UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT
INVESTMENT COMPANIES
INVESTMENT COMPANIES
Investment Company Act file number 811-21769
Highland Special Situations Fund
(Exact name of registrant as specified in charter)
NexBank Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Address of principal executive offices) (Zip code)
R. Joseph Dougherty
Highland Capital Management, L.P.
NexBank Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
Highland Capital Management, L.P.
NexBank Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Name and address of agent for service)
Registrant’s telephone number, including area code: (877) 665-1287
Date of fiscal year end: December 31
Date of reporting period: December 31, 2010
Form N-CSR is to be used by management investment companies to file reports with the Commission not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under Rule 30e-1 under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may use the information provided on Form N-CSR in its regulatory, disclosure review, inspection, and policymaking roles.
A registrant is required to disclose the information specified by Form N-CSR, and the Commission will make this information public. A registrant is not required to respond to the collection of information contained in Form N-CSR unless the Form displays a currently valid Office of Management and Budget (“OMB”) control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. § 3507.
Item 1. Reports to Stockholders.
The Report to Shareholders is attached herewith.
Highland Special Situations Fund
Annual Report
December 31, 2010
December 31, 2010
Highland Special Situations Fund |
TABLE OF CONTENTS
Portfolio Manager’s Letter | 1 | |||
Fund Profile | 2 | |||
Financial Statements | 3 | |||
Investment Portfolio | 4 | |||
Statement of Assets and Liabilities | 5 | |||
Statement of Operations | 6 | |||
Statements of Changes in Net Assets | 7 | |||
Statement of Cash Flows | 8 | |||
Financial Highlights | 9 | |||
Notes to Financial Statements | 10 | |||
Report of Independent Registered Public Accounting Firm | 18 | |||
Additional Information | 19 | |||
Important Information About This Report | 24 |
Economic and market conditions change frequently.
There is no assurance that the trends described in this report will continue or commence.
There is no assurance that the trends described in this report will continue or commence.
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PORTFOLIO MANAGER’S LETTER
Highland Special Situations Fund
Dear Shareholders:
We are pleased to provide you with our report for Highland Special Situations Fund (the “Fund”) for the year ended December 31, 2010. On December 31, 2010 the net asset value of the Fund was $3.60 per share, as compared to $6.98 on December 31, 2009. During the year ended December 31, 2010, the Fund declared distributions to common shareholders of $3.87 per share.
The Fund’s Investments:
The total return, assuming reinvestment of distributions, for the year ended December 31, 2010, was 12.88%.
Fund Data:
As of December 31, 2010, the Fund’s investment portfolio, exclusive of cash and cash equivalents, was allocated as follows:
Respectively submitted, | ||||
Greg Stuecheli | ||||
Portfolio Manager | ||||
Greg Stuecheli has been portfolio manager of the Fund since April 1, 2008.
Past performance does not guarantee future results. Performance during the time period shown is limited and may not reflect the performance in different economic and market cycles. There can be no assurance that similar performance will be experienced. Annualized total return is calculated by BNY Mellon Asset Servicing (US) Inc, formerly known as PNC Global Investment Servicing (US), Inc. The calculation assumes reinvestment of distributions and other income.
Annual Report | 1
FUND PROFILE (unaudited)
Highland Special Situations Fund
Objective
Highland Special Situations Fund (the “Fund”) seeks to achieve high total returns while minimizing losses. |
Total Net Assets of Common Shares as of December 31, 2010
$3.0 million |
Portfolio Data as of December 31, 2010
The information below provides a snapshot of the Fund at the end of the reporting period. The Fund is actively managed and the composition of its portfolio will change over time. |
Quality Breakdown as of 12/31/10 (%)*
B | 35.4 | |||
CCC | 10.9 | |||
NR | 53.7 |
Top 5 Sectors as of 12/31/10 (%)*
Service | 41.9 | |||
Healthcare | 20.2 | |||
Financial | 7.0 | |||
Food/Tobacco | 6.2 | |||
Aerospace | 5.8 |
Top 10 Holdings as of 12/31/10 (%)*
Safety-Kleen Systems, Inc. (Common Stocks) | 32.6 | |||
Thermo Fluids (Northwest), Inc. (Senior Loans) | 9.4 | |||
Genesys Ventures IA, LP (Common Stocks) | 8.9 | |||
Nuveen Investments, Inc. (Senior Loans) | 7.0 | |||
DSW Holdings, Inc. (Senior Loans) | 6.2 | |||
TCD PhaRMA (Corporate Notes and Bonds) | 6.0 | |||
US Airways Group, Inc. (Senior Loans) | 5.8 | |||
Consolidated Container Co., LLC (Senior Loans) | 5.4 | |||
Texas Competitive Electric Holdings Co., LLC (Senior Loans) | 5.0 | |||
Metro-Goldwyn-Mayer, Inc., Class A (Common Stocks) | 4.9 |
* | Quality is calculated as a percentage of total senior loans and corporate notes and bond securities. Sectors and holdings are calculated as a percentage of total assets. The quality ratings reflected were issued by Standard & Poors, a nationally recognized statistical rating organization. Quality ratings reflect the credit quality of the underlying bonds in the Fund’s portfolio and not that of the fund itself. Quality Ratings are subject to change. |
2 | Annual Report
FINANCIAL STATEMENTS
Highland Special Situations Fund
A guide to understanding the Fund’s financial statements
Investment Portfolio | The Investment Portfolio details all of the Fund’s holdings and their value as of the last day of the reporting period. Portfolio holdings are organized by type of asset and industry to demonstrate areas of concentration and diversification. | |
Statement of Assets and Liabilities | This statement details the Fund’s assets, liabilities, net assets and common share price as of the last day of the reporting period. Net assets are calculated by subtracting all the Fund’s liabilities (including any unpaid expenses) from the total of the Fund’s investment and non-investment assets. The net asset value for common shares is calculated by dividing net assets for that class by the number of common shares outstanding in that class as of the last day of the reporting period. | |
Statement of Operations | This statement details income earned by the Fund and the expenses accrued by the Fund during the reporting period. The Statement of Operations also shows any net gain or loss the Fund realized on the sales of its holdings during the period, any unrealized gains or losses recognized over the period as well as any distributions to preferred shareholders. The total of these results represents the Fund’s net increase or decrease in net assets from operations applicable to common shareholders. | |
Statements of Changes in Net Assets | These statements demonstrate how the Fund’s net assets were affected by its operating results, distributions to common shareholders and shareholder transactions from common shares (e.g., subscriptions, redemptions and distribution reinvestments) during the reporting period. The Statements of Changes in Net Assets also detail changes in the number of common shares outstanding. | |
Statement of Cash Flows | This statement reports net cash and foreign currency provided or used by operating, investing and financing activities and the net effect of those flows on cash and foreign currency during the period. | |
Financial Highlights | The Financial Highlights demonstrate how the Fund’s net asset value per common share was affected by the Fund’s operating results. The Financial Highlights also disclose the performance and certain key ratios (e.g., net expenses and net investment income as a percentage of average net assets). | |
Notes to Financial Statements | These notes disclose the organizational background of the Fund, certain of its significant accounting policies (including those surrounding security valuation, income recognition and distributions to shareholders), federal tax information, fees and compensation paid to affiliates and significant risks and contingencies. |
Annual Report | 3
INVESTMENT PORTFOLIO
As of December 31, 2010 | Highland Special Situations Fund |
Principal Amount ($) | Value ($) | |||||||
US Senior Loans (a) - 40.6% | ||||||||
Aerospace - 6.0% | ||||||||
US Airways Group, Inc. | ||||||||
197,260 | Term Loan, 2.79%, 03/31/14 | 178,274 | ||||||
Financial - 7.4% | ||||||||
Nuveen Investments, Inc. Second Lien Term Loan, | ||||||||
200,000 | 12.50%, 07/31/15 (b) | 217,083 | ||||||
Food/Tobacco - 6.5% | ||||||||
DSW Holdings, Inc. | ||||||||
200,000 | Term Loan, 4.29%, 03/02/12 | 193,000 | ||||||
Forest Products/Containers - 5.7% | ||||||||
Consolidated Container Co., LLC Second Lien Term Loan, | ||||||||
200,000 | 5.75%, 09/28/14 | 168,500 | ||||||
Service - 9.8% | ||||||||
Thermo Fluids (Northwest), Inc. Tranche B Term Loan, | ||||||||
323,786 | 5.29%, 06/27/13 | 289,519 | ||||||
Utility - 5.2% | ||||||||
Texas Competitive Electric Holdings Co., LLC Initial Tranche B-2 Term Loan, | ||||||||
197,954 | 3.76%, 10/10/14 | 153,528 | ||||||
Total US Senior Loans (Cost $1,151,837) | 1,199,904 | |||||||
Corporate Notes and Bonds (c) - 11.9% | ||||||||
Healthcare - 11.9% | ||||||||
Celtic Pharma Phinco B.V | ||||||||
211,384 | 17.00%, 06/15/12 | 95,123 | ||||||
Molecular Insight Pharmaceuticals, Inc. | ||||||||
195,426 | 11/01/12 (d) (e) | 68,399 | ||||||
TCD PhaRMA | ||||||||
212,000 | 16.00%, 04/15/24 | 186,560 | ||||||
Total Corporate Notes and Bonds (Cost $564,398) | 350,082 | |||||||
Shares | ||||||||
Common Stocks (f) - 49.8% | ||||||||
Diversified Media - 5.1% | ||||||||
Metro-Goldwyn-Mayer, Inc., | ||||||||
6,363 | Class A | 151,121 | ||||||
Healthcare - 9.3% | ||||||||
140,740 | Genesys Ventures IA, LP (g) | 275,850 | ||||||
Service - 34.1% | ||||||||
93,061 | Safety-Kleen Systems, Inc. (g) | 1,006,917 | ||||||
Shares | Value ($) | |||||||
Wireless Communications - 1.3% | ||||||||
ICO Global Communications | ||||||||
24,889 | Holdings, Ltd | 37,334 | ||||||
Total Common Stocks (Cost $1,101,232) | 1,471,222 | |||||||
Units | ||||||||
Warrants (f) - 0.1% | ||||||||
Wireless Communications - 0.1% | ||||||||
Clearwire Corp., | ||||||||
10,321 | expires 08/15/10 (g) | 2,168 | ||||||
Total Warrants (Cost $20,503) | 2,168 | |||||||
Total Investments - 102.4% (Cost of $2,837,970) (h) | 3,023,376 | |||||||
Preferred Shares at Liquidation Value - 0.0% | 0 | |||||||
Other Assets & Liabilities, Net - (2.4)% | (72,161 | ) | ||||||
Net Assets applicable to Common Shareholders - 100.0% | 2,951,215 | |||||||
(a) | Senior loans (also called bank loans, leveraged loans, or floating rate loans) in which the Fund invests, generally pay interest at rates which are periodically determined by reference to a base lending rate plus a spread. (Unless otherwise identified by footnote (b), all senior loans carry a variable rate interest.) These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Inter-Bank Offered Rate (“LIBOR”) or (iii) the Certificate of Deposit rate. Rate shown represents the weighted average rate at December 31, 2010. Senior loans, while exempt from registration under the Securities Act of 1933 (the “1933 Act”), contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturity shown. | |
(b) | Fixed rate senior loan. | |
(c) | Securities exempt from registration under Rule 144A of the 1933 Act. These securities may only be resold, in transactions exempt from registration, to qualified institutional buyers. At December 31, 2010, these securities amounted to $350,082 or 11.9% of net assets. | |
(d) | Floating rate asset. The interest rate shown reflects the rate in effect at December 31, 2010. | |
(e) | The issuer is in default of its payment obligation. Income is not being accrued. | |
(f) | Non-income producing security. | |
(g) | Represents fair value as determined by the Fund’s Board of Trustees (the “Board”) or its designee in good faith, pursuant to the policies and procedures approved by the Board. Securities with a total aggregate market value of $1,284,935, or 43.5% of net assets, were fair valued as of December 31, 2010. | |
(h) | Cost for U.S. Federal income tax purposes is $2,837,793. |
4 | See accompanying Notes to Financial Statements.
