UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM N-CSR

Kayne Anderson Energy Development Company

(Exact name of registrant as specified in charter)

717 Texas Avenue, Suite 3100, Houston, Texas		77002
(Address of principal executive offices)		(Zip code)

David Shladovsky, Esq.
KA Fund Advisors, LLC, 717 Texas Avenue, Suite 3100, Houston, Texas 77002
(Name and address of agent for service)

Registrant’s telephone number, including area code: (713) 493-2020

Date of fiscal year end: November 30, 2010

Date of reporting period: November 30, 2010

     Form N-CSR is to be used by management investment companies to file reports with the Commission not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under Rule 30e-1 under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may use the information provided on Form N-CSR in its regulatory, disclosure review, inspection, and policymaking roles.

     A registrant is required to disclose the information specified by Form N-CSR, and the Commission will make this information public. A registrant is not required to respond to the collection of information contained in Form N-CSR unless the Form displays a currently valid Office of Management and Budget (“OMB”) control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. § 3507.

 

 

Item 1. Reports to Stockholders.

The report of Kayne Anderson Energy Development Company (the “Registrant”) to stockholders for the fiscal year ended November 30, 2010 is attached below.

CONTENTS

 

 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS:  This report of Kayne Anderson Energy Development Company (the “Company”) contains “forward-looking statements” as defined under the U.S. federal securities laws. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will” and similar expressions identify forward-looking statements, which generally are not historical in nature. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to materially differ from the Company’s historical experience and its present expectations or projections indicated in any forward-looking statements. These risks include, but are not limited to, changes in economic and political conditions; regulatory and legal changes; master limited partnership (“MLP”) industry risk; leverage risk; valuation risk; interest rate risk; tax risk; and other risks discussed in the Company’s filings with the Securities and Exchange Commission (“SEC”). You should not place undue reliance on forward-looking statements, which speak only as of the date they are made. The Company undertakes no obligation to update or revise any forward-looking statements made herein. There is no assurance that the Company’s investment objectives will be attained.

 

January 27, 2011

 

Dear Fellow Stockholders:

 

Last year, we opened our shareholder letter with the phrase: “What a difference a year makes!” We are happy to report that fiscal 2010 has been even better than fiscal 2009 in terms of increasing net asset value and that has translated into very strong stock price performance. Much of this performance was driven by the exceptionally strong returns from our portfolio of MLP securities, significant appreciation in the value of our equity investment in International Resource Partners, and strong returns from our bond portfolio. Yet the year was not without its challenges — two of our private MLPs continued to be hampered by the slow economic recovery. We accomplished several key goals during the year and believe our portfolio is well positioned to benefit from market trends we see continuing into fiscal 2011.

 

The last two years have been very strong for the MLP market as the sector has now fully recovered from the economic crisis of late 2008 and early 2009. When combined with the gains the MLP market enjoyed during fiscal 2009, the sector has generated a total return in excess of 140% since the market low in March 2009. As discussed in greater detail later in this letter, we believe energy industry fundamentals remain positive and the outlook for the MLP sector continues to be quite strong.

 

The performance of the public MLP sector affects us in several ways. First, it directly impacts the value of our public MLPs and MLP affiliates, which represented approximately 32% of our long-term investments as of November 30, 2010. Second, it indirectly impacts our private MLPs, which are generally valued at a discount to the value of comparable public MLPs. The health of the IPO market for MLPs and the merger and acquisitions (M&A) market are also important for the ultimate monetization of these private MLPs. Lastly, we believe the return to more “normal” market conditions for public MLPs will lead to additional private MLP investment opportunities as companies see the value of the MLP structure.

 

The strong performance of the MLP market during the year was the result of a reversion of MLP yields to levels that were more in-line with historical averages. There were several factors that contributed to this tightening, including the strong operating performance of MLPs throughout the financial crisis, the improved prospects for distribution growth across the entire MLP sector and the strong demand for yield securities by individual investors. At the beginning of the fiscal year, the average MLP yield was 7.9%, which represented a 467 basis point premium (a 100 basis points equals one percent) to the yield on 10-year U.S. Treasury Bonds. This difference is often referred to as a “spread to Treasuries.” By the end of the fiscal year, the spread to Treasuries was 352 basis points, which is still well above the 219 basis point average for the five-year period prior to the financial crisis. Since the end of our fiscal year, MLP yields have continued to decline, and overall interest rates have risen, such that the spread to Treasuries is now much closer to historical levels.

 

Capital markets activity for MLPs reached a record high in calendar 2010. MLPs raised $12 billion in follow-on equity offerings and $20 billion in debt. Much of the equity was used to finance acquisitions and growth projects, and MLPs took advantage of attractive interest rates to refinance their debt. The previous record for MLP follow-on equity offerings was $7 billion in 2009. We believe that a strong market for raising new capital will help facilitate distribution growth in the future. Also encouraging was the return of the IPO market. After a two-year absence, the IPO market made a strong comeback with five new MLPs raising $1.3 billion during fiscal 2010. Currently, four of these deals are trading well above their IPO prices.

 

With ample access to capital, MLPs were able to return to a path of more predictable distribution growth. During the last two quarters of the fiscal year, over half of the MLPs increased their distributions, and the remainder provided greater visibility for increasing distributions in 2011. Distribution growth for the universe of midstream MLPs was 4.8% during fiscal 2010 and we believe we will see distribution growth of 5% to 6% for these names in fiscal 2011.

