Dividends from net investment income are declared daily and paid monthly. Net realized capital gains, if any, are distributed at least annually.
Information on financial transactions which have been settled through the receipt or disbursement of cash is presented in the Statement of Cash Flows. The cash and foreign currency amount shown in the Statement of Cash Flows is the amount included within the Fund’s Statement of Assets and Liabilities and includes cash and foreign currency on hand at its custodian bank and sub-custodian bank, respectively, and does not include any short-term investments.
In September 2006, Statement of Financial Accounting Standards No. 157 Fair Value Measurements (“SFAS 157”) was issued and is effective for fiscal years beginning after November 15, 2007. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. At this time, management has evaluated the implications of SFAS 157 and concluded that there is no material impact on the financial statements.
The timing and character of income and capital gain distributions are determined in accordance with income tax regulations, which may differ from GAAP. As a result, net investment income/(loss) and net realized gain/(loss) on investment transactions for a reporting period may differ significantly from distributions during such period.
Reclassifications are made to the Fund’s capital accounts for permanent tax differences to reflect income and gains available for distribution (or available capital loss carryforwards) under income tax regulations.
The tax character of distributions paid during the years ended August 31, 2007 and August 31, 2006, the past two tax year ends, were as follows:
As of August 31, 2007, the most recent tax year end, the components of distributable earnings on a tax basis were as follows:
Portfolio unrealized appreciation and depreciation at February 29, 2008, based on cost of investments for U.S. federal income tax purposes, and excluding any unrealized appreciation and depreciation from changes in the value of other assets and liabilities resulting from changes in exchange rates was:
Effective December 18, 2006, the Investment Adviser receives a monthly investment advisory fee based on the Fund’s average daily managed assets at the following annual rates:
Average daily managed assets of the Fund means the average daily value of the total assets of the Fund less all accrued liabilities of the Fund (other than the aggregate amount of any outstanding borrowings constituting financial leverage).
For the six months ended February 29, 2008, the Fund’s effective investment advisory fee rate was 0.60%.
Prior to December 18, 2006, the Investment Adviser received a monthly investment advisory fee based on the Fund’s average daily net assets at the following annual rates:
| |
NOTES TO FINANCIAL STATEMENTS (unaudited) (continued) |
|
|
| |
February 29, 2008 | Highland Floating Rate Advantage Fund |
Administration Fees
The Investment Adviser provides administrative services to the Fund for a monthly administration fee at the annual rate of 0.20% of the Fund’s average daily managed assets. Under a separate sub-administration agreement, the Investment Adviser has delegated certain administrative functions to PFPC Inc. (“PFPC”). The Investment Adviser pays PFPC directly for these services.
Service and Distribution Fees
PFPC Distributors, Inc. (the “Underwriter”) serves as the principal underwriter and distributor of the Fund’s shares. The Underwriter receives the front end sales charge imposed on the sale of Class A Shares and receives the CDSC imposed on certain redemptions of Class A, Class B and Class C Shares. For the six months ended February 29, 2008, the Underwriter received $35,789 of front end sales charges on Class A Shares and $406,380, $67,042 and $508,085 of CDSC on Class A, Class B and Class C Share redemptions, respectively.
The Fund has adopted a plan pursuant to Rule 12b-1 under the 1940 Act (the “Plan”), which requires the payment of a monthly service fee to the Underwriter at an annual rate of 0.25% of the average daily net assets attributable to Class A, Class B and Class C Shares of the Fund. The Plan also requires the payment of a monthly distribution fee to the Underwriter at an annual rate of 0.10%, 0.45% and 0.60% of the average daily net assets attributable to Class A, Class B and Class C shares, respectively.
Expense Limits and Fee Reimbursements
Effective December 18, 2006, the Investment Adviser has voluntarily agreed to waive management fees (includes both advisory fees and administration fees) so that the Fund’s annual operating expenses (exclusive of advisory fees, administration fees, brokerage commissions, taxes, distribution and service fees, leverage expenses and extraordinary expenses, if any) will not exceed 0.15% of the average daily net assets of the Fund for each share class. This arrangement may be revised or discontinued by the Investment Adviser at any time upon seven days’ prior, written notice to shareholders of the Fund.
Fees Paid to Officers and Trustees
Effective January 1, 2008, each Trustee who is not an “interested person” of the Funds as defined in the 1940 Act (the “Independent Trustees”) receives an annual retainer of $150,000 payable in quarterly installments and allocated among each portfolio in the Highland Fund Complex based on relative net assets. The “Highland Fund Complex” consists of all of the registered investment companies and a business development company advised by the Investment Adviser as of the date of this semi-annual report.
Prior to January 1, 2008, each Independent Trustee received an annual retainer of $25,000 from the Fund for services provided as Trustee of the Fund, and also received compensation from other portfolios in the Highland Fund Complex.
The Fund pays no compensation to its one interested Trustee or any of its officers, all of whom are employees of the Investment Adviser.
Note 5. Portfolio Information
For the six months ended February 29, 2008, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were $210,156,393 and $983,774,250, respectively.
Note 6. Periodic Repurchase Offers
The Fund has adopted a policy to offer each calendar quarter to repurchase a specified percentage (between 5% and 25%) of the shares then outstanding at the Fund’s net asset value (“Repurchase Offers”). Repurchase Offers are scheduled to occur on or about the 15th day (or the next business day if the 15th is not a business day) in the months of February, May, August, and November. It is anticipated that the date on which the repurchase price of shares will be determined (the “Repurchase Pricing Date”) will be the same date as the deadline for shareholders to provide their repurchase requests to the Distributor (the “Repurchase Request Deadline”), and if so, the Repurchase Request Deadline will be set for a time no later than the close of regular trading on the New York Stock Exchange on such date. The Repurchase Pricing Date will occur no later than the 14th day after the Repurchase Request Deadline, or the next business day if the 14th day is not a business day. Repurchase proceeds will be paid to shareholders no later than seven days after the Repurchase Pricing Date. If shareholders tender for repurchase more than the Repurchase Offer amount for a given Repurchase Offer, the Fund may repurchase an additional amount of shares of up to 2% of the shares outstanding on the Repurchase Request Deadline.
