nv2za
As filed with the Securities and Exchange Commission on May 2, 2006
Securities Act Registration No. 333-132436
Investment Company Act Registration No. 811-21869
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-2
|
|
|
|
|
|
|
Registration Statement |
|
|
|
|
under the Securities Act of 1933
|
|
þ |
|
|
Pre-Effective Amendment No. 1
|
|
þ |
|
|
Post-Effective Amendment No.
|
|
o |
and/or
|
|
|
|
|
|
|
Registration Statement |
|
|
|
|
under the Investment Company Act of 1940
|
|
þ |
|
|
Amendment No. 1
|
|
þ |
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
(Registrants 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.
|
|
Nora M. Jordan, Esq. |
Skadden, Arps, Slate, Meagher & Flom LLP
|
|
Davis Polk & Wardwell |
Four Times Square
|
|
450 Lexington Avenue |
New York, New York 10036
|
|
New York, New York 10017 |
Approximate date of proposed public offering:
As soon as practicable after the effective date of this Registration Statement.
If any securities being registered on this form will be offered on a delayed or continuous
basis in reliance on Rule 415 under the Securities Act of 1933, other than securities offered only
in connection with dividend or interest reinvestment plans, check the following box o
It is proposed that this filing will become effective (check appropriate box):
o when declared effective pursuant to section 8(c)
CALCULATION OF REGISTRATION FEE UNDER THE SECURITIES ACT OF 1933
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proposed |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Maximum |
|
|
Proposed Maximum |
|
|
|
|
|
|
|
|
Amount Being |
|
|
Offering |
|
|
Aggregate |
|
|
Amount of |
|
|
Title of Securities Being Registered |
|
|
Registered |
|
|
Price per Unit |
|
|
Offering Price |
|
|
Registration Fee |
|
|
Common Shares, $0.001 par value |
|
|
100,000 shares (1) |
|
|
$20.00 |
|
|
$2,000,000
(2) |
|
|
$214.00
(3) |
|
|
|
|
|
|
(1) |
|
Includes shares that may be offered to the underwriters pursuant to an option to cover
over-allotments. |
|
|
|
(2) |
|
Estimated solely for the purpose of calculating the registration fee. |
|
|
|
(3) |
|
A registration fee of $214.00 was previously paid in connection with the initial filing of this
registration statement on March 15, 2006. |
|
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.
ii
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.
|
|
Inside Front and Outside Back Cover
|
|
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; Underwriters |
Item 6.
|
|
Selling Shareholders
|
|
Not Applicable |
Item 7.
|
|
Use of Proceeds
|
|
Use of Proceeds; Prospectus Summary; The
Trusts Investments |
Item 8.
|
|
General Description of the Registrant
|
|
The Trust; The Trusts Investments; Risks;
Description of Capital Structure;
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 Capital Structure;
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
|
|
Not Applicable |
Item 13.
|
|
Table of Contents of the Statement of
Additional Information
|
|
Table of Contents for the Statement of
Additional 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
Restrictions; 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 for the
Prospectus and Statement of
Additional Information; 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
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 jurisdiction where the offer or sale is not permitted.
PRELIMINARY PROSPECTUS (SUBJECT TO COMPLETION)
ISSUED MAY 2, 2006
Shares
Highland Credit Strategies Fund
COMMON SHARES
Highland Credit Strategies Fund (the Trust) is offering common shares of
beneficial interest. This is the initial public offering of the Trusts common shares, and no
public market exists for its common shares.
Investment Objectives. Highland Credit Strategies Fund is a newly organized, non-diversified,
closed-end management investment company. The Trusts investment objective is to provide both high
income and capital appreciation. 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, mortgage-backed and other
asset-backed securities, collateralized loan and collateralized bond obligations and other debt
obligations; and (iii) debt obligations of distressed and bankrupt issuers, and the Trust may also
invest in these categories of obligations through the use of derivatives. Highland will seek to
achieve the capital appreciation component of this objective by investing in category (iii)
obligations, and to a lesser extent, in category (i) obligations. Under normal market conditions,
at least 80% of the Trusts net assets, plus the amount of any borrowings for investment purposes
(Assets) will be invested in one or more of these principal investment categories. Subject only
to this general guideline, Highland Capital Management, L.P., the Trusts investment adviser
(Highland or the Investment Adviser), has broad discretion to allocate the Trusts assets among
these investment categories and to change allocations as conditions warrant, and the Investment
Adviser has full discretion regarding the capital markets from which it can access investment
opportunities. A significant portion of the Trusts assets may be invested in securities rated
below investment grade, which are commonly referred to as junk securities. The Investment
Adviser does not anticipate a high correlation between the performance of the Trusts portfolio and
the performance of the corporate bond and equity markets. There can be no assurance that the
Trusts investment objectives will be achieved.
(continued on top of next page)
No Prior History. Because the Trust is newly organized, the Trusts shares have no history of
public trading. Shares of closed-end investment companies frequently trade at a discount from
their net asset value, which may increase investors risk of loss. 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 .
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 SummaryPrincipal Risks of the Trust beginning
on page.
PRICE $ A SHARE
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated |
|
|
|
|
|
Price to Public |
|
Sales Load |
|
|
|
|
|
Offering Expenses |
|
Proceeds to Trust |
Per Share |
|
$ |
|
|
|
$ |
|
|
|
|
|
|
|
$ |
|
|
|
$ |
|
|
Total |
|
$ |
|
|
|
$ |
|
|
|
|
|
|
|
$ |
|
|
|
$ |
|
|
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 Underwriters.
Highland Capital Management, L.P. will pay a marketing and structuring fee to Morgan Stanley & Co.
Incorporated calculated based on % of the aggregate price to public of the common shares sold
by Morgan Stanley & Co. Incorporated. Estimated offering expenses in the table above includes
reimbursement to Highland by the Trust for expenses incurred by Highland in connection with this
offering, other than the marketing and structuring fee referred to in the preceding sentence. See
Underwriters.
(continued on bottom of next page)
The Securities and Exchange Commission and state securities regulators have not approved or
disapproved of these securities or determined if this prospectus is truthful or complete. Any
representation to the contrary is a criminal offense.
Morgan
Stanley & Co. Incorporated expects to deliver the common shares
to purchasers on or about , 2006.
MORGAN STANLEY
, 2006
(continued from top of previous page)
Investment Policies and Strategies. Under normal market conditions, the Investment Adviser will
employ, on behalf of the Trust, investment strategies across various markets in which the
Investment Adviser holds significant investment experience: primarily the leveraged loan, high
yield, structured product and distressed markets. The Investment Adviser has full discretion
regarding the capital markets from which it can access investment opportunities.
The Investment Adviser looks to implement selected trading strategies to exploit pricing
inefficiencies across the credit markets, or debt markets, and within an individual issuers
capital structure. The Trust seeks to vary its investments by strategy, industry, security type and
credit market, but reserves the right to re-position its portfolio among these criteria depending
on market dynamics. The Investment Adviser 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
Adviser to assess what it considers to be the best opportunities across multiple markets and to
adjust quickly the Trusts trading strategies and market focus to changing conditions. The
Investment Adviser intends to focus primarily on the U.S. marketplace, but may pursue opportunities
in the non-U.S. credit markets by investing up to 20% of the Trusts assets in non-U.S. credit
market investments.
You should read this prospectus, which contains important information about the Trust, before
deciding whether to invest in the common shares, 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, request the Trusts annual and semi-annual reports, request
information about the Trust and make shareholder inquiries by calling 1-877-665-1287 or by writing
to the Trust at Two Galleria Tower, 13455 Noel Road, Suite 800, Dallas, Texas 75240. You may also
obtain a copy of the Statement of Additional Information (and other information regarding the
Trust) from the Commissions Public Reference Room in Washington, D.C. by calling 1-202-942-8090.
The Commission charges a fee for copies. The Trust does not post a copy of the Statement of
Additional Information on its web site because the Trusts common shares are not continuously
offered, which means the Statement of Additional Information will not be updated after completion
of this offering and the information contained in the Statement of Additional Information will
become outdated. The Trusts annual and semi-annual reports, when produced, will be available,
free of charge, at the Trusts web site (http://www.hcmlp.com). You can get the same information
free from the Commissions web site (http://www.sec.gov).
The Trusts 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.
The underwriters are taking shares on a firm commitment basis. The underwriters may engage in
transactions that stabilize, maintain or otherwise affect the price of common shares. See
Underwriters.
(continued from bottom of previous page)
The Trust will pay offering expenses of the Trust (other than the sales load) up to an aggregate of
$ per share of the Trusts common shares sold in this offering, which expenses may include a
reimbursement of Highlands 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 Trusts 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). Estimated offering expenses includes the estimated offering expenses of the preferred
share offering that is expected to occur soon after the completion of this offering.
Proceeds to the Trust are calculated after total of other expense of issuance and distribution.
ii
TABLE OF CONTENTS
|
|
|
|
|
|
|
|
1 |
|
|
|
|
15 |
|
|
|
|
17 |
|
|
|
|
17 |
|
|
|
|
17 |
|
|
|
|
29 |
|
|
|
|
42 |
|
|
|
|
44 |
|
|
|
|
44 |
|
|
|
|
45 |
|
|
|
|
46 |
|
|
|
|
48 |
|
|
|
|
49 |
|
|
|
|
50 |
|
|
|
|
50 |
|
|
|
|
51 |
|
|
|
|
53 |
|
|
|
|
53 |
|
|
|
|
53 |
|
|
|
|
54 |
|
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. The information contained
in this prospectus is accurate only as of the date of this prospectus, regardless of the time of
delivery of this prospectus or of any sale of common shares. The Trust will amend this prospectus
if, during the period that this prospectus is required to be delivered, there are any subsequent
material changes.
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 delivery obligation is in addition to the dealers
obligation to deliver a prospectus when acting as underwriters and with respect to their unsold
allotments or subscriptions.
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 Morgan Stanley & Co. Incorporated. 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, if any. Highland has agreed to pay (i) all organizational expenses and (ii)
offering expenses (other than sales load) that exceed $ per common share. See
Underwriters.
Investment Objectives
The Trusts investment objective is to provide both high income and capital appreciation. 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, mortgage-backed and other asset-backed securities, collateralized
loan and collateralized bond obligations and other debt obligations; and (iii) debt obligations of
distressed and bankrupt issuers, and the Trust may also invest in these categories of obligations
through the use of derivatives. Highland will seek to achieve the capital appreciation component
of this objective by investing in category (iii) obligations, and to a lesser extent, in category
(i) obligations. Under normal market conditions, at least 80% of the Trusts Assets will be
invested in one or more of these principal investment categories. Subject only to this general
guideline, the Investment Adviser, has broad discretion to allocate the Trusts assets among these
investment categories and to change allocations as conditions warrant, and the Investment Adviser
has full discretion regarding the capital markets from which it can access investment
opportunities. A significant portion of the Trusts assets may be invested in securities rated
below investment grade, which are commonly referred to as junk securities. The Investment
Adviser does not anticipate a high correlation between the performance of the Trusts portfolio and
the performance of the corporate bond and equity markets. The investment objective may be changed
without shareholder approval. There can be no assurance that the Trusts investment objectives
will be achieved. See The Trusts InvestmentsInvestment Objectives and Policies.
Investment Policies and Strategies
Under normal market conditions, the Investment Adviser will employ, on behalf of the Trust,
investment strategies across various markets in which the Investment Adviser holds significant
investment experience: primarily the leveraged loan, high yield, structured products and
distressed markets. Highland makes investment decisions based on quantitative analysis, which
employs sophisticated, data-intensive models to drive the investment process. The Investment
Adviser has full discretion regarding the capital markets from which it can access investment
opportunities.
The Investment Adviser looks to implement selected trading strategies to exploit pricing
inefficiencies across the credit markets, or debt markets, and within an individual issuers
capital structure. The Trust seeks to vary its investments by strategy, industry, security type
and credit market, but reserves the right to re-position its portfolio among these criteria
depending on market dynamics, and thus the Investment Adviser anticipates that the Trust will
experience high portfolio turnover. The Investment Adviser 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
Adviser to assess what it considers to be the best opportunities across multiple markets and to
adjust quickly the Trusts trading strategies and market focus to changing conditions. The
Investment Adviser intends to focus primarily on the U.S. marketplace, but may pursue opportunities
in the non-U.S. credit markets by investing up to 20% of the Trusts assets in non-U.S. credit
market investments.
The Investment Adviser believes that the Trust will benefit from Highlands industry-focused
investment staff and specialist trading skills as well as its years of investment experience (since
1993) in leveraged loan, high yield, structured
products and distressed markets. In finding opportunities, the Investment Adviser looks to
utilize its investment staff of approximately sixty (60) credit investment professionals who
actively monitor approximately 1,200 companies. Their monitoring of the market and existing
positions assists the Investment Adviser in obtaining timely and high-quality information on
prospective investments. Additionally, the Investment Adviser has senior professionals that focus
on individual credit markets, such as the distressed or structured products segments. This broad
staff of industry, product and market specialists differentiates the Investment Adviser from
numerous other funds other investment advisers that rely on a limited number of investment
professionals working in a more generalist capacity. The Investment Adviser believes that credit
investing is a due-diligence intensive process that requires long-term committed resources to
industry, product and market specialization so that investment decisions are proactive as opposed
to reactive in nature.
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; however, no more than 20% of the Trusts Assets will be invested
in equity securities (or derivatives thereof). 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 the
issuance of preferred shares, borrowing from a credit facility or both, and the Trust may invest in
the securities of companies whose capital structures are highly leveraged.
From time to time, the Investment Adviser may also invest a portion of the Trusts 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 Adviser believes that a defensive position is appropriate because of the outlook for
security prices or in order to respond to adverse market, economic, business or political
conditions. From time to time cash balances in the Trusts brokerage account may be placed in a
money market fund. See The Trusts Investments Investment Objectives and Policies and The
Trusts Investments Investment Philosophy.
Investment Adviser and Administrator
Highland is the investment adviser and administrator. As of , 2006, Highland managed
approximately $ billion in debt securities on behalf of institutional investors and retail
clients around the world. In return for its advisory services, the Investment Adviser will receive
an annual fee, payable monthly, in an amount equal to % of the average weekly value of the
Trusts Managed Assets (the Advisory Fee). In return for its administration services, Highland
will receive an annual fee, payable monthly, in an amount equal to % of the average weekly value
of Managed Assets. The Trusts Managed Assets means the total assets of the Trust, including any
form of investment leverage, minus all accrued expenses incurred in the normal course of
operations, but not excluding any liabilities or obligations attributable to investment leverage
obtained through (i) indebtedness of any type (including, without limitation, borrowing through a
credit facility or the issuance debt securities), (ii) the issuance of preferred stock or other
similar preference securities, (iii) the reinvestment of collateral received for securities loaned
in accordance with the Trusts investment objectives and policies, and/or (iv) any other means.
