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Gladstone Investment Corporation (NASDAQ:GAIN)

Q2 2008 Earnings Call

November 5, 2008 8:30 a.m. ET

Executives

David Gladstone – Chairman & CEO

David Dullum – President

Mark Perrigo – CFO

Analysts

Vernon Plack – BB&T Capital Markets

Wayne Silby

Jon Arfstrom – RBC Capital Markets

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Adrian Day – Adrian Day Asset Management

Lee Carter

Robert Dodd – Morgan Keegan, Inc.

Operator

Greetings, ladies and gentlemen and welcome to the Gladstone Investments second quarter 2009 financial results conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the presentation. [Operator instructions] As a reminder this conference is being recorded. It is now my pleasure to introduce your host, Mr. David Gladstone, Chairman of Gladstone Investments. Thank you, Mr. Gladstone, you may begin.

David Gladstone

And thank you, Diego, we appreciate that nice introduction, and hello and good morning to all of you. This is David Gladstone, this is the quarterly conference call for shareholders and analysts for Gladstone Investment. Our trading symbol is GAIN.

And thank you all for calling in. We are happy to talk to shareholders and certainly we would like to see some of you come by our offices here outside Washington DC, we're in McLean, Virginia, it's the suburbs, just a short stop. We'd like to see you come by and say hello. You see a great team working; I think they're just the best in the business.

I do need to read this statement about forward-looking statements. This conference call includes statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regard to the future performance of the company.

These forward-looking statements inherently involve certain risk and uncertainties, even though they are based on our current plans and we believe those plans to be reasonable. There are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by forward-looking statements, including those factors listed under the caption Risk Factors that are in our periodic filings on file with the Securities Exchange Commission and those filings can be found on our website at www.gladstoneinvestment.com and they can also be found on the SECs website.

The company undertakes no obligation to publicly update or revise any forward-looking statements whether it's a result of new information, future events, or otherwise.

As some of you know, we've begun a new tradition here at the company regarding calls to shareholders. In the past, I did all the talking, but we have a lot of talented people here at the company, so we've invited some of them to talk to you today.

I know shareholders would like to hear from some of our talented team. I'm not going anywhere, and neither is Chip Stelljes or Terry Brubaker, we just want to make sure that you hear some of the top people that are part of our great team.

First we will hear from Dave Dullum, our President, and he will cover a lot of ground, including a view of the future of this fund. Dave, take it away.

David Dullum

Thank you, David, and good morning to the participants. Please review Gladstone Investment Corporation's gains because that is principally in the buy-out transactions where we buy small businesses with our management team and private equity sponsors. Our products to this market are primarily the mezzanine or subordinated debt investments, which we combine with an equity co-investment feature for the capital gain aspect of our investment strategy.

We accommodate with this product private equity sponsors in their ability to achieve a necessary leverage for a transaction, which is of major importance in this current environment where senior leverage is very scarce.

We have also invested, in the past, in senior syndicated loans of large and middle market buyouts. However, we no longer are investing here and, in fact, use this part of the portfolio of loans as a source of capital from a principal buyout investing activity.

Terms of buyouts for the first half of fiscal year ending September 30, 2008, we invested in two new buyouts for a total of approximately $27.1 million and made an add-on investment of $3.8 million to one of our portfolio companies which helped facilitate a strategic acquisition on their part. We look forward to being able to participate with our portfolio companies in this regard from time to time.

We had no exits, although we did recapitalize one of our buyout deals, Quench, in which a part, a large private equity firm made a significant growth equity investment in Quench allowing us to receive a debt repayment of approximately $7.

And, as a result, we go forward owing only 4.5% equity in this business, which we are classifying as an affiliate investment. It is still too early to expect exits and realize gains from the buyout type investments and gains, and perhaps in a year or so, something will materialize. And we monitor this and we think about this carefully.

Terms of buyouts after the end of the quarter, we made no new investments, nor exited from any buyout after the end of the quarter.

Turning to syndicated loans, during the quarter we invested in no new syndicated loans. We received repayments from the sales or settlements of these syndicated loans of about $7.9 million, including normal amortization.

We realized a loss of $2.5 million on the syndicated loans, which we sold or settled, which included both Lexicon and Hudson, two of the syndicated loans that we had. As we have mentioned previously, we are selling our syndicated loans when prudent as a means to fund our principle investing activity in proprietary investments.

We evaluate the potential to realize loss on each sale in relation to the new proprietary investment being made, as this does have implications from our cost of funds. Potentially, we look at the trade-off in the realized loss of the syndicated loan and the low current yield on that loan against the increased yield and the upside in the new proprietary investment. After the quarter ended, we made no syndicated loan sales as previously mentioned.

