STATEMENT OF ADDITIONAL INFORMATION
RELATING TO REORGANIZATION OF
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
AND
PROSPECT STREET INCOME SHARES INC.
(each an "Acquired Fund" and collectively the "Acquired Funds")
INTO
HIGHLAND CREDIT STRATEGIES FUND
(the "Acquiring Fund," and together with the Acquired Funds, the "Funds")
DATED April 23, 2008
This Statement of Additional Information ("SAI") is available to the
shareholders of Prospect Street High Income Portfolio Inc. ("High Income
Portfolio") and Prospect Street Income Shares Inc. ("Income Shares") in
connection with proposed reorganizations (each a "Reorganization" and
collectively the "Reorganizations") whereby each Acquired Fund will reorganize
into the Acquiring Fund and shareholders of each Acquired Fund will receive
common shares of the Acquiring Fund equal to the net asset value of their
holdings in that Acquired Fund. Each Acquired Fund will then (1) de-register
with the Securities and Exchange Commission (the "SEC"), (2) de-list from the
NYSE and (3) dissolve under Maryland corporate law. Unless otherwise defined
herein, capitalized terms have the meanings given to them in the Proxy Statement
and Prospectus dated April 23, 2008, relating to the Reorganizations (the "Proxy
Statement/Prospectus").
THIS SAI IS NOT A PROSPECTUS AND SHOULD BE READ IN CONJUNCTION WITH THE PROXY
STATEMENT/PROSPECTUS. A copy of the Proxy Statement/Prospectus may be obtained,
without charge, by writing to Highland Funds, c/o PFPC Inc., P.O. Box 9840,
Providence, RI 02940. You may also obtain a copy of the Proxy
Statement/Prospectus on the SEC's web site at (http://www.sec.gov).
Credit Strategies Fund's annual report to shareholders dated December 31, 2007,
High Income Portfolio's annual report to shareholders dated October 31, 2007,
and Income Shares' annual report to shareholders dated December 31, 2007 are
incorporated by reference into (and therefore legally part of) this Statement of
Additional Information.
TABLE OF CONTENTS FOR THE STATEMENT OF ADDITIONAL INFORMATION
Page
----
Investment Restrictions........................................................1
Additional Investment Information..............................................7
Management of the Funds.......................................................18
Portfolio Transactions and Brokerage..........................................27
Tax Matters...................................................................28
Additional Information........................................................32
Pro Forma Financial Statements................................................32
Appendix A Ratings of Investments............................................A-1
Appendix B Proxy Voting Procedures...........................................B-1
ii
INVESTMENT RESTRICTIONS
CREDIT STRATEGIES FUND
----------------------
Except as described below, the Acquiring Fund, as a fundamental policy, may
not, without the approval of the holders of a majority of the outstanding common
shares and 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 Act of 1940, as amended (the "1940 Act"), or pledge its
assets other than to secure such issuances or in connection with hedging
transactions, short sales, securities lending, when-issued and forward
commitment transactions and similar investment strategies;
(3) make loans of money or property to any person, except through loans of
portfolio securities up to a maximum of 33?% of the Acquiring Fund's 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 33? of the Acquiring Fund's 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 Acquiring Fund may be deemed to be an underwriter;
(5) purchase or sell real estate, except that the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund's ownership of such other assets; or
(6) purchase or sell commodities or commodity contracts for any purposes
except as, and to the extent, permitted by applicable law without the Acquiring
Fund becoming subject to registration with the Commodity Futures Trading
Commission (the "CFTC") as a commodity pool.
As currently relevant to the Acquiring Fund, the 1940 Act requires an asset
coverage of 200% for a closed-end fund issuing preferred stock and for
borrowings exceeding 5% of the Acquiring Fund's assets (excluding temporary
borrowings).
The Acquiring Fund will not engage in any activities described under
investment restriction number 2 pursuant to which the lenders would be able to
foreclose on more than 33 1/3% of the Acquiring Fund's total assets.
The Acquiring Fund is also subject to the following non-fundamental
restrictions and policies, which may be changed by the Acquiring Fund's Board of
Trustees ("Acquiring Fund Board") and without shareholder approval. The
Acquiring Fund 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 Acquiring Fund's total assets and the Acquiring Fund's aggregate short sales
of a particular class of securities of an issuer does not exceed 25% of the then
outstanding securities of that class. The Acquiring Fund 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 Acquiring Fund 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 1940 Act or any exemptive relief obtained
thereunder. Under the 1940 Act, the Acquiring Fund 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 shares of any one investment company, provided the
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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 Acquiring Fund will bear its ratable share of that
investment company's expenses and will remain subject to payment of advisory
fees and other expenses with respect to assets invested therein. Holders of
common shares will therefore be subject to duplicative expenses to the extent
the Acquiring Fund invests in other investment companies. In addition, the
securities of other investment companies may be leveraged and will therefore be
subject to the risks of leverage. The net asset value and market value of
leveraged shares will be more volatile and the yield to shareholders will tend
to fluctuate more than the yield generated by unleveraged shares.
In addition, to comply with the federal tax requirements for qualification
as a regulated investment company, the Acquiring Fund's investments must meet
certain diversification requirements. See "Tax Matters."
For purposes of this SAI, a "majority of the outstanding" shares means (a)
67% or more of a Fund's outstanding voting securities present at a meeting, if
the holders of more than 50% of its outstanding voting securities are present or
represented by proxy, or (b) more than 50% of its outstanding voting securities,
whichever is less (a "1940 Act Majority Vote").
The percentage limitations applicable to the Acquiring Fund's portfolio
described in the Proxy Statement/Prospectus and this SAI apply only at the time
of investment, except that the percentage limitation with respect to borrowing
applies at all times, and the Acquiring Fund will not be required to sell
securities due to subsequent changes in the value of securities it owns.
INCOME SHARES
-------------
Income Shares' investment objectives, its policy to invest at least 50% of
its total assets in debt securities rated in the four highest rating categories
assigned by nationally recognized rating agencies, or other securities such as
U.S. and Canadian government securities, obligations of or guaranteed by banks,
commercial paper and cash equivalents, or nonrated debt securities deemed by
Highland Capital Management, L.P. ("Highland" or "Adviser") to be of comparable
quality, and all of the investment restrictions listed below have been adopted
by Income Shares as fundamental policies. Fundamental policies of Income Shares
may not be changed without a 1940 Act Majority Vote of the shares of common
stock and preferred stock, voting as separate classes. All other investment
policies or practices are considered by Income Shares not to be fundamental and
accordingly may be changed by Income Shares' Board of Directors ("Income Shares
Board") without stockholder approval.
Income Shares will not:
1. Issue senior securities as defined in the 1940 Act, except in
connection with borrowing permitted in restriction 2 below, issuing a class or
classes of preferred stock to the extent permitted under the 1940 Act or to the
extent investments in interest rate futures contracts or fixed income options
permitted in restriction 19 below are considered to result in the issuance of
senior securities.
2. Borrow money, except for investment leverage.
3. Mortgage, pledge or hypothecate its assets, except in connection
with borrowing money as mentioned in restriction 2 above or the issuance of a
class or classes of preferred stock as described in restriction 1 above. This
provision shall not apply to deposits, or similar arrangements, made in
connection with the entering into or holding of interest rate futures contracts
or purchasing, selling, holding or writing fixed income options.
4. Act as underwriter, except to the extent that, in connection with
the disposition of restricted portfolio securities, Income Shares may be deemed
to be an underwriter under applicable laws.
5. Purchase or sell real estate or interests in real estate, except
that Income Shares may invest in securities secured by real estate or interests
therein or issued by companies, including real estate investment trusts, which
deal in real estate or interests therein.
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6. Purchase or sell commodities or commodity contracts, except that
Income Shares may enter into interest rate futures contracts or fixed income
options and make deposits or have similar arrangements in connection therewith.
7. Invest more than 5% of the value of its total assets in the
securities of any one issuer (other than cash items and securities of the U.S.
government or its agencies or instrumentalities), or purchase more than 10% of
any class of the outstanding voting securities of any one issuer.
8. Invest more than 25% of the value of its total assets in
restricted securities, which are securities acquired in private placement
transactions.
9. Invest more than 25% of the value of its total assets in
securities of issuers in any one industry (gas, electric and telephone companies
will be considered to be in separate industries, as will banks, finance
companies, savings and loan associations, insurance companies and other credit
institutions) except that at times when a significant portion of the market for
corporate debt securities is composed of issues in the electric utility industry
or the telephone utility industry, as the case may be, Income Shares may invest
up to 35% of its assets in the issues of such industry if Income Shares has cash
for such investment and if, in the judgment of management, the return available
from such securities and the marketability, quality and availability thereof
justify such concentration in light of Income Shares' investment objectives. The
market for corporate debt securities will be considered to be composed of a
significant portion of debt securities of either, the electric utility industry
or the telephone utility industry, as the case may be, at any time that, to the
best of Income Shares' knowledge, 10% or more of the principal amounts of all
new issue offerings of corporate debt securities in principal amounts of
$25,000,000 or more and within the four highest grades assigned by Moody's
Investors Service, Inc. ("Moody's"), Standard & Poor's, a division of The
McGraw-Hill Companies, Inc. ("Standard & Poor's"), or Fitch, Inc., offered
within the prior 60-day period or scheduled to be offered during the subsequent
30-day period consists of such issues in such industry.
10. Purchase or retain the securities of any issuer, if, to Income
Shares' knowledge, those officers or directors of Income Shares or of the
Adviser who individually own beneficially more than 0.5% of the outstanding
securities of such issuer, together own beneficially more than 5% of such
outstanding securities.
11. Make loans to other persons, except for the purchase of debt
securities in private placement transactions or public offerings in accordance
with Income Shares' investment objectives and policies and for loans of
portfolio securities as described above.
12. Purchase securities on margin, except that Income Shares may
obtain such short-term credits as may be necessary for the clearance of
purchases or sales of securities, and except that Income Shares may enter into
and hold interest rate futures contracts and purchase, sell, hold or write fixed
income options and may make deposits or make similar arrangements in connection
therewith.
13. Participate on a joint or joint and several basis in any
securities trading account. The "bunching" of orders for the sale or purchase of
marketable portfolio securities and other accounts under the management of the
Adviser or affiliates to save commissions or to average prices among them is not
deemed to result in a securities trading account.
14. Purchase interests in oil, gas, or other mineral exploration
programs; however, this limitation will not prohibit the acquisition of
securities of companies engaged in the production of or transmission of oil, gas
or other materials.
15. Invest in puts, calls or combinations thereof except fixed income
options.
16. Make short sales, except sales "against the box."
17. Purchase the securities of other investment companies.
3
18. Invest for the purposes of exercising control or management.
19. Enter into any interest rate futures contract or write any fixed
income option if, immediately thereafter, the sum of (a) the then aggregate
futures and option market prices of financial instruments and fixed income
options required to be delivered under open futures contract sales of Income
Shares and open fixed income call options written by Income Shares and (b) the
aggregate purchase price under open futures contract purchases of Income Shares
and open fixed income put options written by Income Shares, would exceed, in the
aggregate, an amount equal to the lesser of (i) 5% of Income Shares' net asset
value or (ii) one-third of the total assets of Income Shares less all
liabilities not related to fixed income options written by Income Shares and
interest rate futures contracts.
Although the provisions of restriction 3 (with respect to futures
contracts), 6 and 12 permit Income Shares to certain practices to a limited
extent, Income Shares does not have any current intention of engaging in such
practices. Income Shares will not make any investment permitted by the
exceptions to Income Shares' investment restrictions if the investment would
adversely affect the ratings assigned by Moody's and/or Standard & Poor's to its
outstanding preferred stock.
Notwithstanding restriction 6, Income Shares is permitted to buy certain
debt securities, known as Principal Exchange Rate Linked Securities (PERLS), in
which the interest or principal component is determined by calculating with
reference to a formula based on one or more commodities, including currencies,
so long as the security does not constitute a commodity or commodity contract.
For example, Income Shares may buy certain debt securities issued by the Federal
National Mortgage Association ("FNMA"), a U.S. government agency, which carry an
additional risk not associated with other FNMA issues. They pay interest based
upon a specified interest rate and a principal amount denominated in U.S.
dollars. At maturity, the principal is paid in U.S. dollars, but the amount of
principal that will be paid is calculated according to a predetermined formula
involving the value of one or more foreign currencies on a particular date near
the maturity date (the "principal payment formula"). This kind of security is
subject to the risk that the currency that is part of the principal payment
formula may be valued at an amount which could cause the principal paid at
maturity to be greater or less than the amount of principal upon which the
interest rate is calculated.
By virtue of restriction 8, it would be possible for Income Shares to
invest up to 25% of its assets in restricted securities, which are securities
acquired in private placement transactions. Such securities generally may not be
resold without registration under the Securities Act of 1933, as amended (the
"Securities Act"), except in transactions exempt from the registration
requirements of the Securities Act. This limitation on resale can have an
adverse effect on the price obtainable for such securities. Also, if in order to
permit resale, the securities are registered under the Securities Act at Income
Shares' expense, Income Shares' expenses would be increased.
By virtue of restriction 9, it would be possible for Income Shares to
invest up to 70% of its assets in securities of the electric utility and
telephone utility industries (up to 35% in each of such industries) if Income
Shares had cash for such investment and if, in Income Shares' judgment, the
return available from such industry, and the marketability, quality and
availability of the debt securities of such industry, justified such
concentration in light of Income Shares' investment objectives. However, if
sufficient cash was not available or if the securities available did not meet
the above-mentioned tests of return, marketability, quality and availability,
such concentration would not occur. Also, Income Shares would not be required to
sell portfolio securities in order to make cash available for such
concentration, although Income Shares would not be prohibited from doing so.
Furthermore, Income Shares' ability to so concentrate its assets would always be
contingent upon compliance with other applicable investment restrictions.
Concentration of Income Shares' assets in either the electric utility or the
telephone utility industries could result in increased risks. Risks of
investments in either industry may arise from difficulties in obtaining an
adequate return on capital because of financing costs and construction programs
and the fact that regulatory authorities might not approve rate increases
sufficient to offset increases in operating expenses. In addition, risks of
investments in the electric utility industry may arise from environmental
conditions, fuel shortages and government-mandated energy conservation programs.
By virtue of restriction 19, Income Shares has a limited ability to enter
into interest rate futures contracts and to write fixed income options. Interest
rate futures contracts and fixed income options create an obligation by Income
Shares to purchase or to sell a specific financial instrument at a specified
future time at a specified price. The principal risk of interest rate futures
4
contracts and fixed income options is that unexpected changes in the general
level of interest rates could adversely affect the value of the investment.
Income Shares has not written fixed income options for several years and has
never entered into interest rate futures contracts.
If a percentage restriction is adhered to at the time of investment, a
later increase or decrease in percentage resulting from a change in value of
Income Shares' investments or amount of total assets will not be considered a
violation of any of the foregoing restrictions. With respect to restriction 2,
however, if borrowings exceed the amount permitted under the 1940 Act as a
result of a change in values or assets, Income Shares must take steps to reduce
such borrowings at least to the extent of such excess.
HIGH INCOME PORTFOLIO
---------------------
High Income Portfolio's investment objective, its policy to invest at least
65% of its total assets in high-yield securities rated in the lower categories
by recognized rating agencies or nonrated fixed-income securities deemed by the
Adviser to be of comparable quality and the following investment restrictions
have been adopted by High Income Portfolio as fundamental policies. Fundamental
policies of High Income Portfolio may not be changed without a 1940 Act Majority
Vote of the shares of common stock and preferred stock, voting as separate
classes. All other investment policies or practices are considered by High
Income Portfolio not to be fundamental and accordingly may be changed by High
Income Portfolio's Board of Directors ("High Income Board") (collectively, High
Income Board, Income Shares Board and Acquiring Fund Board, the "Boards")
without stockholder approval.
High Income Portfolio may not:
1. Borrow money (through reverse repurchase agreements or otherwise)
or issue any senior securities (as defined in the 1940 Act), except as permitted
by the 1940 Act.
2. Pledge, hypothecate, mortgage or otherwise encumber its assets,
except to secure borrowings permitted by restriction 1 above. Collateral
arrangements with respect to margin for futures contracts and options are not
deemed to be pledges or other encumbrances for purposes of this restriction.
3. Purchase securities on margin, except such short-term credits as
may be necessary for the clearance of purchases and sales of securities and
except that High Income Portfolio may make margin payments in connection with
transactions in futures contracts and options.
4. Make short sales of securities or maintain a short position for
the account of High Income Portfolio unless at all times when a short position
is open High Income Portfolio owns an equal amount of such securities or owns
securities which, without payment of any further consideration, are convertible
into or exchangeable for securities of the same issuer as, and in equal amount
to, the securities sold short.
5. Underwrite securities issued by other persons, except to the
extent that, in connection with the disposition of its portfolio investments,
High Income Portfolio may be deemed to be an underwriter under the federal
securities laws.
6. Purchase or sell real estate, although High Income Portfolio may
purchase securities of issuers that deal in real estate, securities that are
secured by interests in real estate and securities representing interests in
real estate.
7. Purchase or sell commodities or commodity contracts, except that
High Income Portfolio may purchase or sell financial futures contracts and
related options as provided in the Proxy Statement/Prospectus and this SAI.
8. Make loans, except by the acquisition of loan interests and other
debt obligations in which High Income Portfolio may invest consistent with its
investment policies, by entering into repurchase agreements with respect to not
more than 25% of the value of its total assets, or through the lending of its
portfolio securities with respect to not more than one-third of the value of its
total assets.
5
9. With respect to 75% of the value of High Income Portfolio's total
assets, invest in securities of any issuer if, immediately after such
investment, more than 5% of the value of High Income Portfolio's total assets
would be invested in the securities of such issuer, provided that this
limitation does not apply to obligations issued or guaranteed as to interest and
principal by the U.S. government or its agencies or instrumentalities.
10. With respect to 75% of the value of High Income Portfolio's total
assets, acquire more than 10% of the outstanding voting securities of any
issuer.
11. Invest 25% or more of the value of its total assets in any one
industry, provided that this limitation does not apply to obligations issued or
guaranteed as to interest and principal by the U.S. government or its agencies
or instrumentalities.
12. Invest in the securities of other registered investment companies,
except as they may be acquired as part of a merger or consolidation or
acquisition of assets or by purchases in the open market involving only
customary brokers' commissions.
13. Buy or sell oil, gas or other mineral leases, rights or royalty
contracts, although High Income Portfolio may purchase securities of issuers
which deal in, represent interests in or are secured by interests in such
leases, rights or contracts.
14. Make investments for the purpose of exercising control or
management over the issuer of any security.
15. Write, purchase or sell puts, calls or combinations thereof, or
purchase or sell futures contracts or related options, except that High Income
Portfolio may write call options and invest in futures contracts and related
options as provided in the Proxy Statement/Prospectus and this SAI.
With respect to restriction 1, the 1940 Act permits a closed-end investment
company, such as High Income Portfolio, to issue a note in consideration for any
privately arranged loan that is not intended to be publicly distributed, or a
note evidencing a temporary loan that does not exceed 5% of the company's total
assets at the time it is made. The 1940 Act also permits closed-end investment
companies to issue senior securities representing debt or preferred stock,
subject to certain conditions. With respect to restrictions 1 and 2, the 1940
Act permits a closed-end investment company to borrow (leverage) by issuing debt
in an amount up to 33?% of its total assets and by issuing preferred stock in an
amount up to 50% of its total assets (as described in the Proxy
Statement/Prospectus, in the case of debt, the company must have asset coverage
of 300% immediately after such issuance, and, in the case of stock, 200%
coverage is required). As such, under restriction 2, High Income Portfolio may
pledge, hypothecate, mortgage or otherwise encumber its assets in connection
with such borrowings permitted under restriction 1 in amounts up to 33?% of its
total assets. In addition to the prohibitions listed in restriction 6, High
Income Portfolio has no intention to purchase or sell real estate or invest in
real estate mortgages.
Although the provisions of certain restrictions permit High Income
Portfolio to engage in transactions in futures contracts to a limited extent,
High Income Portfolio does not have any current intention of engaging in such
transactions. High Income Portfolio will not make any investment permitted by
the exceptions to High Income Portfolio's investment restrictions if the
investment would adversely affect the ratings assigned by Standard & Poor's
and/or Moody's to its outstanding preferred stock.
If a percentage restriction is adhered to at the time of investment, a
later increase or decrease in percentage resulting from a change in value of
High Income Portfolio's investments or amount of total assets will not be
considered a violation of any of the foregoing restrictions. With respect to
restriction 1, however, if borrowings exceed the amount permitted under the 1940
Act as a result of a change in values or assets, High Income Portfolio must take
steps to reduce such borrowings at least to the extent of such excess.
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ADDITIONAL INVESTMENT INFORMATION
CREDIT STRATEGIES FUND
-----------------------
The following is a description of the various investments Acquiring Fund
may acquire, whether as a primary or secondary strategy. The information
supplements the discussion of the Acquiring Fund's investment objectives,
policies and techniques that are described in the Proxy Statement/Prospectus.
SHORT-TERM DEBT SECURITIES
For temporary defensive purposes or to keep cash on hand, the Acquiring
Fund 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 Acquiring Fund may not be fully
insured by the Federal Deposit Insurance Corporation.
(3) Repurchase agreements, which involve purchases of debt securities. At
the time the Acquiring Fund 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
Acquiring Fund 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 Acquiring Fund to invest
temporarily available cash. The Acquiring Fund 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 Acquiring Fund may invest. Repurchase agreements
may be considered loans to the seller, collateralized by the underlying
securities. The risk to the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund could incur a loss of
both principal and interest. Highland monitors the value of the collateral
at the time the action is entered into and at all times during the term of
the repurchase agreement. Highland does so in an effort to determine that
the value of the collateral always equals or exceeds the agreed-upon
repurchase price to be paid to the Acquiring Fund. If the seller were to be
subject to a federal bankruptcy proceeding, the ability of the Acquiring
Fund to liquidate the collateral could be delayed or impaired because of
certain provisions of the bankruptcy laws.
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(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 Acquiring Fund and a corporation. There is no
secondary market for such notes. However, they are redeemable by the
Acquiring Fund at any time. Highland will consider the financial condition
of the corporation (e.g., earning power, cash flow and other liquidity
ratios) and will continually monitor the corporation's ability to meet all
of its financial obligations, because the Acquiring Fund's liquidity might
be impaired if the corporation were unable to pay principal and interest on
demand. Investments in commercial paper will be limited to commercial paper
rated in the highest categories by a major rating agency and which mature
within one year of the date of purchase or carry a variable or floating
rate of interest.
EQUITY SECURITIES
The Acquiring Fund may invest in equity securities including preferred
stock, warrants and depository receipts.
PREFERRED STOCK. Preferred stock has a preference over common stock in
liquidation (and generally dividends as well) but is subordinated to the
liabilities of the issuer in all respects. As a general rule, the market value
of preferred stock with a fixed dividend rate and no conversion element varies
inversely with interest rates and perceived credit risk, while the market price
of convertible preferred stock generally also reflects some element of
conversion value. Because preferred stock is junior to debt securities and other
obligations of the issuer, deterioration in the credit quality of the issuer
will cause greater changes in the value of a preferred stock than in a more
senior debt security with similar stated yield characteristics. Unlike interest
payments on debt securities, preferred stock dividends are payable only if
declared by the issuer's board of directors. Preferred stock also may be subject
to optional or mandatory redemption provisions.
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 Acquiring Fund 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 security's
market price such as when there is no movement in the level of the underlying
security.
