As filed with the Securities and Exchange Commission on March 15, 2006
Securities Act Registration No. 333-
Investment Company Act Registration No. 811-
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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[GRAPHIC OMITTED]FORM N-2
Registration Statement
Under the Securities Act of 1933 |X|
Pre-Effective Amendment No. |_|
Post-Effective Amendment No. |_|
and/or
Registration Statement
Under the Investment Company Act of 1940 |X|
Amendment No. |_|
___________________________________
Highland Credit Strategies Fund
(Exact Name of Registrant as Specified in Declaration of Trust)
Two Galleria Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Address of Principal Executive Offices)
(877) 665-1287
(Registrant's telephone number, including area code)
James D. Dondero, President
Highland Credit Strategies Fund
Two Galleria Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Name and Address of Agent for Service)
___________________________________
Copies to:
Philip Harris, Esq.
Skadden, Arps, Slate, Meagher & Flom LLP
Four Times Square
New York, New York 10036
___________________________________
Approximate date of proposed public offering:
As soon as practicable after the effective date of this Registration Statement.
___________________________________
CALCULATION OF REGISTRATION FEE UNDER THE SECURITIES ACT OF 1933
==========================================================================================================================
Title of Securities Being Registered Amount Being Proposed Maximum Proposed Maximum Amount of
Offering Aggregate Registration
Registered Price per Unit Offering Price Fee
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Common Shares, $0.001 par value.................. 100,000 shares $20.00 $2,000,000(1) $214.00
==========================================================================================================================
(1) Estimated solely for the purpose of calculating the 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 THE REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATES AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION
8(a), MAY DETERMINE.
HIGHLAND CREDIT STRATEGIES FUND
CROSS REFERENCE SHEET
Part A -- Prospectus
Items in Part A of Form N-2 Location in Prospectus
---------------------------------------------------------------- --------------------------------------------------
Item 1. Outside Front Cover Cover Page
Item 2. Cover Pages; Other Offering Information Cover Page
Item 3. Fee Table and Synopsis Prospectus Summary; Summary of Trust Expenses
Item 4. Financial Highlights Not Applicable
Item 5. Plan of Distribution Cover Page; Prospectus Summary; Underwriting
Item 6. Selling Shareholders Not Applicable
Item 7. Use of Proceeds Use of Proceeds; The Trust's Investments
Item 8. General Description of the Registrant The Trust; The Trust's Investments; Risks;
Description of Shares; Anti-Takeover Provisions
in the Agreement and Declaration of Trust;
Closed-End Trust Structure;
Item 9. Management Management of the Trust; Custodian and Transfer
Agent; Trust Expenses
Item 10. Capital Stock, Long-Term Debt, and Other Securities Description of Shares; Distributions; Dividend
Reinvestment Plan; Anti-Takeover Provisions in
the Agreement and Declaration of Trust; Tax
Matters
Item 11. Defaults and Arrears on Senior Securities Not Applicable
Item 12. Legal Proceedings Legal Opinions
Item 13. Table of Contents of the Statement of Additional Table of Contents for the Statement of Additional
Information Information
Part B -- Statement of Additional Information
Item 14. Cover Page Cover Page
Item 15. Table of Contents Cover Page
Item 16. General Information and History Not Applicable
Item 17. Investment Objective and Policies Investment Objectives and Policies; Investment
Policies and Techniques; Other Investment
Policies and Techniques; Portfolio Transactions
Item 18. Management Management of the Trust; Portfolio Transactions and
Brokerage
Item 19. Control Persons and Principal Holders of Securities Not Applicable
Item 20. Investment Advisory and Other Services Management of the Trust; Experts
Item 21. Portfolio Managers Management of the Trust
Item 22. Brokerage Allocation and Other Practices Portfolio Transactions and Brokerage
Item 23. Tax Status Tax Matters; Distributions
Item 24. Financial Statements Financial Statements; Independent Auditors' Report
Part C -- Other Information
Items 25-34 have been answered in Part C of this Registration Statement
[flag]
The information in this prospectus is not complete and may be changed. We may
not sell these securities until the registration statement filed with the
Securities and Exchange Commission is effective. This prospectus is not an
offer to sell these securities and is not soliciting an offer to buy these
securities in any state where the offer or sale is not permitted.
PRELIMINARY PROSPECTUS Subject to Completion , 2006
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Shares
Highland Credit Strategies Fund
Common Shares
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Investment Objectives. Highland Credit Strategies Fund (the "Trust") is a newly
organized, non-diversified, closed-end management investment company. The
Trust's primary investment objective is to deliver attractive risk-adjusted
returns to its investors by employing a multi-strategy investment approach to
exploit relative value and arbitrage opportunities within the credit markets.
Highland Capital Management, L.P., the Trust's investment manager ("Highland"
or the "Investment Manager"), will execute, on behalf of the Trust,
directional, relative value, capital structure arbitrage and event-driven
investment strategies across various credit markets where the Investment
Manager holds significant investment experience: primarily the leveraged loan,
high yield, structured products, and distressed markets. The Trust will seek to
create a portfolio of investments that will maintain low correlation to the
broader equity and corporate bond markets, as well as to other alternative
investment strategies. A significant portion of the Trust's assets may be
invested in securities rated below investment grade, which are commonly
referred to as "junk bonds." There can be no assurance that the Trust's
investment objectives will be achieved, and the Investment Manager has full
discretion regarding the capital markets from which it can access investment
opportunities.
No Prior History. The Trust's shares have no history of public trading. Shares
of closed-end investment companies frequently trade at a discount from their
net asset value. This risk may be greater for investors expecting to sell their
shares in a relatively short period after completion of the public offering.
The Trust anticipates that its common shares will be listed on the New York
Stock Exchange under the symbol " ."
(continues on next page)
Before buying any common shares you should read the discussion of the material
risks of investing in the Trust in "Principal risks of the Trust" beginning on
page of this prospectus. Certain of the risks are summarized in "Prospectus
summary--Principal Risks of the Trust" beginning on page .
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
Estimated
Offering Proceeds to
Price to Public Sales Load(2) Expenses(3) Trust(4)
------------------------------------------------------- ---------------- -------------- -------------- --------------------
Per Share $ $ $ $
------------------------------------------------------- ---------------- -------------- -------------- --------------------
Total(1) $ $ $ $
------------------------------------------------------- ---------------- -------------- -------------- --------------------
(1) The Trust has granted the underwriters an option to purchase up to
additional common shares at the price to public, less the sales load,
within 45 days of the date of this prospectus solely to cover
over-allotments, if any. If such option is exercised in full, the total
price to public, sales load, estimated offering expenses and proceeds to
the Trust will be $ , $ , $ and $ , respectively. See
"Underwriting."
(2) Highland may pay certain qualifying underwriters a sales incentive fee,
structuring fee or, alternatively, additional compensation in connection
with the offering provided that certain specified sales targets are met.
Highland may pay commissions to employees of its affiliates that
participate in the marketing of the Trust's common shares. See
"Underwriting."
(3) The Trust will pay offering expenses of the Trust (other than the sales
load) up to an aggregate of $ per share of the Trust's common shares
sold in this offering which may include a reimbursement of Highland's
expenses incurred in connection with this offering. Highland has agreed
to pay such offering expenses of the Trust to the extent they exceed
$ per share of the Trust's common shares. The aggregate offering
expenses (other than sales load) to be incurred by the Trust are estimated
to be $ (including amounts incurred by Highland on behalf of the
Trust).
(4) Proceeds to the Trust are calculated after expenses.
The underwriters expect to deliver the common shares to purchasers on or
about , 2006.
___________________
(continued from previous page)
Investment Policies and Strategy. Under normal market conditions, the
Investment Manager will employ, on behalf of the Trust, directional, capital
structure arbitrage, relative value, and event-driven investment strategies
across various credit markets where the Investment Manager holds significant
investment experience; primarily the leveraged loan, high yield, structured
products, and distressed markets. The Trust will utilize a multi-strategy
investment approach to exploit relative value and arbitrage opportunities
within these markets. An objective of the Trust is to maintain low correlation
to the broader equity and corporate bond markets, as well as other alternative
investment strategies, and to provide high risk-adjusted returns on capital. No
assurance can be given that the Trust will achieve its objectives, and the
Investment Manager has full discretion regarding the capital markets from which
it can access investment opportunities.
The Investment Manager looks to implement selected trading strategies to
exploit pricing inefficiencies across the credit markets and within an
individual issuer's capital structure. The Trust seeks to achieve
diversification by strategy, industry, security type and credit market, but
reserves the right to re-position its portfolio toward more concentrated levels
depending on market dynamics. Highland manages interest rate, default, currency
and systemic risks through a variety of trading methods and market tools,
including derivative hedging instruments, as it deems appropriate.
The multi-strategy investment program to be implemented by the Trust will allow
the Investment Manager to assess what it considers to be the best risk-adjusted
opportunities across multiple markets and to quickly adjust the Trust's trading
strategies and market focus to changing conditions. The Investment Manager
intends to focus primarily on the U.S. marketplace, but may pursue
opportunities in the global credit markets.
You should read this prospectus, which contains important information about the
Trust, before deciding whether to invest, and retain it for future reference. A
Statement of Additional Information, dated , 2006, containing additional
information about the Trust, has been filed with the Securities and Exchange
Commission (the "Commission") and is incorporated by reference in its entirety
into this prospectus. You can review the table of contents of the Statement of
Additional Information on page of this prospectus. You may request a free
copy of the Statement of Additional Information by calling (877) 665-1287 or by
writing to the Trust, or obtain a copy (and other information regarding the
Trust) from the Commission's web site (http://www.sec.gov).
The Trust's common shares do not represent a deposit or obligation of, and are
not guaranteed or endorsed by, any bank or other insured depository
institution, and are not federally insured by the Federal Deposit Insurance
Corporation, the Federal Reserve Board or any other government agency.
Until , 2006 (25 days after the date of this prospectus), all dealers that
buy, sell or trade the common shares, whether or not participating in this
offering, may be required to deliver a prospectus. This is in addition to the
dealers' obligation to deliver a prospectus when acting as underwriters and with
respect to their unsold allotments or subscriptions.
ii
TABLE OF CONTENTS
Prospectus Summary.............................................................1
Summary of Trust Expenses.....................................................17
The Trust.....................................................................19
Use of Proceeds...............................................................19
The Trust's Investments.......................................................19
Principal risks of the Trust..................................................31
Management of the Trust.......................................................41
Net asset value...............................................................42
Distributions.................................................................43
Dividend reinvestment plan....................................................43
Description of shares.........................................................44
Anti-Takeover provisions in the Agreement and Declaration of Trust............46
Closed-end fund structure.....................................................47
Repurchase of common shares...................................................47
Tax matters...................................................................48
Underwriting..................................................................49
Custodian and transfer agent..................................................50
Legal opinions................................................................50
Privacy principles of the Trust...............................................50
Table of contents for the Statement of Additional Information.................51
You should rely only on the information contained or incorporated by reference
in this prospectus. We have not, and the underwriters have not, authorized any
other person to provide you with different information. If anyone provides you
with different or inconsistent information, you should not rely on it. We are
not, and the underwriters are not, making an offer to sell these securities in
any jurisdiction where the offer or sale is not permitted. You should assume
that the information in this prospectus is accurate only as of the date of this
prospectus. Our business, financial condition and prospects may have changed
since that date.
iii
PROSPECTUS SUMMARY
This is only a summary. This summary may not contain all of the
information that you should consider before investing in our common shares. You
should review the more detailed information contained in this prospectus and in
the Statement of Additional Information.
The Trust .......................... Highland Credit Strategies Fund is a newly organized, non-diversified, closed-end
management investment company. Throughout this prospectus, we refer to Highland
Credit Strategies Fund simply as the "Trust" or as "we," "us" or "our." See "The
Trust."
The Offering........................ The Trust is offering common shares of beneficial
interest at $20.00 per share through a group of underwriters (the "Underwriters")
led by . The common shares of beneficial interest are called
"common shares" in the rest of this prospectus. You must purchase at least 100
common shares ($2,000) in order to participate in this offering. The Trust has
given the Underwriters an option to purchase up to additional common
shares to cover over-allotments. Highland has agreed to pay (i) all organizational
expenses, and (ii) offering expenses (other than sales load) that exceed $ per
common share. See "Underwriting."
Investment Objectives............... The Trust's primary investment objective is to deliver attractive risk-adjusted
returns to its investors by employing a multi-strategy investment approach to
exploit relative value and arbitrage opportunities within the credit markets.
Highland will execute, on behalf of the Trust, directional, relative value,
capital structure arbitrage and event-driven investment strategies across various
credit markets where the Investment Manager holds significant investment
experience: primarily the leveraged loan, high yield, structured products, and
distressed markets. The Trust will seek to create a portfolio of investments that
will maintain low correlation to the broader equity and corporate bond markets, as
well as to other alternative investment strategies. There can be no assurance
that the Trust's investment objectives will be achieved, and the Investment
Manager has full discretion regarding the capital markets from which it can access
investment opportunities. See "The Trust's investments--Investment Objectives and
Policies."
Investment Policies
And Strategy..................... The Investment Manager looks to implement selected trading strategies to exploit
pricing inefficiencies across the credit markets and within an individual issuer's
capital structure. The Trust seeks to achieve diversification by strategy,
industry, security type and credit market, but reserves the right to re-position
its portfolio toward more concentrated levels depending on market dynamics.
Highland manages interest rate, default, currency and systemic risks through a
variety of trading methods and market tools, including derivative hedging
instruments, as it deems appropriate.
The Investment Manager believes that the Trust will benefit from Highland's
industry focused investment platform and specialist trading skills. In finding
relative value and directional opportunities, the Investment Manager looks to
leverage its investment platform of approximately sixty (60) credit investment
professionals, which actively monitor approximately 1,200 companies and currently
have investments in approximately 1,000 credits. Their continuous monitoring of
the market and existing positions often leads to a meaningful advantage in the
timeliness and quality of information that the Investment Manager can obtain on
prospective investments. Additionally, the Investment Manager has senior
professionals that focus on individual credit markets, such as the distressed or
structured products segments. This broad platform of industry, product and market
specialists differentiates the Investment Manager from numerous funds which rely
on a limited number of investment professionals working in a more generalist
capacity. The Investment Manager believes that credit investing is a
1
due-diligence intensive process that requires long-term committed resources to
industry and product specialization so that investment decisions are proactive as
opposed to reactive in nature.
The multi-strategy investment program to be implemented by the Trust will allow
the Investment Manager to assess what it considers to be the best risk-adjusted
opportunities across multiple markets and to quickly adjust the Trust's trading
strategies and market focus to changing conditions. The Investment Manager
intends to focus primarily on the U.S. marketplace, but may pursue opportunities
in the global credit markets.
Investment Strategy ................ Under normal market conditions, the Investment Manager will employ, on behalf of
the Trust, directional, capital structure arbitrage, relative value, and
event-driven investment strategies across various credit markets where the
Investment Manager holds significant investment experience; primarily the
leveraged loan, high yield, structured products, and distressed markets. The
Trust will utilize a multi-strategy investment approach to exploit relative value
and arbitrage opportunities within these markets. An objective of the Trust is to
maintain low correlation to the broader equity and corporate bond markets, as well
as other alternative investment strategies, and to provide high risk-adjusted
returns on capital. No assurance can be given that the Trust will achieve its
objectives, and the Investment Manager has full discretion regarding the capital
markets from which it can access investment opportunities.
The Investment Manager will select investments from a wide range of trading
strategies and credit markets in order to create the desired amount of
diversification and to optimize the risk-reward parameters of the Trust. Highland
does not intend to invest the Trust's assets according to pre-determined
allocations. The investment team and other Highland personnel will use a wide
range of resources to identify attractive individual investments and promising
investment strategies for consideration in connection with investments by the
Trust. The following is a description of the general types of securities in which
the Trust may invest. This description is merely a summary and the Investment
Manager has discretion to cause the Trust to invest in other types of securities
and to follow other investment criteria and guidelines as described herein. See
"The Trust's Investments - Portfolio Composition" for a more complete description
of the types of securities and investments the Trust intends to make.
The Trust will invest and trade in listed and unlisted, public and private, rated
and unrated, debt and equity instruments and other obligations, including
structured debt and equity instruments as well as financial derivatives.
Investments may include investments in distressed positions, which may include
publicly-traded debt and equity securities, obligations which were privately
placed with banks, insurance companies and other lending institutions, trade
claims, accounts receivable and any other form of obligation recognized as a claim
in a bankruptcy or workout process. The Trust may invest in securities traded in
foreign countries and denominated in foreign currencies.
As part of its investment program, the Trust may invest, from time to time, in
debt or synthetic instruments that are sold in direct placement transactions
between their issuers and their purchasers and that are neither listed on an
exchange, nor traded over the counter. The Trust may also receive equity or
equity-related securities from time to time in connection with a workout
transaction.
The Trust may employ currency hedges (either in the forward or options markets)
in certain circumstances to reduce currency risk. The Trust plans to employ
leverage in the form of preferred shares, and the Trust may invest in the
securities of companies whose capital structures are highly leveraged.
2
From time to time, the Investment Manager may also invest a portion of the
Trust's assets in short-term U.S. Government obligations, certificates of
deposit, commercial paper and other money market instruments, including
repurchase agreements with respect to such obligations to enable the Trust to
make investments quickly and to serve as collateral with respect to certain of
its investments. A greater percentage of Trust assets may be invested in such
obligations if the Investment Manager believes that a defensive position is
appropriate because of expected economic or business conditions or the outlook
for security prices. From time to time cash balances in the Trust's brokerage
account may be placed in a money-market fund.
Investment Manager.................. Highland will be the Trust's investment manager. Highland will receive an annual
fee, payable monthly, in an amount equal to % of the average weekly value of
the Trust's Managed Assets (the "Management Fee"). The Trust's "Managed Assets"
will be an amount equal to the total assets of the Trust (including any assets
attributable to any Preferred Shares of the Trust issued and outstanding or
otherwise attributable to the use of leverage) minus the sum of its accrued
liabilities (other than the aggregate indebtedness constituting financial
leverage). The Management Fee is comprised of two components: % of the
Management Fee is paid to Highland as compensation for the portfolio management
services it provides to the Trust, and % of the Management Fee is paid
to Highland as compensation for the administrative services it provides to the
Trust. See "Management of the Trust."
Borrowings And
Preferred Shares................. The Trust intends to use leverage through the issuance of preferred shares of
beneficial interest ("Preferred Shares"), commercial paper and/or borrowings in
an aggregate amount of up to % of the Trust's Managed Assets after such
issuance or borrowing. The Trust may borrow from banks and other financial
institutions.
The Trust currently intends to issue Preferred Shares approximately one to three
months following the completion of this offering. The issuance of Preferred
Shares will leverage your investment in common shares. If the Trust offers
Preferred Shares, costs of that offering will be borne immediately by common
shareholders and result in a reduction of the net asset value of the common
shares. Any issuance of Preferred Shares, commercial paper, notes or other types
of borrowing will have seniority over the common shares.
Any Preferred Shares issued by the Trust will pay dividends based on short-term
rates, which will be reset frequently. Borrowings may be at a fixed or floating
rate and generally will be based on short-term rates. So long as the rate of
return, net of applicable Trust expenses, on the Trust's portfolio investments
purchased with leverage exceeds the Preferred Share dividend rate, as reset
periodically, or the interest rate on any borrowings, the Trust will generate more
return or income than will be needed to pay such dividends or interest payments.
In this event, the excess will be available to pay higher dividends to holders of
common shares. When leverage is employed, the net asset value and market price of
the common shares and the yield to holders of common shares will be more volatile.
Leverage creates a greater risk of loss, as well as a potential for more gain, for
the common shares than if leverage is not used. The Trust's leveraging strategy
may not be successful. See "Principal Risks of the Trust - Leverage."
Distributions....................... Commencing with the Trust's initial dividend, the Trust intends to make regular
monthly cash distributions of all or a portion of its investment company taxable
income to common shareholders. We expect to declare the initial monthly dividend
on the Trust's common shares within approximately 45 days after completion of this
offering and to pay that initial monthly dividend approximately 60 to 90 days
after completion of this offering. The Trust expects to pay common shareholders
3
annually at least 90% of its investment company taxable income.
Various factors will affect the level of the Trust's current income and current
gains, such as its asset mix. To permit the Trust to maintain more stable monthly
distributions, the Trust may from time to time distribute less than the entire
amount of income and gains earned in a particular period. The undistributed
income and gains would be available to supplement future distributions. As a
result, the distributions paid by the Trust for any particular month may be more
or less than the amount of income and gains actually earned by the Trust during
that month. Undistributed income and gains will add to the Trust's net asset
value and, correspondingly, distributions from undistributed income and gains and
from capital, if any, will deduct from the Trust's net asset value. See
"Distributions." Shareholders will automatically have all dividends and
distributions reinvested in common shares issued by the Trust or common shares of
the Trust purchased in the open market in accordance with the Trust's dividend
reinvestment plan unless an election is made to receive cash. See "Dividend
Reinvestment Plan."
Listing............................. The Trust anticipates that its common shares will be listed on the New York Stock
Exchange under the symbol " ."
Custodian And
Transfer Agent................... ALPS Mutual Trusts Services, Inc. ("ALPS"), located at 1625 Broadway, Suite 2200,
Denver, Colorado 80202, will serve as custodian for the Trust, and in such
capacity, will maintain certain financial and accounting books and records
pursuant to an agreement with the Trust. ALPS will also serve as the Trust's
transfer agent. See "Custodian and Transfer Agent."
Market Price
Of Shares........................ Common shares of closed-end investment companies frequently trade at prices lower
than their net asset value. Common shares of closed-end investment companies like
the Trust that invest primarily in equity securities have during some periods
traded at prices higher than their net asset value and during other periods traded
at prices lower than their net asset value. The Trust cannot assure you that its
common shares will trade at a price higher than or equal to net asset value. The
Trust's net asset value will be reduced immediately following this offering by the
sales load and the amount of the offering costs paid by the Trust. See "Use of
Proceeds." In addition to net asset value, the market price of the Trust's common
shares may be affected by such factors as dividend levels, which are in turn
affected by expenses, dividend stability, liquidity and market supply and demand.
See "Principal Risks of the Trust," "Description of Shares" and the section of the
Statement of Additional Information with the heading "Repurchase of Common
Shares." The common shares are designed primarily for long-term investors and you
should not purchase common shares of the Trust if you intend to sell them shortly
after purchase.
Principal Risks Of
The Trust........................ The following is a summary of some of the risks associated with an investment in
the Trust's common shares. Investors should also refer to "Principal Risks of the
Trust" in this Prospectus for a more detailed explanation of the risks associated
with investing in the Trust's common shares.
No Operating History
The Trust is a non-diversified, closed-end management investment company with no
operating history.
Investment And Market Discount Risk
An investment in the Trust's common shares is subject to investment risk,
including the possible loss of the entire amount that you invest. As with any
stock, the price of the Trust's shares will fluctuate with market conditions and
other
4
factors. If shares are sold, the price received may be more or less than the
original investment. Net asset value will be reduced immediately following the
initial offering by the amount of the sales load and offering expenses paid by
the Trust. Common shares are designed for long-term investors and should not be
treated as trading vehicles. Shares of closed-end management investment companies
frequently trade at a discount from their net asset value. The Trust's shares may
trade at a price that is less than the initial offering price. This risk may be
greater for investors who sell their shares in a relatively short period of time
after completion of the initial offering.
Concentration of the Trust's Portfolio
While the Investment Manager will invest in a number of fixed-income and equity
instruments issued by different institutions and plans to employ multiple
investment strategies with respect to the Trust's portfolio, it is possible that
a significant amount of the Trust's investments could be invested in the
instruments of only a few companies or that at any particular point in time one
investment strategy could be more heavily weighted than the others. The
concentration of the Trust's portfolio in any one obligor would subject the Trust
to a greater degree of risk with respect to defaults by such obligor, and the
concentration of the portfolio in any one industry would subject the Trust to a
greater degree of risk with respect to economic downturns relating to such
industry. The concentration of the Trust's portfolio in any one investment
strategy would subject the Trust to a greater degree of risk than if the Trust's
portfolio was diversified with respect to several investment strategies.
Illiquidity of Investments
The investments made by the Trust may be very illiquid, and consequently the
Trust may not be able to sell such investments at prices that reflects the
Investment Manager's assessment of their fair value or the amount paid for such
investments by the Trust. Illiquidity may result from the absence of an
established market for the investments as well as legal, contractual or other
restrictions on their resale by the Trust and other factors. Furthermore, the
nature of the Trust's investments, especially those in financially distressed
companies, may require a long holding period prior to being able to determine
whether the investment will be profitable or not.
Bank Loans
A portion of the Trust investments may consist of loans and participations
therein originated by banks and other financial institutions, typically referred
to as "bank loans." The Trust investments may include loans of a type generally
incurred by borrowers in connection with highly leveraged transactions, often to
finance internal growth, acquisitions, mergers or stock purchases, or for other
reasons. As a result of the additional debt incurred by the borrower in the
course of the transaction, the borrower's creditworthiness is often judged by the
rating agencies to be below investment-grade. Such loans are typically private
corporate loans which are negotiated by one or more commercial banks or financial
institutions and syndicated among a group of commercial banks and financial
institutions. In order to induce the lenders to extend credit and to offer a
favorable interest rate, the borrower often provides the lenders with extensive
information about its business which is not generally available to the public.
Bank loans are typically at the most senior level of the capital structure, and
are often secured by specific collateral, including, but not limited to,
trademarks, patents, accounts receivable, inventory, equipment, buildings, real
estate, franchises and common and preferred stock of the obligor or its
affiliates. Bank loans often contain restrictive covenants designed to limit the
activities of the borrower in an effort to protect the right of lenders to
receive timely payments of principal and interest. Such covenants may include
restrictions on dividend payments, specific
5
mandatory minimum financial ratios, limits on total debt and other financial
tests. Bank loans usually have shorter terms than subordinated obligations and
may require mandatory prepayments from excess cash flow, asset dispositions and
offerings of debt and/or equity securities. The bank loans and other debt
obligations to be acquired by the Trust are likely to be below investment-grade.
The Trust may acquire interests in bank loans and other debt obligations either
directly (by way of sale or assignment) or indirectly (by way of participation).
The purchaser of an assignment typically succeeds to all the rights and
obligations of the assigning institution and becomes a lender under the credit
agreement with respect to the debt obligation; however, its rights can be more
restricted than those of the assigning institution. A participation interest in a
portion of a debt obligation typically results in a contractual relationship only
with the institution participating out the interest, not with the borrower. In
purchasing participations, the Trust generally will have no right to enforce
compliance by the borrower with the terms of the loan agreement, nor any rights
of set off against the borrower, and the Trust may not directly benefit from the
collateral supporting the debt obligation in which it has purchased the
participation. As a result, the Trust will be exposed to the credit risk of both
the borrower and the institution selling the participation.
Purchasers of bank loans are predominantly commercial banks, investment Trusts
and investment banks. As secondary market trading volumes increase, new bank
loans frequently adopt standardized documentation to facilitate loan trading
which should improve market liquidity. There can be no assurance, however, that
future levels of supply and demand in bank loan trading will provide an adequate
degree of liquidity or that the current level of liquidity will continue. Because
of the provision to holders of such loans of confidential information relating to
the borrower, the unique and customized nature of the loan agreement, and the
private syndication of the loan, bank loans are not as easily purchased or sold
as a publicly traded security, and historically the trading volume in the bank
loan market has been small relative to the high-yield debt market.
Distressed Debt
The Trust is authorized to invest in the securities and other obligations of
distressed and bankrupt issuers, including debt obligations that are in covenant
or payment default. Such investments generally trade significantly below par and
are considered speculative. The repayment of defaulted obligations is subject to
significant uncertainties. Defaulted obligations might be repaid only after
lengthy workout or bankruptcy proceedings, during which the issuer might not make
any interest or other payments. Typically such workout or bankruptcy proceedings
result in only partial recovery of cash payments or an exchange of the defaulted
obligation for other debt or equity securities of the issuer or its affiliates,
which may in turn be illiquid or speculative.
There are a number of significant risks inherent in the bankruptcy process.
First, many events in a bankruptcy are the product of contested matters and
adversary proceedings and are beyond the control of the creditors. While
creditors are generally given an opportunity to object to significant actions,
there can be no assurance that a bankruptcy court in the exercise of its broad
powers would not approve actions that would be contrary to the interests of the
Trust. Second, the effect of a bankruptcy filing on an issuer may adversely and
permanently affect the issuer. The issuer may lose its market position and key
employees and otherwise become incapable of restoring itself as a viable entity.
If for this or any other reason the proceeding is converted to a liquidation, the
value of the issuer may not equal the liquidation value that was believed to
exist at the time of the investment. Third, the duration of a bankruptcy
proceeding is difficult to predict. A creditor's return on investment can be
adversely affected by delays while the plan of
6
reorganization is being negotiated, approved by the creditors and confirmed by
the bankruptcy court and until it ultimately becomes effective. Fourth, the
administrative costs in connection with a bankruptcy proceeding are frequently
high and would be paid out of the debtor's estate prior to any return to
creditors. For example, if a proceeding involves protracted or difficult
litigation, or turns into a liquidation, substantial assets may be devoted to
administrative costs. Fifth, bankruptcy law permits the classification of
"substantially similar" claims in determining the classification of claims in a
reorganization. Because the standard for classification is vague, there exists
the risk that the Trust's influence with respect to the class of securities or
other obligations it owns can be lost by increases in the number and amount of
claims in that class or by different classification and treatment. Sixth, in the
early stages of the bankruptcy process it is often difficult to estimate the
extent of, or even to identify, any contingent claims that might be made.
Seventh, especially in the case of investments made prior to the commencement of
bankruptcy proceedings, creditors can lose their ranking and priority if they
exercise "domination and control" over a debtor and other creditors can
demonstrate that they have been harmed by such actions. Eighth, certain claims
that have priority by law (for example, claims for taxes) may be substantial.
In any investment involving distressed debt obligations, there exists the risk
that the transaction involving such debt obligations will be unsuccessful, take
considerable time or will result in a distribution of cash or a new security or
obligation in exchange for the distressed debt obligations, the value of which
may be less than the Trust's purchase price of such debt obligations.
Furthermore, if an anticipated transaction does not occur, the Trust may be
required to sell its investment at a loss. Given the substantial uncertainties
concerning transactions involving distressed debt obligations in which the Trust
invests, there is a potential risk of loss by the Trust of its entire investment
in any particular investment.
Investments in companies operating in workout modes or under Chapter 11 of the
Bankruptcy Code are also, in certain circumstances, subject to certain additional
liabilities which may exceed the value of the Trust's original investment in a
company. For example, under certain circumstances, creditors who have
inappropriately exercised control over the management and policies of a debtor
may have their claims subordinated or disallowed or may be found liable for
damages suffered by parties as a result of such actions. The Investment Manager's
active management style may present a greater risk in this area than would a more
passive approach. In addition, under certain circumstances, payments to the Trust
and distributions by the Trust or payments on the debt may be reclaimed if any
such payment is later determined to have been a fraudulent conveyance or a
preferential payment.
The Investment Manager on behalf of the Trust may participate on committees
formed by creditors to negotiate with the management of financially troubled
companies that may or may not be in bankruptcy or may negotiate directly with
debtors with respect to restructuring issues. If the Trust does choose to join a
committee, the Trust would likely be only one of many participants, all of whom
would be interested in obtaining an outcome that is in their individual best
interests. There can be no assurance that the Trust would be successful in
obtaining results most favorable to it in such proceedings, although the Trust
may incur significant legal and other expenses in attempting to do so. As a
result of participation by the Trust on such committees, the Trust may be deemed
to have duties to other creditors represented by the committees, which might
thereby expose the Trust to liability to such other creditors who disagree with
the Trust's actions. Participation by the Trust on such committees may cause the
Trust to be subject to certain restrictions on its ability to trade in a
particular investment and may also make the Trust an "insider" for purposes of
the federal securities laws. Either circumstance will restrict the Trust's
ability to trade in or acquire additional positions in a
7
particular investment when it might otherwise desire to do so.
High-Yield Securities
A portion of the Trust's investments will consist of investments that may
generally be characterized as "high-yield securities." Such securities are
typically rated below investment grade by one or more nationally recognized
statistical rating organizations or are unrated but of comparable credit quality
to obligations rated below investment grade, and have greater credit and
liquidity risk than more highly rated obligations. High-yield securities are
generally unsecured and may be subordinate to other obligations of the obligor.
The lower rating of high-yield securities reflects a greater possibility that
adverse changes in the financial condition of the issuer or in general economic
conditions (including, for example, a substantial period of rising interest rates
or declining earnings) or both may impair the ability of the issuer to make
payment of principal and interest. Many issuers of high-yield securities are
highly leveraged, and their relatively high debt to equity ratios create
increased risks that their operations might not generate sufficient cash flow to
service their obligations. Overall declines in the below investment grade bond
and other markets may adversely affect such issuers by inhibiting their ability
to refinance their obligations at maturity.
High-yield securities are often issued in connection with leveraged acquisitions
or recapitalizations in which the issuers incur a substantially higher amount of
indebtedness than the level at which they had previously operated. High-yield
securities that are debt instruments have historically experienced greater
default rates than has been the case for investment grade securities. The Trust
may also invest in equity securities issued by entities whose obligations are
unrated or are rated below investment grade.
The Trust is authorized to invest in obligations of issuers which are generally
trading at significantly higher yields than had been historically typical of the
applicable issuer's obligations. Such investments may include debt obligations
that have a heightened probability of being in covenant or payment default in the
future. Such investments generally are considered speculative. The repayment of
defaulted obligations is subject to significant uncertainties. Defaulted
obligations might be repaid only after lengthy workout or bankruptcy proceedings,
during which the issuer might not make any interest or other payments. Typically
such workout or bankruptcy proceedings result in only partial recovery of cash
payments or an exchange of the defaulted security for other debt or equity
securities of the issuer or its affiliates, which may in turn be illiquid or
speculative.
High-yield securities purchased by the Trust will be subject to certain
additional risks to the extent that such obligations may be unsecured and
subordinated to substantial amounts of senior indebtedness, all or a significant
portion of which may be secured. Moreover, such obligations purchased by the
Trust may not be protected by financial covenants or limitations upon additional
indebtedness.
8
Insolvency Considerations with Respect to Issuers of Debt Obligations
Various laws enacted for the protection of creditors may apply to the debt
obligations held by the Trust. The information in this paragraph is applicable
with respect to U.S. issuers subject to United States bankruptcy laws. Insolvency
considerations may differ with respect to other issuers. If a court in a lawsuit
brought by an unpaid creditor or representative of creditors of an issuer of a
debt obligation, such as a trustee in bankruptcy, were to find that the issuer
did not receive fair consideration or reasonably equivalent value for incurring
the indebtedness constituting the debt obligation and, after giving effect to
such indebtedness, the issuer (i) was insolvent, (ii) was engaged in a business
for which the remaining assets of such issuer constituted unreasonably small
capital or (iii) intended to incur, or believed that it would incur, debts beyond
its ability to pay such debts as they mature, such court could determine to
invalidate, in whole or in part, such indebtedness as a fraudulent conveyance, to
subordinate such indebtedness to existing or future creditors of such issuer, or
to recover amounts previously paid by such issuer in satisfaction of such
indebtedness. The measure of insolvency for purposes of the foregoing will vary.
Generally, an issuer would be considered insolvent at a particular time if the
sum of its debts were then greater than all of its property at a fair valuation,
or if the present fair saleable value of its assets was then less than the amount
that would be required to pay its probable liabilities on its existing debts as
they became absolute and matured. There can be no assurance as to what standard a
court would apply in order to determine whether the issuer was "insolvent" after
giving effect to the incurrence of the indebtedness constituting the debt
obligation or that, regardless of the method of valuation, a court would not
determine that the issuer was "insolvent" upon giving effect to such incurrence.
In addition, in the event of the insolvency of an issuer of a debt obligation,
payments made on such debt obligation could be subject to avoidance as a
"preference" if made within a certain period of time (which may be as long as one
year) before insolvency. Similarly, a court might apply the doctrine of equitable
subordination to subordinate the claim of a lending institution against an
issuer, to claims of other creditors of the borrower, when the lending
institution, another investor, or any of their transferees, is found to have
engaged in unfair, inequitable, or fraudulent conduct. In general, if payments on
a debt obligation are avoidable, whether as fraudulent conveyances or
preferences, such payments can be recaptured either from the initial recipient
(such as the Trust) or from subsequent transferees of such payments (such as the
investors in the Trust). To the extent that any such payments are recaptured from
the Trust the resulting loss will be borne by the investors. However, a court in
a bankruptcy or insolvency proceeding would be able to direct the recapture of
any such payment from a holder of notes only to the extent that such court has
jurisdiction over such holder or its assets. Moreover, it is likely that
avoidable payments could not be recaptured directly from a holder that has given
value in exchange for its note, in good faith and without knowledge that the
payments were avoidable. The Investment Manager does not intend to engage in
conduct that would form the basis for a successful cause of action based upon
fraudulent conveyance, preference or equitable subordination. There can be no
assurance, however, as to whether any lending institution or other investor from
which the issuer acquired the debt obligations engaged in any such conduct (or
any other conduct that would subject the debt obligations and the issuer to
insolvency laws) and, if it did, as to whether such creditor claims could be
asserted in a U.S. court (or in the courts of any other country) against the
issuer.
