SOMERSET EXCHANGE FUND
Semi-Annual Report
June 30, 1997
DEAR SHAREHOLDER Somerset Exchange Fund, June 30, 1997
Somerset Exchange Fund, along with the US equity market overall, had a
volatile but extraordinary first half of 1997. The momentum established
early in 1997 was almost erased by the early part of April, subsequent
to the preemptive increase in short-term interest rates by the Federal
Reserve Board's Federal Open Market Committee on March 25, 1997. A
nearly 10% decline culminated with a 20.69 point drop in the unmanaged
Standard & Poor's 500 (S&P 500) Composite Index on April 11, 1997, its
third-largest single-day decline in history. This became the launching
point for a powerful second-quarter rebound for the equity market,
propelled by continued prospects for subdued inflation and a rallying
bond market. A lackluster first quarter, in which the Fund's reported
net asset value per share declined by 0.78%, was followed by an
explosive rally during the second quarter as the Fund's reported net
asset value per share rose by 18.65%.
The Fund's net assets increased to approximately $93.4 million as of
June 30, 1997 from approximately $79.3 million as of year-end 1996. Our
equity portfolio increased in value by nearly $13 million in the first
half of 1997, and on June 30, 1997 was valued at $94.1 million.
Preferred stock holdings were valued at $25.3 million on June 30, 1997,
and the Fund continues to have outstanding loans of $28 million. The
gains in the equity portfolio were relatively broad-based, as rising
stocks outnumbered declining stocks by a 5-to-2 ratio, led by double-
digit gains in the capital goods (particularly electrical equipment),
communications, healthcare and transportation sectors. Among the
portfolio's best-performing stocks during the six-month period ended
June 30, 1997 were: Caliber Systems, Inc. (+91%); Stratus Computer, Inc.
(+88%); Horizon/CMS Healthcare Corp. (+87%); Warner-Lambert Co. (+59%);
Pinnacle Systems, Inc. (+57%); Regis Corp. (+52%); and Lucent
Technologies, Inc. (+51%). Among the poorest-performing stocks in the
portfolio were: Mercury Finance Company (-80%); Boston Chicken, Inc.
(-60%); Informix Corp. (-57%); HEARx, Ltd. (-53%); and 3Com Corp.
(-43%).
As of June month-end, the Fund's largest equity positions were: Watson
Pharmaceuticals, Inc. ($3.997 million); Medpartners/Mullikin, Inc.
($3.602 million); St. John Knits, Inc. ($3.069 million); MAXXAM Group,
Inc. ($2.996 million); and UST, Inc. ($2.775 million).
Twenty eight of the equity securities were categorized as restricted.
This classification requires the price of each security to be discounted
when computing the net asset value of the Fund. The discounting formula
provided for a gradual elimination of the discount during the two years
following the planned closing. However, in accordance with a revised
regulation affecting these securities, beginning on April 30, 1997, the
discount period changed from two years to one year. The elimination of
the discount applied to the restricted securities was accelerated, and
was completed by July 11, 1997. On December 31, 1996, the Fund's
discounted net asset value per share was $516.04; the net asset value
per share with no discount applied was $540.03 -- an overall discount of
4.44%. On June 30, 1997, the discounted net asset value per share was
$607.47, and with no discount applied was $617.43 per share, a discount
of 1.61%. On a discounted basis, the Fund's total return during the six-
month period ended June 30, 1997 was +17.72%. During the first half of
1997, the S&P 500 Index had a total return of +20.55%. Based on its
starting non-discounted net asset value of $503.02 per share (before
deduction of offering costs), the Fund's total return since inception
was +20.76%. At the time of the Fund's inception, it was necessary to
borrow sufficient capital to pay for the Fund's holdings of preferred
stock as well as its start-up costs. The borrowing consisted of a $25
million floating rate loan, reset quarterly based on 3-month London
Interbank Offered Rate (LIBOR), and a $3 million floating rate loan
reset annually, based on 12-month LIBOR. The quarterly loan was reset on
April 14, 1997 to 5.84375% (plus a 0.60% margin), an increase of 25
basis points over the January 13, 1997 rate of 5.59375%. The rate
increase was offset, however, by the fixed-rate for floating-rate swap
the Fund entered into at inception. On April 15, 1997 the floating rate
to be paid by Goldman Sachs Financial Products was increased to
5.81641%, a 22 basis point increase over the prior rate set on January
15, 1997.
