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Executives

Samuel Flax - Chief Compliance Officer, Executive Vice President, General Counsel and Secretary

John Erickson - Chief Financial Officer, Principal Accounting Officer and President of Structured Finance

Pete Deoudes - Director of Equity Capital Markets

Malon Wilkus - Founder, Chairman, Chief Executive Officer and Chairman of Executive Committee

Analysts

Vernon Plack - BB&T Capital Markets

Richard Shane - JP Morgan Chase & Co

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

Greg Mason - Stifel Nicolaus

Joel Houck

David Chiaverini - BMO Capital Markets U.S.

Jared Cohen - J.M. Cohen & Co.

Matthew Howlett - Macquarie Research

John Hecht - JMP Securities LLC

American Capital (ACAS) Q2 2011 Earnings Call August 3, 2011 11:00 AM ET

Operator

Good morning. My name is Susan, and I will be your conference operator today. At this time, I would like to welcome everyone to American Capital Second Quarter Earnings Call. [Operator Instructions] Thank you, Mr. Pete Deoudes of Equity Capital Markets, you may begin.

Pete Deoudes

Thank you, Susan. Thank you, everyone, for joining American Capital Second Quarter 2011 Earnings Call. Before we begin the call, I'd like to review the Safe Harbor statement. This conference call and corresponding slide presentation contain statements that to the extent that they are not resuscitations of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecasts due to the impact of many factors beyond the control of American Capital. All forward-looking statements included in this presentation are made only as of the date of this presentation, and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be made available on our website, and the telephone recording can be accessed through August 17 by dialing (855) 859-2056. The replay passcode is 83124239. To view the Q2 slide presentation that corresponds with this call, turn to our website, americancapital.com, and click on the Q2 2011 earnings presentation link in the upper right-hand corner of the homepage. Select the webcast option for both Slides and audio or click on the link in the conference call section to view the streaming slide presentation during the call.

Participating on today's call are Malon Wilkus, our Chairman and Chief Executive Officer; John Erickson, President, Structured Finance and Chief Financial Officer; Sam Flax, Executive Vice President and General Counsel; Rich Konzmann, Senior Vice President, Accounting and Recording; and Tom McHale, Senior Vice President, Finance.

With that, I'll turn the call over to Malon.

Malon Wilkus

Pete, thanks. Appreciate everybody joining us today. We had very good quarter. We produced a $0.20 net operating income for the second quarter of 2011. That's about $71 million. Approximately $12 million or $0.03 of that was a decrease that occurred relative to the Q1 2011 associated with some additional non-recurring income recorded in the first quarter relative to what occurred in the second quarter. We had $0.49 realized loss, that's $177 million. However, on our bottom line, our net earnings was $1.13 or $410 million, which is a 38% annualized return on equity. Over the last 8 quarters, as a result of this quarter at end of the last 7, we produced $2 billion of net earnings. That's since the gross domestic product of the U.S. started to turn positive, and we produced a 33% annualized return on equity.

If you go to the next slide, 4, that rose our net asset value to $13.16. That's $5.74 or $0.70 -- 77% growth within our NAV over the last 8 quarters. And relative to the first quarter, it was a 10% increase, a $1.19 increase, and it brings our NAV to $4.5 billion. At the end of the second quarter, we had $1.6 billion of debt outstanding, and that debt is on a weighted average basis, is costing us about 4.8%, on average, given the quarter. We paid down, in the quarter, another $100 million, but that was paid -- that paid down our securitization debt. And so the schedule of the maturity of our $700 million secured debt, which is due in 2013, continues to be fundamentally at the end of the 2013 year. And that $700 million we did not voluntarily paid down in the second quarter. But as a result of all the movements in our balance sheet and the paydown of this debt, we now have a 0.4:1 debt-to-equity ratio, and that of course is something we feel very good about considering the volatility in the market and the economy and some of the uncertainties that are out there.

A very good note for the second quarter was the increase of our assets under management to $52 billion. That's a $36 billion or 222% increase over the second quarter of 2010. And to remind everyone, $6 billion of that is assets that we internally manage at American Capital on our balance sheet, and then $46 billion is externally managed in 4 private funds and 1 public fund. And the bulk of that, well, I'd say all of that increase was due to the raising of new equity and the subsequent assets that we raised and managed for American Capital Agency, which is the public fund that we're discussing, and which has had just tremendous performance over the last 3 years. It is one of the best performing dividend stocks, I think, in those last 3 years.