DEPOSITORY RECEIPTS. The Acquiring Fund 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 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 Acquiring Fund 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 Acquiring Fund 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
8
variable and floating rate instruments must satisfy the same criteria as set
forth above for the Acquiring Fund. The absence of an active secondary market
with respect to particular variable and floating rate instruments, however,
could make it difficult for the Acquiring Fund to dispose of a variable or
floating rate instrument if the issuer defaulted on its payment obligation or
during periods when the Acquiring Fund 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 Acquiring Fund to dispose of a variable or floating rate note
if the issuer defaulted on its payment obligation or during periods that the
Acquiring Fund is not entitled to exercise its demand rights, and the Acquiring
Fund 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 Acquiring Fund 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
Proxy Statement/Prospectus and in addition to its option strategy, the Acquiring
Fund may also enter into certain risk management transactions. In particular,
the Acquiring Fund 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 Acquiring
Fund's portfolio resulting from fluctuations in the securities markets and
changes in interest rates, to protect the Acquiring Fund's unrealized gains in
the value of its portfolio securities, to facilitate the sale of such securities
for investment purposes and to establish a position in the securities markets as
a temporary substitute for purchasing particular securities. Any or all of these
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 Acquiring
Fund to manage them successfully will depend on Highland's ability to predict
pertinent market movements as well as sufficient correlation among the
instruments, which cannot be assured. The Derivative Transactions that the
Acquiring Fund may use are described below. Although the Acquiring Fund
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 Acquiring Fund 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 Acquiring Fund
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 Acquiring Fund will engage in such transactions only
for bona fide risk management and other portfolio management purposes.
FORWARD FOREIGN CURRENCY CONTRACTS. The Acquiring Fund 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.
The Acquiring Fund may engage in various forward currency contract
strategies:
o The Acquiring Fund may purchase a forward currency contract to lock in
the U.S. dollar price of a security denominated in a foreign currency
that the Acquiring Fund intends to acquire. The Acquiring Fund may
9
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.
o The Acquiring Fund may also use forward currency contracts to shift
the Acquiring Fund's exposure to foreign currency exchange rate
changes from one currency to another. For example, if the Acquiring
Fund owns securities denominated in a foreign currency and Highland
believes that currency will decline relative to another currency, the
Acquiring Fund 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.
o The Acquiring Fund 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.
o The Acquiring Fund 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.
o The Acquiring Fund could also enter into a forward currency contract
to sell another currency expected to perform similarly to the currency
in which the Acquiring Fund's existing investments are denominated.
This type of transaction could offer advantages in terms of cost,
yield or efficiency, but may not offset currency exposure as
effectively as a simple forward currency transaction to sell U.S.
dollars. This type of transaction may result in losses if the currency
sold does not perform similarly to the currency in which the Acquiring
Fund's existing investments are denominated.
o The Acquiring Fund 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.
o The cost to the Acquiring Fund 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.
o When the Acquiring Fund 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 Acquiring Fund 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
Acquiring Fund might be unable to close out a forward currency
contract. In either event, the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund 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
10
time during the option period. All such calls sold by the Acquiring Fund must be
"covered" as long as the call is outstanding (i.e., the Acquiring Fund must own
the instrument subject to the call or other securities or assets acceptable for
applicable segregation and coverage requirements). A call sold by the Acquiring
Fund exposes the Acquiring Fund 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 Acquiring Fund to hold
an instrument which it might otherwise have sold. The purchase of a call gives
the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund may also
sell puts on securities, indices or futures contracts on such securities if the
Acquiring Fund's contingent obligations on such puts are secured by segregated
assets consisting of cash or liquid debt securities having a value not less than
the exercise price. In selling puts, there is a risk that the Acquiring Fund 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
Acquiring Fund may enter into are interest rate swaps and the purchase or sale
of interest rate caps and floors. The Acquiring Fund 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 Acquiring Fund anticipates
purchasing at a later date. The Acquiring Fund intends to use these transactions
for risk management purposes and not as a speculative investment. The Acquiring
Fund will not sell interest rate caps or floors that it does not own. Interest
rate swaps involve the exchange by the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund believe such obligations do
not constitute senior securities, and, accordingly will not treat them as being
subject to its borrowing restrictions. The Acquiring Fund will accrue the net
amount of the excess, if any, of the Acquiring Fund's obligations over its
entitlements with respect to each interest rate swap on a daily basis and will
designate on its books and records with a custodian an amount of cash or liquid
high grade securities having an aggregate net asset value at all times at least
equal to the accrued excess. The Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund 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.
11
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 Acquiring Fund 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 Acquiring Fund. The
Acquiring Fund's risk of loss in a credit derivative transaction varies with the
form of the transaction. For example, if the Acquiring Fund purchases a default
option on a security, and if no default occurs with respect to the security, the
Acquiring Fund's loss is limited to the premium it paid for the default option.
In contrast, if there is a default by the grantor of a default option, the
Acquiring Fund's loss will include both the premium that it paid for the option
and the decline in value of the underlying security that the default option
protects.
Below under "General Characteristics of Risks of Derivative Transactions"
is further information about the characteristics, risks and possible benefits of
Derivative Transactions and the Acquiring Fund's 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 Acquiring
Fund's 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 Acquiring Fund being in a worse position than if such
techniques had not been used.
Certain provisions of the Internal Revenue Code of 1986, as amended
("Code"), may affect the Acquiring Fund's ability 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 Proxy Statement/Prospectus, the Acquiring
Fund will engage in Derivative Transactions. The Acquiring Fund will engage in
such activities in the Adviser's discretion, and may not necessarily be engaging
in such activities when movements in interest rates that could affect the value
of the assets of the Acquiring Fund occur. The Acquiring Fund's 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 Acquiring Fund 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 Acquiring Fund 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
Acquiring Fund's holdings in a security or a number of securities against a
substantial decline in the market value. A call option gives the purchaser of
the option the right to buy and the seller the obligation to sell the underlying
security or index at the exercise price during the option period or for a
specified period prior to a fixed date. The purchase of a call option on a
security could protect the Acquiring Fund 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 Acquiring Fund will experience a loss in the amount of the
option premium plus any related commissions. When the Acquiring Fund sells put
and call options, it receives a premium as the seller of the option. The premium
that the Acquiring Fund 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
12
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 Acquiring Fund 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 Acquiring Fund's ability to close out its position as a purchaser or
seller of an exchange listed put or call option is dependent upon the existence
of a liquid secondary market on option exchanges. Among the possible reasons for
the absence of a liquid secondary market on an exchange are: (i) insufficient
trading interest in certain options; (ii) restrictions on transactions imposed
by an exchange; (iii) trading halts, suspensions or other restrictions imposed
with respect to particular classes or series of options or underlying
securities; (iv) interruption of the normal operations on an exchange; (v)
inadequacy of the facilities of an exchange or OCC to handle current trading
volume; or (vi) a decision by one or more exchanges to discontinue the trading
of options (or a particular class or series of options), in which event the
secondary market on that exchange (or in that class or series of options) would
cease to exist, although outstanding options on that exchange that had been
listed by the OCC as a result of trades on that exchange would generally
continue to be exercisable in accordance with their terms. OTC Options are
purchased from or sold to dealers, financial institutions or other
counterparties which have entered into direct agreements with the Acquiring
Fund. With OTC Options, such variables as expiration date, exercise price and
premium will be agreed upon between the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund 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
Acquiring Fund, 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 Acquiring Fund must allocate cash or securities as a deposit payment
("initial margin"). It is expected that the initial margin that the Acquiring
Fund 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 Acquiring Fund
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 Acquiring Fund's
use of futures and options on futures will in all cases be consistent with
applicable regulatory requirements and in particular the rules and regulations
of the CFTC. The Acquiring Fund currently may enter into such transactions
without limit for bona fide strategic purposes, including risk management and
duration management and other portfolio strategies. The Acquiring Fund may also
engage in transactions in futures contracts or related options for non-strategic
purposes to enhance income or gain provided that the Acquiring Fund 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
13
the amount of its initial deposits and premiums on open contracts and options
would exceed 5% of the Acquiring Fund's liquidation value, i.e., net assets
(taken at current value); provided, however, that in the case of an option that
is in-the-money at the time of the purchase, the in-the-money amount may be
excluded in calculating the 5% limitation. The above policies are
non-fundamental and may be changed by the Acquiring Fund's Board 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 Acquiring Fund are generally subject to earmarking and coverage
requirements of either the CFTC or the SEC, with the result that, if the
Acquiring Fund does not hold the security or futures contract underlying the
instrument, the Acquiring Fund 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 Acquiring Fund's
obligations with respect to such instruments.
SUCH AMOUNTS FLUCTUATE AS THE OBLIGATIONS INCREASE OR DECREASE. The
earmarking requirement can result in the Acquiring Fund 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 Acquiring Fund's position. The same is
true for such instruments entered into for income or gain. In addition, certain
instruments and markets may not be liquid in all circumstances. As a result, in
volatile markets, the Acquiring Fund may not be able to close out a transaction
without incurring losses substantially greater than the initial deposit.
Although the contemplated use of these instruments predominantly for 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 Acquiring Fund to successfully utilize Derivative Transactions will
depend on the Adviser's and the sub-adviser's ability to predict pertinent
market movements and sufficient correlations, which cannot be assured. Finally,
the daily deposit requirements in futures contracts that the Acquiring Fund 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 Acquiring Fund 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
BRADY BONDS
The Acquiring Fund's emerging market debt securities may include emerging
market governmental debt obligations commonly referred to as Brady Bonds. Brady
Bonds are debt securities, generally denominated in U.S. dollars, issued under
the framework of the Brady Plan, an initiative announced by U.S. Treasury
Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations (primarily
emerging market countries) to restructure their outstanding external
indebtedness (generally, commercial bank debt). Brady Bonds are created through
the exchange of existing commercial bank loans to foreign entities for new
obligations in connection with debt restructuring. A significant amount of the
Brady Bonds that the Acquiring Fund may purchase have no or limited
collateralization, and the Acquiring Fund 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
Acquiring Fund may invest are likely to be acquired at a discount.
14
MEZZANINE INVESTMENTS
The Acquiring Fund 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 Acquiring Fund 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 Acquiring
Fund's investments in Loans are expected in most instances to be in the form of
participations in Loans ("Participations") and assignments of all or a portion
of Loans ("Assignments") from third parties. Participations typically will
result in the Acquiring Fund having a contractual relationship only with the
Lender not the borrower. The Acquiring Fund 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 Acquiring Fund and only upon
receipt by the Lender of the payments by the borrower. In connection with
purchasing Participations, the Acquiring Fund 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 Acquiring
Fund may not directly benefit from any collateral supporting the Loan in which
is has purchased the Participation. As a result the Acquiring Fund 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 Acquiring Fund 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 Acquiring Fund will acquire Participations only if the Lender
interpositioned between the Acquiring Fund and the borrower is determined by
Highland to be creditworthy. When the Acquiring Fund purchases Assignments from
Lenders, the Acquiring Fund 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 Acquiring Fund as the purchaser of an Assignment may differ from, and be
more limited than, those held by the assigning Lender.
The Acquiring Fund may have difficulty disposing of Assignments and
Participations. Because there is no liquid market for such securities, the
Acquiring Fund 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 Acquiring
Fund's ability to dispose of particular Assignments or Participations when
necessary to meet the Acquiring Fund's liquidity needs or in response to a
specific economic event, such as a deterioration in the creditworthiness of the
borrower. The lack of a liquid secondary market for Assignments and
Participations also may make it more difficult for the Acquiring Fund to assign
a value to those securities for purposes of valuing the Acquiring Fund's
portfolio and calculating its net asset value.
STRUCTURED INVESTMENTS
The Acquiring Fund 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 Acquiring Fund anticipates it will invest typically involve no
credit enhancement, their credit risk generally will be equivalent to that of
the underlying instruments.
15
The Acquiring Fund 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.
Certain issuers of Structured Investments may be deemed to be "investment
companies" as defined in the 1940 Act. As a result, the Acquiring Fund's
investment in these Structured Investments may be limited by the restrictions
contained in the 1940 Act. Structured Investments are typically sold in private
placement transaction, and there currently is no active trading market for
Structured Investments.
PROJECT LOANS
The Acquiring Fund 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.
HIGH INCOME PORTFOLIO
---------------------
The following is a description of the investments of High Income Portfolio
may acquire, whether as a primary or secondary strategy. The following
information supplements the discussion of the High Income Portfolio's investment
objectives, policies and techniques that are described in the Proxy
Statement/Prospectus.
FOREIGN INVESTMENTS
High Income Portfolio may invest up to 10% of the value of its total assets
in securities principally traded in foreign markets and Eurodollar certificates
of deposit issued by branches of U.S. and foreign banks. Foreign investments may
involve risks not present to the same degree in domestic investments, such as
future political and economic developments, the imposition of withholding taxes
on interest income, seizure or nationalization of foreign deposits, the
establishment of exchange controls or the adoption of other foreign governmental
restrictions which might adversely affect the payment of principal and interest
on such obligations. Foreign securities may be less liquid and more volatile
than U.S. securities, and foreign accounting and disclosure standards may differ
from U.S. standards. In addition, settlement of transactions in foreign
securities may be subject to delays, which could result in adverse consequences
to High Income Portfolio including restrictions on the subsequent resale of such
securities. The value of foreign investments may rise or fall because of changes
in currency exchange rates. In addition, the costs of exchanging foreign
currencies for payments in U.S. dollars and nonnegotiated brokerage commissions
in foreign countries may reduce the yield on foreign securities. In the event of
a default in payment on foreign securities, High Income Portfolio may incur
increased costs to obtain a judgment against the foreign issuer in the United
States or abroad.
High Income Portfolio may buy or sell foreign currencies or deal in forward
foreign currency contracts to hedge against possible fluctuations in exchange
rates that may affect the yield of High Income Portfolio when the foreign
currencies are converted in payment in U.S. dollars. High Income Portfolio will
use currency transactions only for hedging and not speculative purposes. High
Income Portfolio may engage in currency exchange transactions to protect against
uncertainty in the level of future exchange rates. 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 contract agreed upon
by the parties, at a price set at the time of the contract. High Income
Portfolio's dealings in forward currency exchange will be limited to hedging
involving either specific transactions or portfolio positions. Transaction
hedging is the purchase or sale of forward currency with respect to specific
receivables or payables of High Income Portfolio generally arising in connection
with the purchase or sale of its portfolio securities. Position hedging is the
sale of forward currency with respect to portfolio security positions
denominated or quoted in the currency. High Income Portfolio may not use
position hedging with respect to a particular currency to an extent greater than
the aggregate market value (at the time of entering into the position hedge) of
the securities held in its portfolio denominated or quoted in or currently
convertible into that particular currency. If High Income Portfolio enters into
a position hedging transaction, High Income Portfolio will set aside cash or
permissible liquid securities in an amount equal to the value of High Income
Portfolio's total assets committed to the consummation of the forward contract.
If the value of the securities set aside declines, High Income Portfolio will
16
set aside additional cash or permissible liquid securities to equal the amount
of High Income Portfolio's commitment with respect to the forward contract.
OPTIONS
High Income Portfolio may write (sell) call options which are traded on
national securities exchanges with respect to securities in its portfolio. High
Income Portfolio may only write "covered" call options, that is, options on
securities it holds in its portfolio or has an immediate right to acquire
through conversion or exchange of securities held in its portfolio. High Income
Portfolio may write call options on its portfolio securities in an attempt to
realize a greater current return than would be realized on the securities alone.
High Income Portfolio also may write call options as a partial hedge against a
possible market decline. In view of its investment objective, High Income
Portfolio generally would write call options only in circumstances in which the
Adviser does not anticipate significant appreciation of the underlying security
in the near future or has otherwise determined to dispose of the security. As
the writer of a call option, High Income Portfolio receives a premium for
undertaking the obligation to sell the underlying security at a fixed price
during the option period if the option is exercised. So long as High Income
Portfolio remains obligated as a writer of a call option, it forgoes the
opportunity to profit from increases in the market price of the underlying
security above the exercise price of the option, except insofar as the premium
represents such a profit (and retains the risk of loss should the value of the
underlying security decline). High Income Portfolio also may enter into "closing
purchase transactions" to terminate its obligation as a writer of a call option
prior to the expiration of the option. Although the writing of call options only
on national securities exchanges increases the likelihood that High Income
Portfolio will be able to make closing purchase transactions, there is no
assurance that High Income Portfolio will be able to effect such transactions at
any particular time or at any acceptable price. The writing of call options
could result in increases in High Income Portfolio's portfolio turnover rate,
especially during periods when market prices of the underlying securities
appreciate. The extent to which High Income Portfolio may enter into
transactions involving call options also may be limited by the requirements of
the Code for qualification as a regulated investment company.
FINANCIAL FUTURES CONTRACTS AND RELATED OPTIONS
Currently, High Income Portfolio has no intention to trade in financial
futures contracts or options on financial futures contracts. However, High
Income Portfolio has reserved the right, subject to the approval of the High
Income Board, to purchase and sell financial futures contracts and options on
such futures contracts for the purpose of hedging its portfolio securities (or
portfolio securities which it expects to acquire) against anticipated changes in
prevailing interest rates. This technique could be employed if the Adviser
anticipates that interest rates may rise, in which event High Income Portfolio
could sell a futures contract to protect against the potential decline in the
value of its portfolio securities. Conversely, if declining interest rates were
anticipated, High Income Portfolio could purchase a futures contract to protect
against a potential increase in the price of securities High Income Portfolio
intends to purchase.
High Income Portfolio will not be a commodity pool. In addition, High
Income Portfolio has claimed an exclusion from the definition of commodity pool
operator and, therefore, is not subject to registration or regulation as a pool
operator under the Commodity Exchange Act.
RISKS OF HEDGING TRANSACTIONS
The use of options, financial futures and options on financial futures may
involve risks not associated with other types of investments which High Income
Portfolio intends to purchase and it is possible that a portfolio that utilizes
hedging strategies may not perform as well as a portfolio that does not make use
of such strategies. In particular, High Income Portfolio's positions in options
and financial futures may be entered and closed out only on a federally licensed
exchange which provides a market therefor, and there can be no assurance that a
liquid market will exist for any particular option or futures contract. Because
financial futures and related options markets generally impose limits on daily
price movement, it is possible that the Adviser will not be able to close out
hedge positions promptly. The inability to close out options and futures
positions could have an adverse impact on High Income Portfolio's ability to
hedge its securities effectively and might, in some cases, require High Income
Portfolio to deposit substantial amounts of additional cash to meet applicable
margin requirements. High Income Portfolio's ability to hedge effectively
through transactions in financial futures or options depends on the degree to
which price movements, which include, in part, changes in interest rates, in
17
High Income Portfolio's holdings correlate with price movements of the hedging
instruments. Inasmuch as High Income Portfolio's options and futures will not
duplicate such underlying securities, the correlation probably will not be
perfect. Consequently, the prices, which include, in part, changes in interest
rates, of the securities being hedged may not move in the same amount as the
hedging instrument. It is possible that there may be a negative correlation
between the hedging instrument and the hedged securities, which would prevent
High Income Portfolio from achieving the anticipated benefits of hedging
transactions or may cause High Income Portfolio to realize losses and thus be in
a worse position than if such strategies had not been used.
ADDITIONAL LEVERAGE
Although it has no current intention of doing so, High Income Portfolio may
borrow to the extent then permitted by the 1940 Act through the public or
private issuance of debt securities and/or from lenders of all types, such as
banks, savings and loan associations, insurance companies and similar financial
institutions. In addition, High Income Portfolio may borrow up to 5% of its
total assets for temporary purposes.
MANAGEMENT OF THE FUNDS
DIRECTORS/TRUSTEES
The Boards provide broad oversight over the operations and affairs of the
Funds and they protect the interests of shareholders. The Boards have overall
responsibility to manage and control the business affairs of the Funds,
including the complete and exclusive authority to establish policies regarding
the management, conduct and operation of the Funds' business. The names and ages
of the Directors/Trustees and officers of the Funds, 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 director/trustee and other
directorships or trusteeships they hold are shown below.
NUMBER OF
PORTFOLIOS IN
POSITION TERM OF OFFICE AND HIGHLAND FUND
NAME, ADDRESS(1) WITH EACH LENGTH OF TIME PRINCIPAL OCCUPATION(S) COMPLEX OTHER DIRECTORSHIPS/
AND AGE FUND SERVED(2) PAST FIVE YEARS OVERSEEN(3) TRUSTEESHIPS HELD
INDEPENDENT DIRECTORS/TRUSTEES(4)
---------------------------------
Timothy Hui Director Director of High Vice President since 12 None
(Age 59) of Income Income Portfolio February 2008, Dean of
Shares and since January 2000, Educational Resources
High current High Income from July 2006 to
Income Portfolio Nominee January 2008; Assistant
Portfolio; for a term to Provost for Graduate
Trustee of expire at the 2011 Education, July 2004 to
Credit annual meeting; June 2006; and
Strategies Director of Income Assistant Provost for
Fund Shares since July Educational Resources,
2001 (with a term July 2001 to June 2004,
expiring at the Philadelphia Biblical
2009 annual University.
meeting); Trustee
of Credit
Strategies Fund
2006 (with a term
expiring at the
2008 annual
meeting).
18
Scott Kavanaugh Director Director of High Vice-Chairman, 12 None
(Age 47) of Income Income Portfolio President and Chief
Shares and since January 2000, Operating Officer,
High current High Income Keller Financial Group
Income Portfolio Nominee since September 2007;
Portfolio; for a term to Chairman and Chief
Trustee of expire at the 2011 Executive Officer,
Credit annual meeting; First Foundation Bank
Strategies Director of Income since September 2007;
Fund Shares since July Private Investor since
2001 (with a term February 2004; Sales
expiring at the Representative at Round
2009 annual Hill Securities, March
meeting); Trustee 2003 to January 2004;
of Credit Executive at Provident
Strategies Fund Funding Mortgage
since 2006 (with a Corporation, February
term expiring at 2003 to July 2003;
the 2008 annual Executive Vice
meeting). President, Director and
CAO, Commercial Capital
Bank, January 2000 to
February 2003; Managing
Principal and Chief
Operating Officer,
Financial Institutional
Partners Mortgage
Company and the
Managing Principal and
President of Financial
Institutional Partners,
LLC (an investment
banking firm), April
1998 to February 2003.
James F. Leary Director Director of High Managing Director, 12 Board Member of
(Age 78) of Income Income Portfolio Benefit Capital Capstone Group of
Shares and since January 2000 Southwest, Inc. (a Funds
High (with a term financial consulting (7 portfolios)
Income expiring at the firm) since January
Portfolio; 2009 annual 1999.
Trustee of meeting); Director
Credit of Income Shares
Strategies since July 2001
Fund (with a term
expiring at the
2010 annual
meeting); Trustee
of Credit
Strategies Fund
since 2006 (with a
term expiring at
the 2010 annual
meeting)
19
Bryan A. Ward Director Director of High Senior Manager, 12 None
(Age 53) of Income Income Portfolio Accenture, LLP (a
Shares and since November 2001 consulting firm) since
High (with a term January 2002.
Income expiring at the
Portfolio; 2009 annual
Trustee of meeting); Director
Credit of Income Shares
Strategies since November 2001
Fund (with a term
expiring at the
2010 annual
meeting); Trustee
of Credit
Strategies Fund
since 2006 (with a
term expiring at
the 2010 annual
meeting)
INTERESTED DIRECTOR/TRUSTEE
---------------------------
R. Joseph Senior Director and Senior Portfolio 12 None
Dougherty(5) Vice Chairman of the Manager of the Adviser
(Age 37) President Board of High since 2000;
of the Income Portfolio Director/Trustee,
Funds; since May 2004 Chairman of the Board
Director (with a term and Senior Vice
of Income expiring at the President of the funds
Shares and 2010 annual in the Highland Fund
High meeting) and Senior Complex.
Income Vice President of
Portfolio; High Income
Trustee of Portfolio since
Credit January 2000;
Strategies Director and
Fund Chairman of the
Board of Income
Shares since May
2004 and Senior
Vice President of
Income Shares since
July 2001, current
Income Shares
Nominee for a term
to expire at the
2011 annual
meeting; Trustee
and Chairman of the
Board of Credit
Strategies Fund
since 2006 (with a
term expiring at
the 2008 annual
meeting) and Senior
Vice President of
Credit Strategies
Fund since 2006.
20
(1) The address of each Director/Trustee 13455 Noel Road, Suite 800, Dallas,
Texas 75240.
