HCD Highland Distressed Opportunities, Inc.

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2009

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period                      to                     

Commission file number: 814-00729

Highland Distressed Opportunities, Inc.

(Exact Name of Registrant as Specified in Charter)

Delaware		205423854
(State or Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

NexBank Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Address of Principal Executive Offices)
(877) 247-1888
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods as the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ       No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o		Accelerated Filer þ		Non-Accelerated Filer o (Do not check if a smaller reporting company)		Smaller reporting company o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

On April 21, 2009, there were 17,716,771 shares outstanding of the Registrant’s common stock, $0.001 par value per share.

 

 

Highland Distressed Opportunities, Inc.

Table of Contents

		Page
PART I Financial Information
Item 1. Financial Statements			3
Schedule of Investments—As of March 31, 2009 (unaudited) and December 31, 2008			3
Statement of Assets and Liabilities—As of March 31, 2009 (unaudited) and December 31, 2008			10
Statement of Operations—For the three months ended March 31, 2009 (unaudited) and March 31, 2008 (unaudited)			11
Statement of Changes in Stockholders’ Equity (Net Assets)—For the three months ended March 31, 2009 (unaudited) and March 31, 2008 (unaudited)			12
Statement of Cash Flows—For the three months ended March 31, 2009 (unaudited) and March 31, 2008 (unaudited)			13
Notes to Financial Statements (unaudited)			14
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			29
Item 3. Quantitative and Qualitative Disclosures About Market Risk			34
Item 4. Controls and Procedures			35
PART II Other Information
Item 1. Legal Proceedings			36
Item 1A. Risk Factors			36
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			36
Item 3. Defaults Upon Senior Securities			36
Item 4. Submission of Matters to a Vote of Security Holders			36
Item 5. Other Information			36
Item 6. Exhibits			37
Signatures			38
EX-10.16
EX-31.1
EX-31.2
EX-32.1

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Schedule of Investments

As of March 31, 2009 (unaudited)		Highland Distressed Opportunities, Inc.

		Principal ($)				Cost ($)				Value ($)
Senior Loans (a) — 37.3%
BROADCASTING — 17.2%
Comcorp Broadcasting, Inc.
Revolving Loan, 7.75%, 10/03/12 (b) (c)			1,884,953				1,884,953				855,391
Term Loan, 7.75%, 04/03/13 (b) (c)			18,849,521				18,546,505				8,553,913
							20,431,458				9,409,304
FOREST PRODUCTS/CONTAINERS — 0.3%
Tegrant Corp.
Second Lien Term Loan, 6.72%, 03/08/15			1,000,000				1,000,000				150,000
GAMING/LEISURE — 13.8%
Fontainebleu Florida Hotel, LLC
Tranche C Term Loan, 7.33%, 06/06/12			6,000,000				6,000,000				4,500,000
Lake at Las Vegas Joint Venture/ LLV-1,LLC
Revolving Loan Credit-Linked Deposit Account, 14.35%, 06/20/12 (d)			3,611,111				3,611,111				347,570
Term Loan, 14.35%, 06/20/12, PIK (d)			35,076,245				28,269,771				2,720,966
							37,880,882				7,568,536
HOUSING — 2.2%
MetroFlag BP, LLC / MetroFlag Cable, LLC
Second Lien Term Loan, 12.00% (d)			5,000,000				5,000,000				375,000
MPH Mezzanine II, LLC
Mezzanine 2B, 7.48% (b) (d)			10,000,000				10,000,000				—
MPH Mezzanine III, LLC
Mezzanine 3, 8.48% (b) (d)			4,000,000				4,000,000				—
Pacific Clarion, LLC
Term Loan, 15.00% (b) (d) (e)			4,950,573				4,939,006				822,785
							23,939,006				1,197,785

See accompanying Notes to Financial Statements.

Schedule of Investments
As of March 31, 2009 (unaudited) (continued)		Highland Distressed Opportunities, Inc.

		Principal ($)				Cost ($)				Value ($)
Senior Loans (continued)
SERVICE — 3.7%
Penhall Holding Co.
Term Loan, 10.00%, 04/01/12			5,797,571				5,742,869				2,029,150
TRANSPORTATION — AUTOMOTIVE — 0.1%
BST Safety Textiles Acquisition GmbH
Second Lien Facility, 16.53%, 06/30/09, PIK (d)			682,415				682,707				44,357
Total Senior Loans							89,676,922				20,399,132
Corporate Notes and Bonds (f) — 32.8%
DIVERSIFIED MEDIA — 3.7%
Baker & Taylor, Inc.
11.50%, 07/01/13			8,300,000				8,746,939				2,033,500
HEALTHCARE — 29.1%
Argatroban Royalty Sub, LLC
18.50%, 09/21/14			3,306,706				3,306,706				2,976,035
Azithromycin Royalty Sub, LLC
16.00%, 05/15/19			5,000,000				4,973,191				4,400,000
Celtic Pharma Phinco B.V.
17.00%, 06/15/12, PIK			10,561,138				10,154,927				6,864,740
Cinacalcet Royalty Sub, LLC
15.50%, 03/30/17, PIK			1,079,002				1,064,448				701,351
Molecular Insight Pharmaceuticals, Inc.
11.19%, 11/01/12, PIK (g)			1,056,993				1,054,148				930,154
							20,553,420				15,872,280
Total Corporate Notes and Bonds							29,300,359				17,905,780
Claims (h) — 0.0%
AEROSPACE — 0.0%
Northwest Airlines, Inc.
ALPA Trade Claim			3,000,000				428,371				2,430
Bell Atlantic Trade Claim			2,500,000				431,553				2,025
EDC Trade Claims			2,500,000				444,852				2,025
Flight Attendant Claim			5,326,500				734,164				4,314
GE Trade Claim			1,500,000				273,682				1,215
IAM Trade Claim			4,728,134				724,198				3,830
Pinnacle Trade Claim			8,433,116				1,520,621				6,831
Retiree Claim			3,512,250				484,102				2,845
Total Claims							5,041,543				25,515

See accompanying Notes to Financial Statements.

Schedule of Investments
As of March 31, 2009 (unaudited) (continued)		Highland Distressed Opportunities, Inc.

		Shares				Cost ($)				Value ($)
Common Stocks (h) — 28.1%
AEROSPACE — 0.1%
Delta Air Lines, Inc.			8,974				85,086				50,523
BROADCASTING — 0.0%
Communications Corp. of America (b) (c)			1,256,635				7,187,203				—
HEALTHCARE — 27.9%
Genesys Ventures IA, LP (b) (c)			12,000,000				12,000,000				15,240,000
WIRELESS COMMUNICATIONS — 0.1%
ICO Global Communications			138,632				500,000				48,521
Total Common Stocks							19,772,289				15,339,044
Total Investments (i) — 98.2%							143,791,113				53,669,471
Other Assets & Liabilities, Net — 1.8%											974,541
Net Assets — 100.0%											54,644,012

See accompanying Notes to Financial Statements.

Schedule of Investments

As of December 31, 2008		Highland Distressed Opportunities, Inc.