Several new positions were acquired by the Fund during the first half of
1997. NCR Corporation was spun-off from AT&T Corp. on January 2, 1997,
and the Fund received 512 shares of NCR. On the same day, MFS
Communications Co., Inc. merged with WorldCom Inc., with the Fund's
holdings of MFS being converted into 19,269 shares of WorldCom. Also on
January 2, Unisource Worldwide, Inc. spun-off from Alco Standard Corp.
(which changed its name to Ikon Office Solutions, Inc. on January 27),
resulting in the Fund receiving 5,000 shares of Unisource. Finally, the
Fund's shares of First USA Holdings, Inc. were converted into 34,956
shares of Banc One Corporation on June 30, 1997 as the result of an
acquisition.
In Conclusion
We thank you for your investment in Somerset Exchange Fund, and we look
forward to reviewing our outlook with you again in our next report to
shareholders.
Sincerely,
/S/TERRY K. GLENN
Terry K. Glenn
President
/S/ERIC S. MITOFSKY
Eric S. Mitofsky
Vice President and Portfolio Manager
August 8, 1997
THE BENEFITS AND RISKS OF LEVERAGING
Somerset Exchange Fund utilizes leverage through borrowings. Investing
borrowed money creates an opportunity for the Fund to be more broadly
invested and to earn higher investment returns. However, investing
borrowed money is a speculative technique that creates risks, including
the likelihood of greater net asset value volatility. Interest rate
fluctuations could negatively impact the Fund's net asset value. In
addition, if the income derived from securities purchased with assets
received from the borrowings is not sufficient to cover the cost of
leverage, the Fund's net income will be less than if leverage had not
been used. As prescribed by the Investment Company Act of 1940, the Fund
has specified asset coverages of at least 300% with respect to any
borrowing immediately following any such borrowing. Loan agreements may
contain other requirements which could limit distributions or require
the Fund to dispose of portfolio investments on unfavorable terms if
market fluctuations or other factors reduce the required asset coverage
to less than the prescribed amount. In the event of a default, the
lender could elect to foreclose on any assets pledged as collateral
without regard to the tax or other consequences of such action on either
any shareholder who contributed a particular security or on shareholders
generally.
OFFICERS AND TRUSTEES
Individual Trustees
Terry K. Glenn
Jack B. Sunderland
Stephen B. Swensrud
J. Thomas Touchton
David Fann
Officers
Terry K. Glenn, President
Norman R. Harvey, Senior Vice President
Donald C. Burke, Vice President
Eric S. Mitofsky, Vice President and Portfolio Manager
Gerald M. Richard, Treasurer
Robert E. Putney III, Secretary
Somerset Exchange Fund
800 Scudders Mill Road
Plainsboro, NJ 08536
Investment Adviser, Adviser Trustee and Administrator
Merrill Lynch Asset Management, L.P.
800 Scudders Mill Road
Plainsboro, NJ 08536
609-282-2800
Sub-Administrator
United States Trust Company of New York
114 West 47th Street
New York, NY 10036
Custodian
The Chase Manhattan Bank, N.A.
Mutual Funds Service Division
770 Broadway
New York, NY 10003-9598
Transfer Agent
Chase Global Funds Services Company
73 Tremont Street
Boston, MA 02108-3913
Placement Agent
Merrill Lynch & Co.
Selected Dealer
UST Financial Services Corp.