(2) Each Fund's Board is divided into three classes with the term of office of
one class expiring each year.
(3) The Highland Fund Complex consists of all of the registered investment
companies advised by the Adviser as of the date of this SAI. In addition, each
of the Directors/Trustees oversees Highland Distressed Opportunities Fund, Inc.,
a closed-end company that has filed an election to be regulated as a business
development company under the 1940 Act.
(4) Independent Directors/Trustees are those who are not "interested persons" as
that term is defined under section 2(a)(19) of the 1940 Act.
(5) Mr. Dougherty is deemed to be an "interested person" of each Fund under the
1940 Act because of his position with the Adviser.
In addition to Mr. Dougherty, each Fund's other executive officers are
James D. Dondero, Mark K. Okada, M. Jason Blackburn and Michael Colvin. Set
forth below are the names and certain biographical and other information for
Messrs. Dondero, Okada, Blackburn and Colvin as reported by them to each Fund.
OFFICERS(1)
-----------
Position with each Fund, Term of Principal Occupation(s) During Past
Name and Age and Address(2) Office(3) and Length of Time Served Five Years
--------------------------- ----------------------------------- -----------------------------------
James D. Dondero Chief Executive Officer and President and Director of Strand
(Age 45) President of Credit Strategies Fund Advisors, Inc. ("Strand"), the
since May 2006, High Income General Partner of the Adviser;
Portfolio since January 2000 and Chairman of the Board of Directors
Income Shares since July 2001. of Highland Financial Partners,
L.P.; and President of the funds in
the Highland Fund Complex.
Mark Okada Executive Vice President of Credit Executive Vice President of Strand;
(Age 46) Strategies Fund since May 2006, High Chief Investment Officer of the
Income Portfolio since January 2000 Adviser; and Executive Vice
and Income Shares since July 2001. President of the funds in the
Highland Fund Complex.
M. Jason Blackburn Secretary and Treasurer of Credit Assistant Controller of the Adviser
(Age 32) Strategies Fund since May 2006, High since November 2001; and Secretary
Income Portfolio and Income Shares and Treasurer of the funds in the
since March 2003. Highland Fund Complex.
Michael Colvin Chief Compliance Officer of the General Counsel and Chief Compliance
(Age 38) Funds since July 2007. Officer of the Adviser since June
2007 and Chief Compliance Officer of
the funds in the Highland Fund
Complex since July 2007; Shareholder
in the Corporate and Securities
Group at Greenberg Traurig, LLP,
January 2007 to June 2007; and
Partner (from January 2003 to
January 2007) and Associate (from
1995 to 2002) in the Private Equity
Practice Group at Weil, Gotshal &
Manges, LLP.
(1) Each officer serves in the same capacity for each of the Highland Funds.
(2) The address of each officer is 13455 Noel Road, Suite 800, Dallas, Texas
75240.
(3) Each officer serves for an indefinite term.
21
COMPENSATION OF DIRECTORS/TRUSTEES
The executive officers of the Funds and the Directors/Trustees who are
"interested persons" (as defined in the 1940 Act) receive no direct remuneration
from the Funds. Effective January 1, 2008, each Independent Director/Trustee
receives an annual retainer of $150,000 payable in quarterly installments and
allocated among each portfolio in the Highland Funds Complex based upon relative
net assets. Prior to January 1, 2008, the Independent Directors/Trustees of High
Income Portfolio, Income Shares and Credit Strategies Fund were compensated at a
rate of $15,000, $5,000 and $7,500 annually. Independent Directors/Trustees are
reimbursed for actual out-of-pocket expenses relating to attendance at meetings.
The following table summarizes the compensation paid by each Fund to the
Directors/Trustees and the aggregate compensation paid by the Highland Fund
Complex to the Directors/Trustees.
Aggregate Aggregate Aggregate
Compensation from Compensation from Compensation from Aggregate Compensation
High Income Income Shares for Credit Strategies from Highland Fund
Portfolio for the the fiscal year Fund for the Complex for the calendar
fiscal year ended ended December fiscal year ended year ended December 31,
Name of Trustee October 31, 2007 31, 2007 December 31, 2007 2007
------------------------------------------------------------------------------------------------------------------------------------
INTERESTED TRUSTEE
R. Joseph Dougherty $0 $0 $0 $0
INDEPENDENT TRUSTEES
Bryan A. Ward $15,000 $5,000 $7,500 $122,722
Scott F. Kavanaugh $15,000 $5,000 $7,500 $122,722
James F. Leary $15,000 $5,000 $7,500 $122,722
Timothy K. Hui $15,000 $5,000 $7,500 $122,722
BOARD COMMITTEES
In connection with the Boards' responsibility for the overall management
and supervision of the Funds' affairs, the Directors/Trustees meet periodically
throughout the year to oversee the Funds' activities, review contractual
arrangements with service providers for the Funds and review the Funds'
performance. To fulfill these duties, each Fund has an Audit Committee, a
Nominating Committee, a Litigation Committee and a Qualified Legal Compliance
Committee.
The Audit Committee consists of Bryan Ward, Scott Kavanaugh, James Leary
and Timothy Hui. The Audit Committee acts according to the Audit Committee
charter. Scott Kavanaugh has been appointed as Chairman of the Audit Committee.
The Audit Committee is responsible for (i) oversight of each Fund's accounting
and financial reporting processes and the audits of each Fund's financial
statements and (ii) providing assistance to the board of directors/trustees of
each Fund in connection with its oversight of the integrity of each Fund's
financial statements, each Fund's compliance with legal and regulatory
requirements and the independent registered public accounting firm's
qualifications, independence and performance. The Boards have determined that
each Fund has one audit committee financial expert serving on its Audit
Committee, Mr. Leary, who is independent for the purpose of the definition of
audit committee financial expert as applicable to each Fund. The Audit Committee
for High Income Portfolio met three times in the fiscal year ended October 31,
2007. The Audit Committee for Income Shares met three times in the fiscal year
ended December 31, 2007. The Audit Committee for Credit Strategies Fund met
three times in the fiscal year ended December 31, 2007.
The Nominating Committee's function is to canvass, solicit, recruit,
interview and nominate directors/trustees. The Nominating Committee will
consider recommendations for nominees from shareholders sent to the Secretary of
each Fund, 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 directors/trustees, as well as information sufficient to
22
evaluate the factors listed above. Nomination submissions must be accompanied by
a written consent of the individual to stand for election if nominated by a
Board 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. Ward, Kavanaugh, Leary and Hui. The Nominating Committee for High Income
Portfolio met one time in the fiscal year ended October 31, 2007. The Nominating
Committee for Income Shares met one time in the fiscal year ended December 31,
2007. The Nominating Committee for Credit Strategies Fund met one time in the
fiscal year ended December 31, 2007.
The Litigation Committee's function is to seek to address any potential
conflicts of interest between or among each Fund and the Adviser in connection
with any potential or existing litigation or other legal proceeding relating to
securities held by each Fund and the Adviser or another client of the Adviser.
The Litigation Committee is comprised of Messrs. Ward, Kavanaugh, Leary and Hui.
The Litigation Committee for High Income Portfolio met 4 times in the fiscal
year ended October 31, 2007. The Litigation Committee for Income Shares did not
meet in the fiscal year ended December 31, 2007. The Litigation Committee for
Credit Strategies Fund also did not meet in the fiscal year ended December 31,
2007.
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 each
Fund who appear and practice before the SEC on behalf of that Fund. The QLCC is
comprised of Messrs. Ward, Kavanaugh, Leary and Hui. There were no QLCC meetings
during the fiscal years ended October 31, 2007 or December 31, 2007.
PROXY VOTING POLICIES AND PROCEDURES
The Boards of the Funds have delegated the voting of proxies for each
Fund's securities to Highland pursuant to Highland's proxy voting policies and
procedures. Under these policies and procedures, Highland will vote proxies
related to each Fund's securities in the best interests of each Fund and its
shareholders. A copy of Highland's proxy voting policies and procedures is
attached as Appendix B to this SAI. Each Fund's proxy voting record for the most
recent 12-month period ending December 31 will be available (i) without charge,
upon request, by calling 1-877-665-1287 and (ii) on the SEC's web site
(http://www.sec.gov).
CODES OF ETHICS
Each Fund and the Adviser have adopted codes of ethics under Rule 17j-1 of
the 1940 Act. These codes permit personnel subject to the codes to invest in
securities, including securities that may be purchased or held by each Fund.
These codes can be reviewed and copied at the SEC's Public Reference Room in
Washington, D.C. Information on the operation of the Public Reference Room may
be obtained by calling the SEC at 1-202-551-8090. The codes of ethics are
available on the EDGAR Database on the SEC's web site (http://www.sec.gov), and
copies of these codes may be obtained, after paying a duplicating fee, by
electronic request at the following e-mail address: publicinfo@sec.gov, or by
writing the SEC's Public Reference Section, Washington, D.C. 20549-0102.
ADMINISTRATION SERVICES
Pursuant to the Acquiring Fund's administration services agreement,
Highland performs the following services: (i) prepare monthly security
transaction listings; (ii) supply various normal and customary statistical data
as requested on an ongoing basis; (iii) prepare for execution and file the
Acquiring Fund's 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 Form 1099 calculations; (iv) coordinate contractual
relationships and communications between the Acquiring Fund and its contractual
service providers; (v) coordinate printing of the Acquiring Fund's annual and
semi-annual shareholder reports; (vi) prepare income and capital gain
distributions; (vii) prepare the semiannual and annual financial statements;
(viii) monitor the Acquiring Fund's compliance with Code, SEC and prospectus
requirements; (ix) prepare, coordinate with the Acquiring Fund's counsel and
coordinate the filing with the SEC: semi-annual reports on Form N-SAR and Form
N-CSR; Form N-Q; and Form N-PX based upon information provided by the Acquiring
Fund, 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 1940
Act for the officers and trustees of the Acquiring Fund, such filings to be
based on information provided by those persons; (x) assist in the preparation of
23
notices of meetings of shareholders; (xi) assist in obtaining the fidelity bond
and trustees' and officers'/errors and omissions insurance policies for the
Acquiring Fund in accordance with the requirements of Rule 17g-1 and 17d-1(d)(7)
under the 1940 Act as such bond and policies are approved by the Acquiring
Fund's board of trustees; (xii) monitor the Acquiring Fund's 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 Acquiring Fund's calendar
to assure compliance with various filing and board approval deadlines; (xvii)
furnish the Acquiring Fund 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 Acquiring Fund; (xviii)
assist the Acquiring Fund in the handling of SEC examinations and responses
thereto; (xix) perform clerical, bookkeeping and all other administrative
services not provided by the Acquiring Fund's other service providers; (xx)
determine or oversee the determination and publication of the Acquiring Fund's
net asset value in accordance with the Acquiring Fund's policy as adopted from
time to time by the Board of Trustees; (xxi) oversee the maintenance by the
Acquiring Fund's custodian and transfer agent and dividend disbursing agent of
certain books and records of the Acquiring Fund as required under Rule
31a-1(b)(2)(iv) of the 1940 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 Acquiring Fund; (xxii)
prepare such information and reports as may be required by any stock exchange or
exchanges on which the Acquiring Fund's shares are listed; (xxiii) determine the
amounts available for distribution as dividends and distributions to be paid by
the Acquiring Fund to its shareholders; prepare and arrange for the printing of
dividend notices to shareholders; and provide the Acquiring Fund's 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 Acquiring Fund's dividend reinvestment plan; (xxiv) serve as liaison between
the Acquiring Fund and each of its service providers; and (xxv) perform such
additional administrative duties relating to the administration of the Acquiring
Fund as may subsequently be agreed upon in writing between the Acquiring Fund
and Highland. Highland shall have the authority to engage a sub-administrator in
connection with the administrative services of the Acquiring Fund, which
sub-administrator may be an affiliate of Highland; provided, however, that
Highland shall remain responsible to the Acquiring Fund with respect to its
duties and obligations set forth in the administration services agreement.
ADMINISTRATION AND ACCOUNTING SERVICES
Each Acquired Fund is a party to an administration and accounting services
agreement with PFPC Inc. dated April 10, 2006 pursuant to which PFPC Inc.
provides administrative and accounting services to each Acquired Fund. PFPC Inc.
will receive an annual fee, payable monthly, in an amount equal to 0.026%,
subject to a minimum fee, of the average weekly value of each Acquired Fund's
Managed Assets plus certain other fees.
PORTFOLIO MANAGERS
Each Acquired Fund is managed by Brad Borud and R. Joseph Dougherty. Mark
Okada, Kurtis Plumer and Brad Borud manage the Acquiring Fund.
As of December 31, 2007, Kurtis Plumer managed the following client
accounts:
NUMBER OF
ACCOUNTS
SUBJECT TO ASSETS SUBJECT
ASSETS OF A TO A
NUMBER OF ACCOUNTS PERFORMANCE PERFORMANCE FEE
TYPE OF ACCOUNT ACCOUNTS ($ MILLIONS) FEE ($ MILLIONS)
--------------- --------- ------------ ----------- ---------------
Registered Investment Companies............... 2 933 1 85
Other Pooled Investment Vehicles.............. 6 3,189 4 2,610
Other Accounts................................ 0 0 0 0
24
As of December 31, 2007, Mark Okada managed the following client accounts:
NUMBER OF
ACCOUNTS
SUBJECT TO ASSETS SUBJECT
ASSETS OF A TO A
NUMBER OF ACCOUNTS PERFORMANCE PERFORMANCE FEE
TYPE OF ACCOUNT ACCOUNTS ($ MILLIONS) FEE ($ MILLIONS)
--------------- --------- ------------ ----------- ---------------
Registered Investment Companies............... 12 8,076 0 0
Other Pooled Investment Vehicles.............. 30 21,227 26 19,821
Other Accounts................................ 0 0 0 0
As of December 31, 2007, R. Joseph Dougherty managed the following client
accounts:
NUMBER OF
ACCOUNTS
SUBJECT TO ASSETS SUBJECT
ASSETS OF A TO A
NUMBER OF ACCOUNTS PERFORMANCE PERFORMANCE FEE
TYPE OF ACCOUNT ACCOUNTS ($ MILLIONS) FEE ($ MILLIONS)
--------------- --------- ------------ ----------- ---------------
Registered Investment Companies............... 6 6,647 0 0
Other Pooled Investment Vehicles.............. 1 359 0 0
Other Accounts................................ 0 0 0 0
As of December 31, 2007, Brad Borud managed the following client accounts:
NUMBER OF
ACCOUNTS
SUBJECT TO ASSETS SUBJECT
ASSETS OF A TO A
NUMBER OF ACCOUNTS PERFORMANCE PERFORMANCE FEE
TYPE OF ACCOUNT ACCOUNTS ($ MILLIONS) FEE ($ MILLIONS)
--------------- --------- ------------ ----------- ---------------
Registered Investment Companies............... 0 0 0 0
Other Pooled Investment Vehicles.............. 0 0 0 0
Other Accounts................................ 0 0 0 0
The 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
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 Adviser furnishes advisory services to numerous clients in addition to each
Fund, and the Adviser may, consistent with applicable law, make investment
recommendations to other clients or accounts (including accounts which are hedge
funds or have performance or higher fees paid to the 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 each Fund. In addition, the
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
Adviser recommends to each Fund. Actions with respect to securities of the same
kind may be the same as or different from the action which the 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
Adviser may refrain from rendering any advice or services concerning securities
of companies of which any of the Adviser's (or its affiliates') officers,
directors or employees are directors or officers, or companies as to which the
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 Adviser includes disclosure regarding these matters to
its clients in both its Form ADV and investment advisory agreements.
The 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
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 each Fund. As a result, the Adviser will face
conflicts in the allocation of investment opportunities to each Fund and other
funds and clients. In order to enable such affiliates to fulfill their fiduciary
25
duties to each of the clients for which they have responsibility, the 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 each Fund and such other clients or may involve a rotation of
opportunities among each Fund and such other clients.
While the Adviser does not believe there will be frequent conflicts of
interest, if any, the Adviser and its affiliates have both subjective and
objective procedures and policies in place designed to manage the potential
conflicts of interest between the Adviser's fiduciary obligations to each Fund
and their similar fiduciary obligations to other clients so that, for example,
investment opportunities are allocated in a fair and equitable manner among each
Fund and such other clients. An investment opportunity that is suitable for
multiple clients of the 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
1940 Act. There can be no assurance that the Adviser's or its affiliates'
efforts to allocate any particular investment opportunity fairly among all
clients for whom such opportunity is appropriate will result in an allocation of
all or part of such opportunity to each Fund. Not all conflicts of interest can
be expected to be resolved in favor of each Fund.
COMPENSATION
The Adviser's financial arrangements with its portfolio managers, its
competitive compensation and its career path emphasis at all levels reflect the
value senior management places on key resources. Compensation may include a
variety of components and may vary from year to year based on a number of
factors including the relative performance of a portfolio managers' underlying
account, the combined performance of the portfolio managers underlying accounts,
and the relative performance of the portfolio managers underlying accounts
measured against other employees. The principal components of compensation
include a base salary, a discretionary bonus, various retirement benefits and
one or more of the incentive compensation programs established by the 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.
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 this 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 Highland.
LONG TERM INCENTIVE PLAN. The purpose of this plan is to create positive
morale and teamwork, to attract and retain key talent, and to encourage the
achievement of common goals. This 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 following table sets forth the dollar range of equity securities of
each Fund beneficially owned by each portfolio manager as of the end of each
Fund's most recently completed fiscal year.
26
------------------------------------------------------------------------------------------------------------------------------------
Name of Portfolio Manager Dollar Range of Equity Dollar Range of Equity Dollar Range of Equity
Securities Securities Securities
Beneficially Owned by Beneficially Owned by Beneficially Owned by
Portfolio Manager in High Portfolio Manager in Portfolio Manager in
Income Portfolio for the Income Shares for the Credit Strategies Fund for
fiscal year ended October fiscal year ended December the fiscal year ended
31, 2007 31, 2007 December 31, 2007
------------------------------------------------------------------------------------------------------------------------------------
Mark Okada Not applicable Not applicable $100,001 - $500,000
------------------------------------------------------------------------------------------------------------------------------------
Kurtis Plumer Not applicable Not applicable $1 - $10,000
------------------------------------------------------------------------------------------------------------------------------------
R. Joseph Dougherty $100,001 - $500,000 $100,001 - $500,000 Not applicable
------------------------------------------------------------------------------------------------------------------------------------
Brad Borud $100,001 - $500,000 $100,001 - $500,000 $1 - $10,000
------------------------------------------------------------------------------------------------------------------------------------
PORTFOLIO TRANSACTIONS AND BROKERAGE
In placing portfolio transactions for each Fund, the Adviser will give
primary consideration to securing the most favorable price and efficient
execution. Consistent with this policy, the 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 Adviser may be a party. Neither
the Funds nor the Adviser has adopted a formula for allocation of the Funds'
investment transaction business. The 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 each Fund
than would otherwise result when allocating brokerage transactions to other
brokers on the basis of seeking the most favorable price and efficient
execution. The Adviser, therefore, is authorized to place orders for the
purchase and sale of securities for each Fund with such brokers, subject to
review by each Fund's Board 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 Adviser in connection with its services to other
clients.
On occasions when the Adviser deems the purchase or sale of a security to
be in the best interest of each Fund as well as other clients, the 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 Adviser in
the manner it considers to be the most equitable and consistent with its
fiduciary obligations to each Fund and to such other clients.
During the fiscal year ended October 31, 2006, High Income Portfolio paid
brokerage commissions of $0, of which $0 was paid to NexBank Securities, Inc.
("NexBank"), an affiliate of Highland.
During the fiscal year ended October 31, 2007, High Income Portfolio paid
brokerage commissions of $58,124, of which $55 was paid to NexBank. During the
fiscal year ended October 31, 2007, transactions in which High Income Portfolio
used NexBank as broker comprised 0.16% of the aggregate dollar amount of
transactions involving the payment of commissions, and 0.01% of the aggregate
brokerage commissions paid by High Income Portfolio. 100% of the $58,069 paid to
other brokers by High Income Portfolio during the fiscal year ended October 31,
2007 (representing commissions on transactions involving approximately
$13,587,070) was directed to those brokers at least partially on the basis of
research services they provided. During the fiscal year ended October 31, 2007,
High Income Portfolio acquired securities of the following of its regular
brokers or dealers: Credit Suisse, JP Morgan Chase, Morgan Stanley & Co., Inc.,
Merrill, Lynch, Fenner & Smith, Inc., Bank of America, Lehman Brothers, Deutsche
Bank, Goldman Sachs & Co., UBS and Citigroup. At that date, High Income
Portfolio did not hold any securities of its regular brokers or dealers.
During the fiscal year ended December 31, 2006, Income Shares paid
brokerage commissions of $0, of which $0 was paid to NexBank.
During the fiscal year ended December 31, 2007, Income Shares paid
brokerage commissions of $6,423, of which $0 was paid to NexBank. During the
fiscal year ended December 31, 2007, transactions in which Income Shares used
27
NexBank as broker comprised 0.00% of the aggregate dollar amount of transactions
involving the payment of commissions, and 0.00% of the aggregate brokerage
commissions paid by Income Shares. 100% of the $6,423 paid to other brokers by
Income Shares during the fiscal year ended December 31, 2007 (representing
commissions on transactions involving approximately $1,903,090) was directed to
those brokers at least partially on the basis of research services they
provided. During the fiscal year ended December 31, 2007, Income Shares acquired
securities of the following of its regular brokers or dealers: JP Morgan Chase,
Bank of America, Morgan Stanley & Co., Inc., Credit Suisse, Merrill, Lynch,
Fenner & Smith, Inc., Goldman Sachs & Co. , Lehman Brothers , Citigroup,
Deutsche Bank and First Union. At that date, Income Shares held the securities
of its regular brokers or dealers with an aggregate value as follows: Bank of
America, $2,101,296.
During the fiscal period ended December 31, 2006, Credit Strategies Fund
paid brokerage commissions of $166,787, of which $1,815 was paid to NexBank.
During the fiscal year ended December 31, 2007, Credit Strategies Fund paid
brokerage commissions of $99,535, of which $26,414 was paid to NexBank. During
the fiscal year ended December 31, 2007, transactions in which Credit Strategies
Fund used NexBank as broker comprised 37.02% of the aggregate dollar amount of
transactions involving the payment of commissions, and 26.54% of the aggregate
brokerage commissions paid by Credit Strategies Fund. 100% of the $73,121 paid
to other brokers by Credit Strategies Fund during the fiscal year ended December
31, 2007 (representing commissions on transactions involving approximately
$67,868,965) was directed to those brokers at least partially on the basis of
research services they provided. During the fiscal year ended December 31, 2007,
Credit Strategies Fund acquired securities of the following of its regular
brokers or dealers: Credit Suisse, Morgan Stanley, JP Morgan Chase, Goldman
Sachs & Co., Bank of America, Deutsche Bank, Lehman Brothers , Citigroup,
Merrill Lynch and BNP Paribas Securities. At that date, Credit Strategies Fund
did not hold any securities of its regular brokers or dealers.
TAX MATTERS
The following discussion summarizes certain material federal income and
excise tax considerations affecting each Fund and the purchase, ownership and
disposition of each Fund's common shares by shareholders that are "United States
persons" (as defined for federal tax purposes) and hold those shares as capital
assets. This discussion is based on current provisions of the Code and the
regulations promulgated thereunder and existing judicial decisions and
administrative pronouncements, all of which are subject to change or differing
interpretations by the courts or the Internal Revenue Service ("IRS"), possibly
with retroactive effect. No attempt is made to present a detailed and complete
explanation of all federal tax concerns affecting the Funds and their
shareholders (including shareholders owning large positions in a Fund) in light
of their particular circumstances. Prospective investors should consult their
own tax advisers with regard to the federal tax consequences of the purchase,
ownership or disposition of common shares, as well as the tax consequences
arising under the laws of any state, locality, foreign country or other taxing
jurisdiction.
