Advisory. Alternative Capital Raising Opportunities in a Down Market Business Development Companies Look Beyond Common Stock Offerings

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1 June 19, 2008 Alternative Capital Raising Opportunities in a Down Market Business Development Companies Look Beyond Common Stock Offerings By Janis F. Kerns The credit crunch continues to negatively affect the markets and its ripple effects continue to be felt in unintended ways. In these down markets, business development companies ( BDCs ), a form of closed end Even in an adverse market environment, BDCs with healthy asset coverage ratios are still afforded a variety of capital-raising alternatives when they are unable to sell common stock at the market. Part II in this series discusses BDC issuances of equitylinked securities that do not constitute senior securities, such as rights offerings, and PIPE transactions. Part One in a Two-Part Series investment company that invests generally in smaller, private and financially troubled companies, have been significantly restricted in their ability to raise capital to continue their investment business. BDCs were created by Congress in 1980 to serve as a source of capital for these companies to whom such access was otherwise limited. BDCs are traded on national securities exchanges and often raise capital by selling common stock in the public markets to fund operations and investment activity. BDCs receive substantive regulation under the Investment Company Act of 1940 ( 1940 Act ) however, that prohibits them from raising capital in this way when those sales would occur below the BDC s book value (net asset value, or NAV ). Shareholders may authorize sales of common stock below NAV, but only at a meeting held within one year immediately prior to such sales. Currently, the market value of the common stock of a significant number of BDCs is below the stock s NAV, and those BDCs are without current authority from shareholders to raise capital by selling common stock at the market. Several alternatives are available that permit a BDC to sell securities to raise capital. This advisory, the first in a two-part series, discusses a BDC s ability to issue securities considered senior to the BDC s common stock and the features and obligations of these issuances. Part II of the series discusses BDC equity-linked offerings not involving senior securities, such as rights offerings, and PIPE (private investment in public equity) transactions.

2 For example, shareholder approval of sales of shares below net asset value alone will not constitute authorization to issue a convertible security priced below net asset value. BDC Senior Securities The Basics BDCs may issue preferred equity securities and debt all termed senior securities under the 1940 Act - without shareholder approval. A senior security is any bond, debenture, note, similar obligation or instrument constituting a security and evidencing indebtedness; and any stock of a class having priority over any other class as to the distribution of assets or payment of dividends. BDCs may issue convertible senior securities only with the prior approval of shareholders. A BDC may only have one class of senior equity security outstanding at any time, but may issue multiple classes of senior securities representing indebtedness. The BDC may divide issuances into series within a class (for equity or debt), but series must have equal rights with respect to distribution of assets of the company and payment of dividends/interest. All senior securities may be redeemed (called) by the issuer in accordance with the 1940 Act pursuant to any conditions as disclosed in the offering documents. All senior security issuances are subject to a 200% asset coverage requirement. Asset coverage is defined (loosely) as the ratio that the BDC s total assets less its liabilities (excluding senior securities) bears to the amount of senior securities outstanding. Senior securities may not be issued by a BDC in an amount that would cause the BDC to fail the asset coverage requirement immediately after the issuance (taking the issuance into consideration). A BDC may obtain blanket authorization from shareholders to issue all forms of convertible securities, but the proposal approved must specifically contemplate convertibility. For example, shareholder approval of sales of shares below net asset value alone will not constitute authorization to issue a convertible security priced below net asset value. The statute permits a BDC to issue warrants, options, or rights to subscribe or convert to voting securities accompanied or unaccompanied by securities. Typical shareholder proposals will specify subscription or convertibility. Attached to this summary are excerpts of shareholder proposals in this regard from recent BDC annual meetings, illustrating the variety of authorization requests and indicating permitted security issuances resulting from the approvals.

3 BDC Senior Securities Features and Obligations Holders of BDC preferred securities and debt are afforded certain protections under the 1940 Act, as described below. Equity Issuances Preferred stock (including convertible preferred) is entitled at all times to elect two directors of the board, and to elect a majority of the board members if their dividend goes unpaid for two full years and until that obligation is satisfied. No dividend or other distribution on common stock may be declared, except a dividend payable in common stock of the BDC, or common stock purchased if the asset coverage ratio would be below 200% after deducting the dividend, distribution or purchase amount. Debt issuances No dividend or any other distribution may be declared on any class of capital stock, except a dividend payable in stock of the issuer, and no capital stock may be purchased, unless asset coverage is at least 200% after deducting the dividend, distribution, or purchase price amount. (This may be of particular importance for a BDC seeking to redeem/retire a class of preferred equity securities, for example.) The debt instrument must provide that, where asset coverage is less than 100%, either (1) after 12 consecutive months at less than 100% asset coverage, the security holders may elect a majority of the board OR (2) after 24 consecutive months at less than 100% asset coverage, a default on the debt has occurred. The election right in provision (1) remains in effect until the BDC experiences three consecutive months at 110% or more asset coverage. Even in an adverse market environment, BDCs with healthy asset coverage ratios are still afforded a variety of capital-raising alternatives when they are unable to sell common stock at the market. Part II in this series discusses BDC issuances of equity-linked securities that do not constitute senior securities, such as rights offerings, and PIPE transactions.

