10-K 1 acas10k123112.htm FORM 10-K ACAS 10K 12.31.12
UNITED STATES
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, 2012
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission file number 814-00149
 
 
AMERICAN CAPITAL, LTD.
(Exact name of registrant as specified in its charter)
Delaware
 
52-1451377
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
2 Bethesda Metro Center
14th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)
(301) 951-6122
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange
on which registered
Common Stock, $0.01 par value per share
 
The NASDAQ Stock Market LLC
(NASDAQ Global Select Market)
 
Securities registered pursuant to section 12(g) of the Act: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  o    No  x.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes  o    No  x.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter 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  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes  o    No  o
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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Act.
Large accelerated filer  x
 
 
  
Accelerated filer  o
Non-accelerated filer  o
 
(Do not check if a smaller reporting company)
  
Smaller Reporting Company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No.  x
As of June 30, 2012, the aggregate market value of the Registrant's common stock held by non-affiliates of the Registrant was approximately $3.1 billion based upon a closing price of the Registrant's common stock of $10.06 per share as reported on The NASDAQ Global Select Market 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 shareholders; such an exclusion shall not be deemed to constitute an admission that any such person is an “affiliate” of the registrant.)
 
As of February 1, 2013, there were 310,409,083 shares of the Registrant's common stock legally outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE. The Registrant's definitive proxy statement for the 2013 Annual Meeting of Stockholders 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.
________________________________________________________________________________________________________________________



AMERICAN CAPITAL, LTD.
TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
 
 
 
 
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
PART II.
 
 
 
 
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
PART III.
 
 
 
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
PART IV.
 
 
 
 
Item 15.
 
 
 


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PART I.
 
Item 1.
Business
 
General
 
American Capital, Ltd. (which is referred to throughout this report as “American Capital”, “we”, “our” and “us”) is a publicly traded private equity firm and global asset manager. American Capital, both directly and through its asset management business, originates, underwrites and manages investments in middle market private equity, leveraged finance, real estate and structured products. We primarily invest in senior and mezzanine debt and equity in buyouts of private companies sponsored by us (“One Stop Buyouts®”) or sponsored by other private equity funds (“Sponsor Finance Investments”) and provide capital directly to early stage and mature private and small public companies. We refer to our investments in these companies as our private finance portfolio. We manage $18.6 billion of assets, including assets on our balance sheet and fee earning assets under management by affiliated managers, with $117 billion of total assets under management (including levered assets). Our alternative asset fund management is conducted through our wholly-owned portfolio company, American Capital Asset Management, LLC (“American Capital Asset Management”). In January 2013, we changed the name of American Capital, LLC to American Capital Asset Management, LLC. American Capital Asset Management manages the following alternative asset funds through various subsidiaries: European Capital Limited (“European Capital”), American Capital Agency Corp. (“Nasdaq: AGNC”), American Capital Mortgage Investment Corp. (“Nasdaq: MTGE”), American Capital Equity I, LLC (“ACE I”), American Capital Equity II, LP (“ACE II”), ACAS CLO 2007-1, Ltd. (“ACAS CLO 2007-1”) and ACAS CLO 2012-1, Ltd. (“ACAS CLO 2012-1”). We also invest in funds managed by affiliated managers.
 
On August 29, 1997, we completed an initial public offering (“IPO”) and became a non-diversified closed end investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (“1940 Act”). Our primary business objectives are to increase our net earnings and net asset value (“NAV”) by making investments with attractive current yields and/or potential for equity appreciation and realized gains.

We are taxed as a corporation and pay federal and applicable state corporate taxes on our taxable income. From 1997 through the tax ended September 30, 2010, we were taxed as a regulated investment company (“RIC”) as defined in Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). As a RIC, we were not subject to federal income tax on the portion of our taxable income and capital gains we distributed to our shareholders, but we were also not able to carry forward net operating losses (“NOL”) from year to year. Beginning with our tax year ended September 30, 2011, our status changed from a RIC subject to taxation under Subchapter M to a corporation subject to taxation under Subchapter C. Under Subchapter C, we are able to carry forward any NOLs historically incurred to succeeding years, which we would not be able to do if we were subject to taxation as a RIC under Subchapter M. This change in tax status does not affect our status as a BDC under the 1940 Act or our compliance with the portfolio composition requirements of that statute.

American Capital Investment Portfolio
 
We invest in senior debt, mezzanine debt and equity of middle market companies, which we generally consider to be companies with revenue between $10 million and $750 million. We also invest in alternative asset funds managed by us and in structured finance investments (“Structured Products”), including collateralized loan obligation (“CLO”) securities, collateralized debt obligation (“CDO”) securities and commercial mortgage backed securities (“CMBS”). Our wholly-owned portfolio company, European Capital, makes similar investments in Europe. Currently, we will invest up to $500 million in a single middle market company in North America and $200 million in a fund managed by us.

Over the last three years, we have committed $1,270 million of capital to new investments, comprised of $923 million of debt securities, $338 million of equity securities and $9 million of Structured Products investments. Of the $1,270 million of new investment commitments over the last three years, $495 million was committed to new portfolio companies, $386 million was committed to add-on investments in our existing portfolio companies and $389 million was committed to American Capital Asset Management or funds that it manages. Over the last three years, we received over $3.8 billion of cash realizations, comprised of $2.7 billion of debt realizations and $1.1 billion of equity realizations. In addition, over the last three years, our investment portfolio has generated operating revenue, net operating income before income taxes and net earnings of $1.8 billion, $890 million and $3.1 billion, respectively. Over the last three years, our weighted average net earnings return on shareholders' equity was 25.2%.

Since our IPO, we have committed capital of $6.0 billion in equity securities, $17.7 billion in debt securities and $1.7 billion in Structured Products. Since our IPO, we have had over 340 exits and repayments of $18.4 billion, representing 72% of our total capital committed since our IPO, earning a 10% compounded annual return on these investments. Since our IPO, our weighted average net earnings return on shareholders' equity was 4.4%.


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Portfolio Composition
 
As of December 31, 2012, we had investments in 139 portfolio companies totaling $5.3 billion at fair value. As of December 31, 2012, our ten largest investments at fair value were $3.0 billion, or 48% of total assets, and are as follows (in millions):
Company 
 
Product Line
 
Industry
 
Fair Value
 
Cost Basis
American Capital Asset Management
 
Asset Management
 
Capital Markets
 
$
828

 
$
149

European Capital
 
European Capital
 
Diversified Financial Services
 
809

 
1,376

Mirion Technologies, Inc.
 
One Stop Buyouts®
 
Electrical Equipment
 
243

 
100

WRH, Inc.
 
One Stop Buyouts®
 
Life Sciences Tools & Services
 
208

 
391

SPL Acquisition Corp.
 
One Stop Buyouts®
 
Pharmaceuticals
 
188

 
169

The Tensar Corporation
 
Sponsor Finance Investments
 
Construction & Engineering
 
170

 
158

SMG Holdings, Inc.
 
One Stop Buyouts®
 
Hotels, Restaurants & Leisure
 
170

 
197

Affordable Care Holding Corp.
 
One Stop Buyouts®
 
Health Care Providers & Services
 
166

 
79

Paradigm Precision Holdings, LLC
 
One Stop Buyouts®
 
Aerospace & Defense
 
147

 
157

Soil Safe Holdings, LLC
 
Sponsor Finance Investments
 
Professional Services
 
111

 
101

Total
 
 
 
 
 
$
3,040

 
$
2,877

 
 
 
 
 
 
 
 
 
 
Our investments can be divided into the following six product lines: (i) One Stop Buyouts®, (ii) Sponsor Finance Investments, (iii) Direct and Other Investments, (iv) European Capital, (v) Asset Management and (vi) Structured Products.

The composition of our investment portfolio as of December 31, 2012, at fair value, as a percentage of total investments based on these product lines, is shown below:
 


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The composition summary of our investment portfolio as of December 31, 2012, at fair value as a percentage of total investments by security type, is shown below:
 

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Other than our investment in European Capital, our investments are primarily in portfolio companies located in the United States. For summary financial information by geographic area, see Note 3 to our consolidated financial statements in this Annual Report on Form 10-K. We have a diversified investment portfolio and do not concentrate in any one or two industry sectors. We use the Global Industry Classification Standards for classifying the industry groupings of our portfolio companies. The following chart shows the portfolio composition by industry grouping at fair value as a percentage of total investments as of December 31, 2012. Our investments in European Capital and CLO and CDO securities are excluded from the table below. Our investments in CMBS are classified in the Real Estate and Real Estate Investment Trusts category.
Private Finance Investments
 
The majority of our private finance investments have been to either assist in the funding of change of control buyouts of privately held middle market companies or to support the growth or recapitalization of an existing portfolio company. A change of control transaction could be the result of a corporate divestiture, a sale of a family-owned or closely-held business, a going private transaction, the sale by a private equity fund of a portfolio company or an ownership transition. Our financing of a change of control transaction could either be for a One Stop Buyout® or for a Sponsor Finance Investment. In One Stop Buyouts®, we lend senior and mezzanine debt and make majority equity investments. As an investor in Sponsor Finance Investments, we lend senior and mezzanine debt and make minority equity co-investments.
 
Our private finance portfolio investments consist of loans and equity securities primarily to privately-held middle market companies. Our private finance loans consist of first lien secured revolving credit facilities, first lien secured loans, second lien secured loans and secured and unsecured mezzanine loans. Our loans typically mature in five to ten years and require monthly or quarterly interest payments at fixed rates or variable rates generally based on LIBOR, plus a margin. Certain of our loans permit the interest to be paid-in-kind by adding it to the outstanding loan balance and paid at maturity. We price our debt and equity investments based on our analysis of each transaction. As of December 31, 2012, the weighted average effective interest rate on our private finance debt investments was 11.6%, which includes the impact of non-accruing loans. As of December 31, 2012, our fully-diluted weighted average ownership interest in our private finance portfolio companies, excluding our investment in European

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Capital and American Capital Asset Management, was 68%, with a total equity investment at fair value of approximately $1.5 billion.
 
There is generally no publicly available information about these companies and a primary or secondary market for the trading of these privately issued loans and equity securities generally does not exist. These investments have been historically exited through normal repayment, a change in control transaction or recapitalization of the portfolio company. However, we may also sell our loans or equity investments in non-change of control transactions.
 
Our ability to fund the entire capital structure is a competitive advantage in completing many middle market transactions. We sponsor One Stop Buyouts® in which we provide most, if not all, of the senior and mezzanine debt and equity financing in the transaction. We may initially fund all of the senior debt at closing and syndicate it to third-party lenders post closing. We have a loan syndications group that arranges to have all or part of the senior loans syndicated to third-party lenders.
 
As a BDC, we are required by law to make significant managerial assistance available to most of our portfolio companies. Such assistance typically involves providing guidance and counsel concerning the management, operations and business objectives and policies of the portfolio company to its management and board of directors, including participating on the company's board of directors. We have an operations team with significant turnaround and bankruptcy experience that assists our investment professionals in providing intensive operational and managerial assistance to our portfolio companies. As of December 31, 2012, we had board seats at 56 out of 96 of our private finance companies and had board observation rights at certain other private finance portfolio companies. Providing assistance to our portfolio companies serves as an opportunity for us to maximize their value.
 
American Capital Asset Management Investment

Our alternative asset management business is conducted through our wholly-owned portfolio company, American Capital Asset Management. In general, a subsidiary of American Capital Asset Management will enter into management agreements with each of its managed alternative asset funds. As of December 31, 2012, our investment in American Capital Asset Management was $149 million at cost basis and $828 million at fair value, or 16% of our total investments at fair value. This discussion of the operations of American Capital Asset Management includes its consolidated subsidiaries. As of December 31, 2012, its earning assets under management totaled $18.6 billion, with $117 billion of total assets under management (including levered assets), including $100 billion of total assets under management at American Capital Agency Corp. (NASDAQ: AGNC) and $8 billion of total assets under management at American Capital Mortgage Investment Corp. (NASDAQ: MTGE), which are publicly traded residential mortgage real estate investment trusts (“REITs”).
 
American Capital Asset Management had over 80 employees as of December 31, 2012, including seven investment teams with over 25 investment professionals located in Bethesda (Maryland), London and Paris. We have entered into service agreements with American Capital Asset Management to provide it with additional asset management service support. Through these agreements, we provide management and other services to American Capital Asset Management, as well as access to our employees, infrastructure, business relationships, management expertise and capital raising capabilities. We charge American Capital Asset Management a fee for the use of these services. American Capital Asset Management generally earns base management fees based on the shareholders' equity or the net cost basis of the assets of the alternative asset funds under management and may earn incentive income, or a carried interest, based on the performance of the funds. In addition, we may invest directly into these alternative asset funds and earn investment income from our investments in those funds.

The following table sets forth certain information with respect to American Capital Asset Management's funds under management as of December 31, 2012:
 
 
European Capital
 
AGNC
 
MTGE
 
ACE I
 
ACE II
 
ACAS CLO 2007-1
 
ACAS CLO 2012-1
Fund type
 
Private Equity Fund
 
Publicly Traded REIT - NASDAQ (AGNC)
 
Publicly Traded REIT - NASDAQ (MTGE)
 
Private Equity Fund
 
Private Equity Fund
 
CLO
 
CLO
Established
 
2005
 
2008
 
2011
 
2006
 
2007
 
2006
 
2012
Assets under management
 
$1.6 Billion
 
$100.5 Billion
 
$7.7 Billion
 
$0.6 Billion
 
$0.3 Billion
 
$0.4 Billion
 
$0.4 Billion
Investment types
 
Senior and Mezzanine Debt,
Equity, Structured Products
 
Agency Securities
 
Mortgage Investments
 
Equity
 
Equity
 
Senior Debt
 
Senior Debt
Capital type
 
Permanent
 
Permanent
 
Permanent
 
Finite Life
 
Finite Life
 
Finite Life
 
Finite Life


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Under its investment management agreement with European Capital, American Capital Asset Management generally receives an annual management fee of 2% of the weighted average monthly consolidated gross asset value of all the investments at fair value of European Capital, an incentive fee equal to 100% of the net earnings in excess of a return of 8% but less than a return of 10%, and 20% of the net earnings thereafter. The investment management agreement with European Capital was amended to waive the incentive fee for 2011 and 2012.
 
AGNC is a publicly traded REIT, which invests on a leveraged basis primarily in residential mortgage pass-through securities and collateralized mortgage obligations, for which the interest and principal payments are guaranteed by a U.S. government agency or U.S. government-sponsored entity. Its shares are traded on The NASDAQ Global Select Market under the symbol “AGNC.” American Capital Asset Management earns a base management fee of 1.25% of AGNC's shareholders' equity, as defined in the management agreement. The management contract is renewable annually and if AGNC were not to renew the management agreement without cause, it would have to pay a termination fee equal to three times the average annual management fee earned by American Capital Asset Management during the 24-month period immediately preceding the most recently completed month prior to the effective date of termination. If the termination fee were calculated for the period ending December 31, 2012, it would have been $252 million. As of December 31, 2012, AGNC's total shareholders' equity was $10.9 billion.

MTGE is also a publicly traded REIT, which invests in and manages a leveraged portfolio of agency mortgage investments, non-agency mortgage investments and other mortgage-related investments. Its shares are traded on The NASDAQ Global Select Market under the symbol “MTGE.” American Capital Asset Management earns a base management fee of 1.50% of MTGE's shareholders' equity, as defined in the management agreement. The management agreement has a current term through August 9, 2014 and is renewable annually thereafter. If MTGE were not to renew the management agreement without cause, it would have to pay a termination fee equal to three times the average annual management fee earned by American Capital Asset Management during the 24-month period immediately preceding the most recently completed month prior to the effective date of termination. If the termination fee were calculated for the period ending December 31, 2012, it would have been $19 million. As of December 31, 2012, MTGE's total shareholders' equity was $926 million.

