(Operator Instructions) I would like to welcome everyone to the Allied Capital Third Quarter Earnings Call. Mr. Walton you may begin your conference.
Welcome to Allied Capital's Third Quarter 2008 Conference Call. I am joined today by Joan Sweeney, our Chief Operating Officer, Penni Roll, our Chief Financial Officer, Shelley Huchel, Director of Investor Relations. We also have with us today Rob Long, Head of Asset Management. Shelley, will you open the discussion with the required conference call information.
Today's call is being recorded and webcast live through our website at www.AlliedCapital.com. An archive of today's webcast will also be available on our website as will an audio replay of the conference call. Replay information is included in our press release today and is posted on our website. Please note that this call is the property of Allied Capital. Any unauthorized rebroadcast of this call in any form is strictly prohibited.
I’d also like to call your attention to the customary Safe Harbor disclosure in our press release today regarding forward looking information. Today's conference call includes forward looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward looking statements unless required by law. To obtain copies of our latest SEC filings please visit our website or call Investor Relations.
For today's conference call, we have provided a companion slide deck that complements our discussion and lays out many of the numbers we will discuss. These slides are available in the presentations and reports section of the investor resources portion of our website. We will make reference to the data included in the slides throughout today's call. Finally, as always, there will be a Q&A session after the presentation.
With that, I will turn it over to Bill.
We’re here today to report on our third quarter 2008 results and to give you an update on our business and the current market environment. Obviously these are tough times. Financial markets are now struggling in the proverbial 100 year flood. Volatility in the credit and equity markets has accelerated in the past few quarters resulting in a relentless mark to market decline in prices in virtually all financial assets.
We now face a period of prolonged de-leveraging of corporate institutional and even personal balance sheets. Economies throughout the world are suffering from this massive contraction in credit so it’s not surprising that both the domestic and global economic conditions have continued to weaken which in turn puts further pressure on the markets and financial institutions in particular.
As a financial institution Allied Capital is confronting these same pressures. Fortunately we have some distinct advantages. First, our balance sheet leverage is low at .8x debt to equity. Second, we tend to invest in companies with a higher return on invested capital, limited CapEx and strong cash flow. Third, our assets and liabilities are essentially match funded in terms of duration. We fund our long term assets with long term unsecured debt and equity capital.
Despite these differences, Allied Capital as well as the rest of the BDC industry has been adversely impacted by the market volatility and negative economic trends. While our operating results for the third quarter included net operating income of $0.26 per share and net realized gains of $0.35 per share we recorded net unrealized depreciation in the portfolio of $425.9 million which resulted in a loss for the quarter of $1.78 per share and reduced our net asset value to $13.51 per share.
This challenging economy and severe disruption in the capital markets causes us to reexamine how we should allocate increasingly scare capital resources in what is likely to be a difficult climate for financial firms for some time to come. Over the long term we will continue our strategy to lend and invest in US middle markets. We also have plans to continue to expand our asset management platform. However, for the immediate future, in order to weather the current economic cycle we have made preservation of capital our highest priority.
To that end we plan to take the following actions; first, we’re acting again to reduce our costs across all areas of our firm which will include further reductions in staff compensation and administrative expenses over the next few months. Perspective staffing however will reflect our focus on building value in our portfolio companies, continue to grow the asset management business and will also reflect our expectations of lower new investment originations.
Second, we plan to direct more of our operating income and cash flow from portfolio access towards retention of cash and building liquidity. We plan to deploy new capital only in the very most attractive long term investment opportunities or in transactions that strategically enhance our franchise. The lack of financing available in the markets has led us to a decision to favor further de-leveraging our balance sheet over making new investments.
The third step is to review our dividend. We’ve already declared it will pay the fourth quarter dividend of $0.65 per share in late December. For 2009 the Board of Directors will examine our dividend with the goal of emphasizing capital preservation and building net asset value over time. As a result we expect as we move into 2009 the dividend will be significantly reduced. As a RIC we are required to distribute 90% of ordinary income and we may retain or deem to distribute capital gains income.
From where we stand right now we anticipate that for 2009 our dividends will more closely approximate our net investment income. We believe that by reducing our cash payout we can preserve and build our capital base.
Finally, we will continue to work aggressively to create value within our existing portfolio of both control and non-control investments. We’ll continue to harvest capital from the portfolio especially targeting lower yielding investments, reserving the proceeds to improve our financial position.
These steps are being taken with a view to maximizing liquidity and shareholder value over time. We’re disappointed with the decline in our stock price however we believe that investors will increasingly focus on stability of our net asset value and by improving our liquidity now we believe we will be in a better position to take advantage of the opportunities being created by the current turmoil.