If you turn to Slide 5. You can now see our earnings are $410 million of earnings in the second quarter of 2011 relative to the U.S. GDP growth, and that shows a 1.3% growth in the second quarter of 2011. And as we pointed out in the past, we continue to correlate well with the change in growth of the GDP. And again, we believe the economy performs and our portfolio will perform since we've been deleveraging some of those at American Capital. And that our portfolio companies -- a decline in the economy will have less of the kind of radical impact that it had in this last recession. So we are not as much a levered play to the company as we might have been entering into this last recession. Nonetheless, we seem to be quite correlated with the GDP growth.

If you turn to Slide 6, we're pleased that we've brought down our past due non-accrual loans from $663 million, down to $519 million. And on a fair value basis, that increased from 7.7% to 9%, which means we expect to be able to recover a larger percent of the loans we have on non-accrual. On a cost basis, it's dropped from 19.3% to 16.7%. I think all these are good numbers, and reflects some improvement in our balance sheet.

If you look at Page 7, we had $179 million of cash realizations, $150 million of that from principal payments, of which $28 million was the collection of PIK and accreted OID. That's a very good thing to collect that, and it just shows the -- how powerful it is to be able to price both with cash interest and dividends, as well as PIK interest and dividends. In addition, part of that $179 million of utilizations was $28 million of sales of our equity investments.

On Slide 8, we had just put that into context, as we now have $3.7 billion of utilizations over the last 2 years. And I should say, over the last 3 years, and as you can see, that the $179 million continues to be good relative to how we generate realizations in the past, though it is somewhat lower than in the last quarters of 2010.

On Slide 9, you can see that we exited those $179 million of 1.6% above the prior quarter's valuation, again, continuing to corroborate the quality of our valuations on the balance sheet. Slide 10, the metrics of our balance sheet, I think, continues to be good. The majority-owned portfolio portion of our portfolio is at 78%, rising from the lowest of 57%, and the fair value of our assets is at 82%. It's quite a material increase from the first quarter of 2011 from 75% to 82% and of course, a very big increase from a low point back in the second quarter of '09 of 60%. The debt to EBITDA of our portfolio company, the mean debt is dropped to 4.1%, and from the peak of 4.6%, the total debt which is kind of the high portion of each portfolio companies, the amount of total that they have relative to EBITDA, is at 5.2%. Again, a nice decline from the first quarter, and extremely good decline from the second quarter of '09 at 6.5%. Our weighted average EBITDA margin continues to perform extremely well, and it's now at 21.3%. So overall, on a blended average, our portfolio companies are doing well. And then when you look at the amount of senior debt, as it continues to drop somewhat from quarter-to-quarter, now sub-debt continues to drop from quarter-to-quarter because keep in mind that is a percent of the total assets at fair value, and our equity assets continue to grow quite rapidly. And it's now 48% of our portfolio versus 27% of our portfolio. And that's of course something we like happening because that growth in equity is at a much higher rate than the kind of growth you can get off of debt asset. And so coming out of recession, we think this is a good mix of portfolio assets, and if the economy continues to perform.

If you look at Slide 11, overall then in the aggregate over on the right-hand side, you can see that all of our investments, since we went public, has produced an average of 8% compounded annual return. We exited only the assets that produce 11% return, and again this is on a blend of senior debt, sub-debt and equities, and after going through 2 recessions.

On Slide 12, this is some new specifics that we haven't shown in the past, and I want to spend just a moment on this slide. Over on the left-hand side, there are 4 bars that are representing -- sorry, from the left to the right, senior debt, mezzanine debt and equity, and in the last yellow bar is the blend of all 3. And the left set of bars reflect the active and exited one-stop buyout companies that has -- that are, or have been in our portfolio since inception. So this includes all the one-stop buyouts we've ever made at American Capital. And you could see the senior debt that we've invested in those companies produced a 9% IRR, the mezz at 11% IRR, the equity at a 16% IRR and on a blended basis, a 13% IRR. So our One Stop Buyout business has performed extremely well. And that's why the amount of equity that we have in our portfolio today, we feel very good about because these are the assets that really have performed some of the best performance of the various sectors that we've invested in over the years. If you look at the middle set of bars, this is tabulating only the exited investments in our One Stop Buyout, so all the One Stop Buyouts that we have exited since we went public. And there, you'll find again that senior debt is at 9%, the sub-debt is 11%. So those performed quite consistently, but the equity produced a 30% return. And that is because American Capital is very thoughtful about when we exit. I think we've been very successful about making this decision, that you exit your equity investments when our multiples are higher, when the -- you're in the right portion of the cycle of the economy where you can get the best return. We also exit the equity investments when the company is performing at its optimal levels and generally, that's certainly not at the beginning of the investment. It's often not at the middle, and you have -- but sometimes it is and you have to time the year that you exit with how the company is performing and how the economy and market is performing, and how much interest there is in the buying community, whether it's strategic or financial buyers, and also we work extremely hard to build these companies, so strategic buyers find them particularly attractive. As you know, most of our companies are too small to take public or there are sectors that don't make sense to go public. So we are constantly trying to build our company so that they are attractive from a strategic buyers’ point of view. And I would say more than half, probably more than 50% or 70% of our companies are sold to strategic buyers.

