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Gladstone Capital Corporation (NASDAQ:GLAD)

F2Q10 Earnings Call

May 5, 2010 8:30 am ET

Executives

David Gladstone – Chairman of the Board & Chief Executive Officer

George Stelljes, III – President, Chief Investment Officer & Director

Gresford Gray – Chief Financial Officer

Analysts

Vernon Plack – BB&T Capital Markets

Greg Mason – Stifel Nicolaus & Company

David West – Davenport & Company

Mark Hughes – Lafayette Investments

John Rogers – Janney Capital Markets

Operator

Welcome to the Gladstone Capital second quarter 2010 earnings conference call. At this time all participants are in a listen only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Mr. David Gladstone, CEO for Gladstone Capital.

David Gladstone

This is the quarterly conference call for Gladstone Capital. Our trading symbol is GLAD and certainly thank you all for calling in and listening to this and those who listen to it remotely from wherever over the next couple of months, we’re happy that you’re listening to our conference call. I wish we could talk to you more often, it’s a great deal of fun to get folks on the phone and answer questions and we’ll do our best to answer your questions today.

I want to take this opportunity to tell you to visit our website, it’s www.GladstoneCapital.com where you can sign up for email notices and you can receive the information about our company on a timely matter. I know it came out late last night, it was about seven o’clock before it got on the wire but it does come out more frequently and quicker. Please remember that if you’re in the Washington DC area you have an open invitation to come by and visit us here in McLean Virginia. Please stop by and say hello, you’ll see some of the finest people in the business working everyday for you.

Now, I need to read this statement on forward-looking statements. This conference call may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and Securities Exchange Act of 1934 including statements with regard to the future performance of the company. These forward-looking statements inherently involve certain risks and uncertainties and even though they are based on our current plans and we certainly believe those plans are reasonable there are many factors that may cause our actual results to be materially different from any future results that are expressed or implied by the forward-looking statements including those factors listed under the caption risk factors in our 10K and 10Q filings and in our prospectus that are filed with the Securities & Exchange Commission.

Those can be found on our website at www.GladstoneCapital.com and also on the SEC website. The company undertakes no obligation to publically update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Alright, we’ll start this morning with the President, Chip Stelljes. Chip is our Chief Investment Officer, he’s the Chief Investment Officer of all the Gladstone companies and he’ll cover a lot of ground here.

George Stelljes, III

As most of you know the difficult economic environment continues and is still compounded by a difficult lending environment. We are seeing some new investments being made with some investors in the marketplace believing that the worst is behind us but the continued instability of the financial lending market combined with only a few real signs of recovery in the economy continues to make us cautious.

We did not close any new investments in the quarter but invested $5.2 million in existing portfolios within the company in the form of additional investments or draws on revolver facilities. During the quarter we received repayments for approximately $23.4 million through the loan sales, payoffs, normal amortization and the pay down of the revolvers. This included the full realization of three investments of [$18.2 million] that will be assets of a small loan, $300,000 on the sale of the syndicated loans worth approximately $300,000.

So we had more pay offs than advances resulting in a net decrease of our portfolio of $18.2 million for the quarter. The net proceeds were used to pay down our line of credit. Since the end of the quarter where we made the first installment of $400,000 in new $2 million investment and about $1.2 million in additional investments in existing portfolio companies. Additionally, after the end of the quarter we received $15 million in repayments which included amortization in a $13.5 million repayment from one portfolio company.

I do want to note that [inaudible] applied we received all of the related prepayment fees, exit fees and capital gains associated with these realized investments so that’s a very good sign for our investment model. Just so you know the companies where we had exits achieved proceeds representing a hardened 7% of our previous quarter values. So as of this call we have about $28.4 million borrowed on our $127 million line of credit so we are in great shape today.

As to the pipeline, we continue to see new investment opportunities with pricing with structures that are attractive and with our line paid down and it’s longer maturity, we believe we can start making new investments at attractive rates of return. We do continue to work to increase the yield of our existing investment portfolio in several ways. First, by refinancing lower yielding senior loans with third party lenders while trying to maintain the higher yield in junior debt and secondly, by increasing pricing where the situation allows for it.

At the end of the March quarter our investment portfolio was valued at approximately $292 million versus a cost basis of $330 million so approximately 88% loss. The values were stable this quarter but we’re not seeing a reassurance in valuations. We still believe the valuations are more reflective of the higher rates new loans are demanding compared to the lower rates of our older loans rather than the specific performance of our portfolio. That being said, we continue to closely monitor our portfolio companies’ revenue and backlogs to judge where we think the underlying businesses are headed.

At the end of the quarter we had loans with six companies on non-accrual and a number of companies experiencing problems that may prevent them from making timely payments in the future. We have taken operating control of several of these companies and we’re working hard to get them back to current pay. On a dollar basis, the loans classified as non-accruing have a cost basis of $26.4 million or about 8% of the cost basis of all loans in our portfolio and on a fair value basis, they’re valued at $12.7 million which is about 4.4% of the fair value of the portfolio.

