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BlackRock Kelso Capital Corp. (NASDAQ:BKCC)

Q3 2008 Earnings Call Transcript

November 6, 2008, 4:30 pm ET

Executives

James Maher – Chairman and CEO

Frank Gordon – CFO

Michael Lazar – COO

Analysts

Adam Waldo [ph]

Jim Ballan – JP Morgan

Cyril Battini – Credit Suisse

Operator

Good afternoon, my name is Kody and I will be your conference facilitator today. At this time, I would like to welcome everyone to the BlackRock Kelso Capital Corporation investor teleconference. Our host for today’s call will be Chairman and Chief Executive Officer, James R. Maher; Chief Operating Officer, Michael B. Lazar; and Chief Financial Officer, Frank D. Gordon. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer period. (Operator instructions) Mr. Maher, you may begin the conference.

James Maher

Thank you, Kody, and welcome to our third quarter conference call. I’m joined by Mike Lazar, our Chief Operating Officer and Frank Gordon, our Chief Financial Officer.

We will begin by having Frank talk about some general conference call information.

Frank Gordon

Thank you, Jim. Before we begin our remarks today, I would like to point out that during the course of this conference call, we may make a number of forward-looking statements. We call to your attention the fact that BlackRock Kelso Capital’s actual results may differ from these statements. As you know, BlackRock Kelso Capital has filed with the SEC reports which list some of the factors which may cause BlackRock Kelso Capital’s results to differ materially from these statements. Finally, BlackRock Kelso Capital assumes no duty to update any forward-looking statements. I would now like to turn the call back over to Jim.

James Maher

Thanks, Frank. We’re delighted to have the opportunity to speak with you this afternoon. We’re pleased with our third quarter results. We continue to deliver on our goals of becoming the premiere provider of capital to middle-market companies, and providing an attractive return to our stockholders.

Since our inception in July 2005, we built a strong team of investment professionals and have an extensive outreach program to access middle-market companies. We have a well-diversified investment portfolio of more than $1 billion in assets and at quarter-end, the weighted average yield on the debt and income producing equity securities in our portfolio was 11.9% up from 11.3% at the end of the second quarter.

While the third quarter was certainly another difficult one for the credit markets and for financial service companies, BlackRock Kelso Capital completed a solid quarter on September 30. We finished the quarter well capitalized with our portfolio performing well and we achieved a high -- a higher return on portfolio assets in this past quarter due in large part to rate increases on many of our investments. We were highly selective and cautious during the third quarter preserving liquidity and availability to take advantage of the dislocations in the credit markets. Although we invested less than $10 million in capital in the quarter we have invested in excess of $1.7 billion across more than 100 portfolio companies since our initial funding in 2005.

We view the turbulence in the credit markets as an opportunity for BlackRock Kelso Capital to enhance the risk adjusted returns on our portfolio. As a business development company, as you know, our balance sheet leverage is limited to one-to-one and BlackRock Kelso Capital’s balance sheet leverage of approximately 0.8 to one on September 30 or had 0.8 to one on September 30.

Net of cash balance on our balance sheet our ratio of balance sheet leverage was 0.7 to one. We have substantial capital resources available to fund additional investments. At September 30, 2008, we had approximately $115 million in cash, cash equivalents availability under our senior credit facility.

Yesterday our Board of Directors declared a fourth quarter dividend of $0.43 a share. This dividend will be paid on September 31 and represents an annualized yield of just under 15% on our net asset value and over 17% based on yesterday’s close. Net investment income for the third quarter was $0.47 a share and our net asset value stood at $11.52 per share at September 31, which represents a decrease in net asset value during the quarter of $0.79 per share. Mike and Frank will discuss more of our financial results shortly.

On August 7, 2008, our Board approved a share repurchase plan under which we may repurchase up to 2.5% of our outstanding shares from time to time. Through October 31, 2008, we had purchased approximately 245,000 shares for $2.1 million. These repurchases equated to approximately 18% of those authorized under the plan and were purchased at a price that was accretive to net asset value. We evaluate share repurchases on much the same basis as we evaluate new investment opportunities. We believe that our shares provide an attractive current return and total return opportunity particularly at the levels we witnessed over the last quarter, over the last three months.