STATEMENT OF ASSETS AND LIABILITIES
As of December 31, 2010 | Highland Special Situations Fund |
($) | ||||
Assets: | ||||
Investments at value (cost $2,837,970) | 3,023,376 | |||
Receivable For: | ||||
Dividends and interest receivable | 65,572 | |||
Other assets | 224,544 | |||
Total assets | 3,313,492 | |||
Liabilities: | ||||
Due to custodian | 18,326 | |||
Payables For: | ||||
Fund shares redeemed | 220,336 | |||
Investment advisory fees (Note 4) | 38,055 | |||
Legal fees | 37,000 | |||
Audit and tax | 30,000 | |||
Trustees’ fees (Note 4) | 1,835 | |||
Accrued expenses and other liabilities | 16,725 | |||
Total liabilities | 362,277 | |||
Net Assets Applicable To Common Shares | 2,951,215 | |||
Compositon of Net Assets: | ||||
Par value of common shares (Note 1) | 819 | |||
Paid-in capital in excess of par value of common shares | 12,608,032 | |||
Overdistributed net investment income | (2,316 | ) | ||
Accumulated net realized gain/(loss) on investments, short positions and foreign currency transactions | (9,840,726 | ) | ||
Net unrealized appreciation/(depreciation) on investments | 185,406 | |||
Net Assets Applicable to Common Shares | 2,951,215 | |||
Common Shares: | ||||
Net assets | 2,951,215 | |||
Shares outstanding (unlimited authorization) | 819,442 | |||
Net asset value per share (net assets/shares outstanding) | 3.60 |
See accompanying Notes to Financial Statements. | 5
STATEMENT OF OPERATIONS
For the Year Ended December 31, 2010 | Highland Special Situations Fund |
($) | ||||
Investment Income: | ||||
Interest from unaffiliated issuers | 1,304,913 | |||
Securities lending income (Note 9) | 90 | |||
Total Investment Income | 1,305,003 | |||
Expenses: | ||||
Investment management fees (Note 4) | 361,825 | |||
Fund administration fees | 159,538 | |||
Transfer agent fees | 3,444 | |||
Trustees’ fees (Note 4) | 8,753 | |||
Custodian fees | 6,584 | |||
Registration fees | 1,380 | |||
Reports to shareholders | 13,503 | |||
Insurance expense | 13,146 | |||
Other expenses | 1,476 | |||
Audit fees | 52,071 | |||
Legal fees | 329,719 | |||
Dividends from short positions | 584 | |||
Net expenses | 952,023 | |||
Net investment income | 352,980 | |||
Net Realized and Unrealized Gain/(Loss) on Investments: | ||||
Net realized gain/(loss) on investments from unaffiliated issuers | (8,295,819 | ) | ||
Net realized gain/(loss) from affiliated issuer* (Note 7) | 1,192,455 | |||
Net realized gain/(loss) on foreign currency transactions | 6 | |||
Net realized gain/(loss) on short positions | (7,584 | ) | ||
Net change in unrealized appreciation/(depreciation) on investments | 8,411,628 | |||
Net change in unrealized appreciation/(depreciation) on short positions | (10,810 | ) | ||
Net realized and unrealized gain/(loss) on investments | 1,289,876 | |||
Distributions to Preferred Shareholders: | ||||
Declared from net investment income | (26,247 | ) | ||
Net increase in net assets, applicable to common shareholders, from operations | 1,616,609 | |||
* | Total amount as a result of redemption-in-kind. |
6 | See accompanying Notes to Financial Statements.
STATEMENTS OF CHANGES IN NET ASSETS
Highland Special Situations Fund
Year Ended December 31, | ||||||||
2010 | 2009 | |||||||
($) | ($) | |||||||
Increase/(Decrease) in Net Assets: | ||||||||
From Operations | ||||||||
Net investment income | 352,980 | 3,148,313 | ||||||
Net realized gain/(loss) on investments from unaffiliated issuers, affiliated issuers, foreign currency transactions and short positions | (7,110,942 | ) | (8,871,608 | ) | ||||
Net change in unrealized appreciation/(depreciation) on investments and short positions | 8,400,818 | 22,030,042 | ||||||
Declared distributions to preferred shareholders from net investment income | (26,247 | ) | (32,879 | ) | ||||
Net change in net assets from operations | 1,616,609 | 16,273,868 | ||||||
Distributions Declared to Common Shareholders | ||||||||
From net investment income | (299,600 | ) | (3,940,263 | ) | ||||
From return of capital | (23,154,074 | — | ||||||
Total distributions declared to common shareholders | (23,453,674 | ) | (3,940,263 | ) | ||||
Share Transactions from Common Shares | ||||||||
Distributions reinvested | 1,955,363 | — | ||||||
Redemption-in-kind | (19,459,881 | ) | — | |||||
Net decrease from share transactions from common shares | (17,504,518 | ) | — | |||||
Total increase/(decrease) in net assets from common shares | (39,341,583 | ) | 12,333,605 | |||||
Net Assets Applicable to Common Shares | ||||||||
Beginning of year | 42,292,798 | 29,959,193 | ||||||
End of year (including overdistributed net investment income of $(2,316) and $(2,734), respectively) | 2,951,215 | 42,292,798 | ||||||
Changes in Common Shares | ||||||||
Issued for distributions reinvested | 487,795 | — | ||||||
Redemptions | (5,730,711 | ) | — | |||||
Net decrease in common shares | (5,242,916 | ) | — |
See accompanying Notes to Financial Statements. | 7
STATEMENT OF CASH FLOWS
For the Year Ended December 31, 2010 | Highland Special Situations Fund |
($) | ||||
Cash Flows Provided by Operating Activities | ||||
Net investment income | 352,980 | |||
Adjustments to Reconcile Net Investment Income to Net Cash and Foreign Currency Provided by Operating Activities | ||||
Purchase of investment securities | (1,539,670 | ) | ||
Proceeds from disposition of investment securities | 25,942,704 | |||
Proceeds from securities sold short | (175,260 | ) | ||
Decrease in cash held as collateral for securities loaned | 992,036 | |||
Decrease in restricted cash | 250,238 | |||
Decrease in dividends and interest receivable | 273,940 | |||
Decrease in other assets | 5,901 | |||
Net amortization/(accretion) of premium/(discount) | (286,772 | ) | ||
Decrease in payable upon receipt of securities loaned | (992,036 | ) | ||
Decrease in payable for distributions to Common Shareholders | (3,113,861 | ) | ||
Decrease in payable for declared distributions to Preferred Shareholders | (32,879 | ) | ||
Decrease in payables to related parties | (147,980 | ) | ||
Decrease in other expenses and liabilities | (5,123 | ) | ||
Net cash flow provided by operating activities | 21,524,218 | |||
Cash Flows Used in Financing Activities | ||||
Redemption of Series P Preferred Shares | (411,000 | ) | ||
Distributions paid in cash to Common Shareholders | (21,498,311 | ) | ||
Declared distributions to Preferred Shareholders from net investment income | (26,247 | ) | ||
Due to custodian | 18,326 | |||
Decrease in cash for redemption-in-kind | (8,672,572 | ) | ||
Net cash flow used in financing activities | (30,589,804 | ) | ||
Net decrease in cash and foreign currency | (9,065,586 | ) | ||
Cash and Foreign Currency | ||||
Beginning of the year | 9,065,586 | |||
End of the year | — | |||
Supplemental Disclosure of Cash Flows Information: | ||||
Market value of securities issued for a redemption-in-kind | $ | 10,787,309 |
8 | See accompanying Notes to Financial Statements.