		Principal ($)				Cost ($)				Value ($)
Senior Loans (a) — 56.8%
BROADCASTING — 16.0%
Comcorp Broadcasting, Inc.
Revolving Loan, 7.52%, 04/03/13 (b) (c) (d)			1,825,953				1,825,953				843,134
Term Loan, 7.75%, 04/03/13 (c) (d)			18,849,521				18,525,278				8,835,713
							20,351,231				9,678,847
CONSUMER NON-DURABLES — 1.7%
Totes Isotoner Corp. Second Lien Term Loan, 9.88%, 01/31/14			3,377,228				3,400,514				1,013,169
DIVERSIFIED MEDIA — 0.7%
Penton Media, Inc. Second Lien Term Loan, 8.42%, 02/01/14			2,000,000				2,035,654				425,000
FINANCIAL — 9.4%
Emerson Reinsurance Ltd. Tranche C Term Loan, 7.25%, 12/15/11			1,500,000				1,495,043				1,297,500
Flatiron Re Ltd.
Closing Date Term Loan, 5.71%, 12/29/10			25,529				25,704				24,796
Delayed Draw Term Loan, 5.71%, 12/29/10			12,366				12,451				12,011
Kepler Holdings Ltd. Term Loan, 7.00%, 06/30/09			5,000,000				5,006,959				4,400,000
							6,540,157				5,734,307
FOREST PRODUCTS/CONTAINERS — 0.2%
Tegrant Corp. Second Lien Term Loan, 6.96%, 03/08/15			1,000,000				1,000,000				103,340
GAMING/LEISURE — 12.4%
Fontainebleu Florida Hotel, LLC Tranche C Term Loan, 8.00%, 06/06/12			6,000,000				6,000,000				5,100,000
Lake at Las Vegas Joint Venture/ LLV-1,LLC
Revolving Loan Credit-Linked Deposit, 14.35%, 06/20/12 (e)			3,611,111				3,611,111				273,831
Term Loan, 14.35%, 06/20/12 PIK (e)			33,756,283				28,269,771				2,143,697
							37,880,882				7,517,528
HEALTHCARE — 3.1%
Life Technologies Corp. Term B Facility, 09/30/15 (f)			1,995,000				1,955,100				1,881,963

See accompanying Notes to Financial Statements.

Schedule of Investments

As of December 31, 2008 (continued)		Highland Distressed Opportunities, Inc.

		Principal ($)				Cost ($)				Value ($)
Senior Loans (continued)
HOUSING — 2.0%
MetroFlag BP, LLC / MetroFlag Cable, LLC Second Lien Term Loan, 12.00%, 01/06/09			5,000,000				5,000,000				375,000
MPH Mezzanine II, LLC Mezzanine 2B, 7.48%, 02/09/08 (d) (e)			10,000,000				10,000,000				—
MPH Mezzanine III, LLC Mezzanine 3, 8.48%, 02/09/08 (d) (e)			4,000,000				4,000,000				—
Pacific Clarion, LLC Term Loan, 15.00%, 01/23/09 (d) (e) (g)			4,950,573				4,945,680				841,053
							23,945,680				1,216,053
SERVICE — 11.1%
LVI Services, Inc. Tranche B Term Loan, 6.49%, 11/16/11			9,377,348				9,317,890				4,102,590
Penhall Holding Co. Term Loan, 12.29%, 04/01/12 PIK			5,821,220				5,762,042				2,619,549
							15,079,932				6,722,139
TRANSPORTATION — AUTOMOTIVE — 0.2%
BST Safety Textiles Acquisition GmbH Second Lien Facility, 14.60%, 06/30/09			673,957				674,415				117,943
Total Senior Loans							112,863,565				34,410,289
Corporate Notes and Bonds (h) — 33.4%
DIVERSIFIED MEDIA — 5.8%
Baker & Taylor, Inc. 11.50%, 07/01/13			8,300,000				8,749,446				3,537,875
HEALTHCARE — 27.6%
Argatroban Royalty Sub, LLC 18.50%, 09/21/14			3,306,706				3,306,706				2,942,968
Azithromycin Royalty Sub, LLC 16.00%, 05/15/19			5,000,000				4,974,238				4,350,000
Celtic Pharma Phinco B.V. 17.00%, 06/15/12 PIK			10,561,138				10,132,572				7,815,242
Cinacalcet Royalty Sub, LLC 15.50%, 03/30/17 PIK			1,038,750				1,023,972				768,675
Molecular Insight Pharmaceuticals, Inc. 10.80%, 11/01/12 (i)			1,027,602				1,026,832				822,081
							20,464,320				16,698,966
Total Corporate Notes and Bonds							29,213,766				20,236,841

See accompanying Notes to Financial Statements .

Schedule of Investments

As of December 31, 2008 (continued)		Highland Distressed Opportunities, Inc.

		Principal ($)				Cost ($)				Value ($)
Claims (j) — 0.1%
AEROSPACE — 0.1%
Northwest Airlines, Inc.
ALPA Trade Claim, 08/21/13			3,000,000				431,377				5,640
Bell Atlantic Trade Claim, 08/21/13			2,500,000				434,058				4,700
EDC Trade Claims, 08/21/13			2,500,000				447,357				4,700
Flight Attendant Claim, 08/21/13			5,326,500				739,501				10,014
GE Trade Claim, 08/21/13			1,500,000				275,185				2,820
IAM Trade Claim, 08/21/13			4,728,134				728,935				8,889
Pinnacle Trade Claim, 08/21/13			8,433,116				1,529,071				15,854
Retiree Claim, 08/21/13			3,512,250				487,621				6,603
Total Claims							5,073,105				59,220

See accompanying Notes to Financial Statements .

Schedule of Investments

As of December 31, 2008 (continued)		Highland Distressed Opportunities, Inc.

		Shares				Cost ($)				Value ($)
Common Stock (j) — 29.6%
AEROSPACE — 0.6%
Delta Air Lines, Inc.			30,433				215,657				348,762
BROADCASTING — 0.0%
Communications Corp. of America (c) (d)			1,256,635				7,187,203				—
HEALTHCARE — 28.7%
Genesys Ventures IA, LP (c) (d)			12,000,000				12,000,000				17,412,000
WIRELESS COMMUNICATIONS — 0.3%
ICO Global Communications			138,632				500,000				153,882
Total Common Stocks							19,902,860				17,914,644
Total Investments (k) — 119.9%							167,053,296				72,620,994
Other Assets & Liabilities, Net — (19.9)%											(12,064,566	)
Net Assets — 100.0%											60,556,428

 

PIK   Payment-in-Kind. All or a portion of the stated interest rate may be PIK interest.

See accompanying Notes to Financial Statements .

Statement of Assets and Liabilities

Highland Distressed Opportunities, Inc.

