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MCG Capital Corporation (NASDAQ:MCGC)

Q4 2013 Earnings Conference Call

March 5, 2014 9:00 AM ET

Executives

B. Hagen Saville – President and Chief Operating Officer

Keith Kennedy – Chief Financial Officer, Executive Vice President and Managing Director

Tod K. Reichert is General Counsel, Chief Compliance Officer

Analysts

Troy L. Ward – Keefe, Bruyette & Woods

Richard E. Fearon – Accretive Capital Partners

Jeff M. Brunner – UBS Financial Services, Inc.

Scott J. Valentin – FBR Capital Markets & Co

Operator

Good day ladies and gentlemen and welcome to the MCG Capital Q4 2013 Earnings Investor Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) And as a reminder this call is being recorded.

I would now like to turn the call over to your host for today Mr. Hagen Saville, CEO. Sir you may begin.

B. Hagen Saville

Thank you operator. Good morning and welcome to the Q4 2013 earnings call for MCG Capital Corporation. I’m here with Keith Kennedy, our Chief Financial Officer; and Tod Reichert, our General Counsel and Chief Compliance Officer. Before we begin, I will ask Tod to take us through the Safe Harbor statement. Tod.

Tod K. Reichert

Thanks Hagen. Good morning everyone. Before we begin, we would like to remind you that various statements that we may make during this morning’s call will include forward-looking statements as defined under applicable securities laws. Management’s assumptions, expectations and opinions reflected in those statements are subject to risks and uncertainties and may cause actual results and to our performance to differ materially from any future results, performance or achievements discussed in or implied by such forward-looking statements. And the Company can give no assurance if they will prove to be correct. Those risks and uncertainties are described in the Company’s earnings release and in the filings with the Securities and Exchange Commission.

With that I will turn the call over to our CEO, Hagen Seville

B. Hagen Saville

Thanks, Tod. This morning we reported Q4 results of $0.09 per share and net operating income and a net loss for the quarter of $18.5 million or$0.26 per share. For 2013 net operating income was $29.9 million or $0.42 per share and net income was $1.2 million or $0.02 per share. Net asset value at year end was $4.74. The loss for the quarter and the reduction in NAV were driven primarily by realized losses and portfolio marks including Color Star $0.19, RadioPharmacy $0.05, Education Management $0.06, Advanced Sleep $0.03 and Virtual Radiologic $0.02.

Originations for the quarter totaled $37 million including three sub-debt transactions to two new issuers; portfolio monetization was $40 million for the quarter. Current yield on the portfolio was 12.1% a slight decline from last quarter; reflects [ph] one asset on non-accrual of $4.5 million loan to Advanced Sleep. At quarter end we had approximately $124 million cash available for new investments.

Following quarter end we monetized the Guggenheim investment very close to our previous mark and we repaid the remaining balance of COO indebtedness. Obviously we are very disappointed by these results, with regard to the realized loss associated on the Color Star investment; we believe that MCG was the victim of the financial fraud. We’ve initiated litigation in that matter and are hopeful to achieve a recovery, but given the nature of the situation and the unpredictable course of litigation, the final outcome is uncertain.

The fair value adjustment to RadioPharmacy was primarily driven by the formulaic impact of our valuation models not a change in our view about the prospects for the company. To the contrary, I’m bullish on the business plan for the company and we are making significant investments to expand the suite of compounded products sold to our hospital customers beyond radiopharmaceuticals and we believe the company can achieve significant growth and earnings, invest enterprise value over the next few years.

The market Education Management is attributable to declining performance, which we hope is bottomed out, we will have better visibility about the direction of this credit in the next two of three quarters. Market conditions remain very challenging and in our view consistent with a peak of a credit cycle, in a noteworthy development we now observe small business commanding pricing and terms typical of larger companies. Leverages is rising, pricing continues to decline and contractual terms are becoming more favorable to issuers.

