Business Context and Reporting Period
Company: Kohlberg Capital Corporation (KCAP), an internally managed, non-diversified closed-end investment company regulated as a Business Development Company (BDC).
Reporting Period: Quarterly period ended June 30, 2011 (Six months ended June 30, 2011).
Business Model: The Company originates, structures, and invests in senior secured term loans, mezzanine debt, and selected equity securities in privately-held middle-market companies. It also owns 100% of Katonah Debt Advisors, an asset manager of Collateralized Loan Obligation (CLO) funds.
Key Financial Metrics
| Metric | Six Months Ended June 30, 2011 | Six Months Ended June 30, 2010 |
|---|---|---|
| Total Investment Income | $13,639,972 | $14,346,631 |
| Total Expenses | $5,732,365 | $11,470,939 |
| Net Investment Income | $7,907,607 | $2,875,692 |
| Net Realized Gains (Losses) | $(13,759,814) | $(7,705,806) |
| Net Change in Unrealized Appreciation | $16,330,670 | $734,108 |
| Net Increase in Net Assets from Operations | $10,478,463 | $(4,096,006) |
| Net Asset Value (NAV) per Share | $8.52 | $9.20 |
| Total Assets | $260,778,603 | $279,822,686 |
| Total Liabilities | $66,186,684 | $92,897,019 |
| Stockholders' Equity | $194,591,919 | $186,925,667 |
Debt and Liquidity:
- Convertible Senior Notes: $60,000,000 outstanding (issued March 2011, 8.75% interest).
- Secured Credit Facility: Fully repaid on January 31, 2011 (balance was $86.7 million at Dec 31, 2010).
- Cash and Cash Equivalents: Approximately $40 million (including time deposits and money market accounts).
- Asset Coverage Ratio: 424% (well above the 200% minimum required for BDCs).
Material Changes vs. Prior Period
- Profitability Improvement: The Company reported a net increase in net assets of $10.5 million for the six months ended June 30, 2011, compared to a net decrease of $4.1 million in the same period in 2010. This turnaround was driven by a significant reduction in expenses and a large unrealized appreciation on investments.
- Expense Reduction: Total expenses dropped by approximately 50% year-over-year (from $11.5 million to $5.7 million). This was primarily due to a decrease in professional fees (legal, accounting, valuation) related to prior litigation and restatement issues, and lower interest expense following the repayment of the secured credit facility.
- Debt Restructuring: The Company replaced its $86.7 million secured credit facility with $60 million in unsecured convertible senior notes. This reduced the average debt outstanding and interest costs significantly.
- Unrealized Gains: Net unrealized appreciation increased by $16.3 million in 2011, compared to $0.7 million in 2010. This was largely due to the write-off of a previously impaired debt security (reducing accumulated unrealized losses) and fair value adjustments on debt securities and CLO funds.
- Realized Losses: Net realized losses increased to $13.8 million in 2011 from $7.7 million in 2010, primarily due to the sale of a CLO fund security and the write-off of a debt security.
Guidance, Outlook, Risks, and Unusual Items
Management Commentary & Outlook:
- Management intends to continue distributing quarterly dividends, aiming to distribute at least 98% of ordinary net taxable income to maintain RIC status.
- The Company plans to grow its portfolio by raising additional capital and utilizing leverage prudently, subject to market conditions.
- Dividends declared for the first and second quarters of 2011 were $0.17 per share each.
Unusual Items:
- Legal Settlement: In Q1 2011, the Company received a $2 million cash settlement from lenders related to the secured credit facility litigation, recognized as "Other Income."
- Write-offs: A debt security with a cost basis of ~$10.7 million was written off, resulting in a realized loss but a corresponding reduction in unrealized depreciation.
Risks and Contingencies:
- Legal Proceedings: The Company is a defendant in consolidated class actions regarding 2008-2009 financial disclosures. The court dismissed the consolidated amended complaint in July 2011, but plaintiffs may file further amendments. A derivative action was dismissed in 2010, with an appeal pending.
- SEC Investigation: The SEC is conducting a formal investigation into the Company's valuation methodology and procedures. The Company is cooperating but cannot predict the outcome.
- Valuation Risk: Substantially all investments are Level III (unobservable inputs), requiring significant management judgment. Fair values may differ materially from values in a liquid market.
- Leverage Risk: The use of leverage magnifies potential gains and losses. The Company is subject to asset coverage requirements under the 1940 Act.
Investor Verification Checklist
- Valuation Methodology: Verify the assumptions used for Level III fair value measurements, particularly for CLO funds and illiquid debt, given the ongoing SEC investigation.
- Legal Exposure: Monitor the status of the class action lawsuits and the SEC investigation for potential financial impact or reputational damage.
- Debt Covenants: Review the covenants associated with the new $60 million Convertible Senior Notes to ensure compliance and understand conversion risks (dilution).
- CLO Fund Performance: Assess the performance and distribution status of the CLO funds, as they represent a significant portion (27%) of the portfolio and are sensitive to credit market conditions.
- Dividend Sustainability: Confirm that Net Investment Income continues to cover the declared dividend rate of $0.17 per share ($0.68 annualized) without relying heavily on return of capital.