On June 26, 2001 the Company closed on the proceeds from the issuance of 5,175 shares of common stock, including the exercise of the underwriters' option to acquire 675 additional shares, for an aggregate purchase price of $131,963. The net proceeds from the sale of the 675 shares of common stock were approximately $16,000. The Company used the proceeds from the offerings to repay outstanding borrowings under its debt funding facility.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Unaudited)
(Dollars in thousands except per share data)
All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: changes in the economic conditions in which the Company operates negatively impacting the financial resources of the Company; certain of the Company's competitors with substantially greater financial resources than the Company reducing the number of suitable investment opportunities offered to the Company or reducing the yield necessary to consummate the investment; increased costs related to compliance with laws, including environmental laws; general business and economic conditions and other risk factors described in the Company's reports filed from time to time with the Securities and Exchange Commission. The Company cautions readers not to place undue reliance on any such forward looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.
The following analysis of the financial condition and results of operations of the Company should be read in conjunction with the Company's financial statements and the notes thereto.
Portfolio Composition
The Company’s primary business is investing in and lending to businesses through investments in senior debt, subordinated debt generally with detachable common or preferred stock warrants, preferred stock, and common stock. The total portfolio value of investments in publicly and non-publicly traded securities was $668,632 and $582,108 at June 30, 2001 and December 31, 2000, respectively. During the three and six months ended June 30, 2001, the Company originated investments totaling $94,236 and $147,061, respectively, and advanced $5,692 and $6,692, respectively, in previously committed under working capital facilities. Included in the $94,236 and $147,061 is $11,160 and $11,226 in funds committed but undrawn under credit facilities. The weighted average effective interest rate on of the investment portfolio was 13.8% and 14.6% at June 30, 2001 and December 31, 2000, respectively.
Results of Operations
The Company's financial performance, as reflected in its Statements of Operations, is composed of three primary elements. The first element, "Net operating income," is primarily the interest and dividends earned from investing in debt and equity securities and the equity in earnings of its unconsolidated operating subsidiary less the operating expenses of the Company. The second element is " Net unrealized (depreciation) appreciation of investments," which is the net change in the estimated fair value of the Company's portfolio assets at the end of the period compared with their estimated fair values at the beginning of the period or their stated costs, as appropriate. The third element is "Net realized gain on investments," which reflects the difference between the proceeds from a sale or maturity of a portfolio investment and the cost at which the investment was carried on the Company's balance sheet.
The operating results for the three and six months ended June 30, 2001 and June 30, 2000 are as follows:
| | Three Months Ended
June 30, 2001 | | Three Months Ended
June 30, 2000 | | Six Months Ended
June 30, 2001 | | Six Months EndedJune 30, 2000 | |
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| Operating income | $ | 20,761 | | $ | 14,893 | | $ | 42,233 | | $ | 26,411 | |
| Operating expenses | 4,544 | | 3,880 | | 9,124 | | 6,294 | |
| Equity in loss of unconsolidated operating subsidiary | (40 | ) | (1,222 | ) | (1,782 | ) | (1,780 | ) |
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| Net operating income | 16,177 | | 9,791 | | 31,327 | | 18,337 | |
| Realized gain on investments | — | | 235 | | — | | 235 | |
| Net unrealized (depreciation) appreciation of investments | (4,583 | ) | 1,203 | | (29,335 | ) | 11,971 | |
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| Net increase in shareholders' equity resulting from operations | $ | 11,594 | | $ | 11,229 | | $ | 1,992 | | $ | 30,543 | |
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Total operating income is comprised of two components: interest and dividend income and loan fees. During the three months ended June 30, 2001 (“Second Quarter 2001”), the Company recorded $20,315 in interest and dividends on non-publicly traded securities and $388 in interest on bank deposits and shareholder loans, offset by $392 of net interest rate swaps expense, compared to $12,720 in interest and dividends on non-publicly traded securities and $374 in interest on government agency securities, bank deposits, repurchase agreements and shareholder loans recorded in the three months ended June 30, 2000 (“Second Quarter 2000”). For the six months ended June 30, 2001 (“2001 YTD Period”), the Company recorded $40,179 in interest and dividends on non-publicly traded securities and $695 in interest on bank deposits and shareholder loans net of interest rate swaps expense; for the six months ended June 30, 2000 (“2000 YTD Period”), the Company recorded $23,393 in interest and dividends on non-publicly traded securities and $739 in interest on government agency securities, bank deposits, repurchase agreements and shareholder loans.