We’ve also confirmed that new business opportunities we recently passed on were completed by others, notwithstanding difficult market conditions we are not satisfied with the performance of our asset management function, while we successfully established new relationships with a handful of top cortile equity sponsors in 2013 and our mix of loans as well as pricing terms have been satisfactory, our origination levels have been inconsistent and our overall activity too.

As a result, I have recommended and the Board of MCG has concurred with the appointment of Keith Kennedy to the position of President of MCG effectively immediately with the responsibilities for the front end of our business. Keith has done an outstanding job reengineering our back office during the last two years and I have complete confidence in his ability to drive our origination engine.

While Keith has been a terrific CFO, his principal career history has been managing teams originating and structuring debt investments primarily at GE, he has led teams in all facets of our business including origination, underwriting, portfolio management and work ups and now as a successful CFO of a public company. He ran the origination effort for a sizable middle market book of business that we believe he is well qualified for the task at MCG.

Keith has significant talents and leadership skills and we look forward to reporting tangible progress on the front end of our business in the coming quarters. In connection with Keith’s promotion, I’m pleased to announce that our Controller, Jane Alley has accepted the position of interim CFO so that Keith can devote his full attention to the asset management function.

When I assess our recent performance two items predominate, one inconsistent origination activity and two portfolio monetization level is much higher than we predicted, and loan repayments starting the last few years been near our original expectations the balance sheet would now be fully deployed. At quarter end, our investment portfolio was $369 million and repayments during 2013 were $210 million, implying an average like well under two years.

As I mentioned during our Q3 call, we’ve experienced repayment of newly originated sub-debt investments with a nine month of origination an unusual occurrence in the lower middle market. In spite of these challenges our business model remains intact. On prior calls I have described our earnings power to be in the mid 50% [ph] range based upon an equal mix of senior and sub-debt originations with yield assumptions of 13.5% for sub-debt and 9% to 9.5% for personal loans.

Today I estimate earnings power of our existing capital to be in the mid 45% [ph] range, the difference in these earnings levels is principally driven by lower yield assumptions we’ve adopted in our financial models which include a 100 basis point decline in yield equating to roughly $0.07 of earnings power. It’s important to realize that this calculation excludes the introduction of any statutory leverage, if we access leverage at levels consistent with the BDC comps at 0.6 to 1 and deploy that capital in higher quality loans even at meaningfully lower spread. We estimate incremental earnings power of $0.08 to $0.16 per share. We also have the ability to shift our origination mix towards sub-debt which would also help maintain earnings power.

Given market conditions and the need to rebuild our asset management function, we intend to proceed in a cautious and deliberate manner with regard to new origination activity, while we have not yet experienced the yield compression described above is our intention to focus on credit quality first not reach to main yield. With regard to capital management is our intention to pay a dividend of $0.12.5 on March 28.

The holders of record as of March 14, but then reduce the dividend to $0.07 per share for the remainder of 2014 subject to board review and approval. At the same time, the board has authorized an increase in our stock repurchase program from $25 million to $35 million. Given our origination and earnings expectations for 2014, we believe that these actions represent the proper balance for our capital at this time.

I will now ask Keith to outline the specific results for the quarter and the full year. Keith.

Keith Kennedy

Thank you Hagen, good morning everyone. I plan to speak about our fourth quarter and fiscal year 2013 results for the period ended December 31, 2013. You may also find our Q4 2013 Investor Presentation in the Investor Center under Events or Presentations.

The slide deck includes key metrics and other highlights that I’m going to mention on the call today. The following highlights occurred during three and 12 month ended December 31, 2013. Net operating income or NOI was $6.3 million or $0.09 per share for the fourth quarter, NOI for the full year was $29.9 million or $0.42 per share.

Net loss was $18.4 million or $0.26 per share for the fourth quarter, net income for the full year was $1.2 million or $0.02 per share. At December 31, 2013 our per share was $4.74, down $0.36 since September 30, 2013 the $0.36 NAV bridge is comprised of $0.09 of NOI and $0.02 attributable to stock transactions, offset by $0.35 of net investment losses and $0.12.5 of dividends declared.