Legal Counsel
Brown & Wood
Independent Auditors
Deloitte & Touche LLP
<TABLE>
<CAPTION>
SCHEDULE OF INVESTMENTS
Common Stock Shares Value
Sectors Industries Investments Held (Note 1a)
<S> <C> <C> <C> <C>
Basic Materials Aluminum +MAXXAM Group, Inc. 64,000 $2,996,000
Chemicals duPont (E.I.) de Nemours & Co. 40,000 2,515,000
Chemicals -- Diverse +Airgas, Inc. 24,000 475,500
Paper & Forest Products Longview Fibre Co. 29,140 484,453
Capital Goods Electrical Equipment +AFC Cable Systems, Inc. (a) 20,000 511,406
General Electric Co. 27,942 1,826,708
Honeywell, Inc. 5,715 433,626
Engineering & +Jacobs Engineering Group, Inc. (a) 77,250 1,964,653
Construction
Manufacturing Dover Corp. 6,900 424,350
Pollution Control World Fuel Services Corp. (a) 46,000 952,784
Consumer Cyclicals Auto Parts Bandag, Inc. (Class A) 6,200 301,863
Entertainment +Pinnacle Systems, Inc. 60,000 1,023,750
Walt Disney Company (The) 29,000 2,327,250
Hotel/Motel +Harrah's Entertainment, Inc. (a) 40,000 681,288
Household Furniture Bassett Furniture Industries, Inc. 12,000 339,000
& Appliances Leggett & Platt, Inc. 43,000 1,849,000
Leisure Time +Grand Casinos, Inc. (a) 61,300 854,908
Office Equipment Ikon Office Solutions, Inc. 10,000 249,375
& Supplies Unisource Worldwide, Inc. 5,000 80,000
Publishing -- Newspaper Times Mirror Co. 11,330 625,983
Restaurants Bob Evans Farms, Inc. 50,000 846,875
+Boston Chicken, Inc. 30,000 420,000
Darden Restaurants, Inc. 18,605 168,608
McDonald's Corp. 4,255 205,570
+Rainforest Cafe, Inc. (a) 15,000 364,070
Retail -- General Casey's General Stores, Inc. (a) 15,000 306,383
Merchandise
Retail -- Specialty Amplicon, Inc. 62,500 1,500,000
+Office Depot, Inc. 48,000 933,000
Regis Corp. 20,000 472,500
+Sunglass Hut International, Inc. (a) 12,000 74,732
Specialized Services +AccuStaff, Inc. 30,600 724,838
+Catalina Marketing Corporation 23,000 1,106,875
Service Corporation International (a) 12,000 385,516
Servicemaster L.P. 55,013 1,248,096
Textiles -- Apparel Russell Corp. 19,900 589,538
Manufacturing St. John Knits, Inc. (a) 59,954 3,068,518
Consumer Staples Beverages -- Soft Drink Coca-Cola Co. 13,800 931,500
PanAmerican Beverages, Inc. (Class A) 28,000 920,500
Foods Archer-Daniels-Midland Co. 10,884 255,774
General Mills, Inc. 4,000 260,500
Heinz (H.J.) Co. 16,200 747,225
Ralston Purina Co. 6,000 493,125
Household Products Procter & Gamble Co. 11,081 1,565,191
Retail -- Food Chains Albertson's, Inc. 7,500 273,750
+Safeway, Inc. 12,000 553,500
Smart & Final, Inc. (a) 60,000 1,393,266
Tobacco Philip Morris Companies, Inc. 41,013 1,819,952
UST, Inc. 100,000 2,775,000
Energy Oil -- International Exxon Corp. 33,000 2,029,500
Healthcare Healthcare -- Abbott Laboratories 37,685 2,515,474
Diversified Johnson & Johnson Co. 19,600 1,261,750
Warner-Lambert Co. 5,500 683,375
Healthcare -- Drugs Pfizer, Inc. 10,200 1,218,900
+Watson Pharmaceuticals, Inc. (a) 100,000 3,997,070
Healthcare -- HMOs +Medpartners/Mullikin, Inc. 13,600 294,100
+Medpartners/Mullikin, Inc. (a) 161,400 3,308,297
+Mid Atlantic Medical Services, Inc. 21,240 330,548
Healthcare -- +Apria Healthcare Group, Inc. (a) 39,060 656,579
Miscellaneous +Community Care of America, Inc. (a) 35,000 119,987
+Exogen, Inc. (a) 35,000 132,157
+HEALTHSOUTH Corporation (a) 56,000 1,334,917
+HEARx, Ltd. (a) 60,000 85,182
+Horizon/CMS Healthcare Corp. (a) 68,451 1,301,158
+OccuSystems, Inc. (a) 36,145 992,415
Hospital Management +Tenet Healthcare Corp. 25,000 739,062
Medical Products +Saint Jude Medical, Inc. (a) 50,000 1,848,356
Interest Rate Sensitive Banks -- Money Center Chase Manhattan Corp. 5,000 485,312
Banks -- Regional First Union Corporation 4,200 388,500
Northern Trust Corp. 18,900 914,287
PNC Bank Corp. 18,860 785,047
Wells Fargo & Company 2,100 565,950
Financial -- Banc One Corporation 34,956 1,693,182
Miscellaneous Forest City Enterprises, Inc. 33,000 1,575,750
