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Executives

Bill Walton – Chairman

Shelley Huchel - Director of Investor Relations

John Scheurer - President and Chief Executive Officer

Joan Sweeney - Chief Operating Officer

Penni Roll - Chief Financial Officer

Rob Long - Head of Asset Management

Analysts

Vernon Plack - BB&T Capital Markets

Troy Ward - Stifel Nicolaus & Company, Inc.

Faye Elliott-Gurney - BAS-ML

Sanjay Sakhrani - Keefe, Bruyette & Woods

Robert Dodd - Morgan, Keegan & Company, Inc.

Scott Valentin - Friedman, Billings, Ramsey & Co.

Samuel Crawford - Stone Harbor Capital

James Shanahan - Wachovia Capital Markets, LLC

[Jim Auschel - Aviation Advisory Services]

Allied Capital Corporation (ALD) Q4 2008 Earnings Call March 2, 2009 8:30 AM ET

Operator

Good morning. My name is [Jackie] and I will be your conference operator today. At this time I would like to welcome everyone to the Allied Capital fourth quarter 2008 conference call. (Operator Instructions)

Thank you, Mr. Walton. You may begin your conference.

Bill Walton

Thanks, [Jackie] and good morning, everyone, and welcome to Allied Capital's fourth quarter 2008 conference call. I'm joined today by John Scheurer, Joan Sweeney, Penni Roll, Rob Long and Shelley Huchel.

Shelley, would you open the discussion today with required conference call information and discussion about forward-looking statements?

Shelley Huchel

Of course. 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 authorized 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 toll free at 888-253-0512.

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'll turn it over to Bill.

Bill Walton

Thanks, Shelley. We're here today to report fourth quarter 2008 results and to give you an update on our business and the current market environment.

As I'm sure you all know, the U.S. and global economies are in a state of severe economic recession, which has had a far-reaching impact on the financial services industry. Like many other financial firms, our strategy to manage through this economic crisis is focused on generating capital from the sale of assets to pay down our indebtedness and to delever our balance sheet. For the time being we've sharply reduced our new investment activities and are keenly focused on strengthening our capital structure so we can weather this economic storm.

As you noticed from today's press release, I have asked our Board of Directors to separate the roles of Chairman and Chief Executive Officer so that we can benefit from additional executive talent as we work through this difficult time and build our company for the future. Our Board of Directors has considered this request and has promoted John Scheurer to become the President and Chief Executive Officer of the company beginning tomorrow. I will retain the title of Chairman and will remain a full-time executive officer of the company. John brings decades of experience and leadership credentials and has a long list of achievements at Allied Capital. I'm thrilled to have him by my side as we develop our plans for the future.

As you know, our most significant task right now is to arrive at a comprehensive solution for our capital structure and John has been leading our discussions with our lenders to modify our debt agreements in order to provide long-term operational flexibility.

I'd now like to turn the discussion to John to discuss where we are in this process. John?

John Scheurer

Thank you, Bill.

We experienced significant unrealized depreciation in 2008 and in the fourth quarter we began discussions with our lenders for certain covenant amendments to our revolving line of credit and private notes in an effort to provide us with the operational flexibility we need in this difficult environment.

We entered into amendments on December 30, 2008, but by the end of January 2009, as our detailed valuation process progressed, it was apparent to us that we would likely not meet the covenant of 200% asset coverage and we reopened discussions with our lenders in an effort to achieve a more comprehensive restructuring and achieve our goal of long-term flexibility.

Our asset coverage at December 31, 2008 was 188%, which is below the 200% required by our line of credit and our private notes. In addition, as a result of our more comprehensive discussions with our lenders, we have not completed the documents contemplated by the December 30, 2008 amendments, which were to include a grant of a first lien security interest on substantially all of our assets.

As a result, events of default have occurred under our revolving credit line and private notes. These are covenant defaults, not payment defaults. Neither our lenders nor the note holders have accelerated repayment of our obligations as a result of these covenant defaults; however, they currently are permitted to do so.

We are diligently working to negotiate a comprehensive restructure of our facilities and reach an acceptable solution with our lenders. Should our lenders accelerate the amounts outstanding under the revolving credit facility or any issue of the private notes, this could have a material adverse impact on our liquidity, financial condition and results of operations.

In conjunction with this risk, you will see that in our Form 10-K that we will file today our auditors have included an explanatory paragraph in their audit opinion that expresses substantial doubt about the company's ability to continue as a going concern.

Clearly in this environment and given the events of default, this is not an unreasonable position for our auditors to take in these circumstances; however, we believe that our plans for asset sales, debt repayment, and debt restructuring will be sufficient to provide us with the ongoing operational flexibility we need to weather this economic environment and eventually start rebuilding for the future.

We have been diligently working on solutions and we recently retained an experienced and talented team from the Blackstone Group to assist us in this process. We are seeking, as I said before, a comprehensive restructure that we believe will benefit all stakeholders and protect our shareholders' equity in this difficult environment. We do not think it is prudent to discuss strategies or company plans at this time, but we will certainly keep you informed as appropriate.

It is very easy in this environment to dwell on the negative, but I also want you to remember that we believe that Allied Capital has many positives. We have also built a portfolio with companies that generate current income and even though we are dealing with covenant default, we operate with a relatively modest level of leverage, slightly over 1 to 1 debt-to-equity, and we are continuing to grow our asset management business. Perhaps most importantly, we have a great team of people here at Allied Capital, and I look forward to working with Bill to lead this company.

