| ALLIED CAPITAL CORP Item 1A Risk Factors |
| Investing in Allied Capital involves a number of significant risks relating to our business and investment objective |
| As a result, there can be no assurance that we will achieve our investment objective |
| Our portfolio of investments is illiquid |
| We generally acquire our investments directly from the issuer in privately negotiated transactions |
| The majority of the investments in our portfolio are subject to certain restrictions on resale or otherwise have no established trading market |
| We typically exit our investments when the portfolio company has a liquidity event such as a sale, recapitalization, or initial public offering of the company |
| The illiquidity of our investments may adversely affect our ability to dispose of debt and equity securities at times when we may need to or when it may be otherwise advantageous for us to liquidate such investments |
| In addition, if we were forced to immediately liquidate some or all of the investments in the portfolio, the proceeds of such liquidation could be significantly less than the current value of such investments |
| Investing in private companies involves a high degree of risk |
| Our portfolio primarily consists of long-term loans to and investments in middle market private companies |
| Investments in private businesses involve a high degree of business and financial risk, which can result in substantial losses for us in those investments and accordingly should be considered speculative |
| There is generally no publicly available 18 _________________________________________________________________ information about the companies in which we invest, and we rely significantly on the diligence of our employees and agents to obtain information in connection with our investment decisions |
| If we are unable to identify all material information about these companies, among other factors, we may fail to receive the expected return on our investment or lose some or all of the money invested in these companies |
| In addition, these businesses may have shorter operating histories, narrower product lines, smaller market shares and less experienced management than their competition and may be more vulnerable to customer preferences, market conditions, loss of key personnel, or economic downturns, which may adversely affect the return on, or the recovery of, our investment in such businesses |
| As an investor, we are subject to the risk that a portfolio company may make a business decision that does not serve our interest, which could decrease the value of our investment |
| Deterioration in a portfolio company’s financial condition and prospects may be accompanied by deterioration in any collateral for the loan |
| Substantially all of our portfolio investments are recorded at fair value as determined in good faith by our Board of Directors and, as a result, there is uncertainty regarding the value of our portfolio investments |
| At December 31, 2005, portfolio investments recorded at fair value were approximately 90prca of our total assets |
| Pursuant to the requirements of the 1940 Act, we value substantially all of our investments at fair value as determined in good faith by our Board of Directors on a quarterly basis |
| Since there is typically no readily available market value for the investments in our portfolio, our Board of Directors determines in good faith the fair value of these investments pursuant to a valuation policy and a consistently applied valuation process |
| There is no single standard for determining fair value in good faith |
| As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a consistently applied valuation process for the types of investments we make |
| Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses; we are instead required by the 1940 Act to specifically value each individual investment on a quarterly basis and record unrealized depreciation for an investment that we believe has become impaired, including where collection of a loan or realization of an equity security is doubtful, or when the enterprise value of the portfolio company does not currently support the cost of our debt or equity investment |
| Enterprise value means the entire value of the company to a potential buyer, including the sum of the values of debt and equity securities used to capitalize the enterprise at a point in time |
| We will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and/or our equity security has appreciated in value |
| Without a readily available market value and because of the inherent uncertainty of valuation, the fair value of our investments determined in good faith by the Board of Directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material |
| Our net asset value could be affected if our determination of the fair value of our investments is materially different than the value that we ultimately realize |
| We adjust quarterly the valuation of our portfolio to reflect the Board of Directors’ determination of the fair value of each investment in our portfolio |
| Any changes in fair value are recorded in our statement of operations as net change in unrealized appreciation or depreciation |
| Economic recessions or downturns could impair our portfolio companies and harm our operating results |
| Many of the companies in which we have made or will make investments may be susceptible to economic slowdowns or recessions |
| An economic slowdown may affect the ability of a company to repay our loans or engage in a liquidity event such as a sale, recapitalization, or initial public offering |
| Our nonperforming assets are likely to increase and the value of our portfolio is likely to decrease during these periods |
| Adverse economic conditions also may decrease the value of collateral securing some of our loans |