Rob could you provide some more perspective on the market?
Over the last 90 days liquidity for all types of financial assets has virtually evaporated. Perhaps the starkest example is the weakness in the senior loan market. Because this market represents the most senior claim and corporate credit more leverage was available to finance this asset class and was used extensively by investors in recent years.
As leverage is now being reduced across financial markets the pressure to sell has fallen more heavily on the senior loan market. Some investors borrowed based on the market value of loan portfolios and a number of these have faced margin calls or forced liquidation which has put significant pressure on market prices. Falling market prices affect the fair value of our portfolio. During the quarter loan prices fell again.
In this chaotic environment new issue activity has also slowed dramatically. During the quarter new issues were down 59% from the second quarter of 2008 as many institutional lenders specifically hedged funds in other leverage vehicles, worked to sell paper and raise cash.
Market loan default rates have been climbing from the record low levels of recent years and reached a five year high of 3.32% in September 2008 up from 2.58% three months earlier. This is not much above the historical average rate of about 3% and is concentrated in only a few industries at present. Current economic indicators suggest that [inaudible]
Over the last 20 years the average recovery rate of senior loans in default has been about 73%. However, recent market prices have seemed to decouple from loan default in recovery realities. With the markets trading at current levels it is clear that technical pressures are setting prices rather than the actual default experience.
The current market price for actively traded loans implies a default rate of nearly 100% at historic recovery levels. Clearly the depth and breadth of this financial crisis suggests that default rates will rise further but the loan market is currently pricing scenarios that would be worse than those of the great depression.
M&A activity is also slowing dramatically as the new issue market is closed to all but a few high quality companies. From slide three you can see that leverage buyout volume continued to decline last quarter falling from an average of approximately $100 billion per quarter in 2007 to only $17 billion for the third quarter 2008. Total year to date 2008 LBO volume was $107.6 billion as compared to $309 billion in the comparable period in 2007.
On slide four we see that leveraged loan debt multiples have fallen significantly in 2008. For the third quarter 2008 industry average total debt multiples for leveraged loans were 5.2x EBITDA. In the middle market structures are more conservative with average total debt multiples at 4.6x EBITDA. Middle market average senior debt leverage was 3.5x EBITDA down significantly from the 4x to 5x multiples over the last few years. Currently we see senior loan ratios at 3x EBITA or less and total debt levels of 4x to 4.5x.
Turning to slide five the few recent transactions that were completed show that purchase price multiples for companies have not declined in a meaningful way yet and stood steady at 8.4x EBITDA through the first three quarters of 2008. Even though debt financing has been greatly reduced private equity sponsors have continued to buy the highest quality companies at fairly high prices choosing to put more equity into deals to get them done.
You can see from slide six that equity contributions comprised 44% of capital structure in the third quarter. Because of the longer term nature of its capital private equity has not been facing the same liquidity pressures as the debt markets or public equity markets. This may change as risk preferences and falling public equity prices lead investors to seek attractive returns in more liquid securities.
Given this market backdrop as Bill said earlier, we believe the best strategy for us right now is to invest only in the most attractive long term opportunities. In addition, we are focused on strategic investments that serve to build our asset management platform. We are also focused on our portfolio and building value within our existing middle market companies. We believe that this is the best strategy in this market and we are keenly focused on this plan.
With that I turn things back to Bill.
Joan could you discuss our third quarter results?
Let’s start with a discussion of our September 30, 2008 balance sheet. Please turn to our summary balance sheet which is on page seven of the slide deck. We ended the quarter with total assets of $4.6 billion, total debt of $2.1 billion and total shareholders equity of $2.4 billion. Our shareholders equity included undistributed earnings of $422 million. Our leverage ratio at September 30, 2008 was 0.88:1 and net of cash and other liquid investments was 0.79:1.
At the end of the quarter we had cash and investments in liquid assets of $215 million. We have had retainment and harvest activity in the first nine months of this year totaling $878.2 million. We are continuing to identify investments that we may exit to generate additional liquidity. As Bill mentioned we are currently biased towards retainment of debt and generating liquidity over any investment activity.
We also plan to seek an amendment to our net worth covenant with our private lenders during this quarter. As the depreciation we experienced in the third quarter reduced our excess margin on this covenant. We would expect that as the economy worsens and should credit spreads widen we may see additional depreciation in the portfolio and we want our balance sheet and our covenant package to be positioned to withstand this. Also, reducing our 2009 dividend payments will assist in stabilizing that work.