The third set of bars are our current active One Stop Buyouts. Now we think very highly of these companies in our portfolio today. But as you can see, the equity value haven't just gone through the worst recession since the Depression, the equity rates of return, the green bar, at 7%, is substantially lower than what we've done on average historically on all of our buyouts. And it's certainly far lower than what we -- with respect to our exit of our equity in the One Stop Buyouts when we sold the companies. And so we -- so what we're faced with here, is there a timing for exiting? Many of these companies are not quite right, and you need to wait until both companies improve their performance, as well as perhaps the economy and in particular, the other sectors where the timing is right. So we're constantly evaluating that and I think historically, we've made good decisions, and I think we'll make good decisions on the active One Stop Buyouts that are in our portfolio today. We'll continue to report on these numbers, I think, in the future, and we can spend some more time talking about it.

Moving to Slide 13, which shows the appreciation, depreciation, gains and losses, predominantly the gain and depreciation that was most powerful for our performance for the second quarter was $137 million appreciation at European Capital and $156 million of appreciation at American Capital LLC, which is the fund asset management portfolio company, and as a result of raising additional equity, about $3 billion of equity at American Capital Agency since the turn of the year. I should go back to European Capital, and also point out that there's some foreign currency translation contributions. And so on top of the 137, there's probably another $15 million or $16 million associated with currency changes for European Capital. When you go through all the pluses and minuses, we have about $339 million of appreciation and depreciation gains and losses. And of course, one large portion is the reversals associated with taking losses in the second quarter.

If you turn to Slide 14, we want to talk for a minute about our tax status. As you all know, we have -- since going public 15 years ago, we have qualified as a Regulated Investment Company for tax purposes. But for the tax year ending September 30, we will be not be a Regulated Investment Company. In the second quarter of this year, we failed to achieve the diversification that's required to meet the diversification test of a Regulated Investment Company. Now this test is essentially evaluating how much control -- more than anything, it's to evaluate how much control companies you have in your portfolio, and there's a certain requirement for that. For many years, we've been very close to the limit, which is 50% of our total assets. And in the June quarter, we exceeded it. Now part -- many people asked exactly what caused it. I'll tell you that there are essentially hundreds of factors that go into this because every asset in our portfolio has to be valued, and every change of those values impacts this test. However, I will say that the 2 that had a very considerable impact on the test was the substantial appreciation at European Capital, and the substantial appreciation of American Capital LLC, our asset management portfolio company.

And with those 2 very substantial appreciations, together with all the other movements in the portfolio, we no longer meet the diversification requirements under the RIC requirements. And if you fail to meet that -- that set is done quarterly at the beginning of each quarter. If you fail to meet it in a quarter of a tax year, then you no longer -- for that tax year, you cannot file your taxes as a RIC. Now that had no impact on our status as a business development company. There's a variety of other tests associated with a business development company and requirements and so forth. We continue to meet all of that. And I have to say there is no penalty for failing to be able to file our returns as a RIC. As you see here in the third diamond, from at least for the 2012 tax year, we will be -- I should say for the 2011 tax year, we'd be filing as a C corporation. And as it turns out, there's a silver lining to this development in that the -- as a RIC, you're unable to roll forward any taxable losses, ordinary taxable losses that you might incur in that tax year into the future tax year. You can roll forward your capital losses, but not your operating losses. Well, being that we no longer are filing as a RIC for this tax year and instead as a C corp, we will be able to roll over the ordinary operating loss. And as of the June quarter, the amount of that ordinary loss totals $138 million, which we'd be able to roll forward. And we do anticipate incurring additional losses, ordinary losses in the third quarter, which is the final quarter of our tax year. In addition, we have $611 million of capital losses, which in any case, will get rolled over into the future tax years.