| These conditions could lead to financial losses in our portfolio and a decrease in our revenues, net income, and assets |
| Our business of making private equity investments and positioning them for liquidity events also may be affected by current and future market conditions |
| The absence of an active senior lending environment or a slowdown in middle market merger and acquisition activity may slow the amount of private equity investment activity generally |
| As a result, the pace of our investment activity may slow |
| In addition, 19 _________________________________________________________________ significant changes in the capital markets could have an effect on the valuations of private companies and on the potential for liquidity events involving such companies |
| This could affect the timing of exit events in our portfolio and could negatively affect the amount of gains or losses upon exit |
| Our borrowers may default on their payments, which may have a negative effect on our financial performance |
| We primarily make long-term unsecured, subordinated loans and invest in equity securities, which may involve a higher degree of repayment risk |
| We primarily invest in companies that may have limited financial resources, may be highly leveraged and may be unable to obtain financing from traditional sources |
| Numerous factors may affect a borrower’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry, or negative economic conditions |
| A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans or foreclosure on its secured assets, which could trigger cross defaults under other agreements and jeopardize our portfolio company’s ability to meet its obligations under the loans or debt securities that we hold |
| In addition, our portfolio companies may have, or may be permitted to incur, other debt that ranks senior to or equally with our securities |
| This means that payments on such senior-ranking securities may have to be made before we receive any payments on our loans or debt securities |
| Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in any related collateral and may have a negative effect on our financial results |
| Our private finance investments may not produce current returns or capital gains |
| Our private finance investments are typically structured as unsecured debt securities with a relatively high fixed rate of interest and with equity features such as conversion rights, warrants, or options, or as buyouts of companies where we invest in debt and equity securities |
| As a result, our private finance investments are generally structured to generate interest income from the time they are made and may also produce a realized gain from an accompanying equity feature |
| We cannot be sure that our portfolio will generate a current return or capital gains |
| Our financial results could be negatively affected if a significant portfolio investment fails to perform as expected |
| Our total investment in companies may be significant individually or in the aggregate |
| As a result, if a significant investment in one or more companies fails to perform as expected, our financial results could be more negatively affected and the magnitude of the loss could be more significant than if we had made smaller investments in more companies |
| At December 31, 2005, our largest investments at value were in Advantage Sales & Marketing, Inc |
| and Business Loan Express, LLC (BLX) and represented 16dtta4prca and 8dtta9prca of our total assets, respectively, and each individually represented 10dtta0prca of our total interest and related portfolio income for the year ended December 31, 2005 |
| BLX is a lender under the Small Business Administration 7(a) Guaranteed Loan Program |
| Our financial results could be negatively affected if government funding for, or regulations related to, this program change |
| We borrow money, which magnifies the potential for gain or loss on amounts invested and may increase the risk of investing in us |
| Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in our securities |
| We borrow from and issue senior debt securities to banks, insurance companies, and other lenders |
| Lenders of these senior securities have fixed dollar claims on our consolidated assets that are superior to the claims of our common shareholders |
| If the value of our consolidated assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more sharply than it would have had we not leveraged |
| Conversely, if the value of our consolidated assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged |
| Similarly, any increase in our consolidated income in excess of consolidated interest payable on the borrowed funds would cause our net income to increase more than it would without the leverage, while any decrease in our consolidated income would cause net income to decline more sharply than it would have had we not borrowed |
| Such a decline could negatively affect our ability to make common stock dividend payments |
| Leverage is generally considered a speculative investment technique |
| Our revolving line of credit, notes payable and debentures contain financial and operating covenants that could restrict our business activities, including our ability to declare dividends if we default under certain provisions |
| 20 _________________________________________________________________ At December 31, 2005, we had dlra1dtta3 billion of outstanding indebtedness bearing a weighted average annual interest cost of 6dtta5prca |
| In order for us to cover these annual interest payments on indebtedness, we must achieve annual returns on our assets of at least 2dtta1prca |
| We may not borrow money unless we maintain asset coverage for indebtedness of at least 200prca, which may affect returns to shareholders |
| We must maintain asset coverage for total borrowings of at least 200prca |