Highland, at its own expense, has the authority to engage both a sub-adviser and a
sub-administrator, each of which may be affiliates of Highland. See Management of the Trust
Investment Adviser and Management of the Trust Administrator/Sub-Administrator.
Preferred Shares and Borrowings
The Trust intends to use leverage through the issuance of preferred shares of beneficial
interest (Preferred Shares) and borrowings in an aggregate amount of up to % of the Trusts
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 six 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
2
value of
the common shares estimated to be $ per common share. 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
Trusts 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 Trusts leveraging strategy may not
be successful. See Principal Risks of the Trust Leverage Risk.
Distributions
Commencing with the Trusts initial dividend, the Trust intends to make regular monthly cash
dividends of all or a portion of its investment company taxable income to common shareholders. We
expect to declare the initial monthly dividend on the Trusts 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. The Trust intends to pay any capital gain
distributions annually.
Various factors will affect the level of the Trusts current income and current gains, such as
its asset mix. To permit the Trust to maintain more stable monthly dividends and annual
distributions, the Trust may from time to time distribute less than the entire amount of income and
gains earned in the relevant month or year, respectively. The undistributed income and gains would
be available to supplement future distributions. As a result, the distributions paid by the Trust
for any particular period may be more or less than the amount of income and gains actually earned
by the Trust during the applicable period. Undistributed income and gains will add to the Trusts
net asset value and, correspondingly, distributions from undistributed income and gains and from
capital, if any, will be deducted from the Trusts 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 Trusts
Dividend Reinvestment Plan unless an election is made to receive cash. Each participant in the
Trusts Dividend Reinvestment Plan will pay a pro rata portion of brokerage commissions incurred in
connection with open market purchases, and participants requesting a sale of securities through the
plan agent of the Trusts Dividend Reinvestment Plan are subject to a sales fee and a brokerage
commission. See Dividend Reinvestment Plan and Distributions.
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 Trusts 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. The Trust cannot assure you that its common shares will trade at a price higher
than or equal to net asset value. The Trusts 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 Trusts 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 Capital Structure and Repurchase of Common Shares in the Statement of Additional
Information. 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.
3
Principal Risks of the Trust
The following is a summary of some of the risks associated with an investment in the Trusts
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 Trusts common
shares.
No Operating History. Because the Trust is newly organized, the Trust is a non-diversified,
closed-end management investment company with no operating history.
Investment and Market Discount Risk. An investment in the Trusts 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 Trusts 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 (estimated to be an additional %). 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 Trusts 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.
Risks of Non-Diversification, Concentration and Other Focused Strategies. While the
Investment Adviser will invest in a number of fixed-income and equity instruments issued by
different issuers and plans to employ multiple investment strategies with respect to the Trusts
portfolio, it is possible that a significant amount of the Trusts investments could be invested in
the instruments of only a few companies or other issuers or that at any particular point in time
one investment strategy could be more heavily weighted than the others. The focus of the Trusts
portfolio in any one issuer would subject the Trust to a greater degree of risk with respect to
defaults by such issuer or other adverse events affecting that issuer, and the concentration of the
portfolio in any one industry or group of industries would subject the Trust to a greater degree of
risk with respect to economic downturns relating to such industry. The focus of the Trusts
portfolio in any one investment strategy would subject the Trust to a greater degree of risk than
if the Trusts portfolio were varied in its investments 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 reflect the
Investment Advisers 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 Trusts 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. There is no limit on the amount of the Trusts portfolio
that can be invested in illiquid securities.
Risks of Investing in Senior Loans. Bank loans are typically at the most senior level of the
capital structure, and are sometimes 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. 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
borrowers 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 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.
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
4
can be more restricted than those of the assigning institution, and, in any event, the Trust
may not be able unilaterally to enforce all rights and remedies under the loan and any associated
collateral. 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, the limited universe of eligible purchasers 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.
Risks of Investing in Obligations of Distressed and Bankrupt Issuers. 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. There is no limit on the amount of the
Trusts portfolio that can be invested in distressed or bankrupt issuers, and the Trust may invest
for purposes of control. 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, a bankruptcy filing by 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 creditors 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 debtors 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 Trusts 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 Trusts 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 Trusts 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 Advisers active management style may present
a greater risk
5
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 Adviser 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 Trusts 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
Trusts ability to trade in or acquire additional positions in a particular investment when it
might otherwise desire to do so.
Risks of Investing in High-Yield Securities. A portion of the Trusts investments will
consist of investments that may generally be characterized as high-yield securities or junk
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 issuers
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 and are unlikely to be secured by collateral.
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
6
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 such a recipient or transferee only to the extent that such court has
jurisdiction over such recipient or transferee or its assets. Moreover, it is likely that
avoidable payments could not be recaptured directly from any such recipient or transferee that has
given value in exchange for its note, in good faith and without knowledge that the payments were
avoidable. Although the Investment Adviser will seek to avoid conduct that would form the basis
for a successful cause of action based upon fraudulent conveyance, preference or equitable
subordination, these determinations are made in hindsight, and, in any event, there can be no
assurance as to whether any lending institution or other investor from which the Trust 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 Trust.
Risks of Investing in 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 difficult. Further, the Investment Adviser 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 Advisers analysis will produce conclusions that lead to profitable investments.
Leverage Risk. 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.
|
|
|
|
Preferred Share Risk. Preferred Share risk is the risk associated with the issuance of
the Preferred Shares to leverage the common shares. If Preferred Shares are issued, the net
asset value and market value of the common shares will be more volatile, and the yield to
the holders of common shares will tend to fluctuate with changes in the shorter-term
dividend rates on the Preferred Shares. If the dividend rate on the Preferred Shares
approaches the net rate of return on the Trusts investment portfolio, the benefit of
leverage to the holders of the common shares would be reduced. If the dividend rate on the
Preferred Shares exceeds the net rate of return on the Trusts portfolio, the leverage will
result in a lower rate of return to the holders of common shares than if the Trust had not
issued Preferred Shares. |
|
|
|
|
|
|
In addition, the Trust will pay (and the holders of common shares will bear) all costs and
expenses relating to the issuance and ongoing maintenance of the Preferred Shares, including
higher advisory fees. Accordingly, the Trust cannot assure you that the issuance of
Preferred Shares will result in a higher yield or return to the holders of the common shares. Costs of the offering of Preferred Shares, estimated to be approximately % of the
total dollar amount of the Preferred Share offering, will be borne immediately by the
Trusts common shareholders and result in a reduction of net asset value of the common shares. |
|
|
|
|
|
|
Similarly, any decline in the net asset value of the Trusts investments will be borne
entirely by the holders of common shares. Therefore, if the market value of the Trusts
portfolio declines, the leverage will result in a greater decrease in net asset value to the
holders of common shares than if the Trust were not leveraged. This greater net asset value
decrease will also tend to cause a greater decline in the market price for the common shares. The Trust might be in danger of failing to maintain the required asset coverage of
the Preferred Shares or of losing its ratings on the Preferred Shares or, in an extreme
case, the Trusts current investment income might not be sufficient to meet the dividend
requirements on the Preferred Shares. In order to counteract such an event, the Trust might
need to liquidate investments in order to fund a redemption of some or all of the Preferred
Shares. Liquidation at times of low municipal bond prices may result in capital loss and may
reduce returns to the holders of common shares. |
|
7
|
|
|
|
Preferred Shareholders may have Disproportionate Influence Over the Trust. If Preferred
Shares are issued, holders or Preferred Shares may have differing interests than holders of
common shares and holders of Preferred Shares may at times have disproportionate influence
over the Trusts affairs. If Preferred Shares are issued, holders of Preferred Shares,
voting separately as a single class, would have the right to elect two members of the board
of trustees at all times. The remaining members of the board of trustees would be elected
by holders of common shares and Preferred Shares, voting as a single class. The Investment
Company Act of 1940 (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 (i) adopt any plan of reorganization that would adversely affect the Preferred
Shares and (ii) 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 Trusts
subclassification as a closed-end investment company or changes in its fundamental
investment restrictions. |
|
|
|
|
|
|
Portfolio Guidelines of Rating Agencies for Preferred Share and/or Credit Facility. In
order to obtain and maintain the required ratings or loans from a credit facility, the
Trust will be required to comply with investment quality, diversification and other
guidelines established by Moodys and/or S&P or the credit facility, respectively. Such
guidelines will likely be more restrictive than the restrictions otherwise applicable to
the Trust as described in this prospectus or in the Statement of Additional Information.
The Trust does not anticipate that such guidelines would have a material adverse effect on
the Trusts 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 Moodys (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. Moodys and S&P receive fees in connection with their ratings
issuances. |
|
|
|
|
|
|
Credit Facility. In the event the Trust leverages through borrowings, the Trust may
enter into definitive agreements with respect to a credit facility. The Trust may negotiate
with commercial banks to arrange a credit facility pursuant to which the Trust would be
entitled to borrow an amount equal to approximately one-third of the Trusts total assets
(inclusive of the amount borrowed) offered hereby. Any such borrowings would constitute
financial leverage. Such a facility is not expected to be convertible into any other
securities of the Trust. Any outstanding amounts are expected to be prepayable by the Trust prior to final maturity without significant penalty, and there are not expected to be
any sinking fund or mandatory retirement provisions. Outstanding amounts would be payable
at maturity or such earlier times as required by the agreement. The Trust may be required
to prepay outstanding amounts under the facility or incur a penalty rate of interest in the
event of the occurrence of certain events of default. The Trust would be expected to
indemnify the lenders under the facility against liabilities they may incur in connection
with the facility. The Trust may be required to pay commitment fees under the terms of any
such facility. With the use of borrowings, there is a risk that the
interest rates paid by the Trust on the amount it borrows will be
higher than the return on the Trusts investments. |
|
|
|
|
|
|
In addition, the Trust expects that such a credit facility would contain covenants that,
among other things, likely will limit the Trusts ability to: (i) pay dividends in certain
circumstances, (ii) incur additional debt and (iii) change its fundamental investment
policies and engage in certain transactions, including mergers and consolidations. In
addition, it may contain a covenant requiring asset coverage ratios in addition to those
required by the Investment Company Act. The Trust may be required to pledge its assets and
to maintain a portion of its assets in cash or high-grade securities as a reserve against
interest or principal payments and expenses. The Trust expects that any credit facility
would have customary covenant, negative covenant and default provisions. There can be no
assurance that the Trust will enter into an agreement for a credit facility on terms and
conditions representative of the foregoing or that additional material terms will not apply.
In addition, if entered into, any such credit facility may in the future be replaced or
refinanced by one or more credit facilities having substantially different terms or by the
issuance of Preferred Shares. |
|
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 debt securities. Therefore, the
Trusts exposure to common stocks could result in worse performance than would be the case had the
Trust been invested solely in debt 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.
8
Dividend Risk. Dividends on common stock are not fixed but are declared at the discretion of
an issuers 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 Trusts distributions will constitute
qualified dividend income. See Principal Risks of the TrustDividend Risk.
Small and Mid-Cap Securities Risk. The Trust may invest in companies with small or medium
capitalizations. Securities issued by smaller and medium companies can be more volatile than, and
perform differently from, larger company securities. There may be less trading in a smaller or
medium companys securities, which means that buy and sell transactions in those securities could
have a larger impact on the securitys price than is the case with larger company securities.
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 companys security price than is the
case for a larger company. In addition, smaller or medium company securities may not be well known
to the investing public.
Non-U.S. Securities Risk. The Trust may invest up to 20% of its total assets in non-U.S.
securities. Investing in non-U.S. securities involves certain risks not involved in domestic
investments, including, but not limited to: (i) fluctuations in foreign exchange rates; (ii) future
foreign economic, financial, political and social developments; (iii) different legal systems; (iv)
the possible imposition of exchange controls or other foreign governmental laws or restrictions;
(v) lower trading volume; (vi) much greater price volatility and illiquidity of certain non-U.S.
securities markets; (vii) different trading and settlement practices; (viii) less governmental
supervision; (ix) changes in currency exchange rates; (x) high and volatile rates of inflation;
(xi) fluctuating interest rates; (xii) less publicly available information; and (xiii) different
accounting, auditing and financial recordkeeping standards and requirements.
Certain countries in which the Trust may invest, especially emerging market countries,
historically have experienced, and may continue to experience, high rates of inflation, high
interest rates, exchange rate fluctuations, large amounts of external debt, balance of payments and
trade difficulties and extreme poverty and unemployment. Many of these countries are also
characterized by political uncertainty and instability. These risks are especially evident in the
Middle East and West Africa. The cost of servicing external debt will generally be adversely
affected by rising international interest rates because many external debt obligations bear
interest at rates which are adjusted based upon international interest rates. In addition, with
respect to certain foreign countries, there is a risk of: (i) the possibility of expropriation or
nationalization of assets; (ii) confiscatory taxation; (iii) difficulty in obtaining or enforcing a
court judgment; (iv) economic, political or social instability; and (v) diplomatic developments
that could affect investments in those countries.
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 in the
Trust and the unrealized appreciation or depreciation of investments. Currencies of certain
countries may be volatile and therefore may affect the value of securities denominated in such
currencies, which means that the Trusts net asset value or current income could decline as a
result of changes in the exchange rates between foreign currencies and the U.S. dollar. Certain
investments in non-U.S. securities also may be subject to foreign withholding taxes. Dividend
income from non-U.S. corporations may not be eligible for the reduced rate for qualified dividend
income. These risks often are heightened for investments in smaller, emerging capital markets. In
addition, individual foreign economies may differ favorably or unfavorably from the U.S. economy in
such respects as: (i) growth of gross domestic product; (ii) rates of inflation; (iii) capital
reinvestment; (iv) resources; (v) self-sufficiency; and (vi) balance of payments position.
As a result of these potential risks, Highland may determine that, notwithstanding otherwise
favorable investment criteria, it may not be practicable or appropriate to invest in a particular
country. The Trust may invest in countries in which foreign investors, including Highland, have
had no or limited prior experience.
Emerging Markets Risk. The Trust may invest up to 20% of its total assets in securities of
issuers based in emerging markets. 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 Trusts 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
9
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 Trusts 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.
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 Trusts 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 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.
Securities Lending Risk. The Trust may lend its portfolio securities (up to a maximum of
one-third of its total assets) 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 Trusts 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 foregoes, during the options 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 Trusts 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.
Exchange-Listed Option Risks. There can be no assurance that a liquid market will exist when
the Trust seeks to close out an option position on an options exchange. Reasons for the absence of
a liquid secondary market on an exchange include the following: (i) there may be insufficient
trading interest in certain options; (ii) restrictions may be imposed by an exchange on opening
transactions or closing transactions or both; (iii) trading halts, suspensions or other
restrictions may be imposed with respect to particular classes or series of options; (iv) unusual
or unforeseen circumstances may interrupt normal operations on an exchange; (v) the facilities of
an exchange or the Options Clearing Corporation may not at all times be
10
adequate to handle current trading volume; or (vi) one or more exchanges could, for economic
or other reasons, decide or be compelled at some future date to discontinue the trading of options
(or a particular class or series of options). If trading were discontinued, the secondary market
on that exchange (or in that class or series of options) would cease to exist. However,
outstanding options on that exchange that had been issued by the Options Clearing Corporation as a
result of trades on that exchange would continue to be exercisable in accordance with their terms.
