Note 1. Organization
Highland Income Fund (the “Fund”) is organized as an unincorporated business trust under the laws of The Commonwealth of Massachusetts. The Fund is registered with the U.S. Securities and Exchange
Commission (the “SEC”) under the Investment Company Act of 1940, as amended (the “1940 Act”), as a non-diversified, closed-end management investment
company. On September 25, 2017, the Fund acquired the assets of Highland Floating Rate Opportunities Fund (the “Predecessor Fund”), a series of Highland Funds I, a Delaware statutory trust. The Fund is the successor to the accounting
and performance information of the Predecessor Fund.
Effective April 11, 2019, the Fund changed its fiscal year end to December 31. The previous
fiscal year end was June 30.
On May 20, 2019, the Fund changed its name from Highland Floating Rate Opportunities Fund to Highland Income Fund.
On November 3, 2017, shareholders of the Fund approved a proposal authorizing the Board of Trustees (the “Board”) of the Fund to convert
the fund from an open-end fund to a closed-end fund at a special meeting of shareholders. The Board took action to convert the Fund to a
closed-end fund effective shortly after 4:00 p.m. Eastern Time on November 3, 2017 (the “Conversion Date”). The Fund also effected an approximately 1-for-2 reverse stock split of the Fund’s issued and outstanding shares on November 3, 2017, thereby reducing the number of shares outstanding. Shareholders were paid cash for any fractional shares
resulting from the reverse stock split. The Fund began listing its shares for trading on the New York Stock Exchange (the “NYSE”) on November 6, 2017 under the ticker symbol “HFRO”. The Fund may issue an unlimited number of
common shares, par value $0.001 per share (“Common Shares”). Prior to the Conversion Date, the Fund issued Class A, Class C, and Class Z shares. The Fund incurred $1,076,274 in Conversion costs related to the fund conversion
to a closed-end fund.
On October 29, 2019, the Board of the Fund authorized the repurchase of up to
$25 million of the Fund’s shares. Under this program, the Fund repurchased 235,049 shares through December 2019. Upon retirement of the repurchased shares, the net asset value (“NAV”) was $3.2mm, or $13.46 per share.
On July 29, 2019, the Fund issued 5.4 million 5.375% Series A Cumulative Preferred shares (NYSE: HFRO.PR.A) with an aggregate liquidation value of $135mm.
Subsequently on August 9, 2019, the underwriters exercised their option to purchase additional overallotment shares of $10mm, resulting in a total Preferred outstanding offering of $145mm.
The Series A Preferred shares are perpetual, non-callable for five years, and have a liquidation preference of $25.00 per
share. Distributions are scheduled quarterly, with payments
beginning on September 30, 2019. Series A Preferred shares trade on the NYSE. Moody’s Investors Service has assigned an A1 rating to the preferred shares.
On October 14, 2019, the Board of the Fund approved an amendment to the Third Amended and Restated Agreement and Declaration of Trust of the Fund to require the
affirmative vote or consent of the holders of 75% of each class of shares outstanding (with each such class voting separately thereon) for certain transactions involving a Principal Shareholder. For purposes of this requirement, Principal
Shareholder is defined any person which is the beneficial owner, directly or indirectly, of more than 5% of the outstanding shares of the Fund or of any class and shall include any “affiliate” or “associate”, as such terms are
defined in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended. The certain transactions covered by this requirement include: (i) a merger or consolidation of the Fund or any subsidiary of the
Fund with or into any Principal Shareholder; (ii) the issuance of any securities of the Fund to any Principal Shareholder for cash; (iii) the sale, lease or exchange of all or any substantial part of the assets of the Fund to any Principal
Shareholder (except assets determined by the Board to have an aggregate fair market value of less than $1,000,000, aggregating for the purpose of such computation all assets sold, leased or exchanged in any series of similar transactions within a
twelve-month period or assets sold in the ordinary course of business); and (iv) the sale, lease or exchange to or with the Fund or any subsidiary thereof, in exchange for securities of the Fund, of any assets of any Principal Shareholder (except
assets determined by the Board to have an aggregate fair market value of less than $1,000,000 aggregating for the purpose of such computation all assets sold, leased or exchanged in any series of similar transactions within a twelve-month period).
Note 2. Significant Accounting Policies
The
following summarizes the significant accounting policies consistently followed by the Fund in the preparation of its financial statements.
Use of
Estimates
The Fund is an investment company that applies the accounting and reporting guidance of Accounting Standards Codification Topic 946
applicable to investment companies. The Fund’s consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which require Highland Capital
Management Fund Advisors, L.P., the Fund’s investment adviser (“HCMFA” or the “Investment Adviser”), 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 consolidated financial
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
statements and the reported amounts of revenue and expenses during the reporting period. Changes in the economic environment, financial markets and any other parameters used in determining these
estimates could cause actual results to differ materially.
Basis of Consolidation
The Fund consolidates HFRO Sub, LLC (“HFRO Sub”), a Delaware wholly owned subsidiary, for financial reporting, and the holdings of HFRO Sub, LLC are included within the Consolidated Financial Statements
for the Fund. HFRO Sub is a bankruptcy remote financing vehicle used to obtain leverage with the portfolio of bank loans serving as collateral. All inter-company accounts and transactions have been eliminated in the consolidation.
Fund Valuation
The NAV of the Fund’s common shares is
calculated daily on each day that the NYSE is open for business as of the close of the regular trading session on the NYSE, usually 4:00 PM, Eastern Time. The NAV is calculated by dividing the value of the Fund’s net assets attributable to
common shares by the numbers of common shares outstanding.
Valuation of Investments
In computing the Fund’s net assets attributable to shares, securities with readily available market quotations on the NYSE, National Association of Securities Dealers Automated Quotation (“NASDAQ”)
or other nationally recognized exchange, use the closing quotations on the respective exchange for valuation of those securities. Securities for which there are no readily available market quotations will be valued pursuant to policies adopted by
the Fund’s Board of Trustees (the “Board”). Typically, such securities will be valued at the mean between the most recently quoted bid and ask 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 may be priced by an independent pricing service. Generally, the Fund’s loan and bond
positions are not traded on exchanges and consequently are valued based on a mean of the bid and ask price from the third-party pricing services or broker-dealer sources that the Investment Adviser has determined to have the capability to provide
appropriate pricing services which have been approved by the Board.
Securities for which market quotations are not readily available, or for which the Fund has determined that the price
received from a pricing service or broker-dealer is “stale” or otherwise does not represent fair value (such as when events materially affecting the value of securities occur between the time when market price is determined and calculation
of the Fund’s net asset value (“NAV”), will be valued by the Fund at fair value, as determined by the Board or its designee in good faith in accordance with procedures approved by the Board, taking into account factors reasonably
determined to be relevant, including, but not limited to: (i) the fundamental analytical data relating to the investment; (ii) the nature and duration of restrictions on disposition of the securities; and (iii) an evaluation of the
forces that influence the market in which these securities are purchased and sold. In these cases, the Fund’s NAV will reflect the affected portfolio securities’ fair value as determined in the judgment of the Board 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 NAVs. Determination of fair value is uncertain because it involves subjective judgments and estimates.
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. Those differences could have a material impact to the Fund. The NAV shown in the Fund’s consolidated financial statements may
vary from the NAV published by the Fund as of its period end because portfolio securities transactions are accounted for on the trade date (rather than the day following the trade date) for financial statement purposes.
Deferred Financing Costs on the Preferred Stock
Deferred
financing costs on the preferred shares consist of fees and expenses incurred in connection with the closing of the preferred stock offerings, and are capitalized at the time of payment. Based on ASC 480-10-S99, preferred stock that, by its terms, is contingently redeemable upon the occurrence of an event that is outside of the issuer’s control should be classified as mezzanine equity; therefore,
these costs are only amortized once it is probable the shares will become redeemable. As of December 31, 2019, the Fund is compliant with all contingent redemption provisions of the preferred offering, therefore the financing costs
are
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
currently unamortized until probable. Deferred financing costs of $5.2 million are presented net with the mezzanine equity on the Consolidated Statement of Assets and Liabilities.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Issuance
|
|
Shares at
December 31,
2018
|
|
|
Beginning
Value as of
December 31,
2018
|
|
|
Issuance Net
Liquidation
Value
|
|
|
Deferred
Issuance
Costs
|
|
|
Paydowns
|
|
|
Balance net of
Deferred Financing
Costs at December 31,
2019
|
|
|
Shares at
December 31,
2019
|
|
|
Cumulative preferred shares (Series A)
|
|
|
—
|
|
|
$
|
—
|
|
|
$
|
145,000,000.00
|
|
|
$
|
5,243,751.00
|
|
|
$
|
—
|
|
|
$
|
139,756,249.00
|
|
|
|
5,800,000.00
|
|
Fair Value Measurements
The Fund has performed an analysis of all existing investments and derivative instruments to determine the significance and character of inputs to their fair value determination. The levels of fair value inputs
used to measure the Fund’s investments are characterized into a fair value hierarchy. Where inputs for an asset or liability fall into more than one level in the fair value hierarchy, the investment is classified in its entirety based on the
lowest level input that is significant to that investment’s valuation. The three levels of the fair value hierarchy are described below:
|
Level 1 —
|
Quoted unadjusted prices for identical instruments in active markets to which the Fund has access at the date of measurement;
|
|
Level 2 —
|
Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active, but
are valued based on executed trades; broker quotations that constitute an executable price; and alternative pricing sources supported by observable inputs are classified within Level 2. Level 2 inputs are either directly or indirectly
observable for the asset in connection with market data at the measurement date; and
|
|
Level 3 —
|
Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. In certain cases, investments classified
within Level 3 may include securities for which the Fund has obtained indicative quotes from broker-dealers that do not necessarily represent prices the broker may be willing to trade on, as such quotes can be subject to material management
judgment. Unobservable inputs are those inputs that reflect the Fund’s own assumptions that market participants would use to price the asset or liability based on the best available information.
|
The Investment Adviser has established policies and procedures, as described above and approved by the Board, to ensure that valuation methodologies for investments
and financial instruments that are categorized within all levels of the fair value hierarchy are fair and consistent. A Pricing Committee has been established to provide oversight of the valuation policies, processes and procedures, and is comprised
of personnel from the Investment Adviser and its affiliates. The Pricing Committee meets monthly to review the proposed valuations for investments and financial instruments and is responsible for
evaluating the overall fairness and consistent application of established policies.
As of December 31, 2019, the Fund’s investments consisted
of senior loans, foreign denominated or domiciled senior loans, collateralized loan obligations, corporate bonds and notes, U.S. asset-backed securities, non-U.S. asset-backed securities, claims, common
stocks, registered investment companies, cash equivalents, rights, warrants, preferred stock, agency collateralized mortgage obligations, LLC interests, purchased call options, and registered investment companies. The fair value of the Fund’s
senior loans and bonds are generally based on quotes received from brokers or independent pricing services. Loans, bonds and asset-backed securities with quotes that are based on actual trades with a sufficient level of activity on or near
the measurement date are classified as Level 2 assets. Loans and bonds that are priced using quotes derived from implied values, indicative bids, or a limited number of actual trades are classified as Level 3 assets because the inputs used
by the brokers and pricing services to derive the values are not readily observable.
The fair value of the Fund’s common stocks, registered
investment companies, rights and warrants that are not actively traded on national exchanges are generally priced using quotes derived from implied values, indicative bids, or a limited amount of actual trades and are classified as Level 3
assets because the inputs used by the brokers and pricing services to derive the values are not readily observable. Exchange-traded options are valued based on the last trade price on the primary exchange on which they trade. If an option does not
trade, the mid-price, which is the mean of the bid and ask price, is utilized to value the option.
At the end of
each calendar quarter, the Investment Adviser evaluates the Level 2 and 3 assets and liabilities for changes in liquidity, including but not limited to: whether a broker is willing to execute at the quoted price, the depth and consistency of
prices from third party services, and the existence of contemporaneous, observable trades in the market. Additionally, the Investment Adviser evaluates the Level 1 and 2 assets and liabilities on a quarterly basis for changes in listings or
delistings on national exchanges.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available
market value, the fair value of the Fund’s investments may fluctuate from period to period. Additionally, the fair value of investments may differ significantly from the values that would
have been used had a ready market existed for such investments and may differ materially from the values the Fund may ultimately realize. Further, such investments may be subject to legal and
other restrictions on resale or otherwise less liquid than publicly traded securities.