Total operating income for the Second Quarter 2001 increased 5,868, or 39%, compared to the Second Quarter 2000. The increase in operating income for the Second Quarter 2001 is a result of the Company closing 31 investments in private companies totaling $326,387 between June 30, 2000 and June 30, 2001, net of a decrease in the prime lending rate from 9.50% at June 30, 2000 to 6.75% at June 30, 2001, and an increase in loan fees. As a result of the investment originations between June 30, 2000 and June 30, 2001, interest and dividend income increased approximately $10,151 compared to the Second Quarter 2000. The decrease in the prime lending rate decreased interest income approximately $2,934 for the Second Quarter 2001 compared to the same period in 2000. Loan fees for the Second Quarter 2001 decreased from $1,799 in the Second Quarter 2000 to $450 in Second Quarter 2001 primarily due to $884 in prepayment penalties recognized in Second Quarter 2000 on the repayment of the Company’s subordinated debt investment in Electrolux, LLC. Loan fees also decreased due to the Company’s investment in approximately $78,500 of buyout transactions in the Second Quarter 2001 compared to none in the Second Quarter 2000. For these types of investments, loan processing and structuring fees are earned by the Company’s subsidiary, ACFS. Loan fees as a percentage of originations, exclusive of prepayment penalties, decreased from 1.5% in the Second Quarter 2000 to 0.4% in the Second Quarter 2001.
For the 2001 YTD Period, total operating income increased $15,822, or 60%, over the same period in 2000. The increase in operating income for the 2001 YTD Period is a result of the Company’s investment originations between June 30, 2000 and June 30, 2001 noted above, net of the decrease in the prime lending rate and the decrease in loan fees. Interest and dividend income increased approximately $16,786 compared to the 2000 YTD Period due to the investment originations between June 30, 2000 and June 30, 2001. The decrease in the prime lending rate decreased interest income approximately $2,240 for the 2001 YTD Period compared to the same period in 2000. For the 2001 YTD Period, loan fees decreased to $1,359 from $2,279 during the same period in 2000. The decrease is due to a decrease in prepayment penalties of $884 due to the transaction noted above, and the decrease in loan fees as noted above. For the 2001 YTD Period, loan fees as a percentage of originations, exclusive of prepayment penalties, decreased to 0.5% from 1.5% during the same period in 2000.
Operating expenses for the Second Quarter 2001 increased $664, or 17%, over the same period in 2000. The increase is primarily due to the increase in interest expense from $2,466 during the Second Quarter 2000 to $2,935 during the Second Quarter 2001. Interest expense increased due to both an increase in weighted average outstanding borrowings from $82,500 in the Second Quarter 2000 to $196,100 in the Second Quarter 2001, net of a decrease in the effective borrowing rate, including amortization of deferred loan costs, from 11.96% for the Second Quarter 2000 to 5.99% for the Second Quarter 2001. For the 2001 YTD Period, interest expense increased $2,214, or 52%, over the same period in 2000. The increase is attributable to the increase in the weighted average outstanding borrowings from $84,297 during the six months ended June 30, 2000 to $182,184 during the 2001 YTD period, net of the decrease in the effective borrowing rate from 10.07% for the 2000 YTD Period to 7.09% for the 2001 YTD Period. General and administrative expenses increased from $650 in the Second Quarter 2000 to $729 in the Second Quarter 2001. General and administrative expenses increased from $1,121 in the 2000 YTD Period to $1,451 in the 2001 YTD Period. The increase for the three and six months ended June 30, 2001 was due to higher facilities expenses and Board of Directors fees, offset by a decrease in professional expenses. For the Second Quarter 2001 and the 2001 YTD Period, salaries and benefits expense increased $116 and $286, respectively, over the comparable periods in 2000. The increase is attributable to the increase in the number of employees from 48 at June 30, 2000 to 67 at June 30, 2001 and an increase in incentive compensation awarded in the Second Quarter 2001. Incentive compensation increased $145 and $201, respectively, during the Second Quarter 2001 and the 2001 YTD Period due to both the higher headcount and the achievement of certain performance measures.