THE DISCUSSIONS SET FORTH HEREIN AND IN THE PROXY STATEMENT/PROSPECTUS DO
NOT CONSTITUTE TAX ADVICE, AND YOU ARE URGED TO CONSULT YOUR OWN TAX ADVISOR TO
DETERMINE THE SPECIFIC FEDERAL, STATE, LOCAL AND FOREIGN TAX CONSEQUENCES TO YOU
OF INVESTING IN A FUND AND OWNING OR DISPOSING OF COMMON SHARES THEREOF.
TAXATION OF EACH FUND
Each Fund has elected to be, and has qualified annually to be treated as, a
regulated investment company under Part I of Subchapter M of Chapter 1 of the
Code ("RIC"). To continue to qualify as a RIC, each Fund must, among other
things, annually meet the following requirements regarding the source of its
income and the diversification of its assets:
(i) Each Fund 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 gain from options, futures
and forward contracts) derived with respect to its business of investing in
such stock, securities or foreign currencies; and (b) net income from an
interest in a "qualified publicly traded partnership" (as defined below)
("QPTP") ("Income Requirement"); and
28
(ii) Each Fund must diversify its holdings so that, at the end of each
quarter of each taxable year, (a) at least 50% of the value of its total
assets is represented by cash and cash items, U.S. government securities,
the securities of other RICs and other securities limited, in respect of
any one issuer, to a value not greater than 5% of the value of the Fund's
total assets and to not more than 10% of the issuer's outstanding voting
securities (equity securities of QPTPs being considered voting securities
for these purposes) and (b) not more than 25% of the value of its total
assets is invested in (1) the securities (other than U.S. government
securities and the securities of other RICs) of any one issuer, (2) the
securities (other than the securities of other RICs) of two or more issuers
that the Fund controls and are engaged in the same, similar or related
trades or businesses or (3) the securities of one or more QPTPs.
A QPTP is defined as a publicly traded partnership (generally, a partnership the
interests in which are "traded on an established securities market" or are
"readily tradable on a secondary market (or the substantial equivalent
thereof)") other than a partnership at least 90% of the gross income of which
consists of income that satisfies the Income Requirement.
If a Fund qualifies as a RIC, it generally will not be subject to federal
income tax on net income and gains that it distributes to its shareholders,
provided that it distributes each taxable year at least the sum of (i) 90% of
its investment company taxable income (generally consisting of net investment
income, the excess of net short-term capital gain over net long-term capital
loss ("short-term capital gain") and net gains and losses from certain foreign
currency transactions, if any, reduced by deductible expenses), determined
without regard to the deduction for dividends paid, plus (ii) 90% of its net
tax-exempt interest (the excess of its gross tax-exempt interest over certain
disallowed deductions) ("Distribution Requirement"). Each Fund intends to
continue to distribute substantially all of such income and its net capital gain
(i.e., the excess of net long-term capital gain over net short-term capital
loss) each taxable year.
If for any taxable year a Fund does not qualify for treatment as a RIC, all
of its taxable income (including its net capital gain) would be subject to tax
at regular corporate rates without any deduction for distributions to its
shareholders and the shareholders would treat all those distributions, including
distributions of net capital gain, as dividends to the extent of the Fund's
earnings and profits, taxable as ordinary income (except that, for individual
shareholders, the part thereof that is "qualified dividend income" would be
subject to federal income tax at the rate for net capital gain -- a maximum of
15%), and those dividends would be eligible for the dividends-received deduction
available to corporations under certain circumstances. In addition, such a Fund
could be required to recognize unrealized gains, pay substantial taxes and
interest and make substantial distributions before requalifying for treatment as
a RIC.
Each Fund will be subject to a nondeductible 4% federal excise tax ("Excise
Tax") to the extent it fails to distribute by the end of any calendar year at
least the sum of (i) 98% of its ordinary income for the calendar year, (ii) 98%
of its capital gain net income (i.e., 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
Fund's fiscal year) plus (iii) 100% of any retained amount of either from the
prior year. While each Fund intends to distribute its income and capital gain in
the manner necessary to minimize imposition of the Excise Tax, there can be no
assurance that each Fund will be able to do so. In that event, a Fund will be
liable for the Excise Tax only on the amount by which it does not meet the
foregoing distribution requirement.
The use of hedging strategies, such as writing (selling) and purchasing
options and futures contracts and entering into forward contracts, involves
complex rules that will determine for income tax purposes the amount, character
and timing of recognition of the gains and losses a Fund realizes in connection
therewith. Gains from the disposition of foreign currencies (except certain
gains that may be excluded by future regulations), and gains from options,
futures and forward contracts a Fund derives with respect to its business of
investing in securities or foreign currencies, will be treated as qualifying
income under the Income Requirement.
Certain of a Fund's investment practices are subject to special and complex
federal income tax rules that may, among other things, (i) disallow, suspend or
otherwise limit the allowance of certain losses or deductions, (ii) convert
lower-taxed long-term capital gain to higher-taxed short-term capital gain or
ordinary income, (iii) convert an ordinary loss or a deduction to a capital loss
(the deductibility of which is more limited), (iv) cause the Fund to recognize
income or gain without a corresponding receipt of cash, (v) adversely affect the
time when a purchase or sale of securities is deemed to occur and (vi) adversely
29
alter the characterization of certain complex financial transactions. Each Fund
will monitor its transactions and may make certain tax elections to mitigate the
effect of these rules and prevent its disqualification as a RIC.
A Fund may invest in the stock of "passive foreign investment companies"
("PFICs"). A PFIC is any foreign corporation (with certain exceptions) that, in
general, meets either of the following tests: (i) at least 75% of its gross
income for the taxable year is passive or (ii) an average of at least 50% of its
assets produce, or are held for the production of, passive income. Under certain
circumstances, if a Fund holds stock of a PFIC, it will be subject to federal
income tax on a portion of any "excess distribution" the Fund receives on the
stock or of any gain on its disposition of the stock (collectively, "PFIC
income"), plus interest thereon, even if the Fund distributes the PFIC income as
a taxable dividend to its shareholders. (Certain elections may be available to a
Fund to avoid such treatment.) The balance of a Fund's PFIC income will be
included in the Fund's investment company taxable income and, accordingly, will
not be taxable to it to the extent it distributes that income to its
shareholders. Fund distributions attributable to PFIC income will not be
eligible for the 15% maximum federal income tax rate on qualified dividend
income mentioned above.
Interest, dividends and other income a Fund receives, and gains it
realizes, on investments outside the United States may be subject to income,
withholding and other taxes imposed by foreign countries and U.S. possessions
that would reduce the total return on its securities. Tax treaties between the
United States and certain other countries may reduce or eliminate such taxes,
however, and many foreign countries do not impose taxes on capital gains in
respect of investments by foreign investors. The Funds do not expect that any of
them 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 or deductions for
such taxes on their own tax returns.
A Fund may acquire zero coupon or other securities that are issued with
original issue discount ("OID"). As a holder of those securities, a Fund must
include in its gross income the OID that accrues on them during the taxable
year, even if it receives no corresponding payment on them during the year.
Similarly, a Fund must include in its gross income securities it receives as
"interest" on payment-in-kind securities. Because each Fund annually must
distribute substantially all of its investment company taxable income, including
any accrued OID and other non-cash income, to satisfy the Distribution
Requirement and avoid imposition of the Excise Tax, it may be required in a
particular year to distribute as a dividend an amount that is greater than the
total amount of cash it actually receives. Those distributions will be made from
a Fund's cash assets, from borrowings, or from the proceeds of sales of its
portfolio securities, if necessary. A Fund may realize capital gains or losses
from those sales, which would increase or decrease its investment company
taxable income and/or net capital gain.
TAXATION OF SHAREHOLDERS
As long as a Fund qualifies for treatment as a RIC, distributions it makes
to you from its investment company taxable income will be taxable to you as
ordinary income to the extent of its earnings and profits. Each Fund currently
expects that most of the dividends it pays will not be eligible for the
dividends-received deduction available to corporations or the 15% maximum
federal income tax rate on "qualified dividend income" received by individuals.
A Fund's distributions to you of net capital gain that it properly designates as
such ("capital gain dividends") will be taxable to you as long-term capital
gain, regardless of how long you have held the Fund's shares. Capital gain
dividends a Fund pays to individuals with respect to net capital gain it
recognizes on sales or exchanges of capital assets through October 31, 2011,
will be subject to a maximum federal income tax rate of 15%.
A Fund may determine to retain for reinvestment all or part of its net
capital gain. If a Fund does so, it may designate all or part of the retained
amount as undistributed capital gains in a notice to its shareholders. If a Fund
makes such a designation, it would be required to pay federal income tax at the
rate of 35% on the undistributed gain ("Fund tax") and each shareholder subject
to federal income tax (i) would be required to include in income, as long-term
capital gain, his or her proportionate share of the designated gain (which would
be taxed at the 15% rate mentioned above to the extent the Fund recognizes the
designated gain on sales or exchanges of capital assets through December 31,
2010), (ii) would be entitled to credit his or her proportionate share of the
Fund tax against his or her federal income tax liability, if any, and to claim a
refund to the extent the credit exceeds that liability and (iii) would increase
the basis in his or her Fund shares by the difference between the included
income and such share of the Fund tax.
30
Distributions to you on a Fund's common shares are generally subject to
federal income tax as described above, even though those distributions may
economically represent a return of your investment. Those distributions are
likely to occur on a Fund's common shares purchased when their net asset value
includes gains that are either unrealized or realized but not distributed or
income that is not distributed. Those realized gains may be required to be
distributed even when the common shares' net asset value reflects unrealized
losses. A Fund's distributions are taxable to you even if they are paid from
income or gains the Fund earned before you invested in its shares (and thus were
reflected in the price you paid).
If a Fund makes a distribution to you in excess of its current and
accumulated earnings and profits, the excess distribution will be treated as a
"return of capital" to the extent of your basis in your Fund shares and
thereafter as capital gain. A return of capital is not taxable, but it reduces
your basis in your shares, thus reducing any loss or increasing any gain on a
subsequent taxable disposition by you of the shares. Current earnings and
profits will be, and accumulated earnings and profits may be, treated as first
being used to pay distributions on an Acquired Fund's preferred stock, and only
the remaining earnings and profits will be treated as being used to pay
distributions on its common stock.
Dividends and other taxable distributions on a Fund's common shares are
taxable to you even if they are reinvested in additional common shares of the
Fund. Dividends and other distributions paid by a Fund are generally treated as
received by you at the time the distribution is made. However, a distribution a
Fund declares in the last quarter of any calendar year that is payable to
shareholders of record on a date in that quarter will be deemed to have been
paid by the Fund and received by those shareholders on December 31 of that year
if the Fund pays the distribution during the following January. Accordingly,
that distribution will be taxed to those shareholders for the taxable year in
which that December 31 falls.
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.
Each Fund will send you information after the end of each year setting
forth the amount and tax status of any distributions it paid to you. Dividends
may also be subject to state and local income taxes.
Each Fund generally is required to withhold and remit to the U.S. Treasury
28% (except as noted below) of all distributions (including capital gain
dividends) and redemption proceeds, if any, otherwise payable to you (if you are
an individual or certain other non-corporate shareholder) if you fail to
properly furnish the Fund with a correct taxpayer identification number.
Withholding at that rate also is required from all distributions by a Fund
otherwise payable to such a shareholder who has under-reported dividend or
interest income or who fails to certify to the Fund that he or she is not
otherwise subject to that withholding (together with the withholding described
in the preceding sentence, "backup withholding"). The backup withholding rate
will increase to 31% for amounts paid after December 31, 2010, unless Congress
enacts legislation providing otherwise. Backup withholding is not an additional
tax, and any amounts withheld with respect to you may be credited against your
federal income tax liability.
If you sell or otherwise dispose of common shares of a Fund, you will
generally recognize a gain or loss in an amount equal to the difference between
your basis in those shares and the amount you receive on the disposition. Any
such gain or loss on common shares held as capital assets will be long-term
capital gain or loss (and thus eligible, in the case of individuals, for the 15%
maximum federal income tax rate on net capital gain described above) if you held
those shares for more than one year; otherwise, any such gain or loss will be
treated as short-term capital gain or loss. Any loss on 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 you received (and amounts
credited to you as undistributed capital gain) with respect to those shares. Any
loss you realize on a disposition of common shares will be disallowed if you
acquire other common shares within a 61-day period beginning 30 days before and
ending 30 days after the disposition. In that case, your basis in the newly
acquired shares will be adjusted to reflect the disallowed loss.
Dividends a Fund pays to a foreign shareholder, other than (i) dividends
paid to a foreign shareholder whose ownership of shares is effectively connected
with a U.S. trade or business the shareholder carries on and (ii) capital gain
31
dividends paid to a nonresident alien individual who is physically present in
the United States for no more than 182 days during the taxable year, generally
will be subject to a federal withholding tax of 30% (or lower treaty rate).
However, two categories of dividends, "interest-related dividends" and
"short-term capital gain dividends," if properly designated by a Fund, will be
exempt from that tax. "Interest-related dividends" are dividends that are
attributable to "qualified net interest income" ("qualified interest income,"
which generally consists of certain original issue discount, interest on
obligations "in registered form" and interest on deposits, less allocable
deductions). "Short-term capital gain dividends" are dividends that are
attributable to short-term capital gain, computed with certain adjustments. The
exemption from withholding tax will apply to interest-related dividends and
short-term capital gain dividends a Fund pays to foreign investors, with certain
exceptions, only with respect to its current taxable year (ending October 31,
2008), unless Congress enacts legislation extending its applicability.
ADDITIONAL INFORMATION
A registration statement on Form N-14, relating to the shares offered by
the Prospectus/Proxy Statement (the "Registration Statement"), has been filed by
the Acquiring Fund with the SEC. The Proxy Statement/Prospectus and this SAI 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 Acquiring Fund and the such shares, reference is made to the
Registration Statement. Statements contained in the Proxy Statement/Prospectus
and this SAI 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 SEC's principal office in Washington, D.C., and copies of all or any part
thereof may be obtained from the SEC upon the payment of certain fees prescribed
by the SEC.
PRO FORMA FINANCIAL STATEMENTS
Shown below are the financial statements for Highland Credit Strategies Fund and
Prospect Street High Income Portfolio, PRO FORMA Highland Credit Strategies Fund
financial statements including the proceeds of its rights offering and pro forma
financial statements for the combined Fund. The PRO FORMA Combined Schedule of
Investments and the PRO FORMA Combined Statement of Assets and Liabilities have
been prepared as though the reorganization had been effective on December 31,
2007. The PRO FORMA Combined Statement of Operations reflects the results of
Highland Credit Strategies Fund and Prospect Street High Income Portfolio for
the twelve months ended December 31, 2007 as if the reorganization occurred on
January 1, 2007.
The first table presents the Schedule of Investments for Highland Credit
Strategies Fund and Prospect Street High Income Portfolio and PRO FORMA figures
for the combined Fund. The second table presents the Statements of Assets and
Liabilities for Highland Credit Strategies Fund and Prospect Street High Income
Portfolio, PRO FORMA figures for Highland Credit Strategies Fund including the
proceeds of its rights offering, and estimated PRO FORMA figures for the
combined Fund. The third table presents the Statements of Operations for
Highland Credit Strategies Fund and Prospect Street High Income Portfolio, PRO
FORMA figures for Highland Credit Strategies Fund including the proceeds of its
rights offering, and estimated PRO FORMA figures for the combined Fund. These
tables are followed by the Notes to the PRO FORMA Financial Statements.
32
PROSPECT PRO FORMA
STREET COMBINED PRO FORMA
HIGHLAND HIGH HIGHLAND PROSPECT COMBINED
CREDIT INCOME CREDIT HIGHLAND STREET HIGH HIGHLAND
STRATEGIES PORTFOLIO STRATEGIES CREDIT INCOME CREDIT
FUND (HCF) (PHY) FUND (HCF) STRATEGIES PORTFOLIO STRATEGIES
PRINCIPAL PRINCIPAL PRINCIPAL FUND (HCF) (PHY) FUND (HCF)
AMOUNT ($) AMOUNT ($) AMOUNT ($) SECURITY VALUE ($) VALUE ($) VALUE ($)
---------------------- ---------- ---------- ------------------------------------------------ ------------ ------------ -----------
SENIOR LOANS (a)- 55.5%
AEROSPACE - AEROSPACE/DEFENSE -
0.9%
AWAS Capital, Inc.
2,022,750 - 2,022,750 Second Priority Term Loan, 11.25%, 03/15/13 1,951,953 - 1,951,953
IAP Worldwide Services, Inc.
2,969,697 - 2,969,697 First Lien Term Loan, 11.50%, 12/30/12 2,663,462 - 2,663,462
2,000,000 - 2,000,000 Second Lien Term Loan, 17.00%, 06/30/13 1,600,000 - 1,600,000
Travelport LLC
356,888 - 356,888 Synthetic Letter of Credit, 7.45%, 08/23/13 339,640 - 339,640
1,778,654 - 1,778,654 Tranche B Dollar Term Loan, 7.08%, 08/23/13 1,690,041 - 1,690,041
-------------------------------------
8,245,096 - 8,245,096
-------------------------------------
AEROSPACE - AIRLINES
- 1.5%
Delta Airlines, Inc.
8,281,894 - 8,281,894 Term Loan Equipment Notes, 8.63%, 09/29/12 7,992,028 - 7,992,028
Northwest Airlines, Inc.
6,930,000 - 6,930,000 Term Loan, 6.97%, 08/21/13 6,545,939 - 6,545,939
US Airways Group, Inc.
- 500,000 500,000 Term Loan, 7.28%, 03/23/14 - 463,330 463,330
-------------------------------------
14,537,967 463,330 15,001,297
-------------------------------------
AUTOMOBILE - 1.4%
Ford Motor Co.
14,850,000 - 14,850,000 Term Loan, 8.70%, 12/15/13 13,773,375 - 13,773,375
-------------------------------------
BROADCASTING - 2.4%
Bresnan Communications, LLC
- 1,000,000 1,000,000 Additional Term Loan B, 06/30/13 (e) - 958,120 958,120
ComCorp Broadcasting, Inc.
622,034 - 622,034 Revolving Loan, 10.84%, 10/02/12 (b) (c) 622,034 - 622,034
11,309,712 - 11,309,712 Term Loan, 10.44%, 04/02/13 (b) 11,309,712 - 11,309,712
Millennium Digital Media Systems, LLC
9,060,582 - 9,060,582 First Lien Term Loan, 8.98%, 06/30/11 8,935,999 - 8,935,999
1,238,322 - 1,238,322 Revolver, 8.43%, 06/30/11 (c) 1,217,357 - 1,217,357
-------------------------------------
22,085,102 958,120 23,043,222
-------------------------------------
CABLE - US CABLE -
0.2%
Charter Communications Operating, LLC
2,000,000 - 2,000,000 New Term Loan, 6.99%, 03/06/14 1,872,200 - 1,872,200
-------------------------------------
CHEMICALS - COMMODITY & FERTILIZER - 0.2%
Ferro Corp.
1,677,500 - 1,677,500 Term Loan, 7.06%, 06/06/12 1,639,756 - 1,639,756
-------------------------------------
CONSUMER DURABLES - 0.3%
Rexair LLC
2,559,468 - 2,559,468 First Lien Term Loan, 9.45%, 06/30/10 2,514,677 - 2,514,677
-------------------------------------
CONSUMER NON-DURABLES - 0.9%
Camelbak Products LLC
1,391,780 - 1,391,780 First Lien Term Loan, 9.18%, 08/04/11 1,303,624 - 1,303,624
DS Waters of America, Inc.
1,980,000 - 1,980,000 Term Loan, 7.10%, 10/27/12 1,910,700 - 1,910,700
Spectrum Brands, Inc.
4,008,292 - 4,008,292 Dollar Term B Loan, 9.31%, 03/30/13 3,898,064 - 3,898,064
201,369 - 201,369 Synthetic Letter of Credit, 4.57%, 03/30/13 195,832 - 195,832
VNU Inc./Nielsen Finance LLC
1,970,056 - 1,970,056 Dollar Term Loan, 7.18%, 08/09/13 1,880,182 - 1,880,182
-------------------------------------
9,188,402 - 9,188,402
-------------------------------------
33
DIVERSIFIED MEDIA -
4.8%
Clarke American Corp.
1,990,000 - 1,990,000 Tranche B Term Loan, 7.70%, 06/30/14 1,795,975 - 1,795,975
Endurance Business Media, Inc.
3,000,000 - 3,000,000 Second Lien Term Loan, 12.10%, 01/26/14 2,970,000 - 2,970,000
Metro-Goldwyn-Mayer Holdings II, Inc.
10,333,487 - 10,333,487 Tranche B Term Loan, 8.61%, 04/08/12 9,594,642 - 9,594,642
2,977,500 - 2,977,500 Tranche B-1 Term Loan, 8.45%, 04/08/12 2,766,842 - 2,766,842
Penton Media, Inc.
5,000,000 - 5,000,000 Second Lien Term Loan, 9.98%, 02/01/14 4,225,000 - 4,225,000
Tribune Co.
11,940,000 - 11,940,000 Initial Tranche B Advance, 7.91%, 05/19/14 10,286,191 - 10,286,191
7,466,667 - 7,466,667 Tranche X Advance, 7.74%, 05/18/09 7,226,091 - 7,226,091
Univision Communications, Inc.
- 110,738 110,738 Delayed Draw Term Loan, 09/29/14 (c) (e) - 101,148 101,148
- 2,389,262 2,389,262 Initial Term Loan, 09/29/14 (e) - 2,182,356 2,182,356
6,000,000 - 6,000,000 Initial Term Loan, 09/29/14 (e) 5,880,000 - 5,880,000
-------------------------------------
44,744,741 2,283,505 47,028,246
-------------------------------------
ENERGY - EXPLORATION & PRODUCTION - 1.1%
ATP Oil & Gas Corp.
11,262,205 - 11,262,205 First Lien Term Loan, 8.48%, 04/14/10 11,132,014 - 11,132,014
-------------------------------------
ENERGY - OTHER ENERGY - 0.5%
Alon USA Energy, Inc.
218,889 - 218,889 Edington Facility, 7.10%, 06/22/13 211,228 - 211,228
1,751,111 - 1,751,111 Paramount Facility , 7.10%, 06/22/13 1,689,822 - 1,689,822
Endeavour International Holding B.V.
3,000,000 - 3,000,000 Second Lien Term Loan, 11.91%, 11/01/11 3,045,000 - 3,045,000
-------------------------------------
4,946,050 - 4,946,050
-------------------------------------
FINANCIAL - 0.5%
Concord Re Ltd.
5,000,000 - 5,000,000 Term Loan, 9.61%, 02/29/12 4,975,000 - 4,975,000
-------------------------------------
FOOD/TOBACCO - BEVERAGES & BOTTLING - 0.2%
PBM Holdings, Inc.
1,888,356 - 1,888,356 Term Loan, 7.35%, 09/28/12 1,850,589 - 1,850,589
-------------------------------------
FOOD/TOBACCO - RESTAURANTS - 0.2%
Restaurant Co., The
1,970,000 - 1,970,000 Term Loan, 7.62%, 05/09/13 1,861,650 - 1,861,650
-------------------------------------
FOREST PRODUCTS - PAPER - 1.1%
Verso Paper Financial Holding LLC
11,000,000 - 11,000,000 Unsecured Loan, 11.16%, 02/01/13 10,395,000 - 10,395,000
-------------------------------------
GAMING/LEISURE - GAMING - 1.6%
Drake Hotel Acquisition
6,041,285 - 6,041,285 B Note 1, 12.90%, 04/01/08 6,041,285 - 6,041,285
Fontainebleu Florida Hotel LLC
10,000,000 - 10,000,000 Tranche C Term Loan, 11.11%, 06/06/12 9,375,000 - 9,375,000
-------------------------------------
15,416,285 - 15,416,285
-------------------------------------
GAMING/LEISURE - OTHER LEISURE - 3.1%
Cedar Fair L.P.
3,940,000 - 3,940,000 US Term Loan, 6.82%, 08/30/12 3,737,484 - 3,737,484
Kuilima Resort Co.