We continue to be pleased with the investment opportunities that have resulted from our direct calling effort. We examined approximately 75 investment opportunities during the quarter and well over 1,300 since our initial funding in 2005. Our well capitalized position and access to additional funding are themselves competitive advantages in today’s difficult marketplace.

During the third quarter, the credit markets were generally characterized by increased instability, culminating with the bankruptcy of Lehman Brothers, the government rescue of AIG, the sale of Merrill Lynch, and the conversion of Goldman Sachs and Morgan Stanley to bank holding companies. While transaction volume and activity in middle market remains significantly slower than it was at this time last year, we continue to see many opportunities today that are of high quality. Many of our best opportunities today are available in the secondary market. The stressed sellers are parting with solid investments and performing companies, what we would describe as far as sale prices. We believe that changes in the environment for syndicated loans and public high-yield debt, which remain at very depressed levels of activity and valuation, have produced opportunities for higher returns and reduced leverage. This environment continues to provide a great opportunity for BlackRock Kelso Capital.

We believe that being actively involved in the due diligence and structuring of the assets that we acquire provides us with a conservative portfolio. The terms of the loans in which we invest are conservatively constructed with adequate covenants, security, and other protections. These structural protections have been an important tool to reduce the risk in our investments as the economy has begun to slow during the past few months. The industry composition of our portfolio is reflective of our investments in companies that demonstrate high sustainable free cash flow. The largest industry sections represented in our portfolio are business and other services, consumer products, and healthcare. Our investments were dominated by investments where we have played an active role in either as the sole or lead investor or as a member of a small club of investors.

Investments made in these negotiated lead and club transactions represent approximately 70% of the assets in our portfolio. We pay close attention to the level and commitment of the financial sponsors with whom we do business. The capital support provided by committed financial sponsors has benefited many of our portfolio companies this year.

We are pleased with our results for the third quarter and the performance of our portfolio investments. We continue to demonstrate our ability to source investment opportunities in middle-market companies and slowing in market for new transactions. We anticipate that we will benefit from the current market dislocation and expect to pursue attractive secondary opportunities.

Mike Lazar will now review our portfolio investment activity in more detail.

Michael Lazar

Thank you, Jim, and thank you for joining our earnings conference call today. For BlackRock Kelso Capital the third quarter was characterized by a slowing environment for new transactions due to the general slowdown in the deal business as well as the uncertainty of the credit markets generally. We sourced our fair share of opportunities but did not close transactions with any new portfolio companies. We were successful in improving our portfolio through a handful of repricing and credit enhancement events in some of our portfolio investments. This includes one new investment in the securities of an existing portfolio company at a significant discount.

Our quarterly shareholder dividend of $0.43 was supported by $0.47 of net investment income as well as an estimated quarterly taxable income of $0.47. Since inception, BlackRock Kelso Capital’s distributions to shareholders have been derived almost exclusively from taxable net investment income. Year-to-date BlackRock Kelso Capital has generated $1.34 of net investment income. Taxable income from which our dividends are derived exceeded GAAP net investment income by approximately $0.05 through the third quarter. BlackRock Kelso Capital has distributed $1.29 in dividends to shareholders year-to-date through September 30.

We believe that our portfolio is well positioned for the current economic environment. On September 30, our net portfolio consisted of 62 companies and was 57% invested in senior secured loans and 5% invested in senior notes. At the end of the third quarter, only 3% of our portfolio was invested in equity securities. The remainder of our portfolio, approximately 29%, was invested in unsecured or subordinated debt securities. The remaining 6% of assets were comprised of cash and cash equivalents. And again as a reminder we do not make and have not made any mortgage or real estate loans and we don’t participate or own any CDO or CLO securities.

Like many we’re very focused on the credit crisis and perhaps more importantly its effects on the economy. We have worked hard to position your portfolio and each investment in it to withstand an economic downturn to the greatest extent possible. Much of his groundwork was laid as the portfolio was constructed. Towards that end BlackRock Kelso Capital enjoyed the benefit of more than $100 million of junior capital invested by equity sponsors in support of our portfolio companies during the third quarter. Those investments represent an increase in the capital and junior securities of those companies of more than 15%.