Equity in loss of unconsolidated operating subsidiary, which represents ACFS’s results, for the Second Quarter 2001 decreased from a loss of $1,222 in Second Quarter 2000 to a loss of $40 in the Second Quarter 2001. For the Second Quarter 2001, ACFS’s results included $5,259 of operating income and $5,299 of operating expenses. For the Second Quarter 2000, ACFS’s results included $1,547 of operating income, $3,519 of operating expenses, $1 of realized gains on investments, and $749 in other income. For the 2001 YTD Period, ACFS’s results included $6,579 of operating income and $8,361 of operating expenses; for the 2000 YTD Period, ACFS’s results included $2,097 of operating income, $4,969 of operating expenses, $1 of realized gains on investments, and $1,091 of other income. The increase in ACFS’s operating income was primarily due to an increase in loan processing and structuring fees generated by the higher investment originations during the Second Quarter 2001. Operating expenses for the Second Quarter 2001 increased $1,780, or 51%, compared to the same period in 2000. For the 2001 YTD Period, operating expenses increased $3,392, or 68%, compared to the same period in 2000. The increase in operating expenses for both the three and six month periods was due to the increase in salaries and benefits caused by the increase in the number of employees from 48 at June 30, 2000 to 67 at June 30, 2001, all of whom are also employees of the Company, and the increase in incentive compensation awarded for the Second Quarter 2001. Incentive compensation, driven by both the increase in headcount and the achievement of certain performance measures, increased $910 and $1,161 compared to the three and six months ended June 30, 2000. The higher operating income, offset by higher operating expenses and a decrease in other income, resulted in a $1,182 decrease in ACFS’s net loss in the Second Quarter 2001 compared to the Second Quarter 2000, and a $2 increase in the net loss in the 2001 YTD Period compared to the 2000 YTD Period.
During the Second Quarter 2000, the Company recorded a realized gain of $235 on the repayment of its subordinated debt investment in Electrolux, LLC. The realized gain on the transaction is comprised of the realization of unamortized loan discounts. The Company recorded no realized gains or losses in 2001.
The change in unrealized depreciation of investments is based on portfolio asset valuations determined by the Company’s Board of Directors. Unrealized depreciation of investments for the Second Quarter 2001 increased $5,786 over the Second Quarter 2000. Unrealized depreciation for the Second Quarter 2001 was comprised of valuation increases of $1,376 on investments in 2 portfolio companies and $1,500 appreciation on interest rate swaps. The unrealized appreciation was offset by valuation decreases of $7,459 on investments in 11 portfolio companies, including depreciation of $1,792 on the Company’s investment in The Inca Group, $1,550 of depreciation on the Company’s investment in Chance Coach, Inc., and $1,500 on the Company’s investment in Chromas Technologies. For the 2001 YTD Period, unrealized depreciation was comprised of valuation decreases of $32,414 on investments in 17 companies, including $12,578 on the Company’s investment in o2 Wireless and $1,054 depreciation on interest rate swaps, and valuation increases of $3,309 on investments in 3 companies, including $2,171 on the Company’s investment in TransCore Holdings, Inc.
Financial Condition, Liquidity, and Capital Resources
At June 30, 2001, the Company had $2,225 in cash and cash equivalents. In addition, the Company had outstanding debt secured by assets of the Company of $19,571 under a $225,000 revolving debt funding facility and $111,091 under an asset securitization. During the three and six months ended June 30, 2001, the Company funded investments using draws on the revolving debt funding facility and proceeds from the asset securitization.
On June 26, 2001, the Company completed a public offering of its common stock and received net proceeds of approximately $114,750 in exchange for 4,500 common shares. On June 29, 2001 the Company sold 675 shares of its common stock pursuant to the underwriter’s overallotment option granted on June 26, 2001 and received net proceeds of approximately $16,000. The proceeds from the offerings were used to repay borrowings outstanding under its debt funding facility.
As a RIC, the Company is required to distribute annually 90% or more of its net operating income and net realized short-term capital gains to shareholders. While the Company provides shareholders with the option of reinvesting their distributions in the Company, the Company anticipates having to issue debt or equity securities in addition to the above borrowings to expand its investments in middle market companies. The terms of the future debt and equity issuances can not be determined and there can be no assurances that the debt or equity markets will be available to the Company on terms it deems favorable.
Portfolio Credit Quality
The Company grades all loans on a scale of 1 to 4. This system is intended to reflect the performance of the borrower’s business, the collateral coverage of the loans and other factors considered relevant.
Under this system, loans with a grade of 4 involve the least amount of risk in the Company’s portfolio. The borrower is performing above expectations and the trends and risk factors are generally favorable. Loans graded 3 involve a level of risk that is similar to the risk at the time of origination. The borrower is performing as expected and the risk factors are neutral to favorable. All new loans are initially graded 3. Loans graded 2 involve a borrower performing below expectations and indicates that the loan’s risk has increased since origination. The borrower may be out of compliance with debt covenants, however, loan payments are not more than 120 days past due. For loans graded 2, the Company’s management will increase procedures to monitor the borrower and the fair value generally will be lowered. A loan grade of 1 indicates that the borrower is performing materially below expectations and that the loan risk has substantially increased since origination. Some or all of the debt covenants are out of compliance and payments are delinquent. Loans graded 1 are not anticipated to be repaid in full and the Company will reduce the fair value of the loan to the amount it anticipates will be recovered.