Now let me turn the discussion back to you, Bill.

Bill Walton

Thanks, John. Now, Joan, could you discuss our 2008 and fourth quarter results in detail?

Joan Sweeney

Yes. Thank you, Bill. Let's start with a discussion of our December 31, 2008 balance sheet. Please turn to our summary balance sheet, which is on Page 3 of the slide deck.

We ended the year with total assets of $3.7 billion, total debt of $1.9 billion, and total shareholders' equity of $1.7 billion. Our shareholders' equity included undistributed earnings of $185 million. Our leverage ratio at December 31, 2008 was 1.13 to 1. At the end of the year we had cash and investments in liquid assets of $51 million.

We invested $1.1 billion in 2008. We had repayments and portfolio exits in the year totaling $1 billion. We invested a total of $50 million in the fourth quarter and were repaid or exited from investments totaling $159 million. This lower origination activity reflects our current efforts to conserve capital and repay debt.

After including the impact of this quarter's valuation and other changes, our portfolio at value was [$3.5] billion at December 31, 2008. The yield on our interest-bearing portfolio of $2.9 billion at December 31, 2008 was 12.1% as compared to 11.9% at December 30, 2008. As December 31, 2008, shareholders' equity or net asset value was $9.62 per share as compared to $13.51 per share at September 30, 2008.

Please turn to Slide 4 for a summary of the changes in NAV for the quarter. During the fourth quarter net inventories income increased NAV by $0.19 per share, net realized losses decreased NAV by $0.99 per share, dividends paid to shareholders decreased NAV by $0.65 per share, and NAV decreased by $2.44 per share due to changes in unrealized appreciation or depreciation.

Now let's move to a discussion of our earnings. For this discussion, please turn to Slide 5. Interest income for the quarter ended December 31, 2008 was $97.2 million as compared to $110.2 million in the third quarter of 2008. Loans placed on nonaccrual during quarter reduced our fourth quarter interest income by approximately $9 million. The remainder of the decline results from the repayment or exit of interest-bearing investments.

With respect to dividend income for the fourth quarter of 2008, we reclassified $5.9 million of dividend income to realized gain primarily as a result of receiving updated tax information related to the distribution of capital we received from two portfolio companies earlier in the year.

Fees and other income were $10.7 million for the fourth quarter of 2008 as compared to $8.5 million in the third quarter. The most significant components of fees and other income included structuring and diligence fees of $3.4 million, management fees related to portfolio companies of $2.4 million, managed fund fees of $2.1 million, and a gain on the prepayment of term debt of $1.1 million.

Total operating expenses were $73.5 million in the fourth quarter of 2008 as compared to $73 million in the third quarter. The comparability of quarter-to-quarter expenses was affected by several items, so please turn to Slide 2006 for a discussion of the more significant operating expense items for the quarter.

Interest expense excluding installment sale interest expense was $37.1 million for the fourth quarter, comparable to the $34 million in the third quarter of 2008. Interest expense in the fourth quarter increased as our line of credit borrowings were $170 million at September 30, 2008 and reached a high of $220 million during the fourth quarter. Then at the end of the fourth quarter we repaid our line of credit to an outstanding balance of $50 million.

Fourth quarter employee expense excluding the individual performance award was $17 million as compared to $19.4 million in the third quarter. As we've discussed previously, we consolidated our investment execution activities to our Washington, D.C. and New York offices and reduced our headcount by approximately 50 employees over the last year. As a result of these headcount reductions, we incurred severance expense of $9.7 million in 2008, of which $4.4 million occurred in the fourth quarter.

During 2008 we substantially decreased our bonus pool from a level of $40.1 million in 2007 to $1 million in 2008. However, we have accrued an additional $11.2 million in 2008 employee expense as a 2009 performance award to be paid over four quarterly installments ending on January 15, 2010 in lieu of paying that as a 2008 bonus, which we would typically pay in the first quarter of 2009. Our most senior executives received no 2008 bonus and will not receive the 2009 performance award.

Our core administrative expenses for the fourth quarter were $12.8 million as compared to $13.7 million in the third quarter.

We had no income tax expense for the quarter and excise tax reversals were $5.6 million in the fourth quarter. We recognized certain tax losses in the fourth quarter of 2008 which reduced our excise tax obligation for 2008.

Now turning back to Slide 5, net investment income was $34.2 million or $0.19 per share in the fourth quarter as compared to $45.6 million or $0.26 per share in the third quarter of 2008. Net realized losses for the fourth quarter were $176.7 million or $0.99 per share. Gross gains totaled $15.3 million for the quarter and gross losses were $192 million. Significant fourth quarter losses included $99 million from the sale of our Class A interest in Ciena and $36 million from the sale of our portfolio company, Alaris Consulting.

Net investment income and net realized losses totaled a loss of $142.6 million for the fourth quarter of 2008 or $0.80 per share. Net unrealized depreciation for the fourth quarter totaled $436.3 million of $2.44 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 $578.8 million or $3.24 per share. For the year we incurred a net loss of $1 billion of $6.01 per share primarily due to $1.1 billion in net unrealized depreciation for the year.

And with that I'll turn the discussion back to Bill.

Bill Walton

Penni, can you talk about our valuation process, portfolio quality statistics and also our taxable income?

