As filed with the Securities and Exchange Commission on October 22, 2009

Registration No. 333-161764

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

 

 

Amendment No. 2

to

Form N-14

 

REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

Pre-Effective Amendment No. 1 x

Post-Effective Amendment No. o

(Check appropriate box or boxes)

 

 

 

 

Prospect Capital Corporation

(Exact Name of Registrant as Specified in Charter)

 

10 East 40th Street, 44th Floor

New York, NY 10016

(Address of Principal Executive Offices)

 

Telephone Number: (212) 448-0702

(Area Code and Telephone Number)

 

John F. Barry III

Brian H. Oswald

c/o Prospect Capital Management, LLC

10 East 40th Street, 44th Floor

New York, NY 10016

(212) 448-0702

(Name and Address of Agent for Service)

 

 

 

 

Copies to:

 

 

Approximate Date of Proposed Public Offering:  As soon as practicable after this registration statement becomes effective and upon completion of the merger described in the enclosed document.

 

 

 

 

CALCULATION OF REGISTRATION FEE

 

 

 

 

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 

SUBJECT TO COMPLETION — DATED OCTOBER  , 2009

 

MERGER PROPOSED — YOUR VOTE IS VERY IMPORTANT

 

Dear Shareholder,

 

On August 3, 2009, Prospect Capital Corporation (“Prospect”) and Patriot Capital Funding, Inc. (“Patriot”) announced a strategic business combination in which Patriot will merge with and into Prospect. If the merger is completed, holders of Patriot common stock will have a right to receive 0.3992 shares of Prospect common stock for each share of Patriot common stock held immediately prior to the merger. As more fully described in this document, the merger agreement requires that Patriot declare a “final” dividend prior to the closing of the merger in an amount equal to its undistributed investment company taxable income (if any), and the exchange ratio will be adjusted for any such dividend that Patriot may declare prior to closing. In connection with the merger, Prospect expects to issue approximately 8.6 million shares of common stock.

 

The market value of the merger consideration will fluctuate with the market price of Prospect common stock. The following table shows the closing sale prices of Prospect common stock and Patriot common stock as reported on the NASDAQ Global Select Market on July 31, 2009, the last trading day before public announcement of the merger, and on          , 2009, the last practicable trading day before the distribution of this document. This table also shows the implied value of the merger consideration proposed for each share of Patriot common stock, which was calculated by multiplying the closing price of Prospect common stock on those dates by 0.3992, the exchange ratio (which will be adjusted for any dividends declared by Patriot prior to the closing).

 

 

The merger is intended to qualify as a “reorganization” within the meaning of Section 368(a) of the Internal Revenue Code of 1986, or the “Code,” and holders of Patriot common stock are not expected to recognize any gain or loss for United States federal income tax purposes upon the exchange of shares of Patriot common stock for shares of Prospect common stock, except with respect to any cash received in lieu of fractional shares of Prospect common stock.

 

The market prices of both Prospect and Patriot common stock will fluctuate before the merger. You should obtain current stock price quotations for Prospect and Patriot common stock. Prospect common stock is quoted on the NASDAQ Global Select Market under the symbol “PSEC.” Patriot common stock is traded on the NASDAQ Global Select Market under the symbol “PCAP.”

 

At a special meeting of Patriot shareholders, Patriot shareholders will be asked to vote on the adoption of the merger agreement described in this document. Adoption of the merger agreement requires the affirmative vote of the holders of a majority of the outstanding shares of Patriot common stock entitled to vote.

 

After careful consideration, the board of directors of Patriot unanimously recommends that its shareholders vote FOR adoption of the merger agreement.

 

This document describes the special meeting, the merger, the documents related to the merger and other related matters. Please carefully read this entire document, including “Risk Factors” beginning on page 20 for a discussion of the risks relating to the proposed merger. You also can obtain information about Prospect and Patriot from documents that each has filed with the Securities and Exchange Commission.

 

Sincerely,

 

 

RICHARD P. BUCKANAVAGE
President and Chief Executive Officer
Patriot Capital Funding, Inc.

 

The Securities and Exchange Commission has not approved or disapproved the Prospect common stock to be issued under this document or determined if this document is accurate or adequate. Any representation to the contrary is a criminal offense.

 

The date of this document is          , 2009, and it is first being mailed or otherwise delivered to Patriot shareholders on or about          , 2009.

 

Notice of Special Meeting of Shareholders

 

To the Shareholders:

 

On November 18, 2009, Patriot Capital Funding, Inc. (“Patriot”) will hold a special meeting of shareholders (the “special meeting”) at the offices of Edwards Angell Palmer & Dodge LLP at Three Stamford Plaza, 301 Tresser Boulevard, Stamford, Connecticut 06901, at 10:30 a.m. (Eastern Daylight Time) to consider and vote upon the following matters:

 

1. A proposal to adopt the Agreement and Plan of Merger (the “merger agreement”), dated as of August 3, 2009, by and between Patriot and Prospect Capital Corporation (“Prospect”), as such merger agreement may be amended from time to time; and

 

2. A proposal to approve the adjournment of the special meeting, if necessary or appropriate, to solicit additional proxies, in the event that there are not sufficient votes at the time of the special meeting to adopt the foregoing proposal.

 

You have the right to receive notice of, and to vote at, the special meeting if you were a shareholder of record at the close of business on October 21, 2009. Whether or not you expect to be present in person at the special meeting, please sign the enclosed proxy and return it promptly in the envelope provided. You may also vote by calling the proxy solicitor at (866) 796-3439. Instructions are shown on the proxy card. If you are present at the special meeting, you may change your vote at any time.

 

The Patriot board of directors has unanimously approved the merger and the merger agreement and unanimously recommends that Patriot shareholders vote “FOR” approval of the merger agreement and the merger and “FOR” the adjournment of the Patriot special meeting if necessary or appropriate to permit further solicitation of proxies.

 

By order of the board of directors,

 

William E. Alvarez, Jr.
Secretary

 

Westport, CT

          , 2009

 

 

 

 

 

TABLE OF CONTENTS

 

 

 

 

 

 

 

 

THE ALTMAN GROUP, INC.
1200 Wall Street West, 3rd Fl.
Lyndhurst, NJ 07071
Call Toll-Free (866) 796-3439
Email: proxyinfo@altmangroup.com

 

 

SUMMARY

 

Information about the Companies

 

Terms of the Merger Agreement

 

Patriot Shareholders Will Receive Shares of Prospect’s Common Stock in the Proposed Merger

										Implied Value of One
		Prospect				Patriot				Share of Patriot
		Common Stock				Common Stock				Common Stock
Closing Price at July 31, 2009		$	10.02			$	1.95			$	4.00
Net Asset Value per Share at June 30, 2009		$	12.40			$	7.66			$	4.95
Closing Price at        , 2009		$				$				$

 

Reasons for the Proposed Merger

	•	Lack of Liquidity; Potential Impact on Tax Status.  Since Patriot can no longer borrow amounts under the Amended Securitization Facility, and because all principal, interest and fees collected from the debt investments secured by the facility must be used to repay amounts outstanding under the facility, Patriot has limited liquidity and no potential sources of free cash flow. Thus, there is no assurance that Patriot will have sufficient cash and liquid assets to fund its operations and dividend distributions to its shareholders, which failure could, among other things, result in adverse tax consequences, including possible loss of its status as a RIC under the Code. In addition, without a strategic transaction, Patriot would likely be required to seek bankruptcy protection in the relatively near future.
	•	Potential Actions by Patriot’s Lenders.  Substantially all of Patriot’s debt investments are secured under the Amended Securitization Facility. As a result of the occurrence of a termination event (i.e., default) under the Amended Securitization Facility, the lenders may, upon notice to Patriot, accelerate amounts outstanding under the facility and exercise other rights and remedies provided by the facility, including the right to sell the collateral under the facility. In such event, the Patriot board of directors is concerned that such forced sales of assets, particularly in the current economic environment, may be done at fire sale prices, thereby diminishing the amount of cash available to distribute to shareholders.
	•	Thorough Review of Strategic Alternatives.  Patriot engaged in a thorough review of the strategic alternatives available to Patriot, including, among other things, negotiations with its lenders under the Amended Securitization Facility, conversion to a bank holding company, the formation of a Small Business Investment Company subsidiary, a stock or cash merger, a significant equity investment, a refinancing of Patriot’s debt, a purchase and sale of Patriot’s assets, and a bankruptcy filing. In furtherance of the evaluation and proposal solicitation process, Patriot publicly announced that it was actively evaluating strategic alternatives (thereby putting potential strategic partners on notice that Patriot was open to discussing such alternatives with interested parties), and, at Patriot’s request, Patriot’s financial advisor, FBR Capital Markets & Co., or “FBR”, contacted 133 potential strategic partners, including business development companies, commercial finance companies, banks, private equity funds, hedge funds and other potential strategic partners, to assess whether they might be interested in pursuing a strategic transaction with Patriot. Of the 133 potential strategic partners contacted, 51 executed non-disclosure agreements with Patriot and received confidential information concerning Patriot’s business, management, assets, liabilities, financial condition and results of operations. Of those 51 potential strategic partners, 22 submitted preliminary indications of interest, and 12 were invited to perform in-depth due diligence and submit final bids, eight of which submitted final bids. Based on this lengthy and thorough process, Patriot’s board of directors believes it has explored all alternatives reasonably available to Patriot.
	•	Best Alternative Reasonably Available to Patriot.  Because Patriot publicly announced that it was actively evaluating strategic alternatives, and contacted such a large number of potential strategic partners to determine their level of interest in a strategic transaction involving Patriot, the Patriot board of directors strongly believes that, of all possible alternatives, and based on the proposed transactions submitted by potential strategic partners, the transaction with Prospect represents the best alternative that is reasonably available to Patriot. In making this determination, the Patriot board of directors considered:

	•	the existing termination event under the Amended Securitization Facility;
	•	the current financial condition of Patriot, particularly the liquidity needed to fund its operations and, potentially, to make required distributions to shareholders;
	•	the distinct possibility that Patriot will run out of available cash in the near future;

	•	the current trading price of Patriot’s common stock;
	•	the lack of progress in negotiations with lenders under the Amended Securitization Facility;
	•	the other alternatives reasonably available to Patriot;
	•	the terms of the other proposals submitted, including the proposed economic terms, the conditions to closing, the expected timing of such transactions, and the likelihood of consummation;
	•	the financial terms of the Prospect proposal, including the proposed exchange ratio and Prospect’s ability and agreement to repay the full amount of principal and interest outstanding under the Amended Securitization Facility;
	•	the fact that although the implied value of the merger consideration of $4.00 proposed for each share of Patriot common stock represented a discount to Patriot’s net asset value for the quarter ended March 31, 2009 and the anticipated net asset value for the quarter ended June 30, 2009, which was based on information available to the board at the time (which value was later confirmed), such discount was generally comparable to the discount to net asset value at which many other business development companies traded;
	•	the business and legal due diligence review of Prospect’s operations, its portfolio companies and other corporate and financial matters conducted over an extended period of time by Patriot and its legal and financial advisors;
	•	the financial strength of Prospect;
	•	the lack of a financing contingency to closing in the Prospect proposal; and
	•	the fact that no shareholder approval of Prospect’s shareholders would be required.

	•	Strategic and Business Considerations.  Because the Patriot shareholders will be shareholders in Prospect following the merger, Patriot shareholders stand to participate in the future growth and prospects of the combined businesses of Patriot and Prospect, without the limitations currently restricting the operations of Patriot. Prospect is an established company with a strong capital position and performance history. The larger equity market capitalization of the combined companies should help create earnings stability and assist Prospect in its efforts to raise capital in the public equity and debt markets.
	•	Terms of the Merger Agreement.  The exchange ratio of 0.3992 of a share of Prospect common stock to be received in exchange for each share of Patriot common stock, which is subject to certain adjustments, represents a 105% premium to the closing price of Patriot common stock on July 31, 2009, based on the closing price of Prospect common stock on that date (which was the last trading day before public announcement of the merger).
	•	Opinion of Patriot’s Financial Advisor.  The financial analysis reviewed and discussed with the board of directors of Patriot by representatives of FBR, as well as the oral opinion of FBR rendered to the board of directors of Patriot on August 3, 2009 (which was subsequently confirmed in writing by delivery of FBR’s written opinion dated the same date) with respect to the fairness, from a financial point of view, to the holders of Patriot common stock of the exchange ratio set forth in the merger agreement. See “The Merger Proposal — Opinion of Patriot’s Financial Advisor”
	•	Tax Free Treatment of Proposed Merger.  The proposed merger is expected to be treated as a tax-free reorganization under Section 368(a) of the Code. If the transaction so qualifies, Patriot’s shareholders generally will not recognize gain or loss to the extent that they receive shares of Prospect common stock in exchange for their shares of Patriot common stock. See “U.S. Federal Income Tax Consequences of the Merger.”
	•	Repayment of Amended Securitization Facility.  As part of the merger agreement, Prospect will repay (i) all principal and interest due under the Amended Securitization Facility, which amounted to $112.7 million as of September 30, 2009, and (ii) up to $1.35 million in other costs, fees and expenses payable to the lenders under the terms of the Amended Securitization Facility.

 

Risks Related to the Proposed Merger

	•	Market Price.  The market value of the per share merger consideration could decrease prior to the closing of the proposed merger if the market price of Prospect’s common stock decreases.
	•	Net Asset Value.  The net asset value per share of Patriot’s common stock, as of June 30, 2009, was $7.66, an amount higher than the implied market value of the merger consideration.
	•	Restrictions on Ability to Solicit Alternative Offers.  The restrictive non-solicitation provisions contained in the merger agreement prohibit Patriot from soliciting alternative offers from third parties, and permit Patriot to consider bona fide alternative proposals from third parties only in certain limited circumstances.
	•	Lack of Dissenters’ Rights.  There are no dissenters’ rights applicable to the proposed merger.

