# Barings BDC, Inc.: Form 10-Q for the period ended Sep 30, 2009

- Company: [Barings BDC, Inc.](/companies/bbdc.md) (CIK 1379785)
- Form: 10-Q
- Filed: 2009-11-04
- Accepted by EDGAR: Nov 4, 2009, 16:09 ET
- Period: 2009-09-30
- Accession: 0000950123-09-057579
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1379785/000095012309057579/g21043e10vq.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1379785/000095012309057579/

## Management's discussion and analysis

As filed, 46,958 characters.

The following discussion is designed to provide a better understanding of our unaudited consolidated financial statements, including a brief discussion of our business, key factors that impacted our performance and a summary of our operating results. The following discussion should be read in conjunction with the Unaudited Financial Statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q, and the Consolidated Financial Statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2008. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

### “Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995

This Quarterly Report contains forward-looking statements which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Some of the statements in this Quarterly Report constitute forward-looking statements because they relate to future events or our future performance or financial condition. Forward-looking statements may include, among other things, statements as to our future operating results, our business prospects and the prospects of our portfolio companies, the impact of the investments that we expect to make, the ability of our portfolio companies to achieve their objectives, our expected financings and investments, the adequacy of our cash resources and working capital, and the timing of cash flows, if any, from the operations of our portfolio companies. Words such as “expect,” “anticipate,” “target,” “goals,” “project,” “intend,” “plan,” “believe,” “seek,” “estimate,” “continue,” “forecast,” “may,” “should,” “potential,” variations of such words, and similar expressions indicate a forward-looking statement, although not all forward-looking statements include these words. Readers are cautioned that the forward-looking statements contained in this Quarterly Report are only predictions, are not guarantees of future performance, and are subject to risks, events, uncertainties and assumptions that are difficult to predict. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors discussed in Item 1A entitled “Risk Factors” in Part I of our 2008 Annual Report on Form 10-K. Other factors that could cause actual results to differ materially include changes in the economy, risks associated with possible disruption due to terrorism in our operations or the economy generally, and future changes in laws or regulations and conditions in our operating areas. These statements are based on our current expectations, estimates, forecasts, information and projections about the industry in which we operate and the beliefs and assumptions of our management as of the date of this Quarterly Report. We assume no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless we are required to do so by law. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

### Overview of Our Business

We are a Maryland corporation which has elected to be treated and operates as an internally managed business development company, or BDC, under the Investment Company Act of 1940, or 1940 Act. Our wholly owned subsidiary, Triangle Mezzanine Fund LLLP (the “Fund”) is licensed as a small business investment company, or SBIC, by the United States Small Business Administration, or SBA, and has also elected to be treated as a BDC under the 1940 Act. We and the Fund invest primarily in debt instruments, equity investments, warrants and other securities of lower middle market privately held companies located in the United States.

Our business is to provide capital to lower middle market companies in the United States. We define lower middle market companies as those with annual revenues between $10.0 and $100.0 million. We focus on investments in companies with a history of generating revenues and positive cash flows, an established market position and a proven management team with a strong operating discipline. Our target portfolio company has annual revenues between $20.0 and $75.0 million and annual earnings before interest, taxes, depreciation and amortization, or EBITDA, between $2.0 and $20.0 million.

We invest primarily in senior and subordinated debt securities secured by first and second lien security interests in portfolio company assets, coupled with equity interests. Our investments generally range from $5.0 to $15.0 million per portfolio company. In certain situations, we have partnered with other funds to provide larger financing commitments.

We generate revenues in the form of interest income, primarily from our investments in debt securities, loan origination and other fees and dividend income. Fees generated in connection with our debt investments are recognized over the life of the loan using the effective interest method or, in some cases, recognized as earned. In addition, we generate revenue in the form of capital gains, if any, on warrants or other equity-related securities that we acquire from our portfolio companies. Our debt investments generally have a term of between three and seven years and typically bear interest at fixed rates between 11.0% and 16.0% per annum. Certain of our debt investments have a form of interest, referred to as paid-in-kind, or PIK, interest, that is not paid currently but that is accrued and added to the loan balance and paid at the end of the term. Cash interest on our debt investments is generally payable monthly;

however, some of our debt investments pay cash interest on a quarterly basis. As of both September 30, 2009 and December 31, 2008, the weighted average yield on all of our outstanding debt investments (including PIK interest) was approximately 14.4%. The weighted average yield on all of our outstanding investments (including equity and equity-linked investments) was approximately 13.3% and 13.2% as of September 30, 2009 and December 31, 2008, respectively.

The Fund is eligible to sell debentures guaranteed by the SBA in the capital markets at favorable interest rates and invest these funds in portfolio companies. We intend to continue to operate the Fund as an SBIC, subject to SBA approval, and to utilize the proceeds of the sale of the Fund’s SBA-guaranteed debentures, referred to herein as SBA leverage, to enhance returns to our stockholders.