 

A balanced mix of acquisitions and new projects is driving distribution growth. Fiscal 2010 saw robust acquisition activity, with over $17 billion of transactions completed during this period. These acquisitions were a

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combination of third-party deals, as well as “drop down” transactions between MLPs and their general partners. These drop down transactions were typically completed at attractive multiples for assets that are operated either by the MLPs or related parties. There were also multiple new projects that were completed or initiated by the MLPs during this period. As we discuss later in greater detail, we believe much of the demand for this new infrastructure is being driven by the rapid development of unconventional oil and natural gas reserves.

 

Now that we have fully recovered from the 2008-2009 financial crisis, it is helpful to look back at the growth and relative performance of the MLP sector over the decade. During this 10-year period, the MLP market (as measured by the Alerian MLP index) has delivered an annualized total return of 19.3%. We believe that investors are beginning to view MLPs as a distinct asset class and recognizing the strong returns and the “yield plus growth” attributes of the sector. Since November 30, 2000, the MLP sector has grown from a niche market consisting of 20 partnerships with a combined equity market capitalization of approximately $14 billion to a much larger universe consisting of 66 partnerships with a combined equity market capitalization of approximately $220 billion at November 30, 2010.

 

Energy Market Overview

 

Without a doubt, the biggest story in the domestic energy business is the development of “unconventional reserves,” which is an industry term that refers to oil and natural gas reserves produced using advanced drilling and completion techniques. Technological advances — such as horizontal drilling and multi-stage hydraulic fracturing — have enabled the development of these reserves which were previously believed to be uneconomic to produce. Unconventional reserves can include oil shales, gas shales and the Canadian oil sands. The rapid development of unconventional reserves has resulted in a substantial increase in both estimated oil and natural gas reserves and production over the past few years. As an example, domestic natural gas reserves, as reported by government agencies, have increased by 44% from 2003 to 2009. Examples of unconventional reserves include the Barnett Shale, Haynesville Shale, Woodford Shale, Fayetteville Shale, Eagle Ford Shale, Marcellus Shale and Bakken Shale.

 

Significant amounts of capital are being spent by energy companies to develop these reserves. In fact, major oil companies, foreign oil companies and national oil companies have spent more than $60 billion in calendar 2010 to acquire these types of reserves. This trend is very important for both upstream companies, which will be able to grow reserves at low relative costs, as well as the MLP sector, as development of these new reserves will require substantial amounts of new midstream infrastructure. An energy industry group estimates that up to $210 billion will need to be spent over the next 20 years to build the necessary midstream assets to develop these reserves. We believe this will provide attractive investment opportunities for MLPs and help drive future distribution growth.

 

With the improving global economy, demand for energy grew modestly in 2010 after experiencing significant declines in 2009. Strong demand for crude oil from China and other developing countries, combined with a weakening dollar, led to substantially higher crude oil prices during fiscal 2010 compared to the prior year. Further, with crude oil trading in the $70 to $85/barrel range for most of the year, this can be described as relatively stable considering the historical volatility of commodity prices. We expect that crude oil prices will continue in this range as both supply and demand are both forecasted to increase modestly.

 

Largely as a result of the development of the unconventional natural gas shales, growth in the supply of natural gas has exceeded the recovery in demand for natural gas. Further, there is a growing perception that the natural gas market will be oversupplied for years to come. As a result, we saw natural gas prices decline substantially during the year, from the $5.75 to $6.00/mcf range in late December 2009 to as low as $3.25/mcf in late October 2010. While natural gas prices have recovered since October, most analysts are projecting that natural gas prices will remain closer to $5.00/mcf for the remainder of 2011. We will continue to focus our portfolio on upstream companies that have solid acreage positions in the unconventional plays and avoid companies that have a large weighting in conventional natural gas properties.

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In the coal markets, strong demand in China, Japan and India, as well as higher utilization rates at domestic steel plants, caused prices for metallurgical coal (“met coal”) to surge during the year. The widely followed international benchmark price increased from $129 per metric ton in 2009 to $209 per metric ton for the fourth quarter of 2010. The spot market for met coal has been even more volatile over the last 12 months. Spot prices were more than $250 per metric ton after the tragic explosion at Massey’s Upper Big Branch mine in April 2010 and recently spiked above $300 per metric ton in response to the devastating flooding in the major producing region of Queensland, Australia.

 

In the steam coal market, domestic utilities began calendar 2010 with record-high levels of coal inventories that gradually declined as a result of stronger demand (a very hot summer!) and increased industrial power consumption. Another factor impacting the steam coal market is the decline in production due to much more intense regulatory oversight in the aftermath of the Upper Big Branch incident. The resulting lower productivity and the difficulties obtaining new mining permits have, in our view, decreased the expected future availability of Central App steam coal. As a result, spot steam coal traded in the $60 to $70 per ton range for most of the year, while term contracts for 2011 are reportedly being settled at prices in the $80 per ton range.

 

On a somber note, the energy industry had more than its share of negative headlines during the year. The tragic events surrounding the Macondo oil spill, as well as several pipeline leaks and explosions, served as powerful reminders of the risks inherent in the energy business. The industry takes great pride in its safety track record, and we believe it is committed to learning the right lessons from these events. We anticipate increased regulatory scrutiny in the years to come, but we do not anticipate that this will materially impact operations or cash flows.

 

2010 Performance

 

We are very pleased with our performance during the past fiscal year. From a stock price perspective, the Company’s shares rose 34.6% during the year compared to 33.5% for the Alerian Index and 7.8% for the S&P 500. A better measure of our performance is Net Asset Value Return, which is equal to the change in net asset value per share plus the cash distributions paid during the period, assuming reinvestment through our dividend reinvestment program. Our Net Asset Value Return was 34.3% for fiscal 2010.

