| You should consider carefully the risks described below and all other information contained in this Annual Report, including our financial statements and the related notes and the schedules and exhibits to this Annual Report |
| Risks Related to Our Business and Financial Results Because there is generally no established market for which to value our investments, our board of directors’ determination of the value of our investments may differ materially from the values that a ready market or third party would attribute to these investments |
| Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our board |
| We are not permitted to maintain a general reserve for anticipated loan losses |
| Instead, we are required by the 1940 Act to specifically value each individual investment and to record any unrealized depreciation for any asset that we believe has decreased in value |
| Because there is typically no public market for the loans and equity securities of the companies in which we invest, our board will determine the fair value of these loans and equity securities on a quarterly basis pursuant to our valuation policy |
| Because of 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 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 |
| 19 ______________________________________________________________________ [47]Table of Contents We make loans to and invest in primarily privately owned middle market companies, which may default on their loans, thereby reducing or eliminating the return on our investments |
| Our portfolio primarily consists of investments in privately owned middle market businesses in the form of secured debt, unsecured debt, and equity |
| Compared to larger publicly owned firms, these companies may be more vulnerable to economic downturns, may have more limited access to capital and higher funding costs, may have a weaker financial position, and may need more capital to expand or compete |
| These businesses also may experience substantial variations in operating results |
| They may face intense competition, including from companies with greater financial, technical and marketing resources |
| Typically, their success depends on the management talents and efforts of an individual or a small group of persons |
| The death, disability or resignation of any of their key employees could harm their financial condition |
| Furthermore, some of these companies do business in regulated industries and could be affected by changes in government regulation |
| Accordingly, these factors could impair their cash flow or result in other events, such as bankruptcy, which could limit their ability to repay their obligations to us, and may adversely affect the return on, or the recovery of, our investment in these businesses |
| Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in any collateral for the loan |
| Accordingly, advances made to these types of customers may entail a higher risk of loss than advances made to customers who are able to utilize traditional credit sources |
| These conditions may also make it difficult for us to obtain repayment of our loans |
| Furthermore, there is generally no publicly available information about such companies and we must rely on the diligence of our employees to obtain information in connection with our investment decisions |
| If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision and we may lose money on our investments |
| If the industries in which we invest experience adverse economic or business conditions, our operating results may be negatively impacted |
| From time to time we target specific industries in which to invest on a recurring basis, which could cause a high concentration of our portfolio in a specific industry |
| At December 31, 2005, approximately 25dtta7prca of our portfolio consisted of customers in the communications industry |
| If our customers in the communications industry, or any other industry in which our portfolio is or may become concentrated, suffer due to adverse business conditions or due to economic slowdowns or downturns, we will be more vulnerable to losses in our portfolios and our operating results may be negatively impacted |
| Our financial results could be negatively affected if Broadview Networks Holdings, Inc |
| At December 31, 2005, our largest portfolio investment was Broadview Networks Holdings, Inc |
| (“Broadview”), which totaled dlra95dtta1 million at fair value, or 8dtta7prca of the fair value of our investments |
| Broadview accounted for approximately 14dtta6prca of our operating income during 2005 |
| We own preferred securities of Broadview, which entitle us to a preferred claim of approximately dlra90 million, plus dividends, which accumulate at an annual rate of 12prca on our preferred claim |
| We currently recognize these dividends as income on a quarterly basis; however, our ability to record income related to these accumulating dividends will be dependent upon the performance and value of Broadview |
| Our financial results could be negatively affected if this portfolio company fails to perform as expected or if we are unable to recognize these dividends as income on a quarterly basis |
| Economic downturns or recessions could impair our customers’ ability to repay our loans, harm our operating results and reduce our volume of new loans |
| Many of our customers may be susceptible to economic downturns or recessions and may be unable to repay our loans during these periods |
| Therefore, our non-performing assets are likely to increase and the value of our 20 ______________________________________________________________________ [48]Table of Contents portfolio is likely to decrease during these periods |
| Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments |
| Economic downturns or recessions could lead to financial losses in our portfolio and decreases in revenue, net income, and assets |
| An economic downturn could disproportionately impact the industries in which we invest, causing us to be more vulnerable to losses in our portfolio, which could negatively impact our financial results |
| Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us |
| These events could prevent us from increasing our loan originations and investments and negatively impact our financial results |
| If we fail to qualify as a regulated investment company, we will have to pay corporate-level taxes on our income and our income available for distribution would be reduced |
| We have elected to be taxed for federal income tax purposes as a regulated investment company under Subchapter M of the Internal Revenue Code |
| If we can meet certain requirements, including source of income, asset diversification and distribution requirements, as well as if we continue to qualify as a business development company, we will qualify to be a regulated investment company and will not have to pay corporate-level taxes on any income we distribute to our stockholders as dividends, allowing us to substantially reduce or eliminate our corporate-level tax liability |
| Covenants and provisions in our credit facilities limit the ability of our subsidiaries and our securitization trusts to make distributions to us, which could affect our ability to make distributions to our stockholders and to maintain our status as a regulated investment company |
