of securities under agreements to repurchase (repurchase agreements or repos) are accounted for as collateralized financings, except where the Company does not have an agreement to sell (or purchase) the same or substantially the same securities before maturity at a fixed or determinable price. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all highly liquid investments with original maturities when purchased of three months or less. RESTRICTED CASH - SWAPS Restricted cash represents amounts required to be pledged under swap contracts (see Note 5). 10 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (CONTINUED) DEFERRED BORROWING COSTS Deferred borrowing costs represent costs incurred in connection with the issuance of long-term debt. Such amounts are amortized using the effective-interest method over the term of the related debt (see Note 5). FINANCING FEE Through September 30, 2004, the Company paid an annual rate of 0.50% on $236,000,000 of its existing long-term debt to a financier to provide credit enhancement of such debt. Such debt was extinguished in connection with the 2004-RR3 re-REMIC transaction (see Note 7). INCOME TAXES The Company has elected to be taxed as a partnership, whereby all income is taxed at the member level, with the exception of ARCap Servicing, Inc., which is taxed at the entity level. ARCap REIT has elected to be taxed as a real estate investment trust for federal income tax purposes. No provision for income taxes has been made for ARCap Servicing, Inc. for the year ended December 31, 2004, as ARCap Servicing, Inc. did not generate taxable income. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of certain assets, liabilities, revenues, and expenses. Actual results could differ from those estimates. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts herein have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts. The Company's CMBS and resecuritization certificates, interest rate swap agreements, and securities borrowed are carried at their estimated fair values. The Company's management believes that the fair values of its cash and cash equivalents, restricted cash, and variable rate repurchase agreements approximate their carrying values due to the nature of the instruments or the fact that their terms approximate current market terms. 11 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (CONTINUED) The fair value of the Company's fixed rate long-term debt and repurchase agreements is comprised of the following at December 31, 2004:
DEBT FACE FAIR VALUE - -------------------------------------------------------------------------------- 2003-1 CDO (see Note 5) $195,800,000 $207,921,350 2004-1 CDO (see Note 5) 175,000,000 179,871,896 Long-term fixed rate repurchase agreements (see Note 6) 25,367,000 24,461,860
Fair value was estimated using a discounted cash flow analysis based on an interest rate of 5.50% for both the CDOs and long-term fixed rate repurchase agreements, which management believes is currently available for the issuance of similarly rated debt. 2. MEMBERS' EQUITY The Limited Liability Company Agreement (LLC Agreement) establishes two classes of membership: Series A Preferred members and Common members. Cash flows are distributed in the following order of priority: - To the Series A Preferred members in an amount equal to the accrued and unpaid Preferred Distributions (12% per annum of the $25.00 price per Unit). - To the Common members in an amount equal to the amount determined by the Board of Managers, provided that if the amount distributable to the Common members shall exceed a cumulative annual return on the Common Units of 12% per annum, the Board of Managers shall notify the Series A Preferred members 30 days in advance of the record date for distribution of Cash Flow. - To the extent that any remaining Cash Flow received during such tax period is not includable in the income of the Company, to members that have been allocated Net Profits in excess of amounts actually distributed to such members, in proportion to such amounts. Net Profits of the Company are allocated as follows: - To the Series A Preferred members to the extent of amounts distributed or distributable to them in such taxable year. - To the Series A Preferred members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the Common members to the extent of amounts distributed or distributable to them in such taxable year. - To the Common members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the members in proportion to their Percentage Interests. Net Losses of the Company are allocated as follows: - To the members in an amount equal to undistributed Net Profits allocated to such members. - To the Common members pro rata to the extent of their Capital Accounts. 12 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 2. MEMBERS' EQUITY (CONTINUED) - To the Series A Preferred members pro rata to the extent of their Capital Accounts. SERIES A PREFERRED UNITS Series A Preferred Units are convertible into Common Units at the Conversion Price in effect on the Conversion Date. If the Series A Preferred Units have not been converted within five years of the effective date of the First Amendment to the LLC Agreement (August 4, 2000), Series A Preferred Units may, at the holder's option, be converted to a note equal to $25.00 per Unit, plus accrued and unpaid Preferred Distributions. On December 31, 2004, 600,000 Series A Preferred Units were converted to Common Units. Eighteen months after the First Closing Date (February 4, 2002), but no later than the fifth anniversary of the First Closing Date (August 4, 2005), the Company may redeem the Series A Preferred Units for $25.00 per unit, plus accrued and unpaid Preferred Distributions, plus a premium that will provide the Series A Preferred members with a total pretax internal rate of return of 17.50%. In addition, upon either a change in control or sale or transfer of all or substantially all of the assets of the Company, Series A Preferred Units may, at the holder's option, be redeemed at $25.00 per unit, plus accrued and unpaid Preferred Distributions. On October 1, 2004, the Company redeemed 1,108,442 Series A Preferred Units and 763,846 Common Units for approximately $51,488,000 with proceeds generated from the 2004-RR3 re-REMIC transaction (see Note 7). At December 31, 2004, there were a total of 4,091,558 Series A Preferred Units and 4,834,071 Common Units issued and outstanding. In addition to its commitment to invest approximately $13,400,000 in the Diversified Risk Fund II and $11,800,000 in the High Yield Fund II, ARCap REIT was required to make a special contribution of $8,330,000 in October 2004 to pay specified costs to raise capital as outlined in the respective LLC agreements. In accordance with the LLC agreements, the special contribution is not entitled to any preferred return. The LLC Agreement contains certain restrictive covenants regarding the amount of variable rate debt, total debt, and certain financial ratios. Failure to meet the covenants in successive quarters can result in the Chief Executive Officer and Chief Operating Officer being removed from the Board of Managers until such time as the covenants are cured for successive quarters. Management believes that the Company has not violated the covenants in successive quarters. 13 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 3. INVESTMENT SECURITIES The Company's available-for-sale CMBS securities are carried at estimated fair value and are comprised of the following at December 31, 2004:
FACE ACCRETED COST FAIR VALUE PERCENTAGE ------------------------------------------------------------- Subordinate CMBS: Security rating: BBB- $ 29,755,000 $ 28,215,299 $ 28,611,861 3.71% BB+ 34,704,000 28,885,122 31,327,573 4.06% BB 216,154,901 173,057,775 187,898,727 24.38% BB- 158,272,775 112,179,255 120,374,523 15.62% B+ 222,496,118 138,520,631 150,342,940 19.51% B 210,110,657 100,969,494 107,972,139 14.01% B- 143,764,610 61,046,203 65,390,185 8.48% NR 317,988,548 86,442,210 78,757,663 10.23% ------------------------------------------------------------- $1,333,246,609 $ 729,315,989 $ 770,675,611 100.00% =============================================================
The Company's trading CMBS securities are carried at estimated fair value and are comprised of the following at December 31, 2004:
FACE COST FAIR VALUE PERCENTAGE ------------------------------------------------------------- Subordinate CMBS: Security rating: BB+ $ 55,591,000 $ 45,003,213 $ 51,868,936 47.85% NR 278,513,663 72,543,757 56,524,469 52.15% ------------------------------------------------------------- $ 334,104,663 $ 117,546,970 $ 108,393,405 100.00% =============================================================
The Company's resecuritization certificates are carried at estimated fair value and are comprised of the following at December 31, 2004:
FACE ACCRETED COST FAIR VALUE PERCENTAGE ------------------------------------------------------------- Subordinate Resecuritization Certificates: Security rating: BB- $ 8,182,000 $ 4,022,601 $ 4,826,102 9.76% B+ 8,863,000 3,610,747 4,338,369 8.77% B 12,954,000 4,446,836 5,347,067 10.82% B- 5,454,000 1,551,272 1,856,704 3.76% NR 38,181,371 3,871,852 4,496,751 9.10% IO -- 23,809,205 28,575,475 57.79% ------------------------------------------------------------- $ 73,634,371 $ 41,312,513 $ 49,440,468 100.00% =============================================================
The interest-only certificate had a notional amount of $545,431,371 at December 31, 2004. 14 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 3. INVESTMENT SECURITIES (CONTINUED) At December 31, 2004, the accumulated accretion of purchase discounts is comprised of the following:
ACCUMULATED ACCRETION --------------- Available-for-sale $ 7,929,000 Trading (7,085,000) Resecuritization certificates (669,000)
The gross cumulative unrealized gains and losses on the Company's available-for-sale investment securities were approximately $73,849,000 and $(8,358,000), respectively, at December 31, 2004, for total accumulated other comprehensive income on available-for-sale securities of approximately $65,491,000. he cumulative unrealized losses of approximately $(8,358,000) on available-for-sale securities at December 31, 2004, are net of approximately $28,826,000 cumulative losses charged to earnings as other than temporary declines in value. The cumulative unrealized losses relate to 30 investment securities, with a fair value of approximately $86,697,000, which have been in an unrealized loss position for less than 12 months. Changes in fair value are impacted by changes in benchmark interest rates, as well as spread changes. Spread changes can be attributable to either sector movements or changes in the credit quality of the underlying collateral. Management believes there are no material changes in the credit quality of the underlying collateral which impacted the remaining cumulative unrealized losses to date, and the Company has the intent and ability to hold these investments until maturity or until the fair value recovers above accreted cost. The gross cumulative unrealized gains and losses on the Company's trading investment securities at December 31, 2004, were approximately $11,240,000 and $(13,308,000), respectively. The gross cumulative unrealized gains and losses on the Company's resecuritization certificates at December 31, 2004, were approximately $8,128,000 and $0, respectively. 15 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 4. BORROWED INVESTMENT SECURITIES AND RELATED INTEREST RATE SWAPS, NET The Company's borrowed investment securities and related interest rate swaps are carried at estimated fair value and are comprised of the following at December 31, 2004:
SECURITY COUPON FAIR UNREALIZED DESCRIPTION RATE FACE BASIS VALUE GAIN (LOSS) - -------------------------------------------------------------------------------------------------------- U.S. Treasury (08-15-11) 5.000% $ (3,423,000) $ (3,390,375) $ (3,644,425) $ (254,050) U.S. Treasury (02-15-12) 4.875% (7,097,000) (7,553,116) (7,501,751) 51,365 U.S. Treasury (11-15-12) 4.000% (3,603,000) (3,579,918) (3,596,808) (16,890) -------------------------------------------------------------- $(14,123,000) $(14,523,409) (14,742,984) $ (219,575) ============================= ============== Reverse repurchase agreements 15,560,101 ------------- Borrowed investment securities, net 817,117 Interest rate swaps (304,209) ------------- Borrowed investment securities and related interest rate swaps, net $ 512,908 =============