The inputs or methodology used for valuing
securities are not necessarily an indication of the risk associated with investing in those securities. Transfers in and out of the levels are recognized at the value at the end of the period. A summary of the inputs used to value the Fund’s
assets as of December 31, 2019 is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total value at
December 31, 2019
$
|
|
|
Level 1
Quoted
Price
$
|
|
|
Level 2
Significant
Observable
Inputs
$
|
|
|
Level 3
Significant
Unobservable
Inputs
$
|
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Senior Loans
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial Services
|
|
|
25,574,694
|
|
|
|
—
|
|
|
|
25,574,694
|
|
|
|
—
|
|
|
Communication Services
|
|
|
11,406,790
|
|
|
|
—
|
|
|
|
5,299,383
|
|
|
|
6,107,407
|
|
|
Consumer Discretionary
|
|
|
29,060,626
|
|
|
|
—
|
|
|
|
29,060,626
|
|
|
|
—
|
|
|
Consumer Products
|
|
|
12,855,251
|
|
|
|
—
|
|
|
|
12,855,251
|
|
|
|
—
|
|
|
Energy
|
|
|
24,607,186
|
|
|
|
—
|
|
|
|
24,607,186
|
|
|
|
—
|
|
|
Financial
|
|
|
24,228,052
|
|
|
|
—
|
|
|
|
24,228,052
|
|
|
|
—
|
|
|
Gaming/Leisure
|
|
|
10,753,914
|
|
|
|
—
|
|
|
|
—
|
|
|
|
10,753,914
|
|
|
Healthcare
|
|
|
81,842,022
|
|
|
|
—
|
|
|
|
34,108,365
|
|
|
|
47,733,657
|
|
|
Industrials
|
|
|
33,324,221
|
|
|
|
—
|
|
|
|
25,219,034
|
|
|
|
8,105,187
|
|
|
Information Technology
|
|
|
110,450,576
|
|
|
|
—
|
|
|
|
53,621,576
|
|
|
|
56,829,000
|
|
|
Manufacturing
|
|
|
3,534,756
|
|
|
|
—
|
|
|
|
3,534,756
|
|
|
|
—
|
|
|
Oil & Gas
|
|
|
9,164,263
|
|
|
|
—
|
|
|
|
9,164,263
|
|
|
|
—
|
|
|
Real Estate
|
|
|
21,096,400
|
|
|
|
—
|
|
|
|
21,096,400
|
|
|
|
—
|
|
|
Retail
|
|
|
52,112,148
|
|
|
|
—
|
|
|
|
52,112,148
|
|
|
|
—
|
|
|
Service
|
|
|
36,429,089
|
|
|
|
—
|
|
|
|
36,429,089
|
|
|
|
—
|
|
|
Transportation
|
|
|
11,698,539
|
|
|
|
—
|
|
|
|
11,698,539
|
|
|
|
—
|
|
|
Utilities
|
|
|
25,299,203
|
|
|
|
—
|
|
|
|
25,299,203
|
|
|
|
—
|
|
|
Preferred Stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Energy
|
|
|
16,530,773
|
|
|
|
16,530,773
|
|
|
|
—
|
|
|
|
—
|
|
|
Financial
|
|
|
36,384,014
|
|
|
|
—
|
|
|
|
36,384,014
|
|
|
|
—
|
|
|
Real Estate
|
|
|
247,311,109
|
|
|
|
12,258,059
|
|
|
|
2,027,753
|
|
|
|
233,025,297
|
|
|
Collateralized Loan Obligations
|
|
|
204,983,767
|
|
|
|
—
|
|
|
|
204,983,767
|
|
|
|
—
|
|
|
Common Stocks
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Communication Services
|
|
|
47,706,590
|
|
|
|
1,603,072
|
|
|
|
38,582,787
|
|
|
|
7,520,731
|
|
|
Consumer Discretionary
|
|
|
7,250,850
|
|
|
|
—
|
|
|
|
7,250,850
|
|
|
|
—
|
|
|
Energy
|
|
|
3,376,340
|
|
|
|
—
|
|
|
|
3,376,339
|
|
|
|
1
|
|
|
Gaming/Leisure(1)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
Healthcare
|
|
|
520,004
|
|
|
|
447,750
|
|
|
|
—
|
|
|
|
72,254
|
|
|
Housing(1)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
Industrials
|
|
|
175,439
|
|
|
|
—
|
|
|
|
175,439
|
|
|
|
—
|
|
|
Materials
|
|
|
1,540,777
|
|
|
|
—
|
|
|
|
1,495,160
|
|
|
|
45,617
|
|
|
Real Estate
|
|
|
104,375,180
|
|
|
|
8,627,649
|
|
|
|
—
|
|
|
|
95,747,531
|
|
|
Agency Collateralized Mortgage Obligations
|
|
|
141,070,606
|
|
|
|
—
|
|
|
|
141,070,606
|
|
|
|
—
|
|
|
LLC Interest
|
|
|
88,777,470
|
|
|
|
—
|
|
|
|
—
|
|
|
|
88,777,470
|
|
|
Corporate Bonds & Notes
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Energy
|
|
|
1,126,400
|
|
|
|
—
|
|
|
|
50,000
|
|
|
|
1,076,400
|
|
|
Industrials
|
|
|
190,395
|
|
|
|
—
|
|
|
|
190,395
|
|
|
|
—
|
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total value at
December 31, 2019
$
|
|
|
Level 1
Quoted
Price
$
|
|
|
Level 2
Significant
Observable
Inputs
$
|
|
|
Level 3
Significant
Unobservable
Inputs
$
|
|
|
Real Estate
|
|
|
1,204,645
|
|
|
|
—
|
|
|
|
1,204,645
|
|
|
|
—
|
|
|
Utilities
|
|
|
27,984,851
|
|
|
|
—
|
|
|
|
27,984,851
|
|
|
|
—
|
|
|
Purchased Call Options
|
|
|
18,359,600
|
|
|
|
17,325,000
|
|
|
|
1,034,600
|
|
|
|
—
|
|
|
Registered Investment Company
|
|
|
17,517,723
|
|
|
|
17,517,723
|
|
|
|
—
|
|
|
|
—
|
|
|
Rights
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Utilities
|
|
|
1,175,995
|
|
|
|
—
|
|
|
|
1,175,995
|
|
|
|
—
|
|
|
Warrants
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Energy
|
|
|
175,480
|
|
|
|
175,480
|
|
|
|
—
|
|
|
|
—
|
|
|
Industrials
|
|
|
1,412
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,412
|
|
|
Claims
|
|
|
52,138
|
|
|
|
—
|
|
|
|
—
|
|
|
|
52,138
|
|
|
Cash Equivalent
|
|
|
33,588,954
|
|
|
|
33,588,954
|
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Assets
|
|
|
1,524,818,242
|
|
|
|
108,074,460
|
|
|
|
860,895,766
|
|
|
|
555,848,016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities Sold Short(2)
|
|
|
(9,076,517
|
)
|
|
|
(9,076,517
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Liabilities
|
|
|
(9,076,517
|
)
|
|
|
(9,076,517
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
1,515,741,725
|
|
|
|
98,997,943
|
|
|
|
860,895,766
|
|
|
|
555,848,016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
|
This category includes securities with a value of zero.
|
|
(2)
|
See Investment Portfolio detail for industry breakout.
|
The table below sets forth a summary of changes in the Fund’s assets measured at fair value using significant unobservable inputs (Level 3) for the year ended December 31, 2019.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance
as of
December 31,
2018
$
|
|
|
Transfers
into
Level 3
$
|
|
|
Transfers
Out
of Level 3
$
|
|
|
Net
Amortization
(Accretion)
of Premium/
(Discount)
$
|
|
|
Net
Realized
Gains/
(Losses)
$
|
|
|
Net
Unrealized
Gains/
(Losses)
$
|
|
|
Net
Purchases
$
|
|
|
Net
(Sales)
$
|
|
|
Distribution
to Return
Capital
$
|
|
|
Balance
as of
December 31,
2019
$
|
|
|
Change
in
Unrealized
Appreciation
(Depreciation)
from
Investments
at of
December 31,
2019
$
|
|
|
Common Stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Communication Services
|
|
|
7,566,587
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(45,856
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
7,520,731
|
|
|
|
(507,948
|
)
|
|
Energy
|
|
|
1
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1
|
|
|
|
—
|
|
|
Healthcare
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
72,254
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
72,254
|
|
|
|
72,254
|
|
|
Housing
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(323,754
|
)
|
|
Information Technology
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
Materials
|
|
|
2,844,759
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(2,799,142
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
45,617
|
|
|
|
(711,006
|
)
|
|
Media
|
|
|
1,258,086
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
6,598,465
|
|
|
|
—
|
|
|
|
(7,856,551
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
6,598,465
|
|
|
Real Estate
|
|
|
17,207,035
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
556,728
|
|
|
|
77,983,768
|
|
|
|
—
|
|
|
|
—
|
|
|
|
95,747,531
|
|
|
|
570,387
|
|
|
Utilities
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
661,135
|
|
|
|
—
|
|
|
|
(661,135
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
635,190
|
|
|
Corporate Bonds & Notes
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Energy
|
|
|
1,076,400
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,076,400
|
|
|
|
—
|
|
|
LLC Interest
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(1,222,530
|
)
|
|
|
90,000,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
88,777,470
|
|
|
|
(1,222,530
|
)
|
|
Preferred Stock
|
|
|
214,305,563
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
16,804,734
|
|
|
|
1,915,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
233,025,297
|
|
|
|
5,007,504
|
|
|
U.S.
Senior Loan
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Communication Services
|
|
|
5,472,828
|
|
|
|
—
|
|
|
|
—
|
|
|
|
548
|
|
|
|
—
|
|
|
|
(6,570
|
)
|
|
|
640,601
|
|
|
|
—
|
|
|
|
—
|
|
|
|
6,107,407
|
|
|
|
(11,448
|
)
|
|
Gaming/Leisure
|
|
|
10,002,768
|
|
|
|
—
|
|
|
|
—
|
|
|
|
58,674
|
|
|
|
28,475
|
|
|
|
147,182
|
|
|
|
938,933
|
|
|
|
(422,118
|
)
|
|
|
—
|
|
|
|
10,753,914
|
|
|
|
259,855
|
|
|
Healthcare
|
|
|
24,398,513
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
16,674,566
|
|
|
|
6,660,578
|
|
|
|
—
|
|
|
|
—
|
|
|
|
47,733,657
|
|
|
|
19,576,293
|
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance
as of
December 31,
2018
$
|
|
|
Transfers
into
Level 3
$
|
|
|
Transfers
Out
of Level 3
$
|
|
|
Net
Amortization
(Accretion)
of Premium/
(Discount)
$
|
|
|
Net
Realized
Gains/
(Losses)
$
|
|
|
Net
Unrealized
Gains/
(Losses)
$
|
|
|
Net
Purchases
$
|
|
|
Net
(Sales)
$
|
|
|
Distribution
to Return
Capital
$
|
|
|
Balance
as of
December 31,
2019
$
|
|
|
Change
in
Unrealized
Appreciation
(Depreciation)
from
Investments
at of
December 31,
2019
$
|
|
|
Housing
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(1,743,503
|
)
|
|
|
1,743,503
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,743,503
|
|
|
Industrials
|
|
|
8,269,728
|
|
|
|
—
|
|
|
|
—
|
|
|
|
363,695
|
|
|
|
—
|
|
|
|
(1,764,280
|
)
|
|
|
1,236,044
|
|
|
|
—
|
|
|
|
—
|
|
|
|
8,105,187
|
|
|
|
(1,518,633
|
)
|
|
Information Technology
|
|
|
57,000,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(171,000
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
56,829,000
|
|
|
|
(171,000
|
)
|
|
Real Estate
|
|
|
1,228,016
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(6,343
|
)
|
|
|
8,756
|
|
|
|
33,403
|
|
|
|
—
|
|
|
|
(1,263,832
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
70,643
|
|
|
Warrant
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Industrials
|
|
|
88,054
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(86,642
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
1,412
|
|
|
|
(22,007
|
)
|
|
Information Technology
|
|
|
51,729
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
3,287
|
|
|
|
(25,564
|
)
|
|
|
—
|
|
|
|
(29,452
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(10,558
|
)
|
|
Claims
|
|
|
52,138
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
52,138
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
350,822,205
|
|
|
|
—
|
|
|
|
—
|
|
|
|
416,574
|
|
|
|
(1,702,985
|
)
|
|
|
37,170,386
|
|
|
|
179,374,924
|
|
|
|
(10,233,088
|
)
|
|
|
—
|
|
|
|
555,848,016
|
|
|
|
30,035,210
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investments designated as Level 3 may include assets valued using quotes or indications furnished by brokers
which are based on models or estimates and may not be executable prices. In light of the developing market conditions, the Investment Adviser continues to search for observable data
points and evaluate broker quotes and indications received for portfolio investments. For the year ended December 31, 2019, there were no transfers between levels. Determination of fair values is
uncertain because it involves subjective judgments and estimates that are unobservable.
The following is a summary of significant
unobservable inputs used in the fair valuations of assets and liabilities categorized within Level 3 of the fair value hierarchy:
|
|
|
|
|
|
|
|
|
|
|
|
|
Category
|
|
Market
Value at
12/31/2019
|
|
|
Valuation Technique
|
|
Unobservable Inputs
|
|
Input Value(s)
|
|
Preferred Stock
|
|
|
233,025,297
|
|
|
Net Asset Value
|
|
N/A
|
|
N/A
|
|
|
|
|
|
|
|
Discounted Cash Flow
|
|
Discount Rate
|
|
11.0%
|
|
U.S. Senior Loans
|
|
|
129,529,165
|
|
|
Adjusted Appraisal
|
|
Liquidity Discount
|
|
10%
|
|
|
|
|
|
|
|
|
|
Asset Specific Discount
|
|
10%
|
|
|
|
|
|
|
|
Multiples Analysis
|
|
Multiple of EBITDA less CAPEX
|
|
6.25x - 11.00x
|
|
|
|
|
|
|
|
Transaction Analysis
|
|
Multiple of EBITDA less CAPEX
|
|
10.0x - 12.0x
|
|
|
|
|
|
|
|
Transaction Indication of Value
|
|
% of Par
|
|
30.0% - 35.0%
|
|
|
|
|
|
|
|
Black-Scholes Model
|
|
Volatility Assumption
|
|
25% - 40%
|
|
|
|
|
|
|
|
Discounted Cash Flow
|
|
Discount Rate
|
|
7.75% - 11.10%
|
|
|
|
|
|
|
|
|
|
Spread Adjustment
|
|
0.10%
|
|
Common Stocks
|
|
|
103,386,134
|
|
|
Multiples Analysis
|
|
Multiple of EBITDA less CAPEX
|
|
6.25x - 11.00x
|
|
|
|
|
|
|
|
|
|
Multiple of EBITDA
|
|
7.0x - 8.75x
|
|
|
|
|
|
|
|
|
|
Unadjusted Price/MHz-PoP
|
|
$0.12 - $0.95
|
|
|
|
|
|
|
|
|
|
Risk Discount
|
|
55.2% - 59.8%
|
|
|
|
|
|
|
|
Discounted Cash Flow
|
|
Discount Rate
|
|
7.75% - 20.0%
|
|
|
|
|
|
|
|
|
|
Capitalization Rate
|
|
10.5%
|
|
|
|
|
|
|
|
Transaction Analysis
|
|
Multiple of EBITDA
|
|
8.25x - 8.75x
|
|
|
|
|
|
|
|
|
|
Multiple of EBITDA less CAPEX
|
|
10.0x - 12.0x
|
|
|
|
|
|
|
|
Transaction Indication of Value
|
|
% of Par
|
|
30.0% - 35.0%
|
|
|
|
|
|
|
|
|
|
Enterprise Value ($mm)
|
|
$365.0 - $771.0
|
|
|
|
|
|
|
|
Black-Scholes Model
|
|
Volatility Assumption
|
|
25% - 40%
|
|
|
|
|
|
|
|
Net Asset Value
|
|
N/A
|
|
N/A
|
|
LLC Interest
|
|
|
88,777,470
|
|
|
Discounted Cash Flow
|
|
Discount Rate
|
|
2.59% - 9.45%
|
|
Corporate Bonds & Notes
|
|
|
1,076,400
|
|
|
Liquidation Analysis
|
|
Claim Amount: Percent of Par
|
|
6.9%
|
|
Claims
|
|
|
52,138
|
|
|
Pricing Feed
|
|
Indication of Value
|
|
1.375
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Category
|
|
Market
Value at
12/31/2019
|
|
|
Valuation Technique
|
|
Unobservable Inputs
|
|
Input Value(s)
|
|
Warrants
|
|
|
1,412
|
|
|
Discounted Cash Flow
|
|
Discount Rate
|
|
20%
|
|
|
|
|
|
|
|
Multiples Analysis
|
|
Multiple of EBITDA
|
|
7.0x - 8.75x
|
|
|
|
|
|
|
|
Transaction Analysis
|
|
Multiple of EBITDA
|
|
8.25x - 8.75x
|
|
|
|
|
|
|
|
Black-Scholes Model
|
|
Volatility Assumption
|
|
30 - 40%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
555,848,016
|
|
|
|
|
|
|
|
In addition to the unobservable inputs utilized for various valuation methodologies, the Fund frequently uses a
combination of two or more valuation methodologies to determine fair value for a single holding. In such instances, the Fund assesses the methodologies and ascribes weightings to each methodology. The weightings ascribed to any individual
methodology ranged from as low as 5% to as high as 70% as of December 31, 2019. The selection of weightings is an inherently subjective process, dependent on professional judgement. These selections may have a material impact to the concluded
fair value for such holdings.
The significant unobservable input used in the fair value measurement of the Fund’s preferred stock asset is the
discount rate. Significant decreases (increases) in any of those inputs in isolation could result in a significantly higher (lower) fair value measurement.
Security Transactions
Security transactions are accounted for on the trade date. Realized gains/(losses) on
investments sold are recorded on the basis of the specific identification method for both financial statement and U.S. federal income tax purposes taking into account any foreign taxes withheld.
Income Recognition
Corporate actions (including cash
dividends) are recorded on the ex-dividend date, net of applicable withholding taxes, except for certain foreign corporate actions, which are recorded as soon after
ex-dividend date as such information becomes available and is verified. Interest income is recorded on the accrual basis.
Accretion of discount on taxable bonds and loans is computed to the call date, while amortization of premium on taxable bonds and loans is computed to the maturity or call date, if shorter, both using the effective
yield method. Withholding taxes on foreign dividends have been provided for in accordance with the Fund’s understanding of the applicable country’s tax rules and rates.
The Fund records distributions received from investments in REITs and partnerships in excess of income from underlying investments as a reduction of cost of investments and/or realized gain. Such amounts are based
on estimates if actual amounts are not available, and actual amounts of income,
realized gain and return of capital may differ from the estimated amounts. The Fund adjusts the estimated amounts once the issuers provide information about the actual composition of the
distributions.