Turning to the portfolio status. At the end of the quarter, we had at-cost $220 million invested in buyouts and $128 million invested in syndicated loans. At the end of the quarter our investment portfolio was valued at about $326 million, with a cost base of $348 million, or a difference of around $22 million. Therefore, our portfolio is now valued at about 94% of its cost.

A significant amount of that depreciation, we should note, occurred in prior quarters while for the quarter ending September 30, 2008, the overall portfolio depreciated about $329,000 from the previous quarter, which is less than one-tenth of 1% depreciation quarter-to-quarter.

In terms of valuation, we wish to call your attention to an important aspect of the methodology that we use current for the equity portion of the investments where we actually have a large ownership position. The valuation methodology we adopted for those investments give us an enterprise value, as we call it, which is based on a multiple unaudited earnings, or earnings before interest passes depreciation and amortization, EBITDA of the portfolio company.

We believe this method is indicative of what the business could be sold for at that time. When a company has good cash flow, or EBITDA, the enterprise value of that portfolio company will go up, and if that portfolio company has poor cash flows or, at the time, limited EBITDA, the enterprise value will go down based on valuation methodology. This typically is the way the stock market values the business.

Therefore, if a company has low cash flows, or a loss, this method will result in an equity value that is very low, or possibly zero, even though the business fundamentals are sound. So we believe this valuation method is very conservative when companies have poor or no earnings at the time of valuation, again, however being fundamentally good businesses. As a result, this method will produce volatility in the value of a portfolio.

Turning to our record, since our inception in July 2005, we completed 12 buyout investments for a total of approximately $220 million at a cost at quarter-end, with no capital gain exits from this portfolio, this portion of the portfolio, I should say. And since July 2005, we have purchased 72 loans in the senior syndicated market for a total of approximately $308 million.

Many of these syndicated loans have paid off, or have been sold, so that the current balance as previously mentioned, is $128 million at cost. Again, over time, we will exit all of our syndicated loans with those proceeds being directed to our principle activity, which is the buyout business.

I should mention that one of our buyouts is currently under-performing, so we do not think it will produce a loss. And, on the other hand, most of our other buyouts are performing very well even in this difficult economic environment. This is an area we continue to monitor very carefully and we do provide assistance as necessary to be sure to maintain the best value for our buyout portfolio.

Terms of ratings, our overall, average loan ratings for the quarter remain relatively unchanged. The risk rating system we use set our originated loans at an average of 5.4 for this quarter, versus an average of 5.5 for the June 30 quarter. The risk rating we use for unrated syndicated loans was an average of 8.2 for this quarter, versus an average of 7.2 for the June 30 quarter, a modest and nice increase.

Our risk rating system gives you a probability of default rating for the portfolio on a scale of zero to ten, with zero representing a high probability of default. Therefore, we see the risk in this unrated portion of the portfolio staying relatively the same as last year.

As for our rated syndicated loans, they had an average rating of B+/B1 for both this quarter and the June 30 quarter end. Therefore, we are quite satisfied with our current portfolio mix, but as previously mentioned, a little change over time to be 100-percent in buyout where we do have large investments and we will ultimately exit all of our syndicated loans.

Discussing the rate situation, which is a topic of conversation these days, we have concentrated on variable rate loans in the syndicated market so that we are generally not hurt at rate increase and therefore, our cost of borrowing increases.

However, rates have come down quite a bit, so we have seen our investment income drop on these syndicated loans. On most of our buyout loans, we have variable rates, but we almost always have a minimum, or a floor, on the rate charge so that if interest rates decline, it will not hurt our ability to pay dividends.

We do have approximately $61 million in fixed rate loans, all in the buyout deals, and they are at relatively high rates, so we should be okay there. In order to have some protection, however on our cost of funding, we did purchase interest rate caps on $60 million of our debt, and in order to keep the reduction in spread to a minimum, if rates do, in fact, rise.

I'll turn now to the marketplace. Since the call to shareholders last quarter, the syndicated loan market for large and middle market companies, which came to a halt in the summer of 2007, seems to be slowly coming back.

As many of you know, the value of loans in that market has declined and our portfolio syndicated loans, again, as previously mentioned, have generally tracked the market. However, this time, the fair value of our syndicated loan value portfolio excluding those sold during the quarter decreased in value by about 7.8% from last quarter. We believe we may be seeing the bottom of this market.

In regards to the marketplace for smaller companies in the buyout side, our market of smaller companies where we focus, that environment is different. The major impact on this market is certainly the recent deterioration of the senior loan market.