 

Another measure of the Company’s performance is Market Return, which is equal to the change in share price plus the cash distributions paid during the period, assuming reinvestment through our dividend reinvestment program. Our Market Return was an impressive 45.8% for fiscal 2010. This reflects the narrowing of the share price discount to Net Asset Value from 18.4% at the beginning of the year to 11.4%.

 

As of November 30, 2010, our portfolio consisted of three main components: public MLPs (32%), traded debt securities (18%), and private MLPs (50%). Our portfolio of public MLPs performed well, increasing approximately 47.5% and outpacing the 42.4% total return on the Alerian MLP index. Our portfolio of traded bank debt and high yield debt also performed well, with a total return of 19.1%. The most significant contributor to our 2010 results was the performance of our private MLP portfolio, which increased 55.3% for the year.

 

We currently have large investments in three private partnerships that operate in the terminal/specialty refining, aggregates and coal sectors. All three of these businesses were hit hard by the recession and credit contraction in 2009 and are in various stages of recovering from the impact of the downturn. During the past year, each of these firms reduced leverage and restructured their senior credit facilities to increase financial flexibility. The best performer among the group was International Resource Partners, which saw a substantial increase in valuation during the year, more than offsetting declines in the valuation of VantaCore Partners and Direct Fuels Partners.

 

International Resources Partners LP (“IRP”) is a fully-integrated coal producer with operations in West Virginia and Kentucky. The Partnership has significant exposure to the high-quality metallurgical coal market, which increased substantially over the course of 2010, largely the result of a global economic recovery and increased global steel production. Strong market conditions, combined with improved operating metrics, resulted in

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EBITDA for the period ending November 2010 that was substantially higher than IRP’s original budget. The Partnership is also increasing its production of steam coal from mining properties acquired in early 2010, and is well positioned to take advantage of recovering demand in the steam coal market as well. With its balanced slate of steam and metallurgical coal and a solid operational track record, we believe IRP is a top tier independent coal producer with opportunities for continued growth. IRP’s management is also considering a number of strategic alternatives which would further enhance its value and may result in a significant liquidity event for us.

 

Direct Fuels Partners, L.P. (“Direct Fuels”) is a leading specialty refiner and fuel terminal operator in the Dallas-Fort Worth area. During fiscal 2010, Direct Fuels continued to sell non-strategic assets, aggressively cut costs and improve operations in response to the severe contraction in the demand for transportation fuels triggered by the recession. Initiatives to increase transmix refining volumes, increase wholesale unit margins and reduce the use of working capital all began to show significant results in the second half of the year. The Partnership was also successful in selling its ethanol terminalling business at an attractive value, which allowed it to reduce debt and enter into a new, more favorable credit agreement. Direct Fuels will continue to evaluate options to monetize other non-strategic assets and reduce debt even further. Looking forward, with continued economic recovery, we expect the domestic demand for transportation fuels to increase and refining margins to expand to more normal levels. As a result, we are cautiously optimistic that Direct Fuels will show improved financial results going forward.

 

VantaCore Partners, LP (“VantaCore”), is an aggregate mining and asphalt company operating in Tennessee and Southern Louisiana that was negatively impacted by the decrease in construction activity during the recession. While we expected 2010 results to improve on a rebound in the housing market and demand from stimulus spending, neither materialized in a meaningful way. The momentum in housing construction faded with the expiration of temporary tax incentives and VantaCore did not see a material increase in demand from new infrastructure projects. As a result, the Partnership’s 2010 results fell short of expectations as very good performance in the Tennessee operations was offset by disappointing volumes and margins in the Louisiana market. The Partnership is very focused on improving performance in Louisiana and has hired a new Chief Operating Officer with considerable industry experience to oversee all operations. From a strategic standpoint, VantaCore welcomed a new equity investor during 2010 and this investor has committed a significant amount of capital to fund growth through acquisitions in what we continue to believe is an attractive business.

 

2010 Key Events

 

A significant event for the Company during the fiscal year was the withdrawal of its election to be treated as a business development company (“BDC”) in July 2010. This change provides us with more discretion in making portfolio allocation decisions and increases our ability to utilize leverage. In particular, the Company will no longer be required to hold a minimum of 70% of its portfolio in “qualifying assets,” which are generally the securities of private domestic companies. As a result of this added flexibility, we believe we are better positioned to meet our investment objective and we continue to target an allocation of 50% to 70% of our portfolio in private MLPs during normal market conditions.

 

In March 2010, we successfully renewed our credit facility. The facility matures in 2013 and gives us flexibility to fund the public portion of our portfolio investments with leverage at very attractive terms. We were very pleased to accomplish this renewal given the troubles certain business development companies had obtaining leverage on acceptable terms. We believe our mix of portfolio investments was a key point of differentiation.

 

With respect to our distribution policy, we were pleased to be able to keep our quarterly distribution constant at $0.30 per share for fiscal 2010. We continue to carefully evaluate our cash distribution policy each quarter, recognizing that a considerable portion of our net distributable income is currently being paid to us in the form of paid-in-kind securities from Direct Fuels. Further, we expect that both Direct Fuels and VantaCore will not pay their full distributions in cash over the next few quarters, resulting in additional paid-in-kind distributions or arrearages on the cash distributions owed to us. Offsetting this is our expectation of a significant liquidity event at IRP in the first half of 2011.

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2011 Outlook

 

In our 2010 Annual Letter, we stated our belief that fiscal 2010 would be a return to “normal.” This was, in fact, an accurate prediction of what happened during the year for the MLP market, and we are starting to see signs of recovery in some of our private businesses as well.