		As of
		March 31, 2009				As of
		(unaudited)				December 31, 2008
		($)				($)
Assets:
Investments in:
Unaffiliated issuers, at value (cost $104,172,452 and $127,514,862, respectively)			29,020,167				45,530,147
Affiliated issuers, at value (cost $39,618,661 and $39,538,434, respectively)			24,649,304				27,090,847
Total investments, at value (cost $143,791,113 and $167,053,296, respectively)			53,669,471				72,620,994
Cash and cash equivalents			2,488,838				—
Foreign currency (cost $10,519 and $10, respectively)			10,245				10
Receivable for:
Investments sold			3,741,270				12,106,871
Dividend and interest			1,992,008				2,337,202
Other assets			9,888				96,923
Total assets			61,911,720				87,162,000
Liabilities:
Due to Custodian			—				122,505
Notes payable (Note 4)			6,500,000				15,500,000
Net discount and unrealized depreciation on unfunded transactions			—				31,756
Payables for:
Investments purchased			—				9,809,787
Investment advisory fee (Note 3)			339,336				627,965
Administration fee (Note 3)			59,384				109,894
Interest expense (Note 4)			78,622				112,469
Directors’ fees (Note 3)			9,138				5,100
Accrued expenses and other liabilities			281,228				286,096
Total liabilities			7,267,708				26,605,572
Stockholders’ equity (net assets)			54,644,012				60,556,428
Composition of stockholders’ equity (net assets):
Common Stock, par value $.001 per share: 550,000,000 common stock authorized, 17,716,771 common stock outstanding			17,717				17,717
Paid-in capital			253,018,580				253,018,580
Undistributed net investment income			1,160,446				1,067,487
Accumulated net realized gain/(loss) on investments, total return swaps and foreign currency transactions			(109,430,815	)			(99,083,521	)
Net unrealized appreciation/(depreciation) on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency			(90,121,916	)			(94,463,835	)
Stockholders’ equity (net assets)			54,644,012				60,556,428
Net Asset Value Per Share (Net Assets/Common Stock Outstanding)			3.08				3.42

See accompanying Notes to Financial Statements .

Statement of Operations

Highland Distressed Opportunities, Inc.

		For the Quarters Ended
		March 31, 2009				March 31, 2008
		(unaudited)				(unaudited)
		($)				($)
Investment Income:
Unaffiliated interest income			982,077				7,387,171
Affiliated interest income (Note 7)			399,081				464,884
Unaffiliated dividends (net of foreign taxes withheld)			—				40,685
Total investment income			1,381,158				7,892,740
Expenses:
Investment advisory fees (Note 3)			339,336				1,484,400
Incentive fees (Note 3)			—				870,369
Administration fees (Note 3)			59,384				259,770
Accounting service fees			38,303				37,288
Transfer agent fees			8,860				7,583
Legal fees			156,685				62,158
Audit and Tax fees			21,000				31,701
Directors’ fees (Note 3)			8,972				6,915
Custody fees			6,539				11,073
Registration fees			23,699				6,041
Reports to stockholders			11,559				3,804
Franchise tax expense			4,316				14,918
Rating agency fees			37,952				20,749
Interest expense (Note 4)			261,928				1,434,603
Reorganization expense (Note 12)			69,705				—
Other expense			239,961				159,893
Net expenses			1,288,199				4,411,265
Net investment income			92,959				3,481,475
Net Realized and Unrealized Gain/(Loss) on Investments:
Net realized gain/(loss) on investments			(10,347,294	)			(12,488,132	)
Net realized gain/(loss) on foreign currency transactions			—				33
Net change in unrealized appreciation/(depreciation) on investments			4,310,660				(22,002,712	)
Net change in unrealized appreciation/(depreciation) on unfunded transactions			31,756				(22,921	)
Net change in unrealized appreciation/(depreciation) on translation of assets and liabilities denominated in foreign currency			(497	)			2,369
Net realized and unrealized gain/(loss) on investments			(6,005,375	)			(34,511,363	)
Net decrease in stockholders’ equity (net assets) resulting from operations			(5,912,416	)			(31,029,888	)

See accompanying Notes to Financial Statements .

Statement of Changes in Stockholders’ Equity (Net Assets)

For the Year Ended December 31, 2008 and for the Quarter Ended March 31, 2009 (unaudited)		Highland Distressed Opportunities, Inc.

																										Total
														Undistributed				Undistributed				Net Unrealized				Stockholders’
		Common Stock								Paid-in Capital				Net Investment				Net Realized				Appreciation/				Equity
		Shares				Amount				in Excess of Par				Income				Gain/(Loss)				(Depreciation)				(Net Assets)
Balance at December 31, 2007			17,716,771			$	17,717			$	253,163,644			$	3,420,147			$	(14,547,689	)		$	(60,038,767	)		$	182,015,052
Distributions declared			—				—				—				(13,287,578	)			—				—				(13,287,578	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations			—				—				(145,064	)			10,934,918				(84,535,832	)			(34,425,068	)			(108,171,046	)
Balance at December 31, 2008			17,716,771			$	17,717			$	253,018,580			$	1,067,487			$	(99,083,521	)		$	(94,463,835	)		$	60,556,428
Distributions declared			—				—				—				—				—				—				—
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations			—				—				—				92,959				(10,347,294	)			4,341,919				(5,912,416	)
Balance at March 31, 2009			17,716,771			$	17,717			$	253,018,580			$	1,160,446			$	(109,430,815	)		$	(90,121,916	)		$	54,644,012

See accompanying Notes to Financial Statements .

Statement of Cash Flows

Highland Distressed Opportunities, Inc.

		For the Quarters Ended
		March 31, 2009				March 31, 2008
		(unaudited)				(unaudited)
		($)				($)
Cash Flow Provided by (Used in) Operating Activities:
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations			(5,912,416	)			(31,029,888	)
Adjustments to reconcile net increase/(decrease) in stockholders’ equity (net assets) resulting from operations to net cash and foreign currency:
Net realized (gain)/loss on investments, total return swaps and foreign currency transactions			10,347,294				12,488,099
Net change in unrealized (appreciation)/depreciation on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency			(4,341,919	)			22,000,343
Purchase of investments securities			(203,351	)			(28,193,997	)
Proceeds from disposition of investment securities, total return swaps and foreign currency transactions			13,160,506				33,745,357
Net amortization/(accretion) of premium/(discount)			(42,266	)			(593,777	)
Net realized and change in unrealized gain/(loss) on foreign currency			(497	)			2,402
(Increase)/Decrease in dividends, interest and fees receivable			345,194				(1,555,110	)
(Increase)/Decrease in receivable for investments sold			8,365,601				23,259,434
(Increase)/Decrease in other assets			87,035				19,914
Increase/(Decrease) in payable for investments purchased			(9,809,787	)			(14,302,942	)
Increase/(Decrease) in payables to related parties			(335,101	)			108,013
Increase/(Decrease) in interest payable			(33,847	)			(384,174	)
Increase/(Decrease) in other liabilities			(4,868	)			(26,993	)
Net Cash Flow Provided by (Used in) Operating Activities			11,621,578				15,536,681
Cash Flows Provided by (Used in) Financing Activities:
Increase/(Decrease) in notes payable			(9,000,000	)			(18,000,000	)
Increase/(Decrease) in due to custodian			(122,505	)			2,827,451
Distributions paid in cash			—				(4,650,652	)
Net Cash Flow Provided by (Used in) Financing Activities			(9,122,505	)			(19,823,201	)
Net Increase (Decrease) in Cash, Cash Equivalents and Foreign Currency			2,499,073				(4,286,520	)
Cash, Cash Equivalents and Foreign Currency:
Beginning of the period			10				4,291,098
End of the period			2,499,083				4,578
Supplemental Information:
Interest paid during the period			295,775				1,818,777

See accompanying Notes to Financial Statements .

