3. EARNINGS PER SHARE

 

The following information sets forth the computation of basic and diluted net increase in stockholders’ equity per share for the three and six months ended June 30, 2010 and 2009:

		Three Months Ended June 30,								Six Months Ended June 30,
		2010				2009				2010				2009
Net increase (decrease) in net assets from operations		$	(5,690,917	)		$	12,982,360			$	(4,096,006	)		$	21,877,858
Net increase (decrease) in net assets allocated to non-vested share awards			—				197,008				—				333,196
Distributable earnings available to common stockholders			(5,690,917	)			12,785,351				(4,096,006	)			21,544,663
Weighted average number of common shares outstanding for basic EPS computation			22,526,498				22,026,253				22,486,201				21,947,953
Effect of dilutive securities - stock options			—				—				—				—
Weighted average number of common and common stock equivalent shares outstanding for diluted EPS computation			22,526,498				22,026,253				22,486,201				21,947,953
Basic and diluted earnings per common shares:
Net income (loss) from operations			(0.25	)			0.58				(0.18	)			0.98
Net income (loss) from operations allocated to non-vested share awards			—				0.01				—				0.02

 

 

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Effective January 1, 2008, the accounting for unvested share-based payment awards included in the calculation of earnings per share changed. Share-based awards that contain nonforfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are now participating securities and included in the computation of both basic and diluted earnings per share. Our grants of restricted stock awards to our employees and directors are considered participating securities and we have prepared our earnings per share calculations to include outstanding unvested restricted stock awards in the basic weighted average shares outstanding calculation. The unvested restricted shares were excluded from the calculation of diluted EPS for the year ended December 31, 2008 because their inclusion would have been anti-dilutive.

 

Options to purchase 40,000 and 20,000 shares were not included in the computation of diluted earnings per share for the periods ended June 30, 2010 and 2009, respectively, because the effect would be antidilutive as the exercise prices exceeded the average market price of the common shares.

 

4. INVESTMENTS

 

The Company invests in senior secured loans and mezzanine debt and, to a lesser extent, equity capital of middle market companies in a variety of industries. The Company generally targets companies that generate positive cash flows because the Company looks to cash flows as the primary source for servicing debt. However, the Company may invest in industries in which it currently has little or no investment if it is presented with attractive opportunities.

 

The following table shows the Company’s portfolio by security type at June 30, 2010 and December 31, 2009:

		June 30, 2010												December 31, 2009
Security Type		Cost				Fair Value					%¹			Cost				Fair Value					%¹
Time Deposits		$	12,491,457			$	12,491,457				6	%		$	126			$	126				-	%
Money Market Account			216,179				216,179				-				-				-				-
Senior Secured Loan			139,191,719				123,337,607				60				179,425,767				159,075,586				74
Junior Secured Loan			112,435,054				98,982,230				48				129,016,237				114,920,499				54
Mezzanine Investment			10,744,497				548,971				-				28,606,852				19,235,444				9
Senior Subordinated Bond			4,240,890				3,598,535				2				3,007,167				2,415,000				1
Senior Unsecured Bond			-				-				-				2,000,000				1,710,000				1
Preferred Stock			400,000				382,800				-				-				-				-
CLO Fund Securities			68,237,622				52,151,000				25				68,195,049				48,971,000				23
Equity Securities			14,216,146				6,554,693				3				12,365,603				4,713,246				2
Affiliate Asset Managers			43,321,870				53,703,377				26				40,751,511				58,064,720				27
Total		$	405,495,434			$	351,966,849				170	%		$	463,368,312			$	409,105,621				191	%

 

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¹     Calculated as a percentage of net asset value.

 

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The unaudited industry concentrations, based on the fair value of the Company’s investment portfolio as of June 30, 2010 and December 31, 2009, were as follows:

		June 30, 2010												December 31, 2009
Industry Classification		Cost				Fair Value					%1			Cost				Fair Value					%1
Aerospace and Defense		$	20,259,434			$	19,505,857				10	%		$	33,652,058			$	33,416,670				16	%
Asset Management Companies2			43,321,870				53,703,377				26				40,751,511				58,064,720				27
Automobile			1,926,102				1,827,222				1				1,940,876				1,800,631				1
Broadcasting and Entertainment			2,987,991				2,943,000				1				2,986,206				2,862,000				1
Buildings and Real Estate3			33,377,558				8,109,665				4				36,498,537				9,840,946				5
Cargo Transport			6,619,233				6,612,824				3				13,389,865				13,359,403				6
Chemicals, Plastics and Rubber			3,974,181				4,000,000				2				3,970,688				4,000,000				2
CLO Fund Securities			68,237,622				52,151,000				25				68,195,049				48,971,000				23
Containers, Packaging and Glass			7,047,400				6,948,239				3				7,056,701				6,852,738				3
Diversified/Conglomerate Manufacturing			3,622,930				3,619,655				2				4,046,728				4,042,346				2
Diversified/Conglomerate Service			15,345,054				13,863,379				7				15,382,035				14,350,438				7
Ecological			2,682,037				2,685,954				1				2,695,103				2,699,907				1
Electronics			6,126,322				5,478,991				3				14,874,472				14,407,265				7
Farming and Agriculture			-				-				-				1,441,277				217,001				-
Finance			4,052,849				3,966,222				2				5,460,445				5,372,881				3
Healthcare, Education and Childcare			35,159,852				35,851,933				17				41,647,084				42,177,498				20
Home and Office Furnishings, Housewares, and Durable Consumer Goods			17,966,790				17,382,586				8				20,694,006				18,080,134				8
Hotels, Motels, Inns and Gaming			3,277,822				3,022,707				2				3,438,128				3,171,363				1
Insurance			4,875,603				3,735,000				2				4,861,123				4,490,000				2
Leisure, Amusement, Motion Pictures, Entertainment			13,202,713				13,041,982				6				14,572,761				14,227,907				7
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)			17,920,833				16,656,914				8				33,015,472				31,956,312				15
Mining, Steel, Iron and Non-Precious Metals			14,324,670				14,454,614				7				13,861,498				13,021,854				6
Oil and Gas			5,998,844				6,000,000				3				5,998,652				6,000,000				3
Personal and Non Durable Consumer Products (Mfg. Only)			12,611,089				8,627,643				4				14,424,931				9,146,146				4
Personal, Food and Miscellaneous Services			14,728,267				4,280,971				2				14,759,522				4,559,444				2
Printing and Publishing			13,444,041				12,880,565				6				23,867,184				23,506,057				11
Retail Stores			3,363,854				3,266,302				2				3,543,046				3,521,787				2
Time Deposits and Money Market Account			12,707,637				12,707,636				6				126				126				-
Utilities			16,332,836				14,642,611				7				16,343,228				14,989,047				6
Total		$	405,495,434			$	351,966,849				170	%		$	463,368,312			$	409,105,621				191	%

   

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1	Calculated as a percentage of net asset value.

2	Represents Katonah Debt Advisors and related asset manager affiliates.

3

Buildings and real estate relate to real estate ownership, builders, managers and developers and excludes mortgage debt investments and mortgage lenders or originators. As of June 30, 2010 and December 31, 2009, the Company had no exposure to mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset backed securities) or companies providing mortgage lending.

 

 

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The Company may invest up to 30% of the investment portfolio in opportunistic investments in high-yield bonds, debt and equity securities of CLO Funds, distressed debt or equity securities of public companies. However, the Company’s investment strategy is to limit the value of its investments in debt or equity securities issued by CLO Funds to not more than 15% of the value of its total investment portfolio at the time of investment. The Company expects that these public companies generally will have debt that is non-investment grade. The Company also may invest in debt of middle market companies located outside of the United States, which investments (excluding the Company’s investments in CLO Funds) are generally not anticipated to be in excess of 10% of the investment portfolio at the time such investments are made. The Company is generally prohibited from buying or selling any security from or to any portfolio company of a private equity fund managed by Kohlberg & Co. without the prior approval of the SEC. In addition, the Company may co-invest on a concurrent basis with Kohlberg & Co. or any of its affiliates, subject to compliance with existing regulatory guidance, applicable regulations and its allocation procedures. Certain types of negotiated co-investments may be made only if the Company receives an order from the SEC permitting it to do so. There can be no assurance that any such order will be applied for or, if applied for, obtained.

 

At June 30, 2010 and December 31, 2009, approximately 19% and 12% of the Company’s investments were foreign assets (including the Company’s investments in CLO Funds, which are typically domiciled outside the U.S. and represented approximately 15% and 12% of its portfolio on such dates), respectively.

 

At June 30, 2010 and December 31, 2009, the Company’s ten largest portfolio companies represented approximately 41% and 37%, respectively, of the total fair value of its investments. The Company’s largest investment, Katonah Debt Advisors which is its wholly-owned portfolio company, represented 15% and 14% of the total fair value of the Company’s investments at June 30, 2010 and December 31, 2009, respectively. Excluding Katonah Debt Advisors and CLO Fund securities, the Company’s ten largest portfolio companies represented approximately 18% and 19% of the total fair value of the Company’s investments at June 30, 2010 and December 31, 2009, respectively.

Investment in CLO Fund Securities

 

The Company typically makes a minority investment in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and may selectively invest in securities issued by funds managed by other asset management companies. However, as noted above, the Company’s investment strategy is to limit the value of its investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of its total investment portfolio at the time of investment. Preferred shares or subordinated securities issued by CLO Funds are entitled to recurring dividend distributions which generally equal the net remaining cash flow of the payments made by the underlying CLO Fund’s securities less contractual payments to senior bond holders and CLO Fund expenses. CLO Funds managed by Katonah Debt Advisors (“CLO fund securities managed by affiliate”) invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The underlying assets in each of the CLO Funds in which the Company has an investment are generally diversified secured or unsecured corporate debt and exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders, fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares.

 

On January 23, 2008, the Company’s wholly-owned asset management company, Katonah Debt Advisors, closed a $315 million CLO Fund. The Company received a structuring fee upon closing and Katonah Debt Advisors earns an ongoing asset management fee based on the par amount of the underlying investments in the CLO Fund. Securities issued by CLO Funds managed by Katonah Debt Advisors are primarily held by third parties. Kohlberg Capital invested approximately $29 million to acquire all of the shares of the most junior class of securities of this latest CLO Fund.

 

The subordinated securities and preferred share securities are considered equity positions in the CLO Funds and, as of June 30, 2010 and December 31, 2009, the Company had approximately $46 million and $45 million, respectively, of such CLO equity investments at fair value. The cost basis of the Company’s investment in CLO Fund equity securities as of June 30, 2010 was approximately $67 million and aggregate unrealized depreciation on the CLO Fund securities totaled approximately $21 million. The cost basis of the Company’s investment in CLO Fund equity securities as of December 31, 2009, was approximately $67 million and aggregate unrealized depreciation on the CLO Fund securities totaled approximately $23 million.

 

In May, 2009 the Company purchased the class B-2L notes of the Katonah 2007-1 CLO investment managed by Katonah Debt Advisors (“Katonah 2007-1 B-2L”).  The Company purchased the Katonah 2007-1 B-2L for 10% of the par value.  The fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment as of June 30, 2010 were approximately $6 million, $1 million, and $5 million, respectively, and at December 31, 2009, the fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment were $4 million, $1 million, and $3 million, respectively. Both the B-2L notes and preferred shares of Katonah 2007-1 are owned 100% by the Company and are making their required quarterly distributions.

 

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Fair Value Measurements

 

The Company follows the provisions of Fair Value Measurements and Disclosures, which among other matters, requires enhanced disclosures about investments that are measured and reported at fair value. This standard defines fair value and establishes a hierarchal disclosure framework which prioritizes and ranks the level of market price observability used in measuring investments at fair value and expands disclosures about assets and liabilities measured at fair value. Fair Value Measurements and Disclosures defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This fair value definition focuses on an exit price in the principal, or most advantageous market, and prioritizes, within a measurement of fair value, the use of market-based inputs (which may be weighted or adjusted for relevance, reliability and specific attributes relative to the subject investment) over entity-specific inputs. Market price observability is affected by a number of factors, including the type of investment and the characteristics specific to the investment. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. Subsequent to the adoption of Fair Value Measurements and Disclosures, the FASB has issued various staff positions clarifying the initial standard (see Note 2. “Significant Accounting Policies—Investments”).

 

Fair Value Measurements and Disclosures establishes the following three-level hierarchy, based upon the transparency of inputs to the fair value measurement of an asset or liability as of the measurement date:

 

Level I – Unadjusted quoted prices are available in active markets for identical investments as of the reporting date. The type of investments included in Level I include listed equities and listed securities. As required by Fair Value Measurements and Disclosures, the Company does not adjust the quoted price for these investments, even in situations where the Company holds a large position and a sale could reasonably affect the quoted price.

 

Level II – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. Such inputs may be quoted prices for similar assets or liabilities, quoted markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full character of the financial instrument, or inputs that are derived principally from, or corroborated by, observable market information. Investments which are generally included in this category include illiquid corporate loans and bonds and less liquid, privately held or restricted equity securities for which some level of recent trading activity has been observed.

 

Level III – Pricing inputs are unobservable for the investment and includes situations where there is little, if any, market activity for the investment. The inputs may be based on the Company’s own assumptions about how market participants would price the asset or liability or may use Level II inputs, as adjusted, to reflect specific investment attributes relative to a broader market assumption. These inputs into the determination of fair value may require significant management judgment or estimation. Even if observable market data for comparable performance or valuation measures (earnings multiples, discount rates, other financial/valuation ratios, etc.) are available, such investments are grouped as Level III if any significant data point that is not also market observable (private company earnings, cash flows, etc.) is used in the valuation methodology.

 

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and the Company considers factors specific to the investment. Substantially all of the Company’s investments are classified as Level III. The Company evaluates the source of inputs, including any markets in which its investments are trading, in determining fair value. Inputs that are backed by actual transactions, those that are highly correlated to the specific investment being valued and those derived from reliable or knowledgeable sources will tend to have a higher weighting in determining fair value. Ongoing reviews by the Company’s investment analysts, Chief Investment Officer, Valuation Committee and independent valuation firms (if engaged) are based on an assessment of each underlying investment, its current and prospective operating and financial performance, consideration of financing and sale transactions with third parties, expected cash flows and market-based information, including comparable transactions, performance factors, and other investment or industry specific market data, among other factors.

 

The following table summarizes the fair value of investments by the above Fair Value Measurements and Disclosures fair value hierarchy levels as of June 30, 2010 (unaudited) and December 31, 2009, respectively:

 

 

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As of June, 30 2010 (unaudited)
		Level I				Level II				Level III				Total
Time deposit and money market account		$	—			$	12,707,637			$	—			$	12,707,637
Debt securities			—				—				226,850,143				226,850,143
CLO fund securities			—				—				52,151,001				52,151,001
Equity securities			—				—				6,554,693				6,554,693
Asset manager affiliate			—				—				53,703,377				53,703,377

As of December 31, 2009
		Level I				Level II				Level III				Total
Time deposit and money market account		$	—			$	126			$	—			$	126
Debt securities			—				—				297,356,529				297,356,529
CLO fund securities			—				—				48,971,000				48,971,000
Equity securities			—				—				4,713,246				4,713,246
Asset manager affiliate			—				—				58,064,720				58,064,720

The following table summarizes the Level III investments by valuation methodology as of June 30, 2010 and December 31, 2009, respectively:

As of June, 30 2010 (unaudited)
Fair Value Based on		Debt Securities				CLO Fund Securities				Equity Securities				Asset Manager Affiliates				Total
Third party pricing service			—	%			—	%			—	%			—	%			—	%
Public / private company comparables			67				—				—				16				83
Discounted cash flow			—				15				—				—				15
Residual enterprise value			—				—				2				—				2
Total			67	%			15	%			2	%			16	%			100	%

As of December 31, 2009
Fair Value Based on		Debt Securities				CLO Fund Securities				Equity Securities				Asset Manager Affiliates				Total
Third party pricing service			—	%			—	%			—	%			—	%			—	%
Public / private company comparables			73				—				—				14				87
Discounted cash flow			—				12				—				—				12
Residual enterprise value			—				—				1				—				1
Total			73	%			12	%			1	%			14	%			100	%

 

As a BDC, it is required that the Company invest primarily in the debt and equity of non-public companies for which there is little, if any, market-observable information.  As a result, most, if not all, of the Company’s investments at any given time will most likely be deemed Level III investments. The Company believes that investments classified as Level III for Fair Value Measurements and Disclosures have a further hierarchal framework which prioritizes and ranks such valuations based on the degree of independent and observable inputs, objectivity of data and models and the level of judgment required to adjust comparable data.  The hierarchy of such methodologies are presented in the above table and discussed below in descending rank.

 

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Investment values derived by a third party pricing service are deemed Level III values since such values are not traded on an active public exchange and may represent a traded or broker quote on an asset that is infrequently traded.

 

The Company derives fair value for its illiquid investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach and also considers recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. The Company has identified these two indices as benchmarks for broad market information related to its loan and debt investments. Because the Company has not identified any market index that directly correlates to the loan and debt investments held by the Company and therefore uses the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy. The appropriateness of specific valuation methods and techniques may change as market conditions and available data change.

 

The Company engaged VRC, an independent valuation firm, to provide third-party valuation estimates for approximately 39% of its portfolio at fair value as of December 31, 2009.  VRC’s valuation estimates were considered as one of the relevant data inputs in the Company’s determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of June 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of the Company’s annual year end valuation process.

 

Values derived for debt securities using public/private company comparables generally utilize market-observable data from such comparables and specific, non-public and non-observable financial measures (such as earnings or cash flows) for the private, underlying company/issuer. Such non-observable company/issuer data is typically provided on a monthly basis, is certified as correct by the management of the company/issuer and audited by an independent accounting firm on an annual basis. Since such private company/issuer data is not publicly available it is not deemed market-observable data and, as a result, such investment values are grouped as Level III assets.

 

Values derived for asset manager affiliates using public/private company comparables generally utilize market-observable data from such comparables and specific, non-public and non-observable financial measures (such as assets under management, historical and prospective earnings) for the asset manager affiliate. The Company recognizes that comparable asset managers may not be fully comparable to its asset manager affiliates and typically identifies a range of performance measures and/or adjustments within the comparable population with which to determine value. Since any such ranges and adjustments are entity specific they are not considered market-observable data and thus require a Level III grouping. Illiquid investments that have values derived through the use of discounted cash flow models and residual enterprise value models are grouped as Level III assets.