 

We are very pleased with the progress that the MLP sector made since the 2008 financial crisis and are pleased with the MLP sector’s natural progression over the last two years to a more stable operating environment. As we formulate our outlook for 2011, we believe MLP valuations remain attractive. While we do not anticipate a continuation of the strong returns generated during fiscal 2009 and 2010, we do expect low double-digit returns for the sector during fiscal 2011. We expect distribution growth to continue with average distribution growth for the sector in the 5% to 6% range.

 

Distribution growth will be driven largely by organic growth projects and acquisitions. We believe the development of our nation’s unconventional reserves will provide substantial growth opportunities for MLPs. We believe acquisition prospects for MLPs remain good, but we are carefully watching the prices being paid by MLPs (and the resulting acquisition multiples). While recent transactions have been accretive, the acquisition multiples have increased substantially over the last 12 to 18 months.

 

With respect to our private MLPs, we expect that a continued recovery in the domestic economy will benefit each of our portfolio companies as end-user demand for transportation fuels increases, and the residential construction market gradually improves to a more normal level. We are also encouraged that these mid-sized private companies have been able to secure access to credit through new bank lines and have delevered their balance sheets over the past two years. Lastly, increasing M&A activity by public MLPs and a more receptive IPO market increase the monetization alternatives for our portfolio companies.

 

We look forward to continuing to execute on our business plan of achieving high after-tax total returns by investing in public MLPs, private MLPs and energy company debt. We invite you to visit our website at kaynefunds.com for the latest updates.

 

 

Sincerely,

 

 

Kevin S. McCarthy

Chairman of the Board of Directors,

President and Chief Executive Officer

 

 

* As a percentage of total investments.

 

Top 10 Holdings by Issuer

 

 

 

Company Overview

 

We are a non-diversified, closed-end management investment company organized under the laws of the State of Maryland. We are a taxable corporation, paying federal and applicable state taxes on our taxable income. Our operations are externally managed and advised by our investment adviser, KA Fund Advisors, LLC (“KAFA”), pursuant to an investment management agreement. Our investment objective is to generate both current income and capital appreciation primarily through equity and debt investments. We will seek to achieve this objective by investing at least 80% of our total assets in securities of Energy Companies. A key focus area for our investments is equity and debt investments in private and public entities structured as limited partnerships (“MLPs”). We also expect to continue to evaluate equity and debt investments in Upstream, Midstream and Other Energy Companies. “Energy Companies,” “Midstream Energy Companies,” “Upstream Energy Companies” and “Other Energy Companies” are each defined in Note 1 — Organization.

 

Withdrawal of Business Development Company Election

 

At our annual meeting of stockholders on June 30, 2010, our stockholders approved the withdrawal of our election to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). The withdrawal of our BDC election was effective on July 7, 2010.

 

We believe the withdrawal was beneficial for the following reasons: (i) to provide us with more flexibility in meeting our investment objective, (ii) to ensure that we have the ability to obtain sources of leverage on reasonable terms, and (iii) to maintain adequate liquidity to repay a portion of our outstanding leverage in the event of a market downturn. In connection with the withdrawal, our investment management agreement with KAFA was amended to remove the incentive fee paid to KAFA. Additionally, we will no longer be subject to the requirement that 70% of our portfolio must be comprised of “qualifying assets,” which generally include domestic private companies.

 

Our investment objective is unchanged after the withdrawal, but our target mix of portfolio investments was revised as follows. Under normal market conditions, our portfolio investments will be allocated (i) between 50% and 70% in private MLPs, (ii) between 30% and 50% in public MLPs and (iii) between 0% and 20% in debt securities of public and private Energy Companies.

 

Portfolio Activity

 

During the quarter ended November 30, 2010, our investment in International Resource Partners LP (“IRP”) appreciated 18.2% based on very strong performance, expected increases in future performance and recent initial public offerings of comparable MLPs, as well as recent transactions of comparable coal companies that supported the increase in value.

 

During the quarter, we received distributions of $1.3 million on the common and preferred units owned by us from Direct Fuels Partners, L.P. (“Direct Fuels”). In lieu of a cash distribution, Direct Fuels paid such distribution in Class D preferred units. The Class D preferred units are senior to the existing convertible preferred units and pay a quarterly dividend of $0.80 per unit (annual rate of 16%). During November 2010, Direct Fuels entered into a new credit agreement, which allows for the payment of cash distributions on common and preferred equity beginning in late 2011 if certain conditions are met.

 

We do not expect Direct Fuels to pay a cash distribution until third quarter 2011 and then only upon achieving certain performance tests. We expect VantaCore Partners LP (“VantaCore”) to pay a portion of its 2011 distributions in units instead of cash.

 

Results of Operations — For the Three Months Ended November 30, 2010

 

Investment Income.  Investment income totaled $0.5 million and consisted primarily of interest income on our debt investments and net dividends and distributions. We received $2.8 million of cash dividends and

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distributions, of which $3.2 million was treated as a return of capital during the period. Return of capital was increased by $1.0 million attributable to 2009 tax reporting information for our portfolio investments that was received during fiscal 2010. We also received $1.4 million of paid-in-kind dividends, of which $1.3 million was from Direct Fuels. These payment-in-kind dividends are not included in investment income, but are reflected as an unrealized gain.

 

Operating Expenses.  Operating expenses totaled $2.0 million, including $1.2 million of investment management fees, $0.4 million of interest expense, of which $0.1 million was the amortization of debt issuance costs, and $0.4 million of other operating expenses. Investment management fees are calculated based on the average total assets under management.