Allied Capital has been known for managing a conservative and simple balance sheet, finance with unsecured debt and we are focused on further bolstering our position for this difficult economy. We invested a total of $434 million in the third quarter and were repaid or exited from investments totaling $281 million.
After including the impact of this quarters valuation and other changes our portfolio at value was $4.2 billion as of September 30, 2008. The yield on our interest bearing portfolio at September 30, 2008 was 11.9% as compared to 12.7% at June 30, 2008. The decline in yield primarily related to our purchase of the $319 million senior secured loan of Ciena Capital on September 30 which we immediately placed on non-accrual. This Ciena loan had a value of $180.2 million at September 30, 2008.
At September 30, shareholders equity or net asset value was $13.51 per share as compared to $15.93 per share at June 30, 2008. Please turn to slide eight for a summary of the changes in NAV for the quarter.
During the third quarter net investment income increased NAV by $0.26 per share, net realized gains increased NAV by $0.35 per share. Dividends paid to shareholders decreased NAV by $0.65 per share and NAV decreased by $2.38 per share due to net changes in unrealized appreciation or depreciation.
Now let’s move to a discussion of our earnings. For this discussion please turn to slide nine. Interest income for the quarter ended September 30, 2008, was $110.2 million as compared to $119 million in the second quarter 2008. In addition to the Ciena loan other loans placed on non-accrual during the quarter reduced our third quarter interest income by approximately $9 million.
Dividend income for the third quarter 2008 was $2 million as compared to $0.2 million in the second quarter. Dividend income will vary from quarter to quarter depending upon the level of dividend declarations from portfolio companies.
Fees and other income were $8.5 million for the third quarter 2008 as compared to $15.4 million in the second quarter. In the third quarter our investment activity was lower than in the previous quarter leading to a decline in fee income. Fees and other income will fluctuate both quarter to quarter depending upon the level of investment activity and types of services provided and the level of fund assets under management from which we earn fees.
Given our current outlook for future investment activity we would expect the future fee income will reflect lower new investment levels.
Total operating expenses were $73 million in the third quarter 2008 as compared to $66.6 million in the second quarter. The comparability of quarter to quarter expenses was affected by several items. Please turn to slide 10 for a discussion of the more significant operating expense items for the quarter.
Interest expense excluding installment sale interest expense was $34 million for the third quarter comparable to the $34.5 million in the second quarter 2008. Third quarter employee expense excluding the individual performance award was $19.4 million which includes severance costs of $3.4 million.
As we discussed last quarter we consolidated our investment execution activity to our Washington DC and New York offices and continue to maintain offices in Chicago and Los Angeles solely for business development activities. As we transitioned and consolidated our operation we reduced our headcount by approximately 30 employees. Excluding severance costs our employee expenses for the third quarter 2008 were $16 million as compared to $11.1 million for the second quarter 2008.
Third quarter expense was higher than second quarter expense because as you may recall employee expenses were lower in the second quarter because of the reduction in our annual bonus pool accrual. As we further reduce our headcount in the fourth quarter 2008 we may incur additional severance costs.
Our core administrative expenses for the third quarter were $13.7 million as compared to $12.3 million in the second quarter. We had some higher than normal costs in the third quarter related to deals that did not close totaling approximately $2 million.
Excise taxes were $0.9 million in the third quarter and we had an income tax expense of $1.2 million for the quarter.
Now turning back to slide nine, net investment income was $45.6 million or $0.26 per share in the third quarter as compared to $63.9 million or $0.37 per share in the second quarter 2008 and $18.3 million or $0.12 per share in the third quarter 2007. Net realized gains for the third quarter were $62 million or $0.35 per share. Growth gains totaled $97.5 million for the quarter which included a realized gain from our sale of Norwesco of $86.9 million and gross losses were $35.5 million.
Net investment income and net realized gains totaled $107.6 million for the third quarter 2008 or $0.60 per share. Net unrealized deprecation for the third quarter totaled $425.9 million or $2.38 per share. Penni will provide further details on the components of net unrealized depreciation for the quarter in a moment. Net investment income and net realized gains reduced by net unrealized depreciation resulted in a net loss for the quarter of $318.3 million or $1.78 per share.
With that I’ll turn the discussion back to you Bill.
Penni, can you walk us through results of valuation process and portfolio quality statistics, etc.?
Let’s start with a discussion about the net change in unrealized appreciation or depreciation if you will please turn to slide 12 of the slide deck.
