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Portman Ridge Finance Corp - Quarter Report: 2010 September (Form 10-Q)

Unassociated Document
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q


x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2010
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
 
Commission File No. 814-00735
 

Kohlberg Capital Corporation
(Exact name of Registrant as specified in its charter)
 


Delaware
 
20-5951150
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 
295 Madison Avenue, 6th Floor
New York, New York 10017
(Address of principal executive offices)
 
(212) 455-8300
(Registrant’s telephone number, including area code)
 

 
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   ¨
 
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   ¨     No   x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer      
¨
 
Accelerated filer  
x
         
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
Smaller reporting company       
¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes   ¨     No   x
 
The number of outstanding shares of common stock of the registrant as of 22,767,130 was October 31, 2010.
 


 
 

 
 
TABLE OF CONTENTS
 
   
   
Page
       
 
Part I. Financial Information
   
       
Item 1.
Financial Statements
 
1
       
 
Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009
 
1
       
 
Statements of Operations (unaudited) for the three and nine months ended September 30, 2010 and 2009
 
2
       
 
Statements of Changes in Net Assets (unaudited) for the nine months ended September 30, 2010 and 2009
 
3
       
 
Statements of Cash Flows (unaudited) for the nine months ended September 30, 2010 and 2009
 
4
       
 
Schedules of Investments as of September 30, 2010  (unaudited) and December 31, 2009
 
5
       
 
Financial Highlights (unaudited) for the nine months ended September 30, 2010 and 2009
 
26
       
 
Notes to Financial Statements (unaudited)
 
27
       
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
48
       
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
72
       
Item 4.
Controls and Procedures
 
73
       
 
Part II. Other Information
   
       
Item 1.
Legal Proceedings
 
75
       
Item 1A.       
Risk Factors
 
76
       
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
76
       
Item 3.
Defaults Upon Senior Securities
 
76
       
Item 4.
[Removed and Reserved]
 
76
       
Item 5.
Other Information
 
76
       
Item 6.
Exhibits
 
76
     
Signatures
   

 
 

 

KOHLBERG CAPITAL CORPORATION
 
BALANCE SHEETS

   
As of
September 30, 2010
   
As of
December 31, 2009
 
   
(unaudited)
       
ASSETS
           
Investments at fair value:
           
Time deposits (cost: 2010 - $24,529,777; 2009 - $126)
  $ 24,529,777     $ 126  
Money market account (cost: 2010 - $212,245; 2009 - $0)
    212,245        
Debt securities (cost: 2010 - $229,736,282; 2009 - $342,056,023)
    190,908,445       297,356,529  
CLO fund securities managed by non-affiliates (cost: 2010 - $15,689,717; 2009 - $15,685,858)
    5,271,000       4,021,000  
CLO fund securities managed by affiliate (cost: 2010 - $52,568,940; 2009 - $52,509,191)
    47,480,000       44,950,000  
Equity securities (cost: 2010 - $14,216,146; 2009 - $12,365,603)
    5,989,599       4,713,246  
Asset manager affiliates (cost: 2010 - $44,219,947; 2009 - $40,751,511)
    49,149,581       58,064,720  
Total Investments at fair value
    323,540,647       409,105,621  
Cash
    2,225,116       4,140,408  
Restricted cash
    2,239,603       18,696,023  
Interest and dividends receivable
    3,083,707       3,836,031  
Receivable for open trades
    8,665,186       2,953,500  
Due from affiliates
    1,643       44,274  
Other assets
    24,290       640,200  
                 
Total assets
  $ 339,780,192     $ 439,416,057  
                 
LIABILITIES
               
Borrowings
  $ 137,159,147     $ 218,050,363  
Accounts payable and accrued expenses
    1,819,730       3,057,742  
Dividend payable
          4,412,228  
                 
Total liabilities
  $ 138,978,877     $ 225,520,333  
Commitments and contingencies  (note 8)
               
                 
STOCKHOLDERS' EQUITY
               
Common stock, par value $0.01 per share, 100,000,000 common shares authorized; 22,708,399 and 22,363,281 common shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively.
  $ 223,687     $ 220,611  
Capital in excess of par value
    284,975,852       283,074,233  
Accumulated undistributed net investment income
    449,558       1,326,380  
Accumulated net realized losses
    (27,215,375 )     (16,462,808 )
Net unrealized depreciation on investments
    (57,632,407 )     (54,262,692 )
                 
Total stockholders' equity
  $ 200,801,315     $ 213,895,724  
                 
Total liabilities and stockholders' equity
  $ 339,780,192     $ 439,416,057  
                 
NET ASSET VALUE PER COMMON SHARE
  $ 8.84     $ 9.56  

See accompanying notes to financial statements.

 
1

 

KOHLBERG CAPITAL CORPORATION
STATEMENTS OF OPERATIONS
(unaudited)

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Investment Income:
                       
Interest from investments in debt securities
  $ 3,774,475     $ 5,855,051     $ 12,019,584     $ 18,808,447  
Interest from cash and time deposits
    3,259       5,092       15,752       14,778  
Dividends from investments in CLO fund securities managed by non-affiliates
    472,972       355,726       1,273,619       1,174,026  
Dividends from investments in CLO fund securities managed by affiliate
    2,222,806       2,035,789       5,935,478       6,246,918  
Dividends from affiliate asset manager
    1,500,000             3,000,000        
Capital structuring service fees
    117,704       (6,814 )     193,415       272,401  
                                 
Total investment income
    8,091,216       8,244,844       22,437,848       26,516,570  
                                 
Expenses:
                               
Interest and amortization of debt issuance costs
    1,623,305       3,137,425       6,723,587       6,223,077  
Compensation
    814,584       760,759       2,418,567       2,386,218  
Professional fees
    1,373,552       471,191       5,325,341       1,111,823  
Insurance
    105,985       95,662       306,752       273,136  
Administrative and other
    342,520       303,175       956,638       832,724  
                                 
Total expenses
    4,259,946       4,768,212       15,730,885       10,826,978  
                                 
Net Investment Income
    3,831,270       3,476,632       6,706,963       15,689,592  
Realized And Unrealized Gains (Losses) On Investments:
                               
Net realized gains (losses) from investment transactions
    (3,046,761 )     (3,769,049 )     (10,752,567 )     (8,901,941 )
Net change in unrealized appreciation (depreciation) on:
                               
Debt securities
    1,334,179       8,218,083       5,871,658       15,800,620  
Equity securities
    (565,094 )     (102,710 )     (574,190 )     (526,590 )
CLO fund securities managed by affiliate
    550,246       4,137,840       2,470,250       11,118,734  
CLO fund securities managed by non-affiliate
    28,720       298,886       1,246,142       (842,722 )
Affiliate asset manager investments
    (5,451,872 )     (1,593,871 )     (12,383,575 )     205,975  
                                 
Net realized and unrealized appreciation (depreciation) on investments
    (7,150,582 )     7,189,179       (14,122,282 )     16,854,076  
                                 
Net Increase (Decrease) In Net Assets Resulting From Operations
  $ (3,319,312 )   $ 10,665,811     $ (7,415,319 )   $ 32,543,668  
                                 
Net Increase (Decrease) In Stockholders' Equity Resulting from Operations per Common Share—Basic and Diluted
  $ (0.15 )   $ 0.48     $ (0.33 )   $ 1.48  
Net Investment Income Per Common Share—Basic and Diluted
  $ 0.17     $ 0.16     $ 0.30     $ 0.71  
Net Investment Income and Net Realized Gains/Losses Per Common Share—Basic and Diluted
  $ 0.03     $ (0.01 )   $ (0.18 )   $ 0.31  
                                 
Weighted Average Shares of Common Stock Outstanding—Basic
    22,677,428       22,194,690       22,547,274       22,030,517  
Weighted Average Shares of Common Stock Outstanding—Diluted
    22,677,428       22,194,695       22,547,274       22,030,517  

See accompanying notes to financial statements.

 
2

 

KOHLBERG CAPITAL CORPORATION
STATEMENTS OF CHANGES IN NET ASSETS
(unaudited)

   
Nine Months Ended
September 30,
 
   
2010
   
2009
 
             
Operations:
           
Net investment income
  $ 6,706,963     $ 15,689,592  
Net realized loss from investment transactions
    (10,752,567 )     (8,901,941 )
Net change in unrealized appreciation (depreciation) on investments
    (3,369,715 )     25,756,017  
                 
Net increase (decrease) in net assets resulting from operations
    (7,415,319 )     32,543,668  
                 
Stockholder distributions:
               
Dividends from net investment income to common stockholders
    (6,706,963 )     (10,396,721 )
Dividends in excess of net investment income to restricted stockholders
    (32,335 )     (106,033 )
Common Stock Dividends in excess of net investment income
    (844,488 )      
                 
Net decrease in net assets resulting from stockholder distributions
    (7,583,786 )     (10,502,754 )
                 
Capital transactions:
               
Issuance of common stock for dividend reinvestment plan
    1,216,946       1,656,531  
Vesting of restricted stock
    647       1,223  
Stock based compensation
    687,104       688,727  
                 
Net increase in net assets resulting from capital transactions
    1,904,697       2,346,481  
                 
Net assets at beginning of period
    213,895,723       196,566,018  
                 
Net assets at end of period (including undistributed net investment income of $449,558 in 2010 and accumulated distributions in excess of net investment income of $8,052,272 in 2009)
  $ 200,801,315     $ 220,953,413  
                 
Net asset value per common share
  $ 8.84     $ 9.93  
Common shares outstanding at end of period
    22,708,399       22,255,149  

See accompanying notes to financial statements.

 
3

 

KOHLBERG CAPITAL CORPORATION
STATEMENTS OF CASH FLOWS
(unaudited)

   
Nine Months Ended
September 30,
 
   
2010
   
2009
 
             
OPERATING ACTIVITIES:
           
Net increase (decrease) in stockholders’ equity resulting from operations
  $ (7,415,319 )   $ 32,543,668  
Adjustments to reconcile net increase (decrease) in stockholders’ equity resulting from operations to net cash provided by operations:
               
Net realized losses on investment transactions
    10,752,567       8,901,941  
Net change in unrealized (appreciation) depreciation on investments
    3,369,715       (25,756,017 )
Net accretion of discount on securities and loans
    (371,110 )     (1,504,703 )
Amortization of debt issuance cost
    561,251       618,520  
Purchases of investments
    (33,790,481 )     (4,597,657 )
Capital contribution to affiliate asset manager
    (3,468,436 )     (3,600,016 )
Payment-in-kind interest income
    (323,418 )     (3,801 )
Proceeds from sale and redemption of investments
    103,683,805       38,417,685  
Stock based compensation expense
    687,104       688,725  
Changes in operating assets and liabilities:
               
Decrease in interest and dividends receivable
    752,324       531,968  
Decrease in other assets
    54,660       165,840  
Decrease in due from affiliates
    42,631       389,251  
Increase (decrease) in accounts payable and accrued expenses
    (1,238,012 )     38,185  
                 
Net cash provided by operating activities
    73,297,281       46,833,589  
                 
FINANCING ACTIVITIES:
               
Issuance of stock (net of offering costs)
    647       1,223  
Dividends paid in cash
    (10,778,426 )     (14,725,882 )
Cash paid on repayment of debt
    (80,891,214 )     (33,826,651 )
Decrease in restricted cash
    16,456,420       1,582,794  
                 
Net cash used in financing activities
    (75,212,573 )     (46,968,516 )
                 
CHANGE IN CASH
    (1,915,292 )     (134,927 )
CASH, BEGINNING OF PERIOD
    4,140,408       251,412  
                 
CASH, END OF PERIOD
  $ 2,225,116     $ 116,485  
                 
Supplemental Information:
               
Interest paid during the period
  $ 6,658,492     $ 5,436,585  
Non-cash dividends paid during the period under the dividend reinvestment plan
  $ 1,216,946     $ 1,656,532  

See accompanying notes to financial statements.

 
4

 

KOHLBERG CAPITAL CORPORATION
SCHEDULE OF INVESTMENTS
As of September 30, 2010
(unaudited)

Debt Securities Portfolio
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Advanced Lighting Technologies, Inc.
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Revolving Loan
4.0%, Due 6/13
  $ 320,000     $ 315,520     $ 317,760  
                             
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Deferred Draw Term Loan (First Lien)
3.1%, Due 6/13
    321,125       321,125       318,877  
                             
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Junior Secured Loan — Second Lien Term Loan Note
6.3%, Due 6/14
    5,000,000       5,000,000       5,000,000  
                             
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan (First Lien)
3.1%, Due 6/13
    1,568,392       1,568,392       1,557,414  
                             
Aero Products International, Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Term Loan
9.5%, Due 4/12
    2,968,560       2,968,560       2,968,560  
                             
Aerostructures Acquisition LLC6
Aerospace and Defense
 
Senior Secured Loan — Delayed Draw Term Loan
7.3%, Due 3/13
    318,191       318,191       318,191  
                             
Aerostructures Acquisition LLC6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
7.3%, Due 3/13
    4,018,058       4,018,058       4,018,058  
                             
AGS LLC6
Hotels, Motels, Inns, and Gaming
 
Senior Secured Loan — Delayed Draw Term Loan
3.3%, Due 5/13
    405,171       402,298       369,111  
                             
AGS LLC6
Hotels, Motels, Inns, and Gaming
 
Senior Secured Loan — Initial Term Loan
3.3%, Due 5/13
    2,895,981       2,875,443       2,638,239  
                             
AmerCable Incorporated6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Senior Secured Loan — Initial Term Loan
3.8%, Due 6/14
    5,575,973       5,575,973       5,481,182  

 
5

 

 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Astoria Generating Company Acquisitions, L.L.C.6
Utilities
 
Junior Secured Loan — Term C
4.0%, Due 8/13
  $ 4,000,000     $ 4,025,351     $ 3,924,000  
                         
Aurora Diagnostics, LLC
Healthcare, Education and Childcare
 
Senior Secured Loan — Tranche B Term Loan
6.3%, Due 5/16
    997,500       983,353       997,500  
                             
Awesome Acquisition Company (CiCi's Pizza)6
Personal, Food and Miscellaneous Services
 
Junior Secured Loan — Term Loan (Second Lien)
5.3%, Due 6/14
    4,000,000       3,984,813       3,944,000  
                         
AZ Chem US Inc.6
Chemicals, Plastics and Rubber
 
Junior Secured Loan — Second Lien Term Loan
5.8%, Due 2/14
    4,000,000       3,975,956       4,000,000  
                             
Bankruptcy Management Solutions, Inc.6, 9
Diversified/Conglomerate Service
 
Junior Secured Loan — Loan (Second Lien)
6.6%, Due 7/13
    2,406,250       2,424,498       517,344  
                         
Bankruptcy Management Solutions, Inc.6
Diversified/Conglomerate Service
 
Senior Secured Loan — Term Loan (First Lien)
6.3%, Due 7/12
    1,870,497       1,875,068       1,221,434  
                             
Bicent Power LLC6
Utilities
 
Junior Secured Loan — Advance (Second Lien)
4.3%, Due 12/14
    4,000,000       4,000,000       3,152,000  
                         
BP Metals, LLC (fka Constellation Enterprises) 6
Mining, Steel, Iron and Non-Precious Metals
 
Senior Secured Loan — Term Loan
10.0%, Due 6/13
    4,096,939       4,096,939       4,096,939  
                             
Caribe Information Investments Incorporated6
Printing and Publishing
 
Senior Secured Loan — Term Loan
2.6%, Due 3/13
    1,611,045       1,607,681       1,427,386  
                         
Charlie Acquisition Corp.9
Personal, Food and Miscellaneous Services
 
Mezzanine Investment — Senior Subordinated Notes
15.5%, Due 6/13
    14,261,996       10,744,496       250,000  
                             
CoActive Technologies LLC (fka CoActive Technologies, Inc.)6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Senior Secured Loan — Term Loan (First Lien)
3.3%, Due 7/14
    3,881,804       3,871,081       3,357,761  
                         
CoActive Technologies LLC (fka CoActive Technologies, Inc.)6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Term Loan (Second Lien)
7.0%, Due 1/15
    2,000,000       1,976,315       1,214,000  

 
6

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Delta Educational Systems, Inc.6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan
6.0%, Due 6/12
  $ 2,301,996     $ 2,301,996     $ 2,301,996  
                         
Dex Media West LLC
Printing and Publishing
 
Senior Secured Loan — New Term Loan
7.0%, Due 10/14
    3,196,857       2,976,183       2,805,242  
                             
Dresser, Inc.6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Term Loan (Second Lien)
6.1%, Due 5/15
    3,000,000       2,974,379       2,967,000  
                         
DRI Holdings, Inc.6
Healthcare, Education and Childcare
 
Junior Secured Loan — US Term Loan (Second Lien)
6.7%, Due 7/15
    6,000,000       5,569,864       6,000,000  
                             
eInstruction Corporation6
Healthcare, Education and Childcare
 
Senior Secured Loan — Initial Term Loan
4.3%, Due 7/13
    3,091,218       3,091,218       3,026,302  
 
                       
eInstruction Corporation6
Healthcare, Education and Childcare
 
Junior Secured Loan — Term Loan (Second Lien)
7.8%, Due 7/14
    10,000,000       10,000,000       10,000,000  
                             
Fasteners For Retail, Inc.6
Diversified/Conglomerate Manufacturing
 
Senior Secured Loan — Term Loan
4.9%, Due 12/12
    3,259,011       3,261,663       3,259,011  
                         
First American Payment Systems, L.P.6
Finance
 
Senior Secured Loan — Term Loan
5.3%, Due 10/13
    2,806,000       2,806,000       2,806,000  
                             
First Data Corporation
Finance
 
Senior Secured Loan — Initial Tranche B-2 Term Loan
3.0%, Due 9/14
    896,947       841,725       791,108  
                         
Freescale Semiconductor, Inc.
Electronics
 
Senior Subordinated Bond — 10.125%
10.1%, Due 12/16
    3,000,000       3,006,397       2,730,000  
                             
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Senior Secured Loan — First Lien Tranche A Credit-Linked Deposit
7.8%, Due 6/11
    1,257,143       1,224,101       69,143  
                         
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Senior Secured Loan — First Lien Tranche B Term Loan
7.8%, Due 6/11
    2,694,857       2,624,028       148,217  
                             
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Junior Secured Loan — Loan (Second Lien)
11.8%, Due 6/12
    3,000,000       2,715,997       15,000  

 
7

 

Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
HMSC Corporation (aka Swett and Crawford)6
Insurance
 
Junior Secured Loan — Loan (Second Lien)
5.8%, Due 10/14
  $ 5,000,000     $ 4,882,962     $ 3,840,000  
                             
Huish Detergents Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Junior Secured Loan — Loan (Second Lien)
4.5%, Due 10/14
    1,000,000       1,000,000       977,000  
                         
Hunter Fan Company6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Initial Term Loan (First Lien)
2.8%, Due 4/14
    3,690,443       3,593,555       3,299,256  
                             
Hunter Fan Company6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Junior Secured Loan — Loan (Second Lien)
7.0%, Due 10/14
    3,000,000       3,000,000       2,778,000  
                         
Infiltrator Systems, Inc.6
Ecological
 
Senior Secured Loan — Term Loan
8.5%, Due 9/12
    2,678,977       2,675,508       2,678,977  
                             
Inmar, Inc.6
Retail Stores
 
Senior Secured Loan — Term Loan
3%, Due 4/13
    3,363,854       3,363,854       3,239,391  
                         
International Architectural Products, Inc.6
Mining, Steel, Iron and Non-Precious Metals
 
Senior Secured Loan — Term Loan
3%, Due 5/15
    959,760       959,760       959,760  
                             
Intrapac Corporation/Corona Holdco6
Containers, Packaging and Glass
 
Senior Secured Loan — 1st Lien Term Loan
4%, Due 5/12
    4,026,082       4,032,011       3,989,847  
                         
Intrapac Corporation/Corona Holdco6
Containers, Packaging and Glass
 
Junior Secured Loan — Term Loans (Second Lien)
7.8%, Due 5/13
    3,000,000       3,010,708       3,000,000  
                             
Jones Stephens Corp.6, 9
Buildings and Real Estate4
 
Senior Secured Loan — Term Loan
7.8%, Due 9/12
    9,541,180       9,527,522       5,381,225  
                         
KIK Custom Products Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Junior Secured Loan — Loan (Second Lien)
5.3%, Due 12/14
    5,000,000       5,000,000       3,357,500  

 
8

 

Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Las Vegas Land Holdings, LLC6
Buildings and Real Estate4
 
Senior Secured Loan — Loan
5.3%, Due 3/16
  $ 271,097     $ 271,097     $ 216,878  
                         
LBREP/L-Suncal Master I LLC9
Buildings and Real Estate4
 
Junior Secured Loan — Term Loan (Third Lien)
15.0%, Due 2/12
    2,332,868       2,332,868       933  
                             
LBREP/L-Suncal Master I LLC6, 9
Buildings and Real Estate4
 
Senior Secured Loan — Term Loan (First Lien)
5.5%, Due 1/10
    3,875,156       3,875,156       58,127  
                         
LBREP/L-Suncal Master I LLC6, 9
Buildings and Real Estate4
 
Junior Secured Loan — Term Loan (Second Lien)
9.5%, Due 1/11
    2,000,000       1,920,211       7,600  
                             
Legacy Cabinets, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan
7.3%, Due 5/14
    456,194       456,194       91,239  
                         
Levlad, LLC & Arbonne International, LLC6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Term Loan (Exit)
10.0%, Due 3/15
    654,935       654,935       654,935  
                             
LN Acquisition Corp. (Lincoln Industrial)6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Initial Term Loan (Second Lien)
6.0%, Due 1/15
    2,000,000       2,000,000       2,000,000  
                         
MCCI Group Holdings, LLC6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan (First Lien)
4.7%, Due 12/12
    5,229,035       5,221,185       5,229,035  
                             
MCCI Group Holdings, LLC6
Healthcare, Education and Childcare
 
Junior Secured Loan — Term Loan (Second Lien)
8.0%, Due 6/13
    1,000,000       1,000,000       1,000,000  
                         
PAS Technologies Inc.
Aerospace and Defense
 
Senior Secured Loan — Incremental Term Loan Add On
5.8%, Due 6/11
    431,882       431,882       431,882  
                             
PAS Technologies Inc.6
Aerospace and Defense
 
Senior Secured Loan — Term Loan Retired 10/06/2010
5.8%, Due 6/11
    2,135,417       2,132,787       2,135,417  
                         
Pegasus Solutions, Inc.
Leisure, Amusement, Motion Pictures, Entertainment
 
Senior Subordinated Bond — Senior Subordinated Second Lien PIK Notes
13.0%, Due 4/14
    1,234,233       1,234,233       1,234,233  

 
9

 

Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Perseus Holding Corp.
Leisure, Amusement, Motion Pictures, Entertainment
 
Preferred Stock — Preferred Stock
14.0%, Due 4/14
  $ 400,000     $ 400,000     $ 384,000  
                         
QA Direct Holdings, LLC6
Printing and Publishing
 
Senior Secured Loan — Term Loan
8.3%, Due 8/14
    4,409,153       4,383,919       4,356,243  
                             
Resco Products, Inc.
Mining, Steel, Iron and Non-Precious Metals
 
Junior Secured Loan — Term Loan (Second Lien)
6.0%, Due 6/14
    2,036,889       2,036,889       2,036,889  
                         
Resco Products, Inc.6
Mining, Steel, Iron and Non-Precious Metals
 
Junior Secured Loan — Term Loan (Second Lien)
12.0%, Due 6/14
    7,050,874       6,929,164       7,050,874  
                             
San Juan Cable, LLC6
Broadcasting and Entertainment
 
Junior Secured Loan — Loan (Second Lien)
5.8%, Due 10/13
    3,000,000       2,988,898       3,000,000  
                         
Schneller LLC6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
3.5%, Due 6/13
    4,080,491       4,061,197       3,876,466  
                             
Seismic Micro-Technology, Inc. (SMT)6
Electronics
 
Senior Secured Loan — Term Loan
2.9%, Due 6/12
    1,170,721       1,169,601       1,071,209  
                         
Seismic Micro-Technology, Inc. (SMT)6
Electronics
 
Senior Secured Loan — Term Loan
2.9%, Due 6/12
    780,480       779,734       714,140  
                             
Specialized Technology Resources, Inc.6
Diversified/Conglomerate Service
 
Junior Secured Loan — Loan (Second Lien)
7.3%, Due 12/14
    7,500,000       7,500,000       7,500,000  
                         
Specialized Technology Resources, Inc.6
Diversified/Conglomerate Service
 
Senior Secured Loan — Term Loan (First Lien)
2.8%, Due 6/14
    3,533,271       3,533,271       3,533,271  
                             
TUI University, LLC6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan (First Lien)
3.3%, Due 10/14
    3,119,818       3,028,287       2,932,629  

 
10

 

Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Twin-Star International, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan
4.5%, Due 4/13
  $ 3,915,834     $ 3,915,834     $ 3,915,834  
                             
Walker Group Holdings LLC
Cargo Transport
 
Junior Secured Loan — Term Loan B
12.5%, Due 12/12
    470,643       470,643       470,643  
                         
Walker Group Holdings LLC6
Cargo Transport
 
Junior Secured Loan — Term Loan B
12.5%, Due 12/12
    4,469,539       4,469,539       4,469,539  
                             
Water PIK, Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Loan (First Lien)
3.5%, Due 6/13
    600,037       598,120       600,037  
                         
Wesco Aircraft Hardware Corp.
Aerospace and Defense
 
Junior Secured Loan — Loan (Second Lien)
6.0%, Due 3/14
    1,906,667       1,858,036       1,906,667  
                             
Wesco Aircraft Hardware Corp.6
Aerospace and Defense
 
Junior Secured Loan — Loan (Second Lien)
6.0%, Due 3/14
    3,940,019       3,957,912       3,940,019  
                         
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Acquisition Term Loan
2.5%, Due 6/12
    761,003       756,831       725,997  
                             
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Synthetic Letter of Credit
2.5%, Due 6/12
    668,412       664,747       637,665  
                         
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Synthetic Revolver Deposit
2.5%, Due 6/12
    167,103       166,187       159,416  
                             
Wolf Hollow I, LP6
Utilities
 
Junior Secured Loan — Term Loan (Second Lien)
4.8%, Due 12/12
    2,683,177       2,685,659       2,573,166  
                         
X-Rite, Incorporated6
Electronics
 
Senior Secured Loan — Term Loan (First Lien)
6.6%, Due 10/12
    483,731       482,725       483,731  
                             
Total Investment in Debt Securities
                       
(95% of net asset value at fair value)
  $ 235,050,484     $ 229,736,282     $ 190,908,445  

 
11

 

Equity Portfolio

Portfolio Company / Principal Business
 
Investment
 
Percentage
Interest/Shares
   
Cost
   
Value2
 
Aerostructures Holdings L.P.7
Aerospace and Defense
 
Partnership Interests
    1.2 %   $ 1,000,000     $ 160,000  
                         
Aerostructures Holdings L.P.7
Aerospace and Defense
 
Series A Preferred Interests
    1.2 %     250,961       250,961  
                             
Coastal Concrete Holding II, LLC7
Buildings and Real Estate4
 
Class A Units
    10.8 %     8,625,626       250,143  
                         
eInstruction Acquisition, LLC7
Healthcare, Education and Childcare
 
Membership Units
    1.1 %     1,079,617       1,503,042  
                             
FP WRCA Coinvestment Fund VII, Ltd.3, 7
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Class A Shares
    1,500       1,500,000       2,205,000  
                         
Perseus Holding Corp.7
Leisure, Amusement, Motion Pictures, Entertainment
 
Common
    0.2 %   $ 400,000     $ 400,000  
                             
Natural Products Group, Inc.7
Personal and Non Durable Consumer Products (Mfg. Only)
 
Series A-1 Common Stock
    0.4 %     687,140       546,276  
                         
International Architectural Products, Inc.7
Mining, Steel, Iron and Non-Precious Metals
 
Common
    2.5 %     292,851       296,599  
                             
Las Vegas Land Holdings, LLC7
Buildings and Real Estate4
 
Common
    0.5 %     264,372       264,372  
                         
Legacy Cabinets, Inc.7
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Equity
    4.0 %     115,580       113,206  
                             
Total Investment in Equity Securities
                       
(3% of net asset value at fair value)
          $ 14,216,146     $ 5,989,599  

 
12

 

CLO Fund Securities

CLO Equity Investments

Portfolio Company
 
Investment
 
Percentage Interest
   
Cost
   
Value2
 
Grant Grove CLO, Ltd.3, 12
 
Subordinated Securities
    22.2 %   $ 4,719,717     $ 3,390,000  
Katonah III, Ltd.3, 12
 
Preferred Shares
    23.1 %     4,500,000       810,000  
Katonah IV, Ltd.3, 12, 13
 
Preferred Shares
    17.1 %     3,150,000       1,070,000  
Katonah V, Ltd.3, 12, 13
 
Preferred Shares
    26.7 %     3,320,000       1,000  
Katonah VII CLO Ltd.3, 8, 12, 13
 
Subordinated Securities
    16.4 %     4,500,000       2,280,000  
Katonah VIII CLO Ltd3, 8, 12
 
Subordinated Securities
    10.3 %     3,400,000       1,890,000  
Katonah IX CLO Ltd3, 8, 12
 
Preferred Shares
    6.9 %     2,000,000       1,300,000  
Katonah X CLO Ltd 3, 8, 12
 
Subordinated Securities
    33.3 %     11,606,522       9,110,000  
Katonah 2007-I CLO Ltd.3, 8, 12
 
Preferred Shares
    100.0 %     29,976,188       26,260,000  
                             
Total Investment in CLO Equity Securities
          $ 67,172,427     $ 46,111,000  
                             
CLO Rated-Note Investment
                           
                             
Portfolio Company
 
Investment
 
Percentage Interest
   
Cost
   
Value2
 
Katonah 2007-I CLO Ltd.3, 8, 12
 
Class B-2L Notes
Par Value of $10,500,000
100.0%, Due 4/22
    100.0 %   $ 1,086,230     $ 6,640,000  
                             
Total Investment in CLO Rated-Note
          $ 1,086,230     $ 6,640,000  
                             
Total Investment in CLO Fund Securities
                       
(26% of net asset value at fair value)
          $ 68,258,657     $ 52,751,000  
                             
Asset Manager Affiliate
                           
                             
Portfolio Company / Principal Business
 
Investment
 
Percentage Interest
   
Cost
   
Value2
 
Katonah Debt Advisors
 
Asset Management Company
    100.0 %   $ 44,219,947     $ 49,149,581  
                             
Total Investment in Asset Manager Affiliate
          $ 44,219,947     $ 49,149,581  
(24% of net asset value at fair value)
                       

 
13

 

Time Deposits and Money Market Account

Time Deposits and Money Market Account
 
Investment
 
Yield
   
Par / Cost
   
Value2
 
US Bank Eurodollar Sweep CL23, 10
 
Time Deposit
    0.1 %   $ 24,529,226     $ 24,529,226  
JP Morgan Asset Account
 
Time Deposit
    0.0 %     551       551  
JP Morgan Business Money Market Account11
 
Money Market Account
    0.2 %     212,245       212,245  
                             
Total Investment in Time Deposit and Money Market Accounts
          $ 24,742,022     $ 24,742,022  
(12% of net asset value at fair value)
                       
                             
Total Investments5
              $ 381,173,054     $ 323,540,647  
(161% of net asset value at fair value)
                       
                             
See accompanying notes to financial statements.
 