If the Trust were unable to close out a covered call option that it had written on a security, it
would not be able to sell the underlying security unless the option expired without exercise.
The hours of trading for options on an exchange may not conform to the hours during which the
underlying securities are traded. To the extent that the options markets close before the markets
for the underlying securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the options markets. Call options are marked to
market daily and their value will be affected by changes in the value and dividend rates of the
underlying common stocks, an increase in interest rates, changes in the actual or perceived
volatility of the stock market and the underlying common stocks and the remaining time to the
options expiration. Additionally, the exercise price of an option may be adjusted downward before
the options expiration as a result of the occurrence of certain corporate events affecting the
underlying equity security, such as extraordinary dividends, stock splits, merger or other
extraordinary distributions or events. A reduction in the exercise price of an option would reduce
the Trusts capital appreciation potential on the underlying security.
Over-the-Counter Option Risk. The Trust may write (sell) unlisted (OTC or
over-the-counter) options, and options written by the Trust with respect to non-U.S. securities,
indices or sectors generally will be OTC options. OTC options differ from exchange-listed options
in that they are two-party contracts, with exercise price, premium and other terms negotiated
between buyer and seller, and generally do not have as much market liquidity as exchange-listed
options. The counterparties to these transactions typically will be major international banks,
broker-dealers and financial institutions. The Trust may be required to treat as illiquid
securities being used to cover certain written OTC options. The OTC options written by the Trust
will not be issued, guaranteed or cleared by the Options Clearing Corporation. In addition, the
Trusts ability to terminate the OTC options may be more limited than with exchange-traded options.
Banks, broker-dealers or other financial institutions participating in such transaction may fail
to settle a transaction in accordance with the terms of the option as written. In the event of
default or insolvency of the counterparty, the Trust may be unable to liquidate an OTC option
position.
Index Option Risk. The Trust may sell index put and call options from time to time. The
purchaser of an index put option has the right to any depreciation in the value of the index below
the exercise price of the option on or before the expiration date. The purchaser of an index call
option has the right to any appreciation in the value of the index over the exercise price of the
option on or before the expiration date. Because the exercise of an index option is settled in
cash, sellers of index call options, such as the Trust, cannot provide in advance for their
potential settlement obligations by acquiring and holding the underlying securities. The Trust
will lose money if it is required to pay the purchaser of an index option the difference between
the cash value of the index on which the option was written and the exercise price and such
difference is greater than the premium received by the Trust for writing the option. The value of
index options written by the Trust, which will be priced daily, will be affected by changes in the
value and dividend rates of the underlying common stocks in the respective index, changes in the
actual or perceived volatility of the stock market and the remaining time to the options
expiration. The value of the index options also may be adversely affected if the market for the
index options becomes less liquid or smaller. Distributions paid by the Trust on its common shares
may be derived in part from the net index option premiums it receives from selling index put and
call options, less the cost of paying settlement amounts to purchasers of the options that exercise
their options. Net index option premiums can vary widely over the short term and long term.
Interest Rate Risk. Interest rate risk is the risk that debt securities, and the Trusts net
assets, may 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 Trusts 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
Trusts income and distributions to shareholders. The Trust may invest in pools of mortgages or
other assets issued or guaranteed by private issuers or U.S. government agencies and
instrumentalities. Mortgage-related securities are especially sensitive to prepayment risk because
borrowers often refinance their mortgages when interest rates drop.
Non-Investment Grade Securities Risk. There is no limit on the amount of the Trusts
portfolio that may be invested in below investment grade securities. Non-investment grade
securities are commonly referred to as junk securities. 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
11
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 Trusts net
asset value.
Derivatives Risk. Derivative transactions in which the Trust may engage for hedging and
speculative 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 (Derivative Transactions), also involve certain risks and special considerations.
Derivative 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
Derivative Transactions depends on the Investment Advisers ability to predict pertinent market
movements, which cannot be assured. Thus, the use of Derivative 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
Trusts 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 Derivative 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 Trusts 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 Adviser 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. 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 bonds
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 bond in which it can realize a coupon rate of 5%, but the rate of inflation increases
from 2% to 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
12
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 Adviser will be able to hedge the Trusts portfolio in the manner necessary to
employ successfully the Trusts strategy
Short Sales Risk. 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. There can be no assurance that the securities necessary to cover a short
position will be available for purchase. 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.
Risks of Investing in Structured Finance Securities. A portion of the Trusts 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 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.
Risks of Investing in Preferred Securities. There are special risks associated with investing
in preferred securities, including:
|
|
|
|
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. |
|
|
|
|
|
|
Subordination. Preferred securities are subordinated to bonds and other debt
instruments in a companys 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. |
|
|
|
|
|
|
Liquidity. Preferred securities may be substantially less liquid than many other
securities, such as common stocks or U.S. government securities. |
|
|
|
|
|
|
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 issuers board. Generally, once all the arrearages have been
paid, the preferred security holders no longer have voting rights. |
|
Risks of Investing in 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, an overabundance 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 Adviser may 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
13
obligation upon which the synthetic security is based. A Reference Obligor is the obligor
on a Reference Obligation. There is no maximum amount of Trusts assets that may be invested in
these securities.
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 Adviser expects to apply to the Commission for
exemptive relief to enable the registered investment companies advised by the Investment Adviser,
including the Trust, to co-invest with other accounts and funds managed by the Investment Adviser
and its affiliates in certain privately placed securities and other situations. There are no
assurances that the Investment Adviser will receive the requested relief. If such relief is not
obtained and until it is obtained, the Investment Adviser 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 Investment Adviser 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.
Risks of Investing in a Trust with Anti-Takeover Provisions. The Trusts 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.
14
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 in an amount equal to % of the
Trusts Managed Assets:
|
|
|
|
|
|
|
Percentage of |
|
|
Offering |
|
|
Price |
Shareholder Transaction Expenses |
|
|
|
|
Sales load paid by you |
|
|
% |
|
Offering expenses borne by the Trust |
|
|
% |
(1) |
Dividend reinvestment and cash purchase plan fees |
|
None (2) |
Preferred Share offering expense borne by the Trust |
|
|
|
|
|
|
|
|
|
|
|
Percentage of Net Assets |
|
|
Attributable to Common Shares |
|
|
(assumes Preferred Shares are |
|
|
issued) (3) |
Annual Expenses |
|
|
|
|
Management fee |
|
|
% |
|
Interest payments on borrowed funds |
|
|
% |
|
Other expenses (including cost of Preferred Shares) |
|
|
% |
(4) |
Total annual expenses |
|
|
% |
|
Dividends on Preferred Shares |
|
|
% |
|
Total annual expenses and dividends on Preferred Shares |
|
|
% |
|
The purpose of the table above and 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 Trusts 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 Trusts net assets attributable to common shares, would increase.
See Management of the Trust and Dividend Reinvestment Plan.
EXAMPLE
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 Trusts Managed Assets
(after their issuance) of $) that you would pay on a $1,000 investment in common shares, assuming
(1) total annual expenses (which excludes dividends on Preferred Shares) plus cost of servicing
Preferred Shares of % of net assets attributable to common shares and (2) a 5% annual
return:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Example |
|
1 Year |
|
|
3 Years |
|
|
5 Years |
|
|
10 Years |
|
|
Total expenses incurred |
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
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, all dividends and distributions are reinvested at
net asset value, and reflects all recurring and nonrecurring fees including underwriting discounts
and commissions. Actual expenses may be greater or less than those assumed. Moreover, the Trusts
actual rate of return may be greater or less than the hypothetical 5% return shown in the example.
|
|
|
|
(1) |
|
The Trust will pay offering expenses of the Trust (other than the sales load) up to an aggregate of
$ per share of the Trusts common shares sold in this offering. These offering expenses will
include reimbursement by the Trust of Highlands expenses incurred in connection with this
offering, other than the marketing and structuring fee paid by Highland to Morgan Stanley & Co.
Incorporated, as described in Underwriters. To the extent that the offering expenses of the
Trust (other than the sales load) exceed $ per share of the Trusts common shares sold in this
offering, Highland has agreed to pay the excess. |
|
|
|
(2) |
|
Common shareholders will be charged a
$ service
charge and a brokerage commission of $
per share sold if they direct the Plan Agent (as defined below) to sell common shares held in
a dividend reinvestment account. Each participant in the Trusts Dividend Reinvestment Plan
will pay a pro rata share of brokerage commissions incurred when dividend reinvestment occurs
in open-market purchases because the net asset value per common share is greater than the
market value per common share. |
|
|
|
(3) |
|
The table presented below in this footnote estimates the Trusts annual expenses stated as
percentages of the Trusts 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. |
|
15
|
|
|
|
|
|
This will be the case, for instance, prior to the Trusts expected issuance of Preferred Shares.
Footnotes used in the table below correspond to the footnotes appearing above this footnote (3).
In accordance with these assumptions, the Trusts expenses would be estimated to be as follows: |
|
|
|
|
|
|
|
|
Percentage of Net Assets Attributable to |
|
|
|
Common Shares (assumes Preferred |
|
|
|
Shares are not issued) |
|
Annual Expenses |
|
|
|
|
|
|
Management fee |
|
|
% |
|
|
|
|
|
Interest payments on borrowed funds |
|
|
% |
|
|
|
|
|
Other expenses |
|
|
% |
(4) |
|
|
|
|
Total annual expenses |
|
|
% |
|
|
|
|
|
|
(4) |
|
Other Expenses includes costs associated with the Trusts short sales on securities. 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 Trusts 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 Trusts capital (after their issuance), these offering costs are
estimated to be approximately $ . These offering costs are not included among
the expenses shown in this table. |
|
Highland will pay Morgan Stanley & Co. Incorporated a marketing and structuring fee in
connection with this public offering of common shares. See Underwriters.
16
THE TRUST
The Trust is a newly organized, non-diversified, closed-end management investment company
registered under 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
Trusts 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 deducting the underwriting
discounts and commissions and estimated organization and offering costs and including reimbursement
of approximately $ of organizational and offering expenses to the underwriters and
Highland. The Trust will invest the net proceeds of this offering in accordance with the Trusts
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 Trusts
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 TRUSTS INVESTMENTS
Investment Objectives and Policies
The Trusts investment objective is to provide both high income and capital appreciation. 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, mortgage-backed and other asset-backed securities, collateralized
loan and collateralized bond obligations and other debt obligations; and (iii) debt obligations of
distressed and bankrupt issuers, and the Trust may also invest in these categories of obligations
through the use of derivatives. Highland will seek to achieve the capital appreciation component
of this objective by investing in category (iii) obligations, and to a lesser extent, in category
(i) obligations. Under normal market conditions, at least 80% of the Trusts Assets will be
invested in one or more of these principal investment categories. Subject only to this general
guideline, the Trusts Investment Adviser, has broad discretion to allocate the Trusts assets
among these investment categories and to change allocations as conditions warrant, and the
Investment Adviser has full discretion regarding the capital markets from which it can access
investment opportunities. A significant portion of the Trusts assets may be invested in
securities rated below investment grade, which are commonly referred to as junk securities. The
Investment Adviser does not anticipate a high correlation between the performance of the Trusts
portfolio and the performance of the corporate bond and equity markets. The investment objective
may be changed without shareholder approval. There can be no assurance that the Trusts investment
objectives will be achieved.
The Investment Adviser will select investments from a wide range of trading strategies and
credit markets in order to vary the Trusts investments and to optimize the risk-reward parameters
of the Trust. Highland does not intend to invest the Trusts 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
Adviser 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; however, no more than 20% of the Trusts Assets will be invested
in equity securities (or derivatives thereof). Investments may include investments in distressed
positions, which may include publicly-traded debt and equity securities, obligations that 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.
17
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 derivative 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 or borrowing
from a credit facility, and the Trust may invest in the securities of companies whose capital
structures are highly leveraged.
From time to time, the Investment Adviser may also invest a portion of the Trusts 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 Adviser 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
Trusts brokerage account may be placed in a money-market fund.
For a more complete discussion of the Trusts portfolio composition, see Portfolio
Composition below.
Investment Philosophy
Under normal market conditions, the Investment Adviser will employ, on behalf of the Trust,
investment strategies across various markets in which the Investment Adviser holds significant
investment experience: primarily the leveraged loan, high yield, structured products, and
distressed markets. Highland makes investment decisions based on quantitative analysis, which
employs sophisticated, data-intensive models to drive the investment process. The Investment
Adviser has full discretion regarding the capital markets from which it can access investment
opportunities.
The Investment Adviser looks to implement selected trading strategies to exploit pricing
inefficiencies across the credit markets and within an individual issuers capital structure. The
Trust seeks to vary its investments by strategy, industry, security type and credit market, but
reserves the right to re-position its portfolio among these criteria depending on market dynamics,
and thus the Investment Adviser anticipates that the Trust will experience high portfolio turnover.
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
Adviser to assess what it considers to be the best opportunities across multiple markets and to
adjust quickly the Trusts trading strategies and market focus to changing conditions. The
Investment Adviser intends to focus primarily on the U.S. marketplace, but may pursue opportunities
in the non-U.S. credit markets by investing up to 20% of the Trusts assets in non-U.S. credit
market investments.
The Investment Adviser believes that the Trust will benefit from Highlands industry-focused
investment staff and specialist trading skills as well as its years of investment experience (since
1993) in leveraged loan, high yield, structured products and distressed markets. In finding
opportunities, the Investment Adviser looks to utilize its investment staff of approximately sixty
(60) credit investment professionals who actively monitor approximately 1,200 companies. Their
monitoring of the market and existing positions assists the Investment Adviser in obtaining timely
and high-quality information on prospective investments. Additionally, the Investment Adviser has
senior professionals that focus on individual credit markets, such as the distressed or structured
products segments. This broad staff of industry, product and market specialists differentiates the
Investment Adviser from numerous other funds other investment advisers that rely on a limited
number of investment professionals working in a more generalist capacity. The Investment Adviser
believes that credit investing is a due-diligence intensive process that requires long-term
committed resources to industry, product and market specialization so that investment decisions are
proactive as opposed to reactive in nature.
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, mortgage-backed and other asset-backed securities,
collateralized loan and collateralized bond obligations and other debt obligations; and (iii) debt
obligations of distressed and bankrupt issuers, and the Trust may also invest in these categories
of obligations through the use of derivatives. Highland will seek to achieve the capital
appreciation component of this objective by investing in category (iii) obligations, and to a
lesser extent, in category (i) obligations.