9
Analysis of Troubled, Distressed or Bankrupt Companies
The Trust may invest in companies that are troubled, in distress, or bankrupt. As
such, they are subject to a multitude of legal, industry, market, economic and
governmental forces that make analysis of these companies inherently risky.
Further, the Investment Manager relies on company management, outside experts,
market participants, and personal experience to analyze potential investments for
the Trust. There can be no assurance that any of these sources will prove
credible, or that the Investment Manager's analysis will produce conclusions that
lead to profitable investments.
Leverage
The use of leverage, which can be described as exposure to changes in price at a
ratio greater than the amount of equity invested, either through the issuance of
Preferred Shares, borrowing or other forms of market exposure, magnifies both the
favorable and unfavorable effects of price movements in the investments made by
the Trust. Insofar as the Trust employs leverage in its investment operations,
the Trust will be subject to substantial risks of loss.
Common Stock Risk
The Trust will have exposure to common stocks. Although common stocks have
historically generated higher average total returns than fixed income securities
over the long-term, common stocks also have experienced significantly more
volatility in those returns and may significantly under-perform relative to fixed
income securities during certain periods. An adverse event, such as an
unfavorable earnings report, may depress the value of a particular common stock
held by the Trust. Also, the price of common stocks is sensitive to general
movements in the stock market and a drop in the stock market may depress the
price of common stocks to which the Trust has exposure. Common stock prices
fluctuate for several reasons, including changes in investors' perceptions of the
financial condition of an issuer or the general condition of the relevant stock
market, or when political or economic events affecting the issuers occur. In
addition, common stock prices may be particularly sensitive to rising interest
rates, as the cost of capital rises and borrowing costs increase.
Dividend Risk
Dividends on common stock are not fixed but are declared at the discretion of an
issuer's board of directors. There is no guarantee that the issuers of the common
stocks in which the Trust invests will declare dividends in the future or that if
declared they will remain at current levels or increase over time. As described
further in "Tax Matters," "qualified dividend income" received by the Trust will
generally be eligible for the reduced tax rate applicable to individuals for
taxable years beginning before January 1, 2009. Higher tax rates will apply to
dividend income beginning in 2009, unless further legislative action is taken by
Congress. There is no assurance as to what portion of the Trust's distributions
will constitute qualified dividend income. See "Principal Risks of the
Trust--Dividend Risk."
Small And Mid-Cap Stock Risk
The Trust may invest in companies with small or medium capitalizations. Smaller
and medium company stocks can be more volatile than, and perform differently
from, larger company stocks. There may be less trading in a smaller or medium
company's stock, which means that buy and sell transactions in that stock could
have a larger impact on the stock's price than is the case with larger company
stocks. Smaller and medium companies may have fewer business lines; changes in
any one line of business, therefore, may have a greater impact on a smaller or
medium company's stock price than is the case for a larger company. In addition,
smaller or medium company stocks may not be well known to the investing public.
Non-U.S. Securities Risk
The Trust anticipates that it will invest a portion of its portfolio in
securities of non-
10
U.S. issuers. When the Trust acquires securities of non-U.S. issuers, it will be
subject to risks not usually associated with owning securities of U.S. issuers.
These risks can include fluctuations in foreign currencies, foreign currency
exchange controls, political and economic instability, expropriation and
nationalization, differences in financial reporting, differences in securities
regulation and trading, and foreign taxation issues.
Emerging Markets Risk
Investing in securities of issuers based in underdeveloped emerging markets
entails all of the risks of investing in securities of non-U.S. issuers to a
heightened degree. Emerging market countries generally include every nation in
the world except the United States, Canada, Japan, Australia, New Zealand and
most countries located in Western Europe. These heightened risks include: (i)
greater risks of expropriation, confiscatory taxation, nationalization, and less
social, political and economic stability; (ii) the smaller size of the markets
for such securities and a lower volume of trading, resulting in lack of liquidity
and in price volatility; and (iii) certain national policies which may restrict
the Trust's investment opportunities including restrictions on investing in
issuers or industries deemed sensitive to relevant national interests.
Foreign Currency Risk
Because the Trust may invest in securities denominated or quoted in currencies
other than the U.S. dollar, changes in foreign currency exchange rates may affect
the value of securities owned by the Trust, the unrealized appreciation or
depreciation of investments and gains on and income from investments. Currencies
of certain countries may be volatile and therefore may affect the value of
securities denominated in such currencies, which means that the Trust's net asset
value could decline as a result of changes in the exchange rates between foreign
currencies and the U.S. dollar. In addition, the Trust may enter into foreign
currency transactions in an attempt to enhance total return which may further
expose the Trust to the risks of foreign currency movements and other risks.
Securities Lending Risk
The Trust may lend its portfolio securities to banks or dealers which meet the
creditworthiness standards established by the board of trustees of the Trust.
Securities lending is subject to the risk that loaned securities may not be
available to the Trust on a timely basis and the Trust may, therefore, lose the
opportunity to sell the securities at a desirable price. Any loss in the market
price of securities loaned by the Trust that occurs during the term of the loan
would be borne by the Trust and would adversely affect the Trust's performance.
Also, there may be delays in recovery, or no recovery, of securities loaned or
even a loss of rights in the collateral should the borrower of the securities
fail financially while the loan is outstanding. These risks may be greater for
non-U.S. securities.
Risks Associated With Options On Securities
There are several risks associated with transactions in options on securities.
For example, there are significant differences between the securities and options
markets that could result in an imperfect correlation between these markets,
causing a given transaction not to achieve its objectives. A decision as to
whether, when and how to use options involves the exercise of skill and judgment,
and even a well conceived transaction may be unsuccessful to some degree because
of market behavior or unexpected events.
As the writer of a covered call option, the Trust forgoes, during the option's
life, the opportunity to profit from increases in the market value of the
security covering the call option above the sum of the premium and the strike
price of the call, but has retained the risk of loss should the price of the
underlying security decline. As the Trust writes covered calls over more of its
portfolio, its ability to benefit from
11
capital appreciation becomes more limited. The writer of an option has no control
over the time when it may be required to fulfill its obligation as a writer of
the option. Once an option writer has received an exercise notice, it cannot
effect a closing purchase transaction in order to terminate its obligation under
the option and must deliver the underlying security at the exercise price.
When the Trust writes covered put options, it bears the risk of loss if the value
of the underlying stock declines below the exercise price minus the put premium.
If the option is exercised, the Trust could incur a loss if it is required to
purchase the stock underlying the put option at a price greater than the market
price of the stock at the time of exercise plus the put premium the Trust
received when it wrote the option. While the Trust's potential gain in writing a
covered put option is limited to distributions earned on the liquid assets
securing the put option plus the premium received from the purchaser of the put
option, the Trust risks a loss equal to the entire exercise price of the option
minus the put premium.
Interest Rate Risk
Interest rate risk is the risk that debt securities, and the Trust's net assets,
will decline in value because of changes in interest rates. Generally, debt
securities will decrease in value when interest rates rise and increase in value
when interest rates decline. This means that the net asset value of the common
shares will fluctuate with interest rate changes and the corresponding changes in
the value of the Trust's debt security holdings.
Prepayment Risk
If interest rates fall, the principal on bonds held by the Trust may be paid
earlier than expected. If this happens, the proceeds from a prepaid security may
be reinvested by the Trust in securities bearing lower interest rates, resulting
in a possible decline in the Trust's income and distributions to shareholders.
The Trust may invest in pools of mortgages issued or guaranteed by private
issuers or U.S. government agencies and instrumentalities. These mortgage-related
securities are especially sensitive to prepayment risk because borrowers often
refinance their mortgages when interest rates drop.
Non-Investment Grade Securities Risk
The Trust may invest in securities that are below investment grade.
Non-investment grade securities are commonly referred to as "junk bonds."
Investments in lower grade securities will expose the Trust to greater risks than
if the Trust owned only higher grade debt securities. Because of the substantial
risks associated with lower grade securities, you could lose money on your
investment in common shares of the Trust, both in the short-term and the
long-term. Lower grade securities, though high yielding, are characterized by
high risk. They may be subject to certain risks with respect to the issuing
entity and to greater market fluctuations than certain lower yielding, higher
rated securities. The retail secondary market for lower grade debt securities may
be less liquid than that of higher rated debt securities. Adverse conditions
could make it difficult at times for the Trust to sell certain securities or
could result in lower prices than those used in calculating the Trust's net asset
value. See "Principal Risks of the Trust--Non-Investment Grade Securities Risk."
Strategic Transactions Risk
Strategic transactions in which the Trust may engage for hedging purposes or to
enhance total return, including engaging in transactions such as options,
futures, swaps, foreign currency transactions including forward foreign currency
contracts, currency swaps or options on currency and currency futures and other
derivatives transactions ("Strategic Transactions"), also involve certain risks
and special considerations. Strategic Transactions have risks, including the
imperfect correlation between the value of such instruments and the underlying
assets, the
12
possible default of the other party to the transaction or illiquidity of the
derivative instruments. Furthermore, the ability to successfully use Strategic
Transactions depends on the Highland's ability to predict pertinent market
movements, which cannot be assured. Thus, the use of Strategic Transactions may
result in losses greater than if they had not been used, may require the Trust to
sell or purchase portfolio securities at inopportune times or for prices other
than current market values, may limit the amount of appreciation the Trust can
realize on an investment or may cause the Trust to hold a security that it might
otherwise sell. The use of foreign currency transactions can result in the Trust
incurring losses as a result of the imposition of exchange controls, suspension
of settlements or the inability of the Trust to deliver or receive a specified
currency. Additionally, amounts paid by the Trust as premiums and cash or other
assets held in margin accounts with respect to Strategic Transactions are not
otherwise available to the Trust for investment purposes. See "Principal Risks of
the Trust--Strategic Transactions Risk."
To the extent that the Trust purchases options pursuant to a hedging strategy,
the Trust will be subject to the following additional risks. If a put or call
option purchased by the Trust is not sold when it has remaining value, and if the
market price of the underlying security remains equal to or greater than the
exercise price (in the case of a put), or remains less than or equal to the
exercise price (in the case of a call), the Trust will lose its entire investment
in the option.
Also, where a put or call option on a particular security is purchased to hedge
against price movements in a related security, the price of the put or call
option may move more or less than the price of the related security. If
restrictions on exercise were imposed, the Trust might be unable to exercise an
option it had purchased. If the Trust were unable to close out an option that it
had purchased on a security, it would have to exercise the option in order to
realize any profit or the option may expire worthless.
In general, there can be no assurance as to the percentage (if any) of
distributions on the common shares that will qualify for taxation to individual
common shareholders as "qualified dividend income." Qualified dividend income
received by individual common shareholders is taxed at long-term capital gains
rates (currently at a maximum rate of 15%) provided certain holding period and
other requirements are satisfied by the Trust and the recipient common
shareholders. The special tax treatment afforded to qualified dividend income is
set to end as of December 31, 2008. Higher tax rates will apply beginning in 2009
unless further legislative action is taken by Congress. See "Tax Matters."
Market Risk Generally
The profitability of a significant portion of the Trust's investment program
depends to a great extent upon correctly assessing the future course of the price
movements of securities and other investments and the movements of interest
rates. There can be no assurance that the Investment Manager will be able to
predict accurately these price and interest rate movements. With respect to the
investment strategies the Trust may utilize, there will be a high degree of
market risk.
Reinvestment Risk
The Trust reinvests the cash flows received from a security. The additional
income from such reinvestment, sometimes called interest-on-interest, is reliant
on the prevailing interest rate levels at the time of reinvestment. There is a
risk that the interest rate at which interim cash flows can be reinvested will
fall. Reinvestment risk is greater for longer holding periods and for securities
with large, early cash flows such as high-coupon bonds. Reinvestment risk also
applies generally to the reinvestment of the proceeds the Trust receives upon the
maturity or sale of a portfolio security.
Timing Risk
13
Many agency, corporate and municipal bonds, and most mortgage-backed securities,
contain a provision that allows the issuer to "call" all or part of the issue
before the bond's maturity date often after 5 or 10 years. The issuer usually
retains the right to refinance the bond in the future if market interest rates
decline below the coupon rate. There are three disadvantages to the call
provision. First, the cash flow pattern of a callable bond is not known with
certainty. Second, because an issuer is more likely to call the bonds when
interest rates have dropped, the Trust is exposed to reinvestment rate risk,
i.e., the Trust may have to reinvest at lower interest rates the proceeds
received when the bond is called. Finally, the capital appreciation potential of
a bond will be reduced because the price of a callable bond may not rise much
above the price at which the issuer may call the bond.
Inflation Risk
Inflation risk results from the variation in the value of cash flows from a
security due to inflation, as measured in terms of purchasing power. For example,
if the Trust purchases a five (5) year bond in which it can realize a coupon rate
of five percent (5%), but the rate of inflation increases from two percent (2%)
to six percent (6%), then the purchasing power of the cash flow has declined. For
all but adjustable bonds or floating rate bonds, the Trust is exposed to
inflation risk because the interest rate the issuer promises to make is fixed for
the life of the security. To the extent that interest rates reflect the expected
inflation rate, floating rate bonds have a lower level of inflation risk.
Arbitrage Risks
The Trust will engage in capital structure arbitrage and other arbitrage
strategies. Arbitrage strategies entail various risks including the risk that
external events, regulatory approvals and other factors will impact the
consummation of announced corporate events and/or the prices of certain
positions. In addition, hedging is an important feature of capital structure
arbitrage. There is no guarantee that the Investment Manager will be able to
hedge the Trust's portfolio in the manner necessary to successfully employ the
Trust's strategy.
Short Sales
Short sales by the Trust that are not made "against the box" theoretically
involve unlimited loss potential since the market price of securities sold short
may continuously increase. Short selling involves selling securities which may or
may not be owned and borrowing the same securities for delivery to the purchaser,
with an obligation to replace the borrowed securities at a later date. Short
selling allows the Trust to profit from declines in market prices to the extent
such decline exceeds the transaction costs and the costs of borrowing the
securities. However, since the borrowed securities must be replaced by purchases
at market prices in order to close out the short position, any appreciation in
the price of the borrowed securities would result in a loss. Purchasing
securities to close out the short position can itself cause the price of the
securities to rise further, thereby exacerbating the loss. The Trust may mitigate
such losses by replacing the securities sold short before the market price has
increased significantly. Under adverse market conditions, the Trust might have
difficulty purchasing securities to meet its short sale delivery obligations, and
might have to sell portfolio securities to raise the capital necessary to meet
its short sale obligations at a time when fundamental investment considerations
would not favor such sales.
Structured Finance Securities
A portion of the Trust's investments may consist of equipment trust certificates,
collateralized mortgage obligations, collateralized bond obligations,
collateralized loan obligations or similar instruments. Structured finance
securities may present risks similar to those of the other types of debt
obligations in which the Trust may invest and, in fact, such risks may be of
greater significance in the case of structured finance securities. Moreover,
investing in structured finance securities
14
may entail a variety of unique risks. Among other risks, structured finance
securities may be subject to prepayment risk. In addition, the performance of a
structured finance security will be affected by a variety of factors, including
its priority in the capital structure of the issuer thereof, and the availability
of any credit enhancement, the level and timing of payments and recoveries on and
the characteristics of the underlying receivables, loans or other assets that are
being securitized, remoteness of those assets from the originator or transferor,
the adequacy of and ability to realize upon any related collateral and the
capability of the servicer of the securitized assets.
Preferred Securities
There are special risks associated with investing in preferred securities,
including:
o Deferral. Preferred securities may include provisions that permit the
issuer, at its discretion, to defer distributions for a stated period
without any adverse consequences to the issuer. If the Trust owns a
preferred security that is deferring its distributions, the Trust may be
required to report income for tax purposes although it has not yet
received such income.
o Subordination. Preferred securities are subordinated to bonds and other
debt instruments in a company's capital structure in terms of priority
to corporate income and liquidation payments, and therefore will be
subject to greater credit risk than more senior debt instruments.
o Liquidity. Preferred securities may be substantially less liquid than
many other securities, such as common stocks or U.S. government
securities.
o Limited Voting Rights. Generally, preferred security holders have no
voting rights with respect to the issuing company unless preferred
dividends have been in arrears for a specified number of periods, at
which time the preferred security holders may elect a number of trustees
to the issuer's board. Generally, once all the arrearages have been
paid, the preferred security holders no longer have voting rights.
Synthetic Securities
In addition to credit risks associated with holding non-investment grade loans
and high-yield debt securities, with respect to synthetic securities the Trust
will usually have a contractual relationship only with the counterparty of such
synthetic securities, and not the Reference Obligor (as defined below) on the
Reference Obligation (as defined below). The Trust generally will have no right
to directly enforce compliance by the Reference Obligor with the terms of the
Reference Obligation nor any rights of set-off against the Reference Obligor, nor
have any voting rights with respect to the Reference Obligation. The Trust will
not benefit directly from any collateral supporting the Reference Obligation or
have the benefit of the remedies on default that would normally be available to a
holder of such Reference Obligation. In addition, in the event of insolvency of
its counterparty, the Trust will be treated as a general creditor of such
counterparty and will not have any claim with respect to the credit risk of the
counterparty as well as that of the Reference Obligor. As a result,
concentrations of synthetic securities with any one counterparty subject the
notes to an additional degree of risk with respect to defaults by such
counterparty as well as by the Reference Obligor. The Investment Manager will not
perform independent credit analyses of the counterparties, any such counterparty,
or an entity guaranteeing such counterparty, individually or in the aggregate. A
"Reference Obligation" is the debt security or other obligation upon which the
synthetic security is based. A "Reference Obligor" is the obligor on a Reference
Obligation.
15
Valuation Risk
Fair value is defined as the amount for which assets could be sold in an orderly
disposition over a reasonable period of time, taking into account the nature of
the asset. Fair value pricing, however, involves judgments that are inherently
subjective and inexact, since fair valuation procedures are used only when it is
not possible to be sure what value should be attributed to a particular asset or
when an event will affect the market price of an asset and to what extent. As a
result, there can be no assurance that fair value pricing will reflect actual
market value and it is possible that the fair value determined for a security
will be materially different from the value that actually could be or is realized
upon the sale of that asset.
Exemptive Relief Consideration
The Investment Manager expects to apply to the Commission for exemptive relief to
enable the registered investment companies advised by the Investment Manager,
including the Trust, to co-invest with other accounts and funds managed by the
Investment Manager and its affiliates in certain privately placed securities and
other situations. There are no assurances that the Investment Manager will
receive the requested relief. If such relief is not obtained and until it is
obtained, the Investment Manager may be required to allocate some investments
solely to the Trust and/or other registered funds and others solely to one or
more accounts that are not registered investment companies. This could preclude
the Trust from investing in certain securities it would otherwise be interested
in and could adversely affect the speed at which the Trust is able to invest its
assets and, consequently, the performance of the Trust.
Market Disruption And Geopolitical Risk
The aftermath of the war in Iraq and the continuing occupation of Iraq,
instability in the Middle East and terrorist attacks in the United States and
around the world may have resulted in market volatility and may have long-term
effects on the U.S. and worldwide financial markets and may cause further
economic uncertainties in the United States and worldwide. The Trust does not
know how long the securities markets will continue to be affected by these events
and cannot predict the effects of the occupation or similar events in the future
on the U.S. economy and securities markets. Given the risks described above, an
investment in the common shares may not be appropriate for all investors. You
should carefully consider your ability to assume these risks before making an
investment in the Trust.
Anti-Takeover Provisions
The Trust's Agreement and Declaration of Trust includes provisions that could
limit the ability of other entities or persons to acquire control of the Trust or
convert the Trust to open-end status. These provisions could deprive the holders
of common shares of opportunities to sell their common shares at a premium over
the then current market price of the common shares or at net asset value.
16
SUMMARY OF TRUST EXPENSES
The following table shows Trust expenses as a percentage of net assets
attributable to common shares and assumes that the Trust has issued Preferred
Shares or employed some other form of leverage in an amount equal to % of
the Trust's Managed Assets:
Shareholder Transaction Expenses
Sales load paid by you (as a percentage of offering price)........................................... %
Offering expenses borne by the Trust (as a percentage of offering price)............................. %(1)
Dividend reinvestment plan fees...................................................................... None(2)
Percentage of Net Assets
Attributable to Common Shares
(assumes Preferred Shares are issued
or other leverage is used)(5)
-------------------------------------------------------------------------------------------------------------------------------
Annual Expenses
---------
Management fee.............................................................................................. %(3)
---------
Other expenses.............................................................................................. %(4)
---------
Total annual expenses................................................................................... %
---------
(1) The Trust will pay offering costs of the Trust (other than the sales load)
up to an aggregate of $ per share of the Trust's common shares sold in
this offering which may include a reimbursement of Highland's expenses
incurred in connection with this offering. Highland has agreed to pay such
offering costs of the Trust to the extent they exceed $ per share of
the Trust's common shares.
(2) You will be charged a $ service charge and a brokerage commission of
$ per share sold if you direct the Plan Agent (as defined below) to
sell your common shares held in a dividend reinvestment account.
(3) Does not include the portion of the Management Fee that is payable to
Highland for the provision of administrative services to the Trust, which
is included in "Other expenses."
(4) Certain of these expenses represent the administrative fee of % payable
to Highland for the provision of administrative services to the Trust and
the reimbursement at cost to Highland for non-advisory services provided to
the Trust by employees of Highland. See "Management of the
Trust--Investment Management Agreement." If the Trust offers Preferred
Shares, costs of that offering, estimated to be approximately % of the
total dollar amount of the Preferred Share offering, will be borne
immediately by the Trust's common shareholders and result in a reduction
of the net asset value of the common shares. Assuming the issuance of
Preferred Shares in an amount equal to % of the Trust's capital (after
their issuance), these offering costs are estimated to be approximately
$ or $. per common share (0. % of the offering price). These
offering costs are not included among the expenses shown in this table.
(5) The table presented below in this footnote estimates what the Trust's
annual expenses would be stated as percentages of the Trust's net assets
attributable to common shares. This table assumes the Trust is the same
size as in the table above, but unlike the table above, assumes that no
Preferred Shares are issued and no other leverage is used. This will be
the case, for instance, prior to the Trust's expected issuance of
Preferred Shares and prior to it employing any other form of leverage.
Footnotes used in the table below correspond to the footnotes appearing
above this footnote (5). In accordance with these assumptions, the Trust's
expenses would be estimated to be as follows:
Percentage of Net Assets
Attributable to Common Shares
(assumes Preferred Shares are
issued or other leverage is used)
---------------------------------------------------------------------------------------------------------------------
Annual Expenses
--------
Management fee........................................................................................ %(3)
--------
Other expenses........................................................................................ %(4)
--------
--------
Total annual expenses............................................................................. %
--------
17
Highland may pay certain qualifying underwriters a sales incentive fee,
structuring fee or, alternatively, additional compensation in connection with
the offering provided that certain specified sales targets are met. Highland
may also pay commissions to employees of its affiliates that participate in the
marketing of the Trust's common shares. See "Underwriting."
The purpose of the table above and the example below is to help you understand
all fees and expenses that you, as a holder of common shares, would bear
directly or indirectly. The expenses shown in the table under "Other Expenses"
and "Total Annual Expenses" are based on estimated amounts for the Trust's
first full year of operations and assume that the Trust issues common
shares. If the Trust issues fewer common shares, all other things being equal,
these expenses, as a percentage of the Trust's net assets attributable to common
shares, would increase. See "Management of the Trust" and "Dividend
Reinvestment Plan."
The following example illustrates the expenses (including the offering expenses
borne by the Trust, the sales load of $ and the estimated offering costs of
issuing Preferred Shares assuming the Trust issues Preferred Shares
representing % of the Trust's Managed Assets (after their issuance) of
$ ) that you would pay on a $1,000 investment in common shares, assuming
(1) total net annual expenses of % of net assets attributable to common
shares and (2) a 5% annual return:(1)
1 Year 3 Years 5 Years 10 Years
---------------------------------- ----------------- ----------------- ---------------- -----------------
Total expenses incurred........... $ $ $ $
(1) The example should not be considered a representation of future expenses.
Actual expenses may be greater or less than those assumed. The example
assumes that the estimated "Other Expenses" set forth in the Annual
Expenses table are accurate and that all dividends and distributions are
reinvested at net asset value. Actual expenses may be greater or less than
those assumed. Moreover, the Trust's actual rate of return may be greater
or less than the hypothetical 5% return shown in the example.
18
THE TRUST
The Trust is a newly organized, non-diversified, closed-end management
investment company registered under the Investment Company Act of 1940 (the
"Investment Company Act"). The Trust was organized as a Delaware statutory
trust on March 10, 2006, pursuant to an Agreement and Declaration of Trust
governed by the laws of the State of Delaware. The Trust has no operating
history. The Trust's principal office is located at Two Galleria Tower, 13455
Noel Road, Suite 800, Dallas, Texas 75240, and its telephone number is (877)
655-1287.
USE OF PROCEEDS
The net proceeds of this offering of common shares will be approximately
$ ($ if the Underwriters exercise the over-allotment option in
full) after payment of the estimated offering costs incurred and paid by the
Trust. The Trust will invest the net proceeds of this offering in accordance
with the Trust's investment objectives and policies as stated below. We
currently anticipate that the Trust will be able to invest primarily in
securities and other investments that meet the Trust's investment objectives and
policies within approximately three months after the completion of this
offering. Pending such investment, it is anticipated that the proceeds of this
offering will be invested in short-term debt securities.
THE TRUST'S INVESTMENTS
Investment Objectives And Policies
The Trust's primary investment objective is to deliver attractive risk-adjusted
returns to its investors by employing a multi-strategy investment approach to
exploit relative value and arbitrage opportunities within the credit markets.
Under normal market conditions, Highland will execute, on behalf of the Trust,
directional, relative value, capital structure arbitrage and event-driven
investment strategies across various credit markets where the Investment
Manager holds significant investment experience: primarily the leveraged loan,
high yield, structured products, and distressed markets. The Trust will seek to
create a portfolio of investments that will maintain low correlation to the
broader equity and corporate bond markets, as well as to other alternative
investment strategies. There can be no assurance that the Trust's investment
objectives will be achieved, and the Investment Manager has full discretion
regarding the capital markets from which it can access investment
opportunities.
Under normal market conditions, the Investment Manager will employ, on behalf
of the Trust, directional, capital structure arbitrage, relative value, and
event-driven investment strategies across various credit markets where the
Investment Manager holds significant investment experience; primarily the
leveraged loan, high yield, structured products, and distressed markets. The
Trust will utilize a multi-strategy investment approach to exploit relative
value and arbitrage opportunities within these markets. An objective of the
Trust is to maintain low correlation to the broader equity and corporate bond
markets, as well as other alternative investment strategies, and to provide
high risk-adjusted returns on capital. No assurance can be given that the Trust
will achieve its objectives, and the Investment Manager has full discretion
regarding the capital markets from which it can access investment
opportunities.
The Investment Manager will select investments from a wide range of trading
strategies and credit markets in order to create the desired amount of
diversification and to optimize the risk-reward parameters of the Trust.
Highland does not intend to invest the Trust's assets according to
pre-determined allocations. The investment team and other Highland personnel
will use a wide range of resources to identify attractive individual
investments and promising investment strategies for consideration in connection
with investments by the Trust. The following is a description of the general
types of securities in which the Trust may invest. This description is merely a
summary and the Investment Manager has discretion to cause the Trust to invest
in other types of securities and to follow other investment criteria and
guidelines as described herein. See "- Portfolio Composition" below for a more
complete description of the types of securities and investments the Trust
intends to make.
The Trust will invest and trade in listed and unlisted, public and private,
rated and unrated, debt and equity instruments and other obligations, including
structured debt and equity instruments as well as financial derivatives.
Investments may include investments in distressed positions, which may include
publicly-traded debt and equity securities, obligations which were privately
placed with banks, insurance companies and other lending institutions, trade
claims, accounts receivable and any other form of obligation recognized as a
claim in a bankruptcy or workout process. The Trust may invest in securities
traded in foreign countries and denominated in foreign currencies.
As part of its investment program, the Trust may invest, from time to time, in
debt or synthetic instruments that are sold in direct placement transactions
between their issuers and their purchasers and that are neither listed on an
exchange, nor traded
19
over the counter. The Trust may also receive equity or equity-related
securities from time to time in connection with a workout transaction.
The Trust may employ currency hedges (either in the forward or options markets)
in certain circumstances to reduce currency risk, and may engage in other
strategic transactions for hedging purposes or to enhance total return. The
Trust may also lend securities and engage in short sales of securities. The
Trust plans to employ leverage in the form of Preferred Shares, and the Trust
may invest in the securities of companies whose capital structures are highly
leveraged.
From time to time, the Investment Manager may also invest a portion of the
Trust's assets in short-term U.S. Government obligations, certificates of
deposit, commercial paper and other money market instruments, including
repurchase agreements with respect to such obligations to enable the Trust to
make investments quickly and to serve as collateral with respect to certain of
its investments. A greater percentage of Trust assets may be invested in such
obligations if the Investment Manager believes that a defensive position is
appropriate because of expected economic or business conditions or the outlook
for security prices. From time to time cash balances in the Trust's brokerage
account may be placed in a money-market fund.
For a more complete discussion of the Trust's portfolio composition, see "The
Trust's Investments--Portfolio Composition."
Investment Philosophy
The Investment Manager looks to implement selected trading strategies to
exploit pricing inefficiencies across the credit markets and within an
individual issuer's capital structure. The Trust seeks to achieve
diversification by strategy, industry, security type and credit market, but
reserves the right to re-position its portfolio toward more concentrated levels
depending on market dynamics. Highland manages interest rate, default, currency
and systemic risks through a variety of trading methods and market tools,
including derivative hedging instruments, as it deems appropriate.
The Investment Manager believes that the Trust will benefit from Highland's
industry focused investment platform and specialist trading skills. In finding
relative value and directional opportunities, the Investment Manager looks to
leverage its investment platform of approximately sixty (60) credit investment
professionals, which actively monitor approximately 1,200 companies and
currently have investments in approximately 1,000 credits. Their continuous
monitoring of the market and existing positions often leads to a meaningful
advantage in the timeliness and quality of information that the Investment
Manager can obtain on prospective investments. Additionally, the Investment
Manager has senior professionals that focus on individual credit markets, such
as the distressed or structured products segments. This broad platform of
industry, product and market specialists differentiates the Investment Manager
from numerous funds which rely on a limited number of investment professionals
working in a more generalist capacity. The Investment Manager believes that
credit investing is a due-diligence intensive process that requires long-term
committed resources to industry and product specialization so that investment
decisions are proactive as opposed to reactive in nature.
The multi-strategy investment program to be implemented by the Trust will allow
the Investment Manager to assess what it considers to be the best risk-adjusted
opportunities across multiple markets and to quickly adjust the Trust's trading
strategies and market focus to changing conditions. The Investment Manager
intends to focus primarily on the U.S. marketplace, but may pursue
opportunities in the global credit markets.
Portfolio Composition
The Trust will pursue its objectives by investing primarily in the
following categories of securities and instruments of corporations and other
business entities: (i) senior, secured floating and fixed rate loans; (ii)
bonds and other debt obligations; and (iii) securities and other obligations of
distressed and bankrupt issuers.
Under normal market conditions, at least 80% of the Fund's total
assets will be invested in its principal investment categories collectively,
including through the use of derivatives. Subject only to this general
guideline, the Investment Manager has broad discretion to allocate the Trust's
assets among investment categories and to change allocations over time as
conditions warrant. The Trust is not obligated to hold investments in each of
its three investment categories and may at times concentrate its investments in
a single category. In order to most effectively pursue its opportunistic
investment strategy, the Trust will not maintain fixed duration, maturity or
credit quality policies. The Trust may invest in debt obligations of any credit
quality. The Trust may invest without limitation in securities and obligations
of both domestic and foreign issuers and obligors.
The Trust's portfolio will be composed principally of the following
investments. Additional information relating to the Trust's investment policies
and restrictions and the Trust's portfolio investments is contained in the
Statement of Additional Information.
20
Senior Loans
Senior loans hold the most senior position in the capital structure of a
business entity, are typically secured with specific collateral and have a
claim on the general assets of the borrower that is senior to that held by
subordinated debtholders and stockholders of the borrower. The proceeds of
senior loans primarily are used to finance leveraged buyouts,
recapitalizations, mergers, acquisitions, stock repurchases, and, to a lesser
extent, to finance internal growth and for other corporate purposes. Senior
loans typically have rates of interest which are redetermined either daily,
monthly, quarterly or semi-annually by reference to a base lending rate, plus a
premium. These base lending rates generally are LIBOR, the prime rate offered
by one or more major United States banks (Prime Rate) or the certificate of
deposit (CD) rate or other base lending rates used by commercial lenders.
The Trust also may purchase unsecured loans, other floating rate debt
securities such as notes, bonds and asset-backed securities (such as securities
issued by special purpose funds investing in bank loans), investment grade and
below investment grade fixed income debt obligations and money market
instruments, such as commercial paper. The Trust also may purchase obligations
issued in connection with a restructuring pursuant to Chapter 11 of the U.S.
Bankruptcy Code. While these investments are not a primary focus of the Trust,
the Trust does not have a policy limiting such investments to a specific
percentage of the Trust's assets.
Loans and other corporate debt obligations are subject to the risk of
non-payment of scheduled interest or principal. Such non-payment would result
in a reduction of income to the Trust, a reduction in the value of the
investment and a potential decrease in the net asset value of the Trust. There
can be no assurance that the liquidation of any collateral securing a senior
loan would satisfy a borrower's obligation in the event of non-payment of
scheduled interest or principal payments, or that such collateral could be
readily liquidated. In the event of bankruptcy of a borrower, the Trust could
experience delays or limitations with respect to its ability to realize the
benefits of the collateral securing a senior loan. To the extent that a senior
loan is collateralized by stock in the borrower or its subsidiaries, such stock
may lose all or substantially all of its value in the event of the bankruptcy
of a borrower. Some senior loans are subject to the risk that a court, pursuant
to fraudulent conveyance or other similar laws, could subordinate senior loans
to presently existing or future indebtedness of the borrower or take other
action detrimental to the holders of senior loans including, in certain
circumstances, invalidating such senior loans or causing interest previously
paid to be refunded to the borrower. If interest were required to be refunded,
it could negatively affect the Trust's performance.
Many loans in which the Investment Manager anticipates the Trust will invest
may not be rated by a rating agency, will not be registered with the Securities
and Exchange Commission or any state securities commission and will not be
listed on any national securities exchange. The amount of public information
available with respect to issuers of senior loans will generally be less
extensive than that available for issuers of registered or exchange listed
securities. In evaluating the creditworthiness of borrowers, Investment Manager
will consider, and may rely in part, on analyses performed by others. The
Investment Manager does not view ratings as the determinative factor in its
investment decisions and relies more upon its credit analysis abilities than
upon ratings. Borrowers may have outstanding debt obligations that are rated
below investment grade by a rating agency. A high percentage of senior loans in
the Trust may be rated below investment grade by independent rating agencies.
In the event senior loans are not rated, they are likely to be the equivalent
of below investment grade quality. Debt securities which are unsecured and
rated below investment grade (i.e., Ba and below by Moody's or BB and below by
S&P) and comparable unrated bonds, are viewed by the rating agencies as having
speculative characteristics and are commonly known as "junk bonds." A
description of the ratings of corporate bonds by Moody's and S&P is included as
Appendix A to the Statement of Additional Information. Because senior loans are
senior in a borrower's capital structure and are often secured by specific
collateral, the Investment Manager believes that senior loans have more
favorable loss recovery rates as compared to most other types of below
investment grade debt obligations. However, there can be no assurance that the
Trust's actual loss recovery experience will be consistent with the Investment
Manager's prior experience or that the Trust's senior loans will achieve any
specific loss recovery rates.
The Trust may hold securities that are unrated or in the lowest ratings
categories (rated C by Moody's or D by S&P). Debt securities rated C by Moody's
are regarded as having extremely poor prospects of ever attaining any real
investment standing. Debt securities rated D by S&P are in payment default or a
bankruptcy petition has been filed and debt service payments are jeopardized.