As senior lenders have dropped out of the market, it has become harder for the private equity firms to raise the necessary capital for individual deals. The result is the following. One, valuations relative to EBITDA have declined, as we have seen in recent transactions; two, private equity firms are being required and are, indeed, investing a higher proportion of equity relative to the debt.

We're seeing it up around 50% today from approximately 30+% not that long ago. Three, the opportunity for mezzanine and equity coinvestment for products has become attractive as a tronch (ph) of investment, which tends to fill the gap between the senior lenders and the equity investors in any individual deal. These factors are to our advantage and we are seeing our pipeline grow very nicely.

In our last quarter's call, we had mentioned seeing some of these signs, and we had begun to position our products accordingly. Our pipeline investing opportunity is robust, and it does include the mezzanine with equity coinvestment and other junior capital instruments.

We will continue to concentrate on this area and build our pipeline, and as we continue to participate in these buyouts and grow our portfolio, our balance sheet will reflect this mix of debt and equity coinvestments that we have provided to these acquisitions.

This mix allows us to generate income from the debt investment portion, which provides cash flow for the dividends, while rebuild the equity portion for future capital gains. I believe the rest of the year will be okay for us and we will continue to grow our asset base, while maintaining our dividend policy.

Given the current conditions of the market, I believe we are well positioned to compete and, indeed, increase the brand image of Gladstone Investment Corporation.

Briefly then, our outlook is our goal for this fund, continues to be the maintenance and consistency of our dividends, while achieving solid goals for the portfolio proprietary investments and long term capital gains potential in the small business buyout market. Now I'll turn it back over to David Gladstone to finish.

David Gladstone

That was great, Dave, good report. We are all excited to have you working on the buyout side of the business. I know this fund is going to pick up steam in the second half of the year. Now let's turn it over to our CFO, Mark. You are on the funds financial reporting side, so why don't you give us your report?

Mark Perrigo

Thank you, David, and good morning everyone. Let's begin with our balance sheet. Our balance sheet continues to remain strong. At the end of the September quarter, we had approximately $265 million in assets. This is an improvement of $26 million in investments at fair value and $39 million in cash and other assets. We had about $130 million borrowed on a line of credit and have about $233 million net assets. So we are at a less than 1:1 leverage.

This is as very conservative balance sheet for a company such as ours and we believe our overall risk profile is low. Please note that in October, after the quarter end, we amended our credit facility to extend a maturity date to April 19 of '09 and reduce the borrowing base past the facility to $125 million.

The September quarter end, total investment income was approximately $6.8 million versus $7.2 million. Our total expenses, including credits were approximately $3 million versus $4.1 million in the prior year quarter, even net investment income, which is before appreciation, depreciation standard losses, were approximately $2.8 million versus $3 million from the quarter last year, an increase of about 27%.

For the six months ending September 30th, total investment income was approximately $12.9 million versus $13.5 million. Our total expenses include credits for approximately $6 million versus $7.6 million in the prior year, leaving net investment income of approximately $6.8 million versus $5.9 million for the six months ended last year, an increase of about 15%.

Now let's turn to realized and unrealized gains and losses. This is a mixture of appreciation, depreciation, actual gains and losses on our investments. Said another way, net realized gains and losses, meaning actual gains versus losses, are from cash due to sale of disposable assets, mean investments.

Net unrealized appreciation, meaning unrealized appreciation versus depreciation, is recognized in our Statement of Operations as non-cash accounting from a change in fair value of our portfolio during the quarter. For the quarter ended September, we had a net realized loss of about $2.5 million from a settlement of two syndicated loans, with one syndicated loan, Lexicon, accounting for over $16,000 of the realized loss.

As has been mentioned on many of our past calls, we are continuing to forecast the selling off of some of our syndicated loans that have low rates, even if that means we have to take a loss. We are then able to vend the proceeds from the sales in higher interest bearing loans.

Moving to unrealized appreciation for the September quarter ended, we had a net unrealized appreciation of a nominal amount of $329,000 over the entire portfolio. This is non-cash and comes from the value put on the portfolio.

Our debt in the prior quarter, the company's adoption of FAS 157 changed the methodology for estimating a fair value to the debt portion we have issued to our non-controlled portfolio companies. Previously, we valued the debt portion of the bundled debt from equity investments in non-controlled companies in accordance with board approved evaluation procedures, which require that the debt portion generally be valued as a contractual principal balance.

Although our aggregate investment portfolio has appreciated, our entire portfolio is fair-valued at 94% of the cost as of September 30th, 2008. The unrealized appreciation of our investments does not impact our ability to pay distributions to stockholders.