U.S. Federal Income Tax Status
The Fund is treated as a separate taxpayer for U.S. federal income tax purposes. The Fund intends to qualify each year as a “regulated investment company”
under Subchapter M of the Internal Revenue Code of 1986, as amended, and will distribute substantially all of its taxable income and gains, if any, for the tax year, and as such will not be subject to U.S. federal income taxes. In addition, the Fund
intends to distribute, in each calendar year, all of its net investment income, capital gains and certain other amounts, if any, such that the Fund should not be subject to U.S. federal excise tax. Therefore, no U.S. federal income or excise tax
provisions are recorded.
The Investment Adviser has analyzed the Fund’s tax positions taken on U.S. federal income tax returns for all open tax
years (current and prior three tax years), and has concluded that no provision for U.S. federal income tax is required in the Fund’s consolidated financial statements. The Fund’s U.S. federal and state income and U.S. federal excise tax
returns for tax years for which the applicable statutes of limitations have not expired are subject to examination by the Internal Revenue Service and state departments of revenue. Furthermore, the Investment Adviser of the Fund is also not aware of
any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next 12 months.
The Fund recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expenses in the Statement of Operations. During the year
ended December 31, 2019, the Fund did not incur any interest or penalties.
Distributions to Shareholders
The Fund plans to pay distributions from net investment income monthly and net realized capital gains annually to common shareholders. To permit the Fund to
maintain more stable monthly distributions and annual distributions, the Fund may from time to time distribute less than the entire amount of income and gains earned in the relevant month or year, respectively. The undistributed income and gains
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
would be available to supplement future distributions. In certain years, this practice may result in the Fund distributing, during a particular taxable year, amounts in excess of the amount of
income and gains earned therein. Such distributions would result in a portion of each distribution occurring in that year to be treated as a return of capital to shareholders. Shareholders of the Fund will automatically have all distributions
reinvested in Common Shares of the Fund issued by the Fund in accordance with the Fund’s Dividend Reinvestment Plan (the “Plan”) unless an election is made to receive cash. The number of newly issued Common Shares to be credited to
each participant’s account will be determined by dividing the dollar amount of the dividend by the lesser of (i) the NAV per Common Share determined on the Declaration Date and (ii) the market price per Common Share as of the close of
regular trading on the NYSE on the Declaration Date. Participants in the Plan requesting a sale of securities through the plan agent of the Plan are subject to a sales fee and a brokerage commission.
Cash & Cash Equivalents
The Fund considers liquid
assets deposited with a bank and certain short-term debt instruments of sufficient credit quality with original maturities of three months or less to be cash equivalents. These investments represent amounts held with financial institutions that are
readily accessible to pay Fund expenses or purchase investments. Cash and cash equivalents are valued at cost plus accrued interest, which approximates market value. The value of cash equivalents denominated in foreign currencies is determined by
converting to U.S. dollars on the date of the Consolidated Statement of Assets and Liabilities.
Foreign Currency
Accounting records of the Fund are maintained in U.S. dollars. Foreign currencies, investments and other assets and liabilities denominated in foreign currencies
are translated into U.S. dollars at exchange rates using the current 4:00 PM London Time Spot Rate. Fluctuations in the value of the foreign currencies and other assets and liabilities resulting from changes in exchange rates, between trade and
settlement dates on securities transactions and between the accrual and payment dates on dividends, interest income and foreign withholding taxes, are recorded as unrealized foreign currency gains/(losses). Realized gains/(losses) and unrealized
appreciation/(depreciation) on investment securities and income and expenses are translated on the respective dates of such transactions. The effects of changes in foreign currency exchange rates on investments in securities are not segregated in
the Consolidated Statement of Operations from the effects of changes in market prices of those securities, but are included with the net realized and unrealized gain or loss on investment securities.
Securities Sold Short
The Fund may sell securities short. A security sold short is a transaction in which the Fund sells a security it does not own in anticipation that the market price of that security will decline. When the Fund sells
a security short, it must borrow the security sold short from a broker-dealer and deliver it to the buyer upon conclusion of the transaction. The Fund may have to pay a fee to borrow particular securities and is obligated to pay over any dividends
or other payments received on such borrowed securities. In some circumstances, the Fund may be allowed by its prime broker to utilize proceeds from securities sold short to purchase additional investments, resulting in leverage. Cash held as
collateral for securities sold short and written options contracts is classified as restricted cash on the Consolidated Statement of Assets and Liabilities, as applicable. Restricted cash in the amount of $9,100,343 was held with the broker for the
Fund. Securities valued at $52,833,848 were posted in the Fund’s segregated account as collateral.
Other Fee Income
Fee income may consist of origination/closing fees, amendment fees, administrative agent fees, transaction break-up fees and
other miscellaneous fees. Origination fees, amendment fees, and other similar fees are non-recurring fee sources. Such fees are received on a transaction by transaction basis and do not constitute a regular
stream of income and are recognized when incurred.
Note 3. Derivative Transactions
The Fund is subject to equity securities risk, interest rate risk and currency risk in the normal course of pursuing its investment objectives. The Fund enters into derivative transactions for the purpose of
hedging against the effects of changes in the value of portfolio securities due to anticipated changes in market conditions, to gain market exposure for residual and accumulating cash positions and for managing the duration of fixed income
investments. As of December 31, 2019 we had no hedge accounting derivatives.
Futures Contracts
A futures contract represents a commitment for the future purchase or sale of an asset at a specified price on a specified date. The Fund may invest in interest
rate, financial and stock or bond index futures contracts subject to certain limitations. The Fund invests in futures contracts to manage its exposure to the stock and bond markets and fluctuations in currency values. Buying futures tends to
increase the Fund’s exposure to the underlying instrument while selling futures tends to decrease the Fund’s exposure to the underlying instrument, or economically hedge other Fund investments. With futures contracts, there is minimal
counterparty credit risk to the Fund since futures contracts are exchange-traded and the exchange’s clearinghouse, as counterparty to all
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
traded futures, guarantees the futures against default. A Fund’s risks in using these contracts include changes in the value of the underlying instruments,
non-performance of the counterparties under the contracts’ terms and changes in the liquidity of the secondary market for the contracts. Futures contracts are valued at the settlement price established
each day by the board of trade or exchange on which they principally trade.
Upon entering into a financial futures contract, the Fund is required to
pledge to the broker an amount of cash and/or other assets equal to a certain percentage of the contract amount, known as initial margin deposit. Subsequent payments, known as variation margins, are made or can be received by the Fund each day,
depending on the daily fluctuation in the fair value of the underlying security. The Fund records an unrealized gain/(loss) equal to the daily variation margin. Should market conditions move unexpectedly, the Fund may not achieve the anticipated
benefits of the futures contracts and may incur a loss. The Fund recognizes a realized gain/(loss) on the expiration or closing of a futures contract.
During the year ended December 31, 2019, the Fund entered into futures transactions for the purpose of hedging against the effects of changes in the value of
portfolio securities due to anticipated changes in market conditions, and to gain market exposure for residual and accumulating cash positions. Cash held as collateral for futures contracts is shown on the Consolidated Statement of Assets and
Liabilities as “Restricted Cash — Futures.”
Options
The Fund may utilize options on securities or indices to varying degrees as part of their principal investment strategy. An option on a security is a contract that gives the holder of the option, in return for a
premium, the right to buy from (in the case of a call) or sell to (in the case of a put) the writer of the option the security underlying the option at a specified exercise or “strike” price. The writer of an option on a security has the
obligation upon exercise of the option to deliver the underlying security upon payment of the exercise price or to pay the exercise price upon delivery of the underlying security. The Fund may hold options, write option contracts, or both.
If an option written by the Fund expires unexercised, the Fund realizes on the expiration date a capital gain equal to the premium received by the Fund
at the time the option was written. If an option purchased by the Fund expires unexercised, the Fund realizes a capital loss equal to the premium paid. Prior to the earlier of exercise or expiration, an exchange-traded option may be closed out by an
offsetting purchase or sale of an option of the same series (type, underlying security, exercise price and expiration). There can be no assurance, however, that a closing purchase or sale transaction can be effected when the Fund desires.
The Fund will realize a capital gain from a closing purchase transaction if the cost of the closing option is less
than the premium received from writing the option, or, if the cost of the closing option is more than the premium received from writing the option, a capital loss. The Fund will realize a capital gain from a closing sale transaction if the premium
received from the sale is more than the original premium paid when the option position was opened, or a capital loss, if the premium received from a sale is less than the original premium paid.
For the year ended December 31, 2019, the Fund had written options to provide leveraged short exposure, and purchased options to provide leveraged long
exposure, to the underlying equity, which is consistent with the investment strategies of the Fund.
Reverse Repurchase Agreements
The Fund engages in reverse repurchase agreement transactions with respect to instruments that are consistent with the Fund’s investment objective or policies.
This creates leverage for the Fund because the cash received can be used to purchase other securities. See Note 6 for additional information on the Fund’s reverse repurchase agreements.
Additional Derivative Information
The Fund follows adopted amendments to authoritative guidance on disclosures
about derivative instruments and hedging activities which require that the Fund disclose; a) how and why an entity uses derivative instruments; b) how derivative instruments and related hedged items are accounted for; c) how derivative instruments
and related hedged items affect an entity’s financial position, financial performance and cash flows; and d) how the netting of derivatives subject to master netting arrangements (if applicable) affects the net exposure of the Fund related to
the derivatives.
The fair value of derivative instruments on the Statement of Assets and Liabilities have the following risk exposure at
December 31, 2019:
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair Value
|
|
|
Risk Exposure
|
|
Asset
Derivative
|
|
|
Liability
Derivative
|
|
|
Equity Price Risk
|
|
$
|
17,325,000
|
(1)(3)
|
|
$
|
(3,807,364
|
)(2)(4)
|
|
Foreign Currency Risk
|
|
|
1,034,600
|
(1)
|
|
|
—
|
|
|
(1)
|
Statement of Assets and Liabilities location: Investments, at value.
|
|
(2)
|
Statement of Assets and Liabilities location: Written options contracts, at value.
|
|
(3)
|
Statement of Assets and Liabilities location: Variation margin receivable.
|
|
(4)
|
Includes cumulative unrealized depreciation of futures contracts as reported in the Investment Portfolio and within the components of net assets section of the
Statement of Assets and Liabilities. Only the current day’s variation margin is reported within the receivables and/or payables of the Statement of Assets and Liabilities.
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
The effect of derivative instruments on the Statement of Operations for the year ended December 31, 2019, is as
follows:
|
|
|
|
|
|
|
|
|
|
|
Risk Exposure
|
|
Net
Realized
Gain/(Loss)
on
Derivatives
|
|
|
Net Change in
Unrealized
Appreciation/
(Depreciation)
on
Derivatives
|
|
|
Equity Price Risk
|
|
$
|
(25,631,591
|
)(1)(2)(3)
|
|
$
|
12,620,163
|
(4)(5)(6)
|
|
Foreign Currency Risk
|
|
|
(3,954,624
|
)(1)
|
|
|
(1,847,650
|
)(4)
|
|
(1)
|
Statement of Operations location: Realized gain (loss) on investments from unaffiliated issuers. Purchased options only.
|
|
(2)
|
Statement of Operations location: Realized gain (loss) on written options contracts.
|
|
(3)
|
Statement of Operations location: Realized gain (loss) on futures contracts.
|
|
(4)
|
Statement of Operations location: Net increase (decrease) in unrealized appreciation (depreciation) on investments. Purchased options only.
|
|
(5)
|
Statement of Operations location: Net increase (decrease) in unrealized appreciation (depreciation) on written options contracts.
|
|
(6)
|
Statement of Operations location: Net increase (decrease) in unrealized appreciation (depreciation) on futures contracts.
|
The average monthly volume of derivative activity for the year ended December 31, 2019 is as follows:
|
|
|
|
|
|
|
|
|
|
|
Income Fund
|
|
Units/
Contracts
|
|
|
Appreciation/
(Depreciation)
|
|
|
Purchased Options Contracts
|
|
|
352,974,595
|
|
|
|
—
|
|
|
Written Options Contracts
|
|
|
10,033
|
|
|
|
—
|
|
|
Futures Contracts
|
|
|
—
|
|
|
|
[15,389
|
]
|
Note 4. Securities Lending
Effective November 8, 2019, HCMFA entered into a custody agreement with Bank of New York Mellon (“BNY”). Prior to November 8, 2019, State Street
Bank and Trust Company (“State Street”) served as the custodian to the Fund.
As of December 31, 2019, the Fund did not participate in
securities lending transactions with BNY.
Prior to November 8, 2019, the Fund could seek additional income by making secured loans of its portfolio
securities through its prior custodian, State Street Bank and Trust. Such loans would be in an amount not greater than one-third of the value of the Fund’s total assets. State Street would charge a fund
fees based on a percentage of the securities lending income.
The Fund would receive collateral consisting of cash (U.S. and foreign currency),
securities issued or guaranteed by the U.S. government or its agencies or instrumentalities, sovereign debt, convertible bonds, irrevocable bank letters of credit or such other collateral as may be agreed on by the parties to a securities lending
arrangement, initially with a value of 102% or 105% of the market value of the loaned securities and thereafter maintained at a value of 100% of
the market value of the loaned securities. If the collateral consists of non-cash collateral, the borrower would pay the Fund a loan premium fee. If the
collateral consists of cash, State Street would reinvest the cash. Although voting rights, or rights to consent, with respect to the loaned securities pass to the borrower, the Fund would recall the loaned securities upon reasonable notice in order
that the securities could be voted by the Fund if the holders of such securities are asked to vote upon or consent to matters materially affecting the investment. The Fund also could call such loans in order to sell the securities involved.
Securities lending transactions were entered into pursuant to Securities Loan Agreements (“SLA”), which would provide the right, in the event
of default (including bankruptcy or insolvency) for the non-defaulting party to liquidate the collateral and calculate a net exposure to the defaulting party or request additional collateral. In the event that
a borrower defaulted, the Fund, as lender, would offset the market value of the collateral received against the market value of the securities loaned. The value of the collateral is typically greater than that of the market value of the securities
loaned, leaving the lender with a net amount payable to the defaulting party. However, bankruptcy or insolvency laws of a particular jurisdiction may impose restrictions on or prohibitions against such a right of offset in the event of an SLA
counterparty’s bankruptcy or insolvency. Under the SLA, the Fund can reinvest cash collateral, or, upon an event of default, resell or repledge the collateral, and the borrower can resell or repledge the loaned securities. The risks of
securities lending also include the risk that the borrower may not provide additional collateral when required or may not return the securities when due. To mitigate this risk, each Fund benefits from a borrower default indemnity provided by State
Street. State Street’s indemnity generally provides for replacement of securities lent or the approximate value thereof.
Note 5. U.S. Federal
Income Tax Information
The character of income and gains to be distributed is determined in accordance with income tax regulations which may differ
from U.S. GAAP. These differences include (but are not limited to) investments organized as partnerships for tax purposes, losses deferred due to wash sale transactions, and tax attributes from Fund reorganizations. Reclassifications are made to the
Fund’s capital accounts to reflect income and gains available for distribution (or available capital loss carryovers) under income tax regulations. These reclassifications have no impact on net investment income, realized gains or losses, or
NAV of the Fund. The calculation of net investment income per share in the Financial Highlights table excludes these adjustments.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
For the year ended December 31, 2019, permanent differences chiefly resulting from partnership basis
adjustments, return of capital distributions paid by the fund, differences in premium amortization methods for book and tax, foreign currency gains and losses, reorganization expenses, and paydown reclasses were identified and reclassified among the
components of the Fund’s net assets as follows:
|
|
|
|
Distributable
Earnings
(Accumulated
Losses)
|
|
Paid-in-Capital
|
|
$(162,876)
|
|
$162,876
|
At December 31, 2019, the Fund’s most recent tax year end, components of distributable earnings on a tax basis are as
follows:
|
|
|
|
|
|
|
|
|
|
Other
Temporary
Differences
|
|
Accumulated
Capital and
Other Losses
|
|
|
Unrealized
Appreciation
(Depreciation)
(1)
|
|
|
$—
|
|
$
|
(213,623,033
|
)
|
|
$
|
(409,683,245
|
)
|
|
(1)
|
Any differences between book-basis and tax-basis net unrealized appreciation/(depreciation) are primarily due to wash sales, non-taxable dividends, partnership,
REIT basis adjustments and difference in premium amortization methods for book and tax.
|
As of December 31, 2019, the Fund has
capital loss carryovers as indicated below. The capital loss carryovers are available to offset future realized capital gains to the extent provided in the Code and regulations promulgated thereunder. To the extent that these carryover losses are
used to offset future capital gains, the gains offset will not be distributed to shareholders.
|
|
|
|
|
|
|
|
|
|
No Expiration
Short-Term(1)
|
|
No Expiration
Long-Term
|
|
|
Total
|
|
|
$38,056,401
|
|
$
|
175,566,632
|
|
|
$
|
213,623,033
|
|
During the year ended December 31, 2019, the Fund did not utilize capital loss carryforwards to offset capital gains.