Our involvement in the due diligence, structuring and documentation of the significant majority of our investments in our portfolio has resulted in our having the opportunity to reprice a portion of the portfolio in the recent credit environment. On a year-to-date basis we have repriced more than 20% of our portfolio. In addition, we have received amendment and other fees of more than 20% of our portfolio.

The average rate increase on those securities has been in excess of 200 basis points and the amendment fees in excess of 100 basis points.

We experienced $60.6 million of portfolio runoff during the third quarter. Consistent with our business model BlackRock Kelso Capital earned prepayment fees on three transactions and sold the participation in an investment that we structured with an initial purchase discount to a third party at par. Sales and repayments recorded in the past quarter also contributed to our shifting -- to our shifting the construction of our portfolio towards more fixed rate assets. Fixed rate assets comprise 53% of our debt investments and 50% of our total assets at market value excluding cash at the end of the quarter.

The fair market values in our GAAP financial statements are derived by dealer quotes for the securities that are quoted and by engaging third-party evaluation firms to perform valuations on all the non-quoted portfolio investments. These valuations are performed on a company-by-company basis and a security-by-security basis for every investment every quarter.

Our portfolio was not immune to the effects of the current economic and credit environment. Total portfolio unrealized depreciation during the quarter was approximately $44.4 million. At quarter-end, our net asset value per share was $11.52 compared to $12.31 at June 30. The unrealized depreciation on investments does not have an impact on our current ability to pay distributions to stockholders. More than 40% of the dollar value of our portfolio is valued by dealer quotes. As we hold most investments to maturity, we anticipate that for investments in companies with adequate fundamental performance, we will not ultimately realize losses in value.

Certain of our portfolio companies valued by dealer quotes experienced significant unrealized depreciation as a result of distress sales by third parties. Distress sales can have a disproportionate effect on the value of an illiquid investment. Market wide increases in interest yields also contribute to unrealized depreciation. Market-wide moments and distressed sales are not necessarily indicative of any fundamental change in the condition or the prospects of our portfolio companies. The largest portion of the increase in unrealized depreciation for nonquoted or apprised investments relates to two portfolio companies. Once again, one portfolio company, Tygem Holdings, has significantly underperformed its plan and its historical results. BlackRock Kelso Capital continues to be actively involved in working out a recovery plan. In the aggregate the value reflected in our financial statements for this company is now de minimis. The other, Wastequip, is a somewhat cyclical business that has also been affected by significant and rapid increases in commodity raw material prices.

While results have been weak due to these factors Jim management has successfully cut costs and streamlined the sales and marketing function while maintaining its leading market share position preparing the company for an eventual economic recovery. As many of you are aware, our incentive fee structure has a high water mark. As a result of this feature which we believe is unique in our industry BlackRock Kelso Capital paid no incentive fees during the quarter or the year-to-date period due to the change in unrealized depreciation.

We are pleased that the performance of our portfolio companies continues to be strong with an overall weighted average rating of 1.37, using our 1 to 4 credit rating scale. This compares to 1.32 at June 30 and 1.23 at December 31, 2007. Approximately 4% of investments at value is rated 3 or 4 with the other 96% of the portfolio rated 1 or 2. As of September 30, 2008, we have investments on non-accrual status representing just over 1.5% of portfolio value. The fair market value of these assets is $16.5 million at September 30 compared with $17.7 million as of June 30.

Currently, our ratio of borrowings to net assets is 0.8 to one leaving us with sufficient capacity for new investment opportunities in what is now a very attractive investment environment. We borrow under our revolving credit facility at LIBOR plus 0.875% and our term loan facility at LIBOR plus 1% and 1.5%. At September 30, we had borrowings of approximately $491 million or $430 million net of cash and cash equivalents.

Our assets to middle-market transactions, our conservative capitalization, and condition of our portfolio remains strong. We remain well positioned to find the best risk-adjusted returns in middle-market companies where we are able to play an active role in due diligence and transaction structuring.

I now like to turn the call over to Frank Gordon to review some of the GAAP financial information for the third quarter.