Now it's possible for us to requalify and elect to be a RIC in future years. And in fact, when you think through this, you do have to be a C corporation for one whole year to be able to take advantage of the roll forward of the ordinary losses, and that would be into then our 2012 tax year. But at the end of that period, throughout that period, for the quarters of that period, we may or may not qualify under the diversification requirements, but we can requalify, and then we can actually elect to file once having requalified as a RIC again. And there's no application process or anything of that sort, we just simply start filing as a RIC. But I should point out that to take advantage of the net operating loss that is rolling forward from the 2011 tax year into the 2012 tax year, we would have to be a C corp for the entire 2012 tax year, which takes us through September of next year. We can, of course, talk more about that when we turn to questions in a minute or 2.

Let me turn to Slide 15 then. We want to review the potential sources of net asset value growth, and we think those are particularly -- falls into 2 categories, retained earnings and asset appreciation. Today, we have $2 billion, or I should just refresh everybody's memory, we had $2 billion of net earnings since the U.S. GDP turned positive over the last 8 quarters, and producing a 33% annualized return on equity. That's of course in our past. Now the question is what will we do in our future to perform. And the first thing we'll point out is we had the potential of retaining future ordinary and capital income as a C corp, and that is being benefited by the net operating capital carry forwards and capital loss carry forwards that I just discussed on the prior slide.

In addition, we have a potential of appreciation at American Capital on the $933 million investment that we have in European Capital. Starting with $102 million of the discounts that's associated between European Capital's NAV and what we value with that on our balance sheet, there was $102 million difference there that has been decreasing over really the last several years and over the last 8 quarters. And there's potential of that discount decreasing some more, and then there's the potential of further appreciation of the $900 million investment on top of that.

Then we also have $2.3 billion of equity assets on the American Capital balance sheet, not counting our investment in European Capital. And as the economy recovers, we would hope we could see appreciation there as well. And just to point out, there's $1.9 billion, actually, I should have -- it leased up that $2.3 billion. Of that $2.3 billion, 1.9 billion of it is at American Capital, and $380 million is at European Capital. These are equity interest in portfolio companies, and we would hope those equity interest would grow if the economies, both in U.S. and Europe, continues to perform.

Finally, we have the potential of additional appreciation associated with $220 million of bond yield discounts where we have performing debt assets that if they repaid at cost, we'll pick up that bond yield discount. $199 million of that is that ECAS, European Capital, and $22 million is at American Capital.

So let's turn to Slide 16 to end the presentation and before I open to questions. Just to say that we expect continued economic growth in 2011. That's our best assessment looking at our portfolio, and how it's performing and what we're seeing there. And so we expect asset valuation to continue to improve both in the U.S. and American Capital and in Europe at European Capital. Now we remain focused on our portfolio companies, and we're providing them operational and financial support. We give high priority to appreciation associated with both organic and add-on acquisition, and we're very pleased about how that has been asset performing for us. And then we are also seeking, and we are -- we've got many teams. We've got many teams of people working very hard to seeking UniTranche, second lien and mezzanine investment opportunities. We've been saying to the market for quite some time now that it just simply takes time for those opportunities to build, and we are pleased at how the opportunities are progressing. We have disclosed a mezzanine investment in the third quarter since the end of the second quarter, $25 million mezz investment that we think is excellent. And we're hopeful and guardedly optimistic of seeing further closings in the third quarter, and then more in the fourth quarter.

In addition, we are pursuing the American Capital One Stop Buyout. And as I've reviewed with you earlier in this presentation, our One Stop Buyouts have performed extremely well, both in the recession of 2001, as well as the very terrible recession that we've just been climbing out of. And so we continue to pursue our One Stop Buyouts. And finally, let me just say I think the -- our practice, as you can see, as we've made some excellent exits and had some great big returns on the exits, we are a long-term patient investor, getting fair values on realizations in a slow M&A market.

And with that, let me open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of John Hecht with JMP Securities.

John Hecht - JMP Securities LLC

First one, just a little follow-on from around your commentary on the last slide about originations. You guys have a pretty large and relatively well-established origination platform. You did comment on you're evaluating a lot of opportunities. I'm wondering if you could just comment on how might we quantify the amount of opportunities you're looking at? Kind of what would the timing be for potential closure? What's the kind of historical average hit ratio? And what do you expect with how the prepayment activity, at this point of the cycle or repayment activity, and all of just surrounding kind of when do you -- when might we expect to see some portfolio growth?

