As filed with the Securities and Exchange Commission on March __, 1998
================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
---------
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998; or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____ to ____
Commission file number __________
---------------------
AMERICAN CAPITAL STRATEGIES, LTD.
<TABLE>
<CAPTION>
<S> <C> <C>
3 Bethesda Metro Center
Suite 860
Delaware Bethesda, Maryland 20814 52-1451377
-------- --------------------------------------- ----------
(State or other jurisdiction of (Address of principal executive offices) (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>
Registrant's telephone number, including area code: (301) 951-6122
Securities registered pursuant to Section 12(b) of the Act: Not Applicable
Securities registered pursuant to section 12(g) of the Act:
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
Common Stock, $0.01 par value Nasdaq Stock Market
per share
Indicate by check mark whether the registrant (1) has filed all report
to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter earlier period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ X ]. No [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
On March 26, 1998, the aggregate market value of the Registrant's
common stock held by nonaffiliates of the Registrant was approximately
$[180,000,000] based upon a closing price of the Registrant's common stock of
$22.88per share as reported on the NASDQ National Market System on that date.
(For this computation, the registrant has excluded the market value of all
shares of its Common Stock reported as beneficially owned by executive officers
and directors of the registrant and certain other stockholders; such an
exclusion shall not be deemed to constitute an admission that any such person is
an "affiliate" of the registrant.) . On March 26, 1997, there were 11,068,767
shares of the Registrant's common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE. The Company's definitive proxy
statement for the Annual Meeting of Stockholders to be held on May 14, 1998 is
incorporated by reference into certain sections of Part III herein.
Certain exhibits previously filed with the Securities and Exchange
Commission are incorporated by reference into Part IV of this report.
================================================================================
<PAGE>
PART I
ITEM 1. BUSINESS OF THE COMPANY
BACKGROUND
American Capital Strategies, Ltd., a Delaware corporation (the
"Company"), was incorporated in 1986 to provide financial advisory services to
and invest in small and medium sized businesses. On August 29, 1997, the Company
completed an initial public offering ("IPO") of 10,382,437 shares of its common
stock ("Common Stock") and became a non-diversified, closed end investment
company that has elected to be treated as a business development company ("BDC")
under the Investment Company Act of 1940, as amended ("1940 Act"). On October 1,
1997, the company began operations so as to qualify to be taxed as a regulated
investment company (RIC) as defined in Subtitle A, Chapter 1, under Subchapter M
of the Internal Revenue Code of 1986 as amended (the "Code"). As contemplated by
these transactions, the Company materially changed its business plan and format
from structuring and arranging financing for buyout transactions on a fee for
services basis to primarily being a lender to and investor in small and medium
sized companies. The Company continues to provides financial advisory services
to businesses through ACS Capital Investments Corporation ("CIC"), a
wholly-owned subsidiary. The Company had established itself as a leading firm in
structuring and obtaining funding for management and employee buyouts of
subsidiaries, divisions and product lines being divested by larger corporations
through the use of an employee stock ownership plans ("ESOPs"). From its
formation in 1986 through the IPO, the Company arranged 29 financing
transactions aggregating over $400 million.
BUSINESS
The Company is a buyout and specialty finance company that is
principally engaged in providing senior debt, subordinated debt and equity to
companies in need of capital for employee buyouts, management buyouts, growth,
acquisitions, liquidity and restructuring. The Company invests up to $20 million
in each transaction and through its subsidiary, CIC, will arrange and secure
capital for larger transactions. The Company's primary business objectives are
to increase its net operating income and net asset value by investing its assets
in senior debt, subordinated debt with detachable warrants and equity of small
to medium sized businesses with attractive current yields and potential for
equity appreciation.
The Company's loans typically range from $1 million to $20 million,
mature in five to ten years, and require monthly or quarterly interest payments
at variable rates based on the prime rate plus a margin. The Company prices its
debt and equity investments based on its analysis of each transaction. As of
December 31, 1997 the weighted average effective interest on the Company's debt
investments was 14.5% and dividend rate on the Company's preferred stock
investment was 15% The Company also invests in common stock which may not
provide a current yield but would share in the appreciation of the investment.
At December 31, 1997, common stock investments represented 6.0% of the Company's
portfolio and common stock investments excluding CIC was 7.6% of the Company's
investment in non-publicly traded securities. The Company expects common stock
investments to represent the smallest percentage of its portfolio.
The Company's equity interests in small and medium sized businesses are
purchased with the goal of disposing of such interests and realizing a gain
within three to seven years. The opportunity to realize such gain may occur if
the business recapitalizes its equity, either through a sale to new owners or
makes a public offering of its equity. The Company generally does not have the
right to require that a business undergo an initial public offering by
registering securities under the Securities Act of 1933, but the Company
generally does have the right to sell its equity interests in a public offering
by the business to the extent permitted by underwriters.
1
<PAGE>
In most cases, the Company also receives the right to require the
business to purchase the warrants or stock held by the Company ("Put Rights")
under various circumstances including, typically, the repayment of the Company's
loans or debt securities. When no public offering is available, the Company may
use its Put Rights to dispose of its equity interest in a business, although the
Company's ability to exercise Put Rights may be limited or nonexistent if a
business is illiquid.
The Company makes available significant managerial assistance to its
portfolio companies. Such assistance typically involves closely monitoring the
operations of the company, participating in its board and management meetings,
being available for consultation with its officers and providing organizational
and financial guidance. Providing assistance to its borrowers serves as a
control for the Company as well as provides an opportunity for the Company to
assist in maximizing the operations of the borrower.
Prior to the IPO, the Company established itself as a leading firm in
structuring and obtaining funding for management and employee buyouts of
subsidiaries, divisions and product lines being divested by larger corporations
through the use of an ESOP. The selling entities have included Sunbeam
Corporation, the U.S. Office of Personnel Management, American Premier
Underwriters, Inc. (formerly Penn Central Corporation), Campbell Soup Company,
Union Carbide Corporation, National Forge Company, Inc., Air Products Company,
Ampco-Pittsburgh Corporation and British Petroleum Company. In most of the ESOP
transactions structured by the Company, the employees agree to restructure their
wages and benefits so that overall cash compensation is reduced while
contributions of stock are made to an ESOP. The resulting company is structured
so that the fair market value of stock contributed to the ESOP can be deducted
from corporate income before paying taxes. Restructuring employee compensation
together with the ESOP tax advantages has the effect of improving the cash flow
of the ESOP company. The Company believes that its ESOP knowledge and experience
and its ability to fund transactions positions the Company favorably in the
market place.
2
<PAGE>
The Company continues providing financial advisory services and
structuring of transactions through its wholly-owned subsidiary CIC. The typical
advisory engagement includes a monthly retainer and a performance fee contingent
upon closing of the transaction or event which is the subject of the engagement.
Management believes that future growth of CIC is attainable through adding
additional professionals, by gaining additional market share and by realizing
the benefits of what is expected to be an increasing client base, which should
expand as a result of its relationship with the Company.
The Company believes that, through the structuring and advisory
business, it has established an extensive referral network comprised of venture
capitalists, investment bankers, attorneys, commercial bankers and business and
financial brokers. CIC is continuing the relationships with the referral network
and the Company utilizes the referral network and CIC's client base as its
primary sources of investment opportunities.
LENDING AND INVESTMENT DECISION CRITERIA
The Company reviews certain criteria in order to make investment
decisions. The criteria listed below provide a general guide for the Company's
lending and investment decisions, although not all criteria are required to be
favorable in order for the Company to make an investment.
Operating History. The Company focuses on target companies that have
stable operating histories and are profitable or near profitable at existing
operating levels. The Company reviews the target companies ability to service
and repay debt based on its historical results of operations. The Company does
not expect to lend or invest in start-up or other early stage companies.
Growth. In addition to generating sufficient cash flow to service its
debt, a potential recipient of the Company's financing generally is required to
establish its ability to grow its cash flow. Anticipated growth will be a key
factor in determining the value ascribed to any warrants and equity interests
acquired by the Company.
Liquidation Value of Assets. Although the Company does not operate as an
asset-based lender, liquidation value of the assets collateralizing the
Company's loans is an important factor in each credit decision. Emphasis is
placed both on tangible assets (accounts receivable, inventory, plant, property
and equipment) as well as intangible assets such as customer lists, networks,
databases and recurring revenue streams.
Experienced Management Team. The Company requires that each borrower
have or promptly obtain a management team that is experienced and properly
incentivized through a significant ownership interest in the borrower. The
Company requires that a potential recipient of the Company's financing have a
management team who have demonstrated the ability to execute the company's
objectives and implement its business plan.
3
<PAGE>
Exit Strategy. Prior to making an investment, the Company analyzes the
potential for the target company to experience a liquidity event that will allow
the Company to realize value for its equity position. Liquidity events include,
among other things, an initial public offering, a private sale of the Company's
financial interest, a sale of the company, or a purchase by the company or one
of its stockholders of the Company's equity position.
OPERATIONS
Marketing and Origination Process. The Company and CIC have thirteen
professionals responsible for originating loans and investments and providing
financial assistance to small and medium sized businesses and intends to hire an
additional five professionals by year end. To originate financing opportunities,
these professionals use an extensive referral network comprised of venture
capitalists, investment bankers, unions, attorneys, accountants, commercial
bankers, unions, business brokers and prospective or existing ESOP companies.
The Company also has an extensive set of internet sites that it uses to attract
financing opportunities.
Approval Process. The Company's financial professionals review
informational packages in search of potential financing opportunities and
conduct a due diligence investigation of each applicant that passes an initial
screening process. This due diligence investigation generally includes one or
more on-site visits, a review of the company's historical and prospective
financial information, interviews with management, employees, customers and
vendors of the applicant, and background checks and research on the applicant's
product, service or particular industry. Upon completion of the due diligence
investigation, the financial professional creates a profile summarizing the
target company's historical financial statements, industry and management team
and analyzing its conformity to the Company's general investment criteria. The
financial professional then presents this profile to the Company's Credit
Committee, which is comprised of David Gladstone, Malon Wilkus and Adam
Blumenthal, the Chairman, President and Executive Vice President, respectively,
of the Company. The Company's Credit Committee and the Company's Board of
Directors must approve each financing.
Support Services. A commercial bank provides certain loan accounting and
administrative services for the Company's investments and also acts as the
custodian of the Company's portfolio assets pursuant to and in accordance with
the 1940 Act.
COMPETITION
The Company's primary competitors include financial institutions and
venture capital firms and other nontraditional lenders. Many of these entities
have greater financial and managerial resources than the Company. Nevertheless,
the Company believes that it competes effectively with these entities through,
among other means, its responsiveness to the needs of its customers and its
flexibility in structuring transactions.