Under normal market conditions, at least 80% of the Trusts Assets will be invested in one or
more of these principal investment categories. Subject only to this general guideline, the
Investment Adviser has broad discretion to allocate the Trusts assets among these investment
categories and to change allocations over time as conditions warrant, and the Investment Adviser
has full discretion regarding the capital markets from which it can access investment
opportunities. In
18
order to pursue most effectively 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 domestic issuers, but may invest only up to 20% of the assets in non-U.S. obligors.
From time to time, the Investment Adviser may also invest a portion of the Trusts 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 Adviser believes that a defensive position is appropriate because of the outlook for
security prices or in order to respond to adverse market, economic, business or political
conditions. From time to time cash balances in the Trusts brokerage account may be placed in a
money market fund.
The Trusts portfolio will be composed principally of the following investments. Additional
information relating to the Trusts investment policies and restrictions and the Trusts portfolio
investments is contained in the Statement of Additional Information.
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 Trusts 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 borrowers 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 Trusts performance. To
the extent a senior loan is subordinated in the capital structure, it will have characteristics
similar to other subordinated debtholders, including a greater risk of nonpayment of interest or
principal.
Many loans in which the Investment Adviser anticipates the Trust will invest, and the issuers
of such loan, 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 Adviser will
consider, and may rely in part, on analyses performed by others. The Investment Adviser 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, if at all, 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
Moodys 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 Moodys and S&P is included as Appendix A to the Statement of
Additional Information. Because senior
19
loans are senior in a borrowers capital structure and are often secured by specific
collateral, the Investment Adviser 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 Trusts actual loss recovery experience will be consistent with the
Investment Advisers prior experience or that the Trusts senior loans will achieve any specific
loss recovery rates.
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 Trusts net asset value.
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 agents 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 persons or entitys bankruptcy estate. If, however, any such amount were included in such
persons or entitys 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 Trusts 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
Adviser 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
lenders 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, 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
20
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 Adviser 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 Trusts
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 multiple different
investments within the portfolio and ongoing analysis and monitoring of borrowers. The Trust also
is subject to market, liquidity, interest rate and other risks. See Principal Risks of the
Trust.
Investment Grade Bonds
The Trust may invest in a wide variety of bonds that are rated or determined by the Investment
Adviser 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 still subject to
market and credit risk. Market risk relates to changes in a securitys 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 Moodys or BB or lower by S&P or are unrated but
determined by the Investment Adviser to be of comparable quality. Debt securities rated below
investment grade are commonly referred to as junk securities and are considered speculative with
respect to the issuers 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 Trusts 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 Trusts 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.
21
Non-Investment Grade Securities
The Trust may invest in securities rated below investment grade, such as those rated Ba or
lower by Moodys Investors Service, Inc. (Moodys) and BB or lower by Standard & Poors 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 Moodys 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
Trusts 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 Trusts 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 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 Trusts
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 Moodys, 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 Trusts ability to achieve its investment objectives will be
more dependent on Highlands credit analysis than would be the case when the Trust invests in rated
securities.
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.
22
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.
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.
The Trust may invest in securities of a company for purposes of gaining control.
Credit Default Swaps
To the extent consistent with Subchapter M of the Internal Revenue Code of 1986, as amended
(the Code), 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 Adviser to be equivalent to such rating. A buyer
also will lose its investment and recover nothing should
23
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 Principal Risks of the Trust Leverage Risk 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 Adviser 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 and to vary
its portfolio. 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 in various ways, including upon the default
of a senior loan secured by such common stock or by acquiring common stock for investment. The
Trust may also acquire warrants or other rights to purchase a borrowers 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 entitys
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 securitys dividend paying capacity rather than
on its potential for capital appreciation.
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 issuers common shares. However, because preferred shares
are equity securities, they may be more susceptible to risks traditionally associated with equity
investments than the Trusts 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
24
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 stocks
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 Trusts 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 issuers 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 Loan Banks; (ii) the discretionary
authority of the U.S. government to purchase the agencys 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 Trusts 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 Trusts 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 Trusts 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.
25
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 ETFs 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 ETFs expenses, including advisory fees. These expenses are in addition to the
direct expenses of the Trusts 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 Trusts distribution obligations, in which case the Trust will forego the purchase of
additional income producing assets with these funds.
Derivative 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 Derivative Transactions described below to earn
income, facilitate portfolio management and mitigate risks. Such Derivative Transactions are
generally accepted under modern portfolio management and are regularly used by many mutual funds
and other institutional investors. Although the Investment Adviser seeks to use the practices to
further the Trusts investment objectives, no assurance can be given that these practices will
achieve this result. While the Trust reserves the ability to use these Derivative Transactions,
the Investment Adviser does not anticipate that Derivative Transactions other than senior loan bond
derivatives will initially be a significant part of the Trusts investment approach. With changes
in the market or the Investment Advisers strategy, it is possible that these instruments may be a
more significant part of the Trusts 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. The Trust generally seeks to use Derivative 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 Trusts
portfolio, protect the value of the Trusts 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 Trusts
portfolio, or establish positions in the derivatives markets as a temporary substitute for
purchasing or selling particular securities.
Derivative 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 Derivative Transactions depends on the Investment Advisers ability to predict
pertinent market movements, which cannot be assured. Thus, the use of Derivative Transactions may
result in losses greater
26
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 Derivative Transactions
are not otherwise available to the Trust for investment purposes.
A more complete discussion of Derivative 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 Trusts 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 Trusts
obligations over its entitlements will be maintained in a segregated account by the Trusts
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 Adviser. 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.
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.
Short Position
When the Trust takes a long position, it purchases a security outright. When the Trust takes
a short position, it sells a security it does not own at the current price and delivers to the
buyer a security that it has borrowed. To complete, or close out, the short sale transaction, the
Trust buys the same security in the market and returns it to the lender. The Trust makes money
when the market price of the security goes down after a short sale. Conversely, if the price of
the security goes up after the sale, the Trust will lose money because it will have to pay more to
replace the borrowed security that it received when it sold the security short.
Repurchase Agreements
The Trust may invest up to % of its assets in repurchase agreements. It may enter into
repurchase agreements with broker-dealers, member banks of the Federal Reserve System and other
financial institutions. Repurchase agreements are loans or 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 Trusts purchase price,
with the difference being income to the Trust. Under the direction of the board of trustees, the
Investment Adviser reviews and
27
monitors the creditworthiness of any institution which enters into a repurchase agreement with
the Trust. The counterpartys 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 Trusts 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 sellers 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 Assets
The Trust may lend up to % of its assets. It may lend assets to registered broker-dealers
or other institutional investors deemed by the Investment Adviser 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 up to 20% of its total assets 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 companys primary business office is not
in the United States; (iii) the principal trading market for such companys securities is not
located in the United States; (iv) less than 50% of such companys assets are located in the United
States; or (v) 50% or more of such issuers 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. 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
28
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 Trusts option strategy will be short-term capital gains which, for
federal income tax purposes, will constitute net investment company taxable income.
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
Trusts 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. Highlands
determination that it is temporarily unable to follow the Trusts 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 Trusts 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 Trusts 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 Trusts
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 (estimated to be an additional %). 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 Trusts 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.
Risks of Non-Diversification, Concentration and other Focused Strategies
While the Investment Adviser will invest in a number of fixed-income and equity instruments
issued by different issuers and plans to employ multiple investment strategies with respect to the
Trusts portfolio, it is possible that a significant amount of the Trusts investment could be
invested in the instruments of only a few companies or other issuers or that at any particular
point in time one investment strategy could be more heavily weighted than the others. The focus of
the Trusts portfolio in any one issuer would subject the Trust to a greater degree of risk with
respect to defaults by such issuer or other adverse events affecting that issuer, and the
concentration of the portfolio in any one industry or group of industries would subject the Trust
to a greater degree of risk with respect to economic downturns relating to such industry. The
focus of the Trusts portfolio in any one investment strategy would subject the Trust to a greater
degree of risk than if the Trusts portfolio were varied in its investments 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 reflect the Investment Advisers 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
Trusts 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.
There is no limit on the maximum percentage of the Trusts
29
portfolio that can be invested in illiquid securities. There is no limit on the amount of the
Trusts portfolio that can be invested in illiquid securities.
Risks of Investing in Senior Loans
Bank loans are typically at the most senior level of the capital structure, and are sometimes
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. 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 borrowers 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 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
below.
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, and in any event, the Trust may not be
able unilaterally to enforce all rights and remedies under the loan and any associated collateral.
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, the limited universe of eligible purchasers 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.
Risks of Obligations of Distressed and Bankrupt Issuers
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. There is no
limit on the amount of the Trusts portfolio that can be invested in distressed or bankrupt
issuers, and the Trust may invest for purposes of control. 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
30
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 creditors 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 debtors 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
Trusts 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 Trusts 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 Trusts 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 Advisers 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 Insolvency Considerations with Respect to Issuers Debt Obligations
below.
The Investment Adviser 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 Trusts 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
Trusts ability to trade in or acquire additional positions in a particular investment when it
might otherwise desire to do so.
Risks of Investing in High-Yield Securities
A portion of the Trusts investments will consist of investments that may generally be
characterized as high-yield securities, or junk 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.
31
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 issuers
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 and are unlikely to be secured by collateral.
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 such a recipient or transferee only to the extent that such court has
jurisdiction over such recipient or transferee or its assets. Moreover, it is likely that
avoidable payments could not be recaptured directly from any such recipient or transferee that has
given value in exchange for its investment, in good faith and without knowledge that the payments
were avoidable. Although the Investment Adviser will seek to avoid conduct that would form the
basis for a successful cause of action based upon fraudulent conveyance, preference or equitable
subordination, these determinations are made in hindsight, and in any event, there can be no
assurance as to whether any lending institution or other investor from which the Trust 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 Trust.
Risks of Investing in 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 difficult. Further, the Investment Adviser relies on
company management, outside experts, market participants and personal experience
32
to analyze potential investments for the Trust. There can be no assurance that any of these
sources will prove credible, or that the Investment Advisers analysis will produce conclusions
that lead to profitable investments.
Leverage Risk
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. 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.
|
|
|
|
Preferred Share Risk. Preferred Share risk is the risk associated with the issuance of
the Preferred Shares to leverage the common shares. If Preferred Shares are issued, the net
asset value and market value of the common shares will be more volatile, and the yield to
the holders of common shares will tend to fluctuate with changes in the shorter-term
dividend rates on the Preferred Shares. If the dividend rate on the Preferred Shares
approaches the net rate of return on the Trusts investment portfolio, the benefit of
leverage to the holders of the common shares would be reduced. If the dividend rate on the
Preferred Shares exceeds the net rate of return on the Trusts portfolio, the leverage will
result in a lower rate of return to the holders of common shares than if the Trust had not
issued Preferred Shares. |
|
|
|
|
|
|
In addition, the Trust will pay (and the holders of common shares will bear) all costs and
expenses relating to the issuance and ongoing maintenance of the Preferred Shares, including
higher advisory fees. Accordingly, the Trust cannot assure you that the issuance of
Preferred Shares will result in a higher yield or return to the holders of the common shares. Costs of the offering of Preferred Shares, estimated to be approximately % of the
total dollar amount of the Preferred Share offering, will be borne immediately by the Trust
common shareholders and result in a reduction of net asset value of the common shares. |
|
|
|
|
|
|
Similarly, any decline in the net asset value of the Trusts investments will be borne
entirely by the holders of common shares. Therefore, if the market value of the Trusts
portfolio declines, the leverage will result in a greater decrease in net asset value to the
holders of common shares than if the Trust were not leveraged. This greater net asset value
decrease will also tend to cause a greater decline in the market price for the common shares. The Trust might be in danger of failing to maintain the required asset coverage of
the Preferred Shares or of losing its ratings on the Preferred Shares or, in an extreme
case, the Trusts current investment income might not be sufficient to meet the dividend
requirements on the Preferred Shares. In order to counteract such an event, the Trust might
need to liquidate investments in order to fund a redemption of some or all of the Preferred
Shares. Liquidation at times of low municipal bond prices may result in capital loss and may
reduce returns to the holders of common shares. |
|
|
|
|
|
|
Preferred Shareholders may have Disproportionate Influence over the Trust. If Preferred
Shares are issued, holders or Preferred Shares may have differing interests than holders of
common shares and holders of Preferred Shares may at times have disproportionate influence
over the Trusts affairs. If Preferred Shares are issued, holders of Preferred Shares,
voting separately as a single class, would have the right to elect two members of the board
of trustees at all times. The remaining members of the board of trustees would be elected
by holders of common shares and Preferred Shares, voting as a single class. 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 (i) adopt any plan of
reorganization that would adversely affect the Preferred Shares, and (ii) 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 Trusts subclassification as a closed-end
investment company or changes in its fundamental investment restrictions. |
|
|
|
|
|
|
Portfolio Guidelines of Rating Agencies for Preferred Share and/or Credit Facility. In
order to obtain and maintain the required ratings or loans from a credit facility, the
Trust will be required to comply with investment quality, diversification and other
guidelines established by Moodys and/or S&P or the credit facility, respectively. Such
guidelines will likely be more restrictive than the restrictions otherwise applicable to
the Trust as described in this prospectus or in the Statement of Additional Information.
The Trust does not anticipate that such guidelines would have a material adverse effect on
the Trusts 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 Moodys (Aaa) or by S&P (AAA), but no assurance can be given that
such ratings will be obtained. No |
|
33
|
|
|
|
minimum rating is required for the issuance of Preferred Shares by the Trust. Moodys and
S&P receive fees in connection with their ratings issuances. |
|
|
|
|
|
|
Credit Facility. In the event the Trust leverages through borrowings, the Trust may
enter into definitive agreements with respect to a credit facility. The Trust may negotiate
with commercial banks to arrange a credit facility pursuant to which the Trust would be
entitled to borrow an amount equal to approximately one-third of the Trusts total assets
(inclusive of the amount borrowed) offered hereby. Any such borrowings would constitute
financial leverage. Such a facility is not expected to be convertible into any other
securities of the Trust. Any outstanding amounts are expected to be prepayable by the Trust prior to final maturity without significant penalty, and there are not expected to be
any sinking fund or mandatory retirement provisions. Outstanding amounts would be payable
at maturity or such earlier times as required by the agreement. The Trust may be required
to prepay outstanding amounts under the facility or incur a penalty rate of interest in the
event of the occurrence of certain events of default. The Trust would be expected to
indemnify the lenders under the facility against liabilities they may incur in connection
with the facility. The Trust may be required to pay commitment fees under the terms of any
such facility. With the use of borrowings, there is a risk that the
interest rates paid by the Trust on the amount it borrows will be
higher than the return on the Trusts investments. |
|
|
|
|
|
|
In addition, the Trust expects that such a credit facility would contain covenants that,
among other things, likely will limit the Trusts ability to: (i) pay dividends in certain
circumstances, (ii) incur additional debt and (iii) change its fundamental investment
policies and engage in certain transactions, including mergers and consolidations. In
addition, it may contain a covenant requiring asset coverage ratios in addition to those
required by the Investment Company Act. The Trust may be required to pledge its assets and
to maintain a portion of its assets in cash or high-grade securities as a reserve against
interest or principal payments and expenses. The Trust expects that any credit facility
would have customary covenant, negative covenant and default provisions. There can be no
assurance that the Trust will enter into an agreement for a credit facility on terms and
conditions representative of the foregoing or that additional material terms will not apply.