### Portfolio Composition

The total value of our investment portfolio was $188.4 million as of September 30, 2009, as compared to $182.1 million as of December 31, 2008. As of September 30, 2009, we had investments in 36 portfolio companies with an aggregate cost of $201.9 million. As of December 31, 2008, we had investments in 34 portfolio companies with an aggregate cost of $180.2 million. As of both September 30, 2009 and December 31, 2008, none of our portfolio investments represented greater than 10% of the total fair value of our investment portfolio.

As of September 30, 2009 and December 31, 2008, our investment portfolio consisted of the following investments:

| September 30, 2009: | Cost | Percentage of Total Portfolio | Fair Value | Percentage of Total Portfolio |
| --- | ---: | ---: | ---: | ---: |
| Subordinated debt and 2nd lien notes | $167,380,542 | 83% | $153,498,784 | 82% |
| Senior debt | 16,834,740 | 9 | 16,440,952 | 9 |
| Equity shares/membership interests | 14,366,846 | 7 | 13,663,300 | 7 |
| Equity warrants | 2,415,370 | 1 | 3,929,000 | 2 |
| Royalty rights | 874,400 | — | 859,000 | — |
|  | $201,871,898 | 100% | $188,391,036 | 100% |
| **December 31, 2008:** |  |  |  |  |
| Subordinated debt and 2nd lien notes | $147,493,871 | 82% | $143,015,291 | 79% |
| Senior debt | 16,269,628 | 9 | 16,269,628 | 9 |
| Equity shares/membership interests | 13,684,269 | 8 | 17,301,372 | 9 |
| Equity warrants | 1,829,370 | 1 | 4,644,600 | 3 |
| Royalty rights | 874,400 | — | 874,400 | — |
|  | $180,151,538 | 100% | $182,105,291 | 100% |

### Investment Activity

During the nine months ended September 30, 2009, we made four new investments totaling $24.0 million and five investments in existing portfolio companies totaling approximately $4.0 million. We sold investments in two portfolio companies for total proceeds of approximately $1.9 million, received a full repayment from one portfolio company totaling approximately $2.0 million, received partial repayments of loans from five portfolio companies totaling approximately $4.4 million and received payment in kind (PIK) interest repayments totaling approximately $1.6 million. In addition, we received normal principal repayments totaling approximately $1.0 million in the nine months ended September 30, 2009.

During the nine months ended September 30, 2008, we made ten new investments totaling $72.5 million, one additional debt investment in an existing portfolio company of $1.0 million and three additional equity investments in existing portfolio companies of approximately $0.1 million. We also sold two investments in portfolio companies for approximately $0.3 million, resulting in realized gains totaling $0.1 million. We had two portfolio company loans repaid at par in the amount of $4.8 million. In addition, we received normal principal repayments, partial loan prepayments and PIK interest repayments totaling approximately $4.0 million in the nine months ended September 30, 2008.

Total portfolio investment activity for the nine months ended September 30, 2009 and 2008 was as follows:

|  | Nine Months Ended September 30, 2009 | Nine Months Ended September 30, 2008 |
| --- | ---: | ---: |
| Fair value of portfolio, beginning of period | $182,105,291 | $113,036,240 |
| New investments | 27,943,735 | 73,645,254 |
| Loan origination fees received | (540,000) | (1,351,996) |
| Proceeds from sales of investments | (1,888,384) | (275,361) |
| Principal repayments received | (7,400,722) | (8,785,117) |
| Paid-in-kind interest earned | 3,587,786 | 2,555,053 |
| Paid-in-kind interest received | (1,579,429) | (766,069) |
| Accretion of loan discounts | 306,075 | 95,132 |
| Accretion of deferred loan origination revenue | 443,135 | 278,515 |
| Realized gains on investments | 848,164 | 51,089 |
| Unrealized losses on investments | (15,434,615) | (718,784) |
| Fair value of portfolio, end of period | $188,391,036 | $177,763,956 |
| Weighted average yield on debt investments at end of period | 14.4% | 14.2% |
| Weighted average yield on total investments at end of period | 13.3% | 13.0% |

### Non-Accrual Assets

As of September 30, 2009, the fair value of our non-accrual assets comprised 3.7% of the total fair value of our portfolio, and the cost of our non-accrual assets comprised 8.5% of the total cost of our portfolio. Our non-accrual assets as of September 30, 2009 are as follows:

#### Gerli and Company

In the third quarter of 2008, we recognized an unrealized loss of $0.3 million on our subordinated note investment in Gerli and Company (“Gerli”), which has a cost as of September 30, 2009 of approximately $3.1 million. This unrealized loss reduced the fair value of our investment in Gerli to $2.8 million as of September 30, 2008. During the third quarter of 2008, we continued to receive interest payments in accordance with our loan agreement. In November 2008, we placed our investment in Gerli on non-accrual status. As a result, under generally accepted accounting principles (“GAAP”), we no longer recognize interest income on our investment in Gerli for financial reporting purposes. Additionally, in the fourth quarter of 2008, we recognized an additional unrealized loss on our investment in Gerli of $0.9 million and in the nine months ended September 30, 2009, we recognized an additional unrealized loss on our investment in Gerli of $0.4 million. As of September 30, 2009, the fair value of our investment in Gerli is $1.5 million.