Malon Wilkus

We've been reviewing hundreds of investment opportunities since the middle of last year, so over the last year for us. And we have approved several dozen of both mezzanine opportunities and senior debt and equity co-investment opportunities. But as you all know, that it takes -- you have to win twice in those efforts because not only do we have to -- our investment community has to improve the investments. And as I mentioned, we've approved several dozen, but then the private equity firm that's sponsoring the buyout has to win the bid by the company. And it's fair to say the strategic buyers are winning more of those bids today than in the past of the percent. Nonetheless, we, as I just mentioned, we just closed the $25 million mezz investment that we feel very good about. And we are optimistic about closing several more that's been our -- that's already been approved, that's already gone through diligence, and it's now up to the sponsor to win the bids and to get to closing. In some cases, they have. But we are confident of being able to get back into that business. Now I do have to say that there is a lot of senior and -- well, particularly senior financing that is being done by BDCs. And some of that financing, in our view, is not going to produce sufficient spread income to make it attractive for our balance sheet. And we think, in the future, there would be future periods where those spreads will come in even more and make it even less attractive. So we're very focused on mezzanine, but we're prepared to do UniTranche financing, in which we will syndicate off the senior, post closing, and get to a mix of assets that work on our balance sheet. We are -- we have upped the amounts of mezz that we're prepared to do, or UniTranche that we're prepared to finance. A year ago, we started at $35 million. We've upped that to $75 million at the turn of the year. And most recently, we brought that now to a $100 million that we're prepared to hold on our balance sheet, and this is -- as our balance sheet continues to improve, then it made more sense for us to extend a willingness to do more credit. At $100 million, really, starting probably at around $75 million, we think we are competing with a much smaller group of competitors to originate mezzanine and UniTranche opportunities and second lien opportunities. There's probably several dozen when you get below $75 million, and there's probably more like half a dozen at the $75 million and up the levels, and then $100 million, we just think, we should be able to get a fair share of the financing opportunities at that level. But it just simply takes time, and we're working at it, and I'm still confident it will happen. We wish it had happened earlier. As you all know, we paid down $300 million of debt in the first quarter of the 2013 maturing debt in the third quarter. First quarter, we did that at our election, and had no other need to do it other than it was the best use of capital relative to our alternatives. And then -- now, our One Stop Buyout business, which I think performs extremely well, it has been outstanding in the past. We did not turn our teams on to start originating new One Stop Buyouts until the middle -- I'm sorry, until the turn of the year in January. And as you know, that takes generally about 7 to 9 months to complete a buyout. And I have to say though we have reviewed some and made some decisions at the investment committee level on some buyouts, we have yet to approve any One Stop Buyouts. And so it will be a while before we make any One Stop Buyouts, but we're very keen on doing it. We're prepared to do up to $350 million-sized One Stop Buyouts.

John Hecht - JMP Securities LLC

Okay. A follow-up question. I fully understand the benefits you're considering your C corp status now and its ability to roll forward and use the NOLs. I'm wondering if you could discuss kind of maybe your alternatives and intent subsequent to that usage of that NOL. And the context of your capital loss carryforwards and your balance sheet, may you want to return to your dividend status.

Malon Wilkus

So keep in mind, just because we're a C corp doesn't mean we can't pay dividends. As you know, on the -- I think I'm the largest single individual shareholder of American Capital, and believe me, I like those dividends. And we'd love to return to paying dividends. But most C corps do not pay a dividend if they haven't produced earnings. And though on a GAAP basis, we are producing fantastic earnings over the last 8 quarters, some of the best earnings, I think, in our industry, I think the best set of earnings in our industry. On a tax basis, we still have been running through losses. And so we are not producing the taxable income that would allow us to pay a dividend without a return of capital. And as soon as we run through all of those ordinary losses and start producing regular -- producing positive ordinary income, we believe it's not a good use of our capital to have a return of capital to our shareholders in that. Instead, we should retain our GAAP income and grow our book value, which we have been doing at really an outstanding rate over the last 8 quarters. I think what we've just shown is a 77% growth in our NAV over the last 8 quarters.