Penni Roll

Yes. Thank you, Bill. Let's start with a discussion about the net change in unrealized appreciation or depreciation. Let's start on Page 8 of the slide deck.

For the quarter ended December 31, 2008, the total net change in unrealized appreciation or depreciation was a decrease of $436.3 million. This change resulted from $605.1 million in net unrealized depreciation from changes in portfolio value, a $169.7 million reversal of previously recorded unrealized depreciation associated with the realization of losses, and a $0.9 million reversal of previously recorded unrealized appreciation associated with the realization of gains and dividend income.

We experienced significant unrealized depreciation in our portfolio for the quarter ended December 31, 2008. We continue to see unprecedented disruption in the capital markets which continued to adversely impact the values of financial assets in the fourth quarter. Drivers of the unrealized depreciation for the fourth quarter included $120 million related to six companies in the consumer products and retail industries, $75 million related to our investment in Ciena, resulting from the decline in value of their residual interest assets and other financial assets, $48 million related to debt investments primarily as a result of using a yield analysis, $34 million related to companies operating in the automotive RV parts and services industries, and $152 million related to our other financial services and asset management portfolio companies and our CLO and CDO investments.

Much of the depreciation this quarter resulted from declining asset values and some of the depreciation results from portfolio company performance issues. As long-term investors, we seek to continue to work through this economic cycle so that as the economy and asset values improve we will be positioned to benefit.

We continued to receive third-party evaluation assistance for our private finance portfolio and as you can see from Slide 9, we received third-party assistance for 91.6% of the private finance portfolio for the fourth quarter of 2008.

In the current economic environment it's difficult to predict when the values for financial assets will cease to decrease in value and as a result we may continue to experience further net unrealized depreciation in our portfolio due to declining values or due to decreased operating performance of our portfolio companies in this difficult economy. You will be able to review the changes in portfolio valuation in more detail in our Form 10-K that we will be filing today.

Now let me turn to a discussion of portfolio quality. During the fourth quarter of 2008 we made a decision to discontinue our proprietary grading system for the portfolio because, given the declines in asset values - which may or may not reflect performance - we believe that our historical grading categories are no longer useful as a tool to measure portfolio quality.

For instance, we have written down our non-buyout debt portfolio due to yield analysis and it's difficult to assess where those assets would fall in our spectrum of grading categories of performing as expected, close monitoring, loss of investment return, or loss of principal. However, to the extent we intend to hold our debt investments to maturity, they may perform as expected. To the extent we may chose to sell these assets in a forced sale prior to maturity we may experience some loss. We are in the process of evaluating the portfolio and may develop an alternative asset quality measurement system at some point in the future.

On Slides 11 and 12 you will see that we have continued to provide an historical analysis of loans and debt securities over 90 days delinquent and of loans and debt securities not accruing interest. On Slide 11 we show loans and debt securities over 90 days delinquent. Loans and debt securities over 90 days delinquent at December 31, 2008 were $108 million or 3.1% of the portfolio at value. At September 30, 2008, loans and debt securities over 90 days delinquent were $21 million of 0.5% of the portfolio at value.

Included in our delinquent loans was our senior loan to Ciena Capital that became delinquent in the fourth quarter and was $105 million or 3% of the portfolio at value. Excluding Ciena, loans and debt securities over 90 days delinquent were $3 million or 0.1% of the portfolio at value at December 31, 2008.

Now if you turn to Slide 12, loans and debt securities not accruing interest at December 31, 2008, were $335.6 million or 9.6% of the portfolio at value as compared to $383.1 million or 9.1% at September 30, 2008. Excluding Ciena Capital, total loans on non-accrual were 6.6% of the total portfolio at value at December 31, 2008 as compared to 4.8% as September 30, 2008.

Our assets on non-accrual are higher than our loans over 90 days delinquent primarily due to the effect of payment in kind interest. A loan that has payment in kind interest experiences no payment delinquency, but collection of that payment in kind interest in the future may be doubtful and we may determine that the loan should be placed on non-accrual.

Loans and debt securities not accruing interest excluding Ciena as a percent of the portfolio at value at December 31, 2008 are now in the similar percentage range we saw in 2002 during the last economic downturn. Given the severity of this economic recession, we would expect that non-accruals and loans over 90 days delinquent may increase in the future.

I'd like to now move to a discussion about our taxable earnings. During the fourth quarter of 2008 we recognized certain tax losses which reduced our taxable income for 2008. As a result, as of December 31, 2008 we estimate that we have met our dividend distribution requirements for the 2008 tax year and we will not carry over any spillover income to 2009. Therefore, we were able to reduce our accrual for excise taxes in the fourth quarter.

We continue to have approximately $217 million in deferred taxable income resulting from installment sale gains. These gains may be deferred for tax purposes until the installment notes are collected in cash.

I want to add a caveat to this discussion with the comment that we experienced numerous temporary and permanent differences in the recognition of book and taxable income. I encourage you to read our tax disclosure in our 2008 Form 10-K for a more detailed discussion of taxable earnings.

And with that, Bill, I'll turn things back to you.

Bill Walton

Thanks, Penni. Rob, could you talk about asset management activities and give us an update on the market?

Rob Long

Yes, thanks, Bill.

As we have described previously, we've been actively building our asset management capabilities. These activities provide us with management fees as well as expand our investment capabilities, primarily for senior loans. Our goal has been the development of a comprehensive asset management platform that can expand through both organic growth and through acquisitions.