 

The changes in investments measured at fair value for which the Company has used unobservable inputs to determine fair value are as follows:

		Six Months Ended June 30, 2010
		Debt Securities				CLO Fund Securities				Equity Securities				Asset Manager Affiliates				Total
Balance, December 31, 2009		$	297,356,529			$	48,971,000			$	4,713,246			$	58,064,720			$	409,105,495
Transfers in/out of Level 3			—				—				—				—				—
Net accretion of discount			223,452				42,573				—				—				266,025
Purchases (sales), net			(67,561,510	)			—				1,850,543				2,570,359				(63,140,608	)
Total loss realized and unrealized included in earnings			(3,168,328	)			3,137,427				(9,096	)			(6,931,702	)			(6,971,699	)
Balance, June 30, 2010		$	226,850,143			$	52,151,000			$	6,554,693			$	53,703,377			$	339,259,213
Changes in unrealized gains (losses) included in earnings related to investments still held at reporting date		$	4,537,479			$	3,137,427			$	(9,096	)		$	(6,931,702	)		$	734,108

 

 

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		Six Months Ended June 30, 2009
		Debt Securities				CLO Fund Securities				Equity Securities				Asset Manager Affiliates				Total
Balance, December 31, 2008		$	353,859,007			$	34,640,000			$	5,087,512			$	54,734,812			$	448,321,331
Transfers in/out of Level 3			—				—				—				—				—
Net accretion of discount			570,235				705,464				—				—				1,275,699
Purchases (sales), net			(32,651,012	)			1,076,250				—				2,184,120				(29,390,642	)
Total loss realized and unrealized included in earnings			4,664,714				5,839,286				(423,130	)			(415,223	)			9,665,647
Balance, December 31, 2009		$	326,442,944			$	42,261,000			$	4,664,382			$	56,503,709			$	429,872,035
Changes in unrealized gains (losses) included in earnings related to investments still held at reporting date		$	7,582,537			$	5,839,286			$	(423,130	)		$	1,799,846			$	14,798,539

 

5. AFFILIATE ASSET MANAGERS

 

Wholly-Owned Asset Manager

 

Prior to its IPO, the Company issued an aggregate of 2,226,333 common shares, having a value of approximately $33 million, to affiliates of Kohlberg & Co. to acquire Katonah Debt Advisors. As a result, Katonah Debt Advisors is a wholly-owned portfolio company. As of June 30, 2010, Katonah Debt Advisors and its affiliates had approximately $2.1 billion of assets under management.

 

Katonah Debt Advisors manages CLO Funds primarily for third party investors that invest in broadly syndicated loans, high yield bonds and other credit instruments issued by corporations. These CLO Funds do not invest in asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings. At June 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of par value of assets under management, and the Company’s 100% equity interest in Katonah Debt Advisors was valued at approximately $54 million.

 

As a manager of the CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees and may receive a one-time structuring fee from the CLO Funds for its management and advisory services. The annual fees which Katonah Debt Advisors receives are generally based on a fixed percentage of assets under management (at par value and not subject to changes in market value), and Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds it operating expenses.  The annual management fees Katonah Debt Advisors receives have two components - a senior management fee and a subordinated management fee.  At June 30, 2010, Katonah Debt Advisors continued to receive all senior management fees payable by the CLO Funds managed by it. However, one CLO Fund (representing approximately $342 million of the $2.1 billion of Katonah Debt Advisors’ assets under management) was not paying its subordinated management fee.  These subordinated management fees, totaling approximately $1.2 million per year, have been restricted from being paid as a result of the failure by the CLO Fund to satisfy certain restrictive covenants contained in their indenture agreements. Such subordinated management fees continue to be accrued by the applicable CLO Fund and will be payable to Katonah Debt Advisors when such CLO Fund becomes compliant with the applicable covenants. As of June 30, 2010, approximately $2 million of previously accrued subordinated management fees (from certain CLO Funds which had deferred subordinated management fees in the past and for which are now paying their current subordinated management fees) had been paid to Katonah Debt Advisors and approximately $3.3 million of subordinated management fees continue to be accrued for which Katonah Debt Advisors currently expects a portion of such fees to be paid to it within the next year. However, there can be no assurance that these fees will become payable or, if they do become payable, that the applicable CLO Fund will have sufficient cash to make the payments to Katonah Debt Advisors.  In future years, Katonah Debt Advisors may receive accrued incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.

 

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On January 2, 2008, the Katonah Debt Advisors platform acquired substantially all of the assets of Scott’s Cove Capital Management LLC (“Scott’s Cove”), an asset manager focused on an event-driven credit long short investment strategy. As a result of the acquisition, approximately $60 million of fee paying assets under management were integrated into the Katonah Debt Advisors asset management platform. In connection with the acquisition, Katonah Debt Advisors entered into employment agreements with three Scott’s Cove investment professionals, and expects these individuals will assist in structuring, raising and investing new funds to be managed by Katonah Debt Advisors.  As of June 30, 2010, Scott’s Cove had approximately $131 million of assets under management.

 

The revenue that Katonah Debt Advisors generates through the fees it receives for managing CLO Funds and after paying the expenses associated with its operations, including compensation of its employees, may be distributed to the Company. Any distributions of Katonah Debt Advisors’ net income are recorded as dividends from affiliate asset manager. As with all other investments, Katonah Debt Advisors’ fair value is periodically determined. The valuation is primarily based on an analysis of both a percentage of its assets under management and Katonah Debt Advisors’ estimated operating income. Any change in value from period to period is recognized as unrealized gain or loss. See Note 2, “Significant Accounting Policies” and Note 4, “Investments” for further information relating to the Company’s valuation methodology.

 

As a separately regarded entity for tax purposes, Katonah Debt Advisors is taxed at normal corporate rates. For tax purposes, any distributions of taxable net income earned by Katonah Debt Advisors to the Company would generally need to be distributed to the Company’s shareholders. Generally, such distributions of Katonah Debt Advisors’ income to the Company’s shareholders will be considered as qualified dividends for tax purposes. Katonah Debt Advisors’ taxable net income will differ from GAAP net income because of deferred tax timing adjustments and permanent tax adjustments. Deferred tax timing adjustments may include differences for the recognition and timing of depreciation, bonuses to employees and stock option expense. Permanent differences may include adjustments, limitations or disallowances for meals and entertainment expenses, penalties and tax goodwill amortization.

 

Goodwill amortization for tax purposes was created upon the purchase of 100% of the equity interests in Katonah Debt Advisors prior to the Company’s IPO in exchange for shares of the Company’s stock valued at $33 million. Although this transaction was a stock transaction rather than an asset purchase and thus no goodwill was recognized for GAAP purposes, such exchange was considered an asset purchase under Section 351(a) of the Code. At the time of the transfer, Katonah Debt Advisors had equity of approximately $1 million resulting in tax goodwill of approximately $32 million which will be amortized for tax purposes on a straight-line basis over 15 years, which accounts for an annual difference between GAAP income and taxable income by approximately $2 million per year over such period.

 

At June 30, 2010 there were no intercompany balances with our affiliates, and at December 31, 2009 a net amount due from affiliates totaled approximately $44,000.

 

Distressed Debt Platform

 

In December 2007, a wholly-owned subsidiary of the Company committed to make an investment in a new distressed debt investment platform organized by Steven Panagos and Jonathan Katz named PKSIL LLC (“PKSIL”). The Company committed to invest up to $2.5 million to fund the operation of PKSIL and to invest in an investment fund to be raised and managed by PKSIL. Due to unfavorable global financial market conditions in 2008, PKSIL was not able to raise the planned fund. During the quarter ended June 30, 2009, both Messrs. Panagos and Katz terminated their employment with PKSIL and PKSIL ceased operations. In connection therewith, the Company recognized a loss of approximately $2.2 million.

 

6. BORROWINGS

 

The Company’s debt obligations consist of the following:

		As of June 30, 2010				As of December 31, 2009
Secured revolving credit facility, $275 million commitment  due September 29, 20101		$	145,445,854			$	218,050,363

1  September 29, 2010 is the last day of the amortization period that the Company has challenged as being wrongfully commenced.

 

 

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On February 14, 2007, the Company entered into an arrangement under which the Company may obtain up to $200 million in financing (the “Facility”). On October 1, 2007, the Company amended the Facility to increase the Company’s borrowing capacity from $200 million to $275 million, extend the maturity date from February 12, 2012 to October 1, 2012 and increase the interest spread charged on outstanding borrowings by 15 basis points to 0.85%. The interest rate is based on prevailing commercial paper rates plus 0.85% or, if the commercial paper market is at any time unavailable, prevailing LIBOR rates plus an applicable spread. Interest is payable monthly. As a result of the assertion of BMO Capital Markets Corp., as the agent (the “Agent”), that a Termination Event occurred under the LFSA, since June 2009 interest under the LFSA has been calculated at a higher default rate (equal to 0.85% above the prime rate plus 0.75%).

Fair Value of Debt.  The Company records debt at cost. The fair value of the Company’s outstanding debt was approximately $146 million and $218 million at June 30, 2010 and December 31, 2009, respectively.  The fair value of the Company’s debt was determined based on market interest rates for similar instruments as of the balance sheet dates.

 

Advances under the Facility (to the extent available to the Company) are used by the Company primarily to make additional investments. The Facility is secured by loans acquired by the Company with the advances under the Facility. The Company borrows under the Facility through its wholly-owned, special-purpose bankruptcy remote subsidiary, KCAP Funding.

 

In connection with the Facility, the Company is party to a Loan Funding and Servicing Agreement, dated as of February 14, 2007 (as amended, the “LFSA”), by and among the Borrower, the Company, as the servicer, BMO Capital Markets Corp, as the agent (the “Agent”), U.S. Bank National Association, a national banking association, as the trustee (the “Trustee”) and the other lender parties and other parties thereto.

 

In August 2008, the Company was notified by the lenders that the banks providing the underlying funding for the Facility did not intend to renew their liquidity facility to the lenders unless the Company agreed to certain revised terms for the Facility. The lenders proposed new terms to the Company as a condition to extending the underlying liquidity purchase agreements. The Company viewed such proposed terms as unfavorable and did not agree to such new terms, which caused the lenders to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility through a maturity date of September 29, 2010 (the last day of the amortization period that the Company has challenged as being wrongfully commenced). Since June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event had occurred, the interest payable under the LFSA has been calculated at an elevated rate (equal to 0.85% above the prime rate plus 0.75%), and the Company has been paying such higher interest under protest. Also, despite its belief that the amortization period has been wrongfully imposed, the Company believes it has sufficient cash and liquid assets which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions. At the end of the amortization period, the Company may be required to sell the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings or the Company may enter into a new agreement with the lenders providing for continued amortization of the Facility borrowings or into alternative financing arrangements with another lender.

 

Under the Facility, the Company is subject to various covenants including a leverage ratio covenant pursuant to which it must maintain a leverage ratio of no more than one to one based on the ratio of the Facility outstanding balance to the Company’s GAAP stockholders’ equity balance. As of July 31, 2010, the Company's leverage ratio did not exceed 1:1.

 

As of the date of filing of this Quarterly Report, the Company believes that it is not in material breach of its obligations under the LFSA, including the leverage ratio. However, as described below, the Company and the Borrower are plaintiffs in a pending lawsuit against the Agent and the lenders involving the LFSA and, as described elsewhere in the Quarterly Report, the Agent has sent additional notices of Termination Events under the LFSA. There can be no assurance that in connection with such lawsuit or otherwise the Agent and the lenders will not assert additional breaches of the LFSA, and there can be no assurance that the Agent and the lenders will not assert that any such breaches give rise to a Termination Event. While the Company and the Borrower believe that they have meritorious claims against the Agent and the lenders in the pending lawsuit and, as a result, the breaches alleged by the Agent and the lenders are not valid in accordance with the terms of the LFSA, there is no assurance that the Company and the Borrower will prevail in such litigation. If the Company and the Borrower do not prevail, the Agent and the lenders may seek to pursue claims based on the alleged breaches, including claims involving alleged Termination Events. If the Agent and the lenders were to seek to accelerate and seize the collateral either at the end of the amortization period (which the Company has challenged as being wrongfully commenced) or otherwise, and the Company and the Borrower were unsuccessful in obtaining court relief, they could be forced to pay the remaining balance of the Facility (approximately $144 million as of July 31, 2010), which would adversely affect the Company’s business, liquidity, financial condition and results of operations.

 

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The Company estimates that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 3% to cover annual interest payments on obligations incurred under the Facility.

 

The weighted average daily debt balance for the six months ended June 30, 2010 and 2009 was approximately $171 million and $237 million, respectively. For the three months ended June 30, 2010 and 2009, the weighted average interest rate on weighted average outstanding borrowings was approximately 5% and 2% respectively, which excludes the amortization of deferred financing costs and facility and program fees on unfunded balances. As of June 30, 2010, the Company had restricted cash and time deposit balances of approximately $4 million which it maintained in accordance with the terms of the Facility.

 

7. DISTRIBUTABLE TAX INCOME

 

Effective December 11, 2006, the Company elected to be treated as a RIC under the Code and adopted a December 31 calendar year end. As a RIC, the Company is not subject to federal income tax on the portion of its taxable income and gains distributed currently to its stockholders as a dividend. The Company’s quarterly dividends, if any, are determined by the Board of Directors. The Company anticipates distributing at least 90% of its taxable income and gains, within the Subchapter M rules, and thus the Company anticipates that it will not incur any federal or state income tax at the RIC level. As a RIC, the Company is also subject to a federal excise tax based on distributive requirements of its taxable income on a calendar year basis (e.g., calendar year 2010). Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income, to the extent required. The Company anticipates timely distribution of its taxable income within the tax rules, however, the Company may incur a U.S. federal excise for the calendar year 2010.

 

The following reconciles net decrease in stockholders’ equity resulting from operations to taxable income for the six months ended June 30, 2010:

		Six Months Ended
		June 30, 2010
		(unaudited)
Pre-tax net decrease in stockholders’ equity resulting from operations		$	(4,096,006	)
Net change in unrealized (appreciation) depreciation from investments			(734,108	)
Excess capital losses over capital gains			7,705,806
Income not on GAAP books currently taxable			1,198,092
Income not currently taxable			(38,589	)
Expenses not currently deductible			301,364
Expenses not on GAAP books currently deductible			(3,978	)
Taxable income before deductions for distributions		$	4,332,581
Taxable income before deductions for distributions per weighted average shares for the period		$	0.19

 

For the quarter ended June 30, 2010, the Company declared a dividend on June 23, 2010 of $0.17 per share for a total of approximately $4 million. The record date was July 7, 2010 and the dividend was distributed on July 29, 2010.

 

Distributable income (loss) differs from GAAP net investment income primarily due to: (1) unrealized appreciation (depreciation) on investments, as investment gains and losses are not included in taxable income until they are realized; (2) amortization of discount on CLO Fund Securities; (3) amortization of organizational costs; (4) non-deductible expenses; (5) stock compensation expense that is not currently deductible for tax purposes; (6) excess of capital losses over capital gains; and (7) recognition of interest income on certain loans.

 

At June 30, 2010, the Company had a net capital loss carryforward of $21.8 million to offset net capital gains, to the extent provided by federal tax law. The capital loss carryforward will begin to expire in the tax year ending December 31, 2015.

 

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The Company adopted Financial Accounting Standards Board ASC Topic 740 Accounting for Uncertainty in Income Taxes (“ASC 740”) as of January 1, 2007. ASC 740 provides guidance for how uncertain tax positions should be recognized, measured, presented, and disclosed in the financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold are recorded as a tax benefit or expense in the current year. Adoption of ASC 740 was applied to all open taxable years as of the effective date. The adoption of ASC 740 did not have an effect on the financial position or results of operations of the Company as there was no liability for unrecognized tax benefits and no change to the beginning capital of the Company. Management’s determinations regarding ASC 740 may be subject to review and adjustment at a later date based upon factors including, but not limited to, an ongoing analysis of tax laws, regulations and interpretations thereof.

 

8. COMMITMENTS AND CONTINGENCIES

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the needs of the Company’s investment in portfolio companies. Such instruments include commitments to extend credit and may involve, in varying degrees, elements of credit risk in excess of amounts recognized on the Company’s balance sheet. Prior to extending such credit, the Company attempts to limit its credit risk by conducting extensive due diligence, obtaining collateral where necessary and negotiating appropriate financial covenants. As of both June 30, 2010 and December 31, 2009, the Company had committed to make a total of approximately $2 million of investments in various revolving senior secured loans, of which approximately $0 had been funded as of June 30, 2010 and $640,000 had been funded as of December 31, 2009.

 

The Company and certain directors and officers are named as defendants in three putative class actions pending in the Southern District of New York brought by shareholders of the Company and filed in December 2009 and January 2010. The complaints in these three actions allege violations of Sections 10 and 20 of the Exchange Act based on the Company’s disclosures of its year-end 2008 and first- and second-quarter 2009 financial statements. In addition, the Company and certain directors and officers are also named as defendants in a derivative action filed on March 2, 2010 pending in the Supreme Court of New York, County of New York. The complaint in this action purports to state causes of action for breaches of fiduciary duties, unjust enrichment, abuse of control, gross mismanagement, and corporate waste. The Company believes that each of the above-mentioned suits is without merit and will defend each vigorously.

 

9. LIQUIDITY

As discussed in Note 6, the Company is currently using any income generated by the assets collateralizing its secured credit Facility to pay principal, interest and other expenses of the Facility – despite the fact that, if it wants to remain a RIC and continue to be afforded favorable tax treatment for U.S. federal income tax purposes, it is required to distribute to the shareholders substantially all of its investment company taxable income, including the net amounts generated by the collateralized assets. These collateralized assets with a market value of approximately $212 million represent approximately 60% of the Company’s total assets (at fair value) at June 30, 2010 and contributed approximately 45% of the Company’s investment income for the quarter ended June 30, 2010.  Because the Company is using net interest income earned on the assets securing the Facility to amortize the Facility during the amortization period, the Company may need to sell other assets not pledged to the Facility, potentially at a loss, in order to generate sufficient cash to make the required dividend distributions necessary to maintain its RIC status. In addition, at the end of the amortization period (which the Company has challenged as being wrongfully commenced), the Company may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings. Any such asset sale could adversely affect the Company’s business, liquidity, financial condition and results of operations. The Company expects that its cash on hand, liquid investments, and cash generated from operations, including income earned from investments and any income distributions made by Katonah Debt Advisors, the Company’s wholly-owned portfolio company, will be adequate to meet the Company’s liquidity needs and distribution requirements over the next twelve months.

 

If the Company is unable to renew or replace the Facility, the Company’s liquidity may be significantly reduced. If these conditions continue for a prolonged period of time, or worsen in the future, the Company could lose key employees and its business prospects could be negatively impacted. Even if the Company is able to renew or replace the Facility, such new debt capital may be at a higher cost and/or on less favorable terms and conditions than the Facility. In addition, equity capital is, and may continue to be, difficult to raise because, subject to limited exceptions, the Company may not issue and sell shares of its common stock at a price below NAV without stockholder approval and issuing equity at depressed stock prices can be dilutive to the Company’s stockholders. These factors and the Company’s inability to raise additional capital to date have resulted in a reduction in new originations, curtailed the Company’s ability to grow and have had a negative impact on the Company’s liquidity and operating results. The continued inability to raise additional capital could further constrain the Company’s liquidity, negatively impact the Company’s business prospects, cause the departure of key employees and negatively impact the Company’s operating results.