FINANCIAL HIGHLIGHTS
Highland Special Situations Fund
Selected data for a share outstanding throughout each period is as follows:
For the | For the | For the | For the | For the | ||||||||||||||||
Year Ended | Year Ended | Year Ended | Year Ended | Year Ended | ||||||||||||||||
Common Shares Per Share | December 31, | December 31, | December 31, | December 31, | December 31, | |||||||||||||||
Operating Performance: | 2010 | 2009 | 2008 | 2007 | 2006 | |||||||||||||||
Net Asset Value, Beginning of Year | $ | 6.98 | $ | 4.94 | $ | 13.81 | $ | 12.49 | $ | 10.65 | ||||||||||
Income from Investment Operations: | ||||||||||||||||||||
Net investment income | 0.06 | (a) | $ | 0.51 | $ | 0.74 | $ | 0.35 | $ | 0.66 | ||||||||||
Net realized and unrealized gain/(loss) on investments | 0.46 | 2.19 | (7.44 | ) | 1.48 | 1.84 | ||||||||||||||
Distributions from net investment income to preferred shareholders, including declared distributions | (0.03 | ) | (0.01 | ) | — | (b) | (0.01 | ) | (0.01 | ) | ||||||||||
Distributions from net realized gains to preferred shareholders | — | — | (0.01 | ) | — | — | ||||||||||||||
Total from investment operations, applicable to common shareholders | 0.49 | 2.69 | (6.71 | ) | 1.82 | 2.49 | ||||||||||||||
Less Distributions Declared to Common Shareholders: | ||||||||||||||||||||
From net investment income | (0.05 | ) | (0.65 | ) | (0.61 | ) | (0.37 | ) | (0.65 | ) | ||||||||||
From return of capital | (3.82 | ) | — | — | (0.01 | ) | — | |||||||||||||
From net realized gains | — | — | (1.55 | ) | (0.12 | ) | — | |||||||||||||
Total distributions declared to common shareholders | (3.87 | ) | (0.65 | ) | (2.16 | ) | (0.50 | ) | (0.65 | ) | ||||||||||
Net Asset Value, End of Year | $ | 3.60 | $ | 6.98 | $ | 4.94 | $ | 13.81 | $ | 12.49 | ||||||||||
Total return (c) | 12.88 | % | 54.56 | % | (48.58 | )% | 14.61 | % | 23.43 | % | ||||||||||
Ratios to Average Net Assets/Supplemental Data: | ||||||||||||||||||||
Common Share Information at End of Year: | ||||||||||||||||||||
Net assets, end of period (000’s) | $ | 2,951 | $ | 42,293 | $ | 29,959 | $ | 83,708 | $ | 73,050 | ||||||||||
Ratios based on net assets of common shares | ||||||||||||||||||||
Net expenses | 3.94 | % | 2.52 | % | 2.23 | % | 3.22 | % | 6.00 | % | ||||||||||
Dividends for short positions | — | (d) | — | (d) | — | — | — | |||||||||||||
Net investment income (e) | 1.46 | % | 7.21 | % | 6.37 | % | 2.55 | % | 5.75 | % | ||||||||||
Common and Preferred Share Information at End of Year: | ||||||||||||||||||||
Ratios based on net assets of common and preferred shares | ||||||||||||||||||||
Net expenses | 3.88 | % | 2.50 | % | 2.22 | % | 3.21 | % | 5.96 | % | ||||||||||
Dividends for short positions | — | (d) | — | (d) | — | — | — | |||||||||||||
Net investment income | 1.33 | % | 7.06 | % | 6.32 | % | 2.50 | % | 5.66 | % | ||||||||||
Portfolio turnover | 3 | %(f) | 87 | % | 113 | % | 51 | % | 73 | % | ||||||||||
Preferred Share Information at End of Year: | ||||||||||||||||||||
Aggregate amount outstanding, end of period (000’s) | $ | — | $ | 411 | $ | 411 | $ | 411 | $ | 411 | ||||||||||
Asset coverage per share (g) | $ | — | $ | 103,902 | $ | 73,893 | $ | 204,670 | $ | 177,737 |
(a) | Per share net investment income has been calculated using the average shares method. | |
(b) | Represents less than $0.005 per common share. | |
(c) | Total return at net asset value assuming all distributions reinvested. | |
(d) | Represents less than 0.005% per share. | |
(e) | Net investment income ratio does not reflect payment to preferred shareholders. The ratio reflecting such payment was 1.34%, 7.13%, 6.36%, 2.51% and 5.70% for the years ended December 31, 2010, December 31, 2009, December 31, 2008, December 31, 2007 and December 31, 2006, respectively. | |
(f) | Portfolio turnover rate excludes securities delivered from processing the redemption-in-kind. | |
(g) | Asset coverage per share equals net assets of common shares plus the redemption value of the preferred shares divided by the total number of preferred shares outstanding at the end of the period. During the year ended December 31, 2010, all of the preferred shares were redeemed. |
See accompanying Notes to Financial Statements. | 9
NOTES TO FINANCIAL STATEMENTS
December 31, 2010 | Highland Special Situations Fund |
Note 1. Organization and Operations
Highland Special Situations Fund (the “Fund”) is a Delaware statutory trust and is registered with the Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940, as amended (the “1940 Act”), as a non-diversified, closed-end management investment company. The Fund commenced operations on May 18, 2005.
Investment Objective
The Fund seeks to achieve high total returns while minimizing losses.
Common Shares
The Fund may issue an unlimited number of common shares, par value $0.001 per share (the “Common Shares”). The Fund will offer Common Shares, only to investors that are both accredited investors and qualified clients on a private placement basis, and only with the approval of a majority of the Fund’s outstanding Shares.
Preferred Shares
The Fund is authorized to issue up to 500 shares of Series P Preferred Shares (“Series P Shares”). Series P Shares pay cumulative preferential dividends of approximately 8% per year and are preferred as to liquidation value over the Common Shares. The purchase price for each Series P Shares is $1,000. The Series P Shares have a liquidation preference equal to $1,000 (the “Liquidation Preference”) plus any accumulated but unpaid dividends and will be redeemable at the option of the Fund in whole or part at any time in an amount equal to the Liquidation Preference plus accumulated and unpaid dividends thereon calculated as of the date of redemption. On or after the fifth anniversary of the commencement of the Fund’s operations, holders of Series P Shares have the right, with no less than 90 days prior written notice to the Fund, to sell such Series P Shares to the Fund at an amount equal to the Liquidation Preference plus accumulated and unpaid dividends. The right of the holders of Series P Shares to sell their shares to the Fund requires Series P Shares to be presented as a liability for financial reporting purposes. The Fund will not issue Series P Shares unless immediately thereafter the Series P Shares have asset coverage of at least 200%. For the year ended December 31, 2010, the Fund redeemed 411 shares of Series P Shares. As of December 31, 2010, there are no Series P Shares issued and outstanding.
The Fund is also authorized to issue one share of Series S Preferred Shares (the “Special Share”). The Special Share will have a liquidation preference equal to $1,000 plus any accumulated and unpaid dividend. The Special Share will be redeemable at the option of the Fund in whole or part at any time after the termination for any or no reason of the investment management agreement in accordance with the provisions thereof in an amount equal to the Liquidation Preference plus accumulated and unpaid dividends thereon calculated as of the date of redemption. The Fund will not issue Series P Shares or a Special Share (together, the “Preferred Shares”) unless immediately thereafter the Preferred Shares have an asset coverage of at least 200%. As of December 31, 2010, the Special Share had not been issued. The Preferred Shares are senior to and have certain class-specific preferences over the Common Shares. Under the 1940 Act, the Preferred Shares must have the right to elect at least two Trustees at all times and a majority of the Trustees in the event of serious dividend arrearages. Preferred Shares also have certain class voting rights under the 1940 Act.
Note 2. Significant Accounting Policies
The following is a summary of significant accounting policies consistently followed by the Fund in the preparation of its financial statements.
Use of Estimates
The Fund’s financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.
Fund Valuation
The net asset value (“NAV”) of the Fund’s Common Shares is calculated as of the last business day of each month, in connection with each issuance of common shares by the Fund, as of each distribution date (after giving effect to the relevant declaration) and on such other dates as determined by the Fund’s Board of Trustees (the “Board” or “Trustees”), or its designee, in accordance with procedures approved by the Board. The NAV is calculated by dividing the value of the Fund’s net assets attributable to Common Shares by the numbers of Common Shares outstanding.
Valuation of Investments
In computing the Fund’s net assets attributable to Common Shares, securities with readily available market quotations use those quotations for valuation. Securities where there are no readily available market quotations, will be valued at the mean between the most recently quoted bid and asked prices provided by the principal market makers. If there is more than one such principal market maker, the value shall be the average of such means. Securities without a sale price or quotations from principal market makers on the valuation day may be priced by an independent pricing service. Generally, the Fund’s loan and bond positions are not traded on exchanges and consequently are valued based on a mean of
10 | Annual Report
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
the bid and ask price from the third-party pricing services or broker-dealer sources that Highland Capital Management, L.P. (the “Investment Adviser”) has determined generally has the capability to provide appropriate pricing services and has been approved by the Trustees.
Securities for which market quotations are not readily available, for which the Fund has determined the price received from a pricing service or broker-dealer is “stale” or otherwise do not represent fair value (including when events materially affect the value of securities that occur between the time when market price is determined and calculation of the Fund’s NAV), will be valued by the Fund at fair value, as determined by the Board or its designee in good faith in accordance with procedures approved by the Board, taking into account factors reasonably determined to be relevant, including: (i) the fundamental analytical data relating to the investment; (ii) the nature and duration of restrictions on disposition of the securities; and (iii) an evaluation of the forces that influence the market in which these securities are purchased and sold. In these cases, the Fund’s NAV will reflect the affected portfolio securities’ fair value as determined in the judgment of the Board or its designee instead of being determined by the market. Using a fair value pricing methodology to value securities may result in a value that is different from a security’s most recent sale price and from the prices used by other investment companies to calculate their NAV. Determination of fair value is uncertain because it involves subjective judgments and estimates not easily substantiated by auditing procedures.
There can be no assurance that the Fund’s valuation of a security will not differ from the amount that it realizes upon the sale of such security. Short-term investments, that is, those with a remaining maturity of 60 days or less, are valued at cost adjusted for amortization of premiums and accretion of discounts. Repurchase agreements are valued at cost plus accrued interest. Foreign price quotations are converted to U.S. dollar equivalents using the 4:00 PM London Time Spot Rate.
Fair Value Measurements
The Fund has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. The levels of fair value inputs used to measure the Fund’s investments are characterized into a fair value hierarchy. Where inputs for an asset or liability fall into more than one level in the fair value hierarchy, the investment is classified in its entirety based on the lowest level input that is significant to that investment’s valuation. The three levels of the fair value hierarchy are described below:
Level 1 — | Quoted unadjusted prices for identical instruments in active markets to which the Fund has access at the date of measurement; | |
Level 2 — | Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active, but are valued based on executed trades; broker quotations that constitute an executable price; and alternative pricing sources supported by observable inputs are classified within Level 2. Level 2 inputs are either directly or indirectly observable for the asset in connection with market data at the measurement date; and | |
Level 3 — | Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. In certain cases, investments classified within Level 3 may include securities for which the Fund has obtained indicative quotes from broker-dealers that do not necessarily represent prices the broker may be willing to trade on, as such quotes can be subject to material management judgment. Unobservable inputs are those inputs that reflect the Fund’s own assumptions that market participants would use to price the asset or liability based on the best available information. |
As of December 31, 2010, the Fund’s investments consisted of senior loans, corporate notes and bonds, asset-backed securities, common stock, preferred stock and warrants. The fair value of the Fund’s loans, bonds and asset-backed securities are generally based on quotes received from brokers or independent pricing services. Loans and bonds with quotes that are based on actual trades with a sufficient level of activity on or near the measurement date are classified as Level 2 assets. Loans, bonds and asset-backed securities that are priced using quotes derived from implied values, indicative bids, or a limited amount of actual trades are classified as Level 3 assets because the inputs used by the brokers and pricing services to derive the values are not readily observable.