Now let's turn to net increase or decrease in net assets from operations. This term is a combination of net investment income, unrealized net appreciation or depreciation, and realized gains and losses. Please note that we are talking about weighted average, fully diluted common shares, not per share numbers. This is the most conservative way of saving earnings-per-share.

The September quarter, this number was an increase of about $1 million versus a decrease of about $4.4 million in the prior year quarter. The change is primarily due to lower interest that occurred on the credit facility and lower net unrealized depreciation in a (inaudible) share from the write-offs (inaudible) this year.

For the September quarter, we have about positive $0.04 per share versus negative $0.20 per share for the prior year quarter. Investors should expect this kind of up and down movement in the value of the portfolio.

As of September 30, 2008, we do not have any loans with paid in time income for original issue discount (inaudible). We term this kind of income phantom income because the company does not receive the cash, so we have to pay out of this phantom income as a dividend. We avoid such phantom income.

Our portfolio companies are paying on time and, as agreed, with the exception of one proprietary loan and one syndicated loan. Even with the current market turmoil, we believe that we are in a great position to take advantage of quality buyout opportunities for the foreseeable future.

And, finally, let me say that to the issuance of new shares in this fiscal year, which caused undilution, we have a net asset value at about $10.57 per share. This is as low as it's ever been; it is also related to the depreciation on the syndication loan portfolio. I'll turn it back over to you, David.

David Gladstone

Thank you, Mark, that was a great report, as well. That was a good summary, I think, of our financials, but I hope each of our listeners will read our press release and also obtain a copy of our quarterly report called the 10Q, which has been filed with the SEC and can be found on our website at www.gladstoneinvestment.com. It's also on the SEC website.

Our biggest worry today, of course, is the debt marketplace for our funds and for our portfolio companies that we finance. We are worried about the banks ability to provide our line of credit and for the banks to provide the line of credit to our portfolio companies. It is a worry that we have across our own internal workings.

We are working to bring in some additional lenders to help out with our line of credit, so I'm expecting certainly by some time next quarter that we'll have in place additional lenders that will join our line of credit.

We do have a lot of worry about our portfolio companies that they can't find low cost bank debt and we'll have some of the future growth slowed to lack of funding. This is a very unsettling time that we have today. I continue to have a difficult time understand how we're ever going to give you shareholders a true estimate of the fair value of our securities.

Of course we get, from our syndicated loans, the marketplace there is based on prices that come from a market that really can only be described as a fire sale. A fire sale market causes the mark down of our securities.

Again, this quarter hedge funds and others, like some of the banks, are dumping securities on the marketplace, and that has very few buyers. And, this is, of course, causing prices to fall again. That fire sale market, I don’t think, truly represents the value for our loans, especially those loans that can be held to maturity if we want to hold them. And, we’re certainly not in the marketplace selling any of them.

But, this is the only market that exists, and the government and the accounting regulations require that we mark these to that fire sale market in order to tell shareholders what the company is worth, it just makes it very difficult for me to truly say to you that this is the value of your portfolio. I don’t agree with it, but unfortunately that’s what we have to do, we have to mark it down each quarter based on what the marketplace says.

We have a lot of other worries, of course. We continue to worry about the cost of oil. I’m glad to see it fall and this should have a good impact on the economy. However, it will surely go back up since the consumption of oil is tied directly to consumers and industrial use.

And, our country just needs to become more energy independent by building, I’d say, 40 additional nuclear plants, drilling for oil in all the large oil fields located on and off shores of our country. We also need to use much more coal. Some estimates say we have a 150 year supply of coal right here in U.S.

These policies of the past seven administrations that have been running the country have been have been dead wrong on this issue, and we’re just hopeful that the new administration will see some way of fixing that problem.

We certainly are no longer worried about inflation the way the government measures inflation, we’re not likely to see much until sometime in 2009, then, I suggest it’ll come on strong, but right now I don’t see anything on the horizon. But, we’re likely to see something certainly in 2009 and 2010, simply because so much money is being spent by the government.

The amount of money being spent on the war in Iraq certainly hurts. All of us think our troops are wonderful, they lay down their lives for us, we certainly support them in every way, but we have to recognize that the war is draining our economy by an awful lot of money.

The worst thing that I can talk about each time as the Federal, state, and local governments’ pork barrel spending. They certainly are acting irresponsible. The government today spends about 44% of all dollars spent in the United States. And, that means we’re in a short ways away from officially qualifying as a socialistic country where the government spends more money than the private enterprise those. I think when they tally up all this reckless spending that’s going on in fact it will exceed 50% this year.