Frank Gordon

Thanks, Mike, and hello everyone. I will now take a few moments to review some of the details of our GAAP financial information for the third quarter of 2008.

Investment income totaled $37.4 million and $108 million for the three and nine months ended September 30, 2008, respectively compared to $34.2 million and $92.4 million for the three and nine months ended September 30, 2007.

The increases reflect the growth of our portfolio as a result of the deployment of debt capital under our credit facility and equity capital from our initial public offering in July 2007. Net expenses for the three and nine months ended September 30, 2008, were $11.9 million and $36 million respectively, versus $11.8 million and $38.7 million for the three and nine months ended September 30, 2007. Of these totals, for the three and nine months ended September 30, 2008, $4.3 million and $13.8 million were interest and other credit facility expenses. Interest and other credit facility expenses totaled $5.3 million and $14.5 million for the corresponding periods in 2007. In addition, performance based incentive fees totaled negative $0.1 million and $9.4 million for the three and nine months ended September 30, 2007. There were no incentive fees for the nine months ended September 30, 2008.

Expenses net of performance based incentive fees, interest, and other credit facility expenses for the three and nine months ended September 30, 2008, were $7.6 million and $22.1 million respectively, compared to $6.6 million and $16.9 million for the three and nine months ended September 30, 2007. Overall, the increase in expenses was driven primarily by an increase in base management fees resulting from the growth of our portfolio and an increase in other general and administrative expenses.

Net investment income totaled $25.6 million or $0.47 per share for the three months ended September 30, 2008 and $72.1 million or $1.34 per share for the nine months ended September 30, 2008. Estimated taxable income exceeded our GAAP net investment income during the three and nine months ended September 30, 2008. For the corresponding periods in 2007, net investment income totaled $22.3 million or $0.44 per share and $53.7 million or $1.23 per share respectively.

Total net realized gains or losses for the three and nine months ended September 30, 2008, was a gain of $29,000 and a loss of $1.3 respectively, compared to gains of $0.3 million and $0.6 million for the three and nine months ended September 30, 2007. For the three and nine months ended September 30, 2008, the net changed in unrealized appreciation or depreciation on our investments in foreign currency translations was depreciation of $44.4 million and $117.2 million respectively versus depreciation of $20.2 million and $22.2 million for the three and nine months ended September 30, 2007. Net unrealized depreciation was $174.7 million at September 30, 2008 and $20.8 million at September 30, 2007. For the three and nine months ended September 30, 2008, the net change in net assets from operations was a net decrease of $18.8 million or $0.34 per share and a net decrease of $46.4 million or $0.87 per share respectively. For the corresponding periods in 2007, the net increases in net assets from operations were $2.5 million or $0.05 per share and $32.1 million or $0.74 per share.

Yesterday, our Board of Directors approved certain amendments to our dividend reinvestment plan. Please refer to our Form 8-K filed today for additional details.

With that, I would like to turn the call back over to Jim.

James Maher

Thanks, Frank. Looking forward to 2009, we are very excited about our business and about our prospects. Our portfolio is well diversified, conservatively constructed, and performing well. The private equity sponsors as Mike mentioned, with whom we have partnered have committed more than $100 million of new capital during the third quarter to support our portfolio companies through this economic downturn and we expect continued support, and we will continue to support their companies.

And finally, I would like to thank you all for joining us on the conference call today.

Kody, will you now please open it up -- open up the call to questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Adam Waldo [ph] a private investor.

Adam Waldo

Yes good afternoon gentlemen. You just a quick question on your funding sources and terms, has anything changed over the course of the quarter in light of the really almost unprecedented dislocation in world bank funding and capital markets credit terms and conditions (inaudible)?

James Maher

No, as Mike mentioned we have a revolver and a term loan and both of those facilities are in place through the end of 2011.

Adam Waldo

Okay.

James Maher

Sorry 2010.

Adam Waldo

2010 as shown in your 10-Q for the second quarter.

James Maher

2010.

Adam Waldo

It is okay. Can you disclose previously -- or can you just comment on terms and conditions under which the providers of the revolving credit facility can amend its terms or reduce your available credit?

James Maher

Mike.