In order to enforce its rights with defaulted securities, the Trust may be
required to retain legal counsel and/or a financial adviser. The Trust may have
to pursue legal remedies, the results of which are uncertain and expensive.
This may increase operating expenses and adversely affect net asset value. The
credit quality of most securities held by the Trust reflects a greater
possibility that adverse changes in the financial condition of an issuer, or in
general economic conditions, or both, may impair the ability of the issuer to
make payments of interest or principal. The inability (or perceived inability)
of issuers to make timely payment of interest and principal would likely make
the values of such securities more volatile and could limit the ability to sell
securities at favorable prices. In the absence of a liquid trading market for
securities held by it,
21
the Trust may have difficulties determining the fair market value of such
securities. Because of the greater number of investment considerations involved
in investing in high yield, high risk bonds, the achievement of the Trust's
objectives depends more on the Investment Manager's judgment and analytical
abilities than would be the case if invested primarily in securities in the
higher ratings categories.
No active trading market may exist for many senior loans, and some senior loans
may be subject to restrictions on resale. The Trust is not limited in the
percentage of its assets that may be invested in senior loans and other
securities deemed to be illiquid. A secondary market may be subject to
irregular trading activity, wide bid/ask spreads and extended trade settlement
periods, which may impair the ability to realize full value on the disposition
of an illiquid senior loan, and cause a material decline in the Trust's net
asset value.
The Trust may invest up to 20% of total assets in obligations of non-U.S.
issuers, predominantly in developed countries, but the Trust may also invest in
securities of emerging market issuers. The value of obligations of non-U.S.
issuers is affected by changes in foreign tax laws (including withholding tax),
government policies (in this country or abroad) and relations between nations,
and trading, settlement, custodial and other operational risks. In addition,
the costs of investing abroad are generally higher than in the United States.
Use of Agents. Senior loans generally are arranged through private negotiations
between a borrower and a group of financial institutions initially represented
by an agent who is usually one of the originating lenders. In larger
transactions, it is common to have several agents. Generally, however, only one
such agent has primary responsibility for on-going administration of a senior
loan. Agents are typically paid fees by the borrower for their services. The
agent is primarily responsible for negotiating the credit agreement which
establishes the terms and conditions of the senior loan and the rights of the
borrower and the lenders. The agent is also responsible for monitoring
collateral and for exercising remedies available to the lenders such as
foreclosure upon collateral.
Credit agreements may provide for the termination of the agent's status in the
event that it fails to act as required under the relevant credit agreement,
becomes insolvent, enters FDIC receivership or, if not FDIC insured, enters
into bankruptcy. Should such an agent, lender or assignor with respect to an
assignment inter-positioned between the Trust and the borrower become insolvent
or enter FDIC receivership or bankruptcy, any interest in the senior loan of
such person and any loan payment held by such person for the benefit of the
Trust should not be included in such person's or entity's bankruptcy estate.
If, however, any such amount were included in such person's or entity's
bankruptcy estate, the Trust would incur certain costs and delays in realizing
payment or could suffer a loss of principal or interest. In this event, the
Trust could experience a decrease in net asset value.
Form of Investment. The Trust's investments in senior loans may take one of
several forms, including acting as one of the group of lenders originating a
senior loan, purchasing an assignment of a portion of a senior loan from a
third party or acquiring a participation in a senior loan. When the Trust is a
member of the originating syndicate for a senior loan, it may share in a fee
paid to the syndicate. When the Trust acquires a participation in, or an
assignment of, a senior loan, it may pay a fee to, or forego a portion of
interest payments from, the lender selling the participation or assignment. The
Trust will act as lender, or purchase an assignment or participation, with
respect to a senior loan only if the agent is determined by the Investment
Manager to be creditworthy.
Original Lender. When the Trust is one of the original lenders, it will have a
direct contractual relationship with the borrower and can enforce compliance by
the borrower with terms of the credit agreement. It also may have negotiated
rights with respect to any funds acquired by other lenders through set-off.
Original lenders also negotiate voting and consent rights under the credit
agreement. Actions subject to lender vote or consent generally require the vote
or consent of the majority of the holders of some specified percentage of the
outstanding principal amount of the senior loan. Certain decisions, such as
reducing the interest rate, or extending the maturity of a senior loan, or
releasing collateral securing a senior loan, among others, frequently require
the unanimous vote or consent of all lenders affected.
Assignments. When the Trust is a purchaser of an assignment, it typically
succeeds to all the rights and obligations under the credit agreement of the
assigning lender and becomes a lender under the credit agreement with the same
rights and obligations as the assigning lender. Assignments are, however,
arranged through private negotiations between potential assignees and potential
assignors, and the rights and obligations acquired by the purchaser of an
assignment may be more limited than those held by the assigning lender.
Participations. The Trust may also invest in participations in senior loans.
The rights of the Trust when it acquires a participation are likely to be more
limited than the rights of an original lender or an investor who acquired an
assignment. Participation by the Trust in a lender's portion of a senior loan
typically means that the Trust has only a contractual relationship with the
lender, not with the borrower. This means that the Trust has the right to
receive payments of principal,
22
interest and any fees to which it is entitled only from the lender selling the
participation and only upon receipt by the lender of payments from the
borrower.
With a participation, the Trust will have no rights to enforce compliance by
the borrower with the terms of the credit agreement or any rights with respect
to any funds acquired by other lenders through set-off against the borrower. In
addition, the Trust may not directly benefit from the collateral supporting the
senior loan because it may be treated as a general creditor of the lender
instead of a senior secured creditor of the borrower. As a result, the Trust
may be subject to delays, expenses and risks that are greater than those that
exist when the Trust is the original lender or holds an assignment. This means
the Trust must assume the credit risk of both the borrower and the lender
selling the participation. The Trust will consider a purchase of participations
only in those situations where the Investment Manager considers the
participating lender to be creditworthy.
In the event of a bankruptcy or insolvency of a borrower, the obligation of the
borrower to repay the senior loan may be subject to certain defenses that can
be asserted by such borrower against the Trust as a result of improper conduct
of the lender selling the participation. A participation in a senior loan will
be deemed to be a senior loan for the purposes of the Trust's investment
objectives and policies.
Investing in senior loans involves investment risk. Some borrowers default on
their senior loan payments. The Trust attempts to manage this credit risk
through portfolio diversification and ongoing analysis and monitoring of
borrowers. The Trust also is subject to market, liquidity, interest rate and
other risks. See "Risk Factors."
Investment Grade Bonds
The Trust may invest in a wide variety of bonds that are rated or determined by
the Investment Manager to be of investment grade quality of varying maturities
issued by U.S. corporations and other business entities. Bonds are fixed or
variable rate debt obligations, including bills, notes, debentures, money
market instruments and similar instruments and securities. Bonds generally are
used by corporations and other issuers to borrow money from investors for a
variety of business purposes. The issuer pays the investor a fixed or variable
rate of interest and normally must repay the amount borrowed on or before
maturity. Certain bonds are "perpetual" in that they have no maturity date.
Some investment grade bonds, such as zero coupon bonds, do not pay current
interest, but are sold at a discount from their face values. Although more
creditworthy and generally less risky than non-investment grade bonds,
investment grade bonds are subject to market and credit risk. Market risk
relates to changes in a security's value as a result of interest rate changes
generally. Investment grade bonds have varying levels of sensitivity to changes
in interest rates and varying degrees of credit quality. In general, bond
prices rise when interest rates fall, and fall when interest rates rise.
Longer-term bonds and zero coupon bonds are generally more sensitive to
interest rate changes. Credit risk relates to the ability of the issuer to make
payments of principal and interest. The values of investment grade bonds like
those of other debt securities may be affected by changes in the credit rating
or financial condition of an issuer. Investment grade bonds are generally
considered medium-and high-quality securities. Some, however, may possess
speculative characteristics, and may be more sensitive to economic changes and
to changes in the financial condition of issuers. The market prices of
investment grade bonds in the lowest investment grade categories may fluctuate
more than higher-quality securities and may decline significantly in periods of
general or regional economic difficulty. Like non-investment grade bonds, such
investment grade bonds in the lowest investment grade categories may be thinly
traded, making them difficult to sell promptly at an acceptable price.
Other Fixed Income Securities
The Trust also may purchase unsecured loans, other floating rate or fixed rate
debt securities such as notes, bonds and asset-backed securities (such as
securities issued by special purpose funds investing in bank loans), investment
grade and below investment grade fixed income debt obligations and money market
instruments, such as commercial paper. The high yield securities in which the
Trust invests are rated Ba or lower by Moody's or BB or lower by S&P or are
unrated but determined by the Investment Manager to be of comparable quality.
Debt securities rated below investment grade are commonly referred to as "junk
bonds" and are considered speculative with respect to the issuer's capacity to
pay interest and repay principal. Below investment grade debt securities
involve greater risk of loss, are subject to greater price volatility and are
less liquid, especially during periods of economic uncertainty or change, than
higher rated debt securities. The Trust's fixed-income securities may have
fixed or variable principal payments and all types of interest rate and
dividend payment and reset terms, including fixed rate, adjustable rate, zero
coupon, contingent, deferred, payment in kind and auction rate features. The
Trust may invest in fixed-income securities with a broad range of maturities.
The Trust may invest in zero coupon bonds, deferred interest bonds and bonds or
preferred stocks on which the interest is payable in-kind (PIK bonds). To the
extent the Trust invests in such instruments, they will not contribute to the
Trust's
23
primary goal of current income. Zero coupon and deferred interest bonds
are debt obligations which are issued at a significant discount from face
value. While zero coupon bonds do not require the periodic payment of interest,
deferred interest bonds provide for a period of delay before the regular
payment of interest begins. PIK bonds are debt obligations that provide that
the issuer thereof may, at its option, pay interest on such bonds in cash or in
the form of additional debt obligations. Such investments may experience
greater volatility in market value due to changes in interest rates. The Trust
may be required to accrue income on these investments for federal income tax
purposes and is required to distribute its net income each year in order to
qualify for the favorable federal income tax treatment potentially available to
regulated investment companies. The Trust may be required to sell securities to
obtain cash needed for income distributions.
Asset-Backed Securities
The Trust may invest a portion of its assets in asset-backed securities.
Asset-backed securities are generally issued as pass-through certificates,
which represent undivided fractional ownership interests in an underlying pool
of assets, or as debt instruments, which are also known as collateralized
obligations, and are generally issued as the debt of a special purpose entity
organized solely for the purpose of owning such assets and issuing such debt.
Asset-backed securities are often backed by a pool of assets representing the
obligations of a number of different parties. Credit card receivables are
generally unsecured, and the debtors are entitled to the protection of a number
of state and federal consumer credit laws which give debtors the right to set
off certain amounts owed on the credit cards, thereby reducing the balance due.
Most issuers of automobile receivables permit the servicers to retain
possession of the underlying obligations. If the servicer were to sell these
obligations to another party, there is a risk that the purchaser would acquire
an interest superior to that of the holders of the related automobile
receivables. In addition, because of the large number of vehicles involved in a
typical issuance and technical requirements under state laws, the trustee for
the holders of the automobile receivables may not have an effective security
interest in all of the obligations backing such receivables. Therefore, there
is a possibility that recoveries on repossessed collateral may not, in some
cases, be able to support payments on these securities.
Second Lien Loans and Debt Obligations
The Trust may invest in loans and other debt securities that have the same
characteristics as senior loans except that such loans are second in lien
property rather than first. Such "second lien" loans and securities, like
senior loans, typically have adjustable floating rate interest payments.
Accordingly, the risks associated with "second lien" loans are higher than the
risk of loans with first priority over the collateral. In the event of default
on a "second lien" loan, the first priority lien holder has first claim to the
underlying collateral of the loan. It is possible, that no collateral value
would remain for the second priority lien holder and therefore result in a loss
of investment to the Trust.
Collateralized Loan Obligations and Bond Obligations
The Trust may invest in certain asset-backed securities that are securitizing
certain financial assets by issuing securities in the form of negotiable paper
that are issued by a financing company (generally called a Special Purpose
Vehicle or "SPV"). These securitized assets are, as a rule, corporate financial
assets brought into a pool according to specific diversification rules. The SPV
is a company founded solely for the purpose of securitizing these claims and
its only asset is the diversified asset pool. On this basis, marketable
securities are issued which, due to the diversification of the underlying risk,
generally represent a lower level of risk than the original assets. The
redemption of the securities issued by the SPV takes place at maturity out of
the cash flow generated by the collected claims.
A collateralized loan obligation ("CLO") is a structured debt security issued
by an SPV that was created to reapportion the risk and return characteristics
of a pool of assets. The assets, typically senior loans, are used as collateral
supporting the various debt tranches issued by the SPV. The key feature of the
CLO structure is the prioritization of the cash flows from a pool of debt
securities among the several classes of securities issued by a CLO.
The Trust may also invest in collateralized bond obligations ("CBOs"), which
are structured debt securities backed by a diversified pool of high yield,
public or private fixed income securities. These may be fixed pools or may be
"market value" (or managed) pools of collateral. The CBO issues debt securities
that are typically separated into tranches representing different degrees of
credit quality. The top tranche of securities has the greatest
collateralization and pays the lowest interest rate. Lower CBO tranches have a
lesser degree of collateralization quality and pay higher interest rates
intended to compensate for the attendant risks. The bottom tranche specifically
receives the residual interest payments (i.e., money that is left over after
the higher tranches have been paid) rather than a fixed interest rate. The
return on the lower tranches of CBOs is especially sensitive to the rate of
defaults in the collateral pool. Under normal market conditions, the Trust
expects to invest in the lower tranches of CBOs.
24
Credit Default Swaps
The Trust may enter into credit default swap agreements. The "buyer" in a
credit default contract is obligated to pay the "seller" a periodic stream of
payments over the term of the contract provided that no event of default on an
underlying reference obligation has occurred. If an event of default occurs,
the seller must pay the buyer the "par value" (full notional value) of the
reference obligation in exchange for the reference obligation. The Trust may be
either the buyer or seller in the transaction. If the Trust is a buyer and no
event of default occurs, the Trust loses its investment and recovers nothing.
However, if an event of default occurs, the buyer receives full notional value
for a reference obligation that may have little or no value. As a seller, the
Trust receives income throughout the term of the contract, which typically is
between six months and three years, provided that there is no default event.
Credit default swaps involve greater risks than if the Trust had invested in
the reference obligation directly. In addition to general market risks, credit
default swaps are subject to illiquidity risk, counterparty risk and credit
risks. The Trust will enter into swap agreements only with counterparties that
are rated investment grade quality by at least one nationally recognized
statistical rating organization at the time of entering into such transaction
or whose creditworthiness is believed by the Investment Manager to be
equivalent to such rating. A buyer also will lose its investment and recover
nothing should no event of default occur. If an event of default were to occur,
the value of the reference obligation received by the seller, coupled with the
periodic payments previously received, may be less than the full notional value
it pays to the buyer, resulting in a loss of value to the seller. When the
Trust acts as a seller of a credit default swap agreement it is exposed to many
of the same risks of leverage described under "Risk Factors - Leverage Risk"
and "Leverage" in this prospectus since if an event of default occurs the
seller must pay the buyer the full notional value of the reference obligation.
Senior Loan Based Derivatives
The Trust may obtain exposure to senior loans and baskets of senior loans
through the use of derivative instruments. Such derivative instruments have
recently become increasingly available. The Investment Manager reserves the
right to utilize these instruments and similar instruments that may be
available in the future. For example, the Trust may invest in a derivative
instrument known as the Select Aggregate Market Index ("SAMI"), which provides
investors with exposure to a reference basket of senior loans. SAMIs are
structured as floating rate instruments. SAMIs consist of a basket of credit
default swaps whose underlying reference securities are senior loans. While
investing in SAMIs will increase the universe of floating rate debt securities
to which the Trust is exposed, such investments entail risks that are not
typically associated with investments in other floating rate debt securities.
The liquidity of the market for SAMIs will be subject to liquidity in the
secured loan and credit derivatives markets. Investment in SAMIs involves many
of the risks associated with investments in derivative instruments discussed
generally below. The Trust may also be subject to the risk that the
counterparty in a derivative transaction will default on its obligations.
Derivative transactions generally involve the risk of loss due to unanticipated
adverse changes in securities prices, interest rates, the inability to close
out a position, imperfect correlation between a position and the desired hedge,
tax constraints on closing out positions and portfolio management constraints
on securities subject to such transactions. The potential loss on derivative
instruments may be substantially greater than the initial investment therein.
Credit-Linked Notes
The Trust may invest in credit-linked notes ("CLNs") for risk management
purposes, including diversification. A CLN is a derivative instrument. It is a
synthetic obligation between two or more parties where the payment of principal
and/or interest is based on the performance of some obligation (a reference
obligation). In addition to credit risk of the reference obligations and
interest rate risk, the buyer/seller of the CLN is subject to counterparty
risk.
Common Stocks
The Trust may acquire an interest in common stocks upon the default of a senior
loan secured by such common stock. The Trust may also acquire warrants or other
rights to purchase a borrower's common stock in connection with the making of a
senior loan. Common stocks are shares of a corporation or other entity that
entitle the holder to a pro rata share of the profits, if any, of the
corporation without preference over any other shareholder or class of
shareholders, including holders of such entity's preferred stock and other
senior equity securities. Common stock usually carries with it the right to
vote and frequently an exclusive right to do so. In selecting common stocks for
investment, the Trust generally expects to focus primarily on the security's
dividend paying capacity rather than on its potential for capital appreciation.
25
Preferred Securities
The Trust may invest in preferred securities. Preferred securities are equity
securities, but they have many characteristics of fixed income securities, such
as a fixed dividend payment rate and/or a liquidity preference over the
issuer's common shares. However, because preferred shares are equity
securities, they may be more susceptible to risks traditionally associated with
equity investments than the Trust's fixed income securities.
Fixed rate preferred stocks have fixed dividend rates. They can be perpetual,
with no mandatory redemption date, or issued with a fixed mandatory redemption
date. Certain issues of preferred stock are convertible into other equity
securities. Perpetual preferred stocks provide a fixed dividend throughout the
life of the issue, with no mandatory retirement provisions, but may be
callable. Sinking fund preferred stocks provide for the redemption of a portion
of the issue on a regularly scheduled basis with, in most cases, the entire
issue being retired at a future date. The value of fixed rate preferred stocks
can be expected to vary inversely with interest rates.
Adjustable rate preferred stocks have a variable dividend rate which is
determined periodically, typically quarterly, according to a formula based on a
specified premium or discount to the yield on particular U.S. Treasury
securities, typically the highest base-rate yield of one of three U.S. Treasury
securities: the 90-day Treasury bill; the 10-year Treasury note; and either the
20-year or 30-year Treasury bond or other index. The premium or discount to be
added to or subtracted from this base-rate yield is fixed at the time of
issuance and cannot be changed without the approval of the holders of the
adjustable rate preferred stock. Some adjustable rate preferred stocks have a
maximum and a minimum rate and in some cases are convertible into common stock.
Auction rate preferred stocks pay dividends that adjust based on periodic
auctions. Such preferred stocks are similar to short-term corporate money
market instruments in that an auction rate preferred stockholder has the
opportunity to sell the preferred stock at par in an auction, normally
conducted at least every 49 days, through which buyers set the dividend rate in
a bidding process for the next period. The dividend rate set in the auction
depends on market conditions and the credit quality of the particular issuer.
Typically, the auction rate preferred stock's dividend rate is limited to a
specified maximum percentage of an external commercial paper index as of the
auction date. Further, the terms of the auction rate preferred stocks generally
provide that they are redeemable by the issuer at certain times or under
certain conditions.
Convertible Securities
The Trust's investment in fixed income securities may include bonds and
preferred stocks that are convertible into the equity securities of the issuer
or a related company. Depending on the relationship of the conversion price to
the market value of the underlying securities, convertible securities may trade
more like equity securities than debt instruments.
Money Market Instruments
Money market instruments include short-term U.S. government securities, U.S.
dollar-denominated, high quality commercial paper (unsecured promissory notes
issued by corporations to finance their short-term credit needs), certificates
of deposit, bankers' acceptances and repurchase agreements relating to any of
the foregoing. U.S. government securities include Treasury notes, bonds and
bills, which are direct obligations of the U.S. government backed by the full
faith and credit of the
United States and securities issued by agencies and instrumentalities of the
U.S. government, which may be guaranteed by the U.S. Treasury, may be supported
by the issuer's right to borrow from the U.S. Treasury or may be backed only by
the credit of the federal agency or instrumentality itself.
U.S. Government Securities
U.S. government securities in which the Trust invests include debt obligations
of varying maturities issued by the U.S. Treasury or issued or guaranteed by an
agency or instrumentality of the U.S. government, including the Federal Housing
Administration, Federal Financing Bank, Farmers Home Administration,
Export-Import Bank of the United States, Small Business Administration,
Government National Mortgage Association (GNMA), General Services
Administration, Central Bank for Cooperatives, Federal Farm Credit Banks,
Federal Home Loan Banks, Federal Home Loan Mortgage Corporation (FHLMC),
Federal National Mortgage Association (FNMA), Maritime Administration,
Tennessee Valley Authority, District of Columbia Armory Board, Student Loan
Marketing Association, Resolution Trust Corporation and various institutions
that previously were or currently are part of the Farm Credit System (which has
been undergoing reorganization since 1987). Some U.S. government securities,
such as U.S. Treasury bills, Treasury notes and Treasury bonds, which differ
only in their interest rates, maturities and times of issuance, are supported
by the full faith and credit of the United States government. Others are
supported by (i) the right of the issuer to borrow from the U.S. Treasury, such
as securities of the Federal Home
26
Loan Banks; (ii) the discretionary authority of the U.S. government to purchase
the agency's obligations, such as securities of the FNMA; or (iii) only the
credit of the issuer. No assurance can be given that the U.S. government will
provide financial support in the future to U.S. government agencies,
authorities or instrumentalities that are not supported by the full faith and
credit of the United States. Securities guaranteed as to principal and interest
by the U.S. government, its agencies, authorities or instrumentalities include
(i) securities for which the payment of principal and interest is backed by an
irrevocable letter of credit issued by the U.S. government or any of its
agencies, authorities or instrumentalities; and (ii) participations in loans
made to non-U.S. governments or other entities that are so guaranteed. The
secondary market for certain of these participations is limited and therefore
may be regarded as illiquid.
Other Investment Companies
The Trust may invest in the securities of other investment companies to the
extent that such investments are consistent with the Trust's investment
objectives and principal investment strategies and permissible under the
Investment Company Act. Under one provision of the Investment Company Act, the
Trust may not acquire the securities of other investment companies if, as a
result, (i) more than 10% of the Trust's total assets would be invested in
securities of other investment companies, (ii) such purchase would result in
more than 3% of the total outstanding voting securities of any one investment
company being held by the Trust or (iii) more than 5% of the Trust's total
assets would be invested in any one investment company. Other provisions of the
Investment Company Act are less restrictive provided that the Trust is able to
meet certain conditions. These limitations do not apply to the acquisition of
shares of any investment company in connection with a merger, consolidation,
reorganization or acquisition of substantially all of the assets of another
investment company. However, the Adviser has obtained an exemptive order from
the Securities and Exchange Commission that permits the Trust to invest cash
balances in money market funds managed by the Adviser.
The Trust, as a holder of the securities of other investment companies, will
bear its pro rata portion of the other investment companies' expenses,
including advisory fees. These expenses will be in addition to the direct
expenses incurred by the Trust.
Exchange Traded Funds
Subject to the limitations on investment in other investment companies, the
Trust may invest in exchange traded funds ("ETFs"). ETFs, such as SPDRs, NASDAQ
100 Index Trading Stock (QQQs), iShares and various country index funds, are
funds whose shares are traded on a national exchange or the National
Association of Securities Dealers' Automatic Quotation System (NASDAQ). ETFs
may be based on underlying equity or fixed income securities. SPDRs, for
example, seek to provide investment results that generally correspond to the
performance of the component common stocks of the S&P 500. ETFs do not sell
individual shares directly to investors and only issue their shares in large
blocks known as "creation units." The investor purchasing a creation unit may
sell the individual shares on a secondary market. Therefore, the liquidity of
ETFs depends on the adequacy of the secondary market. There can be no assurance
that an ETF's investment objective will be achieved. ETFs based on an index may
not replicate and maintain exactly the composition and relative weightings of
securities in the index. ETFs are subject to the risks of investing in the
underlying securities. The Trust, as a holder of the securities of the ETF,
will bear its pro rata portion of the ETF's expenses, including advisory fees.
These expenses are in addition to the direct expenses of the Trust's own
operations.
Zero Coupon Securities
The securities in which the Trust invests may include zero coupon securities,
which are debt obligations that are issued or purchased at a significant
discount from face value. The discount approximates the total amount of
interest the security will accrue and compound over the period until maturity
or the particular interest payment date at a rate of interest reflecting the
market rate of the security at the time of issuance. Zero coupon securities do
not require the periodic payment of interest. These investments benefit the
issuer by mitigating its need for cash to meet debt service but generally
require a higher rate of return to attract investors who are willing to defer
receipt of cash. These investments may experience greater volatility in market
value than securities that make regular payments of interest. The Trust accrues
income on these investments for tax and accounting purposes, which is
distributable to shareholders and which, because no cash is received at the
time of accrual, may require the liquidation of other portfolio securities to
satisfy the Trust's distribution obligations, in which case the Trust will
forgo the purchase of additional income producing assets with these funds.
Strategic Transactions
In addition to the credit default swaps and senior loan bond derivatives
discussed above the Trust may, but is not required to, use various strategic
transactions described below to earn income, facilitate portfolio management
and mitigate risks. Such
27
strategic transactions are generally accepted under modern portfolio management
and are regularly used by many mutual funds and other institutional investors.
Although the Investment Manager seeks to use the practices to further the
Trust's investment objectives, no assurance can be given that these practices
will achieve this result. While the Trust reserves the ability to use these
strategic transactions, the Investment Manager does not anticipate that
strategic transactions other than credit default swaps and senior loan bond
derivatives will initially be a significant part of the Trust's investment
approach. With changes in the market or the Investment Manager's strategy, it
is possible that these instruments may be a more significant part of the
Trust's investment approach in the future.
The Trust may purchase and sell derivative instruments such as exchange-listed
and over-the-counter put and call options on securities, financial futures,
equity, fixed-income and interest rate indices, and other financial
instruments, purchase and sell financial futures contracts and options thereon,
enter into various interest rate transactions such as swaps, caps, floors or
collars and enter into various currency transactions such as currency forward
contracts, currency futures contracts, currency swaps or options on currency or
currency futures or credit transactions and credit default swaps. The Trust
also may purchase derivative instruments that combine features of these
instruments. Collectively, all of the above are referred to as "Strategic
Transactions." The Trust generally seeks to use Strategic Transactions as a
portfolio management or hedging technique to seek to protect against possible
adverse changes in the market value of senior loans or other securities held in
or to be purchased for the Trust's portfolio, protect the value of the Trust's
portfolio, facilitate the sale of certain securities for investment purposes,
manage the effective interest rate exposure of the Trust, protect against
changes in currency exchange rates, manage the effective maturity or duration
of the Trust's portfolio, or establish positions in the derivatives markets as
a temporary substitute for purchasing or selling particular securities.
Strategic Transactions have risks, including the imperfect correlation between
the value of such instruments and the underlying assets, the possible default
of the other party to the transaction or illiquidity of the derivative
instruments. Furthermore, the ability to use successfully Strategic
Transactions depends on the Investment Manager's ability to predict pertinent
market movements, which cannot be assured. Thus, the use of Strategic
Transactions may result in losses greater than if they had not been used, may
require the Trust to sell or purchase portfolio securities at inopportune times
or for prices other than current market values, may limit the amount of
appreciation the Trust can realize on an investment, or may cause the Trust to
hold a security that it might otherwise sell. The use of currency transactions
can result in the Trust incurring losses as a result of the imposition of
exchange controls, suspension of settlements or the inability of the Trust to
deliver or receive a specified currency. Additionally, amounts paid by the
Trust as premiums and cash or other assets held in margin accounts with respect
to Strategic Transactions are not otherwise available to the Trust for
investment purposes.
A more complete discussion of Strategic Transactions and their risks is
contained in the Statement of Additional Information.
Swaps
Swap contracts may be purchased or sold to obtain investment exposure and/or to
hedge against fluctuations in securities prices, currencies, interest rates or
market conditions, to change the duration of the overall portfolio or to
mitigate default risk. In a standard "swap" transaction, two parties agree to
exchange the returns (or differentials in rates of return) on different
currencies, securities, baskets of currencies or securities, indices or other
instruments, which returns are calculated with respect to a "notional value,"
i.e., the designated reference amount of exposure to the underlying
instruments. The Trust intends to enter into swaps primarily on a net basis,
i.e., the two payment streams are netted out, with the Trust receiving or
paying, as the case may be, only the net amount of the two payments. If the
other party to a swap contract defaults, the Trust's risk of loss will consist
of the net amount of payments that the Trust is contractually entitled to
receive. The net amount of the excess, if any, of the Trust's obligations over
its entitlements will be maintained in a segregated account by the Trust's
custodian. The Trust will not enter into a swap agreement unless the
claims-paying ability of the other party thereto is considered to be investment
grade by the Investment Manager. If there is a default by the other party to
such a transaction, the Trust will have contractual remedies pursuant to the
agreements related to the transaction. Swap instruments are not exchange-listed
securities and may be traded only in the over-the-counter market.
Interest Rate Swaps
Interest rate swaps involve the exchange by the Trust with another party of
their respective commitments to pay or receive interest (e.g., an exchange of
fixed rate payments for floating rate payments). The Trust may use interest
rate swaps for risk management purposes and as a speculative investment.
28
Total Return Swaps
Total return swaps are contracts in which one party agrees to make payments of
the total return from the designated underlying asset(s), which may include
securities, baskets of securities, or securities indices, during the specified
period, in return for receiving payments equal to a fixed or floating rate of
interest or the total return from the other designated underlying asset(s). The
Trust may use total return swaps for risk management purposes and as a
speculative investment.
Currency Swaps
Currency swaps involve the exchange of the two parties' respective commitments
to pay or receive fluctuations with respect to a notional amount of two
different currencies (e.g., an exchange of payments with respect to
fluctuations in the value of the U.S. dollar relative to the Japanese yen). The
Trust may enter into currency swap contracts and baskets thereof for risk
management purposes and as a speculative investment.
Repurchase Agreements
The Trust may enter into repurchase agreements with broker-dealers, member
banks of the Federal Reserve System and other financial institutions.
Repurchase agreements are arrangements under which the Trust purchases
securities and the seller agrees to repurchase the securities within a specific
time and at a specific price. The repurchase price is generally higher than the
Trust's purchase price, with the difference being income to the Trust. Under
the direction of the Board of Trustees, the Investment Manager reviews and
monitors the creditworthiness of any institution which enters into a repurchase
agreement with the Trust. The counterparty's obligations under the repurchase
agreement are collateralized with U.S. Treasury and/or agency obligations with
a market value of not less than 100% of the obligations, valued daily.
Collateral is held by the Trust's custodian in a segregated, safekeeping
account for the benefit of the Trust. Repurchase agreements afford the Trust an
opportunity to earn income on temporarily available cash at low risk. In the
event of commencement of bankruptcy or insolvency proceedings with respect to
the seller of the security before repurchase of the security under a repurchase
agreement, the Trust may encounter delay and incur costs before being able to
sell the security. Such a delay may involve loss of interest or a decline in
price of the security. If the court characterizes the transaction as a loan and
the Trust has not perfected a security interest in the security, the Trust may
be required to return the security to the seller's estate and be treated as an
unsecured creditor of the seller. As an unsecured creditor, the Trust would be
at risk of losing some or all of the principal and interest involved in the
transaction.
Lending of Portfolio Securities
The Trust may lend portfolio securities to registered broker-dealers or other
institutional investors deemed by the Investment Manager to be of good standing
under agreements which require that the loans be secured continuously by
collateral in cash, cash equivalents or U.S. Treasury bills maintained on a
current basis at an amount at least equal to the market value of the securities
loaned. The Trust continues to receive the equivalent of the interest or
dividends paid by the issuer on the securities loaned as well as the benefit of
an increase and the detriment of any decrease in the market value of the
securities loaned and would also receive compensation based on investment of
the collateral. The Trust would not, however, have the right to vote any
securities having voting rights during the existence of the loan, but would
call the loan in anticipation of an important vote to be taken among holders of
the securities or of the giving or withholding of consent on a material matter
affecting the investment.
As with other extensions of credit, there are risks of delay in recovery or
even loss of rights in the collateral should the borrower of the securities
fail financially. The Trust will lend portfolio securities only to firms that
have been approved in advance by the Board of Trustees, which will monitor the
creditworthiness of any such firms.
Non-U.S. Securities
The Trust may invest a substantial portion of its portfolio in non-U.S.
securities, which may include securities denominated in U.S. dollars or in
non-U.S. currencies or multinational currency units. The Trust may invest in
non-U.S. securities of so-called emerging market issuers. For purposes of the
Trust, a company is deemed to be a non-U.S. company if it meets the following
tests: (i) such company was not organized in the United States; (ii) such
company's primary business office is not in the United States; (iii) the
principal trading market for such company's securities is not located in the
United States; (iv) less than 50% of such company's assets are located in the
United States; or (v) 50% or more of such issuer's revenues are derived from
outside the United States. Non-U.S. securities markets generally are not as
developed or efficient as those in the United States. Securities of some
non-U.S. issuers are less liquid and more volatile than securities of
comparable U.S. issuers. Similarly, volume and liquidity in most non-U.S.
29
securities markets are less than in the United States and, at times, volatility
of price can be greater than in the United States.
Because evidences of ownership of such securities usually are held outside the
United States, the Trust would be subject to additional risks if it invested in
non-U.S. securities, which include possible adverse political and economic
developments, seizure or nationalization of foreign deposits and adoption of
governmental restrictions which might adversely affect or restrict the payment
of principal and interest on the non-U.S. securities to investors located
outside the country of the issuer, whether from currency blockage or otherwise.
Since non-U.S. securities may be purchased with and payable in foreign
currencies, the value of these assets as measured in U.S. dollars may be
affected favorably or unfavorably by changes in currency rates and exchange
control regulations.
Options
An option on a security is a contract that gives the holder of the option, in
return for a premium, the right to buy from (in the case of a call) or sell to
(in the case of a put) the writer of the option the security underlying the
option at a specified exercise or "strike" price. The writer of an option on a
security has the obligation upon exercise of the option to deliver the
underlying security upon payment of the exercise price or to pay the exercise
price upon delivery of the underlying security. Certain options, known as
"American style" options may be exercised at any time during the term of the
option. Other options, known as "European style" options, may be exercised only
on the expiration date of the option.
If an option written by the Trust expires unexercised, the Trust realizes on
the expiration date a capital gain equal to the premium received by the Trust
at the time the option was written. If an option purchased by the Trust expires
unexercised, the Trust realizes a capital loss equal to the premium paid. Prior
to the earlier of exercise or expiration, an exchange-traded option may be
closed out by an offsetting purchase or sale of an option of the same series
(type, underlying security, exercise price and expiration). There can be no
assurance, however, that a closing purchase or sale transaction can be effected
when the Trust desires. The Trust may sell put or call options it has
previously purchased, which could result in a net gain or loss depending on
whether the amount realized on the sale is more or less than the premium and
other transaction costs paid on the put or call option when purchased. The
Trust will realize a capital gain from a closing purchase transaction if the
cost of the closing option is less than the premium received from writing the
option, or, if it is more, the Trust will realize a capital loss. If the
premium received from a closing sale transaction is more than the premium paid
to purchase the option, the Trust will realize a capital gain or, if it is
less, the Trust will realize a capital loss. Net gains from the Trust's option
strategy will be short-term capital gains which, for federal income tax
purposes, will constitute net investment company taxable income.
Non-Investment Grade Securities
The Trust may invest in securities rated below investment grade, such as those
rated Ba or lower by Moody's Investors Service, Inc. ("Moody's") and BB or
lower by Standard & Poor's Ratings Group, a division of The McGraw-Hill
Companies, Inc. ("S&P") or Fitch Ratings ("Fitch") or securities comparably
rated by other rating agencies or in unrated securities determined by Highland
to be of comparable quality. Securities rated Ba by Moody's are judged to have
speculative elements, their future cannot be considered as well assured and
often the protection of interest and principal payments may be very moderate.