The borrowed U.S. Treasury securities were sold in the open market (i.e., a "short" security sale). The Company is obligated to return the securities in the future and is, therefore, exposed to price risk until it repurchases the securities for delivery to the lender. Short security sales are used by the Company to modify its interest rate risk. The Company must pay the security lender the interest earned by the underlying security. Short security sales are recorded at the estimated fair value of the borrowed securities, and any unrealized gains (losses) are included in earnings. Proceeds from short security sales are used to purchase reverse repurchase agreements of the same security. The transactions are governed by one master repurchase agreement with rights of offset and, therefore, the values of the short security sales and reverse repurchase agreements have been offset and shown as one line item in the accompanying consolidated financial statements. It has been the Company's practice to settle these transactions on a net basis. In August 2004, ARCap REIT repurchased $32,467,000 of its U.S. Treasury securities held against its CMBS for delivery to the lender and sold all offsetting reverse repurchase agreements, consistent with ARCap REIT's practice of settling its borrowed investment transactions on a net basis. Settlement of the transactions resulted in an approximate $1,991,000 realized loss for the year ended December 31, 2004. The Company entered into an interest rate swap agreement with Bear Stearns Bank PLC (Bear Stearns PLC) with a notional amount of $27,000,000, on which the Company paid a fixed rate of 6.015% and received a variable rate based on six-month LIBOR for a term of 10 years scheduled to end April 27, 2011. The swap agreement called for interest to be paid semiannually in arrears. The Company carried the swap agreement at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. The swap was terminated on August 6, 2004, and ARCap REIT recognized a loss of approximately $2,614,000, which has been included in earnings for the year ended December 31, 2004. 16 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 4. BORROWED INVESTMENT SECURITIES AND RELATED INTEREST RATE SWAPS, NET (CONTINUED) In June 2004, the Company entered into a forward-starting swap with Bear Stearns PLC to mitigate the risk of interest-rate fluctuations. The 5.545% fixed rate swap had a notional amount of $4,450,000 and was scheduled to mature April 1, 2019. On August 10, 2004, the forward-starting swap was terminated and ARCap REIT recognized a realized loss of $192,000, which has been included in earnings for the year ended December 31, 2004. In September 2004, the Company entered into another forward-starting swap with Bear Stearns Capital Markets to mitigate the risk of interest-rate fluctuations. The 5.27% fixed rate swap has a notional amount of $10,720,000 and matures April 1, 2016. At December 31, 2004, approximately $544,000 of restricted cash serves as collateral against the swap. At December 31, 2004, the swap had an unrealized loss of approximately $304,000, which has been included in earnings. 5. LONG-TERM DEBT The Diversified Risk Fund II entered into amortizing forward-starting swap agreements to mitigate its proportionate share of the risk of changes in the interest-related cash outflows on the Fund II REIT's contemplated long-term debt issuance. A summary of the swaps held by the Diversified Risk Fund II at December 31, 2004, is as follows:
SECURITY INTEREST UNREALIZED DESCRIPTION RATE NOTIONAL AMOUNT GAIN (LOSS) - ----------------------------------------------------------------------------------- Forward Starting Swap (09-1-17) 4.953% $ 7,820,000 $ 35,354 Forward Starting Swap (12-1-18) 5.043% 5,145,000 17,444 Forward Starting Swap (05-1-19) 5.075% 3,900,000 8,760 Forward Starting Swap (04-1-20) 5.119% 6,500,000 15,022 Forward Starting Swap (04-1-19) 5.507% 4,256,000 (166,762) Forward Starting Swap (02-1-20) 5.694% 13,300,000 (737,413) --------------------------------- $40,921,000 $ (827,595) =================================
The High Yield Fund II entered into amortizing forward-starting swap agreements as a cash flow hedge to mitigate its proportionate share of the risk of changes in the interest-related cash outflows on the Fund II REIT's contemplated long-term debt issuance. A summary of the swaps held by the High Yield Fund II at December 31, 2004, is as follows:
SECURITY INTEREST UNREALIZED DESCRIPTION RATE NOTIONAL AMOUNT GAIN (LOSS) - ----------------------------------------------------------------------------------- Forward Starting Swap (12-1-18) 5.043% $ 5,355,000 $ 21,357 Forward Starting Swap (04-1-20) 5.119% 6,750,000 15,232 Forward Starting Swap (04-1-19) 5.922% 11,700,000 (923,599) Forward Starting Swap (09-1-18) 5.912% 14,100,000 (1,102,998) -------------------------------- $37,905,000 $(1,990,008) ================================
17 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 5. LONG-TERM DEBT (CONTINUED) At December 31, 2004, approximately $4,224,000 of restricted cash serves as collateral against the swaps. The High Yield Fund II swaps qualify for hedge accounting in accordance with SFAS No. 133. Accordingly, its unrealized loss of approximately $1,990,000 is included in other comprehensive income (loss) for the year ended December 31, 2004. No portion of the loss was attributable to the hedge's ineffectiveness during the year ended December 31, 2004. The Diversified Risk Fund II swaps do not qualify for hedge accounting in accordance with SFAS No. 133. Accordingly, its unrealized loss of approximately $828,000 has been included in earnings for the year ended December 31, 2004. In February 2004, the High Yield Fund entered into an amortizing forward-starting swap as a cash flow hedge and the Diversified Risk Fund entered into an amortizing forward-starting swap (the CDO swaps) to mitigate their proportionate share of the risk of changes in the interest-related cash outflows on the Fund REIT's debt issuance. The 4.1625% fixed rate swaps had a notional amount of approximately $108,182,000 for the High Yield Fund and $73,484,000 for the Diversified Risk Fund and a maturity date of April 1, 2015. The CDO swaps were terminated April 16, 2004, concurrent with the pricing of the 2004-1 CDO. In connection with the termination of the CDO swaps, the High Yield Fund and the Diversified Risk Fund recognized a gain of $2,450,000 and $1,665,000, respectively. The High Yield Fund's swap qualified for hedge accounting in accordance with SFAS No. 133. Accordingly, its realized gain of $2,450,000 is included in other comprehensive income (loss) for the year ended December 31, 2004. The gain is being accreted into earnings as a reduction of interest expense over the life of the 2004-1 CDO. For the year ended December 31, 2004, the High Yield Fund had reclassified approximately $271,000 of the realized gain held in accumulated other comprehensive income into earnings and another approximately $388,000 will be reclassified into earnings within the next twelve months. The Diversified Risk Fund's swap did not qualify for hedge accounting in accordance with SFAS No. 133. Accordingly, its realized gain of $1,665,000 has been included in earnings for the year ended December 31, 2004. During April 2004, the Fund REIT contributed 66 CMBS certificates with an approximate fair value of $226,000,000 to its subsidiary, 2004-1 Resecuritization, for deposit with the 2004-1 Trust. The 2004-1 Trust resecuritized the pooled certificates and issued $185,000,000 in notes of Class A through G with fixed rate coupons ranging from 4.73% to 7.61%. The Class A through G notes mature in increments from June 2011 through December 2015. ARCap REIT holds $10,000,000 of Class G notes with a fixed rate coupon of 7.61% as a security, which has been eliminated in consolidation. The notes are secured by the 66 CMBS certificates, which have a carrying value of approximately $242,555,000 at December 31, 2004. Accrued interest payable at December 31, 2004, was approximately $804,000. The High Yield Fund capitalized approximately $4,406,000 of deferred borrowing costs related to the issuance of the 2004-1 CDO. The costs are being amortized over the earliest of the expected lives of the debt, which is seven years (through June 2011). The High Yield Fund amortized approximately $495,000 of the costs for the year ended December 31, 2004. Total accumulated amortization of deferred borrowing costs at December 31, 2004, was approximately $495,000. During August 2003, the Fund REIT contributed 64 CMBS certificates with an approximate fair value of $260,000,000 to its subsidiary, 2003-1 Resecuritization, for deposit with the 2003-1 Trust. The 2003-1 Trust resecuritized the pooled certificates and issued $220,800,000 in notes of Class A through G with fixed rate coupons ranging from 4.97% to 8.74%. The Class A 18 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 5. LONG-TERM DEBT (CONTINUED) through G notes mature in increments from September 2011 through March 2013. ARCap REIT holds $25,000,000 of Class G notes with a fixed rate coupon of 8.74% as a security, which has been eliminated in consolidation. The notes are secured by the 64 CMBS certificates, which have a carrying value of approximately $315,624,000 at December 31, 2004. Accrued interest payable at December 31, 2004, was approximately $1,019,000. The High Yield Fund capitalized approximately $4,800,000 of deferred borrowing costs related to the issuance of the 2003-1 CDO. The costs are being amortized over the earliest of the expected lives of the debt, which is eight years (through September 2011). The High Yield Fund amortized approximately $729,000 of the costs for the year ended December 31, 2004. Total accumulated amortization of deferred borrowing costs at December 31, 2004, was approximately $984,000. During fiscal year 2001, the Company entered into an agreement to sell its interests in 50 CMBS pass-through certificates (the Pooled Certificates) to its subsidiary, the 2001-ABC2 Trust. The 2001-ABC2 Trust resecuritized the Pooled Certificates and offered $98,500,000 Class A-1 Senior Notes with a fixed coupon rate of 7.17% (Fixed Rate Notes) and $137,500,000 Class A-2 Senior Notes with a variable coupon rate based on one-month LIBOR plus 115 basis points (Variable Rate Notes) (together, the 2001-ABC2 Notes). The 2001-ABC2 Notes were scheduled to mature on February 21, 2008. In connection with the 2004-RR3 re-REMIC transaction (see Note 7), the 2001-ABC2 Notes were retired on October 21, 2004. In October 2003, ARCap REIT sold 10 CMBS securities to ARCap Resecuritization, which in turn contributed the 10 CMBS securities to the 2001-ABC2 Trust. ARCap Resecuritization then created a new trust, the 2003-ABC3 Trust, for the purpose of resecuritizing the 2001-ABC2 Trust's pooled certificates. The 2003-ABC3 Trust issued $80,000,000 of Class A Notes (the Class A Notes) bearing interest at 8.6%, and $15,000,000 of Class B Notes bearing interest at 6% (the Class B Notes) (together, the 2003-ABC3 Notes). The 2003-ABC3 Notes, which were scheduled to mature on February 21, 2008, were then distributed to ARCap REIT through ARCap Resecuritization. On October 9, 2003, ARCap REIT sold $30,000,000 of the Class A Notes and used the net proceeds to settle approximately $29,000,000 of repurchase agreements. ARCap REIT retained the balances of the Class A Notes and the Class B Notes. The 60 CMBS securities which originally served as the collateral for the 2001-ABC2 Notes and the 2003-ABC3 Notes were released on September 30, 2004, in exchange for approximately $337,067,000 of cash representing the Optional Redemption Price, as defined in the underlying 2001-ABC2 Trust and 2003-ABC3 Trust agreements, which was used to retire the 2001-ABC2 Notes and the outstanding 2003-ABC3 Notes on October 21, 2004. Interest on the 2001-ABC2 Notes and the 2003-ABC3 Notes was paid monthly. Interest expense on the 2001-ABC2 Notes and the 2003-ABC3 Notes was approximately $14,899,000 for the year ended December 31, 2004. The Company capitalized approximately $5,668,000 of deferred borrowing costs related to the issuance of the 2001-ABC2 Notes. The deferred borrowing costs were being amortized using the effective-interest method over the life of the debt, which was seven years (through February 21, 2008). The Company amortized approximately $591,000 of deferred costs for the year ended December 31, 2004. In connection with the 2004-RR3 re-REMIC transaction (see Note 7), approximately $3,129,000 of the remaining balance of unamortized deferred borrowing costs was recorded as a loss on early extinguishment of debt. The Company capitalized approximately $895,000 of deferred borrowing costs related to the creation of the 2003-ABC3 Trust. The deferred borrowing costs were being amortized using the effective-interest method over the life of the debt through February 21, 2008. The Company amortized approximately $113,000 of 19 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 5. LONG-TERM DEBT (CONTINUED) deferred borrowing costs for the year ended December 31, 2004. In connection with the 2004-RR3 re-REMIC transaction (see Note 7), approximately $751,000 of the remaining balance of unamortized deferred borrowing costs was recorded as a loss on early extinguishment of debt. In conjunction with the issuance of the Variable Rate Notes, the Company entered into an interest rate cap agreement and an interest rate floor agreement with Bear Stearns PLC (the CBO Swap) to effectively fix the interest rate on its variable rate debt at 7.435%. The notional amount for the CBO Swap was $137,500,000. The agreements called for interest to be paid monthly. The Company carried the CBO Swap at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. Upon the deposit of the Optional Redemption Price with the trustee in connection with the 2004-RR3 re-REMIC transaction, the CBO Swap was terminated on September 30, 2004. The Company reversed the previously recognized unrealized loss of $4,125,000 and paid the counterparty a swap termination fee in the amount of $16,091,154, which has been included in loss on early extinguishment of debt in the accompanying consolidated statement of operations. 6. REPURCHASE AGREEMENTS ARCap REIT, the Diversified Risk Fund II, the Fund II REIT, the Diversified Risk Fund, and the Fund REIT have each entered into a credit facility with Liquid Funding, Ltd. (LFL), an affiliate of Bear Stearns & Co. Inc., to finance a portion of their CMBS purchases through both short-term variable rate and long-term fixed rate repurchase agreements. ARCap REIT, the Diversified Risk Fund II, and the Fund II REIT have also entered into short-term repurchase agreements with Morgan Stanley Mortgage Capital Inc. (MSMC) to finance a portion of their CMBS purchases. At December 31, 2004, the Diversified Risk Fund II has short-term variable rate repurchase agreements outstanding with LFL of $4,900,000, with an interest rate of 3.117% and a maturity of 31 days. The balance was collateralized by CMBS investments with a fair value of approximately $8,614,000 at December 31, 2004. Accrued interest payable for the Diversified Risk Fund II under the facility at December 31, 2004, was approximately $2,000. At December 31, 2004, the Diversified Risk Fund II has no obligations outstanding under its facility with MSMC. At December 31, 2004, the Fund II REIT has no obligations outstanding under its facility with LFL and MSMC. At December 31, 2004, the Diversified Risk Fund has short-term variable rate repurchase agreements outstanding with LFL of $4,731,000, with an interest rate of 3.206% and a maturity of 29 days. The balance was collateralized by CMBS investments with a fair value of approximately $10,070,000 at December 31, 2004. The Diversified Risk Fund has a long-term repurchase agreement outstanding with LFL at December 31, 2004, of $25,367,000, which carries a 4.135% fixed interest rate from the initial purchase date of June 2003 until final repurchase in June 2008. The balance was collateralized by CMBS investments with a fair value of approximately $41,799,000 at December 31, 2004. The Diversified Risk Fund's combined accrued interest payable under the LFL facility at December 31, 2004, was approximately $53,000. The Diversified Risk Fund capitalized approximately $228,000 of deferred borrowing costs related to the issuance of the long-term repurchase agreement with LFL. The Diversified Risk Fund amortized approximately $49,000 of deferred costs for the year ended December 31, 2004. Total accumulated amortization of deferred borrowing costs at December 31, 2004, was approximately $74,000. 