It’s just, the stimulus bills are just another form of socialism and the government is taxing the upper income workers and sending checks to the lower income workers. And, this is of course socialism its purest form. The bailout bill is certainly not good for the health of the country. The government has to support the businesses that carry out these ill conceived government programs.

And, this financial mess that we find ourselves in today is a direct result of government intervention in the home lending market place. Now, when the government passed the Community Reinvestment Act and the Fair Housing Bill, and then they used Freddie Mac and Fannie Mae to facilitate this desire to un-collateralize home loans to people that just couldn’t afford them in the first place.

Think about this, no bank would have really made such poor credit loans if they didn’t have a way to get rid of them. And, the government of course passed laws that required them to do so, and then of course facilitated the mechanism for syndicating these loans and sending them out and these loan packages. And, every time the government gets involved in the lending business it’s always a disaster.

And, Congress created this housing bubble and now it’s burst they’re trying to blame everyone else for it. But, it really belongs on Congress the last administration didn’t seem to do much about it either, so there’s some blame there as well.

The trade deficit with China and the other Asian nations is just terrible. China continues to subsidize their industries to the disadvantage of our business is. And, they subsidize oil and food, and it’s subsidized completely in China and the oil usage just keeps growing over there. So, it’s very hard for our companies to compete with people that are subsidized by their government.

In other ways the U.S. economy continues to remain strong, as long as businesses are not related to housing, and autos, and the financial institutions that financed housing and autos. Businesses seem to be not yet undergoing the trauma we’ve seen in those industries.

Entrepreneurs are pretty savvy people; they’re smart business owners in many ways. They kept their cost low and many of the business profits are actually improving. We’ve seen that in our portfolio as well as some of the companies we see.

But, we all know there’s a slowdown going on and we see a few of the companies that are in our portfolio continuing to slow down. Businesses have approached us for financing and some of those have slowed down as well. But, I think if the government would just leave these entrepreneurs alone they’d be able to create jobs and our economy would become strong and great again.

Manufacturing is certainly not operating at full capacity so there’s room for expansion. It certainly won’t make it during this business cycle, maybe in two or three years. There is a noticeable slowdown in hiring and the effect on industries in finance and autos and housing layoffs are excruciatingly bad.

Backlogs are coming down for some of the businesses but others have very strong backlogs, well into 2009, and some even to 2010. Businesses outside of the auto, housing, and the finance areas look like the slowdown is certainly not a recession, but for those businesses affected, that is the auto, housing, and finance area, recession is certainly very strong.

We’ve been lucky, we’ve stayed away from auto manufacturing, we’ve stayed away from housing, and we’ve certainly stayed away from finance companies. We have some investments that touches on some of these areas, but we’re not directly involved. I think in the near term we’re going to see the bottom to this mess that we’re in, and certainly in six months I think things will turn around very well.

And, this is certainly an excellent time to buy some good stocks. And, I think this company will do fine in the future and I hope a lot of folks will buy the shares. I certainly intend to buy some additional shares once we’re out from under this, we have to close a window and can’t buy during this period of time, but once the windows open I plan to buy some additional shares.

Our distribution declared by the Board of Directors in October was $0.08 per share for months October, November, and December. This is a run rate of $0.96 a year. That’s on this distribution rate based on the stock price yesterday of $5.52, makes the yield extremely high, it’s over 17%. We really have no plan to cut the dividends, so you should know that. And, this means the buyers of the stock today are getting just a fabulous return.

Please go to our website and sign up for e-mail notification. We don’t send out junk mail, so go to www.gladstoneinvestment.com and sign up and you’ll get the messages about our company.

In summary, as far as we can see in this calendar year 2008 and into the early part of 2009, things look good. We can only see a couple quarters out, so we want to be careful. We are the stewards of your money and we’ll stay the course and continue to be conservative in our investment approach. And, we want you to know that we’re out there thinking about you every day, every time we do one of these transactions.

If the operator will come on now we’ll open it up for some questions and tell you what we hear from our (inaudible)

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Vernon Plack BB&T Capital Markets. Please state your question.

Vernon Plack – BB&T Capital Markets

Thanks very much. And, this question is for Mark. Mark, could you tell me what the commercial paper rate that your lender’s currently charging you?

Mark Perrigo

Commercial paper is about a little over 2.5%.

Vernon Plack – BB&T Capital Markets

Okay, thanks very much.

Operator

Thank you. (Operator Instructions). Our next question comes from Wayne Silby (ph). Please state your question.

Wayne Silby

Hi David, long time. My question has to do with the fair value accounting versus mark to model versus looking at what other syndicated loans are selling for at distressed prices or market transactions. Then, you seem to indicate that you actually look at actual transactions in the marketplace to mark to those distressed sale prices. Did I hear that correctly so this is kind of a mark-to-market as opposed to a fair value kind of portfolio pricing?