 

Completion of the Proposed Merger

 

Recommendation of the Board of Directors of Patriot

 

Opinion of Patriot’s Financial Advisor

 

Interests of Patriot’s Management in the Proposed Merger

	•	Cancellation of all outstanding stock options in exchange for a cash payment of $0.01 for each share of Patriot common stock for which such option is exercisable.
	•	Vesting of all unvested shares of Patriot restricted stock and, immediately prior to the effective time of the merger, cancellation of a portion of such restricted shares held by each executive officer in exchange for a cash payment from Prospect at the same value as the merger consideration in an amount sufficient to cover the federal, state and local taxes required to be withheld from the executive officer upon the vesting of the shares, with the remaining shares participating in the merger on the same basis as other shares of Patriot common stock.
	•	Employment or severance agreements providing for severance payments and benefits upon a qualifying termination of employment following a change in control. The proposed merger would constitute a “change in control” for this purpose.
	•	As of October 16, 2009, Patriot’s directors and executive officers beneficially owned in the aggregate 3,417,638 shares of Patriot’s common stock (including shares of restricted stock that will vest in connection with the consummation of the merger), representing 15.83% of Patriot’s total outstanding shares. Each of Patriot’s directors and executive officers has indicated that he intends to vote his shares in favor of the merger agreement and the proposed merger.

U.S. Federal Income Tax Consequences of the Merger

Dividends and Distributions

Dissenters’ Rights

Vote Required to Approve the Merger Agreement

 

Voting Power of Patriot’s Management

 

Conditions to the Merger

	•	no legal prohibition on completion of the merger is in effect;
	•	the registration statement, of which this document is a part, filed by Prospect with the SEC in connection with its offer and sale of shares to Patriot’s shareholders in connection with the merger is declared effective by the SEC;
	•	no pending suit, action or proceeding by any governmental entity seeking to enjoin or otherwise interfere with the merger that has a reasonable likelihood of success;
	•	receipt of payoff letters from the lenders under the Amended Securitization Facility; and
	•	receipt of an opinion from Sutherland Asbill & Brennan LLP to the effect that the merger will qualify as a “reorganization” under Section 368(a) of the Code.

 

Termination of the Merger Agreement

	•	any regulatory authority of competent jurisdiction issues a judgment, injunction, order, decree, or action permanently restraining, enjoining or otherwise prohibiting the merger, and the judgment, injunction, order, decree or other action becomes final and nonappealable;
	•	the merger is not completed prior to December 15, 2009, except that neither Patriot nor Prospect may terminate the merger agreement if its willful and material breach is the reason that the merger has not been completed;

	•	the required approval of the merger agreement by Patriot shareholders is not obtained at the special meeting; or
	•	upon a violation or breach by the other party of any agreement, covenant, representation or warranty or if any representation or warranty of either party shall have become untrue, in either case so that the conditions to the completion of the merger would be incapable of being satisfied by the closing date and such violation or breach has not been waived by the terminating party.

	•	by Prospect, prior to receipt of Patriot shareholder approval, within 10 days after the Patriot board of directors effects a change of recommendation; or, in the case an alternative proposal structured as a tender or exchange offer for Patriot common stock commenced by a person unaffiliated with the buyer is received; if the Patriot board of directors fails to issue within 10 days after the public announcement of the alternative proposal a public statement reaffirming the board recommendation and recommending that Patriot’s shareholders reject the alternative proposal; or if Patriot breaches any of the no solicitation provisions of the merger agreement; and
	•	by Patriot, if Patriot receives a superior proposal, the board authorizes Patriot to enter into an agreement to consummate the transaction contemplated by such superior proposal, and concurrently with such termination, Patriot pays the termination fee and enters into a definitive agreement to consummate the transaction contemplated by the superior proposal; or if the board effects a recommendation change in compliance with the no solicitation provisions of the merger agreement.

 

Comparison of Shareholder Rights

 

COMPARATIVE FEES AND EXPENSE RATIOS

 

Patriot and Prospect’s Expenses

		Actual								Pro Forma
		Patriot				Prospect				Combined — Prospect(1)
Shareholder transaction expenses
Sales load (as a percentage of offering price)			None(1	)			None(1	)			None(1	)
Dividend reinvestment plan expenses			None(2	)			None(2	)			None(2	)
		Actual								Pro Forma
		Patriot				Prospect				Combined — Prospect(1)(4)
Annual expenses (as a percentage of net assets attributable to common stock):
Combined base management fee and incentive fees(3)			—	(5)			6.49	%			6.90	%
Interest expense on borrowed funds			4.70	%			1.42	%			1.44	%
Other expenses			4.31	%			1.95	%			2.61	%
Total annual expenses			9.01	%			9.86	%			10.95	%

(1)		Purchases of shares of common stock of Patriot or Prospect on the secondary market are not subject to sales charges but may be subject to brokerage commissions or other charges. The table does not include any sales load (underwriting discount or commission) that shareholders may have paid in connection with their purchase of shares of Patriot or Prospect’s common stock.
(2)		The expenses of the dividend reinvestment plan are included in “other expenses.”
(3)		Prospect’s base management fee is 2% of its gross assets (which include any amount borrowed, i.e., total assets without deduction for any liabilities). The combined base management fee is zero, 3.08% and 3.40% for Actual Patriot, Actual Prospect and Pro Forma Combined-Prospect, respectively. Incentive fees are zero, 3.41% and 3.50% for Actual Patriot, Actual Prospect and Pro Forma Combined-Prospect, respectively.
(4)		Average net assets attributable to common stock for the pro forma combined is based on the summation of the Patriot and Prospect average net assets attributable to common stock less the pro forma adjustment to investments of $69.6 million.
(5)		Patriot does not have an investment adviser and is internally managed by its management team under the supervision of its board of directors. Therefore, Patriot does not pay investment advisory fees, but instead pays the operating costs associated with employing a management team to research, select and supervise its investments. As a result, the estimate of the annual expenses it incurs in connection with the employment of a management team to research, select and supervise its investments is included in the line item “Other expenses.”

		1 Year				3 Years				5 Years				10 Years
Patriot		$	90			$	260			$	416			$	755
Prospect		$	64			$	191			$	313			$	604
Pro Forma Combined — Prospect(1)		$	75			$	218			$	355			$	668

(1)		The pro forma combined row shown assumes the merger is completed.

 

SELECTED FINANCIAL DATA OF PATRIOT

		For the Six Months Ended
		June 30,								Year Ended December 31,
		2009				2008				2008				2007				2006				2005				2004
Income Statement Data:
Investment Income:
Interest income		$	16,128,632			$	21,123,051			$	40,140,087			$	37,147,275			$	25,387,709			$	13,035,673			$	4,616,665
Fees			454,698				355,784				1,409,613				1,280,361				270,176				366,830				241,870
Other investment income			8,804				420,269				749,704				534,901				848,449				46,839				—
Total Investment Income			16,592,134				21,899,104				42,299,404				38,962,537				26,506,334				13,449,342				4,858,535
Expenses:
Compensation expense			1,759,961				2,605,499				3,973,030				5,410,075				3,877,525				2,481,761				1,326,576
Consulting fees(1)			—				—				—				—				—				554,796				1,000,000
Interest expense(2)			4,363,807				3,984,753				8,158,473				7,421,596				4,332,582				3,517,989				1,504,998
Professional fees			1,346,626				670,731				1,635,519				887,021				1,045,613				730,550				192,938
Prepayment penalty(3)			—				—				—				—				—				3,395,335				—
General and administrative expense			1,501,394				1,433,523				2,807,113				2,498,724				2,229,970				1,041,030				227,208
Total Expenses			8,971,788				8,694,506				16,574,135				16,217,416				11,485,690				11,721,461				4,251,720
Net investment income			7,620,346				13,204,598				25,725,269				22,745,121				15,020,644				1,727,881				606,815
Net realized gain (loss) on investments			(12,013,473	)			(433,767	)			(882,588	)			91,601				(3,262,966	)			—				—
Net unrealized appreciation (depreciation) on investments			(16,870,174	)			(13,219,509	)			(39,992,921	)			(3,637,706	)			3,817,931				(2,965,175	)			(876,021	)
Net unrealized gain (loss) on interest rate swaps			861,737				216,783				(2,335,019	)			(775,326	)			12,961				—				—
Net income (loss)		$	(20,401,564	)		$	(231,895	)		$	(17,485,259	)		$	18,423,690			$	15,588,570			$	(1,237,294	)		$	(269,206	)
Earnings (loss) per share, basic		$	(0.97	)		$	(0.01	)		$	(0.84	)		$	0.99			$	1.10			$	(0.17	)		$	(0.07	)
Earnings (loss) per share, diluted		$	(0.97	)		$	(0.01	)		$	(0.84	)		$	0.98			$	1.10			$	(0.17	)		$	(0.07	)
Weighted average shares outstanding, basic			20,940,294				20,671,896				20,713,540				18,670,904				14,145,200				7,253,632				3,847,902
Weighted average shares outstanding, diluted			20,940,294				20,671,896				20,713,540				18,830,213				14,237,952				7,253,632				3,847,902

		For the Six Months Ended
		June 30,								Year Ended December 31,
		2009				2008				2008				2007				2006				2005				2004
Balance Sheet Data:
Total investments		$	283,929,237			$	322,410,700			$	322,370,748			$	384,725,753			$	257,812,235			$	138,302,852			$	65,766,667
Total assets			302,540,169				335,098,619				354,262,646				398,378,808				271,086,364				151,007,186				72,201,700
Total debt outstanding			137,365,363				116,100,000				162,600,000				164,900,000				98,380,000				21,650,000				42,645,458
Stockholder’s equity			160,495,644				208,621,626				180,117,170				221,597,684				164,108,629				127,152,365				27,311,918
Net asset value per common share		$	7.66			$	10.08			$	8.65			$	10.73			$	10.37			$	10.48			$	7.10
Other Data:
Weighted average yield on debt investments(4)			10.7	%			12.3	%			12.1	%			12.4	%			13.4	%			13.5	%			12.6	%
Number of portfolio companies			33				32				35				36				26				15				9
Number of employees			11				14				13				14				11				9				6

(1)		On July 27, 2005, Patriot terminated the consulting agreements pursuant to which it incurred these fees.
(2)		Patriot’s capital structure at December 31, 2004 reflected a higher percentage of leverage than it is permitted to incur as a business development company. Patriot used a portion of the net proceeds it received from its initial public offering to repay all of its outstanding indebtedness, including the $3.4 million prepayment penalty, at the time of its initial public offering. Patriot is generally only allowed to borrow amounts such that its asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing.
(3)		The prepayment penalty was incurred in connection with the repayment in full and termination of Patriot’s $120.0 million financing agreement.
(4)		Computed using actual interest income earned for the fiscal year, including amortization of deferred financing fees and original issue discount, divided by the weighted average fair value of debt investments.

 

SELECTED FINANCIAL DATA OF PROSPECT

		For the Year Ended June 30,
		2009				2008				2007				2006				2005
		(In thousands except data relating to shares, per share and number of
		portfolio companies)
Performance Data:
Interest income		$	62,926			$	59,033			$	30,084			$	13,268			$	4,586
Dividend income			22,793				12,033				6,153				3,601				3,435
Other income			14,762				8,336				4,444				—				72
Total investment income			100,481				79,402				40,681				16,869				8,093
Interest and credit facility expenses			(6,161	)			(6,318	)			(1,903	)			(642	)			—
Investment advisory expense			(26,705	)			(20,199	)			(11,226	)			(3,868	)			(1,808	)
Other expenses			(8,452	)			(7,772	)			(4,421	)			(3,801	)			(3,874	)
Total expenses			(41,318	)			(34,289	)			(17,550	)			(8,311	)			(5,682	)
Net investment income			59,163				45,113				23,131				8,558				2,411
Realized and unrealized gains (losses)			(24,059	)			(17,522	)			(6,403	)			4,338				6,340
Net increase in net assets from operations		$	35,104			$	27,591			$	16,728			$	12,896			$	8,751
Per Share Data:
Net increase in net assets from operations(1)		$	1.11			$	1.17			$	1.06			$	1.83			$	1.24
Distributions declared per share		$	(1.62	)		$	(1.59	)		$	(1.54	)		$	(1.12	)		$	(0.38	)
Average weighted shares outstanding for the period			31,559,905				23,626,642				15,724,095				7,056,846				7,055,100
Assets and Liabilities Data:
Investments		$	547,168			$	497,530			$	328,222			$	133,969			$	55,030
Other assets			119,857				44,248				48,280				4,511				48,879
Total assets			667,025				541,778				376,502				138,480				103,909
Amount drawn on credit facility			124,800				91,167				—				28,500				—
Amount owed to related parties			6,713				6,641				4,838				745				77
Other liabilities			2,916				14,347				71,616				965				865
Total liabilities			134,429				112,155				76,454				30,210				942
Net assets		$	532,596			$	429,623			$	300,048			$	108,270				102,967
Investment Activity Data:
Number of portfolio companies at period end			30				29	(2)			24	(2)			15				6
Acquisitions		$	98,305			$	311,947			$	167,255			$	83,625			$	79,018
Sales, repayments, and other disposals		$	27,007			$	127,212			$	38,407			$	9,954			$	32,083
Weighted-Average Yield at end of period(3)			13.7	%			15.5	%			17.1	%			17.0	%			21.3	%

(1)		Per share data is based on average weighted shares for the period.
(2)		Includes a net profits interest in Charlevoix Energy Trading LLC (“Charlevoix”), remaining after loan was paid.
(3)		Includes dividends from certain equity investments.

 

UNAUDITED SELECTED PRO FORMA CONSOLIDATED FINANCIAL DATA

		For the
		Year Ended
		June 30, 2009
		(In thousands except
		data relating to
		earnings per share)
Performance Data:
Interest and dividend income		$	120,865
Fee income			1,508
Other income			15,100
Total investment income			137,473
Interest expense			(7,947	)
Base management and income incentive fees			(38,024	)
General and administrative expenses			(14,368	)
Total expenses			(60,339	)
Net investment income			77,134
Realized and unrealized gains (losses)			(81,855	)
Net income		$	(4,721	)
Per Share Data:
Earnings per share		$	(0.09	)
Average weighted shares outstanding for the period			54,348
		At June 30, 2009
Assets and Liabilities Data:
Investment securities		$	743,491
Cash			69,979
Other assets			13,512
Total assets			826,982
Borrowings			111,959
Other liabilities			15,235
Total liabilities			127,194
Net assets		$	699,788

 

UNAUDITED PRO FORMA PER SHARE DATA

		Comparative Per Share Data
										Pro Forma				Per
										Combined —				Equivalent
		Prospect				Patriot				Prospect				Patriot Share(3)
Year ended June 30, 2009:
Income from continuing operations per share		$	1.11			$	(1.81	)		$	(0.09	)		$	(0.04	)
Distributions per share declared to date(1)		$	1.6175			$	0.58			$	1.6175			$	0.65
Net asset value per share(2)		$	12.40			$	7.66			$	11.06			$	4.42
Average weighted shares outstanding for the period (in thousands)			31,560				20,847				54,348

(1)		The historical distributions declared per share for Prospect and Patriot is computed by dividing the distributions declared for the year ended June 30, 2009 by their respective historical weighted average shares outstanding. The pro forma combined distributions declared is the distributions per share as declared by Prospect.
(2)		The historical net asset value per share for Prospect and Patriot as of June 30, 2009 are as previously reported by the companies. The pro forma combined net asset value per share as of June 30, 2009 is computed by dividing the pro forma combined net assets by the pro forma combined number of shares outstanding. In addition, the pro forma combined net asset value per share as of June 30, 2009 reflects the write down of the fair value of Patriot’s investments at June 30, 2009 to Prospect’s determination of the fair value of these investments. Prospect, in conjunction with an independent valuation agent, has determined that a fair value of Patriot’s investments at June 30, 2009 that approximates the total purchase price to be paid by Prospect to acquire Patriot in connection with the proposed merger transaction, which is approximately $69.6 million lower than the fair value of those investments as previously determined by Patriot, is appropriate.
(3)		The Patriot equivalent pro forma per share amount is calculated by multiplying the combined pro forma share amounts by the common stock exchange ratio of 0.3992.