20 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 6. REPURCHASE AGREEMENTS (CONTINUED) In April 2004, concurrent with the 2004-1 CDO closing, the Fund REIT paid down all remaining balances under its facility. As of December 31, 2004, the Fund REIT has no obligation under this facility. As of December 31, 2004, ARCap REIT has no obligation under its facility with LFL. ARCap REIT entered into short-term repurchase agreements with Bear Stearns & Co. Inc. and its affiliates to finance a portion of its CMBS purchases. The interest rate on approximately $3,802,000 of such borrowings as of December 31, 2004, was 3.039%, and the maturity of the agreement was 31 days. The short-term repurchase agreements are collateralized by a portion of the Company's portfolio of CMBS investments and resecuritization certificates with a fair value of approximately $26,890,000 at December 31, 2004. ARCap REIT's accrued interest payable under the Bear Stearns & Co. Inc. facility at December 31, 2004, was approximately $4,000. ARCap REIT has short-term repurchase agreements outstanding with MSMC at December 31, 2004, of approximately $16,411,000 with an interest rate of 2.272%, and a maturity of 29 days. The short-term repurchase agreements are collateralized by a portion of the Company's portfolio of CMBS investments and resecuritization certificates with a fair value of approximately $28,575,000 at December 31, 2004. ARCap REIT's accrued interest payable under the MSMC facility at December 31, 2004, was approximately $28,000. 7. 2004-RR3 RE-REMIC TRANSACTION On September 30, 2004, ARCap REIT contributed 57 CMBS securities with an approximate fair value of $431,536,000 to its subsidiary, 2004-RR3, which, in turn, sold the bonds to a separate trust, the ARCap 2004-RR3 Resecuritization Trust (the 2004-RR3 Trust). The 2004-RR3 Trust resecuritized the pooled certificates and issued $471,797,000 of Class A1 through J certificates to third-party investors for gross proceeds of $470,729,119. 2004-RR3 retained the remaining $73,634,371 of Class K through O certificates along with the Class X interest-only certificate, which has a notional amount of $545,431,371 (the Class K through O certificates and the Class X certificates together comprise the Retained Resecuritization Certificates). The Retained Resecuritization Certificates had a fair market value as of December 31, 2004, of $49,440,468. A portion of the cash proceeds was used to fund the Optional Redemption Price, as defined in the respective 2001-ABC2 Trust agreement and in the 2003-ABC3 Trust agreement (see Note 5). The Optional Redemption Price of $337,067,095 was used to retire the 2001-ABC2 Notes and the outstanding 2003-ABC3 Notes on October 21, 2004. The Optional Redemption Price included $15,451,870 of prepayment premiums, which have been reflected as a component of the loss on early extinguishment of debt in the accompanying consolidated statement of operations. The transaction was accounted for as a sale in accordance with Statement of Financial Accounting Standards No. 140, ACCOUNTING FOR THE TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, and, accordingly, the Company recognized a partial gain based on the total cash received and the relative fair value of beneficial interests retained, which included (i) cash proceeds of $470,729,119; (ii) the Retained Resecuritization Certificates; and (iii) a servicing asset which has a carrying value of $1,114,944, net of $20,401 of amortization as of December 31, 2004, and which is included in other assets in the accompanying consolidated balance sheet. 21 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 7. 2004-RR3 RE-REMIC TRANSACTION (CONTINUED) In order to hedge the gross proceeds to be received from the 2004-RR3 re-REMIC transaction, the Company entered into a 4.555% forward-starting swap with a notional amount of approximately $491,170,000 and a scheduled maturity date of May 1, 2016. The forward-starting swap was terminated on September 21, 2004, and the resulting loss of $13,000,000 has been included in earnings as a cost of sales for the year ended December 31, 2004. In order to hedge the amount of the prepayment premiums to be incurred in connection with the retirement of the 2001-ABC2 Notes and the outstanding 2003-ABC3 Notes, the Company also entered into a 5.5% treasury lock with a notional amount of $265,900,000 and a scheduled maturity date of February 15, 2008. The Company terminated this treasury lock on September 23, 2004, and realized a gain of approximately $3,012,000, which is included in earnings as a component of the loss on early extinguishment of debt for the year ended December 31, 2004. A summary of the gain on the sale of the 57 CMBS securities in connection with the 2004-RR3 re-REMIC transaction is as follows:
Proceeds from sale of securities $ 470,729,119 Cost of sales (26,229,488) Relative book value of CMBS securities sold for cash (388,419,625) ------------- Gain on 2004-RR3 re-REMIC transaction $ 56,080,006 =============
In connection with the 2004-RR3 re-REMIC transaction, approximately $20,175,000 of unrealized gains on available-for-sale investment securities in other comprehensive income were reversed into earnings as a realized gain on CMBS and approximately $16,581,000 of unrealized gains on trading investment securities were reversed into realized gain on CMBS. 8. GAIN ON INVESTMENT SECURITIES, NET
The composition of the Company's gain on investment securities, net for the year ended December 31, 2004, is as follows: Unrealized gain - borrowed investment securities $ 2,580,474 Unrealized gain - interest rate swap 7,084,257 Unrealized loss - portion of the CDO swap not qualifying for hedge accounting (827,595) Unrealized gain (loss) - CMBS (704,027) Realized gain - CMBS 36,755,801 Realized gain - 2004-RR3 re-REMIC transaction 56,080,006 Realized loss - other than temporary losses on available-for-sale CMBS (22,227,767) Realized loss - borrowed investment securities, net (1,990,778) Realized loss - interest rate swap (2,805,990) ------------ Gain on investment securities, net $ 73,944,381 ============
22 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 9. OPERATING LEASES The Company leases its office space and certain equipment under operating leases that expire between October 2005 and May 2008. The office leases, as amended, provide for an annual basic rental of approximately $332,000 during the initial lease term and contain an option to extend the term of one of the leases for one extension term of five years, with the basic rental being reset at the then market rate. Future minimum lease payments under these leases are as follows:
2005 $563,000 2006 303,000 2007 65,000 2008 24,000 -------- Total $955,000 ========
Lease expense for the year ended December 31, 2004, was approximately $617,000. 10. OTHER COMPREHENSIVE INCOME (LOSS) The composition of the Company's other comprehensive income (loss), net of minority interest, as of and for the year ended December 31, 2004, is as follows:
CUMULATIVE YEAR ENDED BALANCE AS OF DECEMBER 31, DECEMBER 31, 2004 2004 ----------------------------- Unrealized gain on available-for-sale securities $ 18,880,916 $ 21,121,301 Unrealized loss on swap liability (78,108) (78,108) Realized gain (loss) on hedging instrument - swap, net 495,478 495,478 ----------------------------- Other comprehensive income (loss) $ 19,298,286 $ 21,538,671 =============================
11. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES At times, the Company purchases investment securities at fair value from members of the Company or their affiliates. These purchases represent transactions that are in the normal course of business of the Company and the members. During the year ended December 31, 2004, the Company purchased from such members CMBS with an approximate face value of $84,070,000, at an approximate purchase price of $37,577,000. In January 2005, ARCap REIT sold one bond to the Fund II REIT with a face value of $17,225,000 at an approximate sales price of $13,407,000. In August 2004, ARCap REIT sold one bond to the Diversified Risk Fund II with a face value of $5,743,000 at an approximate sales price of $5,320,000. The gain on the sale has been eliminated in consolidation. In March 2004, ARCap REIT sold eight bonds to the Fund REIT with an approximate face value of $77,977,000 at an approximate sales price of $58,073,000. Although the gain on the sale has been eliminated in consolidation, the transaction resulted in the reclassification of the investment securities from trading to available for sale. 23 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 11. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES (continued) The Company has loaned approximately $231,000 to a key executive for funding of tax liabilities associated with units granted under an incentive compensation arrangement. As of December 31, 2004, there is approximately $51,000 outstanding. The loan bears interest at a rate of 7% per annum, and payment is due quarterly on the distribution date for the Common Units. Payment is due only to the extent that the quarterly distribution is sufficient to pay them. The loan becomes due upon termination of the executive's employment with the Company, and recourse is limited to the Common Units securing the loans. The Company has loaned approximately $901,000 to key executives for funding of their member contributions to AFI. These loans bear an interest rate of 4% per annum. Payments of accrued interest are due quarterly on the earlier of the date of operating cash flow distributions made by AFI or the 30th day after the close of each calendar quarter. Payments of principal are due and payable in (i) an amount equal to 35% of all operating cash flow distributions made by AFI to the borrower on account of a quarter less accrued interest for such quarter to the extent such amount is greater than zero, and (ii) an amount equal to 100% of all permanent financing proceeds distributions received. The loans become due upon the earlier of the dissolution of AFI or June 30, 2016, and the loans are full-recourse to the borrowers. 12. EMPLOYEE BENEFITS The Company holds a contributory defined contribution 401(k) plan that covers substantially all full-time employees. The Company matches participant contributions up to 3% of each participant's total compensation. Matching contributions totaled approximately $198,000 for the year ended December 31, 2004. The Company has a deferred compensation plan for key employees and eligible directors. The Board of Managers originally approved the availability of approximately 690,000 phantom appreciation units and 296,000 phantom grant units for awards to employees, all of which have been granted. Effective January 1, 2004, the Board of Managers approved the availability of an additional 280,000 phantom appreciation units and 120,000 phantom grant units under a second deferred compensation plan, of which 800 phantom grant units have been awarded as of December 31, 2004. On January 1, 2005, approximately 69,000 phantom appreciation units and approximately 25,000 phantom grant units were awarded. All of the phantom grant units which have been awarded are vested. Once vested, employees are entitled to receive additional compensation in an amount equal to the per Unit amount distributed on account of the Common Units times the number of grant units vested in the employee. The employee is entitled to compensation regardless of whether the distribution to the holders of Common Units is an ordinary distribution or an extraordinary distribution. Thus, if the Company is sold or liquidated, the employee would be entitled to share in the proceeds of the sale or liquidation on the same basis as the holders of Common Units with respect to vested grant units. All of the phantom appreciation units which have been awarded are also vested. Once vested, employees begin to "earn" the right to receive compensation on account of each vested appreciation unit by being credited with an amount equal to the per Unit distributions made to holders of Common Units until the amount credited equals the Initial Value (i.e., the price at which a vested employee could obtain the appreciation unit) established by the Compensation Committee. Vested employees are entitled to compensation on account of each vested appreciation unit in an amount equal to the per Unit distributions made to 24 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements (continued) 12. EMPLOYEE BENEFITS (CONTINUED) holders of Common Units only after they have "earned" credits equal to the Initial Value. In the event of a liquidation or sale, employees with vested appreciation units are entitled to compensation in an amount equal to the per Unit proceeds in excess of the Initial Value plus the credits which have been earned. The Company has adopted a Fund I incentive compensation plan (the Fund I promote plan) for participating employees, under which participants are entitled to share in a portion of the High Yield Fund and the Diversified Risk Fund promotes received by ARCap REIT. The Board of Managers approved the availability of 40,000 units for awards to employees of which 10,000 units have been awarded as of December 31, 2004. The units are vested upon issuance. The Company has also adopted a Fund II incentive compensation plan (the Fund II promote plan) for participating employees, under which participants are entitled to share in a portion of the High Yield Fund II and the Diversified Risk Fund II promotes received by ARCap REIT. The Board of Managers approved the availability of 100,000 units for awards to employees, of which 10,000 units have been awarded as of December 31, 2004. The units are vested upon issuance. The Company accrues the estimated value of deferred compensation under these plans over the service period, which ends when the units are fully vested. Subsequent to the final vesting date, changes in the estimated amount of deferred compensation will be recorded as an increase or decrease to earnings in the period in which such change occurs. For the year ended December 31, 2004, the Company expensed approximately $13,774,000 of deferred compensation and paid approximately $651,000 related to the vested grant units. 