 

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9. STOCKHOLDERS’ EQUITY

 

On April 28, 2008, the Company completed a rights offering which resulted in the issuance of 3.1 million common shares and net proceeds of approximately $27 million.  For the year ended December 31, 2008, the Company issued 359,250 shares of restricted stock for which 16,667 shares were forfeited and 3,000 shares were converted to common stock during the year due to vesting.  During the year ended December 31, 2009, the Company issued 501,873 shares under DRIP and 122,333 shares of restricted stock were exercised and converted to common stock.  During the six months ended June 30, 2010, the Company issued 185,954 shares of common stock under its dividend reinvestment plan. The total number of shares issued and outstanding as of June 30, 2010 and December 31, 2009 was 22,549,235 and 22,363,281, respectively.

10. EQUITY INCENTIVE PLAN

 

During 2006 and as amended in 2008, the Company established an equity incentive plan (the “Plan”) and reserved 2,000,000 shares of common stock for issuance under the Plan. The purpose of the Plan is to provide officers and prospective employees of the Company with additional incentives and align the interests of its employees with those of its shareholders. Options granted under the Plan are exercisable at a price equal to the fair market value (market closing price) of the shares on the day the option is granted. Restricted stock granted under the Plan is granted at a price equal to the fair market value (market closing price) of the shares on the day such restricted stock is granted.

 

Stock Options

 

On December 11, 2006, concurrent with the completion of the Company’s IPO, options to purchase a total of 910,000 shares of common stock were granted to the Company’s executive officers and directors with an exercise price per share of $15.00 (the public offering price of the common stock). Such options vest equally over two, three or four years from the date of grant and have a ten-year exercise period. During the year ended December 31, 2007, the Company granted 495,000 options to its employees with a weighted average exercise price per share of $16.63, with a risk-free rate ranging between 4.6% to 5.3%, with volatility rates ranging between 20.5% to 22.4% and for which 25% of such options vest on each of the subsequent four grant date anniversaries and have a ten-year exercise period.  During the year ended December 31, 2008, and as approved by shareholders during the annual shareholders’ meeting on June 13, 2008, 20,000 options were granted to non-employee directors as partial annual compensation for their services as director. These grants were made with a ten-year exercise period with an exercise price of $11.97, with a risk free rate of 4.6% with a volatility rate of 28% and for which 50% of such options vest upon grant date and 50% vest on the first grant date anniversary.  During the six months ended June 30, 2010, no additional options were granted to non-employee directors as partial annual compensation for their services as director.

 

On June 13, 2008, the Company’s Board of Directors authorized the Company to allow employees who agree to cancel options that they hold to receive one share of restricted stock for every five options so cancelled. The shares of restricted stock received by employees through any such transaction will vest annually generally over the remaining vesting schedule as was applicable to the cancelled options. During the year ended December 31, 2008, employees holding options to purchase 1,295,000 shares individually entered into agreements to cancel such options and to receive 259,000 shares of restricted stock. As a result, as of December 31, 2008, all options granted to employees had been converted to restricted stock.

 

As of December 31, 2009, 40,000 options to non-employee directors remained outstanding.  During the six months ended June 30, 2010, no such options were forfeited.  As of June 30, 2010, 40,000 total options were outstanding, 40,000 of which were exercisable. The options have an estimated remaining contractual life of 8 years and 5 months.

 

Information with respect to options granted, exercised and forfeited under the Plan for the six months ended June 30, 2010 is as follows:

 

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		Shares				Weighted Average Exercise Price per Share			Weighted Average Contractual Remaining Term (years)		Aggregate Intrinsic Value1
Options outstanding at January 1, 2008			1,315,000			$	15.52
Granted			20,000			$	11.97
Exercised			—			$	—
Forfeited			(1,315,000	)		$	15.52
Options outstanding at December 31, 2008			20,000			$	11.97
Granted			20,000			$	4.93
Exercised			—			$	—
Forfeited			—			$	—
Options outstanding at December 31, 2009			40,000			$	8.45
Granted			—			$	—
Exercised			—			$	—
Forfeited			—			$	—
Outstanding at June 30, 2010			40,000			$	8.45		8.5		$	-
Total vested at June 30, 2010			40,000			$	8.45		8.5

1	Represents the difference between the market value of shares of the Company upon exercise of the options at June 30, 2010 and the cost for the option holders to exercise the options.

 

The Company uses a Binary Option Pricing Model (American, call option) as its valuation model to establish the expected value of all stock option grants. For the six months ended June 30, 2010 and June 30, 2009, the Company recognized non-cash compensation expense related to stock options of approximately $4,000 and $16,000, respectively. At June 30, 2010, the Company no remaining cost of compensation cost related to unvested stock-based awards.

Restricted Stock

 

On June 13, 2008, the Company’s shareholders approved the Company’s 2006 Equity Incentive Plan, as amended and the board of directors approved the grant of awards of 100,250 shares of restricted stock to certain executive officers of the Company. On August 5, 2009, the board of directors approved the grant of an additional 84,889 shares of restricted stock to a certain executive officer of the Company.  Such awards of restricted stock will vest as to 50% of the shares on the third anniversary of the grant date and the remaining 50% of the shares on the fourth anniversary of the grant date.

 

On June 13, 2008, the Company’s Board of Directors authorized the Company to allow employees who agree to cancel options that they hold to receive shares of the Company's common stock to receive 1 share of restricted stock for every 5 options so cancelled.  The shares of restricted stock received by employees through any such transaction will vest annually generally over the remaining vesting schedule as was applicable to the cancelled options.  Subsequently, employees holding options to purchase 1,295,000 shares individually entered into agreements to cancel such options and to receive 259,000 shares of restricted stock.  As of June 30, 2010, 125,333 of such shares were vested and converted to common shares, and 117,000 of such shares had yet to vest.  The remaining 16,667 shares have been forfeited.

 

During the six months ended June 30, 2010, no shares of restricted stock were vested and converted to common shares.  As of June 30, 2010, after giving effect to these option cancellations and restricted stock awards, there were options to purchase 40,000 shares of common stock outstanding and there were 302,139 shares of restricted stock outstanding.  Information with respect to restricted stock granted, exercised and forfeited under the Plan for the six months ended June 30, 2010 is as follows:

 

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		Non-Vested Restricted Shares				Weighted Average Exercise Price per Share
Non-vested shares outstanding at December 31, 2008			339,583			$	10.83
Granted			84,889			$	5.89
Vested			(122,333	)		$	10.37
Forfeited			—			$	—
Non-vested shares outstanding at December 31, 2009			302,139			$	9.63
Granted			—			$	—
Vested			—			$	—
Forfeited			—			$	—
Outstanding at June 30, 2010			302,139			$	9.63
Total non-vested shares at June 30, 2010			302,139			$	9.63

 

For the six months ended June 30, 2010, non-cash compensation expense related to restricted stock was approximately $436,000; of this amount approximately $296,000 was expensed at the Company and approximately $140,000 was a reimbursable expense allocated to Katonah Debt Advisors. For the six months ended June 30, 2009, non-cash compensation expense related to restricted stock was approximately $464,000; of this amount approximately $323,000 was expensed at the Company and approximately $140,000 was a reimbursable expense allocated to Katonah Debt Advisors. Dividends are paid on all outstanding shares of restricted stock, whether or not vested. In general, shares of unvested restricted stock are forfeited upon the recipient’s termination of employment. As of June 30, 2010, there was approximately $1 million of total unrecognized compensation cost related to nonvested share-based awards. That cost is expected to be recognized over a weighted average period of 1.9 years.

11. OTHER EMPLOYEE COMPENSATION

 

The Company adopted a 401(k) plan (“401K Plan”) effective January 1, 2007. The 401K Plan is open to all full time employees. The Plan permits an employee to defer a portion of their total annual compensation up to the Internal Revenue Service annual maximum based on age and eligibility. The Company makes contributions to the 401K Plan of up to 2.67% of the employee’s first 74.9% of maximum eligible compensation, which fully vest at the time of contribution. For the six months ended June 30, 2010 and 2009 the Company made contributions to the 401K Plan of approximately $19,000 and $17,000, respectively.  At June 30, 2010, the Company had approximately $1 million of compensation cost related to unvested restricted stock based awards, the cost for which is expected to be recognized by the Company over a weighted average period of 1.9 years.

 

The Company has also adopted a deferred compensation plan (“Pension Plan”) effective January 1, 2007. Employees are eligible for the Pension Plan provided that they are employed and working with the Company for at least 100 days during the year and remain employed as of the last day of the year. Employees do not make contributions to the Pension Plan. On behalf of the employee, the Company may contribute to the Pension Plan 1) up to 8.0% of all compensation up to the Internal Revenue Service annual maximum and 2) up to 5.7% excess contributions on any incremental amounts above the social security wage base limitation and up to the Internal Revenue Service annual maximum. Employees vest 100% in the Pension Plan after five years of service. For the six months ended June 30, 2010 and 2009, the Company made no contributions to the Pension Plan.

 

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Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

In this Quarterly Report on Form 10-Q, “Kohlberg Capital,” “Company,” “we,” “us,” and “our” refer to Kohlberg Capital Corporation, its subsidiaries and its wholly-owned portfolio company, Katonah Debt Advisors, L.L.C. (collectively with its affiliates, “Katonah Debt Advisors”), and related companies, unless the context otherwise requires.

 

The information contained in this section should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this Quarterly Report. In addition, some of the statements in this report constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The matters discussed in this Quarterly Report, as well as in future oral and written statements by management of Kohlberg Capital, that are forward-looking statements are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to originate new investments, achieve certain margins and levels of profitability, the availability of funds under our credit facility, the availability of additional capital, and the ability to maintain certain debt to asset ratios. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report should not be regarded as a representation by us that our plans or objectives will be achieved. The forward-looking statements contained in this Quarterly Report include statements as to:

 

•

our future operating results;

•

our business prospects and the prospects of our existing and prospective portfolio companies;

•

the impact of investments that we expect to make;

•

our informal relationships with third parties;

•

the dependence of our future success on the general economy and its impact on the industries in which we invest;

•

the ability of our portfolio companies to achieve their objectives;

•

our expected financings and investments;

•

our regulatory structure and tax treatment;

•

our ability to operate as a business development company and a regulated investment company;

•

the adequacy of our cash resources and working capital;

•

the status of our credit facility, including any requirement that we pay our credit facility in full; and

•

the timing of cash flows, if any, from the operations of our portfolio companies, including Katonah Debt Advisors.

 

There are a number of important risks and uncertainties that could cause our actual results to differ materially from those indicated by such forward-looking statements. For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this Quarterly Report, please see the discussion in Part II, “Item 1A. Risk Factors” below and in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. You should not place undue reliance on these forward-looking statements. The forward-looking statements made in this Quarterly Report relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this Quarterly Report.

GENERAL

 

We are an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). We originate, structure and invest in senior secured term loans, mezzanine debt and selected equity securities primarily in privately-held middle market companies. We define the middle market as comprising companies with earnings before interest, taxes, depreciation and amortization, which we refer to as “EBITDA,” of $10 million to $50 million and/or total debt of $25 million to $150 million. In addition to our middle market investment business, our wholly-owned portfolio company, Katonah Debt Advisors, manages collateralized loan obligation funds (“CLO Funds”) that invest in broadly syndicated loans, high-yield bonds and other corporate credit instruments. We acquired Katonah Debt Advisors and certain related assets prior to our initial public offering from affiliates of Kohlberg & Co., LLC (“Kohlberg & Co.”), a leading private equity firm focused on middle market investing.  As of June 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of assets under management.

 

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Our investment objective is to generate current income and capital appreciation from our investments. We also expect to continue to receive distributions of recurring fee income and to generate capital appreciation from our investment in the asset management business of Katonah Debt Advisors. Our investment portfolio as well as the investment portfolios of the CLO Funds in which we have invested and the investment portfolios of the CLO Funds managed by Katonah Debt Advisors consist exclusively of credit instruments and other securities issued by corporations and do not include any asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings.

 

As a Regulated Investment Company (“RIC”), we intend to distribute to our stockholders substantially all of our net taxable income and the excess of realized net short-term capital gains over realized net long-term capital losses. To qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. Pursuant to these elections, we generally will not have to pay corporate-level taxes on any income that we distribute to our stockholders.

 

Our common stock is traded on The NASDAQ Global Select Market under the symbol “KCAP.” The net asset value (“NAV”) per share of our common stock at June 30, 2010 was $9.20. On June 30, 2010, the last reported sale price of a share of our common stock on The NASDAQ Global Select Market was $5.01.

KEY QUANTITATIVE AND QUALITATIVE FINANCIAL MEASURES AND INDICATORS

 

Net Asset Value

 

Our NAV per share was $9.20 and $9.56 as of June 30, 2010 and December 31, 2009, respectively. As we must report our assets at fair value for each reporting period, NAV also represents the amount of stockholder’s equity per share for the reporting period. Our NAV is comprised mostly of investment assets less debt and other liabilities:

		June 30, 2010								December 31, 2009
		Fair Value ¹				Per Share ¹				Fair Value ¹				Per Share ¹
Investments at fair value:
Investments in time deposits		$	12,491,457			$	0.56			$	126			$	-
Investments in money market accounts			216,179				0.01				—				-
Investments in debt securities			226,850,143				10.07				297,356,529				13.30
Investments in CLO Fund securities			52,151,000				2.31				48,971,000				2.19
Investments in equity securities			6,554,693				0.29				4,713,246				0.21
Investments in asset manager affiliates			53,703,377				2.38				58,064,720				2.60
Cash			314,302				0.01				4,140,408				0.19
Restricted Cash			331,242				0.01				18,696,023				0.84
Other assets			3,226,561				0.14				7,474,005				0.33
Total Assets		$	355,838,954			$	15.78			$	439,416,057			$	19.65
Borrowings		$	145,445,854			$	6.45			$	218,050,363			$	9.75
Other liabilities			3,008,723				0.13				7,469,970				0.34
Total Liabilities		$	148,454,577			$	6.58			$	225,520,333			$	10.09
NET ASSET VALUE		$	207,384,377			$	9.20			$	213,895,724			$	9.56

 

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¹

Our balance sheet at fair value and resultant NAV are calculated on a basis consistent with accounting principles generally accepted in the United States of America ("GAAP").  Our per share presentation of such amounts (other than NAV per share) is an internally derived non-GAAP performance measure calculated by dividing the applicable balance sheet amount by outstanding shares.  We believe that the per share amounts for such balance sheet items are helpful in analyzing our balance sheet both quantitatively and qualitatively in that our shares may trade based on a percentage of NAV and individual investors may weight certain balance sheet items differently in performing an analysis of the Company.

 

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Leverage

 

We use borrowed funds, known as “leverage,” to make investments and to attempt to increase returns to our shareholders by reducing our overall cost of capital. As a BDC, we are limited in the amount of leverage we can incur under the 1940 Act. We are only allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. As of June 30, 2010, we had approximately $145 million of outstanding borrowings and our asset coverage ratio of total assets to total borrowings was 243%, above the minimum asset coverage level generally required for a BDC by the 1940 Act. We may also borrow amounts of up to 5% of the value of our total assets for temporary purposes.

 

Our borrowings are through a secured financing facility (the “Facility”). In connection with the Facility, we are party to a Loan Funding and Servicing Agreement, dated as of February 14, 2007 (as amended, the “LFSA”), by and among us, as the servicer, our wholly-owned, special-purpose bankruptcy remote subsidiary, Kohlberg Capital Funding LLC I, as the borrower (“KCAP Funding” or the “Borrower”), BMO Capital Markets Corp, as the agent (the “Agent”), U.S. Bank National Association, a national banking association, as the trustee (the “Trustee”) and the other lender parties and other parties thereto. In August 2008, we were notified by the lenders that the banks providing the underlying liquidity for the Facility did not intend to renew their liquidity facility to the lenders unless we agreed to certain revised terms for the Facility. The lenders proposed new terms to us as a condition to extending the underlying liquidity purchase agreements. We viewed such proposed terms as unfavorable and did not agree to such new terms, causing the Agent and the lenders to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. On June 9, 2009, we received a letter from a representative of the lenders alleging that our failure to determine ratings on certain pledged loans and our alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods during which a Termination Event had occurred and was continuing. In a letter dated June 11, 2009, we rejected the alleged breaches and the alleged occurrence of a Termination Event and also asserted that the termination of the revolving period and commencement of the amortization period under the LFSA were wrongful. On August 28, 2009, we filed a complaint in the Supreme Court of the State of New York against the Agent and other lender parties to the LFSA. The complaint reflects our beliefs that the termination of the revolving period and commencement of the amortization period under the LFSA were wrongful and that the assertions of alleged breaches of our obligations under the LFSA and the alleged occurrence of Termination Event(s) were without merit. The complaint also seeks to clarify our rights and obligations under the LFSA.

 

Since the time the complaint was filed, the Agent, the lenders, and the lender agent parties to the LFSA have served answers seeking dismissal of the complaint and recovery of the defendants’ attorneys’ fees and costs in the action and discovery has commenced.  In addition, motions for partial summary judgment relating to the claims regarding the Termination Date have been filed by us and by the lenders and while it is expected that such motions will be fully submitted by the end of September 2010, we cannot predict when the court will issue its determination of such motions.

 

The Agent has sent additional notices of Termination Events, the most recent of which is dated June 15, 2010, which we believe are without merit due to the wrongful declaration of a Termination Date, the accompanying termination of the revolving period and commencement of the amortization period. In addition, on April 2, 2010 the Agent sent a notice alleging that our failure to timely deliver annual audited financial statements for the year ended December 31, 2009 would, unless cured within 30 days of the date of the notice, constitute a Termination Event, which we also believe and have asserted is without merit based upon a non-material delay.

 

Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility through a maturity date of September 29, 2010 (the last day of the amortization period that the Company has challenged as being wrongfully commenced). Since June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event occurred, the interest payable under the LFSA has been calculated at an elevated rate (equal to 0.85% above the prime rate plus 0.75%), and we have been paying interest calculated at such higher rate under protest. Also, despite our belief that the amortization period has been wrongfully imposed, we believe we have sufficient cash and liquid assets which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions during the amortization period. At the end of the amortization period, we may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings or we may enter into a new agreement with the lenders providing for continued amortization of the Facility borrowings or into alternative financing arrangements with another lender.

 

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Under the Facility, we are subject to various covenants including a leverage ratio covenant pursuant to which it must maintain a leverage ratio of no more than one to one based on the ratio of the Facility outstanding balance to our GAAP stockholders’ equity balance. As of July 31, 2010, our leverage ratio did not exceed 1:1.