John Erickson

Well, I want to just say that we're not forecasting when we would pay a dividend. But going back to the tax status, what you will be able to follow now that we are a C corp, is we will have a tax accrual footnotes, so you can make your own assessment of where we are with respect to utilizing the tax attributes, and then can turn from tax losses to positive tax income. I would also say, going back to your questions, you do understand it is a benefit to be a C corp economically. We did make that assessment. In terms of the ability to then be a RIC in the future, there's a number of tools. We've managed our tax status since our IPO in '97. There's a number of tools that could be utilized or could've been utilized if we had felt like it was better to be a RIC today than a C corp. For example, we have significant balance sheet capacity, so we could have borrowed money on repo and bought $600 million in treasuries. That would've kept us qualified in Q2. That's a technique we've used in the past. Other things we could have looked at would have been things like taking some of the non-control assets out of European Capital as a dividend to American Capital, and shrinking the amount of our investment in European Capital, and moving assets over to American Capital that would have then been granular in our control assets. We could have done a street transaction to sell-off some of non-qualifying equity, and some of the things that will occur naturally over time would include selling portfolio companies that don't meet the test. So we do have a number of tools at our disposal to manage this. So that if and when we want to be a RIC, I feel like there's an opportunity to reshape the balance sheet to meet the rules at that time. So it is something that we have an ability to manage, and to achieve if we so desire.

Operator

Your next question comes from the line of Sanjay Sakhrani with KBW.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

So maybe just along the lines of that last question and thought process. I mean, does that make sense to stay a RIC and a BDC? Does it -- is it more economically viable just to go down the road and become and remain a C corp? Just trying to think through the mix dynamics in your model and whether or not it makes sense to change that in order to qualify.

Malon Wilkus

Well, we really can't answer that question. Today, we feel completely comfortable with the fact that we are now going to pay taxes as a C corp. We think that works just fine. We think that the ability to roll over the ordinary losses into future tax years is a very good thing for our shareholders, and that we'll be able to grow our NAV at a more rapid pace by retaining our earnings. But the circumstances are going to change in the future. The environment always changes in the future, and we have to evaluate that as they come. And right now, we have a lot of assets on our balance sheet that are private equity assets, our One Stop Buyouts. They have been performing very well for us, and we don't think this is -- for the ones that are on our balance sheet today, we don't think it's an optimal time to sell it or we would have already done so. So we have to pick our timing as to when to get back to those assets. We do have a slide in the presentation that shows the assets that we've sold over the last, since the middle of last year, and actually since the beginning of last year versus where we have deployed those assets. And you can see that from -- this is Slide 55, you can see that we deployed more of our assets into debt instruments, more of the realized proceeds back into debt instruments than we have into equity instruments. So in a sense, we are doing the work that's necessary to have a more income generating set of assets. But we're not doing it at the expense of losing values, good values on rapidly accelerating equity assets or rapidly appreciating equity assets. That would be an unwise thing to do for our shareholders. So for instance, we could sell our equity stakes in our petrol companies to another ACE like vehicle or the American Capital Equity I or the American Capital Equity II. In both of those cases, in the first case, we've sold $1 billion. In the second case, something shy of $700 million of equity stake in a strip of all the equity stakes that we have. We could do an ACE 3. But in today's environment, we get far better value by selling it to an individual company to a strategic buyer than by pooling all of those equity stakes and selling it to a secondary buyer. And now that may change in the future. It could be a year from now, it will be excellent to sell to a secondary buyer. But that's not the case today, and so we're trying to make the best judgment as to how to utilize our assets and grow our assets in our NAV, while always keeping an eye on trying to produce more ordinary income, interest income that will produce more net operating income.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

Okay. And so, John, just a question. I mean, do you expect the tax losses to offset all income next year, or could there be actual taxable income?

John Erickson

Yes, I think -- I'll refer you to the 10-Q we'll be filing hopefully tonight and the tax is in there. I think you can look at the numbers and digest them there and it will break out our tax attributes, and then you can make your own projections as to when they will be utilized.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc.

Okay. Final question, we're obviously getting lots of mixed signals on the U.S. economy. I was just wondering, within your portfolio, do you see any signs of material weakness from an economic standpoint?