In addition, if entered into, any such credit facility may in the future be replaced or
refinanced by one or more credit facilities having substantially different terms or by the
issuance of Preferred Shares. |
|
|
|
|
|
|
Effects of Leverage. The Trust initially intends to employ leverage (by the issuance of
Preferred Shares, borrowing of money or a combination) of approximately 30% to 40% of its
total assets (including the amount obtained from leverage). Under the Investment Company
Act, the Trust is not permitted to issue Preferred Shares unless immediately after such
issuance the total asset value of the Trusts portfolio is at least 200% of the liquidation
value of the outstanding Preferred Shares plus the amount of borrowing (i.e., such
liquidation value and amount of borrowing may not exceed 50% of the Trusts total assets).
In addition, the Trust is not permitted to declare any cash distribution on its common shares unless, at the time of such declaration, the net asset value of the Trusts
portfolio (determined after deducting the amount of such distribution) is at least 200% of
such liquidation value plus amount of any borrowing. If Preferred Shares are issued, the
Trust intends, to the extent possible, to purchase or redeem Preferred Shares, from time to
time, to maintain coverage of any Preferred Shares of at least 200%. If the Trust issues
Preferred Shares resulting in % leverage and borrows in an amount resulting in %
leverage, there will be an asset coverage of the Preferred Shares of %. |
|
|
|
|
|
|
To qualify for federal income taxation as a regulated investment company, the Trust must
distribute in each taxable year at least 90% of its net investment income (including net
interest income and net short-term gain). The Trust also will be required to distribute
annually substantially all of its income and capital gain, if any, to avoid imposition of a
nondeductible 4% federal excise tax. If the Trust is precluded from making distributions on
the common shares because of any applicable asset coverage requirements, the terms of the
Preferred Shares may provide that any amounts so precluded from being distributed, but
required to be distributed for the Trust to meet the distribution requirements for
qualification as a regulated investment company, will be paid to the holders of the
Preferred Shares as a special distribution. This distribution can be expected to decrease
the amount that holders of Preferred Shares would be entitled to receive upon redemption or
liquidation of the shares. |
|
|
|
|
|
|
The Trusts willingness to issue Preferred Shares or borrow for leverage purposes, and the
amount of leverage the Trust will assume, will depend on many factors, the most important of
which are market conditions and interest rates. Successful use of a leveraging strategy may
depend on the Investment Advisers ability to predict correctly interest rates and market
movements, and there is no assurance that a leveraging strategy will be successful during
any period in which it is employed. |
|
|
|
|
|
|
Assuming the utilization of leverage in the amount of % of the Trusts total assets and
an annual dividend rate on Preferred Shares of % and an annual interest rate of % on
borrowings payable on such leverage based on market rates as of the date of this prospectus,
the additional income that the Trust must earn (net of expenses) in order to cover such
dividend payments is %. The Trusts actual cost of leverage will be based on market
rates at |
|
34
|
|
|
|
the time the Trust undertakes a leveraging strategy, and such actual costs of leverage may
be higher or lower than that assumed in the previous example. |
|
|
|
|
|
|
The following table is designed to illustrate the effect on the return to a holder of the
Trusts common shares of leverage in the amount of approximately % of the Trusts total
assets, assuming hypothetical annual returns of the Trusts portfolio of minus 10% to plus
10%. As the table shows, leverage generally increases the return to holders of common shares
when portfolio return is positive and greater than the cost of leverage and decreases the
return when the portfolio return is negative or less than the cost of leverage. The figures
appearing in the table are hypothetical and actual returns may be greater or less than those
appearing in the table. |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assumed portfolio
return (net of
expenses) |
|
|
(10 |
)% |
|
|
(5 |
)% |
|
|
0 |
% |
|
|
5 |
% |
|
|
10 |
% |
Corresponding
common share return
assuming % leverage |
|
|
| % |
|
|
| % |
|
|
| % |
|
|
| % |
|
|
| % |
|
|
|
Until the Trust issues Preferred Shares or borrows money, the common shares will not be
leveraged, and the risks and special considerations related to leverage described in this
prospectus will not apply. |
|
|
|
|
|
Such leveraging of the common shares cannot be achieved until the proceeds resulting from
the use of leverage have been invested in accordance with the Trusts investment objectives
and policies. |
|
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 debt securities. Therefore, the Trusts exposure to
common stocks could result in worse performance than would be the case had the Trust been invested
solely in debt 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.
Dividend Risk
Dividends on common stock are not fixed but are declared at the discretion of an issuers
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 Trusts distributions will constitute qualified dividend income.
Small and Mid-Cap Securities Risk
The Trust may invest in companies with small or medium capitalizations. Securities issued by
smaller and medium companies can be more volatile than, and perform differently from, larger
company securities. There may be less trading in a smaller or medium companys securities, which
means that buy and sell transactions in those securities could have a larger impact on the
securitys price than is the case with larger company securities. 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 companys security price than is the case for a larger company. In
addition, smaller or medium company securities may not be well known to the investing public.
35
Non-U.S. Securities Risk
The Trust may invest up to 20% of its total assets in non-U.S. securities. Investing in
non-U.S. securities involves certain risks not involved in domestic investments, including, but not
limited to: (i) fluctuations in foreign exchange rates; (ii) future foreign economic, financial,
political and social developments; (iii) different legal systems; (iv) the possible imposition of
exchange controls or other foreign governmental laws or restrictions; (v) lower trading volume;
(vi) much greater price volatility and illiquidity of certain non-U.S. securities markets; (vii)
different trading and settlement practices; (viii) less governmental supervision; (ix) changes in
currency exchange rates; (x) high and volatile rates of inflation; (xi) fluctuating interest rates;
(xii) less publicly available information; and (xiii) different accounting, auditing and financial
recordkeeping standards and requirements.
Certain countries in which the Trust may invest, especially emerging market countries,
historically have experienced, and may continue to experience, high rates of inflation, high
interest rates, exchange rate fluctuations, large amounts of external debt, balance of payments and
trade difficulties and extreme poverty and unemployment. Many of these countries are also
characterized by political uncertainty and instability. These risks are especially evident in the
Middle East and West Africa. The cost of servicing external debt will generally be adversely
affected by rising international interest rates because many external debt obligations bear
interest at rates which are adjusted based upon international interest rates. In addition, with
respect to certain foreign countries, there is a risk of: (i) the possibility of expropriation or
nationalization of assets; (ii) confiscatory taxation; (iii) difficulty in obtaining or enforcing a
court judgment; (iv) economic, political or social instability; and (v) diplomatic developments
that could affect investments in those countries.
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 in the
Trust and the unrealized appreciation or depreciation of investments. Currencies of certain
countries may be volatile and therefore may affect the value of securities denominated in such
currencies, which means that the Trusts net asset value or current income could decline as a
result of changes in the exchange rates between foreign currencies and the U.S. dollar. Certain
investments in non-U.S. securities also may be subject to foreign withholding taxes. Dividend
income from non-U.S. corporations may not be eligible for the reduced rate for qualified dividend
income. These risks often are heightened for investments in smaller, emerging capital markets. In
addition, individual foreign economies may differ favorably or unfavorably from the U.S. economy in
such respects as: (i) growth of gross domestic product; (ii) rates of inflation; (iii) capital
reinvestment; (iv) resources; (v) self-sufficiency; and (vi) balance of payments position.
As a result of these potential risks, Highland may determine that, notwithstanding otherwise
favorable investment criteria, it may not be practicable or appropriate to invest in a particular
country. The Trust may invest in countries in which foreign investors, including Highland, have
had no or limited prior experience.
Emerging Markets Risk
The Trust may invest up to 20% of its total assets in securities of issuers based in emerging
markets. 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 Trusts 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 Trusts 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 Derivatives Risk below.
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
36
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
Trusts 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 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.
Securities Lending Risk
The Trust may lend its portfolio securities (up to a maximum of one-third of its total assets)
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 Trusts 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 foregoes, during the options 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 Trusts 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.
Exchange-Listed Option Risks
There can be no assurance that a liquid market will exist when the Trust seeks to close out an
option position. Reasons for the absence of a liquid secondary market on an exchange include the
following: (i) there may be insufficient trading interest in certain options; (ii) restrictions may
be imposed by an exchange on opening transactions or closing transactions or both; (iii) trading
halts, suspensions or other restrictions may be imposed with respect to particular classes or
series of options; (iv) unusual or unforeseen circumstances may interrupt normal operations on an
exchange; (v) the facilities of an exchange or the Options Clearing Corporation may not at all
times be adequate to handle current trading volume; or (vi) one or more exchanges could, for
economic or other reasons, decide or be compelled at some future date to discontinue the trading of
options (or a particular class or series of options). If trading were discontinued, the secondary
market on that
37
exchange (or in that class or series of options) would cease to exist. However, outstanding
options on that exchange that had been issued by the Options Clearing Corporation as a result of
trades on that exchange would continue to be exercisable in accordance with their terms. If the
Trust were unable to close out a covered call option that it had written on a security, it would
not be able to sell the underlying security unless the option expired without exercise.
The hours of trading for options on an exchange may not conform to the hours during which the
underlying securities are traded. To the extent that the options markets close before the markets
for the underlying securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the options markets. Call options are marked to
market daily and their value will be affected by changes in the value and dividend rates of the
underlying common stocks, an increase in interest rates, changes in the actual or perceived
volatility of the stock market and the underlying common stocks and the remaining time to the
options expiration. Additionally, the exercise price of an option may be adjusted downward before
the options expiration as a result of the occurrence of certain corporate events affecting the
underlying equity security, such as extraordinary dividends, stock splits, merger or other
extraordinary distributions or events. A reduction in the exercise price of an option would reduce
the Trusts capital appreciation potential on the underlying security.
Over-the-Counter Option Risk
The Trust may write (sell) unlisted (OTC or over-the-counter) options, and options written
by the Trust with respect to non-U.S. securities, indices or sectors generally will be OTC options.
OTC options differ from exchange-listed options in that they are two-party contracts, with exercise
price, premium and other terms negotiated between buyer and seller, and generally do not have as
much market liquidity as exchange-listed options. The counterparties to these transactions
typically will be major international banks, broker-dealers and financial institutions. The Trust
may be required to treat as illiquid securities being used to cover certain written OTC options.
The OTC options written by the Trust will not be issued, guaranteed or cleared by the Options
Clearing Corporation. In addition, the Trusts ability to terminate the OTC options may be more
limited than with exchange-traded options. Banks, broker-dealers or other financial institutions
participating in such transaction may fail to settle a transaction in accordance with the terms of
the option as written. In the event of default or insolvency of the counterparty, the Trust may be
unable to liquidate an OTC option position.
Index Option Risk
The Trust intends to sell index put and call options from time to time. The purchaser of an
index put option has the right to any depreciation in the value of the index below the exercise
price of the option on or before the expiration date. The purchaser of an index call option has
the right to any appreciation in the value of the index over the exercise price of the option on or
before the expiration date. Because the exercise of an index option is settled in cash, sellers of
index call options, such as the Trust, cannot provide in advance for their potential settlement
obligations by acquiring and holding the underlying securities. The Trust will lose money if it is
required to pay the purchaser of an index option the difference between the cash value of the index
on which the option was written and the exercise price and such difference is greater than the
premium received by the Trust for writing the option. The value of index options written by the
Trust, which will be priced daily, will be affected by changes in the value and dividend rates of
the underlying common stocks in the respective index, changes in the actual or perceived volatility
of the stock market and the remaining time to the options expiration. The value of the index
options also may be adversely affected if the market for the index options becomes less liquid or
smaller. Distributions paid by the Trust on its common shares may be derived in part from the net
index option premiums it receives from selling index put and call options, less the cost of paying
settlement amounts to purchasers of the options that exercise their options. Net index option
premiums can vary widely over the short term and long term.
Interest Rate Risk
Interest rate risk is the risk that debt securities, and the Trusts net assets, may 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 Trusts debt security holdings.
Prepayment Risk
If interest rates fall, the principal on debt 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 Trusts income and
distributions to shareholders. The Trust may invest in pools of mortgages and other assets issued
or guaranteed by private issuers or U.S. government agencies and instrumentalities.
Mortgage-related securities are especially sensitive to prepayment risk because borrowers often
refinance their mortgages when interest rates drop.
38
Non-Investment Grade Securities Risk
There is no limit on the amount of the Trusts portfolio that may be invested in below
investment grade securities. Non-investment grade securities are commonly referred to as junk
securities. 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 Trusts net
asset value.
Derivatives Risk
Derivative Transactions in which the Trust may engage for hedging and speculative purposes or
to enhance total return, including engaging in transactions such as options, futures, swaps,
foreign currency transactions, forward foreign currency contracts, currency swaps or options on
currency futures and other derivatives transactions, also involve certain risks and special
considerations. Derivative 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 Derivative Transactions depends on the Investment Advisers ability to predict
pertinent market movements, which cannot be assured. Thus, the use of Derivative 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
Trusts 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 Derivative 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 Trusts 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 Adviser 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
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 bonds 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
39
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 bond in
which it can realize a coupon rate of 5%, but the rate of inflation increases from 2% to 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 Adviser will be able to hedge the Trusts
portfolio in the manner necessary to employ successfully the Trusts strategy.
Short Sales Risk
Short sales by the Trust that are not made against the box (that is when the Trust has an
offsetting long position in the asset that is selling short) 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.
Risks of Investing in Structured Finance Securities
A portion of the Trusts 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 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.
Risks of Investing in Preferred Securities
There are special risks associated with investing in preferred securities, including:
|
|
|
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. |
|
|
|
|
Subordination. Preferred securities are subordinated to bonds and other debt
instruments in a companys 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. |
40
|
|
|
Liquidity. Preferred securities may be substantially less liquid than many other
securities, such as common stocks or U.S. government securities. |
|
|
|
|
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 issuers board. Generally, once all the arrearages have been
paid, the preferred security holders no longer have voting rights. |
Risks of Investing in 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 (the counterparty) with whom the
Trust contracts for the purpose of making derivative investments. In the event of the
counterpartys 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.
Risks of Investing in 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.
Risks of Investing in 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, an overabundance 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 Adviser may 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. There is no maximum amount of Trusts assets that may be
invested in these securities.
Tax Risk
The Trust may invest in derivative instruments, such as swaps, and other instruments, in order
to obtain investment exposure to its principal investment categories or for other purposes. The
Trust intends only to invest in such instruments to an extent and in a manner consistent with the
Trusts qualification as a regulated investment company for federal income tax purposes. If the
Trust were to fail to qualify as a regulated investment company in any year, then the Trust would
be subject to federal (and state) income tax on its net income and capital gains at regular
corporate income tax rates (without a deduction
41
for distributions to shareholders). Trust income distributed to common shareholders would
also be taxable to shareholders as ordinary dividend income to the extent attributable to the
Trusts earnings and profits. Accordingly, in such event, the Trusts ability to achieve its
investment objectives would be adversely affected, and common shareholders would be subject to the
risk of diminished investment returns.