 

As of the date of filing of this Quarterly Report, the Company believes that it is not in material breach of its obligations under the LFSA, including the financial covenants. However, as described above and further in Part II, “Item 1. Legal Proceedings,” the Company and the Borrower are plaintiffs in a pending lawsuit against the Agent and the lenders involving the LFSA and the Agent has sent additional notices of Termination Events under the LFSA. While the Company and the Borrower intend to vigorously pursue the claims set forth in the complaint, neither the outcome of this litigation nor the amount and range of potential damages recoverable by the Company and the Borrower or their exposure associated with this litigation can be determined at this time. There can be no assurance that in connection with such lawsuit or otherwise the Agent and the lenders will not assert additional breaches of the LFSA, and there can be no assurance that the Agent and the lenders will not assert that any such breaches give rise to a Termination Event. While the Company and the Borrower believe that they have meritorious claims against the Agent and the lenders in the pending lawsuit and, as a result, the breaches alleged by the Agent and the lenders are not valid in accordance with the terms of the LFSA, there is no assurance that the Company and the Borrower will prevail in such litigation. If the Company and the Borrower do not prevail, the Agent and the lenders may seek to pursue claims based on the alleged breaches, including claims involving a Termination Event. If the Agent and the lenders were to seek to accelerate and seize the collateral either at the end of the amortization period (which the Company has challenged as being wrongfully commenced) or otherwise, and the Company was unsuccessful in obtaining court relief, the Company could be forced to pay the remaining balance of the Facility (approximately $144 million as of July 31, 2010), which would adversely affect the Company’s business, liquidity, financial condition and results of operations.

 

We estimate that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 3% to cover annual interest payments on obligations incurred under the Facility.

Investment Portfolio Summary Attributes as of and for the Six Months ended June 30, 2010

 

Our investment portfolio generates net investment income which is generally used to pay principal and interest on our borrowings under the Facility and to fund our dividend. Our investment portfolio consists of three primary components: debt securities, CLO fund securities and our investment in our wholly owned asset manager, Katonah Debt Advisors. We also have investments in equity securities of approximately $7 million, which comprises approximately 2% of our investment portfolio.  Below are summary attributes for each of our primary investment portfolio components (see “—Investment Portfolio” and “—Investments and Operations” for a more detailed description) as of and for the six months ended June 30, 2010:

 

Debt Securities

 

·

represent approximately 64% of total investment portfolio;

 

·

represent credit instruments issued by corporate borrowers;

 

·

no asset-backed securities such as those secured by commercial mortgages or residential mortgages and no consumer borrowings;

 

·

primarily senior secured and junior secured loans (54% and 44% of debt securities, respectively);

 

·

spread across 25 different industries and 68 different entities;

 

·

average balance per investment of approximately $3 million;

 

·

all but five issuers current on their debt service obligations; and

 

·

weighted average interest rate of 5.4%.

 

CLO Fund Securities (as of the last monthly trustee report prior to June 30, 2010 unless otherwise specified)

 

·

represent approximately 15% of total investment portfolio at June 30, 2010;

 

·

88% of CLO Fund Securities represent investments in subordinated securities or equity securities issued by CLO Funds and 12%  of CLO Fund Securities are rated notes;

 

·

all CLO Funds invest primarily in credit instruments issued by corporate borrowers;

 

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·

no asset-backed securities such as those secured by commercial mortgages or residential mortgages and no consumer borrowings;

 

·

ten different CLO Fund securities; six of such CLO Fund securities are managed by Katonah Debt Advisors; and

 

·

five CLO Fund securities, representing 15% of all such securities at fair value or 2% of total investments at fair value, are not currently providing a dividend payment to the Company.

 

Katonah Debt Advisors

 

·

represents approximately 15% of total investment portfolio;

 

·

represents our 100% ownership of the equity interest of a profitable CLO Fund manager focused on corporate credit investing;

 

·

has approximately $2.1 billion of assets under management;

 

·

receives contractual and recurring asset management fees based on par value of managed investments;

 

·

typically receives a one-time structuring fee upon completion of a new CLO Fund;

 

·

may receive an incentive fee upon liquidation of a CLO Fund provided that the CLO Fund achieves a minimum designated return on investment;

 

·

dividends paid by Katonah Debt Advisors are recognized as dividend income from affiliate asset manager on our statement of operations and are an additional source of income to pay our dividend;

 

·

for the six months ended June 30, 2010, Katonah Debt Advisors had pre-tax net income of approximately $1 million; and

 

·

for the six months ended June 30, 2010, Katonah Debt Advisors made distributions of $1.5 million to the Company in the form of a dividend which is recognized as current earnings to the Company.

Revenue

 

Revenues consist primarily of investment income from interest and dividends on our investment portfolio and various ancillary fees related to our investment holdings.

 

Interest from Investments in Debt Securities. We generate interest income from our investments in debt securities which consist primarily of senior and junior secured loans. Our debt securities portfolio is spread across multiple industries and geographic locations, and as such, we are broadly exposed to market conditions and business environments. As a result, although our investments are exposed to market risks, we continuously seek to limit concentration of exposure in any particular sector or issuer.

 

Dividends from Investments in CLO Fund Securities. We generate dividend income from our investments in the securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and selective investments in securities issued by funds managed by other asset management companies. CLO Funds managed by Katonah Debt Advisors invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The Company distinguishes CLO Funds managed by Katonah Debt Advisors as “CLO fund securities managed by affiliate.” The underlying assets in each of the CLO Funds in which we have an investment are generally diversified secured or unsecured corporate debt and exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments. Our CLO Fund securities that are subordinated securities or preferred shares (“junior securities”) are subordinated to senior bond holders who typically receive a fixed rate of return on their investment. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders and less fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares.  The level of excess spread from CLO Fund securities can be impacted from the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly.  In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants my lead to the temporary suspension or deferral of cash distributions to us.

 

For non-junior class CLO Fund securities, such as our investment in the class B-2L notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR index.

 

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Dividends from Affiliate Asset Manager. We generate dividend income from our investment in Katonah Debt Advisors, an asset management company, which is a wholly-owned portfolio company that manages CLO Funds that invest primarily in broadly syndicated non-investment grade loans, high yield bonds and other credit instruments issued by corporations. As a manager of CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees as well as an expected one-time structuring fee from the CLO Funds for its management and advisory services. In addition, Katonah Debt Advisors may also earn income related to net interest on assets accumulated for future CLO issuances on which it has provided a first loss guaranty in connection with loan warehouse arrangements for its CLO Funds. Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds it operating expenses. The annual management fees which Katonah Debt Advisors receives are generally based on a fixed percentage of the par value of assets under management and are recurring in nature for the term of the CLO Fund so long as Katonah Debt Advisors manages the fund. As a result, the annual management fees earned by Katonah Debt Advisors generally are not subject to market value fluctuations in the underlying collateral. In future years, Katonah Debt Advisors may receive incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.

 

Capital Structuring Service Fees. We may earn ancillary structuring and other fees related to the origination and or investment in debt and investment securities.

 

Expenses

 

Expenses consist primarily of interest expense on outstanding borrowings, compensation expense and general and administrative expenses, including professional fees.

 

Interest and Amortization of Debt Issuance Costs. Interest expense is dependent on the average outstanding balance on our Facility and the base index rate for the period. Debt issuance costs represent fees and other direct costs incurred in connection with the Company’s borrowings. These amounts are capitalized and amortized ratably over the contractual term of the borrowing.

 

Compensation Expense. Compensation expense includes base salaries, bonuses, stock compensation, employee benefits and employer related payroll costs. The largest components of total compensation costs are base salaries and bonuses; generally, base salaries are expensed as incurred and annual bonus expenses are estimated and accrued. Our compensation arrangements with our employees contain a significant profit sharing and/or performance based bonus component. Therefore, as our net revenues increase, our compensation costs may also rise. In addition, our compensation expenses may also increase to reflect increased investment in personnel as we grow our products and businesses.

 

Professional Fees and General and Administrative Expenses. The balance of our expenses include professional fees, occupancy costs and general administrative and other costs.

 

Net Change in Unrealized Depreciation on Investments

 

During the three and six months ended June 30, 2010, the Company’s investments had a net change in unrealized depreciation of approximately $554,000 and $734,000, respectively; during the three and six months ended June 30, 2009, the Company’s investments had a net change in unrealized depreciation of approximately $10 million and $15 million, respectively.

 

The net change in unrealized depreciation for the three months ended June 30, 2010 is primarily due to (i) an approximate $869,000 net decrease in the market value of certain broadly syndicated loans as a result of current market conditions; (ii) an approximate $448,000 decrease in the net value of CLO Fund securities; and (iii) an approximate $2 million decrease in the value of Katonah Debt Advisors.

 

The net change in unrealized depreciation for the six months ended June 30, 2010 is primarily due to (i) an approximate $5 million net increase in the market value of certain broadly syndicated loans as a result of current market conditions; (ii) an approximate $3 million increase in the net value of CLO fund securities; and (iii) an approximate $7 million decrease in the value of Katonah Debt Advisors.

 

Net Change in Stockholders’ Equity Resulting From Operations

 

The net change in stockholders’ equity resulting from operations for the three months ended June 30, 2010 and 2009 was a decrease of approximately $6 million and an increase of $13 million, respectively, or a decrease of $2.53 and an increase of $0.59 per share, respectively.  The net change in stockholders’ equity resulting from operations for the six months ended June 30, 2010 and 2009 was a decrease of approximately $4 million, and an increase of approximately $22 million, respectively, or a decrease of $0.18 and an increase of $1.0 per share, respectively.

 

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Net Investment Income and Net Realized Gains (Losses)

 

Net investment income and net realized gains (losses) represents the net change in stockholders’ equity before net unrealized appreciation or depreciation on investments. For the three months ended June 30, 2010 and 2009, net investment income and realized gains (losses) was approximately $5 million and $3 million, respectively, or $2.28 and $0.12, per share, respectively.  For the six months ended June 30, 2010 and 2009, net investment income and realized losses were approximately $5 million and $7 million, respectively, or $0.21 and $0.32, per share, respectively.

Dividends

 

For the three months ended June 30, 2010, we declared a $0.17 dividend per share. As a result, there was a dividend distribution of approximately $4 million for the second quarter declaration, which was booked in the third quarter.  We intend to continue to distribute quarterly dividends to our stockholders. To avoid certain excise taxes imposed on RICs, we currently intend to distribute during each calendar year an amount at least equal to the sum of:

 

•

98% of our ordinary net taxable income for the calendar year;

•

98% of our capital gains, if any, in excess of capital losses for the one-year period ending on October 31 of the calendar year; and

•

any net ordinary income and net capital gains for the preceding year that were not distributed during such year.

 

The amount of our declared dividends, as evaluated by management and approved by our Board of Directors, is based on our evaluation of both distributable income for tax purposes and GAAP net investment income (which excludes unrealized gains and losses). Generally, we seek to fund our dividends from GAAP current earnings, primarily from net interest and dividend income generated by our investment portfolio and without a return of capital or a high reliance on realized capital gains. The following table sets forth the quarterly dividends declared by us in the two most recently completed years, which represent an amount equal to our estimated net investment income for the specified quarter, including income distributed from Katonah Debt Advisors received by the Company, plus a portion of any prior year undistributed amounts of net investment income distributed in subsequent years:

Dividend

Declaration Date

Record Date

Pay Date

2010:

Second quarter

$

0.17

6/23/2010

7/7/2010

7/29/2010

First quarter

0.17

3/19/2010

4/7/2010

4/29/2010

2009:

Fourth quarter

$

0.20

12/15/2009

12/28/2009

1/25/2010

Third quarter

0.24

9/24/2009

10/9/2009

10/29/2009

Second quarter

0.24

6/12/2009

7/9/2009

7/29/2009

First quarter

0.24

3/23/2009

4/8/2009

4/29/2009

Total declared for 2009

$

0.92

Due to our ownership of Katonah Debt Advisors and certain timing, structural and tax considerations our dividend distributions may include a return of capital for tax purposes. For the six months ended June 30, 2010, Katonah Debt Advisors had approximately $1 million of pre-tax net income and made distributions of $1.5 million to us, a portion of which represented undistributable earnings from prior years.  For the six months ended June 30, 2009, Katonah Debt Advisors earned approximately $1 million of pre-tax net income and made no distributions to us; dividends are recorded as declared (where declaration date represents ex-dividend date) by Katonah Debt Advisors as income on our statement of operations.

 

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INVESTMENT PORTFOLIO

 

Investment Objective

 

Our investment objective is to generate current income and capital appreciation from the investments made by our middle market business in senior secured term loans, mezzanine debt and selected equity investments in privately-held middle market companies, and from our investment in Katonah Debt Advisors. We intend to grow our portfolio of assets by raising additional capital, including through the prudent use of leverage available to us. We primarily invest in first and second lien term loans which, because of their priority in a company’s capital structure, we expect will have lower default rates and higher rates of recovery of principal if there is a default and which we expect will create a stable stream of interest income. While our primary investment focus is on making loans to, and selected equity investments in, privately-held middle market companies, we may also invest in other investments such as loans to larger, publicly-traded companies, high-yield bonds and distressed debt securities. We may also receive warrants or options to purchase common stock in connection with our debt investments. In addition, we may also invest in debt and equity securities issued by CLO Funds managed by Katonah Debt Advisors or by other asset managers. However, our investment strategy is to limit the value of our investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of our total investment portfolio at the time of investment. We invest almost exclusively in credit instruments issued by corporations and do not invest in asset-backed securities such as those secured by commercial mortgages, residential mortgages or other consumer borrowings.

 

The following table shows the Company’s portfolio by security type at June 30, 2010 and December 31, 2009:

		June 30, 2010												December 31, 2009
Security Type		Cost				Fair Value				%¹				Cost				Fair Value				%¹
Time Deposits		$	12,491,457			$	12,491,457				4	%		$	126			$	126				—	%
Money Market Account			216,179				216,179				—				-				-				—
Senior Secured Loan			139,191,719				123,337,607				35				179,425,767				159,075,586				39
Junior Secured Loan			112,435,054				98,982,230				28				129,016,237				114,920,499				28
Mezzanine Investment			10,744,497				548,971				—				28,606,852				19,235,444				5
Senior Subordinated Bond			4,240,890				3,598,535				1				3,007,167				2,415,000				1
Senior Unsecured Bond			—				—				—				2,000,000				1,710,000				—
Preferred Stock			400,000				382,800				—				—				—				—
CLO Fund Securities			68,237,622				52,151,000				15				68,195,049				48,971,000				12
Equity Securities			14,216,146				6,554,693				2				12,365,603				4,713,246				1
Affiliate Asset Managers			43,321,870				53,703,377				15				40,751,511				58,064,720				14
Total		$	405,495,434			$	351,966,849				100	%		$	463,368,312			$	409,105,621				100	%

 

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¹     Represents percentage of total portfolio at fair value.

Investment Securities

 

We invest in senior secured loans, mezzanine debt and, to a lesser extent, equity, of middle market companies in a variety of industries. We generally target companies that generate positive cash flows because we look to cash flows as the primary source for servicing debt. However, we may invest in other industries if we are presented with attractive opportunities.

 

We employ a disciplined approach in the selection and monitoring of our investments. Generally, we target investments that will provide a current return through interest income to provide for stability in our net income and place less reliance on realized capital gains from our investments. Our investment philosophy is focused on preserving capital with an appropriate return profile relative to risk. Our investment due diligence and selection generally focuses on an underlying issuer’s net cash flow after capital expenditures to service its debt rather than on multiples of net income, valuations or other broad benchmarks which frequently miss the nuances of an issuer’s business and prospective financial performance. We also avoid concentrations in any one industry or issuer. We manage risk through a rigorous credit and investment underwriting process and an active portfolio monitoring program.

 

Kohlberg Capital’s Board of Directors is ultimately and solely responsible for making a good faith determination of the fair value of portfolio investments on a quarterly basis. Debt and equity securities for which market quotations are readily available are generally valued at such market quotations. Debt and equity securities that are not publicly traded or whose market price is not readily available are valued by the Board of Directors based on detailed analyses prepared by management, the Valuation Committee of the Board of Directors, and, in certain circumstances, third parties with valuation expertise. Valuations are conducted by management on 100% of the investment portfolio at the end of each quarter. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ materially from the values that would have existed had a ready market existed for such investments. Further, such investments may be generally subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities. In addition, changes in the market environment and other events may occur over the life of the investments that may cause the value realized on such investments to be different from the currently assigned valuations.

 

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We derive fair value for our illiquid investments that do not have indicative fair values based upon active trades primarily by using a present value technique that discounts the estimated contractual cash flows for the underlying assets with discount rates imputed by broad market indices, bond spreads and yields for comparable issuers relative to the subject assets (the “Market Yield Approach”) and also consider recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan and debt investments. Because we have not identified any market index that directly correlates to the loan and debt investments held by us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy. The appropriateness of specific valuation methods and techniques may change as market conditions and available data change.

 

In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance that clarifies and requires new disclosures about fair value measurements. The clarifications and requirement to disclose the amounts and reasons for significant transfers between Level I and Level II, as well as significant transfers in and out of Level III of the fair value hierarchy, were adopted by us in the first quarter of 2010. Note 4 –to the financial statements reflects the amended disclosure requirements. The new guidance also requires that purchases, sales, issuances and settlements be presented gross in the Level III reconciliation and that requirement is effective for fiscal years beginning after December 15, 2010 and for interim periods within those years, with early adoption permitted. The Company is evaluating the increased disclosure requirements for implementation by the effective date. Since this new guidance only amends the disclosures requirements, it did not impact our statements of financial position, statements of operations, or cash flow statements.

 

ASC Fair Value Measurements and Disclosures (“Fair Value Measurements and Disclosure ”) requires the disclosure in interim and annual periods of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, during the period.

 

We engaged Valuation Research Corporation (“VRC”), an independent valuation firm, to provide third-party valuation estimates for approximately 39% of investments at fair value as of December 31, 2009. VRC’s valuation estimates were considered as one of the relevant data inputs in the Company’s determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of June 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of our annual year end valuation process.

 

The majority of our investment portfolio is composed of debt and equity securities with unique contract terms and conditions and/or complexity that requires a valuation of each individual investment that considers multiple levels of market and asset specific inputs, including historical and forecasted financial and operational performance of the individual investment, projected cash flows, market multiples, comparable market transactions, the priority of the security compared with those of other securities for such issuers, credit risk, interest rates and independent valuations and reviews.

 

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Loans and Debt Securities.

 

To the extent that our investments are exchange traded and are priced or have sufficient price indications from normal course trading at or around the valuation date (financial reporting date), such pricing will determine fair value. Pricing service marks from third party pricing services may be used as an indication of fair value, depending on the volume and reliability of the marks, sufficient and reasonable correlation of bid and ask quotes, and, most importantly, the level of actual trading activity. However, most of our investments are illiquid investments with little or no trading activity. Further, we have been unable to identify directly comparable market indices or other market guidance that correlate directly to the types of investments we own. As a result, for most of our assets, we determine fair value using alternative methodologies and models using available market data, as adjusted, to reflect the types of assets we own, their structure, qualitative and credit attributes and other asset specific characteristics.

 

We derive fair value for our illiquid investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach and also consider recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan and debt investments. Because we have not identified any market index that directly correlates to the loan and debt investments held by us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy.

 

Equity and Equity-Related Securities.