5,954,660 - 5,954,660 First Lien Term Loan, 11.50%, 09/30/10 5,666,871 - 5,666,871
Lake at Las Vegas Joint Venture
9,000,000 - 9,000,000 Additional Term Loan, 12.50%, 01/24/08 9,000,000 - 9,000,000
2,407,407 - 2,407,407 Synthetic Revolver, 11.96%, 06/20/12 (d) 1,119,444 - 1,119,444
18,193,575 - 18,193,575 Term Loan, 16.35%, 06/20/12 (d) 8,460,013 - 8,460,013
Orbitz Worldwide, Inc.
1,995,000 - 1,995,000 Term Loan, 7.84%, 07/25/14 1,890,263 - 1,890,263
-------------------------------------
29,874,075 - 29,874,075
-------------------------------------
34
HEALTHCARE - ACUTE CARE - 3%
Alliance Imaging, Inc.
8,795,180 - 8,795,180 Tranche C Term Loan, 7.52%, 12/29/11 8,663,252 - 8,663,252
HCA, Inc.
12,870,000 - 12,870,000 Tranche B Term Loan, 7.45%, 11/17/13 12,403,462 - 12,403,462
National Mentor Holdings, Inc.
230,000 - 230,000 Institutional Line of Credit Facility, 5.32%, 225,400 - 225,400
06/29/13
3,713,450 - 3,713,450 Tranche B Term Loan, 7.20%, 06/29/13 3,639,181 - 3,639,181
Triumph Healthcare Second Holdings LLC
4,500,000 - 4,500,000 Second Lien Term Loan, 12.90%, 07/28/14 4,387,500 - 4,387,500
-------------------------------------
29,318,795 - 29,318,795
-------------------------------------
HEALTHCARE - ALTERNATE SITE SERVICES - 0.3%
LifeCare Holdings
2,984,733 - 2,984,733 Term Loan, 8.20%, 08/11/12 2,643,339 - 2,643,339
-------------------------------------
HEALTHCARE - MEDICAL PRODUCTS - 3%
CCS Medical, Inc.
9,851,731 1,977,349 11,829,080 First Lien Term Loan, 8.10%, 09/30/12 9,527,412 1,912,255 11,439,667
Danish Holdco A/S
3,077,311 - 3,077,311 Mezzanine Facility, 12.73%, 05/01/17 PIK 2,984,991 - 2,984,991
2,500,000 - 2,500,000 Second Lien Term Facility D, 8.98%, 11/01/16 2,300,000 - 2,300,000
Golden Gate National Senior Care LLC
4,000,000 - 4,000,000 Second Lien Term Loan, 12.56%, 09/14/11 3,960,000 - 3,960,000
HealthSouth Corp.
2,946,052 - 2,946,052 Term Loan B, 7.75%, 03/11/13 2,819,608 - 2,819,608
Nyco Holdings 3 ApS
3,500,000 - 3,500,000 Facility A, 12/29/13 (e) 3,130,330 - 3,130,330
Warner Chilcott Co., Inc.
1,682,626 - 1,682,626 Tranche B Acquisition Date Term Loan, 7.36%, 1,634,267 - 1,634,267
01/18/12
Warner Chilcott Corp.
578,754 - 578,754 Tranche C Acquisition Date Term Loan, 7.36%, 562,121 - 562,121
01/18/12
-------------------------------------
26,918,729 1,912,255 28,830,984
-------------------------------------
HOUSING - BUILDING MATERIALS - 2.8%
Custom Building Products, Inc.
5,175,258 - 5,175,258 First Lien Term Loan, 6.98%, 10/20/11 4,890,619 - 4,890,619
1,625,000 - 1,625,000 Second Lien Term Loan, 10.20%, 04/20/12 1,543,750 - 1,543,750
Realogy Corp.
- 1,574,920 1,574,920 Initial Term B Loan, 10/10/13 (e) - 1,384,827 1,384,827
- 425,080 425,080 Synthetic Letter of Credit, 10/10/13 (e) - 373,968 373,968
Roofing Supply Group LLC
3,960,000 - 3,960,000 First Lien Term Loan, 9.20%, 08/31/13 3,564,000 - 3,564,000
Spirit Finance Corp.
3,000,000 - 3,000,000 Term Loan, 7.91%, 08/01/13 2,622,480 - 2,622,480
WAICCS Las Vegas 3 LLC
6,000,000 - 6,000,000 First Lien Term Loan, 8.19%, 07/30/08 5,820,000 - 5,820,000
7,000,000 - 7,000,000 Second Lien Term Loan, 14.25%, 07/30/08 6,790,000 - 6,790,000
-------------------------------------
25,230,849 1,758,796 26,989,645
-------------------------------------
HOUSING - REAL ESTATE DEVELOPMENT - 4%
DESA LLC
418,880 - 418,880 Term Loan, 14.25%, 11/26/11 376,297 - 376,297
Ginn LA Conduit Lender, Inc.
2,358,201 - 2,358,201 First Lien Tranche A Credit-Linked Deposit, 1,924,882 - 1,924,882
5.10%, 06/08/11
5,067,988 - 5,067,988 First Lien Tranche B Term Loan, 8.70%, 4,136,745 - 4,136,745
06/08/11
LNR Property Corp.
10,000,000 - 10,000,000 Initial Tranche B Term Loan, 7.63%, 07/12/11 9,541,700 - 9,541,700
MPH Mezzanine II, LLC
6,000,000 - 6,000,000 Mezzanine 2B, 8.27%, 02/09/08 (b) 5,992,680 - 5,992,680
MPH Mezzanine III, LLC
4,000,000 - 4,000,000 Mezzanine 3, 9.27%, 02/09/08 3,990,000 - 3,990,000
November 2005 Land Investors, LLC
2,500,000 - 2,500,000 Second Lien Term Loan, 11.81%, 05/09/12 1,250,000 - 1,250,000
Westgate Investments LLC
7,757,893 - 7,757,893 Senior Secured Loan, 13.00%, 09/25/10 (f) 8,068,209 - 8,068,209
1,740,500 - 1,740,500 Senior Unsecured Loan, 18.00%, 09/25/12 1,792,715 - 1,792,715
Weststate Land Partners LLC
- 2,000,000 2,000,000 Second Lien Term Loan, 13.22%, 05/01/08 - 1,970,000 1,970,000
-------------------------------------
37,073,228 1,970,000 39,043,228
-------------------------------------
35
INFORMATION TECHNOLOGY - 2.8%
DTN, Inc.
1,990,000 - 1,990,000 First Lien Tranche C Term Loan, 8.18%, 1,960,150 - 1,960,150
03/10/13
Freescale Semiconductor, Inc.
- 3,840,302 3,840,302 Term Loan, 7.33%, 11/29/13 - 3,564,453 3,564,453
Infor Enterprise Solutions Holdings, Inc.
2,708,571 - 2,708,571 Delayed Draw Term Loan, 8.95%, 07/28/12 2,548,874 - 2,548,874
3,000,000 - 3,000,000 Dollar Tranche B-1, Second Lien Term Loan, 2,700,000 - 2,700,000
10.81%, 03/02/14
5,191,429 - 5,191,429 Initial US Term Facility, 9.11%, 07/28/12 4,942,655 - 4,942,655
2,566,667 - 2,566,667 Second Lien Delayed Draw Term Loan, 11.45%, 2,319,625 - 2,319,625
03/02/14
4,433,333 - 4,433,333 Second Lien Term Loan, 11.45%, 03/02/14 4,006,625 - 4,006,625
Metrologic Instruments, Inc.
2,000,000 - 2,000,000 Second Lien Term Loan, 11.08%, 12/21/13 1,927,500 - 1,927,500
Secure Computing Corp.
1,222,222 - 1,222,222 Term Loan, 8.45%, 08/31/13 1,210,000 - 1,210,000
Serena Software, Inc.
1,840,000 - 1,840,000 Term Loan, 7.18%, 03/11/13 1,787,119 - 1,787,119
-------------------------------------
23,402,548 3,564,453 26,967,001
-------------------------------------
MANUFACTURING - 2.4%
Acument Global Technologies, Inc.
7,902,475 - 7,902,475 Term Loan, 8.33%, 08/11/13 7,744,425 - 7,744,425
CST Industries, Inc.
2,962,500 - 2,962,500 Term Loan, 7.90%, 08/09/13 2,795,800 - 2,795,800
Generac Acquisition Corp.
1,666,667 - 1,666,667 Second Lien Term Loan, 11.23%, 05/10/14 1,367,717 - 1,367,717
Global Petroleum Inc.
5,900,101 - 5,900,101 Term Loan, 9.49%, 09/18/13 5,723,098 - 5,723,098
Hunter Defense Technologies, Inc.
1,000,000 - 1,000,000 First Lien Term B Loan, 8.08%, 08/13/14 955,000 - 955,000
Matinvest 2 SAS / Butterfly Wendal US, Inc.
2,250,000 - 2,250,000 B-2 Facility, 7.40%, 06/22/14 2,098,125 - 2,098,125
2,250,000 - 2,250,000 C-2 Facility, 7.65%, 06/22/15 2,109,375 - 2,109,375
Matinvest 2 SAS / Deutsche Connector
1,011,458 - 1,011,458 Mezz A USD Facility, 9.33%, 06/22/16 940,656 - 940,656
-------------------------------------
23,734,196 - 23,734,196
-------------------------------------
METALS/MINERALS - OTHER METALS/MINERALS - 1.1%
Euramax International Holdings B.V.
1,326,316 - 1,326,316 Second Lien European Loan, 13.36%, 06/29/13 1,027,895 - 1,027,895
Euramax International, Inc.
2,753,611 - 2,753,611 First Lien Domestic Term Loan, 8.24%, 06/29/12 2,450,713 - 2,450,713
3,673,684 - 3,673,684 Second Lien Domestic Term Loan, 13.24%, 3,039,974 - 3,039,974
06/29/13
Oglebay Norton Co.
1,518,943 - 1,518,943 Tranche B Term Loan, 7.50%, 07/31/12 1,496,159 - 1,496,159
United Central Industrial Supply Co., L.L.C.
1,615,602 - 1,615,602 Term Loan, 7.91%, 03/31/12 1,575,211 - 1,575,211
Universal Buildings Products, Inc.
1,455,231 - 1,455,231 Term Loan, 8.24%, 04/28/12 1,338,813 - 1,338,813
-------------------------------------
10,928,765 - 10,928,765
-------------------------------------
RETAIL - 2.8%
Blockbuster, Inc.
2,352,062 - 2,352,062 Tranche B Term Loan, 9.43%, 08/20/11 2,266,400 - 2,266,400
Burlington Coat Factory Warehouse Corp.
11,680,028 493,530 12,173,558 Term Loan, 7.32%, 05/28/13 10,447,084 441,433 10,888,517
CSK Auto, Inc.
2,962,687 - 2,962,687 Term Loan, 8.25%, 06/30/12 2,755,299 - 2,755,299
Home Interiors & Gifts, Inc.
7,223,706 - 7,223,706 Initial Term Loan, 10.36%, 03/31/11 3,918,861 - 3,918,861
Sports Authority, Inc., The
1,970,000 - 1,970,000 Term Loan B, 7.08%, 05/03/13 1,827,175 - 1,827,175
Toys "R" Us
5,970,149 - 5,970,149 Tranche B Term Loan, 9.16%, 07/19/12 5,876,895 - 5,876,895
-------------------------------------
27,091,714 441,433 27,533,147
-------------------------------------
SERVICE - ENVIRONMENTAL SERVICES - 0.8%
Safety-Kleen Systems, Inc.
1,627,119 - 1,627,119 Synthetic Letter of Credit, 4.75%, 08/02/13 1,562,034 - 1,562,034
6,174,915 - 6,174,915 Term Loan B, 7.75%, 08/02/13 6,051,417 - 6,051,417
-------------------------------------
7,613,451 - 7,613,451
-------------------------------------
36
SERVICE - OTHER SERVICES - 2.1%
Cydcor, Inc.
3,000,000 - 3,000,000 Second Lien Term Loan, 11.30%, 01/30/14 2,985,000 - 2,985,000
Education Management LLC
2,912,289 - 2,912,289 Tranche C Term Loan, 6.63%, 06/01/13 2,780,333 - 2,780,333
NES Rentals Holdings, Inc.
7,765,705 - 7,765,705 Second Lien Permanent Term Loan, 12.13%, 7,299,762 - 7,299,762
07/20/13
Sabre, Inc.
4,859,038 - 4,859,038 Initial Term Loan, 6.96%, 09/30/14 4,428,236 - 4,428,236
Survey Sampling International LLC
1,315,028 - 1,315,028 Term Loan, 7.33%, 05/06/11 1,262,427 - 1,262,427
United Rentals, Inc.
1,633,916 - 1,633,916 Initial Term Loan, 7.11%, 02/14/11 1,597,969 - 1,597,969
309,692 - 309,692 Tranche B Credit-Linked Deposit, 5.43%, 302,984 - 302,984
02/14/11
-------------------------------------
20,656,711 - 20,656,711
-------------------------------------
TELECOMMUNICATIONS - 1.1%
American Messaging Services, Inc.
2,300,901 - 2,300,901 Senior Secured Note, 11.38%, 09/03/08 2,312,406 - 2,312,406
PaeTec Communications, Inc.
4,177,367 - 4,177,367 Initial Term Loan, 7.35%, 02/05/13 4,136,262 - 4,136,262
Sorenson Communications, Inc.
1,824,792 - 1,824,792 Tranche C Term Loan, 8.00%, 02/28/13 1,778,607 - 1,778,607
Stratos Global Corp./Stratos Funding LP
1,225,000 - 1,225,000 Term B Facility, 7.59%, 02/13/12 1,192,084 - 1,192,084
Time Warner Telecom Holdings Inc.
990,000 - 990,000 Term Loan B, 6.85%, 01/07/13 957,825 - 957,825
-------------------------------------
10,377,184 - 10,377,184
-------------------------------------
TRANSPORTATION - AUTO - 2.1%
BST Safety Textiles Acquisition GMBH
2,662,000 - 2,662,000 Second Lien Facility, 12.49%, 06/30/09 2,395,800 - 2,395,800
Dana Corp.
3,000,000 - 3,000,000 DIP Term Loan, 7.36%, 04/13/08 2,994,750 - 2,994,750
Delphi Corp.
5,000,000 - 5,000,000 Tranche C Term Loan, 8.94%, 12/31/08 4,988,100 - 4,988,100
Lear Corp.
4,940,090 - 4,940,090 First Lien Term Loan B, 7.79%, 04/25/12 4,804,238 - 4,804,238
Motor Coach Industries International, Inc.
5,752,270 - 5,752,270 Second Lien Term Loan, 13.64%, 12/01/08 5,579,702 - 5,579,702
-------------------------------------
20,762,590 - 20,762,590
-------------------------------------
TRANSPORTATION - LAND - 0.6%
New Century Transportation, Inc.
1,973,842 - 1,973,842 Term Loan B, 8.08%, 08/14/12 1,677,765 - 1,677,765
SIRVA Worldwide, Inc.
831,429 - 831,429 Revolver, 12.43%, 12/01/08 (c) 552,900 - 552,900
17,143 - 17,143 Revolver, 12.38%, 12/01/08 (c) 11,400 - 11,400
6,008,774 - 6,008,774 Tranche B Term Loan, 12.50%, 12/01/10 3,909,489 - 3,909,489
-------------------------------------
6,151,554 - 6,151,554
-------------------------------------
UTILITIES - 3.3%
ANP Funding I, LLC
4,888,889 - 4,888,889 Tranche A Term Loan, 8.73%, 07/29/10 4,856,280 - 4,856,280
Calpine Construction Finance Company, L.P.
- 5,508 5,508 First Lien Term Loan, 11.34%, 08/26/09 - 5,663 5,663
Coleto Creek Power, LP
5,465,915 - 5,465,915 First Lien Term Loan, 7.95%, 06/28/13 5,274,607 - 5,274,607
4,925,000 - 4,925,000 Second Lien Term Loan, 8.83%, 06/28/13 4,752,625 - 4,752,625
382,166 - 382,166 Synthetic Facility, 5.10%, 06/28/13 368,790 - 368,790
Entegra TC LLC
6,198,643 - 6,198,643 Third Lien Term Loan, 11.20%, 04/19/14 5,815,133 - 5,815,133
GBGH LLC (U S Energy)
5,128,912 - 5,128,912 First Lien Term Loan, 14.25%, 08/07/13 5,141,734 - 5,141,734
5,478,811 - 5,478,811 Second Lien Term Loan, 7.89%, 08/07/14 5,492,508 - 5,492,508
-------------------------------------
31,701,677 5,663 31,707,340
-------------------------------------
WIRELESS - CELLULAR/PCS - 1.3%
Cricket Communications, Inc.
1,970,000 - 1,970,000 Term Loan B, 7.83%, 06/16/13 1,946,596 - 1,946,596
Insight Midwest Holdings, LLC
8,000,000 - 8,000,000 Term Loan B, 7.00%, 04/07/14 7,708,880 - 7,708,880
Level 3 Financing, Inc.
3,000,000 - 3,000,000 New Term Loan, 7.49%, 03/13/14 2,896,500 - 2,896,500
-------------------------------------
12,551,976 - 12,551,976
-------------------------------------
37
WIRELESS COMMUNICATIONS - 1%
Clearwire Corp.
9,975,000 - 9,975,000 Term Loan, 11.15%, 07/03/12 9,625,875 - 9,625,875
-------------------------------------
TOTAL SENIOR LOANS 524,835,160 13,357,554 538,192,714
-------------------------------------
FOREIGN DENOMINATED SENIOR LOANS
(a) - 10.3%
AUSTRALIA - 2%
AUD
Seven Media Group
22,940,476 - 22,940,476 Facility A Term Loan, 12/22/13 19,463,019 - 19,463,019
-------------------------------------
FRANCE - 2.1%
EUR
Ypso Holding SA
2,012,048 - 2,012,048 Eur B Acq 1 Facility, 7.43%, 06/15/14 2,818,373 - 2,818,373
3,282,814 - 3,282,814 Eur B Acq 2 Facility, 7.43%, 06/15/14 4,598,397 - 4,598,397
5,213,674 - 5,213,674 Eur B Recap 1 Facility, 7.43%, 06/15/14 7,277,282 - 7,277,282
1,389,750 - 1,389,750 Eur C Acq Facility, 7.68%, 12/31/15 1,953,538 - 1,953,538
2,610,250 - 2,610,250 Eur C Recap Facility, 7.68%, 12/31/15 3,669,165 - 3,669,165
-------------------------------------
20,316,755 - 20,316,755
-------------------------------------
NETHERLANDS - 1%
EUR
Amsterdamse Beheer- En Consultingmaatschappij B.V.
Casema
2,500,000 - 2,500,000 Kabelcom B Term Loan, 6.67%, 09/12/14 3,595,735 - 3,595,735
2,500,000 - 2,500,000 Kabelcom C Term Loan, 7.17%, 09/12/15 3,636,855 - 3,636,855
1,500,000 - 1,500,000 Kabelcom D Term Loan Second Lien, 8.41%, 2,170,227 - 2,170,227
03/12/16
-------------------------------------
9,402,817 - 9,402,817
-------------------------------------
SWEDEN - 0.5%
SEK
Nordic Cable Acquisition Co., Sub-Holding AB
15,333,333 - 15,333,333 Facility B2, 6.67%, 01/31/14 2,289,372 - 2,289,372
14,666,667 - 14,666,667 Facility C2, 6.79%, 01/31/15 2,201,180 - 2,201,180
-------------------------------------
4,490,552 - 4,490,552
-------------------------------------
UNITED KINGDOM - 1.1%
GBP
Mobileserv Ltd.
2,764,925 - 2,764,925 Facility B , 8.82%, 09/22/14 4,855,901 - 4,855,901
3,250,000 - 3,250,000 Facility C, 9.32%, 09/22/15 5,733,561 - 5,733,561
-------------------------------------
10,589,462 - 10,589,462
-------------------------------------
TOTAL FOREIGN DENOMINATED SENIOR LOANS 64,262,605 - 64,262,605
-------------------------------------
ASSET-BACKED SECURITIES (g) - 0.5%
Commercial Industrial Finance Corp.
1,000,000 - 1,000,000 Series 2006-1BA, Class B2L, 8.88%, 12/22/20 728,906 - 728,906
Marquette US/European CLO, PLC
1,000,000 - 1,000,000 Series 2006-1A, Class D1, 6.99%, 07/15/20 (h) 822,969 - 822,969
Ocean Trails CLO
1,000,000 - 1,000,000 Series 2006-1A, Class D, 9.00%, 10/12/20 (h) 757,969 - 757,969
Venture CDO, Ltd.
2,000,000 - 2,000,000 Series 2007-9A, Class D, 9.27%, 10/12/21 (h) 1,884,062 - 1,884,062
Westbrook CLO, Ltd.
1,000,000 - 1,000,000 Series 2006-1A, Class D, 6.63%, 12/20/20 (h) 788,750 - 788,750
-------------------------------------
TOTAL ASSET-BACKED SECURITIES 4,982,656 - 4,982,656
-------------------------------------
38
FOREIGN ASSET-BACKED SECURITIES (g) - 0.6%
IRELAND - 0.6%
EUR
Static Loan Funding
2,000,000 - 2,000,000 Series 2007-1X, Class D, 07/31/17 2,793,982 - 2,793,982
2,000,000 - 2,000,000 Series 2007-1X, Class E, 07/31/17 2,815,913 - 2,815,913
-------------------------------------
TOTAL FOREIGN ASSET-BACKED SECURITIES 5,609,895 - 5,609,895
-------------------------------------
CORPORATE NOTES AND BONDS - 29.8%
AEROSPACE - AIRLINES - 0.2%
Delta Airlines, Inc.
5,000,000 - 5,000,000 8.00%, 06/30/23 (d) 244,000 - 244,000
- 4,000,000 4,000,000 8.30%, 08/11/20 (d) (l) - 200,000 200,000
Northwest Airlines, Inc.
- 1,899,659 1,899,659 Series 2002-1, Class C2, 9.06%, 05/20/12 - 1,914,322 1,914,322
- 1,500,000 1,500,000 8.88%, 12/30/27 (d) (l) - 56,250 56,250
-------------------------------------
244,000 2,170,572 2,414,572
-------------------------------------
BROADCASTING - 1%
Univision Communications, Inc.
6,000,000 2,960,000 8,960,000 9.75%, 03/15/15 PIK (h) 5,497,500 2,712,100 8,209,600
Young Broadcasting, Inc.
- 2,000,000 2,000,000 10.00%, 03/01/11 - 1,572,500 1,572,500
-------------------------------------
5,497,500 4,284,600 9,782,100
-------------------------------------
CABLE - US CABLE - 1.7%
CCH I Holdings LLC
1,250,000 - 1,250,000 9.92%, 04/01/14 739,062 - 739,062
3,375,000 - 3,375,000 10.00%, 05/15/14 2,012,344 - 2,012,344
2,500,000 - 2,500,000 11.75%, 05/15/14 1,593,750 - 1,593,750
CCH I LLC
8,358,000 4,861,000 13,219,000 11.00%, 10/01/15 6,853,560 3,986,020 10,839,580
Charter Communications, Inc., Convertible
2,634,000 - 2,634,000 6.50%, 10/01/27 1,600,155 - 1,600,155
-------------------------------------
12,798,871 3,986,020 16,784,891
-------------------------------------
CONSUMER NON-DURABLES - 2.8%
Ames True Temper, Inc.
3,000,000 2,000,000 5,000,000 9.24%, 01/15/12 (g) 2,565,000 1,710,000 4,275,000
1,500,000 1,375,000 2,875,000 10.00%, 07/15/12 (l) 832,500 763,125 1,595,625
Outsourcing Services Group, Inc.
- 801,760 801,760 9.00%, 03/01/09 PIK (b) - - -
Spectrum Brands, Inc.