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 Adviser expects to apply to the Commission for exemptive relief to enable the
registered investment companies advised by the Investment Adviser, including the Trust, to
co-invest with other accounts and funds managed by the Investment Adviser and its affiliates in
certain privately placed securities and other situations. There are no assurances that the
Investment Adviser will receive the requested relief. If such relief is not obtained and until it
is obtained, the Investment Adviser 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 Investment
Adviser 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.
Risks of Investing in a Trust with Anti-Takeover Provisions
The Trusts 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 Adviser
Highland acts as the Trusts investment adviser. Highland is located at Two Galleria Tower,
13455 Noel Road, Suite 800, Dallas, Texas 75240. As of , 2006, the Investment
Adviser 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.
Responsibilities. The Investment Adviser provides the following services to the Trust: (i)
furnishes an investment program for the Trust; (ii) determines, subject to the overall supervision
and review of the board of trustees, the investments
42
to be purchased, held, sold or exchanged by the Trust and the portion, if any, of the assets
of the Trust to be held uninvested; (iii) makes changes in the investments of the Trust; and (iv)
votes, exercises consents and exercises all other rights pertaining to such investments. Subject
to the foregoing, the Investment Adviser, at its own expense, will have the authority to engage one
or more sub-advisers in connection with the portfolio management of the Trust, which sub-advisers
may be affiliates of the Adviser; provided, however, that the Adviser shall remain responsible to
the Trust with respect to its duties and obligations set forth in the agreement.
Compensation. In return for its advisory services, the Investment Adviser will receive an
annual fee, payable monthly, in an amount equal to % of the average weekly value of the Trusts
Managed Assets (the Advisory Fee). The accrued fees will be payable monthly as promptly as
possible after the end of each month during which the Investment Advisory Agreement is in effect.
The Investment Adviser may waive a portion of its fees. The Investment Adviser will benefit when
the Trust leverages itself since the amount of the Trusts managed assets will increase with
leverage. A discussion regarding the basis for the approval of the investment advisory agreement
by the Trusts board will be available in the Trusts report to shareholders for the period ending
June 30, 2006.
In addition to the Advisory Fee of Highland, the Trust pays all other costs and expenses of
its operations, including, but not limited to, 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 reimbursement of actual expenses of the Investment Adviser or others for registration and
maintenance of the Trusts registrations with the Commission and other jurisdictions and taxes, if
any.
Administrator/Sub-Administrator
Under an administration agreement dated , 2006, Highland provides
administration services to the Trust, provides executive and other personnel necessary to
administer the Trust and furnishes office space. Highland will receive an annual fee, payable
monthly, in an amount equal to % of the average weekly value of the Trusts Managed Assets.
The accrued fees will be payable monthly as promptly as possible after the end of each month during
which this Agreement is in effect. Highland may waive a portion of its fees. Under a separate
sub-administration agreement, dated , 2006, Highland has delegated certain
administrative functions to
, at an annual rate, payable by Highland, of % of the Trusts average
Managed Assets.
Portfolio Managers
The Trusts portfolio will initially be managed by James Dondero, Mark Okada and Kurtis
Plumer. The investment decisions are not subject to the oversight, approval or ratification of a
committee.
James Dondero, CFA, CPA, CMA. Mr. Dondero is a founder and President of Highland. Formerly,
Mr. Dondero served as Chief Investment Officer of Protective Lifes 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 his 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 Highlands 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 Lifes 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.
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.)
43
where he focused on M&A and financing transactions for the banks 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.
NET ASSET VALUE
The net asset value of the common shares of the Trust will be computed based upon the value of
the Trusts 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 will use the following valuation methods to determine either current market value
for investments for which market quotations are available, or if not available, the fair value, as
determined in good faith pursuant to policies and procedures approved by the board of trustees:
|
|
(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 Adviser 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 Trusts loan and bond positions are not traded on
exchanges and consequently are valued based on market prices 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 Adviser, 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 Trusts non-marketable investments will generally be valued in such manner as the
Investment Adviser determines in good faith to reflect their fair values under procedures
established by, and under the general supervision and responsibility of, the Trusts board
of trustees. The pricing of all assets that are fair valued in this manner will be
subsequently reported to and ratified by the Trusts board of trustees. |
|
When determining the fair value of an asset, the Investment Adviser will seek to determine the
price that the Trust might reasonably expect to receive from the current sale of that asset in an
arms-length transaction. Fair value determinations shall be based upon all available factors that
the Investment Adviser deems relevant.
DISTRIBUTIONS
Commencing with the Trusts initial dividend, the Trust intends to pay regular monthly cash
dividends. We expect to declare the initial monthly dividend on the Trusts 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. The Trust intends to
pay any capital gain distributions annually.
Various factors will affect the level of the Trusts current income and current gains, such as
its asset mix, and the Trusts use of options. To permit the Trust to maintain more stable monthly
dividends and annual distributions, the Trust may from time to time distribute less than the entire
amount of income and gains earned in the relevant month or year, respectively. The undistributed
income and gains would be available to supplement future distributions. As a result, the
distributions paid by the Trust for any particular period may be more or less than the amount of
income and gains actually earned by the Trust during the applicable period. Undistributed income
and gains will add to the Trusts net asset value and, correspondingly,
44
distributions from undistributed income and gains and from capital, if any, will be deducted from
the Trusts 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 Trusts Dividend Reinvestment Plan unless an election is made to receive cash.
Each participant in the Trusts Dividend Reinvestment Plan will pay a pro rata portion of brokerage
commissions incurred in connection with open market purchases, and participants requesting a sale
of securities through the plan agent of the Dividend Reinvestment Plan are subject to a sales fee
and a brokerage commission. 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
Trusts 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.
The Plan Agent will open an account for each common shareholder under the Plan in the same
name in which such common shareholders 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 participants 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-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.
45
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 shareholders 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. Accordingly, any taxable dividend received by a participant that is
reinvested in additional common shares will be subject to federal (and possibly state and local)
income tax even though such participant will not receive a corresponding amount of cash with which
to pay such taxes. See Tax Matters. Participants who request a sale of shares through the Plan
Agent are subject to a $ 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 CAPITAL STRUCTURE
Common Shares
The Trust is a 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 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.
The Trust has no present intention of offering any additional shares other than the Preferred
Shares and common shares issued under the Trusts Dividend Reinvestment Plan. Any additional
offerings of shares will require approval by the Trusts 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 Trusts 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.
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. 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
46
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 Trusts 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.
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.
The Trust intends to issue Preferred Shares as part of its leverage strategy in one to six
months following the completion of this offering. If Preferred Shares are issued, the Trust
currently intends to issue Preferred Shares representing no more than % of the Trusts 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 Trusts 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
(i) adopt any plan of reorganization that would adversely affect the Preferred Shares, and (ii)
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 Trusts subclassification as a closed-end
investment company or changes in its fundamental investment restrictions. As a result of these
voting rights, the Trusts 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 the Preferred
Shares are expected to provide that (i) they are redeemable by the Trust in whole or in part at the
original purchase price per share plus accrued dividends per share, (ii) the Trust may tender for
or purchase Preferred Shares and (iii) 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.
47
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
Trusts 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.
Other Shares
The board of trustees (subject to applicable law and the Trusts 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.
Credit Facility
In the event the Trust leverages through borrowings, the Trust may enter into definitive
agreements with respect to a credit facility. The Trust may negotiate with commercial banks to
arrange a credit facility pursuant to which the Trust would be entitled to borrow an amount equal
to approximately one-third of the Trusts total assets (inclusive of the amount borrowed) offered
hereby. Any such borrowings would constitute financial leverage. Such a facility is not expected to
be convertible into any other securities of the Trust. Any outstanding amounts are expected to be
prepayable by the Trust prior to final maturity without significant penalty, and there are not
expected to be any sinking fund or mandatory retirement provisions. Outstanding amounts would be
payable at maturity or such earlier times as required by the agreement. The Trust may be required
to prepay outstanding amounts under the facility or incur a penalty rate of interest in the event
of the occurrence of certain events of default. The Trust would be expected to indemnify the
lenders under the facility against liabilities they may incur in connection with the facility. The
Trust may be required to pay commitment fees under the terms of any
such facility. With the use of borrowings, there is a risk that the
interest rates paid by the Trust on the amount it borrows will be
higher than the return on the Trust's investments.
In addition, the Trust expects that such a credit facility would contain covenants that, among
other things, likely will limit the Trusts ability to: (i) pay dividends in certain circumstances,
(ii) incur additional debt and (iii) change its fundamental investment policies and engage in
certain transactions, including mergers and consolidations. In addition, it may contain a covenant
requiring asset coverage ratios in addition to those required by the Investment Company Act. The
Trust may be required to pledge its assets and to maintain a portion of its assets in cash or
high-grade securities as a reserve against interest or principal payments and expenses. The Trust
expects that any credit facility would have customary covenant, negative covenant and default
provisions. There can be no assurance that the Trust will enter into an agreement for a credit
facility on terms and conditions representative of the foregoing or that additional material terms
will not apply. In addition, if entered into, any such credit facility may in the future be
replaced or refinanced by one or more credit facilities having substantially different terms or by
the issuance of Preferred Shares.
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 (for cause, and not without cause) 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 Trusts Agreement and Declaration of Trust requires the favorable vote of a
majority of the Trusts 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.
48
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 Trusts 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 Trusts 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
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 Trusts 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
Trusts 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 Trusts
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 Trusts 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 non-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 (less a redemption fee, if applicable, or contingent deferred sales
charge, if applicable). 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 funds 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 Trusts board of trustees might consider
49
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 Trusts
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 Trusts 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 Trusts
common shares will be determined by such factors as relative demand for and supply of such common
shares in the market, the Trusts net asset value, general market and economic conditions and other
factors beyond the control of the Trust. See Net Asset Value. Although the Trusts 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 Trusts 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
Trusts expense ratio and decreasing the asset coverage with respect to any preferred shares
outstanding or borrowings. Any share repurchases or 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 shareholders that are U.S. persons as defined for U.S. federal income tax
purposes. For more information, please see the Statement of Additional Information, under Tax
Matters. Because each shareholders 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.
In general, the Trust does not expect that a significant portion of its ordinary income
dividends will be treated as qualified dividend income, which is eligible for taxation at the rates
applicable to long-term capital gains in the case of individual shareholders, or that a corporate
shareholder will be able to claim a dividends received reduction with respect to any significant
portion of Trust distributions.
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
50
shares as capital assets, any such gain or loss generally 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 shareholders correct taxpayer identification number
(in the case of an individual, generally, such individuals 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.
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.
UNDERWRITERS
Under the terms and subject to the conditions contained in the underwriting agreement dated
the date of this prospectus, the underwriters named below, for whom Morgan Stanley & Co.
Incorporated is acting as representative, have severally agreed to purchase, and the Trust has
agreed to sell to them, severally, the number of common shares indicated below.
|
|
|
|
|
|
|
Number of |
|
Name |
|
Common Shares |
|
Morgan Stanley & Co. Incorporated |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
|
|
|
|
|
|
The underwriters are offering the common shares subject to their acceptance of the common
shares from the Trust and subject to prior sale. The underwriting agreement provides that the
obligations of the several underwriters to pay for and accept delivery of the common shares offered
by this prospectus are subject to the approval of legal matters by their counsel and to certain
other conditions. The underwriters are obligated to take and pay for all of the common shares
offered by this prospectus if any such common shares are taken. However, the underwriters are not
required to take or pay for the common shares covered by the underwriters over allotment option
described below.
The underwriters initially propose to offer part of the common shares directly to the public
at the initial offering price listed on the cover page of this prospectus and part to certain
dealers at a price that represents a concession not in excess of $ a share under the initial
offering price. Any underwriter may allow, and such dealers may reallow, a concession not in
excess of $ a share to the other underwriters or to certain dealers. After the initial
offering of the common shares, the offering price and other selling terms may from time to time be
varied by the representative. The underwriting discounts and commissions (sales load) of $ a
share are equal to % of the initial offering price. Investors must pay for any common
shares purchased on or before , 2006.
The Trust has granted to the underwriters an option, exercisable for 45 days from the date of
this prospectus, to purchase up to an aggregate of common shares at the initial offering
price per common share listed on the cover page of this prospectus, less underwriting discounts and
commissions. The underwriters may exercise this option solely for the purpose of covering over
allotments, if any, made in connection with the offering of the common shares offered by this
prospectus. To the extent the option is exercised, each underwriter will become obligated, subject
to limited conditions, to purchase approximately the same percentage of the additional common
shares as the number listed next to the underwriters name in the preceding table bears to the
total number of common shares listed next to the names of all underwriters in the preceding table.
If the underwriters over allotment option is exercised in full, the total price to the public
would be $ , the total underwriters discounts and commissions (sales load) would be $ ,
the estimated offering expenses would be $ and the total proceeds to the Trust would be $
.
51
The following table summarizes the estimated expenses and compensation that the Trust will
pay:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Per Share |
|
|
Total |
|
|
|
Without |
|
|
With |
|
|
Without |
|
|
With |
|
|
|
Over-allotment |
|
|
Over-allotment |
|
|
Over-allotment |
|
|
Over-allotment |
|
Expenses payable by the Trust |
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
Underwriting discounts and
commissions (sales load) |
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
|
$ |
|
|
The underwriters have informed the Trust that they do not intend sales to discretionary
accounts to exceed five percent of the total number of common shares offered by them.
In order to meet requirements for the New York Stock Exchange, the underwriters have
undertaken to sell lots of 100 or more shares to a minimum of 2,000 beneficial owners. The minimum
investment requirement is 100 common shares ($2,000).
The Trust anticipates that its common shares will be listed on the New York Stock Exchange,
subject to official notice of issuance, under the symbol .
The Trust has agreed that, without the prior written consent of Morgan Stanley & Co.
Incorporated on behalf of the underwriters, it will not, during the period ending 180 days after
the date of this prospectus:
|
|
|
|
offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase
any option or contract to sell, grant any option, right or warrant to purchase, lend, or
otherwise transfer or dispose of, directly or indirectly, any common shares or any
securities convertible into or exercisable or exchangeable for common shares, or |
|
|
|
|
|
|
enter into any swap or other arrangement that transfers to another, in whole or in part,
any of the economic consequences of ownership of the common shares, |
|
whether any such transaction described above is to be settled by delivery of common shares or
such other securities, in cash or otherwise; or file any registration statement with the Securities
and Exchange Commission relating to the offering of any common shares or any securities convertible
into or exercisable or exchangeable for common shares. These lock-up agreements will not apply to
the common shares to be sold pursuant to the underwriting agreement or any common shares issued
pursuant to the Trusts Dividend Reinvestment Plan.