Notes to Financial Statements

Highland Distressed Opportunities, Inc.

Note 1. Organization

Highland Distressed Opportunities, Inc. (the “Company”), is a closed-end company that has filed an election to be treated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). The Company was incorporated under the laws of Delaware on August 22, 2006. In addition, for tax purposes, the Company has elected to be treated as a regulated investment company, or RIC, under the Internal Revenue Code of 1986 (the “Code”). The Company’s investment objective is total return generated by both capital appreciation and current income. The Company intends to invest primarily in financially-troubled or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments.

The Company commenced operations on January 18, 2007. On February 27, 2007, the Company closed its initial public offering (“IPO” or the “Offering”) and sold 17,000,000 shares of its common stock at a price of $15.00 per share, less an underwriting discount and commissions totaling $0.675 per share. The Company received $243,525,000 in total net proceeds from the Offering, before expenses.

On March 23, 2007, the Company issued 284,300 shares of common stock to cover the underwriters’ partial exercise of the over-allotment option on the Offering and received approximately $4,072,698 in net proceeds after deducting underwriting discounts and commissions.

As discussed in Note 14 to the financial statements, on December 19, 2008, the Company’s Board of Directors (the “Board”) approved a reorganization of the Company into Highland Credit Strategies Fund.

Note 2. Significant Accounting Policies

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, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.

Interim unaudited financial statements are prepared in accordance with GAAP for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Regulation S-X, as appropriate. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements have been included. The unaudited interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (“SEC”). Interim results are not necessarily indicative of results for a full year.

The following are significant accounting policies consistently followed by the Company in preparation of its financial statements:

(a) Investments in financial instruments

Investment transactions are recorded on the trade date.

The Company will use the following valuation methods to determine either current market value for investments for which market quotations are available, or if not available, then fair value, as determined in good faith pursuant to policies and procedures approved by the Board:

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Market Quotations Available

The market value of each security listed or traded on any recognized securities exchange or automated quotation system will be the last reported sale price at the relevant valuation date on the composite tape or on the principal exchange on which such security is traded. If no sale is reported on that date, the Company utilizes, when available, pricing quotations from principal market makers. Such quotations may be obtained from third-party pricing services or directly from investment brokers and dealers in the secondary market. Generally, the Company’s loan and bond positions are not traded on exchanges and consequently are valued based on market prices received from third-party pricing services or broker-dealer sources. The Company obtains multiple broker-dealer quotes when available, but places greater reliance on quotes from broker-dealers that serve as underwriters for the issuer. In order to validate market quotations, the Company evaluates information, as available and as applicable, to determine if the quotations are representative of fair value, including, but not limited to, the source and nature of the quotations, qualitative analysis of the issuer and internally developed expectations and models. The valuation of certain securities for which there is little to no market activity may take into account appraisal reports obtained by management from independent valuation firms. Short-term debt securities having a remaining maturity of 60 days or less when purchased and debt securities originally purchased with maturities in excess of 60 days but which currently have maturities of 60 days or less may be valued at cost adjusted for amortization of premiums and accretion of discounts.

Market Quotations Not Available

Securities for which market quotations are not readily available, or for which the Company has determined the price received from a pricing service or broker-dealer is “stale” or otherwise does not represent fair value, are valued by the Company at fair value, taking into account factors reasonably determined to be relevant, including: (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. The Company takes the following steps each time it determines its net asset value in order to determine the value of its securities for which market quotations are not readily available, as determined in good faith pursuant to policies and procedures approved by the Board:

	1.		The valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment.
	2.		Preliminary valuation conclusions are then documented and discussed with Highland Capital Management, L.P.’s (the “Investment Adviser”) senior management.
	3.		The Company’s valuation committee, comprised of the Investment Adviser’s investment professionals and other senior management, will then review these preliminary valuations. An independent valuation firm engaged by the Company’s Board reviews all of these preliminary valuations each quarter.
	4.		Finally, the Board discusses valuations and reviews the fair value of each investment in the Company’s portfolio in good faith, pursuant to policies and procedures approved by the Board, based on the input of the valuation committee and an independent valuation firm.

As part of the valuation process, management takes into account the following types of factors, if relevant, in determining the fair value of our investments: the enterprise value of a portfolio company (an estimate of the total fair value of the portfolio company’s debt and equity), the nature and realizable value of any collateral, 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, changes in the interest rate environment and the credit markets generally that may affect the price at which similar investments may be made in the future and other relevant factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, we use the pricing indicated by the external event to corroborate our valuation.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Adoption of Statement of Financial Accounting Standards No. 157 “Fair Value Measurement” (“FAS 157”):

In September 2006, the Financial Accounting Standards Board (“FASB”) issued FAS 157, “Fair Value Measurement,” which is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. FAS 157 defines how fair value should be determined for financial reporting purposes, establishes a framework for measuring fair value under GAAP, and requires additional disclosures about the use of fair value measurements in interim and annual periods subsequent to initial recognition. FAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. Adoption of FAS 157 requires the Company to assume that the portfolio investment is sold in a principal market to a market participant, or in the absence of a principal market, the most advantageous market, which may be a hypothetical market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact. The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset. In determining the principal market for an asset or liability under FAS 157, it is assumed that the reporting entity has access to the market as of the measurement date. If no market for the asset exists or if the reporting entity does not have access to the principal market, the reporting entity should use a hypothetical market.

The Company has adopted FAS 157 as of January 1, 2008. In accordance with FAS 157 the Company has considered its principal market as the market in which the Company exits its portfolio investments with the greatest volume and level of activity or a hypothetical secondary market as of the measurement date. However, to the extent that an active market exists, the Company considers that as its principal market. The Company has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. Based on this assessment, the adoption of FAS 157 did not have any material effect on the Company’s net asset value. However, the adoption of FAS 157 does require the Company to provide additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in net assets for the reportable periods as contained in the Company’s periodic filings.

The levels of fair value inputs used to measure the Company’s investments are characterized in accordance with the fair value hierarchy established by FAS 157. 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 fair value measurement. The Company employs judgment and considers factors specific to the investment in determining the significance of an input to a fair value measurement. The three levels of the fair value hierarchy established under FAS 157 are described below:

	•		Level 1 — Quoted unadjusted prices for identical instruments in active markets to which the Company 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. Unobservable inputs are those inputs that reflect the Company’s own assumptions that market participants would use to price the asset or liability based on the best available information.