During the year, we made $37.1 million of originations and advances, including $33 million to two new portfolio companies. For the full year, we funded $128.1 million of advances and originations including $104.1 million to seven new portfolio companies, we monetized $39.6 million and $210.1 million of our portfolio in the fourth quarter and for the full year respectively. At December 31, 2013 our portfolio at their value was $368.9 million sequentially down $26.7 million.

On page II of the Investor Presentation, we walked you through recent changes in our investment portfolio. At December 31, 2013 we had $124.1 million of cash on hand to make new investments using unrestricted cash and restricted cash from our small business Investment Company or SBIC. In addition we have $15.3 million in securitization accounts and other restricted cash accounts.

During the year ended December 31 2013 we reduced our outstanding borrowings by $72.9 million, by reducing our borrowings under our 2006-1 Trust from $98.1 million to $25.2 million. On January 31, 2014, we repaid and terminated our 2006-1 Trust. During the year ended December 31, 2013, we incurred severance costs of $0.8 million or $0.01 per share, of which $0.7 million is included in general and administrative expenses and $0.1 million in amortization of employee restricted stock awards.

For the quarter excluding interest expense, our total operating costs were $2.8 million or approximately 0.5% of total assets of $514 million. For the quarter our total loan yield at fair value was 12.1% and our average costs of borrow was 4.6%. For the year our total loan yield at fair value was 12.2% and our average costs of borrow was 4.5%. For the quarter, we generated $11.2 million of revenue or an annualized 1.3% yield on an average $398 million investment of fair value. For the year, we generated $50.5 million in revenue or a 12.1% yield on an average $419 million investment of fair value.

As shown on Page 15 of the investor presentation, we added the $4.5 million senior secured loan to eventually to the balance of loans on non-accrual at fair value, and we wrote off our $13.5 million subordinated loan to Color Star Growers. The cost and fair value of our loans on non-accrual is 6.1% and 1.3% respectively of our loan portfolio.

For the three and twelve month periods ended December 31, 2013, we repurchased 512,100 shares and 1000 or 1,016,739 shares of our common stock at a weighted average purchase prices of $4.73 and $4.62 respectively. We spent $2.4 million in the buyback stock in the fourth quarter, $4.7 million for the fiscal year 2013 and $31.9 million over the past two fiscal years.

Just two years goes I was asked to join MCG to the help the company build a best in class back office platform that would benefit shareholders, as we built out our lower middle market lending platform. Over this two year period, we successfully reduced our operating cost of 3.6% to 2.2% of total assets, and we’ve reduced total operating cost of $48 million to $20 million annually.

As an internally managed BDC, we believe that these savings have been accretive to our shareholders. We also took aggressive steps to buyback stocks and bridged our dividend to manage our capital base. As we position the company, we underestimated the pace of the pending monetization, the compressing the yields into a larger extent our ability to redeploy excess liquidity at the pace required in this operating environment.

At this point, our story is now revenue story and our next challenge. Over the next two quarters, have plan to visit key assets and to make four to five new hires in our management groups, as well as some internal realignment to better position our business for sustainable growth.

As Hagen mentioned, we manage our capital and credit profile efficiently. We project that we can generate $0.10 to $0.12 of NOI per quarter. We are attempting to do this in light of record level of monetization that we feel may continue in light of where we are in this credit cycle. We intend to optimize inherent benefits and opportunities of being an internally managed BDC, and I ask your patience as we make progress deploying capital.

And with that I’ll turn it back to Hagen.

B. Hagen Saville

Thank you, Keith, and congratulations on your promotion. This concludes our prepared remarks and we’ll now open the line for questions. Operator.

Question-and-Answer Session

Operator

Ladies and gentlemen (Operator Instructions) Our first question comes from the line of Troy Ward of KBW. Your line is open. Please go ahead.