1
A majority of the variable rate loans to the Company’s portfolio companies bear interest at a rate that may be determined by reference to either LIBOR or an alternate Base Rate (commonly based on the Federal Funds Rate or the Prime Rate), which typically resets semi-annually, quarterly, or monthly. For each such loan, the Company has provided the weighted average annual stated interest rate in effect at September 30, 2010.
 
2
Reflects the fair market value of all existing investments as of September 30, 2010, as determined by the Company’s Board of Directors.
 
3
Non-U.S. company or principal place of business outside the U.S.
 
4
Buildings and real estate relate to real estate ownership, builders, managers and developers and excludes mortgage debt investments and mortgage lenders or originators. As of September 30, 2010, the Company had no exposure to mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset backed securities), companies providing mortgage lending or emerging markets investments either directly or through the Company’s investments in CLO funds.
 
5
The aggregate cost of investments for federal income tax purposes is approximately $381 million. The aggregate gross unrealized appreciation is approximately $12 million and the aggregate gross unrealized depreciation is approximately $70 million.
 
6
Pledged as collateral for the secured revolving credit facility (see Note 6 to the financial statements).
 
7
Non-income producing.
 
8
An affiliate CLO Fund managed by Katonah Debt Advisors, L.L.C. or its affiliate.
 
9
Loan or debt security is on non-accrual status and therefore is considered non-income producing.
 
10
Time deposit investment partially restricted under terms of the secured credit facility (see Note 6 to financial statements).
 
11
Money market account holding restricted cash for employee flexible spending accounts.
 
12
These securities were acquired in a transaction that was exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Rule 144A thereunder.  These securities may be resold only in transactions that are exempt from the registration requirements of the Securities Act, normally to qualified institutional buyers.
 
13
As of September 30, 2010, these CLO Fund Securities were not providing a dividend distribution.

 
14

 

KOHLBERG CAPITAL CORPORATION
SCHEDULE OF INVESTMENTS
As of December 31, 2009

Debt Securities Portfolio

Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Advanced Lighting Technologies, Inc.
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Revolving Loan
5.0%, Due 6/13
  $ 640,000     $ 634,264     $ 637,440  
                         
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Deferred Draw Term Loan (First Lien)
3.0%, Due 6/13
    323,595       323,595       322,301  
                             
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Junior Secured Loan — Second Lien Term Loan Note
6.2%, Due 6/14
    5,000,000       5,000,000       5,000,000  
                         
Advanced Lighting Technologies, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan (First Lien)
3.0%, Due 6/13
    1,580,565       1,580,565       1,574,242  
                             
Aero Products International, Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Term Loan
9.5%, Due 4/12
    3,118,560       3,118,560       1,721,445  
                         
Aerostructures Acquisition LLC6
Aerospace and Defense
 
Senior Secured Loan — Delayed Draw Term Loan
6.8%, Due 3/13
    412,667       412,667       412,667  
                             
Aerostructures Acquisition LLC6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
6.8%, Due 3/13
    5,219,471       5,219,471       5,219,471  
                         
AGA Medical Corporation6
Healthcare, Education and Childcare
 
Senior Secured Loan — Tranche B Term Loan
2.3%, Due 4/13
    1,832,209       1,831,354       1,799,230  
                             
AGS LLC6
Hotels, Motels, Inns, and Gaming
 
Senior Secured Loan — Delayed Draw Term Loan
3.2%, Due 5/13
    425,866       421,983       389,241  
                         
AGS LLC6
Hotels, Motels, Inns, and Gaming
 
Senior Secured Loan — Initial Term Loan
3.2%, Due 5/13
    3,043,896       3,016,145       2,782,121  
                             
AmerCable Incorporated6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Senior Secured Loan — Initial Term Loan
3.8%, Due 6/14
    5,840,213       5,840,213       5,606,605  
                         
Astoria Generating Company Acquisitions, L.L.C.6
Utilities
 
Junior Secured Loan — Term C
4.0%, Due 8/13
    4,000,000       4,031,898       3,800,000  

 
15

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Atlantic Marine Holding Company6
Cargo Transport
 
Senior Secured Loan — Term Loan
4.6%, Due 3/14
  $ 1,681,287     $ 1,688,586     $ 1,681,287  
                         
Aurora Diagnostics, LLC6
Healthcare, Education and Childcare
 
Senior Secured Loan — Tranche A Term Loan (First Lien)
4.5%, Due 12/12
    4,017,152       3,993,498       4,017,152  
                             
Awesome Acquisition Company (CiCi's Pizza)6
Personal, Food and Miscellaneous Services
 
Junior Secured Loan — Term Loan (Second Lien)
5.3%, Due 6/14
    4,000,000       3,981,723       3,924,000  
                         
AZ Chem US Inc.6
Chemicals, Plastics and Rubber
 
Junior Secured Loan — Second Lien Term Loan
5.7%, Due 2/14
    4,000,000       3,970,688       4,000,000  
                             
Bankruptcy Management Solutions, Inc.6
Diversified/Conglomerate Service
 
Junior Secured Loan — Loan (Second Lien)
6.5%, Due 7/13
    2,418,750       2,441,936       1,777,781  
                         
Bankruptcy Management Solutions, Inc.6
Diversified/Conglomerate Service
 
Senior Secured Loan — Term Loan (First Lien)
4.2%, Due 7/12
    1,870,497       1,876,933       1,509,491  
                             
Bicent Power LLC6
Utilities
 
Junior Secured Loan — Advance (Second Lien)
4.3%, Due 12/14
    4,000,000       4,000,000       3,528,000  
                         
BP Metals, LLC (fka Constellation Enterprises) 6
Mining, Steel, Iron and Non-Precious Metals
 
Senior Secured Loan — Term Loan
10.0%, Due 6/13
    4,383,929       4,383,929       4,383,929  
                             
Broadlane, Inc.6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan
8.5%, Due 8/13
    2,741,832       2,711,990       2,741,832  
                         
Caribe Information Investments Incorporated6
Printing and Publishing
 
Senior Secured Loan — Term Loan
2.5%, Due 3/13
    1,676,743       1,672,195       1,653,269  
                             
Cast & Crew Payroll, LLC (Payroll Acquisition)6
Leisure, Amusement, Motion Pictures, Entertainment
 
Senior Secured Loan — Initial Term Loan
3.2%, Due 9/12
    7,693,290       7,709,678       7,654,824  
                         
CEI Holdings, Inc. (Cosmetic Essence)6, 9
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Term Loan
8.1%, Due 3/13
    1,454,368       1,407,135       780,116  
                             
Charlie Acquisition Corp.9
Personal, Food and Miscellaneous Services
 
Mezzanine Investment — Senior Subordinated Notes
15.5%, Due 6/13
    10,893,401       10,777,799       635,444  
                         
CoActive Technologies, Inc.6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Senior Secured Loan — Term Loan (First Lien)
3.3%, Due 7/14
    3,916,722       3,903,782       2,882,707  

 
16

 
  
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
 
Cost
 
Value2
 
CoActive Technologies, Inc.6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Term Loan (Second Lien)
7.0%, Due 1/15
  $ 2,000,000   $ 1,972,218   $ 1,062,000  
               
Dealer Computer Services, Inc. (Reynolds & Reynolds)6
Electronics
 
Junior Secured Loan — Term Loan (Second Lien)
5.8%, Due 10/13
    1,000,000     1,006,261     1,000,000  
                         
Dealer Computer Services, Inc. (Reynolds & Reynolds)6
Electronics
 
Junior Secured Loan — Term Loan (Third Lien)
7.8%, Due 4/14
    7,700,000     7,538,614     7,700,000  
               
Delta Educational Systems, Inc.6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan
6.0%, Due 6/12
    2,301,996     2,301,996     2,281,278  
                         
Dex Media West LLC
Printing and Publishing
 
Senior Secured Loan — Tranche B Term Loan
7.0%, Due 10/14
    4,696,402     4,312,579     4,348,868  
               
Dresser, Inc.6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Term Loan (Second Lien)
6.0%, Due 5/15
    3,000,000     2,970,206     2,991,000  
                         
DRI Holdings, Inc.6
Healthcare, Education and Childcare
 
Junior Secured Loan — US Term Loan (Second Lien)
6.5%, Due 7/15
    6,000,000     5,502,222     5,700,000  
                     
Edgestone CD Acquisition Corp. (Custom Direct)6
Printing and Publishing
 
Junior Secured Loan — Loan (Second Lien)
6.3%, Due 12/14
    5,000,000     5,000,000     5,000,000  
                   
Edgestone CD Acquisition Corp. (Custom Direct)6
Printing and Publishing
 
Senior Secured Loan — Term Loan (First Lien)
3.1%, Due 12/13
    3,982,724     3,985,832     3,982,724  
                     
eInstruction Corporation6
Healthcare, Education and Childcare
 
Senior Secured Loan — Initial Term Loan
4.3%, Due 7/13
    4,017,321     4,017,321     3,969,113  
                   
eInstruction Corporation6
Healthcare, Education and Childcare
 
Junior Secured Loan — Term Loan (Second Lien)
7.8%, Due 7/14
    10,000,000     10,000,000     10,000,000  
                     
Endeavor Energy Resources, L.P.6
Oil and Gas
 
Junior Secured Loan — Initial Loan (Second Lien)
5.3%, Due 4/12
    4,000,000     4,000,000     4,000,000  
                   
Fasteners For Retail, Inc.6
Diversified/Conglomerate Manufacturing
 
Senior Secured Loan — Term Loan
4.8%, Due 12/12
    4,042,346     4,046,728     4,042,346  
                     
FD Alpha Acquisition LLC  (Fort Dearborn)6
Printing and Publishing
 
Senior Secured Loan — US Term Loan
3.2%, Due 11/12
    1,538,635     1,462,409     1,538,635  
 
 
17

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
 
Cost
 
Value2
 
First American Payment Systems, L.P.6
Finance
 
Senior Secured Loan — Term Loan
3.3%, Due 10/13
  $ 3,198,000   $ 3,198,000   $ 3,198,000  
               
First Data Corporation
Finance
 
Senior Secured Loan — Initial Tranche B-2 Term Loan
3.0%, Due 9/14
    2,440,944     2,262,445     2,174,881  
                         
Ford Motor Company6
Automobile
 
Senior Secured Loan — Tranche B-1 Term Loan
3.3%, Due 12/13
    1,942,429     1,940,876     1,800,631  
               
Freescale Semiconductor, Inc.
Electronics
 
Senior Subordinated Bond —
10.1%, Due 12/16
    3,000,000     3,007,167     2,415,000  
                         
Frontier Drilling USA, Inc.6
Oil and Gas
 
Senior Secured Loan — Term B Advance
9.3%, Due 6/13
    2,000,000     1,998,652     2,000,000  
               
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Senior Secured Loan — First Lien Tranche A Credit-Linked Deposit
7.8%, Due 6/11
    1,257,143     1,224,101     89,634  
                         
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Senior Secured Loan — First Lien Tranche B Term Loan
7.8%, Due 6/11
    2,694,857     2,624,028     195,377  
                     
Ginn LA Conduit Lender, Inc.9
Buildings and Real Estate4
 
Junior Secured Loan — Loan (Second Lien)
11.8%, Due 6/12
    3,000,000     2,715,997     60,000  
                   
Harland Clarke Holdings Corp. (fka Clarke American Corp.)6
Printing and Publishing
 
Senior Secured Loan — Tranche B Term Loan
2.7%, Due 6/14
    2,925,000     2,925,000     2,442,375  
                         
HMSC Corporation (aka Swett and Crawford)6
Insurance
 
Junior Secured Loan — Loan (Second Lien)
5.8%, Due 10/14
    5,000,000     4,861,123     4,490,000  
               
Huish Detergents Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Junior Secured Loan — Loan (Second Lien)
4.5%, Due 10/14
    1,000,000     1,000,000     1,000,000  
                         
Hunter Fan Company6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Initial Term Loan (First Lien)
2.7%, Due 4/14
    3,723,929     3,605,519     3,239,818  
               
Hunter Fan Company6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Junior Secured Loan — Loan (Second Lien)
7.0%, Due 10/14
    3,000,000     3,000,000     2,550,000  
                         
Infiltrator Systems, Inc.6
Ecological
 
Senior Secured Loan — Term Loan
8.5%, Due 9/12
    2,699,907     2,695,103     2,699,907  
 
 
18

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Inmar, Inc.6
Retail Stores
 
Senior Secured Loan — Term Loan
2.5%, Due 4/13
  $ 3,543,046     $ 3,543,046     $ 3,521,787  
                             
International Aluminum Corporation (IAL Acquisition Co.)6, 9
Mining, Steel, Iron and Non-Precious Metals
 
Senior Secured Loan — Term Loan
5.0%, Due 3/13
    2,973,711       2,973,711       1,987,926  
                         
Intrapac Corporation/Corona Holdco6
Containers, Packaging and Glass
 
Senior Secured Loan — 1st Lien Term Loan
3.8%, Due 5/12
    4,034,281       4,042,948       3,852,738  
                             
Intrapac Corporation/Corona Holdco6
Containers, Packaging and Glass
 
Junior Secured Loan — Term Loans (Second Lien)
7.8%, Due 5/13
    3,000,000       3,013,753       3,000,000  
                         
Jones Stephens Corp.6
Buildings and Real Estate4
 
Senior Secured Loan — Term Loan
7.8%, Due 9/12
    9,541,180       9,526,158       8,491,650  
                             
KIK Custom Products Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Junior Secured Loan — Loan (Second Lien)
5.3%, Due 12/14
    5,000,000       5,000,000       3,060,000  
                         
La Paloma Generating Company, LLC6
Utilities
 
Junior Secured Loan — Loan (Second Lien)
3.8%, Due 8/13
    2,000,000       2,011,080       1,622,000  
                             
LBREP/L-Suncal Master I LLC9
Buildings and Real Estate4
 
Junior Secured Loan — Term Loan (Third Lien)
15.0%, Due 2/12
    2,332,868       2,332,868       1,000  
                         
LBREP/L-Suncal Master I LLC6, 9
Buildings and Real Estate4
 
Senior Secured Loan — Term Loan (First Lien)
5.5%, Due 1/10
    3,875,156       3,873,404       116,255  
                             
LBREP/L-Suncal Master I LLC6, 9
Buildings and Real Estate4
 
Junior Secured Loan — Term Loan (Second Lien)
9.5%, Due 1/11
    2,000,000       1,920,211       7,500  
                         
Legacy Cabinets, Inc.6, 9
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan
6.6%, Due 8/12
    2,258,184       2,258,184       537,416  
                             
Levlad, LLC & Arbonne International, LLC6, 9
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Term Loan
7.8%, Due 3/14
    2,660,729       2,660,729       1,341,007  
                             
LN Acquisition Corp. (Lincoln Industrial)6
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Junior Secured Loan — Initial Term Loan (Second Lien)
6.0%, Due 1/15
    2,000,000       2,000,000       1,978,000  
                             
MCCI Group Holdings, LLC6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan (First Lien)
4.3%, Due 12/12
    5,754,849       5,743,304       5,622,487  
 
 
19

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
MCCI Group Holdings, LLC6
Healthcare, Education and Childcare
 
Junior Secured Loan — Term Loan (Second Lien)
7.5%, Due 6/13
  $ 1,000,000     $ 1,000,000     $ 1,000,000  
                         
National Interest Security Company, L.L.C.
Aerospace and Defense
 
Mezzanine Investment — Mezzanine Facility
15.0%, Due 6/13
    3,000,000       3,000,000       3,300,000  
                             
National Interest Security Company, L.L.C.
Aerospace and Defense
 
Junior Secured Loan — Second Lien Term Loan
15.0%, Due 6/13
    1,000,000       1,000,000       1,100,000  
                         
National Interest Security Company, L.L.C.6
Aerospace and Defense
 
Senior Secured Loan — Term Loan - 1st Lien
7.8%, Due 12/12
    7,650,000       7,650,000       7,650,000  
                             
Northeast Biofuels, LP6, 9
Farming and Agriculture
 
Senior Secured Loan — Construction Term Loan
8.8%, Due 6/13
    1,382,120       1,383,944       208,369  
                         
Northeast Biofuels, LP6, 9
Farming and Agriculture
 
Senior Secured Loan — Synthetic LC Term Loan
8.8%, Due 6/13
    57,257       57,333       8,632  
                             
PAS Technologies Inc.
Aerospace and Defense
 
Senior Secured Loan — Incremental Term Loan Add On
4.3%, Due 6/11
    632,022       632,022       632,022  
                         
PAS Technologies Inc.6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
4.3%, Due 6/11
    3,125,000       3,117,290       3,125,000  
                             
Pegasus Solutions, Inc.9
Leisure, Amusement, Motion Pictures, Entertainment
 
Senior Unsecured Bond —
10.5%, Due 4/15
    2,000,000       2,000,000       1,710,000  
                         
Pegasus Solutions, Inc.6, 10
Leisure, Amusement, Motion Pictures, Entertainment
 
Senior Secured Loan — Term Loan
7.8%, Due 4/13
    4,863,083       4,863,083       4,863,083  
                             
Primus International Inc.6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
2.7%, Due 6/12
    1,087,032       1,088,240       1,060,944  
                         
QA Direct Holdings, LLC6
Printing and Publishing
 
Senior Secured Loan — Term Loan
8.3%, Due 8/14
    4,540,186       4,509,168       4,540,186  
                             
Resco Products, Inc.6
Mining, Steel, Iron and Non-Precious Metals
 
Junior Secured Loan — Term Loan (Second Lien)
20.0%, Due 6/14
    6,650,000       6,503,858       6,650,000  
                         
Rhodes Companies, LLC, The6, 9
Buildings and Real Estate4
 
Senior Secured Loan — First Lien Term Loan
11.8%, Due 11/10
    1,685,674       1,636,741       298,241  
 
 
20

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Rhodes Companies, LLC, The6, 9
Buildings and Real Estate4
 
Junior Secured Loan — Second Lien Term Loan
13.0%, Due 11/11
  $ 2,013,977     $ 2,019,403     $ 12,720  
                             
San Juan Cable, LLC6
Broadcasting and Entertainment
 
Junior Secured Loan — Loan (Second Lien)
5.8%, Due 10/13
    3,000,000       2,986,206       2,862,000  
                         
Schneller LLC6
Aerospace and Defense
 
Senior Secured Loan — Term Loan
3.7%, Due 6/13
    4,304,174       4,278,271       4,231,003  
                             
Seismic Micro-Technology, Inc. (SMT)6
Electronics
 
Senior Secured Loan — Term Loan
3.2%, Due 6/12
    838,694       837,545       829,469  
                         
Seismic Micro-Technology, Inc. (SMT)6
Electronics
 
Senior Secured Loan — Term Loan
3.2%, Due 6/12
    1,258,041       1,256,317       1,244,203  
                             
Specialized Technology Resources, Inc.6
Diversified/Conglomerate Service
 
Junior Secured Loan — Loan (Second Lien)
7.2%, Due 12/14
    7,500,000       7,500,000       7,500,000  
                         
Specialized Technology Resources, Inc.6
Diversified/Conglomerate Service
 
Senior Secured Loan — Term Loan (First Lien)
2.7%, Due 6/14
    3,563,166       3,563,166       3,563,166  
                             
Standard Steel, LLC6
Cargo Transport
 
Senior Secured Loan — Delayed Draw Term Loan
8.3%, Due 7/12
    738,349       741,143       738,349  
                         
Standard Steel, LLC6
Cargo Transport
 
Senior Secured Loan — Initial Term Loan
9.0%, Due 7/12
    3,663,267       3,677,125       3,663,267  
                             
Standard Steel, LLC6
Cargo Transport
 
Junior Secured Loan — Loan (Second Lien)
13.8%, Due 7/13
    1,750,000       1,756,512       1,750,000  
                         
TPF Generation Holdings, LLC6
Utilities
 
Junior Secured Loan — Loan (Second Lien)
4.5%, Due 12/14
    2,000,000       2,023,571       1,894,000  
                             
TUI University, LLC6
Healthcare, Education and Childcare
 
Senior Secured Loan — Term Loan (First Lien)
3.2%, Due 10/14
    3,590,407       3,465,781       3,590,407  
                         
Twin-Star International, Inc.6
Home and Office Furnishings, Housewares, and Durable Consumer Products
 
Senior Secured Loan — Term Loan
4.3%, Due 4/13
    4,291,879       4,291,879       4,218,917  
                             
Walker Group Holdings LLC
Cargo Transport
 
Junior Secured Loan — Term Loan B
12.5%, Due 12/12
    526,500       526,500       526,500  
 
 
21

 
 
Portfolio Company / Principal Business
 
Investment
Interest Rate¹ / Maturity
 
Principal
   
Cost
   
Value2
 
Walker Group Holdings LLC6
Cargo Transport
 
Junior Secured Loan — Term Loan B
12.8%, Due 12/12
  $ 5,000,000     $ 5,000,000     $ 5,000,000  
                             
Water PIK, Inc.6
Personal and Non Durable Consumer Products (Mfg. Only)
 
Senior Secured Loan — Loan (First Lien)
3.5%, Due 6/13
    1,243,577       1,238,507       1,243,577  
                         
Wesco Aircraft Hardware Corp.
Aerospace and Defense
 
Junior Secured Loan — Loan (Second Lien)
6.0%, Due 3/14
    2,000,000       1,938,058       2,000,000  
                             
Wesco Aircraft Hardware Corp.6
Aerospace and Defense
 
Junior Secured Loan — Loan (Second Lien)
6.0%, Due 3/14
    4,132,887       4,155,678       4,132,887  
                             
WireCo WorldGroup Inc. 10
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Mezzanine Investment —
11.0%, Due 2/15
    5,000,000       4,829,054       5,100,000  
                         
WireCo WorldGroup Inc. 6, 10
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Mezzanine Investment —
11.0%, Due 2/15
    10,000,000       10,000,000       10,200,000  
                             
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Acquisition Term Loan
2.5%, Due 6/12
    767,269       761,240       743,484  
                         
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Synthetic Letter of Credit
.1%, Due 6/12
    668,412       663,160       647,691  
                             
Wolf Hollow I, LP6
Utilities
 
Senior Secured Loan — Synthetic Revolver Deposit
1.2%, Due 6/12
    167,103       165,790       161,923  
                         
Wolf Hollow I, LP6
Utilities
 
Junior Secured Loan — Term Loan (Second Lien)
4.8%, Due 12/12
    2,683,177       2,686,492       2,591,949  
                             
X-Rite, Incorporated6
Electronics
 
Junior Secured Loan — Loan (Second Lien)
14.4%, Due 10/13
    649,162       649,162       649,162  
                         
X-Rite, Incorporated6
Electronics
 
Senior Secured Loan — Term Loan (First Lien)
7.5%, Due 10/12
    581,049       579,404       569,430  
                             
Total Investment in Debt Securities
                       
(139% of net asset value at fair value)
  $ 344,924,114     $ 342,056,023     $ 297,356,529  
 
 
22

 
 
Equity Portfolio

Portfolio Company / Principal Business
 
Investment
 
Percentage
Interest/Shares
   
Cost
   
Value2
 
Aerostructures Holdings L.P.7
Aerospace and Defense
 
Partnership Interests
  1.2 %   $ 1,000,000     $ 350,280  
                           
Aerostructures Holdings L.P.7
Aerospace and Defense
 
Series A Preferred Interests
  1.2 %     160,361       202,396  
                           
Coastal Concrete Holding II, LLC7
Buildings and Real Estate4
 
Class A Units
  10.8 %     8,625,625       568,570  
                           
eInstruction Acquisition, LLC7
Healthcare, Education and Childcare
 
Membership Units
  1.1 %     1,079,617       1,456,000  
                           
FP WRCA Coinvestment Fund VII, Ltd.3, 7
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
 
Class A Shares
  15,000       1,500,000       2,136,000  
                           
Total Investment in Equity Securities
                     
(2% of net asset value at fair value)
        $ 12,365,603     $ 4,713,246  
CLO Fund Securities
                         
                           
CLO Equity Investments
                         
                           
Portfolio Company
 
Investment
 
Percentage
Interest
   
Cost
   
Value2
 
Grant Grove CLO, Ltd.3, 10, 11
 
Subordinated Securities
  22.2 %   $ 4,715,858     $ 2,780,000  
Katonah III, Ltd.3, 10
 
Preferred Shares
  23.1 %     4,500,000       950,000  
Katonah IV, Ltd.3, 10, 11
 
Preferred Shares
  17.1 %     3,150,000       290,000  
Katonah V, Ltd.3, 10, 11
 
Preferred Shares
  26.7 %     3,320,000       1,000  
Katonah VII CLO Ltd.3, 8, 10, 11
 
Subordinated Securities
  16.4 %     4,500,000       1,840,000  
Katonah VIII CLO Ltd3, 8, 10, 11
 
Subordinated Securities
  10.3 %     3,400,000       1,760,000  
Katonah IX CLO Ltd3, 8, 10, 11
 
Preferred Shares
  6.9 %     2,000,000       1,560,000  
Katonah X CLO Ltd 3, 8, 10
 
Subordinated Securities
  33.3 %     11,589,830       8,280,000  
Katonah 2007-I CLO Ltd.3, 8, 10
 
Preferred Shares
  100.0 %     29,940,867       27,100,000  
                           
Total Investment in CLO Equity Securities
        $ 67,116,555     $ 44,561,000  
 
 
23

 
 
CLO Rated-Note Investment

Portfolio Company
 
Investment
 
Percentage
Interest
   
Cost
   
Value2
 
Katonah 2007-I CLO Ltd.3, 8, 10
 
Class B-2L Notes
Par Value of $10,500,000
5.3%, Due 4/22
    100.0 %   $ 1,078,494     $ 4,410,000  
                             
Total Investment in CLO Rated-Note
          $ 1,078,494     $ 4,410,000  
                             
Total Investment in CLO Fund Securities
                       
(23% of net asset value at fair value)
          $ 68,195,049     $ 48,971,000  
                             
Asset Manager Affiliate
                           
                             
Portfolio Company / Principal Business
 
Investment
 
Percentage
Interest
   
Cost
   
Value2
 
Katonah Debt Advisors, L.L.C.
 