Securities rated BB by S&P or Fitch are regarded as having predominantly
speculative characteristics and, while such obligations have less near-term
vulnerability to default than other speculative grade debt, they face major
ongoing uncertainties or exposure to adverse business, financial or economic
conditions which could lead to inadequate capacity to meet timely interest and
principal payments. Securities rated C are regarded as having extremely poor
prospects of ever attaining any real investment standing. Securities rated D
are in default and the payment of interest and/or repayment of principal is in
arrears. The Trust may purchase securities rated as low as D or unrated
securities deemed by Highland to be of comparable quality. When Highland
believes it to be in the best interests of the Trust's shareholders, the Trust
will reduce its investment in lower grade securities.
Lower grade securities, though high yielding, are characterized by high risk.
They may be subject to certain risks with respect to the issuing entity and to
greater market fluctuations than certain lower yielding, higher rated
securities. The secondary market for lower grade securities may be less liquid
than that of higher rated securities. Adverse conditions could make it
difficult at times for the Trust to sell certain securities or could result in
lower prices than those used in calculating the Trust's net asset value.
The prices of debt securities generally are inversely related to interest rate
changes; however, the price volatility caused by fluctuating interest rates of
securities also is inversely related to the coupon of such securities.
Accordingly, lower grade securities may be relatively less sensitive to
interest rate changes than higher quality securities of comparable maturity,
because of their higher coupon. This higher coupon is what the investor
receives in return for bearing greater credit risk. The
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higher credit risk associated with lower grade securities potentially can have
a greater effect on the value of such securities than may be the case with
higher quality issues of comparable maturity, and will be a substantial factor
in the Trust's relative share price volatility.
Lower grade securities may be particularly susceptible to economic downturns.
It is likely that an economic recession could disrupt severely the market for
such securities and may have an adverse impact on the value of such securities.
In addition, it is likely that any such economic downturn could adversely
affect the ability of the issuers of such securities to repay principal and pay
interest thereon and increase the incidence of default for such securities.
The ratings of Moody's, S&P, Fitch and the other rating agencies represent
their opinions as to the quality of the obligations which they undertake to
rate. Ratings are relative and subjective and, although ratings may be useful
in evaluating the safety of interest and principal payments, they do not
evaluate the market value risk of such obligations. Although these ratings may
be an initial criterion for selection of portfolio investments, Highland also
will independently evaluate these securities and the ability of the issuers of
such securities to pay interest and principal. To the extent that the Trust
invests in lower grade securities that have not been rated by a rating agency,
the Trust's ability to achieve its investment objectives will be more dependent
on Highland's credit analysis than would be the case when the Trust invests in
rated securities.
Short-Term Debt Securities; Temporary Defensive Position; Invest-Up Period
During the period in which the net proceeds of this offering of common shares
are being invested, during periods in which Highland determines that it is
temporarily unable to follow the Trust's investment strategy or that it is
impractical to do so or pending re-investment of proceeds received in
connection with the sale of a security, the Trust may deviate from its
investment strategy and invest all or any portion of its assets in cash or cash
equivalents. Highland's determination that it is temporarily unable to follow
the Trust's investment strategy or that it is impractical to do so will
generally occur only in situations in which a market disruption event has
occurred and where trading in the securities selected through application of
the Trust's investment strategy is extremely limited or absent. In such a case,
shares of the Trust may be adversely affected and the Trust may not pursue or
achieve its investment objectives.
PRINCIPAL RISKS OF THE TRUST
The net asset value of, and dividends paid on, the common shares will fluctuate
with and be affected by, among other things, the risks more fully described
below.
No Operating History
The Trust is a non-diversified, closed-end management investment company with
no operating history.
Investment And Market Discount Risk
An investment in the Trust's common shares is subject to investment risk,
including the possible loss of the entire amount that you invest. As with any
stock, the price of the Trust's shares will fluctuate with market conditions
and other factors. If shares are sold, the price received may be more or less
than the original investment. Net asset value will be reduced immediately
following the initial offering by the amount of the sales load and offering
expenses paid by the Trust. Common shares are designed for long-term investors
and should not be treated as trading vehicles. Shares of closed-end management
investment companies frequently trade at a discount from their net asset value.
The Trust's shares may trade at a price that is less than the initial offering
price. This risk may be greater for investors who sell their shares in a
relatively short period of time after completion of the initial offering.
Concentration of the Trust's Portfolio
While the Investment Manager will invest in a number of fixed-income and equity
instruments issued by different institutions and plans to employ multiple
investment strategies with respect to the Trust's portfolio, it is possible
that a significant amount of the Trust's investment could be invested in the
instruments of only a few companies or that at any particular point in time one
investment strategy could be more heavily weighted than the others. The
concentration of the Trust's portfolio in any one obligor would subject the
Trust to a greater degree of risk with respect to defaults by such obligor, and
the concentration of the portfolio in any one industry would subject the Trust
to a greater degree of risk with respect to economic downturns relating to such
industry. The concentration of the Trust's portfolio in any one investment
strategy would subject the Trust to a greater degree of risk than if the
Trust's portfolio was diversified with respect to several investment
strategies.
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Illiquidity of Investments
The investments made by the Trust may be very illiquid, and consequently the
Trust may not be able to sell such investments at prices that reflect the
Investment Manager's assessment of their value or the amount paid for such
investments by the Trust. Illiquidity may result from the absence of an
established market for the investments as well as legal, contractual or other
restrictions on their resale by the Trust and other factors. Furthermore, the
nature of the Trust's investments, especially those in financially distressed
companies, may require a long holding period prior to being able to determine
whether the investment will be profitable or not.
Bank Loans
A portion of the Trust investments may consist of loans and participations
therein originated by banks and other financial institutions, typically
referred to as "bank loans." The Trust investments may include loans of a type
generally incurred by borrowers in connection with highly leveraged
transactions, often to finance internal growth, acquisitions, mergers or stock
purchases, or for other reasons. As a result of the additional debt incurred by
the borrower in the course of the transaction, the borrower's creditworthiness
is often judged by the rating agencies to be below investment-grade. Such loans
are typically private corporate loans which are negotiated by one or more
commercial banks or financial institutions and syndicated among a group of
commercial banks and financial institutions. In order to induce the lenders to
extend credit and to offer a favorable interest rate, the borrower often
provides the lenders with extensive information about its business which is not
generally available to the public.
Bank loans are typically at the most senior level of the capital structure, and
are often secured by specific collateral, including, but not limited to,
trademarks, patents, accounts receivable, inventory, equipment, buildings, real
estate, franchises and common and preferred stock of the obligor or its
affiliates. Bank loans often contain restrictive covenants designed to limit
the activities of the borrower in an effort to protect the right of lenders to
receive timely payments of principal and interest. Such covenants may include
restrictions on dividend payments, specific mandatory minimum financial ratios,
limits on total debt and other financial tests. Bank loans usually have shorter
terms than subordinated obligations and may require mandatory prepayments from
excess cash flow, asset dispositions and offerings of debt and/or equity
securities. The bank loans and other debt obligations to be acquired by the
Trust are likely to be below investment-grade. For a discussion of the risks
associated with below investment-grade investments, see "-- High-Yield
Securities" above.
The Trust may acquire interests in bank loans and other debt obligations either
directly (by way of sale or assignment) or indirectly (by way of
participation). The purchaser of an assignment typically succeeds to all the
rights and obligations of the assigning institution and becomes a lender under
the credit agreement with respect to the debt obligation; however, its rights
can be more restricted than those of the assigning institution. A participation
interest in a portion of a debt obligation typically results in a contractual
relationship only with the institution participating out the interest, not with
the borrower. In purchasing participations, the Trust generally will have no
right to enforce compliance by the borrower with the terms of the loan
agreement, nor any rights of set off against the borrower, and the Trust may
not directly benefit from the collateral supporting the debt obligation in
which it has purchased the participation. As a result, the Trust will be
exposed to the credit risk of both the borrower and the institution selling the
participation.
Purchasers of bank loans are predominantly commercial banks, investment funds
and investment banks. As secondary market trading volumes increase, new bank
loans frequently adopt standardized documentation to facilitate loan trading
which should improve market liquidity. There can be no assurance, however, that
future levels of supply and demand in bank loan trading will provide an
adequate degree of liquidity or that the current level of liquidity will
continue. Because of the provision to holders of such loans of confidential
information relating to the borrower, the unique and customized nature of the
loan agreement, and the private syndication of the loan, bank loans are not as
easily purchased or sold as a publicly traded security, and historically the
trading volume in the bank loan market has been small relative to the
high-yield debt market.
Distressed Debt
The Trust is authorized to invest in the securities and other obligations of
distressed and bankrupt issuers, including debt obligations that are in
covenant or payment default. Such investments generally trade significantly
below par and are considered speculative. The repayment of defaulted
obligations is subject to significant uncertainties. Defaulted obligations
might be repaid only after lengthy workout or bankruptcy proceedings, during
which the issuer might not make any interest or other payments. Typically such
workout or bankruptcy proceedings result in only partial recovery of cash
payments or an exchange of the defaulted obligation for other debt or equity
securities of the issuer or its affiliates, which may in turn be illiquid or
speculative.
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There are a number of significant risks inherent in the bankruptcy process.
First, many events in a bankruptcy are the product of contested matters and
adversary proceedings and are beyond the control of the creditors. While
creditors are generally given an opportunity to object to significant actions,
there can be no assurance that a bankruptcy court in the exercise of its broad
powers would not approve actions that would be contrary to the interests of the
Trust. Second, the effect of a bankruptcy filing on an issuer may adversely and
permanently affect the issuer. The issuer may lose its market position and key
employees and otherwise become incapable of restoring itself as a viable
entity. If for this or any other reason the proceeding is converted to a
liquidation, the value of the issuer may not equal the liquidation value that
was believed to exist at the time of the investment. Third, the duration of a
bankruptcy proceeding is difficult to predict. A creditor's return on
investment can be adversely affected by delays while the plan of reorganization
is being negotiated, approved by the creditors and confirmed by the bankruptcy
court and until it ultimately becomes effective. Fourth, the administrative
costs in connection with a bankruptcy proceeding are frequently high and would
be paid out of the debtor's estate prior to any return to creditors. For
example, if a proceeding involves protracted or difficult litigation, or turns
into a liquidation, substantial assets may be devoted to administrative costs.
Fifth, bankruptcy law permits the classification of "substantially similar"
claims in determining the classification of claims in a reorganization. Because
the standard for classification is vague, there exists the risk that the
Trust's influence with respect to the class of securities or other obligations
it owns can be lost by increases in the number and amount of claims in that
class or by different classification and treatment. Sixth, in the early stages
of the bankruptcy process it is often difficult to estimate the extent of, or
even to identify, any contingent claims that might be made. Seventh, especially
in the case of investments made prior to the commencement of bankruptcy
proceedings, creditors can lose their ranking and priority if they exercise
"domination and control" over a debtor and other creditors can demonstrate that
they have been harmed by such actions. Eighth, certain claims that have
priority by law (for example, claims for taxes) may be substantial.
In any investment involving distressed debt obligations, there exists the risk
that the transaction involving such debt obligations will be unsuccessful, take
considerable time or will result in a distribution of cash or a new security or
obligation in exchange for the distressed debt obligations, the value of which
may be less than the Trust's purchase price of such debt obligations.
Furthermore, if an anticipated transaction does not occur, the Trust may be
required to sell its investment at a loss. Given the substantial uncertainties
concerning transactions involving distressed debt obligations in which the
Trust invests, there is a potential risk of loss by the Trust of its entire
investment in any particular investment.
Investments in companies operating in workout modes or under Chapter 11 of the
Bankruptcy Code are also, in certain circumstances, subject to certain
additional liabilities which may exceed the value of the Trust's original
investment in a company. For example, under certain circumstances, creditors
who have inappropriately exercised control over the management and policies of
a debtor may have their claims subordinated or disallowed or may be found
liable for damages suffered by parties as a result of such actions. The
Investment Manager's active management style may present a greater risk in this
area than would a more passive approach. In addition, under certain
circumstances, payments to the Trust and distributions by the Trust or payments
on the debt may be reclaimed if any such payment is later determined to have
been a fraudulent conveyance or a preferential payment. See "--Fraudulent
Conveyance Considerations" below.
The Investment Manager on behalf of the Trust may participate on committees
formed by creditors to negotiate with the management of financially troubled
companies that may or may not be in bankruptcy or may negotiate directly with
debtors with respect to restructuring issues. If the Trust does choose to join
a committee, the Trust would likely be only one of many participants, all of
whom would be interested in obtaining an outcome that is in their individual
best interests. There can be no assurance that the Trust would be successful in
obtaining results most favorable to it in such proceedings, although the Trust
may incur significant legal and other expenses in attempting to do so. As a
result of participation by the Trust on such committees, the Trust may be
deemed to have duties to other creditors represented by the committees, which
might thereby expose the Trust to liability to such other creditors who
disagree with the Trust's actions. Participation by the Trust on such
committees may cause the Trust to be subject to certain restrictions on its
ability to trade in a particular investment and may also make the Trust an
"insider" for purposes of the federal securities laws. Either circumstance will
restrict the Trust's ability to trade in or acquire additional positions in a
particular investment when it might otherwise desire to do so.
High-Yield Securities
A portion of the Trust's investments will consist of investments that may
generally be characterized as "high-yield securities." Such securities are
typically rated below investment grade by one or more nationally recognized
statistical rating organizations or are unrated but of comparable credit
quality to obligations rated below investment grade, and have greater credit
and liquidity risk than more highly rated obligations. High-yield securities
are generally unsecured and may be subordinate to other obligations of the
obligor. The lower rating of high-yield securities reflects a greater
possibility that adverse changes in the financial condition of the issuer or in
general economic conditions (including, for example, a substantial period of
rising interest rates or declining earnings) or both may impair the ability of
the issuer to make payment
33
of principal and interest. Many issuers of high-yield securities are highly
leveraged, and their relatively high debt to equity ratios create increased
risks that their operations might not generate sufficient cash flow to service
their obligations. Overall declines in the below investment grade bond and
other markets may adversely affect such issuers by inhibiting their ability to
refinance their obligations at maturity.
High-yield securities are often issued in connection with leveraged
acquisitions or recapitalizations in which the issuers incur a substantially
higher amount of indebtedness than the level at which they had previously
operated. High-yield securities that are debt instruments have historically
experienced greater default rates than has been the case for investment grade
securities. The Trust may also invest in equity securities issued by entities
whose obligations are unrated or are rated below investment grade.
The Trust is authorized to invest in obligations of issuers which are generally
trading at significantly higher yields than had been historically typical of
the applicable issuer's obligations. Such investments may include debt
obligations that have a heightened probability of being in covenant or payment
default in the future. Such investments generally are considered speculative.
The repayment of defaulted obligations is subject to significant uncertainties.
Defaulted obligations might be repaid only after lengthy workout or bankruptcy
proceedings, during which the issuer might not make any interest or other
payments. Typically such workout or bankruptcy proceedings result in only
partial recovery of cash payments or an exchange of the defaulted security for
other debt or equity securities of the issuer or its affiliates, which may in
turn be illiquid or speculative.
High-yield securities purchased by the Trust will be subject to certain
additional risks to the extent that such obligations may be unsecured and
subordinated to substantial amounts of senior indebtedness, all or a
significant portion of which may be secured. Moreover, such obligations
purchased by the Trust may not be protected by financial covenants or
limitations upon additional indebtedness.
Insolvency Considerations with Respect to Issuers of Debt Obligations
Various laws enacted for the protection of creditors may apply to the debt
obligations held by the Trust. The information in this paragraph is applicable
with respect to U.S. issuers subject to United States bankruptcy laws.
Insolvency considerations may differ with respect to other issuers. If a court
in a lawsuit brought by an unpaid creditor or representative of creditors of an
issuer of a debt obligation, such as a trustee in bankruptcy, were to find that
the issuer did not receive fair consideration or reasonably equivalent value
for incurring the indebtedness constituting the debt obligation and, after
giving effect to such indebtedness, the issuer (i) was insolvent, (ii) was
engaged in a business for which the remaining assets of such issuer constituted
unreasonably small capital or (iii) intended to incur, or believed that it
would incur, debts beyond its ability to pay such debts as they mature, such
court could determine to invalidate, in whole or in part, such indebtedness as
a fraudulent conveyance, to subordinate such indebtedness to existing or future
creditors of such issuer, or to recover amounts previously paid by such issuer
in satisfaction of such indebtedness. The measure of insolvency for purposes of
the foregoing will vary. Generally, an issuer would be considered insolvent at
a particular time if the sum of its debts were then greater than all of its
property at a fair valuation, or if the present fair saleable value of its
assets was then less than the amount that would be required to pay its probable
liabilities on its existing debts as they became absolute and matured. There
can be no assurance as to what standard a court would apply in order to
determine whether the issuer was "insolvent" after giving effect to the
incurrence of the indebtedness constituting the debt obligation or that,
regardless of the method of valuation, a court would not determine that the
issuer was "insolvent" upon giving effect to such incurrence. In addition, in
the event of the insolvency of an issuer of a debt obligation, payments made on
such debt obligation could be subject to avoidance as a "preference" if made
within a certain period of time (which may be as long as one year) before
insolvency. Similarly, a court might apply the doctrine of equitable
subordination to subordinate the claim of a lending institution against an
issuer, to claims of other creditors of the borrower, when the lending
institution, another investor, or any of their transferees, is found to have
engaged in unfair, inequitable, or fraudulent conduct. In general, if payments
on a debt obligation are avoidable, whether as fraudulent conveyances or
preferences, such payments can be recaptured either from the initial recipient
(such as the Trust) or from subsequent transferees of such payments (such as
the investors in the Trust). To the extent that any such payments are
recaptured from the Trust the resulting loss will be borne by the investors.
However, a court in a bankruptcy or insolvency proceeding would be able to
direct the recapture of any such payment from a holder of notes only to the
extent that such court has jurisdiction over such holder or its assets.
Moreover, it is likely that avoidable payments could not be recaptured directly
from a holder that has given value in exchange for its note, in good faith and
without knowledge that the payments were avoidable. The Investment Manager does
not intend to engage in conduct that would form the basis for a successful
cause of action based upon fraudulent conveyance, preference or equitable
subordination. There can be no assurance, however, as to whether any lending
institution or other investor from which the issuer acquired the debt
obligations engaged in any such conduct (or any other conduct that would
subject the debt obligations and the issuer to insolvency laws) and, if it did,
as to whether such creditor claims could be asserted in a U.S. court (or in the
courts of any other country) against the issuer.
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Analysis of Troubled, Distressed or Bankrupt Companies
The Trust invests in companies that are troubled, in distress, or bankrupt. As
such, they are subject to a multitude of legal, industry, market, economic and
governmental forces that make analysis of these companies inherently risky.
Further, the Investment Manager relies on company management, outside experts,
market participants, and personal experience to analyze potential investments
for the Trust. There can be no assurance that any of these sources will prove
credible, or that the Investment Manager's analysis will produce conclusions
that lead to profitable investments.
Leverage
The use of leverage, which can be described as exposure to changes in price at
a ratio greater than the amount of equity invested, either through borrowing or
other forms of market exposure, magnifies both the favorable and unfavorable
effects of price movements in the investments made by the Trust. Subject to
applicable margins and other limitations, the Trust may borrow money, or
utilize other transactions, for the purpose of leveraging its investments.
Insofar as the Trust employs leverage in its investment operations,
shareholders will be subject to substantial risks of loss. Interest on
borrowings will be a portfolio expense of the Trust and will affect the
operating results of the Trust. With volatile instruments, downward price
swings can result in margin calls that could require liquidation of securities
at inopportune times or at prices that are not favorable to the Trust and cause
significant losses.
Common Stock Risk
The Trust will have exposure to common stocks. Although common stocks have
historically generated higher average total returns than fixed income
securities over the long-term, common stocks also have experienced
significantly more volatility in those returns and in recent years have
significantly under-performed relative to fixed income securities. An adverse
event, such as an unfavorable earnings report, may depress the value of a
particular common stock held by the Trust. Also, the price of common stocks is
sensitive to general movements in the stock market and a drop in the stock
market may depress the price of common stocks to which the Trust has exposure.
Common stock prices fluctuate for several reasons, including changes in
investors' perceptions of the financial condition of an issuer or the general
condition of the relevant stock market, or when political or economic events
affecting the issuers occur. In addition, common stock prices may be
particularly sensitive to rising interest rates, as the cost of capital rises
and borrowing costs increase. Interest rates are at historical lows and,
accordingly, it is likely that they will rise.
Dividend Risk
Dividends on common stocks are not fixed but are declared at the discretion of
an issuer's board of directors. There is no guarantee that the issuers of the
common stocks in which the Trust invests will declare dividends in the future
or that if declared they will remain at current levels or increase over time.
As described further in "Tax Matters," "qualified dividend income" received by
the Trust will generally be eligible for the reduced tax rate applicable to
such dividends in the case of individual shareholders of the Trust. Unless
subsequent legislation is enacted, this reduced tax rate will expire for
taxable years beginning on or after January 1, 2009. There is no assurance as
to what portion of the Trust's distributions will constitute qualified dividend
income.
Small And Mid-Cap Stock Risk
The Trust may invest in companies with small and mid-capitalizations. Smaller
and medium company stocks can be more volatile than, and perform differently
from, larger company stocks. There may be less trading in a smaller or medium
company's stock, which means that buy and sell transactions in that stock could
have a larger impact on the stock's price than is the case with larger company
stocks. Smaller and medium companies may have fewer business lines; changes in
any one line of business, therefore, may have a greater impact on a smaller and
medium company's stock price than is the case for a larger company. As a
result, the purchase or sale of more than a limited number of shares of a small
and medium company may affect its market price. The Trust may need a
considerable amount of time to purchase or sell its positions in these
securities. In addition, smaller or medium company stocks may not be well known
to the investing public.
Non-U.S. SecuritiesRisk
Investments in securities of non-U.S. issuers involve certain factors not
typically associated with investing in securities issued by U.S. issuers, such
as risks relating to (i) currency exchange matters, including fluctuations in
the rate of exchange between the U.S. dollar (the currency in which the books
of the Trust are maintained) and the various foreign currencies in which the
Trust's portfolio securities will be denominated and costs associated with
conversion of investment principal and income
35
from one currency into another; (ii) differences between the U.S. and foreign
securities markets, including the absence of uniform accounting, auditing and
financial reporting standards and practices and disclosure requirements, and
less government supervision and regulation; (iii) political, social or economic
instability; and (iv) the extension of credit, especially in the case of
sovereign debt.
Emerging Markets Risk
Investing in securities of issuers based in underdeveloped emerging markets
entails all of the risks of investing in securities of non-U.S. issuers to a
heightened degree. These heightened risks include: (i) greater risks of
expropriation, confiscatory taxation, nationalization, and less social,
political and economic stability; (ii) the smaller size of the markets for such
securities and a lower volume of trading, resulting in lack of liquidity and in
price volatility; and (iii) certain national policies which may restrict the
Trust's investment opportunities including restrictions on investing in issuers
or industries deemed sensitive to relevant national interests.
Foreign Currency Risk
Because the Trust will invest in securities denominated or quoted in currencies
other than the U.S. dollar, changes in foreign currency exchange rates may
affect the value of securities owned by the Trust, the unrealized appreciation
or depreciation of investments and gains on and income from investments.
Currencies of certain countries may be volatile and therefore may affect the
value of securities denominated in such currencies, which means that the
Trust's net asset value could decline as a result of changes in the exchange
rates between foreign currencies and the U.S. dollar. In addition, the Trust
may enter into foreign currency transactions in an attempt to enhance total
return which may further expose the Trust to the risks of foreign currency
movements and other risks. See "Principal Risks of the Trust--Strategic
Transactions Risk."
Securities Lending Risk
The Trust may lend its portfolio securities to banks or dealers which meet the
creditworthiness standards established by the board of trustees of the Trust.
Securities lending is subject to the risk that loaned securities may not be
available to the Trust on a timely basis and the Trust may, therefore, lose the
opportunity to sell the securities at a desirable price. Any loss in the market
price of securities loaned by the Trust that occurs during the term of the loan
would be borne by the Trust and would adversely affect the Trust's performance.
Also, there may be delays in recovery, or no recovery, of securities loaned or
even a loss of rights in the collateral should the borrower of the securities
fail financially while the loan is outstanding. These risks may be greater for
non-U.S. securities.
Risks Associated with Options on Securities
There are several risks associated with transactions in options on securities.
For example, there are significant differences between the securities and
options markets that could result in an imperfect correlation between these
markets, causing a given transaction not to achieve its objectives. A decision
as to whether, when and how to use options involves the exercise of skill and
judgment, and even a well conceived transaction may be unsuccessful to some
degree because of market behavior or unexpected events.
As the writer of a covered call option, the Trust forgoes, during the option's
life, the opportunity to profit from increases in the market value of the
security covering the call option above the sum of the premium and the strike
price of the call, but has retained the risk of loss should the price of the
underlying security decline. As the Trust writes covered calls over more of its
portfolio, its ability to benefit from capital appreciation becomes more
limited. The writer of an option has no control over the time when it may be
required to fulfill its obligation as a writer of the option. Once an option
writer has received an exercise notice, it cannot effect a closing purchase
transaction in order to terminate its obligation under the option and must
deliver the underlying security at the exercise price.
When the Trust writes covered put options, it bears the risk of loss if the
value of the underlying stock declines below the exercise price minus the put
premium. If the option is exercised, the Trust could incur a loss if it is
required to purchase the stock underlying the put option at a price greater
than the market price of the stock at the time of exercise plus the put premium
the Trust received when it wrote the option. While the Trust's potential gain
in writing a covered put option is limited to distributions earned on the
liquid assets securing the put option plus the premium received from the
purchaser of the put option, the Trust risks a loss equal to the entire
exercise price of the option minus the put premium.
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Interest Rate Risk
The price of most fixed-income securities moves in the opposite direction of
the change in interest rates. For example, as interest rates rise, the price of
fixed-income securities falls. Consequently, the longer the maturity of a
fixed-income security, the greater the risk that interest rates will rise and
thus the fall in price of the security will be larger than the fall in price
would have been for a security with a shorter maturity. If the Trust holds a
fixed-income security to maturity, the change in its price before maturity will
have little impact on the Trust's performance; however, if the Trust has to
sell the fixed-income security before the maturity date, an increase in
interest rates will result in a loss to the Trust.
Prepayment Risk
If interest rates fall, the principal on bonds held by the Trust may be paid
earlier than expected. If this happens, the proceeds from a prepaid security
may be reinvested by the Trust in securities bearing lower interest rates,
resulting in a possible decline in the Trust's income and distributions to
shareholders. The Trust may invest in pools of mortgages issued or guaranteed
by private issuers or U.S. government agencies and instrumentalities. These
mortgage-related securities are especially sensitive to prepayment risk because
borrowers often refinance their mortgages when interest rates drop.
Non-Investment Grade Securities Risk
The Trust may invest in securities that are below investment grade.
Non-investment grade securities are commonly referred to as "junk bonds."
Investments in lower grade securities will expose the Trust to greater risks
than if the Trust owned only higher grade debt securities. Because of the
substantial risks associated with lower grade securities, you could lose money
on your investment in common shares of the Trust, both in the short-term and
the long-term. Lower grade securities, though high yielding, are characterized
by high risk. They may be subject to certain risks with respect to the issuing
entity and to greater market fluctuations than certain lower yielding, higher
rated securities. The retail secondary market for lower grade debt securities
may be less liquid than that of higher rated debt securities. Adverse
conditions could make it difficult at times for the Trust to sell certain
securities or could result in lower prices than those used in calculating the
Trust's net asset value.
Strategic Transactions Risk
Strategic Transactions in which the Trust may engage for hedging purposes or to
enhance total return also involve certain risks and special considerations.
Strategic Transactions have risks, including the imperfect correlation between
the value of such instruments and the underlying assets, the possible default
of the other party to the transaction or illiquidity of the derivative
instruments. Furthermore, the ability to successfully use Strategic
Transactions depends on Highland's ability to predict pertinent market
movements, which cannot be assured. Thus, the use of Strategic Transactions may
result in losses greater than if they had not been used, may require the Trust
to sell or purchase portfolio securities at inopportune times or for prices
other than current market values, may limit the amount of appreciation the
Trust can realize on an investment or may cause the Trust to hold a security
that it might otherwise sell. The use of foreign currency transactions can
result in the Trust incurring losses as a result of the imposition of exchange
controls, suspension of settlements or the inability of the Trust to deliver or
receive a specified currency. Additionally, amounts paid by the Trust as
premiums and cash or other assets held in margin accounts with respect to
Strategic Transactions are not otherwise available to the Trust for investment
purposes.
To the extent that the Trust purchases options pursuant to a hedging strategy,
the Trust will be subject to the following additional risks. If a put or call
option purchased by the Trust is not sold when it has remaining value, and if
the market price of the underlying security remains equal to or greater than
the exercise price (in the case of a put), or remains less than or equal to the
exercise price (in the case of a call), the Trust will lose its entire
investment in the option.
Also, where a put or call option on a particular security is purchased to hedge
against price movements in a related security, the price of the put or call
option may move more or less than the price of the related security. If
restrictions on exercise were imposed, the Trust might be unable to exercise an
option it had purchased. If the Trust were unable to close out an option that
it had purchased on a security, it would have to exercise the option in order
to realize any profit or the option may expire worthless.
Market Risk Generally
The profitability of a significant portion of the Trust's investment program
depends to a great extent upon correctly assessing the future course of the
price movements of securities and other investments and the movements of
interest rates. There can be no assurance that the Investment Manager will be
able to predict accurately these price and interest rate movements. With
respect to the investment strategies the Trust may utilize, there will be a
high degree of market risk.
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Reinvestment Risk
The Trust reinvests the cash flows received from a security. The additional
income from such reinvestment, sometimes called interest-on-interest, is
reliant on the prevailing interest rate levels at the time of reinvestment.
There is a risk that the interest rate at which interim cash flows can be
reinvested will fall. Reinvestment risk is greater for longer holding periods
and for securities with large, early cash flows such as high-coupon bonds.
Reinvestment risk also applies generally to the reinvestment of the proceeds
the Trust receives upon the maturity or sale of a portfolio security.
Timing Risk
Many agency, corporate and municipal bonds, and most mortgage-backed
securities, contain a provision that allows the issuer to "call" all or part of
the issue before the bond's maturity date often after 5 or 10 years. The issuer
usually retains the right to refinance the bond in the future if market
interest rates decline below the coupon rate. There are three disadvantages to
the call provision. First, the cash flow pattern of a callable bond is not
known with certainty. Second, because an issuer is more likely to call the
bonds when interest rates have dropped, the Trust is exposed to reinvestment
rate risk, i.e., the Trust may have to reinvest at lower interest rates the
proceeds received when the bond is called. Finally, the capital appreciation
potential of a bond will be reduced because the price of a callable bond may
not rise much above the price at which the issuer may call the bond.
Inflation Risk
Inflation risk results from the variation in the value of cash flows from a
security due to inflation, as measured in terms of purchasing power. For
example, if the Trust purchases a five (5) year bond in which it can realize a
coupon rate of five percent (5%), but the rate of inflation increases from two
percent (2%) to six percent (6%), then the purchasing power of the cash flow
has declined. For all but adjustable bonds or floating rate bonds, the Trust is
exposed to inflation risk because the interest rate the issuer promises to make
is fixed for the life of the security. To the extent that interest rates
reflect the expected inflation rate, floating rate bonds have a lower level of
inflation risk.
Arbitrage Risks
The Trust will engage in capital structure arbitrage and other arbitrage
strategies. Arbitrage strategies entail various risks including the risk that
external events, regulatory approvals and other factors will impact the
consummation of announced corporate events and/or the prices of certain
positions. In addition, hedging is an important feature of capital structure
arbitrage. There is no guarantee that the Investment Manager will be able to
hedge the Trust's portfolio in the manner necessary to successfully employ the
Trust's strategy.
Short Sales Risks
Short sales by the Trust that are not made "against the box" theoretically
involve unlimited loss potential since the market price of securities sold
short may continuously increase. Short selling involves selling securities
which may or may not be owned and borrowing the same securities for delivery to
the purchaser, with an obligation to replace the borrowed securities at a later
date. Short selling allows the Trust to profit from declines in market prices
to the extent such decline exceeds the transaction costs and the costs of
borrowing the securities. However, since the borrowed securities must be
replaced by purchases at market prices in order to close out the short
position, any appreciation in the price of the borrowed securities would result
in a loss. Purchasing securities to close out the short position can itself
cause the price of the securities to rise further, thereby exacerbating the
loss. The Trust may mitigate such losses by replacing the securities sold short
before the market price has increased significantly. Under adverse market
conditions, the Trust might have difficulty purchasing securities to meet its
short sale delivery obligations, and might have to sell portfolio securities to
raise the capital necessary to meet its short sale obligations at a time when
fundamental investment considerations would not favor such sales.
Structured Finance Securities
A portion of the Trust's investments may consist of equipment trust
certificates, collateralized mortgage obligations, collateralized bond
obligations, collateralized loan obligations or similar instruments. Structured
finance securities may present risks similar to those of the other types of
debt obligations in which the Trust may invest and, in fact, such risks may be
of greater significance in the case of structured finance securities. Moreover,
investing in structured finance securities may entail a variety of unique
risks. Among other risks, structured finance securities may be subject to
prepayment risk. In addition, the performance of a structured finance security
will be affected by a variety of factors, including its priority in the capital
structure of the issuer thereof, and the availability of any credit
enhancement, the level and timing of payments and
38
recoveries on and the characteristics of the underlying receivables, loans or
other assets that are being securitized, remoteness of those assets from the
originator or transferor, the adequacy of and ability to realize upon any
related collateral and the capability of the servicer of the securitized
assets.
Preferred Securities Risks
There are special risks associated with investing in preferred securities,
including:
o Deferral. Preferred securities may include provisions that permit the
issuer, at its discretion, to defer distributions for a stated period
without any adverse consequences to the issuer. If the Trust owns a
preferred security that is deferring its distributions, the Trust may
be required to report income for tax purposes although it has not yet
received such income.
o Subordination. Preferred securities are subordinated to bonds and
other debt instruments in a company's capital structure in terms of
priority to corporate income and liquidation payments, and therefore
will be subject to greater credit risk than more senior debt
instruments.
o Liquidity. Preferred securities may be substantially less liquid than
many other securities, such as common stocks or U.S. government
securities.
o Limited Voting Rights. Generally, preferred security holders have no
voting rights with respect to the issuing company unless preferred
dividends have been in arrears for a specified number of periods, at
which time the preferred security holders may elect a number of
trustees to the issuer's board. Generally, once all the arrearages
have been paid, the preferred security holders no longer have voting
rights.
Derivative Instruments Risks
Derivative instruments, or "derivatives," include futures, options, swaps,
structured securities and other instruments and contracts that are derived
from, or the value of which is related to, one or more underlying securities,
financial benchmarks, currencies or indices. Derivatives allow an investor to
hedge or speculate upon the price movements of a particular security, financial
benchmark currency or index at a fraction of the cost of investing in the
underlying asset. The value of a derivative depends largely upon price
movements in the underlying asset. Therefore, many of the risks applicable to
trading the underlying asset are also applicable to derivatives of such asset.
However, there are a number of other risks associated with derivatives trading.
For example, because many derivatives are "leveraged," and thus provide
significantly more market exposure than the money paid or deposited when the
transaction is entered into, a relatively small adverse market movement can not
only result in the loss of the entire investment, but may also expose the Trust
to the possibility of a loss exceeding the original amount invested.
Derivatives may also expose investors to liquidity risk, as there may not be a
liquid market within which to close or dispose of outstanding derivatives
contracts, and to counterparty risk. The counterparty risk lies with each party
with whom the Trust contracts for the purpose of making derivative investments
(the "Counterparty"). In the event of the Counterparty's default, the Trust
will only rank as an unsecured creditor and risks the loss of all or a portion
of the amounts it is contractually entitled to receive.
Swaps
Investments in swaps involve the exchange with another party of their
respective commitments. Use of swaps subjects the Trust to risk of default by
the counterparty. If there is a default by the Counterparty to such a
transaction, there may be contractual remedies pursuant to the agreements
related to the transaction although contractual remedies may not be sufficient
in the event the Counterparty is insolvent. However, the swap market has grown
substantially in recent years with a large number of banks and investment
banking firms acting both as principals and agents utilizing standardized swap
documentation. As a result, the swap market has become relatively liquid in
comparison with the markets for other similar instruments which are traded in
the interbank market. The Trust may enter into credit default swaps, currency
swaps or other swaps which may be surrogates for other instruments such as
currency forwards or options.