David Dullum

Well, you did hear correctly. We come at the marketplace from two directions. One, of course, is that on the senior syndicated loans, we can call off the folks that make a market in that and get an indicative bid and use that many times in our evaluation.

Also, we have Standards & Poor’s evaluation service. They also provide a review. They give us a value on some of our loans, and we use that. And I’m pretty sure, I don’t know that absolutely, that they use the transactions that are going on in the marketplace or senior syndicated loans.

And for our regular loans, they have their own model that they use and give us a value on it. I’m not sure there’s a distinguishment between fair value and market price where you have bids and ads are there for securities.

The SEC’s pretty adamant that you use market prices, that is bid and ask prices, when you can find them. And then if you can’t find them, you have to use something else. But I hope that answers your question.

Wayne Silby

Thank you.

David Dullum

Any follow-up Wayne?

Operator

So we have another question from Jon Arfstrom with RBC Capital Markets. Please state your question.

Jon Arfstrom – RBC Capital Markets

Thanks. Good morning, guys.

David Dullum

Good morning.

Jon Arfstrom – RBC Capital Markets

Question for you on a comment you made about an increased appetite potentially on the mezzanine and co-equity investments, could you talk a little bit about how you compare and contrast that against control investing and how large do you think that could get the percentage of the portfolio?

David Dullum

Sure, I’ll ask Dave to answer it as well, but my approach to it is really two areas out there. We do see transactions on our own. That is, there is no sponsor group coming in with them and we do those transactions, but most of those transactions do have a management team and the management team is co-investing.

So, you could say that we’re acting as a prompter with the management team. In other instances, we have a prompter, and these prompters are traditional LBO funds and some of them are what we call fundless sponsors. That is, they are a group with some money but they’re not running a fund per say. They’re raising money each time they find a transaction to put that money in.

And in those cases, we will co-invest in equity with them. But we’ll also provide the mezzanine financing, and in some cases, the senior debt in order to get the deal closed. All of those are in buyouts. These are proprietary deals that we find on our own or with brokers out there in the marketplace. And Dave, do you want to add anything to that?

David Gladstone

No, David, I think that’s a good description. I think the only potentially additional piece might be we’re very sensitive when we make these investments whether they are with a fundless sponsor or as part of a fully invested private equity sponsor. We’re very sensitive to all blended rate of investment, so we don’t really consider ourselves a pure mezzanine funds per say because we are interested in the equity co-investment piece for the capital gains portion.

And that’s really where we’re finding some interest principle based on, again, equity sponsors where, as I mentioned earlier, the fact that their percentage of the transaction is increasing in the capital structures except that they’re able to reduce perhaps some of their equity it gives us an opportunity.

So I think in general we see that trend. It gives us the market we’re in and starting with the senior bank lending fees, most cases, at this point, owe less than two times EBITDA. That does provide us a very interesting opportunity.

David Dullum

Other questions John?

Jon Arfstrom – RBC Capital Markets

Yes, just one more on your net renewal, can you talk a bit about discussions you might have had with other banks to expand that and given the reduced size of this, is it putting any constraints on your business in terms of the ability to grow?

David Dullum

At this point, it’s not putting a constraint on us growing but it will over time and we don’t find additional folks join the credit line. Deutsche Bank is our line of credit. They were very gracious to come into the line again for $125 million.

We do have a commitment letter for one group and we’re negotiating that somewhere between a $35 and a 50 million transaction. We have another group, another bank that came in for $25 million. It’s gone through their credit committee, but we’re not finished yet and go up to their senior management.

And we have a third bank that has indicated $25 million but it’s not gone through their credit committee. If all of those came together you’d have an additional $100 million. I don’t know that all of that will happen, but that’s where we’re going John.

Jon Arfstrom – RBC Capital Markets

Okay, thanks guys.

Operator

Our next question comes from Ross Demmerle with Hilliard Lyons.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Good morning. I just wanted to follow up on the line of credit regarding a potential interest rate on that. I noticed in the Q, your borrowing cost at the end of the quarter were 3.9%. And it looks like the commercial paper rate is 2.5%. And then the line of credit is 3.5 on top of that. So are we looking at a potential increase on borrowing the 6% perhaps in the next quarter? Is that possible?

David Dullum

That’s right. You’ve done the math correctly. Interest rates have gone up and of course we are charging more for our money as well. So we have to pass that on to the small business concerns.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Okay, thanks.

Operator

(Operator Instructions) Our next question comes from Adrian Day with Adrian Day Asset Management. Please state your question.