ACE I is a private equity fund, which was established in 2006 with $1 billion of equity commitments from third-party investors. At the closing of the fund, ACE I used the majority of its committed capital to purchase 30% of our equity investments in 96 portfolio companies for an aggregate purchase price of $671 million. Also, ACE I co-invested with American Capital in an amount equal to 30% of equity investments made by us between October 2006 and November 2007 until the $329 million remaining equity commitment was exhausted. In addition, 10%, or $100 million, of the $1 billion of distributions to the ACE I investors is recallable for add-on investments. As of December 31, 2012, ACE I investors had invested $1,048 million, received distributions of $919 million, had $582 million in total investments at fair value and had $52 million of recallable distributions available for add-on investments. American Capital Asset Management manages ACE I in exchange for a 2% base management fee on the net cost basis of ACE I's assets (as of December 31, 2012, the cost basis of ACE I's assets was $517 million) and 10% to 30% of the net profits of ACE I, subject to certain hurdles (“carried interest”). As of December 31, 2012, American Capital Asset Management has not recorded an accrual related to its carried interest in ACE I.
 
ACE II is a private equity fund, which was established in 2007 with $585 million of equity commitments from third-party investors. At the closing of the fund, ACE II used the majority of its committed capital to purchase 17% of our equity investments in 80 portfolio companies for an aggregate purchase price of $488 million. The remaining $97 million equity commitment is being used to fund add-on investments in the 80 portfolio companies. As of December 31, 2012, ACE II investors had invested $509 million, received distributions of $341 million, had $253 million in total investments at fair value and had $76 million of remaining equity commitments available for future add-on investments or cost contributions. American Capital Asset Management manages ACE II in exchange for a 2% base management fee on the net cost basis of ACE II's assets (as of December 31, 2012, the cost basis of ACE II's assets was $272 million) and a 10% to 35% carried interest, subject to certain hurdles. As of December 31, 2012, American Capital Asset Management has not recorded an accrual related to its carried interest in ACE II.
 
In April 2007, ACAS CLO 2007-1 completed a $400 million securitization that invests in broadly syndicated and middle market commercial senior loans. American Capital Asset Management manages ACAS CLO 2007-1 in exchange for a base management fee of 0.68% of ACAS CLO 2007-1's assets and a 20% carried interest, subject to certain hurdles.

In September 2012, ACAS CLO 2012-1 completed a $362 million securitization that invests in broadly syndicated commercial senior loans. American Capital Asset Management manages ACAS 2012-1 in exchange for a base management fee of 0.42% of ACAS CLO 2012-1's total assets and a 20% carried interest, subject to certain hurdles. A subsidiary of American Capital Asset Management also purchased 70% of the non-rated equity tranche of subordinated notes in ACAS CLO 2012-1 for $30 million.


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European Capital Investment
 
European Capital is a wholly-owned investment fund incorporated in Guernsey. European Capital invests in One Stop Buyouts®, Sponsor Finance Investments and provides capital directly to early stage and mature private and small public companies primarily in Europe. It primarily invests in senior and mezzanine debt and equity.

As of December 31, 2012, 99.5% of European Capital's assets are invested in portfolio companies headquartered in countries with AA rating or better based on Standard & Poor's ratings. As of December 31, 2012, European Capital's NAV at fair value was $931 million. As of December 31, 2012, our investment in European Capital consisted of an equity investment with a cost basis and fair value of $1,267 million and $700 million, respectively, and a debt investment with a fair value and cost basis of $109 million. As of December 31, 2012, we valued our equity investment in European Capital below its NAV as a result of applying several discounts to its NAV in computing the fair value. See Note 2 to our consolidated financial statements in this Annual Report on Form 10-K for a further discussion of our valuation of European Capital.

Structured Products Investments
 
Our Structured Products investments consist of investments in CLO, CDO and CMBS securities. Our Structured Products investments are generally in non-investment grade securities. Non-investment grade tranches have a higher risk of loss, but are expected to provide a higher yield than investment grade securities. We may also make select investments in investment grade tranches if the expected returns meet our overall portfolio targeted returns. We invest in Structured Products with the intention of holding them until maturity. An active market generally does not exist for most of the non-investment grade tranches of Structured Products in which we invest.
 
Our investments in CLO securities are generally secured by diverse pools of commercial corporate loans. Our investments are in 27 CLO funds managed by 19 separate portfolio managers. We also invest in CDO securities, which are generally secured by diverse pools of bonds of other securitizations including commercial loans, CMBS and residential mortgage backed securities. Certain of our commercial CLO investments are in a joint venture portfolio company. As of December 31, 2012, our investment in CLO and CDO securities was $210 million at cost and $229 million at fair value, or 4% of our total investments.
 
Our investments in CMBS bonds are secured by diverse pools of commercial mortgage loans. As of December 31, 2012, our total investment in CMBS bonds was $175 million at cost and $18 million at fair value, or less than 1% of our total investments.
 
Business Actions and Strategy

During the ten years following our 1997 IPO, our common stock generally traded at a premium to our NAV. However, since 2009, our common stock has generally traded at a discount to our NAV. This low stock valuation has had an adverse impact on our shareholders and our ability to raise capital at an attractive cost, among other consequences. The situation may be attributable to numerous factors including our financial performance during the recession, general market conditions and investor expectations with regard to future events and performance. There are a number of actions that we have taken and plan to take that are intended to improve our business, deliver attractive returns to our shareholders and improve our stock valuation. These actions include working to increase the value of our private finance equity investments and our equity investment in European Capital, generating earnings that utilize our NOLs, making appropriate investments in existing portfolio companies, making investments in attractive new portfolio companies, developing our asset management business, repurchasing shares of our common stock when they trade below NAV and paying a dividend when we trade above NAV.

In addition to these actions, we have undertaken a process to evaluate our corporate structure and the various legal, regulatory, tax and accounting regimes under which we operate for the purpose of determining whether they are the optimum means for the operation and capitalization of our business. Our change in 2011 from a RIC to a taxable company, which has allowed us to carry forward NOLs from past periods and to shelter a significant amount of future income from taxation, as well as retain our earnings, which we could not do if we were a RIC, is an illustration of how we can be affected by these regimes in ways that may or may not be in the interests of all of our shareholders. As a result of these evaluations, we may decide to proceed with structural and organizational changes (certain of which may require the approval of our shareholders), which could result in the spinning out to our shareholders an externally managed debt focused BDC, changes in our corporate form, termination of our election to be regulated as a BDC, our conversion from an investment company to an operating company or other fundamental changes. We may conclude, for example, that it would be preferable to purchase and operate businesses as an operating company rather than invest in One Stop Buyouts® as an investment company. If we made that decision, we might also conclude that it would be preferable to continue to invest in debt and minority equity in change of control transactions sponsored by other private equity firms through a BDC. Any such changes would be made with the primary intention of promoting shareholder value. Such changes could result in a change in how we account for our investments and our assets, including the consolidation of certain majority owned companies with which we do not now consolidate as an investment company.


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Our evaluation process is likely to be lengthy and any changes to our structure or operations may not be made for several years, if at all. In completing the evaluation process, we may incur various costs for which we will not receive any benefit and take certain exploratory actions that may not be indicative of any eventual decisions. We may not necessarily make further announcements about the progress or results of this evaluation process.

Lending and Investment Decision Criteria
 
We generally review certain criteria in order to make investment decisions. The list below represents a general overview of the criteria we use in making our lending and investment decisions in our private finance business. Not all criteria are required to be favorable in order for us to make an investment. Add-on investments for growth, acquisitions or recapitalizations are based on the same general criteria. Add-on investments in distressed situations are based on the same general criteria, but are also evaluated on the potential to preserve prior investments.
 
Operating History. We generally focus on middle market companies that have been in business over ten years and have an attractive operating history, including generating positive cash flow. We generally target companies with significant market share in their products or services relative to their competitors. In addition, we consider factors such as customer concentration, performance during recessionary periods, competitive environment and ability to sustain margins. As of December 31, 2012, our current private finance portfolio companies had an average age of 26 years with average revenue and average adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted EBITDA”) for the latest available twelve month period of $162 million, and $44 million, respectively. Adjusted EBITDA may reflect certain adjustments to the reported EBITDA of a portfolio company for non-recurring, unusual or infrequent items or other pro-forma items or events to normalize current earnings which a buyer may consider in a change in control transaction.
 
Growth. We consider a target company's ability to increase its cash flow. Anticipated growth is a key factor in determining the ability of the company to repay its debt and the value ascribed to any warrants and equity interests acquired by us.
 
Liquidation Value of Assets. Although we do not operate as an asset-based lender, liquidation value of the assets collateralizing our loans is a factor in many credit decisions. Emphasis is placed both on tangible assets such as accounts receivable, inventory, plant, property and equipment as well as intangible assets such as brand recognition, market reputation, customer lists, networks, databases and recurring revenue streams.
 
Experienced Management Team. We consider the quality of senior management to be extremely important to the long-term performance of most companies. Therefore, we consider it important that senior management be experienced and properly incentivized through meaningful ownership interest in the company.
 
Exit Strategy. Almost all of our investments consist of securities acquired directly from their issuers in private transactions. These securities are rarely traded in public markets, thus limiting their liquidity. Therefore, we consider it important that a prospective portfolio company have a number of methods by which our financing can be repaid and our equity investment sold or redeemed. These methods would typically include the sale or refinancing of the business or the ability to generate sufficient cash flow to repurchase our equity securities and repay our loans.
 
Structured Products Criteria. We receive extensive information from the issuer regarding their track record and the collateral pool. We underwrite the manager and the collateral securing our investment as appropriate.

Fund Investment Criteria. We receive extensive information from the manager regarding their track record and the investment thesis. We assess the ability to raise capital with the manager and underwrite the manager and the investment strategy as appropriate.
 
Institutional Approach to Investing
 
We have built an institution with a leading capability to originate, underwrite, finance, syndicate, monitor and exit investments that generate attractive returns. Our dedicated teams of investment professionals are the cornerstone of our institution. We have also created an extensive support structure that provides in-house due diligence, operational, legal and human resources support to our investment professionals and to our portfolio company, American Capital Asset Management. The following are the key functional teams that execute our alternative asset management business.
 
Investment Teams: As of December 31, 2012, we had 24 Investment Teams with over 65 professionals located in our six offices in the United States, excluding investment teams and professionals of American Capital Asset Management. The Investment Teams originate, review and screen investment opportunities, conduct business, management and operations due diligence, prepare investment committee reports and models, make recommendations to the investment committee, execute investments, represent us on the boards of directors of portfolio companies, assist in monitoring and valuing of investments and manage acquisitions, divestures and exiting of investments. Our Investment Teams are organized so that each team focuses on a specific investment strategy and work cooperatively to share expertise. Our Investment Teams include:
 

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American Capital Buyout: A 21-person team that implements One Stop Buyouts® of middle market companies including corporate divestitures, acquisitions of portfolio companies from private equity funds, acquisitions of family-owned or closely held businesses, going private transactions and ownership transitions. They originate senior and mezzanine debt and equity in American Capital controlled buyouts.
 
Sponsor Finance: A 13-person team that makes senior and mezzanine debt investments and equity co-investments in Sponsor Finance Investments. In addition, they make senior and mezzanine debt and equity investments in privately and publicly-held middle market companies.
 
Special Situations: A 5-person team that implements One Stop Buyouts®, Sponsor Finance Investments and other direct investments in distressed companies, companies undergoing turnarounds, bankruptcy auctions, debtor-in-possession, exit financing and other special situations in middle market companies. They make senior and mezzanine debt and equity investments.

Technology Investment: A 4-person team that implements our One Stop Buyouts®, Sponsor Finance Investments and other direct investments in technology companies. They will invest in various technology sectors including networking, software, communications, enterprise data, new media, consumer technologies and industrial technology. They make senior and mezzanine debt and equity investments.
 
Commercial Mortgage Asset Management: A 5-person team that invests in commercial mortgages and related assets. The team also participates in underwriting, due diligence and financing of real estate owned by our portfolio companies.
 
Collateralized Loan Obligation: A 7-person team that has responsibility for our investments in and manages senior loan collateral for third-party investors through structured finance products such as a CLO. The team invests in middle market senior loans originated through our various Investment Teams and also by purchasing rated, broadly syndicated commercial senior debt. They also invest in non-rated tranches of CLOs managed by other third-party fund managers.
 
Operations Team: A 13-person team with expertise in manufacturing services, consumer products, financial services, energy services, supply chain management, outsourcing and technology. The Operations Team includes seven former CEOs and presidents, one former COO and four supply chain and outsourcing specialists. The Operations Team conducts operational due diligence on prospective portfolio companies and reports and makes recommendations to our investment committee. The team will also assist portfolio companies post close with operational improvement. If we have a portfolio company that is underperforming, the Operations Team will work closely with the portfolio company to improve performance by providing interim leadership at the portfolio company and to identify business actions to help improve performance. The team will provide hands-on assistance to reduce costs, systemize sales and marketing, develop and align business plans, grow the business and strengthen management talent at the portfolio company.

Investment Committee Support Team: A 3-person team that assists our investment committee (the “Investment Committee”) in establishing procedures and controls, establishing due diligence protocol and working with Investment Teams to establish due diligence plans for each prospective investment, developing standard investment committee reports and models, organizing investment committee meetings, monitoring and reporting investment committee results and tracking subsequent developments.

Financial Accounting and Compliance Team (“FACT”): A 27-person team of valuation and audit professionals. FACT is responsible for providing pre- and post-investment financial due diligence, portfolio monitoring and quarterly valuations of portfolio company investments. FACT assists our Investment Teams in conducting extensive financial, accounting, tax and information technology due diligence of each target investment company, which includes one or more on-site visits, a review of the portfolio company's historical and prospective financial information, and identifying and confirming pro-forma financial adjustments. FACT also monitors the existing portfolio investments by gathering, inputting into an automated database, analyzing and regularly reviewing monthly financial information and other materials to assess financial performance as well as to ensure compliance with loan covenants. Also, FACT, with the assistance of our Investment Teams and subject to the oversight of senior management and the Audit and Compliance Committee, prepares a quarterly valuation of each portfolio company investment.

Syndications Team: A 5-person team that is responsible for arranging syndications of all or part of the senior debt of our portfolio companies either at closing or subsequent to the closing of a senior financing transaction. They perform a variety of functions relating to the marketing and completing of such transactions.

Capital Markets, Finance and Treasury Team: A 24-person team that is responsible for raising equity and debt capital, investor relations, financial budgeting and forecasting and daily liquidity and cash management. Through its debt capital raising activities, the team is responsible for structuring, selling and administering on-balance sheet term debt securitizations of debt investments, secured and unsecured bonds and various other revolving facilities and term debt facilities for us and our alternative asset funds under management. Through its equity capital raising activities, the team is responsible for structuring and selling equity for us and our public and private funds. The team is also responsible for monitoring and reporting on capital market conditions

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and researching, developing and raising private and public capital for new third-party funds for our alternative asset management business. The team is also responsible for arranging syndications of all or part of the equity of our portfolio companies either at closing or subsequent to the closing of an equity financing transaction.
 
Accounting, Tax and Reporting Team: A 36-person team that is responsible for the accounting of our financial results as well as that of our managed funds, including financial reporting and communications to our shareholders, partners and regulatory bodies. Among its tasks are preparing financial statements, investment accounting, analysis of investment performance, loan servicing, billing, accounts receivable and payable, tax compliance, external audit coordination and developing and monitoring our internal controls.

Legal and Compliance Team: A 21-person team that provides legal support on corporate, capital raising and investing matters, is involved in regular reporting and special communications with our shareholders and regulatory bodies and manages the outside law firms that provide transactional, litigation and regulatory services to us. In addition, as required by the Securities and Exchange Commission (“SEC”), we have appointed a Chief Compliance Officer, who is responsible for administering our code of ethics and conduct and our legal compliance activities.
 
Internal Audit Team: A 4-person team that reports directly to the Audit and Compliance Committee of our Board of Directors. The team tests our internal controls over financial reporting to assist management's assessment of the effectiveness of our internal controls over financial reporting under the Sarbanes-Oxley Act of 2002.

Human Resources Team: A 7-person team that assists in recruiting and hiring as well as reviewing, establishing and administering compensation programs and benefit plans for our employees. In addition, the team is available to the Investment Teams and the Operations Team to assist with executive management and other human resources issues at portfolio companies.