For the quarter ended September 30, 2008 the total net change in unrealized appreciation or depreciation was a decrease of $425.9 million. This change resulted from $378.7 million in net unrealized depreciation from changes in portfolio value and $82 million reversal of previously recorded unrealized appreciation associated with the realization of gains and dividend income and a $34.8 million reversal of previously reported unrealized depreciation associated with the realization of losses.
We experienced significant unrealized depreciation in our portfolio for the quarter ended September 30, 2008. We have seen unprecedented disruption in the capital markets which has resulted in widening loan spreads and increased deal expectations for buyers of financial assets. We have also seen an impact from the softening economy which has affected the earnings power of some of our portfolio companies.
The most significant impact on unrealized depreciation this quarter related to our investment in Ciena. On September 30, 2008, our portfolio company Ciena Capital filed voluntary petition for relief under Chapter 11 of the Bankruptcy code. As a result of Ciena’s decision to file for bankruptcy protection our unconditional guarantee of the obligations outstanding under Ciena’s revolving credit facility became due and Allied Capital in lieu of paying under its guarantee purchased the positions of the senior lenders under Ciena’s revolving credit facility.
Our cost basis in Ciena’s senior secured loan is $319 million which had a value of $180.2 million at September 30th. We valued our investment in Ciena this quarter based on the estimated net realizable value of Ciena’s assets including the estimated net realizable value of the cash flows generated from Ciena’s retained interest in its current servicing portfolio.
Ciena has continued to experience deterioration in the value of its assets and residual interest as a result of a continued increase in the uncertainty in the financial markets, decreasing bid prices and a reduction in the number of loan buyers in the market. As a result, we recorded unrealized depreciation related to our investment in Ciena of $151.9 million for the third quarter. We hope that under the protection of the bankruptcy courts Ciena will be able to maximize the value of its assets over the long term.
In addition to the depreciation we recorded on Ciena this quarter we recorded unrealized deprecation related to non-buyout debt investments totaling $32.4 million as a result of using a yield analysis to value these assets. Financial services an asset management portfolio company and our CLO and CDL investments totaling $38.5 million, four companies in the automotive or RV parts and services industry had total depreciation of $63.8 million and we also saw decrease enterprise values in general as the result of lower EBITDA resulting from current economic conditions including oil and food prices.
Given current market conditions we would expect that as the economy worsens and should credit spreads widen we may see additional deprecation in our investment portfolio in future quarters.
We continue to receive third party valuation assistance for our private finance portfolio and as you can see from slide 13 we received third party assistance for 97.2% of the private finance portfolio for the third quarter 2008. You will be able to review the changes in portfolio valuation in more detail in our Form 10-Q that we will file shortly.
Now let me turn to a discussion of our portfolio quality metric. Our grade four and five assets are workout assets, our loans and debt securities not accruing interest and our loans and debt securities over 90 days delinquent. For this please turn to slide 15. Here you see a summary of our grade four and five assets or workout assets for the last 10 years and for the past seven quarters. Grades four and five assets were $379.1 million or 9% of the portfolio value at September 30, 2008, compared to $77.9 million or 1.7% of the portfolio value at June 30, 2008.
The main driver of the deterioration of our measures of credit quality was the purchase of the senior secured loan of Ciena Capital on September 30th. Grades four and five assets excluding Ciena were 4.7% of the total portfolio at value.
One slide 16 we have a similar analysis for loans and debt securities not accruing interest. Loans and debt securities not accruing interest at September 30, 2008, were $383.1 million or 9.1% of the portfolio value as compared to $109.6 million or 2.4% of the portfolio at value at June 30. Excluding Ciena Capital total loans on non-accrual were $202.9 million or 4.8% of the portfolio at value.
As we mentioned earlier we have seen a decline in value of certain companies due to the economic environment and as a result we have seen an increase in our grade four and five assets and non-accruing assets.
On slide 17 we show loans and debt securities over 90 days delinquent. Loans and debt securities over 90 days delinquent at September 30, 2008, were $21.4 million or 0.5% of the total portfolio at value. At June 30, 2008, loans and debt securities over 90 days delinquent were $23.7 million or 0.5% of the portfolio at value.
Since we purchased the Ciena note on September 30, net asset did not impact loans over 90 days delinquent. We are not accruing any interest on this loan and this loan will become delinquent as we will not receive payments while Ciena is in bankruptcy.