Adrian Day – Adrian Day Asset Management

Yes, good morning David. I have two questions about (inaudible). First, on the dividends, unless I’m misreading it, you’re not actually earning the dividend at the moment and I wondered when you’d see that changing and just give us a little bit more comfort on that please.

David Dullum

Alright, the dividend, we are short, but our projections, hopefully by the end of March will show us getting very close to doing that. What we do is we put together a budget for the year and we try to project out that we’re going to make our dividend for the whole year.

So that means sometimes in the early part of the year you might now make it. What has hurt us most here I think is first of all, we issued more shares thinking we were going to put that money out quickly and we didn’t put that our quickly. So that hurt us.

And then the second part of it is that interest rates have actually come back down very far as you know from the fed reducing rates and since our seniors syndicated loans don’t have any floors, those have gone down as well and hurt us on that part of it. So we’ve gotten hurt from both of those.

I think inflation will be with us next year and interest rates will go up. So as a result we’ll have an opportunity to have more money coming in. But if you watch our P&L, what happens is while rates go up and it helps us on the top line, rates also go up as the last person indicated on our expenses from the cost of our financing.

So we sort of give it back to the banks what we get on the top line. But hopefully by March, we’ll be at a break-even in terms of where we are with the dividends and the payout. (Inaudible).

Adrian Day – Adrian Day Asset Management

Sorry, on the line of credit, just one more quick one on that if I may, were you a little bit surprised that they didn’t renew the line for longer periods or is it just part of the overall market environment?

David Dullum

Unfortunately it’s part of the market environment. If you want any of the business development companies and from that standpoint almost any of the finance companies, there’s been an absolute dramatic drop in the amount of credit that’s available to everyone.

Adrian Day – Adrian Day Asset Management

Right, right, okay thank you.

David Dullum

Next question

Operator

Our next question comes from Lee Carter (ph). Please state your question.

Lee Carter

Good morning David. A couple things, have you ever heard of the word exigent? Do you know what that means?

David Dullum

I’m afraid you got me stumped. Go ahead.

Lee Carter

I was too, so I looked it up. Anyhow, exigent is unusual circumstances requiring immediate attention, demanding, and exacting. Now, I’m not being critical of David Gladstone or the Gladstone company, don’t get me wrong. But we are in a little bind here.

And I went through the perspectives, or we did, and on page 30, on gains, it says they are available for opportunist investments, securities of public companies. And that’s on page 37 and page 30. And then on Glad, we may prospect, may purchase other book value. I didn’t plan to think I purchased somebody else. But wouldn’t GAIN at this level, half a book, be a consideration for Glad or GAIN to buyback?

David Dullum

Buybacks are a condition upon banks approving it. And the banks at this point in time would take a dim view of our reducing our equity base by buying back shares. Even at this price.

Lee Carter

Okay, how about having Glad buying the stocks?

David Dullum

The bottom line of that of course is that we can’t buy very much of it because one business development company can’t own another because of their mutual funds. Mutual funds have, under the 1940 act, a prohibition of ownership.

Lee Carter

Okay.

David Dullum

I think the maximum ownership is 3%.

Lee Carter

You wouldn’t be able to get much more than 3% anyway the way things are working out. Anyway, what’s happened is it’s gone below the six and the five and it’s kind of killed the margin accounts. Kind of it has killed them and that’s why I was looking maybe towards something a little bit different. But anyhow, in my mind, the shorts are in our lunch, our breakfast, and our dinner with what’s going on at this price level.

David Dullum

Well, there’s no question there’s about a million shares short on this stock so they’re out there pounding away at us and that’s the problem with our system that a $6 billion hedge fund can come in and short the stock and win every time. And there’s not a thing we can do about it because the SEC just doesn’t have the stomach for putting out that fire.

Lee Carter

Right, at the current time, when you say -- and one of the things -- we get 7% as an investor before the 20% kicks in. Is that based on the book value originally or is that based on the current book value David?

David Dullum

It’s based on the current net asset value of the current book.

Lee Carter

Okay, what does the average company say, what’s it like for them down the pike three to six months?

David Dullum

You mean our average portfolio company?

Lee Carter

Yes.

David Dullum

The portfolio companies are performing very well. We have very few problems in our portfolio today.

Lee Carter

Good.

David Dullum

But it’s relative. You have an investment that’s autos or housing, you’re getting hammered today and of course we don’t have that. So we’re not having that problem.

Lee Carter

Right.

David Dullum

But our biggest problem today is that the banks that have been financing autos and housing are in terrible situations because they’ve overextended their investments in that area and now are reaping the loses and it’s caused them not to make loans to anyone.