Note that the increase in non-accruals cost basis from 3.7% to 8% this quarter is primarily due to the addition of one portfolio company. This company has a new CEO and we wanted to give him some breathing room to increase the sales of the business. That company is in the outdoor advertising business. They have about 1,600 billboards and the market is improving but the company needs to sell the inventory they have. This change to non-accrual will not affect our investment income or our dividend since we have not been accruing the interest on this loan during the last year. This was an old performance based note that only paid and we only recognized interest if the company met certain standards so we decided that they had not met them so we decided it was better to classify the loans as non-accrual.

Our portfolio companies are not immune to the current economic climate so we may have some additional non-performing loans and some write offs but we do seem to be coming to the end of the recession. We continue to have a high concentration of variable rate loans so that when win rates do increase we should participate. While our rates are variable, we often have a minimum interest rate or a floor so that declining interest rates are mitigated. Approximately 85% of our loans have floors, 2% have floors and ceilings, however, 9% of our loans do not have floors at all and the short term floating rates at all time lows are generating less income because the rates are so low. The remaining 4% of our loans have fixed rates.

A measure of the quality of our assets is our average loan rating for the quarter that just ended remained relatively unchanged. Our risk rating system attempts to measure the probability of default of the portfolio by using a zero to 10 scale. Zero represents a high probability of default and 10 represents a low probability. During the quarter we modified our risk rating model to incorporate additional factors and our qualitative and quantitative analysis. While the overall process did not change we believe the additional factors enhanced the quality of the risk ratings of our investments. No adjustments were made to the prior periods as a result of this modification.

Our risk rating system for our non-syndicated loans showed an average rating of 6.3 versus 7.2 for the same quarter for the year prior. The average risk rated for unrated syndicated loans was 7.0 for this quarter versus and average 6.8 for the prior year’s quarter. As for our rated three syndicated loans, they had an average rating of B2 this quarter and CCC [Class CA] one for the prior quarter. Overall, the risk profile has remained relatively constant according to our risk rating model. While the risk rating model is only showing slight changes in portfolio, we do see changes that might not be picked up by our risk rating.

In addition to the quality of the assets, the quality of the income continues to be good. As we discussed before we do not intend to generate from paid in kind or original issued discount structures. These generate non-cash income which has to approved for [inaudible] cash but is not received until much later and sometimes not at all. This income is subject to our 90% payout requirement so the company does not receive the cash but would have to payout the income.

From inception through 3/31/10 we’ve made loans to 127 companies totaling greater than $958 million. Our accumulative net losses have been approximately 3% of total investments since inception. We have been repaid or exited from 86 companies. As of 3/31/2010 the average return of the exits has been about 8% for syndicated loans and 13% for non-syndicated loans. The historical returns have dropped some as we had to sell some of our performing loans during the low point in the recession 2009 to pay down our short term line of credit.

The senior and second lien debt marketplace for larger middle market companies continues to improve. At March 31st we had a cost basis of approximately $9.5 million in senior and second lien syndicated loans. This is where we have most of our variable rate loans that don’t have floors and these loans have seen their values decline more than the others. As I stated earlier we sold the majority of this portfolio since the middle of 2009.

The lower end of the middle market where we invest most of our capital has not seen much new competition. Most banks continue a policy of tightened credit standards especially for the size companies in which we invest. Currently banks are mostly willing to make purely asset based loans to that business segment. We normally compete with our BDCs and private lenders such as mezzanine loan funds and a few remaining hedge funds and some of the small business investment companies out there.

Again, our loan request pipeline is still good and with our new line of credit in place we should be able to make some new investments before the end of our fiscal year in September. With that, I’ll turn it back over to David.

David Gladstone

Most of you out there couldn’t tell it but Chip is getting very excited about the climate today and he’s not one easily excitable. We’ll go now to Gresford and Gresford Gray is our Chief Financial Officer. Gresford, tell us about the financials.

Gresford Gray

Starting with our balance sheet, at the end of the March quarter we had about $312 million in assets consisting of $292 million in investments at fair value and $20 million in cash and other assets. We borrowed $53 million on our line of credit and had approximately $255 million in net assets. As such, we are less than one-to-one leverage and this is a very good and conservative balance sheet for finance companies which are usually leveraged much higher. We believe that our overall risk profile is low.

During the quarter we did not close on any new investments and exited from five companies of which four were payoffs and one was a syndicated loan sale. At quarter end, we had 41 companies in our portfolio and with the Vanacore payoff in April we’re now at 40 companies. In March we entered in to a new $127 million credit facility with KeyBanc, BB&T and ING Capital. Subject to certain terms and conditions the credit facility may be extended up to $202 million through the addition of other committed lenders to the facility.