For the six months ended February 29, 2008, there were two Repurchase Offers. For each Repurchase Offer, the Fund offered to repurchase 15% of its shares. In the November 2007 and February 2008 Repurchase Offers, 14.5% and 17.0%, respectively, of shares outstanding were repurchased. In connection with the February 2008 repurchase offer, the Fund repurchased an additional 2% of the shares outstanding on the Repurchase Request Deadline to accommodate the shareholder repurchase requests.
Semi-Annual Report | 29
| |
NOTES TO FINANCIAL STATEMENTS (unaudited) (continued) |
|
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
Note 7. Senior Loan Participation
Commitments
The Fund invests, under normal conditions, at least 80% of its net assets (plus any borrowings for investment purposes) in adjustable rate senior loans (“Senior Loans”), the interest rates of which float or vary periodically based upon a benchmark indicator of prevailing interest rates to domestic or foreign corporations, partnerships and other entities that operate in a variety of industries or geographic regions (“Borrowers”). If the lead lender in a typical lending syndicate becomes insolvent, enters Federal Deposit Insurance Corporation (“FDIC”) receivership or, if not FDIC insured enters into bankruptcy, the Fund may incur certain costs and delays in receiving payment or may suffer a loss of principal and/or interest. When the Fund purchases a participation of a Senior Loan interest, the Fund typically enters into a contractual agreement with the lender or other third party selling the participation, not with the Borrower directly.
As such, the Fund assumes the credit risk of the Borrowers, selling participants or other persons interpositioned between the Fund and the Borrowers. The ability of Borrowers, selling participants or other persons interpositioned between the Fund and the Borrowers to meet their obligations may be affected by economic developments in a specific industry.
At February 29, 2008, the following sets forth the selling participants with respect to interests in Senior Loans purchased by the Fund on a participation basis.
| | | | | | | |
Selling Participant | | Principal
Amount | | Value | |
Credit Suisse, Cayman Island Branch: | | | | | | | |
Berry Plastics Holding Corp. | | | | | | | |
Term C Loan | | $ | 741,888 | | $ | 643,127 | |
Ginn LA Conduit Lender, Inc. | | | | | | | |
First Lien Tranche A Credit-Linked | | | | | | | |
Deposit | | | 3,948,880 | | | 3,016,944 | |
First Lien Tranche B Term Loan | | | 8,486,502 | | | 6,483,688 | |
Verso Paper Holdings | | | | | | | |
Term B Loan | | | 2,249,452 | | | 2,030,130 | |
|
|
|
|
|
|
|
|
Highland Crusader Offshore | | | | | | | |
Partners, L.P.: | | | | | | | |
Mach Gen, LLC | | | | | | | |
Term C Loan | | | 6,195,833 | | | 5,857,665 | |
|
|
|
|
|
|
|
|
Grand Central Asset Trust | | | | | | | |
HCF Series | | | | | | | |
Realogy Corp. | | | | | | | |
Initial Term B Loan | | | 13,327,529 | | | 11,293,748 | |
Synthetic Letter of Credit | | | 3,588,181 | | | 3,030,362 | |
|
|
|
|
|
|
|
|
Merill Lynch, London Branch | | | | | | | |
Wind Telecommunications S.p.A. | | | | | | | |
B1 Term Loan Facility | | | 1,000,000 | | | 945,000 | |
C1 Term Loan Facility | | | 1,000,000 | | | 945,000 | |
| | | | | | | |
Selling Participant | | Principal
Amount | | Value | |
Morgan Stanley, London Branch | | | | | | | |
YPSO Holding SA | | | | | | | |
Capex Term Loan | | $ | 373,194 | | $ | 518,740 | |
|
|
|
|
|
|
|
|
Morgan Stanley Senior Fund, Inc. | | | | | | | |
Realogy Corp. | | | | | | | |
Delayed Draw Term B Loan | | | 4,000,000 | | | 3,357,120 | |
Note 8. Loan Agreement
Effective October 12, 2006, the Fund entered into a loan agreement with The Bank of Nova Scotia (the “Credit Agreement”) pursuant to which the Fund could borrow up to $650,000,000. Effective June 6, 2007, the Credit Agreement was amended to increase the total commitment to $1,000,000,000.
At February 29, 2008, the Fund’s outstanding borrowing under the Credit Agreement totaled $800,000,000. The interest rate charged at February 29, 2008 was 3.85%. The average daily loan balance was $778,076,923 at a weighted average interest rate of 5.40%. With respect to these borrowings, interest and facility expense of $22,508,056 is included on the Statement of Operations.