In order to facilitate the offering of the common shares, the underwriters may engage in
transactions that stabilize, maintain or otherwise affect the price of the common shares. The
underwriters currently expect to sell more common shares than they are obligated to purchase under
the underwriting agreement, creating a short position in the common shares for their own account.
A short sale is covered if the short position is no greater than the number of common shares
available for purchase by the underwriters under the over allotment option (exercisable for 45 days
from the date of this prospectus). The underwriters can close out a covered short sale by
exercising the over allotment option or purchasing common shares in the open market. In
determining the source of common shares to close out a covered short sale, the underwriters will
consider, among other things, the open market price of the common shares compared to the price
available under the over allotment option. The underwriters may also sell common shares in excess
of the over allotment option, creating a naked short position. The underwriters must close out any
naked short position by purchasing common shares in the open market. A naked short position is
more likely to be created if the underwriters are concerned that there may be downward pressure on
the price of the common shares in the open market after pricing that could adversely affect
investors who purchase in the offering. As an additional means of facilitating the offering, the
underwriters may bid for, and purchase, common shares in the open market to stabilize the price of
the common shares. Finally, the underwriting syndicate may also reclaim selling concessions
allowed to an underwriter or a dealer for distributing the common shares in the offering, if the
syndicate repurchases previously distributed common shares in transactions to cover syndicate short
positions or to stabilize the price of the common shares. Any of these activities may raise or
maintain the market price of the common shares above independent market levels or prevent or retard
a decline in the market price of the common shares. The underwriters are not required to engage in
these activities, and may end any of these activities at any time.
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, the Investment Adviser and the representative. There
can be no assurance, however, that the price at which the common shares trade 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.
52
The Trust anticipates that the representative 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.
We and the underwriters have agreed to indemnify each other against certain liabilities,
including liabilities under the Securities Act of 1933.
Morgan Stanley & Co. Incorporated will be paid a marketing and structuring fee by the Investment
Adviser (and not the Trust) for advice to the Investment Adviser on design, structuring, corporate
finance and marketing and for assistance in connection with distribution. This marketing and
structuring fee will be calculated based on % of the aggregate price to public of the common
shares sold by Morgan Stanley & Co. Incorporated, and totals
$ . The marketing and structuring fee
paid to Morgan Stanley & Co. Incorporated will not exceed % of the total price to the public
of the common shares sold in this offering. The Trust may reimburse the Investment Adviser for all
or a portion of the Investment Advisers expenses incurred in connection with this offering, other
than the marketing and structuring fee referred to above. To the extent that the offering expenses
of the Trust (including such reimbursed expenses) do not exceed
$ per common share, the Trust has
agreed to pay such offering expenses. To the extent that the offering expenses of the Trust
(including such reimbursed expenses) exceed $ per common share, the Investment Adviser will pay
such offering expenses.
The sum total of all compensation to the underwriters in connection with this public offering
of common shares, including sales load and marketing and structuring fees, will be limited to 9% of
the total price to the public of the common shares sold in this offering.
The address of Morgan Stanley & Co. Incorporated is 1585 Broadway, New York, New York 10036.
CUSTODIAN AND TRANSFER AGENT
The Custodian of the assets of the Trust will be ALPS Mutual Trust Services, Inc. (1625
Broadway, Suite 220, Denver, Colorado 80202;
Telephone ). The Custodian
will perform custodial, fund accounting and portfolio accounting services. ALPS Mutual Trust
Services, Inc. will also serve as the Trusts 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 Davis
Polk & Wardwell, New York, New York.
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 Trusts Investment Adviser 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.
53
TABLE OF CONTENTS FOR THE STATEMENT OF ADDITIONAL INFORMATION
|
|
|
|
|
|
|
|
B-2 |
|
|
|
|
B-2 |
|
|
|
|
B-3 |
|
|
|
|
B-10 |
|
|
|
|
B-12 |
|
|
|
|
B-19 |
|
|
|
|
B-19 |
|
|
|
|
B-20 |
|
|
|
|
B-23 |
|
|
|
|
B-24 |
|
|
|
|
F-1 |
|
|
|
|
F-2 |
|
|
|
|
F-3 |
|
|
|
|
F-4 |
|
|
|
|
F-5 |
|
|
|
|
A-1 |
|
|
|
|
B-1 |
|
54
Highland Credit Strategies Fund
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 jurisdiction where
the offer or sale is not permitted.
Subject to Completion
Preliminary Statement of Additional Information
Dated , 2006
HIGHLAND CREDIT STRATEGIES FUND
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 1-877-665-1287. You may also obtain a copy of the prospectus on the
Securities and Exchange Commissions 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 RESTRICTIONS |
|
|
B-2 |
|
INVESTMENT POLICIES AND TECHNIQUES |
|
|
B-3 |
|
OTHER INVESTMENT POLICIES AND TECHNIQUES |
|
|
B-10 |
|
MANAGEMENT OF THE TRUST |
|
|
B-12 |
|
PORTFOLIO TRANSACTIONS AND BROKERAGE |
|
|
B-19 |
|
REPURCHASE OF COMMON SHARES |
|
|
B-19 |
|
TAX MATTERS |
|
|
B-20 |
|
EXPERTS |
|
|
B-23 |
|
ADDITIONAL INFORMATION |
|
|
B-24 |
|
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 RATINGS OF INVESTMENTS |
|
|
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 Trusts 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 TechniquesShort-Term Debt Securities. We currently anticipate
that the Trust will be able to invest primarily in securities that meet the Trusts investment
objectives and policies within approximately three months after the completion of this offering.
INVESTMENT RESTRICTIONS
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 or group of
industries;
(2) issue senior securities or borrow money other than as permitted by the Investment
Company Act1 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 up to a maximum of 331/3% of the Trusts total assets, the purchase of debt
securities, including bank loans (senior loans) and participations therein, or the entry into
repurchase agreements up to a maximum of 331/3% of the Trusts total assets;
(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 Trusts 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 and without shareholder approval. 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 Trusts total assets and the Trusts 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
(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
|
|
|
|
1 |
|
Currently, the Investment Company Act
requires an asset coverage of 200% for a closed-end fund issuing Preferred
Shares and for borrowings exceeding 5% of the Trusts assets (excluding
temporary borrowings). |
|
B-2
|
|
|
|
|
|
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 companys expenses, and will remain subject
to payment of the 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. |
|
The percentage limitations applicable to the Trusts portfolio described in the prospectus and
this Statement of Additional Information apply only at the time of investment, except that the
percentage limitation with respect to borrowing applies at all times, 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 Trusts 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 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
B-3
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 corporations ability to meet
all of its financial obligations, because the Trusts 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 issuers 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 securitys investment value.
Convertible securities rank senior to common stock in a corporations 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
securitys 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 subscription price of the related security may exceed the
value of the subscribed securitys 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 U.S. 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
B-4
more volatile than if such instruments were sponsored by the issuer. Investments in ADRs,
EDRs and GDRs may 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.
Derivative 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. Derivative Transactions may be used to attempt to protect against possible changes
in the market value of the Trusts portfolio resulting from fluctuations in the securities markets
and changes in interest rates, to protect the Trusts 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 Derivative Transactions may be used at any time. There is no
particular strategy that requires use of one technique rather than another. Use of any Derivative
Transaction is a function of market conditions. The ability of the Trust to manage them
successfully will depend on Highlands ability to predict pertinent market movements as well as
sufficient correlation among the instruments, which cannot be assured. The Derivative 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.
Futures Contracts and Options on Futures Contracts. In connection with its Derivative
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 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.
B-5
The Trust may engage in various forward currency contract strategies:
|
|
|
|
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 Trusts 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 Trusts 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 Trusts
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
B-6
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 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 Trusts
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 Derivative 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 Derivative 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 Trusts 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 Trusts 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 Trusts loss is limited to the premium it paid for the
B-7
default option. In contrast, if there is a default by the grantor of a default option, the
Trusts 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.
Below under General Characteristics of Risks of Derivative Transactions is further
information about the characteristics, risks and possible benefits of Derivative Transactions and
the Trusts other policies and limitations (which are not fundamental policies) relating to
investment in futures contracts and options. The principal risks relating to the use of futures
contracts and other Derivative Transactions are: (i) less than perfect correlation between the
prices of the instrument and the market value of the securities in the Trusts portfolio; (ii)
possible lack of a liquid secondary market for closing out a position in such instruments; (iii)
losses resulting from interest rate or other market movements not anticipated by Highland; and (iv)
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
Derivative Transactions. See Tax Matters.
General Characteristics and Risks of Derivative 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 Derivative Transactions. The Trust will
engage in such activities in the Investment Advisers 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 Trusts ability to pursue certain of these strategies may be
limited by applicable regulations of the CFTC. Certain Derivative 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 Trusts 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 below 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 Trusts 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
B-8
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.
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 Trusts 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 Trusts 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 Trusts 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 Trusts 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.
Derivative Transactions Present Certain Risks. With respect to Derivative 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 Trusts 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
B-9
transaction without incurring losses substantially greater than the initial deposit. Although
the contemplated use of these instruments predominantly for Derivative 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 Derivative Transactions will depend on the Investment
Advisers and the sub-advisers 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 Derivative 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.
OTHER INVESTMENT POLICIES AND TECHNIQUES
Restricted and Illiquid Securities
Certain of the Trusts 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 Trusts 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
B-10
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 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 Trusts 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 Trusts ability to dispose of particular
Assignments or Participations when necessary to meet the Trusts 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 Trusts
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.
B-11
Certain issuers of Structured Investments may be deemed to be investment companies as
defined in the Investment Company Act. As a result, the Trusts 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 Trusts investment advisory agreement, the board of trustees received
information specifically related to the approval of the investment advisory 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 Advisory Fee and anticipated total
operating expenses as compared to a peer group of closed-end funds with similar investment policies
and strategies selected by Lipper, Inc.; (iv) Highlands profitability with respect to other funds
in the Highland family of closed-end funds; (v) Highlands overall profitability as compared with
available industry data; (vi) certain expected direct and indirect fallout benefits to Highland
from its relationship with the Trust; and (vii) Highlands 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 Highlands management of relationships
with service providers and resources devoted to compliance with such funds investment objectives
and polices and other matters.
Matters Considered by the Board
In considering the investment advisory 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 Trusts surrounding
circumstances. Matters considered by the board of trustees, including the non-interested trustees
in approving the investment advisory 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:
|
|
|
|
Highlands compliance record, including whether other funds advised or sub-advised by
Highland have operated within their investment objectives, policies and restrictions; and |
|
B-12
|
|
|
|
the resources of Highland and the size, education and experience of the Trusts
portfolio management team and Highlands use of technology and its 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 advisory agreement. The board of
trustees, including the non-interested trustees, also considered the nature and extent of
Highlands supervision of third party service providers.
Fees and Expenses. The board of trustees, including the non-interested trustees, considered
the Advisory Fee and expense ratio in comparison to the investment advisory fee and anticipated
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)
investment advisory fee before fee waivers; (ii) investment advisory 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 investment advisory fee and other expenses paid
by the holders of the common shares of a fund if the investment advisory 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 Highlands profits in respect of the management of Highlands closed-end funds. The board
considered the potential for economies of scale in connection with Highlands 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 Trusts business. The board of trustees, including the
independent trustees, also considered Highlands 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 Highlands 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. 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 advisory 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 Trusts
common shares and to employees of Highland and its affiliates that participate in the offering of
the Trusts 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 Advisory 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
Highlands advisory 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,
.
B-13
The investment advisory agreement was approved by the sole common shareholder of the Trust as
of , 2006. The investment advisory 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 (i) the vote of a majority of the Trusts 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 (ii) by the vote of a majority of the trustees who are not parties to
the investment advisory 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 advisory 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 Trusts board of
trustees or a majority of the outstanding voting securities of the Trust or by Highland, on not
more than 60 days nor less than 30 days prior written notice by either party to the other which
can be waived by the non-terminating party. The investment advisory 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
The board of trustees provides broad oversight over the operations and affairs of the Trust
and protects the interests of shareholders. The board of trustees has overall responsibility to
manage and control the business affairs of the Trust, including the complete and exclusive
authority to establish policies regarding the management, conduct and operation of the Trusts
business. The names and ages of the trustees and officers of the Trust, the year each was first
elected or appointed to office, their principal business occupations during the last five years,
the number of funds overseen by each trustee and other directorships or trusteeships they hold are
shown below. 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 otherwise specified
below.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of |
|
|
|
|
|
|
|
|
|
|
Portfolios in |
|
|
|
|
|
|
Term of |
|
|
|
Highland Fund |
|
Other |
|
|
|
|
Office and |
|
|
|
Complex |
|
Directorships/ |
|
|
Position |
|
Length of |
|
Principal Occupation(s) |
|
Overseen |
|
Trusteeships |
Name, Address and Age |
|
with Trust |
|
Time Served |
|
During Past Five Years |
|
by Trustee1 |
|
Held |
INDEPENDENT TRUSTEES
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INTERESTED TRUSTEE2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
R. Joseph Dougherty
(Age 35)
|
|
Sole Initial Trustee;
President, Chief Executive
Officer, Chief
Financial Officer,
Treasurer and Secretary
|
|
Indefinite Term;
Trustee and
Chairman of the
Board since
inception in 2006
|
|
Portfolio Manager
of the Adviser
since 2000.
|
|
|
11 |
|
|
None |
OFFICERS
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Term of Office |
|
|
|
|
Name, Address |
|
Position |
|
|
and Length of |
|
|
Principal Occupation(s) |
|
and Age |
|
with Trust |
|
|
Time Served |
|
|
During Past Five Years |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
B-14
|
|
|
|
1 |
|
The Highland Fund Complex consists of the following funds: Highland Credit Strategies Fund,
Highland Floating Rate Limited Liability Company, Highland Floating Rate Fund, Highland
Floating Rate Advantage Fund, Highland Institutional Floating Rate Income Fund, Highland
Corporate Opportunities Fund, Restoration Opportunities Fund, Prospect Street® High Income
Portfolio Inc., Prospect Street® Income Shares Inc., Highland Equity Opportunities Fund, and
Highland Real Estate Fund (each a Highland Fund and collectively the Highland Funds). |
|
|
|
2 |
|
Mr. Dougherty is deemed to be an interested person of the Trust under the Investment
Company Act because of his position with the Investment Adviser. |
|
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 Trusts calendar year ending December 31, 2006, assuming the Trust will have been in
existence for the full calendar year.
|
|
|
|
|
|
|
|
|
|
|
Aggregate |
|
|
|
|
|
|
Compensation |
|
|
Total Compensation from the |
|
Name of Trustee |
|
from the Trust |
|
|
Trust and Highland Fund (1) |
|
Interested Trustee |
|
|
|
|
|
|
|
|
R. Joseph Dougherty |
|
$ 0 |
|
|
$ 0 |
|
|
|
|
|
|
|
|
|
|
Independent Trustee |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
Estimates the total compensation to be earned by that person during the calendar year ending
December 31, 2006 from the registered investment companies advised by Highland (the Trust
Complex). |
|
Each Independent Trustee will receive an annual fee calculated as follows:
In connection with the board of trustees responsibility for the overall management and
supervision of the Trusts affairs, the trustees meet periodically throughout the year to oversee
the Trusts activities, review contractual arrangements with service providers for the Trust and
review the Trusts performance. To fulfill these duties, the Trust will have 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 (i) oversight of the Trusts
accounting and financial reporting processes and the audits of the Trusts financial statements and
(ii) providing assistance to the board of trustees of the Trust in connection with its oversight of
the integrity of the Trusts financial statements, the Trusts compliance with legal and regulatory
requirements and the independent registered public accounting firms 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 Committees 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, Two Galleria Tower, 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 Committees function is to seek to address any potential conflicts of interest
between or among the Trust and the Investment Adviser in connection with any potential or existing
litigation or other legal proceeding relating
B-15
to securities held by the Trust and the Investment Adviser or another client of the Investment
Adviser. The Litigation Committee 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 with the exception of
the initial Audit Committee meeting at which all Audit Committee members were present.