The fair value of the Fund’s common stocks, preferred stocks and warrants that are not actively traded on national exchanges are generally priced using quotes derived from implied values, indicative bids, or a limited amount of actual trades and are classified as Level 3 assets because the inputs used by the brokers and pricing services to derive the values are not readily observable.
For investments which do not have readily available quotations or are not priced by a pricing service or broker, the Fund will determine the investments fair value, as determined by the Board or its designee in accordance with procedures approved the Board, taking into account relevant factors. These factors include: 1) fundamental analytical data relating to the investment, 2) the nature and duration of restrictions on disposition of the securities and 3) an evaluation of the forces that influence the market in which the investment is purchased and sold.
Annual Report | 11
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
At the end of each calendar quarter, management evaluates the Level 2 and 3 assets and liabilities for changes in liquidity, including but not limited to: whether a broker is willing to execute at the quoted price, the depth and consistency of prices from third party services, and the existence of contemporaneous, observable trades in the market. Additionally, management evaluates the Level 1 and 2 assets and liabilities on a quarterly basis for changes in listings or delistings on national exchanges.
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 the Fund’s investments may fluctuate from period to period. Additionally, the fair value of investments may differ significantly from the values that would have been used had a ready market existed for such investments and may differ materially from the values the Fund may ultimately realize. Further, such investments may be subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities.
The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. Transfers in and out of the levels are recognized at the value at the end of the period. A summary of the inputs used to value the Fund’s assets as of December 31, 2010 is as follows:
Level 2 | Level 3 | |||||||||||||||
Total Value | Level 1 | Significant | Significant | |||||||||||||
as of | Quoted | Observable | Unobservable | |||||||||||||
Funds | December 31, 2010 | Price | Input | Input | ||||||||||||
Investments in Securities: | ||||||||||||||||
Common Stocks | ||||||||||||||||
Diversified Media | $ | 151,121 | $ | — | $ | — | $ | 151,121 | ||||||||
Healthcare | 275,850 | — | — | 275,850 | ||||||||||||
Service | 1,006,917 | — | — | 1,006,917 | ||||||||||||
Wireless Communication | 37,334 | 37,334 | — | — | ||||||||||||
Warrants | 2,168 | — | — | 2,168 | ||||||||||||
Debt | ||||||||||||||||
Senior Loans | 1,199,904 | — | 838,404 | 361,500 | ||||||||||||
Corporate Debt | 350,082 | — | — | 350,082 | ||||||||||||
Total | $ | 3,023,376 | $ | 37,334 | $ | 838,404 | $ | 2,147,638 | ||||||||
The Fund did not have any liabilities that were measured at fair value on a recurring basis at December 31, 2010.
The tables below set forth a summary of changes in the Fund’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2010.
Net | ||||||||||||||||||||||||||||
amortization/ | ||||||||||||||||||||||||||||
Balance as of | Transfers | (accretion) of | ||||||||||||||||||||||||||
Assets at Fair Value using | December 31 | in/(out) | premium/ | Net realized | Net unrealized | Net | Balance as of | |||||||||||||||||||||
unobservable inputs (Level 3) | 2009 | of Level 3 | (discount) | gains/(losses) | gains/(losses) | purchase/(sales)* | December 31, 2010 | |||||||||||||||||||||
Common Stocks | ||||||||||||||||||||||||||||
Diversified Media | $ | — | $ | — | $ | — | $ | — | $ | (63,970 | ) | $ | 215,091 | $ | 151,121 | |||||||||||||
Healthcare | 1,590,000 | — | — | 747,556 | (454,890 | ) | (1,606,816 | ) | 275,850 | |||||||||||||||||||
Housing | 2,852,544 | — | — | 1,192,456 | (1,209,334 | ) | (2,835,666 | ) | — | |||||||||||||||||||
Service | 4,620,054 | — | — | (466,385 | ) | 821,877 | (3,968,629 | ) | 1,006,917 | |||||||||||||||||||
Warrants | 7,700 | — | — | (339,017 | ) | 347,977 | (14,492 | ) | 2,168 | |||||||||||||||||||
Debt | ||||||||||||||||||||||||||||
Senior Loans | 3,749,704 | 71,981 | 184,502 | (843,115 | ) | 1,250,323 | (4,051,895 | ) | 361,500 | |||||||||||||||||||
Asset Backed Securities | 1,312,168 | — | — | (541,088 | ) | 840,819 | (1,611,899 | ) | — | |||||||||||||||||||
Corporate Debt | 3,167,445 | — | (9,910 | ) | (1,269,637 | ) | 1,019,538 | (2,557,354 | ) | 350,082 | ||||||||||||||||||
Total | $ | 17,299,615 | $ | 71,981 | $ | 174,592 | $ | (1,519,230 | ) | $ | 2,552,340 | $ | (16,431,660 | ) | $ | 2,147,638 | ||||||||||||
* | Includes any applicable borrowings and/or paydowns made on revolving credit facilities held in the Fund’s investment portfolio. |
The net unrealized losses presented in the tables above relate to investments that are still held at December 31, 2010 and the Fund presents these unrealized losses on the Statement of Operations as net change in unrealized appreciation/(depreciation) on investments.
Investments designated as Level 3 may include assets valued using quotes or indications furnished by brokers which are based on models or estimates and may not be executable prices. In light of the developing market conditions, the Investment Adviser continues to search for observable data points and evaluate broker quotes and indications received for portfolio investments. As a result, for the year ended December 31, 2010, a net amount of $71,981 of the Fund’s portfolio investments was transferred to Level 2 from Level 3. Determination of fair values is uncertain because it involves subjective judgments and estimates not easily substantiated by auditing procedures.
12 | Annual Report
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
Security Transactions
Security transactions are accounted for on the trade date. Cost is determined and gains/(losses) are based upon the specific identification method for both financial statement and federal income tax purposes.
Foreign Currency
Foreign currencies, investments and other assets and liabilities are translated into U.S. dollars at the exchange rates using the current 4:00 PM London Time Spot Rate. Fluctuations in the value of the foreign currencies and other assets and liabilities resulting from changes in exchange rates between trade and settlement dates on security transactions and between the accrual and payment dates on dividends, interest income and foreign withholding taxes are recorded as unrealized foreign currency gains/(losses). Realized gains/(losses) and unrealized appreciation/(depreciation) on investment securities and income and expenses are translated on the respective dates of such transactions. The effect of changes in foreign currency exchange rates on investments in securities are not segregated in the Statement of Operations from the effects of changes in market prices of those securities, but are included with the net realized and unrealized gain or loss on investment securities.
Short Sales
The Fund may sell securities short. A short sale is a transaction in which the Fund sells a security it does not own in anticipation that the market price of that security will decline. When the Fund makes a short sale, it must borrow the security sold short from a broker-dealer and deliver it to the buyer upon conclusion of the sale. The Fund may have to pay a fee to borrow particular securities and is often obligated to pay over any payments received on such borrowed securities.
When short sales are employed, the Fund intends to attempt to limit exposure to a possible market decline in the value of its portfolio securities through short sales of securities that the Investment Adviser believes possess volatility characteristics similar to those being hedged. In addition, the Fund may use short sales for non-hedging purposes to pursue its investment objective.
As of December 31, 2010, the Fund did not hold any short positions.
Income Recognition
Interest income is recorded on the accrual basis and includes accretion of discounts and amortization of premiums. Dividend income is recorded on the ex-dividend date.
U.S. Federal Income Tax Status
The Fund intends to qualify each year as a “regulated investment company” under Subchapter M of the Internal Revenue Code (“the Code”) and will distribute substantially all of its taxable income and gains, if any, for its tax year, and as such will not be subject to U.S. federal income taxes.
Management has analyzed the Fund’s tax positions taken on federal income tax returns for all open tax years (current and prior three tax years), and has concluded that no provision for federal income tax is required in the Fund’s financial statements. The Fund’s federal and state income and federal excise tax returns for tax years for which the applicable statutes of limitations have not expired are subject to examination by the Internal Revenue Service and state departments of revenue.
Distributions to Shareholders
Dividends and distributions from net investment income are distributed each year based on the criteria set forth below. Holders of Series P Shares are entitled to receive cumulative dividends in the amount of 8% per year of $1,000 for each Series P Share owned. Distributions to holders of Common Shares will consist of all net investment income remaining after the payment of dividends on the Series P Shares. Capital gain distributions, deemed capital gain distributions and ordinary income dividends will be allocated between the holders of Common Shares and Series P Shares in proportion to the total distributions paid during the taxable year. The Fund will not declare or pay any distribution with respect to Common Shares unless the Preferred Shares have asset coverage of at least 200% after deducting the amount of the dividend. During the year ended December 31, 2010, the Fund made distributions of $0.59, $0.43, and $0.10, per share on February 26, May 28 and June 30, respectively On February 11, the Trustees approved a special distribution of $2.75 per Common Share.
Cash and Cash Equivalents
The Fund considers liquid assets deposited with a bank, money market funds, and certain short term debt instruments with maturities of 3 months or less to be cash equivalents. These investments represent amounts held with financial institutions that are readily accessible to pay Fund expenses or purchase investments. Cash and cash equivalents are valued at cost plus accrued interest, which approximates market value. The value of cash equivalents denominated in foreign currencies is determined by converting to U.S. dollars on the date of the statement of assets and liabilities. At December 31, 2010, the Fund did not have any cash and cash equivalents denominated in foreign currencies.
Statement of Cash Flows
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.
Annual Report | 13
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
Note 3. Federal Tax Information
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.
For year ended December 31, 2010, permanent differences resulting from Section 988 gain/loss, redemption-in-kind transactions and capital loss carry forward limitations were identified and reclassified among the components of the Fund’s net assets as follows:
Undistributed | Accumulated | |||
Net Investment | Net Realized | Paid-In | ||
Income | Loss | Capital | ||
$(26,715) | $9,772,955 | $(9,746,240) |
The tax character of distributions paid during the years ended December 31, 2010, 2009 and 2008 were as follows:
Distributions paid from: | 2010 | 2009 | 2008 | |||||||||
Ordinary income* | $ | 299,600 | $ | 3,973,142 | $ | 3,685,577 | ||||||
Long-term capital gains | — | — | 9,447,303 | |||||||||
Return of Capital | 23,154,074 | — | — |
* | For tax purposes short-term capital gains distributions, if any, are considered ordinary income distributions. |
As of December 31, 2010, the most recent tax year end, the components of distributable earnings on a tax basis were as follows:
Accumulated | ||||||||||||
Capital | Undistributed | Undistributed | ||||||||||
and Other | Ordinary | Long-Term | Net Unrealized | |||||||||
Losses | Income | Capital Gains | (Appreciation) | |||||||||
$(9,840,726) | $ | — | $ | — | $ | (185,583 | ) |
As of December 31, 2010, the most recent year end, for federal income tax purposes, the Fund had capital loss carryforwards, which will expire in the indicated year:
Capital Loss | Expiration | |
Carryforwards | Date | |
$(3,212,361)* | 2017 | |
(3,076,455)* | 2018 |
* | The Fund’s ability to utilize capital loss carryforwards may be limited. |
During the year ended December 31, 2010, the Fund had writeoffs of capital loss carryforwards in the amount of $9,290,378.