4 Examples of Shareholder Proposals at Annual Meetings of Shareholders 4 Patriot Capital Funding, Inc. (Meeting 6/24/08) To approve a proposal to authorize the Company to sell shares of its common stock below the then current net asset value per share in one or more offerings. To approve a proposal to authorize the Company to issue securities to subscribe to, convert to, or purchase shares of the Company s common stock in one or more offerings. Patriot Capital Funding, if approved by shareholders, will have the authority to sell common stock below NAV and issue convertible securities. Kohlberg Capital Corporation (Meeting 6/13/08) To approve a proposal to authorize the Company, with approval of its Board of Directors, to sell shares of its common stock or warrants, options or rights to acquire its common stock at a price below the then current net asset value per share of such stock. Kohlberg shareholders have authorized the sale of common stock, warrants, options and subscription rights below NAV, but not the issuance of convertible securities. Kohlberg has a preliminary shelf registration statement on file dated May 29, 2008 for $200 million in common stock, preferred stock, warrants, subscription rights and debt securities. Highland Distressed Opportunities, Inc. (Meeting 6/6/08) To approve a proposal to authorize the Company, subject to the approval of its Board of Directors, to sell shares of its common stock at a price below net asset value per share, or warrants, options and rights to acquire its common stock at a price below the then current net asset value per share. Highland shareholders have authorized the sale of common stock, warrants, options and subscription rights below NAV, but not the issuance of convertible securities. Hercules Technology Growth Capital, Inc. (Meeting 5/29/08) To approve a proposal to authorize the Company, with the approval of its board of directors, to sell up to 20% of the Company s outstanding common stock at a price below the Company s then current net asset value per share. Hercules shareholders have authorized the sale of common stock below NAV, but not the sale of securities convertible into common stock below NAV.

5 Ares Capital Corporation (Meeting 5/29/08) To consider and vote upon a proposal to authorize the Company to offer and issue debt with warrants and debt convertible into shares of its common stock at an exercise or conversion price that, at the time such warrants or convertible debt are issued, will not be less than the greater of the market value per share of our common stock and the net asset value per share of our common stock. Ares shareholders have authorized the sale of warrants and convertible debt at an exercise or conversion price that may not be below NAV, and also may not be below market price when that price exceeds NAV. Ares has a preliminary shelf registration statement on file dated April 9, 2008 for $600 million in common stock, preferred stock, subscription rights, warrants and debt securities. American Capital Strategies, Ltd. (Meeting May 19, 2008) To approve our ability to issue preferred stock or debt securities convertible into shares of our common stock. American Capital shareholders have authorized the sale of convertible preferred equity securities and convertible debt securities. American Capital has a preliminary shelf registration statement on file dated May 28, 2008 for $7 billion in common stock, preferred stock, and debt securities. BlackRock Kelso Capital Corporation (Meeting 4/24/08) To approve a proposal to authorize flexibility for the Company, with approval of the Board, to sell shares of its common stock at a price below the Company s then current net asset value per share. BlackRock shareholders have authorized the sale of common stock below NAV, but not the sale of securities convertible into common stock below NAV. BlackRock has a preliminary shelf registration statement on file dated June 5, 2008 for $1 billion in common stock, preferred stock, warrants, subscription rights and debt securities. MCG Capital Corporation (Meeting 4/23/08) To approve a proposal to authorize flexibility for the Company, with approval of its Board of Directors, to sell shares of its common stock at a price below the Company s then current net asset value per share. MCG shareholders have authorized the sale of common stock below NAV, but not the sale of securities convertible into common stock below NAV. MCG most recently sold shares in a rights offering to existing shareholders, and has an effective base registration statement on file for sales of common stock only. See Other Related Advisories: SEC Expands Investment Opportunities for Business Development Companies (click on title to follow link)

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