#### Fire Sprinkler Systems, Inc.

In 2008, we recognized an unrealized loss of $1.4 million on our subordinated note investment in Fire Sprinkler Systems, Inc. (“Fire Sprinkler Systems”), which has a cost as of September 30, 2009 of approximately $2.4 million. This unrealized loss reduced the fair value of our investment in Fire Sprinkler Systems to $1.0 million as of December 31, 2008. Through the first nine months of 2008, we continued to receive interest and principal payments in accordance with our loan agreement. In October 2008, we placed our investment in Fire Sprinkler Systems on non-accrual status. As a result, under GAAP, we no longer recognize interest income on our investment in Fire Sprinkler Systems for financial reporting purposes. In the first nine months of 2009, we recognized an additional unrealized loss on our investment in Fire Sprinkler Systems of $0.2 million. As of September 30, 2009, the fair value of our investment in Fire Sprinkler Systems is $0.8 million.

#### American De-Rosa Lamparts, LLC and Hallmark Lighting

In 2008, we recognized an unrealized loss of $1.2 million on our subordinated note investment in American De-Rosa Lamparts, LLC and Hallmark Lighting (collectively “ADL”), which had a cost as of September 30, 2009 of approximately $8.2 million. This unrealized loss reduced the fair value of our investment in ADL to $6.9 million as of December 31, 2008. In the nine months ended September 30, 2009, we recognized an additional unrealized loss on our investment in ADL of $3.2 million. As of September 30, 2009, the fair value of our investment in ADL was approximately $3.9 million. Through August 31, 2009, we continued to receive interest payments from ADL in accordance with the loan agreement. In September 2009, we received notification from ADL’s senior lender that ADL was blocked from making interest payments to us for a period of six months. As a result, we placed our investment in ADL on non-accrual status and under GAAP, we no longer recognize interest income on our investment in ADL for financial reporting purposes.

#### FCL Graphics, Inc. 2nd Lien Note

In the first six months of 2009, we recognized an unrealized loss of $1.7 million on our 2nd Lien note investment in FCL Graphics, Inc. (“FCL”). During the first eight months of 2009, we received cash interest on our 2nd lien note in FCL at the stated contractual rate (20% per annum as of September 30, 2009). In September 2009, FCL did not make the scheduled interest payments on its 2nd Lien notes. As a result, we have placed our 2nd Lien note in FCL on non-accrual status and therefore, under GAAP, we no longer recognize interest income on our 2nd Lien note investment in FCL for financial reporting purposes. We are currently in negotiations with FCL and FCL’s other lenders to amend the terms of our note. The terms of the proposed amendment provide for cash interest at a rate of LIBOR plus 250 basis points per annum and PIK interest at a rate of 8% per annum. In the third quarter of 2009, we recognized an additional unrealized loss on our 2nd Lien note investment in FCL of approximately $0.9 million, which has a cost as of September 30, 2009 of approximately $3.4 million. The fair value of our 2nd Lien note investment in FCL as of September 30, 2009 is approximately $0.8 million.

### Results of Operations

### Comparison of three months ended September 30, 2009 and September 30, 2008

#### Investment Income

For the three months ended September 30, 2009, total investment income was $7.1 million, a 21% increase from $5.9 million of total investment income for the three months ended September 30, 2008. This increase was primarily attributable to a $1.1 million increase in total loan interest (including PIK interest), fee and dividend income due to net increase in our portfolio investments from September 30, 2008 to September 30, 2009. We recognized non-recurring fee income of $0.2 million for the three months ended September 30, 2009 as compared to $0.1 million for the three months ended September 30, 2008.

#### Expenses

For the three months ended September 30, 2009, expenses increased by 27% to $3.4 million from $2.7 million for the three months ended September 30, 2008. The increase in expenses was primarily attributable to a $0.6 million increase in interest expense due to higher average balances of SBA-guaranteed debentures outstanding during the three months ended September 30, 2009 than in the comparable period in 2008.