 

Risks Related to the Merger

 

Patriot and Prospect have agreed to a fixed exchange ratio, and, as a result, the shares of Prospect common stock to be issued in the merger may have a market value that is lower than expected.

 

The exchange ratio of 0.3992 of a share of Prospect common stock for each share of Patriot common stock was fixed on August 3, 2009, the time of the signing of the merger agreement, and is not subject to adjustment based on changes in the trading price of Prospect or Patriot common stock before the closing of the proposed merger. As a result, the market price of Prospect’s common stock at the time of the merger may vary significantly from the price on the date the merger agreement was signed or from the price on either the date of this document or the date of the special meeting. These variances may arise due to, among other things:

 

 

These factors are generally beyond the control of Prospect and Patriot. It should be noted that during the 12-month period ending September 30, 2009, the closing price per share of Prospect’s common stock varied from a low of $6.29 to a high of $13.08. Historical trading prices are not necessarily indicative of future performance.

 

The proposed merger is subject to the receipt of payoff letters from the Amended Securitization Facility lenders that could delay completion of the proposed merger, cause abandonment of the merger or have other negative effects on Patriot and Prospect.

 

Completion of the merger is subject to the receipt of payoff letters from the Amended Securitization Facility lenders. A substantial delay in obtaining such payoff letters, the failure to obtain such payoff letters or the imposition of unfavorable terms or conditions in connection with the receipt of such payoff letters could have an adverse effect on the business, financial condition or results of operations of Patriot and Prospect, or may cause the abandonment of the merger. In this regard, the merger agreement obligates Prospect to pay off (i) all principal and interest due under the Amended Securitization Facility, which amounted to $112.7 million as of September 30, 2009, and (ii) up to $1.35 million (the “Fee Cap”) in other costs, fees and expenses payable to the lenders under the terms of the Amended Securitization Facility. However, immediately subsequent to Patriot’s entry into the merger agreement with Prospect, the agent for the Amended Securitization Facility lenders notified Patriot that the Amended Securitization Facility lenders have not consented to the Fee Cap included in the merger agreement nor do they intend to release their liens on Patriot’s investments unless and until all costs, fees and expenses payable to the lenders under the terms of the Amended Securitization Facility are paid in full in cash. Although Patriot intends to work with the Amended Securitization Facility lenders to resolve this issue, if (i) the Amended Securitization Facility lenders demand payment for costs, fees and expenses that are substantially in excess of the Fee Cap amount, (ii) Patriot does not have sufficient funds to pay such excess amount and (iii) the Amended Securitization Facility lenders refuse to provide Patriot with the payoff letters required by the merger agreement, the merger may be abandoned. If the merger is abandoned, Patriot may not have sufficient liquidity to operate its business or pursue other strategic transactions and, as a result, would likely be required to seek bankruptcy protection.

Patriot shareholders will experience a reduction in percentage ownership and voting power with respect to their shares as a result of the merger.

 

Patriot shareholders will experience a substantial reduction in their respective percentage ownership interests and effective voting power relative to their respective percentage ownership interests in Patriot prior to the merger. If the merger is consummated, based on the number of shares of Prospect common stock issued and outstanding on the date hereof, Patriot shareholders will own approximately 13.6% of the combined entity’s outstanding common stock. In addition, both prior to and after completion of the merger, Prospect may issue additional shares of common stock in public offerings, mergers and acquisitions or otherwise (including at prices below its current net asset value), all of which would further reduce the percentage ownership of Prospect held by former Patriot shareholders. In addition, the issuance or sale by Prospect of shares of its common stock at a discount to net asset value poses a risk of dilution to stockholders. In particular, stockholders who do not purchase additional shares at or below the discounted price in proportion to their current ownership will experience an immediate decrease in net asset value per share (as well as in the aggregate net asset value of their shares if they do not participate at all). These stockholders will also experience a disproportionately greater decrease in their participation in Prospect’s earnings and assets and their voting power than the increase Prospect experiences in its assets, potential earning power and voting interests from such issuance or sale. Shareholders may also experience a reduction in the market price of Prospect’s common stock.

 

Termination of the merger agreement could negatively impact Patriot.

 

If the merger agreement is terminated, there may be various consequences including:

 

 

Under certain circumstances, Patriot is obligated to pay Prospect a termination fee or other amounts upon termination of the merger agreement.

 

No assurance can be given that the merger will be completed. The merger agreement provides for the payment by Patriot of a break-up fee of $3.2 million or an expense reimbursement of up to $250,000 if the merger is terminated by Patriot under certain circumstances. In addition, in certain circumstances involving a sale of Patriot to a third party within one year of termination of the merger agreement, Patriot may be required make an additional payment equal to the termination fee when combined with any previously paid expense reimbursement. The obligation to make that payment may adversely affect the ability of Patriot to engage in another transaction in the event the merger is not completed and may have an adverse impact on the financial condition of Patriot. See “Description of the Merger Agreement — Termination of the Merger Agreement — Expenses; Termination Fees” for a discussion of the circumstances that could result in the payment of a termination fee.

 

The merger agreement severely limits Patriot’s ability to pursue alternatives to the merger.

 

The merger agreement contains “no shop” and other provisions that, subject to limited exceptions, limit Patriot’s ability to discuss, facilitate or commit to competing third-party proposals to acquire all or a significant part of Patriot. These provisions might discourage a potential competing acquiror that might have an interest in acquiring all or a significant part of Patriot from considering or proposing that acquisition even if it were prepared to pay consideration

with a higher per share market price than that proposed in the merger. Patriot can consider and participate in discussions and negotiations with respect to an alternative proposal only in very limited circumstances. Among other things, prior to Patriot entering into any discussions with, or providing confidential information to, a third party in connection with an alternative proposal, the third party must enter into a confidentiality agreement with Patriot, must provide evidence of its commitment and ability to make a superior proposal for a sale or business combination transaction with Patriot without material contingencies, must agree to pay down in full the outstanding balance under the Amended Securitization Facility at closing of the relevant alternative sale or business combination transaction, and must provide Patriot with funds in an amount equal to the termination fee that would be payable upon the occurrence of certain termination events, as discussed elsewhere in this document.

 

The merger is subject to closing conditions, including stockholder approval, that, if not satisfied or waived, will result in the merger not being completed, which may result in material adverse consequences to Patriot’s business and operations.

 

The merger is subject to closing conditions, including the approval of Patriot’s shareholders that, if not satisfied, will prevent the merger from being completed. The closing condition that Patriot’s shareholders adopt the merger agreement may not be waived under applicable law and must be satisfied for the merger to be completed. Patriot currently expects that all directors and executive officers of Patriot will vote their shares of Patriot common stock in favor of the proposals presented at the special meeting. If Patriot’s shareholders do not adopt the merger agreement and the merger is not completed, the resulting failure of the merger could have a material adverse impact on Patriot’s business and operations. In addition to the required approvals and consents from governmental entities and the approval of Patriot’s shareholders, the merger is subject to a number of other conditions beyond Patriot’s control that may prevent, delay or otherwise materially adversely affect its completion. Patriot cannot predict whether and when these other conditions will be satisfied.

 

Certain executive officers and directors of Patriot have interests in the completion of the proposed merger that may differ from or conflict with the interests of Patriot shareholders.

 

When considering the recommendation of the Patriot board of directors to vote “FOR” adoption of the merger agreement, Patriot shareholders should note that certain of the executive officers and directors of Patriot have interests in the merger that are different in certain respects from, and may conflict with, the interests of other Patriot shareholders. Patriot executive officers are entitled to receive certain benefits upon completion of the merger, including accelerated vesting and payout (in cash or merger consideration) of stock options and restricted stock. In addition, pursuant to employment or severance agreements they have with Patriot, assuming qualifying terminations of employment following completion of the merger, certain of Patriot’s executive officers would receive severance payments and benefits. Based on the assumptions set forth in “The Merger Proposal — Interests of Patriot’s Directors and Executive Officers in the Merger,” Patriot’s executive officers may be entitled to receive aggregate payments of up to approximately $2,453,613 for accelerated vesting and payout of stock options and restricted stock upon completion of the merger. The maximum amounts that would be payable to Patriot’s named executive officers in the aggregate under each of their current employment agreements or severance agreements assuming that certain conditions regarding change of control and termination are met would be up to approximately $11,704,415. Certain existing executive officers of Patriot may, however, become paid employees of the merged company or its external investment adviser. See “The Merger Proposal — Interests of Patriot’s Directors and Executive Officers in the Merger” beginning on page    for a further description of these interests, including the payments that each executive officer is or may be entitled to receive upon completion of the merger.

 

Including shares of restricted stock that will vest upon the merger, the directors and executive officers of Patriot, hold approximately 15.83% of the beneficial and record ownership of Patriot’s common stock as of October 16, 2009, and intend to vote their shares in favor of the merger agreement and the transactions contemplated by the merger.

Patriot shareholders who do not timely exchange their Patriot common stock certificates for Prospect common stock after the completion of the merger will be deemed to have elected to receive dividends and other distributions declared after the completion of the merger with respect to Prospect common stock in the form of Prospect common stock in accordance with Prospect’s dividend reinvestment plan, and, as a result, may suffer adverse tax consequences.

 

As soon as reasonably practicable after completion of the merger, the exchange agent will mail a letter of transmittal to each holder of a Patriot common stock certificate at the effective time of the merger. This mailing will contain instructions on how to surrender Patriot common stock certificates in exchange for statements indicating book-entry ownership of Prospect common stock and a check in the amount of cash to be paid instead of fractional shares. Until Patriot common stock is surrendered for exchange, any dividends or other distributions declared after the completion of the merger with respect to Prospect common stock into which shares of Patriot common stock may have been converted will accrue, without interest, but will not be paid. Prospect will pay to former Patriot shareholders any unpaid dividends or other distributions, without interest, only after they have duly surrendered their Patriot stock certificates. In addition, the merger agreement provides that any such unpaid dividends or other distributions will be payable in the form of shares of Prospect’s common stock in accordance with Prospect’s dividend reinvestment plan. Because shareholders who receive distributions in the form of stock generally will be subject to the same federal, state and local tax consequences as shareholders who elect to receive their distributions in cash, Patriot shareholders who do not timely exchange their Patriot common stock certificates for Prospect common stock after the completion of the merger may suffer adverse tax consequences.

 

Prospect may be unable to realize the benefits anticipated by the merger or may take longer than anticipated to achieve such benefits.

 

The realization of certain benefits anticipated as a result of the merger will depend in part on the integration of Patriot’s investment portfolio with Prospect and the successful inclusion of Patriot’s investment portfolio in Prospect’s financing operations. There can be no assurance that Patriot’s business can be operated profitably or integrated successfully into Prospect’s operations in a timely fashion or at all. The dedication of management resources to such integration may detract attention from the day-to-day business of Prospect and there can be no assurance that there will not be substantial costs associated with the transition process or there will not be other material adverse effects as a result of these integration efforts. Such effects, including but not limited to, incurring unexpected costs or delays in connection with such integration and failure of Patriot’s investment portfolio to perform as expected, could have a material adverse effect on the financial results of Prospect.

 

Risks Related to Prospect

 

Recent developments may increase the risks associated with Prospect’s business and an investment in Prospect.

 

The U.S. financial markets have been experiencing a high level of volatility, disruption and distress, which was exacerbated by the failure of several major financial institutions in the last few months of 2008. In addition, the U.S. economy has entered a recession, which is likely to be severe and prolonged. Similar conditions have occurred in the financial markets and economies of numerous other countries and could worsen, both in the U.S. and globally. These conditions have raised the level of many of the risks described in the risk factors contained in this document and could have an adverse effect on Prospect’s portfolio companies as well as on its business, financial condition, results of operations, dividend payments, credit facility, access to capital, valuation of its assets and its stock price.

 

Prospect’s financial condition and results of operations will depend on its ability to manage its future growth effectively.

 

Prospect Capital Management, Prospect’s external investment adviser, has been registered as an investment adviser since March 31, 2004, and Prospect has been organized as a closed-end investment company

since April 13, 2004. As such, each entity is subject to the business risks and uncertainties associated with any young business enterprise, including the limited experience in managing or operating a business development company under the 1940 Act. Prospect’s ability to achieve its investment objective depends on its ability to grow, which depends, in turn, on Prospect Capital Management’s ability to continue to identify, analyze, invest in and monitor companies that meet its investment criteria. Accomplishing this result on a cost-effective basis is largely a function of Prospect Capital Management’s structuring of investments, its ability to provide competent, attentive and efficient services to Prospect and its access to financing on acceptable terms. As Prospect grows, it will need to continue to hire, train, supervise and manage new employees. Failure to manage its future growth effectively could have a materially adverse effect on its business, financial condition and results of operations.

 

Prospect is dependent upon Prospect Capital Management’s key management personnel for its future success.