The facility matures in two years on March 31, 2012 and if the facility is not renewed or extended by that date all principle and interest will be due and payable on March 15, 2013. Advances under the credit facility bear interest at 6.5% per year with a commitment fee of 0.5% per year on the drawn amounts. We expect that this credit facility will allow us to increase the rate of our investment activity and grow the size of our investment portfolio.

In January, the SEC declared our shelf registration statement effective and as such we’re permitted to issue up to $300 million in debt and equity securities. At our annual stockholders’ meeting in February, stockholders approved a proposal that authorizes us to sell our shares at a price below NAV for one year. As such, if our share price falls below NAV we’ll be able to sell our shares if necessary. At quarter end our NAV was $12.10 per share and given our share price yesterday of $13.29 we’re trading at a 10% premium to NAV per share so that’s great news for us.

Turning to our income statement, for the March quarter net investment income was approximately $4.5 million versus $5.6 million for the same quarter last year, a decrease of about 20%. The decrease was primarily due to a decline in investment income resulting from the sale and repayment of loans, incentive fees accrued and lower transactions fees received in the current quarter than during the prior year period.

As you all know from our discussion last quarter, for most of last year we’ve been deleveraging and that means selling loans and encouraging payoffs of lower interest bearing loans in order to pay down our debt. We are now seeking to increase our assets with better paying loans and from the loan payoffs this quarter we received assed fees and prepayment fees of about $1.2 million.

Consistent with prior quarters, LIBOR remains low which has negatively impacted earnings from our syndicated loans. However, since we sold many of our syndicated loans, even if rates go back up we don’t expect that our income will increase materially. On a per share basis, net investment income for the quarter was at $0.21 per share as compared to $0.26 for the same quarter last year. This is a per share decrease of about 19% which again was caused by the changes in our balance sheet. As many of you may be aware, net investment income is the most important number to us because this is the number that is closest to our taxable income which is the income we use to pay our dividend.

Now, let’s turn to unrealized and realized gains and losses. This is a mixture of appreciation, depreciation, gains and losses. I’ll discuss two categories in this section. The first, is with gains and losses because they are cash items and then second, appreciation and depreciation which are non-cash items. For the quarter ended March 31st we had a realized gain of $0.9 million primarily due to the gain of our eight expedited warrants offset by the losses on the [CCS] payoff and both syndicated loan sales.

Regarding unrealized depreciation, for the quarter ended March 31st we had net unrealized depreciation of about $2.5 million. This represents the net change in fair value of our investment portfolio including the reversal of previously recorded unrealized depreciation or appreciation from gains and losses realized. As of March 31st, our entire portfolio was fair valued at 80% of our cost basis and the cumulative unrealized depreciation of our investments does not have an impact on our current ability to pay distributions to stockholders however, it may be an indication of future realized losses which could ultimately reduce our income available for distribution.

As explained in our recent SEC filings, when the market demonstrates characteristics of illiquidity, we are required to value our syndicated loans using a discounted cash flow method. However, in monitoring the market activity during the quarter ended March 31st we continued to use third party bid floats to value our syndicated loans. During the quarter we had another component of unrealized depreciation which related to our credit facility. For the quarter ended March 31st we recorded unrealized depreciation of $131,000. Since we entered in to the new credit facility during the quarter, the fair value was the same as the cost basis of $53 million as of March 31st. As such, on our balance sheet as of March 31st we did not have any cumulative net unrealized depreciation or depreciation on the line of credit.

Now, let’s turn to net increase or decrease in net assets resulting from operations. This term is a combination of net investment income, appreciation, depreciation, gains and losses. Please note that we’re talking about weighted average fully diluted common shares when we use per share numbers. For the March quarter we had a net increase in net assets resulting from operations of $8 million versus a net increase of $10.3 million in the prior year period. This is a positive $0.38 per share for the current quarter versus a positive $0.48 per share for the prior year quarter.

With the continued uncertainty in the current economy and credit markets investors should expect continued volatility in the aggregate value of the portfolio. Now, I’ll turn the program back over to David.

David Gladstone

I hope all our listeners are reading these press releases and going through the 10Q which we filed with the SEC yesterday. You can access the press release and the 10Q on our website at www.GladstoneCapital.com and also on the SEC website that is at www.SEC.gov. The big news this quarter is we completed our goal of paying down our bank debt and renewing our credit lines. We were awful grateful to the folks at KeyBanc and BB&T Bank and ING Capital for providing the loan to the company.

It’s a two year commitment with a one year payout of the principle if we need to do that. It’s really a three year commitment and it’s a good one for us. It will bridge us to the point where we can raise low cost [inaudible] long term debt capital and perhaps some preferred stock over the next two years. We have nearly $100 million available on our line of credit today and are currently working on a number of very good alternatives for long term investing and it just takes a lot to get me excited but I’m looking forward to this summer as a time of rejuvenation for our company as we put new loans and investments on the books.