Malon Wilkus

We are feeling good about the performance of our portfolio of companies. I would take you back to Slide 5. It's interesting to look at this slide because 2 quarters ahead of the negative GDP that occurred in first quarter of '08, our net earnings dropped to close to $21 million, that's very close to 0. And then in the next quarter, it went negative, negative $240 million. Now most of that was depreciation of our assets. We were still producing a lot from that operating income, but valuations started to drop 2 quarters before the GDP turned negative, or I should say the growth in GDP turned negative. Now this quarter, we produced $410 million of net earnings. And so, I think it is interesting to note the comparison and what that might say about the economy going forward. Now look, we don't have any kind of crystal ball with respect to the economy when we look at the performance of our portfolio of companies. This is about as good I think we can kind of convey it to the market. But I'm feeling -- we still continue to feel very good, and we talk about this, of course, everyday here. But we continue to feel good about the economy continuing to perform. Now not that it will produce 3.5% growth rates, but that it will be performing at least positive levels in the next year or so. Though I must say, I have one final thing to say about that. I think the economy has taken a substantial hit from a lot of the concerns that occurred in Europe, about North Africa and Japan. And so even some of the concerns about China. And it wouldn't surprise me entirely if there was one quarter of negative GDP growth coming up here, but I can't tell you that that's somehow being reflected in our portfolio company, because I don't feel it is.

Operator

Your next question comes from the line of Joel Houck with Wells Fargo.

Joel Houck

So I understand the C corp. election and obviously it makes economic sense. I guess just to clarify though, you've got to be a C corp. for one year, which means that whether you're in a taxable income position or not, you could not elect to RIC status until the tax year 2013. Is that correct?

John Erickson

You're right the way to think of it is if you generate an NOL in 2011, you would want to utilize that in 2012. And so you could assume that 2013 would be the first year that, based on tax situation, you would consider converting back.

Joel Houck

Okay, great. Kind of related to that, is there a -- obviously you guys have gone through a lot of changes, particularly in terms of the corporate structure. Is there a stated dividend policy coming out of the company, or are you guys going to evaluate that later? In other words, are you guys going to say we're not going to pay a dividend until we go back to RIC status, or we haven't even decided whether we would even like to go back to a RIC status?

Malon Wilkus

We haven't come up with any kind of policy in that respect. We were evaluating it, really, as we go. What I will say is that we can pay a dividend whether we're a RIC or a C corp. And then our bias to-date is not to pay a dividend when it would be a return of capital, and that we should pay dividends only if we earn it. And think about this for a second, when we went into the last recession and we had negative earnings, I just pointed out starting in the fourth quarter of '07, we had negative earnings of $243 million. But yet we still paid a very sizable dividend back then. Well, the way the BDC and RIC structural works is that you end up paying dividends while you have -- you can end up paying dividends while you have negative earnings but then on the outside, when the economy turns again, you have this residual losses that you've experienced in the course of the recession that then lingers for a while, causing you to start -- even though you may have positive earnings on a GAAP basis, which we've started back in the third quarter of '09, but from a tax position, it's still negative. And so, in a sense, our shareholders had the benefit of us paying a dividend when we were experiencing negative earnings back at the beginning of entering into the recession for some quarters. But on the back end, we're experiencing the lag on the back end of the recession. But we would like to burn through these ordinary losses as fast as we can and start having positive income so that we can be back considering a dividend policy.

John Erickson

Positive taxable income.

Joel Houck

Okay, I appreciate it. I guess the discussion then moved towards a return of capital to shareholders and that can, as you pointed out, could be a dividend, it could be a share buyback. But right now the stock's at 0.7 price to book and shareholders look at this and say, "Look, if you buy back stock or you return my capital, I have a, if you believe the NAV, I have a certain return of north of 30%." Are there any investment opportunities you have today or could see in the next 6 months, or are your equity interests that you have today going to give you at least a 30% IRR over the next 6 to 12 months. And if the answer is no, how can you not return some capital to shareholders? It's a suboptimal IRR decision, I think.

Malon Wilkus

Well, I appreciate that. But as we've just reported, we produced a 33% ROE over the last 8 quarters, and quite consistently so. So I think the answer is that we have been producing those kind of returns, and keep in mind, we've also been in an extraordinarily difficult economy with great uncertainties and we have been focused on delevering our balance sheet. As we've already said, we went into this recession with too much leverage.

Joel Houck

Right. Look, I don't want to belabor the point, but the numbers you cited in the line are backwards looking, and it is true. But what I'm asking, you have to look at this perspectively, right? You're not going to get a 77% return going forward...