 

Our equity and equity-related securities in portfolio companies for which there is no liquid public market are carried at fair value based on the enterprise value of the portfolio company, which is determined using various factors, including EBITDA, cash flows from operations less capital expenditures and other pertinent factors, such as recent offers to purchase a portfolio company’s securities or other liquidation events. The determined fair values are generally discounted to account for restrictions on resale and minority ownership positions. The values of our equity and equity-related securities in public companies for which market quotations are readily available are based upon the closing public market price on the balance sheet date. Securities that carry certain restrictions on sale are typically valued at a discount from the public market value of the security.

 

The significant inputs used to determine the fair value of equity and equity-related securities include prices, earnings, EBITDA and cash flows after capital expenditures for similar peer comparables and the investment entity itself. Equity and equity related securities are classified as Level III when there is limited activity or less transparency around inputs to the valuation given the lack of information related to such equity investments held in nonpublic companies. Significant assumptions observed for comparable companies as applied to relevant financial data for the specific investment. Such assumptions, such as model discount rates or price/earnings multiples, vary by the specific investment, equity position and industry and incorporate adjustments for risk premiums, liquidity and company specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.

 

At June 30, 2010 and June 30, 2009, our investments in loans and debt securities, excluding CLO Fund securities, had a weighted average interest rate of approximately 5.4% and 6.3%, respectively.

 

The investment portfolio (excluding the Company’s investment in asset manager affiliates and CLO Funds) at June 30, 2010 was spread across 25 different industries and 68 different entities with an average balance per entity of approximately $3 million. As of June 30, 2010, all but five of our portfolio companies were current on their debt service obligations. Our portfolio, including the CLO Funds in which it invests, and the CLO Funds managed by Katonah Debt Advisors consist almost exclusively of credit instruments issued by corporations and do not include investments in asset-backed securities, such as those secured by commercial mortgages, residential mortgages or other consumer borrowings.

 

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We may invest up to 30% of our investment portfolio in opportunistic investments in high-yield bonds, debt and equity securities of CLO Funds, distressed debt or equity securities of public companies. However, our investment strategy is to limit the value of our investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of our total investment portfolio at the time of investment. We expect that these public companies generally will have debt that is non-investment grade. We also may invest in debt of middle market companies located outside of the United States, which investments are generally not anticipated to be in excess of 10% of our investment portfolio at the time such investments are made. At June 30, 2010, approximately 19% of our investments were foreign assets (including our investments in CLO Funds, which are typically domiciled outside the U.S. and represent approximately 15% of our portfolio). We are generally prohibited from buying or selling any security from or to any portfolio company of a private equity fund managed by Kohlberg & Co. without the prior approval of the U.S. Securities and Exchange Commission (the “Commission” or the “SEC”). However, we may co-invest on a concurrent basis with Kohlberg & Co. or any of our affiliates, subject to compliance with existing regulatory guidance, applicable regulations and our allocation procedures. Certain types of negotiated co-investments may be made only if we receive an order from the SEC permitting us to do so. There can be no assurance that any such order will be applied for or, if applied for, obtained.

 

At June 30, 2010, our ten largest portfolio companies represented approximately 41% of the total fair value of our investments. Our largest investment, Katonah Debt Advisors which is our wholly-owned portfolio company, represented 15% of the total fair value of our investments. Excluding Katonah Debt Advisors and CLO Fund securities, our ten largest portfolio companies represent approximately 18% of the total fair value of our investments.

 

CLO Fund Securities

 

We typically make a minority investment in the subordinated securities or preferred stock of CLO Funds raised and managed by Katonah Debt Advisors and may selectively invest in securities issued by CLO Funds managed by other asset management companies. As of June 30, 2010, we had approximately $52 million invested in CLO Fund securities, including those issued by funds managed by Katonah Debt Advisors.

 

The CLO Funds managed by Katonah Debt Advisors invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The underlying assets in each of the CLO Funds in which we have an investment are generally diversified secured or unsecured corporate debt. The underlying assets in our CLO Funds exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments.

 

Our CLO Fund investments as of June 30, 2010 and December 31, 2009 are as follows:

							June 30, 2010								December 31, 2009
CLO Fund Securities		Investment		%1			Cost				Fair Value				Cost				Fair Value
Grant Grove CLO, Ltd.		Subordinated Securities		22.2	%		$	4,718,436			$	3,380,000			$	4,715,858			$	2,780,000
Katonah III, Ltd.		Preferred Shares		23.1				4,500,000				880,000				4,500,000				950,000
Katonah IV, Ltd.3		Preferred Shares		17.1				3,150,000				980,000				3,150,000				290,000
Katonah V, Ltd.3		Preferred Shares		26.7				3,320,000				1,000				3,320,000				1,000
Katonah VII CLO Ltd.2, 3		Subordinated Securities		16.4				4,500,000				2,030,000				4,500,000				1,840,000
Katonah VIII CLO Ltd.2, 3		Subordinated Securities		10.3				3,400,000				1,960,000				3,400,000				1,760,000
Katonah IX CLO Ltd.2, 3		Preferred Shares		6.9				2,000,000				1,700,000				2,000,000				1,560,000
Katonah X CLO Ltd.2		Subordinated Securities		33.3				11,600,400				8,330,000				11,589,830				8,280,000
Katonah 2007-1 CLO Ltd.2		Preferred Shares		100.0				29,965,368				26,710,000				29,940,867				27,100,000
Katonah 2007-1 CLO Ltd.2		Class B-2L Notes		100.0				1,083,418				6,180,001				1,078,494				4,410,000
Total							$	68,237,622			$	52,151,001			$	68,195,049			$	48,971,000

 

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¹  Represents percentage of class held.

²  An affiliate CLO Fund managed by Katonah Debt Advisors.

³  As of June 30, 2010, these CLO Fund Securities were not providing a dividend distribution.

 

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Our investments in CLO Fund securities are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the CLO Funds that are approaching or past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions to the class of securities owned by us, (ii) the NAV of the CLO Fund for CLO Funds that are approaching or past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there are negligible net cash distributions to the class of securities owned by us, or (iii) a discounted cash flow model for more recent CLO Funds that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities or preferred shares to those in which we have invested. We recognize unrealized appreciation or depreciation on our investments in CLO Fund securities as comparable yields in the market change and/or based on changes in NAVs or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investments. We determine the fair value of our investments in CLO Fund securities on an individual security-by-security basis.

 

Due to the individual attributes of each CLO Fund security, they are classified as a Level III (as described in—“Critical Accounting Policies—Valuation of Portfolio Investments” below) investment unless specific trading activity can be identified at or near the valuation date. When available, Level II (as described in “—Critical Accounting Policies—Valuation of Portfolio Investments” below) market information will be identified, evaluated and weighted accordingly in the application of such data to the present value models and fair value determination. Significant assumptions to the present value calculations include default rates, recovery rates, prepayment rates, investment/reinvestment rates and spreads and the discount rate by which to value the resulting underlying cash flows. Such assumptions can vary significantly, depending on market data sources which often vary in depth and level of analysis, understanding of the CLO market, detailed or broad characterizations of the CLO market and the application of such data to an appropriate framework for analysis. The application of data points are based on the specific attributes of each individual CLO Fund security’s underlying assets, historic, current and prospective performance, vintage, and other quantitative and qualitative factors that would be evaluated by market participants. We evaluate the source of market data for reliability as an indicative market input, consistency amongst other inputs and results and also the context in which such data is presented.

 

For bond rated tranches of CLO Fund securities (those above the junior class) without transactions to support a fair value for the specific CLO Fund and tranche, fair value is based on discounting estimated bond payments at current market yields, which may reflect the adjusted yield on the leveraged loan index for similarly rated tranches, as well as prices for similar tranches for other CLO Funds, and also considers other factors such as the default and recovery rates of underlying assets in the CLO Fund, as may be applicable. Such model assumptions may vary and incorporate adjustments for risk premiums and CLO Fund specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.

 

The unaudited table below summarizes certain attributes of each CLO Fund as per their most recent trustee reports as of June 30, 2010 and December 31, 2009:

CLO Fund Securities1		Number of Securities				Number of Issuers				Number of Industries				Average Security Position Size				Average Issuer Position Size
Grant Grove CLO, Ltd.			244				177				31			$	1,146,406			$	1,580,356
Katonah III, Ltd.			244				160				31				1,427,674				2,177,202
Katonah IV, Ltd.			222				149				26				977,879				1,456,974
Katonah V, Ltd.			265				172				29				519,130				799,822
Katonah VII CLO Ltd.			260				197				33				1,247,334				1,646,228
Katonah VIII CLO Ltd.			275				205				33				1,360,130				1,824,565
Katonah IX CLO Ltd.			264				203				33				1,538,000				2,000,157
Katonah X CLO Ltd.			260				204				32				1,750,377				2,230,873
Katonah 2007-1 CLO Ltd.			233				181				31				1,328,816				1,710,575

¹  All data from most recent Trustee reports as of June 30, 2010.

 

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In May 2009, we purchased the class B-2L notes of the Katonah 2007-1 CLO investment managed by Katonah Debt Advisors (“Katonah 2007-1 B-2L”). We purchased the Katonah 2007-1 B-2L for 10% of the par value. The fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment as of June 30, 2010 were approximately $6 million, $1 million, and $5 million, respectively, and at December 31, 2009, the fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment were $4 million, $1 million, and $3 million, respectively. Both the B-2L notes and preferred shares of Katonah 2007-1 are owned 100% by us and Katonah 2007-1 is current in the payment of all quarterly distributions in respect of the B-2L notes and the preferred shares.

Katonah Debt Advisors

 

Katonah Debt Advisors is our wholly-owned asset management company that manages CLO Funds that invest in broadly syndicated loans, high yield bonds and other credit instruments. The CLO Funds managed by Katonah Debt Advisors consist exclusively of credit instruments issued by corporations and do not invest in asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings. As of June 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of par value of assets under management on which it earns management fees, and was valued at approximately $54 million.

 

As a manager of the CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees as well as an expected one-time structuring fee from the CLO Funds for its management and advisory services. In addition, Katonah Debt Advisors may also earn income related to net interest on assets accumulated for future CLO issuances on which it has provided a first loss guaranty in connection with loan warehouse arrangements for its CLO Funds. Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds its operating expenses.

 

The annual management fees which Katonah Debt Advisors receives are generally based on a fixed percentage of the par value of assets under management and are recurring in nature for the term of the CLO Fund so long as Katonah Debt Advisors manages the fund. As a result, the annual management fees earned by Katonah Debt Advisors are not subject to market value fluctuations in the underlying collateral. The annual management fees Katonah Debt Advisors receives have two components - a senior management fee and a subordinated management fee.  At June 30, 2010, Katonah Debt Advisors continued to receive all senior management fees payable by the CLO Funds managed by it. However, one CLO Fund (representing approximately $340 million of the $2.1 billion of Katonah Debt Advisors’ assets under management), is not paying its subordinated management fee.  These subordinated management fees, totaling approximately $1.2 million per year, have been restricted from being paid as a result of the failure by the CLO Fund to satisfy certain restrictive covenants contained in their indenture agreements. Such subordinated management fees continue to be accrued by the applicable CLO Fund (and on the books of Katonah Debt Advisors), and will be payable to Katonah Debt Advisors when such CLO Fund becomes compliant with the applicable covenants. As of June 30, 2010, approximately $3.3 million of subordinated management fees have been accrued and Katonah Debt Advisors currently expects a portion of such fees paid to it within the next year. However, there can be no assurance that these fees will become payable or, if they do become payable, that the applicable CLO Fund will have sufficient cash to make the payments to Katonah Debt Advisors.

 

In future years, Katonah Debt Advisors may receive accrued incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.

 

Subject to market conditions, we expect to continue to make investments in CLO Funds managed by Katonah Debt Advisors, which we believe will provide us with a current cash investment return. We believe that these investments will provide Katonah Debt Advisors with greater opportunities to access new sources of capital which will ultimately increase Katonah Debt Advisors’ assets under management and resulting management fee income. We also expect to receive distributions of recurring fee income and, if debt markets stabilize and recover, to generate capital appreciation from our investment in the asset management business of Katonah Debt Advisors.

 

The revenue that Katonah Debt Advisors generates through the fees it receives for managing CLO Funds and after paying the expenses pursuant to an overhead allocation agreement with the Company associated with its operations, including compensation of its employees, may be distributed to Kohlberg Capital. Cash distributions of Katonah Debt Advisors’ net income are recorded as dividends from an affiliate asset manager when declared. As with all other investments, Katonah Debt Advisors’ fair value is periodically determined. Our investment in Katonah Debt Advisors is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis of comparable asset management companies. Katonah Debt Advisors is classified as a Level III investment. Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.

 

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PORTFOLIO AND INVESTMENT ACTIVITY

 

Our primary business is lending to and investing in middle-market businesses through investments in senior secured loans, junior secured loans, subordinated/mezzanine debt investments, CLO equity investments and other equity-based investments, which may include warrants.

 

Total portfolio investment activity (excluding activity in time deposit and money market investments) for the six months ended June 30, 2010 and for the year ended December 31, 2009 was as follows:

		Debt Securities				CLO Fund Securities				Equity Securities				Affiliate Asset Managers				Total Portfolio
Fair Value at December 31, 2008 (as restated)		$	353,859,007			$	34,640,000			$	5,089,365			$	54,734,812			$	448,323,184
2009 Activity:
Purchases / originations /draws		$	1,509,987			$	1,076,250			$	8,625,627			$	4,018,309			$	15,230,173
Pay-downs / pay-offs / sales			(72,227,405)				—				—				—				(72,227,405)
Net accretion of discount			964,724				742,204				—				—				1,706,928
Net realized losses			(12,050,370)				—				(1,516,682)				(2,215,069)				(15,782,121)
Decrease in fair value			25,300,586				12,512,546				(7,485,064)				1,526,668				31,854,736
Fair Value at December 31, 2009			297,356,529				48,971,000				4,713,246				58,064,720				409,105,495
Year to Date 2010 Activity:
Purchases / originations /draws			6,915,919				—				1,850,543				2,570,359				11,336,821
Pay-downs / pay-offs / sales			(74,477,430)				—				—				—				(74,477,430)
Net accretion of discount			223,452				42,573				—				—				266,025
Net realized losses			(7,705,806)				—				—				—				(7,705,806)
Increase (decrease) in fair value			4,537,479				3,137,427				(9,096)				(6,931,702)				734,108
Fair Value at June 30, 2010		$	226,850,143			$	52,151,000			$	6,554,693			$	53,703,377			$	339,259,213

 

The level of investment activity for investments funded and principal repayments for our investments can vary substantially from period to period depending on the number and size of investments that we invest in or divest of, and many other factors, including the amount and competition for the debt and equity securities available to middle market companies, the level of merger and acquisition activity for such companies and the general economic environment.

RESULTS OF OPERATIONS

 

The principal measure of our financial performance is the net increase (decrease) in stockholders’ equity resulting from operations which includes net investment income (loss) and net realized and unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees, and other investment income and our operating expenses. Net realized gain (loss) on investments, is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net change in unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio.

 

Set forth below is a discussion of our results of operations for the three and six months ended June 30, 2010 and 2009.

 

Investment Income

 

Investment income for the three months ended June 30, 2010 and 2009 was approximately $7 million and $9 million, respectively. Of these amounts, approximately $3 million and $6 million was attributable to interest income on our loan and bond investments, respectively. For each of the three months ended June 30, 2010 and 2009, approximately $2 million of investment income is attributable to dividends earned on CLO equity investments.

 

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Investment income for the six months ended June 30, 2010 and 2009 was approximately $14 million and $18 million, respectively. Of this amount, approximately $8 million and $13 million, respectively, was attributable to interest income on our loan and bond investments. For the six months ended June 30, 2010 and 2009, approximately $5 million and $5 million, respectively, of investment income is attributable to dividends earned on CLO equity investments.

 

Investment income is primarily dependent on the composition and credit quality of our investment portfolio. Generally, our debt securities portfolio is expected to generate predictable, recurring interest income in accordance with the contractual terms of each loan. Corporate equity securities may pay a dividend and may increase in value for which a gain may be recognized; generally such dividend payments and gains are less predictable than interest income on our loan portfolio.

 

Dividends from CLO Fund securities are dependent on the performance of the underlying assets in each CLO Fund; interest payments, principal amortization and prepayments of the underlying loans in each CLO Fund are primary factors which determine the level of income on our CLO Fund securities. The level of excess spread from CLO Fund securities can be impacted by the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly.

 

Dividends from Affiliate Asset Manager

 

As of June 30, 2010, our investment in Katonah Debt Advisors was approximately $54 million. For the three months ended June 30, 2010 and 2009, Katonah Debt Advisors had pre-tax net income of approximately $470,000 and $880,000, respectively. For the six months ended June 30, 2010 and 2009, Katonah Debt Advisors had pre-tax net income of approximately $1 million and $1 million, respectively. For the three and six months ended June 30, 2010, Katonah Debt Advisors made distributions of $1.5 million, a portion of which represented undistributed earnings from prior years.  For the three and  six months ended June 30, 2009, Katonah Debt Advisors distributed made no distributions of net income.

 

Distributions of Katonah Debt Advisors’ net income are recorded as dividends from affiliate asset manager. The Company intends to distribute the accumulated undistributed net income of Katonah Debt Advisors in the future. For purposes of calculating distributable tax income for required quarterly dividends as a RIC, Katonah Debt Advisors’ net income is further reduced by approximately $2 million per annum for tax goodwill amortization resulting from its acquisition by us prior to our initial public offering. As a result, the amount of our declared dividends, as evaluated by management and approved by our Board of Directors, is based on our evaluation of both distributable income for tax purposes and GAAP net investment income (which excludes unrealized gains and losses).

 

Expenses

 

Total expenses for the three months ended June 30, 2010 and 2009 were approximately $7 million and $3 million, respectively. Interest expense and amortization on debt issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $2 million and $2 million, respectively, on average debt outstanding of $171 million and $237 million, respectively. Approximately $816,000 and $824,000, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option expense for the three months ended June 30, 2010 and 2009.  For the three months ended June 30, 2010, other expenses included approximately $4 million for professional fees, insurance, administrative and other.  For the three months ended June 30, 2009, other expenses included approximately $658,000 for professional fees, insurance, administrative and other.  For the three months ended June 30, 2010 and 2009, administrative and other costs (including occupancy expense, insurance, technology and other office expenses) totaled approximately $324,000 and $268,000, respectively.

 

Total expenses for the six months ended June 30, 2010 and 2009 were approximately $11 million and $6 million, respectively. Interest expense and amortization on debt issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $5 million and $3 million, on average debt outstanding of $187 million and $246 million, respectively. Approximately $2 million and $2 million, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option expense for the six months ended June 30, 2010 and 2009.  For the six months ended June 30, 2010 and 2009, other expenses included approximately $5 million for professional fees, insurance, administrative and other.  For the six months ended June 30, 2010 and 2009, administrative and other costs totaled approximately $614,000 and $530,000, respectively, and include occupancy expense, insurance, technology and other office expenses.