I’d like now to move to a discussion about our taxable earnings. At September 30, 2007, the company had excess taxable income of $393.3 million available for distribution to shareholders in 2008. The company’s regular quarterly dividend payout for the first three quarters of 2008 was $0.65 per share and totaled $340.4 million. In July our Board of Directors declared the fourth quarter 2008 dividend of $0.65 per share. Most of our 2008 dividend payments have been or will be made from excess 2007 taxable earnings.
We expect to end the 2008 tax year with taxable income that has not been distributed this year and will thus be carried forward for distribution in 2009. As Bill mentioned we are setting our 2009 dividend strategy and we plan to reduce dividends significantly in 2009. As a result our strategy for taxable income distribution and spill over income may change. As we move forward we may choose to employ additional dividend strategies with the focus on preservation of capital such as retaining or deeming to distribute capital gain income.
In addition to spill over taxable income the company has approximately $236 million in deferred taxable income resulting from installment sale gains. These gains may be deferred for tax purposes until the installment notes are sold or collected in cash.
I want to add a caveat to this discussion with the comment that we experience numerous temporary and pertinent differences in the recognition of book and taxable income and I encourage you to read our tax disclosure in our 2007 Form 10-K and our third quarter Form 10-Q for a more detailed discussion of our taxable earnings.
With that I’ll turn it back to you Bill.
Before we wrap up our formal remarks I’d like to add, in light of the current environment the Board has asked Joan to delay her retirement and she has agreed to remain our Chief Operating Officer. Here’s what I think you can take away from today’s call. Rough environment, operating results this quarter reflect that. However, we’re making major adjustments in our operating capital and dividend strategies to navigate through these difficult times. Right now our focus is capital preservation and weathering the cycle. We believe this strategy is the right one for our company, our lenders and our shareholders.
Could we now open the line for questions?
(Operator Instructions) Your first question comes from Troy Ward - Stifel Nicolaus
Troy Ward - Stifel Nicolaus
You went through several, four or five different topics rather quickly, could you go back and give a little more color on potential reduction in staff and severance costs going forward and how we may look at that from the modeling perspective?
We haven’t completed a detailed review of the organization yet. We’re going to start that, we’ve been looking at it preliminarily. We’ll probably have something to talk to people about more concretely pretty soon. We’ll get something out there for you. It will be at or where we were or more than what we did last time.
Troy Ward - Stifel Nicolaus
You talked about further de-leveraging in the balance sheet and clearly in this environment I think investors are probably more comfortable with that. Where are you comfortable with running the leverage assuming that the environment stays status quo, hopefully not, but if it does throughout 2009?
I’ve never liked a lot of leverage anyway. I think as low as we can get it consistent with the liquidity of the portfolio. We’ve enjoyed good realization from the portfolio so far this year I think it’s over $800 million and we’ve got a team organized to do more of that. Of course the last couple weeks have not been a good time to sell assets. We’re going to be using the proceeds by and large to pay down debt. I don’t know what the number would be. It would be great to get to 0.5, 0.6, something like that.
Troy Ward - Stifel Nicolaus
On Callidus, in the press release you talked about you bought the minority stake out in that. Can you provide some color on that decision?
Callidus, as you may remember has been a successfully growing portfolio company and at the time it was coming up to our fifth anniversary of the transaction and we felt that it would be useful to have 100% ownership of this asset. We’re entering a period of some likely consolidation in the asset management area. This puts us in a better position to look at combination with other managers and it’s been a part of our intention all along from the beginning of the transaction.
Troy Ward - Stifel Nicolaus
You said it was coming up on the fifth anniversary. Was there something contractual versus the maturity of it?
As I said, it was part of our original intention when we went into the transaction to affect this and we did this right before the fifth anniversary as we had expected.
Troy Ward - Stifel Nicolaus
You talked about a minimum net worth covenant on your, I believe it was a Bank of America facility, can you tell us what that covenant is?
We have a threshold minimum net worth covenant it’s in our line of credit; it’s also in our privately placed medium term note. It just requires us to have a minimum net worth, there are various thresholds but the highest threshold is about $2.373 billion.
Your next question comes from Vernon Plack - BBT Capital Market
Vernon Plack - BBT Capital Market
What was the minimum net worth requirement again, I’m sorry I didn’t here that?
Vernon Plack - BBT Capital Market
Is there any update at all that you can give us at this point in terms of, I’d like to get a sense for resolution on Ciena from a bankruptcy perspective what’s your sense of urgency there. I’d like to get some color on that if you could.
I think what the bankruptcy filing does is it allows us to sell to loans and pay down the debt in a more orderly fashion. I think we’re not really concerned about the speed as much at this point as we are getting full value in the loans. Selling in this market is not, we think, the right thing to do. I think we hope that the credit market would soft somewhat in first, second quarter and we could get into a more aggressive mode selling down assets and reducing our exposure to it. A bankruptcy like this probably takes a year.