Information Technology Team: A 27-person team that assists all departments in researching, developing, implementing and maintaining communication and technological resources for our multi-office operations, including highly specialized systems for the input, processing and reporting of data.

Investment Process

Investment Sourcing and Screening: We have a multi-disciplined approach to reach diverse channels of deal sources. Our Investment Teams target a referral network comprised of investment bankers, private equity firms, mezzanine debt funds, trade organizations, commercial bankers, attorneys and business and financial brokers. We developed and maintain a proprietary industry-wide database of reported middle market transactions, which enables us to monitor and evaluate the middle market investing environment. This database is used to help us assess whether we are penetrating our target markets and to track terms and pricing. Our financial professionals review financing memorandums and private placement memorandums sourced from this referral network in search of potential buyout or financing opportunities. Our Investment Teams undertake a preliminary evaluation and analysis of potential investment opportunities to determine whether or not they meet our criteria based upon the limited information received in these early stages of the investment process. For investment opportunities that pass an initial screening process, our Investment Teams prepare an initial investment thesis and analysis that is presented to an internal Investment Committee, which includes representatives of our senior officers depending on the nature of the proposed investment, for approval to proceed further.
 
Due Diligence: In our private finance investments, our investment professionals along with FACT and our Operations Team conduct due diligence of each target company that passes the initial screening process. This includes one or more on-site visits, a review of the target company's historical and prospective financial information, identifying and confirming pro-forma financial adjustments, interviews with and assessments of management, employees, customers and vendors, review of the adequacy of the target company's systems, background investigations of senior management and research on the target company's products, services and industry. We often engage professionals such as environmental consulting firms, accounting firms, law firms, risk management companies and management consulting firms with relevant industry expertise to perform elements of the due diligence.

Investment Approval: Upon completion of our due diligence, our Investment Teams, FACT and our Operations Team, as well as any consulting firms that we have engaged, prepare and present a report containing the due diligence information for review by our Investment Committee. Our Board of Directors has delegated authority to the Investment Committee to conduct the initial review and approval of our investments. Our Investment Committee generally must approve each investment. Investments exceeding a certain size or meeting certain other criteria must also be approved by our Board of Directors. Our Investment Committee is supported by a dedicated staff that focuses on the due diligence and other research done with regard to each proposed investment.
 
Documentation and Negotiations: Documentation for the legal agreements for a transaction is completed either by our in-house legal team or through the retention of outside legal counsel. We maintain custody of our investment securities and the original related investment documentation in custodial accounts with qualified banks and members of national securities exchanges in accordance with applicable regulatory and financing requirements.

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Investment Funding: Prior to the release of any funding for investments, our treasury department prepares a summary of the investment terms, the funding amounts approved by our Investment Committee and wiring instructions. Our treasury department performs various procedures to confirm any wiring instructions. A senior executive officer must approve this summary of terms and funding amounts prior to the disbursement of the funds.
 
Portfolio Monitoring: In addition to the due diligence at the time of the original investment decision, we seek to preserve and enhance the performance of our portfolio companies under management through our active involvement with the portfolio companies. As a BDC, we are required by law to make significant managerial assistance available to most of our portfolio companies. This generally includes providing guidance and counsel concerning the management, operations and business objectives and policies of the portfolio company to the portfolio company's management and board of directors, including participating on the company's board of directors. The respective Investment Teams, FACT and Operations Teams regularly review each portfolio company's monthly financial statements to assess performance and trends, periodically conduct on-site financial and operational reviews and evaluate industry and economic issues that may affect the portfolio company.
 
Investment Exits: We regularly evaluate each investment to determine the appropriate time to exit an investment. For investments that we control, portfolio companies are usually sold through an auction process, following the engagement of an investment bank. For performing investments that we do not control, the exit typically occurs when the sponsor or other party in control of the portfolio company decides to recapitalize or sell the business. In both instances, our debt investment is typically paid in full and any equity investment we own realizes a value consistent with the value realized by the controlling parties. For non-performing investments that we do not control, we may determine that based on the facts and circumstances relating to the investment, to accept an amount less than what we are legally owed with any such decision requiring approval by our Investment Committee.

Portfolio Valuation
 
FACT, with the assistance of our Investment Teams, and subject to the oversight of senior management and the Audit and Compliance Committee, prepares a quarterly valuation of each of our portfolio company investments. Our Board of Directors approves our portfolio valuations as required by the 1940 Act.

Competition
 
We compete with strategic buyers, private equity funds, mezzanine debt funds and other buyers and financing sources, including traditional financial services companies such as finance companies, commercial banks, investment banks and other equity and non-equity based investment funds. Some of our competitors are substantially larger and have considerably greater financial resources than we do. Competitors may have a lower cost of funds and many have access to funding sources that are not available to us. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships and build their market shares. There is no assurance that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. In addition, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that we will be able to identify and make investments that satisfy our investment objectives or that we will be able to meet our investment goals.
 
Corporate Information
 
Our executive offices are located at 2 Bethesda Metro Center, 14th Floor, Bethesda, Maryland 20814, and our telephone number is (301) 951-6122. In addition to our executive offices, we or subsidiaries of our wholly-owned portfolio company American Capital Asset Management, maintain offices in New York, Chicago, Dallas, Boston, Annapolis, London and Paris.
 
We make available all of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports free of charge on our internet website at www.AmericanCapital.com as soon as reasonably practical after such material is electronically filed with or furnished to the SEC. These reports are also available on the SEC's internet website at www.sec.gov. The public may also read and copy paper filings that we have made with the SEC at the SEC's Public Reference Room, located at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling (800) SEC-0330.

Employees
 
As of December 31, 2012, we employed 256 full-time employees compared to 249 and 242 full-time employees as of December 31, 2011 and 2010, respectively. We believe that we have excellent relations with our employees.
 


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Business Development Company Requirements
 
We are a closed-end, non-diversified, management investment company that has elected to be regulated as a BDC under the 1940 Act, and, as such, are subject to regulation under that act.
 
Qualifying Assets
 
As a BDC, we may not acquire any asset other than “qualifying assets,” as defined by the 1940 Act, unless, at the time the acquisition is made, the value of our qualifying assets represent at least 70% of the value of our total assets. The principal categories of qualifying assets relevant to our business include the following:
 
securities purchased in transactions not involving any public offering from:
 
a)
an issuer that (i) is organized and has its principal place of business in the United States, (ii) is neither an investment company other than a wholly-owned small business investment company nor an entity that would be an investment company but for certain statutory exemptions, and (iii) does not have any class of securities listed on a national securities exchange with a market capitalization in excess of $250 million; or
 
b)
an issuer that satisfies the criteria set forth in clauses (a) (i) and (ii) above but not clause (a)(iii), so long as, at the time of purchase, we own at least 50% of (i) the greatest amount of equity securities of the issuer, including securities convertible into such securities and (ii) the greatest amount of certain debt securities of such issuer, held by us at any point in time during the period when such issuer was an eligible portfolio company, except that options, warrants, and similar securities which have by their terms expired and debt securities which have been converted, or repaid or prepaid in the ordinary course of business or incident to a public offering of securities of such issuer, shall not be considered to have been held by us, and we are one of the 20 largest holders of record of such issuer's outstanding voting securities;
 
securities of an issuer described in clauses (a)(i) and (ii) above with respect to which we control (alone or together as a part of a group), we in fact exercise a controlling influence over such issuer's management or policies and a person affiliated with us is on the issuer's board of directors;
 
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

cash, cash items, U.S. government securities, or high quality debt securities maturing in one year or less from the time of investment.
 
To include certain securities above as qualifying assets for the purpose of the 70% test, a BDC must either control the issuer of the securities or offer to make significant managerial assistance available to the issuer of those securities, such as providing significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company or making loans to a portfolio company. We make significant managerial assistance available to each of our portfolio companies.
 
Under the 1940 Act, we may not change the nature of our business so as to cease to be, or withdraw our election as, a BDC without consent of the holders of a majority of our outstanding voting securities. Since we made our BDC election, we have not made any substantial change in our structure or in the nature of our business.

Temporary Investments
 
Pending investment in other types of qualifying assets, we may invest our otherwise uninvested cash 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, referred to as temporary investments, so that at least 70% of our assets are qualifying assets.
 
Leverage
 
The 1940 Act permits us, as a BDC, to issue senior debt securities and preferred stock (collectively, “Senior Securities”) in amounts such that our asset coverage is at least 200% after each issuance of Senior Securities. Asset coverage is defined in the 1940 Act as the ratio which the value of the total assets, less all liabilities and indebtedness not represented by Senior Securities, bears to the aggregate amount of Senior Securities representing indebtedness. Such indebtedness may also be incurred for the purpose of effecting share repurchases. As a result, we are exposed to the risks of leverage. Although we have no current intention to do so, we have retained the right to issue preferred stock, subject to certain limitations under the 1940 Act. As permitted by the 1940 Act, we may, in addition, borrow amounts up to 5% of our total assets for temporary purposes. As of December 31, 2012, our asset coverage was 801%.
 

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Under the 1940 Act, if a BDC has any senior debt securities outstanding that were publicly issued, the BDC must make provision to prohibit the declaration of any dividend (except a dividend payable in the stock of the BDC) if its asset coverage is below 200% at the time of the distribution after deducting the amount of such dividend.
 
Issuance of Stock
 
As a BDC, we are generally not able to issue and sell our common stock at a price below our NAV per share, exclusive of any distributing commission or discount, except (i) with the prior approval of a majority of our shareholders, (ii) in connection with a rights offering to our existing shareholders, or (iii) under such other circumstances as the SEC may permit. As of December 31, 2012, our NAV was $17.84 per share and our closing market price was $12.02 per share. As of the date of this filing, we do not have any authorization to issue shares of our common stock below our NAV per share.

Investment Objectives

Our primary business objectives are to increase our net earnings and NAV by investing in senior and mezzanine debt and equity securities of private companies and alternative asset funds managed by American Capital Asset Management with attractive current yields and/or potential for equity appreciation and realized gains. Our investment objectives provide that:
 
We will at all times conduct our business so as to retain our status as a BDC. In order to retain that status, we may not acquire any assets (other than non-investment assets necessary and appropriate to our operations as a BDC) if after giving effect to such acquisition the value of our qualifying assets amounts to less than 70% of the value of our total assets. See Item 1. Business—Business Development Company Requirements for a summary definition of qualifying assets. We believe most of the securities we will acquire (provided that we control, or through our officers or other participants in the financing transaction, make significant managerial assistance available to the issuers of these securities), as well as temporary investments, will generally be qualifying assets. Securities of public companies with a market capitalization in excess of $250 million, on the other hand, are generally not qualifying assets unless they were acquired in a distribution, in exchange for or upon the exercise of a right relating to securities that were qualifying assets.
 
We may invest up to 100% of our assets in securities acquired directly from issuers in privately-negotiated transactions. With respect to such securities, we may, for the purpose of public resale, be deemed an “underwriter” as that term is defined in the Securities Act of 1933. We may invest up to 50% of our assets to acquire securities of issuers for the purpose of acquiring control (up to 100% of the voting securities) of such issuers. We will not concentrate our investments in any particular industry or group of industries. Therefore, we will not acquire any securities (except upon the exercise of a right related to previously acquired securities) if, as a result, 25% or more of the value of our total assets consists of securities of companies in the same industry.

We may issue Senior Securities to the extent permitted by the 1940 Act for the purpose of making investments, to fund share repurchases, or for temporary or emergency purposes. As a BDC, we may issue Senior Securities up to an amount so that the asset coverage, as defined in the 1940 Act, is at least 200% immediately after each issuance of Senior Securities.
 
We generally will not (a) act as an underwriter of securities of other issuers (except to the extent that we may (i) be deemed an “underwriter” of securities purchased by us that must be registered under the Securities Act of 1933 before they may be offered or sold to the public or (ii) underwrite securities to be distributed to or purchased by our shareholders in connection with offerings of securities by companies in which we are a shareholder); (b) sell securities short (except with regard to managing risks associated with publicly traded securities issued by portfolio companies); (c) purchase securities on margin (except to the extent that we may purchase securities with borrowed money); (d) write or buy put or call options (except (i) to the extent of warrants or conversion privileges in connection with our acquisition financing or other investments, and rights to require the issuers of such investments or their affiliates to repurchase them under certain circumstances, or (ii) with regard to managing risks associated with publicly traded securities issued by portfolio companies); (e) engage in the purchase or sale of commodities or commodity contracts, including futures contracts (except where necessary in working out distressed loan or investment situations); or (f) acquire more than 3% of the voting stock of, or invest more than 5% of our total assets in any securities issued by, any other investment company (as defined in the 1940 Act), except as they may be acquired as part of a merger, consolidation or acquisition of assets. With regard to that portion of our investments in securities issued by other investment companies it should be noted that such investments may subject our shareholders to additional expenses.
 
The percentage restrictions set forth above, other than the restriction pertaining to the issuance of Senior Securities, as well as those contained elsewhere herein, apply at the time a transaction is effected, and a subsequent change in a percentage resulting from market fluctuations or any cause other than an action by us will not require us to dispose of portfolio securities or to take other action to satisfy the percentage restriction.
 

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The above investment objectives have been set by our Board of Directors and do not require shareholder consent to be changed.
 
Investment Advisor
 
We have no investment advisor and are internally managed by our executive officers under the supervision of our Board of Directors.






















































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Item 1A.
Risk Factors
 
You should carefully consider the risks described below and all other information contained in this Annual Report on Form 10-K, including our consolidated financial statements and the related notes thereto before making a decision to purchase our securities. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us, or not presently deemed material by us, may also impair our operations and performance.
 
If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. If that happens, the trading price of our securities could decline, and you may lose all or part of your investment.
 
Risks Related to Our Business and Structure
 
Future adverse market and economic conditions could cause harm to our operating results
 
Past recessions have had a significant negative impact on the operating performance and fair value of our portfolio investments. Many of our portfolio companies could be adversely impacted again by any future economic downturn or recession and may be unable to repay our debt investments, may be unable to be sold at a price that would allow us to recover our investment, or may be unable to operate during such recession. Such portfolio company performance could have a material adverse effect on our business, financial condition and results of operations.

We have loans to and investments in middle market borrowers who may default on their loans and we may lose our investment
 
We have invested in and made loans to privately-held, middle market businesses and plan to continue to do so. There is generally a limited amount of publicly available information about these businesses. Therefore, we rely on our principals, associates, analysts, other employees and consultants to investigate and monitor these businesses. The portfolio companies in which we have invested may have significant variations in operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, may require substantial additional capital to support their operations, to finance expansion or to maintain their competitive position, may otherwise have a weak financial position or may be adversely affected by changes in the business cycle. Our portfolio companies may not meet net income, cash flow and other coverage tests typically imposed by senior lenders. Numerous factors may affect a portfolio company's ability to repay its loans, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. Deterioration in a portfolio company's financial condition and prospects may be accompanied by deterioration in the collateral for the loan. We have also made unsecured and mezzanine loans and invested in equity securities, which involve a higher degree of risk than senior secured loans. In certain cases, our involvement in the management of our portfolio companies may subject us to additional defenses and claims from borrowers and third-parties. These conditions may make it difficult for us to obtain repayment of our investments.
 
Middle market businesses typically have narrower product lines and smaller market shares than large businesses. They tend to be more vulnerable to competitors' actions and market conditions, as well as general economic downturns. In addition, these companies may face intense competition, including competition from companies with greater financial resources, more extensive development, manufacturing, marketing, and other capabilities, and a larger number of qualified managerial and technical personnel.
 
These businesses may also experience substantial variations in operating results. Typically, the success of a middle market business also depends on the management talents and efforts of one or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on us. In addition, middle market businesses often need substantial additional capital to expand or compete and may have borrowed money from other lenders with claims that are senior to our claims.
 
Our senior loans generally are secured by the assets of our borrowers, however certain of our senior loans may have a second priority lien and thus, our security interest may be subordinated to the payment rights and security interest of the first lien senior lender. Additionally, our mezzanine loans may or may not be secured by the assets of the borrower; however, if a mezzanine loan is secured, our rights to payment and our security interest are usually subordinated to the payment rights and security interests of the first and second lien senior lenders. Therefore, we may be limited in our ability to enforce our rights to collect our second lien senior loans or mezzanine loans and to recover any of the loan balance through a foreclosure of collateral.