4
<PAGE>
EMPLOYEES
As of March 20, 1998, the Company had twenty-two employees, thirteen of
whom are professionals working on financings for small and medium sized
businesses. The Company believes that its relations with its employees are
excellent. The Company intends to continue maintaining a relatively low overhead
by outsourcing many functions not directly related to marketing or underwriting
its investments and the executive management of the Company.
THE COMPANY'S OPERATIONS AS A BDC AND RIC
As a BDC, the Company may not acquire any asset other than Qualifying
Assets unless, at the time the acquisition is made, Qualifying Assets represent
at least 70% of the value of the Company's total assets. The principal
categories of Qualifying Assets relevant to the business of the Company are the
following:
(i) securities purchased in transactions not involving any public
offering from the issuer of such securities, which issuer is an
eligible portfolio company. An eligible portfolio company is
defined as any issuer that (a) is organized and has its principal
place of business in the United States, (b) is not an investment
company other than a small business investment company
wholly-owned by the BDC and (c) does not have any class of
publicly-traded securities with respect to which a broker may
extend credit;
(ii) securities received in exchange for or distributed with respect
to securities described above, or pursuant to the exercise of
options, warrants or rights relating to such securities; and
(iii) cash, cash items, Government securities, or high quality debt
securities maturing in one year or less from the time of
investment.
The Company may not change the nature of its business so as to cease to
be, or withdraw its election as, a BDC unless authorized by vote of a majority,
as defined in the 1940 Act, of the Company's shares. Since the Company made its
BDC election, it has not made any substantial change in its structure or in the
nature of its business.
The Company operates so as to qualify as a RIC under the Internal
Revenue Code of 1986 as amended. Generally in order to qualify as a RIC, the
Company must distribute to shareholders in a timely manner, at least 90% of its
"investment company taxable income" and 98% of its capital gain net income as
defined by the code. The Company must derive at least 90% of its gross income
from dividends, interest, payments with respect to securities loans, gain from
the sale of stock or other securities, or other income derived with respect to
its business of investing in such stock or securities as defined by the code.
Additionally, the Company must diversify its holdings so that (i) at least 50%
of the value of the Company's assets consists of cash, cash items, government
securities and other securities if such other securities of any one issuer do
not represent more than 5% of the Company's assets and 10% of the outstanding
voting securities of the issuer and (ii) no more than 25% of the value of the
Company's assets are invested in the securities of one issuer (other than U.S.
government securities), or of two or more issuers that are controlled by the
Company and are engaged in the same or similar or related trades or businesses.
5
<PAGE>
TEMPORARY INVESTMENTS
Pending investment in other types of Qualifying Assets, the Company has
invested its otherwise uninvested cash primarily in cash, cash items, government
securities, agency paper or high quality debt securities maturing in one year or
less from the time of investment in such high quality debt investments
("Temporary Investments") so that at least seventy percent (70%) of its assets
are Qualifying Assets. Typically, the Company invests in U.S. Treasury bills or
in repurchase obligations of a "primary dealer" in government securities (as
designated by the Federal Reserve Bank of New York) or of any other dealer whose
credit has been established to the satisfaction of the Board of Directors. There
is no percentage restriction on the proportion of the Company's assets that may
be invested in such repurchase agreements. A repurchase agreement involves the
purchase by an investor, such as the Company, of a specified security and the
simultaneous agreement by the seller to repurchase it at an agreed upon future
date and at a price which is greater than the purchase price by an amount that
reflects an agreed-upon interest rate. Such interest rate is effective for the
period of time during which the investor's money is invested in the arrangement
and is related to current market interest rates rather than the coupon rate on
the purchased security. The Company requires the continual maintenance by its
custodian or the correspondent in its account with the Federal Reserve/Treasury
Book Entry System of underlying securities in an amount at least equal to the
repurchase price. If the seller were to default on its repurchase obligation,
the Company might suffer a loss to the extent that the proceeds from the sale of
the underlying securities were less than the repurchase price. A seller's
bankruptcy could delay or prevent a sale of the underlying securities.
LEVERAGE
For the purpose of making investments other than Temporary Investments
and to take advantage of favorable interest rates, the Company intends to issue
in the future senior debt securities, up to the maximum amount permitted by the
1940 Act, which currently permits the Company, as a BDC, to issue senior debt
securities and preferred stock (collectively, "Senior Securities") in amounts
such that the Company's asset coverage, as defined in the 1940 Act, is at least
200% after each issuance of Senior Securities. Such indebtedness may also be
incurred for the purpose of effecting share repurchases. As a result, the
Company would become exposed to the risks of leverage. Although the Company has
no current intention to do so, it has retained the right to issue preferred
stock. As permitted by the 1940 Act, the Company may, in addition, borrow
amounts up to five percent (5%) of its total assets for temporary or emergency
purposes.
6
<PAGE>
ITEM 2. PROPERTIES
Neither the Company nor any of its subsidiaries owns any real estate or
other physical properties materially important to the operation of the Company
or any of its subsidiaries. The Company leases an aggregate of approximately
10,000 square feet of office space in four locations for terms ranging up to
seven years.
ITEM 3. LEGAL PROCEEDINGS
Although the Company may, from time to time, be involved in litigation
and claims arising out of its operations in the normal course of business, as of
December 31, 1997, the Company was not presently a party to any material legal
proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year ended December 31, 1997,
there were no matters submitted to a vote of the Company's security holders
through the solicitation of proxies or otherwise.
7
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
Since the IPO the Company has distributed and currently intends to
continue to distribute 90% of its net operating income and net realized
short-term capital gains, if any, on a quarterly basis to its stockholders. Net
realized long-term capital gains may be retained to supplement the Company's
equity capital and support growth in its portfolio, unless the Board of
Directors determines in certain cases to make a distribution. There is no
assurance that the Company will achieve investment results or maintain a tax
status that will permit any specified level of cash distributions or
year-to-year increases in cash distributions.
The Common Stock is quoted on the Nasdaq Stock Market under the symbol
ACAS. As of March 25, 1998, the Company had 49 stockholders of record and
approximately 1300 beneficial owners. The following table sets forth the range
of high and low bid prices of the Company's Common Stock as reported on the
Nasdaq Stock Market and the dividends declared by the Company for the period
from August 29, 1997, when public trading of the Common Stock commenced, through
March 25, 1998.
<TABLE>
<CAPTION>
BID PRICE
---------
DIVIDEND
HIGH LOW DECLARED
---- --- --------
<S> <C> <C> <C>
1997
Third Quarter (beginning August 29, 1997) . . $20.25 $18.50 $.00
Fourth Quarter. . . . . . . . . . . . . . . . 20.75 16.50 .21
1998
First Quarter (through March 25, 1998). . . . 22.25 17.25 .25
</TABLE>
8
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
[Furnish the information required by Item 301 of Regulation S-K.]
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION
[Furnish the information required in Item 303 of Regulation S-K.]
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET
RISK
[Furnish the information required by Item 305 of Regulation S-K.]
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
[Furnish the financial statements meeting the requirements of Regulation
S-X, except ss. 210.3-05 and Article 11 thereof, and the supplementary financial
information required by Item 302 of Regulation S-K. Financial statements of the
registrant and its subsidiaries consolidated (as required by Rule 14a-3(b))
shall be filed under this Item. Other financial statements and schedules
required under Regulation S-X may be filed as "Financial Statement Schedules"
pursuant to Item 13, Exhibits, Financial Statement Schedules, and Reports on
Form 8-K, of this Form.]
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
[Furnish the information required by Item 302 of Regulation S-K.]
9
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information in response to this Item is incorporated herein by reference
to the information provided in the Company's Proxy Statement for its Annual
Meeting of Shareholders to be held May 14, 1998 (the "1998 Proxy Statement")
under the heading "Directors and Executive Officers of the Registrant."
ITEM 11. EXECUTIVE COMPENSATION
Information in response to this Item is incorporated herein by reference
to the information provided in the 1998 Proxy Statement under the heading
"Compensation of Directors and Executive Officers."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
Information in response to this Item is incorporated herein by reference
to the information provided in the 1998 Proxy Statement under the heading
"Security Ownership of Management and Certain Beneficial Owners."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this Item is incorporated herein by reference
to the information provided in the 1998 Proxy Statement under the heading
"Certain Transactions."
10
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K
[(a) List the following: (1) all financial statements; (2) financial
statement schedules required by Item 8 and paragraph (d) below; and (3) those
exhibits required by Item 601 of Regulation S-K and paragraph (c) below.
Identify in the list each management contract or compensatory plan or
arrangement required to be filed as an exhibit to this Form pursuant to Item
149c) of this report
(b) State whether any reports on Form 8-K have been filed during the
last quarter of the period covered by this report.
(c) File as exhibits those exhibits required by Item 601 of Regulation
S-K.
(d) Registrants shall file, as financial statement schedules to this
Form, the financial statements required by Regulation S-X which are excluded
from the annual report to shareholders by Rule 14a-3(b), including: (1) separate
financial statements of subsidiaries not consolidated and fifty percent or less
owned persons; (2) separate financial statements of affiliates whose securities
are pledged as collateral; and (3) schedules.]
11
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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
--------------------------
John R. Erickson
Chief Financial Officer
(Principal Financial and
Accounting Officer)
Date: March 31, 1998
12
<PAGE>
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Name Title Date
- ---- ----- ----
<S> <C> <C>
/s/ David J. Gladstone Chairman and Director March __, 1998
- ----------------------
David J. Gladstone
/s/ Malon Wilkus President and Director March __, 1998
- ----------------
Malon Wilkus
/s/ Adam Blumenthal Executive Vice President March __, 1998
- ------------------- and Director
Adam Blumenthal
/s/ John Erickson Vice President and Chief March __, 1998
- ----------------- Financial Officer
John Erickson
/s/ Stephen L. Hester Vice President and General March __, 1998
- --------------------- Counsel
Stephen L. Hester
/s/ Roland Cline Vice President March __, 1998
- ----------------
Roland Cline
/s/ Robert L. Allbritton Director March __, 1998
- ------------------------
Robert L. Allbritton
/s/ Landon Butler Director March __, 1998
- -----------------
Landon Butler
/s/ Neil M. Hahl Director March __, 1998
- ----------------
Neil M. Hahl
/s/ Phillip R. Harper Director March __, 1998
- ---------------------
Phillip R. Harper
/s/ Stan Lundine Director March __, 1998
- ----------------
Stan Lundine
/s/ Stephen P. Walko Director March __, 1998
- --------------------
Stephen P. Walko
</TABLE>
13
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<S> <C> <C>
3.1 American Capital Strategies, Ltd. Second Amended and Restated Certificate of
Incorporation. Incorporated herein by reference to Exhibit 2.a of the Pre-Effective
Amendment Number 1 to the Registration Statement on Form N-2 (File No.
333-29943) filed on August 12, 1997.
3.2 American Capital Strategies, Ltd. 1997 Stock Option Plan. Incorporated herein by
reference to Exhibit i.2 of the Pre-Effective Amendment Number 1 to the
Registration Statement on Form N-2 (File No. 333-29943) filed on August 12, 1997.