Vernon Plack - BBT Capital Market
Could you remind me what your unfunded commitments are that you’re currently carrying?
We’ll look that up and get back to you.
Your next question comes from Jim Shanahan - Wachovia
Jim Shanahan - Wachovia
The minimum net worth coming in of $2.373 billion your tangible shareholders equity is only modestly above that now. Can you talk about what happens here procedurally if you were to revalue the portfolio lower and trip that covenant, what happens from a cash flow perspective and if there are, for example, any fees that you could pay to either negotiate that minimum net worth covenant lower or to avoid anything catastrophic?
What we plan to do is clearly we want to get our third quarter results complete. What our plan is to work with our lenders over the next several weeks and try to negotiate an amendment to that covenant. Clearly in this unprecedented time with respect to asset values declining that’s something that we think is something we will take care of this quarter.
What’s interesting about our capital structure is that we have an absolute 200% asset coverage requirement in our regulatory structure and so it’s fairly manageable to stay within 200% asset coverage. What’s difficult is you can’t really create tangible net worth when you’re looking at portfolio depreciation so we need to go to our lenders and sit down and work with them.
From the standpoint of our balance sheet we’re still in very good shape because we don’t have any secured debt, we have a completely unsecured capital structure all lenders share alike in our capital structure. We’re just going to work with them over the next quarter. My guess is that it will come with some costs to it to get the covenant amended but that’s something we’ll work through with our lenders.
Jim Shanahan - Wachovia
I do recall years ago that there was some criticism around the company relating to your not using lower cost structured financing hopefully to naysayers see the value in that today.
A follow up question related to the minimum net worth covenants. With this extraordinary turn of events here in the last few months in particular, carefully choose my words here, I think its highlighted business model weaknesses or deficiencies is there anything that you’re doing as a company at the highest levels to maybe address some of these business model concerns with the SEC or Congress, modifications to the BDC model that would make it survivability far more likely than maybe some are estimating today?
One regulatory fix that would be extraordinarily helpful is to be able to include preferred stock in our equity base. Right now under the rules it’s considered debt so it doesn’t help us with our leverage. You read and see all the financial institutions getting preferred debt injections; we’re working to get ourselves in that category. That would be extraordinarily helpful. There’s really no analytical reason why it shouldn’t be part of debt. Preferred stock is the same as equity expect with preference and dividend.
I think the other thing is BDC’s have served a wonderful purpose for the middle market economy. We are working as an industry to put together some talking points to take to Congress to take to the Treasury, to take to the other government regulators to highlight that the BDC’s need a little bit more flexibility when you get into rough economic waters as we are in. Hopefully we can be persuasive on that point.
This is something all BDC’s face. We’re working together to get this change made. I think specifically for us it highlights the need to continue to focus on the asset management business. We’ve built a pretty good one and have got a pretty good position. We’ve had people come to us about joint venturing and building that out so it looks like that could also be an access, we’d have access to capital through that. I think the preferred stock is the big one for us. We do have people interested in doing that but it doesn’t help us because of the way that it’s included in leverage.
Your next question comes from Jim Ballan - JP Morgan
Jim Ballan - JP Morgan
Can you talk a little bit about on a cash basis what your run rate net investment income is today? I’m trying to get a sense obviously for ability to predict the dividend for next year. Obviously some one time operating expenses that can you give us a sense of a run rate number?
If you look at the analysis of the expenses it’s a little bit hard to give you a pure run rate. You can kind of look at some of the various expenses. For instance, we said we had some dead deal costs in the second quarter that was about $2 million. We’ll have dead deal costs from time to time but we anticipate that new investment activity is going to slow down here quite a bit. You probably won’t see that dead deal cost going forward.
We have the $3.4 million in severance expense that clearly is not a recurring type of expense. You’re probably somewhere in a range right now of $0.20 to $0.25 a quarter my guess would be in terms of net investment income going forward. As we liquidate assets to de-lever the balance sheet that’s going to hurt our recurring interest income because we’ll see interest income come down. That’s a real big ballpark and core circumstances could change as we move forward.
Jim Ballan - JP Morgan
I understand obviously the need to minimize the amount of investments that you’re making going forward. What are your thoughts on continuing to put new investments into the Unitranche fund and the senior debt fund?