Troy L. Ward – Keefe, Bruyette & Woods

Great, thank you and good morning gentlemen.

B. Hagen Saville

Good morning Troy.

Troy L. Ward – Keefe, Bruyette & Woods

Hagen, can you just talk quickly about in the press release you gave a head count of 17 and then Keith at right at the end of his commentary mentioned, going to make some additional hires in the asset management division. Can you give us a breakdown of kind of what that 17 head count is right now its down from 21 last year, kind of front taking professional folks versus back office, and then add a little more color on kind of what you expect to higher in these new asset management additions?

B. Hagen Saville

A half thousand customer facing and credit folks currently, half dozen in the back office and then basically executives and administrative.

Troy L. Ward – Keefe, Bruyette & Woods

Okay and on the new hire – sorry go ahead.

B. Hagen Saville

On the new hires we’ve budgeted for five hires, we recently hired an individual and we have also – we’ve actually on the third quarter call I announced that we had hired one individual, we subsequently hired a second individual and we are close to hiring a handful of others, those people will come in probably in the vicinity of principal level people Troy.

Troy L. Ward – Keefe, Bruyette & Woods

Okay, and can you remind with your origination platform, how is it structured, is it geographic, is it based on verticals and kind of what do you expect over the next 12 to 24 months as you are trying to seek new attractive opportunities?

B. Hagen Saville

It’s a based first and foremost on vertical market, secondary on geographic basis, as you know, we’ve got expertise in a handful of verticals, healthcare, information services, software, full profit education and a handful of other, So, we will continue to do that. We’ve actually hired an individual and he has got some vertical market expertise, on the secondary basis we will – and we currently go to market on geographic basis, we have an individual in San Francisco and we will probably be hiring individuals in distinct markets around the country, namely New York and Chicago.

Troy L. Ward – Keefe, Bruyette & Woods

Okay, and then Keith a couple of modeling questions. Do you have the cost and the fair value of the interest during asset in the quarter?

Keith Kennedy

This quarter?

Troy L. Ward – Keefe, Bruyette & Woods

Yes, the 1231 [ph], do you have just the costs and fair value of the interest earning assets?

B. Hagen Saville

Well, yes that’s actually a rate volume.

Keith Kennedy

A lot of them is actually…

Troy L. Ward – Keefe, Bruyette & Woods

Is that in your release somewhere and I missed it?

Keith Kennedy

Yes, on Page 10 of the Investor deck, you can see that so that the average – if you go back to slide 10 I have put in there the average loan at fair value and average loan and cost, you can see that or I can read it for you here.

Troy L. Ward – Keefe, Bruyette & Woods

No that’s fine; I see it now that’s good. And then Hagen as you think about the 11% assumption on the portfolio is that – how much of that is driven by expectation for lower origination going forward and how much of it is expected for kind of repayments coming off of the portfolio? I mean because that’s quite a bit lower than where the portfolio sits today?

B. Hagen Saville

I think it’s an equal mix Troy, I mean I think in 2014 its our hope that the portfolio will remain basically consistent in equal amount of pay offs and origination and then begin to grow in 2015, but as you know it’s a very competitive environment and we have – to-day we have not really experienced yield compression, if you look at the loans that we’ve recently originated, they are consistent with yields we’ve talked about before, but we do review deal twice a week, we see what is going on in the marketplace and we are planning for further declines and in a market like this, if you are going to compromise, you compromise on price not credit.

Keith Kennedy

And Troy, I would just add that the market has moved materially in the last quarter or two and it’s seems to be ahead of where people are and we think the banks are fairly aggressive and continue to tighten to levels we haven’t seen before and it just puts pressure on where you end up in the capital structure and the opportunities there, so in order to do deals that we think are the right credit mix, as Hagen said, you want to – it’s going to take a lower price than what we historically thought would when and what we have one. Although we are within the range of where we thought we were going to originate, we just are over a $100 million behind on monetizations and that can continue over the next 12 months.