The tax character of distributions paid during the last two fiscal year/period ended December 31, and the year ended June 30, 2018 is as
follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ordinary
Income
|
|
|
Long-Term
Capital Gain
|
|
|
Return of
Capital
|
|
|
2019
|
|
$
|
58,214,363
|
|
|
$
|
—
|
|
|
$
|
8,201,030
|
|
|
2018
|
|
|
32,468,254
|
|
|
|
—
|
|
|
|
720,948
|
|
|
2018*
|
|
|
49,645,426
|
|
|
|
—
|
|
|
|
6,936,337
|
|
|
(1)
|
For tax purposes, short-term capital gains distributions, if any, are considered ordinary income distributions.
|
Unrealized appreciation and depreciation at December 31, 2019, based on cost of investments for U.S. federal
income tax purposes was:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
Appreciation
|
|
Gross
Depreciation
|
|
|
Net
Appreciation/
(Depreciation)
|
|
|
Cost
|
|
|
$101,121,905
|
|
$
|
(510,805,150
|
)
|
|
$
|
(409,683,245
|
)
|
|
$
|
1,938,328,068
|
|
Qualified Late Year Ordinary and Post October Losses
Under current laws, certain capital losses and specified losses realized after October 31 may be deferred and treated as occurring on the first day of the following fiscal year. For the fiscal year ended
December 31, 2019, the Fund did not elect to defer net realized losses incurred from November 1, 2019 through December 31, 2019.
Note
6. Credit Agreement and Reverse Repurchase Agreement
On February 2, 2018, HFRO Sub, LLC a wholly-owned subsidiary of the Fund entered into a
financing arrangement (the “Financing Arrangement”) with Bank of America Merrill Lynch and Bank of America, N.A. The Fund is in compliance with the Financing Arrangement.
Pursuant to the terms of the Financing Arrangement, and subject to certain customary conditions, HFRO Sub, LLC may borrow on a revolving basis a maximum of $350 million, with a maturity date of
February 2, 2022. In connection with the Financing Arrangement, HFRO Sub, LLC and the Fund have made representations and warranties regarding the loans and underlying collateral and are required to comply with various covenants, reporting
requirements and other customary requirements. The Financing Arrangement also limits the recourse of the lender to the assets of HFRO Sub, LLC and includes usual and customary events of default for senior secured revolving facilities of this nature.
At December 31, 2019, current outstanding and fair value amounts were $300,000,000 and $307,092,068, respectively, and would be categorized as Level 3 within the fair value hierarchy. The Fund’s average daily balance was $370,000,000
at a weighted average interest rate of 3.61% for the days outstanding.
On March 21, 2017, the Fund entered into a leverage facility agreement (the
“BNP Agreement”) with BNP Paribas Prime Brokerage International, Ltd., BNP Prime Brokerage, Inc., acting through its New York Branch, and BNP Paribas (together, the “BNPP Entities”). Under the BNP Agreement, the BNPP Entities may
make margin loans to Fund at a rate of one-month LIBOR + 0.50%. The BNP Agreement may be terminated by either the Fund or the BNPP Entities with 30 days’ notice.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
At December 31, 2019, the Fund had an outstanding balance of $3,324,533 on the BNP Agreement. The Fund’s
average daily balance was $2,533,151 at a weighted average interest rate of 1.72% for the days outstanding.
On February 9, 2018, the Fund entered
into an agreement with BNP Paribas Securities Corporation (“BNP Securities”) under which it may from time to time enter into reverse repurchase transactions pursuant to the terms of a master repurchase agreement and related annexes
(collectively the “Repurchase Agreement”). A reverse repurchase transaction is a repurchase transaction in which the Fund is the seller of securities or other assets and agrees to repurchase them at a date certain or on demand. Pursuant to
the Repurchase Agreement, the Fund may agree to sell securities or other assets to BNP Securities for an agreed upon price (the “Purchase Price”), with a simultaneous agreement to repurchase such securities or other assets from BNP
Securities for the Purchase Price plus a price differential that is economically similar to interest. The price differential is negotiated for each transaction. This creates leverage for the Fund because the cash received can be used to purchase
other securities.
At December 31, 2019, the Fund’s outstanding balance on the BNP Securities was $56,261,600. The Fund’s average daily
balance was $50,171,540 at a weighted average interest rate of 3.78% for the days outstanding.
On March 6, 2019, the Fund entered into an agreement with
Mizuho Securities USA LLC (“Mizuho Securities”) under which it may from time to time enter into reverse repurchase transactions pursuant to the terms of a master repurchase agreement and related annexes (collectively the “Repurchase
Agreement”). A reverse repurchase transaction is a repurchase transaction in which the Fund is the seller of securities or other assets and agrees to repurchase them at a date certain or on demand. Pursuant to the Repurchase Agreement, the Fund
may agree to sell securities or other assets to Mizuho Securities for an agreed upon price (the “Purchase Price”), with a simultaneous agreement to repurchase such securities or other assets from Mizuho Securities for the Purchase Price
plus a price differential that is economically similar to interest. The price differential is negotiated for each transaction. This creates leverage for the Fund because the cash received can be used to purchase other securities.
At December 31, 2019, the Fund’s outstanding balance on the Mizuho Securities was $63,535,000. The Fund’s average daily balance was $34,233,551 at a
weighted average interest rate of 3.51% for the days outstanding.
Note 7. Investment Advisory, Administration and Trustee Fees
For its investment advisory services, the Fund pays the Investment Adviser a monthly fee, computed and accrued daily, based on an annual rate of the Fund’s
Average Daily Managed Assets. Average Daily Managed Assets of a Fund means the average daily value of the total assets of a Fund less all accrued liabilities of a Fund (other than the aggregate amount of any outstanding borrowings constituting
financial leverage).
The table below shows the Fund’s contractual advisory fee with the Investment Adviser for the year ended December 31,
2019:
|
|
|
|
|
|
|
|
|
|
Annual Fee
Rate to the
Investment Advisor
|
|
> 1 Billion
|
|
|
> 2 Billion
|
|
|
0.65%
|
|
|
0.60
|
%
|
|
|
0.55
|
%
|
Administration Fee
The
Investment Adviser provides administrative services to the Fund. For its services, the Investment Adviser receives an annual fee, payable monthly, in an amount equal to 0.20% of the average weekly value of the Fund’s Managed Assets. Under a
separate sub-administration agreement, the Investment Adviser delegates certain administrative functions and pays the sub-administrator directly for these
sub-administration services. Effective October 1, 2018, the Investment Adviser entered into an administrative services agreement with SEI Investments Global Funds Services, a wholly owned subsidiary of SEI Investments Company. Prior to
October 1, 2018, State Street served as sub-administrator to the Fund.
Expense Limits and Fee
Reimbursements
The Investment Adviser had contractually agreed to limit the total annual operating expenses (exclusive of fees paid by the Fund
pursuant to its Plan, taxes, dividend expenses on short sales, interest payments, brokerage commissions and other transaction costs, acquired fund fees and expenses, and extraordinary expenses) of the Fund to 0.95% of average daily net assets of the
Fund (the “HIF Expense Cap”). The HIF Expense Cap expired on October 31, 2016. Under the expense limitation agreement, the Investment Adviser may recoup waived and/or reimbursed amounts with respect to the Fund within thirty-six months of the date such amounts were waived or reimbursed, provided the Fund’s total annual operating expenses, including such recoupment, do not exceed the HIF Expense Cap in effect at the time of
such waiver/reimbursement.
There can be no assurance that these fee reductions will be sufficient to avoid any loss. On December 31, 2019, the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
amounts subject to possible future recoupment under the Fund’s expense limitations were as follows:
|
|
|
Fiscal Years Ended December 31
|
|
2020
|
|
$169,993
|
During the year ended December 31, 2019, the Investment Adviser did not recoup any amounts previously waived or reimbursed.
Fees Paid to Officers and Trustees
Each Trustee
who is not an “interested person” of the Fund as defined in the 1940 Act (the “Independent Trustees”) receives an annual retainer of $150,000 payable in quarterly installments and allocated among each portfolio in the Highland
Funds Complex overseen by such Trustee based on relative net assets. Independent Trustees are reimbursed for actual out-of-pocket expenses relating to attendance at meetings, however, the Chairman of the Board and the Chairman of the Audit Committee
each receive an additional payment of $10,000 payable in quarterly installments and allocated among each portfolio in the Highland Funds Complex based on relative net assets. The Independent Trustees do not receive any separate compensation in
connection with service on Committees or for attending Board or Committee Meetings. The Trustees do not have any pension or retirement plan. The “Highland Funds Complex” consists of all of the registered investment companies advised by the
Investment Adviser or its affiliated advisers and NexPoint Capital, Inc., a closed-end management investment company that has elected to be treated as a business development company under the 1940 Act as of
the date of this report.
The Fund pays no compensation to its officers, all of whom are employees of the Investment Adviser or one of its affiliates.
Expedited Settlement Agreements
On
June 15, 2017 and May 14, 2019, the Fund entered into Expedited Settlement Agreements with two major dealers in the floating rate loan market, pursuant to which the Fund has the right to designate certain loans it sells to the dealer to
settle on or prior to three days from the trade date in exchange for a quarterly fee (the “Expedited Settlement Agreements”). The Expedited Settlement Agreements are designed to reduce settlement times from the standard seven days to three
days for eligible loans. For the year ended December 31, 2019, the Fund paid $81,544 to the dealers as part of the Expedited Settlement Agreements.
While the Expedited Settlement Agreements are intended to provide the Fund with additional liquidity with respect to such loans, and may not represent the exclusive
method of
expedited settlement of such loans, no assurance can be given that the Expedited Settlement Agreements or other methods for expediting settlements will provide the Fund with sufficient liquidity
in the event of abnormally large redemptions.
Indemnification
Under the Fund’s organizational documents, the officers and Trustees have been granted certain indemnification rights against certain liabilities that may arise out of performance of their duties to the Fund.
Additionally, in the normal course of business, the Fund may enter into contracts with service providers that contain a variety of indemnification clauses. The Fund’s maximum exposure under these arrangements is dependent on future claims that
may be made against the Fund and, therefore, cannot be estimated.
Note 8. Disclosure of Significant Risks and Contingencies
The primary risks of investing in the Fund are described below in alphabetical order:
Counterparty Risk
Counterparty risk is the potential loss the Fund may incur as a result of the failure of a
counterparty or an issuer to make payments according to the terms of a contract. Counterparty risk is measured as the loss the Fund would record if its counterparties failed to perform pursuant to the terms of their obligations to the Fund. Because
the Fund may enter into over-the-counter forwards, options, swaps and other derivative financial instruments, the Fund may be exposed to the credit risk of its
counterparties. To limit the counterparty risk associated with such transactions, the Fund conducts business only with financial institutions judged by the Investment Adviser to present acceptable credit risk.
Credit Risk
Investments rated below investment grade are
commonly referred to as high-yield, high risk or “junk debt.” They are regarded as predominantly speculative with respect to the issuing company’s continuing ability to meet principal and/ or interest payments. Investments in high
yield debt and high yield Senior Loans may result in greater NAV fluctuation than if the Fund did not make such investments.
Corporate debt obligations,
including Senior Loans, are subject to the risk of non-payment of scheduled interest and/or principal. Non-payment would result in a reduction of income to the Fund, a
reduction in the value of the corporate debt obligation experiencing non-payment and a potential decrease in the NAV of the Fund.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
Currency Risk
A portion of the Fund’s assets may be quoted or denominated in non-U.S. currencies. These securities may be adversely
affected by fluctuations in relative currency exchange rates and by exchange control regulations. The Fund’s investment performance may be negatively affected by a devaluation of a currency in which the Fund’s investments are quoted or
denominated. Further, the Fund’s investment performance may be significantly affected, either positively or negatively, by currency exchange rates because the U.S. dollar value of securities quoted or denominated in another currency will
increase or decrease in response to changes in the value of such currency in relation to the U.S. dollar.
Derivatives Risk
Derivatives risk is a combination of several risks, including the risks that: (1) an investment in a derivative instrument may not correlate well with the
performance of the securities or asset class to which the Fund seeks exposure, (2) derivative contracts, including options, may expire worthless and the use of derivatives may result in losses to the Fund, (3) a derivative instrument
entailing leverage may result in a loss greater than the principal amount invested, (4) derivatives not traded on an exchange may be subject to credit risk, for example, if the counterparty does not meet its obligations (see also
“Counterparty Risk”), and (5) derivatives not traded on an exchange may be subject to liquidity risk and the related risk that the instrument is difficult or impossible to value accurately. As a general matter, when the Fund
establishes certain derivative instrument positions, such as certain futures, options and forward contract positions, it will segregate liquid assets (such as cash, U.S. Treasury bonds or commercial paper) equivalent to the Fund’s outstanding
obligations under the contract or in connection with the position. In addition, changes in laws or regulations may make the use of derivatives more costly, may limit the availability of derivatives, or may otherwise adversely affect the use, value
or performance of derivatives. A Fund’s ability to pursue its investment strategy, including its strategy of investing in certain derivative instruments, may be limited to or adversely affected by the Fund’s intention to qualify as a
regulated investment company, and its strategy may bear adversely on its ability to so qualify.
Distressed and Defaulted Securities Risk
The Fund may invest in companies that are troubled, in distress or bankrupt. As such, they are subject to a multitude of legal, industry, market,
environmental and governmental forces that make analysis of these companies inherently difficult. Further, the Investment Adviser relies on company management, outside experts, market participants and personal experience to analyze potential
investments for the Fund. There can be no assurance that any of these sources
will prove credible, or that the resulting analysis will produce accurate conclusions.
Financial
Services Industry Risk is the risk associated with the fact that the Trust’s investments in Senior Loans are arranged through private negotiations between a borrower (“Borrower”) and several financial institutions. Investments in the
financial services sector may be subject to credit risk, interest rate risk, and regulatory risk, among others. Banks and other financial institutions can be affected by such factors as downturns in the U.S. and foreign economies and general
economic cycles, fiscal and monetary policy, adverse developments in the real estate market, the deterioration or failure of other financial institutions, and changes in banking or securities regulations. The financial services industry is subject
to extensive government regulation, which can limit both the amounts and types of loans and other financial commitments financial services companies can make and the interest rates and fees they can charge. Profitability is largely dependent on the
availability and cost of capital funds, and can fluctuate significantly when interest rates change. Because financial services companies are highly dependent on short-term interest rates, they can be adversely affected by downturns in the U.S. and
foreign economies or changes in banking regulations. Losses resulting from financial difficulties of Borrowers can negatively affect financial services companies. The financial services industry is currently undergoing relatively rapid change as
existing distinctions between financial service segments become less clear. This change may make it more difficult for the Adviser to analyze investments in this industry. Additionally, the recently increased volatility in the financial markets and
implementation of the recent financial reform legislation may affect the financial services industry as a whole in ways that may be difficult to predict.