The Fund is required to maintain 300% asset coverage with respect to amounts outstanding under the Credit Agreement. Asset coverage is calculated by subtracting the Fund’s total liabilities, not including any bank loans and senior securities, from the Fund’s total net assets and dividing such amount by the principal amount of the debt outstanding. As of the dates indicated below, the Fund’s debt outstanding and asset coverage was as follows:
| | | | |
Date | | Total Amount
Outstanding | | Asset
Coverage per
$1,000 of
Indebtedness |
02/29/2008 | | $800,000,000 | | $3,459 |
|
|
|
|
|
08/31/2007 | | 960,000,000 | | 4,005 |
|
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08/31/2006 | | 335,000,000 | | 7,292 |
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|
|
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08/31/2005 | | 250,000,000 | | 5,129 |
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|
08/31/2004 | | 95,000,000 | | 8,038 |
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|
|
|
08/31/2003 | | 59,500,000 | | 5,156 |
30 | Semi-Annual Report
| |
NOTES TO FINANCIAL STATEMENTS (unaudited) (continued) |
|
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
Note 9. Unfunded Loan Commitments
As of February 29, 2008, the Fund had unfunded loan commitments of $43,783,677, which could be extended at the option of the borrower, pursuant to loan agreements with the following borrowers:
| | | | |
Borrower | | Unfunded
Loan
Commitment | |
AMF Bowling Worldwide, Inc. | | $ | 2,000,000 | |
|
|
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|
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CHS/ Community Health Systems, Inc. | | | 766,643 | |
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Comcorp Broadcasting, Inc. | | | 72,372 | |
|
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Cricket Communications, Inc. | | | 6,500,000 | |
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Delta Air Lines, Inc. | | | 23,893 | |
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DHM Holdings Co., Inc. | | | 9,303 | |
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Fenwal, Inc. | | | 2,319,580 | |
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FleetCor Technologies Operating Co., LLC | | | 666,667 | |
|
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Fontainebleau Las Vegas, LLC | | | 2,333,333 | |
|
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HUB International Ltd. | | | 729,678 | |
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Interstate Bakeries Corp. | | $ | 6,937,500 | |
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Longview Power, LLC | | | 1,125,000 | |
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MEG Energy Corp. | | | 2,014,286 | |
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Mobileserv Ltd. | | | 2,500,000 | |
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Nordic Cable Acquisition | | | 3,068,493 | |
|
|
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Readers Digest Association, Inc., The | | | 550,000 | |
|
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SIRVA Worldwide, Inc. | | | 968,344 | |
|
|
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Sorenson Communications, Inc. | | | 2,000,000 | |
|
|
|
|
|
Univision Communications, Inc. | | | 2,583,893 | |
|
|
|
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|
Valassis Communications, Inc. | | | 426,667 | |
|
|
|
|
|
Vivarte | | | 5,000,000 | |
|
|
|
|
|
Water Pik, Inc. | | | 1,000,000 | |
|
|
|
|
|
Ypso Holding SA | | | 188,025 | |
|
|
|
|
|
| | $ | 43,783,677 | |
| |
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|
Unfunded loan commitments are marked to market on the relevant day of valuation in accordance with the Fund’s valuation policies. Any applicable unrealized gain/(loss) and unrealized appreciation/(depreciation) on unfunded loan commitments are recorded on the Statement of Assets and Liabilities and the Statement of Operations, respectively. As of February 29, 2008, the Fund recognized net discount and unrealized depreciation on unfunded transactions of $5,278,076. The net change in unrealized depreciation on unfunded transactions of $(2,738,365) is recorded in the Statement of Operations.
Note 10. Indemnification
The Fund has a variety of indemnification obligations under contracts with its service providers. The Fund’s maximum exposure under these arrangements is unknown. However, the Fund has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be remote.
Note 11. Disclosure of Significant Risks and Contingencies
Industry Focus Risk
The Fund may focus its investments in certain industries, subjecting it to greater risk than a fund that is more diversified.
Non-Payment Risk
Senior Loans, like other corporate debt obligations, are subject to the risk of non-payment of scheduled interest and/or principal. Non-payment would result in a reduction of income to the Fund, a reduction in the value of the Senior Loan experiencing non-payment and a potential decrease in the net asset value of the Fund.
Credit Risk
Investments rated below investment grade are commonly referred to as high-yield, high risk or “junk debt.” They are regarded as predominantly speculative with respect to the issuing company’s continuing ability to meet principal and/or interest payments. Investments in high-yield securities may result in greater net asset value fluctuation than if the Fund did not make such investments.
Currency Risk
A portion of the Fund’s assets may be quoted or denominated in non-U.S. currencies. These securities may be adversely affected by fluctuations in relative currency exchange rates and by exchange control regulations. The Fund’s investment performance may be negatively affected by a devaluation of a currency in which the Fund’s investments are quoted or denominated. Further, the Fund’s investment performance may be significantly affected, either positively or negatively, by currency exchange rates because the U.S. dollar value of securities quoted or denominated in another currency will increase or decrease in response to changes in the value of such currency in relation to the U.S. dollar.
Foreign Securities Risk
Investments in foreign securities may involve special risks compared to investing in securities of U.S. issuers. These risks are more pronounced to the extent that the Fund invests a significant portion of its non-U.S. investment in one region or in the securities of emerging market issuers. These risks may include (i) less information about non-U.S. issuers or markets being available due to less rigorous disclosure, accounting standards or regulatory requirements; (ii) many non-U.S. markets are smaller, less liquid and more volatile and the Investment Adviser may not be able to sell the Fund’s securities at times, in amounts and at prices it considers reasonable; (iii) the economies of non-U.S. markets may grow at slower rates than expected or may experience a down-turn or recession; and (iv) withholdings and other non-U.S. taxes may decrease the Fund’s returns.
Semi-Annual Report | 31
| |
NOTES TO FINANCIAL STATEMENTS (unaudited) (continued) |
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
Emerging Markets Risk
Investing in securities of issuers based in underdeveloped emerging markets entails all of the risks of investing in foreign securities to a heightened degree. These heightened risks include: (i) greater risks of expropriation, confiscatory taxation, nationalization, and less social political and economic stability; (ii) the smaller size of the markets for such securities and a lower volume of trading, resulting in lack of liquidity and in price volatility; and (iii) certain national policies which may restrict the Fund’s investment opportunities, including restrictions on investing in issuers or industries deemed sensitive to relevant national interest.
Derivatives Risk
Derivative transactions in which the Fund may engage for hedging and speculative purposes or to enhance total return, including engaging in transactions such as options, futures, swaps, foreign currency transactions (including forward foreign currency contracts, currency swaps or options on currency and currency futures) and other derivative transactions, involve certain risks and considerations. These risks include the imperfect correlation between the value of such instruments and the underlying assets, the possible default of the other party to the transaction or illiquidity of the derivative instruments. Furthermore, the ability to successfully use derivative transactions depends on the Investment Adviser’s ability to predict pertinent market movements, which can not be assured. Thus, the use of derivative transactions may result in losses greater than if they had not been used, may require the Fund to sell or purchase portfolio securities at inopportune times or for prices other than current market value, may limit the amount of appreciation the Fund can realize on an investment or may cause the Fund to hold a security that it might otherwise sell.