Troy L. Ward – Keefe, Bruyette & Woods

Okay, and then one last one Hagen, more of a philosophical discussion, and just trying to get a feel for where the board is on kind of the future of MCG, have there been substantive discussions about kind of the direction and if that direction would include potentially make a complete change in the structure or exploring other strategic alternatives of maybe selling the enterprise or something like that. Can you give us any indication on kind of how much discussion had went into changes here at MCGC?

B. Hagen Saville

Significant discussions Troy, we are a public company, so we are for sale everyday. We are constantly evaluating where we sit vis-à-vis some strategic transaction that we might pursue, we have recurring strategic discussions about where we sit and what our business plans are, we continue to believe that the internal management structure is a superior structure on a lot of different fronts, and that if we can get our assets deployed that the share price has an opportunity to trade meaningfully above book value. No one is more disappointed about where we sit in IM [ph] and to the extent that we think if we believe we can do something different for the benefit of the stockholders, we’ll do it.

Troy L. Ward – Keefe, Bruyette & Woods

Okay, great. Thanks for the color.

B. Hagen Saville

Thank you.

Operator

Thank you, our next question comes from the line of Rick Fearon of Accretive Capital Partners. Your line is open. Please go ahead.

Richard E. Fearon – Accretive Capital Partners

Hi, good morning. Yes Hagen.

B. Hagen Saville

Hey, Rick I can’t hear you, you got to speak up.

Richard E. Fearon – Accretive Capital Partners

Can you hear me now?

B. Hagen Saville

Fairly go ahead.

Richard E. Fearon – Accretive Capital Partners

Okay it was exactly year ago today, on the fourth quarter earnings call, that I asked you what benchmarks can we use to measure your success in the coming quarters, and your response was I think you could go back and review my comments in the prepared remarks, the objectives we have are to earn $0.50 in 2013. Today you reported you earned $0.02 in 2013 and now expect NOI in 2014 to be $0.25 to $0.30; NAV has dropped from $5.20 a share to $4.74 today with no appreciation in study.

I think shareholders deserve the opportunity to reinvest the assets into better investments, and following up on the previous caller’s question, I think the MCG ought to be put up for sale immediately, and I think the company ought to be buying back shares as aggressively as possible and I would like some further comments on stock repurchases and why the company has not taken steps to accelerate the stock repurchase program?

B. Hagen Saville

Well Rick we have a stock repurchase program in place currently, it is active and we announced this morning that we’ve increased it from $25 million to $35 million, as I’m sure you know there are a variety of rules around the implementation of stock repurchase programs we operate in accordance with those rules and to the extent that we are constantly evaluating our capital management option. As we talked with you about in the past, we listen to everything you say, we evaluate it, the board discusses it in great detail and we are constantly reevaluating all of those options what you mentioned.

Richard E. Fearon – Accretive Capital Partners

Well I’ll again reiterate just for the record that I think the company ought to be put up for sale and I think that the company ought to be initiating a Dutch auction tender for its stock, which continues to trade at a significant discount NAV and those would be probably close to the team by the open year.

And that that’s about the most accretive thing the company can do on behalf of shareholders until the company gets sold, because I think you rightly pointed out this is not the ideal origination market, it sounds like the winners of the fields are perhaps fall into the category of a winners curse and that time will tell, but I suspect that that’s the case.

And frankly the company isn’t therefore deploying assets as aggressively as others managing this most asset pool. So we as significant shareholders would like to see the asset put to work in what we consider inappropriate investment which would be buying back shares and you would like the opportunity to put the assts work ourselves as soon as possible and so again I encourage management and boards to actively pursue alternative continuing as a separate publically traded company and consider a sale of the business.

B. Hagen Saville

Thank you for your comments Rick, as always we appreciate it.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Jeff Brunner of UBS. Your line is open. Please go ahead.