| Our ability to achieve our investment objective may depend in part on our continued ability to maintain a leveraged capital structure by borrowing from banks, insurance companies or other lenders on favorable terms |
| There can be no assurance that we will be able to maintain such leverage |
| If asset coverage declines to less than 200prca, we may be required to sell a portion of our investments when it is disadvantageous to do so |
| As of December 31, 2005, our asset coverage for senior indebtedness was 309prca |
| Changes in interest rates may affect our cost of capital and net investment income |
| 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 these funds |
| As a result, 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 would reduce our net investment income |
| We use a combination of long-term and short-term borrowings and equity capital to finance our investing activities |
| We utilize our revolving line of credit as a means to bridge to long-term financing |
| We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations |
| Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act |
| We have analyzed the potential impact of changes in interest rates on interest income net of interest expense |
| Assuming that the balance sheet as of December 31, 2005, were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical immediate 1prca change in interest rates would have affected net income by less than 1prca over a one year horizon |
| 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 net increase in net assets resulting from operations, or net income |
| Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate |
| We will continue to need additional capital to grow because we must distribute our income |
| We will continue to need capital to fund growth in our investments |
| Historically, we have borrowed from financial institutions and have issued equity securities to grow our portfolio |
| A reduction in the availability of new debt or equity capital could limit our ability to grow |
| We must distribute at least 90prca of our taxable ordinary income, which excludes realized net long-term capital gains, to our shareholders to maintain our regulated investment company status |
| As a result, such earnings will not be available to fund investment originations |
| In addition, as a business development company, we are generally required to maintain a ratio of at least 200prca of total assets to total borrowings, which may restrict our ability to borrow in certain circumstances |
| We expect to continue to borrow from financial institutions and issue additional debt and equity securities |
| If we fail to obtain funds from such sources or from other sources to fund our investments, it could limit our ability to grow, which could have a material adverse effect on the value of our common stock |
| Loss of regulated investment company tax treatment would substantially reduce net assets and income available for dividends |
| We have operated so as to qualify as a regulated investment company under Subchapter M of the Code |
| If we meet source of income, asset diversification, and distribution requirements, we will not be subject to corporate level income taxation on income we timely distribute to our stockholders as dividends |
| We would cease to qualify for such tax treatment if we were unable to comply with these requirements |
| In addition, we may have difficulty meeting the requirement to make distributions to our shareholders because in certain cases we may recognize income before or without receiving cash representing such income |
| If we fail to qualify as a regulated investment company, we will 21 _________________________________________________________________ have to pay corporate-level taxes on all of our income whether or not we distribute it, which would substantially reduce the amount of income available for distribution to our stockholders |
| Even if we qualify as a regulated investment company, we generally will be subject to a corporate-level income tax on the income we do not distribute |
| If we do not distribute at least 98prca of our annual taxable income in the year earned, we generally will be required to pay an excise tax on amounts carried over and distributed to shareholders in the next year equal to 4prca of the amount by which 98prca of our annual taxable income exceeds the distributions for the current year |
| There is a risk that you may not receive dividends or distributions |
| We intend to make distributions on a quarterly basis to our stockholders |
| We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time |
| In addition, due to the asset coverage test applicable to us as a business development company, we may be limited in our ability to make distributions |
| Also, our credit facilities limit our ability to declare dividends if we default under certain provisions |
| If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of our status as a regulated investment company |
| In addition, in accordance with US generally accepted accounting principles and tax regulations, we include in income certain amounts that we have not yet received in cash, such as contractual payment-in-kind interest, which represents contractual interest added to the loan balance that becomes due at the end of the loan term, or the accrual of original issue discount |
| The increases in loan balances as a result of contractual payment-in-kind arrangements are included in income in advance of receiving cash payment and are separately included in the change in accrued or reinvested interest and dividends in our consolidated statement of cash flows |
| Since we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90prca of our investment company taxable income to maintain our status as a regulated investment company |
| We operate in a competitive market for investment opportunities |