#### Net Investment Income

As a result of the $1.2 million increase in total investment income and the $0.7 million increase in expenses, net investment income for the three months ended September 30, 2009 was $3.7 million compared to net investment income of $3.2 million during the three months ended September 30, 2008.

#### Net Decrease in Net Assets Resulting From Operations

We recognized no realized gains or losses on investments in the three months ended September 30, 2009. During the three months ended September 30, 2008, we recognized a realized gain on the sale of one investment totaling $0.1 million.

During the three months ended September 30, 2009, we recorded net unrealized depreciation of investments in the amount of $4.5 million, comprised of unrealized depreciation on seventeen investments totaling $5.5 million and unrealized appreciation on nine investments totaling $1.0 million. In the three months ended September 30, 2008, we recorded net unrealized depreciation of investments in the amount of $0.7 million, comprised of unrealized appreciation on ten investments totaling $1.8 million and unrealized depreciation on ten investments totaling $2.5 million.

As a result of these events, our net decrease in net assets resulting from operations during the three months ended September 30, 2009 was $0.8 million as compared to a net increase in net assets resulting from operations of $2.5 million for the three months ended September 30, 2008.

### Comparison of nine months ended September 30, 2009 and September 30, 2008

#### Investment Income

For the nine months ended September 30, 2009, total investment income was $20.2 million, a 37% increase from $14.8 million of total investment income for the nine months ended September 30, 2008. This increase was attributable to a $5.3 million increase in total loan interest (including PIK interest), fee and dividend income due to net increase in our portfolio investments from September 30, 2008 to September 30, 2009. We recognized non-recurring fee income of $0.5 million for the nine months ended September 30, 2009 as compared to $0.4 million for the nine months ended September 30, 2008.

#### Expenses

For the nine months ended September 30, 2009, expenses increased by 44% to $10.2 million from $7.1 million for the nine months ended September 30, 2008. The increase in expenses was primarily attributable to a $2.6 million increase in interest expense and a $0.4 million increase in general and administrative expenses. The increase in interest expense is related to higher average balances of SBA-guaranteed debentures outstanding during the nine months ended September 30, 2009 than in the comparable period in 2008. In addition, we experienced an increase in general and administrative costs in 2009, primarily related to compensation costs (including stock-based compensation) and facility costs.

#### Net Investment Income

As a result of the $5.4 million increase in total investment income and the $3.1 million increase in expenses, net investment income for the nine months ended September 30, 2009 was $10.0 million compared to net investment income of $7.7 million during the nine months ended September 30, 2008.

#### Net Decrease in Net Assets Resulting From Operations

In the nine months ended September 30, 2009, we recorded net realized gains of $0.8 million, consisting primarily of i) a realized gain on the sale of one investment of $1.8 million and ii) a loss on the recapitalization of another investment of $0.9 million. During the nine months ended September 30, 2008, we recognized a realized gain on the sale of one investment totaling $0.1 million.

In the nine months ended September 30, 2009, we recorded net unrealized depreciation of investments in the amount of $15.0 million, comprised of net unrealized depreciation reclassification adjustments totaling $0.6 million related to i) the sale of one investment and ii) the recapitalization of another investment noted above, as well as unrealized depreciation on seventeen investments totaling $17.8 million and unrealized appreciation on eleven investments totaling $3.3 million. In the nine months ended September 30, 2008, we recorded net unrealized depreciation of investments in the amount of $1.4 million, comprised of unrealized appreciation on ten investments totaling $4.0 million and unrealized depreciation on thirteen investments totaling $5.4 million.

As a result of these events, our net decrease in net assets resulting from operations during the nine months ended September 30, 2009 was $4.2 million as compared to a net increase in net assets resulting from operations of $6.1 million for the nine months ended September 30, 2008.

### Liquidity and Capital Resources

We believe that our current cash and cash equivalents on hand, our available SBA leverage and our anticipated cash flows from operations will be adequate to meet our cash needs for our daily operations for at least the next twelve months.

In the future, depending on the valuation of the Fund’s assets pursuant to SBA guidelines, the Fund may be limited by provisions of the Small Business Investment Act of 1958, and SBA regulations governing SBICs, in making certain distributions to Triangle Capital Corporation that may be necessary to enable Triangle Capital Corporation to make the minimum required distributions to its stockholders and continue to qualify as a RIC.

#### Cash Flows

For the nine months ended September 30, 2009, we experienced a net increase in cash and cash equivalents in the amount of $6.2 million. During that period, our operating activities used $11.3 million in cash, consisting primarily of purchases of investments totaling $27.9 million, offset by i) net investment income and ii) sales/repayments of portfolio investments of $9.3 million. In the nine months ended September 30, 2009, financing activities provided $17.6 million of cash, consisting of proceeds from our public stock offerings of $27.1 million, net of cash dividends and distributions to stockholders totaling $9.3 million. At September 30, 2009, we had $33.4 million of cash and cash equivalents on hand.