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Non-accruing loans adversely affect our results of operations and financial condition and could result in further losses in the future

As of December 31, 2012 and 2011, our non-accruing loans at cost totaled $260 million and $419 million, or 12.9% and 15.3% of our total loans at cost, respectively. Non-accruing loans adversely affect net income in various ways. While we incur interest expense to fund non-accruing loans, no interest income is recorded on non-accruing loans, thereby adversely affecting income and returns on assets and equity. There is no assurance that we will not experience further increases in non-accruing loans in the future, or that non-accruing loans will not result in further losses to come.

There is uncertainty regarding the value of our portfolio investments
 
A substantial portion of our portfolio investments are not publicly traded. As required by law, we fair value these investments in accordance with the 1940 Act and Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”) based on a determination made in good faith by our Board of Directors. Due to the uncertainty inherent in valuing investments that are not publicly traded, as set forth in our consolidated financial statements in this Annual Report on Form 10-K, our determinations of fair value may differ materially from the values that would exist if a ready market for these investments existed. Our determinations of the fair value of our investments have a material impact on our net earnings through the recording of unrealized appreciation or depreciation of investments as well as our assessment of income recognition. Thus, our NAV could be materially affected in the event of any changes in applicable law or accounting pronouncements governing how we currently fair value assets, or if our determinations regarding the fair value of our investments are materially different from the values that would exist if a ready market existed for these securities.
 
Our business has significant capital requirements and may be adversely affected by a prolonged inability to access the capital markets or to sell assets
 
Our business requires a substantial amount of capital to operate. We historically have financed our operations, including the funding of new investments, through cash generated by our operating activities, the repayment of debt investments, the sale of equity investments, the issuance of debt by special purpose affiliates to which we have contributed loan assets, the sale of our stock and through secured and unsecured borrowings. Our ability to continue to rely on such sources or other sources of capital is affected by restrictions in both the 1940 Act and in certain of our debt agreements relating to the incurrence of additional indebtedness as well as changes in the capital markets from the recent economic recession. It is also affected by legal, structural and other factors. There can be no assurance that we will be able to earn or access the funds necessary for our liquidity requirements.
 
Our ability to recognize the benefits of our deferred tax asset is dependent on future taxable income and could be substantially limited if we experience an “ownership change” within the meaning of Section 382 of the Code

We recognize the expected future tax benefit from a deferred tax asset when the tax benefit is considered more likely than not to be realized. Otherwise, a valuation allowance is applied against the deferred tax asset. Assessing the recoverability of a deferred tax asset requires management to make significant estimates related to expectations of future taxable income. Estimates of future taxable income are based on forecasted cash flows from investments and operations, the character of expected income or loss as either capital or ordinary and the application of existing tax laws in each jurisdiction. To the extent that future cash flows and the amount or character of taxable income differ significantly from estimates, our ability to realize the deferred tax asset could be impacted. See Note 11 to our consolidated financial statements in this Annual Report on Form 10-K.

Additionally, under Sections 382 and 383 of the Code, following an “ownership change,” certain limitations apply to the use by a “loss corporation” of certain tax attributes including net operating loss carryforwards, capital loss carryforwards, unrealized built-in losses and tax credits arising before the “ownership change.” Such tax attributes represent substantially all of our deferred tax assets. In general, an “ownership change” would occur if there is a cumulative change in the ownership of our common stock of more than 50 percentage points by one or more “5% shareholders” during a three-year period. In the event of an “ownership change,” the tax attributes that may be used to offset our future taxable income in each year after the “ownership change” will be subject to an annual limitation. In general, the annual limitation is equal to the product of the fair market value of our common stock on the date of the “ownership change” and the “long term tax exempt rate” (which is published monthly by the Internal Revenue Service), subject to specified adjustments. This limitation could accelerate our cash tax payments and could result in a significant portion of our deferred tax asset expiring before we could fully use them. On April 27, 2012, we amended our Certificate of Incorporation to impose certain restrictions on the transfer of our common stock. These restrictions reduce, but do not eliminate, the risk of an “ownership change.”

Changes in laws or regulations governing our operations or our failure to comply with those laws or regulations may adversely affect our business
 
We and our portfolio companies are subject to regulation by laws at the local, state, federal and foreign level, including with respect to securities laws, tax and accounting standards. These laws and regulations, as well as their interpretation, may be

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changed from time to time. Accordingly, any change in these laws or regulations or the failure to comply with these laws or regulations could have a material adverse impact on our business. Certain of these laws and regulations pertain specifically to BDCs.
 
We may materially change our corporate structure and the nature of our business

We are very much affected by the legal, regulatory, tax and accounting regimes under which we operate. We are evaluating whether those regimes and our existing corporate structure are the optimum means for the operation and capitalization of our business. As a result of these evaluations, we may decide to proceed with structural and organizational changes (certain of which may require the approval of our shareholders), which could result in spinning out to our shareholders an externally managed debt focused BDC, changes in our corporate form, termination of our election to be regulated as a BDC, our conversion from an investment company to an operating company or other fundamental changes. If we were no longer an investment company, our accounting practices would change and, for example, lead to the consolidation of certain majority owned companies with which we do not now consolidate as an investment company. Additionally, if we were no longer an investment company, our shareholders would not benefit from the investor protections provided by the 1940 Act. We may incur certain costs in completing these evaluations and may receive no benefit from these expenditures, particularly if we do not proceed with any changes. No decisions have been made with respect to any such changes and there is no timetable for making any decisions, including any decision not to proceed with any such changes.

A change in interest rates may adversely affect our profitability
 
Because we have funded a portion of our investments with borrowings, our earnings are affected by the spread between the interest rate on our investments and the interest rate at which we borrowed funds. We have attempted to match-fund our liabilities and assets by financing floating rate assets with floating rate liabilities and fixed rate assets with fixed rate liabilities or equity. We have entered into interest rate basis swap agreements to match the interest rate basis of a portion of our assets and liabilities, thereby locking in the spread between our asset yield and the cost of our borrowings, and to fulfill our obligations under the terms of our asset securitizations. However, our derivatives are considered economic hedges that do not qualify for hedge accounting under ASC Topic 815, Derivatives and Hedging (“ASC 815”). Therefore, payments under the hedges are recorded in net realized (loss) gain in our consolidated statements of operations in this Annual Report on Form 10-K and not in interest income or expense.
 
Under our interest rate swap agreements, we generally pay a fixed rate and receive a floating interest rate based on LIBOR. We may enter into interest rate swaption agreements where, if exercised, we would receive a fixed rate and pay a floating rate based on LIBOR. We may also enter into interest rate cap agreements that would entitle us to receive an amount, if any, by which our interest payments on our variable rate debt exceed specified interest rates.
 
An increase or decrease in interest rates could reduce the spread between the rate at which we invest and the rate at which we borrow, and thus, adversely affect our profitability, if we have not appropriately match-funded our liabilities and assets or hedged against such event. Alternatively, our interest rate hedging activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio.
 
Also, the fair value of certain of our debt investments is based in part on the current market yields or interest rates of similar securities. A change in interest rates could have a significant impact on our determination of the fair value of these debt investments. In addition, a change in interest rates could also have an impact on the fair value of our interest rate swap agreements that could result in the recording of unrealized appreciation or depreciation in future periods. For example, a decline, or a flattening, of the forward interest rate yield curve will typically result in the recording of unrealized depreciation of our interest rate swap agreements.
 
Therefore, adverse developments resulting from changes in interest rates could have a material adverse effect on our business, financial condition and results of operations. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Quantitative and Qualitative Disclosures About Market Risk and Item 8. Financial Statements and Supplementary Data for additional information on interest rate swap agreements.
 
A change in currency exchange rates may adversely affect our profitability
 
We have or may make investments in debt instruments that are denominated in currencies other than the U.S. dollar. In addition, we have or may make investments in the equity of portfolio companies whose functional currency is not the U.S. dollar. Our domestic portfolio companies may also transact a significant amount of business in foreign countries and therefore their profitability may be impacted by changes in foreign currency exchange rates. The functional currency of one of our largest portfolio companies, European Capital, is the Euro. European Capital also has investments in other European currencies, including the British Pound. As a result, an adverse change in currency exchange rates may have a material adverse impact on our business, financial condition and results of operations.
 

19


We may experience fluctuations in our quarterly results
 
We have and could experience material fluctuations in our quarterly operating results due to a number of factors including, among others, variations in and the timing of the recognition of realized and unrealized gains or losses, placing and removing investments on non-accrual status, the degree to which we encounter competition in our markets, the ability to sell investments at attractive terms, the ability to fund and close suitable investments, the timing of the recognition of fee income from closing investment transactions and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
 
We are dependent upon our key management personnel for our future success
 
We are dependent on the diligence and skill of our senior management and other members of management for raising capital and the selection, structuring, monitoring, restructuring/amendment, sale and exiting of our investments. Our future success depends to a significant extent on the continued service of our senior management and other members of management. Our failure to raise additional capital that would enhance the growth of our business, or our failure to provide appropriate opportunities for or compensate competitively senior management and other members of management may make it difficult to retain such individuals. The departure of certain executive officers or key employees could materially adversely affect our ability to implement our business strategy. We do not maintain key man life insurance on any of our officers or employees.
 
We operate in a highly competitive market for investment opportunities
 
We compete with strategic buyers and hundreds of private equity and mezzanine debt funds and other financing sources, including traditional financial services companies such as finance companies, commercial banks, investment banks and other equity and non-equity based investment funds. Some of our competitors are substantially larger and have considerably greater financial resources than us. Competitors may have lower cost of funds and many have access to funding sources that are not available to us. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to offer better pricing and terms to prospective portfolio companies, consider a wider variety of investments and establish more relationships and build their market shares. There is no assurance that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. In addition, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that we will be able to identify and make investments that satisfy our investment objectives or that we will be able to meet our investment goals.

We could face losses and potential liability if intrusions, viruses or similar disruptions to our technology jeopardize our confidential information or that of users of our technology
 
Although we have implemented, and will continue to implement, security measures, our technology platform is and will continue to be vulnerable to intrusion, computer viruses or similar disruptive problems caused by transmission from unauthorized users. In addition, any misappropriation of proprietary information could expose us to a risk of loss or litigation.
 
Risks Related to Liquidity and Capital Resources
 
Our secured borrowing arrangements impose significant limitations on us
 
The loans under our four-year $600 million secured term loan facility (“Term Loan Facility”) may only be refinanced at a lower rate, in full or in part, prior to August 22, 2013 for an amount equal to 101% of the principal prepaid plus accrued interest. In addition, our secured term loans have scheduled amortization and mandatory prepayments in the event of a borrowing base deficiency or the issuance of new debt, and in certain cases, if there are realized proceeds from a portfolio company exit or excess cash flow. Any loans that may be outstanding under our four-year $250 million secured revolving credit facility (“Revolving Credit Facility”) are also subject to scheduled amortization after the three year revolving period and mandatory prepayments in the event of a borrowing base deficiency.

The Term Loan Facility and the Revolving Credit Facility have covenants that in certain circumstances limit our ability to incur additional debt and liens, pay cash dividends, repurchase common stock, dispose of assets and make new investments and acquisitions. We are also prohibited from seeking to resume our status as a RIC and changing our regulatory status as a BDC. Both facilities require us to maintain a 100% borrowing base coverage. The Revolving Credit Facility also includes other financial covenants that require us to maintain a maximum total leverage ratio not to exceed 0.75:1.00 and minimum adjusted EBITDA for American Capital Asset Management. There can be no assurance that we will be able to maintain compliance with each of these covenants and a failure to do so could result in an event of default under the facilities. Other events of default under the Term Loan Facility and the Revolving Credit Facility include without limitation, a payment default, an unremedied borrowing base deficiency, a cross default to our other facility, the cross acceleration of any debt in excess of an aggregate $50 million, the liquidation or

20


bankruptcy of us or American Capital Asset Management, the failure by us to conduct our asset management business through American Capital Asset Management, one or more judgments in excess of an aggregate $50 million and a change of control. The occurrence of an event of default under the facilities could have a material adverse effect on our business, financial condition and results of operations.

Additionally, debt obligations outstanding under our asset securitizations currently require that all principal and interest received on the loans securing such debt be used to repay such debt. Accordingly, we do not currently have access to the liquidity or current cash flows from the loans securing the debt in our asset securitizations for funding new investments or general corporate needs.
 
The 1940 Act limits our ability to issue Senior Securities in Certain Circumstances
 
As a BDC, the 1940 Act generally limits our ability to issue Senior Securities if our asset coverage ratio does not exceed 200% immediately after each issuance of Senior Securities or is improved immediately upon the issuance. Asset coverage ratio is defined in the 1940 Act as the ratio that the value of the total assets, less all liabilities and indebtedness not represented by Senior Securities, bears to the aggregate amount of Senior Securities representing indebtedness. We have operated at times in the past with our asset coverage ratio below 200% and there are no assurances that we will always operate above this ratio. The resulting restrictions on issuing Senior Securities could have a material adverse impact on our business operations.

The 1940 Act limits our ability to issue equity below our NAV per share
 
As a BDC, the 1940 Act generally limits our ability to issue and sell our common stock at a price below our NAV per share, exclusive of any distributing commission or discount, without shareholder approval. Since 2008, shares of our common stock have traded below our NAV per share. While our common stock continues to trade at a price below our NAV per share, there are no assurances that we can issue or sell shares of our common stock if needed to fund our business. In addition, even in certain instances where we could issue or sell shares of our common stock at a price below our NAV per share, such issuance could result in dilution in our NAV per share, which could result in a decline of our stock price.
 
Our interest rate swap agreements contain covenants that place limitations on us
 
We enter into interest rate swap agreements to manage interest rate risk and also to fulfill our obligations under the terms of our asset securitizations. Our interest rate swap agreements contain various events of default, including in certain cases an event of default that allows the counterparty to terminate transactions outstanding under the agreement following the occurrence of a cross default on certain of our other indebtedness. Certain of our interest rate swap agreements also contain an event of default that allows a counterparty to terminate transactions outstanding under the agreement if certain of our other indebtedness, as applicable, is accelerated. An event of default under certain of our interest rate swap agreements could also trigger a default under our secured debt facilities if such agreements are terminated early and would result in an aggregate amount due at such time in excess of $50 million. Some of our interest rate swap agreements are secured by first and second priority liens (subject to certain permitted liens) on substantially all of our non-securitized assets pari passu with the Term Loan Facility and, in certain cases, also the Revolving Credit Facility. The remaining interest rate swap agreements are secured by a first priority lien (subject to certain permitted liens) on our securitized assets pari passu with our securitized debt. Thus, if we violate the covenants in any of the interest rate swap agreements, it could have a material adverse effect on our business, financial condition and results of operations.
 
The lack of liquidity in our privately-held securities may adversely affect our business
 
Most of our investments consist of securities acquired directly from their issuers in private transactions. Some of these securities are subject to restrictions on resale or otherwise are less liquid than public securities. The illiquidity of our investments may make it difficult for us to obtain cash equal to the value at which we record our investments upon exiting the investment.
 
Risks Related to Our Investing and Financing Strategy
 
We have and may incur additional debt that could increase your investment risks
 
We and certain of our consolidated affiliates have borrowed money or issued debt securities, which give our lenders and the holder of our debt securities fixed dollar claims on our assets or the assets of such consolidated affiliates that are senior to the claims of our shareholders and, thus, our lenders have preference over our shareholders with respect to these assets. In particular, the assets that our consolidated affiliates have pledged to lenders under our asset securitizations were sold or contributed to separate affiliated statutory trusts prior to such pledge. While we own a beneficial interest in these trusts, these assets are the property of the respective trusts, available to satisfy the debts of the trusts, and would only become available for distribution to our shareholders to the extent specifically permitted under the agreements governing those term debt notes. Additionally, we have granted a security interest in substantially all of our other assets to the lenders of our Term Loan Facility and Revolving Credit Facility which impose certain limitations on us.
 