 

Prospect depends on the diligence, skill and network of business contacts of the senior management of Prospect Capital Management. Prospect also depends, to a significant extent, on Prospect Capital Management’s access to the investment professionals and the information and deal flow generated by these investment professionals in the course of their investment and portfolio management activities. The senior management team of Prospect Capital Management evaluates, negotiates, structures, closes, monitors and services Prospect’s investments. Prospect’s success depends to a significant extent on the continued service of the senior management team, particularly John F. Barry III and M. Grier Eliasek. The departure of any of the senior management team could have a materially adverse effect on Prospect’s ability to achieve its investment objective. In addition, Prospect can offer no assurance that Prospect Capital Management will remain its investment adviser or that it will continue to have access to its investment professionals or its information and deal flow.

 

Prospect operates in a highly competitive market for investment opportunities.

 

A large number of entities compete with Prospect to make the types of investments that it makes in target companies. Prospect competes with other business development companies, public and private funds, commercial and investment banks and commercial financing companies. Additionally, because competition for investment opportunities generally has increased among alternative investment vehicles, such as hedge funds, those entities have begun to invest in areas they have not traditionally invested in, including investments in middle-market companies. As a result of these new entrants, competition for investment opportunities at middle-market companies has intensified, a trend Prospect expects to continue.

 

Many of Prospect’s existing and potential competitors are substantially larger and have considerably greater financial, technical and marketing resources than it does. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to Prospect. In addition, some of its competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more or fuller relationships with borrowers and sponsors than Prospect. Furthermore, many of its competitors are not subject to the regulatory restrictions that the 1940 Act imposes on it as a business development company. Prospect cannot assure its shareholders that the competitive pressures it faces will not have a materially adverse effect on its business, financial condition and results of operations. Also, as a result of existing and increasing competition and its competitors ability to provide a total package solution, it may not be able to take advantage of attractive investment opportunities from time to time, and it can offer no assurance that it will be able to identify and make investments that are consistent with its investment objective.

 

Prospect does not seek to compete primarily based on the interest rates that it offers, and it believes that some of its competitors make loans with interest rates that are comparable to or lower than the rates it offers. Prospect may lose investment opportunities if it does not match its competitors’ pricing, terms and structure. If it matches its competitors’ pricing, terms and structure, it may experience decreased net interest income and increased risk of credit loss.

Most of Prospect’s portfolio investments are recorded at fair value as determined in good faith by its board of directors and, as a result, there is uncertainty as to the value of its portfolio investments.

 

A large percentage of Prospect’s portfolio investments consist of securities of privately held companies. Hence, market quotations are generally not readily available for determining the fair values of such investments. The determination of fair value, and thus the amount of unrealized losses it may incur in any year, is to a degree subjective, and Prospect Capital Management has a conflict of interest in making the determination. Prospect values these securities quarterly at fair value as determined in good faith by its board of directors based on input from Prospect Capital Management, a third party independent valuation firm and its audit committee. Prospect’s board of directors utilizes the services of an independent valuation firm to aid it in determining the fair value of any securities. The types of factors that may be considered in determining the fair values of its investments include the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings, the markets in which the portfolio company does business, comparison to publicly traded companies, discounted cash flow, current market interest rates and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, the valuations may fluctuate significantly over short periods of time due to changes in current market conditions. The determinations of fair value by Prospect’s board of directors may differ materially from the values that would have been used if an active market and market quotations existed for these investments. Prospect’s net asset value could be adversely affected if the determinations regarding the fair value of its investments were materially higher than the values that it ultimately realize upon the disposal of such securities.

 

Senior securities, including debt, expose Prospect to additional risks, including the typical risks associated with leverage.

 

Prospect currently uses its revolving credit facility to leverage its portfolio and it expects in the future to borrow from and issue senior debt securities to banks and other lenders and may securitize certain of its portfolio investments.

 

With certain limited exceptions, as a business development company, Prospect is only allowed to borrow amounts such that its asset coverage, as defined in the 1940 Act, is at least 200% after such borrowing. The amount of leverage that it employs will depend on Prospect Capital Management’s and Prospect’s board of directors’ assessment of market conditions and other factors at the time of any proposed borrowing. There is no assurance that a leveraging strategy will be successful. Leverage involves risks and special considerations for shareholders, including:

 

 

For example, the amount Prospect may borrow under its revolving credit facility is determined, in part, by the fair value of its investments. If the fair value of Prospect’s investments declines, it may be forced to sell investments at a loss to maintain compliance with its borrowing limits. Other debt facilities Prospect may enter into in the future may contain similar provisions. Any such forced sales would reduce Prospect’s net asset value and also make it difficult for the net asset value to recover.

Prospect Capital Management and Prospect’s board of directors in their best judgment nevertheless may determine to use leverage if they expect that the benefits to its shareholders of maintaining the leveraged position will outweigh the risks.

 

Changes in interest rates may affect Prospect’s cost of capital and net investment income.

 

A significant portion of the debt investments Prospect makes bear interest at fixed rates and the value of these investments could be negatively affected by increases in market interest rates. In addition, as the interest rate on Prospect’s revolving credit facility is at a variable rate based on an index, an increase in interest rates would make it more expensive to use debt to finance its investments. As a result, a significant increase in market interest rates could both reduce the value of its portfolio investments and increase its cost of capital, which would reduce Prospect’s net investment income.

 

Prospect needs to raise additional capital to grow because it must distribute most of its income.

 

Prospect needs additional capital to fund growth in its investments. A reduction in the availability of new capital could limit Prospect’s ability to grow. Prospect must distribute at least 90% of its ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, to its shareholders to maintain its RIC status. As a result, such earnings are not available to fund investment originations. Prospect has sought additional capital by borrowing from financial institutions and may issue debt securities or additional equity securities. If Prospect fails to obtain funds from such sources or from other sources to fund its investments, it could be limited in its ability to grow, which may have an adverse effect on the value of its common stock. In addition, as a business development company, Prospect is generally required to maintain a ratio of at least 200% of total assets to total borrowings, which may restrict its ability to borrow in certain circumstances.

 

The lack of liquidity in Prospect’s investments may adversely affect its business.

 

Prospect generally makes investments in private companies. Substantially all of these securities are subject to legal and other restrictions on resale or are otherwise less liquid than publicly traded securities. The illiquidity of Prospect’s investments may make it difficult for it to sell such investments if the need arises. In addition, if Prospect is required to liquidate all or a portion of its portfolio quickly, it may realize significantly less than the value at which it has previously recorded its investments. In addition, Prospect may face other restrictions on its ability to liquidate an investment in a portfolio company to the extent that Prospect or Prospect Capital Management has material non-public information regarding such portfolio company.

 

Prospect may experience fluctuations in its quarterly results.

 

Prospect could experience fluctuations in its quarterly operating results due to a number of factors, including the interest or dividend rates payable on the debt or equity securities it acquires, the default rate on debt securities, the level of its expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which it encounters competition in its markets, the seasonality of the energy industry, weather patterns, changes in energy prices and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.

 

Prospect’s most recent net asset value was calculated on June 30, 2009 and its net asset value when calculated on September 30, 2009 may be higher or lower.

 

Prospect’s most recently estimated net asset value per share is $11.22 on an as adjusted basis solely to give effect to its payment of the July dividend recorded on ex-dividend date of July 6, 2009 and the issuance of common shares on July 20, 2009 in connection with its dividend reinvestment plan, and issuances on July 7, 2009, August 20, 2009 and September 24, 2009 in an underwritten common and two unregistered direct common stock offerings, versus $12.40 determined by Prospect’s Board of Directors on June 30, 2009. Net asset value as of September 30, 2009 may be higher or lower than $11.22 based on potential changes in

valuations. Prospect’s Board of Directors determines the fair value of Prospect’s portfolio investments on a quarterly basis in connection with the preparation of quarterly financial statements and based on input from an independent valuation firm, its Investment Advisor and the audit committee of its Board of Directors.

 

Sales of substantial amounts of Prospect’s securities in the public market may have an adverse effect on the market price of its securities.

 

As of September 30, 2009, Prospect has 54,672,155 shares of common stock outstanding. Sales of substantial amounts of its securities or the availability of such securities for sale could adversely affect the prevailing market price of its securities. If this occurs and continues, it could impair Prospect’s ability to raise additional capital through the sale of securities should it desire to do so.

 

Potential conflicts of interest could impact Prospect’s investment returns.

 

Prospect’s executive officers and directors, and the executive officers of Prospect Capital Management may serve as officers, directors or principals of entities that operate in the same or related lines of business as it does or of investment funds managed by its affiliates. Accordingly, they may have obligations to investors in those entities, the fulfillment of which might not be in Prospect’s best interests or those of its shareholders. Nevertheless, it is possible that new investment opportunities that meet Prospect’s investment objectives may come to the attention of one of these entities in connection with another investment advisory client or program, and, if so, such opportunity might not be offered, or otherwise made available, to Prospect. However, as an investment adviser, Prospect Capital Management has a fiduciary obligation to act in the best interests of its clients, including Prospect. To that end, if Prospect Capital Management or its affiliates manage any additional investment vehicles or client accounts in the future, Prospect Capital Management will endeavor to allocate investment opportunities in a fair and equitable manner over time so as not to discriminate unfairly against any client. If Prospect Capital Management chooses to establish another investment fund in the future, when the investment professionals of Prospect Capital Management identify an investment, they will have to choose which investment fund should make the investment.

 

In the course of Prospect’s investing activities, it pays a base management and incentive fees to Prospect Capital Management in accordance with the terms of an investment advisory agreement, and reimburses Prospect Capital Management for certain expenses it incurs. As a result of these arrangements, there may be times when the senior management team of Prospect Capital Management has interests that differ from those of Prospect’s shareholders, giving rise to a conflict.

 

Prospect Capital Management receives a quarterly income incentive fee based, in part, on Prospect’s pre-incentive fee net investment income, if any, for the immediately preceding calendar quarter. This income incentive fee is subject to a fixed quarterly hurdle rate before providing an income incentive fee return to Prospect Capital Management. This fixed hurdle rate was determined when then current interest rates were relatively low on a historical basis. Thus, if interest rates rise, it would become easier for Prospect’s investment income to exceed the hurdle rate and, as a result, more likely that Prospect Capital Management will receive an income incentive fee than if interest rates on its investments remained constant or decreased. Subject to the receipt of any requisite shareholder approval under the 1940 Act, Prospect’s board of directors may readjust the hurdle rate by amending the investment advisory agreement between it and Prospect Capital Management.

 

The income incentive fee payable by Prospect is computed and paid on income that may include interest that has been accrued but not yet received in cash. If a portfolio company defaults on a loan that has a deferred interest feature, it is possible that interest accrued under such loan that has previously been included in the calculation of the income incentive fee will become uncollectible. If this happens, Prospect Capital Management is not required to reimburse Prospect for any such income incentive fee payments. If Prospect does not have sufficient liquid assets to pay this incentive fee or distributions to shareholders on such accrued income, it may be required to liquidate assets in order to do so. This fee structure could give rise to a conflict of interest for Prospect Capital Management to the extent that it may encourage Prospect Capital Management to favor debt financings that provide for deferred interest, rather than current cash payments of interest.

Prospect has entered into a royalty-free license agreement with Prospect Capital Management. Under this agreement, Prospect Capital Management agrees to grant Prospect a non-exclusive license to use the name “Prospect Capital.” Under the license agreement, Prospect has the right to use the “Prospect Capital” name for so long as Prospect Capital Management or one of its affiliates remains Prospect’s investment adviser. In addition, Prospect rents office space from Prospect Administration, an affiliate of Prospect Capital Management, and pays Prospect Administration its allocable portion of overhead and other expenses incurred by Prospect Administration in performing its obligations as administrator under an administration agreement between Prospect and Prospect Administration, including rent and Prospect’s allocable portion of the costs of its chief financial officer and chief compliance officer and their respective staffs. This may create conflicts of interest that Prospect’s board of directors monitors.

 

Prospect’s incentive fee could induce Prospect Capital Management to make speculative investments.

 

The incentive fee payable by Prospect to Prospect Capital Management may create an incentive for Prospect Capital Management to make investments on Prospect’s behalf that are more speculative or involve more risk than would be the case in the absence of such compensation arrangement. The way in which the incentive fee payable is determined (calculated as a percentage of the return on invested capital) may encourage Prospect Capital Management to use leverage to increase the return on Prospect’s investments. Increased use of leverage and this increased risk of replacement of that leverage at maturity, would increase the likelihood of default, which would disfavor holders of Prospect’s common stock. Similarly, because Prospect Capital Management will receive an incentive fee based, in part, upon net capital gains realized on Prospect’s investments, Prospect Capital Management may invest more than would otherwise be appropriate in companies whose securities are likely to yield capital gains, as compared to income producing securities. Such a practice could result in Prospect’s investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.

 

The incentive fee payable by Prospect to Prospect Capital Management could create an incentive for Prospect Capital Management to invest on Prospect’s behalf in instruments, such as zero coupon bonds, that have a deferred interest feature. Under these investments, Prospect would accrue interest income over the life of the investment but would not receive payments in cash on the investment until the end of the term. Prospect’s net investment income used to calculate the income incentive fee, however, includes accrued interest. For example, accrued interest, if any, on Prospect’s investments in zero coupon bonds will be included in the calculation of its incentive fee, even though it will not receive any cash interest payments in respect of payment on the bond until its maturity date. Thus, a portion of this incentive fee would be based on income that it may not have yet received in cash and in the event of default may never receive.

 

Changes in laws or regulations governing Prospect’s operations may adversely affect its business.

 

Prospect and its portfolio companies are subject to regulation by laws at the local, state and U.S. Federal levels. These laws and regulations, as well as their interpretation, may be changed from time to time. Accordingly, changes in these laws or regulations could have a materially adverse effect on Prospect’s business.

 

Prospect may in the future choose to pay dividends in its own stock, in which case its shareholders may be required to pay tax in excess of the cash they receive.

 

Prospect may distribute taxable dividends that are payable in part in its stock. Under a recently issued IRS revenue procedure, up to 90% of any such taxable dividend for 2009 could be payable in its stock. Taxable stockholders receiving such dividends would be required to include the full amount of the dividend as ordinary income (or as long-term capital gain to the extent such distribution is properly designated as a capital gain dividend) to the extent of its current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, it may be subject to transaction fees (e.g., broker fees or transfer agent fees) and the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price

of Prospect’s stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, Prospect may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of Prospect’s stockholders determine to sell shares of its stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of Prospect’s stock.

 

Prospect Capital Management and its senior management team have limited experience managing a business development company under the 1940 Act.