For the nine months ended September 30, 2008, we experienced a net decrease in cash and cash equivalents in the amount of $5.9 million. During that period, our operating activities used $58.2 million in cash, consisting primarily of new portfolio investments of $73.6 million, offset by repayments of loans received and proceeds from sales of investments of $9.1 million. We generated $52.3 million of cash from financing activities, consisting of proceeds from borrowings under SBA guaranteed debentures payable of $56.1 million and short-term borrowings of $5.1 million, partially offset by financing fees paid to the SBA of $2.3 million and cash dividends paid of $6.6 million. At September 30, 2008, we had $15.9 million of cash and cash equivalents on hand.

#### Financing Transactions

Due to the Fund’s status as a licensed SBIC, the Fund has the ability to issue debentures guaranteed by the SBA at favorable interest rates. Under the Small Business Investment Act and the SBA rules applicable to SBICs, an SBIC (or group of SBICs under common control) can have outstanding at any time debentures guaranteed by the SBA in an amount up to three times the amount of its regulatory capital, which generally is the amount raised from private investors. The maximum statutory limit on the dollar amount of outstanding debentures guaranteed by the SBA issued by a single SBIC is currently $150.0 million. Debentures guaranteed by the SBA have a maturity of ten years, with interest payable semi-annually. The principal amount of the debentures is not required to be paid before maturity but may be pre-paid at any time. Debentures issued prior to September 2006 were subject to pre-payment penalties during their first five years. Those pre-payment penalties no longer apply to debentures issued after September 1, 2006.

In June 2009, the Fund received a new leverage commitment from the SBA which increased the Fund’s ability to issue SBA guaranteed debentures up to the maximum statutory limit of $150.0 million. As of September 30, 2009, the Fund has $115.1 million of SBA guaranteed debentures outstanding. In addition to the one—time 1.0% fee on the total commitment from the SBA, the Company also pays a one—time 2.425% fee on the amount of each debenture issued. These fees are capitalized as deferred financing costs and are amortized over the term of the debt agreements using the effective interest method. The weighted average interest rate for all SBA guaranteed debentures as of September 30, 2009 was 6.03%.

#### Distributions to Stockholders

We have elected to be treated as a RIC under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”) and intend to make the required distributions to our stockholders as specified therein. In order to qualify as a RIC, we must meet certain minimum distribution, source-of-income and asset diversification requirements. If such requirements are met, then we are generally required to pay income taxes only on the portion of our taxable income and gains we do not distribute (actually or constructively) and certain built-in gains. We met our minimum distribution requirements for 2008 and 2007 and continually monitor our distribution requirements for 2009 with the goal of ensuring compliance with the Code.

The minimum distribution requirements applicable to RICs require us to distribute to our stockholders at least 90% of our investment company taxable income (“ICTI”), as defined by the Code, each year. Depending on the level of ICTI earned in a tax year, we may choose to carry forward ICTI in excess of current year distributions into the next tax year and pay a 4% excise tax on such excess. Any such carryover ICTI must be distributed before the end that next tax year through a dividend declared prior to filing the final tax return related to the year which generated such ICTI.

ICTI generally differs from net investment income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses. We may be required to recognize ICTI in certain circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount (such as debt instruments issued with warrants), we must include in ICTI each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. We may also have to include in ICTI other amounts that we have not yet received in cash, such as 1) PIK interest income and 2) interest income from investments that have been classified as non-accrual for financial reporting purposes. Interest income on non-accrual investments is not recognized for financial reporting purposes, but generally is recognized in ICTI. Because any original issue discount or other amounts accrued will be included in our ICTI for the year of accrual, we may be required to make a distribution to our stockholders in order to satisfy the minimum distribution requirements, even though we will not have received and may not ever receive any corresponding cash amount. ICTI also excludes net unrealized appreciation or depreciation, as investment gains or losses are not included in taxable income until they are realized.

#### Current Market Conditions

During 2008 and 2009, the debt and equity capital markets in the United States have been severely impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broadly syndicated bank loan market, among other things. These events, along with the deterioration of the housing market, have led to an economic recession in the U.S and abroad, which could be long-term. Banks, investment companies and others in the financial services industry have continued to report significant write-downs in the fair value of their assets, which has led to the failure of a number of banks and investment companies, a number of distressed mergers and acquisitions, the government take-over of the nation’s two largest government-sponsored mortgage companies, and the passage of the $700 billion Emergency Economic Stabilization of 2008 in October 2008 and the American Recovery and Reinvestment Act of 2009 in February 2009. These events have significantly impacted the financial and credit markets and have reduced the availability of debt and equity capital for the market as a whole, and for financial firms in particular. While we have capacity to issue additional SBA guaranteed debentures as discussed above, we may not be able to access additional equity capital, which could result in the slowing of our origination activity during 2010 and beyond.