21


The following table is designed to illustrate the effect on returns to a holder of our common stock of the leverage created by our use of borrowing, at the weighted average interest rate of 6.1% for the year ended December 31, 2012, and assuming hypothetical annual returns on our portfolio of minus 15% to plus 15%. As illustrated below, leverage generally increases the return to shareholders when the portfolio return is positive and decreases the return when the portfolio return is negative. Actual returns may be greater or less than those appearing in the table.
Assumed Return on Portfolio (Net of Expenses)(1)
(15%)
(10%)
(5%)
—%
5%
10%
15%
Corresponding Return to Stockholders(2)
(19%)
(13%)
(7%)
(1%)
5%
11%
16%
 
(1)
The assumed portfolio return is required by regulation of the SEC and is not a prediction of, and does not represent, our projected or actual performance.
(2)
In order to compute the “Corresponding Return to Shareholders,” the “Assumed Return on Portfolio” is multiplied by the total value of our assets at the beginning of the period to obtain an assumed return to us. From this amount, all interest expense accrued during the period is subtracted to determine the return available to shareholders. The return available to shareholders is then divided by the total value of our net assets as of the beginning of the period to determine the “Corresponding Return to Shareholders.”
 
Although outstanding debt increases the potential for gain, it also increases the risk of loss of income or capital. This is the case, whether we are impacted by an increase or decrease in income or due to increases or decreases in asset values. Our ability to pay dividends is similarly impacted by outstanding debt.
 
We currently have a non-investment grade corporate credit rating and we could experience downgrades
 
As of December 31, 2012, our corporate credit rating was B2, B+ and B+ by Moody's Investor Services, Standard & Poor's Ratings Services and Fitch Ratings, respectively. Any rating below BBB or Baa2 is considered non-investment grade. A non-investment grade rating in general reduces a company's access to debt capital. If these credit ratings were to be downgraded, our ability to refinance or raise additional debt could be negatively impacted. Any of these occurrences could have a material effect on our business, financial condition and results of operations.
 
Our credit ratings may not reflect all risks of an investment in our debt securities
 
Our credit ratings are an assessment by major debt rating agencies of our ability to pay our obligations. Consequently, actual or expected changes in our credit ratings will likely affect the market value of our traded debt securities. Our credit ratings, however, may not fully or accurately reflect all of the credit and market risks associated with our outstanding debt securities.
 
We may not realize gains from our equity investments
 
We invest in equity assets with the goal to realize income and gains from the performance and disposition of these assets. Some or all of these equity assets may not produce income or gains; accordingly, we may not be able to realize income or gains from our equity assets.
 
Our portfolio companies may be highly leveraged with debt
 
The debt levels of our portfolio companies may have important adverse consequences to such companies and to us as an investor. Portfolio companies that are indebted may be subject to restrictive financial and operating covenants. The leverage may impair these companies' ability to finance their future operations and capital needs. As a result, their flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A company's income and net worth will tend to increase or decrease at a greater rate than if the company did not capitalize itself in part with debt.

Investments in non-investment grade Structured Products may be illiquid, may have a higher risk of default, and may not produce current returns
 
Our investments in Structured Products securities are generally non-investment grade. Non-investment grade Structured Products bonds and preferred shares tend to be illiquid, have a higher risk of default and may be more difficult to value than investment grade bonds. Recessions or poor economic or pricing conditions in the markets associated with Structured Products may cause higher defaults or losses than expected on these bonds and preferred shares. Non-investment grade securities are considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not certain.
 




22


Our assets include investments in Structured Products that are subordinate in right of payment to more senior securities
 
Our assets include subordinated CLO, CDO and CMBS securities, which are subordinated classes of securities in a structure of securities secured by a pool of loans. Accordingly, such securities are the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Thus, there is generally only a nominal amount of equity or other debt securities junior to our positions, if any, issued in such structures. Additionally, the estimated fair values of our subordinated interests tend to be much more sensitive to changes in economic conditions than more senior securities.
 
The trading market or market value of our debt securities may fluctuate
 
Many factors may materially adversely affect the trading market for, and market value of, our debt securities including, but not limited to, the following:
 
future defaults under the securities;

our creditworthiness;

the time remaining to the maturity of these debt securities;
 
the outstanding principal amount of debt securities with terms identical to these debt securities;

the supply of debt securities trading in the secondary market, if any;

the redemption or repayment features, if any, of these debt securities;

the level, direction and volatility of market interest rates generally; and

market rates of interest that are higher or lower than rates borne by the debt securities.
 
There may also be a limited number of buyers when an investor decides to sell its debt securities. This too may materially adversely affect the market value of the debt securities or the trading market for the debt securities.
 
We may issue preferred stock in the future to help finance our business, which would magnify the potential for gain or loss and the risks of investing in us in the same way as our borrowings.

Preferred stock, which is another form of leverage, has the same risks to our common stockholders as borrowings because the dividends on any preferred stock we issue must be cumulative. Payment of such dividends and repayment of the liquidation preference of such preferred stock must take preference over any dividends or other payments to our common stockholders, and preferred stockholders are not subject to any of our expenses or losses and are not entitled to participate in any income or appreciation in excess of their stated preference.

We have restrictions on the type of assets we can invest in as a BDC
 
As a BDC, we may not acquire any assets other than “qualifying assets”, as defined in the 1940 Act, unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets. Thus, we may be precluded from investing in potentially attractive investments if such investments are not qualifying assets for purposes of the 1940 Act. In addition, there is a risk that this restriction could prevent us from making additional investments in our existing non-qualifying investments, which could cause our position to be diluted or limit the access to capital of our non-qualifying investments.

There are conflicts of interest with other funds that we manage
 
Through our wholly-owned portfolio company, American Capital Asset Management, we manage various funds that may compete with us for investments. Although we have policies in place to seek to mitigate the effects of conflicts of interest, these policies will not eliminate the conflicts of interest that our officers and employees and the officers and employees of our fund managers and affiliates will face in making investment decisions on behalf of American Capital or any other American Capital-sponsored investment vehicles. Further, we do not have any agreement or understanding with our funds that would give us any priority over them in opportunities to invest in overlapping investments. Accordingly, we may compete for access to investments with other funds that we manage.


23


Risks Related to Our Common Stock
 
We may not pay any cash dividends
 
We are subject to federal and applicable state corporate income taxes on our taxable ordinary income and capital gains beginning with our tax year ended September 30, 2011, and are not subject to the annual distribution requirements under Subchapter M of the Code. We have not paid a cash dividend during the last three fiscal years ended December 31, 2012 and there can be no assurance that we will pay any cash dividends in the future as we may retain our earnings to facilitate the growth of our business, to invest, to provide liquidity, to repurchase our shares or for other corporate purposes.
 
Future equity issuances may be on terms adverse to shareholder interests
 
We may issue equity capital at prices below our NAV per share with shareholder approval. As of the date of this filing, we do not have such authorization; however, we may seek such approval in the future or we may elect to conduct a rights offering, which would not require shareholder approval under the 1940 Act. If we issue any shares of common stock below our NAV per share, the interests of our existing shareholders may be diluted. Any such dilution could include a reduction in our NAV per share as a result of the issuance of shares at a price below the NAV per share and a decrease in a shareholder's interest in our earnings and assets and voting interest. As of December 31, 2012, the closing price of our common stock was below our NAV per share.

The following table is designed to illustrate the dilutive effect on NAV per share if we issue shares of common stock below our NAV per share. The table below reflects NAV per share diluted for the hypothetical issuance of 50,000,000 shares of common stock (about 16% of outstanding shares as of December 31, 2012), at hypothetical sales prices of 5%, 10%, 15%, 20%, 25% and 50% below the December 31, 2012 NAV of $17.84 per share.
 
Assumed Sales price per share below NAV per share(1)
(50%)
(25%)
(20%)
(15%)
(10%)
(5%)
Diluted NAV per share
$16.58
$17.20
$17.33
$17.46
$17.58
$17.71
% Dilution
(7.1%)
(3.5%)
(2.8%)
(2.1%)
(1.4%)
(0.7%)
 
(1)
The assumed sales price per share is assumed to be net of any applicable underwriting commissions or discounts.
 
The market price of our common stock may fluctuate significantly
 
The market price and marketability of shares of our securities may from time to time be significantly affected by numerous factors, including many over which we have no control and that may not be directly related to us. These factors include the following:
 
price and volume fluctuations in the stock market from time to time, which are often unrelated to the operating performance of particular companies;

defaulting on our debt covenants;

significant volatility in the market price and trading volume of securities of BDCs, financial service companies, asset managers or other companies in our sector, which is not necessarily related to the operating performance of particular companies;

changes in laws, regulatory policies, tax guidelines or financial accounting standards, particularly with respect to BDCs;

changes in our earnings or variations in operating results;

any shortfall in revenue or net income or any increase in losses from levels expected by securities analysts and the market in general;

decreases in our NAV per share;

general economic trends and other external factors; and

loss of a major funding source.
 
Fluctuations in the trading price of our common stock may adversely affect the liquidity of the trading market for our common stock and, in the event that we seek to raise capital through future equity financings, our ability to raise such equity capital.


24


Our common stock may be difficult to resell
 
Investors may not be able to resell shares of common stock at or above their purchase prices due to a number of factors, including:
 
actual or anticipated fluctuation in our operating results;

volatility in our common stock price;

changes in expectations as to our future financial performance or changes in financial estimates of securities analysts; and

departures of key personnel.
 
Provisions of our Charter and Bylaws could deter takeover attempts
 
Our charter and bylaws and the Delaware General Corporation Law contain certain provisions that may have the effect of discouraging and delaying or making more difficult a change in control. For example, we are subject to Section 203 of the Delaware General Corporation Law, which prohibits business combinations with interested shareholders except in certain cases. The existence of these provisions may negatively impact the price of our common stock and may discourage third-party bids. These provisions may also reduce any premiums paid to our shareholders for shares of our common stock that they own.
 
Item 1B.
Unresolved Staff Comments
 
None.

Item 2.
Properties
 
We do not own any real estate or other physical properties materially important to our operations. We lease office space in six locations for terms ranging up to eleven years.

Item 3.
Legal Proceedings

Neither we, nor any of our consolidated subsidiaries, are currently subject to any material litigation nor, to our knowledge, is any material litigation threatened against us or any consolidated subsidiary, other than routine litigation and administrative proceedings arising in the ordinary course of business. Such proceedings are not expected to have a material adverse effect on the business, financial conditions, or results of our operations.

Item 4.
Mine Safety Disclosures

Not applicable.


















25



PART II.

Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Quarterly Stock Prices
 
Our common stock is quoted on The NASDAQ Global Select Market under the ticker symbol “ACAS”. As of February 15, 2013, we had 798 shareholders of record. Most of the shares of our common stock are held by brokers and other institutions on behalf of shareholders. We believe that there are currently over 114,500 additional beneficial holders of our common stock. During the years ended December 31, 2012 and 2011, we did not declare any dividends on our common stock. The following table sets forth the range of high and low sales prices of our common stock as reported on The NASDAQ Global Select Market for the years ended December 31, 2012 and 2011.
 
 
Sales Prices
 
 
High
 
Low
2012
 
 
 
 
First Quarter
 
$
9.26

 
$
6.86

Second Quarter
 
$
10.10

 
$
8.16

Third Quarter
 
$
12.00

 
$
9.50

Fourth Quarter
 
$
12.43

 
$
11.12

 
 
 
 
 
2011
 
 
 
 
First Quarter
 
$
9.93

 
$
7.65

Second Quarter
 
$
10.85

 
$
8.60

Third Quarter
 
$
10.29

 
$
6.75

Fourth Quarter
 
$
8.16

 
$
5.98


Stock Repurchase and Dividend Program
 
In September 2011, our Board of Directors adopted a program that may provide for stock repurchases or dividend payments. On April 26, 2012, our Board of Directors extended the stock repurchase and dividend program through December 31, 2013. The following table provides information for the quarter ended December 31, 2012, regarding shares of our common stock that we repurchased in the open market and were subsequently retired (in millions, except per share amounts):
 
Total Number of Shares Purchased(1)
 
Average Price Paid Per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(2)
 
Maximum Number of Shares That May Yet Be Purchased Under the Publicly Announced Plans or Programs
November 5, 2012 through November 16, 2012
6.3

 
$
11.57

 
6.3

 
N/A
December 7, 2012 through December 14, 2012
2.5

 
$
12.10

 
2.5

 
N/A
Fourth Quarter 2012
8.8

 
$
11.72

 
8.8

 
N/A

(1)
All shares were purchased by us pursuant to the stock repurchase and dividend program described in footnote 2 below.
(2)
Under the program described above, we will consider quarterly setting an amount to be utilized for stock repurchases or dividends.

Dividend Reinvestment Plan

At the option of a holder of record of common stock, all cash distributions can be reinvested automatically under our dividend reinvestment plan (“DRIP”) in additional whole and fractional shares. Pursuant to our DRIP, a shareholder whose shares are registered in his own name may opt in to the plan and elect to reinvest all or a portion of his or her dividends in shares of our common stock by providing the required enrollment notice to the plan administrator, Computershare Investor Services. Shareholders whose shares are held in the name of a broker or the nominee of a broker may have distributions reinvested only if such service is provided by the broker or the nominee, or if the broker or the nominee permits participation in our DRIP. Shareholders whose shares are held in the name of a broker or other nominee should contact the broker or nominee for details. Shareholders that participate in the DRIP will receive the number of whole or fractional shares that can be obtained based on the price per share

26


the plan administrator purchases the shares of common stock. Such shares will be acquired by the plan administrator through either receipt of newly issued shares or treasury shares from us or by purchase of outstanding shares of common stock on the open market. If the market price per share of our common stock on the dividend payment date equals or exceeds by at least 110% the NAV per share of our common stock as of the end of the most recently completed fiscal quarter (or as of such other time as may be determined by our Board of Directors), then our plan administrator will acquire shares of our common stock directly from us at a price equal to the greater of NAV per share or the market price on that date less a 2% discount. However, (i) if the market price per share of our common stock on the dividend payment date does not exceed 110% of the NAV per share of our common stock as of the end of the most recently completed fiscal quarter or (ii) if we advise the plan administrator that since such NAV per share was last determined we have become aware of events that indicate the possibility of a change in NAV per share as a result of which the NAV per share of the common stock on the dividend payment date might be higher than the current market price per share of our common stock, then the plan administrator will not acquire any newly issued shares from us at a discount and instead will buy shares of our common stock in the open market. You can find out more information about the DRIP by reading our Third Amended and Restated Dividend Reinvestment Plan, a copy of which is located on our internet website at www.AmericanCapital.com.

Our stock transfer agent, registrar and dividend reinvestment plan administrator is Computershare Investor Services. Requests for information from Computershare can be sent to Computershare Trust Company, N.A., P.O. Box 43078, Providence, RI 02940, and their telephone number is 1-800-733-5001.

For the three fiscal years ended December 31, 2012, we have not sold any equity securities that were not registered under the Securities Act.

Equity Compensation Plans
 
The following table summarizes information, as of December 31, 2012, relating to our equity compensation plans pursuant to which grants of options or other rights to acquire shares of our common stock may be granted from time to time. See Item 8. Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements for a description of our equity compensation plans (shares in millions).  
Plan category
 
Number of securities to be issued upon exercise of outstanding options
 
Weighted-average exercise price of outstanding options
 
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in the first column of this table)
Equity compensation plans approved by security holders(1)
 
58.2

 
$
8.72

 
1.7

Equity compensation plans not approved by security holders(1)
 

 

 

Total
 
58.2

 
$
8.72

 
1.7


(1)
All of our equity compensation plans have been approved by our shareholders.


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Performance Graph
 
The performance graph below compares the total cumulative shareholder return on our common stock with the cumulative shareholder return on the equity securities of companies included in the Standard & Poor's 500 Stock Index (“S&P 500”), S&P 500 Financials Sector Index and BDC Peer Group, measured as of the last trading day of each year shown. The performance graph represents past performance and should not be considered to be an indication of future performance.
The preceding graph and the following table compares a shareholder's cumulative total return for the last five fiscal years, assuming $100 invested at December 31, 2007, with the reinvestment of all dividends without commissions, as if such amounts had been invested in: (i) our common stock; (ii) the stocks included in the S&P 500; (iii) the stocks included in the S&P 500 Financials Sector Index; and (iv) an index of selected issuers in our BDC Peer group, composed of Apollo Investment Corporation, Ares Capital Corporation, BlackRock Kelso Capital Corporation, PennantPark Investment Corporation and Prospect Capital Corporation.
 