The determination of what constitutes “observable” requires significant judgment by management. Management considers observable data to be that market data which is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by independent sources that are actively involved in the relevant market. Categorization within the hierarchy is based upon the pricing transparency of the investment and does not necessarily correspond to the Company’s perceived risk of that investment.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Consistent with the valuation policies and procedures, management evaluates the source of inputs, including any markets in which its investments are trading (or any markets in which securities with similar attributes are trading), in determining fair value. The Company’s valuation policy considers the fact that a readily available market value may not exist for a portion of the investments in its portfolio and that fair value for those investments will typically be determined using unobservable inputs.

Investments whose values are based on quoted market prices in active markets, and are therefore classified within Level 1, generally include active listed equities, certain U.S. government and sovereign obligations, and certain money market securities. The quoted price for such instruments are not adjusted, even in situations where the Company holds a large position and a sale could reasonably impact the quoted price.

Investments that trade in markets that are not considered to be active, but are valued based on executed trades, broker quotations that constitute an executable price, or alternative pricing sources supported by observable inputs are classified within Level 2. These may include investment-grade corporate bonds, certain bank loans and bridge loans, less liquid listed equities and certain loan commitments. While investments classified as Level 2 may include positions that are not traded in active markets and/or are subject to transfer restrictions, the Company does not adjust valuations to reflect illiquidity and/or non-transferability, which are generally based on available market information.

Investments classified within Level 3 have significant unobservable inputs, as they trade infrequently or not at all. Level 3 instruments may include private equity and real estate investments, certain bank loans and bridge loans, and less liquid corporate debt securities (including distressed debt instruments). In certain cases, investments classified within Level 3 may include securities for which the Company 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. When observable prices are not available for these securities, management may employ one or more valuation techniques for which sufficient and reliable data is available.

The inputs used in estimating the value of Level 3 investments may include the original transaction price, comparable transactions in the same or similar instruments, completed or pending third-party transactions in the underlying investment or comparable issuers, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets, and estimates of and changes in financial ratios or cash flows. Level 3 investments may also be adjusted as appropriate for liquidity, credit, market and/or other risk factors to reflect illiquidity and/or non-transferability, with the amount of such discount estimated based on the availability of sufficient and reliable data in the absence of market information. The fair value measurement of Level 3 investments does not include transaction costs that may have been capitalized as part of the security’s cost basis. Assumptions utilized due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s results of operations.

There is no single approach or methodology for determining fair value in good faith and, in fact, for any one portfolio investment, an estimate of fair value may be best expressed as a range of fair values. However, management must derive a single estimate of fair value. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a rational/credible valuation process for the types of investments we the Company makes.

Because of the type of investments that the Company makes and the nature of its business, the Company’s valuation process requires an analysis of various factors. The Company’s fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition, and market changing events that impact valuation.

To determine the fair value of a given investment, management analyzes its historical and projected financial results. Such financial and other information may be obtained from the portfolio company, and may represent unaudited, projected or pro forma financial information.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

The Company may use Level 3 inputs for measuring the fair value of certain investments by employing one or more of the following valuation methodologies:

Enterprise Value (Multiples) Analysis

Under the enterprise value or residual value valuation methodology (“EV”), the Company estimates the portfolio company’s total EV then will allocate that value over the portfolio company’s securities in order of their legal priority relative to one another.

This methodology may be employed in valuing loan and debt securities as well as equity securities or other similar securities, subject to any applicable discounts when the Company has a minority ownership position, restrictions on resale, specific concerns about the receptivity of the capital markets to a specific company at a certain time, or other factors, which the Company believes would lead a market participant to discount such securities.

To estimate the EV of the portfolio company, the Company prepares an analysis consisting of traditional valuation methodologies including market, income and cost approaches, and weighs the use of such methods based on the individual circumstances of the portfolio company in order to conclude on its estimate of the EV.

In determining a reasonable multiple to use for valuation purposes, conventional considerations include not only the fact that a portfolio company may be a private company relative to a peer group of public comparables, but also consider potential “size-of-issue” (e.g. liquidity) and “size-of-company-based” (middle-market company) discounts as well as its specific strengths and weaknesses. If a portfolio company is distressed or has a predetermined life (e.g. patents) a liquidation or exit analysis may provide the best indication of value.

Discounted Cash Flow Model

When relevant observable market data does not exist, an alternative technique of valuing investments is based on discounted cash flow, or DCF. For the purposes of using DCF to provide fair value estimates, the Company considers multiple inputs such as a risk-adjusted discount rate that incorporates adjustments that market participants would make both for nonperformance and liquidity risks.

Akin to the enterprise value methodology of valuation, a multiple is applied to the selected financial measure (e.g. EBITDA), and based on the portfolio company’s presumed horizon and the selected discount rate, the Company arrives at the present value of the portfolio company’s terminal value, which is added to the DCF estimate to determine the portfolio company’s total value.

Yield/Spread Model

The Company may also value its investments in loans and other debt securities by performing spread and yield analyses. To determine a hypothetical current sale of the investment, the analysis requires the Company to estimate the fair value based on such factors as third-party broker quotes and to make assumptions a market participant would use regarding the investments, including, but not limited to, estimated remaining life, current market yield and interest rate spreads of similar securities as of the measurement date. The Company weighs the use of third-party broker quotes in determining fair value based on its understanding of the level of actual transactions used by the broker to develop the quote and whether the quote was an indicative price or binding offer. The assumptions used to estimate the fair value in a hypothetical secondary market incorporate a significant amount of Level 3 inputs.

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 Company’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 Company may ultimately realize. Further, such investments may be subject to legal and other restrictions on resale or otherwise less liquid than publicly traded securities.

In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. A summary of the inputs used to value the Company’s assets as of March 31, 2009 as follows:

Assets at Fair Value		Total				Level 1				Level 2				Level 3
Portfolio Investments		$	53,669,471			$	99,044			$	—			$	53,570,427
Cash and foreign currency			2,499,083				2,499,083				—				—
Total		$	56,168,554			$	2,598,127			$	—			$	53,570,427

At March 31, 2009, portfolio investments recorded at fair value using level 3 inputs (as defined under FAS 157) represented approximately 99.8% of the Company’s portfolio, exclusive of cash and cash equivalents. The Company did not have any liabilities that were measured at fair value on a recurring basis at March 31, 2009.

The table below sets forth a summary of changes in the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter ended March 31, 2009.

		For the Quarter Ended
		March 31, 2009
Assets at Fair Value Using Unobservable Inputs (Level 3)		Portfolio Investments
Balance as of December 31, 2008		$	70,236,387
Net transfers in/(out) of Level 3			—
Net amortization/(accretion) of premium/(discount)			35,289
Net realized gains/(losses)			(10,015,517	)
Net unrealized gains/(losses)			4,510,551
Net purchases/(sales) *			(11,196,283	)
Balance as of March 31, 2009		$	53,570,427

The net unrealized losses presented in the tables above relate to investments that are still held at March 31, 2009, and the Company presents these unrealized losses on the Statement of Operations as net change in unrealized appreciation/(depreciation) on investments.

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.