| In addition, we may have difficulty meeting the requirement to make distributions to our stockholders 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 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 |
| Moreover, if we do not distribute at least 98prca of our income, we generally will be subject to a 4prca excise tax |
| See “Regulation as a Business Development Company” and “Certain US Federal Income Tax Considerations—Taxation as a Regulated Investment Company |
| ” Because we will distribute substantially all of our income to our stockholders, we will continue to need additional capital to finance our growth |
| If additional capital is unavailable or not available on favorable terms, our ability to grow will be impaired |
| In order to satisfy the requirements applicable to a regulated investment company, we intend to distribute to our stockholders substantially all of our income |
| We may elect to make deemed distributions to our stockholders of certain net capital gains |
| In addition, as a business development company, we generally will be required to meet a coverage ratio of total assets to total senior securities, which includes all of our borrowings and any preferred stock we may issue in the future, of at least 200prca |
| This requirement limits the amount that we may borrow |
| Because we will continue to need capital to grow our loan and investment portfolio, this limitation may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so |
| Additional financing may not be available on favorable terms, if at all, or may be restricted by the terms of our debt facilities |
| If additional funds are not available to us, we could be forced to curtail or cease our new lending and investment activities, and our net asset value could decrease |
| We have substantial indebtedness and servicing our indebtedness could reduce funds available to grow our business or make new investments |
| As of December 31, 2005, we had dlra541dtta1 million of outstanding borrowings under our debt facilities |
| As of December 31, 2005, the weighted average annual interest rate on all of our outstanding borrowings was 5dtta26prca |
| In order for us to make our annual interest payments on indebtedness, we must achieve annual returns on our 21 ______________________________________________________________________ [49]Table of Contents December 31, 2005 total assets of at least 2dtta29prca |
| Our ability to service our debt depends largely on our financial performance and will be subject to prevailing economic conditions and competitive pressures |
| In addition, our subsidiaries have sold some of our loans to trusts that serve as the vehicles for our securitization facilities, and we do not hold legal title to these assets |
| However, we bear losses of principal and interest from defaults on these loans held by the trusts up to the amount of our retained interest in the trusts, which was approximately dlra139dtta2 million as of December 31, 2005 |
| Our securitization facilities impose financial and operating covenants that restrict our business activities, including limitations that could hinder our ability to finance additional loans and investments or to make the distributions required to maintain our status as a regulated investment company under Subchapter M of the Internal Revenue Code |
| 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 |
| Leverage is generally considered a speculative investment technique |
| If the value of our consolidated assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more than it otherwise would have had we not utilized leverage |
| Conversely, if the value of our consolidated assets decreases, leveraging would cause net asset value attributable to our common stock to decline more than it otherwise would have had we not utilized leverage |
| Similarly, any increase in our consolidated revenue in excess of consolidated interest expense on our borrowed funds would cause our net income to increase more than it would without the use of leverage |
| Any decrease in our consolidated revenue would cause net income to decline more than it would have had we not borrowed funds and could negatively affect our ability to make distributions on our common stock |
| As a business development company, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior securities, which include all of our borrowings and any preferred stock we may issue in the future, of at least 200prca |
| If this ratio declines below 200prca, we may not be able to incur additional debt and may need to sell a portion of our investments to repay some debt when it is disadvantageous to do so, and we may not be able to make distributions |
| At December 31, 2005, this ratio was approximately 218prca |
| In addition, because substantially all of our assets and liabilities are priced using various short-term rate indices, including one-month to six-month LIBOR, commercial paper rates and the prime rate, the timing of changes in market interest rates or in the relationship between interest rate indices could affect the interest rates earned on interest-earning assets differently than the interest rates paid on interest-bearing liabilities, which could result in a decrease in net income |
| If we are not able to refinance our debt or able to do so on favorable terms, we would not be able to operate our business in the ordinary course |
| Our Commercial Loan Trust 2005-2 dlra250dtta0 million warehouse credit facility with Merrill Lynch is scheduled to expire on September 30, 2006 and our Commercial Loan Funding Trust Facility dlra250dtta0 million warehouse financing facility through Three Pillars Funding, LLC is scheduled to terminate on November 7, 2007, but is subject to annual renewal and may be extended under certain circumstances |
| The next renewal date for this facility is July 28, 2006 |
| We cannot assure you that we will be able to extend the terms of these facilities or obtain sufficient funds to repay any amounts outstanding under these facilities before they expire or terminate either from a replacement facility or alternative debt or equity financing |
| If we are unable to repay amounts outstanding under these facilities and are declared in default or are unable to refinance these facilities, we would not be able to operate our business in the regular course |
| 22 ______________________________________________________________________ [50]Table of Contents You may not receive 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 |
| See “Regulation as a Business Development Company |
| ” 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 |
| We cannot assure you that you will receive any distributions or distributions at a particular level |
| We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income |
| In accordance with generally accepted accounting principles and tax regulations, we include in income certain amounts that we have not yet received in cash, such as contracted payment-in-kind interest, which represents contractual interest added to the loan balance and due at the end of the loan term |
| The increases in loan balances as a result of contracted payment-in-kind arrangements are included in income in advance of receiving cash payment, and are separately identified on our consolidated statements 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 regulated investment company tax treatment |