4 Instruments defining rights of security holders, including indentures.
9 Voting Trust Agreement.
10 Material Contracts.
11 Statement regarding computation of per share earnings.
12 Statement regarding computation of ratios.
13 Annual Report.
18 Letter regarding change in accounting principles.
21 Subsidiaries of the registrant.
22 Published report regarding matters submitted to vote of security holders.
23 Consents of experts and counsel [Where the opinion of
the expert or counsel has been incorporated by
reference into a previously filed Securities Act
registration statement].
24 Power of Attorney.
27 Financial Data Schedule.
</TABLE>
14
EXHIBIT 13
- --------------------------------------------------------------------------------
Dear Shareholders
We would like to extend our warmest welcome to you as shareholders of American
Capital Strategies. It has been a momentous year. You have entrusted us with
$155 million of your capital and we want to convey our commitment and
responsibility to executing our business plan and rewarding your trust.
We wish each of you could be with us to share the excitement in our
organization. It is an excitement bred of seeing long-cherished goals achieved.
It is an excitement fed by the strong reception our capital strategies have had
from the entrepreneurs, managers and employees who provide the vitality to
America's economic heartland. And it is an excitement shared both by the many
seasoned professionals who have devoted a decade or more to the development of
American Capital, and by the select group of extraordinary people we have had
the privilege of hiring since last August.
With the capital you have entrusted to us, American Capital is providing senior
debt, subordinated debt and equity to some of the most dynamic small and medium
sized businesses in America. In the seven months since our IPO, we have executed
our strategy by:
o Reviewing nearly $1 billion of financing opportunities,
o Investing and committing just under $70 million in senior debt, subordinated
debt and equity to nine outstanding companies,
o Funding three add-on acquisitions,
o Capitalizing three buyouts, and
o Committing funds to and raising additional financing for a major employee
buyout.
Over the past thirteen years, American Capital has arranged funding for more
than $400 million of transactions, while becoming a national leader in
structuring and funding employee and management buyouts. Over that time, we
became acutely aware of a tremendous gap in the financial markets for
sophisticated, flexible, long-term capital for the small and medium businesses
who give the American economy its vibrancy and resilience.
We worked intimately with managers and employees who were tough, determined,
creative and tested. Often they were in industries that were out of
favor--manufacturers in the so-called rust belt or in our large inner cities, or
which had a unionized workforce. Sometimes they were corporate stepchildren,
declared "non-core" for the grand corporate strategy du jour, but with a core of
managers and employees who knew they could be dynamic independent businesses.
Sometimes they were small, solid, and ambitious, small fry seeking to eat larger
fish. Always, they were under the radar screen of the great liquidity and
capital machine we refer to as "Wall Street."
For twelve years, we solved financial problems for such companies. We invested
in them and presented them to conventional capital markets. After financing
them, we often became their partners, served on their boards, and saw them
thrive. We became intimate with a gap in the capital markets so dramatic that it
cried out to be filled. Our companies were dynamic. Their capital sources were
moribund and often failed to provide adequate financing to fuel their growth.
Regulations and industry consolidation make it uneconomical for banks to meet
their needs. Pension funds and insurance companies are generally not sources of
capital for this market due to the sophisticated structuring and uniqueness of
each transaction coupled with an average investment size which is smaller than
their appetite.
Venture capital firms, are frequently established as finite life organizations
requiring quick exit strategies that do not mesh with the long-term plans of
these businesses. Private equity funds tend to have an appetite for one specific
tier of financing and cannot meet all of the needs of a small and medium sized
business. Everywhere we turned, we saw structural problems and gaps in the
availability of financing.
Our capital strategies fill the gaps and serve the needs of these dynamic
companies. We approach our transactions with the mindset of a principal and
underwrite it with a rigor unmatched in the industry because we believe in
making strategic investments rather than simply churning capital. The companies
we invest in work directly with our principals, who are talented individuals
with exceptional achievements in finance and investment banking. As a result of
this detailed diligence, we are willing to place long-term, patient capital, to
take mezzanine or equity risks for appropriate returns, or to act quickly to
finance an entire transaction--senior, subdebt, and equity--where speed and
certainty are critical to closing.
Because of our ability to fill the gaps and our expertise in structuring
transactions, many existing financial institutions and financial advisors see us
as partners. Commercial banks, venture capital firms and private equity funds
come to us for capital, advice and expertise. Our organization is excited
because the business plan that we talked to you about at the time of the IPO is
being executed and well received. We now have more than six months experience as
a public company and are very pleased with our performance. We have quickly and
very judiciously invested $55 million and are working to finalize a $15 million
investment in the near future. Additionally, the pipeline of new investment
opportunities continues to fill and we are confident in our ability to deliver
outstanding results.
We have expanded our Bethesda, New York City and San Francisco offices and are
planning to open additional offices and staff them with highly dedicated and
experienced principals and associates. We strongly believe that the success of
our business starts with our people and that we offer an exciting opportunity
for everyone at American Capital.
In closing, we would like to thank all of the employee owners of American
Capital whose energy and efforts have made this fine organization, our
outstanding board of directors for their advice and counsel and of course we
want to thank you, our shareholders, for the support and confidence you have in
us.
Sincerely,
/s/ David Gladstone
- -------------------
David Gladstone
Chairman of the Board
/s/ Malon Wilkus
- ----------------
Malon Wilkus
President
/s/ Adam Blumenthal
- -------------------
Adam Blumenthal
Executive Vice President
<PAGE>
- --------------------------------------------------------------------------------
CORPORATE INFORMATION
CORPORATE HEADQUARTERS
- ----------------------
3 Bethesda Metro Center
Ste. 860
Bethesda, Maryland 20814
(301) 951-6122
STOCK EXCHANGE LISTING
- ----------------------
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- ----------------------------
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DIVIDEND REINVESTMENT AND
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- -------------------
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typography.of computers and state of the art technology. Legibility, image
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ADUITORS
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text of this piece may look like set in this type size and sistent letter and
word spacing, characterconsistent letter of computers and state of the art
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LEGAL COUNSEL
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and word spacing, chtypography.
It is merely a representation
PRICE RANGE OF COMMON STOCK
AND DIVIDENDS
- -------------
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The criteria for quality typography have not changed with the applicaof
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<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Corporate Profile
American Capital Strategies is a buyout and specialty finance company with
capital resources exceeding $150 million. ACAS provides senior debt,
subordinated debt and equity to companies in need of capital for employee or
management buyouts, growth, acquisitions, liquidity and restructuring. ACAS
invests $1 to $20 million in businesses that typically have sales in excess of
$10 million. ACAS does not provide startup financing.
American Capital Strategies was founded in 1985 and completed its initial public
offering in August 1997. Its shares are traded on the NASDAQ stock market under
the symbol ACAS.
American Capital Strategies is headquartered in Bethesda, Maryland with offices
in Boston, New York, Pittsburgh, San Francisco, and Savannah.
Companies interested in learning more about American Capital Strategies and its
unique and flexible financing should visit the ACAS website at
www.AmericanCapital.com.
American Capital Strategies Selected Stock Prices
$25
$20
$15
$10
$5
$0
IPO 12/31/97 3/23/98
[Graph Omitted]
1
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Selected Financial Data
The selected financial data should be read in conjunction with the Company's
financial statements and notes thereto. As discussed in Notes 1 and 2, the
Company completed an initial public offering of its common stock on August 29,
1997 and on October 1, 1997 began to operate so as to qualify to be taxed as a
RIC. As a result of the changes, the financial results of the Company for
periods prior to October 1, 1997 are not comparable to periods commencing
October 1, 1997 and are not expected to be representative of the financial
results of the Company in the future.
<TABLE>
<CAPTION>
Three Months Nine Months
Ended Ended Year Ended December 31,
December 31, September 30, -------------------------------------------
1997 1997 1996 1995 1994 1993
---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
Total operating income ............ $ 2,796,667 $ 2,900,801 $2,746,422 $2,705,632 $2,498,231 $1,882,158
Total operating expenses .......... 551,061 2,651,029 2,861,697 2,927,709 2,605,758 1,659,172
------------ ------------ ---------- ---------- ---------- ----------
Operating income (loss)
before equity in earnings of
unconsolidated operating
subsidiary ..................... 2,245,606 249,772 (115,275) (222,077) (107,527) 222,986
Equity in earnings of
unconsolidated operating
subsidiary ..................... 24,213 -- -- -- -- --
------------ ------------ ---------- ---------- ---------- ----------
Net operating income (loss) ...... 2,269,819 249,772 (115,275) (222,077) (107,527) 222,986
Change in unrealized
appreciation on investments .... 167,573 5,321,421 483,665 370,696 956,294 (61,660)
Realized gain (loss)
on investments ................. -- -- -- 66,148 (22,784) --
------------ ------------ ---------- ---------- ---------- ----------
Income before income taxes ....... 2,437,392 5,571,193 368,390 214,767 825,983 161,326
Provision for income taxes ....... -- 2,128,610 159,251 57,381 421,664 (2,458)
------------ ------------ ---------- ---------- ---------- ----------
Net increase in shareholders'
equity resulting from
operations .................... 2,437,392 3,442,583 209,139 157,386 404,319 163,784
------------ ------------ ---------- ---------- ---------- ----------
Per share data:
Cash dividends ................ $ 0.21
Net operating
income Basic ........ $ 0.21
Diluted ...... $ 0.20
Net increase in shareholders'
equity resulting from
operations Basic ........ $ 0.22
Diluted ...... $ 0.21
Total assets .................... 150,705,354 154,322,393 5,432,265 4,382,994 3,930,365 2,821,611
Total shareholders' equity ...... 150,651,900 150,538,951 3,371,651 2,945,659 2,571,446 1,850,509
</TABLE>
2
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and
Results of Operations
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 report 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 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 therein. As discussed in Notes 1 and 2, the Company
completed an initial public offering (IPO) of its common stock on August 29,
1997 and on October 1, 1997 began to operate so as to qualify to be taxed as a
regulated investment company (RIC). After the IPO, the Company changed its
primary business plan and format from structuring and arranging financing for
buyout transactions on a fee for services basis to being a lender to and
investor in small and medium sized businesses. As a result of the changes, the
Company's predominant source of operating income has changed from financial
performance and advisory fees to interest and dividends earned from investing
the Company's assets in debt and equity of businesses. Additionally, pursuant to
RIC accounting requirements, effective October 1, 1997, the Company's accounting
for its operating subsidiary, ACS Capital Investment Corp. (CIC), changed from a
consolidated basis to the equity method. The financial results of the Company
for the periods through September 30, 1997 are not comparable to periods
commencing October 1, 1997 and are not expected to be representative of the
financial results of the Company in the future. Accordingly, those periods are
discussed separately.