I think we all see now that we’ve gotten through our difficult loans. Those will settle down and I was disappointed of course that our billboard company hasn’t come back as quickly as I’d like to see it come back but they seem to be getting better every month. They are highly dependent on advertising budgets and the budgets are coming back but unfortunately the budgets are coming back slower than we’d like them to come back. I know that this will be a winner down the road. We have a new management team and they’re doing a great job for us. They recently landed a big contract with the number one fast food chain so they have put up those billboards for that fast food chain.

The credit markets continue to get better. There’s still not much long term debt for small businesses and that’s really a shame because they create all the jobs in the economy. But, we’ll be working hard over the this summer and over the next part of the year to put our brand of long term capital to work in these small businesses. Even though we’ve entered in to a nice new line of credit and it’s still a short term line of credit, we can use some of that money to put new loans on the books but we’ll be looking and you should be watching for us to announce that we’ve raised long term capital of some form to match up with the long term loans and investments that we make in these businesses.

In order to make lots of new investments we will need to raise long term debt and long term capital of some time or issue preferred stock or additional common stock in order to finance these investments for the long term. But, we do feel very comfortable about putting $50, $60 maybe even $70 million of new loans on the books using our line of credit and at the same time we’ll be looking at our books to be rounding up some long term debt to match that and pay down the short term debt. That warehouse line we have with the lenders now we’ll pay it down with long term debt then borrow it up and start to leverage back up. We’re back in business again.

Our portfolio of companies we worry too that they will not be able to get lines of credit and term loans that they need at cheap rates from the banks. There are a fair number of regional banks that are making new loans based primarily on assets and these asset based lenders are certainly much more clinical today than they were last year at this time. I think last year this time we had maybe three or four that we could deal with, today there are probably 25 or so that are in the business and that we deal with that are helping some businesses.

But remember, banks are only making short term revolving lines of credit and we still need them to come back in to the market for long term debt. Right now, we’re providing the long term debt and we’d like to see our portfolio of companies get some lower cost long term debt. As far as the economy goes, we’re still worrying about oil prices. As the economy comes back obviously oil demand will go up an oil prices will go up with it as we see the economy improving. We’re certainly worried about inflation and the decision by the lawmakers in Washington to expand the money supply is going to cause inflation to return. In essence the government is really sopping up all the available credit out there today and they’re having the banks buy treasury bills rather than making loans to small businesses today.

The spending in our federal government is way off the charts. If you look at the stimulus package that has come out it is still spending goodies for many of the supporters of the legislators in order to get them reelected again. The amount of money being spent in Iraq and Afghanistan in the war is certainly hurting our economy. All of us support the troops, they’re the true heroes of this period in history. They’re risking their lives every day for us and we certainly wish for them to come home safe and soon but we have to recognize that the expenses we have for the war is very detrimental for our economy.

All this spending obviously means that taxes are going to have go to up. We’re going to have to have more taxes and that will just cause more dislocation as the government tacks on taxes to virtually everything. The government keeps talking about increasing taxes on the so called wealthy and if you watch the definition of wealthy it continues to include more and more the middle class and that really means just about anyone who is listening to this presentation today is going to see their taxes increase either directly or indirectly.

The trade deficit with China and certain other nations is just terrible. China continues to subsidize their industries, their small and midsize businesses and that’s a disadvantage for our company that is trying to compete with them. As they subsidize oil for example, it’s just a very different price difference in oil prices and gas prices in China than it is here and this means our companies can’t compete with them and jobs of course leave the United States and go to Asia or other countries.

Now, even China today has even stopped buying our government paper so the US government is having a hard time finding people to buy the paper. Japan is down in terms of buying our paper so the banks seem to be the only places they can put the treasury bills these days. The turn down in the housing marketplace obviously, is still disaster and home mortgage defaults continue to creep up and I don’t think anybody knows where the home mortgages will ultimately come out in terms of their number of failures. It’s just trillions and trillions of dollars being estimated that can have problems over the next couple of years.

However, we do believe the housing problem is likely to turnaround this year, sometime in 2010. Housing prices are falling enough to bring back a lot of the qualified buyers. There’s only one problem, about 80% of all the new homes that are being financed today are guaranteed by the US government through FHA, VA or something. So you have the government propping up the home buying business these days and hopefully that will change over time and we’ll see that housing come back.

There is a lot of negatives in the marketplace but in spite of all of those, the US economy is still not a disaster. The recession is having an impact on all of us including our portfolio companies but it is not a disastrous one, it’s not like 1929 where so many companies were closing. But, like most companies, our portfolio of companies have not seen much in the way of revenue increases or back log increases. They cut costs dramatically in order to remain profitable. Perhaps we’ll see an increase next quarter and we see some of our companies starting to have increases and that’s a good sign.

At this point we have a low rate of non-paying loans so we’re in pretty good shape today. So all of you who have been bullish while I have been so bearish you called it right a year ago and the economy is coming back and our company is in a position to move forward now. The only thing that is hurting us is the lack of bank lending money today to companies on a long term basis. All the short term lenders are out there however, most of the banks have just about stopped their longer term loans.