Swaps Risk
Investments in swaps involve the exchange with another party of their respective commitments. Use of swaps subjects the Fund to risk of default by the counterparty. If there is a default by the counterparty to such a transaction, there may be contractual remedies pursuant to the agreements related to the transaction although contractual remedies may not be sufficient in the event the counterparty is insolvent. However, the swap market has grown substantially in recent years with a large number of banks and investment banking firms acting both as principals and agents utilizing standardized swap documentation. As a result, the swap market has become relatively liquid in comparison with the markets for other similar instruments which are traded in the interbank market. The Fund may enter into total return swaps, credit default swaps, currency swaps or other swaps which may be surrogates for other instruments such as currency forwards or options.
32 | Semi-Annual Report
| |
ADDITIONAL INFORMATION (unaudited) |
|
|
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
Approval of Investment Advisory Agreement
The Fund has retained the Investment Adviser to manage its assets pursuant to an Investment Advisory Agreement with the Investment Adviser (the “Investment Advisory Agreement”). At a special meeting of shareholders of the Fund held on July 20, 2007 and adjourned until August 3, 2007, the shareholders of the Fund approved the reorganization of the Fund from a Massachusetts Business Trust (the “Predecessor Fund”) to a Delaware statutory trust (the “Reorganization”). The reorganization occurred on December 31, 2007
At a meeting held on December 14, 2007, in connection with the Reorganization, the Board of Trustees, including a majority of the Trustees who are not “interested persons” (as defined in the Investment Company Act of 1940, as amended (the “Independent Trustees”)) approved the Investment Advisory Agreement. Following an initial term of two years, the Investment Advisory Agreement continues in effect from year-to-year provided such continuance is specifically approved at least annually by the vote of the holders of at least a majority of the outstanding shares of the Fund, or by the Board of Trustees, and, in either event, by a majority of the Independent Trustees of the Fund casting votes in person at a meeting called for such purpose.
In light of the fact that the Investment Advisory Agreement contained terms and conditions substantially similar to the terms and conditions of the investment advisory agreement between the Predecessor Fund and the Investment Adviser dated December 18, 2006 (the “Predecessor Fund Investment Advisory Agreement”) approved by the Board of Trustees of the Predecessor Fund at a meeting held on May 19, 2006 and approved at a meeting of shareholders of the Predecessor Fund held on November 17, 2006 and adjourned to December 18, 2006, the Board reconsidered the detailed information provided at the meeting held on May 19, 2006 as part of its deliberations concerning the Investment Advisory Agreement. In addition to the information described below, at each quarterly in-person meeting, the Trustees received detailed reports showing compliance information, portfolio composition, and performance of the Fund as compared to its index and peer group. Specifically, at the meeting held on May 19, 2006, the Board requested, through Fund counsel and its independent legal counsel, and received from the Investment Adviser, various written materials, including: (1) information confirming the financial soundness of the Investment Adviser; (2) information on the advisory and marketing personnel of the Investment Adviser, including compensation arrangements; (3) information on the internal compliance procedures of the Investment Adviser; (4) comparative information showing how the Predecessor Fund’s proposed fee schedule and anticipated operating expenses compare to (i) other registered investment companies that follow investment strategies similar to those of the Predecessor Fund, and (ii) other private and registered pooled investment vehicles or accounts managed by the Investment Adviser, as well as the performance of such vehicles and accounts; (5) information regarding brokerage and portfolio transactions; and (6) information on any legal proceedings or regulatory audits or investigations affecting the Investment Adviser. The Independent Trustees reviewed various factors discussed in independent counsel’s legal memorandum, the detailed information provided by the Investment Adviser and other relevant information and factors, including the following:
The nature, extent, and quality of the services to be provided by the Investment Adviser
The Independent Trustees considered the portfolio management services provided by the Investment Adviser and the activities related to portfolio management, including use of technology, research capabilities, and investment management staff. They discussed the experience and qualifications of the personnel who provide advisory services, including the background and experience of the members of the portfolio management team. The Independent Trustees reviewed the management structure, assets under management and investment philosophies and processes of the Investment Adviser. They also reviewed and discussed the Investment Adviser’s compliance policies and procedures. The Independent Trustees concluded that the Investment Adviser had the quality and depth of personnel and investment methods essential to performing its duties under the Predecessor Fund Investment Advisory Agreement and that the nature of such advisory services is satisfactory.
The Investment Adviser’s historical performance in managing the Predecessor Fund
The Independent Trustees reviewed the Investment Adviser’s historical performance in managing the Predecessor Fund as provided by Lipper. They noted that since the Investment Adviser has become the Predecessor Fund’s Investment Adviser, the Predecessor Fund outperformed its benchmark, the Credit Suisse Leveraged Loan Index, by 231 basis points per year on an annualized basis. Furthermore, when compared to its peer group, all of the Predecessor Fund’s share classes have been the top performing share classes of any peer, in the categories Year-to-Date Total Return, 1-year Total Return, Total Return since 4/15/04, as well as the Annualized Total Rates of Return in 3-Year, 5-Year, since 4/15/04, and since Inception time frames. Moreover, during the 12 months ended March 31, 2006, the Predecessor Fund’s Class Z Shares earned a return of 9.37%, which represents outperformance of 51.37% or 318 basis points compared to its benchmark, which returned 6.19%. The Independent Trustees were satisfied with the Investment Adviser’s historical performance in managing the Predecessor Fund.
