Business Context and Reporting Period
Company: Kohlberg Capital Corporation (KCAP), a Business Development Company (BDC) and Regulated Investment Company (RIC).
Reporting Period: Quarterly period ended March 31, 2010.
Key Context: This filing contains restated financial information for comparative periods in 2009 and 2008 due to material weaknesses in internal controls regarding fair value accounting for illiquid investments and revenue recognition for payment-in-kind (PIK) investments. The company is concurrently filing amended 10-Qs and a 2009 10-K. Management believes it has corrected the accounting errors as of the filing date.
Key Financial Metrics
| Metric | Q1 2010 | Q1 2009 (Restated) |
|---|---|---|
| Net Investment Income | $2,578,494 | $6,453,623 |
| Net Increase in Net Assets from Operations | $1,594,909 | $8,895,498 |
| Net Investment Income Per Share | $0.11 | $0.30 |
| Net Income Per Share (Basic & Diluted) | $0.07 | $0.41 |
| Net Asset Value (NAV) Per Share | $9.62 | $9.41 |
| Total Assets | $417,079,720 | $439,416,057 |
| Total Borrowings | $198,648,255 | $218,050,363 |
| Asset Coverage Ratio | 209% | 184% |
| Cash and Restricted Cash | $2,966,307 | $22,836,431 |
Material Changes vs. Prior Period
- Revenue Decline: Total investment income decreased from $9.45 million in Q1 2009 to $6.96 million in Q1 2010. Interest income from debt securities dropped significantly ($6.72M to $4.78M), while dividend income from CLO funds also declined.
- Expense Increase: Total expenses rose from $3.00 million to $4.39 million. This was driven primarily by a sharp increase in interest and amortization of debt issuance costs ($1.51M to $2.70M), attributed to the application of a higher default interest rate on the company's credit facility.
- Realized Losses: The company recorded a net realized loss of $2.27 million in Q1 2010, compared to $2.01 million in Q1 2009.
- Unrealized Gains/Losses: Q1 2010 saw a net realized and unrealized depreciation of $983,585, contrasting with a net appreciation of $2.44 million in Q1 2009. This was largely due to a $5.08 million decrease in the unrealized appreciation of the affiliate asset manager (Katonah Debt Advisors), partially offset by gains in debt securities and CLO funds.
- Liquidity: Cash and restricted cash balances decreased significantly from approximately $22.8 million to $3.0 million, reflecting debt repayments and operational cash usage.
Guidance, Outlook, Risks, and Contingencies
- Dividend Policy: The company declared a quarterly dividend of $0.17 per share for Q1 2010 (paid April 29, 2010). Management intends to continue distributing quarterly dividends to maintain RIC status.
- Debt Facility Litigation: The company is engaged in active litigation with its lenders regarding its $275 million secured revolving credit facility. Lenders declared a "Termination Event" in June 2009, triggering a default interest rate (Prime + 0.85% + 0.75%) and an amortization period ending September 29, 2010. The company disputes these actions as wrongful and is paying the higher rate under protest. If the company loses the litigation, it may be forced to repay the remaining balance (~$187 million) or sell collateral at a loss.
- Internal Control Weaknesses: Management identified material weaknesses in internal controls over financial reporting related to fair value accounting and PIK revenue recognition. Remediation measures are being implemented.
- SEC Investigation: The SEC has initiated a formal investigation regarding the company's valuation methodology and procedures. A subpoena has been issued.
- Legal Proceedings: The company is a defendant in three putative class actions and one derivative action alleging violations of the Exchange Act and breaches of fiduciary duty related to financial statement disclosures. Management intends to defend these vigorously.
- Liquidity Risk: Due to the amortization of the credit facility, the company may need to sell assets not pledged to the facility to fund dividend distributions. The company believes current cash and liquid assets are sufficient for the next 12 months but notes that raising new equity capital is difficult due to the stock trading below NAV.
Investor Verification Checklist
- Restatement Impact: Verify the specific adjustments made to the 2008 and 2009 financial statements and the extent of the material weaknesses in internal controls.
- Debt Facility Status: Monitor the outcome of the litigation with the lenders regarding the "Termination Event" and the potential requirement to repay ~$187 million by September 2010.
- Valuation Methodology: Review the SEC investigation status and the company's response regarding the fair value determination of illiquid investments (Level III assets).
- Dividend Sustainability: Assess whether the company can maintain its dividend payout given the reduced investment income and the need to service debt at a default rate.
- Asset Manager Performance: Evaluate the performance of Katonah Debt Advisors, which saw a $5 million decrease in unrealized value, and the status of accrued but unpaid subordinated management fees (~$6 million).