25 EX-99 3 exh_2003arcap-amac.txt Exhibit 99 (b) CONSOLIDATED FINANCIAL STATEMENTS ARCap Investors, L.L.C. and Subsidiaries YEAR ENDED DECEMBER 31, 2003 ARCap Investors, L.L.C. and Subsidiaries Consolidated Financial Statements Year ended December 31, 2003 CONTENTS Report of Independent Auditors.................................................1 Audited Consolidated Financial Statements Consolidated Balance Sheet.................. ..................................2 Consolidated Statement of Operations...........................................3 Consolidated Statement of Members' Equity.... .................................4 Consolidated Statement of Cash Flows.......... ................................5 Notes to Consolidated Financial Statements.....................................6 Report of Independent Auditors The Board of Managers ARCap Investors, L.L.C. We have audited the accompanying consolidated balance sheet of ARCap Investors, L.L.C. and subsidiaries (the Company) as of December 31, 2003, and the related consolidated statements of operations, members' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. 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 audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ARCap Investors, L.L.C. and subsidiaries at December 31, 2003, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP February 6, 2004 ARCap Investors, L.L.C. and Subsidiaries Consolidated Balance Sheet December 31, 2003
ASSETS Investment securities - available-for-sale, net (NOTE 3) $ 739,048,867 Investment securities - trading, net (NOTE 3) 282,157,427 Accrued interest receivable 11,433,408 Deferred borrowing costs, net (NOTE 5) 9,331,954 Restricted cash - CBO swap (NOTE 5) 4,376,111 Cash and cash equivalents 2,657,131 Other assets 1,207,425 -------------- Total assets $1,050,212,323 ============== LIABILITIES AND MEMBERS' EQUITY Liabilities: Long-term debt (NOTE 5) $ 461,800,000 Repurchase agreements (NOTE 6) 163,011,000 CBO swap liability (NOTE 5) 4,125,000 Accrued interest payable 2,839,836 Deferred compensation (NOTE 10) 3,140,244 Borrowed investment securities and interest rate swap, net (NOTE 4) 2,155,215 Accrued expenses 985,520 -------------- Total liabilities 638,056,815 Commitments and contingencies Minority interest in consolidated entities 202,589,352 Members' equity: Series A preferred members 67,367,415 Common members 142,198,741 -------------- Total members' equity 209,566,156 -------------- Total liabilities and members' equity $1,050,212,323 ==============
SEE ACCOMPANYING NOTES. 2 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Operations Year ended December 31, 2003
Revenues: Interest income - CMBS $ 100,309,513 Other income 4,602,285 ------------- Total revenues 104,911,798 Expenses: Interest - long-term debt and repurchase agreements 28,314,158 Interest - borrowed investment securities and interest rate swap, net 8,372,835 Salaries and employee benefits 8,831,993 General and administrative 4,398,268 Financing fee 1,180,000 ------------- Total expenses 51,097,254 ------------- Net margin on CMBS and other income 53,814,544 Other revenue (expense): Accretion of purchase discount 9,753,013 Loss on investment securities, net (NOTE 7) (37,655,565) ------------- Deferred compensation expense (NOTE 10) (3,140,244) ------------- (31,042,796) Income before minority interest 22,771,748 Minority interest (6,630,611) ------------- Net income 16,141,137 Other comprehensive income: Unrealized gain on available-for-sale securities, net of minority interest of $4,620,290 2,240,385 ------------- Comprehensive income $ 18,381,522 =============
SEE ACCOMPANYING NOTES. 3 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Members' Equity
SERIES A COMMON PREFERRED MEMBERS MEMBERS TOTAL ------------- ------------- ------------- BALANCE AT JANUARY 1, 2003 $ 77,779,421 $ 147,340,254 $ 225,119,675 Distributions (10,867,864) (18,135,326) (29,003,190) Net income -- 16,141,137 16,141,137 Surrender of common units (31,851) -- (31,851) Costs to raise capital (8,487) 8,487 -- Redemption of preferred units 100,000 (5,000,000) (4,900,000) Other comprehensive income: Unrealized gain on available for - sale securities 396,196 1,844,189 2,240,385 ------------- ------------- ------------- BALANCE AT DECEMBER 31, 2003 $ 67,367,415 $ 142,198,741 $ 209,566,156
SEE ACCOMPANYING NOTES. 4 ARCap Investors, L.L.C. and Subsidiaries Consolidated Statement of Cash Flows Year ended December 31, 2003
OPERATING ACTIVITIES Net income $ 16,141,137 Adjustments to reconcile net income to net cash used in operating activities: Loss on investment securities, net 37,655,565 Accretion of purchase discount (9,753,013) Amortization of deferred borrowing costs 1,045,824 Minority interest 6,630,611 Deferred compensation 3,140,244 Changes in operating assets and liabilities: Investment securities - trading, net (151,017,303) Accrued interest receivable (2,190,366) Restricted cash - CBO swap (50,263) Other assets (517,015) Accrued interest payable (2,013,921) Borrowed investment securities and interest rate swap, net (6,218,328) Accrued expenses 641,739 ------------- Net cash used in operating activities (106,505,089) INVESTING ACTIVITIES Purchases of investment securities - available-for-sale (88,488,096) FINANCING ACTIVITIES Distributions to members (28,867,864) Contributions from minority interest members, net of capital returned 16,821,400 Operating distributions to minority interest members (17,820,580) Redemption of preferred units (4,900,000) Proceeds from repurchase agreements 7,588,000 Proceeds from the issuance of long-term debt 225,800,000 Payment for deferred borrowing costs (5,924,028) ------------- Net cash provided by financing activities 192,696,928 ------------- Net change in cash and cash equivalents (2,296,257) Cash and cash equivalents, beginning of year 4,953,388 ------------- Cash and cash equivalents, end of year $ 2,657,131 ============= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash payments for interest on long-term debt and repurchase agreements $ 26,062,747 ============= SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES Surrender of common units in exchange for other assets $ 31,851 ============= Accrued distribution on preferred units redemption $ 135,326 =============
SEE ACCOMPANYING NOTES. 5 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES Organization - ------------ ARCap Investors, L.L.C. (the Company) was incorporated in January 1999 and commenced its operations on March 17, 1999. The Company was organized to invest primarily in subordinated commercial mortgage-backed securities (CMBS). Principles of Consolidation - --------------------------- The consolidated financial statements include the accounts of: - The Company. - ARCap REIT, Inc. (ARCap REIT), a majority-owned subsidiary of the Company. - ARCap Resecuritization Corporation (ARCap Resecuritization), a wholly owned subsidiary of ARCap REIT. ARCap Resecuritization owns all the residual interest in Commercial Resecuritization Trust 2001 ABC-2 (the Trust) and Commercial Resecuritization Trust 2003-ABC3 (2003-ABC3 Trust). - ARCap High Yield CMBS Fund, L.L.C. (the High Yield Fund), of which ARCap REIT owned an approximate 23% controlling interest as of December 31, 2003. The High Yield Fund owns approximately 60% of ARCap CMBS Fund REIT, Inc. (the Fund REIT). ARCap 2003-1 Resecuritization, Inc. (2003-1 Resecuritization), a wholly owned subsidiary of the Fund REIT, owns all of the equity interest in ARCap 2003-1 Resecuritization Trust (the 2003-1 Trust). - ARCap Diversified Risk CMBS Fund, L.L.C. (the Diversified Risk Fund), of which ARCap REIT owned an approximate 1% controlling interest as of December 31, 2003. The Diversified Risk Fund owns approximately 40% of the Fund REIT. - ARCap Servicing, Inc., a taxable REIT subsidiary wholly owned by ARCap REIT. Minority interests primarily represent outside members' approximate 77% ownership in the High Yield Fund and outside members' approximate 99% ownership in the Diversified Risk Fund. The Company has consolidated the High Yield Fund and Diversified Risk Fund as it exercises control (through ARCap REIT, which acts as the Managing Member of both Funds in accordance with the terms of the respective LLC agreements) over the operations of these Funds. The Company records minority interest expense (income) that reflects the portion of the earnings (losses) of the operations which is applicable to the minority interest members. As the Managing Member of both the High Yield Fund and the Diversified Risk Fund, ARCap REIT is entitled to a 20% promote in the event the Funds achieve a specified investment return. Accordingly, minority interest expense may not equal the earnings of each of the Funds times the respective outside members' ownership percentages. Separate books of accounts are maintained for ARCap REIT, ARCap Resecuritization, the Trust, the High Yield Fund, the Fund REIT, 2003-1 Resecuritization, the 2003-1 Trust, the Diversified Risk Fund, and ARCap Servicing, Inc. and are reflected in the accompanying consolidated financial statements of the Company. All material intercompany transactions and account balances have been eliminated in consolidation. Investment Securities - --------------------- The Company's investment security transactions are recorded on the trade date for existing securities and the settlement date for to-be-issued securities. In October 2003, the Trust reclassified CMBS with a fair value of approximately $386,000,000 from trading to available-for-sale in connection with the creation of 2003-ABC3 Trust (see Note 5). The reclassification effectively established a new basis for financial reporting for the CMBS at the date of transfer. In August 2003, the Fund REIT reclassified CMBS with a fair value of approximately $260,000,000 from trading to available-for-sale in connection with the resecuritization of 64 CMBS securities and the issuance of a collateralized debt obligation (CDO) (see Note 5). The reclassification effectively established a new basis for financial reporting for the CMBS at the date of transfer. CMBS classified as available-for-sale are securities that the Company considers for possible sales or other dispositions prior to the maturity of the securities. Available-for-sale securities are carried at their estimated fair value with unrealized gains and losses reported in other comprehensive income (loss) as a separate component of members' equity. The Company evaluates unrealized losses on its available-for-sale CMBS securities to determine if such declines in fair value are "other than temporary." In the event a decline in the fair value of an available-for-sale CMBS security is deemed "other than temporary," the decline in fair value would be recorded as an impairment to the security and charged through earnings rather than as a component of other comprehensive income. Approximately $6,598,000 of "other than temporary" impairments has been recognized for the year ended December 31, 2003. The Company's CMBS that are designated as trading assets represent securities the Company is holding for possible sales or other dispositions in the near term. Such securities are carried at their estimated fair value, with unrealized gains or losses included in earnings. The fair value of the Company's portfolio of CMBS is generally estimated by management based on market prices provided by certain dealers who make a market in these financial instruments. The market for the Company's CMBS may lack 6 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 liquidity and have limited market volume. Accordingly, the fair values reported reflect estimates and may not necessarily be indicative of the amounts that the Company could realize in a current market exchange. The yield to maturity on the Company's CMBS depends on, among other things, the rate and timing of principal payments, the pass-through rate, and interest rate fluctuations. The subordinated CMBS interests owned by the Company provide credit support to the more senior interests of the related commercial securitization. Cash flow from the mortgages underlying the CMBS interests generally is allocated first to the senior interests, with the most senior interest having a priority entitlement to cash flow. Remaining cash flow is allocated generally among the other CMBS interests in order of their relative seniority. To the extent that there are defaults and unrecoverable losses on the underlying mortgages that result in reduced cash flows, the most subordinated CMBS interest will bear this loss first. To the extent that there are losses in excess of the most subordinated interest's stated entitlement to principal and interest, then the remaining CMBS interests will bear such losses in order of their relative subordination. Revenue Recognition - ------------------- Interest income and servicing fees are recognized as earned. Accretion of discounts is computed using the effective-interest method over the expected life of the securities based on management's estimates regarding the timing and amount of cash flows from the underlying collateral. Derivative Financial Instruments - -------------------------------- Derivative financial instruments are utilized by the Company to reduce interest rate risk. The Company utilizes interest rate swaps and cap and