Hedging Risk
The Fund may engage in “hedging,”
the practice of attempting to offset a potential loss in one position by establishing an opposite position in another investment. Hedging strategies in general are usually intended to limit or reduce investment risk, but can also be expected to
limit or reduce the potential for profit. For example, if the Fund has taken a defensive posture by hedging its portfolio, and stock prices advance, the return to investors will be lower than if the portfolio had not been hedged. No assurance can be
given that any particular hedging strategy will be successful, or that the Investment Adviser will elect to use a hedging strategy at a time when it is advisable.
Illiquid and Restricted Securities Risk
Certain investments made by the Fund are, and others may be, illiquid,
and consequently the Fund may not be able to
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
sell such investments at prices that reflect the Investment Adviser’s assessment of their value or the amount originally paid for such investments by the Fund. Illiquidity may result from
the absence of an established market for the investments as well as legal, contractual or other restrictions on their resale and other factors. Furthermore, the nature of the Fund’s investments, especially those in financially distressed
companies, may require a long holding period prior to profitability.
Restricted securities (i.e., securities acquired in private placement transactions)
and illiquid securities may offer higher yields than comparable publicly traded securities. The Fund, however, may not be able to sell these securities when the Investment Adviser considers it desirable to do so or, to the extent they are sold
privately, may have to sell them at less than the price of otherwise comparable securities. Restricted securities are subject to limitations on resale which 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 a Fund’s expense, the Fund’s expenses would be increased. A high percentage of illiquid securities in a Fund creates a risk that such a Fund may not be able to redeem
its shares without causing significant dilution to remaining shareholders.
Leverage Risk
The Fund may use leverage in its investment program, including the use of borrowed funds and investments in certain types of options, such as puts, calls and
warrants, which may be purchased for a fraction of the price of the underlying securities. While such strategies and techniques increase the opportunity to achieve higher returns on the amounts invested, they also increase the risk of loss. To the
extent the Fund purchases securities with borrowed funds, its net assets will tend to increase or decrease at a greater rate than if borrowed funds are not used. If the interest expense on borrowings were to exceed the net return on the portfolio
securities purchased with borrowed funds, the Fund’s use of leverage would result in a lower rate of return than if the Fund were not leveraged.
Non-U.S. Securities Risk
The Fund may invest in non-U.S. securities. Investing in non-U.S. securities involves certain risks not involved in domestic
investments, including, but not limited to: fluctuations in foreign exchange rates; future foreign economic, financial, political and social developments; different legal systems; the possible imposition of exchange controls or other foreign
governmental laws or restrictions; lower trading volume; much greater price volatility and illiquidity of certain non-U.S. securities markets; different trading and settlement practices; less governmental
supervision;
changes in currency exchange rates; high and volatile rates of inflation; fluctuating interest rates; less publicly available information; and different accounting, auditing and financial
recordkeeping standards and requirements.
Options Risk
There are several risks associated with transactions in options on securities. For example, there are significant differences between the securities and options markets that could result in an imperfect correlation
between these markets, causing a given transaction not to achieve its objectives. A transaction in options or securities may be unsuccessful to some degree because of market behavior or unexpected events.
When the Fund writes a covered call option, the Fund forgoes, during the option’s life, the opportunity to profit from increases in the market value of the
security covering the call option above the sum of the premium and the strike price of the call, but retains the risk of loss should the price of the underlying security decline. The writer of an option has no control over the time when it may be
required to fulfill its obligation and once an option writer has received an exercise notice, it must deliver the underlying security in exchange for the strike price.
When the Fund writes a covered put option, the Fund bears the risk of loss if the value of the underlying stock declines below the exercise price minus the put premium. If the option is exercised, the Fund could
incur a loss if it is required to purchase the stock underlying the put option at a price greater than the market price of the stock at the time of exercise plus the put premium the Fund received when it wrote the option. While the Fund’s
potential gain in writing a covered put option is limited to distributions earned on the liquid assets securing the put option plus the premium received from the purchaser of the put option, the Fund risks a loss equal to the entire exercise
price of the option minus the put premium.
Preferred Share Risk
Preferred share risk is the risk associated with the issuance of preferred shares to leverage the common shares. When preferred shares are issued, the NAV and market value of the common shares become more volatile,
and the yield to the holders of common shares will tend to fluctuate with changes in the shorter-term dividend rates on the preferred shares. The Trust will pay (and the holders of common shares will bear) all costs and expenses relating to the
issuance and ongoing maintenance of the preferred shares, including higher advisory fees. Accordingly, the issuance of preferred shares may not result in a higher yield or return to the holders of the common shares. If the dividend rate and other
costs of the preferred shares approach the net rate of return
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
on the Trust’s investment portfolio, the benefit of leverage to the holders of the common shares would be reduced. If the dividend rate and other costs of the preferred shares exceed the net
rate of return on the Trust’s investment portfolio, the leverage will result in a lower rate of return to the holders of common shares than if the Trust had not issued preferred shares.
Real Estate Investment Trust Risk
Real estate investments are subject to various risk factors. Generally, real
estate investments could be adversely affected by a recession or general economic downturn where the properties are located. Real estate investment performance is also subject to the success that a particular property manager has in managing the
property.
Real Estate Market Risk
The Trust is
exposed to economic, market and regulatory changes that impact the real estate market generally through its investment in NFRO REIT Sub, LLC (the "REIT Subsidiary"), which may cause the Trust’s operating results to suffer. A number of factors
may prevent the REIT Subsidiary’s properties and other real estate-related investments from generating sufficient net cash flow or may adversely affect their value, or both, resulting in less cash available for distribution, or a loss, to us.
These factors include: national, regional and local economic conditions; changing demographics; the ability of property managers to provide capable management and adequate maintenance; the quality of a property’s construction and design;
increases in costs of maintenance, insurance, and operations (including energy costs and real estate taxes); potential environmental and other legal liabilities; the level of financing used by the REIT Subsidiary and the availability and cost of
refinancing; potential instability, default or bankruptcy of tenants in the properties owned by the REIT Subsidiary; the relative illiquidity of real estate investments in general, which may make it difficult to sell a property at an attractive
price or within a reasonable time frame.
Senior Loans Risk
The risk that the issuer of a senior may fail to pay interest or principal when due, and changes in market interest rates may reduce the value of the senior loan or reduce the Fund’s returns. The risks
associated with senior loans are similar to the risks of high yield debt securities. Senior loans and other debt securities are also subject to the risk of price declines and to increases in interest rates, particularly long-term rates. Senior loans
are also subject to the risk that, as interest rates rise, the cost of borrowing increases, which may increase the risk of default. In addition, the interest rates of floating rate loans typically only adjust to changes in short-term interest rates;
long-term interest rates can vary
dramatically from short-term interest rates. Therefore, senior loans may not mitigate price declines in a long-term interest rate environment. The Fund’s investments in senior loans are
typically below investment grade and are considered speculative because of the credit risk of their issuers.
On July 27, 2017, the head of the United
Kingdom’s Financial Conduct Authority announced a desire to phase out the use of LIBOR by the end of 2021. Due to this announcement, there remains uncertainty regarding the future utilization of LIBOR and the nature of any replacement rate. As
such, the potential effect of a transition away from LIBOR on the Fund or the financial instruments in which the Fund invests cannot yet be determined.
Short Sales Risk
Short sales by the Fund that are not made
where there is an offsetting long position in the asset that it is being sold short theoretically involve unlimited loss potential since the market price of securities sold short may continuously increase. Short selling allows the Fund to profit
from declines in market prices to the extent such decline exceeds the transaction costs and costs of borrowing the securities. However, since the borrowed securities must be replaced by purchases at market prices in order to close out the short
position, any appreciation in the price of the borrowed securities would result in a loss. Purchasing securities to close out the short position can itself cause the price of securities to rise further, thereby exacerbating the loss. The Fund may
mitigate such losses by replacing the securities sold short before the market price has increased significantly. Under adverse market conditions, the Fund might have difficulty purchasing securities to meet margin calls on its short sale delivery
obligations, and might have to sell portfolio securities to raise the capital necessary to meet its short sale obligations at a time when fundamental investment considerations would not favor such sales.
Structured Finance Securities Risk
A portion of the
Trust’s investments may consist of equipment trust certificates, collateralized mortgage obligations, collateralized bond obligations, collateralized loan obligations or similar instruments. Such structured finance securities are generally
backed by an asset or a pool of assets, which serve as collateral. Depending on the type of security, the collateral may take the form of a portfolio of mortgage loans or bonds or other assets. The Trust and other investors in structured finance
securities ultimately bear the credit risk of the underlying collateral. In some instances, the structured finance securities are issued in multiple tranches, offering investors various maturity and credit risk characteristics, often categorized as
senior, mezzanine and subordinated/equity according to their degree of risk. The riskiest securities are the equity tranche, which bears the bulk of defaults from the bonds or loans
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
serving as collateral, and thus may protect the other, more senior tranches from default. If there are defaults or the relevant collateral otherwise underperforms, scheduled payments to senior
tranches of such securities take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. A senior tranche typically has higher ratings and lower yields
than the underlying securities, and may be rated investment grade. Despite the protection from the equity tranche, other tranches can experience substantial losses due to actual defaults, increased sensitivity to defaults due to previous defaults
and the disappearance of protecting tranches, market anticipation of defaults and aversion to certain structured finance securities as a class.
Valuation Risk
Certain of the Fund’s assets are fair
valued, including the Fund’s primary illiquid asset, TerreStar. TerreStar is a non-operating company that does not currently generate revenue and which primarily derives its value from two spectrum
frequencies, the license with respect to one of which was terminated by the FCC and is being contested by TerreStar on technical and public policy grounds. TerreStar currently anticipates such contest may take between 12 to 30 months and expects
deployment of its other spectrum asset to require a similar period of time. If TerreStar is ultimately unsuccessful in its efforts, the terminated license
would not be reinstated and the value of the TerreStar equity would likely be materially negatively impacted. The fair valuation of TerreStar involves uncertainty as it is materially dependent on
these estimates. With regard to the likelihood of TerreStar regaining the terminated license, the Investment Adviser assigned a high probability of success, based in part in consultation with outside experts.
Gain Contingency
Claymore Holdings, LLC, a partially-owned
affiliate of the Fund, is engaged in ongoing litigation that could result in a possible gain contingency to the Fund. The probability, timing, and potential amount of recovery, if any, are unknown.
Note 9. Investment Transactions
Purchases &
Sales of Securities
The cost of purchases and the proceeds from sales of investments, other than short-term securities and short-term options, for
the year ended December 31, 2019, were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S Government
Securities
|
|
|
Other Securities
|
|
|
Purchases
|
|
Sales
|
|
|
Purchases
|
|
|
Sales
|
|
|
$80,861,009
|
|
$
|
—
|
|
|
$
|
541,939,379
|
|
|
$
|
257,895,576
|
|
Note 10. Affiliated Issuers and Other
Affiliate Matters
Under Section 2 (a)(3) of the Investment Company Act of 1940, as amended, a portfolio company is defined as
“affiliated” if a fund owns five percent or more of its outstanding voting securities or if the portfolio company is under common control. The table below shows affiliated issuers of the Fund as of December 31, 2019:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Issuer
|
|
Shares at
December 31,
2018
|
|
|
Beginning
Value as of
December 31,
2018
$
|
|
|
Purchases
at Cost
$
|
|
|
Proceeds
from Sales
$
|
|
|
Distribution
to Return
of Capital
$
|
|
|
Net
Realized
Gain/(Loss)
on Sales of
Affiliated
Issuers
$
|
|
|
Change in
Unrealized
Appreciation/
(Depreciation)
$
|
|
|
Ending Value
as of December 31,
2019
$
|
|
|
Shares at
December 31,
2019
|
|
|
Affiliated
Income
$
|
|
|
Majority Owned, Not Consolidated
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Allenby (Common Stocks)
|
|
|
1,291,881
|
|
|
|
1
|
|
|
|
101,797
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(101,797
|
)
|
|
|
1
|
|
|
|
1,393,678
|
|
|
|
—
|
|
|
Claymore (Common Stocks)
|
|
|
8,698,220
|
|
|
|
9
|
|
|
|
671,970
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(671,970
|
)
|
|
|
9
|
|
|
|
9,370,190
|
|
|
|
—
|
|
|
Other Affiliates
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CCS Medical, Inc. (U.S. Senior Loans & Common Stocks)
|
|
|
52,229,448
|
|
|
|
24,398,513
|
|
|
|
7,621,644
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
15,785,754
|
|
|
|
47,805,911
|
|
|
|
58,920,016
|
|
|
|
6,735,585
|
|
|
EDS Legacy Partners (U.S. Senior Loans)
|
|
|
57,000,000
|
|
|
|
57,000,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(171,000
|
)
|
|
|
56,829,000
|
|
|
|
57,000,000
|
|
|
|
4,485,106
|
|
|
Euramax International (U.S. Senior Loans, Common Stocks & Warrants)
|
|
|
8,393,725
|
|
|
|
11,202,541
|
|
|
|
1,236,044
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(4,286,369
|
)
|
|
|
8,152,216
|
|
|
|
9,629,768
|
|
|
|
2,241,584
|
|
|
Gambier Bay LLC (Common Stocks)
|
|
|
10,939,879
|
|
|
|
1,258,086
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(7,856,551
|
)
|
|
|
—
|
|
|
|
6,598,465
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Issuer
|
|
Shares at
December 31,
2018
|
|
|
Beginning
Value as of
December 31,
2018
$
|
|
|
Purchases
at Cost
$
|
|
|
Proceeds
from Sales
$
|
|
|
Distribution
to Return
of Capital
$
|
|
|
Net
Realized
Gain/(Loss)
on Sales of
Affiliated
Issuers
$
|
|
|
Change in
Unrealized
Appreciation/
(Depreciation)
$
|
|
|
Ending Value
as of December 31,
2019
$
|
|
|
Shares at
December 31,
2019
|
|
|
Affiliated
Income
$
|
|
|
LLV Holdco LLC (U.S. Senior Loans, Common Stocks and Warrants)
|
|
|
12,552,393
|
|
|
|
10,002,768
|
|
|
|
938,933
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(187,787
|
)
|
|
|
10,753,914
|
|
|
|
13,442,392
|
|
|
|
40,105
|
|
|
Nevada Land Group LLC (U.S. Senior Loans)
|
|
|
1,743,503
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(1,743,503
|
)
|
|
|
1,743,503
|
|
|
|
—
|
|
|
|
—
|
|
|
|
49,304
|
|
|
NexPoint Strategic Opportunities Fund (Registered Investment Company)
|
|
|
427,345
|
|
|
|
8,516,986
|
|
|
|
9,983,152
|
|
|
|
—
|
|
|
|
(1,887,220
|
)
|
|
|
—
|
|
|
|
904,805
|
|
|
|
17,517,723
|
|
|
|
989,143
|
|
|
|
263,488
|
|
|
NFRO REIT SUB, LLC (Common Stocks)
|
|
|
802,563
|
|
|
|
17,207,025
|
|
|
|
77,210,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,330,496
|
|
|
|
95,747,521
|
|
|
|
4,328,483
|
|
|
|
175,880
|
|
|
SFR WLIF I, II, III, LLC (LLC Interest)
|
|
|
—
|
|
|
|
—
|
|
|
|
90,000,000
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(1,222,530
|
)
|
|
|
88,777,470
|
|
|
|
90,000,000
|
|
|
|
4,427,613
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
154,078,957
|
|
|
|
129,585,929
|
|
|
|
187,763,540
|
|
|
|
—
|
|
|
|
(9,743,771
|
)
|
|
|
(1,743,503
|
)
|
|
|
19,721,570
|
|
|
|
325,583,765
|
|
|
|
245,073,670
|
|
|
|
18,418,665
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The Adviser has been historically affiliated through common control with Highland Capital Management, L.P.