To monitor and manage the investment portfolio risk, management tracks the weighted average investment grade. The weighted average investment grade was 3.1 and 3.2 at June 30, 2001 and December 31, 2000, respectively. As of June 30, 2001, two loans were on non-accrual status. At June 30, 2001 and December 31, 2000, the Company’s portfolio was graded as follows:
| | June 30, 2001 | | December 31, 2000 | |
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| Grade | Investments at Fair Value | | Percentage of Total Portfolio | | Investments at Fair Value | | Percentage of
Total Portfolio | |
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| 4 | $ | 141,170 | | 21.4 | % | $ | 182,964 | | 32.4 | % |
| 3 | 423,569 | | 64.1 | % | 355,015 | | 62.9 | % |
| 2 | 90,135 | | 13.6 | % | 18,971 | | 3.4 | % |
| 1 | 5,853 | | 0.9 | % | 7,432 | | 1.3 | % |
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| | $ | 660,727 | | 100.0 | % | $ | 564,382 | | 100.0 | % |
The amounts at June 30, 2001, and December 31, 2000 do not include the Company’s investments in Capital.com, Wrenchead.com, o2wireless Solutions, Inc., Electrolux, LLC, and ACS Equities, LP as the Company has only invested in the equity securities of these companies. In addition, the amounts at June 30, 2001 do not include the Company’s equity investment in Westwind Group Holdings, Inc.
At June 30, 2001, two loans totaling $22,914 were 0-30 days past due, no loans were 61-120 days past due, and two loans totaling $24,670 were greater than 120 days past due. At December 31, 2000, there were no loans 0-60 days past due, one loan totaling $3,214 was 61-90 days past due, and no loans were greater than 90 days past due.
Interest Rate Risk
Because the Company funds a portion of its investments with borrowings under its revolving debt funding facility and asset securitization, the Company’s net operating income is affected by the spread between the rate at which it invests and the rate at which it borrows. The Company attempts to match fund its liabilities and assets by financing floating rate assets with floating rate liabilities and fixed rate assets with fixed rate liabilities or equity. The Company enters into interest rate basis swap agreements to match the interest rate basis of its assets and liabilities and to fulfill its obligation under the terms of its debt funding facility and asset securitization.
As a result of the Company’s use of interest rate swaps, at June 30, 2001, approximately 52.3% of the Company’s interest bearing assets provided fixed rate returns and approximately 47.7% of the Company’s interest bearing assets provided floating rate returns. Adjusted for the effect of interest rate swaps, at June 30, 2001, the Company had floating rate investments in debt securities with a face amount of approximately $294,000 and had total borrowings outstanding of $131,000. All of the Company’s outstanding debt at June 30, 2001 has a variable rate of interest based on one-month LIBOR. As of June 30, 2001, the Company had entered into seventeen interest rate basis swap agreements under which the Company either pays a floating rate based on the prime rate and receives a floating interest rate based on one-month LIBOR, or pays a fixed rate and receives a floating interest rate based on one-month LIBOR. The total notional amount of the swap agreements was $265,000 and the agreements have a remaining term of approximately 5.1 years. The Company intends to use derivative instruments for non-trading and non-speculative purposes only.
Recent Accounting Pronouncements
The revised version of the AICPA Accounting and Audit Guide for Investment Companies ("the Guide") is effective for annual financial statements issued for fiscal years beginning after December 15, 2000. Management currently is in the process of determining the effects of the Guide.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Neither the Company, nor any of the Company’s subsidiaries, is currently subject to any material litigation nor, to the Company’s knowledge, is any material litigation threatened against the Company or any subsidiary, other than routine litigation and administrative proceedings arising in the ordinary course of business. Such proceedings are not expected to have a material adverse effect on the business, financial conditions, or results of operation of the Company or any subsidiary.
Item 2. Changes in Securities
Not Applicable.
Item 3. Defaults Upon Senior Securities
Not Applicable.