| We compete for investments with a large number of private equity funds and mezzanine funds, other business development companies, investment banks, other equity and non-equity based investment funds, and other sources of financing, including specialty finance companies and traditional financial services companies such as commercial banks |
| Some of our competitors may have greater resources than we do |
| Increased competition would make it more difficult for us to purchase or originate investments at attractive prices |
| As a result of this competition, sometimes we may be precluded from making otherwise attractive investments |
| Our business depends on our key personnel |
| We depend on the continued services of our executive officers and other key management personnel |
| If we were to lose any of these officers or other management personnel, such a loss could result in inefficiencies in our operations and lost business opportunities, which could have a negative effect on our business |
| Changes in the law or regulations that govern us could have a material impact on us or our operations |
| We are regulated by the SEC and the Small Business Administration |
| In addition, changes in the laws or regulations that govern business development companies, regulated investment companies, real estate investment trusts, and small business investment companies may significantly affect our business |
| Any change in the law or regulations that govern our business could have a material impact on us or our operations |
| Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations also are subject to change, which may have a material effect on our operations |
| Our ability to invest in private companies may be limited in certain circumstances |
| If we are to maintain our status as a business development company, we must not acquire any assets other than “qualifying assets” unless, at the time of and after giving effect to such acquisition, at least 70prca of our total assets are qualifying assets |
| If we acquire debt or equity securities from an issuer that has outstanding marginable securities at the time we make an investment, these acquired assets cannot be treated as qualifying assets |
| This result is dictated by the definition of “eligible portfolio company” under the 1940 Act, which in part looks to whether a company has outstanding marginable securities |
| 22 _________________________________________________________________ Amendments promulgated in 1998 by the Federal Reserve expanded the definition of a marginable security under the Federal Reserve’s margin rules to include any non-equity security |
| Thus, any debt securities issued by any entity are marginable securities under the Federal Reserve’s current margin rules |
| As a result, the staff of the SEC has raised the question as to whether a private company that has outstanding debt securities would qualify as an “eligible portfolio company” under the 1940 Act |
| Until the question raised by the staff of the SEC pertaining to the Federal Reserve’s 1998 change to its margin rules has been addressed by legislative, administrative or judicial action, we intend to treat as qualifying assets only those debt and equity securities that are issued by a private company that has no marginable securities outstanding at the time we purchase such securities or those that otherwise qualify as an “eligible portfolio company” under the 1940 Act |
| In November 2004, the SEC issued proposed rules to correct the unintended consequence of the Federal Reserve’s 1998 margin rule amendments of apparently limiting the investment opportunities of business development companies |
| In general, the SEC’s proposed rules would define an eligible portfolio company as any company that does not have securities listed on a national securities exchange or association |
| We currently do not believe that these proposed rules will have a material adverse effect on our operations |
| Results may fluctuate and may not be indicative of future performance |
| Our operating results may fluctuate and, therefore, you should not rely on current or historical period results to be indicative of our performance in future reporting periods |
| Factors that could cause operating results to fluctuate include, but are not limited to, variations in the investment origination volume and fee income earned, variation in timing of prepayments, variations in and the timing of the recognition of net realized gains or losses and changes in unrealized appreciation or depreciation, the level of our expenses, the degree to which we encounter competition in our markets, and general economic conditions |
| Our common stock price may be volatile |
| The trading price of our common stock may fluctuate substantially |
| The price of the common stock may be higher or lower than the price you pay for your shares, depending on many factors, some of which are beyond our control and may not be directly related to our operating performance |
| These factors include, but are not limited to, the following: • price and volume fluctuations in the overall stock market from time to time; • significant volatility in the market price and trading volume of securities of business development companies or other financial services companies; • volatility resulting from trading in derivative securities related to our common stock including puts, calls, long-term equity anticipation securities, or LEAPs, or short trading positions; • changes in laws or regulatory policies or tax guidelines with respect to business development companies or regulated investment companies; • actual or anticipated changes in our earnings or fluctuations in our operating results or changes in the expectations of securities analysts; • general economic conditions and trends; • loss of a major funding source; or • departures of key personnel |