In the event that the United States economy remains in a recession, it is possible that the results of some of the middle market companies in which we invest could experience further deterioration, which could ultimately lead to difficulty in meeting debt service requirements and an increase in defaults. There can be no assurance that the performance of certain of our portfolio companies will not be negatively impacted by challenging economic conditions which could have a negative impact on our future results.

### Recent Developments

On April 23, 2009, we filed a prospectus supplement pursuant to which 1,200,000 shares of common stock were offered for sale at a price to the public of $10.75 per share. Pursuant to this offering, all shares were sold and delivered on April 27, 2009 resulting in net proceeds to us, after underwriting discounts and offering expenses, of approximately $11,700,000. On May 27, 2009, pursuant to the exercise of an overallotment option granted in connection with the offering, the underwriters involved purchased an additional 80,000 shares of our common stock at the same public offering price, less underwriting discounts and commissions, resulting in net proceeds to us of approximately $800,000.

On August 7, 2009, we filed a prospectus supplement pursuant to which 1,300,000 shares of common stock were offered for sale at a price to the public of $10.42 per share. In addition, the underwriters involved were granted an overallotment option to purchase an additional 195,000 shares of our common stock at the same public offering price. Pursuant to this offering, all shares (including the overallotment option shares) were sold and delivered on August 12, 2009 resulting in net proceeds to us, after underwriting discounts and offering expenses, of approximately $14,600,000.

### Critical Accounting Policies and Use of Estimates

The preparation of our financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods covered by such financial statements. We have identified investment valuation and revenue recognition as our most critical accounting estimates. On an on-going basis, we evaluate our estimates, including those related to the matters described below. These estimates are based on the information that is currently available to us and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows.

### Investment Valuation

The most significant estimate inherent in the preparation of our financial statements is the valuation of investments and the related amounts of unrealized appreciation and depreciation of investments recorded. We have established and documented processes and methodologies for determining the fair values of portfolio company investments on a recurring (quarterly) basis. As discussed below, we have engaged an independent valuation firm to assist us in our valuation process.

On January 1, 2008, we adopted FASB ASC Topic 820, *Fair Value Measurements and Disclosures* (formerly Statement of Financial Accounting Standards No. 157, *Fair Value Measurements*), which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements.

ASC Topic 820 clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. ASC Topic 820 provides a consistent definition of fair value which focuses on exit price and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs. In addition, ASC Topic 820 provides a framework for measuring fair value and establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels of valuation hierarchy established by ASC Topic 820 are defined as follows:

*Level 1 —* inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

*Level 2 —* inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

*Level 3 —* inputs to the valuation methodology are unobservable and significant to the fair value measurement.

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A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Our investment portfolio is comprised of debt and equity of privately held companies for which quoted prices falling within the categories of Level 1 and Level 2 inputs are not available. Therefore, we value all of our investments at fair value, as determined in good faith by our Board of Directors, using Level 3 inputs, as further described below. Due to the inherent uncertainty in the valuation process, our Board of Directors’ estimate of fair value may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

Debt and equity securities that are not publicly traded and for which a limited market does not exist are valued at fair value as determined in good faith by our Board of Directors. There is no single standard for determining fair value in good faith, as fair value depends upon circumstances of each individual case. In general, fair value is the amount that we might reasonably expect to receive upon the current sale of the security.

We evaluate the investments in portfolio companies using the most recently available portfolio company financial statements and forecasts. We also consult with the portfolio company’s senior management to obtain further updates on the portfolio company’s performance, including information such as industry trends, new product development and other operational issues. Additionally, we consider some or all of the following factors:

- financial standing of the issuer of the security;
- comparison of the business and financial plan of the issuer with actual results;
- the size of the security held as it relates to the liquidity of the market for such security;
- pending public offering of common stock by the issuer of the security;
- pending reorganization activity affecting the issuer, such as merger or debt restructuring;
- ability of the issuer to obtain needed financing;
- changes in the economy affecting the issuer;
- financial statements and reports from portfolio company senior management and ownership;
- the type of security, the security’s cost at the date of purchase and any contractual restrictions on the disposition of the security;
- discount from market value of unrestricted securities of the same class at the time of purchase;
- special reports prepared by analysts;
- information as to any transactions or offers with respect to the security and/or sales to third parties of similar securities;
- the issuer’s ability to make payments and the type of collateral;
- the current and forecasted earnings of the issuer;
- statistical ratios compared to lending standards and to other similar securities; and
- other pertinent factors.