Michael Lazar

Sure. Obviously the revolving credit facility is dictated by what I would consider a typical revolving credit agreement and it has certain covenants but it is really governed more than anything else by a borrowing based formula and we have a significant amount of excess availability under the borrowing base and have since the inception of the facility and continue to have a very significant amount of excess availability today. That is really the only significant restriction that the credit facility provides for the lenders.

Adam Waldo

Okay. So from your standpoint no changes in terms and conditions versus those that prevailed during the second quarter, and prospectively you are not getting any indications from the financial institutions involved in providing the revolver to you of changes in those terms. Is that a fair summary?

James Maher

That is a fair summary.

Adam Waldo

Okay, thank you.

Operator

The next question comes from the line of Jim Ballan with JP Morgan.

Jim Ballan - JP Morgan

Great, thanks a lot. The language in the press release around the dividend reinvestment plan. It is a little confusing. Could you explain what change related to your program?

James Maher

To take a shot at that it is actually fairly complicated. Go ahead Mike.

Michael Lazar

Sure. You will notice that recently were declared effective under our shelf registration statement and we got some feedback from the SEC that their thought on the dividend reinvestment plan was that dividend reinvestment should not occur at a price less than net asset value. And they’re going to -- that is not their final word on the subject. They said they were going to think that over and talk to other people at the agency but we took their -- took that to heart and made the change in the plan so that it doesn’t allow for reinvestment below net asset value.

James Maher

In order to be crystal clear for this dividend we thought we had to take this position because we’re not sure we’re going to get anything definitive from the SEC between now and the time we pay this dividend. I expect longer term that we will be able to go back to the format that we had previously but at the moment this is way -- the route we had to take.

Jim Ballan - JP Morgan

Got it. Okay great. Thanks for clearing that up. And you know, there was the good amount of cash on the balance sheet at the end of the quarter. Was that -- is that you are you going to maintain more cash on the balance sheet just make sure you have access to liquidity or was this just a timing thing that happened to be at the end of the quarter?

James Maher

No it is really a question of I think you got it access to equity in a very, very difficult environment where for at least a period of time, I think. So we got that period behind us to a large extent but we are -- you didn’t know who was going to be standing the next day. So given the precision of the timing of the end of the quarter we just judged that it was prudent -- Mike [ph] judged that it was prudent to draw the capital and have it in house or rather than have to request it should we want to make a new investment.

Michael Lazar

And we still today have that on our balance sheet and we evaluate that on a pretty regular basis.

Jim Ballan - JP Morgan

Okay great. And then just one last thing, the -- I mean obviously not a lot of capital put to work this quarter. I mean was that -- again is that somewhat of a timing thing which we would expect to see you put in capital to work next quarter, maybe instead of having sort of a negative investment activity may be more investing somewhere to what you have coming back at you?

James Maher

I think it would be fair to expect that we would have investments in the fourth quarter. You know, we certainly had an opportunity to make investments in the third quarter. Markets were moving rather rapidly both in the secondary and in the primary market and we chose to take pretty conservative positions in terms of what we’re offering to potential borrowers. They in some cases choose to go elsewhere and in some cases the deals didn’t get done from a timing standpoint, and in some cases they got pulled.

Michael Lazar

You know, Jim, just to add to what Jim said or maybe not to add but to amplify. There were a lot of transactions that we found ourselves working on during the third quarter where by quarter-end the asset that had come to market. The company that was for sale that gave rise to our financing withdrew itself from the sales process and it just -- I would just characterize it as part of the lumpiness to general lumpiness of the business particularly during this last quarter because of the market conditions.

Jim Ballan - JP Morgan

Okay, understood. That is very helpful. Thank you gentlemen.

Operator

(Operator instructions) Our next question is a follow up question from Adam Waldo, a private investor?

Adam Waldo

Sorry. I just wanted to continue a couple of questions if I may on the funding side. Can you just review for us, I have only been through half of your recent Qs and Ks. But I can’t seem to determine who are the financing sources for your revolver and term loan. Can you comment on specific financial institutions who participated in those.

James Maher

Yes, I think -- sure. On one of our -- I think as an adjunct to one of our prior filings the references actually made to the credit agreement itself. I think it does exist somewhere on the EDGAR system.