Synthetic Securities
In addition to credit risks associated with holding non-investment grade loans
and high-yield debt securities, with respect to synthetic securities the Trust
will usually have a contractual relationship only with the counterparty of such
synthetic securities, and not the Reference Obligor (as defined below) on the
Reference Obligation (as defined below). The Trust generally will have no right
to directly enforce compliance by the Reference Obligor with the terms of the
Reference
39
Obligation nor any rights of set-off against the Reference Obligor,
nor have any voting rights with respect to the Reference Obligation. The Trust
will not benefit directly from any collateral supporting the Reference
Obligation or have the benefit of the remedies on default that would normally
be available to a holder of such Reference Obligation. In addition, in the
event of insolvency of its counterparty, the Trust will be treated as a general
creditor of such counterparty and will not have any claim with respect to the
credit risk of the counterparty as well as that of the Reference Obligor. As a
result, concentrations of synthetic securities with any one counterparty
subject the notes to an additional degree of risk with respect to defaults by
such counterparty as well as by the Reference Obligor. The Investment Manager
will not perform independent credit analyses of the counterparties, any such
counterparty, or an entity guaranteeing such counterparty, individually or in
the aggregate. A "Reference Obligation" is the debt security or other
obligation upon which the synthetic security is based. A "Reference Obligor" is
the obligor on a Reference Obligation.
Tax Considerations
There are certain tax risks related to an investment in the Trust. No assurance
can be given that the income tax laws or the present interpretation thereof
will not be changed (including on a retroactive basis) or that the Internal
Revenue Service will agree with the positions taken on the federal income tax
returns of the Trust. Accordingly, prospective investors should obtain
professional guidance from their personal tax advisors in evaluating the tax
risks involved in investing in the Trust and should take into account the cost
of obtaining such advice in evaluating this investment. See "Tax Matters."
Forward-Looking Statements
Certain statements contained in this Memorandum, including without limitation,
statements containing the words "believes," "anticipates," "intends,"
"expects," and words of similar import constitute "forward-looking statements."
Such forward-looking statements involve known and unknown risks, uncertainties
and other factors that may cause the actual results, performance or
achievements of the Trust to be materially different from any future results,
performance or achievements expressed or implied by such forward-looking
statements. Certain of these factors are discussed in more detail elsewhere in
this Memorandum, including without limitation under "Summary of Terms," "Risk
Factors and Potential Conflicts of Interest," and "Investment Program." Given
these uncertainties, prospective investors are cautioned not to place undue
reliance on such forward-looking statements. The Investment Manager and the
Trust disclaim any obligation to update any such factors or to announce the
result of any revisions to any of the forward-looking statements contained
herein to reflect future events or developments.
Valuation Risk
Fair value is defined as the amount for which assets could be sold in an
orderly disposition over a reasonable period of time, taking into account the
nature of the asset. Fair value pricing, however, involves judgments that are
inherently subjective and inexact, since fair valuation procedures are used
only when it is not possible to be sure what value should be attributed to a
particular asset or when an event will affect the market price of an asset and
to what extent. As a result, there can be no assurance that fair value pricing
will reflect actual market value and it is possible that the fair value
determined for a security will be materially different from the value that
actually could be or is realized upon the sale of that asset.
Investments In Unseasoned Companies
The Trust may invest in the securities of smaller, less seasoned companies.
These investments may present greater opportunities for growth, but also
involve greater risks than customarily are associated with investments in
securities of more established companies. Some of the companies in which the
Trust may invest will be start-up companies which may have insubstantial
operational or earnings history or may have limited products, markets,
financial resources or management depth. Some may also be emerging companies at
the research and development stage with no products or technologies to market
or approved for marketing. Securities of emerging companies may lack an active
secondary market and may be subject to more abrupt or erratic price movements
than securities of larger, more established companies or stock market averages
in general. Competitors of certain companies may have substantially greater
financial resources than many of the companies in which the Trust may invest.
Initial Public Offerings (IPOs) Risk
The Trust may invest in shares of companies through IPOs. IPOs and companies
that have recently gone public have the potential to produce substantial gains
for the Trust, subject to the Trust's option writing strategy. However, there
is no assurance that the Trust will have access to profitable IPOs. The
investment performance of the Trust during periods when it is unable to invest
significantly or at all in IPOs may be lower than during periods when the Trust
is able to do so. Securities
40
issued in IPOs are subject to many of the same risks as investing in companies
with smaller market capitalizations. Securities issued in IPOs have no trading
history, and information about the companies may be available for limited
periods of time. In addition, the prices of securities sold in IPOs may be
highly volatile or may decline shortly after the IPO.
Market Disruption And Geopolitical Risk
The aftermath of the war in Iraq and the continuing occupation of Iraq,
instability in the Middle East and terrorist attacks in the United States and
around the world may have resulted in market volatility and may have long-term
effects on the U.S. and worldwide financial markets and may cause further
economic uncertainties in the United States and worldwide. The Trust does not
know how long the securities markets will continue to be affected by these
events and cannot predict the effects of the occupation or similar events in
the future on the U.S. economy and securities markets. Given the risks
described above, an investment in the common shares may not be appropriate for
all investors. You should carefully consider your ability to assume these risks
before making an investment in the Trust.
Anti-Takeover Provisions
The Trust's Agreement and Declaration of Trust includes provisions that could
limit the ability of other entities or persons to acquire control of the Trust
or convert the Trust to open-end status. These provisions could deprive the
holders of common shares of opportunities to sell their common shares at a
premium over the then current market price of the common shares or at net asset
value.
MANAGEMENT OF THE TRUST
Trustees And Officers
The board of trustees is responsible for the overall management of the Trust,
including supervision of the duties performed by Highland. There are
trustees of the Trust. of the trustees are not "interested persons"
(as defined in the Investment Company Act) of the Trust. The name and business
address of the trustees and officers of the Trust and their principal
occupations and other affiliations during the past five years are set forth
under "Management of the Trust" in the Statement of Additional Information.
Investment Manager
Highland acts as the Trust's investment manager. Highland is located at Two
Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240. As of ,
2006, the Investment Manager managed approximately $ billion in debt
securities on behalf of institutional investors and retail clients around the
world. Highland is controlled by James Dondero and Mark Okada, by virtue of
their respective share ownership, and its general partner, Strand Advisors,
Inc., of which Mr. Dondero is the sole stockholder.
Portfolio Managers
The Trust's portfolio will initially be managed by James Dondero, Mark Okada
and Kurtis Plumer.
James Dondero, CFA, CPA, CMA. Mr. Dondero is a founder and President of
Highland. Formerly, Mr. Dondero served as Chief Investment Officer of
Protective Life's GIC subsidiary and helped grow the business from concept to
over $2 billion between 1989 and 1993. His portfolio management experience
includes mortgage-backed securities, investment grade corporates, leveraged
bank loans, emerging markets, derivatives, preferred stocks and common stocks.
From 1985 to 1989, he managed approximately $1 billion in fixed income funds
for American Express. Prior to American Express, he completed the financial
training at Morgan Guaranty Trust Company. Mr. Dondero is a Beta Gamma Sigma
graduate of the University of Virginia, 1984 with degrees in Accounting and
Finance. Mr. Dondero is a Certified Public Accountant, Chartered Financial
Analyst and a Certified Management Accountant.
Mark Okada, CFA. Mr. Okada is a founder and Chief Investment Officer of
Highland. He is responsible for overseeing Highland's investment activities for
its various funds and has over 19 years of experience in the leveraged finance
market. Formerly, Mr. Okada served as Manager of Fixed Income for Protective
Life's GIC subsidiary from 1990 to 1993. He was primarily responsible for the
bank loan portfolio and other risk assets. Protective was one of the first
non-bank entrants into the syndicated loan market. From 1986 to 1990, he served
as Vice President for Hibernia National Bank, managing over $1 billion of high
yield bank loans. Mr. Okada is an honors graduate of the University of
California Los Angeles with degrees in Economics and Psychology. He completed
his credit training at Mitsui and is a Chartered Financial Analyst. Mr. Okada
is also Chairman of the Board of Directors of Common Grace Ministries Inc.
41
Kurtis Plumer, CFA. Mr. Plumer is a Senior Portfolio Manager and co-head of the
Distressed Group at Highland where he is responsible for managing the sourcing,
investing and monitoring process. He has over 14 years of experience in
distressed, high yield bond and leveraged loan products. Prior to joining
Highland in 1999, Mr. Plumer was a distressed high yield bond trader at Lehman
Brothers in New York, where he managed a $250 million portfolio invested in
global distressed securities. While at Lehman, he also traded emerging market
sovereign bonds. Prior to joining Lehman Brothers, Mr. Plumer was a corporate
finance banker at NationsBanc Capital Markets, Inc. (now Bank of America
Capital Markets, Inc.) where he focused on M&A and financing transactions for
the bank's clients. Mr. Plumer earned a BBA in Economics and Finance from
Baylor University and an MBA in Strategy and Finance from the Kellogg School at
Northwestern University. Mr. Plumer is a Chartered Financial Analyst.
The Statement of Additional Information provides additional information about
the portfolio managers' compensation, other accounts managed by the portfolio
managers and the portfolio managers' ownership of securities issued by the
Trust.
Investment Management Agreement
Pursuant to an investment management agreement between Highland and the Trust,
the Trust has agreed to pay for the investment advisory services and facilities
provided by Highland a fee payable monthly in arrears at an annual rate equal
to % of the average weekly value of the Trust's Managed Assets (the
"ManagementFee"). The Management Fee is comprised of two components: %
of the Management Fee is paid to Highland as compensation for the portfolio
management services it provides to the Trust, and % of the Management Fee is
paid to Highland as compensation for the administrative services it provides to
the Trust.
In addition to the Management Fee of Highland, the Trust pays all other costs
and expenses of its operations, including compensation of its trustees (other
than those affiliated with Highland), custodian, transfer and dividend
disbursing agent expenses, legal fees, listing fees and expenses, expenses of
independent auditors, expenses of preparing, printing and distributing
shareholder reports, notices, proxy statements and reports to governmental
agencies, and taxes, if any.
NET ASSET VALUE
The net asset value of the common shares of the Trust will be computed based
upon the value of the Trust's portfolio securities and other assets. Net asset
value per common share will be determined daily on each day that the New York
Stock Exchange is open for business as of the close of the regular trading
session on the New York Stock Exchange. The Trust calculates net asset value
per common share by subtracting liabilities (including accrued expenses or
dividends) from the total assets of the Trust (the value of the securities plus
cash or other assets, including interest accrued but not yet received) and
dividing the result by the total number of outstanding common shares of the
Trust.
Valuations
The Trust's investments will generally be valued by the Investment Manager as
follows:
(i) The market value of each security listed or traded on any recognized
securities exchange or automated quotation system will be the last
reported sale price at the relevant valuation date on the composite
tape or on the principal exchange on which such security is traded. If
no sale is reported on that date, the Investment Manager utilizes,
when available, pricing quotations from principal market makers. Such
quotations may be obtained from third-party pricing services or
directly from investment brokers and dealers in the secondary market.
Generally, the Trust's loan and bond positions are not traded on
exchanges and consequently are valued based on marks received from
third-party pricing services or broker-dealer sources.
(ii) Dividends declared but not yet received, and rights in respect of
securities which are quoted ex-dividend or ex-rights, will be recorded
at the fair value thereof, as determined by the Investment Manager,
which may (but need not) be the value so determined on the day such
securities are first quoted ex-dividend or ex-rights.
(iii) Listed options, or over-the-counter options for which representative
brokers' quotations are available, will be valued in the same manner
as listed or over-the-counter securities as hereinabove provided.
Premiums for the sale of such options written by the Trust will be
included in the assets of the Trust, and the market value of such
options shall be included as a liability.
(iv) The Trust's non-marketable investments will generally be valued in
such manner as the Investment Manager determines in good faith to
reflect their fair values under procedures established by, and under
the general supervision and responsibility of, the Trust's board of
trustees. The pricing of all assets that are fair valued in this
manner will be subsequently reported to and ratified by the Trust's
board of trustees.
42
When determining the fair value of an asset, the Investment Manager will seek
to determine the price that the Trust might reasonably expect to receive from
the current sale of that asset in an arm's-length transaction. Fair value
determinations shall be based upon all available factors that the Investment
Manager deems relevant.
DISTRIBUTIONS
Commencing with the Trust's initial dividend, the Trust intends to make regular
monthly cash distributions. We expect to declare the initial monthly dividend
on the Trust's common shares within approximately 45 days after completion of
this offering and to pay that initial monthly dividend approximately 60 to 90
days after completion of this offering. The Trust expects to pay common
shareholders annually at least 90% of its investment company taxable income.
Various factors will affect the level of the Trust's current income and current
gains, such as its asset mix, and the Trust's use of options. To permit the
Trust to maintain more stable monthly distributions, the Trust may from time to
time distribute less than the entire amount of income and gains earned in a
particular period. The undistributed income and gains would be available to
supplement future distributions. As a result, the distributions paid by the
Trust for any particular month may be more or less than the amount of income
and gains actually earned by the Trust during that month. Undistributed income
and gains will add to the Trust's net asset value and, correspondingly,
distributions from undistributed income and gains and from capital, if any,
will deduct from the Trust's net asset value. Shareholders will automatically
have all dividends and distributions reinvested in common shares of the Trust
issued by the Trust or purchased in the open market in accordance with the
Trust's dividend reinvestment plan unless an election is made to receive cash.
See "Dividend reinvestment plan."
DIVIDEND REINVESTMENT PLAN
Unless the registered owner of common shares elects to receive cash by
contacting the Plan Agent, all dividends declared for your common shares of the
Trust will be automatically reinvested by ALPS Mutual Trust Services, Inc. (the
"Plan Agent"), agent for shareholders in administering the Trust's Dividend
Reinvestment Plan (the "Plan"), in additional common shares of the Trust. If a
registered owner of common shares elects not to participate in the Plan, you
will receive all dividends in cash paid by check mailed directly to you (or, if
the shares are held in street or other nominee name, then to such nominee) by
ALPS Mutual Trust Services, Inc., as dividend disbursing agent. You may elect
not to participate in the Plan and to receive all dividends in cash by sending
written instructions or by contacting ALPS Mutual Trust Services, Inc., as
dividend disbursing agent, at the address set forth below. Participation in the
Plan is completely voluntary and may be terminated or resumed at any time
without penalty by contacting the Plan Agent before the dividend record date;
otherwise such termination or resumption will be effective with respect to any
subsequently declared dividend or other distribution. Some brokers may
automatically elect to receive cash on your behalf and may re-invest that cash
in additional common shares of the Trust for you. If you wish for all dividends
declared on your common shares of the Trust to be automatically reinvested
pursuant to the Plan, please contact your broker.
The Plan Agent will open an account for each common shareholder under the Plan
in the same name in which such common shareholder's common shares are
registered. Whenever the Trust declares a dividend or other distribution
(together, a "dividend") payable in cash, non-participants in the Plan will
receive cash and participants in the Plan will receive the equivalent in common
shares. The common shares will be acquired by the Plan Agent for the
participants' accounts, depending upon the circumstances described below,
either (i) through receipt of additional unissued but authorized common shares
from the Trust ("newly issued common shares") or (ii) by purchase of
outstanding common shares on the open market ("open-market purchases") on the
New York Stock Exchange or elsewhere.
If, on the payment date for any dividend, the market price per common share
plus estimated brokerage commissions is greater than the net asset value per
common share (such condition being referred to herein as "market premium"), the
Plan Agent will invest the dividend amount in newly issued common shares,
including fractions, on behalf of the participants. The number of newly issued
common shares to be credited to each participant's account will be determined
by dividing the dollar amount of the dividend by the net asset value per common
share on the payment date; provided that, if the net asset value per common
share is less than 95% of the market price per common share on the payment
date, the dollar amount of the dividend will be divided by 95% of the market
price per common share on the payment date.
If, on the payment date for any dividend, the net asset value per common share
is greater than the market value per common share plus estimated brokerage
commissions (such condition being referred to herein as "market discount"), the
Plan Agent will invest the dividend amount in common shares acquired on behalf
of the participants in open-market purchases.
In the event of a market discount on the payment date for any dividend, the
Plan Agent will have until the last business day before the next date on which
the common shares trade on an "ex-dividend" basis or 120 days after the payment
date for such dividend, whichever is sooner (the "last purchase date"), to
invest the dividend amount in common shares acquired in open-
43
market purchases. It is contemplated that the Trust will pay monthly dividends.
Therefore, the period during which open-market purchases can be made will exist
only from the payment date of each dividend through the date before the
"ex-dividend" date of the third month of the quarter. If, before the Plan Agent
has completed its open-market purchases, the market price of a common share
exceeds the net asset value per common share, the average per common share
purchase price paid by the Plan Agent may exceed the net asset value of the
common shares, resulting in the acquisition of fewer common shares than if the
dividend had been paid in newly issued common shares on the dividend payment
date. Because of the foregoing difficulty with respect to open market
purchases, if the Plan Agent is unable to invest the full dividend amount in
open market purchases during the purchase period or if the market discount
shifts to a market premium during the purchase period, the Plan Agent may cease
making open-market purchases and may invest the uninvested portion of the
dividend amount in newly issued common shares at the net asset value per common
share at the close of business on the last purchase date; provided that, if the
net asset value per common share is less than 95% of the market price per
common share on the payment date, the dollar amount of the dividend will be
divided by 95% of the market price per common share on the payment date.
The Plan Agent maintains all shareholders' accounts in the Plan and furnishes
written confirmation of all transactions in the accounts, including information
needed by shareholders for tax records. Common shares in the account of each
Plan participant will be held by the Plan Agent on behalf of the Plan
participant, and each shareholder proxy will include those shares purchased or
received pursuant to the Plan. The Plan Agent will forward all proxy
solicitation materials to participants and vote proxies for shares held under
the Plan in accordance with the instructions of the participants.
In the case of shareholders such as banks, brokers or nominees which hold
shares for others who are the beneficial owners, the Plan Agent will administer
the Plan on the basis of the number of common shares certified from time to
time by the record shareholder's name and held for the account of beneficial
owners who participate in the Plan.
There will be no brokerage charges with respect to common shares issued
directly by the Trust. However, each participant will pay a pro rata share of
brokerage commissions incurred in connection with open-market purchases. The
automatic reinvestment of dividends will not relieve participants of any
federal, state or local income tax that may be payable (or required to be
withheld) on such dividends. See "Tax Matters." Participants that request a
sale of shares through the Plan Agent are subject to $ sales fee and a
brokerage commission of $ per share sold.
The Trust reserves the right to amend or terminate the Plan. There is no direct
service charge to participants in the Plan; however, the Trust reserves the
right to amend the Plan to include a service charge payable by the
participants.
All correspondence concerning the Plan should be directed to the Plan Agent at
ALPS Mutual Trust Services, Inc, 1625 Broadway, Suite 2200, Denver, Colorado
80202; telephone ( ) .
DESCRIPTION OF SHARES
Common Shares
The Trust is an unincorporated statutory trust organized under the laws of
Delaware pursuant to an Agreement and Declaration of Trust dated as of March
10, 2006. The Trust is authorized to issue an unlimited number of common shares
of beneficial interest, par value $0.001 per share. Each common share has one
vote and, when issued and paid for in accordance with the terms of this
offering, will be fully paid and non-assessable, except that the trustees shall
have the power to cause shareholders to pay expenses of the Trust by setting
off charges due from shareholders from declared but unpaid dividends or
distributions owed the shareholders and/or by reducing the number of common
shares owned by each respective shareholder. The Trust currently is not aware
of any expenses that will be paid pursuant to this provision, except to the
extent fees payable under its Dividend Reinvestment Plan are deemed to be paid
pursuant to this provision.
The Trust has no present intention of offering any additional shares other than
the Preferred Shares and common shares issued under the Trust's Dividend
Reinvestment Plan. Any additional offerings of shares will require approval by
the Trust's board of trustees. Any additional offering of common shares will be
subject to the requirements of the Investment Company Act, which provides that
shares may not be issued at a price below the then current net asset value,
exclusive of sales load, except in connection with an offering to existing
holders of common shares or with the consent of a majority of the Trust's
outstanding voting securities.
The Trust anticipates that its common shares will be listed on the New York
Stock Exchange under the symbol " ." Net asset value will be reduced
immediately following the offering of common shares by the amount of the sales
load and offering costs paid by the Trust. See "Summary of Trust Expenses."
44
Unlike open-end funds, closed-end funds like the Trust do not continuously
offer shares and do not provide daily redemptions. Rather, if a shareholder
determines to buy additional common shares or sell shares already held, the
shareholder may do so by trading through a broker on the New York Stock
Exchange or otherwise. Shares of closed-end investment companies frequently
trade on an exchange at prices lower than net asset value. Shares of closed-end
investment companies like the Trust that invest predominantly in equity
securities have during some periods traded at prices higher than net asset
value and during other periods have traded at prices lower than net asset
value. Because the market value of the common shares may be influenced by such
factors as dividend levels (which are in turn affected by expenses), dividend
stability, net asset value, relative demand for and supply of such shares in
the market, general market and economic conditions and other factors beyond the
control of the Trust, the Trust cannot assure you that common shares will trade
at a price equal to or higher than net asset value in the future. The common
shares are designed primarily for long-term investors and you should not
purchase the common shares if you intend to sell them soon after purchase. See
the Statement of Additional Information under "Repurchase of Common Shares."
Preferred Shares
The Agreement and Declaration of Trust provides that the Trust's Board of
Trustees may authorize and issue Preferred Shares with rights as determined by
the Board of Trustees, by action of the Board of Trustees without the approval
of the holders of the common shares. Holders of Common shares have no
preemptive right to purchase any Preferred Shares that might be issued.
The Trust may elect to issue Preferred Shares as part of its leverage strategy.
If Preferred Shares are issued, the Trust currently intends to issue Preferred
Shares representing no more than % of the Trust's Managed Assets immediately
after the Preferred Shares are issued. The Board of Trustees also reserves the
right to change the foregoing percentage limitation and may issue Preferred
Shares to the extent permitted by the Investment Company Act, which currently
limits the aggregate liquidation preference of all outstanding Preferred Shares
to 50% of the value of the Trust's Managed Assets less liabilities and
indebtedness of the Trust. We cannot assure you, however, that any Preferred
Shares will be issued. Although the terms of any Preferred Shares, including
dividend rate, liquidation preference and redemption provisions, will be
determined by the Board of Trustees, subject to applicable law and the
Agreement and Declaration of Trust, it is likely that the Preferred Shares will
be structured to carry a relatively short-term dividend rate reflecting
interest rates on short-term bonds, by providing for the periodic
redetermination of the dividend rate at relatively short intervals through an
auction, remarketing or other procedure. The Trust also believes that it is
likely that the liquidation preference, voting rights and redemption provisions
of the Preferred Shares will be similar to those stated below.
Liquidation Preference. In the event of any voluntary or involuntary
liquidation, dissolution or winding up of the Trust, the holders of Preferred
Shares will be entitled to receive a preferential liquidating distribution,
which is expected to equal the original purchase price per Preferred Share plus
accrued and unpaid dividends, whether or not declared, before any distribution
of assets is made to holders of common shares. After payment of the full amount
of the liquidating distribution to which they are entitled, the holders of
Preferred Shares will not be entitled to any further participation in any
distribution of assets by the Trust.
Voting Rights. The Investment Company Act requires that the holders of any
Preferred Shares, voting separately as a single class, have the right to elect
at least two trustees at all times. The remaining trustees will be elected by
holders of common shares and Preferred Shares, voting together as a single
class. In addition, subject to the prior rights, if any, of the holders of any
other class of senior securities outstanding, the holders of any Preferred
Shares have the right to elect a majority of the trustees of the Trust at any
time two years' dividends on any Preferred Shares are unpaid. The Investment
Company Act also requires that, in addition to any approval by shareholders
that might otherwise be required, the approval of the holders of a majority of
any outstanding Preferred Shares, voting separately as a class, would be
required to (1) adopt any plan of reorganization that would adversely affect
the Preferred Shares, and (2) take any action requiring a vote of security
holders under Section 13(a) of the Investment Company Act, including, among
other things, changes in the Trust's subclassification as a closed-end
investment company or changes in its fundamental investment restrictions. See
"Certain Provisions in the Agreement and Declaration of Trust." As a result of
these voting rights, the Trust's ability to take any such actions may be
impeded to the extent that there are any Preferred Shares outstanding. The
Board of Trustees presently intends that, except as otherwise indicated in this
prospectus and except as otherwise required by applicable law, holders of
Preferred Shares will have equal voting rights with holders of common shares
(one vote per share, unless otherwise required by the Investment Company Act)
and will vote together with holders of common shares as a single class.
The affirmative vote of the holders of a majority of the outstanding Preferred
Shares, voting as a separate class, will be required to amend, alter or repeal
any of the preferences, rights or powers of holders of Preferred Shares so as
to affect materially and adversely such preferences, rights or powers, or to
increase or decrease the authorized number of Preferred
45
Shares. The class vote of holders of Preferred Shares described above will in
each case be in addition to any other vote required to authorize the action in
question.
Redemption, Purchase and Sale of Preferred Shares by the Trust. The terms of
the Preferred Shares are expected to provide that (1) they are redeemable by
the Trust in whole or in part at the original purchase price per share plus
accrued dividends per share, (2) the Trust may tender for or purchase Preferred
Shares and (3) the Trust may subsequently resell any shares so tendered for or
purchased. Any redemption or purchase of Preferred Shares by the Trust will
reduce the leverage applicable to the common shares, while any resale of shares
by the Trust will increase that leverage.
The discussion above describes the possible offering of Preferred Shares by the
Trust. If the Board of Trustees determines to proceed with such an offering,
the terms of the Preferred Shares may be the same as, or different from, the
terms described above, subject to applicable law and the Trust's Agreement and
Declaration of Trust. The Board of Trustees, without the approval of the
holders of common shares, may authorize an offering of Preferred Shares or may
determine not to authorize such an offering, and may fix the terms of the
Preferred Shares to be offered.
ANTI-TAKEOVER PROVISIONS IN THE AGREEMENT AND DECLARATION OF TRUST
The Agreement and Declaration of Trust includes provisions that could have the
effect of limiting the ability of other entities or persons to acquire control
of the Trust or to change the composition of its board of trustees. This could
have the effect of depriving shareholders of an opportunity to sell their
shares at a premium over prevailing market prices by discouraging a third party
from seeking to obtain control over the Trust. Such attempts could have the
effect of increasing the expenses of the Trust and disrupting the normal
operation of the Trust. The board of trustees is divided into three classes,
with the terms of one class expiring at each annual meeting of shareholders. At
each annual meeting, one class of trustees is elected to a three-year term.
This provision could delay for up to two years the replacement of a majority of
the board of trustees. A trustee may be removed from office by the action of a
majority of the remaining trustees followed by a vote of the holders of at
least 75% of the shares then entitled to vote for the election of the
respective trustee.
In addition, the Trust's Agreement and Declaration of Trust requires the
favorable vote of a majority of the Trust's board of trustees followed by the
favorable vote of the holders of at least 75% of the outstanding shares of each
affected class or series of the Trust, voting separately as a class or series,
to approve, adopt or authorize certain transactions with 5% or greater holders
of a class or series of shares and their associates, unless the transaction has
been approved by at least 80% of the trustees, in which case "a majority of the
outstanding voting securities" (as defined in the Investment Company Act) of
the Trust shall be required. For purposes of these provisions, a 5% or greater
holder of a class or series of shares (a "Principal Shareholder") refers to any
person who, whether directly or indirectly and whether alone or together with
its affiliates and associates, beneficially owns 5% or more of the outstanding
shares of all outstanding classes or series of shares of beneficial interest of
the Trust.
The 5% holder transactions subject to these special approval requirements are:
the merger or consolidation of the Trust or any subsidiary of the Trust with or
into any Principal Shareholder; the issuance of any securities of the Trust to
any Principal Shareholder for cash, except pursuant to any automatic dividend
reinvestment plan; the sale, lease or exchange of all or any substantial part
of the assets of the Trust to any Principal Shareholder, except assets having
an aggregate fair market value of less than 2% of the total assets of the
Trust, aggregating for the purpose of such computation all assets sold, leased
or exchanged in any series of similar transactions within a twelve-month
period; or the sale, lease or exchange to the Trust or any subsidiary of the
Trust, in exchange for securities of the Trust, of any assets of any Principal
Shareholder, except assets having an aggregate fair market value of less than
2% of the total assets of the Trust, aggregating for purposes of such
computation all assets sold, leased or exchanged in any series of similar
transactions within a twelve-month period.
To convert the Trust to an open-end investment company, the Trust's Agreement
and Declaration of Trust requires the favorable vote of a majority of the board
of the trustees followed by the favorable vote of the holders of at least 75%
of the outstanding shares of each affected class or series of shares of the
Trust, voting separately as a class or series, unless such amendment has been
approved by at least 80% of the trustees, in which case "a majority of the
outstanding voting securities" (as defined in the Investment Company Act) of
the Trust shall be required. The foregoing vote would satisfy a separate
requirement in the Investment Company Act that any conversion of the Trust to
an open-end investment company be approved by the shareholders. If approved in
the foregoing manner, conversion of the Trust to an open-end investment company
could not occur until 90 days after the shareholders' meeting at which such
conversion was approved and would also require at least 30 days' prior notice
to all shareholders. Following any such conversion, it is possible that certain
of the Trust's investment policies and strategies would have to be modified to
assure sufficient portfolio liquidity. In the event of conversion, the common
shares would cease to be listed on the New York Stock Exchange or other
national securities
46
exchanges or market systems. Shareholders of an open-end investment company may
require the company to redeem their shares at any time, except in certain
circumstances as authorized by or under the Investment Company Act, at their
net asset value, less such redemption charge, if any, as might be in effect at
the time of a redemption. The Trust expects to pay all such redemption requests
in cash, but reserves the right to pay redemption requests in a combination of
cash or securities. If such partial payment in securities were made, investors
may incur brokerage costs in converting such securities to cash. If the Trust
were converted to an open-end fund, it is likely that new shares would be sold
at net asset value plus a sales load. The board of trustees believes, however,
that the closed-end structure is desirable in light of the Trust's investment
objectives and policies. Therefore, you should assume that it is not likely
that the board of trustees would vote to convert the Trust to an open-end fund.
For the purposes of calculating "a majority of the outstanding voting
securities" under the Trust's Agreement and Declaration of Trust, each class
and series of the Trust shall vote together as a single class, except to the
extent required by the Investment Company Act or the Trust's Agreement and
Declaration of Trust, with respect to any class or series of shares. If a
separate class vote is required, the applicable proportion of shares of the
class or series, voting as a separate class or series, also will be required.
The Declaration of Trust also provides that the Trust may be liquidated upon
the approval of 80% of the trustees.
The board of trustees has determined that provisions with respect to the board
of trustees and the shareholder voting requirements described above, which
voting requirements are greater than the minimum requirements under Delaware
law or the Investment Company Act, are in the best interest of shareholders
generally. Reference should be made to the Trust's Agreement and Declaration of
Trust, on file with the Commission for the full text of these provisions.
CLOSED-END FUND STRUCTURE
The Trust is a diversified, closed-end management investment company with no
operating history (commonly referred to as a closed-end fund). Closed-end funds
differ from open-end funds (which are generally referred to as mutual funds) in
that closed-end funds generally list their shares for trading on a stock
exchange and do not redeem their shares at the request of the shareholder. This
means that if you wish to sell your shares of a closed-end fund you must trade
them on the market like any other stock at the prevailing market price at that
time. In a mutual fund, if the shareholder wishes to sell shares of the fund,
the mutual fund will redeem or buy back the shares at "net asset value." Also,
mutual funds generally offer new shares on a continuous basis to new investors,
and closed-end funds generally do not. The continuous inflows and outflows of
assets in a mutual fund can make it difficult to manage a mutual fund's
investments. By comparison, closed-end funds are generally able to stay more
fully invested in securities that are consistent with their investment
objective, and also have greater flexibility to make certain types of
investments, and to use certain investment strategies, such as financial
leverage and investments in illiquid securities.
Shares of closed-end funds frequently trade at a discount to their net asset
value. Because of this possibility and the recognition that any such discount
may not be in the interest of shareholders, the Trust's board of trustees might
consider from time to time engaging in open-market repurchases, tender offers
for shares or other programs intended to reduce the discount. We cannot
guarantee or assure, however, that the Trust's board of trustees will decide to
engage in any of these actions. Nor is there any guarantee or assurance that
such actions, if undertaken, would result in the shares trading at a price
equal or close to net asset value per share. The board of trustees might also
consider converting the Trust to an open-end mutual fund, which would also
require a vote of the shareholders of the Trust.
REPURCHASE OF COMMON SHARES
Shares of closed-end investment companies often trade at a discount to their
net asset value, and the Trust's common shares may also trade at a discount to
their net asset value, although it is possible that they may trade at a premium
above net asset value. The market price of the Trust's common shares will be
determined by such factors as relative demand for and supply of such common
shares in the market, the Trust's net asset value, general market and economic
conditions and other factors beyond the control of the Trust. See "Net Asset
Value." Although the Trust's common shareholders will not have the right to
redeem their common shares, the Trust may take action to repurchase common
shares in the open market or make tender offers for its common shares. This may
have the effect of reducing any market discount from net asset value.
There is no assurance that, if action is undertaken to repurchase or tender for
common shares, such action will result in the common shares trading at a price
which approximates their net asset value. Although share repurchases and
tenders could have a favorable effect on the market price of the Trust's common
shares, you should be aware that the acquisition of common shares by the Trust
will decrease the capital of the Trust and, therefore, may have the effect of
increasing the Trust's expense ratio and decreasing the asset coverage with
respect to any preferred shares outstanding. Any share repurchases or
47
tender offers will be made in accordance with requirements of the Securities
Exchange Act of 1934, as amended, the Investment Company Act and the principal
stock exchange on which the common shares are traded.
TAX MATTERS
The following discussion summarizes certain U.S. federal income tax
considerations affecting the Trust and its U.S. shareholders. For more
information, please see the Statement of Additional Information, under "Tax
Matters." Because each shareholder's tax situation is unique, ask your tax
professional about the tax consequences to you of an investment in the Trust.
The Trust intends to qualify annually as a regulated investment company under
the Internal Revenue Code. Accordingly, the Trust generally will not be subject
to U.S. federal income tax on income and gains that the Trust distributes to
its shareholders.
Distributions paid to you by the Trust from its net realized long-term capital
gains, if any, that the Trust designates as capital gains dividends ("capital
gain dividends") are taxable as long-term capital gains, regardless of how long
you have held your common shares. All other dividends paid to you by the Trust
(including dividends from short-term capital gains) from its current or
accumulated earnings and profits ("ordinary income dividends") are generally
subject to tax as ordinary income.
Special rules apply, however, to ordinary income dividends paid to individuals
with respect to taxable years beginning on or before December 31, 2008. If you
are an individual, any such ordinary income dividend that you receive from the
Trust generally will be eligible for taxation at the rates applicable to
long-term capital gains (currently at a maximum rate of 15%) to the extent
that: (i) the ordinary income dividend is attributable to "qualified dividend
income" (i.e., generally dividends paid by U.S. corporations and certain
foreign corporations) received by the Trust, (ii) the Trust satisfies certain
holding period and other requirements with respect to the stock on which such
qualified dividend income was paid and (iii) you satisfy certain holding period
and other requirements with respect to your common shares. Ordinary income
dividends subject to these special rules are not actually treated as capital
gains, however, and thus will not be included in the computation of your net
capital gain and generally cannot be used to offset any capital losses.
Congress has recently considered certain proposals to extend the preferential
tax rates for qualified dividend income beyond 2008, but no assurances can be
given in this regard.
Dividends and other taxable distributions are taxable to you even if they are
reinvested in additional common shares of the Trust. Dividends and other
distributions paid by the Trust are generally treated as received by you at the
time the dividend or distribution is made. If, however, the Trust pays you a
dividend in January that was declared in the previous October, November or
December and you were the shareholder of record on a specified date in one of
such months, then such dividend will be treated for tax purposes as being paid
by the Trust and received by you on December 31 of the year in which the
dividend was declared.
The price of common shares purchased at any time may reflect the amount of a
forthcoming distribution. If you purchase common shares just prior to a
distribution, you will receive a distribution that will be taxable to you even
though it represents in part a return of your invested capital.
The Trust will send you information after the end of each year setting forth
the amount and tax status of any distributions paid to you by the Trust.
Ordinary income dividends and capital gain dividends may also be subject to
state and local taxes.
If you sell or otherwise dispose of common shares of the Trust (including
exchange them for common shares of another fund), you will generally recognize
a gain or loss in an amount equal to the difference between your tax basis in
such common shares of the Trust and the amount you receive in exchange for such
common shares. If you hold your common shares as capital assets, any such gain
or loss will be long-term capital gain or loss if you have held such common
shares for more than one year at the time of sale.