 

Interest and compensation expense are generally expected to be our largest expenses each period. Interest expense is dependent on the average outstanding principal balance on our Facility and the base index rate for the period. Compensation expense includes base salaries, bonuses, stock compensation, employee benefits and employer related payroll costs. The largest components of total compensation costs are base salaries and bonuses; generally, base salaries are expensed as incurred and bonus expenses are estimated and accrued since bonuses are paid annually.

 

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Professional fee expenses for the three and six months ended June 30, 2010 are significantly higher by approximately $3 million relative to the same prior years periods due to increased legal expenses (approximately $2 million), accounting (approximately $1 million) and valuation services (approximately $470,000).  This increase in professional fees is primarily related to legal proceeding and our complaint against our lenders and additional legal, accounting and valuation costs related to the restatement (and defense on the related class-action and SEC investigation) of our year-end 2008 and first-and second- quarter 2009 financial statements.

 

Net Unrealized Appreciation on Investments

 

During the three months ended June 30, 2010 and 2009, our total investments had a change in net unrealized depreciation of approximately $554,000 and $10 million, respectively. For the three months ended June 30, 2010, Katonah Debt Advisors had a change in unrealized depreciation of approximately $2 million and our middle market portfolio of debt securities, equity securities and CLO Fund securities had a change in net unrealized depreciation of approximately $1 million.  For the three months ended June 30, 2009, Katonah Debt Advisors had a change in unrealized appreciation of $699,000 offset by a change in unrealized depreciation of approximately $10 million on debt securities, equity securities and CLO Fund securities in our investment portfolio.

 

During the six months ended June 30, 2010 and 2009, our total investments had a change in net unrealized appreciation of approximately $734,000 and $15 million, respectively. For the six months ended June 30, 2010, Katonah Debt Advisors had a change in unrealized depreciation of approximately $7 million and our middle market portfolio of debt securities, equity securities and CLO Fund securities had a change in unrealized appreciation of approximately $8 million.  For the six months ended June 30, 2009, Katonah Debt Advisors had a change in unrealized appreciation of approximately $2 million and unrealized gains of approximately $13 million, on debt securities, equity securities and CLO Fund securities in our investment portfolio.

 

Net Increase (Decrease) in Stockholders’ Equity Resulting From Operations

 

The net decrease in stockholders’ equity resulting from operations for the three and six months ended June 30, 2010 was approximately $6 million and $4 million, respectively, or a decrease of $2.53 and $0.18, respectively, per share.  The net increase in stockholders’ equity resulting from operations for the three and six months ended June 30, 2009 was approximately $13 million and $22 million, or $0.59 and $1.00, respectively, per share.

FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES

 

Liquidity is a measure of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, pay dividends to our stockholders and other general business needs. We recognize the need to have funds available for operating our business and to make investments. We seek to have adequate liquidity at all times to cover normal cyclical swings in funding availability and to allow us to meet abnormal and unexpected funding requirements. We plan to satisfy our liquidity needs through normal operations with the goal of avoiding unplanned sales of assets or emergency borrowing of funds.

 

In addition to the traditional sources of available funds (issuance of new equity, debt or undrawn warehouse facility capacity), we also have the ability to raise additional cash funds through the securitization of assets on our balance sheet through our wholly-owned asset manager, Katonah Debt Advisors. Such a securitization would provide cash for new investments on our balance sheet as well as additional management fee income and potentially increased value (as a result of increased assets under management) for Katonah Debt Advisors. No new securitizations by Katonah Debt Advisors have closed since January 2008.

 

As a BDC, we are limited in the amount of leverage we can incur to finance our investment portfolio. In order to incur new debt, we are required to meet a coverage ratio of total assets to total senior securities of at least 200%. For this purpose, senior securities include all borrowings and any preferred stock. As a result, our ability to utilize leverage as a means of financing our portfolio of investments is limited by this asset coverage test. As of June 30, 2010, we had $145 million of outstanding borrowings and our asset coverage was 243%, which is above the minimum asset coverage level generally required by the 1940 Act for a BDC to incur new debt.

 

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As of June 30, 2010 and December 31, 2009 the fair value of investments and cash were as follows:

		Investments at Fair Value
Security Type		June 30, 2010				December 31, 2009
Cash		$	314,302			$	4,140,408
Time Deposits			12,491,457				126
Money Market Accounts			216,179				—
Senior Secured Loan			123,337,607				159,075,586
Junior Secured Loan			98,982,230				114,920,499
Mezzanine Investment			548,971				19,235,444
Senior Subordinated Bond			3,598,535				2,415,000
Senior Unsecured Bond			—				1,710,000
Preferred Stock			382,800				—
CLO Fund Securities			52,151,001				48,971,000
Equity Securities			6,554,693				4,713,246
Affiliate Asset Managers			53,703,377				58,064,720
Total		$	352,281,152			$	413,246,029

 

On February 14, 2007, we entered into the Facility under which we may obtain up to $200 million in financing. On October 1, 2007, we amended the Facility to increase our borrowing capacity from $200 million to $275 million, extend the maturity date from February 12, 2012 to October 1, 2012 and increase the interest spread charged on outstanding borrowings by 15 basis points to 0.85%. The interest rate is based on prevailing commercial paper rates plus 0.85% or, if the commercial paper market is at any time unavailable, prevailing LIBOR rates plus an applicable spread. Interest is payable monthly. As disclosed above, as a result of the Agent’s assertion that a Termination Event occurred under the LFSA, since June 2009 interest under the LFSA has been calculated at a higher default rate (equal to 0.85% above the prime rate plus 0.75%).

 

Advances under the Facility (to the extent available to us) are used by us primarily to make additional investments. The Facility is secured by loans acquired by us with the advances under the Facility. We borrow under the Facility through our wholly-owned, special-purpose bankruptcy remote subsidiary, KCAP Funding. As described further below, we have not drawn on the Facility since August 2008.

 

In connection with the Facility, we are party to the LFSA, by and among us as the servicer, KCAP Funding, as the borrower, the Agent, the Trustee, and the other lender parties and other parties thereto.  As of June 30, 2010 there were outstanding borrowings of approximately $145 million under the LFSA.  In accordance with the terms of the LFSA, the financial assets acquired with the proceeds of borrowings under the LFSA are held in a securities account and are subject to a securities account control agreement granting the Agent certain rights in respect of such securities account and the financial assets held therein.  As of June 30, 2010 there were financial assets held in the securities account with a market value of approximately $212 million. Borrowings under the Facility are secured only by these assets and amounts in respect of such assets on deposit in a concentration account that is subject to an intercreditor and concentration account administration agreement, and the Facility lenders do not have recourse to any other of our assets or the investment income associated with any such other assets. The assets securing the Facility represent approximately 60% of our total assets (at fair value) at June 30, 2010 and contributed approximately 45% of our investment income for the six months ended June 30, 2010.

 

In August 2008, we were notified by the lenders that the banks providing the underlying liquidity for the Facility did not intend to renew their liquidity facility to the lenders unless we agreed to certain revised terms for the Facility. The lenders proposed new terms to us as a condition to extending the underlying liquidity purchase agreements. We viewed such proposed terms as unfavorable and did not agree to such new terms, causing the Agent and the lenders to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. On June 9, 2009, we received a letter from a representative of the lenders alleging that our failure to determine ratings on certain pledged loans and our alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods during which a Termination Event had occurred and was continuing. In a letter dated June 11, 2009, we rejected the alleged breaches and the alleged occurrence of a Termination Event and also asserted that the termination of the revolving period and commencement of the amortization period under the LFSA were wrongful. On August 28, 2009, we filed a complaint in the Supreme Court of the State of New York against the Agent and other lender parties to the LFSA. The complaint reflects our beliefs that the termination of the revolving period and commencement of the amortization period under the LFSA were wrongful and that the assertions of alleged breaches of our obligations under the LFSA and the alleged occurrence of Termination Event(s) were without merit. The complaint also seeks to clarify our rights and obligations under the LFSA.

 

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Since the time the complaint was filed, the Agent, the lenders, and the lender agent parties to the LFSA have served answers seeking dismissal of the complaint and recovery of the defendants’ attorneys’ fees and costs in the action and discovery has commenced.  In addition, motions for partial summary judgment relating to the claims regarding the Termination Date have been filed by us and by the lenders and while it is expected that such motions will be fully submitted by the end of September 2010, we cannot predict when the court will issue its determination of such motions.

 

The Agent has sent additional notices of Termination Events, the latest of which is dated June 15, which we believe are without merit due to the wrongful declaration of a Termination Date, the accompanying termination of the revolving period and commencement of the amortization period. In addition, on April 2, 2010 the Agent sent a notice alleging that our failure to timely deliver annual audited financial statements for the year ended December 31, 2009 would, unless cured within 30 days of the date of the notice, constitute a Termination Event, which we also believe and have asserted is without merit based upon a non-material delay.

 

Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility through a maturity date of September 29, 2010 (the last day of the amortization period that the Company has challenged as being wrongfully commenced). Since June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event occurred, the interest payable under the LFSA has been calculated at an elevated rate (equal to 0.85 % above the prime rate plus 0.75%), and we have been paying interest calculated at such higher rate under protest. Also, despite our belief that the amortization period has been wrongfully imposed, we believe we have sufficient cash and liquid assets which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions during the amortization period. At the end of the amortization period, we may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings or we may enter into a new agreement with the lenders providing for continued amortization of the Facility borrowings or into alternative financing arrangements with another lender.

 

Under the Facility, the Company is subject to various covenants including a leverage ratio covenant pursuant to which it must maintain a leverage ratio of no more than one to one based on the ratio of the Facility’s outstanding balance to the Company’s GAAP stockholders’ equity balance. As of July 31, 2010, the Company’s leverage ratio did not exceed 1:1.

 

As of the date of filing of this Quarterly Report, the Company believes that it is not in material breach of its obligations under the LFSA, including the financial covenants. However, as described above and further in Part II, “Item 1. Legal Proceedings,” the Company and the Borrower are plaintiffs in a pending lawsuit against the Agent and the lenders involving the LFSA. While the Company and the Borrower intend to vigorously pursue the claims set forth in the complaint, neither the outcome of this litigation nor the amount and range of potential damages recoverable by the Company and the Borrower or their exposure associated with this litigation can be determined at this time. There can be no assurance that in connection with such lawsuit or otherwise the Agent and the lenders will not assert additional breaches of the LFSA, including breaches relating to the restatement referred to elsewhere in this Quarterly Report, and there can be no assurance that the Agent and the lenders will not assert that any such breaches give rise to a Termination Event. While the Company and the Borrower believe that they have meritorious claims against the Agent and the lenders in the pending lawsuit and, as a result, the breaches alleged by the Agent and the lenders are not valid in accordance with the terms of the LFSA, there is no assurance that the Company and the Borrower will prevail in such litigation. If the Company and the Borrower do not prevail, the Agent and the lenders may seek to pursue claims based on the alleged breaches, including claims involving a Termination Event. If the Agent and the lenders were to seek to accelerate and seize the collateral either at the end of the amortization period (which the Company has challenged as being wrongfully commenced) or otherwise, and the Company was unsuccessful in obtaining court relief, the Company could be forced to pay the remaining balance of the Facility (approximately $144 million as of July 31, 2010), which would adversely affect our business, liquidity, financial condition and results of operations. We estimate that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 3% to cover annual interest payments on obligations incurred under the Facility.

 

The weighted average daily debt balance for the three months ended June 30, 2010 and 2009 was approximately $171 million and $237 million, respectively. For the three months ended June 30, 2010 and 2009, the weighted average interest rate on weighted average outstanding borrowings was approximately 5% and 2% respectively, which excludes the amortization of deferred financing costs and facility and program fees on unfunded balances. We were in material compliance with all our debt covenants as of June 30, 2010. As of June 30, 2010, we had restricted cash balances of approximately $4 million which we maintained in accordance with the terms of the Facility.  The Facility contains collateral requirements, including, but not limited to, minimum diversity, rating and yield, and limitations on loan size.

 

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We are currently using any income generated by the assets collateralizing the Facility to pay principal, interest and other expenses of the Facility – despite the fact that, if we want to remain a RIC and continue to be afforded favorable tax treatment for U.S. federal income tax purposes, we are required to distribute to the shareholders substantially all of our investment company taxable income, including the net amounts generated by the collateralized assets. These collateralized assets with a market value of approximately $212 million represent approximately 60% of our total assets (at fair value) at June 30, 2010 and contributed approximately 45% of the Company’s investment income for the quarter ended June 30, 2010. Because we are using net interest income earned on the assets securing the Facility to amortize the Facility during the amortization period (which the Company has challenged as being wrongfully commenced), we may need to sell other assets not pledged to the Facility, potentially at a loss, in order to generate sufficient cash to make the required dividend distributions necessary to maintain our RIC status. In addition, at the end of the amortization period, we may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings. Any such asset sale could adversely affect our business, liquidity, financial condition and results of operations. We expect that our cash on hand, liquid investments, and cash generated from operations, including income earned from investments and any income distributions made by Katonah Debt Advisors, our wholly-owned portfolio company, will be adequate to meet our liquidity needs and distribution requirements over the next twelve months.

 

However, if we are unable to renew or replace the Facility, our liquidity may be significantly reduced. If these conditions continue for a prolonged period of time, or worsen in the future, we could lose key employees and our business prospects could be negatively impacted. Even if we are able to renew or replace the Facility, such new debt capital may be at a higher cost and/or on less favorable terms and conditions than the Facility. In addition, equity capital is, and may continue to be, difficult to raise because, subject to limited exceptions, we may not issue and sell shares of our common stock at a price below NAV without stockholder approval and issuing equity at depressed stock prices can be dilutive to our stockholders. These factors and our inability to raise additional capital to date have resulted in a reduction in new originations, curtailed our ability to grow and have had a negative impact on our liquidity and operating results. The continued inability to raise additional capital could further constrain our liquidity, negatively impact our business prospects, cause the departure of key employees and negatively impact our operating results.

COMMITMENTS AND OFF-BALANCE SHEET ARRANGEMENTS

 

We are a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the needs of our investment in portfolio companies. Such instruments include commitments to extend credit and may involve, in varying degrees, elements of credit risk in excess of amounts recognized on our balance sheet. Prior to extending such credit, we attempt to limit our credit risk by conducting extensive due diligence, obtaining collateral where necessary and negotiating appropriate financial covenants. As of both June 30, 2010 and December 31, 2009, we had committed to make a total of approximately $2 million and $2 million, respectively, of investments in various revolving senior secured loans, of which approximately $0 had been funded as of June 30, 2010 and $640,000 had been funded as of December 31, 2009. As of June 30, 2010 and December 31, 2009, we had no investments in delayed draw senior secured loans.

In October 2007, Katonah Debt Advisors entered into a letter agreement (the “Letter Agreement”) with Bear Stearns & Co. Inc. (“Bear Stearns”) in connection with a warehouse credit line established to fund the initial accumulation of assets for three CLO funds, pursuant to which agreement Katonah Debt Advisors undertook certain “first loss” commitments with respect to potential losses on assets purchased using the warehouse credit line. Such “first loss” commitments relate to (i) losses (if any) as a result of individual loan investments being ineligible for purchase by a new CLO Fund (typically due to a payment default on such loan) when such fund formation is completed or (ii) if a new CLO Fund has not been completed before the expiration of the related warehouse credit line, the loss (if any, and net of any accumulated interest income) on the resale of loans and debt securities funded by such warehouse credit line.

 

Under the Letter Agreement, Katonah Debt Advisors also engaged Bear Stearns to structure and raise three CLO funds to be managed by Katonah Debt Advisors (directly or indirectly through a services contract with an affiliate of Katonah Debt Advisors).  While one of these funds, the Katonah 2007-1 CLO Fund, in which Kohlberg Capital invested approximately $29 million to acquire all of the shares of the most junior class of securities, was completed, neither of the other 2008 CLO Funds were successfully raised.

 

As a result, pursuant to the Letter Agreement, both Katonah Debt Advisors and J.P. Morgan Securities Inc. (“JPMorgan”) (f/k/a Bear Stearns & Co. Inc.) asserted claims against each other and defenses thereto with respect to potential “first loss” payments. Without admitting any liability or wrongdoing, Katonah Debt Advisors and JPMorgan agreed to compromise and settle all of the disputes, issues and claims between them relating to the agreements in exchange for an agreement to terminate all obligations and liabilities of Katonah Debt Advisors and of JPMorgan under the existing agreements relating to the 2008 CLO Funds, payment by Katonah Debt Advisors of an aggregate of $6 million in installments over a period of one year and the forfeiture by Katonah Debt Advisors of the net interest income earned through the settlement date on the warehoused assets. In December 2008, Katonah Debt Advisors entered into a settlement and termination agreement with JPMorgan reflecting the settlement terms described above.

 

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As a result of this settlement, Katonah Debt Advisors recognized a $6 million settlement cost and write-off of previously accrued net interest income on warehoused assets of approximately $4 million for the year ended December 31, 2008.  We recognized the impact of this settlement and forfeiture of warehouse income as a non-cash reduction to the unrealized appreciation of our value of its investment in Katonah Debt Advisors and contributed additional equity to Katonah Debt Advisors. Consequently, this settlement is not expected to have a material impact on Kohlberg Capital's net investment income or quarterly dividend.

CRITICAL ACCOUNTING POLICIES

 

The financial statements are based on the selection and application of critical accounting policies, which require management to make significant estimates and assumptions. Critical accounting policies are those that are both important to the presentation of our financial condition and results of operations and require management’s most difficult, complex, or subjective judgments. Our critical accounting policies are those applicable to the valuation of investments and certain revenue recognition matters as discussed below.

 

Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared on the accrual basis of accounting in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information.  Accordingly, they do not include all of the information and footnotes required for annual financial statements. The unaudited interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto in the Company’s Form 10-K for the fiscal year ended December 31, 2009, as filed with the Commission.

 

Accounting Standards Codification. In June 2009, the FASB issued a pronouncement establishing the FASB Accounting Standards Codification (“ASC”) as the source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with GAAP. The ASC reorganized existing U.S. accounting and reporting standards issued by the FASB and other related private sector standard setters into a single source of authoritative accounting principles arranged by topic. The standard explicitly recognizes rules and interpretive releases of the SEC under federal securities laws as authoritative GAAP for SEC registrants. The ASC supersedes all existing U.S. accounting standards; all other accounting literature not included in the ASC (other than SEC guidance for publicly-traded companies) is considered non-authoritative. The ASC was effective on a prospective basis for interim and annual reporting periods ending after September 15, 2009. The adoption of the ASC changed our references to U.S. GAAP accounting standards but did not impact our results of operations, financial position or liquidity.

 

Valuation of Portfolio Investments

 

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.