Unrealized appreciation and depreciation at December 31, 2010, based on cost of investments for U.S. federal income tax purposes and excluding any unrealized appreciation/(depreciation) from changes in the value of other assets and liabilities resulting from changes in exchange rates, was:
Unrealized appreciation | $ | 492,648 | ||
Unrealized depreciation | 307,065 | |||
Net unrealized appreciation | $ | 185,583 | ||
Post October Losses
Under current laws, certain capital losses realized after October 31 may be deferred and treated as occurring on the first day of the following fiscal year. For the fiscal year ended December 31, 2010, the Fund intends to elect to defer net realized capital losses of $3,551,910 incurred from November 1, 2010 through December 31, 2010.
Note 4. Investment Management, Carried Interest, Trustee, and Other Fees
Management Fee
The Investment Adviser receives an investment management fee (the “Management Fee”) of 1.50% per year, calculated monthly and paid quarterly of the aggregate NAV of the Fund. NAV shall mean the market value of all liquid securities at the time of valuation and the cost of any illiquid assets at the time of valuation. Assets are considered “illiquid” if the Investment Adviser reasonably determines, in accordance with procedures adopted by the Board, that (i) reliable market quotations are not readily available for such security, or (ii) although reliable quotations are readily available, the majority of such securities held by accounts managed by the Investment Adviser could not be sold or disposed of in the ordinary course of business (without taking into account any illiquidity or simular discounts) within fourteen trading days at approximately the price at which the security is valued by the Fund without significantly depressing the level of such market quotations. The limitation in (ii) above is not applicable if the inability to dispose of a majority of such securities within such period is due to the fact that the Investment Adviser is an affiliate of the issuer or possesses inside information regarding such issuer.
Carried Interest Fee
The Carried Interest will be paid as a fee pursuant to the Investment Management Agreement between the Fund and the Investment Adviser. The Carried Interest is an amount (payable annually) such that after receipt thereof the Investment Adviser will have received from the Fund 20% of the realized and unrealized cumulative total return of the
14 | Annual Report
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
Fund on its assets attributable to the Common Shares and the Special Share. The Carried Interest shall be payable as of December 31 of each year and shall be paid not later than completion of the audit of the Fund for such year. If there is positive return through any interim month in excess of the high watermark described below, the Fund will accrue an appropriate amount in respect of the earned Carried Interest potentially payable at the end of the year. If there is negative return in any calendar year, no Carried Interest will be paid until the negative return (as a percentage of average net assets attributable to the Common Shares and the Special Share, or, if less, as a percentage of such net assets at the time such negative return is experienced) has been recovered in full (“High Watermark Provision”). For the avoidance of doubt, all total return (positive or negative) will be determined in dollars (the percentage figure in connection with recoupment of negative return being utilized solely to calculate the dollar amount of negative return required to be recouped). For purposes of all Carried Interest calculations, illiquid assets (as defined for purposes of the Management Fee) will be valued at the lesser of cost or fair market value (as determined by the Investment Adviser in good faith). As of December 31, 2010, the Fund did not have any Carried Interest.
Fees Paid to Officers and Trustees
Each Trustee who is not an “interested person” of the Fund 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 advised by the Investment Adviser as of the date of this annual report.
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. Fund Information
For the year ended December 31, 2010, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were $462,817 and $25,453,329, respectively. At the request of the majority shareholder and the approval of the Board of Trustees, the Fund had a redemption-in-kind on March 24, 2010 and October 31, 2010 which resulted in a redemption out of the Fund of $19,459,881 which is comprised of securities, cash and interest accrued in the amounts of $10,787,309, $8,587,023, and $85,549, respectively. These securities are excluded from the proceeds from the sale of securities.
Note 6. Periodic Repurchase Offers
The Fund may make quarterly repurchases at NAV of up to 20% of the outstanding Common Shares that have been held for at least twelve months (“Repurchase Offers”) at the option of the Board. During the year ended December 31, 2010, the Fund did not make any Repurchase Offers.
Note 7. Transactions in Securities of Affiliated Issuers
Under Section 2(a)(3) of the 1940 Act, a portfolio company is defined as “affiliated” if a Fund owns five percent or more of its voting stock. The Fund did not hold any affiliated companies at December 31, 2010.
Note 8. Unfunded Loan Commitments
As of December 31, 2010, the Fund had no unfunded loan commitments.
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.
Note 9. Securities Loans
The Fund may make secured loans of its portfolio securities amounting to not more than one-third of the value of its total assets, thereby realizing additional income. The risks in lending portfolio securities, as with other extensions of credit, consist of possible delays in recovery of the securities or possible loss of rights in the collateral should the borrower fail financially and possible investment losses in the investment of collateral. As a matter of policy, securities loans are made to unaffiliated broker-dealers pursuant to agreements requiring that loans be continuously secured by collateral in cash or short-term debt obligations at least equal at all times to the bid value of the securities subject to the loan. The borrower pays to the Fund an amount equal to any interest or dividends received on securities subject to the loan. The Fund retains all or a portion of the interest received on investment of the cash collateral or receives a fee from the borrower. As of December 31, 2010, the Fund did not have any securities loaned.
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. The Board has approved the advancement of certain expenses to a service provider in connection with pending litigation subject to appropriate documentation and safeguards.
Annual Report | 15
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
Note 11. Disclosure of Significant Risks and Contingencies
Non-Diversification and Industry Concentration Risk
The Fund may focus its investments in instruments of only a few companies. The concentration of the Fund’s portfolio in any one obligor would subject the Fund to a greater degree of risk with respect to defaults by such obligor, and the concentration of the portfolio in any one industry would subject the Fund to a greater degree of risk with respect to economic downturns relating to such industry.
Non-Payment Risk
Corporate debt obligations, including Senior Loans, 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 corporate debt obligation 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 debt may result in greater net asset value fluctuation than if the Fund did not make such investments.
Illiquidity of Investments Risk
The investments made by the Fund may be illiquid, and consequently the Fund may not be able to sell such investments at prices that reflect the Investment Adviser’s assessment of their value or the amount originally paid for such investments by the Fund. Illiquidity may result from the absence of an established market for the investments as well as legal, contractual or other restrictions on their resale and other factors. Furthermore, the nature of the Fund’s investments, especially those in financially distressed companies, may require a long holding period prior to profitability.
Troubled, Distressed or Bankrupt Companies Risk
The Fund invests in companies that are troubled, in distress, or bankrupt. As such, they are subject to a multitude of legal, industry, market, environment and governmental forces that make analysis of these companies inherently difficult. Further, the Investment Adviser relies on company management, outside experts, market participants, and personal experience to analyze potential investments for the Fund. There can be no assurance that any of these sources will prove credible or that the resulting analysis will produce accurate conclusions.
Carried Interest Risk
The Carried Interest may create an incentive for the Investment Adviser to make investments that are risky or more speculative than would otherwise be the case. The way in which the amount of the Carried Interest is determined may encourage the Investment Adviser to use leverage to increase the return on the Fund’s investments. If the Investment Adviser acquires poorly performing assets with such leverage, the loss to the Fund could be substantial. Finally, because a portion of the Carried Interest is likely to reflect interest and dividend income and is calculated on an accrual basis regardless of whether the Fund has received a cash payment, the Investment Adviser might have an incentive to invest in zero coupon or deferred interest securities in circumstances where it would not have done so but for the opportunity to continue to earn Carried Interest even when the issuer would not be able to make cash payments on such securities. The foregoing risks could be increased because the Investment Adviser is not obligated to reimburse the Fund for any Carried Interest received even if the Fund subsequently incurs losses or never receives in cash income that was previously accrued.
Leverage Risk
The Fund may use leverage in its investment program, including the use of borrowed funds and investments in certain types of options, such as puts, calls and warrants, which may be purchased for a fraction of the price of the underlying securities. While such strategies and techniques increase the opportunity to achieve higher returns on the amounts invested, they also increase the risk of loss. To the extent the Fund purchases securities with borrowed funds, its net assets will tend to increase or decrease at a greater rate than if borrowed funds are not used. If the interest expense on borrowings were to exceed the net return on the portfolio securities purchased with borrowed funds, the Fund’s use of leverage would result in a lower rate of return than if the Fund were not leveraged.
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 involve certain factors not typically associated with investing in U.S. securities, such as
16 | Annual Report
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 2010 | Highland Special Situations Fund |
risks relating to (i) currency exchange matters, including fluctuations in the rate of exchange between the U.S. dollar (the currency in which the books of the Fund are maintained) and the various foreign currencies in which the Fund’s portfolio securities will be denominated and costs associated with conversion of investment principal and income from one currency into another; (ii) differences between the U.S. and foreign securities markets, including the absence of uniform accounting, auditing and financial reporting standards and practices and disclosure requirements, and less government supervision and regulation; (iii) political, social or economic instability; and (iv) the extension of credit, especially in the case of sovereign debt.
Short Selling Risk
Short sales by the Fund that are not made where there is an offsetting long position in the asset that is being sold short theoretically involve unlimited loss potential since the market price of securities sold short may continuously increase. Short selling allows the Fund to profit from declines in market prices to the extent such decline exceeds the transaction costs and costs of borrowing the securities. However, since the borrowed securities must be replaced by purchases at market prices in order to close out the short position, any appreciation in the price of the borrowed securities would result in a loss. Purchasing securities to close out the short position can itself cause the price of securities to rise further, thereby exacerbating the loss. The Fund may mitigate such losses by replacing the securities sold short before the market price has increased significantly. Under adverse market conditions, the Fund might have difficulty purchasing securities to meet its short sale delivery obligations, and might have to sell portfolio securities to raise the capital necessary to meet its short sale obligations at a time when fundamental investment considerations would not favor such sales.
Significant Shareholders
At December 31, 2010, one shareholder (“Significant Shareholder”) owned 100% of the net assets applicable to Common Shares. The Fund will not accept any other subscription for Common Shares without the consent of the Board of Trustees and the written consent of the Significant Shareholder.