The Trust may be required to withhold, for U.S. federal backup withholding tax
purposes, a portion of the dividends, distributions and redemption proceeds
payable to a shareholder who fails to provide the Trust (or its agent) with the
shareholder's correct taxpayer identification number (in the case of an
individual, generally, such individual's social security number) or to make the
required certification, or who has been notified by the Internal Revenue
Service that such shareholder is subject to backup withholding. Certain
shareholders are exempt from backup withholding. Backup withholding is not an
additional tax and any amount withheld may be refunded or credited against your
U.S. federal income tax liability, if any, provided that you furnish the
required information to the IRS.
48
The discussions set forth herein and in the Statement of Additional Information
do not constitute tax advice, and you are urged to consult your own tax advisor
to determine the specific U.S. federal, state, local and foreign tax
consequences to you of investing in the Trust.
UNDERWRITING
The Underwriters named below, acting through as their
representatives (the "Representatives"), have severally agreed, subject to the
terms and conditions of a purchase agreement with the Trust and Highland (the
"Underwriting Agreement") to purchase from the Trust the number of common shares
set forth opposite their respective names. The Underwriters are committed to
purchase and pay for all such common shares (other than those covered by the
over-allotment option described below) if any are purchased.
Number of
Underwriters common shares
-------------------------------------------------------------------------------
----------
Total ==========
The Trust granted to the Underwriters an option, exercisable for 45 days from
the date of this prospectus, to purchase up to an additional common shares
to cover over-allotments, if any, at the initial offering price per common share
minus the commission described in the following paragraph. The Underwriters may
exercise such option solely for the purpose of covering over-allotments incurred
in the sale of the common shares offered hereby. To the extent that the
Underwriters exercise this option, each of the Underwriters will have a firm
commitment, subject to certain conditions, to purchase an additional number of
common shares proportionate to such Underwriter's initial commitment.
The Trust has agreed to pay a commission to the Underwriters in the amount of
up to $ per common share ( % of the public offering price per common
share). The Representatives have advised the Trust that the Underwriters may pay
up to $ per common share from such commission to selected dealers who sell the
common shares and that such dealers may reallow a concession of up to $ per
common share to certain other dealers who sell common shares. Investors must pay
for any common shares purchased on or before , 2006.
Prior to this offering, there has been no public or private market for the
common shares or any other securities of the Trust. Consequently, the offering
price for the common shares was determined by negotiation among the Trust,
Highland and the Representatives. There can be no assurance, however, that the
price at which the common shares sell after this offering will not be lower
than the price at which they are sold by the Underwriters or that an active
trading market in the common shares will develop and continue after this
offering. The minimum investment requirement is 100 common shares ($2,000).
The Trust and Highland have agreed not to offer, sell or register with the
Commission any equity securities of the Trust, other than issuances of common
shares as contemplated in this prospectus, for a period of 180 days after the
date of the Underwriting Agreement without the prior written consent of the
Representatives. The Representatives have informed the Trust that the
Underwriters do not intend to confirm any sales to any accounts over which they
exercise discretionary authority.
In connection with this offering, the Underwriters may purchase and sell common
shares in the open market. These transactions may include over-allotment and
stabilizing transactions and purchases to cover syndicate short positions
created in connection with this offering. Stabilizing transactions consist of
certain bids or purchases for the purpose of preventing or retarding a decline
in the market price of the common shares and syndicate short positions involve
the sale of the Underwriters of a greater number of common shares than they are
required to purchase from the Trust in this offering. The Underwriters also may
impose a penalty bid, whereby selling concessions allowed to syndicate members
or other broker-dealers in respect of the common shares sold in this offering
for their account may be reclaimed by the syndicate if such
49
common shares are repurchased by the syndicate in stabilizing or covering
transactions. These activities may stabilize, maintain or otherwise affect the
market price of the common shares, which may be higher than the price that
might otherwise prevail in the open market; and these activities, if commenced,
may be discontinued at any time without notice. These transactions may be
effected on the New York Stock Exchange or otherwise.
The Trust anticipates that the Representatives and certain other Underwriters
may from time to time act as brokers and dealers in connection with the
execution of its portfolio transactions after they have ceased to be
Underwriters and, subject to certain restrictions, may act as such brokers
while they are Underwriters.
In connection with this offering, certain of the Underwriters or selected
dealers may distribute prospectuses electronically.
Highland (and not the Trust) may pay certain qualifying Underwriters a sales
incentive fee, structuring fee or, alternatively, additional compensation in
connection with this offering. The total amount of these payments will not
exceed % of the total price to the public of the common shares sold in this
offering.
Highland (and not the Trust) has agreed to pay a commission to certain
wholesalers of its broker dealer affiliate, , that participate
in the marketing of the Trust's common shares, which commissions will not exceed
% of the total price to the public of the common shares sold in this
offering. The Trust may reimburse Highland for all or a portion of its expenses
incurred in connection with this offering (other than those described in the
preceding sentence), to the extent that the offering expenses of the Trust do
not equal or exceed the $ per common share the Trust has agreed to pay for
the offering expenses of the Trust.
The sum of the fees described above, plus the amount paid by the Trust as the $
per common share partial reimbursement of expenses to the Underwriters, will
not exceed % of the aggregate initial offering price of the common shares
offered hereby. The sum total of all compensation to Underwriters in connection
with this public offering of common shares, including sales load and additional
compensation to and reimbursement of Underwriters, will be limited to 9% of the
total price to the public of the common shares sold in this offering.
CUSTODIAN AND TRANSFER AGENT
The Custodian of the assets of the Trust will be ALPS Mutual Trust Services,
Inc. The Custodian will perform custodial, fund accounting and portfolio
accounting services. ALPS Mutual Trust Services, Inc. will also serve as the
Trust's Transfer Agent with respect to its common shares.
LEGAL OPINIONS
Certain legal matters in connection with the common shares will be passed upon
for the Trust by Skadden, Arps, Slate, Meagher & Flom LLP, New York, New York
and for the Underwriters by , , .
PRIVACY PRINCIPLES OF THE TRUST
The Trust is committed to maintaining the privacy of its shareholders and to
safeguarding their non-public personal information. The following information
is provided to help you understand what personal information the Trust
collects, how the Trust protects that information and why, in certain cases,
the Trust may share information with select other parties.
Generally, the Trust does not receive any non-public personal information
relating to its shareholders, although certain non-public personal information
of its shareholders may become available to the Trust. The Trust does not
disclose any non-public personal information about its shareholders or former
shareholders to anyone, except as permitted by law or as is necessary in order
to service shareholder accounts (for example, to a transfer agent or third
party administrator).
The Trust restricts access to non-public personal information about its
shareholders to employees of the Trust's investment manager and its affiliates
with a legitimate business need for the information. The Trust maintains
physical, electronic and procedural safeguards designed to protect the
non-public personal information of its shareholders.
50
TABLE OF CONTENTS FOR THE STATEMENT OF ADDITIONAL INFORMATION
USE OF PROCEEDS..............................................................B-2
INVESTMENT OBJECTIVES AND POLICIES...........................................B-2
INVESTMENT POLICIES AND TECHNIQUES...........................................B-3
OTHER INVESTMENT POLICIES AND TECHNIQUES.....................................B-8
MANAGEMENT OF THE TRUST.....................................................B-10
PORTFOLIO TRANSACTIONS AND BROKERAGE........................................B-16
DESCRIPTION OF SHARES.......................................................B-16
REPURCHASE OF COMMON SHARES.................................................B-18
TAX MATTERS.................................................................B-19
EXPERTS.....................................................................B-22
ADDITIONAL INFORMATION......................................................B-22
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM......................F-1
STATEMENT OF ASSETS AND LIABILITIES..........................................F-2
STATEMENT OF OPERATIONS......................................................F-3
STATEMENT OF CHANGES IN NET ASSETS...........................................F-4
NOTES TO FINANCIAL STATEMENTS................................................F-5
APPENDIX A GENERAL CHARACTERISTICS AND RISKS OF STRATEGIC TRANSACTIONS.....A-1
APPENDIX B PROXY VOTING PROCEDURES..........................................B-1
Highland Credit Strategies Fund
[flag]
The information in this Statement of Additional Information is not complete and
may be changed. We may not sell these securities until the registration
statement filed with the Securities and Exchange Commission is effective. This
Statement of Additional Information is not an offer to sell these securities
and is not soliciting an offer to buy these securities in any state where the
offer or sale is not permitted.
Subject to Completion
Preliminary Statement of Additional Information
Dated , 2006
STATEMENT OF ADDITIONAL INFORMATION
Highland Credit Strategies Fund (the "Trust") is a newly organized,
non-diversified, closed-end management investment company with no operating
history. This Statement of Additional Information relating to common shares
does not constitute a prospectus, but should be read in conjunction with the
prospectus relating thereto dated , 2006. This Statement of Additional
Information, which is not a prospectus, does not include all information that a
prospective investor should consider before purchasing common shares, and
investors should obtain and read the prospectus prior to purchasing such
shares. A copy of the prospectus may be obtained without charge by calling
(877) 665-1287. You may also obtain a copy of the prospectus on the Securities
and Exchange Commission's web site (http://www.sec.gov). Capitalized terms used
but not defined in this Statement of Additional Information have the meanings
ascribed to them in the prospectus.
TABLE OF CONTENTS
USE OF PROCEEDS..............................................................B-2
INVESTMENT OBJECTIVES AND POLICIES...........................................B-2
INVESTMENT POLICIES AND TECHNIQUES...........................................B-3
OTHER INVESTMENT POLICIES AND TECHNIQUES.....................................B-8
MANAGEMENT OF THE TRUST.....................................................B-10
PORTFOLIO TRANSACTIONS AND BROKERAGE........................................B-16
DESCRIPTION OF SHARES.......................................................B-16
REPURCHASE OF COMMON SHARES.................................................B-18
TAX MATTERS.................................................................B-19
EXPERTS.....................................................................B-22
ADDITIONAL INFORMATION......................................................B-22
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM......................F-1
STATEMENT OF ASSETS AND LIABILITIES..........................................F-2
STATEMENT OF OPERATIONS......................................................F-3
STATEMENT OF CHANGES IN NET ASSETS...........................................F-4
NOTES TO FINANCIAL STATEMENTS................................................F-5
APPENDIX A GENERAL CHARACTERISTICS AND RISKS OF STRATEGIC TRANSACTIONS.....A-1
APPENDIX B PROXY VOTING PROCEDURES..........................................B-1
This Statement of Additional Information is dated , 2006.
B-1
USE OF PROCEEDS
Pending investment in securities that meet the Trust's investment
objectives and policies, the net proceeds of this offering will be invested in
short-term debt securities of the type described under "Investment Policies and
Techniques--Short-Term Debt Securities." We currently anticipate that the Trust
will be able to invest primarily in securities that meet the Trust's investment
objectives and policies within approximately three months after the completion
of this offering.
INVESTMENT OBJECTIVES AND POLICIES
The Trust's primary investment objective is to deliver attractive
risk-adjusted returns to its investors by employing a multi-strategy investment
approach to exploit relative value and arbitrage opportunities within the
credit markets. Highland will execute, on behalf of the Trust, directional,
relative value, capital structure arbitrage and event-driven investment
strategies across various credit markets where the Investment Manager holds
significant investment experience: primarily the leveraged loan, high yield,
structured products, and distressed markets. The Trust will seek to create a
portfolio of investments that will maintain low correlation to the broader
equity and corporate bond markets, as well as to other alternative investment
strategies.
Investment Restrictions
Except as described below, the Trust, as a fundamental policy, may not,
without the approval of the holders of a majority of the outstanding common
shares and any preferred shares, if any, voting together as a single class, and
of the holders of a majority of the outstanding preferred shares, if any,
voting as a separate class:
(1) invest 25% or more of the value of its total assets in any single
industry;
(2) issue senior securities or borrow money other than as permitted by
the Investment Company Act or pledge its assets other than to secure such
issuances or in connection with hedging transactions, short sales,
securities lending, when issued and forward commitment transactions and
similar investment strategies;
(3) make loans of money or property to any person, except through
loans of portfolio securities, the purchase of debt securities, including
bank loans and participations therein, or the entry into repurchase
agreements;
(4) underwrite the securities of other issuers, except to the extent
that, in connection with the disposition of portfolio securities or the
sale of its own securities, the Trust may be deemed to be an underwriter;
(5) purchase or sell real estate, except that the Trust may invest in
securities of companies that deal in real estate or are engaged in the
real estate business, including real estate investment trusts and real
estate operating companies, and instruments secured by real estate or
interests therein and the Trust may acquire, hold and sell real estate
acquired through default, liquidation, or other distributions of an
interest in real estate as a result of the Trust's ownership of such other
assets; or
(6) purchase or sell commodities or commodity contracts for any
purposes except as, and to the extent, permitted by applicable law without
the Trust becoming subject to registration with the Commodity Futures
Trading Commission (the "CFTC") as a commodity pool.
When used with respect to particular shares of the Trust, "majority of the
outstanding" shares means (i) 67% or more of the shares present at a meeting,
if the holders of more than 50% of the shares are present or represented by
proxy, or (ii) more than 50% of the shares, whichever is less.
The Trust is also subject to the following non-fundamental restrictions
and policies, which may be changed by the board of trustees. The Trust may not:
(1) make any short sale of securities except in conformity with
applicable laws, rules and regulations and unless after giving effect to
such sale, the market value of all securities sold short does not exceed
25% of the value of the Trust's total assets and the Trust's aggregate
short sales of a particular class of securities of an issuer does not
exceed 25% of the then outstanding securities of that class. The Trust may
also make short sales "against the box" without respect to such
limitations. In this type of short sale, at the time of the sale, the
Trust owns or has the immediate and unconditional right to acquire at no
additional cost the identical security; and
B-2
(2) purchase securities of open-end or closed-end investment companies
except in compliance with the Investment Company Act or any exemptive
relief obtained thereunder. Under the Investment Company Act, the Trust
may invest up to 10% of its total assets in the aggregate in shares of
other investment companies and up to 5% of its total assets in any one
investment company, provided the investment does not represent more than
3% of the voting stock of the acquired investment company at the time such
shares are purchased. As a shareholder in any investment company, the
Trust will bear its ratable share of that investment company's expenses,
and will remain subject to payment of the Trust's advisory fees and other
expenses with respect to assets so invested. Holders of common shares will
therefore be subject to duplicative expenses to the extent the Trust
invests in other investment companies. In addition, the securities of
other investment companies may be leveraged and will therefore be subject
to the risks of leverage. The net asset value and market value of
leveraged shares will be more volatile and the yield to shareholders will
tend to fluctuate more than the yield generated by unleveraged shares.
In addition, to comply with federal income tax requirements for
qualification as a regulated investment company, the Trust's investments will
be limited in a manner such that at the close of each quarter of each taxable
year, (a) no more than 25% of the value of the Trust's total assets are
invested (i) in the securities (other than U.S. Government securities or
securities of other regulated investment companies) of a single issuer or two
or more issuers controlled by the Trust and engaged in the same, similar or
related trades or businesses or (ii) in the securities of one or more
"qualified publicly traded partnerships" (as defined under Section 851(h) of
the Code) and (b) with regard to at least 50% of the Trust's total assets, no
more than 5% of its total assets are invested in the securities (other than
U.S. Government securities or securities of other regulated investment
companies) of a single issuer and no investment represents more than 10% of the
outstanding voting securities of such issuer. These tax-related limitations may
be changed by the trustees to the extent appropriate in light of changes to
applicable tax requirements.
The percentage limitations applicable to the Trust's portfolio described
in the prospectus and this Statement of Additional Information apply only at
the time of investment and the Trust will not be required to sell securities
due to subsequent changes in the value of securities it owns.
INVESTMENT POLICIES AND TECHNIQUES
The following information supplements the discussion of the Trust's
investment objectives, policies and techniques that are described in the
prospectus.
Short-Term Debt Securities
For temporary defensive purposes or to keep cash on hand, the Trust may
invest up to 100% of its total assets in cash equivalents and short-term debt
securities. Short-term debt investments are defined to include, without
limitation, the following:
(1) U.S. Government securities, including bills, notes and bonds
differing as to maturity and rates of interest that are either issued or
guaranteed by the U.S. Treasury or by U.S. Government agencies or
instrumentalities. U.S. Government securities include securities issued by
(a) the Federal Housing Administration, Farmers Home Administration,
Export-Import Bank of the United States, Small Business Administration,
and Government National Mortgage Association, whose securities are
supported by the full faith and credit of the United States; (b) the
Federal Home Loan Banks, Federal Intermediate Credit Banks, and Tennessee
Valley Authority, whose securities are supported by the right of the
agency to borrow from the U.S. Treasury; (c) the Federal National Mortgage
Association, whose securities are supported by the discretionary authority
of the U.S. Government to purchase certain obligations of the agency or
instrumentality; and (d) the Student Loan Marketing Association, whose
securities are supported only by its credit. While the U.S. Government
provides financial support to such U.S. Government-sponsored agencies or
instrumentalities, no assurance can be given that it always will do so
since it is not so obligated by law. The U.S. Government, its agencies and
instrumentalities do not guarantee the market value of their securities.
Consequently, the value of such securities may fluctuate.
(2) Certificates of deposit issued against funds deposited in a bank
or a savings and loan association. Such certificates are for a definite
period of time, earn a specified rate of return, and are normally
negotiable. The issuer of a certificate of deposit agrees to pay the
amount deposited plus interest to the bearer of the certificate on the
date specified thereon. Certificates of deposit purchased by the Trust may
not be fully insured by the Federal Deposit Insurance Corporation.
(3) Repurchase agreements, which involve purchases of debt securities.
At the time the Trust purchases securities pursuant to a repurchase
agreement, it simultaneously agrees to resell and redeliver such
securities to the
B-3
seller, who also simultaneously agrees to buy back the securities at a
fixed price and time. This assures a predetermined yield for the Trust
during its holding period, since the resale price is always greater than
the purchase price and reflects an agreed-upon market rate. Such actions
afford an opportunity for the Trust to invest temporarily available cash.
The Trust may enter into repurchase agreements only with respect to
obligations of the U.S. Government, its agencies or instrumentalities;
certificates of deposit; or bankers' acceptances in which the Trust may
invest. Repurchase agreements may be considered loans to the seller,
collateralized by the underlying securities. The risk to the Trust is
limited to the ability of the seller to pay the agreed-upon sum on the
repurchase date; in the event of default, the repurchase agreement
provides that the Trust is entitled to sell the underlying collateral. If
the value of the collateral declines after the agreement is entered into,
and if the seller defaults under a repurchase agreement when the value of
the underlying collateral is less than the repurchase price, the Trust
could incur a loss of both principal and interest. Highland monitors the
value of the collateral at the time the action is entered into and at all
times during the term of the repurchase agreement. Highland does so in an
effort to determine that the value of the collateral always equals or
exceeds the agreed-upon repurchase price to be paid to the Trust. If the
seller were to be subject to a federal bankruptcy proceeding, the ability
of the Trust to liquidate the collateral could be delayed or impaired
because of certain provisions of the bankruptcy laws.
(4) Commercial paper, which consists of short-term unsecured
promissory notes, including variable rate master demand notes issued by
corporations to finance their current operations. Master demand notes are
direct lending arrangements between the Trust and a corporation. There is
no secondary market for such notes. However, they are redeemable by the
Trust at any time. Highland will consider the financial condition of the
corporation (e.g., earning power, cash flow and other liquidity ratios)
and will continually monitor the corporation's ability to meet all of its
financial obligations, because the Trust's liquidity might be impaired if
the corporation were unable to pay principal and interest on demand.
Investments in commercial paper will be limited to commercial paper rated
in the highest categories by a major rating agency and which mature within
one year of the date of purchase or carry a variable or floating rate of
interest.
Equity Securities
The Trust may invest in equity securities including preferred stocks,
convertible securities, warrants and depository receipts.
Preferred Stock. Preferred stock has a preference over common stock in
liquidation (and generally dividends as well) but is subordinated to the
liabilities of the issuer in all respects. As a general rule, the market value
of preferred stock with a fixed dividend rate and no conversion element varies
inversely with interest rates and perceived credit risk, while the market price
of convertible preferred stock generally also reflects some element of
conversion value. Because preferred stock is junior to debt securities and
other obligations of the issuer, deterioration in the credit quality of the
issuer will cause greater changes in the value of a preferred stock than in a
more senior debt security with similar stated yield characteristics. Unlike
interest payments on debt securities, preferred stock dividends are payable
only if declared by the issuer's board of directors. Preferred stock also may
be subject to optional or mandatory redemption provisions.
Convertible Securities. A convertible security is a bond, debenture, note,
preferred stock or other security that may be converted into or exchanged for a
prescribed amount of common stock or other equity security of the same or a
different issuer within a particular period of time at a specified price or
formula. A convertible security entitles the holder to receive interest paid or
accrued on debt or the dividend paid on preferred stock until the convertible
security matures or is redeemed, converted or exchanged. Before conversion,
convertible securities have characteristics similar to nonconvertible income
securities in that they ordinarily provide a stable stream of income with
generally higher yields than those of common stocks of the same or similar
issuers, but lower yields than comparable nonconvertible securities. The value
of a convertible security is influenced by changes in interest rates, with
investment value declining as interest rates increase and increasing as
interest rates decline. The credit standing of the issuer and other factors
also may have an effect on the convertible security's investment value.
Convertible securities rank senior to common stock in a corporation's capital
structure but are usually subordinated to comparable nonconvertible securities.
Convertible securities may be subject to redemption at the option of the issuer
at a price established in the convertible security's governing instrument.
Warrants. Warrants, which are privileges issued by corporations enabling
the owners to subscribe to and purchase a specified number of shares of the
corporation at a specified price during a specified period of time.
Subscription rights normally have a short life span to expiration. The purchase
of warrants involves the risk that the Trust could lose the purchase value of a
right or warrant if the right to subscribe to additional shares is not
exercised prior to the warrants' expiration. Also, the purchase of warrants
involves the risk that the effective price paid for the warrant added to the
B-4
subscription price of the related security may exceed the value of the
subscribed security's market price such as when there is no movement in the
level of the underlying security.
Depository Receipts. The Trust may invest in both sponsored and
unsponsored American Depository Receipts ("ADRs"), European Depository Receipts
("EDRs"), Global Depository Receipts ("GDRs") and other similar global
instruments. ADRs typically are issued by an American bank or trust company and
evidence ownership of underlying securities issued by a non-U.S. corporation.
EDRs, which are sometimes referred to as Continental Depository Receipts, are
receipts issued in Europe, typically by non-U.S. banks and trust companies,
that evidence ownership of either non-U.S. or domestic underlying securities.
GDRs are depository receipts structured like global debt issues to facilitate
trading on an international basis. Unsponsored ADR, EDR and GDR programs are
organized independently and without the cooperation of the issuer of the
underlying securities. As a result, available information concerning the issuer
may not be as current as for sponsored ADRs, EDRs and GDRs, and the prices of
unsponsored ADRs, EDRs and GDRs may be more volatile than if such instruments
were sponsored by the issuer. Investments in ADRs, EDRs and GDRs present
additional investment considerations of non-U.S. securities.
Variable and Floating Rate Instruments
The Trust may purchase rated and unrated variable and floating rate
instruments. These instruments may include variable amount master demand notes
that permit the indebtedness thereunder to vary in addition to providing for
periodic adjustments in the interest rate. The Trust may invest in leveraged
inverse floating rate debt instruments ("Inverse floaters"). The interest rate
of an inverse floater resets in the opposite direction from the market rate of
interest to which it is indexed. An inverse floater may be considered to be
leveraged to the extent that its interest rate varies by a magnitude that
exceeds the magnitude of the change in the index rate of interest. The higher
degree of leverage inherent in inverse floaters is associated with greater
volatility in their market values. Issuers of unrated variable and floating
rate instruments must satisfy the same criteria as set forth above for the
Trust. The absence of an active secondary market with respect to particular
variable and floating rate instruments, however, could make it difficult for
the Trust to dispose of a variable or floating rate instrument if the issuer
defaulted on its payment obligation or during periods when the Trust is not
entitled to exercise its demand rights.
With respect to purchasable variable and floating rate instruments,
Highland will consider the earning power, cash flows and liquidity ratios of
the issuers and guarantors of such instruments and, if the instruments are
subject to a demand feature, will monitor their financial status to meet
payment on demand. Such instruments may include variable amount master demand
notes that permit the indebtedness thereunder to vary in addition to providing
for periodic adjustments in the interest rate. The absence of an active
secondary market with respect to particular variable and floating rate
instruments could make it difficult for the Trust to dispose of a variable or
floating rate note if the issuer defaulted on its payment obligation or during
periods that the Trust is not entitled to exercise its demand rights, and the
Trust could, for these or other reasons, suffer a loss, with respect to such
instruments. In determining average-weighted portfolio maturity, an instrument
will be deemed to have a maturity equal to either the period remaining until
the next interest rate adjustment or the time the Trust involved can recover
payment of principal as specified in the instrument, depending on the type of
instrument involved.
Strategic Transactions and Risk Management
Consistent with its investment objectives and policies set forth in the
prospectus and in addition to its option strategy, the Trust may also enter
into certain risk management transactions. In particular, the Trust may
purchase and sell futures contracts, exchange listed and over-the-counter put
and call options on securities, equity and other indices and futures contracts,
forward foreign currency contracts, and may enter into various interest rate
transactions (collectively, "Strategic Transactions"). Strategic Transactions
may be used to attempt to protect against possible changes in the market value
of the Trust's portfolio resulting from fluctuations in the securities markets
and changes in interest rates, to protect the Trust's unrealized gains in the
value of its portfolio securities, to facilitate the sale of such securities
for investment purposes and to establish a position in the securities markets
as a temporary substitute for purchasing particular securities. Any or all of
these Strategic Transactions may be used at any time. There is no particular
strategy that requires use of one technique rather than another. Use of any
Strategic Transaction is a function of market conditions. The ability of the
Trust to manage them successfully will depend on Highland's ability to predict
pertinent market movements as well as sufficient correlation among the
instruments, which cannot be assured. The Strategic Transactions that the Trust
may use are described below. Although the Trust recognizes it is not likely
that it will use certain of these strategies in light of its investment
policies, it nevertheless describes them here because the Trust may seek to use
these strategies in certain circumstances.
B-5
Futures Contracts and Options on Futures Contracts. In connection with its
Strategic Transactions and other risk management strategies, the Trust may also
enter into contracts for the purchase or sale for future delivery ("futures
contracts") of securities, aggregates of securities or indices or prices
thereof, other financial indices and U.S. government debt securities or options
on the above. The Trust will engage in such transactions only for bona fide
risk management and other portfolio management purposes.
Forward Foreign Currency Contracts. The Trust may enter into forward
currency contracts to purchase or sell foreign currencies for a fixed amount of
U.S. dollars or another foreign currency. A forward currency contract involves
an obligation to purchase or sell a specific currency at a future date, which
may be any fixed number of days (term) from the date of the forward currency
contract agreed upon by the parties, at a price set at the time the forward
currency contract is entered into. Forward currency contracts are traded
directly between currency traders (usually large commercial banks) and their
customers. The Trust may purchase a forward currency contract to lock in the
U.S. dollar price of a security denominated in a foreign currency that the
Trust intends to acquire. The Trust may sell a forward currency contract to
lock in the U.S. dollar equivalent of the proceeds from the anticipated sale of
a security or a dividend or interest payment denominated in a foreign currency.
The Trust may also use forward currency contracts to shift the Trust's exposure
to foreign currency exchange rate changes from one currency to another. For
example, if the Trust owns securities denominated in a foreign currency and
Highland believes that currency will decline relative to another currency, the
Trust might enter into a forward currency contract to sell the appropriate
amount of the first foreign currency with payment to be made in the second
currency. The Trust may also purchase forward currency contracts to enhance
income when Highland anticipates that the foreign currency will appreciate in
value but securities denominated in that currency do not present attractive
investment opportunities. The Trust may also use forward currency contracts to
offset against a decline in the value of existing investments denominated in a
foreign currency. Such a transaction would tend to offset both positive and
negative currency fluctuations, but would not offset changes in security values
caused by other factors. The Trust could also enter into a forward currency
contract to sell another currency expected to perform similarly to the currency
in which the Trust's existing investments are denominated. This type of
transaction could offer advantages in terms of cost, yield or efficiency, but
may not offset currency exposure as effectively as a simple forward currency
transaction to sell U.S. dollars. This type of transaction may result in losses
if the currency sold does not perform similarly to the currency in which the
Trust's existing investments are denominated. The Trust may also use forward
currency contracts in one currency or a basket of currencies to attempt to
offset against fluctuations in the value of securities denominated in a
different currency if Highland anticipates that there will be a correlation
between the two currencies. The cost to the Trust of engaging in forward
currency contracts varies with factors such as the currency involved, the
length of the contract period and the market conditions then prevailing.
Because forward currency contracts are usually entered into on a principal
basis, no fees or commissions are involved. When the Trust enters into a
forward currency contract, it relies on the counterparty to make or take
delivery of the underlying currency at the maturity of the contract. Failure by
the counterparty to do so would result in the loss of some or all of any
expected benefit of the transaction. Secondary markets generally do not exist
for forward currency contracts, with the result that closing transactions
generally can be made for forward currency contracts only by negotiating
directly with the counterparty. Thus, there can be no assurance that the Trust
will in fact be able to close out a forward currency contract at a favorable
price prior to maturity. In addition, in the event of insolvency of the
counterparty, the Trust might be unable to close out a forward currency
contract. In either event, the Trust would continue to be subject to market
risk with respect to the position, and would continue to be required to
maintain a position in securities denominated in the foreign currency or to
maintain cash or liquid assets in a segregated account. The precise matching of
forward currency contract amounts and the value of the securities involved
generally will not be possible because the value of such securities, measured
in the foreign currency, will change after the forward currency contract has
been established. Thus, the Trust might need to purchase or sell foreign
currencies in the spot (cash) market to the extent such foreign currencies are
not covered by forward currency contracts. The projection of short-term
currency market movements is extremely difficult, and the successful execution
of a short-term strategy is highly uncertain.
Calls on Securities, Indices and Futures Contracts. In addition to its
option strategy, in order to enhance income or reduce fluctuations on net asset
value, the Trust may sell or purchase call options ("calls") on securities and
indices based upon the prices of futures contracts and debt or equity
securities that are traded on U.S. and non-U.S. securities exchanges and in the
over-the-counter markets. A call option gives the purchaser of the option the
right to buy, and obligates the seller to sell, the underlying security,
futures contract or index at the exercise price at any time or at a specified
time during the option period. All such calls sold by the Trust must be
"covered" as long as the call is outstanding (i.e., the Trust must own the
instrument subject to the call or other securities or assets acceptable for
applicable segregation and coverage requirements). A call sold by the Trust
exposes the Trust during the term of the option to possible loss of opportunity
to realize appreciation in the market price of the underlying security, index
or futures contract and may require the Trust to hold an instrument which it
might otherwise have sold. The purchase of a
B-6
call gives the Trust the right to buy a security, futures contract or index at
a fixed price. Calls on futures on securities must also be covered by assets or
instruments acceptable under applicable segregation and coverage requirements.
Puts on Securities, Indices and Futures Contracts. In addition to its
option strategy, the Trust may purchase put options ("puts") that relate to
securities (whether or not it holds such securities in its portfolio), indices
or futures contracts. For the same purposes, the Trust may also sell puts on
securities, indices or futures contracts on such securities if the Trust's
contingent obligations on such puts are secured by segregated assets consisting
of cash or liquid debt securities having a value not less than the exercise
price. In selling puts, there is a risk that the Trust may be required to buy
the underlying security at a price higher than the current market price.
Interest Rate Transactions. Among the Strategic Transactions in which the
Trust may enter into are interest rate swaps and the purchase or sale of
interest rate caps and floors. The Trust expects to enter into these
transactions primarily to preserve a return or spread on a particular
investment or portion of its portfolio as a duration management technique or to
protect against any increase in the price of securities the Trust anticipates
purchasing at a later date. The Trust intends to use these transactions for
risk management purposes and not as a speculative investment. The Trust will
not sell interest rate caps or floors that it does not own. Interest rate swaps
involve the exchange by the Trust with another party of their respective
commitments to pay or receive interest, e.g., an exchange of floating rate
payments for fixed rate payments with respect to a notional amount of
principal. The purchase of an interest rate cap entitles the purchaser, to the
extent that a specified index exceeds a predetermined interest rate, to receive
payments of interest on a notional principal amount from the party selling such
interest rate cap. The purchase of an interest rate floor entitles the
purchaser, to the extent that a specified index falls below a predetermined
interest rate, to receive payments of interest on a notional principal amount
from the party selling such interest rate floor.
The Trust may enter into interest rate swaps, caps and floors on either an
asset based or liability-based basis, depending on whether it is offsetting
volatility with respect to its assets or liabilities, and will usually enter
into interest rate swaps on a net basis, i.e., the two payment streams are
netted out, with the Trust receiving or paying, as the case may be, only the
net amount of the two payments on the payment dates. Inasmuch as these
Strategic Transactions are incurred into for good faith risk management
purposes. Highland and the Trust believe such obligations do not constitute
senior securities, and, accordingly will not treat them as being subject to its
borrowing restrictions. The Trust will accrue the net amount of the excess, if
any, of the Trust's obligations over its entitlements with respect to each
interest rate swap on a daily basis and will designate on its books and records
with a custodian an amount of cash or liquid high grade securities having an
aggregate net asset value at all times at least equal to the accrued excess.
The Trust will not enter into any interest rate swap, cap or floor transaction
unless the unsecured senior debt or the claims paying ability of the other
party thereto is rated in the highest rating category of at least one
nationally recognized statistical rating organization at the time of entering
into such transaction. If there is a default by the other party to such a
transaction, the Trust will have contractual remedies pursuant to the
agreements related to the transaction. The swap market has grown substantially
in recent years with a large number of banks and investment banking firms
acting both as principals and as agents utilizing standardized swap
documentation. Caps and floors are more recent innovations for which
standardized documentation has not yet been developed and, accordingly, they
are less liquid than swaps.
Credit Derivatives. The Trust may engage in credit derivative
transactions. There are two broad categories of credit derivatives: default
price risk derivatives and market spread derivatives. Default price risk
derivatives are linked to the price of reference securities or loans after a
default by the issuer or borrower, respectively. Market spread derivatives are
based on the risk that changes in market factors, such as credit spreads, can
cause a decline in the value of a security, loan or index.
There are three basic transactional forms for credit derivatives: swaps,
options and structured instruments. The use of credit derivatives is a highly
specialized activity which involves strategies and risks different from those
associated with ordinary portfolio security transactions. If Highland is
incorrect in its forecasts of default risks, market spreads or other applicable
factors, the investment performance of the Trust would diminish compared with
what it would have been if these techniques were not used. Moreover, even if
Highland is correct in its forecasts, there is a risk that a credit derivative
position may correlate imperfectly with the price of the asset or liability
being purchased. There is no limit on the amount of credit derivative
transactions that may be entered into by the Trust. The Trust's risk of loss in
a credit derivative transaction varies with the form of the transaction. For
example, if the Trust purchases a default option on a security, and if no
default occurs with respect to the security, the Trust's loss is limited to the
premium it paid for the default option. In contrast, if there is a default by
the grantor of a default option, the Trust's loss will include both the premium
that it paid for the option and the decline in value of the underlying security
that the default option protects.
Appendix A contains further information about the characteristics, risks
and possible benefits of Strategic Transactions and the Trust's other policies
and limitations (which are not fundamental policies) relating to investment in
B-7
futures contracts and options. The principal risks relating to the use of
futures contracts and other Strategic Transactions are: (a) less than perfect
correlation between the prices of the instrument and the market value of the
securities in the Trust's portfolio; (b) possible lack of a liquid secondary
market for closing out a position in such instruments; (c) losses resulting
from interest rate or other market movements not anticipated by Highland; and
(d) the obligation to meet additional variation margin or other payment
requirements, all of which could result in the Trust being in a worse position
than if such techniques had not been used.
Certain provisions of the Code may restrict or affect the ability of the
Trust to engage in Strategic Transactions. See "Tax Matters."
OTHER INVESTMENT POLICIES AND TECHNIQUES
Restricted and Illiquid Securities
Certain of the Trust's investments may be illiquid. Illiquid securities
are subject to legal or contractual restrictions on disposition or lack an
established secondary trading market. The sale of restricted and illiquid
securities often requires more time and results in higher brokerage charges or
dealer discounts and other selling expenses than does the sale of securities
eligible for trading on national securities exchanges or in the
over-the-counter markets. Restricted securities may sell at a price lower than
similar securities that are not subject to restrictions on resale.