 
Cumulative Total Return
 
 
12/07
 
12/08
 
12/09
 
12/10
 
12/11
 
12/12
AMERICAN CAPITAL
 
$
100

 
$
12

 
$
12

 
$
37

 
$
33

 
$
59

S&P 500
 
100

 
63

 
80

 
92

 
94

 
109

S&P 500 FINANCIALS SECTOR INDEX
 
100

 
45

 
52

 
59

 
49

 
63

BDC PEER GROUP
 
100

 
67

 
105

 
140

 
127

 
163


28




Item 6.Selected Financial Data

AMERICAN CAPITAL, LTD.
 
Consolidated Selected Financial Data
(in millions, except per share data)
 
The selected financial data should be read in conjunction with our consolidated financial statements in this Annual Report on Form 10-K and notes thereto.
 
 
 
Year Ended December 31, 
 
 
2012
 
2011
 
2010
 
2009
 
2008
Total operating revenue
 
$
646

 
$
591

 
$
600

 
$
697

 
$
1,051

Total operating expenses
 
263

 
288

 
396

 
582

 
521

Net operating income before income taxes
 
383

 
303

 
204

 
115

 
530

Tax benefit (provision)(1)
 
14

 
145

 

 
20

 
(37
)
Net operating income (“NOI”)
 
397

 
448

 
204

 
135

 
493

(Loss) gain on extinguishment of debt, net of tax
 
(3
)
 

 

 
12

 

Net realized (loss) gain(1)
 
(270
)
 
(310
)
 
(576
)
 
(825
)
 
32

Net realized earnings (loss)
 
124

 
138

 
(372
)
 
(678
)
 
525

Net unrealized appreciation (depreciation)(1)
 
1,012

 
836

 
1,370

 
(232
)
 
(3,640
)
Net increase (decrease) in net assets resulting from operations (“Net earnings (loss)”)
 
$
1,136

 
$
974

 
$
998

 
$
(910
)
 
$
(3,115
)
 
 
 

 
138

 
 

 
 

 
 

Per share data:
 
 

 
 
 
 

 
 

 
 

NOI:
 
 

 
 
 
 

 
 

 
 

Basic
 
$
1.24

 
$
1.30

 
$
0.63

 
$
0.56

 
$
2.42

Diluted
 
$
1.20

 
$
1.26

 
$
0.62

 
$
0.56

 
$
2.42

Net earnings (loss):
 
 
 
 
 
 

 
 

 
 

Basic
 
$
3.55

 
$
2.83

 
$
3.06

 
$
(3.77
)
 
$
(15.29
)
Diluted
 
$
3.44

 
$
2.74

 
$
3.02

 
$
(3.77
)
 
$
(15.29
)
Dividends declared(2)
 
$

 
$

 
$

 
$
1.07

 
$
3.09

Balance sheet data:
 
 

 
 

 
 

 
 

 
 

Total assets
 
$
6,319

 
$
5,961

 
$
6,084

 
$
6,672

 
$
7,910

Total debt
 
$
775

 
$
1,251

 
$
2,259

 
$
4,142

 
$
4,428

Total shareholders’ equity
 
$
5,429

 
$
4,563

 
$
3,668

 
$
2,329

 
$
3,155

NAV per share
 
$
17.84

 
$
13.87

 
$
10.71

 
$
8.29

 
$
15.41

Other data (unaudited):
 
 

 
 

 
 

 
 

 
 

Number of portfolio companies at period end
 
139

 
152

 
160

 
187

 
223

New investments(3)
 
$
719

 
$
317

 
$
234

 
$
109

 
$
2,607

Realizations(4)
 
$
1,498

 
$
1,066

 
$
1,293

 
$
1,143

 
$
2,176

Weighted average effective interest rate on private finance debt investments at period end(5)
 
11.4
%
 
10.7
%
 
10.2
%
 
9.9
%
 
10.8
%
NOI return on average shareholders’ equity(6)
 
7.7
%
 
10.7
%
 
6.8
%
 
5.5
%
 
9.5
%
Net realized earnings return (loss) on average shareholders’ equity(6)
 
2.5
%
 
3.3
%
 
(12.5
%)
 
(27.8
%)
 
10.1
%
Net earnings return (loss) on average shareholders’ equity(6)
 
22.1
%
 
23.3
%
 
33.5
%
 
(37.3
%)
 
(60.0
%)
Assets under management(7)
 
$
116,800

 
$
68,129

 
$
22,645

 
$
14,022

 
$
12,804

Earning assets under management(8)
 
$
18,642

 
$
13,496

 
$
8,989

 
$
8,518

 
$
9,608

 
(1)
Beginning in 2011, we were no longer taxed as a RIC under Subchapter M of the Code and instead became subject to taxation as a corporation under Subchapter C of the Code. As a result, we recorded a net deferred tax asset of $428 million in 2011 recorded as a deferred tax benefit of $145 million in NOI, $75 million in net realized (loss) gain and $208 million in net unrealized appreciation (depreciation) in our consolidated statements of operations in this Annual Report on Form 10-K. In 2012, we recorded a tax benefit of

29


$14 million in NOI, $87 million in net realized (loss) gain, $2 million in (loss) gain on extinguishment of debt, net of tax and a tax provision of $82 million in net unrealized appreciation (depreciation) in our consolidated statements of operations in this Annual Report on Form 10-K.
(2)
In 2009, we declared a dividend of $1.07 per share, which was paid part in cash and stock in August 2009.
(3)
New investments include amounts as of the investment dates that are committed.
(4)
Realizations represent cash proceeds received upon the exit of investments including payment of scheduled principal amortization, debt prepayments, proceeds from loan syndications and sales, payment of accrued payment-in-kind (“PIK”) notes, and dividends and payments associated with accreted original issue discounts and sale of equity and other securities.
(5)
Weighted average effective interest rate on private finance debt investments as of period end is computed as (a) annual stated interest rate or yield earned plus the net annual amortization of original issue discount and market discount earned on accruing debt, divided by (b) total debt at amortized cost.
(6)
Return represents net increase or decrease in net assets resulting from operations. Average equity is calculated based on the quarterly shareholders' equity balances.
(7)
Assets under management include both (i) the total assets of American Capital and (ii) the total assets of the funds under management by American Capital Asset Management, excluding any direct investment we have in those funds.
(8)
Earning assets under management include both (i) the total assets of American Capital and (ii) the total third-party earning assets under management by American Capital Asset Management from which the associated base management fees are calculated, excluding any direct investment we have in those funds.











































30



ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (in millions, except per share data)

Forward-Looking Statements
 
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: (i) changes in the economic conditions in which we operate negatively impacting our financial resources; (ii) certain of our competitors have greater financial resources than us, reducing the number of suitable investment opportunities offered to us or reducing the yield necessary to consummate the investment; (iii) there is uncertainty regarding the value of our privately-held securities that require our good faith estimate of fair value, and a change in estimate could affect our NAV; (iv) our investments in securities of privately-held companies may be illiquid, which could affect our ability to realize the investment; (v) our portfolio companies could default on their loans or provide no returns on our investments, which could affect our operating results; (vi) we use external financing to fund our business, which may not always be available; (vii) our ability to retain key management personnel; (viii) an economic downturn or recession could impair our portfolio companies and therefore harm our operating results; (ix) our borrowing arrangements impose certain restrictions; (x) changes in interest rates may affect our cost of capital and NOI; (xi) we cannot incur additional indebtedness unless immediately after a debt issuance we maintain an asset coverage of at least 200%, or equal to or greater than our asset coverage prior to such issuance, which may affect returns to our shareholder; (xii) our common stock price may be volatile; and (xiii) general business and economic conditions and other risk factors described in our reports filed from time to time with the SEC. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, please see the information under the caption “Risk Factors” described in this Annual Report on Form 10-K. We caution readers not to place undue reliance on any such forward-looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.

American Capital Investing Activity
 
We primarily invest in senior debt, mezzanine debt and equity of middle market companies, which we generally consider to be companies with revenue between $10 million and $750 million. We primarily invest in One Stop Buyouts® or Sponsor Finance Investments and provide capital directly to early stage and mature private and small public companies. Currently, we will invest up to $500 million in a single middle market company in North America. We also invest in alternative asset funds that we manage and Structured Products.

We seek to be a long-term partner with our portfolio companies. As a long-term partner, we will invest capital in a portfolio company subsequent to our initial investment if we believe that it can achieve appropriate returns for our investment. Add-on financings to our portfolio companies fund (i) strategic acquisitions by a portfolio company of either a complete business or specific lines of a business that are related to the portfolio company's business, (ii) recapitalization of a portfolio company to raise financing on better terms, buyout one or several owners or to pay a dividend, (iii) growth of the portfolio company such as product development or plant expansions, or (iv) working capital for a portfolio company, sometimes in distressed situations, that needs capital to fund operating costs, debt service or growth in receivables or inventory.

The total fair value of our investment portfolio was $5.3 billion, $5.1 billion and $5.5 billion as of December 31, 2012, 2011 and 2010, respectively. Our new investments totaled $719 million, $317 million and $234 million during the years ended December 31, 2012, 2011 and 2010, respectively. The amounts of our new investments include both funded commitments and unfunded commitments as of the investment date.


31


The type and aggregate dollar amount of new investments were as follows (in millions):
 
2012
 
2011
 
2010
One Stop Buyouts®
$
301

 
$
1

 
$

Sponsor Finance Investments
109

 
25

 

Investments in managed funds
50

 
137

 
75

Direct and other investments

 
15

 
35

Structured Products
9

 

 

Add-on investment in American Capital Asset Management
116

 
11

 

Add-on financing for growth and working capital
22

 
4

 
2

Add-on financing for acquisitions
19

 
58

 
22

Add-on financing for working capital in distressed situations
22

 
35

 
38

Add-on financing for recapitalizations, not including distressed investments
71

 
27

 
5

Add-on financing for purchase of debt of a portfolio company

 
4

 
57

       Total
$
719

 
$
317

 
$
234

    
The amounts of our new investments include both funded commitments and unfunded commitments as of the investment date.

We received cash proceeds from realizations and repayments of portfolio investments as follows (in millions):
 
2012
 
2011
 
2010
Principal prepayments
$
938

 
$
510

 
$
874

Sale of equity investments
274

 
394

 
266

Payment of accrued PIK notes and dividend and accreted original issue discounts
242

 
108

 
77

Loan syndications and sales
3

 
16

 
40

Scheduled principal amortization
41

 
38

 
36

Total
$
1,498

 
$
1,066

 
$
1,293


RESULTS OF OPERATIONS

The following analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements in this Annual Report on Form 10-K and the notes thereto.

Our consolidated financial performance, as reflected in our consolidated statements of operations, is composed of the following three primary elements:

The first element is “NOI,” which is primarily the interest, dividends, prepayment fees, finance and transaction fees and portfolio company management fees earned from investing in debt and equity securities and the fees we earn from fund asset management, less our operating expenses and provision for income taxes.
The second element is “Net realized gain (loss),” which reflects the difference between the proceeds from an exit of an investment and the cost at which the investment was carried on our consolidated balance sheets and periodic interest settlements and termination receipts or payments on derivatives, foreign currency transaction gains or losses and taxes on realized gains or losses.
The third element is “Net unrealized appreciation (depreciation),” which is the net change in the estimated fair value of our portfolio investments and of our interest rate derivatives at the end of the period compared with their estimated fair values at the beginning of the period or their stated costs, as appropriate, and taxes on unrealized gains or losses. In addition, our net unrealized depreciation includes the foreign currency translation from converting the cost basis of our assets and liabilities denominated in a foreign currency to the US dollar.


32


The consolidated operating results were as follows (in millions):
 
2012
 
2011
 
2010
Operating revenue
$
646

 
$
591

 
$
600

Operating expenses
263

 
288

 
396

NOI before income taxes
383

 
303

 
204

Tax benefit
14

 
145

 

NOI
397

 
448

 
204

Loss on extinguishment of debt, net of tax
(3
)
 

 

Net realized loss
(270
)
 
(310
)
 
(576
)
Net realized earnings (loss)
124

 
138

 
(372
)
Net unrealized appreciation
1,012

 
836

 
1,370

Net earnings
$
1,136

 
$
974

 
$
998


Fiscal Year 2012 Compared to Fiscal Year 2011

Operating Revenue

We derive the majority of our operating revenue by investing in senior and mezzanine debt and equity of middle market companies with attractive current yields and/or potential for equity appreciation and realized gains. We also derive operating revenue from investing in Structured Products and in our wholly-owned asset manager, American Capital Asset Management. Operating revenue consisted of the following (in millions):
 
2012
 
2011
Interest income on debt investments
$
274

 
$
350

Interest income on Structured Products investments
67

 
56

Dividend income on private finance portfolio investments
161

 
106

Dividend income from American Capital Asset Management
83

 
30

Interest income on bank deposits
1

 
1

Interest and dividend income
586

 
543

Portfolio company advisory and administrative fees
16

 
14

Advisory and administrative services - American Capital Asset Management
20

 
20

Other fees
24

 
14

Fee income
60

 
48

          Total operating revenue
$
646

 
$
591



33


Interest and Dividend Income

The following table summarizes selected data for our debt, Structured Products and equity investments outstanding, at cost (dollars in millions):
 
2012
 
2011
Debt investments at cost(1)
$
2,302

 
$
3,198

Average non-accrual debt investments at cost(2)
$
361

 
$
574

Effective interest rate on debt investments
11.9
%
 
11.0
%
Effective interest rate on debt investments, excluding non-accrual prior period adjustments
11.7
%
 
10.9
%
Structured Products investments at cost(1)
$
414

 
$
547

Effective interest rate on Structured Products investments
16.2
%
 
10.3
%
Debt and Structured Products investments at cost(1)
$
2,716

 
$
3,745

Effective interest rate on debt and Structured Products investments
12.6
%
 
10.9
%
Average daily one-month LIBOR
0.2
%
 
0.2
%
Equity investments - private finance portfolio at cost(1)(3)
$
2,124

 
$
2,228

Effective dividend yield on equity investments - private finance portfolio(3)
7.6
%
 
4.7
%
Effective dividend yield on equity investments - private finance portfolio, excluding non-accrual prior period adjustments(1)(3)
5.8
%
 
3.1
%
Debt, Structured Products and equity investments at cost(1)(3)
$
4,840

 
$
5,973

Effective yield on debt, Structured Products and equity investments(3)
10.4
%
 
8.6
%
Effective yield on debt, Structured Products and equity investments, excluding non-accrual prior period adjustments(1)(3)
9.5
%
 
7.9
%
 ——————————
(1)
Monthly weighted average of investments at cost.
(2)
Quarterly average of investments at cost.
(3)
Excludes our equity investment in American Capital Asset Management and European Capital.

Debt Investments

Interest income on debt investments decreased by $76 million, or 22%, for the year ended December 31, 2012 over the comparable period in 2011, primarily due to a decrease in our monthly weighted average debt investments outstanding. Our weighted average debt investments outstanding decreased by $896 million for the year ended December 31, 2012 over the comparable period in 2011 primarily as a result of the repayment or sale of debt investments. In addition, the average non-accrual debt investments outstanding decreased from $574 million during 2011 to $361 million during 2012. As a result of these factors, the effective interest rate on debt investments at cost increased 90 basis points from 11.0% in 2011 to 11.9% in 2012.

When a debt investment is placed on non-accrual, we may record reserves on uncollected PIK interest income recorded in prior periods as a reduction of interest income in the current period. Conversely, when a debt investment is removed from non-accrual, we may record interest income in the current period on prior period uncollected PIK interest income which was reserved in prior periods. For the years ended December 31, 2012 and 2011, we recorded additional interest income on uncollected PIK interest income recorded in prior periods of $6 million and $2 million, respectively, as a result of debt investments being removed from non-accrual.