Results of Operations
The Company's financial performance as reflected in its Statements of Operations
is composed of four primary elements. The first element is "Net operating income
(loss)," which for periods prior to October 1, 1997 (Pre-RIC) is the difference
between the Company's revenue earned from arranging commercial loans for small
and medium sized businesses and other financial advisory work and its total
operating expenses including ESOP contributions, depreciation and interest
expense. For periods prior to October 1, 1997, ESOP contributions represented a
significant component of total operating expenses. All required contributions to
the Company's ESOP have been made by the Company, and further contributions will
be made at the discretion of the Company's Board of Directors. Net operating
income (loss) for periods commencing October 1, 1997 (Post-RIC) is primarily the
interest and dividends earned from investing in debt and equity securities and
the equity in earnings of unconsolidated operating subsidiary less the operating
expenses of the Company. The second element is "Change in unrealized
appreciation of investments," which is the net change in the fair value of the
Company's portfolio assets at the end of the period compared with their fair
values at the beginning of the period or their stated costs, as appropriate. The
third element is "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
fourth element is "Provision for income taxes," which reflects a statutory tax
rate applied to the Company's GAAP pretax income for pre-RICperiods. Actual
taxes paid have historically been lower than the provision primarily due to the
temporary difference of the unrealized appreciation of investments which has
resulted in a deferred tax liability on the Company's balance sheet. For
post-RIC periods, the Company intends to operate so as to qualify to be taxed as
a RIC. As long as the Company qualifies as a RIC, it will be able to take a
deduction against its otherwise taxable income for certain dividends it pays,
allowing it to substantially reduce or eliminate its corporate-level tax
liability. As a result, the provisions for income taxes for post-RIC periods are
expected to be minimal.
As discussed above, as a RIC, the Company is required to account for investments
in operating subsidiaries under the equity method, regardless of ownership
interest. Accordingly, the Company's investment in CIC, which prior to RIC
status was consolidated, is presented on the equity method effective October 1,
1997. Therefore, commencing on October 1, 1997, and consistent with the equity
method of accounting, the portfolio companies owned by CIC are not reported
separately by the Company.
3
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Three months ended December 31, 1997
Operating results for the three months ended December 31, 1997 (post-RIC) are
summarized as follows:
Three Months Ended
December 31, 1997
-----------------
Operating income ........................................... $2,796,667
Operating expenses ......................................... 551,061
Equity in earnings of unconsolidated
operating subsidiary ..................................... 24,213
----------
Net operating income ....................................... 2,269,819
Change in unrealized appreciation
of investments ........................................... 167,573
----------
Net increase in shareholders' equity
resulting from operations ................................ $2,437,392
==========
Total operating income consisted of approximately $700,000 in loan processing
fees and $200,000 in interest on non- publicly traded securities and $1.9
million in interest on government agency securities and overnight repurchase
agreements. The loan fees were earned as a result of closing three investments
in private companies totaling $20.5 million during the period.
Operating expenses for the period consisted of $243,000 in salaries and benefits
and $308,000 in general and administrative expenses.
Equity in earnings of unconsolidated operating subsidiary represents CIC's
results including the portfolio companies. For the three months ended December
31, 1997, CIC's results included $414,000 of operating income, $987,000 of
operating expenses, $605,000 of unrealized appreciation of investment and $8,000
in tax provisions.
The change in unrealized appreciation of investments as discussed in Note 2 to
the financial statements is determined by the Company's Board of Directors. The
change in unrealized appreciation of investments for the three month period is
$167,000 which consists of an increase of $52,000 in the valuation of the
government agency securities and an increase of $115,000 in the valuation of the
investments in private companies.
Nine months ended September 30, 1997 compared to nine months ended September 30,
1996
Nine Months Ended
September 30,
1997 1996
---- ----
Operating income .......................... $ 2,900,801 $ 1,757,972
Operating expenses ........................ 2,651,029 1,921,195
----------- -----------
Net operating income (loss) ............... 249,772 (163,223)
Change in unrealized
appreciation of investments ............. 5,321,421 441,081
Provision for income taxes ................ 2,128,610 109,223
----------- -----------
Net increase in shareholders'
equity resulting from
operations .............................. $ 3,442,583 $ 168,635
=========== ===========
Total operating income was $2.9 million for the nine months ended September 30,
1997, compared to $1.8 million for the nine months ended September 30, 1996, a
65.0% increase. Financial advisory fees were $1.1 million and $1.3 million for
the nine months ended September 30, 1997 and 1996, respectively. The decline in
financial advisory fees was attributable to a relative increase in management
attention to engagements producing financial performance fees, and to the IPO.
Financial performance fees were $798,000 and $241,000 for the nine months ended
September 30, 1997 and 1996, respectively. The increase in financial performance
fees was associated with the Company's successful completion of an engagement to
advise the Allied Pilots Association on the structuring of an employee option
plan at American Airlines. Other operating income was $428,000 and $265,000 for
the nine months ended September 30, 1997 and 1996, respectively. The increase in
other operating income was attributable to a higher level of expense
reimbursement for the Company. Included in total operating revenue for the nine
months ended September 30, 1997 was interest income earned on investment
securities and overnight repurchase agreements of $553,000.
4
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Total operating expenses for the nine months ended September 30, 1997 and 1996
were $2.7 million and $1.9 million, respectively, an increase of 38.0%. Salaries
and benefits for the nine months ended September 30, 1997 and 1996, were $1.2
million and $935,000, respectively, a 30.6% increase which was predominantly
associated with increased levels of staffing. General and administrative
expenses for the nine months ended September 30, 1997 and 1996, were $1.5
million and $772,000, respectively, a 96.1% increase primarily associated with
the increased use of consultants by the Company. The increase in other expenses
is attributable to a variety of expenses associated with potential transactions.
For the nine months ended September 30, 1997 and 1996, interest expense was
$60,000 and $21,000, respectively. The increase in interest expense relates to
the Company's increased levels of working capital for the period in 1997 prior
to the initial public offering.
During the nine months ended September 30, 1997, the Company changed its
evaluation of collectibility of a receivable from Martino's Bakery, Inc. due to
Martino's improved financial condition, restructuring of repayment terms, and
subsequent payment history. Therefore, the Company recorded a reversal in its
provision for doubtful accounts totaling $177,000. During the nine months ended
September 30, 1996, the Company had accrued $164,000 as a provision for doubtful
accounts related to two companies, one of which was Martino's Bakery, Inc.
For the nine months ended September 30, 1997 and 1996, the Company recorded net
increases in unrealized appreciation of investments in its portfolio companies
of $5.3 million and $441,000, respectively. Included in unrealized appreciation
of investments during the first nine months of 1997 was $4.4 million associated
with the acquisition of Biddeford Textile Company, formerly the blanket
operation of the electric blanket manufacturing division of Sunbeam Products,
Inc. Also included in unrealized appreciation of investments during the first
nine months of 1997 was appreciation of $731,000 associated with the Company's
investment in Mobile Tool International, Inc., appreciation of $356,000
associated with Four S Baking Company, Inc., and depreciation of $138,000
associated with Martino's Bakery, Inc.
The following table sets forth the components of unrealized appreciation of
investments for the nine months ended September 30, 1997 and 1996:
Nine Months Ended
September 30,
1997 1996
---- ----
Government Securities ...................... $ (26,720) --
Erie Forge and Steel, Inc. ................. $ -- $152,930
Four S Baking Company, Inc. ................ 355,675 (54,000)
Indiana Steel & Wire Corporation ........... -- 6,792
Martino's Bakery, Inc. ..................... (138,250) 143,459
Mobile Tool International, Inc. ............ 731,111 191,900
Biddeford Textile Corporation .............. 4,399,605 --
----------- --------
Change in Unrealized Appreciation
of Investments ........................... $ 5,321,421 $441,081
=========== ========
The Company recorded provisions for income taxes for the nine months ended
September 30, 1997 and 1996 of $2.1 million and $109,000, respectively.
Unrealized appreciation (depreciation) of investments does not affect the actual
tax paid by the Company. However, under GAAP, the Company provides for income
taxes based on its GAAP pretax income, which includes unrealized appreciation
(depreciation) of investments. Actual income taxes paid may differ substantially
from the provision for income taxes. The Company accounted for this difference
by recognition of the deferred tax liability shown on the balance sheet.
Years ended December 31, 1996 and 1995
Year Ended
December 31,
1996 1995
---- ----
Operating income ............................. $2,746,422 $2,705,632
Operating expense excluding
ESOP contribution .......................... 2,645,814 2,710,882
ESOP contribution ............................ 215,883 216,827
---------- ----------
Total operating expense ...................... 2,861,697 2,927,709
---------- ----------
Net operating loss before
investment activity ........................ (115,275) (222,077)
Change in unrealized appreciation
of investments ............................. 483,665 370,696
Realized gain on investments ................. -- 66,148
Provision for income taxes ................... 159,251 57,381
---------- ----------
Net increase in shareholders' equity
resulting from operations .................. $ 209,139 $ 157,386
========== ==========
5
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Operating income consists predominantly of financial advisory fees, which are
hourly or periodic fees earned by the Company for providing advice and analysis
to small and medium sized businesses, and financial performance fees, which are
fees earned on a contingent basis for structuring, financing, or executing
transactions. During 1996, financial advisory fees and financial performance
fees constituted 86.9% of total revenue; during 1995, financial advisory fees
and financial performance fees constituted 90.1% of total revenue. During each
of the years ended December 31, 1996 and 1995, the Company earned operating
income of $2.7 million. Other components of operating income consisted primarily
of expense reimbursements.
Total operating expenses at the Company were $2.862 million in 1996, a 2.3%
decrease from $2.928 million in 1995. Salaries and benefits, excluding ESOP
contributions, were $1.5 million in 1995 and declined 28.1% to $1.1 million in
1996. The reduction in salaries and benefits is the result of an increased use
of outside consultants in the Company's financial advisory work and the
reduction in bonuses in 1996. General and administrative and other expenses
increased 51% from $.9 million in 1995, to $1.3 million in 1996. The increased
use of consultants was the primary reason for the increase in general and
administrative expenses from 1995 to 1996.
The Company's interest expense was $33,000 in 1996 and $37,000 in 1995. Interest
expense is primarily associated with credit facilities used by the Company to
support its working capital requirements and, beginning in 1996, to finance a
portion of its investments in small and medium sized businesses. The Company's
total borrowings under these facilities were approximately $430,000 at December
31, 1996 and $161,000 at December 31, 1995. In addition, the Company had a note
payable to its President in the amount of $74,000 at December 31, 1996 and
$66,000 at December 31, 1995. During 1995 and 1996, the Company has paid
interest on its debt obligations to unrelated parties at rates ranging from 1.5%
above the lender's base rate of interest to 3% above such rate. The rate of
interest on the Company's note payable to its President is 4% above the prime
rate of interest.
The Company made ESOP contributions of $216,000 in 1996 and $217,000 in 1995.