Mercury Finance Company 37,000 90,187
Student Loan Marketing Association 4,110 521,970
Insurance -- Brokers Marsh & McLennan Companies, Inc. 8,800 628,100
Insurance -- Life John Alden Financial Corporation 11,536 241,535
Insurance -- Multiline American International Group, Inc. 5,015 749,116
Insurance -- Property Commerce Group, Inc. (a) 50,000 1,166,830
Savings & Loan Ahmanson (H.F) & Co. 50,400 2,167,200
CCB Financial Corp. 6,643 485,769
Miscellaneous Miscellaneous +Imation Corp. 286 7,543
Minnesota Mining & Manufacturing Co. 2,860 291,720
Technology Communication +WorldCom, Inc. 19,269 616,608
Equipment
Computer Software +Informix Corp. 13,273 119,457
+Parametric Technology Company 7,000 297,937
+SunGard Data Systems, Inc. 8,100 376,650
Computer Systems +3Com Corp. (a) 6,000 268,820
+COMPAQ Computer Corp. 6,300 625,275
+Cerplex Group, Inc. (a) 50,000 29,285
Hewlett-Packard Co. 16,000 896,000
International Business Machines Corp. 13,000 1,172,437
+Stratus Computer, Inc. (a) 10,000 472,243
Electronics -- +Genrad, Inc. 25,000 565,625
Instruments
Electronics -- Intel Corporation 4,000 567,250
Semiconductors Motorola, Inc. (a) 31,500 2,363,133
+Solectron Corp. 9,750 682,500
Telecommunications AT&T Corp. 8,200 287,512
Lucent Technologies, Inc. 2,657 191,470
+NCR Corporation 512 15,232
Transportation Truckers +Anuhco, Inc. (a) 34,221 291,820
Caliber Systems, Inc. 8,600 320,350
Utilities Electric Utilities +Citizens Utilities Company (Class A) 26,637 249,726
Telephone ALLTELL Corp. (a) 35,000 1,109,538
+C-TEC Corp. (Class B) 35,000 1,203,125
Telephone & Data Systems, Inc. 11,300 429,400
Preferred Stock Banks -- Foreign Banesto Holdings Corp. (10.50%, Series A)
(ADR)* (a) 476,786 14,899,562
Indosuez Holdings, S.C.A. (10.375%,
Series A) (ADR)* (a) 379,000 10,422,500
Short-Term Commercial Paper** General Motors Acceptance Corp., 6.25%
Investments due 7/01/1997 $2,265,000 2,264,607
Investments, at Value 121,666,186
Interest Rate Swaps (391,752)
Liabilities in Excess of Other Assets (27,905,382)
------------
Net Assets $93,369,052
============
(a) Restricted securities as to resale. The value of the Fund's investment in restricted securities was approximately
$55,357,000, representing 59.3% of net assets.
<CAPTION>
Value as of
Acquisition Value as of 6/30/97
Common Stock Date++ 7/11/96 (Note 1a)
<S> <C> <C> <C>
3Com Corp. 7/11/1996 $273,000 $268,820
AFC Cable Systems, Inc. 7/11/1996 325,000 511,406
ALLTELL Corp. 7/11/1996 1,041,250 1,109,538
Anuhco, Inc. 7/11/1996 286,601 291,820
Apria Healthcare Group, Inc. 7/11/1996 1,122,975 656,579
Casey's General Stores, Inc. 7/11/1996 281,250 306,383
Cerplex Group, Inc. 7/11/1996 343,750 29,285
Commerce Group, Inc. 7/11/1996 1,075,000 1,166,830
Community Care of America, Inc. 7/11/1996 273,438 119,987
Exogen, Inc. 7/11/1996 288,750 132,157
Grand Casinos, Inc. 7/11/1996 1,478,863 854,908
HEALTHSOUTH Corporation 7/11/1996 973,000 1,334,917
HEARx, Ltd. 7/11/1996 367,500 85,182
Harrah's Entertainment, Inc. 7/11/1996 945,000 681,288
Horizon/CMS Healthcare Corp. 7/11/1996 855,638 1,301,158
Jacobs Engineering Group, Inc. 7/11/1996 2,018,156 1,964,653
Medpartners/Mullikin, Inc. 7/11/1996 3,086,775 3,308,297
Motorola, Inc. 7/11/1996 1,823,063 2,363,133
OccuSystems, Inc. 7/11/1996 1,125,013 992,415
Rainforest Cafe, Inc. 7/11/1996 395,625 364,070
Saint Jude Medical, Inc. 7/11/1996 1,653,125 1,848,356
Service Corporation
International 7/11/1996 336,000 385,516
Smart & Final, Inc. 7/11/1996 1,507,500 1,393,266
St. John Knits, Inc. 7/11/1996 2,682,942 3,068,518
Stratus Computer, Inc. 7/11/1996 261,250 472,243
Sunglass Hut International, Inc. 7/11/1996 237,000 74,732
Watson Pharmaceuticals, Inc. 7/11/1996 3,487,500 3,997,070
World Fuel Services Corp. 7/11/1996 828,000 952,784
------------- -------------
29,372,964 30,035,311
============= =============
Preferred Stock Cost
Banesto Holdings Corp.