This is like 1990, the recession of 1990 the federal government was pouring money in to the banking system by buying assets and shutting down banks today. Of course, they’re investing in the banks although we do see them taking over a few banks here and there but it’s not like then were about 1,100 banks were shut down. We believe the downturn that began in 2008 will continue as it is today through most of 2010. However, the economy is stabilized now and if that’s true we’re going to be able to take advantage of it. It’s just a great time for us over the next two to four years.

Every time we make a new loan there is fee income and there is income that comes in to us more and more and that should make it available to us to increase our dividends over time. Our plan today is to seek long term debt for our fund. That’s the next goal and objective on the right hand side of the balance sheet. Obviously on the left hand side of the balance sheet we need to put more money to work. We’d like to borrow long term again because we’re making long term loans and we want to match the book as they say in the business and make sure that we don’t have short term borrowing problems as all of us did during this last part of the recession.

We are looking at issuing some preferred stock but it would be very expensive today so we sort of backed off of that but we’re still trying to figure out how we can raise some long term capital, either preferred stock or debt and that’s a major goal during the next 60 days. We’re not considering issuing any common stock today. While the stock price is relatively high to the dividend it doesn’t take in to account the fact that we expect to increase the dividend over time and we have to match those in any new shares we give out. Plus any issuance of shares today would be a dilution to our existing shareholders and all of you know how much I hate to do that.

Our distribution today is $0.07 per share for each of the months of April, May and June. We declared that back in April. Our projections, we didn’t assume we were going to be making any new investments so as we make new investments our projections should come up and hopefully we can make some use of that extra money by paying out extra dividends. There really no guarantee, I’d love to tell you that we’re going to increase the dividend next month or next quarter but at this point until we put deals on the books we just can’t do that. We can’t make those kind of projections.

The run rate that we’ve declared may leave us with the need to pay a small extra dividend at our next meeting so I hope that’s a problem that we have. You’ll certainly hear about it in our call that we do at sort of the end of June or July. We’ll give everyone the same information and don’t want to hold back. I just want to say one thing, I think this is a great opportunity given the yield on this stock and dividend and putting new loans on and so I plan to buy some stock. I’m always buying stock in to my dividend reinvestment plan. I’ve been doing that for the last nine years but I plan to buy some additional shares with the additional cash that I have. I just think this is a great time to buy stock in this company. That will probably cause us to look at increasing the dividend over time and I’m hopeful that we can do that.

Please go to our website www.GladstoneCapital.com, sign up for our email notification so that you get all of the information about your company. In summary, I’d say that the economic conditions are looking like they will change for the future and I think the next six months are going to be very telling. I think the economy is at the bottom today. We’re gaining strength every month and I think over the next two years it’s going to be a great time. Again, the next six months are really going to be telling for whether we are flat or we’re going to go up.

We are stewards of your money. We’re going to stay the course, we’re going to be careful, make sure we can make good investments. Operator, at this point in time if you’ll come on and we’ll answer some questions from the guys and gals out there.

Question-and-Answer Session

Operator

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

Vernon Plack – BB&T Capital Markets

I had a question, I was actually looking for a little more color on the types and the characteristics of the deals that you’re currently viewing and are attracted to. So, perhaps a little more color there please?

George Stelljes, III

The market as you know, one of the negatives that David mentioned as far as our ability to access senior debt is still pretty restricted at the lower end of the middle market. That’s negative for the portfolio but for doing new deals it’s pretty attractive. You don’t end up with a lot of term debt in front of you so your junior debt is further up the balance sheet at lower leverage levels than we’ve seen in the past. At the same time, therefore you’ve probably got more equity going in to those deals. We certainly are seeing improved pricing on junior debt at the smaller end of the middle market or the lower end, you’re not seeing much get sort of priced at sort of less than maybe LIBOR plus 1,000 with a 2% floor.

We’re not seeing a lot of things that are getting done that don’t have some level of an equity component to it whether it be a warrant or equity co-invest. You probably remember at the trough of those in ’07 and the beginning of ’08 it was pretty hard to negotiate those type deals. It feels like it’s going to be a good time and we’ll see what we can find. You will probably have five or six deals that we’re actually looking at right now and so I’m optimistic. As David said it’s hard to get overly excited but I’m optimistic we’re going to find some good opportunities. But, that’s what we’re seeing in our marketplace.

Vernon Plack – BB&T Capital Markets

Is there any industry focus there or what are some of the industries or sub industries that you’re really attracted to at this point?

George Stelljes, III

We continue to look at mostly the same things we’ve looked at historically. Where we have probably increased our business is we have not been active investors historically in government contractors but as we talk about it around the table here with 30% of our GDP is going to be government, we better get interested in it. So we’re spending some time studying that. I wouldn’t want to tell you anything specific so basically business services, light specialty manufacturing but we are continuing to look at healthcare services. We’ve had good luck there but obviously we’re, as everybody is, sensitive to the reimbursement environment and what’s going to happen through healthcare legislation. But, it’s a big part of the economy and so we continue to look at it and as I said we’ve had good luck with it in the past.