Membership Interests
    100 %   $ 40,751,511     $ 58,064,720  
                             
Total Investment in Asset Manager Affiliate
(27% of net asset value at fair value)
          $ 40,751,511     $ 58,064,720  
                             
Time Deposits and Money Market Account
                 
                             
Time Deposits and Money Market Account
 
Investment
 
Yield
   
Par / Cost
   
Value2
 
JP Morgan Asset Account
 
Time Deposit
    0.07 %     126       126  
                             
Total Investment in Time Deposit and Money Market Accounts
(0% of net asset value at fair value)
          $ 126     $ 126  
                             
Total Investments5
(191% of net asset value at fair value)
              $ 463,368,313     $ 409,105,621  

See accompanying notes to financial statements.

1
A majority of the variable rate loans to the Company’s portfolio companies bear interest at a rate that may be determined by reference to either LIBOR or an alternate Base Rate (commonly based on the Federal Funds Rate or the Prime Rate), which typically resets semi-annually, quarterly, or monthly. For each such loan, the Company has provided the weighted average annual stated interest rate in effect at December 31, 2009.

 
24

 

2
Reflects the fair market value of all existing investments as of December 31, 2009, as determined by the Company’s Board of Directors.
3
Non-U.S. company or principal place of business outside the U.S.
4
Buildings and real estate relate to real estate ownership, builders, managers and developers and excludes mortgage debt investments and mortgage lenders or originators. As of December 31, 2009, the Company had no exposure to mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset backed securities), companies providing mortgage lending or emerging markets investments either directly or through the Company’s investments in CLO funds.
5
The aggregate cost of investments for federal income tax purposes is approximately $463 million. The aggregate gross unrealized appreciation is approximately $24 million and the aggregate gross unrealized depreciation is approximately $78 million.
6
Pledged as collateral for the secured revolving credit facility (see Note 6 to the financial statements).
7
Non-income producing.
8
An affiliate CLO Fund managed by Katonah Debt Advisors L.L.C. or its affiliate.
9
Loan or debt security is on non-accrual status and therefore is considered non-income producing.
10
These securities were acquired in a transaction that was exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Rule 144A thereunder.  These securities may be resold only in transactions that are exempt from the registration requirements of the Securities Act, normally to qualified institutional buyers.
11
As of December 31, 2009, these CLO Fund securities were not providing a dividend distribution.

 
25

 

KOHLBERG CAPITAL CORPORATION
FINANCIAL HIGHLIGHTS
(unaudited)
($ per share)

   
Nine Months Ended
September 30,
 
   
2010
   
2009
 
         
(as restated)
 
Per Share Data:
           
Net asset value, at beginning of period
  $ 9.56     $ 9.03  
Net income (loss)
               
Net investment income1
    0.30       0.71  
Net realized losses1
    (0.48 )     (0.40 )
Net change in unrealized appreciation/depreciation on investments1
    (0.29 )     0.97  
Net income
    (0.47 )     1.28  
Net decrease in net assets resulting from distributions
               
From net investment income
    (0.29 )     (0.48 )
In excess of net investment income
    (0.04 )        
Net decrease in net assets resulting from distributions
    (0.33 )     (0.48 )
Net increase in net assets relating to stock-based transactions
               
Issuance of common stock (not including DRIP)
    -       -  
Issuance of common stock under dividend reinvestment plan
    0.05       0.07  
Stock based compensation expense
    0.03       0.03  
Net increase in net assets relating to stock-based transactions
    0.08       0.10  
                 
Net asset value, end of period
  $ 8.84     $ 9.93  
Total net asset value return2
    1.7 %     15.2 %
                 
Ratio/Supplemental Data:
               
Per share market value at beginning of period
  $ 4.56     $ 3.64  
Per share market value at end of period
  $ 6.69     $ 6.03  
Total market return3
    54.1 %     78.6 %
Shares outstanding at end of period
    22,708,399       22,255,149  
Net assets at end of period
  $ 200,801,315     $ 220,953,413  
Portfolio turnover rate4
    2.5 %     1.0 %
Average debt outstanding
  $ 171,738,698     $ 240,843,511  
Asset coverage ratio
    246 %     197 %
Ratio of net investment income to average net assets5
    4.3 %     10.0 %
Ratio of total expenses to average net assets5
    10.0 %     6.9 %
Ratio of interest expense to average net assets5
    4.3 %     4.0 %
Ratio of non-interest expenses to average net assets5
    5.7 %     2.9 %

     Based on weighted average number of common shares outstanding for the period.
     Total net asset value return (not annualized) equals the change in the net asset value per share over the beginning of period net asset value per share plus dividends, divided by the beginning net asset value per share.
     Total market return (not annualized) equals the change in the ending market price over the beginning of period price per share plus dividends, divided by the beginning price.
     Not annualized
     Annualized

See accompanying notes to financial statements.

 
26

 
 
KOHLBERG CAPITAL CORPORATION
 
NOTES TO FINANCIAL STATEMENTS
(unaudited)

1. ORGANIZATION
 
Kohlberg Capital Corporation (“Kohlberg Capital” or the “Company”) is an internally managed, non-diversified closed-end investment company that is regulated as a business development company (“BDC”) under the Investment Company Act of 1940. The Company originates, structures and invests in senior secured term loans, mezzanine debt and selected equity securities primarily in privately-held middle market companies. The Company defines the middle market as comprising companies with earnings before interest, taxes, depreciation and amortization (“EBITDA”), of $10 million to $50 million and/or total debt of $25 million to $150 million. The Company was formed as a Delaware limited liability company on August 8, 2006 and, prior to the issuance of shares of the Company’s common stock in its initial public offering, converted to a corporation incorporated in Delaware on December 11, 2006. Prior to its initial public offering (“IPO”), the Company did not have material operations. The Company’s IPO of 14,462,000 shares of common stock raised net proceeds of approximately $200 million. Prior to the IPO, the Company issued 3,484,333 shares to affiliates of Kohlberg & Co., LLC (“Kohlberg & Co.”), a leading middle market private equity firm, in exchange for the contribution of their ownership interests in Katonah Debt Advisors, L.L.C. (collectively with its affiliates, “Katonah Debt Advisors”) and in securities issued by collateralized loan obligation funds (“CLO Funds”) managed by Katonah Debt Advisors and two other asset managers to the Company. As of September 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of assets under management.
 
The Company’s investment objective is to generate current income and capital appreciation from investments made in senior secured term loans, mezzanine debt and selected equity investments in privately-held middle market companies. The Company also expects to continue to receive distributions of recurring fee income and to generate capital appreciation from its investment in the asset management business of Katonah Debt Advisors. Katonah Debt Advisors manages CLO Funds which invest in broadly syndicated loans, high-yield bonds and other credit instruments. The Company’s investment portfolio as well as the investment portfolios of the CLO Funds in which it has invested and the investment portfolios of the CLO Funds managed by Katonah Debt Advisors consist exclusively of credit instruments and other securities issued by corporations and do not include any asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings.
 
The Company has elected to be treated as a Regulated Investment Company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). To qualify as a RIC, the Company must, among other things, meet certain source-of-income and asset diversification requirements. Pursuant to this election, the Company generally will not have to pay corporate-level taxes on any income that it distributes to its stockholders.

2. SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The financial statements include the accounts of the Company and the accounts of its special purpose financing subsidiary, Kohlberg Capital Funding LLC I. In accordance with Article 6 of Regulation S-X under the Securities Act of 1933 and Securities Exchange Act of 1934, the Company does not consolidate portfolio company investments, including those in which it has a controlling interest (Katonah Debt Advisors, including its affiliates, is currently the only company in which the Company has a controlling interest).
 
The accompanying unaudited financial statements have been prepared on the accrual basis of accounting in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required for annual financial statements. The unaudited interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto in the Company’s Form 10-K for the year ended December 31, 2009, as filed with the Securities and Exchange Commission (the “Commission” or the “SEC”).

The financial statements reflect all adjustments, both normal and recurring which, in the opinion of management, are necessary for the fair presentation of the Company’s results of operations and financial condition for the periods presented. Furthermore, the preparation of the financial statements requires management to make significant estimates and assumptions including the fair value of investments that do not have a readily available market value. Actual results could differ from those estimates, and the differences could be material. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for the full year.

 
27

 
 
Accounting Standards Codification.  In June 2009, the Financial Accounting Standards Board (“FASB”) issued a pronouncement establishing the FASB Accounting Standards Codification (“ASC”) as the source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with GAAP. The ASC reorganized existing U.S. accounting and reporting standards issued by the FASB and other related private sector standard setters into a single source of authoritative accounting principles arranged by topic. The standard explicitly recognizes rules and interpretive releases of the Commission under federal securities laws as authoritative GAAP for SEC registrants. The ASC supersedes all existing U.S. accounting standards; all other accounting literature not included in the ASC (other than SEC guidance for publicly-traded companies) is considered non-authoritative. The ASC was effective on a prospective basis for interim and annual reporting periods ending after September 15, 2009. The adoption of the ASC changed the Company’s references to U.S. GAAP accounting standards but did not impact its results of operations, financial position or liquidity.
 
Investments
 
Investment transactions are recorded on the applicable trade date. Realized gains or losses are determined using the specific identification method.
 
Valuation of Portfolio Investments. The Company’s Board of Directors is ultimately and solely responsible for making a good faith determination of the fair value of portfolio investments on a quarterly basis. Debt and equity securities for which market quotations are readily available are generally valued at such market quotations. Debt and equity securities that are not publicly traded or whose market price is not readily available are valued by the Board of Directors based on detailed analyses prepared by management, the Valuation Committee of the Board of Directors, and, in certain circumstances, third parties with valuation expertise. Valuations are conducted by management on 100% of the investment portfolio at the end of each quarter. The Company follows the provisions of ASC Fair Value Measurements and Disclosures (“Fair Value Measurements and Disclosures ”). This standard defines fair value, establishes a framework for measuring fair value, and expands disclosures about assets and liabilities measured at fair value. Fair Value Measurements and Disclosures defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Subsequent to the adoption of Fair Value Measurements and Disclosures, the FASB has issued various staff positions clarifying the initial standard as noted below.
 
In January 2010, the FASB issued guidance that clarifies and requires new disclosures about fair value measurements. The clarifications and requirement to disclose the amounts and reasons for significant transfers between Level I and Level II, as well as significant transfers in and out of Level III of the fair value hierarchy, were adopted by the Company in the first quarter of 2010. Note 4 below reflects the amended disclosure requirements. The new guidance also requires that purchases, sales, issuances and settlements be presented gross in the Level III reconciliation and that requirement is effective for fiscal years beginning after December 15, 2010 and for interim periods within those years. The Company is evaluating the increased disclosure requirements for implementation by the effective date. Since this new guidance only amends the disclosures requirements, it did not impact our statements of financial position, statements of operations, or cash flow statements.
 
Fair Value Measurements and Disclosures requires the disclosure in interim and annual periods of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, during the period.
 
The Company engaged Valuation Research Corporation (“VRC”), an independent valuation firm, to provide third-party valuation estimates for approximately 39% of its portfolio at fair value as of December 31, 2009.  VRC’s valuation estimates were considered as one of the relevant data inputs in the Company’s determination of fair value.   Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of September 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of the Company’s annual year end valuation process.
 
The Board of Directors may consider other methods of valuation than those set forth above to determine the fair value of Level III investments as appropriate in conformity with GAAP. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments may differ materially from the values that would have been used had a ready market existed for such investments.  Further, such investments may be generally subject to legal and other restrictions on resale or otherwise be less liquid than publicly traded securities. In addition, changes in the market environment and other events may occur over the life of the investments that may cause the value realized on such investments to be different from the currently assigned valuations.

 
28

 
 
The Company’s valuation methodology and procedures are as follows:
 
1) 
Each portfolio company or investment is cross-referenced to an independent pricing service to determine if a current market quote is available. The nature and quality of such quote is reviewed to determine reliability and relevance of the quote. Factors considered in this determination include whether the quote is from a transaction or is a broker quote, the date and aging of such quote, whether the transaction is arms-length, whether it is of a liquidation or distressed nature and certain other factors judged to be relevant by management within the framework of Fair Value Measurements and Disclosures.
 
2) 
If an investment does not have a market quotation on either a broad market exchange or from an independent pricing service, the investment is initially valued by the Company’s investment professionals responsible for the portfolio investment in conjunction with the portfolio management team.
 
3) 
Preliminary valuation conclusions are discussed and documented by management.
 
4) 
Illiquid loans, junior and mezzanine securities, equity investments, CLO Fund securities and Katonah Debt Advisors may be selected for review by an independent valuation firm, which is engaged by the Company’s Board of Directors. Such independent valuation firm reviews management’s preliminary valuations and makes their own independent valuation assessment.
 
5) 
The Valuation Committee of the Board of Directors reviews the portfolio valuations, as well as the input and report of such independent valuation firm, as applicable.
 
6) 
Upon approval of the investment valuations by the Valuation Committee of the Board of Directors, the Audit Committee of the Board of Directors reviews the results for inclusion in the Company’s quarterly and annual financial statements, as applicable.
 
7) 
The Board of Directors discusses the valuations and determines in good faith that the fair values of each investment in the portfolio is reasonable based upon any applicable independent pricing service, input of management, estimates from independent valuation firms (if any) and the recommendations of the Valuation Committee of the Board of Directors.
 
The majority of the Company’s investment portfolio is composed of debt and equity securities with unique contract terms and conditions and/or complexity that requires a valuation of each individual investment that considers multiple levels of market and asset specific inputs, including historical and forecasted financial and operational performance of the individual investment, projected cash flows, market multiples, comparable market transactions, the priority of the security compared with those of other securities for such issuers, credit risk, interest rates, and independent valuations and reviews.
 
Loans and Debt Securities. To the extent that the Company’s investments are exchange traded and are priced or have sufficient price indications from normal course trading at or around the valuation date (financial reporting date), such pricing will determine fair value. Pricing service marks from third party pricing services may be used as an indication of fair value, depending on the volume and reliability of the marks, sufficient and reasonable correlation of bid and ask quotes, and, most importantly, the level of actual trading activity. However, most of the Company’s investments are illiquid investments with little or no trading activity. Further, the Company has been unable to identify directly comparable market indices or other market guidance that correlate directly to the types of investments the Company owns. As a result, for most of its assets, the Company determines fair value using alternative methodologies using available market data, as adjusted, to reflect the types of assets the Company owns, their structure, qualitative and credit attributes and other asset specific characteristics.
29

 
The Company derives fair value for its illiquid investments that do not have indicative fair values based upon active trades primarily by using a present value technique that discounts the estimated contractual cash flows for the underlying assets with discount rates imputed by broad market indices, bond spreads and yields for comparable issuers relative to the subject assets (the “Market Yield Approach”) and also considers recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. The Company has identified these two indices as benchmarks for broad market information related to its loan and debt investments. Because the Company has not identified any market index that directly correlates to the loan and debt investments held by the Company and therefore uses the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy. Other significant assumptions, such as coupon and maturity, are asset-specific and are noted for each investment in the Schedules of Investments.
 
Equity and Equity-Related Securities. The Company’s equity and equity-related securities in portfolio companies for which there is no liquid public market are carried at fair value based on the enterprise value of the portfolio company, which is determined using various factors, including EBITDA and cash flows from operations less capital expenditures and other pertinent factors, such as recent offers to purchase a portfolio company’s securities or other liquidation events. The determined fair values are generally discounted to account for restrictions on resale and minority ownership positions. The values of the Company’s equity and equity-related securities in public companies for which market quotations are readily available are based upon the closing public market prices on the balance sheet date. Securities that carry certain restrictions on sale are typically valued at a discount from the public market value of the security.
 
The significant inputs used to determine the fair value of equity and equity-related securities include prices, earnings, EBITDA and cash flows after capital expenditures for similar peer comparables and the investment entity itself. Equity and equity related securities are classified as Level III, as described in Note 4 below, when there is limited activity or less transparency around inputs to the valuation given the lack of information related to such equity investments held in nonpublic companies. Significant assumptions observed for comparable companies are applied to relevant financial data for the specific investment. Such assumptions, such as model discount rates or price/earnings multiples, vary by the specific investment, equity position and industry and incorporate adjustments for risk premiums, liquidity and company specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.
 
Affiliate Asset Manager. The Company’s investment in its wholly-owned asset management company, Katonah Debt Advisors, is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis of comparable asset management companies. Katonah Debt Advisors is classified as a Level III investment (as described below). Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.
 
CLO Fund Securities.  The Company typically makes a minority investment in the most junior class of securities of CLO Funds raised and managed by Katonah Debt Advisors and may selectively invest in securities issued by funds managed by other asset management companies (collectively “CLO Fund securities”). The Company’s CLO Fund securities relate exclusively to credit instruments issued by corporations and do not include any asset-backed securities secured by commercial mortgages, residential mortgages, or consumer borrowings.
 
The Company’s investments in CLO Fund securities are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the CLO Funds that are approaching or past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions to the class of securities owned by the Company, or (ii) a discounted cash flow model for more recent CLO Funds that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities or preferred shares to those in which the Company has invested. The Company recognizes unrealized appreciation or depreciation on the Company’s investments in CLO Fund securities as comparable yields in the market change and/or based on changes in NAVs or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investment. The Company determines the fair value of its investments in CLO Fund securities on an individual security-by-security basis.
 
30

 
Due to the individual attributes of each CLO Fund security, they are classified as a Level III investment unless specific trading activity can be identified at or near the valuation date. When available, observable market information will be identified, evaluated and weighted accordingly in the application of such data to the present value models and fair value determination. Significant assumptions to the present value calculations include default rates, recovery rates, prepayment rates, investment/reinvestment rates and spreads and the discount rate by which to value the resulting underlying cash flows. Such assumptions can vary significantly, depending on market data sources which often vary in depth and level of analysis, understanding of the CLO market, detailed or broad characterization of the CLO market and the application of such data to an appropriate framework for analysis. The application of data points are based on the specific attributes of each individual CLO Fund security’s underlying assets, historic, current and prospective performance, vintage, and other quantitative and qualitative factors that would be evaluated by market participants. The Company evaluates the source of market data for reliability as an indicative market input, consistency amongst other inputs and results and also the context in which such data is presented.
 
For bond rated tranches of CLO Fund securities (those above the junior class) without transactions to support a fair value for the specific CLO Fund and tranche, fair value is based on discounting estimated bond payments at current market yields, which may reflect the adjusted yield on the leveraged loan index for similarly rated tranches, as well as prices for similar tranches for other CLO Funds and also other factors such as the default and recovery rates of underlying assets in the CLO Fund, as may be applicable. Such model assumptions may vary and incorporate adjustments for risk premiums and CLO Fund specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.
 
Cash. The Company defines cash as demand deposits. The Company places its cash with financial institutions and, at times, cash held in checking accounts may exceed the Federal Deposit Insurance Corporation insured limit.
 
Restricted Cash.  Restricted cash consists mostly of cash held in an operating account pursuant to the Company’s secured credit facility agreement with its lender.
 
Time Deposits and Money Market Accounts.  Time deposits primarily represent overnight Eurodollar investments of cash held in non-demand deposit accounts. Such time deposits are partially restricted under terms of the secured credit facility. The money market account contains restricted cash held for employee flexible spending accounts.
 
Interest Income.  Interest income, including the amortization of premium and accretion of discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. The Company generally places a loan or security on non-accrual status and ceases recognizing cash interest income on such loan or security when a loan or security becomes 90 days or more past due or if the Company otherwise does not expect the debtor to be able to service its debt obligations. Non-accrual loans remain in such status until the borrower has demonstrated the ability and intent to pay contractual amounts due or such loans become current. As of September 30, 2010, five issuers representing 2% of total investments at fair value were considered in default.
 
Dividends from Affiliate Asset Manager. The Company records dividend income from its affiliate asset manager on the declaration date, which represents the ex-dividend date.
 
Dividend Income from CLO Fund Securities.  The Company generates dividend income from its investments in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and selective investments in securities issued by funds managed by other asset management companies. The Company’s CLO Fund junior class securities are subordinated to senior bond holders who typically receive a fixed rate of return on their investment. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders and less fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares. The Company makes estimated interim accruals of such dividend income based on recent historical distributions and CLO Fund performance and adjusts such accruals on a quarterly basis to reflect actual distributions.
 
For non-junior class CLO Fund securities, such as the Company’s investment in the Class B-2L Notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR index.
 
Capital Structuring Service Fees. The Company may earn ancillary structuring and other fees related to the origination, investment, disposition or liquidation of debt and investment securities. Generally, the Company will capitalize loan origination fees, then amortize these fees into interest income over the term of the loan using the effective interest rate method , recognizes prepayment and liquidation fees upon receipt and equity structuring fees as earned, which generally occurs when an investment transaction closes.
 
Debt Issuance Costs.  Debt issuance costs represent fees and other direct costs incurred in connection with the Company’s borrowings. These amounts are capitalized and amortized ratably over the contractual term of the borrowing. At September 30, 2010, there was an unamortized debt issuance cost of approximately $57,000 included in other assets in the accompanying balance sheet. Amortization expense for the nine months ended September 30, 2010 and 2009 was approximately $561,000 and $619,000, respectively.

 
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Expenses. The Company is internally managed and expenses costs, as incurred, with regard to the running of its operations. Primary operating expenses include employee salaries and benefits, the costs of identifying, evaluating, negotiating, closing, monitoring and servicing the Company’s investments and related overhead charges and expenses, including rental expense, and any interest expense incurred in connection with borrowings. The Company and its asset manager affiliates share office space and certain other operating expenses. The Company has entered into an Overhead Allocation Agreement with its asset manager affiliates which provides for the sharing of such expenses based on an equal sharing of office lease costs and the ratable usage of other shared resources. The aggregate net payments of such expenses under the Overhead Allocation Agreement are not material.
 
Dividends. Dividends and distributions to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the Board of Directors each quarter and is generally based upon the earnings estimated by management for the period and year.
 
The Company has adopted a dividend reinvestment plan (“DRIP”) that provides for reinvestment of its distributions on behalf of its stockholders, unless a stockholder “opts out” of the plan to receive cash in lieu of having their cash dividends automatically reinvested in additional shares of the Company’s common stock.
 
Recent Accounting Pronouncements

Improved Disclosures Regarding Fair Value Measurements. In January 2010, the FASB issued Accounting Standards Update No. 2010-06, Fair Value Measurements and Improving Disclosures About Fair Value Measurements (Topic 820), which provides for improving disclosures about fair value measurements, primarily significant transfers in and out of Levels I and II, and activity in Level III fair value measurements. The new disclosures and clarifications of existing disclosures are effective for the interim and annual reporting periods beginning after December 15, 2009, while the disclosures about the purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements are effective for fiscal years beginning after December 15, 2010 and for the interim periods within those fiscal years. Except for certain detailed Level III disclosures, which are effective for fiscal years beginning after December 15, 2010 and interim periods within those years, the new guidance became effective for the Company’s fiscal 2010 second quarter. The Company did not have transfers of assets or liabilities in or out of Level I and Level II fair value measurements. The adoption of this disclosure-only guidance is included in Note 3 “— Portfolio Investments” and did not have a material impact on the Company’s financial results.
 
Fair Value Measurements for Alternative Investments. In September 2009, the FASB issued Accounting Standards Update 2009-12, Fair Value Measurements and Disclosures (Topic 820) — Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), which provides guidance on estimating the fair value of an alternative investment, amending ASC 820-10. The amendment is effective for interim and annual periods ending after December 15, 2009. The adoption of this guidance did not have a material impact on either the Company’s financial position or results of operations.
 
32

 
3. EARNINGS PER SHARE
 
The following information sets forth the computation of basic and diluted net increase in stockholders’ equity per share for the three and nine months ended September 30, 2010 and 2009:

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net increase (decrease) in net assets from operations
  $ (3,319,312 )   $ 10,665,810     $ (7,415,319 )   $ 32,543,669  
Net increase (decrease) in net assets allocated to non-vested share awards
          129,675             461,696  
Net increase (decrease) in net assets available to common stockholders
    (3,319,312 )     10,536,135       (7,415,319 )     32,081,973  
Weighted average number of common shares outstanding for basic shares computation
    22,677,428       22,194,690       22,547,274       22,030,517  
Effect of dilutive securities - stock options
          5              
Weighted average number of common and common stock equivalent shares outstanding for diluted shares computation
    22,677,428       22,194,695       22,547,274       22,030,517  
Basic and diluted net increase (decrease) in net assets per common shares:
                               
Net increase (decrease) in net assets from operations
    (0.15 )     0.47       (0.33 )     1.46  
Net increase (decrease) in net assets allocated to non-vested share awards
          0.01             0.02  
 
Effective January 1, 2008, the accounting for unvested share-based payment awards included in the calculation of earnings per share changed. Share-based awards that contain nonforfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are now participating securities and included in the computation of both basic and diluted earnings per share. Our grants of restricted stock awards to our employees and directors are considered participating securities when there are earnings in the period. We have prepared our earnings per share calculations to include outstanding unvested restricted stock awards in the basic weighted average shares outstanding calculation.
 
Options to purchase 40,000 and 20,000 shares were not included in the computation of diluted earnings per share for the periods ended September 30, 2010 and 2009, respectively, because the effect would be antidilutive as the exercise prices exceeded the average market price of the common shares.
 
4. INVESTMENTS
 
The Company invests in senior secured loans and mezzanine debt and, to a lesser extent, equity capital of middle market companies in a variety of industries. The Company generally targets companies that generate positive cash flows because the Company looks to cash flows as the primary source for servicing debt. However, the Company may invest in industries in which it currently has little or no investment if it is presented with attractive opportunities.
 
The following table shows the Company’s portfolio by security type at September 30, 2010 and December 31, 2009:

   
September 30, 2010
   
December 31, 2009
 
Security Type
 
Cost
   
Fair Value
     
   
Cost
   
Fair Value
     
 
Time Deposits
  $ 24,529,777     $ 24,529,777       12 %   $ 126     $ 126       - %
Money Market Account
    212,245       212,245       -       -       -       -  
Senior Secured Loan
    110,660,494       95,668,038       48       179,425,767       159,075,586       74  
Junior Secured Loan
    103,690,662       90,642,174       45       129,016,237       114,920,499       54  
Mezzanine Investment
    10,744,496       250,000       -       28,606,852       19,235,444       9  
Senior Subordinated Bond
    4,240,630       3,964,233       2       3,007,167       2,415,000       1  
Senior Unsecured Bond
    -       -       -       2,000,000       1,710,000       1  
Preferred Stock
    400,000       384,000       -       -       -       -  
CLO Fund Securities
    68,258,657       52,751,000       26       68,195,049       48,971,000       23  
Equity Securities
    14,216,146       5,989,599       3       12,365,603       4,713,246       2  
Affiliate Asset Managers
    44,219,947       49,149,581       25       40,751,511       58,064,720       27  
Total
  $ 381,173,054     $ 323,540,647       161 %   $ 463,368,312     $ 409,105,621       191 %
 

¹ Calculated as a percentage of net asset value.
 