| See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” and “Certain US Federal Income Tax Considerations—Taxation as a Regulated Investment Company |
| ” If we fail to manage our growth, our financial results could be adversely affected |
| We have expanded our operations significantly since purchasing our business from First Union National Bank in 1998 |
| Our growth has placed and could continue to place significant strain on our management systems and resources |
| We must continue to refine and expand our marketing capabilities, our management of the investment process, our access to financing resources and our technology |
| As we grow, we must continue to hire, train, supervise and manage new employees |
| We may not develop sufficient lending and administrative personnel and management and operating systems to manage our expansion effectively |
| If we are unable to manage our growth, our operations could be adversely affected and our financial results could be adversely affected |
| If we need to sell any of our investments, we may not be able to do so at a favorable price and, as a result, we may suffer losses |
| Our investments are usually subject to contractual or legal restrictions on resale or are otherwise illiquid because there is usually no established trading market for such investments |
| The illiquidity of most of our investments may make it difficult for us to dispose of them at a favorable price, and, as a result, we may suffer losses |
| In addition, if we were forced to immediately liquidate some or all of the investments in our portfolio, the proceeds of such liquidation could be significantly less than the current value of such investments |
| We may be required to liquidate some or all of our portfolio to meet our debt service obligations or to maintain our qualification as a business development company and as a regulated investment company if we do not satisfy one or more of the applicable criteria under the respective regulatory frameworks |
| Our business depends on our key personnel |
| Our future success depends to a significant extent on the continued services of Bryan J Mitchell, our Chief Executive Officer, Steven F Tunney, our President and Chief Operating Officer, B Hagen Saville, one of our Executive Vice Presidents, and Robert J Merrick, our Chief Credit Officer, as well as other key personnel |
| The loss of any of these key employees would likely have a significant detrimental effect on our business |
| Mitchell, Mr |
| Saville, Mr |
| Tunney or Mr |
| Merrick cease to be actively involved in our 23 ______________________________________________________________________ [51]Table of Contents management, the lender under one of our warehouse financing facilities could, absent a waiver or cure, replace us as the servicer of the loans and declare a default |
| Saville cease to be an executive officer of MCG actively involved in the management of MCG, the lender of our dlra50dtta0 million revolving unsecured credit facility could, absent a waiver or cure, declare a default |
| We currently do not have employment agreements with Messrs |
| Tunney, Saville, or Merrick |
| Fluctuations in interest rates could adversely affect our income |
| A significant increase in market interest rates could harm our ability to attract new customers and originate new loans and investments, our non-performing assets could increase and the value of our portfolio could decrease because our floating-rate loan customers may be unable to meet higher payment obligations |
| Conversely, a significant decrease in interest rates would reduce our net income, all other things being equal |
| A decrease in interest rates may reduce net income despite the increased demand for our capital that the decrease in interest rates may produce |
| Approximately 70dtta9prca of the loans in our portfolio, based on amounts outstanding at cost as of December 31, 2005, were at variable rates determined on the basis of a benchmark LIBOR or prime rate and approximately 29dtta1prca were at fixed rates |
| From January 1, 2004 to December 31, 2005, the three-month LIBOR has increased from 1dtta15prca to 4dtta54prca |
| Regulations governing our operation as a business development company will affect our ability to, and the way in which we, raise additional capital |
| We have issued debt securities and may issue debt securities and/or borrow money from banks or other financial institutions, which we refer to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act |
| Under the provisions of the 1940 Act, we are permitted, as a business development company, to issue senior securities only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200prca after each issuance of senior securities |
| If that happens, we may be required to sell a portion of our investments and, depending on the nature of our leverage, repay a portion of our indebtedness at a time when such sales may be disadvantageous |
| We are not generally able to issue and sell our common stock at a price below net asset value per share |
| We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our board of directors determines that such sale is in the best interests of MCG and its stockholders, and our stockholders approve such sale |
| In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any distributing commission or discount) |
| Any change in regulation of our business could negatively affect the profitability of our operations |
| Changes in the laws, regulations or interpretations of the laws and regulations that govern business development companies, regulated investment companies or non-depository commercial lenders could significantly affect our operations and our cost of doing business |
| We are subject to federal, state and local laws and regulations and are subject to judicial and administrative decisions that affect our operations |
| If these laws, regulations or decisions change, or if we expand our business into jurisdictions that have adopted more stringent requirements than those in which we currently conduct business, we may have to incur significant expenses in order to comply or we might have to restrict 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 generally cannot be treated as qualifying 24 ______________________________________________________________________ [52]Table of Contents assets |
| This result is dictated by the definition of “eligible portfolio company” under the 1940 Act, which in part focuses on whether a company has outstanding marginable securities |
| Amendments promulgated in 1998 by the Board of Governors of the Federal Reserve System 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 under the relevant portion of the “eligible portfolio company” criteria |
| The SEC has proposed rules to include any company that does not have a class of securities listed on a national securities exchange or association in the definition of “eligible portfolio company |
| ” 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 final 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 that otherwise qualifies as an “eligible portfolio company” under the 1940 Act |