Semi-Annual Report | 33
| |
ADDITIONAL INFORMATION (unaudited) (continued) | |
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
The investment performance of other accounts or funds managed by the Investment Adviser
The Independent Trustees reviewed the performance of the Investment Adviser for accounts or funds that are similar to the Predecessor Fund compared with other investment companies of similar investment objectives and size. They reviewed the Investment Adviser’s historical performance in managing Highland Floating Rate Limited Liability Company (“FRLLC”). Highland Floating Rate Fund (“FRF”) prior to the conversion of FRF to a single fund scructure and liquidation and dissolution of FRLLC, invested substantially all of its assets in FRLLC, which then invested such assets in securities and other assets in accordance with the investment objectives of FRF and FRLLC. The Independent Trustees noted that as a result of its investment in FRLLC, FRF had consistently outperformed its benchmark, the Credit Suisse Leveraged Loan Index, as well as both its peers that employ leverage and those that do not employ leverage. During the 12 months ended March 31, 2006, the FRF’s Class Z Shares earned a return of 7.61%, which represents a 22.94% incremental return or 142 basis points more than its benchmark. Additionally, in Lipper’s Annualized Rate of Return categories, all of FRF’s share classes were ranked in the Top 5 for the 5-Year and Since Inception Total Return sets, and the top 6 for the 3-Year Total Return set. The Independent Trustees were satisfied with the Investment Adviser’s overall performance records.
The costs of the services to be provided by the Investment Adviser and the profits to be realized by the Investment Adviser and its affiliates from the relationship with the Predecessor Fund
The Independent Trustees also gave substantial consideration to the fees payable under the Predecessor Fund Investment Advisory Agreement, including: (i) the basis points to be paid to Highland; (ii) the anticipated expenses the Investment Adviser would incur in providing advisory services; and (iii) a comparison of the fees payable to the Investment Adviser under the Predecessor Fund Investment Advisory Agreement to fees paid to the Investment Adviser by other trusts and to investment advisers serving other investment companies with similar investment programs to that of the Predecessor Fund. After such review, the Independent Trustees determined that the anticipated profitability rates to the Investment Adviser with respect to the Predecessor Fund Investment Advisory Agreement were fair and reasonable.
The extent to which economies of scale would be realized as the Predecessor Fund grows and whether fee levels reflect these economies of scale for the benefit of shareholders
The Independent Trustees considered the effective fees under the Predecessor Fund Investment Advisory Agreement, as a percentage of assets at different asset levels, and possible economies of scale to the Investment Adviser. They considered the anticipated asset levels of the Predecessor Fund, the information provided by the Investment Adviser relating to its estimated costs, and information comparing the fee rate to be charged by the Investment Adviser with fee rates charged by other unaffiliated investment advisers to their clients. They also considered the Investment Adviser’s willingness to reinstate its voluntary “other expenses” cap if shareholders approved the Predecessor Fund Investment Advisory Agreement. The Independent Trustees concluded that the fee structures were reasonable and appropriately would result in a sharing of economies of scale in the current environment in view of the information provided by the Investment Adviser.
In determining whether to approve the Predecessor Fund Investment Advisory Agreement, the Independent Trustees concluded that, based on the materials presented to them and the conversations the Board had with representatives of the Investment Adviser, the Predecessor Fund’s auditors, the Predecessor Fund’s counsel and counsel to the Independent Trustees, submission of the Predecessor Fund Investment Advisory Agreement to shareholders would be in the best interests of shareholders. The Independent Trustees determined that the advisory fee rates under the Predecessor Fund Investment Advisory Agreement are fair and reasonable, in light of the excellent performance of the Predecessor Fund during the period the Investment Adviser has served as the investment adviser and in view of the fact that the advisory fee rates for the Predecessor Fund are substantially below the average advisory/management fee rate in the Predecessor Fund’s Lipper peer groups.
Additional Portfolio Information
The Investment Adviser and its affiliates manage other accounts, including registered and private funds and individual accounts. Although investment decisions for the Fund are made independently from those of such other accounts, the Investment Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts that may be the same or different from those made to the Fund, including investments in different levels of the capital structure of a company, such as equity versus senior loans, or that take contrary provisions in multiple levels of the capital structure. The Investment Adviser has adopted policies and procedures that address the allocation of investment opportunities, execution of portfolio transactions, personal trading by employees and other potential conflicts of interest that are designed to ensure that all client accounts are treated equitably over time. Nevertheless, this may create situations where a client could be disadvantaged because of the investment activities conducted by the Investment Adviser for other client accounts. When the Fund and one or more of such other accounts is prepared to invest in, or desires to dispose of, the same security, available investments
34 | Semi-Annual Report
| |
ADDITIONAL INFORMATION (unaudited) (continued) | |
|
|
February 29, 2008 | Highland Floating Rate Advantage Fund |
or opportunities for each will be allocated in a manner believed by the Investment Adviser to be equitable to the Fund and such other accounts. The Investment Adviser also may aggregate orders to purchase and sell securities for the Fund and such other accounts. Although the Investment Adviser believes that, over time, the potential benefits of participating in volume transactions and negotiating lower transaction costs should benefit all accounts including the Fund, in some cases these activities may adversely affect the price paid or received by the Fund or the size of the position obtained or disposed of by the Fund.
Semi-Annual Report | 35
|
IMPORTANT INFORMATION ABOUT THIS REPORT |
|
Investment Adviser
Highland Capital Management, L.P.
NexBank Tower
13455 Noel Road, Suite 800
Dallas, TX 75240
Transfer Agent
PFPC Inc.
101 Sabin Street
Pawtucket, RI 02860
Underwriter
PFPC Distributors, Inc.
760 Moore Road
King of Prussia, PA 19406
Custodian
PFPC Trust Company
8800 Tinicum Boulevard
Philadelphia, PA 19153
Independent Registered Public Accounting Firm
PricewaterhouseCoopers LLP
2001 Ross Avenue, Suite 1800
Dallas, TX 75201
Fund Counsel
Ropes & Gray LLP
One International Place
Boston, MA 02110-2624
This report has been prepared for shareholders of Highland Floating Rate Advantage Fund.
The Fund mails one shareholder report to each shareholder address. If you would like more than one report, please call shareholder services at 1-877-665-1287 to request that additional reports be sent to you.
A description of the policies and procedures that the Fund uses to determine how to vote proxies relating to its portfolio securities, and the Fund’s proxy voting record for the most recent 12-month period ended June 30, are available (i) without charge, upon request, by calling 1-877-665-1287 and (ii) on the Securities and Exchange Commission’s website at http://www.sec.gov.