 
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The industry concentrations, based on the fair value of the Company’s investment portfolio as of September 30, 2010 and December 31, 2009, were as follows:
 
   
September 30, 2010 (unaudited)
   
December 31, 2009
 
Industry Classification
 
Cost
   
Fair Value
     
%¹
   
Cost
   
Fair Value
     
%¹
 
Aerospace and Defense
  $ 18,029,023     $ 17,037,661       9 %   $ 33,652,058     $ 33,416,670       16 %
Asset Management Companies2
    44,219,947       49,149,581       25       40,751,511       58,064,720       27  
Automobile
    -       -       -       1,940,876       1,800,631       1  
Broadcasting and Entertainment
    2,988,898       3,000,000       2       2,986,206       2,862,000       1  
Buildings and Real Estate3
    33,380,978       6,411,638       3       36,498,537       9,840,946       5  
Cargo Transport
    4,940,182       4,940,182       2       13,389,865       13,359,403       6  
Chemicals, Plastics and Rubber
    3,975,956       4,000,000       2       3,970,688       4,000,000       2  
CLO Fund Securities
    68,258,657       52,751,000       26       68,195,049       48,971,000       23  
Containers, Packaging and Glass
    7,042,719       6,989,847       3       7,056,701       6,852,738       3  
Diversified/Conglomerate Manufacturing
    3,261,662       3,259,010       2       4,046,728       4,042,346       2  
Diversified/Conglomerate Service
    15,332,837       12,772,049       6       15,382,035       14,350,438       7  
Ecological
    2,675,508       2,678,977       1       2,695,103       2,699,907       1  
Electronics
    5,438,457       4,999,080       2       14,874,472       14,407,265       7  
Farming and Agriculture
    -       -       -       1,441,277       217,001       -  
Finance
    3,647,725       3,597,108       2       5,460,445       5,372,881       3  
Healthcare, Education and Childcare
    32,275,520       32,990,504       16       41,647,084       42,177,498       20  
Home and Office Furnishings, Housewares, and Durable Consumer Goods
    18,286,200       17,391,586       9       20,694,006       18,080,134       8  
Hotels, Motels, Inns and Gaming
    3,277,741       3,007,350       1       3,438,128       3,171,363       1  
Insurance
    4,882,962       3,840,000       2       4,861,123       4,490,000       2  
Leisure, Amusement, Motion Pictures, Entertainment
    2,034,233       2,018,233       1       14,572,761       14,227,907       7  
Machinery (Non-Agriculture, Non-Construction, Non-Electronic)
    17,897,748       17,224,943       9       33,015,472       31,956,312       15  
Mining, Steel, Iron and Non-Precious Metals
    14,315,602       14,441,061       7       13,861,498       13,021,854       6  
Oil and Gas
    -       -       -       5,998,652       6,000,000       3  
Personal and Non Durable Consumer Products (Mfg. Only)
    10,908,755       9,104,308       5       14,424,931       9,146,146       4  
Personal, Food and Miscellaneous Services
    14,729,308       4,194,000       2       14,759,522       4,559,444       2  
Printing and Publishing
    8,967,784       8,588,871       4       23,867,184       23,506,057       11  
Retail Stores
    3,363,854       3,239,391       2       3,543,046       3,521,787       2  
Time Deposits and Money Market Account
    24,742,023       24,742,023       12       126       126       -  
Utilities
    12,298,775       11,172,244       6       16,343,228       14,989,047       6  
Total
  $ 381,173,054     $ 323,540,647       161 %   $ 463,368,312     $ 409,105,621       191 %
 

1
Calculated as a percentage of net asset value.
Represents Katonah Debt Advisors and related asset manager affiliates.
Buildings and real estate relate to real estate ownership, builders, managers and developers and excludes mortgage debt investments and mortgage lenders or originators. As of September 30, 2010 and December 31, 2009, the Company had no exposure to mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset backed securities) or companies providing mortgage lending.
 
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The Company may invest up to 30% of the investment portfolio in opportunistic investments in high-yield bonds, debt and equity securities of CLO Funds, distressed debt or equity securities of public companies. However, the Company’s investment strategy is to limit the value of its investments in debt or equity securities issued by CLO Funds to not more than 15% of the value of its total investment portfolio at the time of investment. The Company expects that these public companies generally will have debt that is non-investment grade. The Company also may invest in debt of middle market companies located outside of the United States, which investments (excluding the Company’s investments in CLO Funds) are generally not anticipated to be in excess of 10% of the investment portfolio at the time such investments are made. The Company is generally prohibited from buying or selling any security from or to any portfolio company of a private equity fund managed by Kohlberg & Co. without the prior approval of the SEC. In addition, the Company may co-invest on a concurrent basis with Kohlberg & Co. or any of its affiliates, subject to compliance with existing regulatory guidance, applicable regulations and its allocation procedures. Certain types of negotiated co-investments may be made only if the Company receives an order from the SEC permitting it to do so. There can be no assurance that any such order will be applied for or, if applied for, obtained.
 
At September 30, 2010 and December 31, 2009, approximately 25% and 12% of the Company’s investments were foreign assets (including the Company’s investments in CLO Funds, which are typically domiciled outside the U.S. and represented approximately 16% and 12% of its portfolio on such dates), respectively. At September 30, 2010, approximately $25 million of foreign assets were in U.S. dollar denominated over-night time Eurodollar deposits which revert to cash each business morning.
 
At September 30, 2010 and December 31, 2009, the Company’s ten largest portfolio companies represented approximately 47% and 37%, respectively, of the total fair value of its investments. The Company’s largest investment, Katonah Debt Advisors which is its wholly-owned portfolio company, represented 15% and 14% of the total fair value of the Company’s investments at September 30, 2010 and December 31, 2009, respectively. Excluding Katonah Debt Advisors and CLO Fund securities, the Company’s ten largest portfolio companies represented approximately 19% and 19% of the total fair value of the Company’s investments at September 30, 2010 and December 31, 2009, respectively.

Investment in CLO Fund Securities
 
The Company typically makes a minority investment in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and may selectively invest in securities issued by funds managed by other asset management companies. However, as noted above, the Company’s investment strategy is to limit the value of its investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of its total investment portfolio at the time of investment. Preferred shares or subordinated securities issued by CLO Funds are entitled to recurring dividend distributions which generally equal the net remaining cash flow of the payments made by the underlying CLO Fund’s securities less contractual payments to senior bond holders and CLO Fund expenses. CLO Funds managed by Katonah Debt Advisors (“CLO fund securities managed by affiliate”) invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The underlying assets in each of the CLO Funds in which the Company has an investment are generally diversified secured or unsecured corporate debt and exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders, fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares.
 
On January 23, 2008, the Company’s wholly-owned asset management company, Katonah Debt Advisors, closed the Katonah 2007-1 CLO, a $315 million CLO Fund. The Company received a structuring fee upon closing and Katonah Debt Advisors earns an ongoing asset management fee based on the par amount of the underlying investments in the CLO Fund. Securities issued by CLO Funds managed by Katonah Debt Advisors are primarily held by third parties. Kohlberg Capital invested approximately $29 million to acquire all of the shares of the most junior class of securities of this CLO Fund.
 
The subordinated securities and preferred share securities are considered equity positions in the CLO Funds and, as of September 30, 2010 and December 31, 2009, the Company had approximately $46 million and $45 million, respectively, of such CLO equity investments at fair value. The cost basis of the Company’s investment in CLO Fund equity securities as of September 30, 2010 was approximately $67 million and aggregate unrealized depreciation on the CLO Fund securities totaled approximately $21 million. The cost basis of the Company’s investment in CLO Fund equity securities as of December 31, 2009, was approximately $67 million and aggregate unrealized depreciation on the CLO Fund securities totaled approximately $23 million.
 
In May, 2009 the Company purchased the class B-2L notes of the Katonah 2007-1 CLO investment managed by Katonah Debt Advisors (“Katonah 2007-1 B-2L”). The Company purchased the Katonah 2007-1 B-2L for 10% of the par value. The fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment as of September 30, 2010 were approximately $7 million, $1 million, and $6 million, respectively, and at December 31, 2009, the fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment were $4 million, $1 million, and $3 million, respectively. Both the B-2L notes and preferred shares of Katonah 2007-1 are owned 100% by the Company and are making their required quarterly distributions.
 
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Fair Value Measurements
 
The Company follows the provisions of Fair Value Measurements and Disclosures, which among other matters, requires enhanced disclosures about investments that are measured and reported at fair value. This standard defines fair value and establishes a hierarchal disclosure framework which prioritizes and ranks the level of market price observability used in measuring investments at fair value and expands disclosures about assets and liabilities measured at fair value. Fair Value Measurements and Disclosures defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This fair value definition focuses on an exit price in the principal, or most advantageous market, and prioritizes, within a measurement of fair value, the use of market-based inputs (which may be weighted or adjusted for relevance, reliability and specific attributes relative to the subject investment) over entity-specific inputs. Market price observability is affected by a number of factors, including the type of investment and the characteristics specific to the investment. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. Subsequent to the adoption of Fair Value Measurements and Disclosures, the FASB has issued various staff positions clarifying the initial standard (see Note 2. “Significant Accounting Policies—Investments”).
 
Fair Value Measurements and Disclosures establishes the following three-level hierarchy, based upon the transparency of inputs to the fair value measurement of an asset or liability as of the measurement date:
 
Level I – Unadjusted quoted prices are available in active markets for identical investments as of the reporting date. The type of investments included in Level I include listed equities and listed securities. As required by Fair Value Measurements and Disclosures, the Company does not adjust the quoted price for these investments, even in situations where the Company holds a large position and a sale could reasonably affect the quoted price.
 
Level II – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. Such inputs may be quoted prices for similar assets or liabilities, quoted markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full character of the financial instrument, or inputs that are derived principally from, or corroborated by, observable market information. Investments which are generally included in this category include illiquid corporate loans and bonds and less liquid, privately held or restricted equity securities for which some level of recent trading activity has been observed.
 
Level III – Pricing inputs are unobservable for the investment and includes situations where there is little, if any, market activity for the investment. The inputs may be based on the Company’s own assumptions about how market participants would price the asset or liability or may use Level II inputs, as adjusted, to reflect specific investment attributes relative to a broader market assumption. These inputs into the determination of fair value may require significant management judgment or estimation. Even if observable market data for comparable performance or valuation measures (earnings multiples, discount rates, other financial/valuation ratios, etc.) are available, such investments are grouped as Level III if any significant data point that is not also market observable (private company earnings, cash flows, etc.) is used in the valuation methodology.
 
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and the Company considers factors specific to the investment. Substantially all of the Company’s investments are classified as Level III. The Company evaluates the source of inputs, including any markets in which its investments are trading, in determining fair value. Inputs that are backed by actual transactions, those that are highly correlated to the specific investment being valued and those derived from reliable or knowledgeable sources will tend to have a higher weighting in determining fair value. Ongoing reviews by the Company’s investment analysts, Chief Investment Officer, Valuation Committee and independent valuation firms (if engaged) are based on an assessment of each underlying investment, its current and prospective operating and financial performance, consideration of financing and sale transactions with third parties, expected cash flows and market-based information, including comparable transactions, performance factors, and other investment or industry specific market data, among other factors.
 
The following table summarizes the fair value of investments by the above Fair Value Measurements and Disclosures fair value hierarchy levels as of September 30, 2010 (unaudited) and December 31, 2009, respectively:

 
36

 
 
As of September, 30 2010
 
   
Level I
   
Level II
   
Level III
   
Total
 
Time deposit and money market account
  $     $ 24,742,022     $     $ 24,742,022  
Debt securities
                190,908,445       190,908,445  
CLO fund securities
                52,751,000       52,751,000  
Equity securities
                5,989,599       5,989,599  
Asset manager affiliate
                49,149,581       49,149,581  

As of December 31, 2009
 
   
Level I
   
Level II
   
Level III
   
Total
 
Time deposit and money market account
  $     $ 126     $     $ 126  
Debt securities
                297,356,529       297,356,529  
CLO fund securities
                48,971,000       48,971,000  
Equity securities
                4,713,246       4,713,246  
Asset manager affiliate
                58,064,720       58,064,720  


 
37

 
 
Investment values derived by a third party pricing service are deemed Level III values since such values are not traded on an active public exchange and may represent a traded or broker quote on an asset that is infrequently traded.
 
The Company derives fair value for its illiquid investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach and also considers recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. The Company has identified these two indices as benchmarks for broad market information related to its loan and debt investments. Because the Company has not identified any market index that directly correlates to the loan and debt investments held by the Company and therefore uses the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy. The appropriateness of specific valuation methods and techniques may change as market conditions and available data change.
 
The Company engaged VRC, an independent valuation firm, to provide third-party valuation estimates for approximately 39% of its portfolio at fair value as of December 31, 2009. VRC’s valuation estimates were considered as one of the relevant data inputs in the Company’s determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of September 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of the Company’s annual year end valuation process.
 
Values derived for debt securities using public/private company comparables generally utilize market-observable data from such comparables and specific, non-public and non-observable financial measures (such as earnings or cash flows) for the private, underlying company/issuer. Such non-observable company/issuer data is typically provided on a monthly basis, is certified as correct by the management of the company/issuer and/or audited by an independent accounting firm on an annual basis. Since such private company/issuer data is not publicly available it is not deemed market-observable data and, as a result, such investment values are grouped as Level III assets.
 
Values derived for asset manager affiliates using public/private company comparables generally utilize market-observable data from such comparables and specific, non-public and non-observable financial measures (such as assets under management, historical and prospective earnings) for the asset manager affiliate. The Company recognizes that comparable asset managers may not be fully comparable to its asset manager affiliates and typically identifies a range of performance measures and/or adjustments within the comparable population with which to determine value. Since any such ranges and adjustments are entity specific they are not considered market-observable data and thus require a Level III grouping. Illiquid investments that have values derived through the use of discounted cash flow models and residual enterprise value models are grouped as Level III assets.
 
The changes in investments measured at fair value for which the Company has used unobservable inputs to determine fair value are as follows:

   
Nine Months Ended September 30, 2010
 
         
CLO Fund
   
Equity
   
Asset Manager
       
   
Debt Securities
   
Securities
   
Securities
   
Affiliates
   
Total
 
Balance, December 31, 2009
  $ 297,356,529     $ 48,971,000     $ 4,713,246     $ 58,064,720     $ 409,105,495  
Transfers in/out of Level III
                             
Net accretion of discount
    307,500       63,608                      371,108  
Purchases (sales), net
    (101,874,675 )           1,850,543       3,468,436       (96,555,696 )
Total loss realized and unrealized included in earnings
    (4,880,909 )     3,716,392       (574,190 )     (12,383,575 )     (14,122,282 )
Balance, September 30, 2010
  $ 190,908,445     $ 52,751,000     $ 5,989,599     $ 49,149,581     $ 298,798,625  
Changes in unrealized gains (losses) included in earnings related to investments still held at reporting date
  $ 5,871,658     $ 3,716,392     $ (574,190 )   $ (12,383,575 )   $ (3,369,715 )
 
 
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Nine Months Ended September 30, 2009
 
   
Debt Securities
   
CLO Fund
Securities
   
Equity
Securities
   
Asset Manager
Affiliates
   
Total
 
Balance, December 31, 2008
  $ 353,859,007     $ 34,640,000     $ 5,087,512     $ 54,734,812     $ 448,321,331  
Transfers in/out of Level III
                             
Net accretion of discount
    780,964       723,739                   1,504,703  
Purchases (sales), net
    (40,448,631 )     1,076,250             4,018,309       (35,354,072 )
                                         
Total loss realized and unrealized included in earnings
    9,156,290       10,276,011       (567,278 )     (2,009,094 )     16,855,929  
Balance, September 30, 2009
  $ 323,347,630     $ 46,716,000     $ 4,520,234     $ 56,744,027     $ 431,327,891  
Changes in unrealized gains (losses) included in earnings related to investments still held at reporting date
  $ 15,800,620     $ 10,276,011     $ (567,279 )   $ 205,975     $ 25,715,327  
 
5. AFFILIATE ASSET MANAGERS
 
Wholly-Owned Asset Manager
 
Prior to its IPO, the Company issued an aggregate of 2,226,333 common shares, having a value of approximately $33 million, to affiliates of Kohlberg & Co. to acquire Katonah Debt Advisors. As a result, Katonah Debt Advisors is a wholly-owned portfolio company. Katonah Debt Advisors manages CLO Funds primarily for third party investors that invest in broadly syndicated loans, high yield bonds and other credit instruments issued by corporations. These CLO Funds do not invest in asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings. At September 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of par value of assets under management, and the Company’s 100% equity interest in Katonah Debt Advisors was valued at approximately $49 million.
 
As a manager of the CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees and may receive a one-time structuring fee from the CLO Funds for its management and advisory services. The annual fees which Katonah Debt Advisors receives are generally based on a fixed percentage of assets under management (at par value and not subject to changes in market value), and Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds it operating expenses. The annual management fees Katonah Debt Advisors receives have two components - a senior management fee and a subordinated management fee. At September 30, 2010, Katonah Debt Advisors continued to receive all senior management fees payable by the CLO Funds managed by it.
 
During 2009, certain CLO funds managed by Katonah Debt Advisors were restricted from currently paying their subordinated management fees as a result of the failure by those CLO Funds to satisfy certain restrictive covenants contained in their indenture agreements. At such time, those subordinated management fees continued to be accrued by the applicable CLO Fund to become payable to Katonah Debt Advisors when such CLO Fund becomes compliant with the applicable covenants. During the nine months ended September 30, 2010, all those CLO Funds which deferred payment of their subordinated management fees regained compliance with all applicable covenants in order to pay current subordinated management fees as well as a portion of previously accrued subordinated management fees. During the nine months ended September 30, 2010, approximately $4 million of deferred subordinated management fees have been paid and approximately $1 million of deferred subordinated management fees on one CLO remain deferred for payment in the fourth quarter of 2010. Currently, all CLO Funds managed by Katonah Debt Advisors are paying both their senior and subordinated management fees on a current basis.

 
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In future years, Katonah Debt Advisors may receive accrued incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.
 
On January 2, 2008, the Katonah Debt Advisors platform acquired substantially all of the assets of Scott’s Cove Capital Management LLC (“Scott’s Cove”), an asset manager focused on an event-driven credit long short investment strategy. As a result of the acquisition, approximately $60 million of fee paying assets under management were integrated into the Katonah Debt Advisors asset management platform. In connection with the acquisition, Katonah Debt Advisors entered into employment agreements with three Scott’s Cove investment professionals, and expects these individuals will assist in structuring, raising and investing new funds to be managed by Katonah Debt Advisors. As of September 30, 2010, Scott’s Cove had approximately $150 million of assets under management.
 
The revenue that Katonah Debt Advisors generates through the fees it receives for managing CLO Funds and after paying the expenses associated with its operations, including compensation of its employees, may be distributed to the Company. Any distributions of Katonah Debt Advisors’ net income are recorded as dividends from affiliate asset manager. For the nine months ended September 30, 2010, Katonah Debt Advisors had approximately $2 million of pre-tax net income and made distributions of $3 million to the Company, a portion of which represented undistributed earnings from prior years. For the nine months ended September 30, 2009, Katonah Debt Advisors earned approximately $2 million of pre-tax net income and made no distributions to the Company; dividends are recorded as declared (where declaration date represents ex-dividend date) by Katonah Debt Advisors as income on our statement of operations.
 
As with all other investments, Katonah Debt Advisors’ fair value is periodically determined. The valuation is primarily based on an analysis of both a percentage of its assets under management and Katonah Debt Advisors’ estimated operating income. Any change in value from period to period is recognized as unrealized gain or loss. See Note 2, “Significant Accounting Policies” and Note 4, “Investments” for further information relating to the Company’s valuation methodology.
 
As a separately regarded entity for tax purposes, Katonah Debt Advisors is taxed at normal corporate rates. For tax purposes, any distributions of taxable net income earned by Katonah Debt Advisors to the Company would generally need to be distributed to the Company’s shareholders. Generally, such distributions of Katonah Debt Advisors’ income to the Company’s shareholders will be considered as qualified dividends for tax purposes. Katonah Debt Advisors’ taxable net income will differ from GAAP net income because of deferred tax timing adjustments and permanent tax adjustments. Deferred tax timing adjustments may include differences for the recognition and timing of depreciation, bonuses to employees and stock option expense. Permanent differences may include adjustments, limitations or disallowances for meals and entertainment expenses, penalties, tax goodwill amortization and net operating loss carryforward.
 
Goodwill amortization for tax purposes was created upon the purchase of 100% of the equity interests in Katonah Debt Advisors prior to the Company’s IPO in exchange for shares of the Company’s stock valued at $33 million. Although this transaction was a stock transaction rather than an asset purchase and thus no goodwill was recognized for GAAP purposes, such exchange was considered an asset purchase under Section 351(a) of the Code. At the time of the transfer, Katonah Debt Advisors had equity of approximately $1 million resulting in tax goodwill of approximately $32 million which will be amortized for tax purposes on a straight-line basis over 15 years, which accounts for an annual difference between GAAP income and taxable income by approximately $2 million per year over such period.
 
At September 30, 2010 a net amount due from affiliates totaled approximately  $1,643 , and at December 31, 2009 a net amount due from affiliates totaled approximately $44,000.
 
6. BORROWINGS
 
The Company’s debt obligations consist of the following:
   
As of
 
As of
 
 
September 30, 2010
 
December 31, 2009
 
Secured credit facility, due February 28, 2011
    137,159,147       218,050,363  
 
1 February 28, 2011 is the maturity date as established by a Forbearance and Settlement Agreement dated September 20, 2010.
 
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On February 14, 2007, the Company entered into an arrangement under which the Company may obtain up to $200 million in financing (the “Facility”). On October 1, 2007, the Company amended the Facility to increase the Company’s borrowing capacity from $200 million to $275 million, extend the maturity date from February 12, 2012 to October 1, 2012 and increase the interest spread charged on outstanding borrowings by 15 basis points to 0.85%. The interest rate is based on prevailing commercial paper rates plus 0.85% or, if the commercial paper market is at any time unavailable, prevailing LIBOR rates plus an applicable spread. Interest is payable monthly. As a result of the assertion of BMO Capital Markets Corp., as the agent (the “Agent”), that a Termination Event occurred under the LFSA, for the period June 2009 through September 2010, interest under the LFSA has been calculated at a higher default rate (equal to 0.85% above the prime rate plus 0.75%).
 
Fair Value of Debt. The Company records debt at cost. The fair value of the Company’s outstanding debt was approximately $133 Million and $218 million at September 30, 2010 and December 31, 2009, respectively. The fair value of the Company’s debt was determined based on market interest rates for similar instruments as of the balance sheet dates.The Facility is secured by loans acquired by the Company with the advances under the Facility. The Company borrows under the Facility through its wholly-owned, special-purpose bankruptcy remote subsidiary, KCAP Funding.
 
In connection with the Facility, the Company is party to a Loan Funding and Servicing Agreement, dated as of February 14, 2007 (as amended, the “LFSA”), by and among the Borrower, the Company, as the servicer, BMO Capital Markets Corp, as the agent (the “Agent”), U.S. Bank National Association, a national banking association, as the trustee (the “Trustee”) and the other Lender Parties and other parties thereto (the “Lender Parties”).
 
In August 2008, The Company was notified by the Lender Parties that the banks providing the underlying funding for the Facility did not intend to renew their liquidity facility to the lenders unless the Company agreed to certain revised terms for the Facility. The Lender Parties proposed new terms to us as a condition to extending the underlying liquidity purchase agreements. The Company viewed such proposed terms as unfavorable and did not agree to such new terms, causing the Agent and Lender Parties to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating The Company’s ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility. On June 9, 2009, The Company received a letter from a representative of the Lender Parties alleging that The Company’s failure to determine ratings on certain pledged loans and The Company’s alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods during which a Termination Event had occurred and was continuing. Beginning June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event had occurred, the interest payable under the LFSA began to be calculated at such elevated rate and the Company has paid such higher interest under protest.
 
As a result of the actions of the Lender Parties, on August 28, 2009, the Company filed a complaint with the Supreme Court of the State of New York against the Agent and the other Lender Parties to the LFSA (the “Litigation”). The Litigation reflected the Company’s beliefs that the termination date of the revolving period and the commencement of the amortization period under the LFSA were wrongful and that the assertions of alleged breaches of our obligations under the LFSA and the alleged occurrence of Termination Event(s) were without merit.
 
On September 20, 2010, the Company entered into a Forbearance and Settlement Agreement (the “Settlement Agreement”) with the Agent and Lender Parties (the Company, Agent and lenders collectively known as the “Parties”) in order to settle all outstanding claims of the Parties under the LFSA and all related claims asserted by the Parties in connection with the Litigation noted above as filed by the Company.
 
Pursuant to the Settlement Agreement, the Lender Parties have agreed to refrain, during the Forbearance Term, from the exercise of any right or remedy relating to any termination events alleged by any of the Lender Parties to have occurred (or that resulted from or otherwise relates to an event that occurred or a condition that existed prior to the date of the Settlement Agreement and that was known or reasonably should have been known to the Lender Parties) under the LFSA and the related documents on or before September 20, 2010, the date of the Settlement Agreement.  The Forbearance Term is defined in the Settlement Agreement to include the period from the date of the Settlement Agreement through the earliest to occur of (i) any new termination event under the LFSA (as modified by the Settlement Agreement to provide that the Company’s failure to comply with certain provisions of the LFSA, including those relating to the maximum amount of outstanding advances, minimum overcollateralization, permissible equity shortfalls and a rolling three-month default ratio, collateral quality and required ratings for specified loans, will not give rise to a termination event during the Forbearance Term), (ii) the first determination date on which the Company fails to maintain an overcollaterization ratio of at least 115%, (iii) the first date on which the Company fails to maintain a minimum net worth of at least $150 million, (iv) the date on which it is determined that any representation or warranty made by the Company pursuant to the Settlement Agreement is untrue or misleading in any material respect, (v) the date on which any action is commenced challenging the terms of the Settlement Agreement, the LFSA, the amount of outstanding advances under the LFSA or the existence, priority or enforceability of the liens or other security interests in any of the collateral securing the obligations under the LFSA, (vi) February 28, 2011 and (vii) the failure, subject to certain exceptions, to pay to the Lender Parties amounts sufficient to reduce the advances outstanding under the LFSA as set forth in the following amortization schedule:

 
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Date
 
Advances Outstanding
September 30, 2010
 
$125 million or less
November 3, 2010
 
$115 million or less
December 1, 2010
 
$105 million or less
January 3, 2011
 
$95 million or less
February 1, 2011
 
$85 million or less
February 28, 2011
  
$0
 
Under the terms of the Settlement Agreement, (i) the Lender Parties have agreed to pay to the Company $2 million so long as all outstanding advances under the LFSA and accrued interest thereon (exclusive of any fees or expenses, including attorneys’ fees and indemnification payments, of the Lender Parties incurred in connection with the Litigation or any other fees or expenses payable to the Lender Parties under the LFSA or the related documents other than fees or expenses incurred in connection with or related to the exercise of remedies following the occurrence of a Forbearance Term termination event) are repaid in full on or before February 28, 2011, (ii) from September 10, 2010 through the end of the Forbearance Term, interest on advances outstanding under the LFSA will accrue at the rate provided for under the LFSA prior to the occurrence of a termination event (equal to 0.85% above the prevailing commercial paper rate, or prevailing LIBOR if the commercial paper market is at any time unavailable), (iii) upon execution of the Settlement Agreement, the Company has agreed to release the Lender Parties from any and all claims that any of them may have under the LFSA and the related documents or the Litigation, (iv) upon payment in full in accordance with the Agreement of all outstanding advances and accrued interest thereon and all other amounts due to the Lender Parties under the LFSA, the Lender Parties have agreed to release the Company from any and all claims that any of them may have under the LFSA and the related documents or the Litigation and (v) the parties have stipulated to dismiss the Litigation, with prejudice, by stipulation of discontinuance filed with the Court on September 21, 2010.
 
The Company will generally be permitted, without further consent from the Lender Parties, to make discretionary sales of loans included in the collateral securing the LFSA so long as the proceeds from any such sale are at least equal to 90% of par value of such loans (or, in certain circumstances, 90% of the Company’s most recent mark-to-market valuation or 90% of such loan’s purchase price).  Other discretionary sales will require the prior written consent of the Lender Parties.
 
As noted above, prior to entering into the Settlement Agreement, the interest rate being charged on outstanding amounts under the Facility was at a rate equal to 0.85% above the prime rate plus 0.75%, or approximately 4.9%, and the Company had been paying interest at such rate under protest. Under the terms of the Settlement Agreement, commencing on September 10, 2010, the advances under the Facility will accrue interest at the rate provided for under the LFSA prior to the occurrence of a termination event, equal to 0.85% above the prevailing commercial paper rate, or 1.2% as of such date.
 
The Company is in compliance with all covenants and terms as provided in the Settlement Agreement. Under the Settlement Agreement, the Company must have advances outstanding under the Facility of no greater than $125 million as of September 30, 2010. Under the terms of the Settlement Agreement, the Company calculates the advances outstanding under the Facility after consideration of amortization and pre-payments in the next scheduled distribution to the lenders, and as of September 30, 2010 the Company’s advances outstanding, calculated in accordance with the Settlement Agreement, was approximately $116 million as of September 30, 2010 (the reported outstanding balance of $137 million less approximately $20 million of pre-payments scheduled for settlement on October 10, 2010).
 
Under the Settlement Agreement, the Company must maintain an overcollateralization ratio of at least 115%. As of September 30, 2010, the Company’s overcollateralization ratio was 152%. As a BDC, the Company is limited in the amount of leverage it can incur and is required to meet a coverage ratio of total asset to total senior securities of at least 200% before incurring new debt. As of September 30, 2010, the Company’s asset coverage ratio was 246%.
 
Under the terms of the Settlement Agreement, the Lender Parties will pay to the Company $2 million provided all outstanding advances and accrued interest under the LFSA are repaid in full on or before February 28, 2011. As this payment is contingent on the repayment of the Facility and other terms and conditions per the Settlement Agreement, the Company has not currently recognized such settlement payment.
 