I think most all financial firms in our area are taking an extremely cautious view of making new commitments until we’re through this period of uncertainty. We don’t really think that there’s going to be a high level of origination in the industry in general and probably not in the Unitranche area either until we see stabilization in the markets.
Jim Ballan - JP Morgan
Are you anticipating any incremental costs related to the Ciena bankruptcy or are those going to fairly minimal?
I think Ciena’s bankruptcy costs will be incurred by Ciena within the bankruptcy trust.
I think it’s contained within the Ciena bankruptcy now. Its cash flow to financing what its doing.
Your next question comes from Jasper Birch – Fox-Pitt, Kelton
Jasper Birch – Fox-Pitt, Kelton
In terms of ignoring Ciena for now in terms of your increasing grades four and five assets about how much of that is due to actual deterioration in your company’s operations right now.
The increase in grades four and five assets in addition to Ciena really just came primarily from just two portfolio companies. One of the companies provides a product to the truck after market, they do truck bed liners and clearly people aren’t buying trucks right now so that company’s having some trouble. Pick up trucks. The other is our investment in an apparel company. Clearly with the softness at retail you can understand why that company would be in a grade four or five category.
We’re definitely seeing this recession that people are talking about affecting the consumer. It’s here.
Jasper Birch – Fox-Pitt, Kelton
In terms of your leverage and your net worth have you guys been talking at all about doing any rights offerings or anything in terms of that? Can you comment on that?
It’s interesting we’ve been looking at a variety of things. A rights offering is a little bit difficult to do in market that’s this volatile. You have to question whether at what cost of capital do you end up issuing those shares back. Although Allied has used that in years past and it’s been an attractive way to rise equity capital, in a capital market like this we’re not sure how effective that would be.
That’s why looking at dividend strategy in its simplest form you can look at a decrease in the dividend is almost like a rights offering in a sense because it as similar effect in that not as much capital leaves the company and its being done with incumbent shareholder group. I think that looks to be a preferable strategy.
Jasper Birch – Fox-Pitt, Kelton
You guys mentioned your asset management business and how it might be attractive to expand that. I know Aries just had raised a substantial external fund is that something that you think you’ll be able to do in this environment either as Allied or through Callidus or what are the outlooks on that?
There are two dimensions worth noting here. The structured finance market is obviously going to be very inactive for a while. However, the majority of loans are actually owned by institutional investors not banks. These institutional investors, particularly pension funds will likely put capital into a market that to us seems pretty cheap at the moment. We do expect that there will be some new fund formation driven by long term institutional investors and we hope to participate in creating new asset management vehicles with these investors.
I also think that it’s possible as I mentioned earlier that there will be some consolidation of loan managers in particular and that we will expect to grow the assets in our asset management business through that direction as well.
Jasper Birch – Fox-Pitt, Kelton
It would be more like, from that commentary that Callidus would acquire another asset manager than the other way around?
Allied and there are still a large number of managers that manage three or fewer funds. For those managers it may be better to combine with a larger platform like ours.
Your next question comes from [Dan Kronski] – UBS
[Dan Kronski] – UBS
Would you consider de-leveraging by buying back some of your publicly traded debt?
Yes, we would consider it if we thought the price was attractive, absolutely we would consider it. I think retail notes are very thinly traded its hard to get much volume of that to matter but yes we would do all that and that would be continuing part of our balance sheet strategy.
Your next question comes from Robert Kelly – Bank of America
Robert Kelly – Bank of America
As an individual investor you’ve said that you plan on paying the fourth quarter dividend and you’re going to reduce the dividend in ’09. On a scale of one to ten what are you projecting how much of a reduction in the dividend or will you pay one at all?
We talked about that before. I think we currently anticipate based on what we know now and of course this past 18 months has sort of thrown forward looking statements into a whole new light where it’s hard to predict what’s going to happen. We talked about a run rate operating income of $0.20 to $0.25 and something in that range. I could be $0.15; it could be $0.30 I don’t know. It’s something like that. That’s sort of the mention we’re thinking about based on the way we see the economy right now. That’s per quarter by the way not annually.
Your next question comes from Corey Gelormini - John Hancock
Corey Gelormini - John Hancock
In terms of your estimated portfolio collections next year just in terms of your principle not prepayments what that would be. Second, there’s been a lot of talk about finance companies may be getting access to top. Have you talked to anyone in the Treasury about that and do you think if they did that it would apply to a BDC company?
It should. We are the engine; we’re one of the drivers of the economy growth capital for small and middle market companies. We’re definitely in the category of the kind of financials that they want to provide assistance to. We talked about that over the weekend about the strategy to figure out how to work with the Treasury. Nothing concrete, nothing set up yet, we’re still thinking through how that might work.