These contributions represent an allocation of the preferred stock held by the
ESOP to the Company's employees which preferred stock was converted into common
stock on a one for one basis on July 28, 1997. As a result, these contributions
did not result in a cash outflow from the Company. These contributions were
deductible for tax purposes and served to reduce the Company's tax obligations.
At December 31, 1996, unearned ESOP shares totaled $117,000, and the Company's
obligation to make further contributions to the ESOP was limited to that amount.
When an investment is sold, disposed of, or liquidated, the difference between
the ultimate value realized on the investment and its cost is shown as a
realized gain or loss on the investment. The Company realized a gain of $66,000
in 1995 on the sale of an investment in a portfolio company.
For the years ended December 31, 1996 and 1995, the Company recorded net
increases in unrealized appreciation of investments of $484,000 and $371,000,
respectively. Unrealized appreciation represents the periodic increases and
decreases in the fair market value of the investments in the Company's
portfolio. Fair market value is determined by the Board of Directors of the
Company, taking into account recent independent third party valuations of these
investments. The following chart sets forth the components of Change in
unrealized appreciation of investments for the years ended December 31, 1996 and
1995:
Year Ended
December 31,
1996 1995
---- ----
Erie Forge and Steel, Inc. ................... $203,808 $(208,937)
Four S Baking Company, Inc. .................. (81,000) 499,250
Indiana Steel & Wire Corporation ............. 9,057 (5,719)
Martino's Bakery, Inc. ....................... 156,500 (18,250)
Mobile Tool International, Inc. .............. 195,300 170,500
The C.M. Kemp Manufacturing
Company(1) ................................. -- (66,148)
-------- ---------
Change in Unrealized Appreciation
of Investments ............................. $483,665 $ 370,696
======== =========
- ----------
(1) The Company's investment in the C.M. Kemp Manufacturing Company (Kemp) was
sold in 1995 for a gain over the original cost of the investment. The
Company had recorded unrealized appreciation in the amount of this gain
prior to the sale and, thus, at the time of sale, Kemp was sold for the
value at which it was then reflected on the Company's balance sheet. The
Company then recorded depreciation of $66,000 in 1995 to reverse the
unrealized appreciation and recognize the realized appreciation associated
with the sale of Kemp.
6
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
During 1996 and 1995, the Company was taxed as a C Corporation. Unrealized
appreciation (depreciation) of investments does not affect the actual tax paid
by the Company. However, under GAAP, the Company provides for income taxes based
on its GAAP pretax income, which includes unrealized appreciation (depreciation)
of investments. The Company accounted for this difference by recognition of
deferred tax provisions of $159,000 in 1996 and $57,000 in 1995.
Financial Condition, Liquidity, and Capital Resources
The Company received proceeds of $143.6 million in connection with its IPO which
was completed on August 29, 1997. At December 31, 1997, the Company had $8.9
million in cash and cash equivalents and $112.8 million in investments in
Federal agency securities. 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 will provide shareholders with
the option of reinvesting their distributions in the Company, the Company
anticipates having to borrow to obtain liquidity after the proceeds of the IPO
have been fully invested in the debt and equity of small and medium sized
businesses. No assurance can be given that such liquidity will be obtainable, or
obtainable at interest rates favorable to the Company.
Impact of The Year 2000
The "Year 2000 Issue" is the result of computer programs being written using two
digits rather than four to define the applicable year. The Company's computer
programs that have time-sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or miscalculations causing disruption of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in similar normal business activities.
The Company principally utilizes for its internal accounting and administrative
requirements software written by third parties for sale to the public and not
specifically written for the Company. Many of these software developers are
reviewing and updating their programs to address the Year 2000 issue. The
Company does not anticipate that it has significant exposure to the Year 2000
issue for its internal accounting and administrative software. The Company
utilizes a commercial bank for loan processing and loan accounting. The Company
will receive an assessment from the commercial bank of the potential for
exposure and develop a plan to minimize or eliminate potential exposure in the
loan processing and accounting area during 1998. The Company invests and will
continue to invest in small and medium sized businesses. The Company will review
the Year 2000 issue with the investee companies and make a determination of the
potential impact. The Company currently cannot assess its exposure or the
potential impact of the Year 2000 issue on its investees.
7
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Balance Sheets
<TABLE>
<CAPTION>
December 31, December 31,
1997 1996
---- ----
<S> <C> <C>
Assets (Note 2)
Investments at fair value (cost or initial value of $133,274,408 and
$905,748, respectively) .................................................. $133,415,261 $3,980,421
Cash and cash equivalents .................................................. 8,862,416 322,664
Investment in unconsolidated operating subsidiary .......................... 6,868,880 --
Due from unconsolidated operating subsidiary ............................... 861,028 --
Interest receivable ........................................................ 643,687 --
Accounts receivable (net of allowance for doubtful accounts of
$0 and $249,609, respectively) ........................................... -- 917,625
Income taxes receivable .................................................... -- 52,225
Property and equipment:
Computer equipment ....................................................... -- 154,182
Office furniture and equipment ........................................... -- 96,827
Less: accumulated depreciation ........................................... -- (130,495)
------------ ----------
-- 120,514
Other ...................................................................... 54,082 38,816
------------ ----------
Total assets ............................................................... $150,705,354 $5,432,265
============ ==========
Liabilities and Shareholders' Equity
Accounts payable and accrued liabilities ................................... $ 53,454 $ 322,252
Due to related parties ..................................................... -- 78,142
Deferred taxes ............................................................. -- 1,230,536
Notes payable .............................................................. -- 429,684
------------ ----------
Total liabilities .......................................................... 53,454 2,060,614
Shareholders' equity:
Undesignated preferred stock, $0.01 par value, 90,000 and 5,000,000 shares
authorized, respectively, 0 issued and outstanding ..................... -- --
Class A preferred stock, $50 par value, 0 and 10,000 shares authorized,
respectively, and $0 and 6,857 issued and outstanding, respectively .... -- 1,419,399
Unearned ESOP shares ..................................................... -- (116,668)
Common stock, $.01 par value, 20,000,000 and 2,985,900 shares authorized,
and 11,068,767 and 481,058 issued and outstanding, respectively ........ 110,688 4,811
Capital in excess of par value ........................................... 144,939,913 10,407
Retained earnings ........................................................ -- 2,053,702
Undistributed net realized earnings ...................................... (54,624) --
Unrealized appreciation of investments ................................... 5,655,923 --
------------ ----------
Total shareholders' equity ................................................. 150,651,900 3,371,651
------------ ----------
Total liabilities and shareholders' equity ................................. $150,705,354 $5,432,265
============ ==========
</TABLE>
See accompanying notes.
8
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Schedule of Investments
December 31, 1997
<TABLE>
<CAPTION>
Effective
Interest Rate(1) Industry Cost Fair Value
---------------- -------- ---- ----------
<S> <C> <C> <C> <C>
Senior Debt--4.07%
Four S Baking Company ................................... 9.50%
11.00 Baking $ 1,825,477 $ 1,825,477
BIW Connector Systems, LLC .............................. Manufacturing 3,890,000 3,890,000
------------ ------------
Subtotal 5,715,477 5,715,477
Subordinated Debt--7.88%
Four S Baking Company ................................... 20.00 Baking 1,491,797 1,491,797
BIW Connector Systems, LLC .............................. 15.40 Manufacturing 6,350,260 6,350,260
Westwinds Group Holdings, Inc. .......................... 17.20 Restaurant 3,205,662 3,205,662
------------ ------------
Subtotal ................................................ 11,047,719 11,047,719
Convertible Preferred Stock(3)--1.64%
Four S Baking Company 15% dividend convertible into
51,390 shares of common stock or 10.89% of Co. ........ Baking 2,302,500 2,302,500
Common Stock Warrants(2)(3)--1.13%
Four S Baking Company 15,390 shares 3.26% of Co. ........ Baking 461,700 577,125
BIW Connector Systems, LLC 8% of LLC .................... Manufacturing 652,000 652,000
Westwinds Group Holdings, Inc. 5% of Co. ................ Restaurant 350,000 350,000
------------ ------------
Subtotal ................................................ 1,463,700 1,579,125
Subtotal--non-publicly traded securities--14.72% ........ 20,529,396 20,644,821
Government Securities--80.39%
FHLB Discount Note due 2/4/98 ........................... 20,969,205 20,981,628
FHLB Discount Note due 3/6/98 ........................... 10,892,628 10,898,000
FHLB Discount Note due 4/1/98 ........................... 9,865,203 9,868,130
FNMA Discount Note due 4/24/98 .......................... 6,877,260 6,883,007
FFCB 5.90% due 6/2/98 ................................... 20,016,853 20,016,000
FHLB Discount Note due 6/8/98 ........................... 14,645,792 14,643,875
FHLB Discount Note due 8/20/98 .......................... 14,483,150 14,479,800
FNMA 5.71% due 9/9/98 ................................... 14,994,920 15,000,000
------------ ------------
Total Investments ....................................... 12,745,011 112,770,440
Investment in Unconsolidated Operating
Subsidiary--4.90%
ACS Capital Investment Corporation(3)(2)--100% of Co. ... Banking 402,700 6,868,880
------------ ------------
Totals .................................................. $133,677,107 $140,284,141
============ ============
Schedule of Investments
December 31, 1996
Industry Cost Fair Value
-------- ---- ----------
Common Stock(2)
Erie Forge and Steel, Inc. 120,773 Shares ............. Manufacturing $ 500,000 $ 2,736,418
Four S Baking Company 27,000 Shares ............. Baking 67,750 486,000
Indiana Steel & Wire
Corporation 7,547 Shares ............. Manufacturing 42,914 58,869
Martino's Bakery, Inc. 50,000 Shares ............. Baking 120,750 259,000
Mobile Tool International,
Inc. 6,130 Shares ............. Manufacturing 74,334 440,134
------------ ------------
Totals .................................................. $ 905,748 $ 3,980,421
============ ============
</TABLE>
- ----------
(1) Effective interest rate includes amortization of original issue discount if
any
(2) Non-income producing
(3) Affiliate
See accompanying notes.