- 2,000,000 2,000,000 11.50%, 10/02/13 PIK (g) (l) - 1,810,000 1,810,000
- 2,450,000 2,450,000 7.38%, 02/01/15 (l) - 1,825,250 1,825,250
Solo Cup Co.
11,875,000 8,300,000 20,175,000 8.50%, 02/15/14 (l) 10,271,875 7,179,500 17,451,375
-------------------------------------
13,669,375 13,287,875 26,957,250
-------------------------------------
DIVERSIFIED MEDIA - 0.6%
Network Communications, Inc.
4,500,000 1,500,000 6,000,000 10.75%, 12/01/13 4,432,500 1,477,500 5,910,000
-------------------------------------
ELECTRONICS - 0.1%
WII Components, Inc.
- 1,000,000 1,000,000 10.00%, 02/15/12 - 1,007,500 1,007,500
-------------------------------------
ENERGY - EXPLORATION & PRODUCTION - 0.2%
McMoran Exploration Co.
- 1,800,000 1,800,000 11.88%, 11/15/14 - 1,815,750 1,815,750
Opti Canada, Inc.
375,000 - 375,000 8.25%, 12/15/14 (h) 373,125 - 373,125
-------------------------------------
373,125 1,815,750 2,188,875
-------------------------------------
39
ENERGY - OTHER ENERGY - 1.1%
Energy XXI Gulf Coast, Inc.
6,000,000 1,750,000 7,750,000 10.00%, 06/15/13 5,535,000 1,614,375 7,149,375
Helix Energy Solutions
2,000,000 1,100,000 3,100,000 9.50%, 01/15/16 (h) 2,045,000 1,124,750 3,169,750
-------------------------------------
7,580,000 2,739,125 10,319,125
-------------------------------------
FINANCIAL - 2.1%
HUB International Holdings, Inc.
14,200,000 7,000,000 21,200,000 10.25%, 06/15/15 (h) 12,141,000 5,985,000 18,126,000
Penhall International, Corp.
2,000,000 - 2,000,000 12.00%, 08/01/14 (h) 1,870,000 - 1,870,000
-------------------------------------
14,011,000 5,985,000 19,996,000
-------------------------------------
FOOD AND DRUG - 0.1%
Cinacalcet Royalty Sub LLC
441,291 - 441,291 8.00%, 03/30/17 516,311 - 516,311
-------------------------------------
FOOD/TOBACCO - 1.7%
Chiquita Brands International, Inc.
3,000,000 5,300,000 8,300,000 7.50%, 11/01/14 2,647,500 4,677,250 7,324,750
5,000,000 - 5,000,000 8.88%, 12/01/15 4,550,000 - 4,550,000
Land O' Lakes Capital Trust I
- 500,000 500,000 7.45%, 03/15/28 (h) - 440,000 440,000
Pinnacle Foods Group Inc.
- 500,000 500,000 9.25%, 04/01/15 (h) - 458,750 458,750
- 2,000,000 2,000,000 10.63%, 04/01/17 (h) (l) - 1,730,000 1,730,000
Select Medical Corporation
- 975,000 975,000 7.63%, 02/01/15 - 838,500 838,500
- 1,162,000 1,162,000 11.26%, 09/15/15 (g) (l) - 1,016,750 1,016,750
-------------------------------------
7,197,500 9,161,250 16,358,750
-------------------------------------
FOREST PRODUCTS - CONTAINERS - 0%
NewPage Corporation
- 279,321 279,321 11.82%, 11/01/13 PIK (g) - 269,545 269,545
-------------------------------------
GAMING/LEISURE - OTHER LEISURE - 2%
Six Flags, Inc.
4,081,000 2,267,000 6,348,000 4.50%, 05/15/15 2,963,826 1,646,409 4,610,235
4,500,000 2,000,000 6,500,000 8.88%, 02/01/10 (l) 3,712,500 1,650,000 5,362,500
Tropicana Entertainment LLC
6,525,000 8,000,000 14,525,000 9.63%, 12/15/14 (h) (l) 4,176,000 5,120,000 9,296,000
-------------------------------------
10,852,326 8,416,409 19,268,735
-------------------------------------
HEALTHCARE - ACUTE CARE - 3.1%
Argatroban Royalty Sub LLC
9,803,340 3,640,494 13,443,834 18.50%, 09/21/14 9,852,357 3,658,696 13,511,053
Eszopiclone Royalty Sub LLC
- 1,794,000 1,794,000 12.00%, 06/30/14 - 1,865,760 1,865,760
HCA, Inc.
10,000,000 - 10,000,000 6.30%, 10/01/12 8,950,000 8,950,000
- 500,000 500,000 7.50%, 11/15/49 - 384,623 384,623
- 500,000 500,000 7.69%, 06/15/25 - 416,451 416,451
3,000,000 - 3,000,000 8.36%, 04/15/24 2,652,669 - 2,652,669
Risperidone Royalty Sub LLC
- 2,000,000 2,000,000 7.00%, 01/01/18 - 1,830,000 1,830,000
-------------------------------------
21,455,026 8,155,529 29,610,555
-------------------------------------
HEALTHCARE - ALTERNATE SITE SERVICES - 0.3%
LifeCare Holdings
5,000,000 - 5,000,000 9.25%, 08/15/13 3,325,000 - 3,325,000
-------------------------------------
HOUSING - BUILDING MATERIALS - 2.2%
Associated Materials, Inc.
- 1,767,000 1,767,000 0.00%, 03/01/14 (l) (m) - 1,139,715 1,139,715
Masonite Corp.
4,000,000 250,000 4,250,000 11.00%, 04/06/15 (l) 3,140,000 196,250 3,336,250
Realogy Corp.
8,000,000 5,000,000 13,000,000 10.50%, 04/15/14 (h) (l) 6,000,000 3,750,000 9,750,000
5,500,000 - 5,500,000 11.00%, 04/15/14 PIK (h) 3,836,250 - 3,836,250
4,000,000 570,000 4,570,000 12.38%, 04/15/15 (h) (l) 2,530,000 360,525 2,890,525
-------------------------------------
15,506,250 5,446,490 20,952,740
-------------------------------------
40
INFORMATION TECHNOLOGY - 2.7%
Charys Holding Co., Inc.
- 2,500,000 2,500,000 8.75%, 02/16/12 (h) - 1,762,500 1,762,500
Freescale Semiconductor, Inc.
3,800,000 - 3,800,000 10.13%, 12/15/16 3,154,000 - 3,154,000
- 2,000,000 2,000,000 8.87%, 12/15/14 (g) - 1,710,000 1,710,000
MagnaChip Semiconductor
8,000,000 6,500,000 14,500,000 8.24%, 12/15/11 (g) 7,160,000 5,817,500 12,977,500
NXP BV/NXP Funding LLC
2,000,000 - 2,000,000 7.99%, 10/15/13 (g) 1,847,500 - 1,847,500
Spansion LLC
5,000,000 - 5,000,000 11.25%, 01/15/16 (h) 4,275,000 - 4,275,000
-------------------------------------
16,436,500 9,290,000 25,726,500
-------------------------------------
RETAIL - 2.6%
Blockbuster, Inc.
11,500,000 8,000,000 19,500,000 9.00%, 09/01/12 (l) 9,890,000 6,880,000 16,770,000
Dollar General Corp.
5,500,000 3,250,000 8,750,000 10.63%, 07/15/15 (h) (l) 5,073,750 2,998,125 8,071,875
-------------------------------------
14,963,750 9,878,125 24,841,875
-------------------------------------
TELECOMMUNICATIONS - 2.5%
Digicel Group, Ltd.
12,454,260 6,537,854 18,992,114 9.13%, 01/15/15 PIK (h) (l) 11,395,648 5,982,136 17,377,784
Grande Communications Holdings, Inc.
- 2,000,000 2,000,000 14.00%, 04/01/11 - 2,065,000 2,065,000
Intelsat Bermuda, Ltd.
- 4,500,000 4,500,000 11.25%, 06/15/16 (h) - 4,657,500 4,657,500
-------------------------------------
11,395,648 12,704,636 24,100,284
-------------------------------------
TRANSPORTATION - 1.8%
American Tire Distributors Holdings, Inc.
5,000,000 3,500,000 8,500,000 11.48%, 04/01/12 (g) 4,875,000 3,412,500 8,287,500
Delphi Corp.
2,933,000 - 2,933,000 6.55%, 06/15/06 (d) 1,759,800 - 1,759,800
7,834,000 - 7,834,000 7.13%, 05/01/29 (d) 4,817,910 - 4,817,910
1,200,000 417,000 1,617,000 6.50%, 05/01/09 (d) (l) 726,000 252,285 978,285
200,000 - 200,000 6.50%, 08/15/13 (d) 117,000 - 117,000
Federal-Mogul Corp.
1,579,000 - 1,579,000 7.50%, 01/15/09 (d) - - -
1,000,000 - 1,000,000 7.75%, 07/01/06 (d) - - -
Motor Coach Industries International, Inc.
- 1,000,000 1,000,000 11.25%, 05/01/09 - 852,500 -
Nordic Telephone Company Holdings
- 500,000 500,000 8.88%, 05/01/16 (h) - 515,000 -
-------------------------------------
12,295,710 5,032,285 17,327,995
-------------------------------------
UTILITIES - 0%
Enron Corp.
1,000,000 - 1,000,000 6.63%, 11/15/05 (d) (i) 182,500 - 182,500
USGen New England, Inc.
- 56,303 56,303 01/02/15 (d) (h) - - -
-------------------------------------
182,500 - 182,500
-------------------------------------
WIRELESS COMMUNICATIONS - 1.2%
SunCom Wireless Holdings, Inc.
5,000,000 6,000,000 11,000,000 8.50%, 06/01/13 5,200,000 6,240,000 11,440,000
-------------------------------------
TOTAL CORPORATE NOTES AND BONDS 177,932,892 111,348,211 289,281,103
-------------------------------------
CLAIMS - 0.1%
AEROSPACE - AIRLINES - 0.1%
Delta Airlines, Inc.
581,794 - 581,794 Delta ALPA Claim, 12/31/10 (d) 29,334 - 29,334
Northwest Airlines, Inc.
2,000,000 600,000 2,600,000 ALPA Trade Claim, 08/21/13 (d) 72,500 21,750 94,250
3,551,000 1,065,300 4,616,300 Flight Attendant Claim, 08/21/13 (d) 128,724 38,617 167,341
2,107,500 632,250 2,739,750 IAM Trade Claim, 08/21/13 (d) 76,397 22,919 99,316
2,341,500 702,450 3,043,950 Retiree Claim, 08/21/13 (d) 84,879 25,464 110,343
-------------------------------------
TOTAL CLAIMS 391,834 108,750 500,584
-------------------------------------
COMMON STOCKS - 6.9%
AEROSPACE - AIRLINES - 1%
199,342 91,819 291,161 Delta Air Lines, Inc. (j) 2,968,198 1,367,183 4,335,381
253,611 113,554 367,165 Northwest Airlines Corp. (j) 3,679,896 1,647,676 5,327,572
-------------------------------------
6,648,094 3,014,858 9,662,952
-------------------------------------
BROADCASTING - 0.4%
357,343 - 357,343 Gray Television, Inc. 2,865,891 - 2,865,891
121,072 - 121,072 Gray Television, Inc., Class A 1,029,112 - 1,029,112
- 1,184 1,184 Time Warner Cable, Inc. (j) - 32,678 32,678
-------------------------------------
3,895,003 32,678 3,927,681
-------------------------------------
41
CONSUMER NON-DURABLES - 0%
- 24,015 24,015 Outsourcing Services Group, Inc. (b) (j) - - -
-------------------------------------
DIVERSIFIED MEDIA - 0.1%
- 46,601 46,601 American Banknote Corp. (j) - 1,095,124 1,095,124
-------------------------------------
FINANCIAL - 0%
- 555,258 555,258 Altiva Financial Corp. (j) - 5,553 5,553
-------------------------------------
FOREST PRODUCTS - CONTAINERS - 0.4%
563,258 - 563,258 Graphic Packaging Corp. (j) 2,078,422 - 2,078,422
100,067 - 100,067 Louisiana-Pacific Corp. 1,368,917 - 1,368,917
-------------------------------------
3,447,339 - 3,447,339
-------------------------------------
HOUSING - BUILDING MATERIALS - 0.3%
150,285 - 150,285 Owens Corning, Inc. (j) 3,038,755 - 3,038,755
-------------------------------------
HOUSING - REAL ESTATE DEVELOPMENT - 0%
8 - 8 Westgate Investments LLC (b) - - -
-------------------------------------
INFORMATION TECHNOLOGY - 0%
- 303 303 Viatel Holding Bermuda, Ltd. (j) - 7 7
-------------------------------------
SERVICE - ENVIRONMENTAL SERVICES - 0.3%
136,990 - 136,990 Safety-Kleen Systems, Inc. (j) 2,876,790 - 2,876,790
-------------------------------------
TELECOMMUNICATIONS - 0.5%
753,981 - 753,981 Communications Corp. of America (b) (j) 5,004,775 - 5,004,775
- 232 232 Knology, Inc. (j) - 2,965 2,965
-------------------------------------
5,004,775 2,965 5,007,740
-------------------------------------
TRANSPORTATION - 0.2%
1,544,148 - 1,544,148 Delphi Corp. (j) 223,901 - 223,901
58,949 - 58,949 Federal-Mogul Corp., Class A (j) 1,473,725 - 1,473,725
-------------------------------------
1,697,626 - 1,697,626
-------------------------------------
UTILITIES - 0.5%
81,194 - 81,194 Entegra TC LLC 2,715,939 - 2,715,939
59,600 - 59,600 NRG Energy, Inc. (j) 2,583,064 - 2,583,064
-------------------------------------
5,299,003 - 5,299,003
-------------------------------------
WIRELESS COMMUNICATIONS - 3.2%
225,000 853,905 1,078,905 ICO Global Communications Holding Ltd. (j) (l) 715,500 2,715,418 3,430,918
1,037,196 - 1,037,196 SunCom Wireless Holdings, Inc., Class A (j) 27,547,926 - 27,547,926
-------------------------------------
28,263,426 2,715,418 30,978,844
-------------------------------------
TOTAL COMMON STOCKS 60,170,811 6,866,602 67,037,413
-------------------------------------
WARRANTS - 0.0%
20,000 - 20,000 Clearwire Corp., expires 08/15/10 (j) 3,688 - 3,688
- 5,000 5,000 XM Satellite Radio, Inc., expires 03/05/10 (j) - - -
-------------------------------------
TOTAL WARRANTS 3,688 - 3,688
-------------------------------------
TOTAL INVESTMENTS - 135.0% 838,189,541 131,681,117 969,870,658
-------------------------------------
42
Investments sold short
outstanding as of December 31,
2007:
PRO FORMA
PRO FORMA COMBINED
HIGHLAND COMBINED HIGHLAND HIGHLAND
CREDIT PROSPECT STREET HIGHLAND CREDIT PROSPECT STREET CREDIT
STRATEGIES HIGH INCOME CREDIT STRATEGIES STRATEGIES HIGH INCOME STRATEGIES
FUND (HCF) PORTFOLIO (PHY) FUND (HCF) FUND (HCF) PORTFOLIO (PHY) FUND (HCF)
----------- ---------------- ----------------- ------------------------------ ---------- --------------- ------------
# OF SHARES # OF SHARES # OF SHARES SECURITY VALUE ($) VALUE ($) VALUE ($)
----------- ---------------- ----------------- ------------------------------ ---------- --------------- ------------
19,593 - 19,593 Superior Industries 116,578 - 116,578
International, Inc.
51,587 - 51,587 IndyMac Bancorp, Inc. 937,336 - 937,336
------------
1,053,914
Forward foreign currency contracts outstanding as of December 31, 2007 were as follows:
PRO FORMA COMBINED
HIGHLAND CREDIT PROSPECT STREET HIGH HIGHLAND CREDIT
STRATEGIES FUND (HCF) INCOME PORTFOLIO (PHY) STRATEGIES FUND (HCF)
-----------------------------------------------------------------------
CONTRACTS PRINCIPAL AMOUNT PRINCIPAL AMOUNT PRINCIPAL AMOUNT
TO BUY OR COVERED COVERED COVERED
TO SELL CURRENCY BY CONTRACTS BY CONTRACTS BY CONTRACTS
---------------------------------------------------------------------------------------------------
Sell AUD 4,000,000 0 4,000,000
Sell AUD 5,400,000 0 5,400,000
Sell AUD 2,700,000 0 2,700,000
Sell EUR 11,000,000 0 11,000,000
Sell EUR 4,900,000 0 4,900,000
Sell EUR 5,100,000 0 5,100,000
Sell GBP 4,000,000 0 4,000,000
Sell GBP 500,000 0 500,000
Sell GBP 500,000 0 500,000
PRO FORMA COMBINED
HIGHLAND CREDIT PROSPECT STREET HIGH HIGHLAND CREDIT
STRATEGIES FUND (HCF) INCOME PORTFOLIO (PHY) STRATEGIES FUND (HCF)
-----------------------------------------------------------------------
NET UNREALIZED NET UNREALIZED NET UNREALIZED
APPRECIATION/ APPRECIATION/ APPRECIATION/
EXPIRATION (DEPRECIATION) (DEPRECIATION) (DEPRECIATION)
------------------------------------------------------------------------------------
02/28/2008 ($236,992) 0 ($236,992)
02/29/2008 -353,149 0 ($353,149)
03/11/2008 -147,955 0 ($147,955)
02/04/2008 -940,067 0 ($940,067)
05/29/2008 108,967 0 $108,967
05/30/2008 54,955 0 $54,955
02/07/2008 169,210 0 $169,210
05/29/2008 36,435 0 $36,435
05/30/2008 33,338 0 $33,338
(a) Senior loans in which the Fund invests generally pay interest at rates which are periodically predetermined
by reference to a base lending rate plus a premium. (Unless otherwise identified by Note (f), all senior
loans carry a variable rate interest.) These base lending rates are generally (i) the Prime Rate offered by
one or more major United States banks, (ii) the lending rate offered by one or more European banks such as
the London Inter-Bank Offered Rate ("LIBOR") or (iii) the Certificate of Deposit rate. Rate shown
represents the weighted average rate at December 31, 2007. Senior loans, while exempt from registration
under the Security Act of 1933, as amended (the "1933 Act"), contain certain restrictions on resale and
cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow
or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a
contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual
remaining maturity may be substantially less than the stated maturities shown.
(b) Represents fair value as determined in good faith under the direction of the Board.
(c) Senior Loan Notes have additional unfunded loan commitments.
(d) The issuer is in default of certain debt covenants. Income is not being accrued.
(e) All or a portion of this position has not settled. Contract rates do not take effect until settlement date.
(f) Fixed Rate Senior Loan.
(g) Floating rate security. The interest rate shown reflects the rate in effect at December 31, 2007.
(h) Securities exempt from registration pursuant to Rule 144A under the 1933 Act. These securities may only be
resold, in transactions exempt from registration, to qualified institutional buyers. These securities have
been determined by the Adviser to be liquid securities.
(i) This issuer is under the protection of the U.S. federal bankruptcy court.
(j) Non-income producing security.
(l) Securities (or a portion of securities) on loan as of December 31, 2007.
(m) Step Coupon. A bond that pays an initial coupon rate for the first period and then a higher coupon rate for
the following periods until maturity.
AUD Australia Dollar
DIP Debtor in Possession
EUR Euro Currency
GBP Great Britian Pound
PIK Payment in Kind
SEK Swedish Krona
43
STATEMENT OF ASSETS AND LIABILITIES
PRO FORMA COMBINED STATEMENT OF ASSETS AND LIABILITIES FOR HIGHLAND CREDIT
STRATEGIES FUND AND PROSPECT STREET HIGH INCOME PORTFOLIO INC. AS OF
DECEMBER 31, 2007 (UNAUDITED)
PRO FORMA
INCLUDING RIGHTS PRO FORMA
HIGHLAND OFFERING COMBINED
CREDIT RIGHTS OFFERING HIGHLAND CREDIT PROSPECT STREET HIGHLAND CREDIT
STRATEGIES PRO FORMA STRATEGIES HIGH INCOME PRO FORMA STRATEGIES
FUND (HCF) ADJUSTMENTS FUND (HCF) PORTFOLIO (PHY) ADJUSTMENTS FUND (HCF)
---------- --------------- ---------------- --------------- ------------ ---------------
Assets:
Investments, at value 838,189,541 838,189,541 131,681,117 969,870,658
Cash 2,837,166 143,563,458[3] 146,400,624 3,954,306 150,354,930
Restricted Cash 39,261,591 39,261,591 - 39,261,591
Net unrealized appreciation
on forward currency
contracts 402,905 402,905 - 402,905
Receivable for: -
Investments Sold 22,028,985 22,028,985 2,180,241 24,209,226
Swap agreements 1,054,833 1,054,833 - 1,054,833
Dividends and interest
receivables 13,150,972 13,150,972 2,526,024 15,676,996
Other assets 41,483 41,483 80,287 121,770
------------- -------------- --------------- ------------- ----------- --------------
Total assets 916,967,476 143,563,458 1,060,530,934 140,421,974 - 1,200,952,908
------------- -------------- --------------- ------------- ----------- --------------
LIABILITIES:
Note payable 248,000,000 248,000,000 - 40,000,000 288,000,000
Securities sold short, at
value 1,053,914 1,053,914 - 1,053,914
Net discount and unrealized
depreciation on unfunded
transactions 1,556,736 1,556,736 - 1,556,736
Net unrealized depreciation
on forward currency
contracts 1,678,163 1,678,163 - 1,678,163
Net unrealized depreciation
on credit default swaps 29,158 29,158 - 29,158
Net unrealized depreciation
on total return swaps 6,341,169 6,341,169 - 6,341,169
Payables for: -
Distributions 5,178,082 5,178,082 - 5,178,082
Investments purchased 29,734,707 29,734,707 3,841,806 33,576,513
Investment advisory fee
payable 748,663 748,663 76,695 825,358
Preferred dividend
payable - - 34,262 34,262
Administration fee 149,733 149,733 6,482 156,215
Interest Expense 1,278,012 1,278,012 - 1,278,012
Accrued expenses and
other liabilities 140,978 140,978 105,414 561,950[1] 808,342
------------- ------------- --------------- -------------- ----------- --------------
Total liabilities 295,889,315 - 295,889,315 4,064,658 40,561,950 340,515,923
============= ============= =============== ============== =========== ==============
AUCTION RATE PREFERRED STOCK - - - 40,000,000[4] (40,000,000) -
NET ASSETS APPLICABLE TO
COMMON SHARES: 621,078,161 764,641,619 96,357,317 (561,950) 860,436,986
COMPOSITION OF NET ASSETS:
Par value of common shares 34,521 11,536[3] 46,057 926,241 (920,438) 51,860
Paid-in capital in excess
of par value of common
shares 657,755,847 143,551,922[3] 801,307,769 116,809,414 920,438 919,037,621
Undistributed net
investment income 7,645,585 7,645,585 1,935,367 (561,950)[1] 9,019,002
Accumulated net realized
gain/(loss) from
investments, swaps and
foreign currency
transactions 10,712,407 10,712,407 16,912 10,729,319
Net unrealized
appreciation/
(depreciation) on
investments, unfunded
transactions, short
positions, -
forward currency
contracts, swaps and
translation of assets
and liabilities
denominated -
in foreign currency (55,070,199) (55,070,199) (23,330,617) (78,400,816)
------------- ------------- --------------- ----------- ----------- -------------
NET ASSETS APPLICABLE TO
COMMON SHARES 621,078,161 143,563,458 764,641,619 96,357,317 (561,950)[1] 860,436,986
============= ============= =============== =========== =========== =============
COMMON SHARES
Net Assets 621,078,161 764,641,619 96,357,317 860,436,986
Shares outstanding
(unlimited
authorization) 34,520,550 46,056,165 30,874,699 (25,070,395)[2] 51,860,469
Net asset value per
share (net assets/
shares outstanding) 17.99 16.60 3.12 16.59
[1] Reflects adjustments for estimated reorganization expenses of $561,950.