Item 4. Submission of Matters to a Vote of Security Holders
On May 9, 2001, the Company held its Annual Meeting of Stockholders. Five matters were submitted to the stockholders for consideration.
| | 1. | To elect three directors of the Company each to serve a three-year term and until their successors are elected and qualified;
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| | 2. | To approve the adoption of an amendment to the Company’s 2000 Employee Stock Option Plan increasing the number of shares available for grant thereunder;
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| | 3. | To approve a proposal to issue warrants to purchase up to 1,000,000 shares of the Company’s common stock;
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| | 4. | To consider an amendment to the Company’s fundamental policies so as to permit the Company to sell securities short or write or buy options with regard to managing the risks associated with certain portfolio securities; and
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| | 5. | To ratify the selection of Ernst & Young LLP to serve as independent public accountants for the Company for the year ending December 31, 2001. |
The results of the shares voted with regard to each of these matters is as follows:
| Director | For | | Against | | Withheld | |
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| Mary C. Baskin | 24,244,727 | | 1,474,358 | | | |
| David Gladstone | 25,378,202 | | 340,883 | | | |
| Alvin N. Puryear | 25,419,088 | | 299,997 | | | |
Continuing Directors whose terms did not expire at the annual meeting were as follows: Adam Blumenthal, Neil M. Hahl, Phillip P. Harper, Stan Lundine, Kenneth D. Peterson, Jr. and Malon Wilkus.
| | 2. | Approval of the amendment to the 2000 Employee Stock Option Plan: |
| For | Against | | Abstain | | Broker Non-Vote | |
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| 16,369,791 | 2,964,839 | | 183,704 | | 6,200,752 | |
| | 3. | Approval of the proposal to issue warrants to purchase Common Stock: |
| For | Against | | Abstain | | Broker Non-Vote | |
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| 23,672,668 | 1,921,005 | | 125,411 | | 1 | |
| | 4. | Approval of amendment to Fundamental Policies regarding short sales of securities: |
| For | Against | | Abstain | | Broker Non-Vote | |
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| 18,683,213 | 687,675 | | 147,449 | | 6,200,750 | |
| | 5. | Ratification of appointment of Ernst & Young LLP as auditors: |
| For | Against | | Abstain | |
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| 25,531,632 | 150,980 | | 36,473 | |
Item 5. Other Information
Not Applicable.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
| Exhibit Number | | Description |
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| *10.1 | | Amended and Restated Employment Agreement between the Company and Adam Blumenthal, dated May 9, 2001, incorporated herein by reference to Exhibit 2.i.2 of the Post-Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.2 | | Employment Agreement between the Company and Ira Wagner, dated as of May 16, 2001, incorporated herein by reference to Exhibit 2.i.20 of the Post-Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.3 | | Stock Option Exercise Agreement between the Company and Malon Wilkus, dated March 7, 2001, incorporated herein by reference to Exhibit 2.i.23 of the Post-Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.4 | | Stock Option Exercise Agreement between the Company and Malon Wilkus, dated March 2, 2001, incorporated herein by reference to Exhibit 2.i.24 of the Post-Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.5 | | Purchase Note by Malon Wilkus in favor of the Company, dated March 7, 2001, incorporated herein by reference to Exhibit 2.i.27 of the Post Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.6 | | Purchase Note by Malon Wilkus in favor of the Company, dated March 2, 2001, incorporated herein by reference to Exhibit 2.i.28 of the Post-Effective Amendment No. 2 to the Registration Statement on Form N-2 (File No. 333-36818), filed May 29, 2001.
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| *10.7 | | Amendment No. 7 to Loan Funding and Servicing Agreement among ACS Funding Trust I, American Capital Strategies, Ltd., Variable Funding Capital Corporation, First Union Securities, Inc., First Union National Bank, Wells Fargo Bank Minnesota, N.A. and certain investors named therein, dated as of April 19, 2001, incorporated herein by reference to Exhibit 2.k.3 of Registration Statement on Form N-2 (file No. 333-63200), filed June 15, 2001.
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| *10.8 | | Amended, Restated and Substituted FUNB Note in the aggregate principal amount of $30,000,000 made by ACS Funding Trust I in favor of First Union National Bank, dated as of March 31, 1999, incorporated herein by reference to Exhibit 2.k.5 of Registration Statement on Form N-2 (File No. 333-63200), filed June 15, 2001. |
| | (b) | The registrant has not filed any reports on a Current Report on Form 8-K during the quarter for which this report 10-Q is filed. |
* Previously filed in whole or in part.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERICAN CAPITAL STRATEGIES, LTD.
| | By: | /s/ John R. Erickson |
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| | | John R. Erickson |
| | | Executive Vice President and |
| | | Chief Financial Officer |
Date: August 14, 2001