(“HCMLP”), an SEC-registered investment adviser. On October 16, 2019, HCMLP filed for Chapter 11 bankruptcy protection with the United States Bankruptcy Court for the District of Delaware. The case was subsequently transferred to the
United States Bankruptcy Court for the Northern District of Texas. On January 9, 2020, the bankruptcy court approved a change of control of HCMLP, which involved the resignation of James Dondero as the sole director of, and the appointment of an
independent board to, HCMLP’s general partner. Mr. Dondero will, however, remain as an employee of HCMLP and as portfolio manager for all funds and vehicles for which he currently holds such titles. Nevertheless, given Mr. Dondero’s
historic role with HCMLP and his continued ownership interest and roles with respect to the Highland platform as a whole, as well as the shared services agreements between HCMLP and our Adviser, we still treat HCMLP and its affiliates as our
affiliates for purposes hereof.
Note 11. Regulatory Matters
On August 17, 2018, the SEC adopted amendments to Regulation S-X. These changes are effective for periods after November 5, 2018. The updates to Registered
Investment Companies were mainly focused on simplifying the presentation of distributable earnings by eliminating the need to present the components of distributable earnings on a book basis in the Statements of Assets and Liabilities. The update
also impacted the presentation of undistributed net investment income and distribution to shareholders on the
Statements of Changes in Net Assets. The amounts presented in the current Statements of Changes in Net Assets represent the aggregated total distributions of net investment income and realized
capital gains, except for distributions classified as return of capital which are still presented separately.
Note 12. New Accounting Pronouncements
In November 2016, the FASB issued Accounting Standards Update 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. The amendments in this
update require the statement of cash flows to explain the change during the period in the total of cash, restricted cash and cash equivalents. Amounts generally described as restricted cash or restricted cash equivalents should be included with cash
and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. For public entities this update will be effective for fiscal years beginning after December 15, 2017, and for interim
periods within those fiscal years. The Investment Adviser has evaluated the impact of this new guidance and effective April 1, 2018, the Fund no longer reports the change in restricted cash and cash equivalents in the operating and investing
sections in our Consolidated Statement of Cash Flows. Restricted cash and cash equivalents are now included in the beginning and end of the period cash and cash equivalents on the Consolidated Statement of Cash Flows. These changes have been applied
using a retrospective transition method to each period presented.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
In March 2017, the FASB issued Accounting Standards Update 2017-08, Receivables — Nonrefundable Fees and Other
Costs (Subtopic 310-20). The amendments in this update shorten the amortization period for certain callable debt securities held at premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments
do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. For public entities this update will be effective for fiscal years beginning after December 15, 2018, and for interim periods
within those fiscal years. The Investment Adviser has evaluated the impact of this new guidance and the adoption of this guidance did not have a material impact on the Fund’s consolidated financial statements.
In February 2018, the FASB issued Accounting Standards Update 2018-03, Technical Corrections and Improvements to Financial Instruments — Overall (Subtopic
825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this update provide a variety of technical corrections and improvements to how entities should account for financial instruments. For public
entities this update will be effective for fiscal years beginning after December 15, 2017, and for interim periods within those fiscal years beginning after June 15, 2018. The Investment Adviser has evaluated the impact of this new guidance and the
adoption of this guidance did not have a material impact on the Fund’s consolidated financial statements.
In August 2018, the FASB issued
Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820). The new guidance includes additions and modifications to disclosures requirements for fair value measurements. For public entities, the
amendments are effective for consolidated financial statements issued for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The Investment Adviser has evaluated the impact of this new guidance and
the adoption of this guidance did not have a material impact on the Fund’s consolidated financial statements.
Note 13. Asset Coverage
The Fund is required to maintain 300% asset coverage with respect to amounts outstanding (excluding short-term borrowings) under its various
leverage facilities. Additionally the fund is required to maintain 200% asset coverage with respect to the preferred share issuance as well as its various leverage facilities. Asset coverage is calculated by subtracting the Fund’s total
liabilities, not including any amount representing bank borrowings and senior securities, from the Fund’s total assets and dividing the result by the principal amount of the borrowings outstanding. As of the dates indicated below, the
Fund’s debt outstanding and asset coverage was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Date
|
|
Amount
Outstanding
Excluding
Preferred
Shares
|
|
|
% of Asset
Coverage of
Indebtedness
Excluding
Preferred
Shares
|
|
|
Amount
Outstanding
Including
Preferred
Shares
|
|
|
% of Asset
Coverage
of
Indebtedness
Including
Preferred
Shares(2)
|
|
|
12/31/2019
|
|
|
419,796,600
|
|
|
|
337.13
|
%
|
|
|
564,796,600
|
|
|
|
276.25
|
%
|
|
12/31/2018(1)
|
|
|
496,141,100
|
|
|
|
306.80
|
%
|
|
|
496,141,100
|
|
|
|
306.80
|
%
|
|
6/30/2018
|
|
|
498,563,423
|
|
|
|
317.70
|
%
|
|
|
498,563,423
|
|
|
|
317.70
|
%
|
|
6/30/2017
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
6/30/2016
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
6/30/2015
|
|
|
51,500,000
|
|
|
|
1641.40
|
%
|
|
|
51,500,000
|
|
|
|
1641.40
|
%
|
|
6/30/2014
|
|
|
60,000,000
|
|
|
|
1577.60
|
%
|
|
|
60,000,000
|
|
|
|
1577.60
|
%
|
|
6/30/2013
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
|
N/A
|
|
|
6/30/2012
|
|
|
89,000,000
|
|
|
|
718.40
|
%
|
|
|
89,000,000
|
|
|
|
718.40
|
%
|
|
6/30/2011
|
|
|
135,000,000
|
|
|
|
659.90
|
%
|
|
|
135,000,000
|
|
|
|
659.90
|
%
|
|
6/30/2010
|
|
|
115,000,000
|
|
|
|
606.00
|
%
|
|
|
115,000,000
|
|
|
|
606.00
|
%
|
|
6/30/2009
|
|
|
181,000,000
|
|
|
|
465.80
|
%
|
|
|
181,000,000
|
|
|
|
465.80
|
%
|
|
1
|
For the six month period ended December 31, 2018. Effective April 11, 2019, the Fund had a fiscal year change from June 30 to December 31
(Note 1).
|
|
2
|
As referenced in Note 1, the Fund issued $145mm in preferred shares subject to the 200% Asset Coverage of Indebtedness requirements under the 40 Act.
|
Note 14. Unconsolidated Significant Subsidiaries
In accordance with Regulation S-X and GAAP, the Fund is not permitted to consolidate any subsidiary or other entity that is not an investment company, including those in
which the Fund has a controlling interest unless the business of the controlled subsidiary consists of providing services to the Fund. In accordance with Regulation S-X Rules
3-09 and 4-08(g), the Fund evaluates its unconsolidated controlled subsidiaries as significant subsidiaries under the respective rules. As of December 31, 2019,
NFRO REIT Sub LLC was considered a significant unconsolidated subsidiary under Regulation S-X Rule 4-08(g). This subsidiaries is wholly owned by the Fund. Based on the
requirements under Regulation S-X Rule 4-08(g), the summarized consolidated financial information of these unconsolidated subsidiaries is presented below:
|
|
|
|
|
|
|
|
|
NFRO REIT Sub, LLC
December 31, 2019
|
|
|
Balance Sheet:
|
|
|
|
|
|
Current Assets
|
|
$
|
3,939,000
|
|
|
Noncurrent Assets
|
|
|
205,094,000
|
|
|
|
|
|
|
|
|
Total Assets
|
|
|
209,033,000
|
|
|
Current Liabilities
|
|
|
5,838,000
|
|
|
Noncurrent Liabilities
|
|
|
122,262,000
|
|
|
|
|
|
|
|
|
Total Liabilities
|
|
|
128,100,000
|
|
|
Preferred Stock
|
|
|
1,000
|
|
|
Non-controlling interest (in consolidated investments)
|
|
|
104,000
|
|
|
Invested Equity
|
|
|
80,828,000
|
|
|
|
|
|
|
|
|
Total Equity
|
|
$
|
80,933,000
|
|
|
|
|
|
|
|
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (concluded)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
NFRO REIT Sub, LLC
For the Year Ended
December 31, 2019
|
|
|
Summary of Operations:
|
|
|
|
|
|
Net Sales
|
|
$
|
7,168,000
|
|
|
Gross Profit (Loss)
|
|
|
(13,105,000
|
)
|
|
Net Income (Loss)
|
|
|
(13,105,000
|
)
|
|
Net Income (Loss) attributable to non-controlling interest (in consolidated investments),
preferred shares, and other comprehensive income
|
|
|
—
|
|
Note 15. Subsequent Events
The Investment Adviser has evaluated the impact of all subsequent events on the Fund through the date the consolidated financial statements were issued, and has determined that there were no such subsequent events
to report which have not already been recorded or disclosed in these financial statements and accompanying notes.
An outbreak of respiratory disease
caused by a novel coronavirus was first detected in China in December 2019 and subsequently spread internationally. This coronavirus has resulted in closing borders, enhanced health screenings, healthcare service preparation and delivery,
quarantines, cancellations, disruptions to supply chains and customer activity, as well as general concern and uncertainty. The impact of this coronavirus may be short term or may last for an extended period of time and result in a substantial
economic downturn. Health crises caused by outbreaks, such as the coronavirus outbreak, may exacerbate other pre-existing political, social and economic risks. The impact of this outbreak, and other epidemics and pandemics that may arise in the
future, could negatively affect the worldwide economy, as well as the economies of individual countries, individual companies and the market in general in significant and unforeseen ways. Any such impact could adversely affect a Fund’s
performance, the performance of the securities in which the Fund invests, lines of credit available to the Fund and may lead to losses on your investment in the Fund.
As a result of the decreases in market value of the Fund’s assets pledged at derivative counterparties, the Fund has been required to post additional collateral relating to its margin requirements. The Fund
has posted all required collateral; however, the Fund’s ability to meet future margin calls may be impacted by continued unfavorable market conditions.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Trustees and Shareholders of Highland Income Fund
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated statement of assets and liabilities, including the consolidated investment portfolio, of Highland Income Fund
and its subsidiary (the “Fund”) as of December 31, 2019, the related consolidated statements of operations and cash flows for the year ended December 31, 2019, the consolidated statement of changes in net assets for the year
ended December 31, 2019 and the period July 1, 2018 through December 31, 2018, including the related notes, and the consolidated financial highlights for the year ended December 31, 2019, the period July 1, 2018 through
December 31, 2018, and for the year ended June 30, 2015 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the
financial position of the Fund as of December 31, 2019, and the results of its operations and its cash flows for the year then ended, the changes in its net assets for the year ended December 31, 2019 and the period July 1, 2018
through December 31, 2018, and the financial highlights for the year ended December 31, 2019, the period July 1, 2018 through December 31, 2018 and for the year ended June 30, 2015 in conformity with accounting principles
generally accepted in the United States of America.
The financial statements of the Fund as of and for the year ended June 30, 2018 and the
financial highlights for each of the years ended June 30, 2018, 2017 and 2016 (not presented herein, other than the statement of changes in net assets and the financial highlights) were audited by other auditors whose report dated
September 24, 2018 expressed an unqualified opinion on those financial statements and financial highlights.
Basis for Opinion
These consolidated financial statements are the responsibility of the Fund’s management. Our responsibility is to express an opinion on the Fund’s
consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Fund in accordance
with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our
audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are
free of material misstatement, whether due to error or fraud.
Our audits included performing procedures to assess the risks of material misstatement of
the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated
financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our procedures included
confirmation of securities owned as of December 31, 2019 by correspondence with the custodian and brokers; when replies were not received from brokers, we performed other auditing procedures. We believe that our audits provide a reasonable
basis for our opinion.
April 10, 2020
We have
served as the auditor of one or more investment companies of Highland Capital Management Fund Advisors, L.P. and its affiliates since 2004.
ADDITIONAL INFORMATION (unaudited)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
Additional Portfolio Information
The Investment Adviser and its affiliates manage other accounts, including registered and private funds and individual accounts. Although investment decisions for the Fund are made independently from those of such
other accounts, the Investment Adviser may, consistent with applicable law, make investment recommendations to other clients or accounts that may be the same or different from those made to the Fund, including investments in different levels of the
capital structure of a company, such as equity versus senior loans, or that involve taking contradictory positions in multiple levels of the capital structure. The Investment Adviser has adopted policies and procedures that address the allocation of
investment opportunities, execution of portfolio transactions, personal trading by employees and other potential conflicts of interest that are designed to ensure that all client accounts are treated equitably over time. Nevertheless, this may
create situations where a client could be disadvantaged because of the investment activities conducted by the Investment Adviser for other client accounts. When the Fund and one or more of such other accounts is prepared to invest in, or desire to
dispose of, the same security, available investments or opportunities for each will be allocated in a manner believed by the Investment Adviser to be equitable to the Fund and such other accounts. The Investment Adviser also may aggregate orders to
purchase and sell securities for the Fund and such other accounts. Although the Investment Adviser believes that, over time, the potential benefits of participating in volume transactions and negotiating lower transaction costs should benefit all
accounts including the Fund, in some cases these activities may adversely affect the price paid or received by the Fund or the size of the position obtained or disposed of by the Fund.
Tax Information
For shareholders that do not have a December 31, 2019 tax year end, this notice is for
informational purposes only. For shareholders with a December 31, 2019 tax year end, please consult your tax adviser as to the pertinence of this notice. For the fiscal year ended December 31, 2019, the Fund hereby designates the following
items with regard to distributions paid during the year.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Return of
Capital
|
|
Ordinary
Income
Distribution
|
|
|
Total
|
|
|
Qualified
Dividends
and Corporate
Dividends
Received
Deduction*
|
|
|
Qualified
Dividend
Income
(15% tax
rate
for QDI)**
|
|
|
Interest
Related
Dividends***
|
|
|
12.35%
|
|
|
87.65
|
%
|
|
|
100.00
|
%
|
|
|
4.57
|
%
|
|
|
4.63
|
%
|
|
|
38.37
|
%
|
|
*
|
The percentage in this column represents the amount of “Qualifying for Corporate Receivable Deduction Dividends” and is reflected as a
percentage of ordinary income distributions.
|
|
**
|
The percentage in this column represents the amount of “Qualifying Dividend Income” and is reflected as a percentage of “Ordinary Income
Distributions.” It is the intention of the Fund to designate the maximum amount permitted by law. The information reported herein may differ from the information and distributions taxable to the shareholders for the calendar year ending
December 31, 2019. Complete information will be computed and reported in conjunction with your 2019 Form 1099-DIV.
|
|
***
|
The percentage in this column represents the amount of “Interest Related Dividends” and is reflected as a percentage of ordinary income
distributions exempt from U.S. withholding tax when paid to foreign investors.
|
The information herein may differ from the information
and distributions taxable to the shareholder for the calendar year ended December 31, 2019. Complete information will be computed and reported with your 2019 Form 1099-DIV.
Dividend Reinvestment Plan
Unless the registered owner of Common Shares elects to receive cash by contacting
American Stock Transfer & Trust Company, LLC (“AST” or the “Plan Agent”), as agent for shareholders in administering the Plan, a registered owner will receive newly issued Common Shares for all dividends declared for
Common Shares of the Fund. If a registered owner of Common Shares elects not to participate in the Plan, they will receive all dividends in cash paid by check mailed directly to them (or, if the shares are held in street or other nominee name, then
to such nominee) by AST, as dividend disbursing agent. Shareholders may elect not to participate in the Plan and to receive all dividends in cash by sending written instructions or by contacting AST, as dividend disbursing agent, at the address set
forth below.
Participation in the Plan is completely voluntary and may be terminated or resumed at any time without penalty by contacting the Plan Agent
before the dividend record date; otherwise such termination or resumption will be effective with respect to any subsequently declared dividend. Some brokers may automatically elect to receive cash on the shareholders’ behalf and may reinvest
that cash in additional Common Shares of the Fund for them. The Plan Agent will open an account for each shareholder under the Plan in the same name in which such shareholder’s Common Shares are registered.