9
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Statements of Operations
<TABLE>
<CAPTION>
Three Months Nine Months Year Ended
Ended Ended --------------------------
December 31, September 30, December 31, December 31,
1997 1997 1996 1995
<S> <C> <C> <C> <C>
Operating Income (Note 2)
Financial advisory fees ................................. -- $1,122,357 $1,738,295 $1,148,752
Financial performance fees .............................. -- 797,600 649,030 1,288,797
Interest income ......................................... $2,122,876 553,267 -- --
Loan processing fees .................................... 653,568 -- -- --
Other ................................................... 20,223 427,577 359,097 268,083
---------- ---------- ---------- ----------
Total operating income .................................. 2,796,667 2,900,801 2,746,422 2,705,632
Operating Expenses
Salaries and benefits ................................... 243,142 1,220,907 1,283,198 1,701,660
General, administrative and other ....................... 307,919 1,514,122 1,282,195 851,314
Provision for (reversal of) doubtful accounts ........... -- (177,198) 224,329 302,283
Interest ................................................ -- 60,034 32,959 37,037
Depreciation and amortization ........................... -- 33,164 39,016 35,415
---------- ---------- ---------- ----------
Total operating expenses ................................ 551,061 2,651,029 2,861,697 2,927,709
---------- ---------- ---------- ----------
Operating income (loss) before equity in earnings of
unconsolidated operating subsidiary ................... 2,245,606 249,772 (115,275) (222,077)
Equity in earnings of unconsolidated operating
subsidiary ............................................ 24,213 -- -- --
---------- ---------- ---------- ----------
Net operating income (loss) ............................. 2,269,819 249,772 (115,275) (222,077)
Realized gain on investments ............................ -- -- -- 66,148
Change in unrealized appreciation of investments ........ 167,573 5,321,421 483,665 370,696
---------- ---------- ---------- ----------
Income before income taxes .............................. 2,437,392 5,571,193 368,390 214,767
Provision for income taxes .............................. -- 2,128,610 159,251 57,381
---------- ---------- ---------- ----------
Net increase in shareholders' equity resulting
from operations ....................................... $2,437,392 $3,442,583 $ 209,139 $ 157,386
========== ========== ========== ==========
Net operating income per share Basic ......... $ 0.21
Diluted ....... $ 0.20
Net increase in shareholders' equity Basic ......... $ 0.22
resulting from operations per share Diluted ....... $ 0.21
Weighted average shares of Basic ......... 11,068,767
common stock outstanding Diluted ....... 11,405,385
</TABLE>
See accompanying notes.
10
<PAGE>
AMERICAN CAPITAL STRATEGIES, INC.
- --------------------------------------------------------------------------------
Statements of Shareholders' Equity
<TABLE>
<CAPTION>
Unearned Common Stock Capital
Preferred ESOP ------------------ in Excess of Retained
Stock Shares Shares Amount Par Value Earnings
----- ------ ------ ------ --------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance at
December 31, 1994 ........... $ 1,419,399 $(549,378) 480,312 $ 4,804 $ 9,444 $ 1,687,177
Net increase in share-
holders' equity result-
ing from operations ....... -- -- -- -- -- 157,386
ESOP shares earned .......... -- 216,827 -- -- -- --
----------- --------- --------- ------- ------------ -----------
Balance at
December 31, 1995 ........... $ 1,419,399 $(332,551) 480,312 $ 4,804 $ 9,444 $ 1,844,563
Net increase in share-
holders' equity result-
ing from operations ......... -- -- -- -- -- 209,139
Options exercised ............. -- -- 746 7 963 --
ESOP shares earned ............ -- 215,883 -- -- -- --
----------- --------- --------- ------- ------------ -----------
Balance at
December 31, 1996 ........... $ 1,419,399 $(116,668) 481,058 $ 4,811 $ 10,407 $ 2,053,702
----------- --------- --------- ------- ------------ -----------
Net increase in share-
holders' equity result-
ing from operations ....... -- -- -- -- -- 3,442,583
Contribution of common
stock to ESOP ............. -- -- 529 5 7,930 (7,935)
Conversion of preferred
stock to common
stock ..................... (1,419,399) -- 204,743 2,047 1,417,352 --
Issuance of common
stock ..................... -- -- 10,382,437 103,825 143,504,224 --
ESOP shares earned .......... -- 116,668 -- -- -- --
----------- --------- --------- ------- ------------ -----------
Balance at
September 30, 1997 .......... $ -- $ -- 11,068,767 $110,688 $144,939,913 $ 5,488,350
=========== ========= ========== ======== ============ ===========
Effect of reorganization as
a RIC (Note 2) ............ -- -- -- -- -- (5,488,350)
Net increase in share-
holders' equity result-
ing from operations ....... -- -- -- -- -- 2,437,392
Distributions ............... -- -- -- -- -- (2,324,443)
----------- --------- --------- ------- ------------ -----------
Balance at
December 31, 1997 ........... $ -- $ -- 11,068,767 $110,688 $144,939,913 $ 5,601,299
=========== ========= ========== ======== ============ ===========
</TABLE>
<TABLE>
<CAPTION>
Undistributed Unrealized Total
Net Realized Appreciation Shareholders'
Earnings of Investments Equity
-------- -------------- ------
<S> <C> <C> <C>
Balance at
December 31, 1994 ........... $ 2,571,446
Net increase in share-
holders' equity result-
ing from operations ......... 157,386
ESOP shares earned .......... 216,827
----------- ---------- ------------
Balance at
December 31, 1995 ........... $ 2,945,659
----------- ---------- ------------
Net increase in share-
holders' equity result-
ing from operations ......... 209,139
Options exercised ............. 970
ESOP shares earned ............ 215,883
----------- ---------- ------------
Balance at
December 31, 1996 ........... $ 3,371,651
----------- ---------- ------------
Net increase in share-
holders' equity result-
ing from operations ....... 3,442,583
Contribution of common
stock to ESOP ............. --
Conversion of preferred
stock to common
stock ..................... --
Issuance of common
stock ..................... 143,608,049
ESOP shares earned .......... 116,668
----------- ---------- ------------
Balance at
September 30, 1997 .......... $150,538,951
=========== ========== ============
Effect of reorganization as
a RIC (Note 2) ............ $ 5,488,350
Net increase in share-
holders' equity result-
ing from operations ....... $ 2,269,819 167,573 --
Distributions ............... (2,324,443) -- --
----------- ---------- ------------
Balance at
December 31, 1997 ........... $ (54,624) $5,655,923 $150,651,900
=========== ========== ============
</TABLE>
See accompanying notes.
11
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Statements of Cash Flows
<TABLE>
<CAPTION>
Three Months Nine Months Year Ended
Ended Ended -----------------------------
December 31, September 30, December 31, December 31,
1997 1997 1996 1995
---- ---- ---- ----
<S> <C> <C> <C> <C>
Operating activities (Note 2)
Net increase in shareholders' equity resulting
from operations .................................... $ 2,437,392 $ 3,442,583 $ 209,139 $ 157,386
Adjustments to reconcile net increase in
shareholders' equity resulting from
operations to net cash provided by
(used in) operating activities:
Depreciation and amortization .................. -- 32,332 39,016 35,415
Unrealized appreciation of investments ......... (167,537) (5,321,421) (483,665) (370,696)
Realized gain on investments ................... -- -- -- (66,148)
Net amortization of securities ................. (1,233,443) (337,159) -- --
Amortization of deferred finance costs ......... -- 3,357 11,088 7,332
Provision for deferred income taxes ............ -- 2,102,243 120,578 115,485
Loss on disposal of property
and equipment ................................ -- -- 629 91
ESOP contribution .............................. -- 116,668 215,883 216,827
Increase in interest receivable ................ (206,946) (122,074) -- --
Provision for doubtful accounts ................ -- (177,198) 224,329 302,283
Increase in due from unconsolidated
operating subsidiary ......................... (526,149) -- -- --
Increase in accounts receivable ................ -- 486,198 (865,311) (182,056)
(Increase) decrease in income taxes receivable.. -- 24,554 100,922 (32,822)
Decrease (increase) in other assets ............ 61,947 (112,483) 5,665 (3,554)
Increase (decrease) in accounts payable and
accrued liabilities .......................... (328,195) 128,419 227,930 29,538
Gain of unconsolidated operating subsidiary .... (24,213) -- -- --
------------ ------------- --------- ---------
Net cash provided by (used in) operating activities .... 12,856 266,019 (193,797) 209,081
Investing activities
Proceeds from sale or maturity of investments ........ 35,000,000 60,000 -- 66,148
Purchase of investments .............................. (20,529,396) (482,889) (74,640) (6,674)
Purchase of securities ............................... (16,592,667) (129,896,447) -- --
Purchases of property and equipment,
net of disposals ................................... -- (28,415) (39,669) (20,304)
------------ ------------- --------- ---------
Net cash provided by (used in) investing activities .... (2,122,063) (130,347,751) (114,309) 39,170
Financing activities
Proceeds from notes payable .......................... -- 589,625 429,684 --
Principal payments of notes payable .................. -- (1,019,309) (160,833) (77,500)
Increase in deferred finance costs ................... -- -- (4,000) (25,849)
Increase (decrease) in due to related parties ........ -- (78,142) 5,920 10,893
Issuance of common stock ............................. -- 143,608,049 -- --
Options exercised .................................... -- -- 970 --
Distributions ........................................ (2,324,443) -- -- --
------------ ------------- --------- ---------
Net cash provided by (used in) financing activities .... (2,324,443) 143,100,223 271,741 (92,456)
------------ ------------- --------- ---------
Net increase (decrease) in cash and cash equivalents ... (4,433,650) 13,018,491 (36,365) 155,795
Cash and cash equivalents at beginning of year ......... 13,296,066 322,664 359,029 203,234
------------ ------------- --------- ---------
Cash and cash equivalents at end of year ............... $ 8,862,416 $ 13,341,155 $ 322,664 $ 359,029
============ ============= ========= =========
</TABLE>
See accompanying notes.
12
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Financial Highlights
<TABLE>
<CAPTION>
Three Months Ended
December 31, 1997
-----------------
<S> <C>
Per Share Data(1)
Net asset value at beginning of the period $ 13.60
Net operating income 0.21
Net realized and unrealized gains on investments 0.01
------------
Net increase in shareholders' equity from operations 0.22
Distribution of net investment income 0.21
------------
Net asset value at end of period $ 13.61
Per share market value at end of period $ 18.125
Shares outstanding at end of period 11,068,767
Ratio/Supplemental Data
Net assets at end of period $150,651,900
Ratio of operating expenses to average net assets(2) 1.46%
Ratio of net operating income to net assets(2) 6.03%
</TABLE>
- ----------
(1) Basic per share data
(2) Amounts were annualized since the results are for a three-month period.
See accompanying notes.
13
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Notes to Financial Statements
Note 1. Organization
American Capital Strategies, Ltd. (the Company) is a Delaware Corporation formed
in 1986 to provide merchant banking services to and invest in small and medium
sized businesses.