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The Company believes it has sufficient cash and liquid assets (both those securing the Facility and those not included in the collateral securing the Facility) which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions as well as any Facility outstanding balance that may exist at February 28, 2011 or any interim date by which a maximum advances outstanding balance is calculated. The Company may enter into a new agreement with other lenders or into alternative financing arrangements with another lender.
 
The Company estimates that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 1% to cover annual interest payments on obligations incurred under the Facility.
 
The weighted average daily debt balance for the nine months ended September 30, 2010 and 2009 was approximately $141 million and $231 million, respectively. For the three months ended September 30, 2010 and 2009, the weighted average interest rate on weighted average outstanding borrowings was approximately 4% and 5% respectively, which excludes the amortization of deferred financing costs and facility and program fees on unfunded balances. As of September 30, 2010, the Company had restricted cash and time deposit balances of approximately $20 million which it maintained in accordance with the terms of the Facility.
  
7. DISTRIBUTABLE TAX INCOME
 
Effective December 11, 2006, the Company elected to be treated as a RIC under the Code and adopted a December 31 calendar year end. As a RIC, the Company is not subject to federal income tax on the portion of its taxable income and gains distributed currently to its stockholders as a dividend. The Company’s quarterly dividends, if any, are determined by the Board of Directors. The Company anticipates distributing at least 90% of its taxable income and gains, within the Subchapter M rules, and thus the Company anticipates that it will not incur any federal or state income tax at the RIC level. As a RIC, the Company is also subject to a federal excise tax based on distributive requirements of its taxable income on a calendar year basis (e.g., calendar year 2010). Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income, to the extent required. The Company anticipates timely distribution of its taxable income within the tax rules, and the Company anticipates that it will not incurr a US federal excise tax for the calendar year 2010.
 
The following reconciles net decrease in net assets resulting from operations to taxable income for the nine months ended September 30, 2010:

   
Nine Months Ended
September 30, 2010
 
   
(unaudited)
 
Net decrease in net assets resulting from operations
  $  (7,415,319 )
Net change in unrealized (appreciation) depreciation from investments
    3,369,715  
Excess capital losses over capital gains
    10,752,567  
Income not on GAAP books currently taxable
    1,729,018  
Income not currently taxable
    (57,348 )
Expenses not currently deductible
    166,089  
Expenses not on GAAP books currently deductible
    (3,978 )
Taxable income before deductions for distributions
  $ 8,540,744  
Taxable income before deductions for distributions per weighted average shares for the period
  $ 0.38  
 
For the quarter ended September 30, 2010, the Company declared a dividend on September 20, 2010 of $0.17 per share for a total of approximately $4 million. The record date was October 8, 2010 and the dividend was distributed on October 29, 2010.

 
43

 
Taxable income differs from net decrease in net assets resulting from operations primarily due to: (1) unrealized appreciation (depreciation) on investments, as investment gains and losses are not included in taxable income until they are realized; (2) amortization of discount on CLO Fund Securities; (3) amortization of organizational costs; (4) non-deductible expenses; (5) stock compensation expense that is not currently deductible for tax purposes; (6) excess of capital losses over capital gains; and (7) recognition of interest income on certain loans.
 
At September 30, 2010, the Company had a net capital loss carryforward of $25 million to offset net capital gains, to the extent provided by federal tax law. The capital loss carryforward will begin to expire in the tax year ending December 31, 2015.
 
The Company adopted Financial Accounting Standards Board ASC Topic 740 Accounting for Uncertainty in Income Taxes (“ASC 740”) as of January 1, 2007. ASC 740 provides guidance for how uncertain tax positions should be recognized, measured, presented, and disclosed in the financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold are recorded as a tax benefit or expense in the current year. Adoption of ASC 740 was applied to all open taxable years (the last three fiscal years) as of the effective date. The adoption of ASC 740 did not have an effect on the financial position or results of operations of the Company as there was no liability for unrecognized tax benefits and no change to the beginning capital of the Company. Management’s determinations regarding ASC 740 may be subject to review and adjustment at a later date based upon factors including, but not limited to, an ongoing analysis of tax laws, regulations and interpretations thereof.
 
8. COMMITMENTS AND CONTINGENCIES
 
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the needs of the Company’s investment in portfolio companies. Such instruments include commitments to extend credit and may involve, in varying degrees, elements of credit risk in excess of amounts recognized on the Company’s balance sheet. Prior to extending such credit, the Company attempts to limit its credit risk by conducting extensive due diligence, obtaining collateral where necessary and negotiating appropriate financial covenants. As of both September 30, 2010 and December 31, 2009, the Company had committed to make a total of approximately $2 million of investments in various revolving senior secured loans, of which approximately $320,000 had been funded as of September 30, 2010 and $640,000 had been funded as of December 31, 2009.
 
The Company and certain directors and officers are named as defendants in three putative class actions pending in the Southern District of New York brought by shareholders of the Company and filed in December 2009 and January 2010. The complaints in these three actions allege violations of Sections 10 and 20 of the Exchange Act based on the Company’s disclosures of its year-end 2008 and first- and second-quarter 2009 financial statements. The Company believes that the above-mentioned suits are without merit and will defend itself vigorously.
 
In addition, the Company and certain directors and officers were also named as defendants in a derivative action filed on March 2, 2010 in the Supreme Court of New York, County of New York. The complaint in this action purported to state causes of action for breaches of fiduciary duties, unjust enrichment, abuse of control, gross mismanagement, and corporate waste. On October 19, 2010, the court dismissed the complaint, and found that plaintiff had not alleged that any of the Company’s directors “‘knowingly’ misrepresented or permitted others to misrepresent KCAP’s financial condition,” or that the directors were confronted with “red flags” sufficient to put them on notice of potential problems with KCAP’s investment valuations. The court afforded the plaintiff 45 days in which to move for leave to amend his complaint, after which, without such a motion, the dismissal will become final.
  
9. LIQUIDITY

As discussed in Note 6 above, the Company is currently using any income generated by the assets collateralizing its secured credit Facility to pay principal, interest and other expenses of the Facility – despite the fact that, if it wants to remain a RIC and continue to be afforded favorable tax treatment for U.S. federal income tax purposes, it is required to distribute to the shareholders substantially all of its investment company taxable income, including the net amounts generated by the collateralized assets. These collateralized assets with a market value of approximately $196 million represent approximately 58% of the Company’s total assets (at fair value) at September 30, 2010 and contributed approximately 38% of the Company’s investment income for the quarter ended September 30, 2010.  Because the Company is using net interest income earned on the assets securing the Facility to amortize the Facility during the amortization period, the Company may need to sell other assets not pledged to the Facility, potentially at a loss, in order to generate sufficient cash to make the required dividend distributions necessary to maintain its RIC status. In addition, at maturity, the Company may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings. Any such asset sale could adversely affect the Company’s business, liquidity, financial condition and results of operations. The Company expects that its cash on hand, liquid investments, and cash generated from operations, including income earned from investments and any income distributions made by Katonah Debt Advisors, the Company’s wholly-owned portfolio company, will be adequate to meet the Company’s liquidity needs and distribution requirements over the next twelve months.

 
44

 
 
If the Company is unable repay the Facility according to the Settlement Agreement terms or is unable to renew or replace the Facility, the Company’s liquidity may be significantly reduced. Even if the Company is able to renew or replace the Facility, such new debt capital may be at a higher cost and/or on less favorable terms and conditions than the Facility. In addition, equity capital is, and may continue to be, difficult to raise because, subject to limited exceptions, the Company may not issue and sell shares of its common stock at a price below NAV without stockholder approval and issuing equity at depressed stock prices can be dilutive to the Company’s stockholders. These factors and the Company’s inability to raise additional capital to date have resulted in a reduction in new originations, curtailed the Company’s ability to grow and have had a negative impact on the Company’s liquidity and operating results. The continued inability to raise additional capital could further constrain the Company’s liquidity, negatively impact the Company’s business prospects, cause the departure of key employees and negatively impact the Company’s operating results.

10. STOCKHOLDERS’ EQUITY
 
On April 28, 2008, the Company completed a rights offering which resulted in the issuance of 3.1 million common shares and net proceeds of approximately $27 million. For the year ended December 31, 2008, the Company issued 359,250 shares of restricted stock for which 16,667 shares were forfeited and 3,000 shares were converted to common stock during the year due to vesting. During the year ended December 31, 2009, the Company issued 501,873 shares under its DRIP and 122,333 shares of restricted stock were exercised and converted to common stock. During the nine months ended September 30, 2010, the Company issued 242,932 shares of common stock under its DRIP. The total number of shares issued and outstanding as of September 30, 2010 and December 31, 2009 was 22,708,399 and 22,363,281, respectively.

11. EQUITY INCENTIVE PLAN
 
During 2006 and as amended in 2008, the Company established an equity incentive plan (the “Plan”) and reserved 2,000,000 shares of common stock for issuance under the Plan. The purpose of the Plan is to provide officers and prospective employees of the Company with additional incentives and align the interests of its employees with those of its shareholders. Options granted under the Plan are exercisable at a price equal to the fair market value (market closing price) of the shares on the day the option is granted. Restricted stock granted under the Plan is granted at a price equal to the fair market value (market closing price) of the shares on the day such restricted stock is granted.
 
Stock Options
 
 During the year ended December 31, 2008, and as approved by shareholders during the annual shareholders’ meeting on June 13, 2008, 20,000 options were granted to non-employee directors as partial annual compensation for their services as director. These grants were made with a ten-year exercise period with an exercise price of $11.97, with a risk free rate of 4.6% with a volatility rate of 28% and for which 50% of such options vest upon grant date and 50% vest on the first grant date anniversary. During the year ended December 31, 2009, an additional 20,000 options were granted to non-employee directors as partial annual compensation for their services as director. These grants were made with a ten-year exercise period with an exercise price of $4.93, with a risk free rate of 4.3% with a volatility rate of 41% and for which 50% of such options vest upon grant date and 50% vest on the first grant date anniversary. During the nine months ended September 30, 2010, 20,000 additional options were granted to non-employee directors as partial annual compensation for their services as director. These grants were made with a ten-year exercise period with an exercise price of $4.83, with a risk free rate of 3.1% with a volatility rate of 59% and for which 50% of such options vest upon grant date and 50% vest on the first grant date anniversary.
 
On June 13, 2008, the Company’s Board of Directors authorized the Company to allow employees who agree to cancel options that they hold to receive one share of restricted stock for every five options so cancelled. The shares of restricted stock received by employees through any such transaction will vest annually generally over the remaining vesting schedule as was applicable to the cancelled options. During the year ended December 31, 2008, employees holding options to purchase 1,295,000 shares individually entered into agreements to cancel such options and to receive 259,000 shares of restricted stock. As a result, as of December 31, 2008, all options granted to employees had been converted to restricted stock.

 
45

 
 
As of December 31, 2009, 40,000 options to non-employee directors remained outstanding. During the nine months ended September 30, 2010, no such options were forfeited. As of September 30, 2010, 60,000 total options were outstanding, 50,000 of which were exercisable. The options have an estimated remaining contractual life of 8.5 years.
 
Information with respect to options granted, exercised and forfeited under the Plan for the period January 1, 2009 through September 30, 2010 is as follows:
 
   
Shares
   
Weighted Average
Exercise Price per
Share
   
Weighted Average
Contractual
Remaining Term
(years)
   
Aggregate
Intrinsic Value1
 
Options outstanding at January 1, 2009
    20,000     $ 11.97              
Granted
    20,000     $ 4.93              
Exercised
        $              
Forfeited
        $              
Options outstanding at December 31, 2009
    40,000     $ 8.45              
Granted
    20,000     $ 4.83              
Exercised
        $              
Forfeited
        $              
Outstanding at September 30, 2010
    60,000     $ 7.24       8.7     $ -  
                                 
Total vested at September 30, 2010
    50,000     $ 7.73       8.5          
 
Represents the difference between the market value of shares of the Company upon exercise of the options at September 30, 2010 and the cost for the option holders to exercise the options.
 
The Company uses a Binary Option Pricing Model (American, call option) as its valuation model to establish the expected value of all stock option grants. For the nine months ended September 30, 2010 and September 30, 2009, the Company recognized non-cash compensation expense related to stock options of approximately $22,000 and $19,000, respectively. At September 30, 2010, there was $12,000 remaining of compensation cost related to unvested stock-based awards.

Restricted Stock
 
On June 13, 2008, the Company’s shareholders approved the Company’s 2006 Equity Incentive Plan, as amended and the board of directors approved the grant of awards of 100,250 shares of restricted stock to certain executive officers of the Company. On July 22, 2010 and August 5, 2009, the board of directors approved the grant of an additional 103,519 and 84,889 shares of restricted stock, respectively, to a certain executive officer of the Company. Such awards of restricted stock will vest as to 50% of the shares on the third anniversary of the grant date and the remaining 50% of the shares on the fourth anniversary of the grant date.
 
On June 13, 2008, the Company’s Board of Directors authorized the Company to allow employees who agree to cancel options that they hold to receive shares of the Company's common stock to receive 1 share of restricted stock for every 5 options so cancelled. The shares of restricted stock received by employees through any such transaction will vest annually generally over the remaining vesting schedule as was applicable to the cancelled options. Subsequently, employees holding options to purchase 1,295,000 shares individually entered into agreements to cancel such options and to receive 259,000 shares of restricted stock. As of September 30, 2010, 190,000 of such shares were vested and converted to common shares, and 51,000 of such shares had yet to vest. The remaining 18,000 shares have been forfeited.
 
During the nine months ended September 30, 2010, 64,667 shares of restricted stock were vested and converted to common shares. As of September 30, 2010, after giving effect to these option cancellations and restricted stock awards, there were options to purchase 60,000 shares of common stock outstanding and there were 339,658 shares of restricted stock outstanding. Information with respect to restricted stock granted, exercised and forfeited under the Plan for the nine months ended September 30, 2010 is as follows:
 
 
46

 
  
   
Non-Vested
Restricted
Shares
   
Weighted Average
Exercise Price per
Share
 
Non-vested shares outstanding at December 31, 2008
    339,583     $ 10.83  
Granted
    84,889     $ 5.89  
Vested
    (122,333 )   $ 10.37  
Forfeited
        $  
Non-vested shares outstanding at December 31, 2009
    302,139     $ 9.63  
Granted
    103,519     $ 4.83  
Vested
    (64,667 )   $ 10.32  
Forfeited
    (1,333 )   $ 8.41  
Outstanding at September 30, 2010
    339,658     $ 8.03  
                 
Total non-vested shares at September 30, 2010
    339,658     $ 8.03  
 
For the nine months ended September 30, 2010, non-cash compensation expense related to restricted stock was approximately $665,000; of this amount approximately $475,000 was expensed at the Company and approximately $190,000 was a reimbursable expense allocated to Katonah Debt Advisors. For the nine months ended September 30, 2009, non-cash compensation expense related to restricted stock was approximately $692,000; of this amount approximately $481,000 was expensed at the Company and approximately $211,000 was a reimbursable expense allocated to Katonah Debt Advisors. Dividends are paid on all outstanding shares of restricted stock, whether or not vested. In general, shares of unvested restricted stock are forfeited upon the recipient’s termination of employment. As of September 30, 2010, there was approximately $2 million of total unrecognized compensation cost related to nonvested share-based awards. That cost is expected to be recognized over a weighted average period of 2.5 years.

12. OTHER EMPLOYEE COMPENSATION
 
The Company adopted a 401(k) plan (“401K Plan”) effective January 1, 2007. The 401K Plan is open to all full time employees. The Plan permits an employee to defer a portion of their total annual compensation up to the Internal Revenue Service annual maximum based on age and eligibility. The Company makes contributions to the 401K Plan of up to 2.67% of the employee’s first 74.9% of maximum eligible compensation, which fully vest at the time of contribution. For the nine months ended September 30, 2010 and 2009 the Company made contributions to the 401K Plan of approximately $24,000 and $22,000, respectively.

 
The Company has also adopted a deferred compensation plan (“Pension Plan”) effective January 1, 2007. Employees are eligible for the Pension Plan provided that they are employed and working with the Company for at least 100 days during the year and remain employed as of the last day of the year. Employees do not make contributions to the Pension Plan. On behalf of the employee, the Company may contribute to the Pension Plan 1) up to 8.0% of all compensation up to the Internal Revenue Service annual maximum and 2) up to 5.7% excess contributions on any incremental amounts above the social security wage base limitation and up to the Internal Revenue Service annual maximum. Employees vest 100% in the Pension Plan after five years of service. For the nine months ended September 30, 2010 and 2009, the Company made no contributions to the Pension Plan.
 
47

 
Item 2.        Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
In this Quarterly Report on Form 10-Q, “Kohlberg Capital,” “Company,” “we,” “us,” and “our” refer to Kohlberg Capital Corporation, its subsidiaries and its wholly-owned portfolio company, Katonah Debt Advisors, L.L.C. (collectively with its affiliates, “Katonah Debt Advisors”), and related companies, unless the context otherwise requires.
 
The information contained in this section should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this Quarterly Report. In addition, some of the statements in this report constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The matters discussed in this Quarterly Report, as well as in future oral and written statements by management of Kohlberg Capital, that are forward-looking statements are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to originate new investments, achieve certain margins and levels of profitability, the availability of funds under our credit facility, the availability of additional capital, and the ability to maintain certain debt to asset ratios. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report should not be regarded as a representation by us that our plans or objectives will be achieved. The forward-looking statements contained in this Quarterly Report include statements as to:

our future operating results;

our business prospects and the prospects of our existing and prospective portfolio companies;

the impact of investments that we expect to make;

our informal relationships with third parties;

the dependence of our future success on the general economy and its impact on the industries in which we invest;

the ability of our portfolio companies to achieve their objectives;

our expected financings and investments;

our regulatory structure and tax treatment;

our ability to operate as a business development company and a regulated investment company;

the adequacy of our cash resources and working capital;

• 
the status of our credit facility, including any requirement that we pay our credit facility in full; and

the timing of cash flows, if any, from the operations of our portfolio companies, including Katonah Debt Advisors.
 
There are a number of important risks and uncertainties that could cause our actual results to differ materially from those indicated by such forward-looking statements. For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this Quarterly Report, please see the discussion in Part II, “Item 1A. Risk Factors” below and in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. You should not place undue reliance on these forward-looking statements. The forward-looking statements made in this Quarterly Report relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this Quarterly Report.

GENERAL
 
We are an internally managed, 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 (the “1940 Act”). We originate, structure and invest in senior secured term loans, mezzanine debt and selected equity securities primarily in privately-held middle market companies. We define the middle market as comprising companies with earnings before interest, taxes, depreciation and amortization, which we refer to as “EBITDA,” of $10 million to $50 million and/or total debt of $25 million to $150 million. In addition to our middle market investment business, our wholly-owned portfolio company, Katonah Debt Advisors, manages collateralized loan obligation funds (“CLO Funds”) that invest in broadly syndicated loans, high-yield bonds and other corporate credit instruments. We acquired Katonah Debt Advisors and certain related assets prior to our initial public offering from affiliates of Kohlberg & Co., LLC (“Kohlberg & Co.”), a leading private equity firm focused on middle market investing. As of September 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of assets under management.

 
48

 
 
Our investment objective is to generate current income and capital appreciation from our investments. We also expect to continue to receive distributions of recurring fee income and to generate capital appreciation from our investment in the asset management business of Katonah Debt Advisors. Our investment portfolio as well as the investment portfolios of the CLO Funds in which we have invested and the investment portfolios of the CLO Funds managed by Katonah Debt Advisors consist exclusively of credit instruments and other securities issued by corporations and do not include any asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings.
 
As a Regulated Investment Company (“RIC”), we intend to distribute to our stockholders substantially all of our net taxable income and the excess of realized net short-term capital gains over realized net long-term capital losses. To qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. Pursuant to these elections, we generally will not have to pay corporate-level taxes on any income that we distribute to our stockholders.
 
Our common stock is traded on The NASDAQ Global Select Market under the symbol “KCAP.” The net asset value (“NAV”) per share of our common stock at September 30, 2010 was $8.84. On September 30, 2010, the last reported sale price of a share of our common stock on The NASDAQ Global Select Market was $6.69.

KEY QUANTITATIVE AND QUALITATIVE FINANCIAL MEASURES AND INDICATORS
 
Net Asset Value
 
Our NAV per share was $8.84 and $9.56 as of September 30, 2010 and December 31, 2009, respectively. As we must report our assets at fair value for each reporting period, NAV also represents the amount of stockholder’s equity per share for the reporting period. Our NAV is comprised mostly of investment assets less debt and other liabilities:

   
September 30, 2010
   
December 31, 2009
 
   
Fair Value ¹
   
Per Share ¹
   
Fair Value ¹
   
Per Share ¹
 
Investments at fair value:
                       
Investments in time deposits
  $ 24,529,777     $ 1.08     $ 126     $ -  
Investments in money market accounts
    212,245       0.01             -  
Investments in debt securities
    190,908,445       8.41       297,356,529       13.30  
Investments in CLO Fund securities
    52,751,000       2.32       48,971,000       2.19  
Investments in equity securities
    5,989,599       0.26       4,713,246       0.21  
Investments in asset manager affiliates
    49,149,581       2.16       58,064,720       2.60  
Cash
    2,225,116       0.10       4,140,408       0.19  
Restricted Cash
    2,239,603       0.10       18,696,023       0.84  
Other assets
    11,774,826       0.52       7,474,005       0.33  
Total Assets
  $ 339,780,192     $ 14.96     $ 439,416,057     $ 19.65  
Borrowings
  $ 137,159,147     $ 6.04     $ 218,050,363     $ 9.75  
Other liabilities
    1,819,730       0.08       7,469,970       0.34  
Total Liabilities
  $ 138,978,877     $ 6.12     $ 225,520,333     $ 10.09  
NET ASSET VALUE
  $ 200,801,315     $ 8.84     $ 213,895,724     $ 9.56  
 

¹
Our balance sheet at fair value and resultant NAV are calculated on a basis consistent with accounting principles generally accepted in the United States of America ("GAAP"). Our per share presentation of such amounts (other than NAV per share) is an internally derived non-GAAP performance measure calculated by dividing the applicable balance sheet amount by outstanding shares. We believe that the per share amounts for such balance sheet items are helpful in analyzing our balance sheet both quantitatively and qualitatively in that our shares may trade based on a percentage of NAV and individual investors may weight certain balance sheet items differently in performing an analysis of the Company.

 
49

 
 
Leverage
 
We use borrowed funds, known as “leverage,” to make investments and to attempt to increase returns to our shareholders by reducing our overall cost of capital. As a BDC, we are limited in the amount of leverage we can incur under the 1940 Act. We are only allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. As of September 30, 2010, we had approximately $137 million of outstanding borrowings and our asset coverage ratio of total assets to total borrowings was 246%, compliant with the minimum asset coverage level of 200% generally required for a BDC by the 1940 Act. We may also borrow amounts of up to 5% of the value of our total assets for temporary purposes.
 
Our borrowings are through a secured financing facility (the “Facility”). In connection with the Facility, we are party to a Loan Funding and Servicing Agreement, dated as of February 14, 2007 (as amended, the “LFSA”), by and among us, as the servicer, our wholly-owned, special-purpose bankruptcy remote subsidiary, Kohlberg Capital Funding LLC I, as the borrower (“KCAP Funding” or the “Borrower”), BMO Capital Markets Corp, as the agent (the “Agent”), U.S. Bank National Association, a national banking association, as the trustee (the “Trustee”) and the other Lender Parties and other parties thereto (the “Lender Parties”).
 
In August 2008, we were notified by the Lender Parties that the banks providing the underlying funding for the Facility did not intend to renew their liquidity facility to the lenders unless we agreed to certain revised terms for the Facility. The Lender Parties proposed new terms to us as a condition to extending the underlying liquidity purchase agreements. We viewed such proposed terms as unfavorable and did not agree to such new terms, causing the Agent and Lender Parties to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility. On June 9, 2009, we received a letter from a representative of the Lender Parties alleging that our failure to determine ratings on certain pledged loans and our alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods during which a Termination Event had occurred and was continuing. Beginning June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event had occurred, the interest payable under the LFSA began to be calculated at such elevated rate and we have paid such higher interest under protest.
 
As a result of the actions of the Lender Parties, on August 28, 2009, we filed a complaint (the “Litigation”) with the Supreme Court of the State of New York against the Agent and the other Lender Parties to the LFSA. The Litigation reflected our beliefs that the termination date of the revolving period and the commencement of the amortization period under the LFSA were wrongful and that the assertions of alleged breaches of our obligations under the LFSA and the alleged occurrence of Termination Event(s) were without merit.
 
On September 20, 2010, we entered into a Forbearance and Settlement Agreement (the “Settlement Agreement”) with the Agent and Lender Parties (the Company, Agent and lenders collectively known as the “Parties”) in order to settle all outstanding claims of the Parties under the LFSA and all related claims asserted by the Parties in connection with the Litigation noted above as filed by us.
 
Pursuant to the Settlement Agreement, the Lender Parties have agreed to refrain, during the Forbearance Term, from the exercise of any right or remedy relating to any termination events alleged by any of the Lender Parties to have occurred (or that resulted from or otherwise relates to an event that occurred or a condition that existed prior to the date of the Settlement Agreement and that was known or reasonably should have been known to the Lender Parties) under the LFSA and the related documents on or before September 20, 2010, the date of the Settlement Agreement.  The Forbearance Term is defined in the Settlement Agreement to include the period from the date of the Settlement Agreement through the earliest to occur of (i) any new termination event under the LFSA (as modified by the Settlement Agreement to provide that our failure to comply with certain provisions of the LFSA, including those relating to the maximum amount of outstanding advances, minimum overcollateralization, permissible equity shortfalls and a rolling three-month default ratio, collateral quality and required ratings for specified loans, will not give rise to a termination event during the Forbearance Term), (ii) the first determination date on which we fail to maintain an overcollaterization ratio of at least 115%, (iii) the first date on which the we fail to maintain a minimum net worth of at least $150 million, (iv) the date on which it is determined that any representation or warranty made by us pursuant to the Settlement Agreement is untrue or misleading in any material respect, (v) the date on which any action is commenced challenging the terms of the Settlement Agreement, the LFSA, the amount of outstanding advances under the LFSA or the existence, priority or enforceability of the liens or other security interests in any of the collateral securing the obligations under the LFSA, (vi) February 28, 2011 and (vii) the failure, subject to certain exceptions, to pay to the Lender Parties amounts sufficient to reduce the advances outstanding under the LFSA as set forth in the following amortization schedule:

 
50

 
 
Date
 
Advances Outstanding
September 30, 2010
 
$125 million or less
November 3, 2010
 
$115 million or less
December 1, 2010
 
$105 million or less
January 3, 2011
 
$95 million or less
February 1, 2011
 
$85 million or less
February 28, 2011
 
$0
 
Under the terms of the Settlement Agreement, (i) the Lender Parties have agreed to pay to us $2 million so long as all outstanding advances under the LFSA and accrued interest thereon (exclusive of any fees or expenses, including attorneys’ fees and indemnification payments, of the Lender Parties incurred in connection with the Litigation or any other fees or expenses payable to the Lender Parties under the LFSA or the related documents other than fees or expenses incurred in connection with or related to the exercise of remedies following the occurrence of a Forbearance Term termination event) are repaid in full on or before February 28, 2011, (ii) from September 10, 2010 through the end of the Forbearance Term, interest on advances outstanding under the LFSA will accrue at the rate provided for under the LFSA prior to the occurrence of a termination event (equal to 0.85% above the prevailing commercial paper rate, or prevailing LIBOR if the commercial paper market is at any time unavailable), (iii) upon execution of the Settlement Agreement, we have agreed to release the Lender Parties from any and all claims that any of them may have under the LFSA and the related documents or the Litigation, (iv) upon payment in full in accordance with the Agreement of all outstanding advances and accrued interest thereon and all other amounts due to the Lender Parties under the LFSA, the Lender Parties have agreed to release us from any and all claims that any of them may have under the LFSA and the related documents or the Litigation and (v) the parties have stipulated to dismiss the Litigation, with prejudice, by stipulation of discontinuance filed with the Court on September 21, 2010.
 
We will generally be permitted, without further consent from the Lender Parties, to make discretionary sales of loans included in the collateral securing the LFSA so long as the proceeds from any such sale are at least equal to 90% of par value of such loans (or, in certain circumstances, 90% of our most recent mark-to-market valuation or 90% of such loan’s purchase price).  Other discretionary sales will require the prior written consent of the Lender Parties.
 