We are pleased to announce that we have acquired the management contracts for the Emporia Funds, three additional senior loan funds with managed assets totaling $1.2 billion. These funds consistent of a combination of middle market and broadly syndicated senior secured loans similar to the assets currently managed by us and by our portfolio company, Caladis Capital.

We also hired five experienced professionals that have been managing the Emporia assets. As managers of these funds, we expect to earn annual management fees and may earn incentive fees in the future. We are not an investor in the Emporia Funds and we did not acquire any of the investments in these funds.

We now manage $2.4 billion in senior loan assets and our portfolio company, Caladis Capital, manages $3.5 billion in senior debt assets. Our reach and experience in the senior loan market is expanding.

The recent market turbulence is having a big impact on the loan management business. A number of firms are reducing their commitments to the business and some investors are looking for replacement managers. We believe that this is leading to more opportunities for us to acquire or assume the management of existing loan funds. The addition of Emporia and its team increases our platform and positions us well for further growth.

Now let me turn to a discussion of the current market environment. While each quarter of 2008 saw a decline in the capital markets, activity in Q4 came to a full stop for much of the credit markets. The largest portion of loan capital in recent years has come from the securitization market. In the fourth quarter of 2008 there were no collateralized loan obligations closed according to S&P data.

As the pace of deleveraging quickened, large amounts of loans were sold in the secondary market, which depressed prices to record lows for the broadly syndicated market. In this environment, where secondary bid levels were so depressed, new issue activity effectively ceased for all but a few issuers.

According to market data, for the fourth quarter of 2008 less than $500 million of new middle market loans were funded, which represented 6% of the total for the year. A number of the new loans funded in the middle market represented in most part refinancing of existing facilities by existing lenders.

The toll on the leveraged buyout business was clear. As you can see on Page 16, the total volume of LBOs fell in 2008 by over 75%, with the fourth quarter being the quietest of last year. Credit standards have been tightened to levels seen at the low point of the last recession, though the leverage statistics for the 2008 period do not fully reflect the new standards. Many of the financings in 2008 were likely launched in a more optimistic climate than the low point reached in the fourth quarter.

And for the full year there was a decline in capital raised by the private equity community. According to market data, the fourth quarter fundraising activity fell by about 50%, though the total for the year was only off about 18.5%. The only areas that saw growth were mezzanine and distressed investment vehicles.

Looking forward is not easy. There has been a modest uptick in 2009 for the price of some of the higher quality loans. There is a modest amount of new issue activity, again, largely refinancings by existing lender groups. However, the lack of new activity means that there is capital on the sidelines, which, when it returns to work, could help offset the downward pressure on the market.

Now back to you, Bill.

Bill Walton

Thanks, Rob.

Before we open the line for questions I'd like to discuss our current thinking about dividends in this unsettled economy. We believe it's in the best interest of shareholders and the company right now to retain as much of our capital as possible as we restructure our debt obligations, delever our balance sheet, and work to restore 200% asset coverage. In addition, while an event of default exists under the revolving line of credit and private notes we're precluded form declaring dividends.

We estimate that we've met our dividend distribution requirements for 2008 and we do not foresee declaring dividends in 2009. We would be able to carry forward any 2009 taxable income for distribution in 2010 should we return to 200% asset coverage and should we believe such distribution is prudent in those circumstances.

In closing, I think it's important for you to recognize we're working to position our business for the long term even if this economic schlub should continue for some time. I also want to point out that we are long-term investors and while we intend to sell certain assets in order to reduce debt, we remain patient and do not plan to sell more of our assets than we believe is necessary in this oversold environment. I also think that with John in his new role we've increased leadership and focus to execute on this strategy.

Jackie, can we now open the lines for questions, please?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Vernon Plack - BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Bill, I had a question about overhead at this point. Given the fact that you've reduced headcount in 2008, what about for right now, is headcount, is your overhead at a place where you want it to be? Can that number come down further? What are you thinking?

Bill Walton

Well, I think you've seen what we've done with the expense piece is we've reduced bonuses. I mean, we only paid out about $1 million in 2008, so I think we've taken care of the employee expense through that and through the bonus thinking.

We think our staffing is appropriate right now because we still have a large portfolio. We're in a time of sort of maximum stress, but on the other hand we think there's a lot of long-term value creation from the companies in the portfolio which is going to require people to work with those portfolio companies to either fix a model that's sideways in this environment or work with them on acquisitions to grow the business. So we don't want to cut anymore from where we are, at least as we see things now, because we think there's a lot more upside in the portfolio than there is downside.

Vernon Plack - BB&T Capital Markets

And the dividend credit in the fourth quarter of $5.9 million, Joan, I know you explained that a little but, but could you go over that again, please?

Joan Sweeney

Yes. It simply was a reclassification. We received a distribution in the fourth quarter from some portfolio companies. At that time their tax estimate was such that it was dividend income. It turns out based on their revised tax estimate it's capital gain income. It's that simple.

Bill Walton

And also to amplify my earlier answer, I think the asset management business which Rob described is something that we think we're pretty well positioned to build. While we don't have access to capital on our balance sheet, we intend to have access to capital from other sources and we want to keep the investment team, the senior piece, the mezzanine piece, the buyout piece and the real estate piece, intact. I think that's the way to look forward long term for our shareholders.

Vernon Plack - BB&T Capital Markets

Could you give me the current fair value of Ciena, the fair value as of the end of the fourth quarter?