Adam Waldo

Okay.

James Maher

However, the major lenders under the original credit facility were Citigroup, JP Morgan, Wachovia, Merrill Lynch, Bear Stearns, and UBS. Since that time other lenders have joined that group including Credit Suisse and others and the original lenders remain lenders today. Obviously Bear Stearns position has been assumed by JP Morgan and they provide the funding on what was originally the Bear Stearns piece and we anticipate that when the pending two transactions involving Wachovia and Merrill Lynch are completed that the funding obligations under our credit agreement will transfer to the ultimate parents of those two institutions, Bank of America and Wells Fargo.

Adam Waldo

Okay, and have you had any preliminary conversations with the bank group about extending the duration of the revolver or is it really premature to try to extend duration in the current credit environment, given the new salvations of the bank group.

Michael Lazar

It would be pretty, this is Mike again. It would be pretty irregular to approach the bank group about an extension two years ahead of the maturity of a facility of this type.

Adam Waldo

Okay.

Michael Lazar

That furthermore -- this would not be the best time to do it. If we were to break with tradition (inaudible) 24 months or 26 months in advance, this wouldn’t be the credit environment in which to make that determination.

Adam Waldo

Right I didn’t want to presume the answer for you. But I suggest what I am coming from on this is your putting out investments with somewhat longer duration than your remaining revolver term and I guess my concern is do you potentially get a rollover issue there or a duration mismatch or both, you know, (inaudible) if the general credit markets’ environment remains challenging, then how would help us think through how you would manage through that potential situation?

Michael Lazar

Well, I think again the agreement remains in effect until the end of 2010. So, we do see ourselves as having plenty of runway in that regard. Other BDCs as well as other financial companies have found ready access to capital even in this terrible credit environment. They have just had to pay a pretty healthy premium in pricing to obtain that credit and so what you have seen or what we have seen in the marketplace is people only come to the market when they absolutely have to and those that have come to market have required some small premium versus their prior borrowing rate to get a new deal done or a deal extended and towards that end we wouldn’t look to extend this current 2 year maturity in the current credit market environment because (inaudible).

Adam Waldo

Fair enough because you don’t want the terms and conditions to change materially till you have to face that.

Michael Lazar

Correct.

Adam Waldo

Okay, but let us assume the current environment exists two years out. And gosh, we all hope it doesn’t but how should we think about your ability to at least maintain that interest margin spreads as you potentially face that rollover issue?

James Maher

A couple of things. One in terms of assets coming over our books, they’re coming on our books at substantially higher prices than some of the assets that exist on higher yields and some of the assets that exist on our portfolio.

Adam Waldo

Right. Then the capital you are putting out is at higher rates plus you got favorable resets.

James Maher

And they will be -- and during the couple of years I suspect there will be some turnover in the portfolio of some significance. So we sort of view it as not a question of difficulty in terms of refinancing it is really just a question of cost and I think it maybe if the spread gets narrowed it may not be at that point in time because it depends a lot on I think what the rate that we’re borrowing at or we will be borrowing at will be very reflective of the rates that we are lending at. They can’t be disconnected by much.

Adam Waldo

They can’t be disconnected by very much for very long. Is that fair?

James Maher

Right. I think that is fair.

Adam Waldo

Okay, thank you gentlemen.

Operator

Gentlemen there are no further questions at this time.

James Maher

Terrific. Well thank you all.

Operator

Excuse me gentlemen. We do have one last question?

Michael Lazar

Sure.

Operator

From Cyril Battini from Credit Suisse.

Cyril Battini – Credit Suisse

Yes, Hi good evening. I just wanted to make sure that I understood correctly, you said that the financial sponsors injected $100 million in your portfolio companies and that represents an additional 15% of equity or in total 15% of equity?

James Maher

It represented -- in the companies that they injected company -- I mean money into, equity money into it represented 15% of what they had already invested in the companies.

Cyril Battini – Credit Suisse

Got it. Great, thank you very much.

James Maher

Sure. Thanks again.

Operator

Ladies and gentlemen this does conclude today’s conference call. You may now disconnect your lines.

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