Vernon Plack – BB&T Capital Markets

A quick question for you David regarding long term debt, could we expect an announcement on that from you within the next quarter?

David Gladstone

I don’t know. We’ve engaged a placement agent, they are working on our behalf. We have had several sessions with insurance companies, I just don’t know. As you probably know better than I do, most of the insurance companies have for at least the last 18 months have said no to everything in the finance sector whether they’re finally now interested in the finance sector I can’t answer but we are able to talk to them which I say one quarter ago you couldn’t even reach them on the telephone, they wouldn’t talk about it. So, I think they’re coming back. Whether we could announce something in the next quarter I don’t know, it’s too early to tell.

Operator

Your next question comes from Greg Mason – Stifel Nicolaus & Company.

Greg Mason – Stifel Nicolaus & Company

David, can you talk about I think you mentioned $1.2 million this quarter of exit and success fees, I think that’s up from like $500,000 last quarter. What are your expectations for those fees going forward?

David Gladstone

It’s hard to say what those fees will be like going forward and here’s the point, the existing amount of fees that are building up in our portfolio as you probably know we don’t do paid in kind so it’s not being added to our portfolio and you can’t see it building it up. But, we do what we call success fees and those do build up on the balance sheet. You don’t see them but we calculate them here. We have a good amount of those and if those loans prepay and if they want to pay off the success fee at that point in time that’s great, if they want to pay it off when they sell the business, that’s fine as well.

I just can’t predict when they’re going to pay off and when they’re going to sell their business. As you know, this company follows around most of the LBO funds, most of the LBO funds do sell their businesses eventually so we can collect on those at some point in the future but right now it’s hard to say. I’m hopeful now that the economy is coming back and more and more people are interested in buying businesses that we’ll see a good number of these going forward. We certainly build them in to all of our new transactions so you should see a buildup in warrants or success fees being talked about in the 10K or the 10Q.

Greg Mason – Stifel Nicolaus & Company

Do you have an amount of success fees for the total portfolio that is built up or are you able to give us that number, the potential for the total portfolio?

David Gladstone

I know we have a memo account, let us go back and look at that and maybe we should be recording that someplace and telling people what it looks like, just to give you an example. It’s not in the Q is it?

Gresford Gray

No.

David Gladstone

But, we have a memo account on that. I’m talking to Gresford our CEO, he tracks all of that and if we have – we should probably start revealing that in our Qs and Ks just so people can see it. It’s no guarantee that we’re going to collect it, it’s just sitting out there as something that might be collected. We’ll take a look at that and see if we can put it in our Q&A section on the website for this quarter that just ended and then we’ll look at putting it in a memo account in the future Qs.

Greg Mason – Stifel Nicolaus & Company

Just to dig in to the origination potential, in the press release you said now is the time to become active lenders and you talked about $50 to $70 million of capacity on your credit facility. Do you think you can deploy that by the end of this year or is it a 12 month time frame? I’m just trying to dig down a little further on your expectations?

David Gladstone

Well, Chip can answer that better than I can.

George Stelljes, III

I think we can. With the realizations we’ve just gotten in, with the ability we have on the line, I think we’ve got our origination team in place. As you know, we did go through the significant layoffs that a lot of our competitors did so we’ve still got our offices open in Dallas, Atlanta, Chicago, New York and obviously servicing the rest of the east coast. We’ve got almost all of our junior and mid level talent available to do new deals.

As David said, we’ve gotten the portfolio settled down and there’s less work we have to do on individual companies. So I think we’re in pretty good shape to do it. The real thing we never want to promise is that we’re just going to book it for the sake of booking because we want to make sure we deliver good quality loans and not making difficult core decisions on loan quality. So part of it’s going to be a function of what we see and we’ll start to see as the year goes on whether that’s a good number but I do feel like that’s a good number and certainly it’s a number we’ve been able to meet in the past with our team.

Greg Mason – Stifel Nicolaus & Company

David, have you heard anything from the SBA new about a potential SBIC license?

David Gladstone

No, we’re hung up down there on a number of issues and I just don’t know at this point in time whether we’re going to go forward or not. The SBA is a different world today than it was when I ran four of these 10 years ago.

Greg Mason – Stifel Nicolaus & Company

Then one final question, can you touch a little bit more on credit quality? As we looked at your internal ratings we looked at the weighted average I think it went from 7.1 down to 5.9. I think you said your straight line average went to 6.3. Was there just a couple of movements and when do you expect the credit quality to kind of stabilize in your portfolio?