Joan Sweeney

I believe it's $105 million.

Vernon Plack - BB&T Capital Markets

Total?

Joan Sweeney

Yes.

Operator

Your next question comes from Troy Ward - Stifel Nicolaus & Company, Inc.

Troy Ward - Stifel Nicolaus & Company, Inc.

Can you just provide some quick color on the deferred installment sales? I think it's just north of $200 million. Can you remind me what the structure of that is, what's the maturity and can that be accelerated?

Joan Sweeney

With respect to the installment gains, these primarily relate to gains that we had over the last few years where we took a note back when we sold the equity securities in certain portfolio companies. It is about $217 million at the end of 2008. That does not come into our taxable income until we actually receive those notes in cash. That cash could come in either through a repayment by the portfolio company, but could be accelerated by simply selling the note to a third party, so that is an option for us to have that.

Troy Ward - Stifel Nicolaus & Company, Inc.

And I'd assume that's something that would be on the table for the negotiations with the creditors?

John Scheurer

You know, I think, as I said earlier, there's a number of strategies and things that we're working on and we just don't think it's prudent to disclose any of them right now until we've finalized our negotiation.

Troy Ward - Stifel Nicolaus & Company, Inc.

Asset sales and maturity, can you talk to us a little bit about your ability to monetize assets in, let's say, the next three to six months because we know that has a bit of a time lag to it, so what's in the process there as well as how do you view maturing portfolio assets in the next 12 months considering the current environment?

Bill Walton

Taking the last part of the question first, I think there's not a whole lot maturing in the next 12 months because these are loans that have been on the books for two - three years and have longer maturities than that. But we started into the process of looking at assets that we could sell at prices we liked, oh, I guess, 60 - 90 days ago, and we've been sort of carefully working through a process.

While par bids are not exactly abundant in this market, I think we're benefiting from the fact that we went into a lot of transactions in 2006 and 2007 at relatively lower leverage levels and good pricing and with good covenant packages. And so, as we find ourselves looking at selling things they're relatively more attractive than maybe some of the other loans that are available right now.

So we're in progress. We really don't want to jinx it with any numbers or timetables, but we're pleased with the way it's going right now.

Troy Ward - Stifel Nicolaus & Company, Inc.

Can you just give a little bit of color on what do you see in the current market, the appetite for assets with any amount of stress on them versus something that's trading at maybe $0.85 on the dollar just because of the current market mark?

Bill Walton

It's hard to speak generically about it because, you know, these are all very different. They're all individual companies. It's not like a residential real estate market where you've got maybe a statistical regularity to the asset class.

It's interesting. The performing assets are probably $0.80 to $0.90. And interestingly, there's some distressed assets that are trading at pretty good prices because they're in the, quote, loan to own category, and those are attractive to more activist loan holders. Even those bids are not bad.

Troy Ward - Stifel Nicolaus & Company, Inc.

On credit quality, as a lender at some point hopefully liquidity will straighten itself out and it's just got to be about underwriting. If you look at Slide 12, your current underwriting, your current credit quality metrics are clearly on the increase. How are you viewing that going forward and when do you think that may peak?

Penni Roll

You know, if you look at Slide 12, Troy, I mean, you can see, you know, what's nice about this slide is it takes you all the way back to 1998. And you can see we did tick up in terms of credit quality in the 2002 timeframe when we were in the last economic downturn. We've ticked up on a loans and debt securities not accruing interest just because we put PIC interest on non-accrual. You know, if you look at the delinquencies we're actually in pretty good shape, but we do put the PIC interest on non-accrual if we think that the enterprise value of the company can't support the additional PIC principal balance.

Given the severity of this recession, you probably would expect that you would see nonaccruals and delinquencies increase from here but, you know, it's really hard to tell.

Operator

Your next question comes from Faye Elliott-Gurney - BAS-ML.

Faye Elliott-Gurney - BAS-ML

Is the asset coverage breach relevant to your public debt covenants -- or, I guess, the one -- isn't there just one debt covenant on the public debt?

Bill Walton

That's exactly right - one 200% is on the public debt.

Joan Sweeney

Right. But the public debt covenant is simply that we comply with the '40 Act, which basically means that if we fall below 200% we cannot borrow additional debt versus the private notes and the revolving line of credit; that's a hard and fast financial covenant calculation at 200%.

Faye Elliott-Gurney - BAS-ML

So since you're not in compliance, then, with that, does that mean they have - I think you just answered it, but does that mean they have - is there any way that you could have to unwind this or not unwind but -

John Scheurer

What you're asking is are we in default on the public bonds.

Faye Elliott-Gurney - BAS-ML

Yes, basically.

John Scheurer

That's the question. And as long as we're not borrowing and we comply with the '40 Act, we're not in default on the public bonds.

Faye Elliott-Gurney - BAS-ML

So as long as you just abstain from borrowing then there shouldn't be an event of default?

John Scheurer

And our plan is not to add any new borrowing; our plan is to reduce borrowing. So even strategically it's not, I mean, as we think about access to capital, it's not going to be through borrowing on our balance sheet. It's going to be through managed funds.

So since we're not looking to grow to the portfolio but instead reduce debt levels, this is not a big issue.

Faye Elliott-Gurney - BAS-ML

And then does that mean no borrowing meaning if you paid back some debt that you can then not redraw it down? Is that a net change or once you pay something off is that then locked and you can't draw down again if you want to invest?