(10.50%, Series A) (ADR) 7/11/1996 14,121,115 14,899,562
Indosuez Holdings, S.C.A.
(10.375%, Series A) (ADR) 7/11/1996 10,418,170 10,422,500
------------- -------------
24,539,285 25,322,062
------------- -------------
Total $53,912,249 $55,357,373
============= =============
++ For Federal income tax purposes, the date the contributing shareholder
acquired the security represents the acquisition date.
+ Non-income producing security.
* American Depositary Receipts (ADR).
** Commercial Paper is traded on a discount basis; the interest rate shown is
the discount rate paid at the time of purchase by the Fund.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF ASSETS AND LIABILITIES
As of June 30, 1997
<S> <C> <C> <C>
Assets: Investments, at value (cost at closing -- $105,314,019) (Note 1a) $121,666,186
Cash 659
Dividends receivable 639,997
Deferred organization expenses (Note 1e) 276,838
-------------
Total assets 122,583,680
-------------
Liabilities: Loans (Note 5) 28,000,000
Interest rate swaps, at value (Notes 1b & 3) 391,752
Payables:
Interest on loans (Note 5) $552,824
Investment adviser (Note 2) 127,053
Interest rate swap contracts (Notes 1b & 3) 51,224
Administrator (Note 2) 42,351 773,452
-------------
Accrued expenses and other liabilities 49,424
-------------
Total liabilities 29,214,628
-------------
Net Assets: Net assets $93,369,052
=============
Net Assets Capital stock $76,850,423
Consist of: Undistributed investment income -- net 558,207
Undistributed realized capital gains on investments -- net 7
Unrealized appreciation on investments -- net 15,960,415
-------------
Net assets -- Equivalent to $607.47 per share based on 153,701
shares of beneficial interest outstanding $93,369,052
=============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS
For the Six Months Ended June 30, 1997
<S> <C> <C> <C>
Investment Dividends $1,631,063
Income (Note 1d): Interest and discount earned 56,227
-------------
Total income 1,687,290
-------------
Expenses: Loan interest expense (Note 5) $899,932
Investment advisory fees (Note 2) 245,086
Interest rate swap expense (Notes 1b & 3) 139,991
Administrative fees (Note 2) 81,695
Amortization of organization expenses (Note 1e) 31,377
Professional fees 28,603
Trustees' fees and expenses 6,961
Borrowing costs (Note 5) 3,500
Pricing fees 340
-------------
Total expenses 1,437,485
-------------
Investment income -- net 249,805
-------------
Realized & Unrealized Realized gain on investments -- net 7
Gain on Investments Change in unrealized appreciation on investments -- net 13,804,142
(Notes 1b, 1d & 3): -------------
Net Increase in Net Assets Resulting from Operations $14,053,954
=============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
For the Six For the Period
Months Ended July 11, 1996+
June 30, to Dec. 31,
Increase (Decrease) in Net Assets: 1997 1996
<S> <C> <C> <C>
Operations: Investment income -- net $249,805 $308,402
Realized gain on investments -- net 7 --
Change in unrealized appreciation on investments -- net 13,804,142 2,156,273
----------- -----------
Net increase in net assets resulting from operations 14,053,954 2,464,675
----------- -----------
Beneficial Interest Investments contributed -- 78,510,168
Transactions (Note 4): Cash contributions -- 544,000
Selling commissions and offering expenses resulting from
issuance of capital stock -- (2,203,745)
----------- -----------
Net increase in net assets derived from beneficial interest
transactions -- 76,850,423
----------- -----------
Net Assets: Total increase in net assets 14,053,954 79,315,098
Beginning of period 79,315,098 --
----------- -----------
End of period* $93,369,052 $79,315,098
=========== ===========
* Undistributed investment income -- net $558,207 $308,402
=========== ===========
+ Commencement of Operations.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF CASH FLOWS
For the Six Months Ended June 30, 1997
<S> <C> <C>
Cash Provided by Net increase in net assets resulting from operations $14,053,954