When-Issued and Forward Commitment Securities
The Trust may purchase securities on a "when-issued" basis and may
purchase or sell securities on a "forward commitment" basis in order to acquire
the security or to offset against anticipated changes in interest rates and
prices. When such transactions are negotiated, the price, which is generally
expressed in yield terms, is fixed at the time the commitment is made, but
delivery and payment for the securities take place at a later date. When-issued
securities and forward commitments may be sold prior to the settlement date,
but the Trust will enter into when-issued and forward commitments only with the
intention of actually receiving or delivering the securities, as the case may
be. If the Trust disposes of the right to acquire a when-issued security prior
to its acquisition or disposes of its right to deliver or receive against a
forward commitment, it might incur a gain or loss. At the time the Trust enters
into a transaction on a when-issued or forward commitment basis, it will
designate on its books and records cash or liquid debt securities equal to at
least the value of the when-issued or forward commitment securities. The value
of these assets will be monitored daily to ensure that their marked to market
value will at all times equal or exceed the corresponding obligations of the
Trust. There is always a risk that the securities may not be delivered and that
the Trust may incur a loss. Settlements in the ordinary course, which may take
substantially more than five business days, are not treated by the Trust as
when-issued or forward commitment transactions and accordingly are not subject
to the foregoing restrictions.
Pay-in-kind Bonds
The Trust may invest in Pay-in-kind, or "PIK" bonds. PIK bonds are bonds
which pay interest through the issuance of additional debt or equity
securities. Similar to zero coupon obligations, PIK bonds also carry additional
risk as holders of these types of securities realize no cash until the cash
payment date unless a portion of such securities is sold and, if the issuer
defaults, the Trust may obtain no return at all on its investment. The market
price of PIK bonds is affected by interest rate changes to a greater extent,
and therefore tends to be more volatile, than that of securities which pay
interest in cash. Additionally, current federal tax law requires the holder of
certain PIK bonds to accrue income with respect to these securities prior to
the receipt of cash payments. To maintain its qualification as a regulated
investment company and avoid liability for federal income and excise taxes, the
Trust may be required to distribute income accrued with respect to these
securities and may have to dispose of portfolio securities under
disadvantageous circumstances in order to generate cash to satisfy these
distribution requirements.
Brady Bonds
The Trust's emerging market debt securities may include emerging market
governmental debt obligations commonly referred to as Brady Bonds. Brady Bonds
are debt securities, generally denominated in U.S. dollars, issued under the
framework of the Brady Plan, an initiative announced by U.S. Treasury Secretary
Nicholas F. Brady in 1989 as a mechanism for debtor nations (primarily emerging
market countries) to restructure their outstanding external indebtedness
(generally, commercial bank debt). Brady Bonds are created through the exchange
of existing commercial bank loans to foreign entities for new obligations in
connection with debt restructuring. A significant amount of the Brady Bonds
that the Trust may purchase have no or limited collateralization, and the Trust
will be relying for payment
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of interest and (except in the case of principal collateralized Brady Bonds)
principal primarily on the willingness and ability of the foreign government to
make payment in accordance with the terms of the Brady Bonds. A substantial
portion of the Brady Bonds and other sovereign debt securities in which the
Trust may invest are likely to be acquired at a discount.
Mezzanine Investments
The Trust may invest in certain high yield securities known as mezzanine
investments, which are subordinated debt securities which are generally issued
in private placements in connection with an equity security (e.g., with
attached warrants). Such mezzanine investments may be issued with or without
registration rights. Similar to other high yield securities, maturities of
mezzanine investments are typically seven to ten years, but the expected
average life is significantly shorter at three to five years. Mezzanine
investments are usually unsecured and subordinate to other obligations of the
issuer. Loan Participations and Assignments
The Trust may invest in fixed and floating rate loans ("Loans") arranged
through private negotiations between a corporation or foreign government and
one or more financial institutions ("Lenders"). The Trust's investments in
Loans are expected in most instances to be in the form of participations in
Loans ("Participations") and assignments of all or a portion of Loans
("Assignments") from third parties. Participations typically will result in the
Trust having a contractual relationship only with the Lender not the borrower.
The Trust will have the right to receive payments of principal, interest and
any fees to which it is entitled only from the Lender selling the Participation
and the Trust and only upon receipt by the Lender of the payments by the
borrower. In connection with purchasing Participations, the Trust generally has
no direct right to enforce compliance by the borrower with the terms of the
loan agreement relating to the Loan, nor any rights of set-off against the
borrower, and the Trust may not directly benefit from any collateral supporting
the Loan in which is has purchased the Participation. As a result the Trust
will assume the credit risk of both the borrower and the Lender that is selling
the Participation. In the event of the insolvency of the Lender selling a
Participation, the Trust may be treated as a general creditor of the Lender and
may not benefit from any set-off between the Lender and the borrower. The Trust
will acquire Participations only if the Lender interpositioned between the
Trust and the borrower is determined by Highland to be creditworthy. When the
Trust purchases Assignments from Lenders, the Trust will acquire direct rights
against the borrower on the Loan. However, since Assignments are arranged
through private negotiations between potential assignees and assignors, the
rights and obligations acquired by the Trust as the purchaser of an Assignment
may differ from, and be more limited than, those held by the assigning Lender.
The Trust may have difficulty disposing of Assignments and Participations.
Because there is no liquid market for such securities, the Trust anticipates
that such securities could be sold only to a limited number of institutional
investors. The lack of a liquid secondary market will have an adverse impact on
the value of such securities and on the Trust's ability to dispose of
particular Assignments or Participations when necessary to meet the Trust's
liquidity needs or in response to a specific economic event, such as a
deterioration in the creditworthiness of the borrower. The lack of a liquid
secondary market for Assignments and Participations also may make it more
difficult for the Trust to assign a value to those securities for purposes of
valuing the Trust's portfolio and calculating its net asset value.
Structured Investments
The Trust may invest a portion of its assets in interests in entities
organized and operated solely for the purpose of restructuring the investment
characteristics of securities. This type of restructuring involves the deposit
with or purchase by an entity, such as a corporation or a trust, of specified
instruments and the issuance by that entity of one or more classes of
securities ("Structured Investments") backed by, or representing interests in
the underlying instruments. The cash flow on the underlying instruments may be
apportioned among the newly issued Structured Investments to create securities
with different investment characteristics such as varying maturities, payment
priorities and interest rate provisions, and the extent of the payments made
with respect to Structured Investments is dependent on the extent of the cash
flow on the underlying instruments. Because Structured Investments of the type
in which the Trust anticipates it will invest typically involve no credit
enhancement, their credit risk generally will be equivalent to that of the
underlying instruments.
The Trust is permitted to invest in a class of Structured Investments that
is either subordinated or not subordinated to the right of payment of another
class. Subordinated Structured Investments typically have higher yields and
present greater risks than unsubordinated Structured Investments,
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Certain issuers of Structured Investments may be deemed to be "investment
companies" as defined in the Investment Company Act. As a result, the Trust's
investment in these Structured Investments may be limited by the restrictions
contained in the Investment Company Act. Structured Investments are typically
sold in private placement transaction, and there currently is no active trading
market for Structured Investments.
Project Loans
The Trust may invest in project loans, which are fixed income securities
of issuers whose revenues are primarily derived from mortgage loans to
multi-family, nursing home and other real estate development projects. The
principal payments on these mortgage loans will be insured by agencies and
authorities of the U.S. Government.
Zero Coupons and Deferred Payment Obligations
The Trust may invest in zero-coupon bonds, which are normally issued at a
significant discount from face value and do not provide for periodic interest
payments. Zero-coupon bonds may experience greater volatility in market value
than similar maturity debt obligations which provide for regular interest
payments. Additionally, current federal tax law requires the holder of certain
zero-coupon bonds to accrue income with respect to these securities prior to
the receipt of cash payments. To maintain its qualification as a regulated
investment company and to potentially avoid liability for federal income and
excise taxes, the Trust may be required to distribute income accrued with
respect to these securities and may have to dispose of Trust securities under
disadvantageous circumstances in order to generate cash to satisfy these
distribution requirements.
The Trust may invest in Deferred Payment Securities. Deferred Payment
Securities are securities that remain Zero-Coupon Securities until a
predetermined date, at which time the stated coupon rate becomes effective and
interest becomes payable at regular intervals. Deferred Payment Securities are
subject to greater fluctuations in value and may have lesser liquidity in the
event of adverse market conditions than comparably rated securities paying cash
interest at regular interest payment periods.
MANAGEMENT OF THE TRUST
Information Received by the Board
In considering the Trust's investment management agreement, the board of
trustees received information specifically related to the approval of the
investment management agreement including information regarding: (i) the team
of investment advisory personnel assigned to the Trust; (ii) the structure,
expertise and finances of Highland; (iii) the Trust's management fee and total
operating expenses as compared to a peer group of closed-end funds with similar
investment policies and strategies selected by Lipper, Inc.; (iv) Highland's
profitability with respect to other funds in the Highland family of closed-end
funds; (v) Highland's overall profitability as compared with available industry
data; (vi) certain direct and indirect "fallout" benefits to Highland from its
relationship with the Trust; and (vii) Highland's policies and procedures in
respect of execution of portfolio transactions. Periodically, the trustees, in
connection with their duties as trustees or directors of other funds in the
Highland family of closed-end funds, have received other information including
general information regarding Highland's management of relationships with
service providers and resources devoted to compliance with the such funds'
investment objectives and polices and other matters.
Matters Considered by the Board
In considering the investment management agreement, the board of trustees,
including the non-interested trustees, did not identify any factor as
all-important or all-controlling and instead considered these factors
collectively in light of all of the Trust's surrounding circumstances. Matters
considered by the board of trustees, including the non-interested trustees in
approving the investment management agreement included the following:
Nature and Quality of Investment Advisory Services. The board of trustees,
including the non-interested trustees, considered the nature and quality of the
services to be provided by Highland to the Trust. In this connection the board
reviewed:
o Highland's compliance record, including whether other funds advised or
sub-advised by Highland have operated within their investment
objectives, policies and restrictions; and
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o the resources of Highland and the size, education and experience of
the Trust's portfolio management team and Highland's use of technology
and their approach to recruiting, training and retaining portfolio
managers and other research, advisory and management personnel.
Nature and Quality of Other Services. The board of trustees, including the
non-interested trustees, considered the nature, quality, cost and extent of
administrative and shareholder services to be performed by Highland under the
investment management agreement. The board of trustees, including the
non-interested trustees, also considered the nature and extent of Highland's
supervision of third party service providers.
Fees and Expenses. The board of trustees, including the non-interested
trustees, considered the Trust's management fee and expense ratio in comparison
to the management fee and expense ratios of two peer groups of funds.
The first peer group selected for the Trust was the group. The
peer group contained closed-end funds (including the Trust). Some but
not all of the funds in the peer group used leverage.
The peer group comparison was done within four sub-categories of fees and
expenses: (i) management fee before fee waivers; (ii) management fee after fee
waivers; (iii) total expenses before fee waivers; and (iv) total expenses after
fee waivers. Each comparison was done both with and without giving effect to
leverage for those funds in the peer group that use leverage, because leverage
increases the effective management fee and other expenses paid by the holders
of the common shares of a fund if the management fee or other expenses are
payable on total managed assets.
When compared to funds in the peer group and after giving effect to
leverage, when ranked from lowest fee to highest fee, the Trust ranked as
follows within each of the four sub-categories of fees and expenses:
(i) ; (ii) ; (iii) ; and (iv) .
When compared to funds in the peer group assuming no leverage was used by
any of the funds, when ranked from lowest fee to highest fee, the Trust ranked
as follows within each of the four sub-categories: (i) ;
(ii) ; (iii) ; and (iv) .
Profitability. The board of trustees, including the independent trustees,
considered the level of Highland's profits in respect of the management of
Highland's closed-end funds. The board considered the potential for economies
of scale in connection with Highland's management of the Highland closed-end
funds. It also considered the profits realized from non-fund businesses which
may benefit from or be related to the Trust's business. The board of trustees,
including the independent trustees, also considered Highland's profit margins
in comparison with available industry data.
Other Benefits. The board of trustees, including the non-interested
trustees, also considered the benefits to Highland associated with Highland and
its affiliates providing non-advisory services to the Trust, including
administrative services. The board of trustees, including the independent
trustees, considered the intangible benefits that accrue to Highland and its
affiliates by virtue of their relationship with the Trust, including potential
benefits accruing to Highland and its affiliates as a result of potentially
stronger relationships with members of the broker dealer community, increased
name recognition of Highland and its affiliates, enhanced sales of other
investment funds and products sponsored by Highland and its affiliates and
increased assets under management which may increase the benefits realized by
Highland from soft dollar arrangements with broker dealers. The board also
considered the unquantifiable nature of these potential benefits.
Miscellaneous. During the board of trustees' deliberations in connection
with its approval of the management fee, the board of trustees was aware that
Highland intended to pay compensation, out of its own assets, to the lead
underwriter and to certain qualifying underwriters of the Trust's common shares
and to employees of Highland and its affiliates that participate in the
offering of the Trust's common shares, the anticipated amounts of such
compensation and the general nature of the services to be rendered to Highland
in consideration of such compensation. The board of trustees also considered
whether the management fee met applicable standards in light of the services
provided by Highland, without regard to whether Highland ultimately pays any
portion of the anticipated compensation to the underwriters. The board of
trustees considered the scale of Highland's management operations and the
potential for economies of scale in the context of the Trust.
Conclusion
Based on the information reviewed and discussions held with respect to
each of the foregoing items, the board of trustees, including a majority of the
non-interested trustees, .
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The investment management agreement was by the sole common
shareholder of the Trust as of , 2006. The investment management
agreement will continue in effect for a period of two years from its effective
date, and if not sooner terminated, will continue in effect for successive
periods of 12 months thereafter, provided that each continuance is specifically
approved at least annually by both (1) the vote of a majority of the Trust's
board of trustees or the vote of a majority of the outstanding voting securities
of the Trust (as such term is defined in the Investment Company Act) and (2) by
the vote of a majority of the trustees who are not parties to the investment
management agreement or interested persons (as such term is defined in the
Investment Company Act) of any such party, cast in person at a meeting called
for the purpose of voting on such approval. The investment management agreement
may be terminated as a whole at any time by the Trust, without the payment of
any penalty, upon the vote of a majority of the Trust's board of trustees or a
majority of the outstanding voting securities of the Trust or by Highland, on 60
days' written notice by either party to the other which can be waived by the
non-terminating party. The investment management agreement will terminate
automatically in the event of its assignment (as such term is defined in the
Investment Company Act and the rules thereunder).
Trustees and Officers
The officers of the Trust manage its day-to-day operations. The officers
are directly responsible to the Trust's board of trustees which sets broad
policies for the Trust and chooses its officers. Below is a list of the
trustees and officers of the Trust and their present positions and principal
occupations during the past five years. Trustees who are interested persons of
the Trust (as defined in the Investment Company Act) are denoted by an asterisk
(*). Trustees who are independent trustees (as defined in the Investment
Company Act) (the "Independent Trustees") are denoted without an asterisk. The
business address of the Trust, Highland and their board members and officers is
Two Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240, unless
specified otherwise below.
The trustees listed below are either trustees or directors of other
closed-end funds in which Highland acts as investment manager.
Principal Occupation During the
Name and Age Title Past Five Years and Other Affiliations
--------------------- -------------------- -------------------------------------------------------------
R. Joseph Dougherty Sole Initial Trustee and Chairman of the Board since inception in 2006;
Age: 35 Trustee, President, Portfolio Manager of Highland since 2000.
Chief Executive
Officer, Chief
Financial Officer,
Treasurer and
Secretary
Aggregate Dollar Range of Equity
Name of Dollar Range of Equity Securities Overseen by Directors in the Family in
Director Securities in the Trust (*) all Registered Investment Companies (*)
--------------------- --------------------------- --------------------------------------------------
The Trustees do not own shares in the Trust as the Trust has no operating
history.
The fees and expenses of the Independent Trustees of the Trust are paid by
the Trust. The trustees who are members of the Highland organization receive no
compensation from the Trust. It is estimated that the Independent Trustees will
receive from the Trust the amounts set forth below for the Trust's calendar
year ending December 31, 2006, assuming the Trust will have been in existence
for the full calendar year.
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Estimated Total Compensation from the
Name of Board Compensation Trust and Trust Complex
Member from the Trust Paid to Board Members((1))
----------------------------------------- ------------------------ -------------------------------------
---------------------
(1) Estimates the total compensation to be earned by that person during the
calendar year end December 31, 2006 from the closed-end funds advised by
Highland (the "Trust Complex").
Each Independent Trustee will receive an annual fee calculated as follows:
The board of trustees of the Trust currently has four committees: an Audit
Committee, a Nominating Committee, a Litigation Committee and a Qualified Legal
Compliance Committee.
The Audit Committee consists of Messrs. , , and . The Audit
Committee acts according to the Audit Committee charter. has been appointed as
Chairman of the Audit Committee. The Audit Committee is responsible for (1)
oversight of the Trust's accounting and financial reporting processes and the
audits of the Trust's financial statements and (2) providing assistance to the
board of trustees of the Trust in connection with its oversight of the
integrity of the Trust's financial statements, the Trust's compliance with
legal and regulatory requirements and the independent registered public
accounting firm's qualifications, independence and performance. The board of
trustees of the Trust has determined that the Trust has audit committee
financial experts serving on its Audit Committee, , and , all of whom
are independent for the purpose of the definition of audit committee financial
expert as applicable to the Trust.
The Nominating Committee's function is to canvass, recruit, interview,
solicit and nominate Trustees. The Nominating Committee will consider
recommendations for nominees from shareholders sent to the Secretary of the
Trust, 13455 Noel Road, Suite 800, Dallas, Texas 75240. A nomination submission
must include all information relating to the recommended nominee that is
required to be disclosed in solicitations or proxy statements for the election
of Trustees, as well as information sufficient to evaluate the factors listed
above. Nomination submissions must be accompanied by a written consent of the
individual to stand for election if nominated by the Board of Trustees and to
serve if elected by the shareholders, and such additional information must be
provided regarding the recommended nominee as reasonably requested by the
Nominating Committee. The Nominating Committee is comprised of Messrs.
, , and .
The Litigation Committee's function is to seek to address any potential
conflicts of interest between or among the Trust and the Investment Manager in
connection with any potential or existing litigation or other legal proceeding
relating to securities held by the Trust and the Investment Manager or another
client of the Investment Manager. The Litigation Committee is comprised of
Messrs. , , and .
The Qualified Legal Compliance Committee (the "QLCC") is charged with
compliance with Rules 205.2(k) and 205.3(c) of the Code of Federal Regulations
regarding alternative reporting procedures for attorneys representing the Trust
who appear and practice before the Commission on behalf of the Trust. The QLCC
is comprised of Messrs. , , and .
As the Trust is a closed-end investment company with no prior investment
operations, no meetings of the above committees have been held in the current
fiscal year.
Prior to this offering, all of the outstanding shares of the Trust were
owned by an affiliate of Highland Advisors.
Proxy Voting Policies
The board of trustees of the Trust has delegated the voting of proxies for
Trust securities to Highland pursuant to Highland's proxy voting guidelines.
Under these guidelines, Highland will vote proxies related to Trust securities
in the
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best interests of the Trust and its shareholders. A copy of Highland's proxy
voting procedures is attached as Appendix B to this Statement of Additional
Information.
Codes of Ethics
The Trust and the Advisor have adopted codes of ethics under Rule 17j-1 of
the Investment Company Act. These codes permit personnel subject to the codes
to invest in securities, including securities that may be purchased or held by
the Trust. These codes can be reviewed and copied at the Securities and
Exchange Commission's Public Reference Room in Washington, D.C. Information on
the operation of the Public Reference Room may be obtained by calling the
Securities and Exchange Commission at 1-202-942-8090. The code of ethics are
available on the EDGAR Database on the Securities and Exchange Commission's web
site (http://www.sec.gov), and copies of these codes may be obtained, after
paying a duplicating fee, by electronic request at the following e-mail
address: publicinfo@sec.gov, or by writing the Securities and Exchange
Commission's Public Reference Section, Washington, D.C. 20549-0102.
Investment Manager
Highland acts as the Trust's investment manager. Highland is located at
Highland Capital Management, L.P., Two Galleria Tower, 13455 Noel Road, Suite
800, Dallas, Texas 75240. As of , 2006, the Investment Manager managed
approximately $ billion in debt securities on behalf of institutional
investors and retail clients around the world. Highland is controlled by James
Dondero and Mark Okada, by virtue of their respective share ownership, and its
general partner, Strand Advisors, Inc., of which Mr. Dondero is the sole
stockholder.
Portfolio Managers
The portfolio managers of the Trust are James Dondero, Mark Okada and
Kurtis Plumer.
As of , 2006, James Dondero managed the following client accounts:
Number of
Accounts
Subject to a Assets Subject
Number of Assets of Performance to a
Type of Account Accounts Accounts Fee Performance Fee
Registered Investment Companies...................... $ billion $ billion
Pooled Investment Vehicles........................... $ billion $ billion
Other Accounts....................................... $ billion $ billion
-----------------------------------------------------------------------------------------------------------------------------
As of , 2006, Mark Okada managed the following client accounts:
Number of
Accounts
Subject to a Assets Subject
Number of Assets of Performance to a
Type of Account Accounts Accounts Fee Performance Fee
Registered Investment Companies...................... $ billion $ billion
Pooled Investment Vehicles........................... $ billion $ billion
Other Accounts....................................... $ billion $ billion
-----------------------------------------------------------------------------------------------------------------------------
As of , 2006, Kurtis Plumer managed the following client accounts:
Number of
Accounts
Subject to a Assets Subject
Number of Assets of Performance to a
Type of Account Accounts Accounts Fee Performance Fee
Registered Investment Companies...................... $ billion $ billion
Pooled Investment Vehicles........................... $ billion $ billion
Other Accounts....................................... $ billion $ billion
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The Investment Manager has built a professional working environment,
firm-wide compliance culture and compliance procedures and systems designed to
protect against potential incentives that may favor one account over another.
The Investment Manager has adopted policies and procedures that address the
allocation of investment opportunities, execution of portfolio transactions,
personal trading by employees and other potential conflicts of interest that
are designed to ensure that all client accounts are treated equitably over
time. Nevertheless, the Investment Manager furnishes investment management and
advisory services to numerous clients in addition to the Trust, and the
Investment Manager may, consistent with applicable law, make investment
recommendations to other clients or accounts (including accounts which are
hedge funds or have performance or higher fees paid to the Investment Manager,
or in which portfolio managers have a personal interest in the receipt of such
fees), which may be the same as or different from those made to the Trust. In
addition, the Investment Manager, its affiliates and any officer, director,
stockholder or employee may or may not have an interest in the securities whose
purchase and sale the Investment Manager recommends to the Trust. Actions with
respect to securities of the same kind may be the same as or different from the
action which the Investment Manager, or any of its affiliates, or any officer,
director, stockholder, employee or any member of their families may take with
respect to the same securities. Moreover, the Investment Manager may refrain
from rendering any advice or services concerning securities of companies of
which any of the Investment Managers' (or its affiliates') officers, directors
or employees are directors or officers, or companies as to which the Investment
Manager or any of its affiliates or the officers, directors and employees of
any of them has any substantial economic interest or possesses material
non-public information. In addition to its various policies and procedures
designed to address these issues, the Investment Manager includes disclosure
regarding these matters to its clients in both its Form ADV and investment
management agreements.
The Investment Manager, its affiliates or their officers and employees
serve or may serve as officers, directors or principals of entities that
operate in the same or related lines of business or of investment funds managed
by affiliates of the Investment Manager. Accordingly, these individuals may
have obligations to investors in those entities or funds or to other clients,
the fulfillment of which might not be in the best interests of the Trust. As a
result, the Investment Manager will face conflicts in the allocation of
investment opportunities to the Trust and other funds and clients. In order to
enable such affiliates to fulfill their fiduciary duties to each of the clients
for which they have responsibility, the Investment Manager will endeavor to
allocate investment opportunities in a fair and equitable manner which may,
subject to applicable regulatory constraints, involve pro rata co-investment by
the Trust and such other clients or may involve a rotation of opportunities
among the Trust and such other clients.
The Investment Manager and its affiliates have procedures and policies in
place designed to manage the potential conflicts of interest that may arise
from time to time between the Investment Manager's fiduciary obligations to the
Trust and their similar fiduciary obligations to other clients so that, for
example, investment opportunities are allocated in a fair and equitable manner
among the Trust and such other clients. An investment opportunity that is
suitable for multiple clients of the Investment Manager and its affiliates may
not be capable of being shared among some or all of such clients due to the
limited scale of the opportunity or other factors, including regulatory
restrictions imposed by the Investment Company Act. There can be no assurance
that the Investment Manager's or its affiliates' efforts to allocate any
particular investment opportunity fairly among all clients for whom such
opportunity is appropriate will result in an allocation of all or part of such
opportunity to the Trust. Not all conflicts of interest can be expected to be
resolved in favor of the Trust.
Under current Commission regulations, the Trust may be prohibited from
co-investing with any unregistered fund managed now or in the future by the
Investment Manager (the "Unregistered Trusts") in certain private placements in
which the Investment Manager negotiates non-pricing terms. The Trust intends to
file for exemptive relief from the Commission to enable it to co-invest with
other unregistered funds managed by the Investment Manager.
Compensation
The Investment Manager's financial arrangements with its portfolio
managers, its competitive compensation and its career path emphasis at all
levels reflect the value senior management places on key resources.
Compensation may include a variety of components and may vary from year to year
based on a number of factors including the relative performance of a portfolio
managers underlying account, the combined performance of the portfolio managers
underlying accounts, and the relative performance of the portfolio managers
underlying accounts measured against other employees. The principal components
of compensation include a base salary, a discretionary bonus, various
retirement benefits and one or more of the incentive compensation programs
established by the Investment Manager such as Option It Plan and the Long-Term
Incentive Plan.
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Base compensation
Generally, portfolio managers receive base compensation based on their
seniority and/or their position with the firm, which may include the amount of
assets supervised and other management roles within the firm.
Discretionary compensation
In addition to base compensation, portfolio managers may receive
discretionary compensation, which can be a substantial portion of total
compensation. Discretionary compensation can include a discretionary cash bonus
as well as one or more of the following:
Option It Plan. The purpose of the Plan is to attract and retain the
highest quality employees for positions of substantial responsibility,
and to provide additional incentives to a select group of management or
highly compensated employees of Highland so as to promote the success
of the Highland.
Long Term Incentive Plan. The purpose of the Plan is to create positive
morale and teamwork, to attract and retain key talent, and to encourage
the achievement of common goals. The Plan seeks to reward participating
Employees based on the increased value of Highland through the use of
Long-term Incentive Units.
Senior portfolio managers who perform additional management functions may
receive additional compensation in these other capacities. Compensation is
structured such that key professionals benefit from remaining with the firm.
Securities Ownership of Portfolio Managers
The Trust is a newly organized investment company. Accordingly, as of the
date of this Statement of Additional Information, none of the portfolio
managers beneficially owns any securities issued by the Trust.
PORTFOLIO TRANSACTIONS AND BROKERAGE
In placing orders for the Company's portfolio, the Investment Manager is
required to give primary consideration to obtaining the most favorable price
and efficient execution. This means that the Investment Manager will seek to
execute each transaction at a price and commission, if any, which provides the
most favorable total cost or proceeds reasonably attainable in the
circumstances. In seeking the most favorable price and execution, the
Investment Manager, having in mind the Company's best interests, will consider
all factors it deems relevant, including, by way of illustration: price; the
size, type and difficulty of the transaction; the nature of the market for the
security; the amount of the commission; the timing of the transaction taking
into account market prices and trends; operational capabilities; the
reputation, experience and financial stability of the broker-dealer involved;
and the quality of service rendered by the broker-dealer in other transactions.
Though the Investment Manager generally seeks reasonably competitive
commissions or spreads, the Company will not necessarily be paying the lowest
commission or spread available. Within the framework of the policy of obtaining
the most favorable price and efficient execution, the Investment Manager does
not consider "brokerage and research services" (as defined in the Securities
Exchange Act of 1934, as amended) provided by brokers who effect portfolio
transactions with the Investment Manager or the Company. "Brokerage and
research services" are those which brokerage houses customarily provide to
institutional investors and include statistical and economic data and research
reports on particular issuers and industries.
DESCRIPTION OF SHARES
Common Shares
The Trust intends to hold annual meetings of shareholders so long as the
common shares are listed on a national securities exchange and such meetings
are required as a condition to such listing. All common shares are equal as to
dividends, assets and voting privileges and have no conversion, preemptive or
other subscription rights. The Trust will send annual and semi-annual reports,
including financial statements, to all holders of its shares.
Preferred Shares
The Trust currently intends to issue Preferred Shares. The Agreement and
Declaration of Trust provides that the Trust's board of trustees may authorize
and issue Preferred Shares with rights as determined by the board of trustees,
by
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action of the board of trustees without the approval of the holders of the
common shares. Holders of common shares have no preemptive right to purchase
any Preferred Shares that might be issued. Whenever Preferred Shares are
outstanding, the holders of common shares will not be entitled to receive any
distributions from the Trust unless all accrued dividends on Preferred Shares
have been paid, unless asset coverage (as defined in the Investment Company
Act) with respect to Preferred Shares would be at least 200% after giving
effect to the distributions and unless certain other requirements imposed by
any rating agencies rating the Preferred Shares have been met.
Liquidation Preference. In the event of any voluntary or involuntary
liquidation, dissolution or winding up of the Trust, the holders of Preferred
Shares will be entitled to receive a preferential liquidating distribution,
which is expected to equal the original purchase price per Preferred Share plus
accrued and unpaid dividends, whether or not declared, before any distribution
of assets is made to holders of common shares. After payment of the full amount
of the liquidating distribution to which they are entitled, the holders of
Preferred Shares will not be entitled to any further participation in any
distribution of assets by the Trust.
Voting Rights The Investment Company Act requires that the holders of any
Preferred Shares, voting separately as a single class, have the right to elect
at least two trustees at all times. The remaining trustees will be elected by
holders of common shares and Preferred Shares, voting together as a single
class. In addition, subject to the prior rights, if any, of the holders of any
other class of senior securities outstanding, the holders of any Preferred
Shares have the right to elect a majority of the trustees of the Trust at any
time two years' dividends on any Preferred Shares are unpaid. The Investment
Company Act also requires that, in addition to any approval by shareholders
that might otherwise be required, the approval of the holders of a majority of
any outstanding Preferred Shares, voting separately as a class, would be
required to (1) adopt any plan of reorganization that would adversely affect
the Preferred Shares, and (2) take any action requiring a vote of security
holders under Section 13(a) of the Investment Company Act, including, among
other things, changes in the Trust's subclassification as a closed-end
investment company or changes in its fundamental investment restrictions. As a
result of these voting rights, the Trust's ability to take any such actions may
be impeded to the extent that there are any Preferred Shares outstanding. The
board of trustees presently intends that, except as otherwise indicated in this
prospectus and except as otherwise required by applicable law, holders of
Preferred Shares will have equal voting rights with holders of common shares
(one vote per share, unless otherwise required by the Investment Company Act)
and will vote together with holders of common shares as a single class.
The affirmative vote of the holders of a majority of the outstanding
Preferred Shares, voting as a separate class, will be required to amend, alter
or repeal any of the preferences, rights or powers of holders of Preferred
Shares so as to affect materially and adversely such preferences, rights or
powers, or to increase or decrease the authorized number of Preferred Shares.
The class vote of holders of Preferred Shares described above will in each case
be in addition to any other vote required to authorize the action in question.
Redemption, Purchase and Sale of Preferred Shares by the Trust. The terms
of any Preferred Shares would typically provide that (1) they are redeemable by
the Trust in whole or in part at the original purchase price per share plus
accrued dividends per share, (2) the Trust may tender for or purchase Preferred
Shares and (3) the Trust may subsequently resell any shares so tendered for or
purchased. Any redemption or purchase of Preferred Shares by the Trust will
reduce the leverage applicable to the common shares, while any resale of shares
by the Trust will increase that leverage.
The discussion above describes the possible offering of Preferred Shares
by the Trust. If the board of trustees determines to proceed with such an
offering, the terms of the Preferred Shares may be the same as, or different
from, the terms described above, subject to applicable law and the Trust's
Agreement and Declaration of Trust. The board of trustees, without the approval
of the holders of common shares, may authorize an offering of Preferred Shares
or may determine not to authorize such an offering, and may fix the terms of
the Preferred Shares to be offered.
The Trust may apply for ratings for any Preferred Shares from Moody's, S&P
or Fitch. In order to obtain and maintain the required ratings, the Trust will
be required to comply with investment quality, diversification and other
guidelines established by Moody's and/or S&P. Such guidelines will likely be
more restrictive than the restrictions otherwise applicable to the Trust as
described in the Trust's prospectus or above in this Statement of Additional
Information. The Trust does not anticipate that such guidelines would have a
material adverse effect on the Trust's holders of common shares or its ability
to achieve its investment objectives. The Trust anticipates that any Preferred
Shares that it issues would be initially given the highest ratings by Moody's
("Aaa") or by S&P ("AAA"), but no assurance can be given that such ratings will
be obtained. No minimum rating is required for the issuance of Preferred Shares
by the Trust. Moody's and S&P receive fees in connection with their ratings
issuances.
B-17
Other Shares
The board of trustees (subject to applicable law and the Trust's Agreement
and Declaration of Trust) may authorize an offering, without the approval of
the holders of either common shares or Preferred Shares, of other classes of
shares, or other classes or series of shares, as they determine to be
necessary, desirable or appropriate, having such terms, rights, preferences,
privileges, limitations and restrictions as the board of trustees see fit. The
Trust currently does not expect to issue any other classes of shares, or series
of shares, except for the common shares and the Preferred Shares.
REPURCHASE OF COMMON SHARES
The Trust is a closed-end management investment company and as such its
shareholders will not have the right to cause the Trust to redeem their shares.
Instead, the Trust's common shares will trade in the open market at a price
that will be a function of several factors, including dividend levels (which
are in turn affected by expenses), net asset value, call protection, dividend
stability, relative demand for and supply of such shares in the market, general
market and economic conditions and other factors. Because shares of a
closed-end investment company may frequently trade at prices lower than net
asset value, the Trust's board of trustees may consider action that might be
taken to reduce or eliminate any material discount from net asset value in
respect of common shares, which may include the repurchase of such shares in
the open market or in private transactions, the making of a tender offer for
such shares, or the conversion of the Trust to an open-end investment company.
The board of trustees may decide not to take any of these actions. In addition,
there can be no assurance that share repurchases or tender offers, if
undertaken, will reduce market discount.
Notwithstanding the foregoing, at any time when the Trust's Preferred
Shares are outstanding, the Trust may not purchase, redeem or otherwise acquire
any of its common shares unless (1) all accrued Preferred Shares dividends have
been paid and (2) at the time of such purchase, redemption or acquisition, the
net asset value of the Trust's portfolio (determined after deducting the
acquisition price of the common shares) is at least 200% of the liquidation
value of the outstanding Preferred Shares (expected to equal the original
purchase price per share plus any accrued and unpaid dividends thereon). Any
service fees incurred in connection with any tender offer made by the Trust
will be borne by the Trust and will not reduce the stated consideration to be
paid to tendering shareholders.
Subject to its investment restrictions, the Trust may borrow to finance
the repurchase of shares or to make a tender offer. Interest on any borrowings
to finance share repurchase transactions or the accumulation of cash by the
Trust in anticipation of share repurchases or tenders will reduce the Trust's
net income. Any share repurchase, tender offer or borrowing that might be
approved by the Trust's board of trustees would have to comply with the
Securities Exchange Act of 1934, as amended, the Investment Company Act and the
rules and regulations thereunder.
Although the decision to take action in response to a discount from net
asset value will be made by the board of trustees at the time it considers such
issue, it is the board's present policy, which may be changed by the board of
trustees, not to authorize repurchases of common shares or a tender offer for
such shares if: (1) such transactions, if consummated, would (a) result in the
delisting of the common shares from the New York Stock Exchange, or (b) impair
the Trust's status as a regulated investment company under the Code (which
would make the Trust a taxable entity, causing the Trust's income to be taxed
at the corporate level in addition to the taxation of shareholders who receive
dividends from the Trust), or as a registered closed-end investment company
under the Investment Company Act; (2) the Trust would not be able to liquidate
portfolio securities in an orderly manner and consistent with the Trust's
investment objectives and policies in order to repurchase shares; or (3) there
is, in the board's judgment, any (a) material legal action or proceeding
instituted or threatened challenging such transactions or otherwise materially
adversely affecting the Trust, (b) general suspension of or limitation on
prices for trading securities on the New York Stock Exchange, (c) declaration
of a banking moratorium by federal or state authorities or any suspension of
payment by United States or New York banks, (d) material limitation affecting
the Trust or the issuers of its portfolio securities by federal or state
authorities on the extension of credit by lending institutions or on the
exchange of foreign currency, (e) commencement of war, armed hostilities or
other international or national calamity directly or indirectly involving the
United States or (f) other event or condition which would have a material
adverse effect (including any adverse tax effect) on the Trust or its
shareholders if shares were repurchased. The board of trustees may in the
future modify these conditions in light of experience.