Structured Products

Interest income on Structured Products investments increased by $11 million, or 20%, for the year ended December 31, 2012, respectively, over the comparable period in 2011 primarily due to increases in projected cash flows on our CLO investments. Our weighted average Structured Products investments outstanding decreased for the year ended December 31, 2012 over the comparable period in 2011 primarily as a result of the write-off of non-performing CMBS investments. See Note 2—Interest and Dividend Income Recognition policy to our consolidated financial statements in this Annual Report on Form 10-K for a description of how projected cash flows affect revenue recognition on our Structured Products investments.

Equity Investments - Private Finance Portfolio

Dividend income on private finance portfolio investments increased by $55 million, or 52%, for the year ended December 31, 2012 over the comparable period in 2011 primarily due to both an improvement in preferred equity investments that were previously non-accruing and an increase in non-recurring dividends on equity investments. As a result, the monthly weighted average effective

34


dividend yield on equity investments was 7.6% for the year ended December 31, 2012, a 290 basis point increase over the comparable period in 2011.

When a preferred equity investment is placed on non-accrual, we may record net reserves on uncollected accrued dividend income recorded in prior periods as a reduction of dividend income in the current period. Conversely, when a preferred equity investment is removed from non-accrual, we may record dividend income in the current period for prior period uncollected accrued dividend income which was reserved in prior periods. For the year ended December 31, 2012, we recorded additional dividend income for the reversal of reserves of accrued dividend income attributable to prior periods from private finance preferred stock investments of $37 million, which had an approximate 180 basis point impact on the effective dividend yield on equity investments. For the year ended December 31, 2011, we recorded additional dividend income for the reversal of reserves of accrued dividend income attributable to prior periods from private finance preferred stock investments of $36 million, which had an approximate 160 basis point impact on the effective dividend yield on equity investments.

For the year ended December 31, 2012, we recorded $36 million of dividend income for non-recurring dividends on common equity investments compared to $7 million in 2011.

Equity Investments - American Capital Asset Management

Dividend income from American Capital Asset Management increased by $53 million, or 177%, for the year ended December 31, 2012 over the comparable period in 2011 primarily due to an increase in net income of American Capital Asset Management, which was primarily generated from an increase in fees earned for the management of AGNC and MTGE, both of which experienced significant growth in their equity capital as a result of follow-on equity offerings. For the years ended December 31, 2012 and 2011, we received an additional $9 million and $11 million, respectively, of dividends from American Capital Asset Management that was recorded as a reduction to our cost basis.

Fee Income

Portfolio Company Advisory and Administrative Fees

As a BDC, we are required by law to make significant managerial assistance available to most of our portfolio companies. This generally includes providing guidance and counsel concerning the management, operations and business objectives and policies of the portfolio company to the portfolio company's management and board of directors, including participating on the company's board of directors. Our portfolio company advisory and administrative fees for the years ended December 31, 2012 and 2011 were $16 million and $14 million, respectively.

Advisory and Administrative Services - American Capital Asset Management

We have entered into service agreements with American Capital Asset Management to provide additional asset management service support so that American Capital Asset Management can fulfill its responsibilities under its management agreements. The fees generated from these service agreements for the years ended December 31, 2012 and 2011 were $20 million and $20 million, respectively.

Other Fees

Other fees are primarily composed of transaction fees for structuring, financing and executing middle market portfolio transactions, which may not be recurring in nature. Other fees increased by $10 million, or 71%, for the year ended December 31, 2012 over the comparable period in 2011, primarily due to transaction structuring fees generated from the increased volume of One Stop Buyouts® investments in 2012.

Operating Expenses

Operating expenses decreased $25 million, or 9%, for the year ended December 31, 2012, respectively, over the comparable period in 2011. Operating expenses consisted of the following (in millions):
 
2012
 
2011
Interest
$
59

 
$
90

Salaries, benefits and stock-based compensation
148

 
143

General and administrative
56

 
55

Total operating expenses
$
263

 
$
288



35


Interest

Interest expense for the year ended December 31, 2012 decreased $31 million, or 34%, over the comparable period in 2011. The decrease in interest expense was primarily attributable to a decrease in the weighted average borrowings outstanding for the year ended December 31, 2012 over the comparable period in 2011 as well as a decrease in the amortization of deferred financing costs primarily as a result of unscheduled payments on our secured borrowings during 2011.

The components of interest expense, cash paid for interest expense, average interest rates and average outstanding balances for our borrowings are as follows (dollars in millions):
 
2012
 
2011
Asset Securitizations:
 
 
 
Cash interest expense
$
5

 
$
8

Amortization of deferred financing costs
3

 
3

Total interest expense
$
8

 
$
11

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
2.0
%
 
1.3
%
Weighted average interest rate, excluding amortization of deferred financing costs
1.3
%
 
0.9
%
Weighted average balance outstanding
$
371

 
$
915

 
 
 
 
Public and Private Borrowings:
 
 
 
Cash interest expense
$
43

 
$
59

Amortization of deferred financing costs
8

 
20

Total interest expense
$
51

 
$
79

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
8.7
%
 
10.6
%
Weighted average interest rate, excluding amortization of deferred financing costs
7.3
%
 
7.9
%
Weighted average balance outstanding
$
589

 
$
747

 
 
 
 
Total Borrowings:
 
 
 
Cash interest expense
$
48

 
$
67

Amortization of deferred financing costs
11

 
23

Total interest expense
$
59

 
$
90

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
6.1
%
 
5.5
%
Weighted average interest rate, excluding amortization of deferred financing costs
5.0
%
 
4.1
%
Weighted average balance outstanding
$
960

 
$
1,662


Amortization of deferred financing costs on our public and private borrowings for the year ended December 31, 2012 decreased $12 million from the comparable period in 2011 primarily due to the acceleration of the amortization of deferred financing costs resulting from additional unscheduled principal paydowns on our secured debt in 2011.

Salaries, Benefits and Stock-based Compensation

Salaries, benefits and stock-based compensation consisted of the following (in millions):
 
2012
 
2011
Base salaries
$
55

 
$
53

Incentive compensation
40

 
35

Benefits
11

 
10

Stock-based compensation
42

 
45

Total salaries, benefits and stock-based compensation
$
148

 
$
143


Salaries, benefits and stock-based compensation for the year ended December 31, 2012 increased $5 million, or 3%, from the comparable period in 2011 primarily due to an increase in base salaries for non-executive officers and incentive compensation partially offset by a reduction in stock-based compensation. As of December 31, 2012, we had 256 total employees compared to 249 total employees as of December 31, 2011.

In 2012, we granted 8.8 million stock options with a weighted average fair value of $4.97 per option, or $44 million, and in 2011, we granted 23.6 million stock options with a weighted average fair value of $3.05 per option, or $72 million. For a further

36


discussion on stock-based compensation, see Note 5 and Note 6 to our consolidated financial statements in this Annual Report on Form 10-K.

Tax (Provision) Benefit

Our tax (provision) benefit consisted of the following (in millions):
 
2012
 
2011
Tax benefit - net operating income
$
14

 
$
145

Tax benefit - net realized loss
87

 
75

Tax benefit - loss on extinguishment of debt
2

 

Tax (provision) benefit - net unrealized appreciation
(82
)
 
208

Total tax benefit
$
21

 
$
428


During our tax year ended September 30, 2011, we became subject to taxation as a corporation under Subchapter C of the Code. During 2011, we reversed part of our valuation allowance totaling $428 million, which is recorded in our consolidated statements of operations for the year ended December 31, 2011 as $145 million in net operating income, $75 million in total net realized loss and $208 million in total net unrealized appreciation. See Note 11 to our consolidated financial statements in this Annual Report on Form 10-K for a further discussion of deferred taxes.

Net Realized Gain (Loss)

Our net realized gain (loss) consisted of the following individual portfolio company realized gains (losses) greater than $15 million (in millions):
 
2012
 
2011
VP Acquisition Holdings, Inc.
$

 
$
93

CIBT Travel Solutions, LLC
12

 
43

Other, net
54

 
22

Total gross realized portfolio gain
66

 
158

 
 
 
 
FPI Holding Corporation
(81
)
 

Small Smiles Holding Company, LLC
(66
)
 
(19
)
Halex Holdings Inc.
(27
)
 

FreeConference.com, Inc.
(24
)
 

Wachovia Bank Commercial Mortgage Trust, Series 2007-C32
(23
)
 
(12
)
Contec, LLC
(17
)
 
(117
)
Orchard Brands Corporation

 
(174
)
J.P. Morgan Chase Commercial Mortgage Securities Trust 2007-LDP11

 
(47
)
Citigroup Commercial Mortgage Securities Trust 2007-C6

 
(30
)
GE Commercial Mortgage Corporation, Series 2007-C1

 
(18
)
NECCO Holdings, Inc.

 
(18
)
European Touch, LTD. II

 
(18
)
Other, net
(99
)
 
(40
)
Total gross realized portfolio loss
(337
)
 
(493
)
Total net realized portfolio loss
(271
)
 
(335
)
Tax benefit
87

 
75

Interest rate derivative periodic interest payments, net
(25
)
 
(45
)
Interest rate derivative termination payments
(62
)
 
(5
)
Foreign currency transactions
1

 

Total net realized loss
$
(270
)
 
$
(310
)
 


37


The following are summary descriptions of portfolio company realized gains or losses greater than $30 million.

During 2012, due to declining performance, we wrote off all of our equity investments and mezzanine debt investments in FPI Holding Corporation and realized a loss of $81 million, which was offset by a reversal of unrealized depreciation of $81 million.

During 2012, a U.S. Bankruptcy Court issued an order authorizing the sale of substantially all of the assets of Small Smiles Holding Company, LLC (“Small Smiles”). The fair value of the consideration we received was zero. Accordingly, in the second quarter of 2012, we wrote off all of our equity investment and our senior debt investment in Small Smiles and realized a loss of $66 million, which was offset by a reversal of unrealized depreciation of $66 million.

During 2011, we sold all of our equity investments and received full repayment of our debt investments in VP Acquisition Holdings, Inc. for $138 million in total proceeds, realizing a gain of $93 million partially offset by a reversal of unrealized appreciation of $60 million.

During 2011, we sold substantially all of our equity investments and received full repayment of our debt investments in CIBT Travel Solutions, LLC and its subsidiaries for $229 million in total cash proceeds, realizing a gain of $43 million fully offset by a reversal of unrealized appreciation of $45 million. During 2012, we received additional proceeds from the original sale that were placed in escrow realizing an additional gain of $12 million. We also expect to receive $1 million of additional cash proceeds from CIBT Travel Solutions, LLC that remain held in a sale escrow as of December 31, 2012.

During 2011, we wrote off a portion of our unsecured mezzanine debt investment in Contec, LLC. We did not receive any proceeds, realizing a loss of $117 million fully offset by a reversal of unrealized depreciation.

During 2011, Appleseed's Intermediate Holdings, LLC, a wholly-owned operating subsidiary of Orchard Brands Corporation, emerged from bankruptcy after voluntarily filing for bankruptcy protection under Chapter 11 of the US Bankruptcy Code. Based on the reorganization plan, our existing senior first lien notes and senior second lien term A notes were exchanged for new senior first lien notes, junior term notes and common equity of Orchard Brands Corporation and our remaining senior second lien term notes were canceled. As a result, we recognized a realized loss of $174 million partially offset by a reversal of unrealized depreciation of $173 million.

During 2011, we wrote off $47 million of non-investment grade CMBS bonds in J.P. Morgan Chase Commercial Mortgage Securities Trust 2007-LDP11. We did not receive any proceeds, realizing a loss of $47 million fully offset by a reversal of unrealized depreciation.

We have entered into interest rate swap agreements in which we pay a fixed rate and receive a floating rate based on LIBOR. The net interest payments or receipts are recorded as a realized gain (loss) on the interest settlement dates. For the year ended December 31, 2012, we made $62 million in early termination payments to terminate certain interest rate swap agreements, which were partially offset by a reversal of unrealized depreciation of $55 million. For the years ended December 31, 2012 and 2011, we recorded a realized loss of $25 million and $45 million, respectively, for net interest rate derivative periodic interest payments due to the significant decline in LIBOR as compared to LIBOR at the date of the origination of the interest rate swap agreements.


38


Net Unrealized Appreciation (Depreciation)

The following table itemizes the change in net unrealized appreciation (depreciation) (in millions):
 
2012
 
2011
Gross unrealized appreciation of private finance portfolio investments
$
412

 
$
403

Gross unrealized depreciation of private finance portfolio investments
(218
)
 
(428
)
Net unrealized appreciation (depreciation) of private finance portfolio investments
194

 
(25
)
Net unrealized appreciation (depreciation) of European Capital investment
146

 
(34
)
Net unrealized (depreciation) appreciation of European Capital foreign currency translation
(19
)
 
3

Net unrealized appreciation of American Capital Asset Management
329

 
280

Net unrealized appreciation (depreciation) of American Capital Mortgage Investment Corp.
12

 
(5
)
Net unrealized appreciation of Structured Products investments
47

 
52

Reversal of prior period net unrealized depreciation upon realization
296

 
375

Net unrealized appreciation of portfolio investments
1,005

 
646

Foreign currency translation - European Capital
26

 
(29
)
Foreign currency translation - other
1

 
(2
)
Derivative agreements
7

 
8

Reversal of prior period net unrealized depreciation upon realization of terminated swaps
55

 
5

Tax (provision) benefit
(82
)
 
208

Net unrealized appreciation
$
1,012

 
$
836


See our “Investment Valuation Policy” in Note 2 in this Annual Report on Form 10-K for a description of our valuation methodologies.
 
Private Finance Portfolio

Our private finance portfolio investments consist of loans and equity securities primarily to privately-held middle market companies with a cost basis of $3,932 million and fair value of $3,381 million as of December 31, 2012. There is generally no publicly available information about these companies and an active primary or secondary market for the trading of these privately issued loans and securities generally does not exist. Our investments have been historically exited through normal repayment or a change in control transaction such as a sale or recapitalization of the portfolio company.

For the year ended December 31, 2012, the $194 million of net unrealized appreciation on our private finance portfolio investments was driven primarily by improved company performance, multiple expansion of comparable companies and narrowing investment spreads. For the year ended December 31, 2012, our private finance portfolio of One Stop Buyouts® experienced $97 million of net unrealized appreciation while our private finance portfolio of Sponsor Finance Investments, direct and other investments experienced $97 million of net unrealized appreciation.

For the year ended December 31, 2011, the $25 million of net unrealized depreciation on our private finance portfolio investments was driven primarily by specific company performance. For the year ended December 31, 2011, our private finance portfolio of One Stop Buyouts® experienced $97 million of net unrealized appreciation while our private finance portfolio of Sponsor Finance Investments, direct and other investments experienced $122 million of net unrealized depreciation.

European Capital

As of December 31, 2012, our investment in European Capital consisted of an equity investment with a cost basis and fair value of $1,267 million and $700 million, respectively, and a debt investment with a cost basis and fair value of $109 million. For the year ended December 31, 2012, we recognized net unrealized appreciation of $127 million on our investment in European Capital comprised of $146 million unrealized appreciation on our investment and $19 million of unrealized depreciation from foreign currency translation of the cumulative unrealized depreciation of European Capital. For the year ended December 31, 2011, we recognized net unrealized depreciation of $31 million on our investment in European Capital comprised of $34 million unrealized depreciation on our investment and $3 million of unrealized appreciation from foreign currency translation of the cumulative unrealized depreciation of European Capital. As of December 31, 2011, our investment in European Capital consisted of an equity investment with a cost basis and fair value of $1,267 million and $547 million, respectively, and a debt investment with a cost basis and fair value of $73 million.