floor agreements as a means of hedging the potential financial statement impact of changes in the fair value of its portfolio of CMBS and variable rate long-term debt due to changes in interest rates. Risks in these contracts arise from the movements in interest rates and from the possible inability of counterparties to meet the terms of their contracts. The Company carries its derivative financial instruments at fair value with any unrealized gain or loss included in earnings, in accordance with the provisions of SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. Resale and Repurchase Agreements - -------------------------------- Transactions involving purchases of securities under agreements to resell (reverse repurchase agreements or reverse repos) or sales of securities under agreements to repurchase (repurchase agreements or repos) are accounted for as collateralized financings, except where the Company does not have an agreement to sell (or purchase) the same or substantially the same securities before maturity at a fixed or determinable price. Cash and Cash Equivalents - ------------------------- Cash and cash equivalents include all highly liquid investments with original maturity when purchased of three months or less. Restricted Cash - --------------- Restricted cash represents amounts required to be pledged under interest rate cap and floor agreements (see Note 5). Deferred Borrowing Costs - ------------------------ Deferred borrowing costs represent costs incurred in connection with the issuance of long-term debt. Such amounts are amortized using the effective-interest method over the term of the related debt (see Note 5). During 2003, the Company paid approximately $228,000 in connection with the issuance of a long-term repurchase agreement, approximately $4,825,000 in connection with the High Yield Fund's CDO offering, and approximately $871,000 in connection with the creation of 2003-ABC3 Trust. Financing Fee - ------------- The Company pays an annual rate of 0.50% on $236,000,000 of its existing long-term debt to a financier to provide credit enhancement of such debt. Income Taxes - ------------ The Company has elected to be taxed as a partnership, whereby all income is taxed at the member level, with the exception of ARCap Servicing, Inc., which is taxed at the entity level. ARCap REIT has elected to be taxed as a real estate investment trust for federal income tax purposes. No provision for income taxes has been made for ARCap Servicing, Inc. for the year ended December 31, 2003, as ARCap Servicing, Inc. did not generate any taxable income. 7 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 Use of Estimates - ---------------- The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of certain assets, liabilities, revenues, and expenses. Actual results could differ from those estimates. Fair Value of Financial Instruments - ----------------------------------- The estimated fair value amounts herein have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts. The Company's portfolio of CMBS and securities borrowed is carried at their estimated fair values. The Company's management believes that the fair values of its cash and cash equivalents, restricted cash, long-term debt, and repurchase agreements approximate their carrying values due to the nature of the instruments or the fact that their terms approximate current market terms. The Fixed Rate Notes (see Note 5) with a carrying value of $98,500,000 have an estimated fair value of approximately $107,313,000 at December 31, 2003. Fair value was estimated using a discounted cash flow analysis, based on an interest rate of 5% which management believes is currently available for the issuance of similarly rated debt. 2. MEMBERS' EQUITY The Limited Liability Company Agreement (LLC Agreement) establishes two classes of membership: Series A Preferred members and Common members. Cash Flows are distributed in the following order of priority: - - To the Series A Preferred members in an amount equal to the accrued and unpaid Preferred Distributions (12% per annum of the $25.00 price per Unit). - To the Common members in an amount equal to the amount determined by the Board of Managers, provided that if the amount distributable to the Common members shall exceed a cumulative annual return on the Common Units of 12% per annum, the Board of Managers shall notify the Series A Preferred members 30 days in advance of the record date for distribution of Cash Flow. - To the extent that any remaining Cash Flow received during such tax period is not includable in the income of the Company, to members that have been allocated Net Profits in excess of amounts actually distributed to such members, in proportion to such amounts. Net Profits of the Company are allocated as follows: - To the Series A Preferred members to the extent of amounts distributed or distributable to them in such taxable year. - To the Series A Preferred members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the Common members to the extent of amounts distributed or distributable to them in such taxable year. - To the Common members to the extent of amounts distributed or distributable to them in such taxable year. - To the Common members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the members in proportion to their Percentage Interests. Net Losses of the Company are allocated as follows: - To the members in an amount equal to undistributed Net Profits allocated to such members. - To the Common members pro rata to the extent of their Capital Accounts. - To the Series A Preferred members pro rata to the extent of their Capital Accounts. 8 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 Series A Preferred Units - ------------------------ Series A Preferred Units are convertible into Common Units at the Conversion Price in effect on the Conversion Date. If the Series A Preferred Units have not been converted within five years of the effective date of the First Amendment to the LLC Agreement (August 4, 2000), Series A Preferred Units may, at the holder's option, be converted to a note equal to $25.00 per Unit, plus accrued and unpaid Preferred Distributions. Eighteen months after the First Closing Date (February 4, 2002), but no later than the fifth anniversary of the First Closing Date (August 4, 2005), the Company may redeem the Series A Preferred Units for $25.00 per unit, plus accrued and unpaid Preferred Distributions, plus a premium that will provide the Series A Preferred members with a total pretax internal rate of return of 17.50%. In addition, upon either a change in control or sale or transfer of all or substantially all of the assets of the Company, Series A Preferred Units may, at the holder's option, be redeemed at $25.00 per unit, plus accrued and unpaid Preferred Distributions. In December 2003, a Series A Preferred unit holder accepted a redemption of its 200,000 units for consideration of $4,900,000, plus accrued distributions through the date of redemption. Accrued distributions in connection with the redemption in the amount of $135,326 are included in accrued expenses in the accompanying consolidated balance sheet. At December 31, 2003, there were a total of 5,800,000 Series A Preferred Units and 4,997,917 Common Units issued and outstanding. The LLC Agreement contains certain restrictive covenants regarding the amount of variable rate debt, total debt, and certain financial ratios. Failure to meet the covenants in successive quarters can result in the Chief Executive Officer and Chief Operating Officer being removed from the Board of Managers until such time as the covenants are cured for successive quarters. Management believes that the Company has not violated the covenants in successive quarters. 3. INVESTMENT SECURITIES The Company's available-for-sale securities are carried at estimated fair value and are comprised of the following at December 31, 2003:
FACE ACCRETED COST FAIR VALUE PERCENTAGE ------------------------------------------------------------------- Subordinated CMBS: Security rating: BB+ $ 115,969,711 $100,476,507 $100,989,593 13.66% BB 187,510,690 151,286,305 152,973,681 20.70% BB- 141,923,565 103,046,413 102,883,384 13.92% B+ 207,933,210 129,402,233 129,725,184 17.55% B 239,353,347 130,807,073 126,630,338 17.13% B- 160,278,326 72,779,789 74,040,639 10.02% NR 211,411,772 50,987,832 51,806,048 7.02% ------------------------------------------------------------------- $ 1,264,380,621 $738,786,152 $739,048,867 100.00% =================================================================== The Company's trading securities are carried at estimated fair value and are comprised of the following at December 31, 2003: FACE ACCRETED COST FAIR VALUE PERCENTAGE ------------------------------------------------------------------- Subordinated CMBS: Security rating: BB+ $ 83,615,000 $ 67,653,304 $ 69,376,540 24.59% BB 63,340,512 48,069,924 47,647,477 16.89% BB- 41,236,511 27,084,333 29,403,288 10.42% B+ 65,740,512 38,821,364 42,978,057 15.23% B 45,104,511 23,655,960 25,634,761 9.09% B- 17,561,512 7,276,006 4,982,478 1.77% NR 282,727,504 72,543,757 62,134,826 22.01% ------------------------------------------------------------------- $599,326,062 $285,104,648 $282,157,427 100.00% ===================================================================
At December 31, 2003, the accumulated accretion of purchase discounts on available-for sale and trading securities, was approximately $2,932,000 and $6,245,000, respectively. 9 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 The gross cumulative unrealized gains and losses on the Company's available-for-sale investment securities were approximately $12,064,000 and $(5,203,000), respectively, at December 31, 2003 for a total accumulated other comprehensive income on available for-sale securities of approximately $6,861,000. The gross cumulative unrealized gains and losses on the Company's trading investment securities at December 31, 2003, were approximately $10,941,000 and $(20,133,000), respectively. 4. BORROWED INVESTMENT SECURITIES AND INTEREST RATE SWAP, NET The Company's borrowed investment securities and interest rate swap are carried at estimated fair value and are comprised of the following at December 31, 2003:
COUPON FAIR UNREALIZED SECURITY DESCRIPTION RATE FACE BASIS VALUE GAIN (LOSS) - -------------------------------------------------------------------------------------------------------------- U.S. Treasury (08-15-09) 6.000% $ (4,791,000) $ (4,675,342) $ (5,429,550) $ (754,208) U.S. Treasury (02-15-11) 5.000% (14,850,000) (14,587,658) (15,956,789) (1,369,131) U.S. Treasury (08-15-11) 5.000% (12,501,000) (12,546,518) (13,385,835) (839,317) U.S. Treasury (02-15-12) 4.875% (10,845,000) (11,647,608) (11,494,006) 153,602 U.S. Treasury (11-15-12) 4.000% (3,603,000) (3,579,918) (3,570,912) 9,006 ----------------------------------------------------------------------- $ (46,590,000) $ (47,037,044) (49,837,092) $ (2,800,048) Reverse repurchase agreements 50,945,341 ------------- Borrowed investment securities, net 1,108,249 Interest rate swap (3,263,464) ------------- Borrowed investment securities and interest rate swap, net $ (2,155,215) =============
The borrowed U.S. Treasury securities were sold in the open market (i.e., a "short" security sale). The Company is obligated to return the securities in the future and is, therefore, exposed to price risk until it repurchases the securities for delivery to the lender. Short security sales are used by the Company to modify its interest rate risk. The Company must pay the security lender the interest earned by the underlying security. Short security sales are recorded at the estimated fair value of the borrowed securities, and any unrealized gains (losses) are included in earnings. Proceeds from short security sales are used to purchase reverse repurchase agreements of the same security. The transactions are governed by one master repurchase agreement with rights of offset and, therefore, the values of the short security sales and reverse repurchase agreements have been offset and shown as one line item in the accompanying consolidated financial statements. It has been the Company's practice to settle these transactions on a net basis. In October 2003, ARCap REIT repurchased approximately $20,300,000 of its U.S. Treasury securities held against its CMBS for delivery to the lender and sold all offsetting reverse repurchase agreements, consistent with ARCap REIT's practice of settling its borrowed investment transactions on a net basis. Settlement of the transactions resulted in an approximate $1,207,000 realized loss to ARCap REIT. In July 2003, the High Yield Fund repurchased approximately $260,000,000 of its U.S. Treasury securities and, in November 2003, it repurchased the remaining $19,000,000 of the U.S. Treasury securities held against its CMBS for delivery to the lender. The High Yield Fund sold all offsetting reverse repurchase agreements, consistent with the High Yield Fund's practice of settling its borrowed investment transactions on a net basis. Settlement of the transactions resulted in an approximate $17,000,000 realized loss to the High Yield Fund, of which approximately $6,000,000 was attributable to current year earnings. In June 2003, the Diversified Risk Fund repurchased approximately $18,000,000 of its U.S. Treasury securities. The Diversified Risk Fund realized a loss of approximately $600,000 in connection with the transaction. The Company entered into an interest rate swap agreement with Bear Stearns Capital Markets (Bear Stearns) with a notional amount at December 31, 2003, of $27,000,000, on which the Company pays a fixed rate of 6.015% and receives a variable rate based on six month LIBOR for a term of 10 years ending April 27, 2011. The swap agreement calls for interest to be paid semiannually in arrears. The Company carries the swap agreement at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. The Company was required under the swap agreement to pledge collateral valued at 1% of the notional amount of the swap to ensure its performance in the event that the swap declines in value. At December 31, 2003, the Company pledged CMBS valued at approximately $9,112,000 as additional collateral against the interest rate swap. 10 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 5. LONG-TERM DEBT During August 2003, the Fund REIT contributed 64 CMBS certificates with an approximate fair value of $260,000,000 to its subsidiary, 2003-1 Resecuritization, for pass-through to the 2003-1 Trust. The 2003-1 Trust resecuritized the pooled certificates and offered $220,800,000 in senior notes of Classes A through G with fixed rate coupons ranging from 4.97% to 8.74%. The Classes A through G notes mature in increments from September 2011 through March 2013. The notes are secured by 64 CMBS certificates which have a carrying value of approximately $269,000,000 at December 31, 2003. Accrued interest payable at December 31, 2003, was approximately $1,019,000. At December 31, 2003, $220,800,000 of the Class A through G senior notes is issued and outstanding, of which ARCap REIT holds $25,000,000 of Class G senior notes with a fixed rate coupon of 8.74% as a security, which has been eliminated in consolidation. The High Yield Fund capitalized approximately $4,825,000 of deferred borrowing costs related to the issuance of the collateralized debt obligation notes. The costs are being amortized using the effective-interest method over the earliest of the expected lives of the debt, which is eight years (through September 2011). The High Yield Fund amortized approximately $256,000 of deferred borrowing costs for the year ended December 31, 2003. During fiscal year 2001, the Company entered into an agreement to sell its interests in 50 CMBS pass-through certificates (the Pooled Certificates) to its subsidiary, the Trust. The Trust resecuritized the Pooled Certificates and offered $98,500,000 Class A-1 Senior Notes with a fixed coupon rate of 7.17% (Fixed Rate Notes) and $137,500,000 Class A-2 Senior Notes with a variable coupon rate based on one-month LIBOR plus 115 basis points (Variable Rate Notes) (together, the Notes). The Notes mature on February 17, 2008. In October 2003, ARCap REIT sold 10 CMBS securities to ARCap Resecuritization, which in turn contributed the 10 CMBS securities to the Trust. ARCap Resecuritization then created a new trust, 2003-ABC3 Trust, for the purpose of resecuritizing the Trust's pooled certificates. 2003-ABC3 Trust issued $80,000,000 of Class A Notes (the Class A Notes) bearing interest at 8.6%, and $15,000,000 of Class B Notes bearing interest at 6% (the Class B Notes) (together, the CRC3-ABC3 Notes). The CRC3-ABC3 Notes, which mature on February 22, 2008, were then distributed to ARCap REIT through ARCap Resecuritization. On October 9, 2003, ARCap REIT sold $30,000,000 of the Class A Notes and used the net proceeds to settle approximately $29,000,000 of repurchase agreements. ARCap REIT has retained the balances of the Class A Notes and the Class B Notes. The Notes and the CRC3-ABC3 Notes are secured by the investment securities of the Company with a carrying value of approximately $382,000,000 at December 31, 2003. Interest on the Notes and the CRC3-ABC3 Notes is paid monthly. Interest expense on the Notes and the CRC3-ABC3 Notes was approximately $17,900,000 for the year ended December 31, 2003, and the related accrued interest payable was approximately $695,000. The Company capitalized approximately $5,668,000 of deferred borrowing costs related to the issuance of the Notes. The deferred borrowing costs are being amortized using the effective-interest method over the life of the debt, which is seven years (through February 22, 2008). The Company amortized approximately $734,000 of deferred costs for the year ended December 31, 2003. Total accumulated amortization of deferred borrowing costs at December 31, 2003, was approximately $1,948,000. The Company capitalized approximately $871,000 of deferred borrowing costs related to the creation of the 2003-ABC3 Trust. The deferred borrowing costs are being amortized using the effective-interest method over the life of the debt through February 22, 2008. The Company amortized approximately $31,000 of deferred borrowing costs for the year ended December 31, 2003. In conjunction with the issuance of the Variable Rate Notes, the Company entered into an interest rate cap agreement and an interest rate floor agreement with Bear Stearns (CBO Swap) to effectively fix the interest rate on its variable rate debt at 7.435%. The notional amount for the CBO Swap is $137,500,000. The agreements call for interest to be paid monthly. The Company carries the CBO Swap at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. The Company originally deposited $4,125,000 of cash to ensure its performance in the event that the CBO Swap declines in value. If the market value of the CBO Swap falls below defined thresholds, the Company may be required to deposit additional restricted cash. Amounts in excess of the minimum requirements may be withdrawn by the Company. 6. REPURCHASE AGREEMENTS The Fund REIT and the Diversified Risk Fund each entered into a credit facility with Liquid Funding, Ltd., an affiliate of Bear Stearns & Co., to finance a portion of its CMBS purchases through both short-term variable rate and long-term fixed rate repurchase agreements. 11 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 At December 31, 2003, the Diversified Risk Fund has short-term variable rate repurchase agreements outstanding of $5,031,000, with an interest rate of 2.154% and a maturity of 32 days. The balance was collateralized by CMBS investments with a fair value of approximately $8,962,000 at December 31, 2003. The Diversified Risk Fund has a long-term repurchase agreement outstanding at December 31, 2003 of $25,367,000, which carries a 4.135% fixed interest rate from the initial purchase date of June 2003 until final repurchase in June 2008. The balance was collateralized by CMBS investments with a fair value of approximately $36,509,000 at December 31, 2003. The Diversified Risk Fund's combined accrued interest payable under the facility at December 31, 2003 was approximately $55,000. The Fund REIT's repurchase agreements outstanding of $65,577,000 have a weighted average interest rate as of December 31, 2003 of 2.185%, and the average maturity of the agreements was 32 days. The repurchase agreements are collateralized by a portion of the Company's portfolio of CMBS investments with a fair value of approximately $102,773,000 at December 31, 2003. Accrued interest payable at December 31, 2003 was approximately $56,000. ARCap REIT entered into short-term repurchase agreements with Bear Stearns & Co. and its affiliates to finance a portion of its CMBS purchases. The weighted-average interest rate on $67,036,000 of such borrowings as of December 31, 2003, was 2.269%, and the average maturity of the agreements was 30 days. The short-term repurchase agreements are collateralized by a portion of the Company's portfolio of CMBS investments with a fair value of approximately $125,550,000 at December 31, 2003. Accrued interest payable at December 31, 2003, was approximately $68,000. 7. LOSS ON INVESTMENT SECURITIES, NET The composition of the Company's gain (loss) on investment securities, net for the year ended December 31, 2003, is as follows:
DECEMBER 31, 2003 ------------ Unrealized gain - borrowed investment securities $ 14,553,693 Unrealized gain - interest rate swap 805,831 Unrealized loss - CMBS (14,825,322) Realized loss - CMBS, net (12,346,305) Realized loss - borrowed investment securities, net (19,245,505) Realized loss - "other than temporary" losses on available-for-sale CMBS (6,597,957) ------------ Loss on investment securities, net $(37,655,565) ============
8. OPERATING LEASES The Company leases its office space and certain equipment under operating leases that expire between April 2004 and May 2008. The office leases, as amended, provide for an annual basic rental of approximately $332,000 during the initial lease term and contain an option to extend the term of one of the leases for one extension term of five years, with the basic rental being reset at the then market rate. Future minimum lease payments under these leases are as follows:
2004 $ 547,000 2005 492,000 2006 278,000 2007 66,000 2008 24,000 ---------- Total $1,407,000 ==========
Lease expense for the year ended December 31, 2003, was approximately $552,000. 9. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES At times, the Company purchases investment securities at fair value from members of the Company or their affiliates. These purchases represent transactions that are in the normal course of business of the Company and the members. During the year ended December 31, 2003, the Company purchased from such members CMBS with an approximate face of $325,177,000 at an approximate purchase price of $168,227,000. 12 ARCap Investors, L.L.C. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2003 The Company has loaned approximately $231,000 to key executives for funding of tax liabilities associated with units granted under an incentive compensation arrangement. In June 2003, approximately $32,000 of such loans was satisfied through the surrender of 1,465 Common Units to the Company. As of December 31, 2003, there is approximately $137,000 outstanding. These loans are classified as other assets in the consolidated balance sheet. The loans bear interest at a rate of 7% per annum, and payments are due quarterly on the distribution date for the Common Units. Payments are due only to the extent that the quarterly distribution is sufficient to pay them. The loans become due upon termination of the executives' employment with the Company, and recourse is limited to the Common Units securing the loans. 10. EMPLOYEE BENEFITS The Company holds a contributory defined contribution 401(k) plan that covers substantially all full-time employees. The Company matches participant contributions up to 3% of each participant's total compensation. Matching contributions totaled approximately $153,000 for the year ended December 31, 2003. The Company has a deferred compensation plan for key employees. The Board of Managers approved the availability of approximately 690,000 phantom appreciation units and 296,000 phantom grant units for awards to employees, all of which have been granted. Grant units granted each have a vesting period, which generally is ratable over a period of three years. Once vested, employees are entitled to receive additional compensation in an amount equal to the per Unit amount distributed on account of the Common Units times the number of grant units vested in the employee. The employee is entitled to this compensation regardless of whether the distribution to the holders of Common Units is an ordinary distribution or an extraordinary distribution. Thus, if the Company is sold or liquidated, the employee would be entitled to share in the proceeds of the sale or liquidation on the same basis as the holders of Common Units with respect to vested grant units. Appreciation units granted also have a vesting period, which is generally spread ratably over a three-year period. Once vested, employees begin to "earn" the right to receive compensation on account of each vested appreciation unit by being credited with an amount equal to the per Unit distributions made to holders of Common Units until the amount credited equals the Initial Value (i.e., the price at which a vested employee could obtain the appreciation unit) established by the Compensation Committee. Vested employees are entitled to compensation on account of each vested appreciation unit in an amount equal to the per Unit distributions made to holders of Common Units only after they have "earned" credits equal to the Initial Value. In the event of a liquidation or sale, employees with vested appreciation units are entitled to compensation in an amount equal to the per Unit proceeds in excess of the Initial Value plus the credits which have been earned. The Company accrues the estimated value of deferred compensation under this plan over the service period, which ends when the units are fully vested. Subsequent to the final vesting date, changes in the estimated amount of deferred compensation will be recorded as an increase or decrease to net income in the period in which such change occurs. For the year ended December 31, 2003, the Company expensed approximately $3,140,000 of deferred compensation and paid approximately $359,000 for the year ended December 31, 2003, related to the vested grant units. 11. SUBSEQUENT EVENT On January 23, 2004, the Company issued a special distribution in the amount of $1,443,000 to the Common Unit holders, along with its regular quarterly distribution. 13 EX-99 4 exh_2002arcap-amac.txt Exhibit 99 (c) CONSOLIDATED FINANCIAL STATEMENTS ARCap Investors, L.L.C. and Subsidiaries YEAR ENDED DECEMBER 31, 2002 ARCap Investors, L.L.C. and Subsidiaries Consolidated Financial Statements Year ended December 31, 2002 CONTENTS Report of Independent Auditors.................................................1 Audited Consolidated Financial Statements Consolidated Balance Sheet.................. ..................................2 Consolidated Statement of Operations...........................................3 Consolidated Statement of Members' Equity.... .................................4 Consolidated Statement of Cash Flows.......... ................................5 Notes to Consolidated Financial Statements.....................................6 INDEPENDENT AUDITORS' REPORT The Board of Managers ARCap Investors, L.L.C. We have audited the accompanying consolidated balance sheet of ARCap Investors, L.L.C. and subsidiaries (the Company) as of December 31, 2002, and the related consolidated statements of operations, members' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. 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 audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ARCap Investors, L.L.C. and subsidiaries at December 31, 2002, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Dallas, Texas February 4, 2003 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET ASSETS