 

The 1940 Act imposes numerous constraints on the operations of business development companies. For example, business development companies are, with narrow exceptions, required to invest at least 70% of their total assets in securities of certain privately held, thinly traded or distressed U.S. companies, cash, cash equivalents, U.S. government securities and other high quality debt investments that mature in one year or less. Prospect Capital Management and its senior management team’s limited experience in managing a portfolio of assets under such constraints may hinder their ability to take advantage of attractive investment opportunities and, as a result, achieve Prospect’s investment objective. In addition, Prospect’s investment strategies differ in some ways from those of other investment funds that have been managed in the past by the investment adviser’s investment professionals.

 

A failure on Prospect’s part to maintain its status as a business development company would significantly reduce its operating flexibility.

 

If Prospect does not continue to qualify as a business development company, it might be regulated as a registered closed-end investment company under the 1940 Act. Prospect’s failure to qualify as a business development company would make it subject to additional regulatory requirements, which may significantly decrease its operating flexibility by limiting its ability to employ leverage.

 

If Prospect fails to qualify as a RIC, it will have to pay corporate-level taxes on its income, and its income available for distribution would be reduced.

 

To maintain its qualification for U.S. Federal income tax purposes as a RIC under Subchapter M of the Code, and obtain RIC tax treatment, Prospect must meet certain source of income, asset diversification and annual distribution requirements.

 

The source of income requirement is satisfied if Prospect derives at least 90% of its annual gross income from interest, dividends, payments with respect to certain securities loans, gains from the sale or other disposition of stock, securities or options thereon or foreign currencies, or other income derived with respect to its business of investing in such stock, securities or currencies, and net income from interests in “qualified publicly traded partnerships,” as defined in the Code.

 

The annual distribution requirement for a RIC is satisfied if Prospect distributes at least 90% of its investment company taxable income (which generally is its ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses), if any, to its shareholders on an annual basis. Because Prospect uses debt financing, it is subject to certain asset coverage ratio requirements under the 1940 Act and financial covenants that could, under certain circumstances, restrict it from making distributions necessary to qualify for RIC tax treatment. If it is unable to obtain cash from other sources, Prospect may fail to qualify for RIC tax treatment and, thus, may be subject to corporate-level income tax.

 

To maintain its qualification as a RIC, Prospect must also meet certain asset diversification requirements at the end of each calendar quarter. Failure to meet these tests may result in its having to dispose of certain investments quickly in order to prevent the loss of RIC status. Because most of its investments are in private companies, any such dispositions could be made at disadvantageous prices and may result in substantial losses.

 

If Prospect fails to qualify as a RIC for any reason or become subject to corporate income tax, the resulting corporate taxes could substantially reduce its net assets, the amount of income available for

distribution, and the actual amount of its distributions. Such a failure would have a materially adverse effect on Prospect and its shareholders.

 

Regulations governing Prospect’s operation as a business development company affect its ability to raise, and the way in which it raises, additional capital.

 

Prospect has incurred indebtedness under its revolving credit facility and, in the future, may issue preferred stock and/or borrow additional money from banks or other financial institutions, which it refers to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act. Under the provisions of the 1940 Act, Prospect is permitted, as a business development company, to incur indebtedness or issue senior securities only in amounts such that its asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. If the value of its assets declines, it may be unable to satisfy this test, which could prohibit it from paying dividends and could prohibit Prospect from qualifying as a RIC. If Prospect cannot satisfy this test, it may be required to sell a portion of its investments or sell additional shares of common stock at a time when such sales may be disadvantageous in order to repay a portion of its indebtedness. In addition, issuance of additional common stock could dilute the percentage ownership of its current shareholders in it.

 

As a business development company regulated under provisions of the 1940 Act, Prospect is not generally able to issue and sell its common stock at a price below the current net asset value per share. If its common stock trades at a discount to net asset value, this restriction could adversely affect its ability to raise capital. Prospect may, however, sell its common stock, or warrants, options or rights to acquire its common stock, at a price below the current net asset value of its common stock in certain circumstances, including if (1) the holders of a majority of its shares (or, if less, at least 67% of a quorum consisting of a majority of its shares) and a similar majority of the holders of its shares who are not affiliated persons of it approve the sale of its common stock at a price that is less than the current net asset value, and (2) a majority of its directors who have no financial interest in the transaction and a majority of its independent directors (a) determine that such sale is in its and its shareholders’ best interests and (b) in consultation with any underwriter or underwriters of the offering, make a good faith determination as of a time either immediately prior to the first solicitation by it or on its behalf of firm commitments to purchase such shares, or immediately prior to the issuance of such shares, that the price at which such shares are to be sold is not less than a price which closely approximates the market value of such shares, less any distributing commission or discount.

 

To generate cash for funding new investments, Prospect pledged a substantial portion of its portfolio investments under its revolving credit facility. These assets are not available to secure other sources of funding or for securitization. Prospect’s ability to obtain additional secured or unsecured financing on attractive terms in the future is uncertain.

 

Alternatively, Prospect may securitize its future loans to generate cash for funding new investments. To securitize loans, it may create a wholly owned subsidiary and contribute a pool of loans to such subsidiary. This could include the sale of interests in the loans by the subsidiary on a non-recourse basis to purchasers who it would expect to be willing to accept a lower interest rate to invest in investment grade loan pools. Prospect would retain a portion of the equity in the securitized pool of loans. An inability to successfully securitize its loan portfolio could limit its ability to grow its business and fully execute its business strategy, and could decrease its earnings, if any. Moreover, the successful securitization of its loan portfolio exposes it to a risk of loss for the equity it retains in the securitized pool of loans and might expose it to losses because the residual loans in which it does not sell interests may tend to be those that are riskier and more likely to generate losses. A successful securitization may also impose financial and operating covenants that restrict its business activities and may include limitations that could hinder its ability to finance additional loans and investments or to make the distributions required to maintain its status as a RIC under Subchapter M of the Code. The 1940 Act may also impose restrictions on the structure of any securitizations.

Prospect’s common stock may trade at a discount to its net asset value per share.

 

Common stock of business development companies, like that of closed-end investment companies, frequently trades at a discount to current net asset value. Recently, Prospect’s common stock has traded at a discount to its net asset value. The risk that its common stock may continue to trade at a discount to its net asset value is separate and distinct from the risk that its net asset value per share may decline.

 

If Prospect sells common stock at a discount to its net asset value per share, shareholders who do not participate in such sale will experience immediate dilution in an amount that may be material.

 

At Prospect’s annual meeting of shareholders held on February 12, 2009, its shareholders approved its ability to sell an unlimited number of shares of its common stock at any level of discount from net asset value per share during the 12 month period following such approval. The issuance or sale by Prospect of shares of its common stock at a discount to net asset value poses a risk of dilution to its shareholders. In particular, shareholders who do not purchase additional shares at or below the discounted price in proportion to their current ownership will experience an immediate decrease in net asset value per share (as well as in the aggregate net asset value of their shares if they do not participate at all). These shareholders will also experience a disproportionately greater decrease in their participation in Prospect’s earnings and assets and their voting power than the increase Prospect experiences in its assets, potential earning power and voting interests from such issuance or sale. They may also experience a reduction in the market price of its common stock. In addition, sales of common stock at a discount to net asset value will benefit Prospect’s investment advisor because the investment advisor will earn additional investment management fees on the proceeds of such offerings, as it would from the offering of any other securities of Prospect or from the offering of Prospect’s common stock at a premium to net asset value per share.

 

Prospect may have difficulty paying its required distributions if it recognizes income before or without receiving cash representing such income.

 

For U.S. federal income tax purposes, Prospect includes in income certain amounts that it has not yet received in cash, such as original issue discount, which may arise if it receives warrants in connection with the making of a loan or possibly in other circumstances, or payment-in-kind interest, which represents contractual interest added to the loan balance and due at the end of the loan term. Such original issue discount, which could be significant relative to its overall investment activities, or increases in loan balances as a result of payment-in-kind arrangements, are included in its taxable income before it receives any corresponding cash payments. Prospect also may be required to include in taxable income certain other amounts that it does not receive in cash. While Prospect focuses primarily on investments that will generate a current cash return, its investment portfolio currently includes, and it may continue to invest in, securities that do not pay some or all of their return in periodic current cash distributions.

 

The income incentive fee payable by Prospect is computed and paid on income that may include interest that has been accrued but not yet received in cash. If a portfolio company defaults on a loan that is structured to provide accrued interest, it is possible that accrued interest previously used in the calculation of the income incentive fee will become uncollectible.

 

Since in some cases Prospect may recognize taxable income before or without receiving cash representing such income, it may have difficulty meeting the tax requirement to distribute at least 90% of its ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, to maintain RIC tax treatment. Accordingly, Prospect may have to sell some of its investments at times it would not consider advantageous, raise additional debt or equity capital or reduce new investment originations to meet these distribution requirements. If Prospect is not able to obtain cash from other sources, it may fail to qualify for RIC treatment and thus become subject to corporate-level income tax.

 

Prospect’s ability to enter into transactions with its affiliates is restricted.

 

Prospect is prohibited under the 1940 Act from knowingly participating in certain transactions with its affiliates without the prior approval of its independent directors. Any person that owns, directly or indirectly,

5% or more of its outstanding voting securities is Prospect’s affiliate for purposes of the 1940 Act and Prospect is generally prohibited from buying or selling any security or other property from or to such affiliate, absent the prior approval of its independent directors. The 1940 Act also prohibits “joint” transactions with an affiliate, which could include investments in the same portfolio company (whether at the same or different times), without prior approval of its independent directors. Prospect is prohibited from buying or selling any security or other property from or to Prospect Capital Management and its affiliates and persons with whom Prospect is in a control relationship, or entering into joint transactions with any such person, absent the prior approval of the SEC.

 

Prospect may not realize gains or income from its investments.

 

Prospect seeks to generate both current income and capital appreciation. However, the securities it invests in may not appreciate and, in fact, may decline in value, and the issuers of debt securities it invests in may default on interest and/or principal payments. Accordingly, it may not be able to realize gains from its investments, and any gains that it does realize may not be sufficient to offset any losses it experience.

 

Prospect’s portfolio is currently concentrated in a limited number of portfolio companies in the energy industry, which subject it to a risk of significant loss if any of these companies defaults on its obligations under any of the securities that it holds or if the energy industry experiences a downturn.

 

As of June 30, 2009, Prospect had invested in a number of companies in the energy and energy related industries. A consequence of this lack of diversification is that the aggregate returns it realizes may be significantly and adversely affected if a small number of such investments perform poorly or if it needed to write down the value of any one investment. Beyond its income tax diversification requirements, it does not have fixed guidelines for diversification, and its investments are concentrated in relatively few portfolio companies. In addition, to date Prospect has concentrated on making investments in the energy industry. While it expects to be less focused on the energy and energy related industries in the future, Prospect anticipates that it will continue to have significant holdings in the energy and energy related industries. As a result, a downturn in the energy industry could materially and adversely affect it.

 

The energy industry is subject to many risks.

 

Prospect has a significant concentration in the energy industry. Prospect’s definition of energy, as used in the context of the energy industry, is broad, and different sectors in the energy industry may be subject to variable risks and economic pressures. As a result, it is difficult to anticipate the impact of changing economic and political conditions on Prospect’s portfolio companies and, as a result, its financial results. The revenues, income (or losses) and valuations of energy companies can fluctuate suddenly and dramatically due to any one or more of the following factors:

 

 

 

 

Prospect’s investments in prospective portfolio companies may be risky and it could lose all or part of its investment.

 

Some of Prospect’s portfolio companies have relatively short or no operating histories. These companies are and will be subject to all of the business risk and uncertainties associated with any new business enterprise, including the risk that these companies may not reach their investment objective and the value of Prospect’s investment in them may decline substantially or fall to zero.

 

In addition, investment in the middle market companies that Prospect is targeting involves a number of other significant risks, including:

 

 

In addition, Prospect’s executive officers, directors and Prospect Capital Management could, in the ordinary course of business, be named as defendants in litigation arising from proposed investments or from its investments in the portfolio companies.

Economic recessions or downturns could impair Prospect’s portfolio companies and harm its operating results.

 

The U.S. and most other economies have entered a recessionary period, which may be prolonged and severe. Prospect’s portfolio companies will generally be affected by the conditions and overall strength of the national, regional and local economies, including interest rate fluctuations, changes in the capital markets and changes in the prices of their primary commodities and products. These factors also impact the amount of residential, industrial and commercial growth in the energy industry. Additionally, these factors could adversely impact the customer base and customer collections of Prospect’s portfolio companies.

 

As a result, many of Prospect’s portfolio companies may be susceptible to economic slowdowns or recessions and may be unable to repay their loans or meet other obligations during these periods. Therefore, Prospect’s non-performing assets are likely to increase, and the value of its portfolio is likely to decrease, during these periods. Adverse economic conditions also may decrease the value of collateral securing some of Prospect’s loans and the value of its equity investments. Economic slowdowns or recessions could lead to financial losses in its portfolio and a decrease in revenues, net income and assets. Unfavorable economic conditions also could increase Prospect’s funding costs, limit its access to the capital markets or result in a decision by lenders not to extend credit to it. These events could prevent Prospect from increasing investments and harm its operating results.

 

A portfolio company’s failure to satisfy financial or operating covenants imposed by Prospect or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize a portfolio company’s ability to meet its obligations under the debt or equity securities that Prospect holds. Prospect may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company. In addition, if one of its portfolio companies were to go bankrupt, even though it may have structured its interest as senior debt or preferred equity, depending on the facts and circumstances, including the extent to which it actually provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize its debt or equity holding and subordinate all or a portion of its claim to those of other creditors.

 

The lack of liquidity in Prospect’s investments may adversely affect its business.

 

Prospect makes investments in private companies. A portion of these investments may be subject to legal and other restrictions on resale, transfer, pledge or other disposition or will otherwise be less liquid than publicly traded securities. The illiquidity of its investments may make it difficult for Prospect to sell such investments if the need arises. In addition, if Prospect is required to liquidate all or a portion of its portfolio quickly, it may realize significantly less than the value at which it has previously recorded its investments. In addition, Prospect faces other restrictions on its ability to liquidate an investment in a business entity to the extent that it or its investment adviser has or could be deemed to have material non-public information regarding such business entity.

 

Prospect may have limited access to information about privately held companies in which it invests.