Note 12. Subsequent Events
Management has evaluated the impact of all subsequent events on the Fund through the date the financial statements were issued, and has determined that there were the following subsequent events requiring recognition or disclosure in the financial statements:
Upon completion of a redemption-in-kind on October 31, 2010, shares of ICO Global Communications Holdings, Ltd. were not distributed. The physical shares had to be re-registered in order to transfer to the shareholder. The Fund did not distribute these shares until January 11, 2011. As such, at December 31, 2010 the value of the shares is presented on the Statement of Assets and Liabilities as a Receivable for Other Assets and a Payable for Shares Redeemed.
Annual Report | 17
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Trustees and Shareholders of Highland Special Situations Fund:
In our opinion, the accompanying statement of assets and liabilities, including the investment portfolio, and the related statements of operations and of changes in net assets and of cash flows and the financial highlights present fairly, in all material respects, the financial position of Highland Special Situations Fund (the “Fund”) at December 31, 2010, and the results of its operations and its cash flows for the year then ended, the changes in its net assets and the financial highlights for each of the periods indicated, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as “financial statements”) are the responsibility of the Fund’s management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit, which included confirmation of securities at December 31, 2010 by correspondence with the custodian and the banks with whom the Fund owns participations in loans, provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Dallas, Texas
February 25, 2011
Dallas, Texas
February 25, 2011
18 | Annual Report
ADDITIONAL INFORMATION (unaudited)
December 31, 2010 | Highland Special Situations Fund |
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 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.
Approval of Investment Management Agreement
The Fund has retained the Investment Adviser to manage its assets pursuant to an Amended Investment Management Agreement with the Investment Adviser (the “Management Agreement”), which has been approved by the Fund’s Board of Trustees, including a majority of the Trustees who are not “interested persons” (as defined in the 1940 Act) of the Fund (the “Independent Trustees”).
Following an initial term of two years, the Management 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.
The Board of Trustees, including the Independent Trustees, approved the Management Agreement at a meeting held on December 9-10, 2010. As part of its review process, the Board of Trustees requested, through Fund counsel and its independent legal counsel, and received from the Investment Adviser written and oral information including: (i) information confirming the financial soundness of the Investment Adviser and on the general profitability of the Management Agreement; (ii) information on the advisory and compliance personnel of the Investment Adviser, including compensation arrangements; (iii) information on the internal compliance procedures of the Investment Adviser; (iv) information showing how the Fund’s fees and expected operating expenses compare to those of (a) other registered and private investment funds that follow investment strategies and objectives similar to those of the Fund and having a similar asset size, and (b) other private and registered pooled investment vehicles or accounts managed by the Investment Adviser, as well as performance of such vehicles and accounts; (v) information comparing the services provided to the Fund by the Investment Adviser versus those provided to the Investment Adviser’s other institutional and hedge fund clients; (vi) information regarding brokerage and portfolio transactions; and (vii) information on any legal proceedings or regulatory audits or investigations affecting the Fund, the Investment Adviser or its affiliates. The Trustees reviewed the detailed information provided by the Investment Adviser and other relevant information and factors with independent legal counsel.
The Trustees’ conclusion as to the continuation of the Management Agreement was based on a comprehensive consideration of all information provided to the Trustees without any single factor being dispositive in and of itself. Some of the factors that figured particularly in the Trustees’ deliberations are described below, although individual Trustees may have evaluated the information presented differently from one another, giving different weights to various factors. The fee arrangements for the Fund are the result of review and discussion between the Independent Trustees and the Investment Adviser since the Fund’s inception. Certain aspects of such arrangements may receive greater scrutiny in some years than in others, and the Trustees’ conclusions may be based, in part, on their consideration of these same arrangements during the course of the year and in prior years.
The Nature, Extent, and Quality of the services Provided by the Investment Adviser. The 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 relevant experience and qualifications of the personnel providing advisory services, including the background and experience of the members of the Fund’s portfolio management team. The 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 Trustees concluded that the Investment Adviser has the quality and depth of personnel and investment methods essential to performing its duties under the Management
Annual Report | 19
ADDITIONAL INFORMATION (unaudited)
December 31, 2010 | Highland Special Situations Fund |
Agreement and that the nature and quality of such advisory services are satisfactory.
The Investment Adviser’s Historical Performance in Managing the Fund. The Trustees reviewed the Investment Adviser’s historical performance in managing the Fund over various time periods and reflected on previous discussions regarding matters bearing on the Investment Adviser’s performance at their meetings throughout the year. The Trustees discussed relative performance and contrasted the Fund’s performance versus that of the Dow Jones Credit Suisse Event Driven Distressed Hedge Fund Index, Credit Suisse Leveraged Loan Index and the S&P 500 Index. After reviewing these and related factors, the Trustees concluded that they were satisfied with the Investment Adviser’s responses and efforts relating to performance.
The Costs of the Services to be Provided by the Investment Adviser and the Profits Realized by the Investment Adviser and its Affiliates from the Relationship with the Fund. The Trustees also gave substantial consideration to the fees payable under the Management Agreement, including: (i) the annual fee as a portion of the Net Asset Value of the Fund paid to the Investment Adviser under the Management Agreement and the Administration Agreement; (ii) the expenses the Investment Adviser incurs in providing advisory services; and (iii) a comparison of the fees payable to the Investment Adviser under the Management Agreement to fees payable to (a) other investment advisers serving other registered investment companies and business development companies that follow investment strategies similar to those of the Fund and (b) the Investment Adviser by Crusader Fund in comparison to the fees payable by the Fund. After reviewing these and related factors, the Trustees determined that the fees payable to the Investment Adviser under the Management Agreement represent reasonable compensation in light of the services being provided by the Investment Adviser to the Fund.
The Extent to which Economies of Scale would be Realized as the Fund Grows and Whether Fee Levels Reflect these Economies of Scale for the Benefit of Shareholders. The Trustees considered the asset level of the Fund, the information provided by the Investment Adviser relating to its costs and information comparing the fee rate charged by the Investment Adviser with fee rates charged by other unaffiliated investment advisers to their clients. The Trustees also considered that, due to its nature as a closed-end fund, and the limitations on additional shareholders imposed by the organizational documents of the Fund, the Fund’s asset level is not expected to increase significantly as a result of new capital contributions. As a result, the Trustees did not view the potential for realization of economies of scale as the Fund’s assets grow to be a material factor in their deliberations. The Trustees noted that they would consider economies of scale in the future in the event the Fund experiences significant asset growth through a merger, rights offering, material increase in the market value of the Fund’s portfolio securities or otherwise. The Trustees considered whether breakpoints in the fee under the Management Agreement for the Fund would be appropriate in light of the Fund’s assets and current fee structure, including any waivers, and determined not to recommend any breakpoints for the Fund at this time.
Following a further discussion of the factors deemed material, including those described above, and the merits of the Management Agreement and its various provisions, the Trustees, including all of the Independent Trustees, determined that the Management Agreement, including the advisory fee paid to the Investment Adviser under the Management Agreement, is fair and reasonable to the Fund and approved the continuation, for a period of one year commencing December 31, 2010, of the Management Agreement.
20 | Annual Report
ADDITIONAL INFORMATION (unaudited) (continued)
December 31, 2010 | Highland Special Situations Fund |
Trustees and Officers
The Board provides broad oversight over the operations and affairs of the Fund and protects the interests of shareholders. The Board has overall responsibility to manage and control the business affairs of the Fund, including the complete and exclusive authority to establish policies regarding the management, conduct and operation of the Fund’s business. The names and ages of the Trustees and officers of the Fund, the year each was first elected or appointed to office, their principal business occupations during the last five years, the number of funds overseen by each Trustee and other directorships or trusteeships they hold are shown below. The business address for each Trustee and officer of the Fund is c/o Highland Capital Management, L.P., NexBank Tower, 13455 Noel Road, Suite 800, Dallas, TX 75240.