In making the good faith determination of the value of debt securities, we start with the cost basis of the security, which includes the amortized original issue discount, and paid—in—kind (PIK) interest, if any. We also use a risk rating system to estimate the probability of default on the debt securities and the probability of loss if there is a default. The risk rating system covers both qualitative and quantitative aspects of the business and the securities held. In valuing debt securities, we utilize an “income approach” model that considers factors including, but not limited to, (i) the portfolio investment’s current risk rating (discussed below), (ii) the portfolio company’s current trailing twelve months’ (“TTM”) results of operations as compared to the portfolio company’s TTM results of operations as of the date the investment was made and the portfolio company’s outlook for the next twelve months of operations, (iii) the portfolio company’s current leverage as compared to its leverage as of the date the investment was made, and (iv) current pricing and credit metrics for similar proposed and executed investment transactions. In valuing equity securities of private companies, we consider valuation methodologies consistent with industry practice, including (i) valuation using a valuation model based on original transaction multiples and the portfolio company’s recent financial performance, (ii) valuation of the securities based on recent sales in comparable transactions, and (iii) a review of similar companies that are publicly traded and the market multiple of their equity securities.

Unrealized appreciation or depreciation on portfolio investments are recorded as increases or decreases in investments on the balance sheets and are separately reflected on the statements of operations in determining net increase or decrease in net assets resulting from operations.

Duff & Phelps, LLC (“Duff & Phelps”), an independent valuation firm, provides third party valuation consulting services to us, which consist of certain limited procedures that we identified and requested Duff & Phelps to perform (hereinafter referred to as the “procedures”). We generally request Duff & Phelps to perform the procedures on each portfolio company at least once in every calendar year and for new portfolio companies, at least once in the twelve-month period subsequent to the initial investment. In certain instances, we may determine that it is not cost-effective, and as a result is not in our stockholders’ best interest, to request Duff

& Phelps to perform the procedures on one or more portfolio companies. Such instances include, but are not limited to, situations where the fair value of our investment in the portfolio company is determined to be insignificant relative to our total investment portfolio.

For the quarter ended March 31, 2009, we asked Duff & Phelps to perform the procedures on investments in seven portfolio companies comprising approximately 26% of the total investments at fair value (exclusive of the fair value of new investments made during the quarter) as of March 31, 2009. For the quarter ended June 30, 2009, we asked Duff & Phelps to perform the procedures on investments in six portfolio companies comprising approximately 20% of the total investments at fair value (exclusive of the fair value of new investments made during the quarter) as of June 30, 2009. For the quarter ended September 30, 2009, we asked Duff & Phelps to perform the procedures on investments in seven portfolio companies comprising approximately 24% of the total investments at fair value (exclusive of the fair value of new investments made during the quarter) as of September 30, 2009. Upon completion of the procedures, Duff & Phelps concluded that the fair value, as determined by the Board of Directors, of those investments subjected to the procedures did not appear to be unreasonable. Our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith.

### Revenue Recognition

#### Interest and Dividend Income

Interest income, adjusted for amortization of premium and accretion of original issue discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. Generally, when interest and/or principal payments on a loan become past due, or if we otherwise do not expect the borrower to be able to service its debt and other obligations, we will place the loan on non-accrual status and will generally cease recognizing interest income on that loan for financial reporting purposes until all principal and interest have been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. We write off any previously accrued and uncollected interest when it is determined that interest is no longer considered collectible. Dividend income is recorded on the ex-dividend date.

#### Fee Income

Loan origination, facility, commitment, consent and other advance fees received by us on loan agreements or other investments are recorded as deferred income and recognized as income over the term of the loan.

#### Paid-in-Kind Interest (PIK)

We currently hold, and we expect to hold in the future, some loans in our portfolio that contain a PIK interest provision. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan, rather than being paid to us in cash, and is recorded as interest income. Thus, the actual collection of PIK interest may be deferred until the time of debt principal repayment.

To maintain our status as a RIC, this non-cash source of income must be paid out to stockholders in the form of dividends, even though we have not yet collected the cash. Generally, when current cash interest and/or principal payments on a loan become past due, or if we otherwise do not expect the borrower to be able to service its debt and other obligations, we will place the loan on non-accrual status and will generally cease recognizing PIK interest income on that loan for financial reporting purposes until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. We write off any previously accrued and uncollected PIK interest when it is determined that the PIK interest is no longer collectible.

### New Accounting Standards

In May 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 165, *Subsequent Events*, which was later codified as FASB ASC Topic 855, *Subsequent Events (“*ASC Topic 855”). ASC Topic 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. ASC Topic 855 includes a new required disclosure of the date through which an entity has evaluated subsequent events and is effective for interim periods or fiscal years ending after June 15, 2009. Our adoption of ASC Topic 855 did not have a material effect on our financial position or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 168, *The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162 (“*SFAS 168”). The Codification will become the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of SFAS 168, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification will become non-authoritative. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of SFAS 168 only impacted our disclosures by requiring Codification references.