 

Prospect invests primarily in privately-held companies. Generally, little public information exists about these companies, and it is required to rely on the ability of Prospect Capital Management’s investment professionals to obtain adequate information to evaluate the potential returns from investing in these companies. These companies and their financial information are not subject to the Sarbanes-Oxley Act and other rules that govern public companies. If Prospect is unable to uncover all material information about these companies, it may not make a fully informed investment decision, and it may lose money on its investment.

 

Prospect may not be in a position to control a portfolio investment when it is a debt or minority equity investor and its management may make decisions that could decrease the value of its investment.

 

Prospect makes both debt and minority equity investments in portfolio companies. As a result, it is subject to the risk that a portfolio company may make business decisions with which it disagrees, and the

management of such company, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not serve its interests. As a result, a portfolio company may make decisions that could decrease the value of its portfolio holdings.

 

Prospect’s portfolio companies may incur debt or issue equity securities that rank equally with, or senior to, its investments in such companies.

 

Prospect may invest in mezzanine debt and dividend-paying equity securities issued by its portfolio companies. Prospect’s portfolio companies usually have, or may be permitted to incur, other debt, or issue other equity securities, that rank equally with, or senior to, the securities in which it invests. By their terms, such instruments may provide that the holders are entitled to receive payment of dividends, interest or principal on or before the dates on which it is entitled to receive payments in respect of the securities in which it invests. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of securities ranking senior to its investment in that portfolio company would typically be entitled to receive payment in full before it receives any distribution in respect of its investment. After repaying the senior security holders, the portfolio company may not have any remaining assets to use for repaying its obligation to Prospect. In the case of securities ranking equally with securities in which Prospect invests, it would have to share on an equal basis any distributions with other security holders in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.

 

Prospect may not be able to fully realize the value of the collateral securing its debt investments.

 

Although a substantial amount of Prospect’s debt investments are protected by holding security interests in the assets of the portfolio companies, it may not be able to fully realize the value of the collateral securing its investments due to one or more of the following factors:

 

 

Prospect’s investments in foreign securities may involve significant risks in addition to the risks inherent in U.S. investments.

 

Prospect’s investment strategy contemplates potential investments in securities of foreign companies. Investing in foreign companies may expose it to additional risks not typically associated with investing in U.S. companies. These risks include changes in exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the United States, higher transaction costs, less government supervision of exchanges, brokers and issuers, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility.

Although currently most of Prospect’s investments are, and Prospect expects that most of its investments will be, U.S. dollar-denominated, Prospect’s investments that are denominated in a foreign currency will be subject to the risk that the value of a particular currency will change in relation to one or more other currencies. Among the factors that may affect currency values are trade balances, the level of short-term interest rates, differences in relative values of similar assets in different currencies, long-term opportunities for investment and capital appreciation, and political developments.

 

Prospect may expose itself to risks if it engages in hedging transactions.

 

Prospect may employ hedging techniques to minimize certain investment risks, such as fluctuations in interest and currency exchange rates, but it can offer no assurance that such strategies will be effective. If it engages in hedging transactions, it may expose itself to risks associated with such transactions. Prospect may utilize instruments such as forward contracts, currency options and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of its portfolio positions from changes in currency exchange rates and market interest rates. Hedging against a decline in the values of its portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the portfolio positions should increase. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is so generally anticipated that it is not able to enter into a hedging transaction at an acceptable price.

 

The success of Prospect’s hedging transactions depends on its ability to correctly predict movements, currencies and interest rates. Therefore, while it may enter into such transactions to seek to reduce currency exchange rate and interest rate risks, unanticipated changes in currency exchange rates or interest rates may result in poorer overall investment performance than if it had not engaged in any such hedging transactions. The degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged may vary. Moreover, for a variety of reasons, Prospect may not seek to establish a perfect correlation between such hedging instruments and the portfolio holdings being hedged. Any such imperfect correlation may prevent it from achieving the intended hedge and expose it to risk of loss. In addition, it may not be possible to hedge fully or perfectly against currency fluctuations affecting the value of securities denominated in non-U.S. currencies.

 

Prospect’s board of directors may change its operating policies and strategies without prior notice or shareholder approval, the effects of which may be adverse to Prospect and could impair the value of its shareholders’ investment.

 

Prospect’s board of directors has the authority to modify or waive its current operating policies and its strategies without prior notice and without shareholder approval. Prospect cannot predict the effect any changes to its current operating policies and strategies would have on its business, financial condition, and value of its common stock. However, the effects might be adverse, which could negatively impact its ability to pay dividends and cause shareholders to lose all or part of their investment.

 

Investing in Prospect’s securities may involve a high degree of risk.

 

The investments Prospect makes in accordance with its investment objective may result in a higher amount of risk than alternative investment options and volatility or loss of principal. Prospect’s investments in portfolio companies may be speculative and aggressive, and therefore, an investment in its shares may not be suitable for someone with low risk tolerance.

The market price of Prospect’s securities may fluctuate significantly.

 

The market price and liquidity of the market for Prospect’s securities may be significantly affected by numerous factors, some of which are beyond its control and may not be directly related to its operating performance. These factors include:

 

 

There is a risk that shareholders may not receive dividends or that Prospect’s dividends may not grow over time.

 

Prospect has made and intends to continue to make distributions on a quarterly basis to its shareholders out of assets legally available for distribution. Prospect cannot assure shareholders that it will achieve investment results or maintain a tax status that will allow or require any specified level of cash distributions or year-to-year increases in cash distributions. In addition, due to the asset coverage test applicable to it as a business development company, it may be limited in its ability to make distributions.

 

Provisions of the Maryland General Corporation Law and of Prospect’s charter and bylaws could deter takeover attempts and have an adverse impact on the price of its common stock.

 

Prospect’s charter and bylaws and the Maryland General Corporation Law contain provisions that may have the effect of delaying, deferring or preventing a transaction or a change in control that might involve a premium price for its shareholders or otherwise be in their best interest. These provisions may prevent shareholders from being able to sell shares of its common stock at a premium over the current of prevailing market prices.

 

Prospect’s charter provides for the classification of its board of directors into three classes of directors, serving staggered three-year terms, which may render a change of control or removal of its incumbent management more difficult. Furthermore, any and all vacancies on its board of directors will be filled generally only by the affirmative vote of a majority of the remaining directors in office, even if the remaining directors do not constitute a quorum, and any director elected to fill a vacancy will serve for the remainder of the full term until a successor is elected and qualifies.

 

Prospect’s board of directors is authorized to create and issue new series of shares, to classify or reclassify any unissued shares of stock into one or more classes or series, including preferred stock and,

without shareholder approval, to amend its charter to increase or decrease the number of shares of common stock that it has authority to issue, which could have the effect of diluting a shareholder’s ownership interest. Prior to the issuance of shares of common stock of each class or series, including any reclassified series, Prospect’s board of directors is required by its governing documents to set the terms, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications and terms or conditions of redemption for each class or series of shares of stock.

 

Prospect’s charter and bylaws also provide that its board of directors has the exclusive power to adopt, alter or repeal any provision of its bylaws, and to make new bylaws. The Maryland General Corporation Law also contains certain provisions that may limit the ability of a third party to acquire control of Prospect, such as:

 

 

The provisions of the Maryland Business Combination Act will not apply, however, if Prospect’s board of directors adopts a resolution that any business combination between it and any other person will be exempt from the provisions of the Maryland Business Combination Act. Although its board of directors has adopted such a resolution, there can be no assurance that this resolution will not be altered or repealed in whole or in part at any time. If the resolution is altered or repealed, the provisions of the Maryland Business Combination Act may discourage others from trying to acquire control of Prospect.

 

As permitted by Maryland law, Prospect’s bylaws contain a provision exempting from the Maryland Control Share Acquisition Act any and all acquisitions by any person of its common stock. Although its bylaws include such a provision, such a provision may also be amended or eliminated by its Board of Directors at any time in the future, provided that Prospect will notify the Division of Investment Management at the SEC prior to amending or eliminating this provision.

 

Risks Related to Patriot

 

An event of termination occurred under Patriot’s Amended Securitization Facility which allows Patriot’s lenders to accelerate repayment of the outstanding obligations under the facility and exercise other rights and remedies provided by the Amended Securitization Facility, including the right to sell the collateral under the Amended Securitization Facility.

 

On April 3, 2009, a termination event (i.e., default) occurred under Patriot’s Amended Securitization Facility. As a result of the occurrence of the termination event under the Amended Securitization Facility, Patriot can no longer make additional advances under the Amended Securitization Facility. In addition, the interest rate payable under the Amended Securitization Facility increased from the commercial paper rate plus 1.75% to the prime rate plus 3.75%. Also, the terms of the Amended Securitization Facility require that all principal, interest and fees collected from the debt investments secured by the Amended Securitization Facility must be used to pay down amounts outstanding under the Amended Securitization Facility within 24 months following the date of the termination event. Substantially all of Patriot’s debt investments are secured under the Amended Securitization Facility. The Amended Securitization Facility also permits the lenders, upon notice to Patriot, to accelerate amounts outstanding under the Amended Securitization Facility and exercise other rights and remedies provided by the Amended Securitization Facility, including the right to sell the

collateral under the Amended Securitization Facility. As of the date hereof, Patriot has not received any such notice from the lenders; however, there can be no assurance that they will not accelerate repayment in the future. Patriot does not have sufficient cash resources to repay these obligations should the lenders accelerate these obligations. Acceleration of the amounts outstanding under the Amended Securitization Facility could have a material adverse impact on Patriot’s liquidity, financial condition and operations.

 

There is substantial doubt about Patriot’s ability to continue as a going concern.

 

Patriot’s independent registered public accounting firm has issued an opinion on its consolidated financial statements that states that the consolidated financial statements were prepared assuming Patriot will continue as a going concern and further states that the uncertainty regarding the renewal of its liquidity facility raises substantial doubt about Patriot’s ability to continue as a going concern. On April 3, 2009, a termination event occurred under its Amended Securitization Facility. As a result of the occurrence of the termination event under the Amended Securitization Facility, Patriot can no longer make additional advances under the Amended Securitization Facility. Also, the terms of the Amended Securitization Facility require that all principal, interest and fees collected from the debt investments secured by the Amended Securitization Facility must be used to pay down amounts outstanding under the Amended Securitization Facility within 24 months following the date of the termination event.

 

Because substantially all of Patriot’s debt investments are secured by its Amended Securitization Facility, Patriot cannot provide any assurance that it would have sufficient cash and liquid assets to fund normal operations and dividend distributions to its shareholders during the period of time when it is required to repay amounts outstanding under the Amended Securitization Facility if such amounts became due.

 

We are currently in a period of capital markets disruption and recession and Patriot does not expect these conditions to improve in the near future. These conditions could adversely affect Patriot’s financial position and operating results and impair its portfolio companies’ financial positions and operating results, which could, in turn, harm Patriot’s financial position and operating results.

 

The capital markets have been experiencing extreme volatility and disruption since mid-2007 and the U.S. economy has entered into a recession. Disruptions in the capital markets have increased the spread between the yields realized on risk-free and higher risk securities, resulting in illiquidity in parts of the capital markets. Patriot believe these conditions may continue for a prolonged period of time or worsen in the future. A prolonged period of market illiquidity may have an adverse effect on Patriot’s business, financial condition, and results of operations. Unfavorable economic conditions also could increase Patriot’s funding costs, limit its access to the capital markets or result in a decision by lenders not to extend credit to Patriot. These events, including the non-renewal of the liquidity facility, could limit Patriot’s investment originations, limit its ability to grow and pay dividends and negatively impact its operating results.

 

In addition, many of Patriot’s portfolio companies are susceptible to economic slowdowns or recessions. An economic slowdown or recession, including the current one and any future slowdowns or recessions, may affect the ability of Patriot’s portfolio companies to repay their loans or engage in a liquidity event such as a sale, recapitalization or initial public offering. Patriot’s nonperforming assets are likely to increase and the value of its portfolio is likely to decrease during these periods. Adverse economic conditions also may decrease the value of any collateral securing some of its loans. These conditions could lead to losses of value in Patriot’s portfolio and a decrease in its revenues, net income and assets.

 

Because Patriot must distribute at least 90% of its taxable income to its shareholders in connection with its election to be treated as a RIC, Patriot will continue to need additional capital to finance its growth. If additional funds are unavailable or not available on favorable terms, Patriot’s ability to grow will be impaired.

 

In order to qualify for treatment as a RIC under Subchapter M of the Code, Patriot must distribute annually to its shareholders at least 90% of its investment company taxable income. As a result, Patriot will likely need to raise capital from other sources to grow its business. As a business development company, Patriot generally is required to meet a coverage ratio of total assets, less liabilities and indebtedness not

represented by senior securities to total senior securities, which includes all of its borrowings and any preferred stock Patriot may issue in the future, of at least 200%. This requirement limits the amount that Patriot may borrow. Because Patriot will continue to need capital to grow its investment portfolio, this limitation may prevent it from incurring debt and require it to raise additional equity at a time when it may be disadvantageous to do so. Patriot cannot assure its shareholders that debt and equity financing will be available to it on favorable terms, if at all. If additional funds are not available to Patriot, it could be forced to curtail or cease new investment activities, and its net asset value could decline.

 

Regulations governing Patriot’s operation as a business development company will affect its ability to, and the way in which it, raises additional capital.

 

Patriot’s business will require capital. Patriot may acquire additional capital from the following sources:

 

Senior Securities and Other Indebtedness.  Patriot may issue debt securities or preferred stock and/or borrow money from banks or other financial institutions, which is referred to collectively as senior securities, up to the maximum amount permitted by the 1940 Act. If Patriot issues senior securities, including debt or preferred stock, it will be exposed to additional risks, including the following:

 

 

Additional Common Stock.  Patriot is not generally able to issue and sell its common stock at a price below net asset value per share. Patriot may, however, sell its common stock, warrants, options or rights to acquire its common stock, at a price below the current net asset value of the common stock if its board of directors determines that such sale is in its best interests and that of its shareholders, and its shareholders approve such sale. In any such case, the price at which Patriot’s securities are to be issued and sold may not be less than a price which, in the determination of its board of directors, closely approximates the market value of such securities (less any distributing commission or discount). Patriot may also make rights offerings to its shareholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. If Patriot raises additional funds by issuing more common stock or senior securities convertible into, or exchangeable for, its common stock, the percentage ownership of its shareholders at that time would decrease and they may experience dilution. Moreover, Patriot can offer no assurance that it will be able to issue and sell additional equity securities in the future, on favorable terms or at all.