Joan Sweeney

It's somewhat complicated, Faye, but basically as long as we are beneath the 200%, we could not issue additional indebtedness, but under Section 18E of the Act we have the ability to refinance certain instruments in certain ways.

Operator

Your next question comes from Sanjay Sakhrani - Keefe, Bruyette & Woods.

Sanjay Sakhrani - Keefe, Bruyette & Woods

I just had a question on unfunded commitments. Could you talk about how much those are in the context of current liquidity available?

Penni Roll

If you look at our unfunded commitments - we will have this in detail outlined in our 10K  but we have about $682 million of commitments at the end of December. Keep in mind about $400 million of those commitments are to the Unitranche Fund and it's really at our discretion to make a determination as to whether we would invest in that fund or not, so that's pretty controllable.

The rest of the commitments are - some are revolving lines of credit; others are related to financing obligations that we have, but there has to be some approval by us to be able to fund that. So we feel pretty good about the level of commitments that we would need to fund and are currently funding existing commitments out of our current cash flow from the portfolio and operations.

Sanjay Sakhrani - Keefe, Bruyette & Woods

And just what you guys have available to you right now is the cash on the balance sheet and what else, I'm sorry?

Penni Roll

Well, you have the cash on the balance sheet at December 31, but you also have income coming in from the portfolio that's generated cash flow as well as - net of expenses - but also you have repayments coming in from the existing portfolio as well.

Sanjay Sakhrani - Keefe, Bruyette & Woods

And I guess the second question, I know you guys wanted to hold off on a strategic discussion, but could you just talk about some of the options? Is one of the options being discussed kind of changing the structure away from being a BDC?

Bill Walton

Our current thinking is we want to create a capital structure that works in the BDC format. People have come to us with a lot of different ideas about structure, but it's way to early to begin thinking about whether that makes any sense or not. We think we can fix this capital structure issue within the context of the BDC model. We'll look at that after we get the restructuring done and see what makes sense to go forward, but right now no change.

Sanjay Sakhrani - Keefe, Bruyette & Woods

And just one maybe final one, then, as a follow up. I know you can't give us the blow by blow on your negotiations with lenders, but kind of where are we right now? Have you worked through some of them? Are they all voting still? I just wanted to get a sense of kind of where we were.

John Scheurer

As I said earlier, we retained the Blackstone Group, certain individuals there, last week to help in that process, so we are really kind of at the beginning - not at the beginning, but almost the beginning - of trying to come up with a real comprehensive plan, and I think the lenders are sort of in the same place, looking at what their options are. They're going to do the same thing to confirm that everything that we've been telling them is true and that they feel good about it. And then I think the two groups jointly will come together and come up with a structure that works.

Operator

Your next question comes from Robert Dodd - Morgan, Keegan & Company, Inc.

Robert Dodd - Morgan, Keegan & Company, Inc.

I just had a follow up on Vern's question on overhead and expenses. If I look at the employment expenses, employee expense, in Q4, take out the IPA and take out the severance, it looks like the run rate is about $12.5 million. I realize that doesn't have much bonus accrual or anything like that, but is that an appropriate level of run rate for 2009 or are we looking at some level rather more elevated than that?

Joan Sweeney

It'll probably be a little bit higher than that because, as Rob mentioned, we just took on the management of three new managed funds and hired five additional employees for that activity, and as we see other opportunities in managed funds we may choose to add some staffing there. We don't really have a run rate that we can give you at this time.

Operator

Your next question comes from Jasper Birch – Fox-Pitt Kelton.

Jasper BirchFox-Pitt Kelton

Sort of a follow up on Troy's question on divestiture. Can you give us any color on post-quarter and your run rate of sales, and also, I mean, any color on what types of investments you're looking to offload and how, whether it's more one-offs or do auctions, etc.

Bill Walton

Well, we have some buyout investments - some, not the majority, just some - that we're looking at selling through perhaps an auction process, maybe another type process. That's ongoing. And then we have some debt investments which we're looking at selling selectively.

But as I pointed out earlier, this is not the time to hit the panic button and sell everything at prices that don't make any sense. We think we've got enough assets to develop a pool of capital that will make the lenders comfortable and also give us working capital to run the business and fund commitments that Penni was asked about earlier. I think in this environment we think we're making progress on that.

Robert Dodd - Morgan, Keegan & Company, Inc.

And then I'm assuming you can't give us any numbers in terms of sales that have gone on so far?

Bill Walton

I can't do that right now. As John pointed out, to the extent we get important things we need to share with the market, we'll do that, but it's early right now in terms of precise numbers.

Robert Dodd - Morgan, Keegan & Company, Inc.

And then on the different tax, can you give us any color on possible regulatory relief from Washington, if you're in talks with anyone there, and sort of what we might be able to expect or what types of things might come out of it?

Bill Walton

Well, I think as [Milan] mentioned in his press release, there is a group of BDCs that's talking with Congress and the SEC about various regulatory changes. Nothing's developed to the point that it's clear if or how it might change.

But we do think we're one of the companies that, both individually and as a class with other BDCs, that, as a matter of public policy should be supported. I mean, we talk about providing capital to middle market companies and small businesses to create jobs, we've got 100,000 jobs in our portfolio we're supporting. The rest of the BDCs have, you know, [ACAS] has 250,000 or something like that.

So there's a clear public policy issue here and we think we're on the right side of it, but whether and how we get changes to help us manage through this, it's politics. We'll see.