### Off-Balance Sheet Arrangements

We currently have no off-balance sheet arrangements.

## Market risk

As filed, 4,266 characters.

Beginning in late 2007, the United States entered a recession, which many believe could be prolonged. As the economy continued to deteriorate in 2008, spending by both consumers and businesses declined significantly, which has impacted the broader financial and credit markets and has reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. This reduction in spending has had an adverse effect on a number of the industries in which some of our portfolio companies operate, and on certain of our portfolio companies as well.

During 2009, we experienced write-downs in our portfolio, several of which were due to decline in the performance of those portfolio companies. As of September 30, 2009, the fair value of our non-accrual assets was approximately $7.0 million, which comprised approximately 3.7% of the total fair value of our portfolio, and the cost of our non-accrual assets was approximately $17.1 million, or 8.5% of the total cost of our portfolio. In addition to these non-accrual assets, as of September 30, 2009, we had, on a fair value basis, approximately $21.0 million of debt investments, or 11.1% of the total fair value of our portfolio, which were current with respect to scheduled principal and interest payments, but which were carried at less than cost. The cost of these assets as of September 30, 2009 was approximately $25.1 million, or 12.4% of the total cost of our portfolio.

In the event that the current recession continues for a significant time or the economy deteriorates further, the financial position and results of operations of certain of the middle-market companies in our portfolio could be further affected adversely, which ultimately could lead to difficulty in our portfolio companies meeting debt service requirements and an increase in defaults. There can be no assurance that the performance of our portfolio companies will not be further impacted by economic conditions, which could have a negative impact on our future results.

In addition, we are subject to interest rate risk. Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest earning assets and our interest expense incurred in connection with our interest bearing debt and liabilities. Changes in interest rates can also affect, among other things, our ability to acquire and originate loans and securities and the value of our investment portfolio. Our investment income is affected by fluctuations in various interest rates, including LIBOR and prime rates. We regularly measure exposure to interest rate risk and determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. As of September 30, 2009, we were not a party to any hedging arrangements.

As of September 30, 2009, approximately 87.8%, or $161.8 million of our debt portfolio investments bore interest at fixed rates and approximately 12.2%, or $22.4 million of our debt portfolio investments bore interest at variable rates. A 200 basis point decrease in the interest rates on our variable-rate debt investments would decrease our investment income by approximately $0.4 million on an annual basis. All of our pooled SBA-guaranteed debentures bear interest at fixed rates.

Because we currently borrow, and plan to borrow in the future, money to make investments, our net investment income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest the funds borrowed. Accordingly, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds would increase, which could reduce our net investment income if there is not a corresponding increase in interest income generated by our investment portfolio.

## Controls and procedures

As filed, 1,812 characters.

### Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

### Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during the third quarter of 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

## Risk factors

As filed, 2,256 characters.

The following risk factors should be considered in addition to the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2008.

***Recent developments may increase the risks associated with our business and an investment in us.***

The U.S. economy and financial markets have been experiencing a high level of volatility, disruption and stress, which was exacerbated by the failure of several major financial institutions in the last few months of 2008. In addition, the U.S. economy has entered a recession, which is likely to be severe and prolonged. Similar conditions have occurred in the financial markets and economies of numerous other countries and could worsen, both in the U.S. and globally. These conditions have raised the level of many of the risks described in the accompanying prospectus and could have an adverse effect on our portfolio companies and on their results of operations, financial conditions, access to credit and capital. The stress in the credit market and upon banks has led other creditors to tighten credit and the terms of credit. In certain cases, senior lenders to our customers can block payments by our customers in respect of our loans to such customers. In turn, these could have adverse effects on our business, financial condition, results of operations, dividend payments, access to capital, valuation of our assets and our stock price.

### We are dependent upon our key investment personnel for our future success.

We depend on the members of our senior management team, particularly executive officers Garland S. Tucker, III, Brent P.W. Burgess and Steven C. Lilly, for the identification, final selection, structuring, closing and monitoring of our investments. These executive officers have critical industry experience and relationships that we rely on to implement our business plan. If we lose the services of these individuals, we may not be able to operate our business as we expect, and our ability to compete could be harmed, which could cause our operating results to suffer. Effective February 21, 2009, Messrs. Tucker, Burgess and Lilly are no longer employed by us pursuant to an employment agreement. Rather, each is currently employed by us on an at-will basis.

Filed Nov 4, 2009.
Source: SEC EDGAR, the filing index for accession 0000950123-09-057579. Last ingested by Listed: Nov 9, 2026, 19:13 ET. No prices; not investment advice.