David Gladstone

Well there was a fact that we changed the rating system and we made the rating system probably more critical than it was before because we felt like there were a couple of things that weren’t being captured in that so we started to capture those so they would jump out at us and give us a better indication of what’s going on. So this round that happened in March 31st may have been a more critical valuation of our portfolio. It’s hard to say, we didn’t go back and risk rate the portfolio at December or any prior period so we didn’t try and spot check that. Gresford, what have you got in terms of that? Any answers to Greg’s question?

Gresford Gray

Basically Greg, as David mentioned we wanted to do more objective analysis using the qualitative and quantitative factors that went in to the risk rating model. What we expect going forward is we’ll expect the smoothness to continue now. As David said, this quarter with us making the change, you see this modification.

Greg Mason – Stifel Nicolaus & Company

One quick follow up on the SBA commentary, you said it is a little surprising that someone of your background isn’t able to secure a new license. Do you think that is a change the SBA is having towards BDCs or what are you seeing there? Can you add a little more color?

David Gladstone

I think it’s really me and I don’t like to say this in public but I have not been a big fan of the SBA since I left Allied years ago because it was so difficult. As you know, when I took over American Capital and ran American we never got an SBIC license because I just didn’t want to do that. Money is freeing up now and I am not sure the attraction of the SBA lower cost money is that great. We’ve looked at a couple of situations that if they come through would give us money at nearly – add to the SBA cost of money all the costs that go in to the fact that you’ve got to do all of these extra things.

You have to run a different set of books, you have to do different forms, you fill out forms for each time you do a deal and all of that adds to the cost of your business model. If you take that business model and compare it then to say just straight preferred stock, I think we can raise money either in debt or equity at a rate that would be comparable and not have the difficulty of trying to fit everything in to an SBIC model. It’s a great technique for getting started. If you’re a two or three man team and you’re going out to start an investment company it’s wonderful to have them as your partner because it’s just about the only place you can get that kind of capital.

But, once you reach a certain stage it’s like all of these government programs, you graduate from it and I would be shocked if Apollo or Aeris ever decided they wanted to have an SBIC and certainly Allied after I left and after they grew a little bit more from where I was they surrendered all of their licenses and they had four different licenses that they surrendered and got all their debt back. When people look at it and you get a certain size it becomes not advantageous to have the SBA.

I know a lot of BDCs ran in to the SBA because there really was no other way of getting long term debt so as a result they felt like it was necessary. I am just at a point of inflection here in looking all that we have available to us to think that maybe doing an SBIC is probably not the right thing. Now, we have a license down there, we haven’t prosecuted it perhaps as vigorously as we should and we’ll let you know how we come out on this analysis but I’ve looked at two situations that if either one of those came through I would not go forward on the SBIC license.

Operator

Your next question comes from David West – Davenport & Company.

David West – Davenport & Company

I just wondered if you could give a little bit more color on the repayment activity and what has been the source of the repayment? Is someone providing refinancing for some of these portfolio companies?

George Stelljes, III

Of the main ones that were realized this quarter with one exception of the sale was [inaudible] and the others were repayments and refinancing which is good news for our model. Those companies had done well, we received our success fees and in a couple of cases prepayment fees and that obviously generates capital that we can put back to work at higher returns. But the majority of it was refinancing but the large payment on was the sale of that company with the warrant gain that Gresford mentioned.

David Gladstone

You also know Dave that I think all of those were valued by Standard & Poor’s at a lower number than we actually got when they paid off. Obviously, they were discounting it for the fact that it’s private and of course they paid off at 100% on the dollar. That’s an indication of how conservative Standard & Poor’s is and we don’t begrudge them for being conservative, we run in that mode as well. But, you should know that generally speaking we do collect all of the money under our loans.

David West – Davenport & Company

Just to get a better grasp on this, who are the other parties providing the refinance in this market?

George Stelljes, III

In a couple cases the senior lender had enough assets and they stepped up. In the case after the quarter, Vanacore, the equity firm actually decided to take all of the debt off the balance sheet, the junior debt and go with an equity structured balance sheet so they actually wrote an equity check for that. The other ones were just other lenders that came in and again, had enough assets to be able to do it and give them more senior debt pricing.

David Gladstone

So they paid off their more expensive debt which would be ours by borrowing from their bank on their revolving line of credit and they were able to do that because they had paid down the revolving line of credit from the time they were acquired. The typical fashion for us is that a business will be bought, it will be loaded up with debt including ours and then over time it pays down the debt and obviously ours is the first one they want to pay off because we are the most expensive.

That’s good for us. It proves our model, proves that we selected correctly and that’s going to happen more and more as the capital markets get better. But at the same time there’s still no one out there providing the long term debt to do the new transactions so we’re still in good stead in terms of putting that to work it’s just over time we get paid back.

George Stelljes, III

We did have one issue where our junior lender who was junior to us decided to step up because they liked our loan and they replaced us. Quite frankly, it was a relationship that had been difficult over the years. The company’s performance had somewhat improved and we weren’t necessarily sorry to see that one go.