And so as a result, many of our portfolio companies have been pinched by their own banks saying that it’s very difficult for them to get credit lines. Now, the normal credit line that they get, which is a revolving line of credit and a little bit of return debt, is actually not too hard to get from the banks.

They’re still doing asset-based loans. And that part of the banking community seems to be fine. But the old days of getting a cash flow loan from a bank are gone, at least in the near term. And so that hurts a lot of small businesses, especially those that don’t have a lot of assets such as companies in the serving area.

It’s good for us because it gives us the opportunity to go in and finance those businesses but at the same time, it makes it more difficult for them to make money if they’re paying higher rates rather than the low rates of the bank.

Lee Carter

So what does that mean? What you told the other fellows that called up was basically the line of credit now is not really a pinch on the amount of business that you can do currently.

David Dullum

That’s right. But we need to increase it back to the 200 if we want to grow this the way we want to grow it. We have two alternatives here. First of all, we can sell our senior syndicated loans. We have about $125 million of those that we could sell off. We had some cash at the end of the quarter.

So that obviously can be used. And then finally, if those who don’t work, we’ve got to find a way to raise additional followings. We’ve got to increase the 125 back up to 200. Those are the two areas which we’ll be using over the next six months to fund our growth.

Lee Carter

Okay, alright. Thank you, David, in this incredible environment, doing great. Thank you.

David Dullum

We’ll come out of this. I know everybody gets worried about this kind of stuff, but this is a typical kind of down turn that everybody -- I remember it in 1990, people were, as they say, standing on a ledge worried about what was going to happen tomorrow. In six months we’ll look back. Maybe it’ll take a year, but we’ll wind our way through this situation that we’re in and we’ll start climbing back out of it and business will be fine.

Lee Carter

You said last quarter this is your time.

David Dullum

This is our time. We’re just making sure that we don’t make a misstep and that there isn’t one more big downturn. We actually thought the economy turned around in March and April of this year but it turned out not to be true. Luckily, we have not weighed it in. As you know, we’ve not done that many transactions since March 31st. And luckily that’s been a good thing for us.

Lee Carter

One last question, what is your leverage right now?

David Dullum

What’s the amount of loans that we have outstanding now, Mark?

Mark Perrigo

Is it about three-quarters to one?

David Dullum

It’s about .6 to one.

Lee Carter

It’s a good way to be. Thank you.

David Dullum

Next question.

Operator

Our next question comes from Ross Demmerle with Hilliard Lyons. Please state your question.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Yes, I had a follow up regarding just some miscellaneous expenses. It looked like professional fees, stockholder related costs, and general administrative expenses combined moved up about 200,000 from the previous quarter and I’m wondering if that’s an aberration or it’s likely to go down in the current quarter we’re in right now. And each line item isn’t a whole lot, but 200,000, I guess, that’s real money.

David Dullum

Well, Mark, why don’t you explain that?

Mark Perrigo

Right, a good chunk of that really is related to the direct offering cost that came through this quarter and as well as some additional audits. We went through our year in audits but we have additional audit fees. We spent them when incurred. So those came through in the quarter as well.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

So, I mean it sounds like some of those line items might come down in the current quarter.

Mark Perrigo

It’s mostly a timing issue.

David Dullum

Well, and the right’s offering was obviously -- we’re not doing another write off.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Yes, okay.

David Dullum

So that’ll come off.

Ross Demmerle – J.J.B. Hilliard W. L. Lyons

Alright, very good.

David Dullum

Okay, next question.

Operator

And Mr. Gladstone, there are no further questions at this time.

David Dullum

Do we have any last questions?

Operator

One just queued up here, one moment. Our next question comes from Robert Dodd with Morgan Keegan, Inc.

Robert Dodd – Morgan Keegan, Inc.

Hi guys, going back to the debt equity at 0.6, I’ve got that number a little high on the actual debt outstanding. Could you give us the actual number?

David Dullum

I’ve got it right here on the P&L. Let me pull them out for you. (Inaudible) 130 divided by 208, 0.56. Is that close enough for you?

Robert Dodd – Morgan Keegan, Inc.

Yes, that’s perfect.

David Dullum

Okay, who’s next? Any other questions?

Operator

There are no other questions at this time, sir.

David Gladstone

Alright, thank you all for attending the meeting. We hope we gave you the information you need. If not, please call us here at the office and we’ll try to answer any questions we can after the call. That’s the end of this call. Thank you Diego.

Operator

Thank you, sir. Ladies and gentlemen this does conclude today’s teleconference. (Operator Instructions) Thank you all for your participation.

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Source: Gladstone Investment Corporation, Q2 2008 Earnings Call Transcript
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