 

Net Investment Loss.  Our net investment loss totaled $1.0 million and included a deferred income tax benefit of $0.6 million.

 

Net Realized Gains.  We had net realized gains from our investments of $1.1 million, net of $0.6 million of deferred income tax expense.

 

Net Change in Unrealized Gains.  We had net unrealized gains of $17.6 million. The net unrealized gain consisted of $27.9 million of unrealized gains from investments and a deferred income tax expense of $10.3 million. The majority of these gains are attributable to our investment in IRP and our investments in public MLPs. During the quarter, our valuation for IRP appreciated by $13.5 million (an 18% increase).

 

Net Increase in Net Assets Resulting from Operations.  We had an increase in net assets resulting from operations of $17.7 million. This increase is composed of a net investment loss of $1.0 million; net realized gains of $1.1 million; and net unrealized gains of $17.6 million, as noted above.

 

Results of Operations — For the Year Ended November 30, 2010

 

Investment Income.  Investment income totaled $4.7 million and consisted primarily of interest income on our debt investments and net dividends and distributions. We received $10.6 million of cash dividends and distributions, of which $9.5 million was treated as a return of capital during the period. Return of capital was increased by $1.0 million attributable to 2009 tax reporting information for our portfolio investments that was received during fiscal 2010. Cash dividends for 2010 were $5.2 million less than 2009, primarily due to less cash distributions from our investment in Direct Fuels. We also received $5.4 million of paid-in-kind dividends, of which $5.1 million was from Direct Fuels. These payment-in-kind dividends are not included in investment income but are reflected as an unrealized gain.

 

Operating Expenses.  Operating expenses totaled $7.5 million, including $4.0 million of investment management fees, $1.7 million of interest expense, of which $0.5 million was the amortization of debt issuance costs, and $1.8 million of other operating expenses. Investment management fees are calculated based on the average total assets under management. Operating expenses for 2010 were $0.9 million higher than 2009, which was the result of increased management fees partially offset by less professional fees.

 

Net Investment Loss.  Our net investment loss totaled $1.8 million and included a deferred income tax benefit of $1.0 million.

 

Net Realized Gains.  We had net realized gains from our investments of $7.6 million, net of $4.4 million of deferred income tax expense.

 

Net Change in Unrealized Gains.  We had net unrealized gains of $47.4 million. The net unrealized gain consisted of $74.8 million of unrealized gains from investments and a deferred income tax expense of $27.4 million. The majority of these gains are attributable to our investment in IRP and our investments in public MLPs. During the fiscal year, our valuation for IRP appreciated by $53.5 million (a 154% increase) based on continued strong performance and increases in valuations for comparable coal companies.

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Net Increase in Net Assets Resulting from Operations.  We had an increase in net assets resulting from operations of $53.2 million. This increase is composed of a net investment loss of $1.8 million; net realized gains of $7.6 million; and net unrealized gains of $47.4 million, as noted above.

 

Distributions to Common Stockholders

 

We pay quarterly distributions to our common stockholders, funded in part by net distributable income (“NDI”) generated from our portfolio investments. Prior to our fourth quarter of 2011, we referred to NDI as “distributable cash flow” or “DCF.” The calculations of NDI and DCF are the same. NDI is the amount of income received by us from our portfolio investments less operating expenses, subject to certain adjustments as described below. NDI is not a financial measure under the accounting principles generally accepted in the United States of America (“GAAP”). Refer to the “Reconciliation of NDI to GAAP” section below for a reconciliation of this measure to our results reported under GAAP.

 

Income from portfolio investments includes (a) cash distributions paid by MLPs, (b) paid-in-kind dividends received from MLPs and MLP Affiliates and (c) interest income from debt securities.

 

Operating expenses include (a) management fees paid to KAFA, (b) other expenses (mostly attributable to fees paid to other service providers) and (c) leverage costs, including interest expense.

 

Net Distributable Income (NDI)
(amounts in millions, except for per share amounts)

 

 

Payment of future distributions is subject to board of directors approval, as well as meeting the covenants of our credit facility. In determining our quarterly distribution to common stockholders, our Board of Directors considers a number of factors which include, but are not limited to:

 

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On January 19, 2011, we declared our quarterly distribution of $0.30 per common share for the period September 1, 2010 through November 30, 2010 for a total of $3.1 million. A substantial portion of our quarterly distribution of $0.30 per common share was attributable to the PIK distribution that we received from Direct Fuels. Offsetting this, is our current expectation of a significant liquidity event at IRP during the first half of 2011. The distribution is payable on February 4, 2011 to stockholders of record on January 31, 2011. During the year ended November 30, 2010, we paid distributions totaling $12.2 million, or $1.20 per common share.

 

The component of our distribution that is from our current or accumulated earnings and profits will be taxable to a stockholder as dividend income. Currently, this income will be treated as qualified dividends for Federal income tax purposes at a rate of 15%. Distributions that exceed our current or accumulated earnings and profits will be treated as a tax-deferred return of capital to the extent of a stockholder’s basis. During fiscal 2010, approximately 58% of the distributions paid were treated as a return of capital for tax purposes.

 

Reconciliation of NDI to GAAP

 

The difference between distributions and other income from investments in the NDI calculation and total investment income as reported in our Statement of Operations is reconciled as follows:

 

 

The treatment of expenses included in NDI also differs from what is reported in the Statement of Operations as follows:

 

 

Liquidity and Capital Resources

 

As of November 30, 2010, we had approximately $2.1 million in short-term investments, which consisted of money market funds and repurchase agreements. Our repurchase agreements are collateralized by U.S. Treasury securities, and our counterparty is J.P. Morgan Securities Inc.