Whenever the Fund declares a dividend payable in cash, non-participants in the Plan will receive cash and participants in
the Plan will receive the equivalent in Common Shares. The Common Shares will be acquired by the Plan Agent through receipt of additional unissued but authorized Common Shares from the Fund (“newly issued Common Shares”). The number of
newly issued Common Shares to be credited to each participant’s account will be determined by dividing the dollar amount of the dividend by the lesser of (i) the net asset value per Common Share determined on the Declaration Date and
(ii) the market price per Common Share as of the close of regular trading on the New York Stock Exchange (the “NYSE”) on the Declaration Date. The
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
Plan Agent maintains all shareholders’ accounts in the Plan and furnishes written confirmation of all transactions in the accounts, including information needed by shareholders for tax
records. Common Shares in the account of each Plan participant will be held by the Plan Agent on behalf of the Plan participant, and each shareholder proxy will include those shares purchased or received pursuant to the Plan. The Plan Agent will
forward all proxy solicitation materials to participants and vote proxies for shares held under the Plan in accordance with the instructions of the participants. In the case of shareholders such as banks, brokers or nominees which hold shares for
others who are the beneficial owners, the Plan Agent will administer the Plan on the basis of the number of Common Shares certified from time to time by the record shareholder’s name and held for the account of beneficial owners who participate
in the Plan. There will be no brokerage charges with respect to Common Shares issued directly by the Fund.
The automatic reinvestment of dividends will
not relieve participants of any federal, state or local income tax that may be payable (or required to be withheld) on such dividends. Accordingly, any taxable dividend received by a participant that is reinvested in additional Common Shares will be
subject to federal (and possibly state and local) income tax even though such participant will not receive a corresponding amount of cash with which to pay such taxes. Participants who request a sale of shares through the Plan Agent are subject to a
$2.50 sales fee and pay a brokerage commission of $0.05 per share sold. The Fund reserves the right to amend or terminate the Plan. There is no direct service charge to participants in the Plan; however, the Fund reserves the right to amend the Plan
to include a service charge payable by the participants. All correspondence concerning the Plan should be directed to the Plan Agent at American Stock Transfer & Trust Company, LLC 6201 15th Avenue Brooklyn, NY 11219; telephone (718) 921-8200.
Approval of Highland Income Fund Advisory Agreement
The Fund has retained Highland Capital Management Fund Advisors, L.P. (the “Investment Adviser”) to manage the assets of the Fund pursuant to an
investment advisory agreement between the Investment Adviser and the Investment Adviser and the Fund (the “Advisory Agreement”). The Advisory Agreement has been approved by the Fund’s Board of Trustees, including a majority of the
Independent Trustees. The Advisory Agreement continues in effect from year-to-year, provided that such continuance is specifically approved at least annually by the vote
of holders of at least a majority of the outstanding shares of the Fund or by the Board of Trustees and, in either event, by a majority of the Independent Trustees of the Fund casting votes in person at a meeting called for such purpose.
During a telephonic meeting held on August 15, 2019, the Board of Trustees gave preliminary consideration to
information bearing on the continuation of the Agreement for a one-year period commencing November 1, 2019 with respect to the Fund. The primary objective of the meeting was to ensure that the Trustees
had the opportunity to consider matters they deemed relevant in evaluating the continuation of the Agreement, and to request any additional information they considered reasonably necessary for their deliberations.
At an in-person meeting held on September 19-20, 2019, the Board of Trustees,
including the Independent Trustees, approved the continuance of the Agreement for a one-year period commencing on November 1, 2019. As part of its review process, the Board requested, through its
independent legal counsel, and received from the Investment Adviser, various information and written materials, including: (1) information regarding the financial soundness of the Investment Adviser and the profitability of the Advisory
Agreement to the Investment Adviser; (2) information on the advisory and compliance personnel of the Investment Adviser, including compensation arrangements; (3) information on internal compliance procedures of the Investment Adviser,
including policies and procedures for personal securities transactions and with respect to cybersecurity, business continuity and disaster recovery; (4) comparative information showing how the Fund’s fees and expenses compare to those of
other registered investment companies and comparable funds managed by the Investment Adviser that follow investment strategies similar to those of the Fund, if any; (5) information regarding the investment performance of the Fund, including
comparisons of the Fund’s performance against that of other registered investment companies and comparable funds managed by the Investment Adviser that follow investment strategies similar to the Fund, if any; (6) premium and discount
information with respect to the Fund; (7) information regarding brokerage and portfolio transactions; and (8) information on any legal proceedings or regulatory audits or investigations affecting the Investment Adviser or its affiliates.
After the August 2019 meeting, the Trustees requested that the Investment Adviser provide additional information regarding various matters. In addition, the Board of Trustees received an independent report from FUSE Research Network
(“FUSE”), an independent source of investment company data, relating to the Fund’s performance and expenses compared to the performance and expenses of a group of funds deemed by FUSE to be comparable to the Fund (the “peer
group”), and to a larger group of comparable funds (the “peer universe”). The Board also received data relating to the Fund’s leverage and distribution rates as compared to its peer group.
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
The Board of Trustees’ evaluation process with respect to the Investment Adviser is an ongoing one. In this
regard, the Board of Trustees also took into account discussions with management and information provided to the Board of Trustees at periodic meetings of the Board of Trustees over the course of the year with respect to the services provided by the
Investment Adviser to the Fund, including quarterly performance reports prepared by management containing reviews of investment results and prior presentations from the Investment Adviser with respect to the Fund. The information received and
considered by the Board of Trustees in connection with the September 19-20, 2019 meeting and throughout the year was both written and oral.
The Board of Trustees reviewed various factors that were discussed in a legal memorandum provided by independent counsel regarding trustee responsibilities in considering the Advisory Agreement, the detailed
information provided by the Investment Adviser and other relevant information and factors. The Board of Trustees also considered other factors (including conditions and trends prevailing generally in the economy, the securities markets, and the
industry). The Board of Trustees’ conclusions as to the approval of the Advisory Agreement were based on a comprehensive consideration of all information provided to the Trustees without any single factor being dispositive in and of itself.
Some of the factors that figured particularly in the Board of Trustees’ deliberations are described below, although individual Trustees may have
evaluated the information presented differently from one another, giving different weights to various factors. In addition, the Board of Trustees’ conclusions may be based in part on its consideration of the advisory arrangements in prior years
and on the Board’s ongoing regular review of fund performance and operations throughout the year.
Throughout the process, the Board of Trustees had
the opportunity to ask questions of and request additional information from the Investment Adviser. The Board of Trustees was assisted by legal counsel for the Trust and the Independent Trustees were also separately assisted by independent legal
counsel throughout the process. The Independent Trustees were advised by and met in executive sessions with their independent legal counsel at which no representatives of management were present to discuss the proposed continuation of the Advisory
Agreement, including prior to the September 19-20, 2019 meeting.
The nature, extent, and quality of the
services to be provided by the Investment Adviser.
The Board considered the portfolio management services to be provided by the Investment Adviser
under the Advisory Agreement and the activities related to portfolio management, including use of technology, research capabilities and
investment management staff. The Board discussed the relevant experience and qualifications of the personnel who would provide advisory services, including the background and experience of the
members of the Fund’s portfolio management team. The Trustees reviewed the management structure, assets under management and investment philosophies and processes of the Investment Adviser, including with respect to liquidity management. The
Board also reviewed and discussed information regarding the Investment Adviser’s compliance policies, procedures and personnel, including compensation arrangements and with respect to valuation, cybersecurity, business continuity and disaster
recovery. The Board also considered the Investment Adviser’s risk management processes. The Board of Trustees took into account the terms of the Advisory Agreement and considered that, the Investment Adviser, subject to the direction of the
Board of Trustees, is responsible for providing advice and guidance with respect to the Fund and for managing the investment of the assets of the Fund. The Board of Trustees also took into account that the scope of services provided by the
Investment Adviser and the undertakings required of the Investment Adviser in connection with those services, including maintaining and monitoring its own and the Fund’s compliance program, had expanded over time as a result of regulatory,
market and other developments. In this regard, they considered the Adviser’s preparation with respect to the reporting modernization and liquidity risk management requirements required by new SEC regulations. The Board of Trustees also
considered the quality of the Investment Adviser’s compliance oversight program with respect to the Fund’s service providers. The Board of Trustees also considered both the investment advisory services and the nature, quality and extent of
any administrative and other non-advisory services, including shareholder servicing and distribution support services, provided to the Fund and its shareholders by the Investment Adviser and its affiliates.
The Board also considered the significant risks assumed by the Investment Adviser in connection with the services provided to the Fund, including entrepreneurial risk and ongoing risks including investment, operational, enterprise, litigation,
regulatory and compliance risks with respect to the Fund. The Board of Trustees also noted various cost-savings initiatives that had been implemented by the Adviser with respect to the Fund and the other funds in the Highland complex over the years.
The Board of Trustees also noted that on a regular basis it receives and reviews information from the Fund’s Chief Compliance Officer (CCO)
regarding the Fund’s compliance policies and procedures established pursuant to Rule 38a-1 under the Investment Company Act of 1940.
In considering the nature, extent, and quality of the services provided by the Investment Adviser, the Board also took into
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
account its knowledge of the Investment Adviser’s management and the quality of the performance of its duties, through discussions and reports during the preceding year and in past years.
The Board took into account the Investment Adviser’s risk assessment, monitoring process and regulatory history. The Board concluded that the
Investment Adviser had the quality and depth of personnel and investment methods essential to performing its duties under the Advisory Agreement, and that the nature and the quality of such advisory services supported the approval of the Advisory
Agreement.
The Investment Adviser’s historical performance.
In considering the Fund’s performance, the Board of Trustees noted that it reviews at its regularly scheduled meetings information about the Fund’s performance results. The Board of Trustees reviewed the
historical performance of the Fund over various time periods and reflected on previous discussions regarding matters bearing on the Investment Adviser’s performance at its meetings throughout the year. The Board of Trustees discussed the
performance of the Fund and considered the relative performance of the Fund and its portfolio management team as compared to that of the Fund’s peer group as selected by FUSE, as well as comparable indices. Among other data, the Board of
Trustees also received data with respect to the Fund’s leverage and distribution rates as compared to its peer group. The Board of Trustees noted that while it found the data provided by FUSE, the independent third-party data provider,
generally useful, it recognized its limitations, including in particular that the data may vary depending on the end date selected and the results of the performance comparisons may vary depending on the selection of the peer group. The Board of
Trustees also took into account management’s discussion of the category in which the Fund was placed for comparative purposes, including any differences between the Fund’s investment strategy and the strategy of the funds in the
Fund’s respective category, as well as compared to the peer group selected by FUSE.
Among other data relating specifically to the Fund’s
performance, the Board took note of FUSE’s explanatory note that the peer group and universe consist of bank loan funds with similar pricing characteristics. The Board took into account that the Fund had changed its name from the Highland
Floating Rate Opportunities Fund, expanded its investment strategy and removed the policy to invest at least 80% of net assets in floating rate securities in May 2019. The Board took into account the differences in the Fund’s strategy from the
funds in its peer group constructed by FUSE.
The Board of Trustees then considered that the Fund had outperformed the Credit Suisse Leveraged Loan USD
Index and universe for three- and ten-year periods and had
underperformed its index and universe for one- and five-year periods. The Board also took into account management’s discussion of the Fund’s
performance, including that the Fund’s performance does not generally move with the market, as well as the differences in the Fund’s strategy from its peer group.
The Board of Trustees concluded that the Fund’s overall performance and other relevant factors, including the Adviser’s actions to address any underperformance, supported the continuation of the Agreement
with respect to the Fund for an additional one-year period.
The costs of the services to be provided by the
Investment Adviser and the profits to be realized by the Investment Adviser and its affiliates from the relationship with the Fund.
The Board of
Trustees also gave consideration to the fees payable under the Agreement, the expenses the Investment Adviser incur in providing advisory services and the profitability to the Investment Adviser from managing the Fund, including:
(1) information regarding the financial condition of the Investment Adviser; (2) information regarding the total fees and payments received by the Investment Adviser for its services and, with respect to the Investment Adviser, whether
such fees are appropriate given economies of scale and other considerations; (3) comparative information showing (a) the fees payable under the Agreement versus the investment advisory fees of certain registered investment companies and
comparable funds that follow investment strategies similar to those of the Fund and (b) the expense ratios of the Fund versus the expense ratios of certain registered investment companies and comparable funds that follow investment strategies
similar to those of the Fund; and (4) information regarding the total fees and payments received and the related amounts waived and/or reimbursed by the Investment Adviser for providing administrative services with respect to the Fund under
separate agreements and whether such fees are appropriate. The Board of Trustees took into account the management fee structure, including that management fees for the Fund were based on the Fund’s total managed assets.
Among other data, the Board of Trustees considered that the Fund’s net management fee (including administrative fees) was lower than its peer group median and
that the Fund’s total net expense was about equal to both its peer group and its peer universe. The Board of Trustees also took into account management’s discussion of the Fund’s expenses.
The Board of Trustees also considered the so-called “fall-out benefits” to
the Investment Adviser with respect to the Fund, such as the reputational value of serving as Investment Adviser to the Fund, potential fees paid to the Investment Adviser’s affiliates by the Fund or portfolio companies for
ADDITIONAL INFORMATION (unaudited) (concluded)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
services provided, including administrative services provided to the Fund by the Investment Adviser pursuant to separate agreements, the benefits of scale from investment by the Fund in
affiliated funds, and the benefits of research made available to the Investment Adviser by reason of brokerage commissions (if any) generated by the Fund’s securities transactions. The Board of Trustees concluded that the benefits received by
the Investment Adviser and its affiliates were reasonable in the context of the relationship between the Investment Adviser and the Fund.
After such
review, the Board of Trustees determined that the profitability to the Investment Adviser and its affiliates from their relationship with the Fund was not excessive. The Trustees also took into consideration the amounts waived and/or reimbursed, if
any, where expense caps or advisory fee waivers had been implemented.
The extent to which economies of scale would be realized as the Fund grows and
whether fee levels reflect these economies of scale for the benefit of shareholders.
The Board considered the effective fee under the Advisory
Agreement for the Fund as a percentage of assets at different asset levels and possible economies of scale that may be realized if the assets of the Fund grow. The Board noted that the advisory fee for the Fund includes breakpoints. The Board
considered the Investment Adviser’s discussion of the Fund’s advisory fee structure. The Board of Trustees concluded that the fee structure is reasonable, and with respect to the Investment Adviser, should result in a sharing of economies
of scale in view of the information provided. The Board determined to continue to review ways, and the extent to which, economies of scale might be shared between the Investment Adviser on the one hand and shareholders of the Fund on the other.
Conclusion.
Following a further discussion of the factors above, it was noted that in considering the approval of the Advisory Agreement, no single factor was determinative to
the decision of the Board of Trustees. Rather, after weighing all factors and considerations, including those discussed above, the Board of Trustees, including separately, the Independent Trustees, unanimously agreed that the Advisory Agreement,
including the advisory fee to be paid to the Investment Adviser, is fair and reasonable to the Fund in light of the services that the Investment Adviser proposes to provide, the expenses that it incurs and the reasonably foreseeable asset levels of
the Fund.