The Fund files its complete schedule of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year on Form N-Q. The Fund’s Forms N-Q are available on the Commission’s website at http://www.sec.gov and also may be reviewed and copied at the Commission’s Public Reference Room in Washington, DC. Information on the Public Reference Room may be obtained by calling 1-800-SEC-0330.
The Statement of Additional Information includes information about Fund Trustees and is available upon request without charge by calling 1-877-665-1287.
36 | Semi-Annual Report
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Highland Floating Rate Advantage Fund | Semi-Annual Report, February 29, 2008 |
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www.highlandfunds.com | HLC-ADV-SEMI-02/08 |
Item 2. Code of Ethics.
Not applicable.
Item 3. Audit Committee Financial Expert.
Not applicable.
Item 4. Principal Accountant Fees and Services.
Not applicable.
Item 5. Audit Committee of Listed registrants.
Not applicable.
Item 6. Schedule of Investments.
Schedule of Investments in securities of unaffiliated issuers as of the close of the reporting period is included as part of the report to shareholders filed under Item 1 of this form.
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
Not applicable.
Item 8. Portfolio Managers of Closed-End Management Investment Companies.
Effective April 1, 2008, Brad Borud was appointed portfolio manager of Highland Floating Rate Advantage Fund (the “Fund”).
The Fund’s portfolio is managed by Mark Okada, Brad Borud and R. Joseph Dougherty.
Mark Okada. Mr. Okada is a founder and Chief Investment Officer of Highland Capital Management, L.P. (“Highland or the “Adviser”). He is responsible for overseeing Highland’s investment activities for its various strategies and has over 20 years of experience in the credit markets. Prior to co-founding Highland, Mr. Okada served as Manager of Fixed Income for the Guaranteed Investment Contract subsidiary of Protective Life Insurance (one of the first non-bank entrants into the syndicated loan market) from 1990 to 1993, where he was primarily responsible for the bank loan portfolio and other risk assets. From 1986 to 1990, Mr. Okada served as Vice President at Hibernia National Bank, managing a portfolio of high-yield loans in excess of $1 billion. Mr. Okada is a Director of NexBank and Highland Financial Partners, L.P., and Chairman of the Board of Directors of Common Grace Ministries, Inc. Mr. Okada is an honors graduate of the University of California Los Angeles with degrees in Economics and Psychology. He has earned the right to use the Chartered Financial Analyst designation.
Brad Borud. Mr. Borud is a Partner, Senior Trader and Chief Investment Officer - Retail Products at Highland. Prior to his current duties, Mr. Borud served as a Senior Trader and Co-Director of Portfolio Management for Highland from 2003 to 2008, as a Portfolio Manager and Team Leader from 2001 to 2003, as a Portfolio Manager from 1998 to 2001, and as a Portfolio Analyst from 1996 to 1998. As a Portfolio Manager, Mr. Borud covered a wide range of industries, including wireline telecommunications, wireless telecommunications, telecommunication equipment manufacturers, multichannel video and media. Prior to joining Highland in November 1996, Mr. Borud worked as a Global Finance Analyst in the Corporate Finance Group at NationsBank from 1995 to 1996 where he was involved in the originating, structuring, modeling and credit analysis of leveraged transactions for large corporate accounts in the Southwest region of the United States. In 1994, Mr. Borud served at Conseco Capital Management as an Analyst Intern in the Fixed Income Research Department, following the transportation and energy sectors. Mr. Borud has a BS in Business Finance from Indiana University.
R. Joseph Dougherty. Mr. Dougherty is a Partner and Senior Portfolio Manager of Highland and heads its retail products business unit. He serves as Portfolio Manager, Senior Vice President, Trustee and/or Director of Highland’s New York Stock Exchange-listed funds and Investment Company Act of 1940, as amended (the “1940 Act”) registered funds. He also serves as Portfolio Manager for Highland’s subadvised closed-end funds. In this capacity, Mr. Dougherty oversees investment decisions for the retail funds, alongside several other Portfolio Managers, and manages the team dedicated to the day-to-day operations of the retail funds. Prior to his current duties, Mr. Dougherty served as Portfolio Analyst for Highland from 1998 to 1999. As a Portfolio Analyst, Mr. Dougherty followed companies within the chemical, retail, supermarket, wireless and restaurant sectors. Prior to joining Highland in March 1998, Mr. Dougherty served as an Investment Analyst with Sandera Capital Management from 1997 to 1998. Formerly, he was a Business Development Manager at Akzo Nobel from 1994 to 1996 and a Senior Accountant at Deloitte & Touche, LLP from 1992 to 1994. He received an MBA from Southern Methodist University and a BS in Accounting from Villanova University. Mr. Dougherty is a Certified Public Accountant, and has earned the right to use the Chartered Financial Analyst designation.
The following tables provide information about the funds and accounts, other than the Fund, for which the Fund’s managers are primarily responsible for the day-to-day portfolio management. This information is provided for R. Joseph Dougherty and Mark Okada as of August 31, 2007 and for Brad Borud as of February 29, 2008.