 

Our senior secured revolving credit facility (the “Credit Facility”) has a $70 million commitment and a three year term (maturing on March 30, 2013). Outstanding loan balances under the Credit Facility accrue interest at an

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annual rate equal to LIBOR plus 2.00% based on the current borrowings and the current borrowing base. If borrowings exceed the borrowing base attributable to “quoted” securities (generally defined as equity investments in public MLPs and investments in bank debt and high yield bonds that are traded), the interest rate will increase to LIBOR plus 3.00%. We pay a commitment fee of 0.50% per annum on any unused amounts of the Credit Facility.

 

Our borrowing base, subject to certain limitations, is generally calculated by multiplying the fair value of each of our investments by an advance rate. The total contribution to our borrowing base from private MLPs is limited to no more than 25% of the total borrowing base, and there is a $7 million limit of borrowing base contribution from any single issuer.

 

As of November 30, 2010, we had $57.0 million of borrowings under our Credit Facility (at an interest rate of 2.26%), which represented 66.4% of our borrowing base of $85.8 million (76.7% of our borrowing base of $74.3 million attributable to quoted securities). As of January 27, 2010, we had $61.0 million of borrowings under our Credit Facility (at an interest rate of 2.27%), which represented 71.5% of our borrowing base of $85.3 million (81.2% of our borrowing base of $75.1 million attributable to quoted securities). The maximum amount that we can borrow under our Credit Facility is limited to the lesser of our commitment amount of $70.0 million and our borrowing base.

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
SCHEDULE OF INVESTMENTS
AS OF NOVEMBER 30, 2010
(amounts in 000’s)

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
SCHEDULE OF INVESTMENTS
AS OF NOVEMBER 30, 2010
(amounts in 000’s)

 

 

 

 

See accompanying notes to financial statements.

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
SCHEDULE OF INVESTMENTS
AS OF NOVEMBER 30, 2009
(amounts in 000’s)

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
SCHEDULE OF INVESTMENTS
AS OF NOVEMBER 30, 2009
(amounts in 000’s)

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
STATEMENT OF ASSETS AND LIABILITIES
(amounts in 000’s, except share and per share amounts)

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
STATEMENT OF OPERATIONS
(amounts in 000’s)

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
STATEMENT OF CHANGES IN NET ASSETS
(amounts in 000’s, except share amounts)

 

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
STATEMENT OF CASH FLOWS
(amounts in 000’s)

 

 

 

Supplemental disclosure of cash flow information:

 

Non-cash financing activities not included herein consist of reinvestment of distributions pursuant to the Company’s dividend reinvestment plan of $1,532 and $766 for the fiscal years ended November 30, 2010 and 2009, respectively.

 

During the fiscal years ended November 30, 2010 and 2009, there were no state income taxes paid and interest paid was $1,134 and $1,571, respectively.

 

During the fiscal years ended November 30, 2010 and 2009, the Company received $5,360 and $242, respectively, of paid-in-kind dividends and distributions. See Note 2 — Significant Accounting Policies.

 

 

See accompanying notes to financial statements.

 

 

See accompanying notes to financial statements.

 

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
FINANCIAL HIGHLIGHTS
(amounts in 000’s, except share and per share amounts)

 

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
NOTES TO FINANCIAL STATEMENTS
NOVEMBER 30, 2010
(amounts in 000’s, except share and per share amounts)

 

 

Kayne Anderson Energy Development Company (the “Company”) was organized as a Maryland corporation on May 24, 2006. The Company is an externally managed, non-diversified closed-end management investment company. The Company commenced investment operations on September 21, 2006. The Company’s shares of common stock are listed on the New York Stock Exchange (“NYSE”) under the symbol “KED.” Prior to November 30, 2007, the Company was treated as a regulated investment company (“RIC”) under the U.S. Internal Revenue Code of 1986, as amended (the “Code”). Since December 1, 2007, the Company has been taxed as a corporation. See Note 4 — Income Taxes.

 

From inception through July 6, 2010, the Company had elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). On June 30, 2010, the Company’s stockholders approved the withdrawal of its election to be treated as a BDC under the 1940 Act, and on July 7, 2010, the Company filed the withdrawal with the SEC, which was effective upon receipt. The Company is also no longer subject to the requirement that 70% of its portfolio must be comprised of “qualifying assets,” which generally include domestic private companies.

 

The Company’s investment objective is to generate both current income and capital appreciation primarily through equity and debt investments. The Company seeks to achieve this objective by investing at least 80% of its total assets in securities of companies that derive the majority of their revenue from activities in the energy industry (“Energy Companies”), including: (a) Midstream Energy Companies, which are businesses that operate assets used to gather, transport, process, treat, terminal and store natural gas, natural gas liquids, propane, crude oil or refined petroleum products; (b) Upstream Energy Companies, which are businesses engaged in the exploration, extraction and production of natural resources, including natural gas, natural gas liquids and crude oil, from onshore and offshore geological reservoirs; and (c) Other Energy Companies, which are businesses engaged in owning, leasing, managing, producing, processing and selling of coal and coal reserves; the marine transportation of crude oil, refined petroleum products, liquefied natural gas, as well as other energy-related natural resources using tank vessels and bulk carriers; and refining, marketing and distributing refined energy products, such as motor gasoline and propane, to retail customers and industrial end-users.

 

 

A. Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ materially from those estimates.

 

B. Cash and Cash Equivalents — Cash and cash equivalents include short-term, liquid investments with an original maturity of three months or less and include money market fund accounts and repurchase agreements.