Term of | Principal | Number of Portfolios | ||||||||||
Office and | Occupation(s) | in Highland Fund | Other | |||||||||
Position | Length of | During Past | Complex Overseen | Directorships/ | ||||||||
Name and Age | with Fund | Time Served | Five Years | by Trustee1 | Trusteeships Held | |||||||
INDEPENDENT TRUSTEES | ||||||||||||
Timothy K. Hui (Age 62) | Trustee | Indefinite Term; Trustee since 2004 | Vice President since February 2008, Dean of Educational Resources from July 2006 to January 2008 and Assistant Provost for Graduate Education from July 2004 to June 2006 at Philadelphia Biblical University. | 6 | None | |||||||
Scott F. Kavanaugh (Age 49) | Trustee | Indefinite Term; Trustee since 2004 | Vice-Chairman, President and Chief Operating Officer at Keller Financial Group since September 2007; Chairman and Chief Executive Officer at First Foundation Bank since September 2007; Vice Chairman, President and Chief Operating Officer of First Foundation, Inc. (holding com- pany) since September 2007 and private investor since February 2004. | 6 | None |
Annual Report | 21
ADDITIONAL INFORMATION (unaudited)
December 31, 2010 | Highland Special Situations Fund | |
Trustees and Officers |
Term of | Principal | Number of Portfolios | ||||||||||
Office and | Occupation(s) | in Highland Fund | Other | |||||||||
Name, Address, | Position | Length of | During Past | Complex Overseen | Directorships/ | |||||||
and Age | with Fund | Time Served | Five Years | by Trustee1 | Trusteeships Held | |||||||
INDEPENDENT TRUSTEES | ||||||||||||
James F. Leary (Age 80) | Trustee | Indefinite Term; Trustee since 2004 | Managing Director, Benefit Capital Southwest, Inc. (a finan- cial consulting firm) since January 1999. | 6 | Board Member of Capstone Group of Funds (7 port- folios) | |||||||
Bryan A. Ward (Age 55) | Trustee | Indefinite Term; Trustee since 2004 | Senior Manager, Accenture, LLP (a consulting firm) since January 2002. | 6 | None | |||||||
INTERESTED TRUSTEE2 | ||||||||||||
R. Joseph Dougherty2 (Age 40) | Trustee and Chairman of the Board, President and Chief Executive Officer | Indefinite Term; Trustee and Chairman of the Board since 2004 | Team Leader of the Investment Adviser since 2000, Trustee of the funds in the Highland Fund Complex since 2004 and President and Chief Executive Officer of the funds in the Highland Fund Complex since December 2008; Director of NexBank Securities, Inc. since June 2009; Senior Vice President of Highland Distressed Opportunities, Inc. from September 2006 to June 2009; Senior Vice President of the funds in the Highland Fund Complex from 2004 to December 2008. | 6 | None |
1 | The Highland Fund Complex consists of all of the registered investment companies advised by the Investment Adviser as of the date of this report. | |
2 | Mr. Dougherty is deemed to be an “interested person” of the Fund under the 1940 Act because of his position with the Investment Adviser. |
22 | Annual Report
ADDITIONAL INFORMATION (unaudited)
December 31, 2010 | Highland Special Situations Fund | |
Trustees and Officers |
Term of | ||||||
Office and | ||||||
Name, Address, | Position | Length of | ||||
and Age | with Fund | Time Served | Principal Occupation(s) During Past Five Years | |||
OFFICERS | ||||||
R. Joseph Dougherty (Age 40) | Trustee and Chairman of the Board, President and Chief Executive Officer | Indefinite Term; Trustee and Chairman of the Board since 2004; President and Chief Executive Officer since December 2008 | Team Leader of the Adviser since 2000, Director/Trustee of the funds in the Highland Fund Complex since 2004 and President and Chief Executive Officer of the funds in the Highland Fund Complex since December 2008; Director of NexBank Securities, Inc. since June 2009; Senior Vice President of Highland Distressed Opportunities, Inc. from September 2006 to June 2009; Senior Vice President of the funds in the Highland Fund Complex from 2004 to December 2008. | |||
Brian Mitts (Age 40) | Treasurer (Principal Accounting Officer and | Indefinite Term; Treasurer since November 2010 | Senior Retail Fund Analyst of the Adviser since 2007 and Principal Accounting Officer and Treasurer of the funds in the Highland Fund Complex since November 2010; Manager of Financial Reporting at HBK Investments (a hedge fund) from 2005 to 2007. | |||
Principal Financial Officer) | ||||||
Ethan Powell (Age 35) | Secretary | Indefinite Term; Secretary since November 2010 | Senior Retail Fund Analyst of the Adviser since 2007 and Secretary of the funds in the Highland Fund Complex since November 2010; Manager in the Merger and Acquisitions Division at Ernst & Young from 1999 to 2006. | |||
Matthew S. Okolita (Age 29) | Chief Compliance Officer | Indefinite Term; Chief Compliance Officer since May 2010 | Chief Compliance Officer of the Adviser and Cummings Bay Capital Management, L.P. since May 2010; Chief Compliance Officer of Highland Capital Management Europe, LTD. (an FSA registered adviser) and certain other investment advisers affiliated with the Adviser since June 2010; Compliance Manager of the Adviser from March 2008 to May 2010; Legal Associate at NewStar Financial Inc. (a commercial finance company) from August 2006 to December 2007; Compliance Associate at Commonwealth Financial Network (a registered investment adviser/broker-dealer) from January 2004 to August 2006. |
Annual Report | 23
IMPORTANT INFORMATION ABOUT THIS REPORT
Investment Adviser Highland Capital Management, L.P. NexBank Tower 13455 Noel Road, Suite 800 Dallas, TX 75240 | ||
Transfer Agent BNY Mellon Investment Servicing (US) Inc. 101 Sabin Street Pawtucket, RI 02860 | ||
Custodian PFPC Trust Company 301 Bellevue Parkway Wilmington, DE 19809 | ||
Independent Registered Public Accounting Firm PricewaterhouseCoopers LLP | ||
2001 Ross Avenue, Suite 1800 | ||
Dallas, TX 75201 | ||
Fund Counsel | ||
Ropes & Gray LLP | ||
Prudential Tower | ||
800 Boylston Street | ||
Boston, MA 02199-3600 |
This report has been prepared for shareholders of Highland Special Situations Fund (the “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 and additional reports will 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 SEC’s website at http://www.sec.gov.
The Fund files its complete schedule of portfolio holdings with the SEC for the first and third quarters of each fiscal year on Form N-Q. The Fund’s Forms N-Q are available on the SEC’s website at http://www.sec.gov and also may be reviewed and copied at the SEC’s Public Reference Room in Washington, DC. Information on the Public Reference Room may be obtained by calling 1-800-SEC-0330. Shareholders may obtain the Form N-Q by visiting the Fund’s website at www.highlandfunds.com.
24 | Annual Report
Highland Special Situations Fund | Annual Report, December 31, 2010 | |
www.highlandfunds.com | HLC-HSSF-AR-12/10 |
Item 2. Code of Ethics.
(a) | The registrant, as of the end of the period covered by this report, has adopted a code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party. | ||
(b) | Not applicable. | ||
(c) | There have been no amendments, during the period covered by this report, to a provision of the code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party, and that relates to any element of the code of ethics description. | ||
(d) | The registrant has not granted any waivers, including an implicit waiver, from a provision of the code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party, that relates to one or more of the items set forth in paragraph (b) of this item’s instructions. | ||
(e) | Not applicable. | ||
(f) | The registrant’s code of ethics is attached. |
Item 3. Audit Committee Financial Expert.
As of the end of the period covered by the report, the registrant’s board of trustees has determined that James Leary is qualified to serve as an audit committee financial expert serving on its audit committee and that he is “independent,” as defined by Item 3 of Form N-CSR.
Item 4. Principal Accountant Fees and Services.
Audit Fees
(a) | The aggregate fees billed for each of the last two fiscal years for professional services rendered by the principal accountant for the audit of the registrant’s annual financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those fiscal years are $60,000 for 2009 and $135,000 for 2010. |
Audit-Related Fees
(b) | The aggregate fees billed in each of the last two fiscal years for assurance and related services by the principal accountant that are reasonably related to the performance of the audit of the registrant’s financial statements and are not reported under paragraph (a) of this Item are $8,500 for 2009 and $35,000 for 2010. The nature of the services related to agreed-upon procedures, performed on the Fund’s semi-annual financial statements. |
Tax Fees
(c) | The aggregate fees billed in each of the last two fiscal years for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning are $6,750 for 2009 and $15,000 for 2010. The nature of the services related to assistance on the Fund’s tax returns and excise tax calculations. |
All Other Fees
(d) | The aggregate fees billed in each of the last two fiscal years for products and services provided by the principal accountant, other than the services reported in paragraphs (a) through (c) of this Item are $0 for 2009 and $0 for 2010. |
(e)(1) | Disclose the audit committee’s pre-approval policies and procedures described in paragraph (c)(7) of Rule 2-01 of Regulation S-X. | ||
The Audit Committee shall: |
(a) | have direct responsibility for the appointment, compensation, retention and oversight of the Fund’s independent auditors and, in connection therewith, to review and evaluate matters potentially affecting the independence and capabilities of the auditors; and | ||
(b) | review and pre-approve (including associated fees) all audit and other services to be provided by the independent auditors to the Fund and all non-audit services to be provided by the independent auditors to the Fund’s investment adviser or any entity controlling, controlled by or under common control with the investment adviser (an “Adviser Affiliate”) that provides ongoing services to the Fund, if the engagement relates directly to the operations and financial reporting of the Fund; and | ||
(c) | establish, to the extent permitted by law and deemed appropriate by the Audit Committee, detailed pre-approval policies and procedures for such services; and | ||
(d) | consider whether the independent auditors’ provision of any non-audit services to the Fund, the Fund’s investment adviser or an Adviser Affiliate not pre-approved by the Audit Committee are compatible with maintaining the independence of the independent auditors. |
(e)(2) | The percentage of services described in each of paragraphs (b) through (d) of this Item that were approved by the audit committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X are as follows: |
(b) | 100% |
(c) | 100% | ||
(d) | N/A |
(f) | The percentage of hours expended on the principal accountant’s engagement to audit the registrant’s financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountant’s full-time, permanent employees was less than fifty percent. | ||
(g) | The aggregate non-audit fees billed by the registrant’s accountant for services rendered to the registrant, and rendered to the registrant’s investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the adviser that provides ongoing services to the registrant for each of the last two fiscal years of the registrant was $0 for 2009 and $652,504 for 2010. | ||
(h) | The registrant’s audit committee of the board of directors has considered whether the provision of non-audit services that were rendered to the registrant’s investment adviser (not including any sub-adviser whose role is primarily portfolio management and is subcontracted with or overseen by another investment adviser), and any entity controlling, controlled by, or under common control with the investment adviser that provides ongoing services to the registrant that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-X is compatible with maintaining the principal accountant’s independence. |
Item 5. Audit Committee of Listed registrants.
Not applicable.
Item 6. Investments.
(a) | 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. | |
(b) | Not applicable. |
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
The Proxy Voting Policies are attached herewith.
APPENDIX E
HIGHLAND CAPITAL MANAGEMENT, L.P.
PROXY VOTING POLICY
1. Application; General Principles
1.1 This proxy voting policy (the “Policy”) applies to securities held in Client accounts (including registered investment companies and other pooled investment vehicles) as to which the above-captioned investment adviser (the “Company”) has voting authority, directly or indirectly. Indirect voting authority exists where the Company’s voting authority is implied by a general delegation of investment authority without reservation of proxy voting authority.
1.2 The Company shall vote proxies in respect of securities owned by or on behalf of a Client in the Client’s best economic interests and without regard to the interests of the Company or any other Client of the Company.
2. Voting; Procedures
2.1 Monitoring. A member of the settlement group (the “settlement designee”) of the Company shall have responsibility for monitoring portfolios managed by the Company for securities subject to a proxy vote. Upon the receipt of a proxy notice related to a security held in a portfolio managed by the Company, the settlement designee shall forward all relevant information to the portfolio manager(s) with responsibility for the security. The portfolio manager(s) may consult a member of the settlement group as necessary.
2.2 Voting. Upon receipt of notice from the settlement designee, the portfolio manager(s) of the fund(s) in which the security subject to a proxy vote shall evaluate the subject matter of the proxy and cause the proxy to be voted on behalf of the Client in accordance with the Guidelines set forth below.
2.3 Guideline. In determining how to vote a particular proxy, the portfolio manager(s) shall consider, among other things, the interests of each Client account as it relates to the subject matter of the proxy, any potential conflict of interest the Company may have in voting the proxy on behalf of the Client and the procedures set forth in this Policy. This Policy is designed to be implemented in a manner reasonably expected to ensure that voting rights are exercised in the best interests of the Company’s clients. Each proxy is voted on a case-by-case basis taking into consideration any relevant contractual obligations as well as other relevant facts and circumstances. In general, the Company reviews and considers corporate governance issues related to proxy matters and generally supports proposals that foster good corporate governance practices. Portfolio manager(s) may vote proxies as recommended by the security issuers management on routine matters related to the operation of the issuer and on matters not expected to have a significant impact on the issuer and/or its shareholders, because the Company believes that recommendations by the issuer are generally in shareholders’ best interests, and therefore in the best economic interest of the Company’s clients.