As noted above, prior to entering into the Settlement Agreement, the interest rate being charged on outstanding amounts under the Facility was at a rate equal to 0.85% above the prime rate plus 0.75%, or approximately 4.9%, and we had been paying interest at such rate under protest. Under the terms of the Settlement Agreement, commencing on September 10, 2010, the advances under the Facility will accrue interest at the rate provided for under the LFSA prior to the occurrence of a termination event, equal to 0.85% above the prevailing commercial paper rate, or 1.2% as of such date.
 
We are in compliance with all covenants and terms as provided in the Settlement Agreement. Under the Settlement Agreement, we must have advances outstanding under the Facility of no greater than $125 million as of September 30, 2010. Under the terms of the Settlement Agreement, we calculate the advances outstanding under the Facility after consideration of amortization and pre-payments in the next scheduled distribution to the lenders, and as of September 30, 2010 the Company’s advances outstanding, calculated in accordance with the Settlement Agreement, was approximately $116 (the reported outstanding balance of $137 million less approximately $20 million of pre-payments scheduled for settlement on October 10, 2010).
 
Under the Settlement Agreement, we must maintain an overcollateralization ratio of at least 115%. As of September 30, 2010, our overcollateralization ratio was 152%. As a BDC, we are limited in the amount of leverage it can incur and is required to meet a coverage ratio of total asset to total senior securities of at least 200% before incurring new debt. As of September 30, 2010, our asset coverage ratio was 246%.
 
Under the terms of the Settlement Agreement, the Lender Parties will pay to the Company $2 million provided all outstanding advances and accrued interest under the LFSA are repaid in full on or before February 28, 2011. As this payment is contingent on the repayment of the Facility, the Company has not currently recorded such settlement payment as a receivable or income. At the date the Facility is repaid in accordance with the Settlement Agreement, the Company will recognize the settlement payment from the Lending Parties as income.

 
51

 
 
The Company believes it has sufficient cash and liquid assets (both thosesecuring the Facility and those not included in the collateral securing the Facility) which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions as well as any Facility outstanding balance that may exist at February 28, 2011 or any interim date by which a maximum advances outstanding balance is calculated. The Company may enter into a new agreement with other lenders or into alternative financing arrangements with another lender.
 
The Company estimates that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 1% to cover annual interest payments on obligations incurred under the Facility.
 
The weighted average daily debt balance for the six months ended September 30, 2010 and 2009 was approximately $141 million and $231 million, respectively. For the three months ended September 30, 2010 and 2009, the weighted average interest rate on outstanding borrowings was approximately 4% and 5% respectively, which excludes the amortization of deferred financing costs and facility and program fees on unfunded balances. As of September 30, 2010, the Company had restricted cash and time deposit balances of approximately $20 million which it maintained in accordance with the terms of the Facility.

Investment Portfolio Summary Attributes as of and for the Nine Months ended September 30, 2010
 
Our investment portfolio generates net investment income which is generally used to pay principal and interest on our borrowings under the Facility and to fund our dividend. Our investment portfolio consists of three primary components: debt securities, CLO fund securities and our investment in our wholly owned asset manager, Katonah Debt Advisors. We also have investments in equity securities of approximately $6 million, which comprises approximately 2% of our investment portfolio. Below are summary attributes for each of our primary investment portfolio components (see “—Investment Portfolio” and “—Investments and Operations” for a more detailed description) as of and for the nine months ended September 30, 2010:
 
Debt Securities
 
 
·
represent approximately 59% of total investment portfolio;
 
 
·
represent credit instruments issued by corporate borrowers;
 
 
·
no asset-backed securities such as those secured by commercial mortgages or residential mortgages and no consumer borrowings;
 
 
·
primarily senior secured and junior secured loans (50% and 47% of debt securities, respectively);
 
 
·
spread across 23 different industries and 56 different entities;
 
 
·
average balance per investment of approximately $3 million;
 
 
·
all but five issuers current on their debt service obligations; and
 
 
·
weighted average interest rate of 5.0%.
 
CLO Fund Securities (as of the last monthly trustee report prior to September 30, 2010 unless otherwise specified)
 
·
represent approximately 16% of total investment portfolio at September 30, 2010;
 
 
·
87% of CLO Fund Securities represent investments in subordinated securities or equity securities issued by CLO Funds and 13% of CLO Fund Securities are rated notes;
 
 
·
all CLO Funds invest primarily in credit instruments issued by corporate borrowers;
 
 
·
no asset-backed securities such as those secured by commercial mortgages or residential mortgages and no consumer borrowings;
 
 
·
ten different CLO Fund securities; six of such CLO Fund securities are managed by Katonah Debt Advisors; and
 
 
·
three CLO Fund securities, representing 6% of all such securities at fair value or 1% of total investments at fair value, are not currently providing a dividend payment to the Company.
 
Katonah Debt Advisors
 
 
·
represents approximately 15% of total investment portfolio;
 
 
·
represents our 100% ownership of the equity interest of a profitable CLO Fund manager focused on corporate credit investing;

 
52

 
 
 
·
has approximately $2.1 billion of assets under management;
 
 
·
receives contractual and recurring asset management fees based on par value of managed investments;
 
 
·
typically receives a one-time structuring fee upon completion of a new CLO Fund;
 
 
·
may receive an incentive fee upon liquidation of a CLO Fund provided that the CLO Fund achieves a minimum designated return on investment;
 
 
·
dividends paid by Katonah Debt Advisors are recognized as dividend income from affiliate asset manager on our statement of operations and are an additional source of income to pay our dividend;
 
 
·
for the nine months ended September 30, 2010, Katonah Debt Advisors had pre-tax net income of approximately $2 million; and
 
 
·
for the nine months ended September 30, 2010, Katonah Debt Advisors made distributions of $3 million to the Company in the form of a dividend which is recognized as current earnings to the Company.

Revenue
 
Revenues consist primarily of investment income from interest and dividends on our investment portfolio and various ancillary fees related to our investment holdings.
 
Interest from Investments in Debt Securities. We generate interest income from our investments in debt securities which consist primarily of senior and junior secured loans. Our debt securities portfolio is spread across multiple industries and geographic locations, and as such, we are broadly exposed to market conditions and business environments. As a result, although our investments are exposed to market risks, we continuously seek to limit concentration of exposure in any particular sector or issuer.
 
Dividends from Investments in CLO Fund Securities. We generate dividend income from our investments in the securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and selective investments in securities issued by funds managed by other asset management companies. CLO Funds managed by Katonah Debt Advisors invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The Company distinguishes CLO Funds managed by Katonah Debt Advisors as “CLO fund securities managed by affiliate.” The underlying assets in each of the CLO Funds in which we have an investment are generally diversified secured or unsecured corporate debt and exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments. Our CLO Fund securities that are subordinated securities or preferred shares (“junior securities”) are subordinated to senior bond holders who typically receive a fixed rate of return on their investment. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders and less fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares. The level of excess spread from CLO Fund securities can be impacted from the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly. In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants my lead to the temporary suspension or deferral of cash distributions to us.
 
For non-junior class CLO Fund securities, such as our investment in the class B-2L notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR index.
 
Dividends from Affiliate Asset Manager. We generate dividend income from our investment in Katonah Debt Advisors, an asset management company, which is a wholly-owned portfolio company that manages CLO Funds that invest primarily in broadly syndicated non-investment grade loans, high yield bonds and other credit instruments issued by corporations. As a manager of CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees as well as an expected one-time structuring fee from the CLO Funds for its management and advisory services. In addition, Katonah Debt Advisors may also earn income related to net interest on assets accumulated for future CLO issuances on which it has provided a first loss guaranty in connection with loan warehouse arrangements for its CLO Funds. Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds it operating expenses. The annual management fees which Katonah Debt Advisors receives are generally based on a fixed percentage of the par value of assets under management and are recurring in nature for the term of the CLO Fund so long as Katonah Debt Advisors manages the fund. As a result, the annual management fees earned by Katonah Debt Advisors generally are not subject to market value fluctuations in the underlying collateral. In future years, Katonah Debt Advisors may receive incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.

 
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Capital Structuring Service Fees. We may earn ancillary structuring and other fees related to the origination, investment, disposition or liquidation of debt and investment securities.
 
Expenses
 
We are internally managed and directly incur the cost of management and operations; as a result, we incur no management fees or other fees to an external advisor. Our expenses consist primarily of interest expense on outstanding borrowings, compensation expense and general and administrative expenses, including professional fees.
 
Interest and Amortization of Debt Issuance Costs. Interest expense is dependent on the average outstanding balance on our Facility and the base index rate for the period. Debt issuance costs represent fees and other direct costs incurred in connection with the Company’s borrowings. These amounts are capitalized and amortized ratably over the contractual term of the borrowing.
 
Compensation Expense. Compensation expense includes base salaries, bonuses, stock compensation, employee benefits and employer related payroll costs. The largest components of total compensation costs are base salaries and bonuses; generally, base salaries are expensed as incurred and annual bonus expenses are estimated and accrued. Our compensation arrangements with our employees contain a significant profit sharing and/or performance based bonus component. Therefore, as our net revenues increase, our compensation costs may also rise. In addition, our compensation expenses may also increase to reflect increased investment in personnel as we grow our products and businesses.
 
Professional Fees and General and Administrative Expenses. The balance of our expenses include professional fees (primarily legal, accounting, valuation and other professional services), occupancy costs and general administrative and other costs.
 
Net Change in Unrealized Depreciation on Investments
 
During the three and nine months ended September 30, 2010, the Company’s investments had a net change in unrealized depreciation of approximately $4 million and $3 million, respectively; during the three and nine months ended September 30, 2009, the Company’s investments had a net change in unrealized depreciation of approximately $11 million and $26 million, respectively.
 
The net change in unrealized depreciation for the three months ended September 30, 2010 is primarily due to (i) an approximate $1 million net decrease in the market value of certain loans as a result of credit considerations and current market conditions; (ii) an approximate $579,000 decrease in the net value of CLO Fund securities; and (iii) an approximate $5 million decrease in the value of Katonah Debt Advisors.
 
The net change in unrealized depreciation for the nine months ended September 30, 2010 is primarily due to (i) an approximate $6 million net increase in the market value of certain loans as a result of credit considerations and current market conditions; (ii) an approximate $4 million increase in the net value of CLO fund securities; and (iii) an approximate $12 million decrease in the value of Katonah Debt Advisors.
 
Net Change in Stockholders’ Equity Resulting From Operations
 
The net change in stockholders’ equity resulting from operations for the three months ended September 30, 2010 and 2009 was a decrease of approximately $3 million and an increase of $11 million, respectively, or a decrease of $0.15 and an increase of $0.48 per share, respectively. The net change in stockholders’ equity resulting from operations for the nine months ended September 30, 2010 and 2009 was a decrease of approximately $7 million, and an increase of approximately $33 million, respectively, or a decrease of $0.33 and an increase of $1.48 per share, respectively.
 
Net Investment Income and Net Realized Gains (Losses)
 
Net investment income and net realized gains (losses) represents the net change in stockholders’ equity before net unrealized appreciation or depreciation on investments. For the three months ended September 30, 2010, net investment income and realized gains was approximately $785,000, or $0.03 per share. For the three months ended September 30, 2009, net investment income and realized losses was approximately $292,000, or $0.01, per share. For the nine months ended September 30, 2010, net investment income and realized losses was approximately $4 million, or $0.18 per share. For the nine months ended September 30, 2009, net investment income and realized gains was approximately $7 million, or $0.31 per share.
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Dividends
 
For the three months ended September 30, 2010, we declared a $0.17 dividend per share. As a result, there was a dividend distribution of approximately $4 million for the third quarter declaration, which was booked in the fourth quarter. We intend to continue to distribute quarterly dividends to our stockholders. To avoid certain excise taxes imposed on RICs, we currently intend to distribute during each calendar year an amount at least equal to the sum of:

98% of our ordinary net taxable income for the calendar year;

98% of our capital gains, if any, in excess of capital losses for the one-year period ending on October 31 of the calendar year; and
 
any net ordinary income and net capital gains for the preceding year that were not distributed during such year.
 
The amount of our declared dividends, as evaluated by management and approved by our Board of Directors, is based on our evaluation of both distributable income for tax purposes and GAAP net investment income (which excludes unrealized gains and losses). Generally, we seek to fund our dividends from GAAP current earnings, primarily from net interest and dividend income generated by our investment portfolio and without a return of capital or a high reliance on realized capital gains. The following table sets forth the quarterly dividends declared by us in the two most recently completed years, which represent an amount equal to our estimated net investment income for the specified quarter, including income distributed from Katonah Debt Advisors received by the Company, plus a portion of any prior year undistributed amounts of net investment income distributed in subsequent years:

   
Dividend
 
Declaration
Date
 
Record Date
 
Pay Date
2010:
  
   
  
         
Third quarter
 
$
0.17 
 
9/20/2010
 
10/8/2010
 
10/29/2010
Second quarter
   
0.17 
 
6/23/2010
 
7/7/2010
 
7/29/2010
First quarter
   
0.17 
 
3/19/2010
 
4/7/2010
 
4/29/2010
                   
2009:
  
   
  
         
Fourth quarter
 
$
0.20 
 
12/15/2009
 
12/28/2009
 
1/25/2010
Third quarter
   
0.24 
 
9/24/2009
 
10/9/2009
 
10/29/2009
Second quarter
   
0.24 
 
6/12/2009
 
7/9/2009
 
7/29/2009
First quarter
   
0.24 
 
3/23/2009
 
4/8/2009
 
4/29/2009
Total declared for 2009
 
$
0.92 
           

Due to our ownership of Katonah Debt Advisors and certain timing, structural and tax considerations our dividend distributions may include a return of capital for tax purposes. For the nine months ended September 30, 2010, Katonah Debt Advisors had approximately $2 million of pre-tax net income and made distributions of $3 million to us, a portion of which represented undistributed earnings from prior years. For the nine months ended September 30, 2009, Katonah Debt Advisors earned approximately $2 million of pre-tax net income and made no distributions to us; dividends are recorded as declared (where declaration date represents ex-dividend date) by Katonah Debt Advisors as income on our statement of operations.

INVESTMENT PORTFOLIO
 
Investment Objective
 
Our investment objective is to generate current income and capital appreciation from the investments made by our middle market business in senior secured term loans, mezzanine debt and selected equity investments in privately-held middle market companies, and from our investment in Katonah Debt Advisors. We intend to grow our portfolio of assets by raising additional capital, including through the prudent use of leverage available to us. We primarily invest in first and second lien term loans which, because of their priority in a company’s capital structure, we expect will have lower default rates and higher rates of recovery of principal if there is a default and which we expect will create a stable stream of interest income. While our primary investment focus is on making loans to, and selected equity investments in, privately-held middle market companies, we may also invest in other investments such as loans to larger, publicly-traded companies, high-yield bonds and distressed debt securities. We may also receive warrants or options to purchase common stock in connection with our debt investments. In addition, we may also invest in debt and equity securities issued by CLO Funds managed by Katonah Debt Advisors or by other asset managers. However, our investment strategy is to limit the value of our investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of our total investment portfolio at the time of investment. We invest almost exclusively in credit instruments issued by corporations and do not invest in asset-backed securities such as those secured by commercial mortgages, residential mortgages or other consumer borrowings.

 
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The following table shows the Company’s portfolio by security type at September 30, 2010 and December 31, 2009:

   
September 30, 2010
   
December 31, 2009
 
Security Type
 
Cost
   
Fair Value
     
   
Cost
   
Fair Value
     
 
Time Deposits
  $ 24,529,777     $ 24,529,777       8 %   $ 126     $ 126      
%
Money Market Account
    212,245       212,245             -       -        
Senior Secured Loan
    110,660,494       95,668,038       30       179,425,767       159,075,586       39  
Junior Secured Loan
    103,690,662       90,642,174       28       129,016,237       114,920,499       28  
Mezzanine Investment
    10,744,496       250,000             28,606,852       19,235,444       5  
Senior Subordinated Bond
    4,240,630       3,964,233       1       3,007,167       2,415,000       1  
Senior Unsecured Bond
                      2,000,000       1,710,000        
Preferred Stock
    400,000       384,000                          
CLO Fund Securities
    68,258,657       52,751,000       16       68,195,049       48,971,000       12  
Equity Securities
    14,216,146       5,989,599       2       12,365,603       4,713,246       1  
Affiliate Asset Managers
    44,219,947       49,149,581       15       40,751,511       58,064,720       14  
Total
  $ 381,173,054     $ 323,540,647       100 %   $ 463,368,312     $ 409,105,621       100 %
   
¹      Represents percentage of total portfolio at fair value.
 

Investment Securities
 
We invest in senior secured loans, mezzanine debt and, to a lesser extent, equity, of middle market companies in a variety of industries. We generally target companies that generate positive cash flows because we look to cash flows as the primary source for servicing debt. However, we may invest in other industries if we are presented with attractive opportunities.
 
We employ a disciplined approach in the selection and monitoring of our investments. Generally, we target investments that will provide a current return through interest income to provide for stability in our net income and place less reliance on realized capital gains from our investments. Our investment philosophy is focused on preserving capital with an appropriate return profile relative to risk. Our investment due diligence and selection generally focuses on an underlying issuer’s net cash flow after capital expenditures to service its debt rather than on multiples of net income, valuations or other broad benchmarks which frequently miss the nuances of an issuer’s business and prospective financial performance. We also avoid concentrations in any one industry or issuer. We manage risk through a rigorous credit and investment underwriting process and an active portfolio monitoring program.
 
Our Board of Directors is ultimately and solely responsible for making a good faith determination of the fair value of portfolio investments on a quarterly basis. Debt and equity securities for which market quotations are readily available are generally valued at such market quotations. Debt and equity securities that are not publicly traded or whose market price is not readily available are valued by the Board of Directors based on detailed analyses prepared by management, the Valuation Committee of the Board of Directors, and, in certain circumstances, third parties with valuation expertise. Valuations are conducted by management on 100% of the investment portfolio at the end of each quarter. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ materially from the values that would have existed had a ready market existed for such investments. Further, such investments may be generally subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities. In addition, changes in the market environment and other events may occur over the life of the investments that may cause the value realized on such investments to be different from the currently assigned valuations.

 
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We derive fair value for our illiquid investments that do not have indicative fair values based upon active trades primarily by using a present value technique that discounts the estimated contractual cash flows for the underlying assets with discount rates imputed by broad market indices, bond spreads and yields for comparable issuers relative to the subject assets (the “Market Yield Approach”) and also consider recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan and debt investments. Because we have not identified any market index that directly correlates to the loan and debt investments held by us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy. The appropriateness of specific valuation methods and techniques may change as market conditions and available data change.
 
In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance that clarifies and requires new disclosures about fair value measurements. The clarifications and requirement to disclose the amounts and reasons for significant transfers between Level I and Level II, as well as significant transfers in and out of Level III of the fair value hierarchy, were adopted by us in the first quarter of 2010. Note 4 to the financial statements reflects the amended disclosure requirements. The new guidance also requires that purchases, sales, issuances and settlements be presented gross in the Level III reconciliation and that requirement is effective for fiscal years beginning after December 15, 2010 and for interim periods within those years, with early adoption permitted. The Company is evaluating the increased disclosure requirements for implementation by the effective date. Since this new guidance only amends the disclosures requirements, it did not impact our statements of financial position, statements of operations, or cash flow statements.
 
Accounting Standards Codification Fair Value Measurements and Disclosures (“Fair Value Measurements and Disclosure ”) requires the disclosure in interim and annual periods of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, during the period.
 
We engaged Valuation Research Corporation (“VRC”), an independent valuation firm, to provide third-party valuation estimates for approximately 39% of investments at fair value as of December 31, 2009. VRC’s valuation estimates were considered as one of the relevant data inputs in the Company’s determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of September 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of our annual year end valuation process.
 
The majority of our investment portfolio is composed of debt and equity securities with unique contract terms and conditions and/or complexity that requires a valuation of each individual investment that considers multiple levels of market and asset specific inputs, including historical and forecasted financial and operational performance of the individual investment, projected cash flows, market multiples, comparable market transactions, the priority of the security compared with those of other securities for such issuers, credit risk, interest rates and independent valuations and reviews.
 
Loans and Debt Securities.
 
To the extent that our investments are exchange traded and are priced or have sufficient price indications from normal course trading at or around the valuation date (financial reporting date), such pricing will determine fair value. Pricing service marks from third party pricing services may be used as an indication of fair value, depending on the volume and reliability of the marks, sufficient and reasonable correlation of bid and ask quotes, and, most importantly, the level of actual trading activity. However, most of our investments are illiquid investments with little or no trading activity. Further, we have been unable to identify directly comparable market indices or other market guidance that correlate directly to the types of investments we own. As a result, for most of our assets, we determine fair value using alternative methodologies and models using available market data, as adjusted, to reflect the types of assets we own, their structure, qualitative and credit attributes and other asset specific characteristics.

 
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We derive fair value for our illiquid investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach and also consider recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan and debt investments. Because we have not identified any market index that directly correlates to the loan and debt investments held by us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications and given relatively less weight based on their relevancy.
 
Equity and Equity-Related Securities.
 
Our equity and equity-related securities in portfolio companies for which there is no liquid public market are carried at fair value based on the enterprise value of the portfolio company, which is determined using various factors, including EBITDA, cash flows from operations less capital expenditures and other pertinent factors, such as recent offers to purchase a portfolio company’s securities or other liquidation events. The determined fair values are generally discounted to account for restrictions on resale and minority ownership positions. The values of our equity and equity-related securities in public companies for which market quotations are readily available are based upon the closing public market price on the balance sheet date. Securities that carry certain restrictions on sale are typically valued at a discount from the public market value of the security.
 
The significant inputs used to determine the fair value of equity and equity-related securities include prices, earnings, EBITDA and cash flows after capital expenditures for similar peer comparables and the investment entity itself. Equity and equity-related securities are classified as Level III when there is limited activity or less transparency around inputs to the valuation given the lack of information related to such equity investments held in nonpublic companies. Significant assumptions observed for comparable companies as applied to relevant financial data for the specific investment. Such assumptions, such as model discount rates or price/earnings multiples, vary by the specific investment, equity position and industry and incorporate adjustments for risk premiums, liquidity and company specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.
 
At September 30, 2010 and September 30, 2009, our investments in loans and debt securities, excluding CLO Fund securities, had a weighted average interest rate of approximately 5.0% and 6.3%, respectively.
 
The investment portfolio (excluding the Company’s investment in asset manager affiliates and CLO Funds) at September 30, 2010 was spread across 23 different industries and 56 different entities with an average balance per entity of approximately $3 million. As of September 30, 2010, all but five of our portfolio companies were current on their debt service obligations. Our portfolio, including the CLO Funds in which it invests, and the CLO Funds managed by Katonah Debt Advisors consist almost exclusively of credit instruments issued by corporations and do not include investments in asset-backed securities, such as those secured by commercial mortgages, residential mortgages or other consumer borrowings.
 
We may invest up to 30% of our investment portfolio in opportunistic investments in high-yield bonds, debt and equity securities of CLO Funds, distressed debt or equity securities of public companies. However, our investment strategy is to limit the value of our investments in the debt or equity securities issued by CLO Funds to not more than 15% of the value of our total investment portfolio at the time of investment. We expect that these public companies generally will have debt that is non-investment grade. We also may invest in debt of middle market companies located outside of the U.S., which investments are generally not anticipated to be in excess of 10% of our investment portfolio at the time such investments are made. At September 30, 2010, approximately 25% of our investments were foreign assets (including our investments in CLO Funds, which are typically domiciled outside the U.S. and represent approximately 16% of our portfolio). We are generally prohibited from buying or selling any security from or to any portfolio company of a private equity fund managed by Kohlberg & Co. without the prior approval of the U.S. Securities and Exchange Commission (the “Commission” or the “SEC”). However, we may co-invest on a concurrent basis with Kohlberg & Co. or any of our affiliates, subject to compliance with existing regulatory guidance, applicable regulations and our allocation procedures. Certain types of negotiated co-investments may be made only if we receive an order from the SEC permitting us to do so. There can be no assurance that any such order will be applied for or, if applied for, obtained.

 
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At September 30, 2010, our ten largest portfolio companies represented approximately 47% of the total fair value of our investments. Our largest investment, Katonah Debt Advisors which is our wholly-owned portfolio company, represented 15% of the total fair value of our investments. Excluding Katonah Debt Advisors and CLO Fund securities, our ten largest portfolio companies represent approximately 19% of the total fair value of our investments.
 
CLO Fund Securities
 
We typically make a minority investment in the subordinated securities or preferred stock of CLO Funds raised and managed by Katonah Debt Advisors and may selectively invest in securities issued by CLO Funds managed by other asset management companies. As of September 30, 2010, we had approximately $53 million invested in CLO Fund securities, including those issued by funds managed by Katonah Debt Advisors.
 
The CLO Funds managed by Katonah Debt Advisors invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of corporate issuers. The underlying assets in each of the CLO Funds in which we have an investment are generally diversified secured or unsecured corporate debt. The underlying assets in our CLO Funds exclude mortgage pools or mortgage securities (residential mortgage bonds, commercial mortgage backed securities, or related asset-backed securities), debt to companies providing mortgage lending and emerging markets investments.
 
Our CLO Fund investments as of September 30, 2010 and December 31, 2009 are as follows:

             
September 30, 2010
   
December 31, 2009
 
CLO Fund Securities
 
Investment
   
%1
   
Cost
   
Fair Value
   
Cost
   
Fair Value
 
Grant Grove CLO, Ltd.
 
Subordinated Securities
    22.2 %   $ 4,719,717     $ 3,390,000     $ 4,715,858     $ 2,780,000  
Katonah III, Ltd.
 
Preferred Shares
    23.1       4,500,000       810,000       4,500,000       950,000  
Katonah IV, Ltd.
 
Preferred Shares
    17.1       3,150,000       1,070,000       3,150,000       290,000  
Katonah V, Ltd.
 
Preferred Shares
    26.7       3,320,000       1,000       3,320,000       1,000  
Katonah VII CLO Ltd.2, 3
 
Subordinated Securities
    16.4       4,500,000       2,280,000       4,500,000       1,840,000  
Katonah VIII CLO Ltd.
 
Subordinated Securities
    10.3       3,400,000       1,890,000       3,400,000       1,760,000  
Katonah IX CLO Ltd.
 
Preferred Shares
    6.9       2,000,000       1,300,000       2,000,000       1,560,000  
Katonah X CLO Ltd.
 
Subordinated Securities
    33.3       11,606,522       9,110,000       11,589,830       8,280,000  
Katonah 2007-1 CLO Ltd.
 
Preferred Shares
    100.0       29,976,188       26,260,000       29,940,867       27,100,000  
Katonah 2007-1 CLO Ltd.
 
Class B-2L Notes
    100.0       1,086,230       6,640,000       1,078,494       4,410,000  
Total
              $ 68,258,657     $ 52,751,000     $ 68,195,049     $ 48,971,000  
   
¹ Represents percentage of class held.
 
² An affiliate CLO Fund managed by Katonah Debt Advisors.
 
³ As of September 30, 2010, these CLO Fund Securities were not providing a dividend distribution.
 
 
Our investments in CLO Fund securities are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the CLO Funds that are approaching or past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions to the class of securities owned by us, (ii) a discounted cash flow model for more recent CLO Funds that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities or preferred shares to those in which we have invested. We recognize unrealized appreciation or depreciation on our investments in CLO Fund securities as comparable yields in the market change and/or based on changes in NAVs or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investments. We determine the fair value of our investments in CLO Fund securities on an individual security-by-security basis.

 
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Due to the individual attributes of each CLO Fund security, they are classified as a Level III (as described in—“Critical Accounting Policies—Valuation of Portfolio Investments” below) investment unless specific trading activity can be identified at or near the valuation date. When available, Level II (as described in “—Critical Accounting Policies—Valuation of Portfolio Investments” below) market information will be identified, evaluated and weighted accordingly in the application of such data to the present value models and fair value determination. Significant assumptions to the present value calculations include default rates, recovery rates, prepayment rates, investment/reinvestment rates and spreads and the discount rate by which to value the resulting underlying cash flows. Such assumptions can vary significantly, depending on market data sources which often vary in depth and level of analysis, understanding of the CLO market, detailed or broad characterizations of the CLO market and the application of such data to an appropriate framework for analysis. The application of data points are based on the specific attributes of each individual CLO Fund security’s underlying assets, historic, current and prospective performance, vintage, and other quantitative and qualitative factors that would be evaluated by market participants. We evaluate the source of market data for reliability as an indicative market input, consistency amongst other inputs and results and also the context in which such data is presented.
 