Operator

Your next question comes from Scott Valentin - Friedman, Billings, Ramsey & Co.

Scott Valentin - Friedman, Billings, Ramsey & Co.

As you pointed out, the default's a covenant default not a payment default and I think lenders are obviously much more comfortable working with you given the ability to continue paying as agreed. I guess I'm just trying to comfort with your cash flow projections maybe in terms of uses and sources of cash flow and the ability to continue to service the debt.

Joan Sweeney

Well, clearly, I mean, that's something that we're looking at on a daily basis and monitoring what's going through things. As Bill mentioned, we're looking at a variety of different exit events from the portfolio that would have the potential to generate cash that could be used to pay down debt; that's pretty much kind of our full-time strategy right now. But it is too soon to say how successful we'll be with respect to asset sales and how much debt will be paid down.

Bill Walton

But we've talked - if you think of it, we're credit people, our lenders are credit people, we understand what kind of visibility they need in the cash flow and cash buildups and things like that, and so we're managing the business so that we're in a position to deliver something that's attractive.

Scott Valentin - Friedman, Billings, Ramsey & Co.

Any large debt maturities coming due in '09?

John Scheurer

We've got $250 million in November of '09.

Scott Valentin - Friedman, Billings, Ramsey & Co.

And some of your peers have, I guess, applied for SBIC status. I don't know if that was something available to you guys or not or if you've considered?

Bill Walton

At our size it's not really that helpful, and I think we're just going to go it alone with this structure.

Operator

Your next question comes from Samuel Crawford - Stone Harbor Capital.

Samuel Crawford - Stone Harbor Capital

Sources and uses of cash are obviously problematic. Could you break down for me, however, the cash element of GAAP net income as reported?

Joan Sweeney

Well, we will file our 10-K today which will have a full blown cash flow statement, so perhaps that's the best way to go through that because obviously there's many elements of cash from operations. So I would just refer you to our 10-K filing that will happen today.

Samuel Crawford - Stone Harbor Capital

Let me make it a little simpler. I've worked with the cash flow statement and found it quite difficult in the past. Why don't we just talk about the interest income and the dividend line? What are the cash elements of that? How much of that is PIC, how much of it is accrual, and how much is cash?

Joan Sweeney

Well, if you - and, again, this will outlined in our 10-K when we file later today - but if you look at our interest income for the year, it was about $444 million, and in our cash flow statement you'll see that we had PIC and interest and dividends net of our cash collections during 2008 of about $53 million. So [inaudible] the PIC component.

Samuel Crawford - Stone Harbor Capital

Two other related questions, if I may. In the funds and contingent funding requirements off balance sheet that you all discussed earlier, are there any contingent funding triggers in those agreements? Anything that is tied to a covenant ratio? Anything that might be tied to a rating agency evaluation? Anything that might be tied to your auditor's opinion or other similar treatments?

Joan Sweeney

Would you ask the question again? You're saying with respect to the managed funds are they any?

Samuel Crawford - Stone Harbor Capital

With respect to your funding, your off balance sheet funding or on balance sheet, for that matter, the on balance sheet portfolio. Things that are required to support your business, forward commitments.

Joan Sweeney

Nothing with respect to ratings downgrades. We've had nothing of significance in that area. With respect to funding commitments for portfolio companies, those would happen regardless because they're really not dependent on our creditworthiness. We would have to fund if we had a commitment that came through.

So [inaudible] not following the question.

Samuel Crawford - Stone Harbor Capital

Yes. I understand the funding commitments to be basically if you were to file, for example, those would be unsecured claims. And what I'm wondering is, given that you all have indicated you have some discretion over the timing of certainly all of the funding decisions related to Unitranche because either you decide to invest or you don't, as well as some discretion over things that are not related to Unitranche because there some degree of your decision governs timing and amount.

What I'm wondering is in those forward agreements, those legal agreements, are there any clauses that remove discretion from you or lessen your degree of control over when and how much to fund that would relate to your economic health, whether or not you're a going concern or other similar qualities.

Rob Long

I think I'll try a crack at this. The majority of those relate to investment funds that we have discretion over, as you said, in that in order to fund under them we need to make a proactive decision to do so. They are not tied to a rating or any other financial constraint of the BDC itself, but remain subject to our discretion, of investment decision process.

So the general answer to your question is no, we're not aware of any and there's not any significant amount of revolvers - a small amount, but it's not like a bank that has a large revolver portfolio.

Samuel Crawford - Stone Harbor Capital

More to sort of understand how things work between what is on balance sheet in the portfolio and what's in the fund, do you have the ability to transfer on balance sheet investments to the funds? If you do not intend, for example, to access capital through the balance sheet and you are constrained by the public notes to not borrow, will there be any asset transfer?

Rob Long

I think if you look back in our historic reports you will see that there have been some purchases by our managed funds by assets that have been on the Allied balance sheet. There is some cash in the funds and they might choose to continue to buy assets, some of which might come from Allied.

I wouldn't say that this is a majority of what they do because each one of them has its own independent investment process, but the asset quality of some of the Allied [owns] on our balance sheet are high, as you know, from previous years. We've retained a much more conservative approach to the leverage of assets that we've put on our books, and so it is possible that these funds could be buyers of some amount of assets from the BDC in the future as they have in the past.

Operator

Your next question comes from James Shanahan - Wachovia Capital Markets, LLC.