New Accounting Pronouncements

In April 2009, FASB Staff Position No. 157-4 — Determining Fair Value when the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”) was issued. FSP 157-4 clarifies the process for measuring the fair value of financial instruments when the markets become inactive and quoted prices may reflect distressed transactions. FSP 157-4 provides an illustrative list of factors a reporting entity should consider when determining whether there has been a significant decrease in the volume and level of activity for an asset or liability when compared with normal market activity. Under FSP 157-4, if a reporting entity concludes there has been a significant decrease in volume and level of activity for the asset or liability (or similar assets or liabilities), transactions or quoted prices may not be determinative of fair value. Further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value in accordance with FASB Statement No. 157 — Fair Value Measurements. FSP 157-4 is effective for interim and annual reporting periods ending after June 15, 2009, and shall be applied prospectively. Early adoption is permitted for periods ending after March 15, 2009. Earlier adoption for periods ending before March 15, 2009, is not permitted. At this time, management is evaluating the impact of FSP 157-4 on the Company’s financial statements and has not elected to adopt FSP 157-4 for the quarter ended March 31, 2009.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

(b) Net asset value per share

The net asset value per share disclosed on the Statement of Assets and Liabilities is calculated by dividing the net assets attributable to the shares of the Company’s common stock by the number of such shares outstanding at period-end.

(c) Securities transactions

All securities transactions are accounted for on a trade-date basis. Gains or losses on the sale of investments are calculated by using the specific identification method.

(d) Interest income

Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as interest income. Payment-in-kind (“PIK”) interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of distributions, even though the Company has not yet collected cash. For the quarter ended March 31, 2009, approximately $0.4 million of PIK interest income was recorded. For the year ended December 31, 2008, approximately $1.0 million of PIK interest income was recorded.

(e) Taxation — general

The Company intends to comply with the applicable provisions of the Code pertaining to regulated investment companies to make distributions of taxable income sufficient to relieve it from substantially all Federal income tax. However, depending on the level of taxable income earned in a year, the Company may choose to carry forward taxable income in excess of distributions and pay the 4% excise tax on the difference. Additionally, the Company is subject to franchise taxes in the states of Texas and Delaware.

In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 provides guidance on how uncertain tax positions should be recognized, measured, presented, and disclosed in the financial statements. FIN 48 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authorities. Tax positions not deemed to satisfy the “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the current year. As of March 31, 2009 and December 31, 2008 the Company has evaluated the implications of FIN 48 and determined that there is no material impact on the financial statements.

(f) Taxation of distributions

Book and tax basis differences relating to stockholder distributions and other permanent book and tax differences are reclassified to paid-in capital. In addition, the character of income and gains to be distributed is determined in accordance with income tax regulations that may differ from GAAP.

(g) Payment of distributions

Distributions to common stockholders are recorded as of the date of declaration. The amount to be paid out as a distribution is determined by the Board and is generally based upon the earnings estimated by management. Net realized capital gains, if any, are distributed at least annually. The determination of the tax attributes of the Company’s distributions is made annually as of the end of the Company’s fiscal year based upon its taxable income for the full year and distributions paid during the full year, therefore, a determination of tax attributes made on a quarterly basis may not be representative of the actual tax attributes of its distributions for a full year.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

(h) Foreign currency

The accounting records of the Company are maintained in U.S. dollars. All assets and liabilities denominated in foreign currencies are translated into U.S. dollars based on the rate of exchange of such currencies against U.S. dollars on the date of valuation. The Company’s investments in foreign securities may involve certain risks such as foreign exchange restrictions, expropriation, taxation or other political, social or economic risks, all of which could affect the market and/or credit risk of the investment. In addition, changes in the relationship of foreign currencies to the U.S. dollar can significantly affect the value of these investments and therefore the earnings of the Company.

(i) Forward contracts

The Company may enter into forward exchange contracts in order to hedge against foreign currency risk. These contracts are marked-to-market by recognizing the difference between the contract exchange rate and the current market rate as unrealized appreciation or depreciation. Realized gains or losses are recognized when contracts are settled.

(j) Investment in swap agreements

Swap agreements are recorded at fair value as estimated by management in good faith. The net unrealized gain or loss on swap agreement is recorded as an asset or liability on the Statement of Assets and Liabilities. The change in unrealized gain or loss is recorded in the Statement of Operations. Cash paid or received on net settlements is recorded as realized gain or loss in the Statement of Operations.

(k) Cash and cash equivalents

Cash and cash equivalents consist of demand deposits and highly liquid investments with original maturities of three months or less when purchased. Cash and cash equivalents are carried at cost which approximates fair value.

(l) Incentive fee expense recognition

The realized capital gain component of the incentive fee (the “Capital Gains Fee”), is payable in arrears as of the end of each calendar year (or upon termination of the investment advisory agreement, as of the termination date.) The Capital Gains Fee is estimated as of the end of the each calendar quarter based on the Company’s realized capital gains, if any, net of all realized capital losses, unrealized capital depreciation and fees paid on such net capital gains, computed on a cumulative basis. To the extent that Capital Gains Fees are earned by the Investment Adviser, an accrual is made in the amount of the estimated Capital Gains Fee. Because unrealized losses may fluctuate from quarter to quarter, the accrual, if any, may fluctuate as well. For the quarter ended March 31, 2009 and for the year ended December 31, 2008 there were no Capital Gains Fees paid or accrued. (See Note 3 for additional information.)

Note 3. Agreements

Investment Advisory Fee

The Company has entered into an Investment Advisory and Management Agreement with the Investment Adviser, under which the Investment Adviser, subject to the overall supervision of the Company’s Board, manages the day-to-day operations of, and provides investment advisory services to, the Company. For providing these services, the Investment Adviser receives a base management fee and an incentive fee from the Company.

The base management fee is equal to 2.00% per annum of the Company’s Managed Assets. Managed Assets are the value of total assets of the Company less all accrued liabilities of the Company (other than the aggregate amount of any outstanding borrowings, preferred stock issuances, or other instruments or obligations constituting financial leverage). The base management fee is payable quarterly in arrears.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Incentive Fee

The incentive fee consists of two components: (1) the Pre-Incentive Fee Net Investment Income and (2) the Capital Gains Fee. Pre-Incentive Fee Net Investment Income is calculated and payable quarterly in arrears. For this purpose, Pre-Incentive Fee Net Investment Income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus the Company’s operating expenses for the quarter (including the base management fee, any expenses payable under the administration agreement, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as market discount, debt instruments with PIK interest, preferred stock with PIK dividends and zero coupon securities), and accrued income that we have not yet received in cash. The Investment Adviser is not under any obligation to reimburse the Company for any part of the Incentive Fee it received that was based on accrued income that we never received as a result of a default by an entity on an obligation that resulted in the accrual of such income. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized and unrealized capital losses or unrealized capital appreciation or depreciation.

Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value of the Company’s net assets at the end of the immediately preceding calendar quarter, is compared to the “hurdle rate” of 1.75% per quarter (7.00% annualized) (the “Hurdle Rate”). The Company will pay the Investment Adviser an Incentive Fee with respect to the Company’s Pre-Incentive Fee Net Investment Income in each calendar quarter as follows: (1) no incentive fee in any calendar quarter in which Pre-Incentive Fee Net Investment Income does not exceed the Hurdle Rate; (2) 100% of Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle Rate but is less than 2.1875% in any calendar quarter (8.75% annualized) (the “Catch-up Provision”); and (3) 20% of the amount of Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.1875% in any calendar quarter (8.75% annualized).

The Investment Adviser agreed to waive the net investment income based incentive fees earned for the three-month period ended June 30, 2008. This voluntary waiver applied only to the second quarter ended June 30, 2008.

These calculations are appropriately prorated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter.

The second part of the Incentive Fee (the “Capital Gains Fee”) is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory and Management Agreement), beginning on December 31, 2007, and is calculated at the end of each applicable year by subtracting (A) the sum of the Company’s cumulative aggregate realized capital losses and aggregate unrealized capital depreciation from (B) the Company’s cumulative aggregate realized capital gains, in each case calculated from the date of the IPO of the Company’s shares. If such amount is positive at the end of such year, then the Capital Gains Fee for such year is equal to 20% of such amount, less the aggregate amount of Capital Gains Fees paid in all prior years. If such amount is negative, then there is no Capital Gains Fee paid for such year.

For the quarter ended March 31, 2009, the Investment Adviser earned approximately $0.3 million, $0 and $0 in base management fees, in incentive fees related to pre-incentive fee net investment income and in incentive management fees related to capital gains, respectively.

For the year ended December 31, 2008, the Investment Adviser earned $4.2 million in base management fees, $1.7 million in incentive fees related to pre-incentive fee net investment income and $0 in incentive management fees related to capital gains.

For the quarter ended March 31, 2009, the Investment Adviser did not waive any of its base management or incentive fee.

For the year ended December 31, 2008, the Investment Adviser agreed to waive $0 in base management fees, and $0.8 million in incentive fees related to pre-incentive fee net investment income.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Administration Fee

Pursuant to a separate administration services agreement, the Investment Adviser furnishes the Company with office facilities, equipment, clerical, bookkeeping and recordkeeping services at such facilities. Under the administration agreement, the Investment Adviser also will perform, or oversee the performance of, the Company’s required administrative services, which include, among other things, being responsible for the financial records that the Company is required to maintain, monitoring portfolio and regulatory compliance matters and preparing reports to the Company’s stockholders and reports filed with the SEC. In addition, the Investment Adviser will assist the Company in determining, and arranging for the publishing of, the Company’s net asset value, overseeing the preparation and filing of tax returns and the printing and disseminating of reports to stockholders, and generally overseeing the payment of expenses and the performance of administrative and professional services rendered to the Company by others. For providing these services, the Investment Adviser will receive an annual administration fee, payable quarterly in arrears at an annual rate of 0.35% of the Company’s Managed Assets. Under a separate sub-administration agreement, the Investment Adviser has delegated certain administrative functions to PNC Global Investment Servicing (U.S.) Inc. (formerly PFPC Inc.) The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party. For the quarter ended March 31, 2009 and year ended December 31, 2008, the Investment Adviser earned administration fees of approximately $0.1 million and $0.7 million, respectively.

The Investment Adviser paid to the underwriters an additional sales load of $0.15 per share, for a total sales load of $0.825 per share. The Company had agreed to pay this amount to the Investment Adviser, together with an interest factor, pursuant to an Agreement Regarding Payment of Sales Load (i) if during either the period commencing with the date of the IPO through the end of the Company’s first fiscal year or during the period of the Company’s second fiscal year (each a “Measuring Period”), the sum of (a) the Company’s aggregate distributions to its stockholders plus (b) the change in the Company’s net assets, equaled or exceeded 7.00% of the net assets of the Company at the beginning of such Measuring Period (but after adjusting, if necessary, the net assets of the Company at the end of such Measuring Period as follows: by subtracting the net proceeds of any of the Company’s stock issuances, and by adding the amount of any of the Company’s stock repurchases, that occurred during such Measuring Period) and without taking into account any accrual for the total payment amount; or (ii) upon the Company’s liquidation. Inasmuch as neither (i) nor (ii) above has occurred by the conclusion of the second Measuring Period, the Agreement Regarding Payment of Sales Load terminated on December 31, 2008, without the Company having any payment obligation to the Investment Adviser.

Fees Paid to Directors and Officers

Each Director who is not an “interested person” of the Company as defined in the 1940 Act (the “Independent Directors”) receives an annual retainer of $150,000 payable in quarterly installments and allocated among each portfolio in the Highland Fund Complex based on relative net assets. The “Highland Fund Complex” consists of the Company and all of the registered investment companies advised by the Investment Adviser as of the date of this quarterly report.

The Company pays no compensation to its one interested Director or any of its Officers, all of whom are employees of the Investment Adviser.

Note 4. Credit Facility

In accordance with the 1940 Act, with certain limited exceptions, the Company is only allowed to borrow amounts such that its asset coverage, as defined in the 1940 Act, is at least 200% after such borrowing. On June 27, 2008, the Company entered into a Revolving Credit and Security Agreement (the “Credit Agreement”) with Liberty Street Funding LLC, as conduit lender, and The Bank of Nova Scotia, acting through its New York agency, as secondary lender and agent (the “Agent”). Under the Credit Agreement, the Company was permitted to borrow on a revolving basis up to $100 million, subject to the satisfaction of certain conditions including compliance with borrowing base tests and asset coverage limits. The Credit Agreement imposed stricter limitations than the 1940 Act, requiring generally that asset coverage be at least 300% after a borrowing. The Credit Agreement expired in December 2008 and borrowings thereunder were secured by substantially all of the assets in the Company’s portfolio, including cash and cash equivalents. The interest rate charged was based on prevailing commercial paper rates plus commitment and utilization fees. However, if the commercial paper market was at any time unavailable, the interest rate was, at the

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Company’s election, based on the prevailing Eurodollar rate, Federal Funds rate or the agent’s reference rate, in each case plus an applicable spread and commitment and utilization fees. The Company paid a commitment fee at the annual rate of 0.70% on the total commitment amount, and a utilization fee at the annual rate of 0.30% on outstanding borrowings. The Credit Agreement contained, and as amended, contains customary events of default (with grace periods where customary) including, among other things, failure to pay interest or principal when due and failure to comply with certain asset coverage and borrowing base tests.

On November 25, 2008, the Company entered into Amendment No. 1 to the Credit Agreement. As amended, the credit facility expires on May 29, 2009, and the Company may borrow up to $60 million. The credit facility, as amended, requires generally that asset coverage be at least 350% after a borrowing. The credit facility is secured by substantially all of the assets in the Company’s portfolio. Generally, the interest rate charged is based on prevailing commercial paper rates plus commitment and utilization fees. However, if the Company is unable to borrow at commercial paper rates, the interest rate is based on the prevailing Eurodollar rate, Federal Funds rate or the agent’s reference rate, in each case plus an applicable spread and commitment and utilization fees. The Company pays a commitment fee at the annual rate of 1.25% on the total commitment amount, and a utilization fee at the annual rate of 0.75% on outstanding borrowings.