[2] Reflects adjustments to the number of shares outstanding due to the reorganization
[3] Reflects the proceeds received from the rights offering that closed on January 28, 2008
[4] Auction Rate Preferred Stock (1,000,000 shares authorized, and 1,600 shares issued at $25,000 per share)
See Notes to Pro Forma Combined Financial Statements
44
STATEMENT OF OPERATIONS
PRO FORMA COMBINED STATEMENT OF OPERATIONS FOR HIGHLAND CREDIT
STRATEGIES FUND AND PROSPECT STREET HIGH INCOME PORTFOLIO INC.
FOR THE TWELVE MONTHS ENDED DECEMBER 31, 2007 (UNAUDITED)
PRO FORMA
INCLUDING RIGHTS PRO FORMA
HIGHLAND OFFERING COMBINED
CREDIT RIGHTS OFFERING HIGHLAND CREDIT PROSPECT STREET HIGHLAND CREDIT
STRATEGIES PRO FORMA STRATEGIES HIGH INCOME PRO FORMA STRATEGIES
FUND (HCF) ADJUSTMENTS(f) FUND (HCF) PORTFOLIO (PHY) ADJUSTMENTS FUND (HCF)
---------- --------------- ---------------- --------------- ------------ ---------------
INVESTMENT INCOME:
Interest 85,031,062 85,031,062 12,132,742 - 97,163,804
Accretion of bond discount - - 678,083 678,083
Dividends 1,826,564 1,826,564 - - 1,826,564
Securities lending income 7,479 7,479 163,872 - 171,351
---------- -------------- ---------------- --------------- ------------ ---------------
Total investment income 86,865,105 - 86,865,105 12,974,697 - 99,839,802
---------- -------------- ---------------- --------------- ------------ ---------------
EXPENSES:
Investment advisory fees 9,368,976 1,967,689 11,336,665 947,447 501,770(b) 12,785,882
Administration fees 1,873,796 393,538 2,267,334 33,406(a) 289,884(b) 2,509,624
Accounting service fees 449,908 38,470 488,378 33,406(a) (6,846)(c) 514,938
Transfer agent fees 34,147 - 34,147 29,371 (29,371)(c) 34,147
Professional fees 332,701 - 332,701 64,245 (64,245)(c) 332,701
Trustees' fees 32,295 - 32,295 46,036 (46,036)(c) 32,295
Custodian fees 118,582 24,905 143,487 13,640 - 157,127
Registration fees 37,005 - 37,005 29,746 (29,746)(c) 37,005
Preferred shares broker
expense - - - 102,437 (102,437)(d) -
Reports to shareholders 113,710 23,882 137,592 40,216 (22,627)(c) 155,181
Other Expenses 413,714 19,696 433,410 82,223 (72,909)(c) 442,724
----------- -------------- ---------------- --------------- ------------ --------------
NET OPERATING EXPENSES 12,774,834 2,468,180 15,243,014 1,422,173 417,437 17,082,624
----------- -------------- ---------------- --------------- ------------ --------------
Interest Expense 14,759,102 14,759,102 14,204 2,331,990(g) 17,105,297
Dividends on securities
sold short 226,480 226,480 - - 226,480
----------- -------------- ---------------- --------------- ------------ --------------
TOTAL EXPENSES 27,760,416 2,468,180 30,228,596 1,436,377 2,749,427 34,414,401
----------- -------------- ---------------- --------------- ------------ --------------
Less: Fee waiver - - - - (791,654)(e) (791,654)
----------- -------------- ---------------- --------------- ------------ --------------
NET EXPENSE 27,760,416 2,468,180 30,228,596 1,436,377 1,957,773 33,622,747
----------- -------------- ---------------- --------------- ------------ --------------
NET INVESTMENT INCOME 59,104,689 (2,468,180) 56,636,509 11,538,320 (1,957,773) 66,217,055
----------- -------------- ---------------- --------------- ------------ --------------
NET REALIZED AND UNREALIZED
GAIN/(LOSS) ON INVESTMENTS:
Net realized gain/(loss)
on investments 17,716,313 17,716,313 3,680,385 21,396,698
Net realized gain/(loss)
on swaps 877,812 877,812 - 877,812
Net realized gain/(loss)
on foreign currency
transactions (988,007) (988,007) 76,789 (911,218)
Net change in unrealized
appreciation/
(depreciation) on
investments (72,891,311) (72,891,311) (14,923,803) (87,815,114)
Net change in unrealized
appreciation/
(depreciation) on
unfunded transactions (1,205,082) (1,205,082) - (1,205,082)
Net change in unrealized
appreciation/
(depreciation) on short
positions 324,633 324,633 - 324,633
Net change in unrealized
appreciation/
(depreciation) on
forward currency
contracts (1,275,258) (1,275,258) - (1,275,258)
Net change in unrealized
appreciation/
(depreciation) on swaps (6,370,327) (6,370,327) - (6,370,327)
Net change in unrealized
appreciation/
(depreciation) on
translation of assets
and -
liabilities denominated
in foreign currency (55,214) (55,214) 73,767 18,553
----------- -------------- ---------------- --------------- ------------ --------------
NET REALIZED AND
UNREALIZED GAIN/(LOSS)
ON INVESTMENTS (63,866,441) - (63,866,441) (11,092,863) - (74,959,304)
Distributions to Preferred
Shareholders - - - (2,149,833) 2,149,833(d) -
NET (DECREASE)/INCREASE
IN NET ASSETS, APPLICABLE
TO COMMON SHAREHOLDERS,
FROM OPERATIONS (4,761,752) (2,468,180) (7,229,932) (1,704,376) 192,060 (8,742,248)
See Notes to Pro Forma Combined Financial Statements
(a) On historical financial statements the administration fee has included both
accounting and administrative services payable to third party service
providers.
(b) Reflects the increase in the advisory fee due to the higher advisory fee of
HCF relative to PHY and a higher administration fee for HCF relative to
PHY.
(c) Reflects the elimination of duplicative expenses and economies of scale due
to the proposed merger.
(d) Reflects the redemption of the preferred shares outstanding prior to the
reorganization and thus elimination of related expenses.
(e) Reflects the contractual fee waiver implemented upon shareholder approval
of the reorganization.
(f) Reflects adjustments due to proceeds received from the rights offering that
closed on January 28, 2008.
(g) Reflects adjustments due to incurring interest expense via a credit
facility versus distributions to preferred shares.
45
PROSPECT STREET HIGH INCOME PORTFOLIO INC. MERGER WITH
AND INTO HIGHLAND CREDIT STRATEGIES FUND
NOTES TO PRO FORMA COMBINED FINANCIAL STATEMENTS (UNAUDITED)
1. BASIS OF COMBINATION:
The accompanying unaudited Pro Forma Combined Statement of Assets and
Liabilities, the Pro Forma Combined Schedule of Investments at December 31, 2007
and the related Pro Forma Combined Statement of Operations ("Pro Forma
Statements") for the twelve months ended December 31, 2007, reflect the accounts
of Prospect Street High Income Portfolio Inc. ("Acquired Fund") and Highland
Credit Strategies Fund ("Acquiring Fund"), each a "Fund." Following the
reorganization, Highland Credit Strategies Fund will be the accounting survivor.
The Pro Forma Statements assume the preferred shares of the Acquired Fund were
redeemed prior the reorganization and a corresponding amount was borrowed under
the credit facility of the Acquiring Fund. For the Acquiring Fund an adjustment
has been made to the Pro Forma Statements to reflect the proceeds received from
the rights offering that closed on January 28, 2008.
Under the terms of the Agreement and Plan of Reorganization, the
Reorganization is intended to qualify as a "reorganization" within the meaning
of Section 368(a)(1) of the Internal Revenue Code of 1986, as amended. If the
Reorganization so qualifies, in general, stockholders of the Acquired Fund will
recognize no gain or loss upon the receipt solely of shares of the Acquiring
Fund in connection with the Reorganization. Additionally, the Acquired Fund will
recognize no gain or loss as a result of the Reorganization. Neither the
Acquiring Fund nor its shareholders will recognize any gain or loss in
connection with the Reorganization. However, stockholders of the Acquired Fund
may recognize gain or loss with respect to cash such holders receive pursuant to
the Agreement and Plan of Reorganization in lieu of fractional shares. The
reorganization would be accomplished by an acquisition of the net assets of the
Acquired Fund in exchange for shares of the Acquiring Fund at net asset value.
The unaudited Pro Forma Combined Schedule of Investments and the unaudited Pro
Forma Combined Statement of Assets and Liabilities have been prepared as though
the combination had been effective on December 31, 2007. The unaudited Pro Forma
Combined Statement of Operations reflects the results of the Funds for the
twelve months ended December 31, 2007 as if the merger occurred on January 1,
2007. These pro forma statements have been derived from the books and records of
the Funds utilized in calculating daily net asset values at the dates indicated
above in conformity with U.S. generally accepted accounting principles. The
historical cost of investment securities will be carried forward to the
surviving entity. The fiscal year ends are October 31 for the Prospect Street
High Income Portfolio Inc. and December 31 for the Highland Credit Strategies
Fund. The Pro Forma Combined Financial Statements should be read in conjunction
with the historical financial statements of each Fund, which are incorporated by
reference in the Statement of Additional Information.
2. USE OF ESTIMATES:
The preparation of financial statements in conformity with U.S.
generally accepted accounting principles ("GAAP") requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expenses during
the reporting period. Actual results could differ from those estimates.
3. INVESTMENT VALUATION:
In computing the Fund's net assets attributable to Common Shares,
securities with readily available market quotations use those quotations for
valuation. When portfolio securities are traded on the relevant day of
valuation, the valuation will be the last reported sale price on that day. If
there are no such sales on that day, the security will be valued at the mean
between the most recently quoted bid and asked prices provided by the principal
market makers. If there is more than one such principal market maker, the value
shall be the average of such means. Securities without a sale price or
quotations from principal market makers on the valuation day will be valued by
an independent pricing service. If securities do not have readily available
market quotations or pricing service prices, including circumstances under which
such are determined not to be accurate or current (including when events
materially affect the value of securities occurring between the time when market
price is determined and calculation of the Fund's net asset value), such
46
securities are valued at their fair value, as determined by Highland Capital
Management, L.P. in good faith in accordance with procedures approved by the
Fund's Board of Trustees. In these cases, the Fund's net asset value will
reflect the affected portfolio securities' value as determined in the judgment
of the Board of Trustees or its designee instead of being determined by the
market. Using a fair value pricing methodology to value securities may result in
a value that is different from a security's most recent sale price and from the
prices used by other investment companies to calculate their net asset values.
There can be no assurance that the Fund's valuation of a security will not
differ from the amount that it realizes upon the sale of such security.
Short-term investments, that is, those with a remaining maturity of 60 days or
less, are valued at amortized cost. Repurchase agreements are valued at cost
plus accrued interest. Foreign price quotations are converted to U.S. dollar
equivalents using the 4 PM London Time Spot Rate.
4. CAPITAL SHARES:
The unaudited pro forma net asset values per share assumes additional
shares of capital stock of the Acquiring Fund were issued in connection with the
proposed acquisition of the Acquired Fund as of December 31, 2007. The number of
additional shares issued was calculated by dividing the net asset value of each
class of the Acquired Fund by the respective class net asset value per share of
the Acquiring Fund.
5. PRO FORMA OPERATIONS:
In the Pro Forma Combined Statement of Operations certain expenses have
been adjusted to reflect the expected expenses of the combined entity. The pro
forma investment management fees of the combined entity are based on the fee
schedules in effect for the Acquiring Fund's combined level of average net
assets for the twelve months ended December 31, 2007.
6. FEDERAL INCOME TAXES:
It is the policy of the Funds to comply with the federal income and
excise tax requirements of the Internal Revenue Code of 1986, as amended,
applicable to regulated investment companies. Accordingly, the Funds intend to
distribute substantially all of their net investment income and net realized
gains on investments, if any, to their shareholders. Therefore, no federal
income tax provision is required.
47
APPENDIX A
RATINGS OF INVESTMENTS
Standard & Poor's--A brief description of the applicable rating symbols of
Standard & Poor's and their meanings (as published by Standard & Poor's)
follows:
ISSUE CREDIT RATING DEFINITIONS
A Standard & Poor's issue credit rating is a current opinion of the
creditworthiness of an obligor with respect to a specific financial obligation,
a specific class of financial obligations, or a specific financial program
(including ratings on medium-term note programs and commercial paper programs).
It takes into consideration the creditworthiness of guarantors, insurers, or
other forms of credit enhancement on the obligation and takes into account the
currency in which the obligation is denominated. The issue credit rating is not
a recommendation to purchase, sell, or hold a financial obligation, inasmuch as
it does not comment as to market price or suitability for a particular investor.
Issue credit ratings are based on current information furnished by the
obligors or obtained by Standard & Poor's from other sources it considers
reliable. Standard & Poor's does not perform an audit in connection with any
credit rating and may, on occasion, rely on unaudited financial information.
Credit ratings may be changed, suspended, or withdrawn as a result of changes
in, or unavailability of, such information, or based on other circumstances.
Issue credit ratings can be either long-term or short-term. Short-term
ratings are generally assigned to those obligations considered short-term in the
relevant market. In the U.S., for example, that means obligations with an
original maturity of no more than 365 days, including commercial paper, are
considered short-term. Short-term ratings are also used to indicate the
creditworthiness of an obligor with respect to put features on long-term
obligations. The result is a dual rating, in which the short-term rating
addresses the put feature, in addition to the usual long-term rating.
Medium-term notes are assigned long-term ratings.
LONG-TERM ISSUE CREDIT RATINGS
Issue credit ratings are based, in varying degrees, on the following
considerations:
o Likelihood of payment--capacity and willingness of the obligor to meet its
financial commitment on an obligation in accordance with the terms of the
obligation;
o Nature of and provisions of the obligation; and
o Protection afforded by, and relative position of, the obligation in the
event of bankruptcy, reorganization, or other arrangement under the laws of
bankruptcy and other laws affecting creditors' rights.
The issue rating definitions are expressed in terms of default risk. As such,
they pertain to senior obligations of an entity. Junior obligations are
typically rated lower than senior obligations, to reflect the lower priority in
bankruptcy, as noted above. (Such differentiation applies when an entity has
both senior and subordinated obligations, secured and unsecured obligations, or
operating company and holding company obligations.) Accordingly, in the case of
junior debt, the rating may not conform exactly with the category definition.
AAA
An obligation rated "AAA" has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is extremely strong.
A-1
AA
An obligation rated "AA" differs from the highest-rated obligations only to a
small degree. The obligor's capacity to meet its financial commitment on the
obligation is very strong.
A
An obligation rated "A" is somewhat more susceptible to the adverse effects
of changes in circumstances and economic conditions than obligations in
higher-rated categories. However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.
BBB
An obligation rated "BBB" exhibits adequate protection parameters. However,
adverse economic conditions or changing circumstances are more likely to lead to
a weakened capacity of the obligor to meet its financial commitment on the
obligation.
BB, B, CCC, CC, and C
Obligations rated "BB", "B", "CCC", "CC", and "C" are regarded as having
significant speculative characteristics. "BB" indicates the least degree of
speculation and "C" the highest. While such obligations will likely have some
quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
An obligation rated "BB" is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to the
obligor's inadequate capacity to meet its financial commitment on the
obligation.
B
An obligation rated "B" is more vulnerable to nonpayment than obligations
rated "BB", but the obligor currently has the capacity to meet its financial
commitment on the obligation. Adverse business, financial, or economic
conditions will likely impair the obligor's capacity or willingness to meet its
financial commitment on the obligation.
CCC
An obligation rated "CCC" is currently vulnerable to nonpayment, and is
dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation. In the event of
adverse business, financial, or economic conditions, the obligor is not likely
to have the capacity to meet its financial commitment on the obligation.
CC
An obligation rated "CC" is currently highly vulnerable to nonpayment.
C
A subordinated debt or preferred stock obligation rated "C" is currently
highly vulnerable to nonpayment. The "C" rating may be used to cover a situation
where a bankruptcy petition has been filed or similar action taken, but payments
on this obligation are being continued. A "C" also will be assigned to a
preferred stock issue in arrears on dividends or sinking fund payments, but that
is currently paying.
D
An obligation rated "D" is in payment default. The "D" rating category is
used when payments on an obligation are not made on the date due even if the
A-2
applicable grace period has not expired, unless Standard & Poor's believes that
such payments will be made during such grace period. The "D" rating also will be
used upon the filing of a bankruptcy petition or the taking of a similar action
if payments on an obligation are jeopardized.
PLUS (+) OR MINUS (--)
The ratings from "AA" to "CCC" may be modified by the addition of a plus (+)
or minus (--) sign to show relative standing within the major rating categories.
NR
This indicates that no rating has been requested, that there is insufficient
information on which to base a rating, or that Standard & Poor's does not rate a
particular obligation as a matter of policy.
SHORT-TERM ISSUE CREDIT RATINGS
A-1
A short-term obligation rated "A-1" is rated in the highest category by
Standard & Poor's. The obligor's capacity to meet its financial commitment on
the obligation is strong. Within this category, certain obligations are
designated with a plus sign (+). This indicates that the obligor's capacity to
meet its financial commitment on these obligations is extremely strong.
A-2
A short-term obligation rated "A-2" is somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than
obligations in higher rating categories. However, the obligor's capacity to meet
its financial commitment on the obligation is satisfactory.
A-3
A short-term obligation rated "A-3" exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation.
B
A short-term obligation rated "B" is regarded as having significant
speculative characteristics. Ratings of "B-1", "B-2", and "B-3" may be assigned
to indicate finer distinctions within the "B" category. The obligor currently
has the capacity to meet its financial commitment on the obligation; however, it
faces major ongoing uncertainties which could lead to the obligor's inadequate
capacity to meet its financial commitment on the obligation.
B-1
A short-term obligation rated "B-1" is regarded as having significant
speculative characteristics, but the obligor has a relatively stronger capacity
to meet its financial commitments over the short-term compared to other
speculative-grade obligors.
B-2
A short-term obligation rated "B-2" is regarded as having significant
speculative characteristics, and the obligor has an average speculative-grade
capacity to meet its financial commitments over the short-term compared to other
speculative-grade obligors.
A-3
B-3
A short-term obligation rated "B-3" is regarded as having significant
speculative characteristics, and the obligor has a relatively weaker capacity to
meet its financial commitments over the short-term compared to other
speculative-grade obligors.
C
A short-term obligation rated "C" is currently vulnerable to nonpayment and
is dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation.
D
A short-term obligation rated "D" is in payment default. The "D" rating
category is used when payments on an obligation are not made on the date due
even if the applicable grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such grace period. The "D"
rating also will be used upon the filing of a bankruptcy petition or the taking
of a similar action if payments on an obligation are jeopardized.
ACTIVE QUALIFIERS (CURRENTLY APPLIED AND/OR OUTSTANDING)
i
This subscript is used for issues in which the credit factors, terms, or
both, that determine the likelihood of receipt of payment of interest are
different from the credit factors, terms or both that determine the likelihood
of receipt of principal on the obligation. The "i" subscript indicates that the
rating addresses the interest portion of the obligation only. The "i" subscript
will always be used in conjunction with the "p" subscript, which addresses
likelihood of receipt of principal. For example, a rated obligation could be
assigned ratings of "AAAp NRi" indicating that the principal portion is rated
"AAA" and the interest portion of the obligation is not rated.
L
Ratings qualified with "L" apply only to amounts invested up to federal
deposit insurance limits.
P
This subscript is used for issues in which the credit factors, the terms, or
both, that determine the likelihood of receipt of payment of principal are
different from the credit factors, terms or both that determine the likelihood
of receipt of interest on the obligation. The "p" subscript indicates that the
rating addresses the principal portion of the obligation only. The "p" subscript
will always be used in conjunction with the "i" subscript, which addresses
likelihood of receipt of interest. For example, a rated obligation could be
assigned ratings of "AAAp N.R.i" indicating that the principal portion is rated
"AAA" and the interest portion of the obligation is not rated.
pi
Ratings with a "pi" subscript are based on an analysis of an issuer's
published financial information, as well as additional information in the public
domain. They do not, however, reflect in-depth meetings with an issuer's
management and are therefore based on less comprehensive information than
ratings without a "pi" subscript. Ratings with a "pi" subscript are reviewed
annually based on a new year's financial statements, but may be reviewed on an
interim basis if a major event occurs that may affect the issuer's credit
quality.
pr
The letters "pr" indicate that the rating is provisional. A provisional
rating assumes the successful completion of the project financed by the debt
being rated and indicates that payment of debt service requirements is largely
or entirely dependent upon the successful, timely completion of the project.
This rating, however, while addressing credit quality subsequent to completion
of the project, makes no comment on the likelihood of or the risk of default
A-4
upon failure of such completion. The investor should exercise his own judgment
with respect to such likelihood and risk.
PRELIMINARY
Preliminary ratings are assigned to issues, including financial programs, in
the following circumstances.
o Preliminary ratings may be assigned to obligations, most commonly
structured and project finance issues, pending receipt of final
documentation and legal opinions. Assignment of a final rating is
conditional on the receipt and approval by Standard & Poor's of appropriate
documentation. Changes in the information provided to Standard & Poor's
could result in the assignment of a different rating. In addition, Standard
& Poor `s reserves the right not to issue a final rating.
o Preliminary ratings are assigned to Rule 415 Shelf Registrations. As
specific issues, with defined terms, are offered from the master
registration, a final rating may be assigned to them in accordance with
Standard & Poor's policies. The final rating may differ from the
preliminary rating.
t
This symbol indicates termination structures that are designed to honor their
contracts to full maturity or, should certain events occur, to terminate and
cash settle all their contracts before their final maturity date.
INACTIVE QUALIFIERS (NO LONGER APPLIED OR OUTSTANDING)
*
This symbol indicated continuance of the ratings is contingent upon Standard
& Poor `s receipt of an executed copy of the escrow agreement or closing
documentation confirming investments and cash flows. Discontinued use in August
1998.
c
This qualifier was used to provide additional information to investors that
the bank may terminate its obligation to purchase tendered bonds if the
long-term credit rating of the issuer is below an investment-grade level and/or
the issuer's bonds are deemed taxable. Discontinued use in January 2001.
q
A "q" subscript indicates that the rating is based solely on quantitative
analysis of publicly available information. Discontinued use in April 2001.
r
The "r" modifier was assigned to securities containing extraordinary risks,
particularly market risks, that are not covered in the credit rating. The
absence of an "r" modifier should not be taken as an indication that an
obligation will not exhibit extraordinary non-credit related risks. Standard &
Poor's discontinued the use of the "r" modifier for most obligations in June
2000 and for the balance of obligations (mainly structured finance transactions)
in November 2002.
A-5
MOODY'S INVESTORS SERVICE, INC.--A brief description of the applicable
Moody's rating symbols and their meanings (as published by Moody's) follows:
LONG-TERM OBLIGATION RATINGS
Moody's long-term obligation ratings are opinions of the relative credit risk
of a fixed income obligations with an original maturity of one year or more.
They address the possibility that a financial obligation will not be honored as
promised. Such ratings reflect both the likelihood of default and any financial
loss suffered in the event of default.
MOODY'S LONG-TERM RATING DEFINITIONS:
Aaa
Obligations rated Aaa are judged to be of the highest quality, with minimal
credit risk.
Aa
Obligations rated Aa are judged to be of high quality and are subject to very
low credit risk.
A
Obligations rated A are considered upper medium-grade and are subject to low
credit risk.
Baa
Obligations rated Baa are subject to moderate credit risk. They are
considered medium-grade and as such may possess certain speculative
characteristics.
Ba
Obligations rated Ba are judged to have speculative elements and are subject
to substantial credit risk.
B
Obligations rated B are considered speculative and are subject to high credit
risk.
Caa
Obligations rated Caa are judged to be of poor standing and are subject to
very high credit risk.
Ca
Obligations rated Ca are highly speculative and are likely in, or very near,
default, with some prospect of recovery of principal and interest.