For bond rated tranches of CLO Fund securities (those above the junior class) without transactions to support a fair value for the specific CLO Fund and tranche, fair value is based on discounting estimated bond payments at current market yields, which may reflect the adjusted yield on the leveraged loan index for similarly rated tranches, as well as prices for similar tranches for other CLO Funds, and also considers other factors such as the default and recovery rates of underlying assets in the CLO Fund, as may be applicable. Such model assumptions may vary and incorporate adjustments for risk premiums and CLO Fund specific attributes. Such adjustments require judgment and may be material to the calculation of fair value.
 
The unaudited table below summarizes certain attributes of each CLO Fund as per their most recent trustee reports as of September 30, 2010:

CLO Fund Securities
 
Number of
Securities
   
Number of
Issuers
   
Number of
Industries
   
Average Security
Position Size
   
Average Issuer
Position Size
 
Grant Grove CLO, Ltd.
    245       186       32     $ 1,156,965     $ 1,523,960  
Katonah III, Ltd.
    226       145       30       1,443,585       2,250,002  
Katonah IV, Ltd.
    209       138       25       970,378       1,469,630  
Katonah V, Ltd.
    254       161       29       508,308       801,927  
Katonah VII CLO Ltd.
    255       194       33       1,240,989       1,631,197  
Katonah VIII CLO Ltd.
    273       205       33       1,301,341       1,733,005  
Katonah IX CLO Ltd.
    264       207       33       1,498,008       1,910,503  
Katonah X CLO Ltd.
    267       206       33       1,732,210       2,245,146  
Katonah 2007-1 CLO Ltd.
    235       184       31       1,312,520       1,676,316  
                                         
¹ All data from most recent Trustee reports as of September 30, 2010.
                 
 
In May 2009, we purchased the class B-2L notes of the Katonah 2007-1 CLO investment managed by Katonah Debt Advisors (“Katonah 2007-1 B-2L”). We purchased the Katonah 2007-1 B-2L for 10% of the par value. The fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment as of September 30, 2010 were approximately $7 million, $1 million, and $6 million, respectively, and at December 31, 2009, the fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment were $4 million, $1 million, and $3 million, respectively.  Both the B-2L notes and preferred shares of Katonah 2007-1 are owned 100% by us and Katonah 2007-1 is current in the payment of all quarterly distributions in respect of the B-2L notes and the preferred shares.
 
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Katonah Debt Advisors
 
Katonah Debt Advisors is our wholly-owned asset management company that manages CLO Funds that invest in broadly syndicated loans, high yield bonds and other credit instruments. The CLO Funds managed by Katonah Debt Advisors consist exclusively of credit instruments issued by corporations and do not invest in asset-backed securities secured by commercial mortgages, residential mortgages or other consumer borrowings. As of September 30, 2010, Katonah Debt Advisors had approximately $2.1 billion of par value of assets under management on which it earns management fees, and was valued at approximately $49 million.
 
As a manager of the CLO Funds, Katonah Debt Advisors receives contractual and recurring management fees as well as an expected one-time structuring fee from the CLO Funds for its management and advisory services. In addition, Katonah Debt Advisors may also earn income related to net interest on assets accumulated for future CLO issuances on which it has provided a first loss guaranty in connection with loan warehouse arrangements for its CLO Funds. Katonah Debt Advisors generates annual operating income equal to the amount by which its fee income exceeds its operating expenses.
 
The annual management fees which Katonah Debt Advisors receives are generally based on a fixed percentage of the par value of assets under management and are recurring in nature for the term of the CLO Fund so long as Katonah Debt Advisors manages the fund. As a result, the annual management fees earned by Katonah Debt Advisors are not subject to market value fluctuations in the underlying collateral. The annual management fees Katonah Debt Advisors receives have two components - a senior management fee and a subordinated management fee.  During 2009, certain CLO funds managed by Katonah Debt Advisors were restricted from currently paying their subordinated management fees as a result of the failure by those CLO Funds to satisfy certain restrictive covenants contained in their indenture agreements. At such time, those subordinated management fees continued to be accrued by the applicable CLO Fund to become payable to Katonah Debt Advisors when such CLO Fund becomes compliant with the applicable covenants.  During the nine months ended September 30, 2010, all those CLO Funds which deferred payment of their subordinated management fees regained compliance with all applicable covenants in order to pay current subordinated management fees as well as a portion of previously accrued subordinated management fees.  During the nine months ended September 30, 2010, approximately $4 million of deferred subordinated management fees have been paid and approximately $1 million of deferred subordinated management fees on one CLO remain deferred for payment in the fourth quarter of 2010.  Currently, all CLO Funds managed by Katonah Debt Advisors are paying both their senior and subordinated management fees on a current basis.
 
In future years, Katonah Debt Advisors may receive accrued incentive fees upon the liquidation of CLO Funds it manages, provided such CLO Funds have achieved a minimum investment return to holders of their subordinated securities or preferred shares.
 
Subject to market conditions, we expect to continue to make investments in CLO Funds managed by Katonah Debt Advisors, which we believe will provide us with a current cash investment return. We believe that these investments will provide Katonah Debt Advisors with greater opportunities to access new sources of capital which will ultimately increase Katonah Debt Advisors’ assets under management and resulting management fee income. We also expect to receive distributions of recurring fee income and, if debt markets stabilize and recover, to generate capital appreciation from our investment in the asset management business of Katonah Debt Advisors.
 
The revenue that Katonah Debt Advisors generates through the fees it receives for managing CLO Funds and after paying the expenses pursuant to an overhead allocation agreement with the Company associated with its operations, including compensation of its employees, may be distributed to Kohlberg Capital. Cash distributions of Katonah Debt Advisors’ net income are recorded as dividends from an affiliate asset manager when declared. As with all other investments, Katonah Debt Advisors’ fair value is periodically determined. Our investment in Katonah Debt Advisors is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis of comparable asset management companies. Katonah Debt Advisors is classified as a Level III investment. Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.

PORTFOLIO AND INVESTMENT ACTIVITY
 
Our primary business is lending to and investing in middle-market businesses through investments in senior secured loans, junior secured loans, subordinated/mezzanine debt investments, CLO equity investments and other equity-based investments, which may include warrants.
 
Total portfolio investment activity (excluding activity in time deposit and money market investments) for the nine months ended September 30, 2010 and for the year ended December 31, 2009 was as follows:

 
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Debt Securities
   
CLO Fund
Securities
   
Equity Securities
   
Affiliate Asset
Managers
   
Total Portfolio
 
Fair Value at December 31, 2008 (as restated)
 
$
353,859,007 
   
$
34,640,000 
   
$
5,089,365 
   
$
54,734,812 
   
$
448,323,184 
 
2009 Activity:
                                       
Purchases / originations /draws
 
$
1,509,987 
   
$
1,076,250 
   
$
8,625,627 
   
$
4,018,309 
   
$
15,230,173 
 
Pay-downs / pay-offs / sales
   
(72,227,405)
     
— 
     
— 
     
— 
     
(72,227,405)
 
Net accretion of discount
   
964,724 
     
742,204 
     
— 
     
— 
     
1,706,928 
 
Net realized losses
   
(12,050,370)
     
— 
     
(1,516,682)
     
(2,215,069)
     
(15,782,121)
 
Decrease in fair value
   
25,300,586 
     
12,512,546 
     
(7,485,064)
     
1,526,668 
     
31,854,736 
 
Fair Value at December 31, 2009
   
297,356,529 
     
48,971,000 
     
4,713,246 
     
58,064,720 
     
409,105,495 
 
Year to Date 2010 Activity:
                                       
Purchases / originations /draws
   
8,304,867 
     
— 
     
1,850,543 
     
3,468,436 
     
13,623,846 
 
Pay-downs / pay-offs / sales
   
(110,179,542)
     
— 
     
— 
     
— 
     
(110,179,542)
 
Net accretion of discount
   
307,500 
     
63,608 
     
— 
     
— 
     
371,108 
 
Net realized losses
   
(10,752,567)
     
— 
     
— 
     
— 
     
(10,752,567)
 
Increase (decrease) in fair value
   
5,871,658 
     
3,716,392 
     
(574,190)
     
(12,383,575)
     
(3,369,715)
 
                                         
Fair Value at September 30, 2010
 
$
190,908,445 
   
$
52,751,000 
   
$
5,989,599 
   
$
49,149,581 
   
$
298,798,625 
 
 
The level of investment activity for investments funded and principal repayments for our investments can vary substantially from period to period depending on the number and size of investments that we invest in or divest of, and many other factors, including the amount and competition for the debt and equity securities available to middle market companies, the level of merger and acquisition activity for such companies and the general economic environment.

RESULTS OF OPERATIONS
 
The principal measure of our financial performance is the net increase (decrease) in stockholders’ equity resulting from operations which includes net investment income (loss) and net realized and unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees, and other investment income and our operating expenses. Net realized gain (loss) on investments, is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net change in unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio.
 
Set forth below is a discussion of our results of operations for the three and nine months ended September 30, 2010 and 2009.
 
Investment Income
 
Investment income for the three months ended September 30, 2010 and 2009 was approximately $8 million and $8 million, respectively. Of these amounts, approximately $4 million and $6 million was attributable to interest income on our loan and bond investments, respectively. For each of the three months ended September 30, 2010 and 2009, approximately $3 million of investment income is attributable to dividends earned on CLO equity investments.
 
Investment income for the nine months ended September 30, 2010 and 2009 was approximately $22 million and $27 million, respectively. Of this amount, approximately $12 million and $19 million, respectively, was attributable to interest income on our loan and bond investments. For the nine months ended September 30, 2010 and 2009, approximately $7 million and $7 million, respectively, of investment income is attributable to dividends earned on CLO equity investments.
 
Investment income is primarily dependent on the composition and credit quality of our investment portfolio. Generally, our debt securities portfolio is expected to generate predictable, recurring interest income in accordance with the contractual terms of each loan. Corporate equity securities may pay a dividend and may increase in value for which a gain may be recognized; generally such dividend payments and gains are less predictable than interest income on our loan portfolio.

 
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Dividends from CLO Fund securities are dependent on the performance of the underlying assets in each CLO Fund; interest payments, principal amortization and prepayments of the underlying loans in each CLO Fund are primary factors which determine the level of income on our CLO Fund securities. The level of excess spread from CLO Fund securities can be impacted by the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly.
 
Dividends from Affiliate Asset Manager
 
As of September 30, 2010, our investment in Katonah Debt Advisors was approximately $49 million. For the three months ended September 30, 2010 and 2009, Katonah Debt Advisors had pre-tax net income of approximately $630,000 and $790,000, respectively. For the nine months ended September 30, 2010 and 2009, Katonah Debt Advisors had pre-tax net income of approximately $2 million and $2 million, respectively. For the three and nine months ended September 30, 2010, Katonah Debt Advisors made distributions of $1.5 million and $3 million, respectively, a portion of which represented undistributed earnings from prior years.  For the three and nine months ended September 30, 2009, Katonah Debt Advisors distributed made no distributions of net income.
 
Distributions of Katonah Debt Advisors’ net income are recorded as dividends from affiliate asset manager. The Company intends to distribute the accumulated undistributed net income of Katonah Debt Advisors in the future. For purposes of calculating distributable tax income for required quarterly dividends as a RIC, Katonah Debt Advisors’ net income is further reduced by approximately $2 million per annum for tax goodwill amortization resulting from its acquisition by us prior to our initial public offering. As a result, the amount of our declared dividends, as evaluated by management and approved by our Board of Directors, is based on our evaluation of both distributable income for tax purposes and GAAP net investment income (which excludes unrealized gains and losses).
 
Expenses
 
Total expenses for the three months ended September 30, 2010 and 2009 were approximately $4 million and $5 million, respectively. Interest expense and amortization on debt issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $2 million and $3 million, respectively, on average debt outstanding of $141 million and $231 million, respectively. Approximately $815,000 and $761,000, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option expense for the three months ended September 30, 2010 and 2009.  For the three months ended September 30, 2010, other expenses included approximately $2 million for professional fees, insurance, administrative and other.  For the three months ended September 30, 2009, other expenses included approximately $870,000 for professional fees, insurance, administrative and other.  For the three months ended September 30, 2010 and 2009, administrative and other costs (including occupancy expense, insurance, technology and other office expenses) totaled approximately $343,000 and $303,000, respectively.
 
Total expenses for the nine months ended September 30, 2010 and 2009 were approximately $16 million and $11 million, respectively. Interest expense and amortization on debt issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $7 million and $6 million, on average debt outstanding of $172 million and $241 million, respectively. Approximately $2 million and $2 million, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option expense for the nine months ended September 30, 2010 and 2009.  For the nine months ended September 30, 2010 and 2009, other expenses included approximately $7 million for professional fees, insurance, administrative and other.  For the nine months ended September 30, 2010 and 2009, administrative and other costs totaled approximately $957,000 and $833,000, respectively, and include occupancy expense, insurance, technology and other office expenses.
 
Interest and compensation expense are generally expected to be our largest expenses each period. Interest expense is dependent on the average outstanding principal balance on our Facility and the base index rate for the period. Compensation expense includes base salaries, bonuses, stock compensation, employee benefits and employer related payroll costs. The largest components of total compensation costs are base salaries and bonuses; generally, base salaries are expensed as incurred and bonus expenses are estimated and accrued since bonuses are paid annually.
 
Professional fee expenses for the three and nine months ended September 30, 2010 are significantly higher by approximately $4 million relative to the same prior years periods due to increased legal expenses (approximately $2 million), accounting (approximately $2 million) and valuation services (approximately $470,000).  This increase in professional fees is primarily related to legal proceedings and our complaint against our lenders and additional legal, accounting and valuation costs related to the restatement (and defense on the related class-action and SEC investigation net of reimbursable legal fees covered by directors’ and officers’ insurance) of our year-end 2008 and first-and second- quarter 2009 financial statements.

 
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Net Unrealized Appreciation on Investments
 
During the three months ended September 30, 2010 and 2009, our total investments had a change in net unrealized depreciation of approximately $4 million, and a change in net unrealized appreciation of approximately $11 million, respectively. For the three months ended September 30, 2010, Katonah Debt Advisors had a change in unrealized depreciation of approximately $5 million and our middle market portfolio of debt securities, equity securities and CLO Fund securities had a change in net unrealized appreciation of approximately $1 million.  For the three months ended September 30, 2009, Katonah Debt Advisors had a change in unrealized depreciation of $2 million offset by a change in unrealized appreciation of approximately $13 million on debt securities, equity securities and CLO Fund securities in our investment portfolio.
 
During the nine months ended September 30, 2010 and 2009, our total investments had a change in net unrealized depreciation of approximately $3 million and had a change in net unrealized appreciation of approximately $26 million, respectively. For the nine months ended September 30, 2010, Katonah Debt Advisors had a change in unrealized depreciation of approximately $12 million and our middle market portfolio of debt securities, equity securities and CLO Fund securities had a change in unrealized appreciation of approximately $9 million.  For the nine months ended September 30, 2009, Katonah Debt Advisors had a change in unrealized appreciation of approximately $206,000 and unrealized gains of approximately $26 million, on debt securities, equity securities and CLO Fund securities in our investment portfolio.
 
Net Increase (Decrease) in Stockholders’ Equity Resulting From Operations
 
The net decrease in stockholders’ equity resulting from operations for the three and nine months ended September 30, 2010 was approximately $3 million and $7 million, respectively, or a decrease of $0.15 and $0.33, respectively, per share.  The net increase in stockholders’ equity resulting from operations for the three and nine months ended September 30, 2009 was approximately $11 million and $33 million, or $0.48 and $1.48, respectively, per share.

FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
 
Liquidity is a measure of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, pay dividends to our stockholders and other general business needs. We recognize the need to have funds available for operating our business and to make investments. We seek to have adequate liquidity at all times to cover normal cyclical swings in funding availability and to allow us to meet abnormal and unexpected funding requirements. We plan to satisfy our liquidity needs through normal operations with the goal of avoiding unplanned sales of assets or emergency borrowing of funds.
 
In addition to the traditional sources of available funds (issuance of new equity, debt or undrawn warehouse facility capacity), we also have the ability to raise additional cash funds through the securitization of assets on our balance sheet through our wholly-owned asset manager, Katonah Debt Advisors. Such a securitization would provide cash for new investments on our balance sheet as well as additional management fee income and potentially increased value (as a result of increased assets under management) for Katonah Debt Advisors. No new securitizations by Katonah Debt Advisors have closed since January 2008.
 
As a BDC, we are limited in the amount of leverage we can incur to finance our investment portfolio. In order to incur new debt, we are required to meet a coverage ratio of total assets to total senior securities of at least 200%. For this purpose, senior securities include all borrowings and any preferred stock. As a result, our ability to utilize leverage as a means of financing our portfolio of investments is limited by this asset coverage test. As of September 30, 2010, we had $137 million of outstanding borrowings and our asset coverage was 246%, which is above the minimum asset coverage level generally required by the 1940 Act for a BDC to incur new debt.
 
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As of September 30, 2010 and December 31, 2009 the fair value of investments and cash were as follows:

   
Investments at Fair Value
 
Security Type
 
September 30, 2010
   
December 31, 2009
 
             
Cash
  $ 2,225,116     $ 4,140,408  
Time Deposits
    24,529,777       126  
Money Market Accounts
    212,245        
Senior Secured Loan
    95,668,038       159,075,586  
Junior Secured Loan
    90,642,174       114,920,499  
Mezzanine Investment
    250,000       19,235,444  
Senior Subordinated Bond
    3,964,233       2,415,000  
Senior Unsecured Bond
          1,710,000  
Preferred Stock
    384,000        
CLO Fund Securities
    52,751,000       48,971,000  
Equity Securities
    5,989,599       4,713,246  
Affiliate Asset Managers
    49,149,581       58,064,720  
Total
  $ 325,765,763     $ 413,246,029  
 
On February 14, 2007, we entered into the Facility under which we may obtain up to $200 million in financing. On October 1, 2007, we amended the Facility to increase our borrowing capacity from $200 million to $275 million, extend the maturity date from February 12, 2012 to October 1, 2012 and increase the interest spread charged on outstanding borrowings by 15 basis points to 0.85%. The interest rate is based on prevailing commercial paper rates plus 0.85% or, if the commercial paper market is at any time unavailable, prevailing LIBOR rates plus an applicable spread. Interest is payable monthly. As disclosed above, as a result of the Agent’s assertion that a Termination Event occurred under the LFSA, for the period June 2009 to September 2010 interest under the LFSA has been calculated at a higher default rate (equal to 0.85% above the prime rate plus 0.75%).
 
Advances under the Facility (to the extent available to us) are used by us primarily to make additional investments. The Facility is secured by loans acquired by us with the advances under the Facility. We borrow under the Facility through our wholly-owned, special-purpose bankruptcy remote subsidiary, KCAP Funding. As described further below, we have not drawn on the Facility since August 2008.
 
In connection with the Facility, we are party to the LFSA, by and among us as the servicer, KCAP Funding, as the borrower, the Agent, the Trustee, and the other lender parties and other parties thereto.  As of September 30, 2010 there were outstanding borrowings of approximately $137 million under the LFSA.  In accordance with the terms of the LFSA, the financial assets acquired with the proceeds of borrowings under the LFSA are held in a securities account and are subject to a securities account control agreement granting the Agent certain rights in respect of such securities account and the financial assets held therein.  As of September 30, 2010 there were financial assets held in the securities account with a market value of approximately $196 million. Borrowings under the Facility are secured only by these assets and amounts in respect of such assets on deposit in a concentration account that is subject to an intercreditor and concentration account administration agreement, and the Facility lenders do not have recourse to any other of our assets or the investment income associated with any such other assets. The assets securing the Facility represent approximately 58% of our total assets (at fair value) at September 30, 2010 and contributed approximately 38% of our investment income for the nine months ended September 30, 2010.
 
In August 2008, we were notified by the Lender Parties that the banks providing the underlying funding for the Facility did not intend to renew their liquidity facility to the lenders unless the we agreed to certain revised terms for the Facility. The Lender Parties proposed new terms to us as a condition to extending the underlying liquidity purchase agreements. We viewed such proposed terms as unfavorable and did not agree to such new terms, causing the Agent and Lender Parties to declare a Termination Date based upon their contention that the underlying liquidity purchase agreements had expired, thereby terminating our ability to obtain revolving advances and commencing the amortization of existing borrowings under the Facility. Since September 2008, all principal and excess interest collected from the assets securing the Facility have been and continue to be used to amortize the Facility.  On June 9, 2009, we received a letter from a representative of the Lender Parties alleging that our failure to determine ratings on certain pledged loans and our alleged breach of certain covenants had resulted in the occurrence of a Termination Event under the LFSA and that, as a result, the interest payable under the LFSA would be calculated at the higher default rate (equal to 0.85% above the prime rate plus 0.75%) applicable to periods during which a Termination Event had occurred and was continuing.  Beginning June 2009, based on the Agent’s assertion (despite our disagreement with such assertion) that a Termination Event had occurred, the interest payable under the LFSA began to be calculated at such elevated rate and we have paid such higher interest under protest.
 
As a result of the actions of the Lender Parties, on August 28, 2009, we filed a complaint with the Supreme Court of the State of New York against the Agent and the other Lender Parties to the LFSA (the “Litigation”).  The Litigation reflected our beliefs that the termination date of the revolving period and the commencement of the amortization period under the LFSA were wrongful and that the assertions of alleged breaches of our obligations under the LFSA and the alleged occurrence of Termination Event(s) were without merit.

 
65

 
 
On September 20, 2010, we entered into a Forbearance and Settlement Agreement (the “Settlement Agreement”) with the Agent and Lender Parties (the Company, Agent and lenders collectively known as the “Parties”) in order to settle all outstanding claims of the Parties under the LFSA and all related claims asserted by the Parties in connection with the Litigation noted above as filed by us.
 
Pursuant to the Settlement Agreement, the Lender Parties have agreed to refrain, during the Forbearance Term, from the exercise of any right or remedy relating to any termination events alleged by any of the Lender Parties to have occurred (or that resulted from or otherwise relates to an event that occurred or a condition that existed prior to the date of the Settlement Agreement and that was known or reasonably should have been known to the Lender Parties) under the LFSA and the related documents on or before September 20, 2010, the date of the Settlement Agreement.  The Forbearance Term is defined in the Settlement Agreement to include the period from the date of the Settlement Agreement through the earliest to occur of (i) any new termination event under the LFSA (as modified by the Settlement Agreement to provide that our failure to comply with certain provisions of the LFSA, including those relating to the maximum amount of outstanding advances, minimum overcollateralization, permissible equity shortfalls and a rolling three-month default ratio, collateral quality and required ratings for specified loans, will not give rise to a termination event during the Forbearance Term), (ii) the first determination date on which we fail to maintain an overcollaterization ratio of at least 115%, (iii) the first date on which the we fail to maintain a minimum net worth of at least $150 million, (iv) the date on which it is determined that any representation or warranty made by us pursuant to the Settlement Agreement is untrue or misleading in any material respect, (v) the date on which any action is commenced challenging the terms of the Settlement Agreement, the LFSA, the amount of outstanding advances under the LFSA or the existence, priority or enforceability of the liens or other security interests in any of the collateral securing the obligations under the LFSA, (vi) February 28, 2011 and (vii) the failure, subject to certain exceptions, to pay to the Lender Parties amounts sufficient to reduce the advances outstanding under the LFSA as set forth in the following amortization schedule:

Date
Advances Outstanding
September 30, 2010
$125 million or less
November 3, 2010
$115 million or less
December 1, 2010
$105 million or less
January 3, 2011
$95 million or less
February 1, 2011
$85 million or less
February 28, 2011
$0
 
Under the terms of the Settlement Agreement, (i) the Lender Parties have agreed to pay to the us $2 million so long as all outstanding advances under the LFSA and accrued interest thereon (exclusive of any fees or expenses, including attorneys’ fees and indemnification payments, of the Lender Parties incurred in connection with the Litigation or any other fees or expenses payable to the Lender Parties under the LFSA or the related documents other than fees or expenses incurred in connection with or related to the exercise of remedies following the occurrence of a Forbearance Term termination event) are repaid in full on or before February 28, 2011, (ii) from September 10, 2010 through the end of the Forbearance Term, interest on advances outstanding under the LFSA will accrue at the rate provided for under the LFSA prior to the occurrence of a termination event (equal to 0.85% above the prevailing commercial paper rate, or prevailing LIBOR if the commercial paper market is at any time unavailable), (iii) upon execution of the Settlement Agreement, we have agreed to release the Lender Parties from any and all claims that any of them may have under the LFSA and the related documents or the Litigation, (iv) upon payment in full in accordance with the Agreement of all outstanding advances and accrued interest thereon and all other amounts due to the Lender Parties under the LFSA, the Lender Parties have agreed to release us from any and all claims that any of them may have under the LFSA and the related documents or the Litigation and (v) the parties have stipulated to dismiss the Litigation, with prejudice, by stipulation of discontinuance filed with the Court on September 21, 2010.
 
We will generally be permitted, without further consent from the Lender Parties, to make discretionary sales of loans included in the collateral securing the LFSA so long as the proceeds from any such sale are at least equal to 90% of par value of such loans (or, in certain circumstances, 90% of our most recent mark-to-market valuation or 90% of such loan’s purchase price).  Other discretionary sales will require the prior written consent of the Lender Parties.
 
As noted above, prior to entering into the Settlement Agreement, the interest rate being charged on outstanding amounts under the Facility was at a rate equal to 0.85% above the prime rate plus 0.75%, or approximately 4.9%, and we had been paying interest at such rate under protest.  Under the terms of the Settlement Agreement, commencing on September 10, 2010, the advances under the Facility will accrue interest at the rate provided for under the LFSA prior to the occurrence of a termination event, equal to 0.85% above the prevailing commercial paper rate, or 1.2% as of such date.

 
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We are in compliance with all covenants and terms as provided in the Settlement Agreement.  Under the Settlement Agreement, we must have advances outstanding under the Facility of no greater than $125 million as of September 30, 2010.  Under the terms of the Settlement Agreement, we calculate the advances outstanding under the Facility after consideration of amortization and pre-payments in the next scheduled distribution to the lenders, and as of September 30, 2010 the Company’s advances outstanding, calculated in accordance with the Settlement Agreement, was approximately $116 million (the GAAP outstanding balance of $136 million less approximately $20 million of pre-payments scheduled for settlement on October 10, 2010).
 
Under the Settlement Agreement, we must maintain an overcollateralization ratio of at least 115%.  As of September 30, 2010, our overcollateralization ratio was 152%.  As a BDC, we are limited in the amount of leverage it can incur and is required to meet a coverage ratio of total asset to total senior securities of at least 200% before incurring new debt.  As of September 30, 2010, our asset coverage ratio was 246%.
 
Under the terms of the Settlement Agreement, the Lender Parties will pay to the Company $2 million provided all outstanding advances and accrued interest under the LFSA are repaid in full on or before February 28, 2011.  As this payment is contingent on the repayment of the Facility, the Company has not currently recorded such settlement payment as a receivable or income.  At the date the Facility is repaid in accordance with the Settlement Agreement, the Company will recognize the settlement payment from the Lending Parties as income.
 
The Company believes it has sufficient cash and liquid assets (both those securing the Facility and those not included in the collateral securing by the Facility) which could be sold, potentially at a loss, to generate cash to fund normal operations and dividend distributions as well as any Facility outstanding balance that may exist at February 28, 2011 or any interim date by which a maximum advances outstanding balance is calculated.  The Company may enter into a new agreement with other lenders or into alternative financing arrangements with another lender.
 
We estimate that the portfolio of loans securing the Facility will be required to generate an annual rate of return of approximately 1% to cover annual interest payments on obligations incurred under the Facility.
 
The weighted average daily debt balance for the three months ended September 30, 2010 and 2009 was approximately $141 million and $231 million, respectively. For the three months ended September 30, 2010 and 2009, the weighted average interest rate on weighted average outstanding borrowings was approximately 4% and 5% respectively, which excludes the amortization of deferred financing costs and facility and program fees on unfunded balances. As of September 30, 2010, we had restricted cash balances of approximately $20 million which we maintained in accordance with the terms of the Facility.
 
We are currently using any income generated by the assets collateralizing the Facility to pay principal, interest and other expenses of the Facility – despite the fact that, if we want to remain a RIC and continue to be afforded favorable tax treatment for U.S. federal income tax purposes, we are required to distribute to the shareholders substantially all of our investment company taxable income, including the net amounts generated by the collateralized assets. These collateralized assets with a market value of approximately $196 million represent approximately 58% of our total assets (at fair value) at September 30, 2010 and contributed approximately 38% of the Company’s investment income for the quarter ended September 30, 2010. Because we are using net interest income earned on the assets securing the Facility to amortize the Facility during the amortization period (which the Company has challenged as being wrongfully commenced), we may need to sell other assets not pledged to the Facility, potentially at a loss, in order to generate sufficient cash to make the required dividend distributions necessary to maintain our RIC status. In addition, at maturity, we may be required to sell or transfer the remaining assets securing the Facility, potentially at a loss, to repay any remaining outstanding borrowings. Any such asset sale could adversely affect our business, liquidity, financial condition and results of operations. We expect that our cash on hand, liquid investments, and cash generated from operations, including income earned from investments and any income distributions made by Katonah Debt Advisors, our wholly-owned portfolio company, will be adequate to meet our liquidity needs and distribution requirements over the next twelve months.
 