R. Joseph Dougherty
| | | | |
Type of Accounts | Total
Number of
Accounts
Managed | Total Assets
Managed
(millions) | Total Number of
Accounts Managed
with Performance-
Based Advisory Fee | Total Assets Managed
with Performance-
Based Advisory Fee
(millions) |
|
|
|
|
|
Registered Investment
Companies: | 13 | $8,462 | — | — |
| | | | |
Other Pooled Investment
Vehicles: | 1 | $ 357 | — | — |
| | | | |
Other Accounts: | — | — | — | — |
Mark Okada
| | | | |
Type of Accounts | Total
Number of
Accounts
Managed | Total Assets
Managed
(millions) | Total Number of
Accounts Managed
with Performance-
Based Advisory Fee | Total Assets Managed
with Performance-
Based Advisory Fee
(millions) |
|
|
|
|
|
Registered Investment
Companies: | 14 | $ 9,398 | — | — |
| | | | |
Other Pooled Investment
Vehicles: | 30 | $17,536 | 24 | $15,686 |
| | | | |
Other Accounts: | — | — | — | — |
Brad Borud
| | | | |
Type of Accounts | Total
Number of
Accounts
Managed | Total Assets
Managed
(millions) | Total Number of
Accounts Managed
with Performance-
Based Advisory Fee | Total Assets Managed
with Performance-
Based Advisory Fee
(millions) |
|
|
|
|
|
Registered Investment
Companies: | — | — | — | — |
| | | | |
Other Pooled Investment
Vehicles: | — | — | — | — |
| | | | |
Other Accounts: | — | — | — | — |
| | | | |
Conflicts of Interests
The Adviser has built a professional working environment, a firm-wide compliance culture and compliance procedures and systems designed to protect against potential incentives that may favor one account over another. The Adviser has adopted policies and procedures that address the allocation of investment opportunities, execution of portfolio transactions, personal trading by employees and other potential conflicts of interest that are designed to ensure that all client accounts are treated equitably over time. Nevertheless, the Adviser furnishes advisory services to numerous clients in addition to the Fund, and the Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts (including accounts that are hedge funds or have performance or higher fees paid to the Adviser or in which portfolio managers have a personal interest in the receipt of such fees) that may be the same as or different from those made to the Fund. In addition, the Adviser, its affiliates and any
of their partners, directors, officers, stockholders or employees may or may not have an interest in the securities whose purchase and sale the Adviser recommends to the Fund. Actions with respect to securities of the same kind may be the same as or different from the action that the Adviser, or any of its affiliates, or any of their partners, directors, officers, stockholders or employees or any member of their families may take with respect to the same securities. Moreover, the Adviser may refrain from rendering any advice or services concerning securities of companies of which any of the Adviser’s (or its affiliates’) partners, directors, officers or employees are directors or officers, or companies as to which the Adviser or any of its affiliates or partners, directors, officers and employees of any of them has any substantial economic interest or possesses material non-public information. In addition to its various policies and procedures designed to address these issues, the Adviser includes disclosure regarding these matters to its clients in both its Form ADV and investment advisory agreements.
The Adviser, its affiliates or their partners, directors, officers and employees similarly serve or may serve other entities that operate in the same or related lines of business. Accordingly, these individuals may have obligations to investors in those entities or funds or to other clients, the fulfillment of which might not be in the best interests of the Fund. As a result, the Adviser will face conflicts in the allocation of investment opportunities to the Fund and other funds and clients. In order to enable such affiliates to fulfill their fiduciary duties to each of the clients for which they have responsibility, the Adviser will endeavor to allocate investment opportunities in a fair and equitable manner which may, subject to applicable regulatory constraints, involve pro rata co-investment by the Fund and such other clients or may involve a rotation of opportunities among the Fund and such other clients.
While the Adviser does not believe there will be frequent conflicts of interest, if any, the Adviser and its affiliates have both subjective and objective procedures and policies in place designed to manage the potential conflicts of interest between the Adviser’s fiduciary obligations to the Fund and their similar fiduciary obligations to other clients so that, for example, investment opportunities are allocated in a fair and equitable manner among the Fund and such other clients. An investment opportunity that is suitable for multiple clients of the Adviser and its affiliates may not be capable of being shared among some or all of such clients due to the limited scale of the opportunity or other factors, including regulatory restrictions imposed by the 1940 Act. There can be no assurance that the Adviser’s or its affiliates’ efforts to allocate any particular investment opportunity fairly among all clients for whom such opportunity is appropriate will result in an allocation of all or part of such opportunity to the Fund. Not all conflicts of interest can be expected to be resolved in favor of the Fund.
Compensation
Highland’s financial arrangements with its portfolio managers, its competitive compensation and its career path emphasis at all levels reflect the value senior management places on key resources. Compensation may include a variety of components and may vary from year to year based on a number of factors including the relative performance of a portfolio manager’s underlying account, the combined performance of the portfolio managers’ underlying accounts, and the relative performance of the portfolio managers’ underlying accounts measured against other employees. The principal components of compensation include a base salary, a discretionary bonus, various retirement benefits and one or more of the incentive compensation programs established by Highland, such as its “Option It Plan” and its “Long-Term Incentive Plan,” described below.
Base compensation. Generally, portfolio managers receive base compensation based on their seniority and/or their position with Highland, which may include the amount of assets supervised and other management roles within Highland.
Discretionary compensation. In addition to base compensation, portfolio managers may receive discretionary compensation, which can be a substantial portion of total compensation. Discretionary compensation can include a discretionary cash bonus as well as one or more of the following:
| |
| Option It Plan. The purpose of this plan is to attract and retain the highest quality employees for positions of substantial responsibility, and to provide additional incentives to a select group of management or highly-compensated employees of Highland in order to promote the success of Highland. |
| |
| Long Term Incentive Plan. The purpose of this plan is to create positive morale and teamwork, to attract and retain key talent and to encourage the achievement of common goals. This plan seeks to reward participating employees based on the increased value of Highland. |
Senior portfolio managers who perform additional management functions may receive additional compensation in these other capacities. Compensation is structured such that key professionals benefit from remaining with Highland.
Ownership of Securities
The following table sets forth the dollar range of equity securities of the Fund beneficially owned by each portfolio manager. This information is provided for R. Joseph Dougherty and Mark Okada as of August 31, 2007 and for Brad Borud as of February 29, 2008.
| | |
Name of Portfolio Manager | | Dollar Range of Equity Securities
Beneficially Owned by Portfolio Manager |
| |
|
R. Joseph Dougherty | | None |
Mark Okada | | $100,001 - $500,000 |
Brad Borud | | None |
Item 9. Purchases of Equity Securities by Closed-End Management Investment Company and Affiliated Purchasers.
None.
Item 10. Submission of Matters to a Vote of Security Holders.
On April 16, 2007 the Board of Trustees of the Fund approved changes to the Nominating Committee Charter, including the addition of Annex A which provides procedures for shareholders to propose nominations for Trustee candidates.