C
Obligations rated C are the lowest rated class of bonds and are typically in
default, with little prospect for recovery of principal or interest.
NOTE: Moody's appends numerical modifiers 1, 2, and 3 to each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of
that generic rating category.
A-6
MEDIUM-TERM NOTE RATINGS
Moody's assigns long-term ratings to individual debt securities issued from
medium-term note (MTN) programs, in addition to indicating ratings to MTN
programs themselves. Notes issued under MTN programs with such indicated ratings
are rated at issuance at the rating applicable to all pari passu notes issued
under the same program, at the program's relevant indicated rating, provided
such notes do not exhibit any of the characteristics listed below:
o Notes containing features that link interest or principal to the credit
performance of any third party or parties (i.e., credit-linked notes);
o Notes allowing for negative coupons, or negative principal
o Notes containing any provision that could obligate the investor to make any
additional payments
o Notes containing provisions that subordinate the claim.
For notes with any of these characteristics, the rating of the individual
note may differ from the indicated rating of the program.
For credit-linked securities, Moody's policy is to "look through" to the
credit risk of the underlying obligor. Moody's policy with respect to non-credit
linked obligations is to rate the issuer's ability to meet the contract as
stated, regardless of potential losses to investors as a result of non-credit
developments. In other words, as long as the obligation has debt standing in the
event of bankruptcy, we will assign the appropriate debt class level rating to
the instrument.
Market participants must determine whether any particular note is rated, and
if so, at what rating level. Moody's encourages market participants to contact
Moody's Ratings Desks or visit www.moodys.com directly if they have questions
regarding ratings for specific notes issued under a medium-term note program.
Unrated notes issued under an MTN program may be assigned an NR (not rated)
symbol.
SHORT-TERM RATINGS:
Moody's short-term ratings are opinions of the ability of issuers to honor
short-term financial obligations. Ratings may be assigned to issuers, short-term
programs or to individual short-term debt instruments. Such obligations
generally have an original maturity not exceeding thirteen months, unless
explicitly noted.
Moody's employs the following designations to indicate the relative repayment
ability of rated issuers:
P-1
Issuers (or supporting institutions) rated Prime-1 have a superior ability to
repay short-term debt obligations.
P-2
Issuers (or supporting institutions) rated Prime-2 have a strong ability to
repay short-term debt obligations.
P-3
Issuers (or supporting institutions) rated Prime-3 have an acceptable ability
to repay short-term obligations.
NP
Issuers (or supporting institutions) rated Not Prime do not fall within any
of the Prime rating categories.
A-7
NOTE: Canadian issuers rated P-1 or P-2 have their short-term ratings
enhanced by the senior most long-term rating of the issuer, its guarantor or
support provider.
A-8
APPENDIX B
HIGHLAND CAPITAL MANAGEMENT, L.P.
PROXY VOTING POLICY
1. Application; General Principles
1.1 This proxy voting policy (the "Policy") applies to securities held
in Client accounts as to which the above-captioned investment adviser (the
"Company") has voting authority, directly or indirectly. Indirect voting
authority exists where the Company's voting authority is implied by a general
delegation of investment authority without reservation of proxy voting
authority.
1.2 The Company shall vote proxies in respect of securities owned by or
on behalf of a Client in the Client's best economic interests and without regard
to the interests of the Company or any other Client of the Company.
2. Voting; Procedures
2.1 MONITORING. A settlement designee of the Company shall have
responsibility for monitoring portfolios managed by the Company for securities
subject to a proxy vote. Upon the receipt of a proxy notice related to a
security held in a portfolio managed by the Company, the settlement designee
shall forward all relevant information to the portfolio manager(s) with
responsibility for the security.
2.2 Voting.
2.2.1. Upon receipt of notice from the settlement designee, the
portfolio manager(s) with responsibility for purchasing the security subject to
a proxy vote shall evaluate the subject matter of the proxy and cause the proxy
to be voted on behalf of the Client. In determining how to vote a particular
proxy, the portfolio manager (s) shall consider, among other things, the
interests of each Client account as it relates to the subject matter of the
proxy, any potential conflict of interest the Company may have in voting the
proxy on behalf of the Client and the procedures set forth in this Policy.
2.2.2 If a proxy relates to a security held in a registered
investment company or business development company ("Retail Fund") portfolio,
the portfolio manager(s) shall notify the Compliance Department and a designee
from the Retail Funds group. Proxies for securities held in the Retail Funds
will be voted by the designee from the Retail Funds group in a manner consistent
with the best interests of the applicable Retail Fund and a record of each vote
will be reported to the Retail Fund's Board of Directors in accordance with the
procedures set forth in Section 4 of this Policy.
2.3 CONFLICTS OF INTEREST. If the portfolio manager(s) determine that
the Company may have a potential material conflict of interest (as defined in
Section 3 of this Policy) in voting a particular proxy, the portfolio manager(s)
shall contact the Company's Compliance Department prior to causing the proxy to
be voted.
2.3.1. For a security held by a Retail Fund, the Company shall
disclose the conflict and the determination of the manner in which it
proposes to vote to the Retail Fund's Board of Directors. The
Company's determination shall take into account only the interests of
the Retail Fund, and the Compliance Department shall document the
basis for the decision and furnish the documentation to the Board of
Directors.
2.3.2. For a security held by an unregistered investment company,
such as a hedge fund and structured products ("Non-Retail Funds"),
where a material conflict of interest has been identified the Company
may resolve the conflict by following the recommendation of a
disinterested third party or by abstaining from voting.
B-1
2.4 NON-VOTES. The Company may determine not to vote proxies in respect
of securities of any issuer if it determines it would be in its Client's overall
best interests not to vote. Such determination may apply in respect of all
Client holdings of the securities or only certain specified Clients, as the
Company deems appropriate under the circumstances. As examples, the portfolio
manager(s) may determine: (a) not to recall securities on loan if, in its
judgment, the negative consequences to Clients of disrupting the securities
lending program would outweigh the benefits of voting in the particular instance
or (b) not to vote certain foreign securities positions if, in its judgment, the
expense and administrative inconvenience outweighs the benefits to Clients of
voting the securities.
2.5 RECORDKEEPING. Following the submission of a proxy vote, the
applicable portfolio manager(s) shall submit a report of the vote to a
settlement designee of the Company. Records of proxy votes by the Company shall
be maintained in accordance with Section 4 of this Policy.
2.6 CERTIFICATION. On a quarterly basis, each portfolio manager shall
certify to the Compliance Department that they have complied with this Policy in
connection with proxy votes during the period.
3. Conflicts of Interest
3.1 Voting the securities of an issuer where the following
relationships or circumstances exist are deemed to give rise to a material
conflict of interest for purposes of this Policy:
3.1.1 The issuer is a Client of the Company accounting for more
than 5% of the Company's annual revenues.
3.1.2 The issuer is an entity that reasonably could be expected to
pay the Company more than $1 million through the end of the Company's
next two full fiscal years.
3.1.3 The issuer is an entity in which a "Covered Person" (as
defined in the Retail Funds' and the Company's Policies and Procedures
Designed to Detect and Prevent Insider Trading and to Comply with Rule
17j-1 of the Investment Company Act of 1940, as amended (each, a "Code
of Ethics")) has a beneficial interest contrary to the position held
by the Company on behalf of Clients.
3.1.4 The issuer is an entity in which an officer or partner of
the Company or a relative(1) of any such person is or was an officer,
director or employee, or such person or relative otherwise has
received more than $150,000 in fees, compensation and other payment
from the issuer during the Company's last three fiscal years;
provided, however, that the Compliance Department may deem such a
relationship not to be a material conflict of interest if the Company
representative serves as an officer or director of the issuer at the
direction of the Company for purposes of seeking control over the
issuer.
3.1.5 The matter under consideration could reasonably be expected
to result in a material financial benefit to the Company through the
end of the Company's next two full fiscal years (for example, a vote
to increase an investment advisory fee for a Retail Fund advised by
the Company or an affiliate).
3.1.6 Another Client or prospective Client of the Company,
directly or indirectly, conditions future engagement of the Company on
voting proxies in respect of any Client's securities on a particular
matter in a particular way.
3.1.7 The Company holds various classes and types of equity and
debt securities of the same issuer contemporaneously in different
Client portfolios.
3.1.8 Any other circumstance where the Company's duty to serve its
Clients' interests, typically referred to as its "duty of loyalty,"
could be compromised.
--------------
(1) For the purposes of this Policy, "relative" includes the following family
members: spouse, minor children or stepchildren or children or stepchildren
sharing the person's home.
B-2
3.2 Notwithstanding the foregoing, a conflict of interest described in
Section 3.1 shall not be considered material for the purposes of this Policy in
respect of a specific vote or circumstance if:
3.2.1 The securities in respect of which the Company has the power
to vote account for less than 1% of the issuer's outstanding voting
securities, but only if: (i) such securities do not represent one of
the 10 largest holdings of such issuer's outstanding voting securities
and (ii) such securities do not represent more than 2% of the Client's
holdings with the Company.
3.2.2 The matter to be voted on relates to a restructuring of the
terms of existing securities or the issuance of new securities or a
similar matter arising out of the holding of securities, other than
common equity, in the context of a bankruptcy or threatened bankruptcy
of the issuer.
4. Recordkeeping and Retention
4.1 The Company shall retain records relating to the voting of proxies,
including:
4.1.1 Copies of this Policy and any amendments thereto.
4.1.2 A copy of each proxy statement that the Company receives
regarding Client securities.
4.1.3 Records of each vote cast by the Company on behalf of
Clients.
4.1.4 A copy of any documents created by the Company that were
material to making a decision how to vote or that memorializes the
basis for that decision.
4.1.5 A copy of each written request for information on how the
Company voted proxies on behalf of the Client, and a copy of any
written response by the Company to any (oral or written) request for
information on how the Company voted.
4.2 These records shall be maintained and preserved in an easily
accessible place for a period of not less than five years from the end of the
Company's fiscal year during which the last entry was made in the records, the
first two years in an appropriate office of the Company.
4.3 The Company may rely on proxy statements filed on the SEC's EDGAR
system or on proxy statements and records of votes cast by the Company
maintained by a third party, such as a proxy voting service (provided the
Company had obtained an undertaking from the third party to provide a copy of
the proxy statement or record promptly on request).
4.4 Records relating to the voting of proxies for securities held by
the Retail Funds will be reported periodically to the Retail Funds' Boards of
Directors/Trustees/Managers and, with respect to Retail Funds other than
business development companies, to the SEC on an annual basis pursuant to Form
N-PX.
Revised: February 22, 2007
B-3
PROSPECT STREET(R)
HIGH INCOME PORTFOLIO INC.
Using a BLACK INK pen, mark your votes with an X as shown in this example. /x/
Please do not write outside the designated areas.
-------------------------------------------------------------------------------
ANNUAL MEETING PROXY CARD COMMON SHARES
-------------------------------------------------------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
A. PROPOSALS - THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR PROPOSAL 1 AND FOR
THE NOMINEE LISTED.
1. To approve an Agreement and Plan FOR AGAINST ABSTAIN
of Reorganization between Prospect / / / / / /
Street High Income Portfolio Inc.
and Highland Credit Strategies
Fund, as more fully described in
the proxy statement.
2. Nominee: FOR WITHHOLD
01 - Mr. Scott F. Kavanaugh / / / /
3. In their discretion, on such matters as may properly come before
the Annual Meeting and any adjournment thereof.
B. NON-VOTING ITEMS
CHANGE OF ADDRESS -- Please print new address below. COMMENTS -- Please print your comments below.
--------------------------------------------------------------- ----------------------------------------------------
--------------------------------------------------------------- ----------------------------------------------------
C. AUTHORIZED SIGNATURES -- THIS SECTION MUST BE COMPLETED FOR YOUR VOTE TO BE
COUNTED. -- DATE AND SIGN BELOW
Please sign exactly as names appear on this proxy. If shares are held jointly,
each holder should sign. If signing as an attorney, trustee, executor,
administrator, custodian, guardian or corporate officer, please give full title.
Date (mm/dd/yyyy) -- Please print Signature 1 -- Please keep Signature 2 -- Please keep
date below. signature within the box. signature within the box.
------------------------------------ ---------------------------------- ---------------------------------
/ /
------------------------------------ ---------------------------------- ---------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
PROXY -- PROSPECT STREET(R) HIGH INCOME PORTFOLIO INC.
--------------------------------------------------------------------------------
ANNUAL MEETING OF STOCKHOLDERS -- JUNE 6, 2008
COMMON STOCK PROXY SOLICITED ON BEHALF OF BOARD OF DIRECTORS
The undersigned holder of shares of Common Stock of Prospect Street(R) High
Income Portfolio Inc., a Maryland corporation ("PHY"), hereby appoints Mark K.
Okada, Michael Colvin and M. Jason Blackburn, and each of them, with full power
of substitution and revocation, as proxies to represent the undersigned at the
Annual Meeting of Stockholders of PHY to be held at Galleria Tower I, 13355 Noel
Road, Suite 275 - The Chicago Room, Dallas, Texas 75240, on Friday, June 6,
2008, at 8:00 a.m. Central Time, and at any and all adjournments thereof (the
"Annual Meeting"), and thereat to vote all Common Stock of PHY which the
undersigned would be entitled to vote, with all powers the undersigned would
possess if personally present, in accordance with the instructions on this
proxy.
THIS PROXY IS SOLICITED BY PHY'S BOARD OF DIRECTORS AND WILL BE VOTED FOR THE
PROPOSALS UNLESS OTHERWISE INDICATED. BY SIGNING THIS PROXY CARD, RECEIPT OF THE
ACCOMPANYING NOTICE OF ANNUAL MEETING AND COMBINED PROXY STATEMENT AND
PROSPECTUS IS ACKNOWLEDGED.
PLEASE VOTE, DATE AND SIGN ON REVERSE AND RETURN PROMPTLY IN THE ENCLOSED
ENVELOPE.
PROSPECT STREET(R)
HIGH INCOME PORTFOLIO INC.
Using a BLACK INK pen, mark your votes with an X as shown in this example. /x/
Please do not write outside the designated areas.
-------------------------------------------------------------------------------
ANNUAL MEETING PROXY CARD PREFERRED SHARES
-------------------------------------------------------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
A. PROPOSALS - THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR PROPOSAL 1 AND FOR
THE NOMINEE LISTED.
1. To approve an Agreement and Plan FOR AGAINST ABSTAIN
of Reorganization between Prospect / / / / / /
Street High Income Portfolio Inc.
and Highland Credit Strategies
Fund, as more fully described in
the proxy statement.
2. Nominee: FOR WITHHOLD
01 - Mr. Timothy K. Hui / / / /
3. In their discretion, on such matters as may properly come before
the Annual Meeting and any adjournment thereof.
B. NON-VOTING ITEMS
CHANGE OF ADDRESS -- Please print new address below. COMMENTS -- Please print your comments below.
--------------------------------------------------------------- ----------------------------------------------------
--------------------------------------------------------------- ----------------------------------------------------
C. AUTHORIZED SIGNATURES -- THIS SECTION MUST BE COMPLETED FOR YOUR VOTE TO BE
COUNTED. -- DATE AND SIGN BELOW
Please sign exactly as names appear on this proxy. If shares are held jointly,
each holder should sign. If signing as an attorney, trustee, executor,
administrator, custodian, guardian or corporate officer, please give full title.
Date (mm/dd/yyyy) -- Please print Signature 1 -- Please keep Signature 2 -- Please keep
date below. signature within the box. signature within the box.
------------------------------------ ---------------------------------- ---------------------------------
/ /
------------------------------------ ---------------------------------- ---------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
PROXY -- PROSPECT STREET(R) HIGH INCOME PORTFOLIO INC.
--------------------------------------------------------------------------------
ANNUAL MEETING OF STOCKHOLDERS -- JUNE 6, 2008
PREFERRED STOCK PROXY SOLICITED ON BEHALF OF BOARD OF DIRECTORS
The undersigned holder of shares of Preferred Stock of Prospect Street(R) High
Income Portfolio Inc., a Maryland corporation ("PHY"), hereby appoints Mark K.
Okada, Michael Colvin and M. Jason Blackburn, and each of them, with full power
of substitution and revocation, as proxies to represent the undersigned at the
Annual Meeting of Stockholders of PHY to be held at Galleria Tower I, 13355 Noel
Road, Suite 275 - The Chicago Room, Dallas, Texas 75240, on Friday, June 6,
2008, at 8:00 a.m. Central Time, and at any and all adjournments thereof (the
"Annual Meeting"), and thereat to vote all Preferred Shares of PHY which the
undersigned would be entitled to vote, with all powers the undersigned would
possess if personally present, in accordance with the instructions on this
proxy.
THIS PROXY IS SOLICITED BY PHY'S BOARD OF DIRECTORS AND WILL BE VOTED FOR THE
PROPOSALS UNLESS OTHERWISE INDICATED. BY SIGNING THIS PROXY CARD, RECEIPT OF THE
ACCOMPANYING NOTICE OF ANNUAL MEETING AND COMBINED PROXY STATEMENT AND
PROSPECTUS IS ACKNOWLEDGED.
PLEASE VOTE, DATE AND SIGN ON REVERSE AND RETURN PROMPTLY IN THE ENCLOSED
ENVELOPE.
PROSPECT STREET(R) INCOME
SHARES INC.
Using a BLACK INK pen, mark your votes with an X as shown in this example. /x/
Please do not write outside the designated areas.
-------------------------------------------------------------------------------
ANNUAL MEETING PROXY CARD COMMON SHARES
-------------------------------------------------------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
A. PROPOSALS - THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR PROPOSAL 1 AND FOR
THE NOMINEE LISTED.
1. To approve an Agreement and Plan FOR AGAINST ABSTAIN
of Reorganization between Prospect / / / / / /
Street Income Shares Inc.
and Highland Credit Strategies
Fund, as more fully described in
the proxy statement.
2. Nominee: FOR WITHHOLD
01 - Mr. R. Joseph Dougherty / / / /
3. In their discretion, on such matters as may properly come before
the Annual Meeting and any adjournment thereof.
B. NON-VOTING ITEMS
CHANGE OF ADDRESS -- Please print new address below. COMMENTS -- Please print your comments below.
--------------------------------------------------------------- ----------------------------------------------------
--------------------------------------------------------------- ----------------------------------------------------
C. AUTHORIZED SIGNATURES -- THIS SECTION MUST BE COMPLETED FOR YOUR VOTE TO BE
COUNTED. -- DATE AND SIGN BELOW
Please sign exactly as names appear on this proxy. If shares are held jointly,
each holder should sign. If signing as an attorney, trustee, executor,
administrator, custodian, guardian or corporate officer, please give full title.
Date (mm/dd/yyyy) -- Please print Signature 1 -- Please keep Signature 2 -- Please keep
date below. signature within the box. signature within the box.
------------------------------------ ---------------------------------- ---------------------------------
/ /
------------------------------------ ---------------------------------- ---------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
PROXY -- PROSPECT STREET(R) INCOME SHARES INC.
--------------------------------------------------------------------------------
ANNUAL MEETING OF STOCKHOLDERS -- JUNE 6, 2008
COMMON STOCK PROXY SOLICITED ON BEHALF OF BOARD OF DIRECTORS
The undersigned holder of shares of Common Stock of Prospect Street(R) Income
Shares Inc., a Maryland corporation ("CNN"), hereby appoints Mark K. Okada,
Michael Colvin and M. Jason Blackburn, and each of them, with full power of
substitution and revocation, as proxies to represent the undersigned at the
Annual Meeting of Stockholders of CNN to be held at Galleria Tower I, 13355 Noel
Road, Suite 275 - The Chicago Room, Dallas, Texas 75240, on Friday, June 6,
2008, at 8:00 a.m. Central Time, and at any and all adjournments thereof (the
"Annual Meeting"), and thereat to vote all Common Stock of CNN which the
undersigned would be entitled to vote, with all powers the undersigned would
possess if personally present, in accordance with the instructions on this
proxy.
THIS PROXY IS SOLICITED BY CNN'S BOARD OF DIRECTORS AND WILL BE VOTED FOR THE
PROPOSALS UNLESS OTHERWISE INDICATED. BY SIGNING THIS PROXY CARD, RECEIPT OF THE
ACCOMPANYING NOTICE OF ANNUAL MEETING AND COMBINED PROXY STATEMENT AND
PROSPECTUS IS ACKNOWLEDGED.
PLEASE VOTE, DATE AND SIGN ON REVERSE AND RETURN PROMPTLY IN THE ENCLOSED
ENVELOPE.
PROSPECT STREET(R) INCOME
SHARES INC.
Using a BLACK INK pen, mark your votes with an X as shown in this example. /x/
Please do not write outside the designated areas.
-------------------------------------------------------------------------------
ANNUAL MEETING PROXY CARD PREFERRED SHARES
-------------------------------------------------------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
A. PROPOSALS - THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR PROPOSAL 1 AND FOR
THE NOMINEE LISTED.
1. To approve an Agreement and Plan FOR AGAINST ABSTAIN
of Reorganization between Prospect / / / / / /
Street Income Shares Inc.
and Highland Credit Strategies
Fund, as more fully described in
the proxy statement.
2. Nominee: FOR WITHHOLD
01 - Mr. R. Joseph Dougherty / / / /
3. In their discretion, on such matters as may properly come before
the Annual Meeting and any adjournment thereof.
B. NON-VOTING ITEMS
CHANGE OF ADDRESS -- Please print new address below. COMMENTS -- Please print your comments below.
--------------------------------------------------------------- ----------------------------------------------------
--------------------------------------------------------------- ----------------------------------------------------
C. AUTHORIZED SIGNATURES -- THIS SECTION MUST BE COMPLETED FOR YOUR VOTE TO BE
COUNTED. -- DATE AND SIGN BELOW
Please sign exactly as names appear on this proxy. If shares are held jointly,
each holder should sign. If signing as an attorney, trustee, executor,
administrator, custodian, guardian or corporate officer, please give full title.
Date (mm/dd/yyyy) -- Please print Signature 1 -- Please keep Signature 2 -- Please keep
date below. signature within the box. signature within the box.
------------------------------------ ---------------------------------- ---------------------------------
/ /
------------------------------------ ---------------------------------- ---------------------------------
PLEASE FOLD ALONG THE PERFORATION, DETACH AND RETURN THE BOTTOM PORTION IN THE
ENCLOSED ENVELOPE.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
PROXY -- PROSPECT STREET(R) INCOME SHARES INC.
--------------------------------------------------------------------------------
ANNUAL MEETING OF STOCKHOLDERS -- JUNE 6, 2008
PREFERRED STOCK PROXY SOLICITED ON BEHALF OF BOARD OF DIRECTORS
The undersigned holder of shares of Preferred Stock of Prospect Street(R) Income
Shares Inc., a Maryland corporation ("CNN"), hereby appoints Mark K. Okada,
Michael Colvin and M. Jason Blackburn, and each of them, with full power of
substitution and revocation, as proxies to represent the undersigned at the
Annual Meeting of Stockholders of CNN to be held at Galleria Tower I, 13355 Noel
Road, Suite 275 - The Chicago Room, Dallas, Texas 75240, on Friday, June 6,
2008, at 8:00 a.m. Central Time, and at any and all adjournments thereof (the
"Annual Meeting"), and thereat to vote all Preferred Shares of CNN which the
undersigned would be entitled to vote, with all powers the undersigned would
possess if personally present, in accordance with the instructions on this
proxy.
THIS PROXY IS SOLICITED BY CNN'S BOARD OF DIRECTORS AND WILL BE VOTED FOR THE
PROPOSALS UNLESS OTHERWISE INDICATED. BY SIGNING THIS PROXY CARD, RECEIPT OF THE
ACCOMPANYING NOTICE OF ANNUAL MEETING AND COMBINED PROXY STATEMENT AND
PROSPECTUS IS ACKNOWLEDGED.
PLEASE VOTE, DATE AND SIGN ON REVERSE AND RETURN PROMPTLY IN THE ENCLOSED
ENVELOPE.