Securitization of Loans.  In addition to issuing securities to raise capital, Patriot will continue to seek to securitize its loans to generate cash for funding new investments. To securitize loans, Patriot would generally create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. This could include the sale of interests in the subsidiary on a non-recourse basis to purchasers who Patriot would expect to be willing to accept a lower interest rate to invest in investment grade loan pools, and it retains a portion of the equity in the securitized pool of loans. An inability to successfully securitize Patriot’s loan portfolio could limit its ability to grow its business, fully execute its business strategy and adversely affect its earnings, if any. Moreover, the securitization of Patriot’s loan portfolio might expose it to losses as the residual loans in which it does not sell interests will tend to be those that are riskier and more apt to generate losses.

 

Patriot is dependent upon its key investment personnel for its future success.

 

Patriot depends on the diligence, skill and network of business contacts of the investment professionals it employs for the sourcing, evaluation, negotiation, structuring and monitoring of its investments. Patriot’s future success will also depend, to a significant extent, on the continued service and coordination of its senior management team, particularly, Richard P. Buckanavage, its president and chief executive officer, and Timothy W. Hassler, its chief investment officer. The departure of Mr. Buckanavage, Mr. Hassler or any member of Patriot’s senior management team could have a material adverse effect on its ability to achieve its investment objective. In addition, if both of Messrs. Buckanavage and Hassler cease to be employed by Patriot, the lender under its Amended Securitization Facility could, absent a waiver or cure, terminate the facility.

 

Patriot’s business model depends to a significant extent upon strong referral relationships with private equity sponsors, and its inability to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect its business.

 

Patriot expects that members of its management team will maintain their relationships with private equity sponsors, and it will rely to a significant extent upon these relationships to provide it with potential investment opportunities. If Patriot’s management team fails to maintain its existing relationships or develop new relationships with other sponsors or sources of investment opportunities, it will not be able to grow its investment portfolio. In addition, individuals with whom members of Patriot’s management team have relationships are not obligated to provide it with investment opportunities, and, therefore, there is no assurance that such relationships will generate investment opportunities for it.

 

Patriot operates in a competitive market for investment opportunities.

 

Patriot competes for investments with other business development companies and other investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies such as commercial banks and other sources of funding. Many of Patriot’s competitors are substantially larger and have considerably greater financial, technical and marketing resources than it does. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to Patriot, including from federal government agencies through federal rescue programs such as the U.S. Department of the Treasury’s Financial Stability Plan (which was formerly known as the Trouble Asset Relief Program). In addition, some of Patriot’s competitors may have higher risk tolerances or different risk assessments. These characteristics could allow Patriot’s competitors to consider a wider variety of investments, establish more relationships and offer better pricing and more flexible structuring than it. Patriot may lose investment opportunities if it does not match its competitors’ pricing, terms and structure. If Patriot is forced to match its competitors’ pricing, terms and structure, it may not be able to achieve acceptable returns on its investments or may bear substantial risk of capital loss. Furthermore, many of Patriot’s competitors have greater experience operating under, or are not subject to, the regulatory restrictions that the 1940 Act imposes on it as a business development company.

 

Patriot cannot assure its shareholders that the competitive pressures it faces will not have a material adverse effect on its business, financial condition and results of operations. Also, as a result of this competition, Patriot may not be able to take advantage of attractive investment opportunities from time to

time, and it cannot assure its shareholders that it will continue to be able to identify and make investments that are consistent with its investment objective.

 

Patriot will be subject to corporate-level income tax if it fails to maintain its status as a RIC under Subchapter M of the Code.

 

To maintain RIC tax treatment under the Code, Patriot must meet the following annual distribution, income source and asset diversification requirements.

 

 

If Patriot fails to qualify as a RIC under Subchapter M of the Code for any reason and is subject to corporate income tax, the resulting corporate taxes could substantially reduce its net assets, the amount of income available for distribution and the amount of its distributions.

 

Patriot may in the future choose to pay dividends in its own stock, in which case its shareholders may be required to pay tax in excess of the cash they receive.

 

Patriot may distribute taxable dividends that are payable in part in its stock. Under a recently issued IRS revenue procedure, up to 90% of any such taxable dividend for 2009 could be payable in stock. Taxable shareholders receiving such dividends would be required to include the full amount of the dividend as ordinary income (or as long-term capital gain to the extent such distribution is properly designated as a capital gain dividend) to the extent of Patriot’s current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. shareholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. shareholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of Patriot’s stock at the time of the sale. Furthermore, with respect to non-U.S. shareholders, Patriot may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of Patriot’s shareholders determine to sell shares of its stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of its stock.

 

Patriot may have difficulty paying its required distributions if its recognizes income before or without receiving cash representing such income.

 

For federal income tax purposes, Patriot will include in income certain amounts that it has not yet received in cash, such as original issue discount, which may arise if it receives warrants in connection with the origination of a loan or possibly in other circumstances, such as in connection with the receipt of contractual payment-in-kind, or PIK, interest or dividends, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term or contractually deferred dividends added to

Patriot’s equity investment in the portfolio company. Such original issue discount or contractual payment-in-kind arrangements will result in the recognition of income before Patriot receives any corresponding cash payments. Patriot also may be required to include in income certain other amounts that it will not receive in cash.

 

Since, in certain cases, Patriot may recognize income before or without receiving cash representing such income, it may have difficulty meeting the annual distribution requirement necessary to qualify as a RIC under subchapter M of the Code. Accordingly, Patriot may have to (i) sell some of its investments at times and/or at prices it would not consider advantageous, (ii) raise additional debt or equity capital or (iii) reduce new investment originations for this purpose. If Patriot is not able to obtain cash from other sources, it may fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax.

 

Patriot borrows money, which magnifies the potential for gain or loss on amounts invested and may increase the risk of investing in it.

 

Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in Patriot. Patriot borrows from and issues senior debt securities to banks and other lenders. Holders of these senior securities have fixed dollar claims on its assets that are superior to the claims of its common shareholders. If the value of Patriot’s assets increases, then leveraging would cause the net asset value attributable to its common stock to increase more sharply than it would have had it not leveraged. Conversely, if the value of its assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had it not leveraged. Similarly, any increase in Patriot’s income in excess of interest payable on the borrowed funds would cause its net income to increase more than it would without the leverage, while any decrease in Patriot’s income would cause net income to decline more sharply than it would have had it not borrowed. Such a decline could negatively affect Patriot’s ability to make common stock dividend payments. Leverage is generally considered a speculative investment technique.

 

At June 30, 2009, Patriot had $137.4 million of indebtedness outstanding, which had a weighted average annualized interest cost of 7.5% for the quarter ended June 30, 2009. In order for Patriot to cover these annualized interest payments on indebtedness, Patriot must achieve annual returns on its assets of at least 3.5%.

 

Illustration.  The following table illustrates the effect of leverage on returns from an investment in Patriot’s common stock assuming various annual returns, net of expenses. The calculations in the table below are hypothetical and actual returns may be higher or lower than those appearing below. The calculation assumes (i) $302.5 million in total assets, (ii) a weighted average cost of funds of 7.5%, (iii) $137.4 million in debt outstanding and (iv) $160.5 million in stockholders’ equity.

 

Assumed Return on Patriot’s Portfolio
(net of expenses)

 

 

Changes in interest rates may affect Patriot’s cost of capital and net investment income.

 

Because Patriot borrows to fund its investments, a portion of its income is dependent upon the difference between the interest rate at which it borrows funds and the interest rate at which it invests these funds. A portion of Patriot’s investments will have fixed interest rates, while a portion of its borrowings will likely have floating interest rates. As a result, a significant change in market interest rates could have a material adverse effect on Patriot’s net investment income. In periods of rising interest rates, Patriot’s cost of funds could increase, which would reduce its net investment income. Patriot may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contracts, subject to applicable legal requirements, including without limitation, all necessary registrations (or exemptions from registration) with

the Commodity Futures Trading Commission. These activities may limit Patriot’s ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on Patriot’s business, financial condition and results of operations. Also, Patriot has limited experience in entering into hedging transactions, and it will initially have to rely on outside parties with respect to the use of such financial instruments or develop such expertise internally.

 

A significant portion of Patriot’s investment portfolio is and will continue to be recorded at fair value as determined in good faith by its board of directors and, as a result, there is and will continue to be uncertainty as to the value of its portfolio investments.

 

Under the 1940 Act, Patriot is required to carry its portfolio investments at market value or, if there is no readily available market value, at fair value as determined by its board of directors. Patriot is not permitted to maintain a general reserve for anticipated losses. Instead, Patriot is required by the 1940 Act to specifically value each individual investment and record an unrealized loss for any asset Patriot believes has decreased in value. Typically there is not a public market for the securities of the privately-held companies in which Patriot has invested and will generally continue to invest. As a result, Patriot values its investments in privately-held companies on a quarterly basis based on a determination of their fair value made in good faith and in accordance with the written guidelines established by its board of directors. In accordance with Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” Patriot principally utilizes the market approach to estimate the fair value of its equity investments where there is not a readily available market and it principally utilize the income approach to estimate the fair value of its debt investments where there is not a readily available market. Under the market approach, Patriot estimates the enterprise value of the portfolio companies in which it invests. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values from which Patriot derives a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, Patriot analyzes various factors, including the portfolio company’s historical and projected financial results. Patriot generally requires portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value. The private equity industry uses financial measures such as EBITDA in order to assess a portfolio company’s financial performance and to value a portfolio company. When using EBITDA to determine enterprise value, Patriot may adjust EBITDA for non-recurring items. Such adjustments are intended to normalize EBITDA to reflect the portfolio company’s earnings power. Adjustments to EBITDA may include compensation to previous owners, acquisition, recapitalization, restructuring related items and, one-time non-recurring income or expense items.

 

Under the income approach, Patriot generally prepares and analyzes discounted cash flow models based on its projections of the future free cash flows of the business. Patriot also uses bond yield models to determine the present value of the future cash flow streams of its debt investments. Patriot reviews various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assesses the information in the valuation process.

 

The types of factors that may be considered in determining the fair value of Patriot’s investments include the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments on its indebtedness, the markets in which the portfolio company does business, comparison to publicly traded companies, discounted cash flow and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, Patriot’s determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. Patriot’s net asset value could be adversely affected if its determinations regarding the fair value of its investments were materially higher than the values that it ultimately realizes upon the disposal of such securities.

The lack of liquidity in Patriot’s investments may adversely affect its business.

 

Patriot generally makes investments in private companies. Substantially all of these securities are subject to legal and other restrictions on resale or are otherwise less liquid than publicly traded securities. The illiquidity of Patriot’s investments may make it difficult for Patriot to sell such investments if the need arises. In addition, if Patriot is required to liquidate all or a portion of its portfolio quickly, it may realize significantly less than the value at which it had previously recorded its investments. Patriot may also face other restrictions on its ability to liquidate an investment in a portfolio company to the extent that it has material non-public information regarding such portfolio company.

 

Patriot may experience fluctuations in its quarterly results.

 

Patriot could experience fluctuations in its quarterly operating results due to a number of factors, including its ability to make investments in companies that meet its investment criteria, the interest rate payable on the debt securities Patriot acquires, the level of its expenses, prepayments of its debt securities, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which Patriot encounters competition in its markets and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.

 

Changes in laws or regulations governing Patriot’s operations may adversely affect its business.

 

Patriot and its portfolio companies are subject to local, state and federal laws and regulations. These laws and regulations, as well as their interpretation, may be changed from time to time. Accordingly, any change in these laws or regulations could have a material adverse affect on its business.

 

Patriot’s board of directors may change its operating policies and strategies without prior notice or shareholder approval, the effects of which may be adverse.

 

Patriot’s board of directors has the authority to modify or waive its current operating policies and strategies without prior notice and without shareholder approval. Patriot cannot predict the effect any changes to its current operating policies and strategies would have on its business, operating results and value of its stock. However, the effects might be adverse, which could negatively impact its ability to pay dividends and cause its shareholders to lose all or part of their investment.

 

Patriot’s investments in portfolio companies may be risky, and it could lose all or part of its investment.

 

Investing in small- to mid-sized companies involves a number of significant risks. Among other things, these companies:

 

 

 

Patriot’s portfolio is and may continue to be concentrated in a limited number of portfolio companies and industries, which will subject it to a risk of significant loss if any of these companies defaults on its obligations under any of its debt instruments or by a downturn in the particular industry.

 

Patriot’s portfolio is and may continue to be concentrated in a limited number of portfolio companies and industries. Beyond the asset diversification requirements associated with Patriot’s qualification as a RIC, it does not have fixed guidelines for diversification, and while Patriot is not targeting any specific industries, its investments are, and could continue to be, concentrated in relatively few industries. As a result, the aggregate returns Patriot realizes may be significantly adversely affected if a small number of investments perform poorly or if Patriot needs to write down the value of any one investment. Additionally, a downturn in any particular industry in which Patriot is invested could also significantly impact the aggregate returns it realizes.

 

Price declines and illiquidity in the large corporate leverage loan market have adversely affected, and may continue to adversely affect, the fair value of Patriot’s syndicated loan portfolio, reducing its net asset value through increased net unrealized depreciation.

 

The continuing unprecedented declines in prices and illiquidity in the large corporate leverage loan market have resulted in significant unrealized depreciation in Patriot’s syndicated loan portfolio. Conditions in the large corporate leverage loan market may continue to deteriorate which could cause pricing levels to continue to decline. As a result, Patriot may continue to suffer additional unrealized losses and could incur significant realized losses in future periods in connection with the sale of its syndicated loans, which could have a material adverse impact on its business, financial condition and results of operations.

 

Patriot’s portfolio companies may incur debt that ranks equally with, or senior to, its investments in such companies.

 

Patriot invests primarily in senior secured loans, junior secured loans and subordinated debt issued by small- to mid-sized companies. Patriot’s portfolio companies may have, or may be permitted to incur, other debt that ranks equally with, or senior to, the debt in which it invests. By their terms, such debt instruments may entitle the holders to receive payment of interest or principal on or before the dates on which Patriot is entitled to receive payments with respect to the debt instruments in which it invests. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to Patriot’s investment in that portfolio company would typically be entitled to receive payment in full before it receives any distribution. After repaying such senior creditors, such portfolio company may not have any remaining assets to use for repaying its obligation to Patriot. In the case of debt ranking equally with debt instruments in which Patriot invests, it would have to share on an equal basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.