 

C. Calculation of Net Asset Value — The Company determines its net asset value as of the close of regular session trading on the NYSE no less frequently than the last business day of each quarter. Net asset value is computed by dividing the value of the Company’s assets (including accrued interest and distributions), less all of its liabilities (including accrued expenses, distributions payable and any borrowings) by the total number of common shares outstanding.

 

D. Investment Valuation — Readily marketable portfolio securities listed on any exchange other than the NASDAQ Stock Market, Inc. (“NASDAQ”) are valued, except as indicated below, at the last sale price on the business day as of which such value is being determined. If there has been no sale on such day, the securities are valued at the mean of the most recent bid and ask prices on such day. Securities admitted to trade on the NASDAQ

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
NOTES TO FINANCIAL STATEMENTS
(amounts in 000’s, except share and per share amounts)

 

are valued at the NASDAQ official closing price. Portfolio securities traded on more than one securities exchange are valued at the last sale price on the business day as of which such value is being determined at the close of the exchange representing the principal market for such securities.

 

Equity securities traded in the over-the-counter market, but excluding securities admitted to trading on the NASDAQ, are valued at the closing bid prices. Debt securities that are considered bonds are valued by using the mean of the bid and ask prices provided by an independent pricing service. For debt securities that are considered bank loans, the fair market value is determined by using the mean of the bid and ask prices provided by the syndicate bank or principal market maker. When price quotes are not available, fair market value will be based on prices of comparable securities. In certain cases, the Company may not be able to purchase or sell debt securities at the quoted prices due to the lack of liquidity for these securities.

 

Exchange-traded options and futures contracts are valued at the last sale price at the close of trading in the market where such contracts are principally traded or, if there was no sale on the applicable exchange on such day, at the mean between the quoted bid and ask price as of the close of trading on such exchange.

 

The Company’s portfolio includes securities that are privately issued or illiquid. For these securities, as well as any other portfolio security held by the Company for which reliable market quotations are not readily available, valuations are determined in good faith by the Board of Directors of the Company under a valuation policy and a consistently applied valuation process. Unless otherwise determined by the Board of Directors, the following valuation process, approved by the Board of Directors, is used for such securities:

 

 

During the course of such valuation process, whenever possible, privately-issued equity and debt investments are valued using comparisons of valuation ratios of the portfolio companies that issued such equity and debt securities to any peer companies that are publicly traded. The value derived from this analysis is then discounted to reflect the illiquid nature of the investment. The Company also utilizes comparative information such as acquisition transactions, public offerings or subsequent equity sales to corroborate its valuations. Due to the inherent

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
NOTES TO FINANCIAL STATEMENTS
(amounts in 000’s, except share and per share amounts)

 

uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments in privately-issued securities may differ significantly from the values that would have been used had a ready market existed for such investments, and the differences could be material.

 

Factors that the Company may take into account in fair value pricing its investments include, as relevant, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business, comparison to publicly traded securities, the nature and realizable value of any collateral and other relevant factors.

 

Unless otherwise determined by the Board of Directors, securities that are convertible into or otherwise will become publicly traded (e.g., through subsequent registration or expiration of a restriction on trading) will be valued through the process described above, using a valuation based on the market value of the publicly traded security less a discount. The discount will initially be equal in amount to the discount negotiated at the time of purchase. To the extent that such securities are convertible or otherwise become publicly traded within a time frame that may be reasonably determined, KAFA will determine an applicable discount in accordance with a methodology approved by the Valuation Committee.

 

At November 30, 2010, the Company held 68.1% of its net assets applicable to common stockholders (51.2% of total assets) in securities that were fair valued pursuant to the procedures adopted by the Board of Directors. The aggregate fair value of these securities at November 30, 2010 was $143,811. See Note 9 — Restricted Securities.

 

At November 30, 2009, the Company held 58.9% of its net assets applicable to common stockholders (43.9% of total assets) in securities that were fair valued pursuant to the procedures adopted by the Board of Directors. The aggregate fair value of these securities at November 30, 2009 was $99,192. See Note 9 — Restricted Securities.

 

E. Repurchase Agreements — The Company has agreed to purchase securities from financial institutions subject to the seller’s agreement to repurchase them at an agreed-upon time and price (“repurchase agreements”). The financial institutions with whom the Company enters into repurchase agreements are banks and broker/dealers which KAFA considers creditworthy. The seller under a repurchase agreement is required to maintain the value of the securities as collateral, subject to the agreement, at not less than the repurchase price plus accrued interest. KAFA monitors daily the mark-to-market of the value of the collateral, and, if necessary, requires the seller to maintain additional securities, so that the value of the collateral is not less than the repurchase price. Default by or bankruptcy of the seller would, however, expose the Company to possible loss because of adverse market action or delays in connection with the disposition of the underlying securities.

 

F. Security Transactions — Security transactions are accounted for on the date the securities are purchased or sold (trade date). Realized gains and losses are reported on an identified cost basis.

 

G. Derivative Financial Instruments — The Company may utilize derivative financial instruments in its operations.

 

Interest rate swap contracts.  The Company may use interest rate swap contracts to hedge against increasing interest expense on its leverage resulting from increases in short term interest rates. The Company does not hedge any interest rate risk associated with portfolio holdings. Interest rate transactions the Company may use for hedging purposes may expose it to certain risks that differ from the risks associated with its portfolio holdings. A decline in interest rates may result in a decline in the value of the swap contracts, which, everything else being held constant, would result in a decline in the net assets of the Company. In addition, if the counterparty to an interest rate swap or cap defaults, the Company would not be able to use the anticipated net receipts under the interest rate swap or cap to offset its cost of financial leverage.