 

Value, as defined in Section 2(a)(41) of 1940 Act, is generally (1) the market price for those securities for which a market quotation is readily available and (2) for all other securities and assets, fair value as determined in good faith by our Board of Directors pursuant to a valuation methodology approved by our Board of Directors. Our valuation policy is intended to provide a consistent basis for determining the fair value of the portfolio based on the nature of the security, the market for the security and other considerations including the financial performance of the portfolio company. Because of the inherent uncertainty of valuation, the Board of Directors’ determined values may differ materially from the values that would have been used had a ready market existed for the investments.

 

We are, for GAAP purposes, an investment company under the American Institute of Certified Public Accountants’ Audit and Accounting Guide for Investment Companies. As a result, we reflect our investments on our balance sheet at their estimated fair value with unrealized gains and losses resulting from changes in fair value reflected as a component of unrealized gains or losses on our statements of operations. Fair value is the amount that would be received to sell the investments in an orderly transaction between market participants at the measurement date (i.e., the exit price). Additionally, we do not consolidate majority or wholly-owned and controlled investments.

 

Effective January 1, 2008 we adopted Fair Value Measurements and Disclosures . Among other things, this standard requires enhanced disclosures about financial instruments carried at fair value. See Note 4 to the financial statements for the additional information about the level of market observability associated with investments carried at fair value.

 

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We have valued our investments, in the absence of observable market prices, using the valuation methodology described below applied on a consistent basis. For some investments little market activity may exist; management’s determination of fair value is then based on the best information available in the circumstances, and may incorporate management’s own assumptions and involves a significant degree of management’s judgment.

 

Our investments in CLO Fund securities are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the CLO Funds which are approaching or are past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions to the class of securities owned by us, or (ii) the NAV of the CLO Funds which are approaching or are past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there are negligible net cash distributions to the class of securities owned by us, or (iii) a discounted cash flow model for more recent CLO Funds that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities or preferred shares to those in which we have invested. We recognize unrealized appreciation or depreciation on our investments in CLO Fund securities as comparable yields in the market change and/or based on changes in NAVs or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investments. We determine the fair value of our investments in CLO Fund securities on an individual security-by-security basis.

 

Our investment in Katonah Debt Advisors is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis of comparable asset management companies. Katonah Debt Advisors is classified as a Level III investment (as described below). Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.

 

Fair values of other equity investments for which market prices are not observable are determined by reference to public market or private transactions or valuations for comparable companies or assets in the relevant asset class and or industry when such amounts are available. Generally these valuations are derived by multiplying a key performance metric of the investee company or asset (e.g., EBITDA) by the relevant valuation multiple observed for comparable companies or transactions, adjusted by management for differences between the investment and the referenced comparable. If the fair value of such investments cannot be valued by reference to observable valuation measures for comparable companies, then the primary analytical method used to estimate the fair value is a discounted cash flow method and/or cap rate analysis. A sensitivity analysis is applied to the estimated future cash flows using various factors depending on the investment, including assumed growth rates (in cash flows), capitalization rates (for determining terminal values) and appropriate discount rates to determine a range of reasonable values or to compute projected return on investment.

 

We derive fair value for our illiquid loan investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach, and also consider recent loan amendments or other activity specific to the subject asset as described above. Other significant assumptions, such as coupon and maturity, are asset-specific and are noted for each investment in the Schedules of Investments. Our Board of Directors may consider other methods of valuation to determine the fair value of investments as appropriate in conformity with GAAP.

 

The determination of fair value using this methodology takes into consideration a range of factors, including but not limited to the price at which the investment was acquired, the nature of the investment, local market conditions, trading values on public exchanges for comparable securities, current and projected operating performance and financing transactions subsequent to the acquisition of the investment. This valuation methodology involves a significant degree of management’s judgment.

 

After our adoption of Fair Value Measurements and Disclosures, investments measured and reported at fair value are classified and disclosed in one of the following categories:

•

Level I – Unadjusted quoted prices are available in active markets for identical investments as of the reporting date. The type of investments included in Level I include listed equities and listed securities. As required by Fair Value Measurements and Disclosures , the Company does not adjust the quoted price for these investments, even in situations where the Company holds a large position and a sale could reasonably affect the quoted price.

 

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•

Level II – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. Such inputs may be quoted prices for similar assets or liabilities, quoted markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full character of the financial instrument, or inputs that are derived principally from, or corroborated by, observable market information. Investments which are generally included in this category include illiquid corporate loans and bonds and less liquid, privately held or restricted equity securities for which some level of recent trading activity has been observed.

 

•

Level III – Pricing inputs are unobservable for the investment and includes situations where there is little, if any, market activity for the investment. The inputs may be based on the Company’s own assumptions about how market participants would price the asset or liability or may use Level II inputs, as adjusted, to reflect specific investment attributes relative to a broader market assumption. These inputs into the determination of fair value may require significant management judgment or estimation. Even if observable market data for comparable performance or valuation measures (earnings multiples, discount rates, other financial/valuation ratios, etc.) are available, such investments are grouped as Level III if any significant data point that is not also market observable (private company earnings, cash flows, etc.) is used in the valuation methodology.

 

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and it considers factors specific to the investment. Substantially all of our investments are classified as Level III.

 

Interest Income

 

Interest income, adjusted for amortization of premium and accretion of discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. We generally place a loan on non-accrual status and cease recognizing interest income on such loan or security when a loan or security becomes 90 days or more past due or if we otherwise do not expect the debtor to be able to service its debt obligations. Non-accrual loans remain in such status until the borrower has demonstrated the ability and intent to pay contractual amounts due or such loans become current.  As of June 30, 2010, five issuers representing 2% of our total investments were on non-accrual status.  As of December 31, 2009, eight issuers representing 2% of our total investments were on non-accrual status.

 

Dividend Income from CLO Fund Securities

 

We generate dividend income from our investments in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and selective investments in securities issued by funds managed by other asset management companies. Our CLO Fund securities are subordinate to senior bond holders who typically receive a fixed rate of return on their investment. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders, fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares. The level of excess spread from CLO Fund securities can be impacted by the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly. In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants may lead to the temporary suspension or deferral of cash distributions to us. We make estimated interim accruals of such dividend income based on recent historical distributions and CLO Fund performance and adjust such accruals on a quarterly basis to reflect actual distributions.

 

For non-junior class CLO Fund securities, such as our investment in the class B-2L notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR index.

 

Dividends from Affiliate Asset Manager

 

We record dividend income from our affiliate asset manager on the declaration date, which represents the ex-dividend date.

 

Payment in Kind Interest

 

We may have loans in our portfolio that contain a payment-in-kind (“PIK”) provision. PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain our RIC status, 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.

 

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Fee Income

 

Fee income includes fees, if any, for due diligence, structuring, commitment and facility fees, and, if any, for transaction services and management services rendered by us to portfolio companies and other third parties. Commitment and facility fees are generally recognized as income over the life of the underlying loan, whereas due diligence, structuring, transaction service and management service fees are generally recognized as income when the services are rendered.

 

Management Compensation

 

We may, from time to time, issue stock options or restricted stock under the Kohlberg Capital Amended and Restated 2006 Equity Incentive Plan to officers and employees for services rendered to us. We follow Compensation-Stock Compensation , a method by which the fair value of options or restricted stock is determined and expensed. We use a Binary Option Pricing Model (American, call option) to establish the expected value of all stock option grants.

 

We are internally managed and therefore do not incur management fees payable to third parties.

 

United States Federal Income Taxes

 

We have elected and intend to continue to qualify for the tax treatment applicable to RICs under Subchapter M of the Internal Revenue Code (“Code”) and, among other things, intend to make the required distributions to our stockholders as specified therein. In order to qualify as a RIC, we are required to timely distribute to our stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income, to the extent required.

 

Dividends

 

Dividends and distributions to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the Board of Directors each quarter and is generally based upon the earnings estimated by management for the period and year.

 

We have adopted a dividend reinvestment plan that provides for reinvestment of our distributions on behalf of our stockholders, unless a stockholder “opts out” of the plan to receive cash in lieu of having their dividends automatically reinvested in additional shares of our common stock.

 

Recent Accounting Pronouncements

 

On April 9, 2009, Accounting Standards Codification — Interim Disclosures about Fair Value of Financial Instruments was issued. This standard requires disclosures about financial instruments, including fair value, carrying amount, and method and significant assumptions used to estimate the fair value. We adopted this standard as of June 30, 2009 and the adoption of this standard did not affect our financial statement disclosures.

 

Two-Class Method of Presenting Earnings Per Share. In June 2008, Accounting Standards Codification – Determining Whether Instruments Granted in Share-based Payment Transactions are Participating Securities was issued. This standard requires companies to include unvested share-based payment awards that contain non-forfeitable rights to dividends in the computation of earnings per share pursuant to the two-class method. This standard is effective for financial statements issued for the years beginning after December 15, 2008, and interim periods within those years. We adopted this standard beginning with our financial statements ended March 31, 2009 and, as required, applied this standard retroactively to all reported periods. The adoption of this standard did not have a material impact on our calculations of earnings per share.

Item 3.           Quantitative and Qualitative Disclosures about Market 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.

 

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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. As of June 30, 2010, approximately 95% of our loans at fair value in our portfolio were at floating rates with a spread to an interest rate index such as LIBOR or the prime rate. We generally expect that future portfolio investments will predominately be floating rate investments. As of June 30, 2010, we had $145 million of borrowings outstanding at a floating rate tied to prevailing commercial paper rates plus a margin of 0.85%.  However, we are currently required to pay interest on our borrowings under the Facility at the higher default rate equal to 0.85% above the prime rate plus 0.75% due to the alleged breach of our obligations under the Facility asserted by the Agent, which we believe to be without merit.

 

Because we borrow 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 floating rate assets in our investment portfolio.

 

We have analyzed the potential impact of changes in interest rates on interest income net of interest expense. Assuming that our balance sheet at June 30, 2010 were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical increase or decrease of a 1% change in interest rates would correspondingly affect net interest income proportionately by approximately $1.4 million over a one-year period. Correspondingly, a hypothetical increase or decrease of a 1% change in interest rates would correspondingly affect net interest expense proportionately by approximately $1.4 million over a one-year period. Because most of our investments at June 30, 2010 were floating rate with a spread to an index similar to our Facility, we would not expect a significant impact on our net interest spread.

 

Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect a net change in assets resulting from operations or net income. Accordingly, no assurances can be given that actual results would not materially differ from the potential outcome simulated by this estimate.

 

We did not hold any derivative financial instruments for hedging purposes as of June 30, 2010. In connection with the Facility established on February 14, 2007 and as amended on October 1, 2007, our special purpose subsidiary may be required under certain circumstances to enter into interest rate swap agreements or other interest rate hedging transactions.

 

Portfolio Valuation

 

We carry our investments at fair value, as determined in good faith by our Board of Directors pursuant to a valuation methodology approved by our Board of Directors. Investments for which market quotations are generally readily available are generally valued at such market quotations. Investments for which there is not a readily available market value are valued at fair value as determined in good faith by our Board of Directors under a valuation policy and consistently applied valuation process. However, due to the inherent uncertainty of determining the fair value of investments that cannot be marked to market, the fair value of our investments may differ materially from the values that would have been used had a ready market existed for such investments. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the value realized on these investments to be different than the valuations that are assigned. The types of factors that we may take into account in fair value pricing of our investments include, as relevant, the nature and realizable value of any collateral, third party valuations, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business, comparison to publicly-traded securities, recent sales of or offers to buy comparable companies, and other relevant factors.

 

We engaged VRC, an independent valuation firm, to provide third-party valuation estimates for 39% of our investments at fair value as of December 31, 2009. VRC’s valuation estimates were considered as one of the relevant data inputs in our determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of June 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of our annual year end valuation process.

 

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Item 4             Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

As required by Rule 13a-15 under the Exchange Act, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and implementing possible controls and procedures.

 

The Company’s management, under the supervision and with the participation of various members of management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this report.  Based upon that evaluation, our CEO and CFO have concluded that our current disclosure controls and procedures are effective as of the end of the period covered by this report.

 

Changes in Internal Control Over Financial Reporting

 

Restatement of Previously Issued Financial Statements

 

Following the Company’s engagement of Grant Thornton LLP as its independent registered public accounting firm in January 2010, the Company’s management and Audit Committee concluded that the Company would have to restate its previously issued financial statements for the year ended December 31, 2008 (and the quarterly periods included in such year) as well as the quarterly periods ended March 31, 2009 and June 30, 2009. Management and the Audit Committee determined that such restatement was necessary to correct errors in the application of accounting for the fair value of the Company’s illiquid investments and the revenue recognition for certain non-cash PIK investments, which errors impacted the amount of unrealized gains (losses) reported for the Company's illiquid investments, which affects the calculation of the Company's NAV and net income, and also impacted net investment income as well as the cost basis and the net change in unrealized appreciation on certain non-cash PIK investments. The error related to fair value measurements was identified through the use and weighting of additional valuation techniques and a broader consideration of secondary market inputs.  In addition, management concluded that the Company had material weaknesses in its internal control over financial reporting related to errors in the application of accounting for the fair value of the Company’s illiquid investments and the revenue recognition for certain non-cash payment-in-kind (“PIK”) investments as of the end of each of the years ended December 31, 2009 and December 31, 2008 and each of the quarterly periods included in such years.

 

Changes in Internal Control Over Financial Reporting

 

To address these material weaknesses, during the quarter ended June 30, 2010, the Company revised its valuation procedures for estimating the fair value of its illiquid investments and has revised its accounting for non-cash PIK interest income. Under the revised valuation procedures, management considers the following factors in determining the appropriate weighting of market inputs: comparability of the market input relative to the investment being valued, the source of the information, the correlation of the data to any actual observed transaction activity, the internal consistency of such inputs to other inputs noted by the same source, and other qualitative factors that may impact the reliability, comparability, or weighting of the inputs. In addition, for investments which earn non-cash PIK interest and for which there has been a substantial decline in fair value due to underlying credit concerns for an extended period, the Company no longer accrues such non-cash PIK interest as income.  Management continues to implement the foregoing measures which it believes will effectively remediate these material weaknesses.  As of the date of filing of this report, the Company believes that it has modified its accounting for the fair value of its investments and its accounting for its non-cash PIK investments to the extent necessary to prepare the financial statements and the other financial information contained herein. As the Company continues to evaluate and work to improve its internal control over financial reporting, including remediating the material weakness with respect to maintaining effective controls over its independent review of the fair value model valuation process, management may determine to take additional measures to address the material weakness and other control deficiencies.

 

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PART II. Other Information

 

Item 1.          Legal Proceedings

 

Legal Action against Lenders under the Loan Funding and Servicing Agreement Governing The Facility

 

On August 28, 2009 the Company and KCAP Funding (the Borrower under the LFSA) filed a complaint in the Supreme Court of the State of New York against the Agent and the other lender parties to the LFSA. The Company’s discussions with the Agent to reach a mutually agreeable amendment to the LFSA were terminated prior to the filing of the complaint. The complaint reflects the Company’s and the Borrower’s beliefs that the Agent’s declaration of a Termination Date (which ended the revolving period and commenced the amortization period) was wrongful and the Agent’s assertion of the occurrence of a Termination Event based upon certain alleged breaches by the Company and the Borrower of their obligations under the LFSA is without merit. The complaint also seeks to clarify the Company’s and the Borrower’s rights and obligation under the LFSA.

 

In particular, the complaint alleges that the defendants improperly failed to make advances to the Borrower in violation of the terms of the LFSA; that the defendants’ termination of the revolving period was wrongful and improperly triggered the amortization period and default interest rate under the LFSA; that the defendants’ failure to provide relevant documents and disclose information to enable the Company and the Borrower to cure the alleged defaults constitutes material breaches of their obligations under the LFSA; and that the defendants’ actions amount to a scheme to avoid their obligations owed to the Company and the Borrower under the LFSA ( i.e. , their obligation to lend money on the terms specified in the LFSA) and an anticipatory repudiation of such obligations, thus resulting in extensive and irreparable harm to the Company and the Borrower and a suspension and/or discharge of the Company and the Borrower’s obligations under the LFSA. Based on the foregoing, the complaint requests the court to, among other things:

·

render a declaration that the termination notices were unlawful and invalid and that neither a termination date nor a termination event occurred under the LFSA;

·

order specific performance of the defendants’ obligations to make further advances under the LFSA, to withdraw the termination notices and to refrain from charging the default rate of interest;

·

award the Company and the Borrower a judgment suspending and/or discharging their obligations under the LFSA (as appropriate) as well as a judgment against the defendants in an amount to be determined at trial (but no less than $5,000,000); and

·

award the Company and the Borrower the costs, disbursements and attorneys’ fees of the action.

 

Since the time the complaint was filed, the Agent, the lenders, and the lender agent parties to the LFSA have served answers seeking dismissal of the complaint and recovery of the defendants’ attorneys’ fees and costs in the action and discovery has commenced.  In addition, motions for partial summary judgment relating to the claims regarding the Termination Date have been filed by us and by the lenders and while it is expected that such motions will be fully submitted by the end of September 2010, we cannot predict when the court will issue its determination of such motions.

 

While the Company and the Borrower intend to vigorously litigate the claims set forth in the complaint, neither the outcome of this litigation nor the amount and range of potential damages recoverable by the Company and the Borrower or their exposure associated with this litigation can be determined at this time. There can be no assurance that in connection with such lawsuit or otherwise the Agent and the lenders will not assert additional breaches of the LFSA, including breaches relating to the restatement referred to elsewhere in this Quarterly Report, and there can be no assurance that the Agent and the lenders will not assert that any such breaches give rise to a Termination Event. Pursuant to the LFSA, the Company and the Borrower are obligated to indemnify the defendants and their respective affiliates, officers, directors, employees and agents against all of their losses, expenses (including reasonable attorneys’ fees) and non-monetary damages arising out of or as a result of the LFSA, except to the extent resulting from their fraud, gross negligence or willful misconduct. The Company and the Borrower have asserted that no indemnity obligation has been triggered.

 

The Agent has sent additional notices of Termination Events, the most recent of which is dated June 15, 2010, which the Company believes are without merit due to the wrongful declaration of a Termination Date, the accompanying termination of the revolving period and commencement of the amortization period. In addition, on April 2, 2010 the Agent sent a notice alleging that the Company’s failure to timely deliver annual audited financial statements for the year ended December 31, 2009 would, unless cured within 30 days of the date of the notice, constitute a Termination Event, which the Company also believes and has asserted is without merit based upon a non-material delay.

 

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Class Actions against the Company and Certain Directors and Officers

 

The Company and certain directors and officers are named as defendants in three putative class actions pending in the Southern District of New York brought by shareholders of the Company and filed in December 2009 and January 2010. The complaints in these three actions allege violations of Sections 10 and 20 of the Exchange Act based on the Company's disclosures of its year-end 2008 and first- and second-quarter 2009 financial statements.

 

The Company and certain directors and officers are also named as defendants in a derivative action filed on March 2, 2010 pending in the Supreme Court of New York, County of New York. The complaint in this action purports to state causes of action for breaches of fiduciary duties, unjust enrichment, abuse of control, gross mismanagement, and corporate waste. The Company believes that each of the above-mentioned suits is without merit and will defend each vigorously.