However, if we are unable to renew or replace the Facility, our liquidity may be significantly reduced. If these conditions continue for a prolonged period of time, or worsen in the future, we could lose key employees and our business prospects could be negatively impacted. Even if we are able to renew or replace the Facility, such new debt capital may be at a higher cost and/or on less favorable terms and conditions than the Facility. In addition, equity capital is, and may continue to be, difficult to raise because, subject to limited exceptions, we may not issue and sell shares of our common stock at a price below NAV without stockholder approval and issuing equity at depressed stock prices can be dilutive to our stockholders. These factors and our inability to raise additional capital to date have resulted in a reduction in new originations, curtailed our ability to grow and have had a negative impact on our liquidity and operating results. The continued inability to raise additional capital could further constrain our liquidity, negatively impact our business prospects, cause the departure of key employees and negatively impact our operating results.
 
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COMMITMENTS AND OFF-BALANCE SHEET ARRANGEMENTS
 
We are a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the needs of our investment in portfolio companies. Such instruments include commitments to extend credit and may involve, in varying degrees, elements of credit risk in excess of amounts recognized on our balance sheet. Prior to extending such credit, we attempt to limit our credit risk by conducting extensive due diligence, obtaining collateral where necessary and negotiating appropriate financial covenants. As of both September 30, 2010 and December 31, 2009, we had committed to make a total of approximately $2 million and $2 million, respectively, of investments in various revolving senior secured loans, of which approximately $320,000 had been funded as of September 30, 2010 and $640,000 had been funded as of December 31, 2009. As of September 30, 2010 and December 31, 2009, we had no investments in delayed draw senior secured loans.

In October 2007, Katonah Debt Advisors entered into a letter agreement (the “Letter Agreement”) with Bear Stearns & Co. Inc. (“Bear Stearns”) in connection with a warehouse credit line established to fund the initial accumulation of assets for three CLO funds, pursuant to which agreement Katonah Debt Advisors undertook certain “first loss” commitments with respect to potential losses on assets purchased using the warehouse credit line. Such “first loss” commitments relate to (i) losses (if any) as a result of individual loan investments being ineligible for purchase by a new CLO Fund (typically due to a payment default on such loan) when such fund formation is completed or (ii) if a new CLO Fund has not been completed before the expiration of the related warehouse credit line, the loss (if any, and net of any accumulated interest income) on the resale of loans and debt securities funded by such warehouse credit line.
 
Under the Letter Agreement, Katonah Debt Advisors also engaged Bear Stearns to structure and raise three CLO funds to be managed by Katonah Debt Advisors (directly or indirectly through a services contract with an affiliate of Katonah Debt Advisors).  While one of these funds, the Katonah 2007-1 CLO Fund, in which Kohlberg Capital invested approximately $29 million to acquire all of the shares of the most junior class of securities, was completed, neither of the other 2008 CLO Funds were successfully raised.
 
As a result, pursuant to the Letter Agreement, both Katonah Debt Advisors and J.P. Morgan Securities Inc. (“JPMorgan”) (f/k/a Bear Stearns & Co. Inc.) asserted claims against each other and defenses thereto with respect to potential “first loss” payments. Without admitting any liability or wrongdoing, Katonah Debt Advisors and JPMorgan agreed to compromise and settle all of the disputes, issues and claims between them relating to the agreements in exchange for an agreement to terminate all obligations and liabilities of Katonah Debt Advisors and of JPMorgan under the existing agreements relating to the 2008 CLO Funds, payment by Katonah Debt Advisors of an aggregate of $6 million in installments over a period of one year and the forfeiture by Katonah Debt Advisors of the net interest income earned through the settlement date on the warehoused assets. In December 2008, Katonah Debt Advisors entered into a settlement and termination agreement with JPMorgan reflecting the settlement terms described above.
 
As a result of this settlement, Katonah Debt Advisors recognized a $6 million settlement cost and write-off of previously accrued net interest income on warehoused assets of approximately $4 million for the year ended December 31, 2008.  We recognized the impact of this settlement and forfeiture of warehouse income as a non-cash reduction to the unrealized appreciation of our value of its investment in Katonah Debt Advisors and contributed additional equity to Katonah Debt Advisors. Consequently, this settlement is not expected to have a material impact on Kohlberg Capital's net investment income or quarterly dividend.

CRITICAL ACCOUNTING POLICIES
 
The financial statements are based on the selection and application of critical accounting policies, which require management to make significant estimates and assumptions. Critical accounting policies are those that are both important to the presentation of our financial condition and results of operations and require management’s most difficult, complex, or subjective judgments. Our critical accounting policies are those applicable to the valuation of investments and certain revenue recognition matters as discussed below.
 
Basis of Presentation

The accompanying unaudited financial statements have been prepared on the accrual basis of accounting in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information.  Accordingly, they do not include all of the information and footnotes required for annual financial statements. The unaudited interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto in the Company’s Form 10-K for the fiscal year ended December 31, 2009, as filed with the Commission.

 
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Accounting Standards Codification. In June 2009, the FASB issued a pronouncement establishing the FASB Accounting Standards Codification (“ASC”) as the source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with GAAP. The ASC reorganized existing U.S. accounting and reporting standards issued by the FASB and other related private sector standard setters into a single source of authoritative accounting principles arranged by topic. The standard explicitly recognizes rules and interpretive releases of the SEC under federal securities laws as authoritative GAAP for SEC registrants. The ASC supersedes all existing U.S. accounting standards; all other accounting literature not included in the ASC (other than SEC guidance for publicly-traded companies) is considered non-authoritative. The ASC was effective on a prospective basis for interim and annual reporting periods ending after September 15, 2009. The adoption of the ASC changed our references to U.S. GAAP accounting standards but did not impact our results of operations, financial position or liquidity.
 
Valuation of Portfolio Investments
 
The most significant estimate inherent in the preparation of our financial statements is the valuation of investments and the related amounts of unrealized appreciation and depreciation of investments recorded.
 
Value, as defined in Section 2(a)(41) of 1940 Act, is generally (1) the market price for those securities for which a market quotation is readily available and (2) for all other securities and assets, fair value as determined in good faith by our Board of Directors pursuant to a valuation methodology approved by our Board of Directors. Our valuation policy is intended to provide a consistent basis for determining the fair value of the portfolio based on the nature of the security, the market for the security and other considerations including the financial performance of the portfolio company. Because of the inherent uncertainty of valuation, the Board of Directors’ determined values may differ materially from the values that would have been used had a ready market existed for the investments.
 
We are, for GAAP purposes, an investment company under the American Institute of Certified Public Accountants’ Audit and Accounting Guide for Investment Companies. As a result, we reflect our investments on our balance sheet at their estimated fair value with unrealized gains and losses resulting from changes in fair value reflected as a component of unrealized gains or losses on our statements of operations. Fair value is the amount that would be received to sell the investments in an orderly transaction between market participants at the measurement date (i.e., the exit price). Additionally, we do not consolidate majority or wholly-owned and controlled investments.
 
Effective January 1, 2008 we adopted Fair Value Measurements and Disclosures . Among other things, this standard requires enhanced disclosures about financial instruments carried at fair value. See Note 4 to the financial statements for the additional information about the level of market observability associated with investments carried at fair value.
 
We have valued our investments, in the absence of observable market prices, using the valuation methodology described below applied on a consistent basis. For some investments little market activity may exist; management’s determination of fair value is then based on the best information available in the circumstances, and may incorporate management’s own assumptions and involves a significant degree of management’s judgment.
 
Our investments in CLO Fund securities are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the CLO Funds which are approaching or are past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions to the class of securities owned by us, or (ii) the NAV of the CLO Funds which are approaching or are past the end of their reinvestment period and therefore are selling assets and/or using principal repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there are negligible net cash distributions to the class of securities owned by us, or (iii) a discounted cash flow model for more recent CLO Funds that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities or preferred shares to those in which we have invested. We recognize unrealized appreciation or depreciation on our investments in CLO Fund securities as comparable yields in the market change and/or based on changes in NAVs or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investments. We determine the fair value of our investments in CLO Fund securities on an individual security-by-security basis.
 
Our investment in Katonah Debt Advisors is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis of comparable asset management companies. Katonah Debt Advisors is classified as a Level III investment (as described below). Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.

 
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Fair values of other equity investments for which market prices are not observable are determined by reference to public market or private transactions or valuations for comparable companies or assets in the relevant asset class and or industry when such amounts are available. Generally these valuations are derived by multiplying a key performance metric of the investee company or asset (e.g., EBITDA) by the relevant valuation multiple observed for comparable companies or transactions, adjusted by management for differences between the investment and the referenced comparable. If the fair value of such investments cannot be valued by reference to observable valuation measures for comparable companies, then the primary analytical method used to estimate the fair value is a discounted cash flow method and/or cap rate analysis. A sensitivity analysis is applied to the estimated future cash flows using various factors depending on the investment, including assumed growth rates (in cash flows), capitalization rates (for determining terminal values) and appropriate discount rates to determine a range of reasonable values or to compute projected return on investment.
 
We derive fair value for our illiquid loan investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach, and also consider recent loan amendments or other activity specific to the subject asset as described above. Other significant assumptions, such as coupon and maturity, are asset-specific and are noted for each investment in the Schedules of Investments. Our Board of Directors may consider other methods of valuation to determine the fair value of investments as appropriate in conformity with GAAP.
 
The determination of fair value using this methodology takes into consideration a range of factors, including but not limited to the price at which the investment was acquired, the nature of the investment, local market conditions, trading values on public exchanges for comparable securities, current and projected operating performance and financing transactions subsequent to the acquisition of the investment. This valuation methodology involves a significant degree of management’s judgment.
 
After our adoption of Fair Value Measurements and Disclosures, investments measured and reported at fair value are classified and disclosed in one of the following categories:
 
 
Level I – Unadjusted quoted prices are available in active markets for identical investments as of the reporting date. The type of investments included in Level I include listed equities and listed securities. As required by Fair Value Measurements and Disclosures , the Company does not adjust the quoted price for these investments, even in situations where the Company holds a large position and a sale could reasonably affect the quoted price.
 
 
Level II – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. Such inputs may be quoted prices for similar assets or liabilities, quoted markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full character of the financial instrument, or inputs that are derived principally from, or corroborated by, observable market information. Investments which are generally included in this category include illiquid corporate loans and bonds and less liquid, privately held or restricted equity securities for which some level of recent trading activity has been observed.
 
 
Level III – Pricing inputs are unobservable for the investment and includes situations where there is little, if any, market activity for the investment. The inputs may be based on the Company’s own assumptions about how market participants would price the asset or liability or may use Level II inputs, as adjusted, to reflect specific investment attributes relative to a broader market assumption. These inputs into the determination of fair value may require significant management judgment or estimation. Even if observable market data for comparable performance or valuation measures (earnings multiples, discount rates, other financial/valuation ratios, etc.) are available, such investments are grouped as Level III if any significant data point that is not also market observable (private company earnings, cash flows, etc.) is used in the valuation methodology.
 
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and it considers factors specific to the investment. Substantially all of our investments are classified as Level III.
 
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Interest Income
 
Interest income, adjusted for amortization of premium and accretion of discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. We generally place a loan on non-accrual status and cease recognizing interest income on such loan or security when a loan or security becomes 90 days or more past due or if we otherwise do not expect the debtor to be able to service its debt obligations. Non-accrual loans remain in such status until the borrower has demonstrated the ability and intent to pay contractual amounts due or such loans become current.  As of September 30, 2010, five issuers representing 2% of our total investments were on non-accrual status.  As of December 31, 2009, eight issuers representing 2% of our total investments were on non-accrual status.
 
Dividend Income from CLO Fund Securities
 
We generate dividend income from our investments in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by Katonah Debt Advisors and selective investments in securities issued by funds managed by other asset management companies. Our CLO Fund securities are subordinate to senior bond holders who typically receive a fixed rate of return on their investment. The CLO Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the fund less payments made to senior bond holders, fund expenses and management fees) is paid to the holders of the CLO Fund’s subordinated securities or preferred shares. The level of excess spread from CLO Fund securities can be impacted by the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund bond liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary significantly. In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants may lead to the temporary suspension or deferral of cash distributions to us. We make estimated interim accruals of such dividend income based on recent historical distributions and CLO Fund performance and adjust such accruals on a quarterly basis to reflect actual distributions.
 
For non-junior class CLO Fund securities, such as our investment in the class B-2L notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR index.
 
Dividends from Affiliate Asset Manager
 
We record dividend income from our affiliate asset manager on the declaration date, which represents the ex-dividend date.
 
Payment in Kind Interest
 
We may have loans in our portfolio that contain a payment-in-kind (“PIK”) provision. PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain our RIC status, this non-cash source of income must be paid out to stockholders in the form of dividends, even though we have not yet collected the cash.
 
Fee Income
 
Fee income includes fees, if any, for due diligence, structuring, commitment and facility fees, and, if any, for transaction services and management services rendered by us to portfolio companies and other third parties. Commitment and facility fees are generally recognized as income over the life of the underlying loan, whereas due diligence, structuring, transaction service and management service fees are generally recognized as income when the services are rendered.
 
Management Compensation
 
We may, from time to time, issue stock options or restricted stock under the Kohlberg Capital Amended and Restated 2006 Equity Incentive Plan to officers and employees for services rendered to us. We follow Compensation-Stock Compensation, a method by which the fair value of options or restricted stock is determined and expensed. We use a Binary Option Pricing Model (American, call option) to establish the expected value of all stock option grants.
 
We are internally managed and therefore do not incur management fees payable to third parties.
 
United States Federal Income Taxes
 
We have elected and intend to continue to qualify for the tax treatment applicable to RICs under Subchapter M of the Internal Revenue Code (“Code”) and, among other things, intend to make the required distributions to our stockholders as specified therein. In order to qualify as a RIC, we are required to timely distribute to our stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income, to the extent required.

 
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Dividends
 
Dividends and distributions to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the Board of Directors each quarter and is generally based upon the earnings estimated by management for the period and year.
 
We have adopted a dividend reinvestment plan that provides for reinvestment of our distributions on behalf of our stockholders, unless a stockholder “opts out” of the plan to receive cash in lieu of having their dividends automatically reinvested in additional shares of our common stock.
 
Recent Accounting Pronouncements
 
On April 9, 2009, Accounting Standards Codification — Interim Disclosures about Fair Value of Financial Instruments was issued. This standard requires disclosures about financial instruments, including fair value, carrying amount, and method and significant assumptions used to estimate the fair value. We adopted this standard as of June 30, 2009 and the adoption of this standard did not affect our financial statement disclosures.
 
Two-Class Method of Presenting Earnings Per Share. In June 2008, Accounting Standards Codification – Determining Whether Instruments Granted in Share-based Payment Transactions are Participating Securities was issued. This standard requires companies to include unvested share-based payment awards that contain non-forfeitable rights to dividends in the computation of earnings per share pursuant to the two-class method. This standard is effective for financial statements issued for the years beginning after December 15, 2008, and interim periods within those years. We adopted this standard beginning with our financial statements ended March 31, 2009 and, as required, applied this standard retroactively to all reported periods. The adoption of this standard did not have a material impact on our calculations of earnings per share.
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
Interest Rate Risk
 
Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest earning assets and our interest expense incurred in connection with our interest bearing debt and liabilities. Changes in interest rates can also affect, among other things, our ability to acquire and originate loans and securities and the value of our investment portfolio.
 
Our investment income is affected by fluctuations in various interest rates, including LIBOR and prime rates. As of September 30, 2010, approximately 95% of our loans at fair value in our portfolio were at floating rates with a spread to an interest rate index such as LIBOR or the prime rate. We generally expect that future portfolio investments will predominately be floating rate investments. As of September 30, 2010, we had $137 million of borrowings outstanding at a floating rate tied to prevailing commercial paper rates plus a margin of 0.85%.
 
Because we borrow money to make investments, our net investment income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest the funds borrowed. Accordingly, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds would increase, which could reduce our net investment income if there is not a corresponding increase in interest income generated by floating rate assets in our investment portfolio.
 
We have analyzed the potential impact of changes in interest rates on interest income net of interest expense. Assuming that our balance sheet at September 30, 2010 were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical increase or decrease of a 1% change in interest rates would correspondingly affect net interest income proportionately by approximately $1.2 million over a one-year period. Correspondingly, a hypothetical increase or decrease of a 1% change in interest rates would correspondingly affect net interest expense proportionately by approximately $1.2 million over a one-year period. Because most of our investments at September 30, 2010 were floating rate with a spread to an index similar to our Facility, we would not expect a significant impact on our net interest spread.
 
Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect a net change in assets resulting from operations or net income. Accordingly, no assurances can be given that actual results would not materially differ from the potential outcome simulated by this estimate.

 
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We did not hold any derivative financial instruments for hedging purposes as of September 30, 2010. In connection with the Facility established on February 14, 2007 and as amended on October 1, 2007, our special purpose subsidiary may be required under certain circumstances to enter into interest rate swap agreements or other interest rate hedging transactions.
 
Portfolio Valuation
 
We carry our investments at fair value, as determined in good faith by our Board of Directors pursuant to a valuation methodology approved by our Board of Directors. Investments for which market quotations are generally readily available are generally valued at such market quotations. Investments for which there is not a readily available market value are valued at fair value as determined in good faith by our Board of Directors under a valuation policy and consistently applied valuation process. However, due to the inherent uncertainty of determining the fair value of investments that cannot be marked to market, the fair value of our investments may differ materially from the values that would have been used had a ready market existed for such investments. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the value realized on these investments to be different than the valuations that are assigned. The types of factors that we may take into account in fair value pricing of our investments include, as relevant, the nature and realizable value of any collateral, third party valuations, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business, comparison to publicly-traded securities, recent sales of or offers to buy comparable companies, and other relevant factors.
 
We engaged VRC, an independent valuation firm, to provide third-party valuation estimates for 39% of our investments at fair value as of December 31, 2009. VRC’s valuation estimates were considered as one of the relevant data inputs in our determination of fair value. Though the Board of Directors did not engage VRC to provide valuation estimates for any of the assets in the Company’s portfolio as of September 30, 2010, the Board of Directors intends to continue to engage an independent valuation firm in the future to provide certain valuation services, including the review of certain portfolio assets, as part of our annual year end valuation process.
 
Item 4
Controls and Procedures
 
Evaluation of Disclosure Controls and Procedures
 
As required by Rule 13a-15 under the Exchange Act, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and implementing possible controls and procedures.
 
The Company’s management, under the supervision and with the participation of various members of management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this report.  Based upon that evaluation, our CEO and CFO have concluded that our current disclosure controls and procedures are effective as of the end of the period covered by this report.
 
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Changes in Internal Control Over Financial Reporting
 
Restatement of Previously Issued Financial Statements
 
Following the Company’s engagement of Grant Thornton LLP as its independent registered public accounting firm in January 2010, the Company’s management and Audit Committee concluded that the Company would have to restate its previously issued financial statements for the year ended December 31, 2008 (and the quarterly periods included in such year) as well as the quarterly periods ended March 31, 2009 and June 30, 2009. Management and the Audit Committee determined that such restatement was necessary to correct errors in the application of accounting for the fair value of the Company’s illiquid investments and the revenue recognition for certain non-cash PIK investments, which errors impacted the amount of unrealized gains (losses) reported for the Company's illiquid investments, which affects the calculation of the Company's NAV and net income, and also impacted net investment income as well as the cost basis and the net change in unrealized appreciation on certain non-cash PIK investments. The error related to fair value measurements was identified through the use and weighting of additional valuation techniques and a broader consideration of secondary market inputs.  In addition, management concluded that the Company had material weaknesses in its internal control over financial reporting related to errors in the application of accounting for the fair value of the Company’s illiquid investments and the revenue recognition for certain non-cash payment-in-kind (“PIK”) investments as of the end of each of the years ended December 31, 2009 and December 31, 2008 and each of the quarterly periods included in such years.
 
 Changes in Internal Control Over Financial Reporting
 
To address these material weaknesses, during the quarter ended June 30, 2010, the Company revised its valuation procedures for estimating the fair value of its illiquid investments and has revised its accounting for non-cash PIK interest income. Under the revised valuation procedures, management considers the following factors in determining the appropriate weighting of market inputs: comparability of the market input relative to the investment being valued, the source of the information, the correlation of the data to any actual observed transaction activity, the internal consistency of such inputs to other inputs noted by the same source, and other qualitative factors that may impact the reliability, comparability, or weighting of the inputs. In addition, for investments which earn non-cash PIK interest and for which there has been a substantial decline in fair value due to underlying credit concerns for an extended period, the Company no longer accrues such non-cash PIK interest as income.  Management continues to implement the foregoing measures which it believes will effectively remediate these material weaknesses.  As of the date of filing of this report, the Company believes that it has modified its accounting for the fair value of its investments and its accounting for its non-cash PIK investments to the extent necessary to prepare the financial statements and the other financial information contained herein. As the Company continues to evaluate and work to improve its internal control over financial reporting, including remediating the material weakness with respect to maintaining effective controls over its independent review of the fair value model valuation process, management may determine to take additional measures to address the material weakness and other control deficiencies.

 
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PART II. Other Information
 
Item 1.
Legal Proceedings
 
Legal Action against Lenders under the Loan Funding and Servicing Agreement Governing The Facility
 
On August 28, 2009 the Company and KCAP Funding (the Borrower under the LFSA) filed a complaint in the Supreme Court of the State of New York against the Agent and the other lender parties to the LFSA. The Company’s discussions with the Agent to reach a mutually agreeable amendment to the LFSA were terminated prior to the filing of the complaint. The complaint reflects the Company’s and the Borrower’s beliefs that the Agent’s declaration of a Termination Date (which ended the revolving period and commenced the amortization period) was wrongful and the Agent’s assertion of the occurrence of a Termination Event based upon certain alleged breaches by the Company and the Borrower of their obligations under the LFSA is without merit. The complaint also seeks to clarify the Company’s and the Borrower’s rights and obligation under the LFSA.
 
On September 20, 2010, the Company entered into a Forbearance and Settlement Agreement (the “Settlement Agreement”) with the Agent and Lender Parties (the Company, Agent and lenders collectively known as the “Parties”) in order to settle all outstanding claims of the Parties under the LFSA and all related claims asserted by the Parties in connection with the Litigation noted above as filed by us.
 
Pursuant to the Settlement Agreement, the Lender Parties have agreed to refrain, during the Forbearance Term, from the exercise of any right or remedy relating to any termination events alleged by any of the Lender Parties to have occurred (or that resulted from or otherwise relates to an event that occurred or a condition that existed prior to the date of the Settlement Agreement and that was known or reasonably should have been known to the Lender Parties) under the LFSA and the related documents on or before September 20, 2010, the date of the Settlement Agreement. 
 
Under the terms of the Settlement Agreement, (i) the Lender Parties have agreed to pay to the Company $2 million so long as all outstanding advances under the LFSA and accrued interest thereon (exclusive of any fees or expenses, including attorneys’ fees and indemnification payments, of the Lender Parties incurred in connection with the Litigation or any other fees or expenses payable to the Lender Parties under the LFSA or the related documents other than fees or expenses incurred in connection with or related to the exercise of remedies following the occurrence of a Forbearance Term termination event) are repaid in full on or before February 28, 2011, (ii) from September 10, 2010 through the end of the Forbearance Term, interest on advances outstanding under the LFSA will accrue at the rate provided for under the LFSA prior to the occurrence of a termination event (equal to 0.85% above the prevailing commercial paper rate, or prevailing LIBOR if the commercial paper market is at any time unavailable), (iii) upon execution of the Settlement Agreement, the Company has agreed to release the Lender Parties from any and all claims that any of them may have under the LFSA and the related documents or the Litigation, (iv) upon payment in full in accordance with the Agreement of all outstanding advances and accrued interest thereon and all other amounts due to the Lender Parties under the LFSA, the Lender Parties have agreed to release us from any and all claims that any of them may have under the LFSA and the related documents or the Litigation and (v) the parties have stipulated to dismiss the Litigation, with prejudice, by stipulation of discontinuance filed with the Court on September 21, 2010.
 
Class Actions against the Company and Certain Directors and Officers
 
The Company and certain directors and officers are named as defendants in three putative class actions pending in the Southern District of New York brought by shareholders of the Company and filed in December 2009 and January 2010. The complaints in these three actions allege violations of Sections 10 and 20 of the Exchange Act based on the Company's disclosures of its year-end 2008 and first- and second-quarter 2009 financial statements.  The Company believes that the above-mentioned suit is without merit and will defend each vigorously.
 
In addition, the Company and certain directors and officers were also named as defendants in a derivative action filed on March 2, 2010 in the Supreme Court of New York, County of New York. The complaint in this action purported to state causes of action for breaches of fiduciary duties, unjust enrichment, abuse of control, gross mismanagement, and corporate waste.  On October 19, 2010, the court dismissed the complaint, and found that plaintiff had not alleged that any of the Company’s directors “‘knowingly’ misrepresented or permitted others to misrepresent KCAP’s financial condition,” or that the directors were confronted with “red flags” sufficient to put them on notice of potential problems with KCAP’s investment valuations.  The court afforded the plaintiff 45 days in which to move for leave to amend his complaint, after which, without such a motion, the dismissal will become final.
 
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SEC Investigation
 
On January 11, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an informal inquiry. The focus of the inquiry concerns the valuation methodology and procedures used by the Company to value its investments. On April 30, 2010, the SEC Staff advised the Company that a formal order of private investigation had been issued and that the informal inquiry was now a formal investigation. A subpoena has been issued to the Company in connection with the formal investigation. The subpoena requests that the Company produce documents and/or testimony that primarily relates to the valuation methodology and procedures used by the Company to value its investments. Since January 2010, the Company has been providing documents in response to the informal inquiry and the subpoena. The Company is cooperating fully with the SEC Staff’s investigation. The Company cannot predict the outcome of, or the timeframe for, the conclusion of this investigation.
 
Except as set forth above, neither the Company, nor any of its subsidiaries, is currently a party to any material legal proceedings, 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 condition, or results of the Company’s operations.
 
Item 1A.
Risk Factors
 
Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2009 and our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2010 contain important risk factors that could cause our actual results to differ materially from our historical experience or our present expectations and projections. If any such risks (or any risks we face) occur, our business, financial condition and results of our operations could be materially adversely affected. In such case, the NAV and trading price of our common stock could decline, and you may lose all or part of your investment. There have been no material changes from the risk factors previously disclosed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2010, which should be read together with the other risk factors and information disclosed elsewhere in this Quarterly Report on Form 10-Q and our other reports filed with the SEC.
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
None.
 
Item 3.
Defaults Upon Senior Securities
 
None.
 
Item 4.
[Removed and Reserved]
 
None.
 
Item 5.
Other Information
 
None.
 
Item 6.
Exhibits
 
Exhibit
   
Number
  
Description of Document
     
10.1*
 
Forbearance and Settlement Agreement dated September 20, 2010, by and among the Company, BMO Capital Markets Corp., and the other lender parties thereto.
     
31.1*
  
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
31.2*
  
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
32.1*
  
Certification of Chief Executive Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
32.2*
  
Certification of Chief Financial Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
*
Submitted herewith.
 
 
76

 
 
Table of Contents
 
SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
       
KOHLBERG CAPITAL CORPORATION
       
Date: November 9, 2010
     
By
 
/s/ Dayl W. Pearson
               
Dayl W. Pearson
               
President and Chief Executive Officer
               
(Principal Executive Officer)
       
Date: November 9, 2010
     
By
 
/s/ Michael I. Wirth
               
Michael I. Wirth
               
Chief Financial Officer, Chief Compliance Officer, Secretary and Treasurer
               
(Principal Financial and Accounting Officer)
 
* * * * *
 
 
77

 
 
Table of Contents
 
Exhibit Index
 
Exhibit
   
Number
  
Description of Document
     
10.1*
  
Forbearance and Settlement Agreement dated September 20, 2010, by and among the Company, BMO Capital Markets Corp., and the other lender parties thereto.
     
31.1*
  
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
31.2*
  
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
32.1*
  
Certification of Chief Executive Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
32.2*
  
Certification of Chief Financial Officer Pursuant to 18 U. S. C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*
Submitted herewith.
 
 
78