 

Second priority liens on collateral securing loans that Patriot makes to its portfolio companies may be subject to control by senior creditors with first priority liens. If there is a default, the value of the collateral may not be sufficient to repay in full both the first priority creditors and it.

 

Certain loans that Patriot makes to portfolio companies may be secured on a second priority basis by the same collateral securing senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio company’s obligations under any outstanding senior debt and may secure certain other

future debt that may be permitted to be incurred by the portfolio company under the agreements governing the loans. The holders of obligations secured by the first priority liens on the collateral will generally control the liquidation of and be entitled to receive proceeds from any realization of the collateral to repay their obligations in full before Patriot. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from the sale or sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If such proceeds are not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then Patriot, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim against the portfolio company’s remaining assets, if any.

 

The rights Patriot may have with respect to the collateral securing the loans it makes to its portfolio companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that Patriot enters into with the holders of senior debt. Under such an intercreditor agreement, at any time that obligations that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken in respect of the collateral will be at the direction of the holders of the obligations secured by the first priority liens: the ability to cause the commencement of enforcement proceedings against the collateral; the ability to control the conduct of such proceedings; the approval of amendments to collateral documents; releases of liens on the collateral; and waivers of past defaults under collateral documents. Patriot may not have the ability to control or direct such actions, even if its rights are adversely affected.

 

There may be circumstances where Patriot’s debt investments could be subordinated to claims of other creditors or it could be subject to lender liability claims.

 

Even though Patriot may have structured certain of its investments as senior loans, if one of its portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which it actually provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize its debt investment and subordinate all or a portion of its claim to that of other creditors. Patriot may also be subject to lender liability claims for actions taken by it with respect to a borrower’s business or instances where Patriot exercises control over the borrower. It is possible that Patriot could become subject to a lender’s liability claim, including as a result of actions taken in rendering significant managerial assistance.

 

Patriot may not control any of its portfolio companies.

 

Patriot may not control any of its portfolio companies, even though it may have board representation or board observation rights and its debt agreements may contain certain restrictive covenants. As a result, Patriot is subject to the risk that a portfolio company in which it invests may make business decisions with which it disagrees and the management of such company, as representatives of the equity shareholders, may take risks or otherwise act in ways that do not serve its interests as debt investors.

 

Defaults by Patriot’s portfolio companies will harm its operating results.

 

A portfolio company’s failure to satisfy financial or operating covenants imposed by Patriot or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize the portfolio company’s ability to meet its obligations under the debt investments that Patriot holds. Patriot may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company.

 

Prepayments of Patriot’s debt investments by its portfolio companies could adversely impact its results of operations and reduce its return on equity.

 

Patriot is subject to the risk that the investments it makes in its portfolio companies may be repaid prior to maturity. When this occurs, Patriot will generally reinvest these proceeds in temporary investments, pending their future investment in new portfolio companies. These temporary investments will typically have

substantially lower yields than the debt being prepaid and Patriot could experience significant delays in reinvesting these amounts. Any future investment in a new portfolio company may also be at lower yields than the debt that was repaid. As a result, Patriot’s results of operations could be materially adversely affected if one or more of its portfolio companies elects to prepay amounts owed to it. Additionally, prepayments could negatively impact Patriot’s return on equity, which could result in a decline in the market price of its common stock.

 

Patriot may not realize gains from its equity investments.

 

Certain investments that Patriot has made in the past and may make in the future include warrants or other equity securities. In addition, Patriot may from time to time make non-control, equity co-investments in companies in conjunction with private equity sponsors. Patriot’s goal is ultimately to realize gains upon its disposition of such equity interests. However, the equity interests Patriot receives may not appreciate in value and, in fact, may decline in value. Accordingly, Patriot may not be able to realize gains from its equity interests, and any gains that it does realize on the disposition of any equity interests may not be sufficient to offset any other losses it experiences. Patriot also may be unable to realize any value if a portfolio company does not have a liquidity event, such as a sale of the business, recapitalization or public offering, which would allow it to sell the underlying equity interests.

 

There is a risk that Patriot’s shareholders may not receive dividends or that Patriot’s dividends may not grow over time.

 

Patriot cannot assure its shareholders that it will achieve investment results that will allow it to make a specified level of cash distributions or year-to-year increases in cash distributions. As a result of the termination event that occurred under the Amended Securitization Facility on April 3, 2009, Patriot is required to dedicate a significant portion of its operating cash flow to repay the principal amount outstanding under the Amended Securitization Facility by April 2011. As a result, it may be required to severely limit or otherwise cease making cash distributions to its shareholders. In addition, due to the asset coverage test applicable to it as a business development company and financial covenants contained in its loan agreements, Patriot may be limited in its ability to make distributions.

 

Investing in Patriot’s shares may involve an above average degree of risk.

 

The investments Patriot makes in accordance with its investment objective may result in a higher amount of risk than alternative investment options and volatility or loss of principal. Patriot’s investments in portfolio companies may be highly speculative and aggressive, and therefore, an investment in its shares may not be suitable for someone with lower risk tolerance.

 

The market price of Patriot’s common stock may fluctuate significantly.

 

The market price and liquidity of the market for shares of Patriot’s common stock may be significantly affected by numerous factors, some of which are beyond its control and may not be directly related to its operating performance. These factors include:

 

 

 

Shares of closed-end investment companies, including business development companies, may trade at a discount to their net asset value.

 

Shares of closed-end investment companies, including business development companies, may trade at a discount from net asset value. This characteristic of closed-end investment companies and business development companies is separate and distinct from the risk that Patriot’s net asset value per share may decline. Patriot cannot predict whether its common stock will trade at, above or below net asset value. In recent quarters, the price of its common stock has traded at prices below its net asset value. It should be noted that share prices of many other business development companies have also traded at prices below their net asset value.

 

In addition, if Patriot’s common stock trades below net asset value, it will generally not be able to issue additional common stock at the market price unless its shareholders approve such a sale and its board of directors makes certain determinations.

 

Patriot’s common stock could be delisted from the NASDAQ Global Select Market if it is unable to maintain its compliance with NASDAQ listing requirements.

 

In recent months, many public companies whose securities trade on the NASDAQ Global Select Market have experienced significant volatility and sharp declines in their stock prices. In general, in order to meet NASDAQ’s continued listing standards, the closing bid of a company’s common stock must be at least $1.00 per share.

 

If the closing bid price per share for Patriot’s common stock were to fall below $1.00 per share for 30 consecutive business days, it would receive notification from NASDAQ indicating that it is not in compliance with NASDAQ Marketplace Rule 4450(a)(5). In accordance with NASDAQ Marketplace Rule 4450(e)(2), Patriot would then be provided 180 calendar days to regain compliance.

 

To regain compliance with the minimum bid price requirement, the closing bid price of Patriot’s common stock must remain at $1.00 per share or more for a minimum of ten consecutive business days. If Patriot were unable to regain compliance, it would be able to apply to list its common stock on the NASDAQ Capital Market and NASDAQ will determine whether it meets the NASDAQ Capital Market initial listing criteria as set forth in NASDAQ Marketplace Rule 4310(c), except for the minimum bid price requirement. If Patriot was able to meet the NASDAQ Capital Market initial listing criteria, NASDAQ may notify it that it has been granted an additional 180 calendar days to come into compliance with the minimum bid price requirement. If Patriot were not able to meet the initial listing criteria, NASDAQ may provide it with written notification that its common stock would be delisted. At that time, Patriot would be permitted to appeal NASDAQ’s determination to delist its common stock to a NASDAQ Listings Qualifications Panel.

 

Delisting from the NASDAQ could have an adverse effect on Patriot’s business and on the trading of its common stock. If a delisting of Patriot’s common stock from NASDAQ were to occur, its common stock would trade on the Over-the-Counter Bulletin Board or on the “pink sheets” maintained by the National Quotation Bureau, Inc. Such alternatives generally are considered to be less efficient markets, and Patriot’s stock price, as well as the liquidity of its common stock, could be affected adversely.

Terrorist attacks, acts of war or natural disasters may affect any market for Patriot’s common stock, impact the businesses in which it invests and harm its business, operating results and financial condition.

 

Terrorist acts, acts of war or natural disasters may disrupt Patriot’s operations, as well as the operations of the businesses in which it invests. Such acts have created, and continue to create, economic and political uncertainties and have contributed to global economic instability. Future terrorist activities, military or security operations, or natural disasters could further weaken the domestic/global economies and create additional uncertainties, which may negatively impact the businesses in which Patriot invests directly or indirectly and, in turn, could have a material adverse impact on its business, operating results and financial condition. Losses from terrorist attacks and natural disasters are generally uninsurable.

 

Certain provisions of Patriot’s restated certificate of incorporation and restated bylaws as well as the Delaware General Corporation Law could deter takeover attempts and have an adverse impact on the price of its common stock.

 

Patriot’s restated certificate of incorporation and its restated bylaws as well as the Delaware General Corporation Law contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for it. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of Patriot’s common stock the opportunity to realize a premium over the market price for its common stock.

 

Some of the statements in this document may constitute forward-looking statements because they relate to future events or future performance or financial condition. These forward-looking statements may include statements as to:

 

 

In addition, words such as “anticipate,” “believe,” “expect” and “intend” indicate a forward-looking statement, although not all forward-looking statements include these words. The forward-looking statements contained in this document involve risks and uncertainties. Actual results could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth in “Risk Factors” and elsewhere in this document.

 

The forward-looking statements included in this document have been based on information available to Patriot and Prospect on the date of this document, as appropriate, and Patriot and Prospect assume no obligation to update any such forward-looking statements. Although Patriot and Prospect undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that Patriot and Prospect may make directly to you or through reports that Patriot and Prospect in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The forward-looking statements in this document are excluded from the safe harbor protection provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

 

The special meeting of Patriot shareholders will take place on November 18, 2009, at 10:30 a.m. (Eastern Daylight Time), at the offices of Edwards Angell Palmer & Dodge LLP at Three Stamford Plaza, 301 Tresser Boulevard, Stamford, Connecticut 06901.

 

Patriot shareholders are being asked to consider and vote on the following items at the special meeting:

 

 

See “The Merger Proposal” and “Description of the Merger Agreement.”

 

Patriot’s board of directors, including the independent directors, unanimously recommends that shareholders vote “FOR” approval of the merger agreement and the transactions contemplated by the merger agreement.

 

Only holders of record of Patriot’s common stock at the close of business on October 21, 2009, the record date, are entitled to notice of and to vote at the special meeting. On the record date, approximately 20,950,501 shares of common stock were issued and outstanding and held by approximately           holders of record.

 

A quorum is required to be present in order to conduct business at the special meeting. A quorum will be present if a majority of the votes entitled to be cast are present, in person or by proxy. Proxies properly executed and marked with a positive vote, a negative vote or an abstention will be considered to be present at the special meeting for purposes of determining whether a quorum is present for the transaction of all business at the special meeting.

 

Shareholders will also be asked to consider a proposal to adjourn or postpone of the meeting for the solicitation of additional votes, if necessary. Any such adjournment will only be permitted if approved by the holders of shares representing a majority of the votes present in person or by proxy at the special meeting, whether or not a quorum exists. Abstentions will be treated for purposes of the adjournment vote as votes cast “against” the adjournment.

 

Holders of record of Patriot’s common shares on the record date are entitled to one vote per share.

 

Merger proposal.  The affirmative vote of the holders of a majority of Patriot’s outstanding shares entitled to vote is required to approve the merger agreement and the proposed merger. Shareholders who abstain, fail to return their proxies or do not otherwise vote, will be voting “against” the merger agreement and the proposed merger. Brokers who hold shares of stock in street name cannot vote those shares if the brokers are not provided with voting instructions in accordance with their procedures, and this would also be counted as a vote “against” the merger proposal.

 

Adjournment proposal.  The affirmative vote of the holders of a majority of Patriot’s shares present at the special meeting is required to approve the adjournment proposal. Shareholders who abstain will be voting

“against” the adjournment proposal. It is expected that brokers and other nominees will not have discretionary authority to vote on the proposal to adjourn the special meeting. As a result, broker shares for which written authority to vote has not been obtained will be treated as not present and not entitled to vote with respect to this proposal and will, therefore, reduce the absolute number (but not the percentage) of the affirmative votes required for approval of such proposal.

 

At the close of business on October 21, 2009, Patriot’s executive officers and directors owned and were entitled to vote 3,417,638 shares of Patriot’s common stock, representing 15.83% of Patriot’s outstanding shares of common stock on that date. None of Patriot’s executive officers or directors has entered into any voting agreement relating to the proposed merger; however, each of Patriot’s executive officers and directors has indicated that he intends to vote his shares of common stock in favor of the approval of the merger and the merger agreement as long as the merger agreement is in effect.

 

All shares represented by properly executed proxies received in time for the special meeting will be voted at the special meeting in the manner specified by the shareholders giving those proxies. Properly executed proxies that do not contain voting instructions will be voted “for” the approval of each matter to be voted on at the special meeting, including approval of the proposed merger and the merger agreement. Shareholders may also vote by calling the proxy solicitor at (866) 796-3439.

 

Under Delaware Law and Patriot’s Bylaws, only the matters stated in the notice of special meeting will be presented for action at the special meeting or at any adjournment or postponement of the special meeting.

 

Submitting a proxy on the enclosed form does not preclude a shareholder from voting in person at the special meeting. A shareholder may revoke a proxy at any time before it is voted by filing with Patriot a duly executed revocation of proxy, by submitting a duly executed proxy to Patriot with a later date, by re-voting by calling the proxy solicitor at (866) 796-3439, or by appearing at the special meeting and voting in person. Shareholders may revoke a proxy by any of these methods, regardless of the method used to deliver a shareholder’s previous proxy. Attendance at the special meeting without voting will not itself revoke a proxy.

 

Patriot will bear the expenses incurred in connection with the printing and furnishing of this document to its shareholders. In addition to solicitation by mail, Patriot’s executive officers, who will not be specially compensated, may solicit proxies from Patriot’s shareholders by telephone, facsimile, telegram or other electronic means or in person. Patriot has retained The Altman Group, Inc. to assist in the solicitation of proxies from shareholders for a maximum fee of $24,000. Arrangements may also be made with brokerage houses and other custodians, nominees and fiduciaries for the forwarding of solicitation materials to the beneficial owners of shares held of record by these persons, and Patriot will reimburse them for their reasonable out-of-pocket expenses.