With respect to scheduled maturities or repayments we are, as Bill mentioned, we’re actively looking to actually exit from investments to generate some additional liquidity. We’ve done a lot through the first three quarters of this year. We want to continue on that path being mindful of course of not leaving too much money on the table in doing something like that. Stay tuned on that because we’re actively looking at that on a daily basis.
I think the other thing we’re thinking about I talked about this phrase building value and portfolio companies. What that really means is we’ve got some really very good buyouts that we own. The narrative like insurance services where they’ve been very stable and they’re growing. We’ve got some companies we can see building we might. We talk about redeploying capital we might put some money into those companies but other than that I think we’re looking at paying down debt.
Corey Gelormini - John Hancock
Just a clarifying question a previous caller asked about the increase, I don’t know if it was the grades four and five or something and outside Ciena you made some comment that was the truck company and then something else. You said two specific.
Corey Gelormini - John Hancock
Could you comment what those exposure are and generally if you took those three out could you give some comment on how hit is EBITDA in some of the other portfolios, obviously its hit but how significant? Obviously I heard investors trying to wrestle with is this a pervasive significant hit throughout the portfolio or is most of this obviously declining EBITDA, declining multiples but certainly not a horrendous drop off in either in most of the portfolio companies.
The two companies that I referenced one of them is a company as I say with the truck bed liner company that the exposure at value is $37 million. The other, which is the children’s apparel company the exposure, is $77.7 million of value. For what’s in the grade four and five category those investments were why the Q3 non-accruals decreased interest income by $9 million. Those were the primary drivers of that.
I wouldn’t say it’s pervasive across the portfolio. I think you can look at the companies that are most exposed to the consumer. As Penni mentioned we have a handful of companies that are somewhere in either RV or in automotive parts or spore companies. Those companies contributed to unrealized depreciation this quarter by $63.8 million. We are seeing softening but I wouldn’t say it’s pervasive across the portfolio.
No, its not.
Your last question comes from Faye Elliott - Merrill Lynch
Faye Elliott - Merrill Lynch
You were talking about selling some assets and bringing down leverage and so forth. When you’re talking about that do you mean just the natural sale and not re-deploying or are you talking about actually going out into the market and seeking buyers what some might deem a stress sale?
The answer to that question is both. I think on the later part though we’re not going to do something that’s too stressed because you don’t want to leave a lot of money on the table.
Over the years of 2006 and 2007 Allied made significant investments in senior loans at the top of the balance sheet in very conservatively capitalized companies. In a market like today investors can see the quality of those loans and we have been successful as we mentioned earlier with moving several hundred million dollars off of our balance sheet and a lot of that is the very high quality loans that we own.
Our asset management vehicles have been purchasers of some of those and third party investors in the market have been purchasers of some of those. We expect this will continue along with the natural redemptions and maturities of some of the loans themselves plus cash flow sweeps that exist in loans like Unitranches which are often 50% or 75% of cash flow going to pay down principle. It’s a blend, as Joan said it’s not likely to be distressed selling at willy-nilly prices its reasonable prices.
We’re managing our cash flow. We talked about cost reduction and we talked about the dividend. With those in place we don’t believe we’re going to need to go out and sell at the stress levels which is what I think our shareholders and lenders would want us to do. If you get $0.98 or $0.95 on something that might be attractive.
Faye Elliott - Merrill Lynch
That’s really kind of the low point we would expect to see.
I don’t want to price every asset on that. By doing the things we’re doing with our cash flow, operating expenses and the dividend we don’t believe we need to do that. That’s why we’re attacking it this way. The key I think for any financial institution we’ve seen so many business models hit the wall in the last 12 months is maintaining your capital and liquidity and getting through to the other side of this however long that takes. I think we’re taking steps to enable us to do just that.
Faye Elliott - Merrill Lynch
Do you have any timeframe when you might try and shore up everything? Is this going to be 4Q, 1Q, 2Q or are you going to see how the market firms up? What’s the timeframe we should expect on all this activity?
We’re moving on this now. This is something we’ll be doing the things we need to do in the next 60 to 120 days to get our cost structure sorted out for 2009.
Thanks everyone. Not a great quarter but not a great capital market. Hopefully we’ll be back next quarter with a more positive outlook on events. Thank everyone for joining us.
Vernon, on the commitments there’s a whole table in the 10-Q that’s going to be on file today. If you can go there it’s got a lot of good granular detail.
This does conclude today’s conference call you may now disconnect.
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