The repurchase by the Trust of its shares at prices below net asset value
will result in an increase in the net asset value of those shares that remain
outstanding. However, there can be no assurance that share repurchases or
tender offers at or below net asset value will result in the Trust's shares
trading at a price equal to their net asset value. Nevertheless, the fact that
the Trust's shares may be the subject of repurchase or tender offers from time
to time, or that the Trust may be converted to an open-end investment company,
may reduce any spread between market price and net asset value that might
otherwise exist.
B-18
Before deciding whether to take any action if the common shares trade
below net asset value, the Trust's board of trustees would likely consider all
relevant factors, including the extent and duration of the discount, the
liquidity of the Trust's portfolio, the impact of any action that might be
taken on the Trust or its shareholders and market considerations. Based on
these considerations, even if the Trust's shares should trade at a discount,
the board of trustees may determine that, in the interest of the Trust and its
shareholders, no action should be taken.
TAX MATTERS
The following discussion summarizes certain U.S. federal income tax
considerations affecting the Trust and the purchase, ownership and disposition
of the Trust's common shares by U.S. persons. This discussion is based upon
current provisions of the Internal Revenue Code of 1986, as amended (the
"Code"), the regulations promulgated thereunder and judicial and administrative
authorities, all of which are subject to change or differing interpretations by
the courts or the Internal Revenue Service (the "IRS"), possibly with
retroactive effect. No attempt is made to present a detailed explanation of all
U.S. federal tax concerns affecting the Trust and its shareholders (including
shareholders owning large positions in the Trust).
The discussions set forth herein and in the Prospectus do not constitute
tax advice, and you are urged to consult your own tax advisor to determine the
specific U.S. federal, state, local and foreign tax consequences to you of
investing in the Trust.
Taxation of the Trust
The Trust intends to elect to be treated and to qualify annually as a
regulated investment company under Subchapter M of the Code. Accordingly, the
Trust must, among other things, meet the following requirements regarding the
source of its income and the diversification of its assets:
(i) The Trust must derive in each taxable year at least 90% of its gross
income from the following sources: (a) dividends, interest (including
tax-exempt interest), payments with respect to certain securities loans, and
gains from the sale or other disposition of stock, securities or foreign
currencies, or other income (including but not limited to gain from options,
futures and forward contracts) derived with respect to its business of
investing in such stock, securities or foreign currencies; and (b) interests in
"qualified publicly traded partnerships" (as defined in the Code).
(ii)The Trust must diversify its holdings so that, at the end of each
quarter of each taxable year: (a) at least 50% of the market value of the
Trust's total assets is represented by cash and cash items, U.S. government
securities, the securities of other regulated investment companies and other
securities, with such other securities limited, in respect of any one issuer,
to an amount not greater than 5% of the value of the Trust's total assets and
not more than 10% of the outstanding voting securities of such issuer and (b)
not more than 25% of the market value of the Trust's total assets is invested
in the securities (other than U.S. government securities and the securities of
other regulated investment companies) of: (I) any one issuer, (II) any two or
more issuers that the Trust controls and that are determined to be engaged in
the same business or similar or related trades or businesses or (III) any one
or more "qualified publicly traded partnerships" (as defined in the Code).
As a regulated investment company, the Trust generally will not be subject
to U.S. federal income tax on income and gains that the Trust distributes to
its shareholders provided that it distributes each taxable year at least the
sum of: (i) 90% of the Trust's investment company taxable income (which
includes, among other items, dividends, interest and the excess of any net
short-term capital gain over net long-term capital loss and other taxable
income, other than any net long-term capital gain, reduced by deductible
expenses) determined without regard to the deduction for dividends paid and
(ii) 90% of the Trust's net tax-exempt interest (the excess of its gross
tax-exempt interest over certain disallowed deductions). The Trust intends to
distribute substantially all of such income each year. The Trust will be
subject to income tax at regular corporation rates on any taxable income or
gains that it does not distribute to its shareholders.
The Code imposes a 4% nondeductible excise tax on the Trust to the extent
the Trust does not distribute by the end of any calendar year at least the sum
of: (i) 98% of its ordinary income (not taking into account any capital gain or
loss) for the calendar year and (ii) 98% of its capital gain in excess of its
capital loss (adjusted for certain ordinary losses) for a one-year period
generally ending on October 31 of the calendar year (unless an election is made
to use the Trust's fiscal year). In addition, the minimum amounts that must be
distributed in any year to avoid the excise tax will be increased or decreased
to reflect any under-distribution or over-distribution, as the case may be,
from the previous year. While the Trust intends to distribute any income and
capital gain in the manner necessary to minimize imposition of the 4% excise
tax, there can be no assurance that sufficient amounts of the Trust's taxable
income and capital gain will be distributed to
B-19
avoid entirely the imposition of the excise tax. In that event, the Trust will
be liable for the excise tax only on the amount by which it does not meet the
foregoing distribution requirement.
If for any taxable year the Trust does not qualify as a regulated
investment company, all of its taxable income (including its net capital gain)
will be subject to tax at regular corporate rates without any deduction for
distributions to shareholders, and such distributions will be taxable to the
shareholders as ordinary dividends to the extent of the Trust's current or
accumulated earnings and profits. Such dividends, however, would be eligible
(i) to be treated as qualified dividend income in the case of shareholders
taxed as individuals and (ii) for the dividends-received deduction in the case
of shareholders taxed as corporations. The Trust could be required to recognize
unrealized gains, pay taxes and make distributions (which could be subject to
interest charges) before requalifying for taxation as a regulated investment
company. If the Trust fails to qualify as a regulated investment company in any
year, it must pay out its earnings and profits accumulated in that year in
order to qualify again as a regulated investment company. If the Trust fails to
qualify as a regulated investment company for a period greater than two taxable
years, the Trust may be required to recognize and pay tax on any net built-in
gains with respect to certain of its assets (i.e., the excess of the aggregate
gains, including items of income, over aggregate losses that would have been
realized with respect to such assets if the Trust had been liquidated) or,
alternatively, to elect to be subject to taxation on such built-in gain
recognized for a period of ten years, in order to qualify as a regulated
investment company in a subsequent year.
Certain of the Trust's investment practices are subject to special and
complex U.S. federal income tax provisions that may, among other things: (i)
treat dividends that would otherwise constitute qualified dividend income as
non-qualified dividend income, (ii) treat dividends that would otherwise be
eligible for the corporate dividends-received deduction as ineligible for such
treatment, (iii) disallow, suspend or otherwise limit the allowance of certain
losses or deductions, (iv) convert lower taxed long-term capital gain into
higher taxed short-term capital gain or ordinary income, (v) convert an
ordinary loss or deduction into a capital loss (the deductibility of which is
more limited) or (vi) cause the Trust to recognize income or gain without a
corresponding receipt of cash.
If the Trust purchases common shares in certain foreign investment
entities, called passive foreign investment companies ("PFICs"), the Trust may
be subject to U.S. federal income tax on a portion of any "excess distribution"
or gain from the disposition of such common shares even if such income is
distributed as a taxable dividend by the Trust to the shareholders. Additional
charges in the nature of interest may be imposed on the Trust in respect of
deferred taxes arising from such distributions or gains. Elections may be
available to the Trust to mitigate the effect of this tax, but such elections
generally accelerate the recognition of income without the receipt of cash.
Dividends paid by PFICs will not be qualified dividend income, as discussed
below under "Taxation of Shareholders."
If the Trust invests in the common shares of a PFIC, or any other
investment that produces income that is not matched by a corresponding cash
distribution to the Trust, the Trust could be required to recognize income that
it has not yet received. Any such income would be treated as income earned by
the Trust and therefore would be subject to the distribution requirements of
the Code. This might prevent the Trust from distributing 90% of its net
investment income as is required in order to avoid Trust-level U.S. federal
income taxation on all of its income, or might prevent the Trust from
distributing enough ordinary income and capital gain net income to avoid
completely the imposition of the excise tax. To avoid this result, the Trust
may be required to borrow money or dispose of securities to be able to make
required distributions to the shareholders.
Dividend, interest and other income received by the Trust from investments
outside the United States may be subject to withholding and other taxes imposed
by foreign countries. Tax treaties between the United States and other
countries may reduce or eliminate such taxes. The Trust does not expect that it
will be eligible to elect to treat any foreign taxes it pays as paid by its
shareholders, who therefore will not be entitled to credits for such taxes on
their own tax returns. Foreign taxes paid by a Trust will reduce the return
from the Trust's investments.
Taxation of Shareholders
The Trust will determine either to distribute or to retain for
reinvestment all or part of its net capital gain. If any such gain is retained,
the Trust will be subject to a corporate income tax (currently at a maximum
rate of 35%) on such retained amount. In that event, the Trust expects to
designate the retained amount as undistributed capital gain in a notice to its
shareholders, each of whom: (i) will be required to include in income for U.S.
federal tax purposes as long-term capital gain its share of such undistributed
amounts, (ii) will be entitled to credit its proportionate share of the tax
paid by the Trust against its U.S. federal income tax liability and to claim
refunds to the extent that the credit exceeds such liability and (iii) will
increase its basis in its common shares of the Trust by an amount equal to 65%
of the amount of undistributed capital gain included in such shareholder's
gross income.
B-20
Distributions paid to you by the Trust from its net realized long-term
capital gains, if any, that the Trust designates as capital gains dividends
("capital gain dividends") are taxable as long-term capital gains, regardless
of how long you have held your common shares. All other dividends paid to you
by the Trust (including dividends from short-term capital gains) from its
current or accumulated earnings and profits ("ordinary income dividends") are
generally subject to tax as ordinary income.
Special rules apply, however, to ordinary income dividends paid to
individuals with respect to taxable years beginning on or before December 31,
2008. If you are an individual, any such ordinary income dividend that you
receive from the Trust generally will be eligible for taxation at the rates
applicable to long-term capital gains (currently at a maximum rate of 15%) to
the extent that: (i) the ordinary income dividend is attributable to "qualified
dividend income" (i.e., generally dividends paid by U.S. corporations and
certain foreign corporations) received by the Trust, (ii) the Trust satisfies
certain holding period and other requirements with respect to the stock on
which such qualified dividend income was paid and (iii) you satisfy certain
holding period and other requirements with respect to your common shares.
Ordinary income dividends subject to these special rules are not actually
treated as capital gains, however, and thus will not be included in the
computation of your net capital gain and generally cannot be used to offset any
capital losses. Congress has recently considered certain proposals to extend
the preferential tax rates for qualified dividend income beyond 2008, but no
assurances can be given in this regard.
Any distributions you receive that are in excess of the Trust's current or
accumulated earnings and profits will be treated as a tax-free return of
capital to the extent of your adjusted tax basis in your common shares, and
thereafter as capital gain from the sale of common shares. The amount of any
Trust distribution that is treated as a tax-free return of capital will reduce
your adjusted tax basis in your common shares, thereby increasing your
potential gain or reducing your potential loss on any subsequent sale or other
disposition of your common shares.
Dividends and other taxable distributions are taxable to you even if they
are reinvested in additional common shares of the Trust. Dividends and other
distributions paid by the Trust are generally treated under the Code as
received by you at the time the dividend or distribution is made. If, however,
the Trust pays you a dividend in January that was declared in the previous
October, November or December and you were the shareholder of record on a
specified date in one of such months, then such dividend will be treated for
tax purposes as being paid by the Trust and received by you on December 31 of
the year in which the dividend was declared.
The price of common shares purchased at any time may reflect the amount of
a forthcoming distribution. If you purchase common shares just prior to a
distribution, you will receive a distribution that will be taxable to you even
though it represents in part a return of your invested capital.
The Trust will send you information after the end of each year setting
forth the amount and tax status of any distributions paid to you by the Trust.
Ordinary income dividends and capital gain dividends may also be subject to
state and local taxes.
If you sell or otherwise dispose of common shares of the Trust (including
exchange them for common shares of another fund), you will generally recognize
a gain or loss in an amount equal to the difference between your tax basis in
such common shares of the Trust and the amount you receive upon disposition of
such common shares. If you hold your common shares as capital assets, any such
gain or loss will be long-term capital gain or loss if you have held such
common shares for more than one year at the time of sale. Any loss upon the
sale or exchange of common shares held for six months or less will be treated
as long-term capital loss to the extent of any capital gain dividends received
(including amounts credited as an undistributed capital gain dividend) by you
with respect to such common shares. Any loss you realize on a sale or exchange
of common shares will be disallowed if you acquire other common shares (whether
through the automatic reinvestment of dividends or otherwise) within a 61-day
period beginning 30 days before and ending 30 days after your sale or exchange
of the common shares. In such case, your tax basis in the common shares
acquired will be adjusted to reflect the disallowed loss.
Current law taxes both long-term and short-term capital gain of
corporations at the rates applicable to ordinary income. For non-corporate
taxpayers, short-term capital gain is currently taxed at rates applicable to
ordinary income (currently at a maximum of 35%) while long-term capital gain
generally is taxed at a maximum rate of 15%.
Shareholders may be entitled to offset their capital gain dividends with
capital loss. The Code contains a number of statutory provisions affecting when
capital loss may be offset against capital gain and limiting the use of loss
from certain investments and activities. Accordingly, shareholders that have
capital losses are urged to consult their tax advisors.
B-21
The Trust may be required to withhold, for U.S. federal backup withholding
tax purposes, a portion of the dividends, distributions and redemption proceeds
payable to a shareholder who fails to provide the Trust (or its agent) with the
shareholder's correct taxpayer identification number (in the case of an
individual, generally, such individual's social security number) or to make the
required certification, or who has been notified by the IRS that such
shareholder is subject to backup withholding. Certain shareholders are exempt
from backup withholding. Backup withholding is not an additional tax and any
amount withheld may be refunded or credited against your U.S. federal income
tax liability, if any, provided that you furnish the required information to
the IRS.
EXPERTS
The Statement of Net Assets of the Trust as of , 2006 appearing in
this Statement of Additional Information has been audited by , independent
auditors, as set forth in their report thereon appearing elsewhere herein, and
is included in reliance upon such report given upon the authority of such firm
as experts in accounting and auditing. , located at , , ,
provides accounting and auditing services to the Trust.
ADDITIONAL INFORMATION
A Registration Statement on Form N-2, including amendments thereto,
relating to the shares offered hereby, has been filed by the Trust with the
Securities and Exchange Commission (the "Commission"), Washington, D.C. The
prospectus and this Statement of Additional Information do not contain all of
the information set forth in the Registration Statement, including any exhibits
and schedules thereto. For further information with respect to the Trust and
the shares offered hereby, reference is made to the Registration Statement.
Statements contained in the prospectus and this Statement of Additional
Information as to the contents of any contract or other document referred to
are not necessarily complete and in each instance reference is made to the copy
of such contract or other document filed as an exhibit to the Registration
Statement, each such statement being qualified in all respects by such
reference. A copy of the Registration Statement may be inspected without charge
at the Commission's principal office in Washington, D.C., and copies of all or
any part thereof may be obtained from the Commission upon the payment of
certain fees prescribed by the Commission.
B-22
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Trustees and Shareholder of Highland Credit Strategies Fund:
We have audited the accompanying statement of assets and liabilities of
Highland Credit Strategies Fund (the "Trust") as of , 2006 and the related
statements of operations and changes in net assets for the period from March
10, 2006 (date of inception) to , 2006. These financial statements are the
responsibility of the Trust's management. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Highland Credit Strategies
Fund as of , 2006, and the results of its operations and the changes in
its net assets for the period from March 10, 2006 (date of inception) to ,
2006, in conformity with accounting principles generally accepted in the United
States of America.
,
, 2006
F-1
HIGHLAND CREDIT STRATEGIES FUND
STATEMENT OF ASSETS AND LIABILITIES
, 2006
F-2
HIGHLAND CREDIT STRATEGIES FUND
STATEMENT OF OPERATIONS
For the period March 10, 2006 (date of inception) to , 2006
F-3
HIGHLAND CREDIT STRATEGIES FUND
STATEMENT OF CHANGES IN NET ASSETS
For the period March 10, 2006 (date of inception) to , 2006
F-4
HIGHLAND CREDIT STRATEGIES FUND
NOTES TO FINANCIAL STATEMENTS
F-5
APPENDIX A
GENERAL CHARACTERISTICS AND RISKS
OF STRATEGIC TRANSACTIONS
In order to manage the risk of its securities portfolio, or to enhance
income or gain as described in the prospectus, the Trust will engage in
Strategic Transactions. The Trust will engage in such activities in the
Investment Manager's discretion, and may not necessarily be engaging in such
activities when movements in interest rates that could affect the value of the
assets of the Trust occur. The Trust's ability to pursue certain of these
strategies may be limited by applicable regulations of the CFTC. Certain
Strategic Transactions may give rise to taxable income.
Put and Call Options on Securities and Indices
The Trust may purchase and sell put and call options on securities and
indices. A put option gives the purchaser of the option the right to sell and
the writer the obligation to buy the underlying security at the exercise price
during the option period. The Trust may also purchase and sell options on
securities indices ("index options"). Index options are similar to options on
securities except that, rather than taking or making delivery of securities
underlying the option at a specified price upon exercise, an index option gives
the holder the right to receive cash upon exercise of the option if the level
of the securities index upon which the option is based is greater, in the case
of a call, or less, in the case of a put, than the exercise price of the
option. The purchase of a put option on a security could protect the Trust's
holdings in a security or a number of securities against a substantial decline
in the market value. A call option gives the purchaser of the option the right
to buy and the seller the obligation to sell the underlying security or index
at the exercise price during the option period or for a specified period prior
to a fixed date. The purchase of a call option on a security could protect the
Trust against an increase in the price of a security that it intended to
purchase in the future. In the case of either put or call options that it has
purchased, if the option expires without being sold or exercised, the Trust
will experience a loss in the amount of the option premium plus any related
commissions. When the Trust sells put and call options, it receives a premium
as the seller of the option. The premium that the Trust receives for selling
the option will serve as a partial offset, in the amount of the option premium,
against changes in the value of the securities in its portfolio. During the
term of the option, however, a covered call seller has, in return for the
premium on the option, given up the opportunity for capital appreciation above
the exercise price of the option if the value of the underlying security
increases, but has retained the risk of loss should the price of the underlying
security decline. Conversely, a secured put seller retains the risk of loss
should the market value of the underlying security decline be low the exercise
price of the option, less the premium received on the sale of the option. The
Trust is authorized to purchase and sell exchange listed options and
over-the-counter options ("OTC Options") which are privately negotiated with
the counterparty. Listed options are issued by the Options Clearing Corporation
("OCC") which guarantees the performance of the obligations of the parties to
such options.
The Trust's ability to close out its position as a purchaser or seller of
an exchange listed put or call option is dependent upon the existence of a
liquid secondary market on option exchanges. Among the possible reasons for the
absence of a liquid secondary market on an exchange are: (i) insufficient
trading interest in certain options; (ii) restrictions on transactions imposed
by an exchange; (iii) trading halts, suspensions or other restrictions imposed
with respect to particular classes or series of options or underlying
securities; (iv) interruption of the normal operations on an exchange; (v)
inadequacy of the facilities of an exchange or OCC to handle current trading
volume; or (vi) a decision by one or more exchanges to discontinue the trading
of options (or a particular class or series of options), in which event the
secondary market on that exchange (or in that class or series of options) would
cease to exist, although outstanding options on that exchange that had been
listed by the OCC as a result of trades on that exchange would generally
continue to be exercisable in accordance with their terms. OTC Options are
purchased from or sold to dealers, financial institutions or other
counterparties which have entered into direct agreements with the Trust. With
OTC Options, such variables as expiration date, exercise price and premium will
be agreed upon between the Trust and the counterparty, without the
intermediation of a third party such as the OCC. If the counterparty fails to
make or take delivery of the securities underlying an option it has written, or
otherwise settle the transaction in accordance with the terms of that option as
written, the Trust would lose the premium paid for the option as well as any
anticipated benefit of the transaction.
The hours of trading for options on securities may not conform to the
hours during which the underlying securities are traded. To the extent that the
option markets close before the markets for the underlying securities,
significant price movements can take place in the underlying markets that
cannot be reflected in the option markets.
A-1
Futures Contracts and Related Options
Characteristics. The Trust may sell financial futures contracts or
purchase put and call options on such futures as an offset against anticipated
market movements. The sale of a futures contract creates an obligation by the
Trust, as seller, to deliver the specific type of financial instrument called
for in the contract at a specified future time for a specified price. Options
on futures contracts are similar to options on securities except that an option
on a futures contract gives the purchaser the right in return for the premium
paid to assume a position in a futures contract (a long position if the option
is a call and a short position if the option is a put).
Margin Requirements. At the time a futures contract is purchased or sold,
the Trust must allocate cash or securities as a deposit payment ("initial
margin"). It is expected that the initial margin that the Trust will pay may
range from approximately 1% to approximately 5% of the value of the securities
or commodities underlying the contract. In certain circumstances, however, such
as periods of high volatility, the Trust may be required by an exchange to
increase the level of its initial margin payment. Additionally, initial margin
requirements may be increased generally in the future by regulatory action. An
outstanding futures contract is valued daily and the payment in case of
"variation margin" may be required, a process known as "marking to the market."
Transactions in listed options and futures are usually settled by entering into
an offsetting transaction, and are subject to the risk that the position may
not be able to be closed if no offsetting transaction can be arranged.
Limitations on Use of Futures and Options on Futures. The Trust's use of
futures and options on futures will in all cases be consistent with applicable
regulatory requirements and in particular the rules and regulations of the
CFTC. The Trust currently may enter into such transactions without limit for
bona fide strategic purposes, including risk management and duration management
and other portfolio strategies. The Trust may also engage in transactions in
futures contracts or related options for non-strategic purposes to enhance
income or gain provided that the Trust will not enter into a futures contract
or related option (except for closing transactions) for purposes other than
bona fide strategic purposes, or risk management including duration management
if, immediately thereafter, the sum of the amount of its initial deposits and
premiums on open contracts and options would exceed 5% of the Trust's
liquidation value, i.e., net assets (taken at current value); provided,
however, that in the case of an option that is in-the-money at the time of the
purchase, the in-the-money amount may be excluded in calculating the 5%
limitation. The above policies are non-fundamental and may be changed by the
Trust's board of trustees at any time. Also, when required, an account of cash
equivalents designated on the books and records will be maintained and marked
to market on a daily basis in an amount equal to the market value of the
contract.
Segregation and Cover Requirements. Futures contracts, interest rate
swaps, caps, floors and collars, short sales, reverse repurchase agreements and
dollar rolls, and listed or OTC options on securities, indices and futures
contracts sold by the Trust are generally subject to earmarking and coverage
requirements of either the CFTC or the SEC, with the result that, if the Trust
does not hold the security or futures contract underlying the instrument, the
Trust will be required to designate on its books and records an ongoing basis,
cash, U.S. government securities, or other liquid high grade debt obligations
in an amount at least equal to the Trust's obligations with respect to such
instruments.
Such amounts fluctuate as the obligations increase or decrease. The
earmarking requirement can result in the Trust maintaining securities positions
it would otherwise liquidate, segregating assets at a time when it might be
disadvantageous to do so or otherwise restrict portfolio management.
Strategic Transactions Present Certain Risks. With respect to Strategic
Transactions and risk management, the variable degree of correlation between
price movements of strategic instruments and price movements in the position
being offset create the possibility that losses using the strategy may be
greater than gains in the value of the Trust's position. The same is true for
such instruments entered into for income or gain. In addition, certain
instruments and markets may not be liquid in all circumstances. As a result, in
volatile markets, the Trust may not be able to close out a transaction without
incurring losses substantially greater than the initial deposit. Although the
contemplated use of these instruments predominantly for Strategic Transactions
should tend to minimize the risk of loss due to a decline in the value of the
position, at the same time they tend to limit any potential gain which might
result from an increase in the value of such position. The ability of the Trust
to successfully utilize Strategic Transactions will depend on the Advisor's and
the Sub-Advisor's ability to predict pertinent market movements and sufficient
correlations, which cannot be assured. Finally, the daily deposit requirements
in futures contracts that the Trust has sold create an on going greater
potential financial risk than do options transactions, where the exposure is
limited to the cost of the initial premium. Losses due to the use of Strategic
Transactions will reduce net asset value.
Regulatory Considerations. The Trust has claimed an exclusion from the
term "commodity pool operator" under the Commodity Exchange Act and, therefore,
is not subject to registration or regulation as a commodity pool operator under
the Commodity Exchange Act.
A-2
APPENDIX B
PROXY VOTING PROCEDURES
B-1
Part C
Other Information
Item 25. Financial Statements And Exhibits
Financial Statements
Part A--None.
Part B--Statement of Assets and Liabilities. (1)
EXHIBITS
(a) Agreement and Declaration of Trust.(1) (b) By-Laws.(1)
--------------------------------
(1) To be filed by amendment.
Item 26. Marketing Arrangements
Reference is made to the Form of Underwriting Agreement for the
Registrant's shares of beneficial interest to be filed by amendment to this
registration statement.
Item 27. Other Expenses Of Issuance And Distribution
The following table sets forth the estimated expenses to be incurred in
connection with the offering described in this registration statement:
Registration fee $
NYSE listing fee $
Printing (other than certificates) $
Engraving and printing certificates $
Accounting fees and expenses related to the offering $
Legal fees and expenses related to the offering $
NASD fee $
Miscellaneous (i.e. travel) related to the offering $
--- ---------------------
Total $
=== =====================
Item 28. Persons Controlled By Or under Common Control With The Registrant
None.
Item 29. Number Of Holders Of Shares
As of , 2006
Title Of Class Number Of
Record Holders
-------------------------------------------------------------------------------------------------------- -----------------
Shares of Beneficial Interest 0
Item 30. Indemnification
Article V of the Registrant's Agreement and Declaration of Trust provides
as follows:
5.1 No Personal Liability of Shareholders, Trustees, etc. No
Shareholder of the Trust shall be subject in such capacity to any personal
liability whatsoever to any Person in connection with Trust Property or
the acts, obligations or affairs of the Trust. Shareholders shall have the
same limitation of personal liability as is extended to stockholders of a
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private corporation for profit incorporated under the Delaware General
Corporation Law. No Trustee or officer of the Trust shall be subject in
such capacity to any personal liability whatsoever to any Person, save
only liability to the Trust or its Shareholders arising from bad faith,
willful misfeasance, gross negligence or reckless disregard for his duty
to such Person; and, subject to the foregoing exception, all such Persons
shall look solely to the Trust Property for satisfaction of claims of any
nature arising in connection with the affairs of the Trust. If any
Shareholder, Trustee or officer, as such, of the Trust, is made a party to
any suit or proceeding to enforce any such liability, subject to the
foregoing exception, he shall not, on account thereof, be held to any
personal liability. Any repeal or modification of this Section 5.1 shall
not adversely affect any right or protection of a Trustee or officer of
the Trust existing at the time of such repeal or modification with respect
to acts or omissions occurring prior to such repeal or modification.
5.2 Mandatory Indemnification. (a) The Trust hereby agrees to
indemnify each person who at any time serves as a Trustee or officer of
the Trust (each such person being an "indemnitee") against any liabilities
and expenses, including amounts paid in satisfaction of judgments, in
compromise or as fines and penalties, and reasonable counsel fees
reasonably incurred by such indemnitee in connection with the defense or
disposition of any action, suit or other proceeding, whether civil or
criminal, before any court or administrative or investigative body in
which he may be or may have been involved as a party or otherwise or with
which he may be or may have been threatened, while acting in any capacity
set forth in this Article V by reason of his having acted in any such
capacity, except with respect to any matter as to which he shall not have
acted in good faith in the reasonable belief that his action was in the
best interest of the Trust or, in the case of any criminal proceeding, as
to which he shall have had reasonable cause to believe that the conduct
was unlawful, provided, however, that no indemnitee shall be indemnified
hereunder against any liability to any person or any expense of such
indemnitee arising by reason of (i) willful misfeasance, (ii) bad faith,
(iii) gross negligence, or (iv) reckless disregard of the duties involved
in the conduct of his position (the conduct referred to in such clauses
(i) through (iv) being sometimes referred to herein as "disabling
conduct"). Notwithstanding the foregoing, with respect to any action, suit
or other proceeding voluntarily prosecuted by any indemnitee as plaintiff,
indemnification shall be mandatory only if the prosecution of such action,
suit or other proceeding by such indemnitee (1) was authorized by a
majority of the Trustees or (2) was instituted by the indemnitee to
enforce his or her rights to indemnification hereunder in a case in which
the indemnitee is found to be entitled to such indemnification. The rights
to indemnification set forth in this Declaration shall continue as to a
person who has ceased to be a Trustee or officer of the Trust and shall
inure to the benefit of his or her heirs, executors and personal and legal
representatives. No amendment or restatement of this Declaration or repeal
of any of its provisions shall limit or eliminate any of the benefits
provided to any person who at any time is or was a Trustee or officer of
the Trust or otherwise entitled to indemnification hereunder in respect of
any act or omission that occurred prior to such amendment, restatement or
repeal.
(b) Notwithstanding the foregoing, no indemnification shall be made
hereunder unless there has been a determination (i) by a final decision on
the merits by a court or other body of competent jurisdiction before whom
the issue of entitlement to indemnification hereunder was brought that
such indemnitee is entitled to indemnification hereunder or, (ii) in the
absence of such a decision, by (1) a majority vote of a quorum of those
Trustees who are neither "interested persons" of the Trust (as defined in
Section 2(a)(19) of the Investment Company Act) nor parties to the
proceeding ("Disinterested Non-Party Trustees"), that the indemnitee is
entitled to indemnification hereunder, or (2) if such quorum is not
obtainable or even if obtainable, if such majority so directs, independent
legal counsel in a written opinion concludes that the indemnitee should be
entitled to indemnification hereunder. All determinations to make advance
payments in connection with the expense of defending any proceeding shall
be authorized and made in accordance with the immediately succeeding
paragraph (c) below.
(c) The Trust shall make advance payments in connection with the
expenses of defending any action with respect to which indemnification
might be sought hereunder if the Trust receives a written affirmation by
the indemnitee of the indemnitee's good faith belief that the standards of
conduct necessary for indemnification have been met and a written
undertaking to reimburse the Trust unless it is subsequently determined
that the indemnitee is entitled to such indemnification and if a majority
of the Trustees determine that the applicable standards of conduct
necessary for indemnification appear to have been met. In addition, at
least one of the following conditions must be met: (i) the indemnitee
shall provide adequate security for his undertaking, (ii) the Trust shall
be insured against losses arising by reason of any lawful advances, or
(iii) a majority of a quorum of the Disinterested Non-Party Trustees, or
if a majority vote of such quorum so direct, independent legal counsel in
a written opinion, shall conclude, based on a review of readily available
facts (as opposed to a full trial-type inquiry), that there is substantial
reason to believe that the indemnitee ultimately will be found entitled to
indemnification.
(d) The rights accruing to any indemnitee under these provisions shall
not exclude any other right which any person may have or hereafter acquire
under this Declaration, the By-Laws of the Trust, any statute, agreement,
vote of
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stockholders or Trustees who are "disinterested persons" (as defined in
Section 2(a)(19) of the 1940 Act) or any other right to which he or she
may be lawfully entitled.
(e) Subject to any limitations provided by the 1940 Act and this
Declaration, the Trust shall have the power and authority to indemnify and
provide for the advance payment of expenses to employees, agents and other
Persons providing services to the Trust or serving in any capacity at the
request of the Trust to the full extent corporations organized under the
Delaware General Corporation Law may indemnify or provide for the advance
payment of expenses for such Persons, provided that such indemnification
has been approved by a majority of the Trustees.
5.3 No Bond Required of Trustees. No Trustee shall, as such, be
obligated to give any bond or other security for the performance of any of
his duties hereunder.
5.4 No Duty of Investigation; Notice in Trust Instruments, etc. No
purchaser, lender, transfer agent or other person dealing with the
Trustees or with any officer, employee or agent of the Trust shall be
bound to make any inquiry concerning the validity of any transaction
purporting to be made by the Trustees or by said officer, employee or
agent or be liable for the application of money or property paid, loaned,
or delivered to or on the order of the Trustees or of said officer,
employee or agent. Every obligation, contract, undertaking, instrument,
certificate, Share, other security of the Trust, and every other act or
thing whatsoever executed in connection with the Trust shall be
conclusively taken to have been executed or done by the executors thereof
only in their capacity as Trustees under this Declaration or in their
capacity as officers, employees or agents of the Trust. The Trustees may
maintain insurance for the protection of the Trust Property, its
Shareholders, Trustees, officers, employees and agents in such amount as
the Trustees shall deem adequate to cover possible tort liability, and
such other insurance as the Trustees in their sole judgment shall deem
advisable or is required by the 1940 Act.
5.5 Reliance on Experts, etc. Each Trustee and officer or employee of
the Trust shall, in the performance of its duties, be fully and completely
justified and protected with regard to any act or any failure to act
resulting from reliance in good faith upon the books of account or other
records of the Trust, upon an opinion of counsel, or upon reports made to
the Trust by any of the Trust's officers or employees or by any advisor,
administrator, manager, distributor, selected dealer, accountant,
appraiser or other expert or consultant selected with reasonable care by
the Trustees, officers or employees of the Trust, regardless of whether
such counsel or expert may also be a Trustee.
Insofar as indemnification for liabilities arising under the Act, may be
terminated to Trustees, officers and controlling persons of the Trust, pursuant
to the foregoing provisions or otherwise, the Trust has been advised that in
the opinion of the Securities and Exchange Commission such indemnification is
against public policy as expressed in the Securities Act and is, therefore,
unenforceable. In the event that a claim for indemnification against such
liabilities (other than the payment by the Registrant of expenses incurred or
paid by a Trustee, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
Trustee, officer or controlling person in connection with the securities being
registered, the Registrant will, unless in the opinion of its counsel the
matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed
by the final adjudication of such issue. Reference is made to Article of the
underwriting agreement attached as Exhibit (h), which is incorporated herein by
reference.
Item 31. Business And Other Connections Of Investment Advisor
Not Applicable.
Item 32. Location Of Accounts And Records
The Registrant's accounts, books and other documents are currently located
at the offices of the Registrant, c/o Highland Capital Management, L.P., Two
Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240 and at the
offices of the Registrant's Custodian and Transfer Agent.
Item 33. Management Services
Not Applicable.
Item 34. Undertakings
(1) The Registrant hereby undertakes to suspend the offering of its
units until it amends its prospectus if (a) subsequent to the effective
date of its registration statement, the net asset value declines more than
10 percent from its
C-3
net asset value as of the effective date of the Registration Statement or
(b) the net asset value increases to an amount greater than its net
proceeds as stated in the prospectus.
(2) Not applicable.
(3) Not applicable.
(4) Not applicable.
(5) (a) For the purposes of determining any liability under the
Securities Act of 1933, the information omitted from the form of
prospectus filed as part of a registration statement in reliance upon Rule
430A and contained in the form of prospectus filed by the Registrant under
Rule 497 (h) under the Securities Act of 1933 shall be deemed to be part
of the Registration Statement as of the time it was declared effective.
(b) For the purpose of determining any liability under the Securities
Act of 1933, each post-effective amendment that contains a form of
prospectus shall be deemed to be a new registration statement relating to
the securities offered therein, and the offering of the securities at that
time shall be deemed to be the initial bona fide offering thereof.
(6) The Registrant undertakes to send by first class mail or other
means designed to ensure equally prompt delivery within two business days
of receipt of a written or oral request, any Statement of Additional
Information.
C-4
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933 and the Investment
Company Act of 1940, the Registrant has duly caused this Registration Statement
to be signed on its behalf by the undersigned, thereunto duly authorized, in
the City of Dallas, and State of Texas, on the 15th day of March 2006.
/s/ R. Joseph Dougherty
------------------------------------------------
R. Joseph Dougherty
Sole Initial Trustee, President, Chief Executive
Officer and Principal Financial Officer
Pursuant to the requirements of the Securities Act of 1933, this Registration
Statement has been signed by the following persons in the capacities set forth
below on the 15th day of March 2006.
NAME TITLE
---- -----
Sole Initial Trustee, President, Chief
/s/ R. Joseph Dougherty Executive Officer and Principal Financial
------------------------------ Officer
R. Joseph Dougherty
INDEX TO EXHIBITS
None.