Jeff M. Brunner – UBS Financial Services, Inc.

Good morning and thank you for taking my question. It’s pretty much been answered in that I also was wondering about increasing the share buyback program or possibly putting the company up to sale, but being that we’ve lowered the dividend essentially to be inline with investment income, with the net asset value at $4.74 per share at the end of 2013 would you anticipate a further reduction in NAV in 2014? A possible stability here or possibly an increase in NAV by this time next year?

Keith Kennedy

The primary driver of NAV is the performance of the credit portfolio, we own a handful of small equity investments, the principal equity investment we own is RadioPharmacy, company called Pharmalogic, there is an opportunity for equity appreciation there and then there is a basket of small equity co-investment of investments that we own that is principal opportunity for growth in NAV. The risk to NAV is continuing is deterioration in loan portfolio and to lesser extent paying dividends in excess of earning. So those are the three drivers and I would certainly hope that NAV would be stable.

Jeff M. Brunner – UBS Financial Services, Inc.

Okay, thank you very much.

Operator

Thank you. Our next question is a follow-up from line of Troy Ward of KBW. Your line is open. Please go ahead.

Troy L. Ward – Keefe, Bruyette & Woods

Thanks. Just a quick question on year-to-date activity Hagen, can you give us any color on what origination you have already booked year-to-date and what do you expect to close by the end of the first quarter?

B. Hagen Saville

We haven’t booked any originations quarter to-date; we’ve reviewed a lot of opportunities, we have elected to pass on many, we have not closed any year-to-date.

Troy L. Ward – Keefe, Bruyette & Woods

What about repayments year-to-date?

B. Hagen Saville

One loan the Guggenheim investment along with a significant equity co-investment in that transaction.

Troy L. Ward – Keefe, Bruyette & Woods

Okay, great thanks.

B. Hagen Saville

Thank you.

Operator

Thank you. Our next question comes from the line of Scott Valentin of FBR Capital Markets. Your line is open. Please go ahead.

Scott J. Valentin – FBR Capital Markets & Co

Good morning and thanks for taking my question. Just with regard to the hiring, intention to hire some fine employees. Just wondering expense control has been a kind of mandate, you guys have done a good job on reducing expenses. Just wondering how should we think about as we look forward, do we expect to see expenses increase as you add additional payroll expense?

B. Hagen Saville

I think the expense phase of the company will rise from its current level, approximately 2% to 2.2%, 2.3% of total assets, it probably rise up to 2.6% to 2.8% of total assets that’s in our budget that’s included in the forecast we provided you. So yes, expenses will be going up.

Keith Kennedy

And we walked you through that in the outlook section, you can see we’ve put some more detail on there for you to – on the modeling purpose for the analysts.

Scott J. Valentin – FBR Capital Markets & Co

Okay. Thank you.

B. Hagen Saville

Thank you.

Operator

Thank you. (Operator Instructions) and we have a question from the line of Rodney Acto, Private Investor. Your line is open. Please go ahead.

Unidentified Analyst

Gentlemen, I would just like to make a comment. I hope sincerely that you’re taking into consideration the percentage of your investors, most likely a small percentage but nevertheless a percentage of elderly folks myself who in their 70s and 80s, we’ve invested into MCGC and to their faith and user group to make some provision for them as they go into their retirement. And I look at the price of the stock now, and I realize how much money I have lost and it just bothers me that no one seems to bother about the old folk that’s invested for different reasons. Thank you.

B. Hagen Saville

Thank you, sir.

Operator

Thank you. And it does conclude our Q&A session; I would like to turn the conference back over to the company for any closing remarks.

B. Hagen Saville

Thank you very much for your participation on our call today. We look forward to speaking to you next quarter. Thank you.

Operator

Ladies and gentlemen thank you for your participation in today’s conference. This does conclude the program and you may all disconnect. Have a great rest of your day.

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