Submission of Proposal to a Vote of Shareholders
The annual meeting of shareholders of the Fund was held on June 14, 2019. The following is a summary of the proposal submitted to shareholders for a vote at the meeting and the votes cast.
|
|
|
|
|
|
|
|
|
|
|
Proposal
|
|
Votes For
|
|
|
Votes
Withheld
|
|
|
To elect Ethan Powell as a Class I Trustee of the Fund, to serve for a three-year term expiring at the 2022 Annual Meeting.
|
|
|
43,068,510
|
|
|
|
3,817,939
|
|
|
To elect Bryan A. Ward as a Class I Trustee of the Fund, to serve for a three-year term expiring at the 2022 Annual
Meeting.
|
|
|
43,087,170
|
|
|
|
3,799,278
|
|
|
|
|
|
|
Proposal
|
|
Votes For
|
|
|
Votes
Against
|
|
|
To approve a change to the Fund’s fundamental policy regarding concentration such that the Fund will invest at least 25% of the value
of its total assets in the real estate industry
|
|
|
32,441,337
|
|
|
|
4,121,423
|
|
In addition to the two Trustees who were elected at the annual meeting, as noted above, the following other Trustees continued in
office after the Fund’s annual meeting: Dr. Bob Froehlich, Dustin Norris, Ethan Powell and Bryan A. Ward.
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
Trustees and Officers
The Board is responsible for the overall management of the
Fund, including supervision of the duties performed by the Investment Adviser. The names and birth dates of the Trustees and officers of the Fund, the year each was first elected or appointed to office, their principal business occupations during
the last five years, the number of funds overseen by each Trustee and other directorships they hold are shown below. The business address for each Trustee and officer of the Fund is c/o Highland Capital Management Fund Advisors, L.P., 300 Crescent
Court, Suite 700, Dallas, TX 75201.
The “Highland Funds Complex,” as referred to herein consists of: the Fund, each series of Highland
Funds I (“HFI”), each series of Highland Funds II (“HFII”), Highland Global Allocation Fund (“GAF”), NexPoint Strategic Opportunities Fund (“NHF”), NexPoint Event-Driven Fund (“NEDF”),
NexPoint Latin American Opportunities Fund (“NLAF”), NexPoint Real Estate Strategies Fund (“NRESF”), NexPoint Strategic Income Fund (“NSIF”), NexPoint Energy and Materials Opportunities Fund (“NEMO”), NexPoint
Discount Strategies Fund (“NDSF”), NexPoint Healthcare Opportunities Fund (“NHOF”, and together with NEDF, NLAF, NRESF, NSIF, NEMO, and NDSF, the “Interval Funds”), and NexPoint Capital, Inc. (the “BDC”), a
closed-end management investment company that has elected to be treated as a business development company under the 1940 Act.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Name and
Date of Birth
|
|
Position(s)
with the
Fund
|
|
Term of
Office1 and
Length of
Time Served
|
|
Principal
Occupation(s)
During Past
Five Years
|
|
Number of
Portfolios
in
the
Highland
Funds
Complex
Overseen
by the
Trustee
|
|
Other
Directorships/
Trusteeships
Held During the Past
Five
Years
|
|
Experience,
Qualifications,
Attributes, Skills for
Board
Membership
|
|
|
|
Independent Trustees
|
|
|
|
|
|
|
|
|
|
Dr. Bob Froehlich (4/28/1953)
|
|
Trustee
|
|
3 year term (expiring at 2020 annual meeting); Trustee since August 2017.
|
|
Retired.
|
|
20
|
|
Trustee of ARC Realty Finance Trust, Inc. (from January 2013 to May 2016); Director of KC Concessions, Inc. (since January 2013); Trustee of Realty Capital
Income Funds Trust (from January 2014 to December 2016); Director of American Realty Capital Healthcare Trust II (from January 2013 to June 2016); Director, American Realty Capital Daily Net Asset Value Trust, Inc. (from November 2012 to July 2016);
Director of American Sports Enterprise, Inc. (since January 2013); Director of Davidson Investment Advisors (from July 2009 to July 2016); Chairman and owner, Kane County Cougars Baseball Club (since January 2013); Advisory Board of Directors,
Internet Connectivity Group, Inc. (from January 2014 to April 2016); Director of AXAR Acquisition Corp. (formerly AR Capital Acquisition Corp.) (from October 2014 to October 2017); Director of The Midwest League of Professional Baseball Clubs, Inc.;
Director of Kane County Cougars Foundation, Inc.; Director of Galen Robotics, Inc.; Chairman and Director of FC Global Realty, Inc. (from May 2017 to June 2018); and Chairman; Director of First Capital Investment Corp. (from March 2017 to March
2018); and Director and Special Advisor to Vault Data, LLC (since February 2018).
|
|
Significant experience in the financial industry; significant managerial and executive experience; significant experience on other boards of directors,
including as a member of several audit committees.
|
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Name and
Date of Birth
|
|
Position(s)
with the
Fund
|
|
Term of
Office1 and
Length
of
Time Served
|
|
Principal
Occupation(s)
During Past
Five Years
|
|
Number of
Portfolios
in
the
Highland
Funds
Complex
Overseen
by the
Trustee
|
|
Other
Directorships/
Trusteeships
Held During the Past
Five
Years
|
|
Experience,
Qualifications,
Attributes, Skills for
Board Membership
|
|
|
|
Independent Trustees
|
|
|
|
|
|
|
|
|
|
John Honis2 (6/16/1958)
|
|
Trustee
|
|
3 year term (expiring at 2021 annual meeting); Trustee since August 2017.
|
|
President of Rand Advisors, LLC since August 2013; and Partner of Highland Capital Management, L.P. (“HCMLP”) from February 2007 until his resignation in November
2014.
|
|
20
|
|
Manager of Turtle Bay Resort, LLC (August 2011 — December 2018); Manager of American Home Patient (November 2011 to February 2016).
|
|
Significant experience in the financial industry; significant managerial and executive experience, including experience as president, chief executive officer
or chief restructuring officer of five telecommunication firms; experience on other boards of directors.
|
|
|
|
|
|
|
|
|
|
Ethan Powell3 (6/20/1975)
|
|
Trustee; Chairman of the Board
|
|
3 year term (expiring at 2022 annual meeting); Trustee since August 2017; Chairman of the Board since December 2013; and Executive Vice President and Principal Executive
Officer from June 2012 until December 2015.
|
|
CEO, Chairman and Founder of Impact Shares LLC since December 2015; Trustee/Director of the Highland Funds Complex from June 2012 until July 2013 and since December 2013;
Chief Product Strategist of HCMFA from 2012 until December 2015; Senior Retail Fund Analyst of HCMLP from 2007 until December 2015 and HCMFA from its inception until December 2015; President and Principal Executive Officer of NHF from June 2012
until May 2015; Secretary of NHF from May 2015 until December 2015; Executive Vice President and Principal Executive Officer of HFI and HFII from June 2012 until December 2015; and Secretary of HFI and HFII from November 2010 to May
2015.
|
|
20
|
|
Trustee of Impact Shares Funds I Trust
|
|
Significant experience in the financial industry; significant executive experience including past service as an officer of funds in the Highland Funds
Complex; significant administrative and managerial experience.
|
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Name and
Date of Birth
|
|
Position(s)
with the
Fund
|
|
Term of
Office1 and
Length of
Time Served
|
|
Principal
Occupation(s)
During Past
Five Years
|
|
Number of
Portfolios
in
the
Highland
Funds
Complex
Overseen
by the
Trustee
|
|
Other
Directorships/
Trusteeships
Held During the
Past
Five Years
|
|
Experience,
Qualifications,
Attributes, Skills for
Board
Membership
|
|
|
|
Independent Trustees
|
|
|
|
|
|
|
|
|
|
Bryan A. Ward (2/4/1955)
|
|
Trustee
|
|
3 year term (expiring at 2022 annual meeting); Trustee since August 2017.
|
|
Senior Advisor, CrossFirst Bank since April 2019; Private Investor, BW Consulting, LLC since 2014; Senior Manager, Accenture, LLP (a consulting firm) from 1991 until
retirement in 2014.
|
|
20
|
|
Director of Equity Metrix, LLC
|
|
Significant experience in the financial industry; significant executive experience including past service as an officer of funds in the Highland Funds
Complex; significant administrative and managerial experience.
|
ADDITIONAL INFORMATION (unaudited) (continued)
|
|
|
|
|
|
|
|
December 31, 2019
|
|
Highland Income Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Name and
Date of Birth
|
|
Position(s)
with the
Fund
|
|
Term of
Office1 and
Length of
Time Served
|
|
Principal
Occupation(s)
During Past
Five Years
|
|
Number of
Portfolios
in
the
Highland
Funds
Complex
Overseen
by the
Trustee
|
|
Other
Directorships/
Trusteeships
Held During the
Past
Five Years
|
|
Experience,
Qualifications,
Attributes, Skills for
Board
Membership
|
|
|
|
Interested Trustees
|
|
|
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Dustin Norris
(1/6/1984)
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Trustee
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Initial 3 year term (expiring at 2022 annual meeting); Trustee since February 2018.
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Head of Distribution and Chief Product Strategist at NexPoint since March 2019; President of NexPoint Securities, Inc. (“NSI”) (formerly, Highland Capital Funds
Distributor, Inc.) since April 2018; Head of Distribution at HCMFA from November 2017 until March 2019; Secretary of HFRO, GAF, HFI and HFII from October 2017 until April 2019; Assistant Secretary of HFRO and GAF II from August 2017 to October 2017;
Chief Product Strategist at HCMFA from September 2015 to March 2019; Director of Product Strategy at HCMFA from May 2014 to September 2015; Assistant Secretary of HFI and HFII from March 2017 to October 2017; Secretary of NHF from December 2015
until April 2019; Assistant Treasurer of NexPoint Real Estate Advisors, L.P. since May 2015; Assistant Treasurer of NexPoint Real Estate Advisors II, L.P. since June 2016; Assistant Treasurer of HFI and HFII from November 2012 to March 2017;
Assistant Treasurer of NHF from November 2012 to December 2015; Secretary of the BDC from 2014 until April 2019; and Secretary of the Interval Funds from March 2016 until April 2019.
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20
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None
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Significant experience in the financial industry; significant managerial and executive experience, including experience as an officer of the Highland Funds
Complex since 2012.
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ADDITIONAL INFORMATION (unaudited) (concluded)
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December 31, 2019
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Highland Income Fund
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1
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On an annual basis, as a matter of Board policy, the Governance and Compliance Committee reviews each Trustee’s performance and determines whether
to extend each such Trustee’s service for another year. Effective June 2013, the Board adopted a retirement policy wherein the Governance and Compliance Committee shall not recommend the continued service as a Trustee of a Board member who is
older than 80 years of age at the time the Governance and Compliance Committee reports its findings to the Board.
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2
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Since May 1, 2015, Mr. Honis has been treated as an Independent Trustee of the Trust. Prior to that date, Mr. Honis was treated as an
Interested Trustee because he was a partner of an investment adviser affiliated with the Adviser until his resignation in November 2014. As of September 30, 2019, Mr. Honis was entitled to receive aggregate severance and/or deferred
compensation payments of approximately $230,000 from another affiliate of the Adviser. Mr. Honis also serves as a director of a portfolio company affiliated with the Adviser.
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In addition, Mr. Honis serves as a trustee of a trust that owns substantially all of the economic interest in an investment adviser affiliated with
the Adviser. Mr. Honis indirectly receives an asset-based fee in respect of such interest, which is projected to range from $450,000-$550,000 annually. Additionally, an investment adviser controlled by
Mr. Honis has entered into a shared services arrangement with an affiliate of the Adviser, pursuant to which the affiliate provides back office support in exchange for approximately $50,000 per quarter. The affiliated adviser was paid $147,000
and $208,000 in 2017 and 2018, respectively. In light of these relationships between Mr. Honis and affiliates of the Adviser, it is possible that the SEC might in the future determine Mr. Honis to be an interested person of the Trust.
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3
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Prior to December 8, 2017, Mr. Powell was treated as an Interested Trustee of the Trust for all purposes other than compensation and the
Trust’s code of ethics.
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Name and
Date of Birth
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Position(s)
with the Fund
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Term of
Office and
Length of
Time Served
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Principal Occupation(s) During Past Five Years
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Officers
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Frank Waterhouse
(4/14/1971)
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Treasurer, Principal Accounting Officer, Principal Financial Officer and Principal Executive Officer
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Indefinite Term; Treasurer since May 2015. Principal Financial Officer and Principal Accounting Officer since October 2017. Principal Executive Officer since February
2018.
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Partner and Chief Financial Officer of HCMLP; Treasurer of the Highland Funds Complex since May 2015.
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Clifford Stoops
(11/17/1970)
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Assistant Treasurer
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Indefinite Term; Assistant Treasurer since March 2017.
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Chief Accounting Officer at HCMLP; Assistant Treasurer of the Highland Funds Complex since March 2017.
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Jason Post
(1/9/1979)
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Chief Compliance Officer
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Indefinite Term; Chief Compliance Officer since September 2015.
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Chief Compliance Officer for HCMFA and NexPoint since September 2015; Chief Compliance Officer and Anti-Money Laundering Officer of the Highland Funds Complex since
September 2015. Prior to his current role at HCMFA and NexPoint, Mr. Post served as Deputy Chief Compliance Officer and Director of Compliance for HCMLP.
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Dustin Norris
(1/6/1984)
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Executive Vice President; Trustee
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Indefinite Term; Executive Vice President since April 2019; Trustee since February 2018
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Head of Distribution and Chief Product Strategist at NexPoint since March 2019; President of NexPoint Securities, Inc. since April 2018; Head of Distribution at HCMFA from
November 2017 until March 2019; Chief Product Strategist at HCMFA from September 2015 to March 2019; Director of Product Strategy at HCMFA from May 2014 to September 2015; Officer of the Highland Funds Complex since November 2012.
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Lauren Thedford (1/7/1989)
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Secretary since April 2019
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Indefinite Term: Secretary since April 2019
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Associate General Counsel at HCMLP since September 2017; In-House Counsel at HCMLP from January 2015 until September 2017; Secretary
of the Highland Funds Complex since April 2019; member of the AT&T Performance Arts Center, Education and Community Committee since March 2019.
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IMPORTANT INFORMATION ABOUT THIS REPORT
Investment Adviser
Highland Capital Management Fund Advisors, L.P.
300 Crescent Court, Suite 700
Dallas, TX 75201
Transfer Agent
American Stock Transfer & Trust Company, LLC
6201 15th
Avenue
Brooklyn, NY 11219
Underwriter
NexPoint Securities, Inc.
200 Crescent Court, Suite
700
Dallas, TX 75201
Custodian
Bank of New York Mellon
240 Greenwich Street
New York, NY 10286
Independent Registered Public Accounting
Firm
PricewaterhouseCoopers LLP
2121 N. Pearl
Street, Suite 2000
Dallas, TX 75201
Fund Counsel
K&L Gates LLP
1 Lincoln Street
Boston, MA 02111
This report has been prepared for shareholders of Highland Income Fund (the “Fund”). The Fund mails one
shareholder report to each shareholder address. If you would like more than one report, please call shareholder services at
1-800-357-9167 to request that additional reports be sent to you.
A description of the policies and procedures that the Fund uses to determine how to vote proxies relating to their portfolio securities, and the Fund’s proxy voting records for the most recent 12-month period ended June 30, are available (i) without charge, upon request, by calling
1-800-357-9167 and (ii) on the Securities and Exchange Commission’s website at http://www.sec.gov.
The Fund files its complete schedules of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year as an
exhibit to its report on Form N-PORT. The Fund’s Form N-PORT are available on the Commission’s website at http://www.sec.gov and also may be reviewed and
copied at the Commission’s Public Reference Room in Washington, DC. Information on the Public Reference Room may be obtained by calling
1-800-SEC-0330. Shareholders may also obtain the Form N-PORT by visiting the Fund’s
website at www.highlandfunds.com.
The Statement of Additional Information includes additional information about the Fund’s Trustees and is
available upon request without charge by calling 1-800-357-9167.
THIS PAGE LEFT BLANK INTENTIONALLY
Highland Funds
c/o American Stock Transfer & Trust Company, LLC
6201 15th Avenue
Brooklyn, NY 11219
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Highland Income Fund
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Annual Report, December 31, 2019
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