ANNEX A
NOMINATING COMMITTEE POLICY REGARDING
SELECTION / RECOMMENDATION OF DIRECTOR NOMINEES
A candidate for nomination as Director submitted by a shareholder will not be deemed to be properly submitted to the Committee for the Committee’s consideration unless the following qualifications have been met and procedures followed:
| | |
| 1. | A shareholder or group of shareholders (referred to in either case as a “Nominating Shareholder”) that beneficially owned, in the aggregate, more than 5% of the Fund’s voting common shares, with each of the shares used to calculate that ownership held for at least one year as of the date the recommendation was made, may submit one candidate to the Committee for consideration at an annual meeting of shareholders. |
| | |
| 2. | The Nominating Shareholder must submit any such recommendation (a “Shareholder Recommendation”) in writing to the Fund, to the attention of the Secretary, at the address of the principal executive offices of the Fund. |
| | |
| 3. | The Shareholder Recommendation must be delivered to or mailed and received at the principal executive offices of the Fund not less than 120 calendar days before the date of the Fund’s proxy statement released to shareholders in connection with the previous year’s annual meeting. If, however, the Fund did not hold an annual meeting in the previous year, or if the date of this year’s annual meeting has been changed by more than 30 days from the date of the previous year’s annual meeting, then the deadline is a reasonable time before the Fund begins to print and mail its proxy materials. |
| | |
| 4. | The Shareholder Recommendation must include: (i) a statement in writing setting forth (A) the name, date of birth, business address and residence address of the person recommended by the Nominating Shareholder (the “candidate”); (B) any position or business relationship of the candidate, currently or within the preceding five years, with the Nominating Shareholder or an Associated Person of the Nominating Shareholder (as defined below); (C) the class or series and number of all shares of the Fund owned of record or beneficially by the candidate, as reported to such Nominating Shareholder by the candidate; (D) any other information regarding the candidate that is required to be disclosed about a nominee in a proxy statement or other filing required to be made in connection with the solicitation of proxies for election of Directors of the Fund; (E) whether the Nominating Shareholder believes that the candidate is or will be an “interested person” of the Fund (as defined in the 1940 Act) and, if believed not to be an “interested person,” information regarding the candidate that will be sufficient for the Fund to make such determination; and (F) information as to the candidate’s knowledge of the investment company industry, experience as a Director or senior officer of public companies, directorships/trusteeships on the boards of other registered investment companies and educational background; (ii) the written and signed consent of the candidate to be named as a nominee and to serve as a Director if elected; (iii) the written and signed agreement of the candidate to complete a Directors’ questionnaire if elected; (iv) the Nominating Shareholder’s consent to be named as such by the Fund; (v) the class or series and number of all shares of the Fund owned beneficially and of record by the Nominating Shareholder and any Associated Person of the Nominating Shareholder and the dates on which such shares were acquired, specifying the number of shares owned beneficially but not of record by each, and stating the names of each as they appear on the |
| | |
| | Fund’s record books and the names of any nominee holders for each; and (vi) a description of all arrangements or understandings between the Nominating Shareholder, the candidate and/or any other person or persons (including their names) pursuant to which the recommendation is being made by the Nominating Shareholder. “Associated Person of the Nominating Shareholder” as used in this paragraph 4 means any person required to be identified pursuant to clause (v) and any other person controlling, controlled by or under common control with, directly or indirectly, (a) the Nominating Shareholder or (b) any person required to be identified pursuant to clause (v). |
| | |
| 5. | The Committee may require the Nominating Shareholder to furnish such other information as it may reasonably require or deem necessary to verify any information furnished pursuant to paragraph 4 above or to determine the qualifications and eligibility of the candidate proposed by the Nominating Shareholder to serve on the Board. If the Nominating Shareholder fails to provide such other information in writing within seven days of receipt of a written request from the Committee, the recommendation of such candidate as a nominee will be deemed not properly submitted for consideration, and will not be considered, by the Committee. |
Item 11. Controls and Procedures.
| | |
| (a) | The registrant’s principal executive and principal financial officers, or persons performing similar functions, have concluded that the registrant’s disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940, as amended (the “1940 Act”) (17 CFR 270.30a-3(c))) are effective, as of a date within 90 days of the filing date of the report that includes the disclosure required by this paragraph, based on their evaluation of these controls and procedures required by Rule 30a-3(b) under the 1940 Act (17 CFR 270.30a-3(b)) and Rules 13a-15(b) or 15d-15(b) under the Securities Exchange Act of 1934, as amended (17 CFR 240.13a-15(b) or 240.15d-15(b)). |
| |
| (b) | There were no changes in the registrant’s internal control over financial reporting (as defined in Rule 30a-3(d) under the 1940 Act (17 CFR 270.30a-3(d)) that occurred during the registrant’s second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting. |
Item 12. Exhibits.
| | |
| (a)(1) | Not applicable. |
| | |
| (a)(2) | Certifications pursuant to Rule 30a-2(a) under the 1940 Act and Section 302 of the Sarbanes-Oxley Act of 2002 are attached hereto. |
| |
| (a)(3) | Not applicable. |
| |
| (b) | Certifications pursuant to Rule 30a-2(b) under the 1940 Act and Section 906 of the Sarbanes-Oxley Act of 2002 are attached hereto. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| |
(registrant) | Highland Floating Rate Advantage Fund |
|
|
| |
By (Signature and Title)* | /s/ James D. Dondero |
|
|
| James D. Dondero, Chief Executive Officer and President |
| (principal executive officer) |
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| |
By (Signature and Title)* | /s/ James D. Dondero |
|
|
| James D. Dondero, Chief Executive Officer and President |
| (principal executive officer) |
| |
By (Signature and Title)* | /s/ M. Jason Blackburn |
|
|
| M. Jason Blackburn, Chief Financial Officer, Treasurer |
| and Secretary |
| (principal financial officer) |
* Print the name and title of each signing officer under his or her signature.