 

SEC Investigation

 

On January 11, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an informal inquiry. The focus of the inquiry concerns the valuation methodology and procedures used by the Company to value its investments. On April 30, 2010, the SEC Staff advised the Company that a formal order of private investigation had been issued and that the informal inquiry was now a formal investigation. A subpoena has been issued to the Company in connection with the formal investigation. The subpoena requests that the Company produce documents and/or testimony that primarily relates to the valuation methodology and procedures used by the Company to value its investments. Since January 2010, the Company has been providing documents in response to the informal inquiry and the subpoena. The Company is cooperating fully with the SEC Staff’s investigation. The Company cannot predict the outcome of, or the timeframe for, the conclusion of this investigation.

 

Except as set forth above, neither the Company, nor any of its subsidiaries, is currently a party to any material legal proceedings, other than routine litigation and administrative proceedings arising in the ordinary course of business. Such proceedings are not expected to have a material adverse effect on the business, financial condition, or results of the Company’s operations.

 

Item 1A.        Risk Factors

 

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2009 contains important risk factors that could cause our actual results to differ materially from our historical experience or our present expectations and projections. If any such risks (or any risks we face) occur, our business, financial condition and results of our operations could be materially adversely affected. In such case, the NAV and trading price of our common stock could decline, and you may lose all or part of your investment. Except as set forth below, there have been no material changes from the risk factors previously disclosed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009, which should be read together with the other risk factors and information disclosed elsewhere in this Quarterly Report on Form 10-Q, in our Annual Report on Form 10-K for the year ended December 31, 2009 and our other reports filed with the SEC.

 

Changes in the laws or regulations governing our business, or changes in the interpretations thereof, and any failure by us to comply with these laws or regulations, could negatively affect the profitability of our operations.

 

Changes in the laws or regulations or the interpretations of the laws and regulations that govern BDCs, RICs or non-depository commercial lenders, could significantly affect our operations and our cost of doing business. We are subject to federal, state and local laws and regulations and are subject to judicial and administrative decisions that affect our operations, including our loan originations, maximum interest rates, fees and other charges, disclosures to portfolio companies, the terms of secured transactions, collection and foreclosure procedures and other trade practices. If these laws, regulations or decisions change, or if we expand our business into jurisdictions that have adopted more stringent requirements than those in which we currently conduct business, we may have to incur significant expenses in order to comply or we might have to restrict our operations. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act was recently signed into law by the President.  We cannot determine the ultimate effect that new or potential legislation, or subsequent implementing regulations, if enacted, would have upon our financial position.  In addition, if we do not comply with applicable laws, regulations and decisions, we may lose licenses needed for the conduct of our business and be subject to civil fines and criminal penalties, any of which could have a material adverse effect upon our business, results of operations or financial condition.

 

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Debt-Related Risk Factors

 

Because we have outstanding indebtedness, we are exposed to additional risks, including the typical risks associated with leverage.

 

We borrow funds or may issue senior securities, pursuant to our existing Facility or other agreements, to make additional investments. With certain limited exceptions, we are only allowed to borrow amounts or issue senior securities such that our asset coverage, as defined in the 1940 Act, is at least 200% immediately after such borrowing or issuance. The amount of leverage that we employ will depend on our management’s and our Board of Directors’ assessment of market and other factors at the time of any proposed borrowing. Our Board of Directors, in their judgment, may authorize the use of leverage if they expect that the benefits to our stockholders of maintaining the leveraged position will outweigh the risks. There is no assurance that a leveraging strategy will be successful. Leverage involves risks and special considerations of stockholders, including:

 

•

a likelihood of greater volatility of NAV and market price of our common stock than a comparable portfolio without leverage;

 

•

exposure to increased risk of loss if we incur debt or issue senior securities to finance investments because a decrease in the value of our investments would have a greater negative impact on our returns and therefore the value of our common stock than if we did not use leverage;

 

•

that the covenants contained in the documents governing the Facility or other debt instruments could restrict our operating flexibility. Such covenants may impose asset coverage or investment portfolio composition requirements that are more stringent than those imposed by the 1940 Act and could require us to liquidate investments at an inopportune time; and

 

•

that we, and indirectly our stockholders, will bear the cost of leverage, including issuance and servicing costs (i.e., interest).

 

Any requirement that we sell assets at a loss to redeem or pay interest or dividends on any leverage, or for other reasons, would reduce our NAV and also make it difficult for the NAV to recover. The lenders purport to have the right to accelerate the indebtedness under the Facility at any time based on the alleged Termination Events, and as a result the lenders could seize the collateral securing the Facility at any time.  If we are unable to refinance the indebtedness under our existing Facility or come to an agreement with the lenders under the Facility before September 29, 2010 (the last day of the amortization period that we have challenged as being wrongfully commenced), neither of which has occurred as of the date of this report, then at such time, the indebtedness under the Facility will become immediately due and payable and the lenders could also seek to seize the collateral securing the Facility at that time.  If the Agent and the lenders were to seek to accelerate the indebtedness and seize the collateral either at the end of the amortization period or otherwise, and we were unsuccessful in obtaining court relief, we could be forced to sell assets to pay the remaining balance of the Facility, which would adversely affect our business, liquidity, financial condition and results of operations.

 

The agreements governing our Facility and the related funding and servicing agreement contain various covenants that limit our discretion in operating our business and also include certain financial covenants. In addition, our lenders have declared a Termination Date under the LFSA.

 

We have entered into a credit facility that is backed by a revolving pool of loans. Under the Facility, we are subject to limitations as to how borrowed funds may be used, including restrictions on geographic and industry concentrations, loan size, payment frequency and status, average life, collateral interests and investment ratings, as well as regulatory restrictions on leverage which may affect the amount of funding that may be obtained. There are also certain requirements relating to portfolio performance, including required minimum portfolio yield, limitations on delinquencies and charge-offs and a maximum leverage ratio, a violation of any of which could result in the early amortization of the Facility, limit further advances and, in some cases, result in an event of default. An event of default under the Facility could result, among other things, in the termination of the availability of further funds under the Facility and an accelerated maturity date for all amounts outstanding under the Facility, which would likely disrupt our business and, potentially, the portfolio companies whose loans we financed through the Facility. This could reduce our revenues and, by delaying any cash payment allowed to us under the Facility until the lender has been paid in full, reduce our liquidity and cash flow and impair our ability to grow our business and maintain our qualification as a RIC. If we default under certain provisions of the Facility, the remedies available to the lender may limit our ability to declare dividends. As described below and elsewhere in this report, the Agent and the lenders have declared a Termination Date under the LFSA, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the LFSA and we have filed a complaint against the Agent and the lenders alleging, among other things, that the termination of the revolving period and the commencement of the amortization period were wrongful.   The lenders purport to have the right to accelerate the indebtedness under the Facility at any time based on Termination Events they have alleged to have occurred, and as a result the lenders could seize the collateral securing the Facility at any time.

 

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In connection with the Facility, we are party to a LFSA, dated as of February 14, 2007, by and among us, the Agent, the Trustee and the other lender parties and other parties thereto. As of June 30, 2010, there were outstanding borrowings of approximately $145 million under the LFSA. In accordance with the terms of the LFSA, the financial assets acquired with the proceeds of borrowings under the LFSA are held in a securities account and are subject to a securities account control agreement granting the Agent certain rights in respect of such securities account and the financial assets held therein. As of June 30, 2010 there were financial assets held in the securities account with a market value of approximately $212 million. Borrowings under the Facility are secured only by these assets and amounts in respect of such assets on deposit in a concentration account that is subject to an intercreditor and concentration account administration agreement.  While the Facility lenders do not have recourse to any other of our assets or the investment income associated with any such other assets, the assets securing the Facility represent approximately 60% of our total assets (at fair value) at June 30, 2010 and contributed approximately 45% of our investment income for the six months ended June 30, 2010.

 

In August 2008, we were notified by the lenders that the banks providing the underlying funding for the Facility did not intend to renew their liquidity facility to the lenders unless we agreed to certain revised terms for the Facility. The lenders proposed new terms as a condition to extending the underlying liquidity purchase agreements. We viewed such proposed terms as unfavorable and did not accept them, which caused the Agent and the lenders to declare a Termination Date, based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. On June 9, 2009, we received a letter from a representative of the lenders alleging that our failure to determine ratings on certain pledged loans and our alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods in which a Termination Event had occurred and was continuing. In a letter dated June 11, 2009, we rejected the alleged breaches and the alleged occurrence of a Termination Event and also asserted that the termination of the revolving period and commencement of the amortization period under the LFSA were wrongful. On August 28, 2009, we filed a complaint in the Supreme Court of the State of New York against the Agent and other lender parties to the LFSA. The complaint reflects our beliefs that the termination of the revolving period under the LFSA (and the corresponding commencement of the amortization period) were wrongful and that the lenders’ assertions that we breached our obligations under the LFSA and that a Termination Event had occurred are without merit. The complaint also seeks to clarify our rights and obligations under the LFSA.

 

Since the time the complaint was filed, the Agent, the lenders, and the lender agent parties to the LFSA have served answers seeking dismissal of the complaint and recovery of the defendants’ attorneys’ fees and costs in the action and discovery has commenced.  In addition, motions for partial summary judgment relating to the claims regarding the Termination Date have been filed by us and by the lenders and while it is expected that such motions will be fully submitted by the end of September 2010, we cannot predict when the court will issue its determination of such motions.

 

Since September 2008, all principal and excess interest collected from the assets securing the Facility under the LFSA has been and continues to be used to amortize the Facility through a maturity date of September 29, 2010 (the last day of the amortization period that we have challenged as being wrongfully commenced). Since June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event occurred, the interest payable under the LFSA has been calculated at an elevated rate (equal to 0.85% above the prime rate plus 0.75%) and we have been paying interest calculated at such higher rate under protest.

 

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Because we are using net interest income earned on the assets securing the Facility to amortize the Facility during the amortization period, we may need to sell other assets not pledged to the Facility, potentially at a loss, in order to generate sufficient cash to make the required dividend distributions necessary to maintain our RIC status. In addition, if we are unable to refinance the indebtedness under our existing Facility or come to an agreement with the lenders under the Facility before September 29, 2010 (the last day of the amortization period that we have challenged as being wrongfully commenced), neither of which has occurred as of the date of this report, then at such time, the indebtedness under the Facility will become immediately due and payable and the lenders could also seek to seize the collateral securing the Facility at that time.  If the Agent and the lenders were to seek to accelerate the indebtedness and seize the collateral either at the end of the amortization period or otherwise, and we were unsuccessful in obtaining court relief, we may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings. Any such asset sale could adversely affect our business, liquidity, financial condition and results of operations.

 

If we are not able to amend, refinance or renew our debt on terms acceptable to us or if we receive an unfavorable outcome from the legal action we are taking regarding the LFSA, our operations could be adversely affected.

 

As noted above, on August 28, 2009, we filed a complaint in the Supreme Court of New York against the Agent and other lender parties to the LFSA. Since the time the complaint was filed, the Agent, the lender, and the lender agent parties to the LFSA have served answers seeking dismissal of the complaint and recovery of the defendants’ attorneys’ fees and costs in the action, U.S. Bank National Association, as Trustee, has been voluntarily dismissed without prejudice from the lawsuit, and discovery has commenced. The Agent has sent additional notices of Termination Events, most recently as of June 15, 2010, which the Company and the Borrower believe and have asserted are without merit, based on the Company’s and the Borrower’s alleged inability to comply with certain covenants under the LFSA due to the actions by the Agent and the lenders in wrongfully declaring a Termination Date. In addition, on April 2, 2010 the Agent sent a notice alleging that our failure to timely deliver annual audited financial statements for the year ended December 31, 2009 would, unless cured within 30 days of the date of the notice, constitute a Termination Event, which we also believe and have asserted is without merit based upon a non-material delay.

 

While we intend to vigorously litigate the claims set forth in the complaint, neither the outcome of this litigation nor the amount and range of potential damages recoverable by us or our exposure associated with this litigation can be determined at this time and there can be no assurance that in connection with such lawsuit or otherwise the Agent and the lenders will not assert additional breaches of the LFSA, including breaches relating to the restatement described elsewhere in this report. Further, there can be no assurance that the Agent and the lenders will not assert that any such breaches give rise to a Termination Event. An unfavorable decision or determination that we are required to pay the higher rate of interest under LFSA for an extended period of time, could have an adverse effect on our business, liquidity and financial condition.  As of the date of this report, we have not amended, renewed or refinanced the indebtedness under our existing Facility or come to an agreement with the lenders under the Facility.   If the Agent and the lenders were to seek to accelerate and seize the collateral either at the end of the amortization period, September 29, 2010 (which we have challenged as being wrongfully commenced), or otherwise (as they currently purport to have such rights), and we were unsuccessful in obtaining court relief, we could be forced to pay the remaining balance of the Facility (approximately $145 million as of June 30, 2010), which would adversely affect our business, liquidity, financial condition and results of operations. Due to the current economic environment and the severely limited availability of credit, we may not be able to enter into another facility to replace the Facility whether or not any of the foregoing should occur.

 

Following a default under the LFSA relating to our Facility, we may not have the ability to manage the assets securing the Facility, which may adversely impact our liquidity and operations.

 

On the basis of the alleged Termination Events, the Agent purports to have the right under the securities account control agreement entered into in respect of the security interest granted to the Trustee, as agent, pursuant to the LFSA to take, at any time, exclusive control of the financial assets in the securities accounts covered by the securities account control agreement. If the Agent exercises this right,  the Trustee will no longer accept instructions from us regarding management of such financial assets under the LFSA and the Trustee will act at the direction of the Agent in respect of all matters relating to such financial assets. The securities account control agreement provides that the Agent will not exercise its right to take exclusive control of the financial assets in the securities account covered by the securities account control agreement unless there has occurred a Termination Event (as defined in the LFSA), which the Agent has alleged to have occurred. If we are prevented by the Agent from effecting transactions in the collateral securing the Facility, we may suffer losses (or greater losses than we otherwise would have suffered) in respect of the collateral, which could have a material adverse effect on our business, financial condition and results of operations. To date, notwithstanding our receipt of the notices of alleged Termination Events, the Agent has not provided the Company or KCAP Funding with any notice of action to exercise such rights of control over the financial assets in the securities accounts covered by the securities account control agreement. However, there can be no assurance that the Agent will not take such action in the future, at the end of the amortization period or otherwise, or that we will be able to reach a resolution with the Agent regarding the alleged breach of our obligations under the LFSA on terms acceptable to us or at all.

 

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If market constraints further prevent us from obtaining additional debt or equity capital, our liquidity could be adversely affected, our business prospects could be negatively impacted, we could lose key employees and our operating results could be negatively affected.

 

The current economic and capital market conditions in the U.S. have resulted in a severe reduction in the availability of debt and equity capital for the market as a whole, and financial services firms in particular. These conditions have constrained us and other companies in the financial services sector, limiting or completely preventing access to markets for debt and equity capital needed to maintain operations, continue investment originations and to grow. Reflecting concern about the stability of the financial markets, many lenders and institutional investors have reduced or ceased providing funding to borrowers. This market turmoil and tightening of credit has led to increased market volatility and widespread reduction of business activity generally. If we are unable to renew or replace the Facility, neither of which has occurred as of the date of this report, our liquidity will be significantly reduced. If these conditions continue for a prolonged period of time, or worsen in the future, we could lose key employees and our business prospects could be negatively impacted. Even if we are able to renew or replace the Facility, we may not be able to do so on favorable terms. In addition, the debt capital that will be available, if at all, may be at a higher cost and/or on less favorable terms and conditions. Equity capital is, and may continue to be, difficult to raise because, subject to some limited exceptions, we are not generally able to issue and sell our common stock at a price below NAV per share without stockholder approval. In addition, issuing equity at depressed stock prices can be dilutive to our stockholders. These events and our inability to raise capital have resulted in a reduction in new originations, curtailed our ability to grow and have had a negative impact on our liquidity and operating results. The continued inability to raise additional capital could further constrain our liquidity, negatively impact our business prospects, cause the departure of key employees and negatively impact our operating results.

 

 

 

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Item 2.          Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3.          Defaults Upon Senior Securities

 

None.

Item 4.          [Removed and Reserved]

 

None.

Item 5.          Other Information

 

None.

 Item 6.         Exhibits

 

Exhibit Number		Description of Document
31.1*		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*		Certification of Chief Executive Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2*		Certification of Chief Financial Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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*        Submitted herewith.

 

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Table of Contents

 

SIGNATURES

 

Pursuant to the requirements 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.

 

	Kohlberg Capital Corporation
Date: August 9, 2010	By	/s/ Dayl W. Pearson
		Dayl W. Pearson
		President and Chief Executive Officer
		(Principal Executive Officer)
Date: August 9, 2010	By	/s/ Michael I. Wirth
		Michael I. Wirth
		Chief Financial Officer, Chief Compliance Officer, Secretary and Treasurer
		(Principal Financial and Accounting Officer)

 

* * * * *

 

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Table of Contents

 

Exhibit Index

Exhibit Number		Description of Document
31.1*		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*		Certification of Chief Executive Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2*		Certification of Chief Financial Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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*        Submitted herewith.

 

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CERTIFICATION PURSUANT TO

RULE 13a-14(a) and 15d-14(a) UNDER THE SECURITIES EXCHANGE ACT OF 1934,

AS AMENDED

 

I, Dayl W. Pearson, certify that:

 

1. I have reviewed this Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 of Kohlberg Capital Corporation (the “registrant”);

 

2. Based on my knowledge, this Report does not contain any untrue statement of a material fact or omit to state a material fact necessary 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 report;

 

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

 

4. The registrant’s other certifying officer(s) 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 have:

 

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its subsidiaries, is made known to us by others within those entities, particularly during the period in which this 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 principles;

 

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this 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 (the registrant’s fourth fiscal quarter in the case of an annual report) 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 officer(s) 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 the 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: August 9, 2010						By:		/ S / Dayl W. Pearson
								Dayl W. Pearson
								President and Chief Executive Officer
								(Principal Executive Officer)

 

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CERTIFICATION PURSUANT TO

RULE 13a-14(a) and 15d-14(a) UNDER THE SECURITIES EXCHANGE ACT OF 1934,

AS AMENDED

 

I, Michael I. Wirth, certify that:

 

1. I have reviewed this Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 of Kohlberg Capital Corporation (the “registrant”);

 

2. Based on my knowledge, this Report does not contain any untrue statement of a material fact or omit to state a material fact necessary 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 report;

 

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

 

4. The registrant’s other certifying officer(s) 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 have:

 

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its subsidiaries, is made known to us by others within those entities, particularly during the period in which this 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 principles;

 

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this 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 (the registrant’s fourth fiscal quarter in the case of an annual report) 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 officer(s) 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 the 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: August 9, 2010						By:		/ S / Michael I. Wirth
								Michael I. Wirth
								Chief Financial Officer and Chief Compliance Officer
								(Principal Financial Officer)

 

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