December 31, 2002 ----------------- Investment securities - trading, net (Note 3) $798,856,791 Accrued interest receivable 9,243,042 Cash and cash equivalents 4,953,388 Deferred borrowing costs, net (Note 5) 4,453,750 Restricted cash - CBO swap (Note 5) 4,325,848 Other assets 722,261 ------------ Total assets $822,555,080 ============ LIABILITIES AND MEMBERS' EQUITY Liabilities: Long-term debt (Note 5) $236,000,000 Repurchase agreements (Note 6) 155,423,000 Accrued interest payable 4,853,757 Borrowed investment securities and interest rate swap, net (Note 4) 4,487,562 CBO swap liability (Note 5) 4,125,000 Accrued expenses 208,455 ------------ Total liabilities 405,097,774 ------------ Commitments and contingencies Minority interest in consolidated entities 192,337,631 Members' equity: Series A preferred members 147,340,254 Common members 77,779,421 Total members' equity 225,119,675 ------------ Total liabilities and members' equity $822,555,080 ============
See notes to consolidated financial statements 2 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS
December 31, 2002 ----------------- Revenues: Interest income - CMBS $ 76,306,706 Other investment income 2,175,975 ------------ Total revenues 78,482,681 ------------ Expenses: Interest - long-term debt and repurchase agreements 20,527,438 Interest - borrowed investment securities and interest rate swap, net 7,287,485 Financing fee 1,180,000 Salaries and employee benefits 5,508,718 General and administrative 4,442,601 ------------ Total expenses 38,946,242 ------------ Net margin on CMBS and other investments 39,536,439 Other revenue (expense): Accretion of purchase discount 17,137,362 Loss on trading securities, net (Note 7) (11,068,375) ------------ 6,068,987 Income before minority interest 45,605,426 Minority interest (14,456,330) ------------ Net income $ 31,149,096 ============
See notes to consolidated financial statements 3 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF MEMBERS' EQUITY YEAR EMDED DECEMBER 31, 2002
Series A Common Preferred Members Members Total ------------------------------------------------ Balance at January 1, 2002 $ 78,156,400 $145,827,125 $223,983,525 Costs to raise capital of consolidated subsidiaries (386,470) (863,826) (1,250,296) Distributions (10,890,994) (17,871,656) (28,762,650) Net income 10,900,485 20,248,611 31,149,096 ------------ ------------ ------------ Balance at December 31, 2002 $ 77,779,421 $147,340,254 $225,119,675 ============ ============ ============
See notes to consolidated financial statements 4 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS
December 31, 2002 ----------------- OPERATING ACTIVITIES Net income $ 31,149,096 Adjustments to reconcile net income to net cash used in operating activities: Loss on trading securities, net 11,068,375 Accretion of purchase discount (17,137,362) Amortization of deferred borrowing costs 680,930 Minority interest 14,456,330 Changes in operating assets and liabilities: Investment securities - trading, net (205,485,635) Accrued interest receivable (3,410,351) Restricted cash - CBO swap (73,117) Other assets (93,381) Accrued interest payable 1,616,725 Borrowed investment securities and interest rate swap, net (14,765,069) Accrued expenses (190,995) ------------- Net cash used in operating activities (182,184,454) ------------- FINANCING ACTIVITIES Distributions to members (28,762,650) Contributions from minority interest members 148,576,742 Distributions to minority interest members (14,093,989) Costs to raise capital (1,350,296) Proceeds from repurchase agreements 69,321,000 ------------- Net cash provided by financing activities 173,690,807 ------------- NET CHANGE IN CASH AND CASH EQUIVALENTS (8,493,647) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 13,447,035 ------------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 4,953,388 ============= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash payments for interest on repurchase agreements and long-term debt $ 20,489,835 =============
See notes to consolidated financial statements 5 s ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES A) Organization - ARCap Investors, L.L.C. (the Company) was incorporated in January 1999 and commenced its operations on March 17, 1999. The Company was organized to invest primarily in subordinated commercial mortgage-backed securities (CMBS). B) Principles of Consolidation - The consolidated financial statements include the accounts of: - The Company. - ARCap REIT, Inc. (ARCap REIT), a majority-owned subsidiary of the Company. - ARCAP Resecuritization Corporation (ARCap Resecuritization), a wholly owned subsidiary of ARCap REIT. ARCap Resecuritization owns all the residual interest in Commercial Resecuritization Trust 2001 ABC-2 (the Trust). - ARCap High Yield CMBS Fund, L.L.C. (the High Yield Fund), of which ARCap REIT owned an approximate 23% controlling interest as of December 31, 2002. The High Yield Fund owns approximately 60% of ARCap CMBS Fund REIT, Inc. (the Fund REIT). - ARCap Diversified Risk CMBS Fund, L.L.C. (the Diversified Risk Fund), of which ARCap REIT owned an approximate 1% controlling interest as of December 31, 2002. The Diversified Risk Fund owns approximately 40% of the Fund REIT. - ARCap Special Servicing, Inc. (Special Servicing), a taxable REIT subsidiary wholly owned by ARCap REIT. Minority interests primarily represent outside members' approximate 77% ownership in the High Yield Fund and outside members' approximate 99% ownership in the Diversified Risk Fund. The Company has consolidated the High Yield Fund and Diversified Risk Fund as it exercises control (through ARCap REIT, which acts as the Managing Member of both Funds in accordance with the terms of the respective LLC agreements) over the operations of these Funds. The Company records minority interest expense (income) that reflects the portion of the earnings (losses) of the operations which is applicable to the minority interest members. Separate books of accounts are maintained for ARCap REIT, ARCap Resecuritization, the Trust, the High Yield Fund, the Fund REIT, the Diversified Risk Fund, and Special Servicing and are reflected in the accompanying consolidated financial statements of the Company. All material intercompany transactions and account balances have been eliminated in consolidation. C) Investment Securities - The Company's investment security transactions are recorded on the trade date for existing securities and the settlement date for to-be-issued securities. CMBS are designated as trading assets since the Company is holding the securities for possible sales or other dispositions in the near term. Such securities are carried at their estimated fair value, with unrealized gains or losses included in earnings. The fair value of the Company's portfolio of CMBS is generally estimated by management based on market prices provided by certain dealers who make a market in these financial instruments. The market for the Company's CMBS may lack liquidity and have limited market volume. Accordingly, the fair values reported reflect estimates and may not necessarily be indicative of the amounts that the Company could realize in a current market exchange. The yield to maturity on the Company's CMBS depends on, among other things, the rate and timing of principal payments, the pass-through rate and interest rate fluctuations. The subordinated CMBS interests owned by the Company provide credit support to the more senior interests of the related commercial securitization. Cash flow from the mortgages underlying the CMBS interests generally is allocated first to the senior interests, with the most senior interest having a priority entitlement to cash flow. Remaining cash flow is allocated generally among the other CMBS interests in order of their relative seniority. To the extent that there are defaults and unrecoverable losses on the underlying mortgages that result in reduced cash flows, the most subordinated CMBS interest will bear this loss first. To the extent that there are losses in excess of the most subordinated interest's stated entitlement to principal and interest, then the remaining CMBS interests will bear such losses in order of their relative subordination. D) Revenue Recognition - Interest income and special servicing fees are recognized as earned. Accretion of discounts is computed using the effective-yield method over the life of the underlying assets. E) Derivative Financial Instruments - Derivative financial instruments are utilized by the Company to reduce interest rate risk. The Company utilizes interest rate swaps and cap and floor agreements as a means of hedging the potential financial statement impact of changes in the fair value of its portfolio of CMBS and variable rate long-term debt due to changes in interest rates. Risks in these contracts arise from the movements in interest rates and from the possible inability of counterparties to meet the terms of their contracts. The Company carries its derivative financial instruments at fair 6 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 value with any unrealized gain or loss included in earnings, in accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. F) Resale and Repurchase Agreements - Transactions involving purchases of securities under agreements to resell (reverse repurchase agreements or reverse repos) or sales of securities under agreements to repurchase (repurchase agreements or repos) are accounted for as collateralized financings, except where the Company does not have an agreement to sell (or purchase) the same or substantially the same securities before maturity at a fixed or determinable price. G) Cash and Cash Equivalents - Cash and cash equivalents include all highly liquid investments with original maturities when purchased of three months or less. H) Restricted Cash - Restricted cash represents amounts required to be pledged under interest rate cap and floor agreements (see Note 5). I) Deferred Borrowing Costs - Deferred borrowing costs represent costs incurred in connection with the issuance of long-term debt. Such amounts are amortized using the effective interest method over the term of the related debt (see Note 5). J) Financing Fee - The Company pays an annual rate of 0.50% of the face of its existing long-term debt to a financier to provide credit enhancement of such debt. K) Income Taxes - The Company has elected to be taxed as a partnership, whereby all income is taxed at the member level, with the exception of Special Servicing which is taxed at the entity level. ARCap REIT has elected to be taxed as a real estate investment trust for federal income tax purposes. No provision for income taxes has been made for Special Servicing for the period April 1, 2002 (inception of Special Servicing) through December 31, 2002 as Special Servicing did not generate any taxable income. L) Use of Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of certain assets, liabilities, revenues, and expenses. Actual results could differ from those estimates. M) Fair Value of Financial Instruments - The estimated fair value amounts herein have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts. The Company's portfolio of CMBS and securities borrowed is carried at their estimated fair values. The Company's management believes that the fair values of its cash and cash equivalents, restricted cash, and repurchase agreements approximate their carrying values due to the nature of the instruments or the fact that their terms approximate current market terms. NOTE 2. MEMBERS' EQUITY The Limited Liability Company Agreement (LLC Agreement) establishes two classes of membership: Series A Preferred members and Common members. Cash Flows are distributed in the following order of priority: - To the Series A Preferred members in an amount equal to the accrued and unpaid Preferred Distributions (12% per annum of the $25.00 price per Unit). - To the Common members in an amount equal to (a) during the 18-month period that ended February 4, 2002, the amount determined by the Board of Managers, but no more than a cumulative return on the Common Units at the rate of 10% per annum on an established value of $21.74 per 7 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 unit, and (b) subsequent to such 18-month period, the amount determined by the Board of Managers, provided that if the amount distributable to the Common members shall exceed a cumulative annual return on the Common Units of 12% per annum, the Board of Managers shall notify the Series A Preferred members 30 days in advance of the record date for distribution of Cash Flow. - To the extent that any remaining Cash Flow received during such tax period is not includable in the income of the Company, to members that have been allocated Net Profits in excess of amounts actually distributed to such members, in proportion to such amounts. Net Profits of the Company are allocated as follows: - To the Series A Preferred members to the extent of amounts distributed or distributable to them in such taxable year. - To the Series A Preferred members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the Common members to the extent of amounts distributed or distributable to them in such taxable year. - To the Common members to the extent Net Losses previously allocated to such members exceed undistributed Net Profits previously allocated to them. - To the members in proportion to their Percentage Interests. Net Losses of the Company are allocated as follows: - To the members in an amount equal to undistributed Net Profits allocated to such member. - To the Common members pro rata to the extent of their Capital Accounts. - To the Series A Preferred members pro rata to the extent of their Capital Accounts. Series A Preferred Units - ------------------------ Series A Preferred Units are convertible into Common Units at the Conversion Price in effect on the Conversion Date. If the Series A Preferred Units have not been converted within five years of the effective date of the First Amendment to the LLC Agreement (August 4, 2000), Series A Preferred Units may, at the holder's option, be converted to a note equal to $25.00 per Unit, plus accrued and unpaid Preferred Distributions. Eighteen months after the First Closing Date (February 4, 2002), but no later than the fifth anniversary of the First Closing Date (August 4, 2005), the Company may redeem the Series A Preferred Units for $25.00 per unit, plus accrued and unpaid Preferred Distributions, plus a premium that will provide the Series A Preferred members with a total pretax internal rate of return of 17.50%. In addition, upon either a change in control or sale or transfer of all or substantially all of the assets of the Company, Series A Preferred Units may, at the holder's option, be redeemed at $25.00 per unit, plus accrued and unpaid Preferred Distributions. At December 31, 2002, there were a total of 6,000,000 Series A Preferred Units and 4,999,382 Common Units issued and outstanding. The LLC Agreement contains certain restrictive covenants regarding the amount of variable rate debt, total debt, and certain financial ratios. Failure to meet the covenants in successive quarters can result in the Chief Executive Officer and Chief Operating Officer being removed from the Board of Managers until such time as the covenants are cured for successive quarters. Management believes that the Company has not violated the covenants in successive quarters. 8 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 NOTE 3. INVESTMENT SECURITIES The Company's trading securities are carried at estimated fair value and are comprised of the following at December 31, 2002:
Face Cost Fair Value Percentage ---------------------------------------------------------- Subordinated CMBS: Security rating: BB+ $ 115,923,711 $ 91,176,800 $103,776,027 12.99% BB 170,077,178 127,903,052 141,264,695 17.68% BB- 134,295,076 90,149,121 99,793,698 12.49% B+ 215,067,722 127,005,619 137,774,880 17.25% B 264,721,814 151,661,428 144,486,471 18.09% B- 161,254,347 79,612,839 70,601,239 8.84% NR 420,501,779 110,757,808 101,159,781 12.66% --------------- ------------- ------------ ------- $ 1,481,841,627 $ 778,266,667 $798,856,791 100.00% =============== ============= ============ =======
The Company accretes purchase discounts using the effective yield method over the life of the CMBS. The accumulated accretion of purchase discounts at December 31, 2002, was approximately $30,627,000. The gross cumulative unrealized gains and losses on the Company's trading investment securities at December 31, 2002, were approximately $41,709,000 and ($51,746,000), respectively. NOTE 4. BORROWED INVESTMENT SECURITIES AND INTEREST RATE SWAP, NET The Company's borrowed investment securities and interest rate swap are carried at estimated fair value and are comprised of the following at December 31, 2002:
Security Coupon Cost Fair Unrealized Description Rate Face Basis Value Gain (Loss) - ------------------------------------------------------------------------------------------------------ U.S. Treasury (08-15-09) 6.000% $ (11,239,000) $ (10,974,728) $( 13,072,362) $ (2,097,634) U.S. Treasury (02-15-11) 5.000% (17,818,000) (17,523,195) (19,591,448) (2,068,253) U.S. Treasury (08-15-11) 5.000% (136,603,000) (138,334,790) (149,900,450) (11,565,660) U.S. Treasury (02-15-12) 4.875% (85,300,000) (91,513,064) (92,697,111) (1,184,047) U.S. Treasury (11-15-12) 4.000% (20,468,000) (20,336,877) (20,775,020) (438,143) -------------- -------------- -------------- ------------ $(271,428,000) $( 278,682,654) (296,036,391) $(17,353,737) ============== =============== ============= Reverse repurchase agreements 295,618,149 ------------- Borrowed investment securities, net (418,242) Interest rate swap (4,069,320) ------------- Borrowed investment securities and interest rate swap, net $ (4,487,562) ==============
The borrowed U.S. Treasury securities were sold in the open market (i.e., a "short" security sale). The Company is obligated to return the securities in the future and is therefore exposed to price risk until it repurchases the securities for delivery to the lender. Short security sales are used by the Company to modify its interest rate risk. The Company must pay the security lender the interest earned by the underlying security. Short security sales are recorded at the estimated fair value of the borrowed securities, and any unrealized gains (losses) are included in earnings. Proceeds from short security sales are used to purchase reverse repurchase agreements of the same security. The transactions are governed by one master repurchase agreement with rights of offset and, therefore, the values of the short security sales and reverse repurchase agreements have been offset and shown as one line item in the accompanying consolidated financial statements. It has been the Company's practice to settle these transactions on a net basis. 9 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 At December 31, 2002, the Company pledged CMBS valued at approximately $10,363,000 as additional collateral against the borrowed investment securities outstanding as of December 31, 2002. The Company entered into an interest rate swap agreement with Bear Stearns Capital Markets (Bear Stearns) with a notional amount at December 31, 2002, of $27,000,000, on which the Company pays a fixed rate of 6.015% and receives a variable rate based upon a six-month LIBOR for a term of 10 years ending April 27, 2011. The swap agreement calls for interest to be paid semiannually in arrears. The Company carries the swap agreement at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. The Company was required under the swap agreement to pledge collateral valued at 1% of the notional amount of the swap to ensure its performance in the event that the swap declines in value. At December 31, 2002, the Company pledged CMBS valued at approximately $14,611,000 as additional collateral against the interest rate swap outstanding as of December 31, 2002. NOTE 5. LONG-TERM DEBT During fiscal year 2001, the Company entered into an agreement to sell its interests in 50 CMBS pass-through certificates (the Pooled Certificates) to its subsidiary, the Trust. The Trust resecuritized the Pooled Certificates and offered $98,500,000 Class A-1 Senior Notes with a fixed coupon rate of 7.17% (Fixed Rate Notes) and $137,500,000 Class A-2 Senior Notes with a variable coupon rate based on one-month LIBOR plus 115 basis points (Variable Rate Notes) (together, the Notes). The Notes are secured by the investment securities of the Company with a carrying value of approximately $345,512,000 at December 31, 2002. The Company capitalized $5,667,580 of deferred borrowing costs related to the issuance of the Notes. The deferred borrowing costs are being amortized, using the effective-interest method, over the life of the debt, which is seven years (through February 22, 2008). The Company amortized $680,930 of deferred costs for the year ended December 31, 2002. Total accumulated amortization of deferred borrowing costs at December 31, 2002, was $1,213,830. In conjunction with the issuance of the Variable Rate Notes, the Company entered into an interest rate cap agreement and an interest rate floor agreement with Bear Stearns (CBO Swap) to effectively fix the interest rate on its variable rate debt at 7.435%. The notional amount for the CBO Swap is $137,500,000. The agreements call for interest to be paid monthly. The Company carries the CBO Swap at its estimated fair value, with all periodic changes in estimated fair value recognized in earnings. The Company originally deposited $4,125,000 of cash to ensure its performance in the event that the CBO Swap declines in value. If the market value of the CBO Swap falls below defined thresholds, the Company may be required to deposit additional restricted cash. Amounts in excess of the minimum requirements may be withdrawn by the Company. Interest on the Notes is paid monthly. Interest expense on the Notes was approximately $17,238,000 for the year ended December 31, 2002, and the related accrued interest payable at December 31, 2002, was approximately $480,000. NOTE 6. REPURCHASE AGREEMENTS The Company entered into repurchase agreements to finance a portion of its CMBS purchases. The weighted-average interest rate as of December 31, 2002, was 2.73%, and the average maturity of the agreements was 30 days. The repurchase agreements are collateralized by a portion of the Company's portfolio of CMBS investments with a fair value of approximately $284,943,000 at December 31, 2002. Accrued interest payable at December 31, 2002, was approximately $209,000. NOTE 7. LOSS ON TRADING SECURITIES, NET The composition of the Company's gain (loss) on trading securities, net for the year ended December 31, 2002, is as follows:
Unrealized loss - borrowed investment securities $(17,594,455) Unrealized loss - interest rate swap (3,395,007) Unrealized loss - CBO Swap (1,408,400) Unrealized gain - CMBS 12,443,165 Realized loss - CMBS (1,086,698) Realized loss - borrowed investment securities (26,980) ------------- Loss on trading securities, net $(11,068,375) =============
10 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 NOTE 8. OPERATING LEASES The Company leases its office space and certain equipment under operating leases that expire between April 2004 and January 2007. The office lease, as amended, provides for an annual basic rental of $206,244 during the initial lease term and contains an option to extend the term of the lease for one extension term of five years, with the basic rental being reset at the then market rate. Future minimum lease payments under these leases are as follows:
2003 $313,851 2004 243,455 2005 207,384 2006 206,244 2007 17,187 -------- Total $988,121 ========
Lease expense for the year ended December 31, 2002 was approximately $316,000. NOTE 9. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES At times, the Company purchases investment securities from members of the Company or their affiliates. These purchases represent transactions that are in the normal course of business of the Company and the members. During the year ended December 31, 2002, the Company purchased from such members CMBS with an approximate face of $387,327,000 at an approximate purchase price of $210,382,000. The Company has loaned approximately $231,000 to key executives for funding of tax liabilities associated with units granted under an incentive compensation arrangement. As of December 31, 2002, there is approximately $190,000 outstanding. These loans are classified as other assets in the consolidated balance sheet. The loans bear interest at a rate of 7% per annum, and payments are due quarterly on the distribution date for the Common Units. Payments are due only to the extent that the quarterly distribution is sufficient to pay them. The loans become due upon termination of the executives' employment with the Company, and recourse is limited to the Common Units securing the loans. Under a fee arrangement, ARCap REIT paid C.P. Eaton & Associates, Inc. a monthly retainer fee and an incentive fee to assist ARCap REIT in raising capital for fund operations with respect to which ARCap REIT acts as the Managing Member. The total costs incurred under this fee arrangement are allocated proportionately (based on total dollars raised) to all funds for which capital dollars are raised. NOTE 10. EMPLOYEE BENEFITS The Company holds a contributory defined contribution 401(k) plan that covers substantially all full-time employees. The Company matches participant contributions up to 3% of each participant's total compensation. Matching contributions totaled approximately $75,000 for the year ended December 31, 2002. The Company has a deferred compensation plan for key employees. The Board of Managers approved the availability of approximately 690,000 phantom appreciation units and 296,000 phantom grant units for future awards to employees. In order to grant these awards, the Compensation Committee must recommend that they be granted, and the Compensation Committee's recommendation must be approved by the Board of Managers. As of December 31, 2002, the Company has granted approximately 551,000 and 193,000 appreciation units and grant units, respectively. The Board of Managers approved the Compensation Committee's recommendations to grant additional appreciation units and grant units of approximately 138,000 and 95,000, respectively, effective January 1, 2003. Grant units granted each have a vesting period, which generally is ratable over a period of three years. Once vested, employees are entitled to receive a bonus in an amount equal to the per Unit amount distributed on account of the Common Units times the number of grant units vested in the employee. The employee is entitled to this compensation regardless of whether the distribution to the holders of Common Units is an ordinary distribution or an extraordinary distribution. Thus, if the Company is sold or liquidated, the employee would be entitled to share in the proceeds of the sale or liquidation on the same basis as the holders of Common Units with respect to vested grant units. Appreciation units granted also have a vesting period which is generally spread ratably over a three year period. Once vested, employees begin to "earn" the right to receive compensation on account of each vested appreciation unit by being credited with an amount equal to the per Unit distributions made to holders of Common Units until the amount credited equals the Initial Value (i.e. the price at which a vested employee could obtain the appreciation unit) established by the Compensation Committee. Vested employees are entitled to compensation on account of each vested appreciation unit in an amount equal to the per Unit distributions made to holders of Common Units only after they have "earned" credits equal to the Initial Value. In the event of a liquidation or 11 ARCap INVESTORS, L.L.C. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2002 sale, employees with vested appreciation units are entitled to compensation in an amount equal to the per Unit proceeds in excess of the Initial Value plus the credits which have been earned. The amount actually received by employees on account of the vested grant and appreciation units is compensation. For the year ended December 31, 2002, the Company expensed approximately $157,000 relating to compensation paid on account of vested grant units. 12 -----END PRIVACY-ENHANCED MESSAGE-----