For foreign currency denominated investments recorded at fair value, such as European Capital, the net unrealized appreciation or depreciation from foreign currency translation on the accompanying consolidated statements of operations

39


represents the economic impact of translating the cost basis of the investment from a foreign currency, such as the Euro, to the U.S. dollar. However, the economic impact of translating the cumulative unrealized appreciation or depreciation from a foreign currency to the U.S. dollar is not recorded as net unrealized depreciation or appreciation from foreign currency translation but rather is included as net unrealized appreciation or depreciation of portfolio company investments on the accompanying consolidated statements of operations. For the year ended December 31, 2012, we recorded unrealized appreciation of $26 million for foreign currency translation on the cost basis in our investment in European Capital (included in our total unrealized appreciation of $27 million for foreign currency translation for the year ended December 31, 2012). For the year ended December 31, 2011, we recorded unrealized depreciation of $29 million for foreign currency translation on the cost basis in our investment in European Capital (included in our total unrealized depreciation of $31 million for foreign currency translation for the year ended December 31, 2011).

European Capital, a wholly-owned portfolio company of American Capital, is an investment fund that invests in One Stop Buyouts®, Sponsor Finance Investments and provides capital directly to early stage and mature private and small public companies primarily in Europe. It primarily invests in senior and mezzanine debt and equity. European Capital's underlying portfolio investments are recorded at fair value determined in accordance with ASC 820. In determining the fair value of our investment in European Capital, we concluded that our investment should be less than the NAV of European Capital due to comparable public traded funds which were trading at a discount to NAV on the measurement date and the risks associated with our ability to realize the full fair value of European Capital's underlying assets for several reasons, including a public to private liquidity discount and the ability to demonstrate an implied market return on equity required by market participants for a measurable period of time, which indicate fair values at a discount to the NAV.

During the year ended December 31, 2012, the unrealized appreciation on our investment of $146 million, excluding unrealized appreciation (depreciation) on foreign currency translation, was due primarily to an increase in the NAV of European Capital and a decrease to the discount applied to NAV. During the year ended December 31, 2011, the unrealized depreciation on our investment of $34 million, excluding unrealized appreciation (depreciation) on foreign currency translation, was due primarily to a decrease in the NAV of European Capital and an increase to the discount applied to NAV.

The following is a summary composition of European Capital's NAV at fair value and our equity investment's implied discount to European Capital's NAV at fair value (€ and $ in millions) as of December 31, 2012 and 2011:
 
2012
 
2011
Debt investments at fair value
786

 
712

Equity investments at fair value
341

 
262

Other assets and liabilities, net
20

 
92

Third-party secured debt at cost
(250
)
 
(271
)
Third-party unsecured debt at cost
(109
)
 
(111
)
American Capital unsecured debt at cost
(83
)
 
(57
)
NAV (Euros)
705

 
627

Exchange rate
1.32

 
1.30

NAV (US dollars)
$
931

 
$
815

Fair value of American Capital equity investment
$
700

 
$
547

Implied discount to NAV
24.8
%
 
32.9
%

American Capital Asset Management

American Capital Asset Management manages the following funds through various subsidiaries: European Capital, AGNC, MTGE, ACE I, ACE II, ACAS CLO 2007-1 and ACAS CLO 2012-1. American Capital Asset Management had a cost basis of $149 million and fair value of $828 million as of December 31, 2012. During the years ended December 31, 2012 and 2011, we recognized $329 million and $280 million of unrealized appreciation on our investment in American Capital Asset Management, respectively.

The unrealized appreciation on our investment in American Capital Asset Management for the years ended December 31, 2012 and 2011 was primarily due to increases in the historical and projected management fees for managing AGNC and MTGE due to significant growth in the equity capital of each company. During the year ended December 31, 2012, AGNC and MTGE raised $3.8 billion and $580 million of equity capital, respectively. During the year ended December 31, 2011, AGNC and MTGE raised $4.4 billion and $199 million of equity capital, respectively.




40


Structured Products Investments

American Capital has investments in Structured Products such as investment and non-investment grade tranches of CLO, CDO and CMBS securities with a cost basis of $385 million and fair value of $247 million as of December 31, 2012. During the year ended December 31, 2012, we recorded $47 million of net unrealized appreciation on our Structured Products investments. Our investments in CLO and CDO portfolios of commercial loans experienced $45 million of net unrealized appreciation during the year ended December 31, 2012, due primarily to a narrowing of investment spreads, higher broker quotes and improved projected cash flows. Our CMBS portfolio experienced $2 million of net unrealized appreciation during the year ended December 31, 2012.

During the year ended December 31, 2011, we recorded $52 million of net unrealized appreciation on our Structured Products investments. Our investments in CLO and CDO portfolios of commercial loans experienced $41 million of net unrealized appreciation during the year ended December 31, 2011, due primarily to a narrowing of investment spreads, higher broker quotes and improved projected cash flows. Our CMBS portfolio experienced $11 million of net unrealized appreciation during the year ended December 31, 2011.

Derivative Agreements

During the years ended December 31, 2012 and 2011, we recorded $7 million and $8 million, respectively, of net unrealized appreciation from derivative agreements. During the year ended December 31, 2012, cash termination payments totaling $62 million were made to settle terminated interest rate swap agreements, partially offset by a reversal of unrealized depreciation of $55 million. The fair value of the net liability for our derivative agreements as of December 31, 2012 was $27 million, which included a $3 million net reduction related to the incorporation of an adjustment for nonperformance risk of us and our counterparties. The fair value of the net liability for our derivative agreements as of December 31, 2011 was $89 million, which included a $17 million net reduction related to the incorporation of an adjustment for nonperformance risk of us and our counterparties.

For interest rate swap agreements, we estimate the fair value based on the estimated net present value of the future cash flows using a forward interest rate yield curve in effect as of the end of the measurement period, adjusted for nonperformance risk, if any, including an evaluation of our credit risk and our counterparty's credit risk. A negative fair value would represent an amount we would have to pay a third-party and a positive fair value would represent an amount we would receive from a third-party to assume our obligation under an interest rate swap agreement. The derivative agreements generally appreciate or depreciate primarily based on relative market interest rates and their remaining term to maturity as well as changes in our and our counterparty's credit risk.
 
Fiscal Year 2011 Compared to Fiscal Year 2010

Operating Revenue

We derive the majority of our operating revenue by investing in senior and mezzanine debt and equity of middle market companies with attractive current yields and/or potential for equity appreciation and realized gains. We also derive operating revenue from investing in Structured Products and in our wholly-owned asset manager, American Capital Asset Management. Operating revenue consisted of the following (in millions):
 
2011
 
2010
Interest income on debt investments
$
350

 
$
434

Interest income on Structured Products investments
56

 
52

Dividend income on private finance portfolio investments
106

 
58

Dividend income from American Capital Asset Management
30

 

Interest income on bank deposits
1

 
2

Interest and dividend income
543

 
546

Portfolio company advisory and administrative fees
14

 
18

Advisory and administrative services - American Capital Asset Management
20

 
16

Other fees
14

 
20

Fee income
48

 
54

          Total operating revenue
$
591

 
$
600



41


Interest and Dividend Income

The following table summarizes selected data for our debt, Structured Products and equity investments outstanding, at cost (dollars in millions):
 
2011
 
2010
Debt investments at cost(1)
$
3,198

 
$
4,137

Average non-accrual debt investments at cost(2)
$
574

 
$
723

Effective interest rate on debt investments
11.0
%
 
10.5
%
Effective interest rate on debt investments, excluding non-accrual prior period adjustments
10.9
%
 
10.6
%
Structured Products investments at cost(1)(3)
$
547

 
$
749

Effective interest rate on Structured Products investments(3)
10.3
%
 
6.9
%
Debt and Structured Products investments at cost(1)(3)
$
3,745

 
$
4,886

Effective interest rate on debt and Structured Products investments(3)
10.9
%
 
9.9
%
Average daily one-month LIBOR
0.2
%
 
0.3
%
Equity investments - private finance portfolio at cost(1)(3)
$
2,228

 
$
2,313

Effective dividend yield on equity investments - private finance portfolio(3)
4.7
%
 
2.5
%
Effective dividend yield on equity investments - private finance portfolio, excluding non-accrual prior period adjustments(3)
3.1
%
 
3.0
%
Debt, Structured Products and equity investments at cost(1)(3)
$
5,973

 
$
7,199

Effective yield on debt, Structured Products and equity investments(3)
8.6
%
 
7.6
%
Effective yield on debt, Structured Products and equity investments, excluding non-accrual prior period adjustments(3)
7.9
%
 
7.8
%
 ——————————
(1)
Monthly weighted average of investments at cost.
(2)
Quarterly average of investments at cost.
(3)
Excludes our equity investment in American Capital Asset Management and European Capital.

Debt Investments

Interest income on debt investments decreased by $84 million, or 19%, for the year ended December 31, 2011 over the comparable period in 2010, primarily due to a decrease in our monthly weighted average debt investments outstanding. Our weighted average debt investments outstanding decreased by $0.9 billion for the year ended December 31, 2011 over the comparable period in 2010 primarily as a result of the repayment or sale of debt investments or write-off of non-performing debt investments.

When a debt investment is placed on non-accrual, we may record reserves on uncollected PIK interest income recorded in prior periods as a reduction of interest income in the current period. Conversely, when a debt investment is removed from non-accrual, we may record interest income in the current period on prior period uncollected PIK interest income which was reserved in prior periods. For the year ended December 31, 2011, we recorded additional interest income on uncollected PIK interest income recorded in prior periods of $2 million as a result of debt investments being removed from non-accrual. For the year ended December 31, 2010, we recorded net reserves on uncollected PIK interest income recorded in prior periods of $7 million as a result of debt investments being placed on non-accrual.

Structured Products

Interest income on Structured Products investments increased by $4 million, or 8%, for the year ended December 31, 2011, respectively, over the comparable period in 2010 primarily due to an increase in interest income recognized on our CLO investments due to increases in projected cash flows. Our weighted average Structured Products investments outstanding decreased for the year ended December 31, 2011 over the comparable period in 2010 primarily as a result of the write-off of non-performing CMBS investments. See Note 2—Interest and Dividend Income Recognition policy to our consolidated financial statements in this Annual Report on Form 10-K for a description of how projected cash flows affect revenue recognition on our Structured Products investments.

Equity Investments - Private Finance Portfolio

Dividend income on private finance portfolio investments increased by $48 million, or 83%, for the year ended December 31, 2011 over the comparable period in 2010 primarily due to the recognition of prior period dividend income for private finance preferred stock investments removed from non-accrual during the year ended December 31, 2011, as well as the recording of reserves on uncollected accrued dividend income recorded in prior periods from private finance preferred stock investments during

42


the year ended December 31, 2010. As a result, the monthly weighted average effective dividend yield on equity investments was 4.7% for the year ended December 31, 2011, a 220 basis point increase over the comparable period in 2010.

When a preferred equity investment is placed on non-accrual, we may record net reserves on uncollected accrued dividend income recorded in prior periods as a reduction of dividend income in the current period. Conversely, when a preferred equity investment is removed from non-accrual, we may record dividend income in the current period for prior period uncollected accrued dividend income which was reserved in prior periods. For the year ended December 31, 2011, we recorded additional dividend income for the reversal of reserves of accrued dividend income attributable to prior periods from private finance preferred stock investments of $36 million, which had an approximate 160 basis point impact on the effective dividend yield on equity investments. For the year ended December 31, 2010, we recorded reserves on uncollected accrued dividend income recorded in prior periods from private finance preferred stock investments of $11 million, which had an approximate 50 basis point impact on the effective dividend yield on equity investments.

Equity Investments - American Capital Asset Management

Dividend income from American Capital Asset Management was $30 million and $0 million for the years ended December 31, 2011 and 2010, respectively. For the years ended December 31, 2011 and 2010, we received an additional $11 million and $17 million, respectively, of dividends from American Capital Asset Management that was recorded as a reduction to our cost basis. The increase in dividends received in 2011 was primarily due to an increase in net income primarily generated from management fees earned for the management of AGNC, which experienced significant growth in their equity capital as a result of follow-on equity offerings.

Fee Income

Portfolio Company Advisory and Administrative Fees

As a BDC, we are required by law to make significant managerial assistance available to most of our portfolio companies. This generally includes providing guidance and counsel concerning the management, operations and business objectives and policies of the portfolio company to the portfolio company's management and board of directors, including participating on the company's board of directors. Our portfolio company advisory and administrative fees for the years ended December 31, 2011 and 2010 were $14 million and $18 million, respectively.

Advisory and Administrative Services - American Capital Asset Management

We have entered into service agreements with American Capital Asset Management to provide additional asset management service support so that American Capital Asset Management can fulfill its responsibilities under its management agreements. The fees generated from these service agreements for the years ended December 31, 2011 and 2010 were $20 million and $16 million, respectively.

Other Fees

Other fees are primarily composed of transaction fees for structuring, financing and executing middle market portfolio transactions, which may not be recurring in nature. These fees amounted to $14 million and $20 million for the years ended December 31, 2011 and 2010, respectively.

Operating Expenses

Operating expenses decreased $108 million, or 27%, for the year ended December 31, 2011, respectively, over the comparable period in 2010. Operating expenses consisted of the following (in millions):
 
2011
 
2010
Interest
$
90

 
$
177

Salaries, benefits and stock-based compensation
143

 
134

General and administrative
55

 
64

Debt refinancing costs

 
21

Total operating expenses
$
288

 
$
396

 
Interest

Interest expense for the year ended December 31, 2011 decreased $87 million, or 49%, over the comparable period in 2010. The decrease in interest expense was primarily attributable to a decrease in the weighted average borrowings outstanding for the

43


year ended December 31, 2011 over the comparable period in 2010 partially offset by a $12 million increase in the amortization of deferred financing costs primarily as a result of unscheduled payments on our outstanding secured borrowings during 2011.

The components of interest expense, cash paid for interest expense, average interest rates and average outstanding balances for our borrowings are as follows (dollars in millions):
 
2011
 
2010
Asset Securitizations:
 
 
 
Cash interest expense
$
8

 
$
12

Amortization of deferred financing costs
3

 
4

Total interest expense
$
11

 
$
16

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
1.3
%
 
1.0
%
Weighted average interest rate, excluding amortization of deferred financing costs
0.9
%
 
0.8
%
Weighted average balance outstanding
$
915

 
$
1,537

 
 
 
 
Public and Private Borrowings:
 
 
 
Cash interest expense
$
59

 
$
154

Amortization of deferred financing costs
20

 
7

Total interest expense
$
79

 
$
161

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
10.6
%
 
9.3
%
Weighted average interest rate, excluding amortization of deferred financing costs
7.9
%
 
8.9
%
Weighted average balance outstanding
$
747

 
$
1,738

 
 
 
 
Total Borrowings:
 
 
 
Cash interest expense
$
67

 
$
166

Amortization of deferred financing costs
23

 
11

Total interest expense
$
90

 
$
177

 
 
 
 
Weighted average interest rate, including amortization of deferred financing costs
5.5
%
 
5.4
%
Weighted average interest rate, excluding amortization of deferred financing costs
4.1
%
 
5.1
%
Weighted average balance outstanding
$
1,662

 
$
3,275


Amortization of deferred financing costs on our public and private borrowings for the year ended December 31, 2011 increased $13 million from the comparable period in 2010 primarily due to the acceleration of the amortization of deferred financing costs resulting from additional principal paydowns on our secured debt in 2011.

Salaries, Benefits and Stock-based Compensation

Salaries, benefits and stock-based compensation consisted of the following (in millions):
 
2011
 
2010
Base salaries
$
53

 
$
56

Incentive compensation
35

 
26

Benefits
10

 
10

Stock-based compensation
45

 
42

Total salaries, benefits and stock-based compensation
$
143

 
$
134


Salaries, benefits and stock-based compensation for the year ended December 31, 2011 increased $9 million, or 7%, from the comparable period in 2010 primarily due to an increase in stock-based and incentive compensation. As of December 31, 2011, we had 249 total employees compared to 242 total employees as of December 31, 2010.

In 2011, we granted 23.6 million stock options with a weighted average fair value of $3.05 per option, or $72 million, and in 2010, we granted 17.7 million stock options with a weighted average fair value of $2.07 per option, or $37 million. For a further discussion on stock-based compensation, see Note 5 and Note 6 to our consolidated financial statements in this Annual Report on Form 10-K.



44


General and Administrative

General and administrative expenses decreased by $9 million, or 14%, for the year ended December 31, 2011, respectively, over the