2.4 Conflicts of Interest. If the portfolio manager(s) determine that the Company may have a potential material conflict of interest (as defined in Section 3 of this Policy) in voting a particular proxy, the portfolio manager(s) shall contact the Company’s compliance department prior to causing the proxy to be voted.
2.4.1. For a security held by a an investment company, the Company shall disclose the conflict and its reasoning for voting as it did to the Retail Fund’s Board of Trustees at the next regularly scheduled quarterly meeting. In voting proxies for securities held by an investment company, the Company may consider only the interests of the Fund. It is the responsibility of the
compliance department to document the basis for the decision and furnish the documentation to the Board of Trustees. The Company may resolve the conflict of interest by following the proxy voting recommendation of a disinterested third party (such as ISS, Glass Lewis, or another institutional proxy research firm).
2.5 Non-Votes. The Company may determine not to vote proxies in respect of securities of any issuer if it determines it would be in its Client’s overall best interests not to vote. Such determination may apply in respect of all Client holdings of the securities or only certain specified Clients, as the Company deems appropriate under the circumstances. As examples, the portfolio manager(s) may determine: (a) not to recall securities on loan if, in its judgment, the matters being voted upon are not material events affecting the securities and the negative consequences to Clients of disrupting the securities lending program would outweigh the benefits of voting in the particular instance or (b) not to vote certain foreign securities positions if, in its judgment, the expense and administrative inconvenience outweighs the benefits to Clients of voting the securities.
2.6 Recordkeeping. Following the submission of a proxy vote, the applicable portfolio manager(s) shall submit a report of the vote to a settlement designee of the Company. Records of proxy votes by the Company shall be maintained in accordance with Section 4 of this Policy.
3. Conflicts of Interest
3.1 Voting the securities of an issuer where the following relationships or circumstances exist are deemed to give rise to a material conflict of interest for purposes of this Policy:
3.1.1 The issuer is a Client of the Company, or of an affiliate, accounting for more than 5% of the Company’s or affiliate’s annual revenues.
3.1.2 The issuer is an entity that reasonably could be expected to pay the Company or its affiliates more than $1 million through the end of the Company’s next two full fiscal years.
3.1.3 The issuer is an entity in which a “Covered Person” (as defined in the Company’s Policies and Procedures Designed to Detect and Prevent Insider Trading and to Comply with Rule 17j-1 of the Investment Company Act of 1940, as amended (the “Code of Ethics”)) has a beneficial interest contrary to the position held by the Company on behalf of Clients.
3.1.4 The issuer is an entity in which an officer or partner of the Company or a relative1 of any such person is or was an officer, director or employee, or such person or relative otherwise has received more than $150,000 in fees, compensation and other payment from the issuer during the Company’s last three fiscal years; provided, however, that the Compliance Department may deem such a relationship not to be a material conflict of interest if the Company representative serves as an officer or director of the issuer at the direction of the Company for purposes of seeking control over the issuer.
3.1.5 The matter under consideration could reasonably be expected to result in a material financial benefit to the Company or its affiliates through the end of the Company’s next
1 | For the purposes of this Policy, “relative” includes the following family members: spouse, minor children or stepchildren or children or stepchildren sharing the person’s home. |
two full fiscal years (for example, a vote to increase an investment advisory fee for a Fund advised by the Company or an affiliate).
3.1.6 Another Client or prospective Client of the Company, directly or indirectly, conditions future engagement of the Company on voting proxies in respect of any Client’s securities on a particular matter in a particular way.
3.1.7 The Company holds various classes and types of equity and debt securities of the same issuer contemporaneously in different Client portfolios.
3.1.8 Any other circumstance where the Company’s duty to serve its Clients’ interests, typically referred to as its “duty of loyalty,” could be compromised.
3.2 Notwithstanding the foregoing, a conflict of interest described in Section 3.1 shall not be considered material for the purposes of this Policy in respect of a specific vote or circumstance if:
3.2.1 The securities in respect of which the Company has the power to vote account for less than 1% of the issuer’s outstanding voting securities, but only if: (i) such securities do not represent one of the 10 largest holdings of such issuer’s outstanding voting securities and (ii) such securities do not represent more than 2% of the Client’s holdings with the Company.
3.2.2 The matter to be voted on relates to a restructuring of the terms of existing securities or the issuance of new securities or a similar matter arising out of the holding of securities, other than common equity, in the context of a bankruptcy or threatened bankruptcy of the issuer.
4. Recordkeeping, Retention and Compliance Oversight
4.1 The Company shall retain records relating to the voting of proxies, including:
4.1.1 Copies of this Policy and any amendments thereto.
4.1.2 A copy of each proxy statement that the Company receives regarding Client securities.
4.1.3 Records of each vote cast by the Company on behalf of Clients.
4.1.4 A copy of any documents created by the Company that were material to making a decision how to vote or that memorializes the basis for that decision.
4.1.5 A copy of each written request for information on how the Company voted proxies on behalf of the Client, and a copy of any written response by the Company to any (oral or written) request for information on how the Company voted.
4.2 These records shall be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the Company’s fiscal year during which the last entry was made in the records, the first two years in an appropriate office of the Company.
4.3 The Company may rely on proxy statements filed on the SEC’s EDGAR system or on proxy statements and records of votes cast by the Company maintained by a third party, such as a proxy voting service (provided the Company had obtained an undertaking from the third party to provide a copy of the proxy statement or record promptly on request).
4.4 Records relating to the voting of proxies for securities held by investment company clients will be reported periodically, as requested, to the investment company’s Board of Trustees and, to the SEC on an annual basis pursuant to Form N-PX.
4.5 Compliance oversees the implementation of this procedure, including oversight over voting and the retention of proxy ballots voted. The CCO may review proxy voting pursuant to the firm’s compliance program.
Adopted by the Company’s Compliance Committee: March 24, 2009, amended June 17, 2009.
Approved by the Highland Funds Board of Trustees for all Funds (except Highland Long/Short Equity Fund): June 5, 2009.
Item 8. Portfolio Managers of Closed-End Management Investment Companies.
(a)(1) | Identification of Portfolio Manager(s) or Management Team Members and Description of Role of Portfolio Manager(s) or Management Team Members |
The Fund’s portfolio manager, who is primarily responsible for the day-to-day management of the Fund’s portfolio, is Greg Stuecheli.
Greg Stuecheli — Mr. Stuecheli is a Senior Portfolio Manager at Highland. Prior to his current duties, Mr. Stuecheli was a Portfolio Manager for Highland covering distressed and special situation credit and equity investments. Prior to joining Highland in June 2002, Mr. Stuecheli served as an analyst for Gryphon Management Partners, LP from 2000 to 2002, where his primary responsibilities included researching long and short investment ideas. In 1999, Mr. Stuecheli was a Summer Associate at Hicks, Muse, Tate & Furst, and from 1995 to 1998, Mr. Stuecheli worked as a chemical engineer at Jacobs Engineering Group and Cytec Industries. Mr. Stuecheli received an MBA from Southern Methodist University and a BS in Chemical Engineering from Rensselaer Polytechnic Institute. He has earned the right to use the Chartered Financial Analyst designation.
(a)(2) | Other Accounts Managed by Portfolio Manager(s) or Management Team Member and Potential Conflicts of Interest |
Other Accounts Managed by Portfolio Manager(s) or Management Team Member
The following table provides information about funds and accounts, other than the Fund, for which the Fund’s portfolio manager is primarily responsible for the day-to-day portfolio management as of December 31, 2010.
Greg Stuecheli
# of Accounts | Total Assets with | |||||||||||||||
Total | Managed with | Performance-Based | ||||||||||||||
# of Accounts | Total Assets | Performance-Based | Advisory Fee | |||||||||||||
Type of Accounts | Managed | (millions) | Advisory Fee | (millions) | ||||||||||||
Registered Investment Companies: | 3 | 1,637 | — | — | ||||||||||||
Other Pooled Investment Vehicles: | — | — | — | — | ||||||||||||
Other Accounts: | — | — | — | — |
Potential Conflicts of Interests
Highland and/or its general partner, limited partners, officers, affiliates and employees provide investment advice to other parties and manage other accounts and private investment vehicles similar to the Fund. In connection with such other investment management activities, the Adviser and/or its general partner, limited partners, officers, affiliates and employees may decide to invest the funds of one or more other accounts or recommend the investment of funds by other parties, rather than the Fund’s monies, in a particular security or strategy. In addition, the Adviser and such other persons will determine the allocation of funds from the Fund and such other accounts to investment strategies and techniques on whatever basis they consider appropriate or desirable in their sole and absolute discretion.
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.
(a)(3) | Compensation Structure of Portfolio Manager(s) or Management Team Members |
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 pre-tax relative performance of a portfolio manager’s underlying account, the pre-tax combined performance of the portfolio managers’ underlying accounts, and the pre-tax 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 “Short-Term Incentive 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. Base compensation is determined by taking into account current industry norms and market data to ensure that Highland pays a competitive base compensation.
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 paid to recognize specific business contributions and to ensure that the total level of compensation is competitive with the market, as well as participation in incentive plans, including one or more of the following:
Short-Term Incentive 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.
Because each person’s compensation is based on his or her individual performance, Highland does not have a typical percentage split among base salary, bonus and other compensation. 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.
(a)(4) | Disclosure of Securities Ownership |
The following table sets forth the dollar range of equity securities beneficially owned by the portfolio manager in the Fund as of December 31, 2010.
Dollar Ranges of Equity Securities Beneficially Owned by | ||
Name of Portfolio Manager | Portfolio Manager | |
Greg Stuecheli | $0 |
(b) | Not applicable. |
Item 9. Purchases of Equity Securities by Closed-End Management Investment Company and Affiliated Purchasers.
Not applicable.
Item 10. Submission of Matters to a Vote of Security Holders.
There have been no material changes to the procedures by which the shareholders may recommend nominees to the registrant’s board of directors.
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) | Code of ethics, or any amendment thereto, that is the subject of disclosure required by Item 2 is attached hereto. | ||
(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 Special Situations Fund
By (Signature and Title)* | /s/ R. Joseph Dougherty | |||
(principal executive officer) | ||||
Date 3/9/11 |
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/ R. Joseph Dougherty | |||
(principal executive officer) | ||||
Date 3/9/11 | ||||
By (Signature and Title)* | /s/ Brian Mitts | |||
Brian Mitts, Chief Financial Officer and Treasurer | ||||
(principal financial officer) | ||||
Date 3/9/11 |
* | Print the name and title of each signing officer under his or her signature. |