David West – Davenport & Company

Just one other question, on the [Lenmark] loan, the billboard company, I don’t quite understand given what you said that you hadn’t been recognizing income from the past on that. Why was that not put on non-accrual before?

David Gladstone

We took over that company and when we took it over we put some of the loans in the category of you pay it if you have the money to pay it. So it really didn’t have to pay it and so as a result we were sitting there not collecting the interest because they were building the company on the inside and making lots of changes. Then, we decided look it’s better to reclassify this, I think it was after nine months of looking at their ability to pay and said we ought to just classify this not as a loan that’s paid when they have money to pay but put it in a non-accrual so we moved it over to that category.

That’s why it didn’t have an impact on the earnings of the company and didn’t have an impact on our ability to pay dividends simply because they weren’t paying under the performance based analysis that we put in place. Now, that company has come a long way since the time that we took it over and a lot of that was due to the very aggressive acquisition schedule that they had. They were acquiring lots of smaller billboard companies and also building billboards at a rapid pace and of course they hit the recession head on and started having cancellations of their billboard signs and at the same time had obligations out to continue to build things. It was an unfortunate circumstance.

But, we have now sold off some of the extraneous pieces where they were trying to go in to new areas and we’re taking that money and plowing it back in to improving the existing operations. My guess is that it may be six months away but I think that company will come back pretty strong in the next six to eight months.

Operator

Your next question comes from Mark Hughes – Lafayette Investments.

Mark Hughes – Lafayette Investments

First a comment and then a question, David I appreciate your sensitivity to diluting shareholders and restraining from issuing shares if you can place some long term debt or a preferred issuance. It is certainly appreciated by the shareholders that you’re sensitive to that issue. Then just a question, on the decline in the average asset risk rating, part of it is because you’ve changed how you’re computing the model but is part of it because you’ve made basically no new loans the past six months and the ones that have paid off might have had a higher risk rating than the ones remaining? If that’s the case, what was your internal risk rating of the payoffs, of the loans that have paid off the last six months?

David Gladstone

That’s a difficult one. What was the risk rating of the ones that paid off, do you remember guys? Let me take a quick look, we’ve got a schedule here.

Mark Hughes – Lafayette Investments

Or just in the general sense, in general were they higher than the average of what’s remaining?

David Gladstone

I wouldn’t be able to do that one on queue. It looks like we had two sixes and a seven and where’s the other exit – three sixes and a seven where the four payoffs so they were a little higher perhaps than the average but not much, not material. They look like they’re right in line.

Mark Hughes – Lafayette Investments

I would say that speaks very highly for your conservatism them than you’re able to get a price higher than your mark at payoff and on the surface a six or a seven seems very average but if you’re getting paid off above your book on it that seems very commendable.

David Gladstone

Oh, I think we’re in good shape today. Mark, you’re probably the only person that complements us for our conservatism. Everybody else calls us too picky and not growing fast enough and all those other things but unfortunately, that’s our nature here.

Operator

Your final question comes from John Rogers – Janney Capital Markets.

John Rogers – Janney Capital Markets

I have a question for you on the out of period adjustment from the Q. I think you talked about in the Q a reversal of interest income, an adjustment related to professional fees that negatively impacted net investment income by about $0.02 per share. I’m just wondering what that relates to and if you have more detail on that?

David Gladstone

I do want to go in to one part of it, we had a law firm that we were doing a work out with and they were sending their bill out but they were sending it to an unknown address and so we never got the bills. The good news about that is after we all found them and we were able to negotiate with them because they were a bit too high and we got them substantially, I think if we had paid them on a current basis we probably wouldn’t have gotten the discount that we got. That was one that kind of slipped and should have been in the prior period but Gresford, why don’t you weigh in on that, you know the numbers behind it much better than I do.

Gresford Gray

For the interest reversal John, it related to one portfolio company in particular and we were working very closely with that portfolio company throughout fiscal year ’09 on restructuring the loan. As time went on we did an internal analysis and we determined that it was prudent to basically write off that loan based on the financial condition of the company. We did that in the current period FY 2010 and then we basically said look as of 9/30/09 this amount should have also been written off so that’s why it was an out of period adjustment.

David Gladstone

That was about $500,000 of the $900,000?

Gresford Gray

That’s correct.

David Gladstone

The others were smaller adjustments. We had the law firm was about $200,000 and some and what were the others?

Gresford Gray

Those were the two.

David Gladstone

That made up about $700,000 of the $900,000 and the others were minor adjustments.

Operator

Mr. Gladstone there are no further questions. I’d like to hand the floor back over to you for any closing comments.

David Gladstone

Thank you all for calling in and we feel pretty bullish about the future. We’ll talk to you again next quarter and hopefully have a lot of good news. That’s the end of this conference call.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you all for your participation.

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Source: Gladstone Capital Corporation F2Q10 (Quarter End 03/31/10) Earnings Call Transcript
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