Operating Activities: Adjustments to reconcile net increase in net assets resulting from
operations to net cash provided by operating activities:
Decrease in receivables 7,188
Increase in other liabilities 68,688
Realized and unrealized gain on investments -- net (13,804,149)
Amortization of discount (56,228)
-----------
Net cash provided by operating activities 269,453
-----------
Cash Used for Proceeds from sales of long-term securities 47
Operating Activities: Purchases of short-term investments (257,084,186)
Proceeds from sales and maturities of short-term investments 256,814,000
-----------
Net cash used for financing activities (270,139)
-----------
Cash: Net decrease in cash (686)
Cash at beginning of period 1,345
-----------
Cash at end of period $659
===========
Cash Flow Information: Cash paid for interest $941,654
===========
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
FINANCIAL HIGHLIGHTS
The following per share data and ratios have been derived For the Six For the Period
from information provided in the financial statements. Months Ended July 11, 1996+
June 30, 1997 to Dec. 31, 1996
Increase (Decrease) in Net Asset Value:
<S> <C> <C> <C>
Per Share Operating Net asset value, beginning of period $516.04 $503.02
Performance: Capital charge resulting from issuance of shares -- (3.02)
----------- -----------
Net asset value, beginning of period, net of capital charges 516.04 500.00
----------- -----------
Investment income -- net 1.62 2.01
Realized and unrealized gain on investments -- net (including
discount for restricted securities) 89.81 14.03
----------- -----------
Total from investment operations 91.43 16.04
----------- -----------
Net asset value, end of period $607.47 $516.04
=========== ===========
Total Investment Based on net asset value per share 17.72% 2.59%
Return:** Based on net asset value, net of capital charge 17.72% 3.21%
=========== ===========
Ratios to Average Expenses, excluding interest expense 1.05%* 1.05%*
Net Assets: =========== ===========
Expenses 3.79%* 3.78%*
=========== ===========
Investment income -- net .66%* .87%*
=========== ===========
Supplemental Data: Net assets, end of period (in thousands) $93,369 $79,315
=========== ===========
Portfolio turnover 0.00% 0.00%
=========== ===========
Leverage: Amount of borrowings, end of period (in thousands) $28,000 $28,000
=========== ===========
Average amount of borrowings outstanding during the period
(in thousands) $28,000 $28,000
=========== ===========
Average amount of borrowings per share during the period $182.17 $182.17
=========== ===========
* Annualized.
** Aggregate total investment return.
+ Commencement of Operations
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 1997
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies:
Somerset Exchange Fund (the "Fund") is a Delaware business trust
registered under the Investment Company Act of 1940 as a diversified,
closed-end management investment company. These unaudited financial
statements reflect all adjustments which are, in the opinion of
management, necessary to a fair statement of the results for the interim
period presented. All such adjustments are of a normal recurring nature.
Investments in the Fund were made by investors contributing publicly-
traded equity securities in exchange for shares of beneficial interest
in the Fund. Shares of beneficial interest are illiquid unless and until
shareholders vote to convert the Fund into an open-end investment
company (or, if appropriate, an interval fund, which is a closed-end
investment company which makes scheduled periodic repurchase offers, if
at that time redemptions in kind are permissible). No present market
exists for the shares of beneficial interest and none is expected to
develop. The Fund is not listed on an exchange or otherwise regularly
traded. No provision is made initially for the Fund to provide liquidity
through cash tender offers or other means that may be available to
closed-end investment companies. The following is a summary of
significant accounting policies followed by the Fund.