Prior to this offering, all of the outstanding shares of the Trust were owned by of Highland.
Proxy Voting Policies and Procedures
The board of trustees of the Trust has delegated the voting of proxies for Trust securities to
Highland pursuant to Highlands proxy voting policies and procedures. Under these policies and
procedures, Highland will vote proxies related to Trust securities in the best interests of the
Trust and its shareholders. A copy of Highlands proxy voting policies and procedures is attached
as Appendix B to this Statement of Additional Information. The Funds proxy voting record for the
most recent 12-month period ending June 30 will be available (i) without charge, upon request, by
calling 1-877-665-1287 and (ii) on the Commissions web site (http://www.sec.gov).
Codes of Ethics
The Trust and the Investment Adviser 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 Commissions Public Reference Room in Washington, D.C. Information on the operation
of the Public Reference Room may be obtained by calling the Commission at 1-202-551-8090. The code
of ethics are available on the EDGAR Database on the Commissions 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 Commissions Public Reference
Section, Washington, D.C. 20549-0102.
Administration Services
Pursuant to the Trusts administration services agreement, Highland will perform the following
services: (i) prepare monthly security transaction listings; (ii) supply various normal and
customary Trust statistical data as requested on an ongoing basis; (iii) prepare for execution and
file the Trusts federal and state tax returns; prepare a fiscal tax provision in coordination with
the annual audit; prepare an excise tax provision; and prepare all relevant 1099 calculations; (iv)
coordinate contractual relationships and communications between the Trust and its contractual
service providers; (v) coordinate printing of the Trusts annual and semi-annual shareholder
reports; (vi) prepare income and capital gain distributions; (vii) prepare the semiannual and
annual financial statements; (viii) monitor the Trusts compliance with Internal Revenue Code,
Commission and prospectus requirements; (ix) prepare, coordinate with the Trusts counsel and
coordinate the filing with the Commission: semi-annual reports on Form N-SAR and Form N-CSR; Form
N-Q; and Form N-PX based upon information provided by the Trust, assist in the preparation of Forms
3, 4 and 5 pursuant to Section 16 of the Securities Exchange Act of 1934, as amended, and Section
30(f) of the Investment Company Act for the officers and trustees of the Trust, such filings to be
based on information provided by those persons; (x) assist in the preparation of notices of
meetings of shareholders; (xi) assist in obtaining the fidelity bond and trustees and
officers/errors and omissions insurance policies for the Trust in accordance with the requirements
of Rule 17g-1 and 17d-1(d)(7) under the Investment Company Act as such bond and policies are
approved by the Trusts board of trustees; (xii) monitor the Trusts assets to assure adequate
fidelity bond coverage is maintained; (xiii) draft agendas and resolutions for quarterly and
special board meetings; (xiv) coordinate the preparation, assembly and distribution of board
materials; (xv) attend board meetings and draft minutes thereof; (xvi) maintain the Trusts
calendar to assure compliance with various filing and board approval deadlines; (xvii) furnish the
Trust office space in the offices of Highland, or in such other place or places as may be agreed
upon from time to time, and all necessary office facilities, simple business equipment, supplies,
utilities and telephone service for managing the affairs and investments of the Trust; (xviii)
assist the Trust in the handling of SEC examinations and responses thereto; (xix) perform clerical,
bookkeeping and all other administrative services not provided by the Trusts other service
providers; (xx) determine or oversee the determination and publication of the Trusts net asset
value in accordance with the Trusts policy as adopted from time to time by the
B-16
Board of Trustees; (xxi) oversee the maintenance by the Trusts custodian and transfer agent
and dividend disbursing agent of certain books and records of the Trust as required under Rule
31a-1(b)(2)(iv) of the Investment Company Act and maintain (or oversee maintenance by such other
persons as approved by the board of trustees) such other books and records required by law or for
the proper operation of the Trust; (xxii) prepare such information and reports as may be required
by any stock exchange or exchanges on which the Trusts shares are listed; (xxiii) determine the
amounts available for distribution as dividends and distributions to be paid by the Trust to its
shareholders; prepare and arrange for the printing of dividend notices to shareholders; and provide
the Trusts dividend disbursing agent and custodian with such information as is required for such
parties to effect the payment of dividends and distributions and to implement the Trusts dividend
reinvestment plan; (xxiv) serve as liaison between the Trust and each of its service providers; and
(xxv) perform such additional administrative duties relating to the administration of the Trust as
may subsequently be agreed upon in writing between the Trust and Highland. Highland shall have the
authority to engage a sub-administrator in connection with the administrative services of the
Trust, which sub-administrator may be an affiliate of Highland; provided, however, that Highland
shall remain responsible to the Trust with respect to its duties and obligations set forth in the
administration services agreement.
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 |
|
|
Assets |
|
|
|
|
|
|
|
|
|
|
|
Subject to a |
|
|
Subject to a |
|
|
|
Number of |
|
|
Assets of |
|
|
Performance |
|
|
Performance |
|
Type of Account |
|
Accounts |
|
|
Accounts |
|
|
Fee |
|
|
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 |
|
|
Assets |
|
|
|
|
|
|
|
|
|
|
|
Subject to a |
|
|
Subject to a |
|
|
|
Number of |
|
|
Assets of |
|
|
Performance |
|
|
Performance |
|
Type of Account |
|
Accounts |
|
|
Accounts |
|
|
Fee |
|
|
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 |
|
|
Assets |
|
|
|
|
|
|
|
|
|
|
|
Subject to a |
|
|
Subject to a |
|
|
|
Number of |
|
|
Assets of |
|
|
Performance |
|
|
Performance |
|
Type of Account |
|
Accounts |
|
|
Accounts |
|
|
Fee |
|
|
Fee |
|
Registered Investment Companies |
|
|
|
|
|
$ billion |
|
|
|
|
|
$ billion |
Pooled Investment Vehicles |
|
|
|
|
|
$ billion |
|
|
|
|
|
$ billion |
Other Accounts |
|
|
|
|
|
$ billion |
|
|
|
|
|
$ billion |
The Investment Adviser has built a professional working environment, a firm-wide compliance
culture and compliance procedures and systems designed to protect against potential incentives that
may favor one account over another. The Investment Adviser 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 Adviser furnishes
advisory services to numerous clients in addition to the Trust, and the Investment Adviser may,
consistent with
B-17
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 Adviser,
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 Adviser, 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 Adviser 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 Adviser, 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
Adviser may refrain from rendering any advice or services concerning securities of companies of
which any of the Investment Advisers (or its affiliates) officers, directors or employees are
directors or officers, or companies as to which the Investment Adviser 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 Adviser includes disclosure regarding these
matters to its clients in both its Form ADV and investment advisory agreements.
The Investment Adviser, 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 Adviser. 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
Adviser 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 Adviser 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 Adviser 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
Advisers 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 Adviser 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 Advisers 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 Adviser (the Unregistered
Trusts) in certain private placements in which the Investment Adviser 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 Adviser.
Compensation
The Investment Advisers 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 Adviser such as Option It Plan and the Long-Term Incentive Plan.
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.
B-18
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 portfolio transactions for the Trust, the Investment Adviser will give primary
consideration to securing the most favorable price and efficient execution. Consistent with this
policy, the Investment Adviser may consider the financial responsibility, research and investment
information and other services provided by brokers or dealers who may effect or be a party to any
such transaction or other transactions to which other clients of the Investment Adviser may be a
party. Neither the Trust nor the Investment Adviser has adopted a formula for allocation of the
Trusts investment transaction business. The Investment Adviser has access to supplemental
investment and market research and security and economic analysis provided by brokers who may
execute brokerage transactions at a higher cost to the Trust than would otherwise result when
allocating brokerage transactions to other brokers on the basis of seeking the most favorable price
and efficient execution. The Investment Adviser, therefore, is authorized to place orders for the
purchase and sale of securities for the Trust with such brokers, subject to review by the Trusts
board of trustees from time to time with respect to the extent and continuation of this practice.
The services provided by such brokers may be useful or beneficial to the Investment Adviser in
connection with its services to other clients.
On occasions when the Investment Adviser deems the purchase or sale of a security to be in the
best interest of the Trust as well as other clients, the Investment Adviser, to the extent
permitted by applicable laws and regulations, may, but shall be under no obligation to, aggregate
the securities to be so sold or purchased in order to obtain the most favorable price or lower
brokerage commissions and efficient execution. In such event, allocation of the securities so
purchased or sold, as well as the expenses incurred in the transaction, will be made by the
Investment Adviser in the manner it considers to be the most equitable and consistent with its
fiduciary obligations to the Trust and to such other clients.
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 Trusts 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 Trusts 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 Trusts Preferred Shares are outstanding
or there are outstanding borrowings, the Trust may not purchase, redeem or otherwise acquire any of
its common shares unless (i) all
B-19
accrued Preferred Shares dividends have been paid and (ii) at the time of such purchase,
redemption or acquisition, the net asset value of the Trusts 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 Trusts net income. Any share repurchase, tender offer or borrowing that
might be approved by the Trusts 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 boards 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
Trusts status as a regulated investment company under the Code (which would make the Trust a
taxable entity, causing the Trusts 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 Trusts investment objectives and
policies in order to repurchase shares; or (3) there is, in the boards 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
Trusts shares trading at a price equal to their net asset value. Nevertheless, the fact that the
Trusts 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.
Before deciding whether to take any action if the common shares trade below net asset value,
the Trusts board of trustees would likely consider all relevant factors, including the extent and
duration of the discount, the liquidity of the Trusts 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 Trusts 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 Trusts common shares by shareholders
that are U.S. persons, as defined for U.S. federal income tax purposes. 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.
B-20
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 Trusts 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 Trusts 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
Trusts 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 Trusts 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 Trusts 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 Trusts
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 Trusts taxable income and capital gain will be
distributed to 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 Trusts current or
accumulated earnings and profits. Provided that shareholders satisfy certain holding period and
other requirements with respect to their common shares, such dividends 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.
B-21
Certain of the Trusts 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.
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, such as investments
in debt securities that have original issue discount, 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 Trusts 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 shareholders gross income.
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. The Trust does not expect that a corporate shareholder will be able to
claim a dividends received deduction with respect to any significant portion of the Trust
distributions.
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. In general, the Trust does not expect that a significant portion of its ordinary
income dividends will
B-22
be treated as qualified dividend income. 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 Trusts 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 by exchanging 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.
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 shareholders correct taxpayer identification number
(in the case of an individual, generally, such individuals 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. Corporate shareholders and certain other 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 Assets and Liabilities of the Trust as of , 2006
and related Statement of Operations and Statement of Changes in Net Assets for the period March 10,
2006 (date of inception) to , 2006 appearing in this Statement of Additional Information have
been audited by , independent registered public accounting firm, as set
forth in their report thereon appearing elsewhere herein, and is included in reliance upon such
report given
B-23
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 Commissions 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-24
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 Trusts
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
RATINGS OF INVESTMENTS
A-1
APPENDIX B
PROXY VOTING POLICIES AND PROCEDURES
B-1
Part C
Other Information
Item 25. Financial Statements And Exhibits
Financial Statements
Part ANone.
Part BReport of Independent Registered Accounting Firm, Statement of Assets and Liabilities
and Notes to Financial Statements. (1)
EXHIBITS
|
|
|
(a)
|
|
Agreement and Declaration of Trust. (1) |
(b)
|
|
By-Laws. (1) |
(c)
|
|
Not applicable (1) |
(d)
|
|
Form of Specimen Certificate (1) |
(e)
|
|
Form of Dividend Reinvestment Plan (1) |
(f)
|
|
Not applicable (1) |
(g)
|
|
Investment Advisory Agreement (1) |
(h)
|
|
Form of Underwriting Agreement (1) |
(i)
|
|
Exemptive Order (1) |
(j)
|
|
Form of Custody Agreement (1) |
(k)(1)
|
|
Transfer Agent Agreement (1) |
(k)(2)
|
|
Administration Services Agreement (1) |
(l)
|
|
Opinion and Consent of Counsel to the Trust (1) |
(m)
|
|
Not applicable (1) |
(n)
|
|
Independent Registered Public Accounting Firm Consent (1) |
(o)
|
|
Not applicable (1) |
(p)
|
|
Subscription Agreement (1) |
(q)
|
|
Not applicable (1) |
(r)(1)
|
|
Code of Ethics of Trust (1) |
(r)(2)
|
|
Code of Ethics of Adviser (1) |
(s)
|
|
Powers of Attorney (1) |
|
|
|
(1) |
|
To be filed by amendment. |
Item 26. Marketing Arrangements
Reference is made to the Form of Underwriting Agreement for the Registrants 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:
C-1
|
|
|
|
|
Registration and filing fees |
|
$ |
|
|
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
|
|
|
|
|
|
|
Number Of |
Title Of Class |
|
Record Holders |
|
|
|
Shares of Beneficial Interest |
|
|
0 |
|
Item 30. Indemnification
Article V of the Registrants 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 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
C-2
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 indemnitees 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 stockholders or trustees who are disinterested
persons (as defined in Section 2(a)(19) of the Investment Company Act) or any other right to
which he or she may be lawfully entitled.
(e) Subject to any limitations provided by the Investment Company 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 Investment Company 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 Trusts 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.
C-3
Insofar as indemnification for liabilities arising under the Securities Act of 1933, may be
permitted 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 Commission such
indemnification is against public policy as expressed in the Securities Act of 1933 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 of 1933 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 Registrants 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 Registrants 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 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
2nd day of May 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 2nd day of May
2006.
|
|
|
NAME |
|
TITLE |
|
|
|
/s/ R. Joseph Dougherty
R. Joseph Dougherty
|
|
Sole Initial Trustee, President, Chief Executive Officer and
Principal Financial Officer |