At March 31, 2009, the Company had borrowings outstanding under the Credit Agreement of $6.5 million. The interest rate charged on this loan as of March 31, 2009 was approximately 1.45%. The average daily loan balance during the three months ended March 31, 2009 on the facility was approximately $9.5 million at a weighted average interest rate of approximately 1.80%. Interest expense incurred during the quarter ended March 31, 2009 was approximately $0.3 million.

At December 31, 2008, the Company had borrowings outstanding under the Credit Agreement of $15.5 million. The interest rate charged on this loan as of December 31, 2008 was approximately 2.61%. The average daily loan balance during the three months ended December 31, 2008 on the facility was approximately $28.9 million at a weighted average interest rate of approximately 3.13%. Interest expense incurred for the year ended December 31, 2008 was approximately $3.2 million.

See Note 13 below for information on the Credit Agreement subsequent to March 31, 2009.

Note 5. Net Asset Value Per Share

At March 31, 2009, and December 31, 2008, the Company’s total net assets and net asset value per share were $54,644,012 and $60,556,428, and $3.08 and $3.42, respectively.

Note 6. Unfunded Loan Commitments

As of March 31, 2009, the Company’s portfolio had no unfunded loan commitments.

As of March 31, 2009 and December 31, 2008, the Company’s portfolio had unfunded loan commitments of approximately $0.0 million, and $0.1 million, respectively. Unfunded loan commitments are marked to fair value along with the funded portion of the respective loans, in accordance with the Company’s valuation policy discussed in Note 2(a).

		Unfunded Loan Commitment
Borrower		March 31, 2009				December 31, 2008
Comcorp Broadcasting, Inc.		$	0			$	58,999

Unfunded loan commitments are marked to market on the relevant day of valuation in accordance with the Company’s valuation policies. Any applicable unrealized gain/(loss) and unrealized appreciation/(depreciation) on unfunded loan commitments are recorded on the Statement of Assets and Liabilities and the Statement of Operations, respectively. As of December 31, 2008, the Company recognized net unrealized depreciation on unfunded transactions of approximately $0.03 million. The net change in unrealized depreciation on unfunded transactions for the year ending December 31, 2008 was approximately $0.03 million and is recorded in the Statement of Operations.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Note 7. Transactions in Securities of Affiliated Issuers

Under Section 2(a) (3) of the Investment Company Act of 1940, a portfolio company is defined as “affiliated” if a company owns five percent or more of its voting securities. Set forth in the tables below are the issuers in which the Company held at least five percent of the outstanding voting securities as of March 31, 2009 and December 31, 2008:

March 31, 2009

Borrower		Shares				Principal				Market Value
Comcorp Broadcasting, Inc.*
Revolving Loan						$	1,884,953			$	855,391
Term Loan							18,849,521				8,553,913
Communications Corp. of America			1,256,635								—
Genesys Ventures IA, LP			12,000,000								15,240,000
Total										$	24,649,304

December 31, 2008

Borrower		Shares				Principal				Market Value
Comcorp Broadcasting, Inc.*
Revolving Loan						$	1,825,953			$	843,134
Term Loan							18,849,521				8,835,713
Communications Corp. of America			1,256,635								—
Genesys Ventures IA, LP			12,000,000								17,412,000
Total										$	27,090,847

Note 8. Portfolio Information

For the three months ended March 31, 2009, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were approximately $203,351 and $13,160,506, respectively.

For the year ended December 31, 2008, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were approximately $98,191,348 and $219,668,727, respectively.

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Note 9. Financial Highlights

The following is a schedule of financial highlights for the three months ended March 31, 2009 and March 31, 2008:

		Quarter Ended				Quarter Ended
		March 31, 2009				March 31, 2008
Net asset value, beginning of period		$	3.42			$	10.27
Net investment income			0.01				0.19
Net realized and unrealized loss on investments			(0.35	)			(1.94	)
Total from investment operations			(0.34	)			(1.75	)
Distributions Paid			—				(0.26	)
Net asset value, end of period		$	3.08			$	8.26
Market price per share, beginning of period		$	2.15			$	8.57
Market price per share, end of period		$	1.99			$	7.00
Total investment return (a)
Based on net asset value per share			(9.94	)%  (b)			(16.73	)%  (b)
Based on market price per share			(7.44	)%  (b)			(15.43	)%  (b)
Net assets, end of period (c)		$	54,644			$	146,335
Ratios to Average Net Assets/Supplemental Data:
Net expense			9.04	%			10.72	%
Interest expense			1.84	%			3.49	%
Net investment income			0.65	%			8.46	%
Portfolio turnover rate			—	%  (b)(e)			10	%  (b)
Debt:
Total loan outstanding, end of period (c)		$	6,500			$	124,000
Asset Coverage per $1000 indebtedness, end of period (d)		$	9,407			$	2,180

Notes to Financial Statements (continued)

Highland Distressed Opportunities, Inc.

Note 10. Income Tax Information and Distributions to Stockholders

For the quarter ended March 31, 2009, the Company’s Board did not declare a distribution.

For the year end December 31, 2008, the Company’s Board declared the following distributions:

Date Declared		Record Date		Payment Date		Amount
March 7, 2008		March 20, 2008		March 31, 2008		$	0.2625
June 6, 2008		June 20, 2008		June 30, 2008		$	0.2625
September 5, 2008		September 19, 2008		September 30, 2008		$	0.1500
December 4, 2008		December 19, 2008		December 31, 2008		$	0.0750
Total declared during 2008						$	0.7500

Reclassifications are made to the Company’s capital accounts for permanent tax differences to reflect income and gains available for distribution (or available capital loss carryforwards) under income tax regulations.

The tax character of distributions paid during the year ended December 31, 2008 and the period ended December 31, 2007 were as follows:

Distributions paid from:		2008				2007
Ordinary income*		$	13,287,578			$	13,915,795
Long-term capital gains		$	—			$	—

As of December 31, 2008 and December 31, 2007, the components of distributable earnings on a tax basis were as follows:

		2008				2007
Capital loss carryforward		$	(79,324,572	)*		$	(9,946,969	)**
Undistributed ordinary income		$	1,165,348			$	3,525,488
Post-October Losses		$	(8,442,951	)		$	(4,600,720	)
Net unrealized appreciation/(depreciation)		$	(105,779,833	)		$	(60,038,767	)

For the year ended December 31, 2008, and the period ended December 31, 2007, the Company elected to defer capital losses of $8,442,951 and $4,600,720, respectively attributable to post-October losses.

Unrealized appreciation and depreciation at March 31, 2009, based on cost of investments for U.S. federal income tax purposes and excluding any unrealized appreciation and depreciation from changes in the value of other assets and liabilities resulting from changes in exchange rates was:

Unrealized appreciation		$	3,240,001
Unrealized depreciation			(93,361,643	)
Net unrealized depreciation		$	(90,121,642	)