(a) Valuation of securities -- Securities for which market quotations
are readily available and which are not restricted securities, including
listed options and futures contracts, are valued at their current market
values in the principal market on which such securities are normally
traded. The value of equity securities that are not restricted
securities and are listed on the New York or American Stock Exchanges or
listed on the NASDAQ National Market System are at the closing sale
prices or, lacking any closing price, the closing bid price. Equity
securities that are not restricted securities and are not listed on the
New York or American Stock Exchanges but that are listed on any other
securities exchange are valued as if listed on the New York Stock
Exchange, providing the close of trading coincides. If the close of
trading on such securities exchange does not coincide with the close of
trading on the New York Stock Exchange, the value is based on the latest
available price data at the time of determination of net asset value.
Unlisted readily marketable equity securities that are not restricted
securities are valued at the bid price in the over-the-counter market.
Merrill Lynch Asset Management, L.P. ("MLAM"), subject to the
supervision of the Trustees of the Fund, generally values restricted
securities at discounts to the fair market value of freely tradable
securities of the same class. CTC Consulting, Inc. may assist MLAM in
the valuation of restricted securities. Such discounts, which may vary
with respect to particular securities, we initially expected to range
between 5% and 25% of the fair market value of freely tradable
securities with such discounts diminishing until the time the restricted
securities become freely tradable.
Pursuant to procedures authorized by the Trustees of the Fund, the
preferred stock holdings are valued at fair value as determined by MLAM
or its designee, after consideration of all relevant factors, data and
information, which may include information from various firms with
knowledge of such issues, and the prices of comparable preferred stock
issues. Unlisted options and interest rate and equity swaps are valued
at their fair values determined in good faith by or on behalf of the
Trustees of the Fund.
(b) Derivative financial instruments -- The Fund engages
in various portfolio strategies to seek to increase its return by
hedging its portfolio against adverse movements in the debt
and equity markets. Losses may arise due to changes in the
value of the contract or if the counterparty does not perform under the
contract.
[bullet] Options -- The Fund is authorized to write call options and
purchase put options. When the Fund writes an option, an amount equal to
the premium received by the Fund is reflected as an asset and an
equivalent liability. The amount of the liability is subsequently marked
to market to reflect the current market value of the option written.
When a security is purchased or sold through an exercise of an option,
the related premium paid (or received) is added to (or deducted from)
the basis of the security acquired or deducted from (or added to) the
proceeds of the security sold. When an option expires (or the Fund
enters into a closing transaction), the Fund realizes a gain or loss on
the option to the extent of the premium received or paid (or gain or
loss to the extent the cost of the closing transaction exceeds the
premium paid or received). The Fund does not expect to sell securities
contributed by shareholders upon exercise of written call options and
purchased put options.
Written and purchased options are non-income producing investments.
[bullet] Financial futures contracts -- The Fund may purchase or sell
financial futures contracts as a hedge against adverse changes in
interest rates and the stock market. A futures contract is an agreement
between two parties to buy and sell a security, respectively, for a set
price on a future date. Upon entering into a contract, the Fund deposits
and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract,
the Fund agrees to receive from or pay to the broker an amount of cash
equal to the daily fluctuation in value of the contract. Such receipts
or payments are known as variation margin and are recorded by the Fund
as unrealized gains or losses. When the contract is closed, the Fund
records a realized gain or loss equal to the difference between the
value of the contract at the time it was opened and the value at the
time it was closed.
[bullet] Interest rate swaps -- The Fund is authorized to enter into
interest rate swaps and purchase or sell interest rate caps and floors.
In an interest rate swap, the Fund exchanges with another party their
respective commitments to pay or receive interest on a specified
notional principal amount. The purchase of an interest rate cap (or
floor) entitles the purchaser, to the extent that a specified index
exceeds (or falls below) a predetermined interest rate, to receive
payments of interest equal to the difference between the index and the
predetermined rate on a notional principal amount from the party selling
such interest rate cap (or floor).
(c) Income taxes -- The Fund is treated as a partnership for federal
income tax purposes. As a partnership for federal income tax purposes,
the Fund does not incur federal income tax liability. Items of
partnership income, gain, loss and deduction pass through to the
shareholders as partners in the Fund.
(d) Security transactions and investment income -- Interest income
(including amortization of discount) is recognized on the accrual basis.
Dividend income is recorded on the ex-dividend date. Realized gains and
losses on security transactions are determined on the identified cost
basis.
(e) Deferred organization expenses -- Deferred organization expenses are
amortized on a straight-line basis over a five-year period.