On August 29, 1997, the Company completed an initial public offering (IPO) of
10,382,437 shares of common stock, and elected to be treated as a Business
Development Company under the Investment Company Act of 1940, as amended. On
October 1, 1997, the Company began operations so as to qualify to be taxed as a
regulated investment company (RIC) as defined in Subtitle A, Chapter 1, under
Subchapter M of the Internal Revenue Code. As contemplated by these
transactions, the Company materially changed its business plan and format from
structuring and arranging financing for buyout transactions on a fee for
services basis to primarily being a lender to and investor in small and medium
sized companies. As a result of the changes, the Company is operating as a
holding company whose predominant source of operating income has changed from
financial performance and advisory fees to interest and dividends earned from
investing the Company's assets in debt and equity of businesses. The Company's
investment objectives are to achieve current income from the collection of
interest and dividends, as well as long-term growth in its shareholders' equity
through appreciation in value of the Company's equity interests. The Company
also provides financial advisory services to businesses through ACS Capital
Investment Corporation (CIC), a wholly-owned subsidiary. The Company is
headquartered in Bethesda, Maryland, and has offices in New York, Boston,
Pittsburgh, San Francisco, and Savannah.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying financial statements have been prepared in accordance with
generally accepted accounting principles and for periods commencing with the
Company's election to be treated as a RIC, in accordance with Article 6 of
Regulation S-X of the Code of Federal Regulations. For the nine months ended
September 30, 1997 and the years ended December 31, 1996 and 1995 the financial
statements are prepared on a consolidated basis with the accounts of the CIC,
the Company's wholly owned subsidiary. All intercompany transactions and
balances were eliminated. Effective October 1, 1997, pursuant to RIC accounting
requirements, CIC was deconsolidated, and, as a result, for the three months
ended December 31, 1997 the Company accounted for its investment in CIC under
the equity method. In connection with this change, the Company contributed the
following assets and liabilities to CIC:
Investment in Erie Forge and Steel ................................. $2,736,418
Other assets ....................................................... $ 791,228
Other liabilities .................................................. $ 68,996
Deferred tax liability ............................................. $3,332,771
As a result of these changes, the Company's financial statements for periods
through September 30, 1997 (pre-RIC periods) are not comparable with the
financial statements for periods commencing after October 1, 1997 (post-RIC
periods).
Valuation of Investments
Investments are carried at fair value, as determined by the Board of Directors.
Securities which are publicly traded are valued at the closing bid price on the
valuation date.
Debt and equity securities which are not publicly traded, are valued at fair
value as determined in good faith by the Board of Directors. In making such
determination, the Board of Directors will value non-convertible debt securities
at cost plus amortized original issue discount, if any, unless adverse factors
lead to a determination of a lesser valuation. In valuing convertible debt,
equity or other securities, the Board of Directors determines the fair value
based on the collateral, the issuer's ability to make payments, the earnings of
the issuer, sales to third parties of similar securities and other pertinent
factors. Due to the uncertainty inherent in the valuation process, such
estimates of fair value may differ significantly from the values that would have
been used had a ready market for the securities existed, and the differences
could be material.
Cash and Cash Equivalents
Cash and cash equivalents consist of demand, deposits and highly liquid
investments with original maturities of three months or less. Cash and cash
equivalents are carried at cost which approximates fair value.
Interest and Dividend Income Recognition
Interest income is recorded on the accrual basis to the extent that such amounts
are expected to be collected. Original issue discount is amortized into interest
income using the effective interest method. Dividend income is recognized on the
ex-dividend date.
14
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Financial Advisory and Performance Fee Recognition
Financial advisory fees represent amounts received for providing advice and
analysis to small and medium sized businesses and are recognized as earned based
on hours incurred. Financial performance fees represent amounts received for
structuring, financing, and executing transactions and are generally payable
only if the transaction closes and are recognized as earned when the transaction
is completed. Financial advisory and performance fees are for services provided
by CIC.
Loan Processing Fee Recognition
Loan processing fees are recorded as income on the closing date of the related
loan.
Realized Gain or Loss and Unrealized Appreciation
or Depreciation on Investments
Realized gain or loss is recorded at the disposition of an investment and is the
difference between the net proceeds from the sale and the cost basis of the
investment. Unrealized appreciation or depreciation reflects the difference
between the Board of Directors' valuation of the investments and the cost basis
of the investments.
Distributions to Shareholders
Distributions to shareholders are recorded on the ex-dividend date.
Federal Income Taxes
The Company operates so as to qualify to be taxed as a RIC under the Internal
Revenue Code. Generally, a RIC is entitled to deduct dividends it pays to its
shareholders from its income to determine "taxable income." The Company has
distributed and currently intends to distribute sufficient dividends to
eliminate taxable income. Therefore, the statement of operations contains no
provision for income taxes for the three months ended December 31, 1997.
During the pre-RIC periods, the Company operated under Subchapter C of the
Internal Revenue Code and calculated its tax provision pursuant to Statement of
Financial Accounting Standards No. 109. Deferred income taxes were determined
based on the differences between financial reporting and tax basis of assets and
liabilities.
Use of Estimates in Preparation of
Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets, liabilities, revenues and expenses and
disclosure of contingent assets and liabilities. Actual results could differ
from those estimates.
Property and Equipment
Property and equipment is carried at cost and is depreciated using the
straight-line method over the estimated useful lives of the related assets
ranging from five to seven years.
Management Fees
The Company is self-managed and therefore does not incur management fees payable
to third parties.
Reclassifications
Certain previously reported amounts have been reclassified to conform with the
current financial statement presentation.
Recent Accounting Pronouncements
In February, 1997, the Financial Accounting Standards Board issued Statement No.
128, "Earnings Per Share," (SFAS 128). The Company adopted SFAS 128 for the
three months ended December 31, 1997. The Company has not restated the earnings
per share for prior periods since it is not meaningful due to the significant
change in the Company's capital structure as a result of the IPO, and its change
in operating activities to a RIC on October 1, 1997.
In June 1997, Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income" (SFAS 130) was issued and is effective for fiscal years
beginning after December 15, 1997. SFAS 130 establishes standards for the
reporting and display of comprehensive income and its components (revenues,
expenses, gains, losses) in a full set of general purpose financial statements.
SFAS 130 requires the disclosure of an amount that represents total
comprehensive income and the components of comprehensive income in a financial
statement. The adoption of SFAS 130 is not expected to have a material impact on
the financial statements of the Company.
In June 1997, Statement of Financial Accounting Standards No. 131, "Disclosures
about Segments of an Enterprise and Related Information" (SFAS 131) was issued
and is effective for fiscal years beginning after December 15, 1997. SFAS 131
establishes standards for determining an entity's operating segments and the
type and level of financial information to be disclosed in both annual and
interim financial statements. It also establishes standards for related
disclosures about products and services, geographic areas and major customers.
The adoption of SFAS 131 is not expected to have a material impact on the
financial statements of the Company.
15
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Notes to Financial Statements (Continued)
Note 3. Investments
Investments consists of securities issued by various agencies of the Federal
government valued at $112,770,440 with maturities of less than one year from the
date of purchase and securities issued by privately-held companies valued at
$20,644,821. The securities issued by privately-held companies consists of
senior loans, subordinated loans with equity warrants, convertible preferred
stock and common stock. The loans have effective interest rates ranging from
9.5% to 20% and are payable in installments with final maturities from 5 to 7
years and are collateralized by assets of the borrower. The Company's
investments in equity warrants and common stock are non-income producing. The
net unrealized appreciation in investments for Federal income tax purposes is
the same as for book purposes and none of the Company's investments are on
non-accrual status.
Note 4. Investment in Unconsolidated
Operating Subsidiary
As discussed in Note 2, CIC is an operating subsidiary of the Company and is
accounted for under the equity method effective October 1, 1997. The investment
in CIC is carried at fair value as determined by the Board of Directors.
Condensed financial information for CICat December 31, 1997 and for the three
months then ended is as follows:
Assets
Investments in portfolio companies,
at fair value.................................. $10,360,904
Other assets, net................................ 990,926
-----------
Total assets................................... $11,351,830
===========
Liabilities and Shareholder's Equity
Deferred income taxes............................ $ 3,322,688
Due to parent.................................... 861,028
Other liabilities................................ 299,234
Shareholder's Equity............................. 6,868,880
-----------
Total liabilities and shareholder's equity......... $11,351,830
===========
Total revenue...................................... $ 532,496
Operating expense.................................. 1,084,570
-----------
Net operating loss............................... (552,074)
Unrealized appreciation of investments............. 605,045
Other.............................................. (28,758)
-----------
Net income......................................... $ 24,213
===========
Note 5. Stock Option Plan
The Company applies APB 25 and related interpretations in accounting for its
stock-based compensation plan. In accordance with SFAS 123, "Accounting for
Stock-Based Compensation," the Company elected to continue to apply the
provisions of APB 25 and provide pro forma disclosure of the Company's net
operating income and net increase in shareholders' equity resulting from
operations calculated as if compensation costs were computed in accordance with
SFAS 123. The Company is providing this information for the post-RICperiod as
discussed in Notes 1 and 2 and from the time the 1997 Stock Option plan was
established by the Company.
Three months ended
December 31, 1997
-----------------
Net operating income as reported ...... $2,269,819
pro forma ........ $2,029,525
Net increase in shareholders'
equity resulting from operations as reported ...... $2,437,392
pro forma ........ $2,197,098
The effects of applying SFAS 123 for providing pro forma disclosures are not
likely to be representative of the effects on reported net operating income and
net increase in shareholders' equity resulting from operations for future years.
The Company estimated a fair value per option on the date of grant of $2.33
using a Black-Scholes option pricing model and the following assumptions;
dividend yield 6.5%, risk free interest rate 6.5%, expected volatility factor
.25, expected lives of the options of 7 years, and an annual forfeiture rate of
5%.
The Company established the 1997 Stock Option Plan (the 1997 Plan) which
provides for the granting of options to purchase common stock at a price of not
less than the fair market value of the common stock on the date of issuance to
employees of the Company. There are 1,328,252 shares available to be granted
under the 1997 Plan. Upon closing the IPO, the Company granted 1,302,703 fixed
options at $15.00 per share, the market value at the date of grant. At December
31, 1997, all of the granted options were outstanding.
On November 6, 1997, the Board of Directors authorized the establishment of a
stock option plan for the non- employee directors. The plan must receive
shareholder approval at the annual meeting to be held on May 14, 1998 before it
becomes effective. Upon shareholder approval, the Board of Directors has
authorized the Company to issue 15,000 options to each of the six non-employee
directors.
16
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Notes to Financial Statements (Continued)
Note 6. Related Parties
ACS Partners I, L.P. was formed with a wholly owned subsidiary of the Company as
sole general partner and several principals of the Company as limited partners
to allow the principals the opportunity to co-invest in transactions with the
Company. Pursuant to the terms of the partnership agreement of ACS Partners I,
L.P. , the Company through its wholly owned subsidiary as sole general partner
has all discretion over the purchase, sale, restructuring and disposition of the
assets of ACS Partners I, L.P. As of December 31, 1997, principals of the
Company had invested $260,000 in ACS Partners I, L.P.
As of December 31, 1996, the Company had a note payable to its president for
approximately $74,000. The interest rate was based on prime plus 4%. The related
interest expense for the nine months ended September 30, 1997 and the years
ended December 31, 1996 and 1995 was approximately $6,000, $8,000 and $3,000,
respectively. In August 1997, the Company repaid the note in full.