 

Interest rate swap contracts are recorded at fair value with changes in value during the reporting period, and amounts accrued under the agreements, included as unrealized gains or losses in the Statement of Operations. Monthly cash settlements under the terms of interest rate swap agreements are recorded as realized gains or losses in

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
NOTES TO FINANCIAL STATEMENTS
(amounts in 000’s, except share and per share amounts)

 

the Statement of Operations. The Company generally values interest rate swap contracts based on dealer quotations, if available, or by discounting the future cash flows from the stated terms of the interest rate swap agreement by using interest rates currently available in the market.

 

Option contracts.  The Company is exposed to financial market risks including changes in the valuations of its investment portfolio. The Company may purchase or write (sell) call options. A call option on a security is a contract that gives the holder of the option, in return for a premium, the right to buy from the writer of the option the security underlying the option at a specified exercise price at any time during the term of the option.

 

The Company would normally purchase call options in anticipation of an increase in the market value of securities of the type in which it may invest. The Company would ordinarily realize a gain on a purchased call option if, during the option period, the value of such securities exceeded the sum of the exercise price, the premium paid and transaction costs; otherwise the Company would realize either no gain or a loss on the purchased call option. The Company may also purchase put option contracts. If a purchased put option is exercised, the premium paid increases the cost basis of the securities sold by the Company.

 

The Company may also write (sell) call options with the purpose of generating income or reducing its ownership of certain securities. 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.

 

When the Company writes a call option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on the expiration date as realized gains from investments. If the Company repurchases a written call option prior to its exercise, the difference between the premium received and the amount paid to repurchase the option is treated as a realized gain or loss. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security in determining whether the Company has realized a gain or loss. The Company, as the writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option.

 

H. Return of Capital Estimates — Distributions received from the Company’s investments in public and private master limited partnerships (“MLPs”) generally are comprised of income and return of capital. The Company records investment income and return of capital based on estimates made at the time such distributions are received. Such estimates are based on historical information available from MLPs and other industry sources. These estimates may subsequently be revised based on information received from MLPs after their tax reporting periods are concluded.

 

The following table sets forth the Company’s estimated return of capital for distributions received from its public and private MLPs, both as a percentage of total distributions and in thousands of dollars. The return of capital portion of the distributions is a reduction to investment income, results in an equivalent reduction in the cost basis of the associated investments and increases Net Realized Gains and Net Change in Unrealized Gains in each of the comparative periods.

 

 

For the fiscal year ended November 30, 2010, the Company estimated the return of capital portion of distributions received to be $8,522 or 80%. This amount was increased by $995 attributable to 2009 tax reporting

KAYNE ANDERSON ENERGY DEVELOPMENT COMPANY
NOTES TO FINANCIAL STATEMENTS
(amounts in 000’s, except share and per share amounts)

 

information received by the Company in fiscal 2010. The tax reporting information was used to adjust the Company’s prior year return of capital estimate. As a result, the return of capital percentage for the year ended November 30, 2010 was 90%.

 

For the fiscal year ended November 30, 2009, the Company estimated the return of capital portion of distributions received to be $13,009 or 82%. This amount was reduced by $2,289 attributable to 2008 tax reporting information received by the Company in fiscal 2009. The tax reporting information was used to adjust the Company’s prior year return of capital estimate. As a result, the return of capital percentage for the year ended November 30, 2009 was 68%.

 

I. Investment Income — The Company records dividends and distributions on the ex-dividend date. Interest income is recognized on the accrual basis, including amortization of premiums and accretion of discounts to the extent that such amounts are expected to be collected. When investing in securities with payment in-kind interest, the Company will accrue interest income during the life of the security even though it will not be receiving cash as the interest is accrued. To the extent that interest income to be received is not expected to be realized, a reserve against income is established. During the years ended November 30, 2010 and 2009, the Company did not have a reserve against interest income, since all interest income accrued is expected to be received.

 

Many of the Company’s debt securities were purchased at a discount or premium to the par value of the security. The non-cash accretion of a discount to par value increases interest income while the non-cash amortization of a premium to par value decreases interest income. The amount of these non-cash adjustments can be found in the Company’s Statement of Cash Flows. The non-cash accretion of a discount increases the cost basis of the debt security, which results in an offsetting unrealized loss. The non-cash amortization of a premium decreases the cost basis of the debt security which results in an offsetting unrealized gain. To the extent that par value is not expected to be realized, the Company discontinues accruing the non-cash accretion of the discount to par value of the debt security.

 

During the year ended November 30, 2010, the Company recognized no interest income related to its investment in ProPetro Services, Inc. (“ProPetro”). Beginning December 1, 2009, the Company discontinued the non-cash accretion of the discount to par value of the debt security based on its expectation that it will not realize par value on its investment.

 

During the year ended November 30, 2009, the Company recognized interest income of $770 related to its debt investment in ProPetro. This interest income was the result of the non-cash accretion of the discount to par value of this debt security. The Company also recognized an equal and offsetting unrealized loss related to the original discount on the Company’s investment in ProPetro.

 

The Company receives paid-in-kind dividends in the form of additional units from its investments in Direct Fuels Partners, L.P., Enbridge Energy Management, L.L.C. and Kinder Morgan Management, LLC. The additional units are not reflected in investment income during the period received but are recorded as unrealized gains upon receipt. During each of the fiscal periods set forth below, the Company received the following stock dividends in total from Direct Fuels Partners, L.P., Enbridge Energy Management, L.L.C. and Kinder Morgan Management, LLC.