(f) Distributions -- Distributions of cash from investment income are
made at least annually in such amounts as the Trustees of the Fund
determine. Distributions of cash from realized capital gains are made at
least annually in years in which such gains are realized. The Fund does
not offer a dividend reinvestment plan.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with MLAM.
The general partner of MLAM is Princeton Services, Inc. ("PSI"), an
indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc. ("ML &
Co."), which is the limited partner.
MLAM is responsible for the management of the Fund's portfolio and
provides the necessary personnel, facilities, equipment and certain
other services necessary to the operation of the Fund. For such
services, the Fund pays a quarterly fee of 0.60%, on an annual basis, of
the Fund's average weekly net assets. For this purpose, "average weekly
net assets" means the average weekly value of the total assets of the
Fund minus the sum of (i) accrued liabilities of the Fund, and (ii) any
accrued and unpaid interest on outstanding borrowings.
The Fund has also entered into an Administration Agreement with MLAM
whereby MLAM provides or arranges for the provision of administrative
services (other than investment advice and related portfolio activities)
necessary for the operation of the Fund. Such services include
maintaining books and records and providing or arranging for the
provision of custody and transfer agency services. For such services,
the Fund pays a quarterly fee of 0.20%, on an annual basis, of the
Fund's average weekly net assets as defined above.
MLAM has entered into a Sub-Administration Agreement with United States
Trust Company of New York ("US Trust") whereby US Trust provides
information and advice relating to securities valuation and portfolio
activities. For such services, MLAM pays US Trust a quarterly fee of
0.05%, on an annual basis, of the Fund's average weekly net assets as
defined above. US Trust is compensated directly by MLAM out of the
administration fee at no additional cost to the Fund.
MLAM has entered into a Shareholder Servicing Agreement with US Trust
whereby US Trust provides or arranges for the provision of shareholder
reporting services. For such services, MLAM pays to US Trust a quarterly
fee of 0.15%, on an annual basis, of the Fund's average weekly net
assets, as defined above, multiplied by the percentage of such assets
(excluding any assets attributable to borrowings by the Fund)
attributable to shareholders of the Fund who purchased their shares
through a US Trust affiliate. US Trust is compensated directly by MLAM
at no additional cost to the Fund.
Certain officers and/or trustees of the Fund are officers and/or
directors of MLAM, PSI, ML & Co., or US Trust.
3. Investments:
Sales of investments, excluding short-term securities, for the six
months ended June 30, 1997 was $47.
Net realized and unrealized gains (losses) as of the June 30, 1997 were
as follows:
Realized Unrealized
Gains Gains (Losses)
Long-term investments $7 $16,352,167
Interest rate swaps -- (391,752)
----------- -----------
Total $7 $15,960,415
=========== ===========
The Fund has entered into the following interest rate swap as of June
30, 1997:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 5.81641% Variable* 6.89% Fixed 7/15/2001
* 3-month LIBOR at reset date.
As of June 30, 1997, net unrealized appreciation for Federal income tax
purposes aggregated $16,352,167, of which $21,413,325 related to
appreciated securities and $5,061,158 related to depreciated securities.
The aggregate cost of investments at June 30, 1997 for Federal income
tax purposes was $105,314,019.
4. Beneficial Interest Transactions:
For the six months ended June 30, 1997, shares issued and outstanding
remained constant at 153,701. At June 30, 1997, total capital amounted
to $76,850,423.
5. Short-Term Borrowings:
On July 11, 1996, the Fund entered into a loan commitment in the amount
of $35,000,000 with Merrill Lynch International Bank Limited, an
indirect wholly-owned subsidiary of ML & Co. For this commitment, the
Fund pays 0.10% on any unused balance. For the six months ended June 30,
1997, the amount borrowed remained constant at $28,000,000 and the daily
weighted average interest rate was 6.48%. For the six months ended June
30, 1997, facility and commitment fees aggregated $3,500.
Past performance results shown in this report should not be considered a
representation of future performance. The Fund has leveraged its
portfolio by investing borrowed money to seek the opportunity for a more
broadly invested portfolio and potentially higher investment returns.
However, leveraging may exaggerate changes in the net asset value of the
Fund's shares and in the yield on the Fund's portfolio. Leveraging also
exposes Fund shareholders to the risk of potential adverse tax
consequences in the event of default or adverse market action.
Statements and other information herein are as dated and are subject to
change.
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