The Company and CIC have entered into an expense sharing agreement whereby CIC
reimburses the Company for expenses paid by the Company on CIC's behalf.
Note 7. Notes Payable
At December 31, 1996, the Company had a line of credit with a term conversion
provision with a finance company. During the first two years of the agreement,
the Company had the ability to borrow up to $500,000 with interest payable
monthly. The balance outstanding after the initial two-year period was repayable
as a term loan in equal monthly installments of principal plus accrued interest
over three years. The interest rate was the finance company's base rate plus
1.5%. This arrangement was secured by accounts receivable, furniture, fixtures,
equipment, and 56,270 shares of common stock in Erie Forge and Steel, one of the
Company's investments. At December 31, 1996, the outstanding balance was
approximately $283,000, and the interest rate was 9.75%. In July 1997, the
Company repaid the outstanding balance and closed the line of credit.
At December 31, 1996, the Company had a term loan commitment with a finance
company in the amount $750,000 which was subject to a two-year draw down period
ending in October 1997. The interest rate was the finance company's base rate
plus 3%. This arrangement was secured by accounts receivable, furniture,
fixtures, equipment, and the Company's investments in shares of common stock. At
December 31, 1996, the outstanding balance was approximately $146,000, was due
in 2001, and the interest rate was 11.25%. On May 30, 1997, certain terms of the
above described loan were amended. The term loan commitment was increased from
$750,000 to $1,000,000 and the draw down period was extended until May 1999.
Interest only was assessed over a four year term from the date of the draw, and
thereafter, monthly payments of principal and interest are payable until all
outstanding amounts became fully due in May 2004. In August 1997, the Company
repaid the outstanding balance of $636,000 and extinguished the note.
During the nine months ended September 30, 1997 and the years ended December 31,
1996 and 1995, the cash paid for interest was approximately $88,000, $43,000 and
$36,000, respectively. The weighted average interest rates, including
amortization of deferred finance costs, for the years nine months ended
September 30, 1997 and the years ended December 31, 1996 and 1995 were 16.9%,
17.3% and 13.7%, respectively. There was no outstanding debt at December 31,
1997.
Note 8. Income Taxes
Significant components of the Company's deferred tax liabilities and assets were
as follows:
December 31,
1996
----
Deferred tax liabilities:
Investments ............................................. $1,303,911
Depreciation ............................................ 21,393
----------
1,325,304
Deferred tax assets:
Net operating loss carryforward ......................... 63,085
Alternative minimum tax ................................. 25,509
Other ................................................... 6,174
----------
94,768
----------
Net deferred tax liabilities ............................ $1,230,536
==========
The components of the income tax provision were as follows:
Year Ended
December 31,
1996 1995
---- ----
Current provision (benefit) ............................ $ 38,673 $(58,104)
Deferred provision ..................................... 120,578 115,485
-------- --------
$159,251 $ 57,381
======== ========
17
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Notes to Financial Statements (Continued)
The differences between taxes at the Federal statutory tax rate and the
effective tax rate were as follows:
<TABLE>
<CAPTION>
Nine Months
Ended Year Ended
Sept. 30 December 31,
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Statutory rate ................ $1,803,681 $125,253 $ 73,021
State taxes ................... 342,218 14,747 8,589
Change in valuation
allowance ................... -- (25,509) (19,130)
Other ......................... (17,289) 44,760 (5,099)
---------- -------- --------
Effective rate ................ $2,128,610 $159,251 $ 57,381
========== ======== ========
</TABLE>
During the nine months ended September 30, 1997 and years ended December 31,
1996 and 1995, cash paid for income taxes was approximately $2,000, $1,000 and
$45,000, respectively.
The aggregate gross and net unrealized appreciation over the cost for Federal
income tax purposes was $7,413,705, $3,399,423 and $2,915,758 as of December 31,
1997, 1996 and 1995, respectively. The aggregate cost of securities for Federal
income tax purposes were $132,870,434, $580,998 and $506,664 as of December 31,
1997, 1996 and 1995, respectively.
As discussed in Note 1, the Company has historically been taxed under subchapter
C and is currently operating so as to qualify and intends to file as a
subchapter M corporation for Federal income tax purposes. The tax consequences
of converting a corporation from taxation under subchapter C to subchapter M are
uncertain. The Company has requested a ruling from the IRS to clarify the
consequences of the conversion. The Company expects to receive a favorable
ruling but there are no assurances that it will receive a favorable ruling. If
the Company does not receive a timely favorable ruling, it intends to treat the
conversion as a deemed sale which will result in taxes of approximately $3.1
million and will result in the Company declaring an additional dividend of
approximately $5.9 million.
Note 9. Lease Commitments
The Company has non-cancelable operating leases for office space and office
equipment. The leases expire over the next seven years and contain provisions
for certain annual rental escalations.
Rent expense for operating leases for three months ended December 31, 1997, the
nine months ended September 30, 1997 and the years ended December 31, 1996 and
1995, was approximately $73,000, $97,000, $101,000 and $95,000, respectively.
Future minimum lease payments under non-cancelable operating leases at December
31, 1997 were as follows:
1998 ............................................................... $ 331,000
1999 ............................................................... 237,000
2000 ............................................................... 237,000
2001 ............................................................... 242,000
2002 and thereafter ................................................ 604,000
----------
Total .............................................................. $1,653,000
==========
Note 10. Employee Stock Ownership Plan
The Company maintains an ESOP, which includes all employees and is fully funded
by the Company. Contributions are made at the Company's discretion up to $30,000
or 25% of annual compensation expense for each employee. Employees are not fully
vested until completing five years of service.
The Company sponsors an employee stock ownership trust to act as the depository
of employer contributions to the ESOP as well as to administer and manage the
actual trust assets which are deposited into the ESOP.
Note 11. Capital Stock
In July, 1997, all unearned ESOP shares became earned and were distributed to
the employees. Pursuant to the Company's Class A preferred stock declaration,
the Class A preferred stock held by the ESOP was converted into common stock on
a one share to one share basis. The Company also contributed an additional 529
shares of common stock to the ESOP.
In August 1997, the Company increased its authorized shares of unallocated
preferred stock to 5,000,000 and increased its authorized shares of common stock
to 20,000,000.
On August 27, 1997, the Company declared a stock split effective August 29,
1997, effected in the form of a stock dividend pursuant to which each
outstanding share of common stock was effectively converted into 29.859 shares.
Outstanding shares and per share amounts for all periods presented have been
restated to reflect this stock split.
18
<PAGE>
AMERICAN CAPITAL STRATEGIES, LTD.
- --------------------------------------------------------------------------------
Notes to Financial Statements (Continued)
On August 29, the Company completed its IPO and sold 10,382,437 shares of its
common stock at a price of $15.00 per share. Pursuant to the terms of the
Company's agreement with the underwriter of the offering, the Company issued
442,751 common stock warrants (Warrants) to the underwriter. The Warrants have a
term of five years from the date of issuance and may be exercised at a price of
$15.00 per share.
The Company distributed $2,324,443 or $0.21 per share to its shareholders for
the three months ended December 31, 1997. For Federal income tax purposes, the
distribution was 100% from ordinary income.
Note 12. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per
share for the three months ended December 31, 1997. For all other periods,
earnings per share is not presented since it is not considered meaningful due to
the IPO and reorganization of the Company as a RIC.
Three Months Ended
December 31, 1997
-----------------
Numerator for basic and diluted
net increase in shareholders' equity
resulting from operations.............................. $ 2,437,392
Denominator for basic-weighted
average shares......................................... 11,068,767
Employee stock options................................... 251,232
Warrants................................................. 85,386
-----------
Dilutive potential common shares......................... 333,618
-----------
Denominator for diluted.................................. 11,405,385
===========
Basic earnings per share................................. $ 0.22
Diluted earnings per share............................... $ 0.21
19
<PAGE>
- --------------------------------------------------------------------------------
Report of Independent Auditors
Board of Directors
American Capital Strategies, Ltd.
We have audited the accompanying balance sheets of American Capital Strategies,
Ltd., including the schedules of investments, as of December 31, 1997 and 1996,
the related statements of operations, shareholders' equity and cash flows for
the three months ended December 31, 1997, the nine months ended September 30,
1997, the years ended December 31, 1996 and 1995, and the financial highlights
for the three months ended December 31, 1997. These financial statements and the
financial highlights are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material aspects, the financial position of American Capital Strategies,
Ltd. at December 31, 1997 and 1996, and the results of its operations and its
cash flows for the three months ended December 31, 1997, the nine months ended
September 30, 1997, the years ended December 31, 1996 and 1995, and the
financial highlights for the three months ended December 31, 1997 in conformity
with generally accepted accounting principles.
Ernst & Young LLP
Washington, D.C.
February 12, 1998
20
<PAGE>
- --------------------------------------------------------------------------------
Corporate Information
Corporate Headquarters
- ----------------------
American Capital Strategies
3 Bethesda Metro Center
Suite 860
Bethesda, MD 20814
http://www.finance-company.com
Stock Exchange Listing
- ----------------------
American Capital Strategies is listed on the National Association of Securities
Dealers (NASDAQ Symbol: ACAS). Price information for the common stock appears
daily in major newspapers.
Transfer Agent and Registrar
- ----------------------------
Boston EquiServe, LP
150 Royall Street
Canton, MA 02021
(781) 575-2393
Financial Publications
- ----------------------
Shareholders may receive a copy of the 1997 Form 10-K, annual report and
quarterly reports filed with the Securities and Exchange Commission in
Washington, D.C., by writing to: American Capital Strategies Investor Relations
Office 3 Bethesda Metro Center Suite 860 Bethesda, MD 20814
Dividend Reinvestment and
Stock Purchase Plan
- -------------------
American Capital Strategies offers a dividend reinvestment plan to its
shareholders. Shareholders are enrolled in the plan upon purchasing the
Company's stock and must contact their broker to elect to receive dividends in
cash.
Investor Inquiries
- ------------------
Securities analysts, portfolio managers and others seeking information about the
Company's business operations and financial performance are invited to contact
the Investor Relations Office at (301) 951-6122.
Auditors
- --------
Ernst & Young LLP
Washington, D.C.
Legal Counsel
- -------------
Arnold & Porter
Washington, D.C.
Price Range of Common Stock & Dividends
- ---------------------------------------
The Common Stock is quoted on NASDAQ stock market since August 29, 1997. The
following table sets forth the range of high and low bid prices on the NASDAQ
Stock Market for the applicable periods.
Dividends
1997 High Low Declared
- ---- ---- --- --------
Third quarter (beginning
August 29, 1997)................................. $20.25 $18.50 --
Fourth quarter .................................... $20.75 $16.50 $0.21
As of March 20, 1997, there were 49 shareholders of record of the common stock.
Included in this number are shares held by nominees or in "street name.
21