James Shanahan - Wachovia Capital Markets, LLC

What, Bill, is the actual headcount today?

Bill Walton

It's about 130.

James Shanahan - Wachovia Capital Markets, LLC

Is there any opportunity to repurchase any of your publicly traded debt to reduce your financial leverage? The retail bonds come to mind that are trading at pretty cheap levels at this point.

John Scheurer

Clearly it would be an attractive thing to do, but we are working with our lenders and, as I said before, this is one of the strategies that we're working on and looking at, but for right now we're not doing anything.

James Shanahan - Wachovia Capital Markets, LLC

You answered the question about the BDC structure. Is there any advantage to thinking about renouncing your RIC status or with the level of taxable income is it not really helpful?

Joan Sweeney

Well, I mean, right now we are a BDC/RIC, and we met our distribution requirements for 2008. As we said, we would have the ability to carry forward taxable income from 2009 to 2010, so it's very, very early to be thinking about any sort of structure change.

James Shanahan - Wachovia Capital Markets, LLC

And to make sure I understand this, if you had taxable income in '09 that spilled over, you wouldn't have to pay that until actually the second half of 2010. Is that correct?

Joan Sweeney

That would be kind of the last point you could do it before you filed your 2009 tax return, which would be September 2010 for declaring it.

Penni Roll

Right. As long as you declare the dividends prior to filing our tax return - which for us is typically September 15 of the following year - and distribute those dividends by the end of that following year, then they would be available to be deemed to be distributed on that year's tax return.

Bill Walton

I don't think we're thinking about those sorts of things at all right now. I think it's status quo. We want to get things worked through with our lenders, restructure the balance sheet obligations, and end up with something that works going forward.

You know, this is a period of maximum stress in the capital markets and the economy and you've got to be careful not to panic here and try to do different things that might seem like a good short-term fix but really get you in a worse position. So we're taking it one step at a time.

James Shanahan - Wachovia Capital Markets, LLC

On that note, Bill, you're talking about you're negotiating a comprehensive solution. What specifically, if you could have everything that you wished for, what would that look like in your view?

Bill Walton

I'm going to let you use your imagination on that. I can't - as John said, we've got five or six different ways to think about this and we haven't yet figured out which one makes sense. It's really premature to say what that is.

John Scheurer

And I'll add if you made that list back in November or December you would have changed your list dramatically by January or February. And, as we've seen, even in Washington our own leaders are changing their lists daily or weekly. It's very tough. So we're working hard to come up with the right solution that does give us that flexibility. And we'll let you know as soon as we get it figured it out and make a deal.

Operator

Your last question comes from [Jim Auschel - Aviation Advisory Services].

Jim Auschel - Aviation Advisory Services

First of all, I understand that there's a new accounting rule that allows you to writedown the value of your [inaudible] liabilities on the balance sheet if a lower valuation is appropriate, and I'm aware of at least one other publicly traded BDC that has done that. Have you done that or are you thinking of doing that?

Bill Walton

That's 159 and there was a window of opportunity to elect that in the first quarter of 2008. It was considered, I think, at the time - there was a lot of controversy about whether that was the proper accounting treatment and we elected not to do that. It would affect the value of our liabilities pretty dramatically. As I understand it, there is some possibility we could elect that if we restructured some debt or something like that, but nothing right now.

It's sort of a fiction in terms of accounting if you just writedown a liability, but you still owe more to your lenders. Your lenders don't feel like it's gone down. So I think we're just going to work with our liabilities side as it is and fix that.

Jim Auschel - Aviation Advisory Services

You made reference to, though, I guess the $250 million principal payment you have to make in November. Do you have any principal payments of any consequence in the next few months that you've got to deal with?

John Scheurer

No.

Jim Auschel - Aviation Advisory Services

And can you give us a little update on Ciena, because you had another writedown. Can you tell us a little about the performance, the assets there and why did you have to take yet another writedown because there's been a whole string of them over the past few years?

Rob Long

I think primarily Ciena, what happened to Ciena is that the portfolio had held up pretty well through October, November. December and January we saw a real increase in delinquencies  and this was mostly in the conventional portfolio - an increase to the level that, when you pro forma the potential results and residual interest, you would come up with a much different number than we've had before.

And I think some of that's just reflecting what's been going on in the overall economy and the stress that's being placed on these small businesses and small companies and how they're able to cope with it. And a lot of them made it through the end of the year and started to really have bigger problems, much the same thing, I think, as you're seeing in the overall economy.

Jim Auschel - Aviation Advisory Services

Have there been any developments in their bankruptcy and is there anything you can tell us about what would be a likely outcome? Is somebody interested in buying the business? Are you going to try to reorganize it somehow? And do you have any further commitments that would require you to lay out some money related to Ciena?

Rob Long

I think this is another one where the bankruptcy is progressing pretty much along the lines of where we thought it would. There are some key things that will be coming up in the next few months that potentially could get it closer to where we want it, but I don't think at this point we're really ready to disclose what's going to happen with it at this point. We do have plans for it, certainly, and we'll let you know about those as soon as we can.

Bill Walton

Okay. Well, thanks, everyone, and thanks, Jackie. We'll be back in three months hopefully  we'll be back with the next quarterly report; that will certainly happen - but hopefully we'll have some progress reports to give you on these matters. And thanks for your patience and your support.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Allied Capital Corporation Q4 2008 Earnings Call Transcript
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