Malon Wilkus

Unfortunately, though, Joe, I can only answer this by at least pointing to some data looking backwards. But you're right, it's backwards. But our decisions about this topic is focused on the future. And I think your calculus is, in parts, something that we accept as well. Though I do think you have to overlay it, the question of improving your balance sheet when the world is still very unstable. And we've been in the process of doing that. As you know, we can get an 8 3/4% riskless return by paying down debt and we have $700 million of that debt still outstanding. But finally, let me say that we are not -- when I said earlier that we had a bias not to return capital by paying a dividend when we haven't earned the income, the taxable income, I used that word carefully, it's a bias of ours. I think you've probably had that bias as well. And that's not to say that we are fixated on it, I can see circumstances where a dividend could be paid by a company even though that company doesn't have the taxable income to pay it if they return the capital.

John Erickson

But I would say that in that environment if you're creating a significant discount to book, it would probably make more sense to buy the stock back versus returning the capital be a dividend at par. But those are all things that we would consider.

Operator

Your next question comes from the line of Vernon Plack with BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

John or Malon, I know that in the press release you mentioned that one of your primary focuses was improving the balance sheet and the leverages are very high right now. What do you mean by that?

Malon Wilkus

You know for a BDC and actually for any kind of investment company that is making investments in companies that are themselves levered, you really have to look at the full leverage on a consolidated basis. And we'll be honest with you, we did not scrutinize that hard enough or come to the right conclusions in doing so in advance of the recession. On a consolidated basis, we were probably levered about 6.5x debt to EBITDA going into the recession. Now at American Capital, as you know, we were only levered 1:1 debt to equity, that's being modest, but you have to really include the risk profile of the leverage associated with portfolio companies.

Vernon Plack - BB&T Capital Markets

So you're telling me, Malon, that there's an intent here to reduce your leverage ratio or the risk profile of the overall organization?

Malon Wilkus

Yes. In taking into account the underlying portfolio investments in their leverage. And I would say that the delevering that we've done, I would guess has brought our leverage on a consolidated basis, perform a consolidated basis to something in the order of less than 5.5x debt to EBITDA. And I feel much, much better about that than the 6.5x. And I think our shareholders in the market should feel the same. Is that still optimal? Well, I'm not really quite prepared to answer that question, but I feel like about 4.5 is a heck a lot better than 6.5.

John Erickson

Right. And I would probably add some other color on that, which there's a number of ways to look at balance sheet strength, one that obviously we get into a long discussion on the rating agencies and their validity. But at the end of the day, going to an investment grade rating as a BDC is important for financing the business in the future, because the banks will all tell you now the Basel III that they're going to need investment grade ratings to do things like putting revolvers in place. And so staying in the high yield market with a below investment grade rating is not an optimal capital structure. And so continuing to retain capital and reposition the balance sheet, hopefully gets you to a point where you can move towards that investment grade rating. That's one of the ways to look at strengthening the balance sheet.

Vernon Plack - BB&T Capital Markets

And John what's that suggest about the portfolio composition between senior debt, sub-debt and equity? What's that mean to you?

John Erickson

Look, I think that having more senior and sub-debt assets would also lend itself towards the investment grade rating. Not having a portfolio that it has is much in the way of equity mistakes.

Vernon Plack - BB&T Capital Markets

Okay. I know on Page 14 of the presentation, you mentioned you that have $138 million NOL, that's up to with additional losses expected in Q3. Are those additional losses, are those taxable net operating losses, or are those capital losses?

John Erickson

It would be -- I think we would expect net operating losses from a tax perspective is our current best guess.

Vernon Plack - BB&T Capital Markets

Okay, and just one other question, John. Help me with my thinking, because I'm looking at this. You have $138 million operating losses, and this is, I know, an oversimplification, but if you look at what net operating income was for the quarter, and assume that's sort of a run rate, that really covers 2 quarters worth of NOI. Help me to understand, am I looking at this the right way or not?

John Erickson

Well, I think what you have to also look at is how much do we have in the way of depreciated assets. Because what effectively has been happening is, take Orchard Branch for example, that was an asset that should have been depreciated probably 12 months ago. But then we did the transaction to restructure in Q2. It triggered a loss and it was a ordinary loss. So really what's happening -- if you were to assume there was no more losses that would be taken, then you're right. The $138 million could get burned up by NOI in a fairly short time, but obviously you still have net depreciation on the books. You can see asset by asset, so embedded in part of that is there's some expectation of additional losses to be taken.

Vernon Plack - BB&T Capital Markets

Okay. And will those be in the form of either realizations or recapitalizations or both or what?

John Erickson

No, they will flow through our books in the form of realizations of price. So we take [ph], it does get realized which is one other proxy, which would show you directionally, it's not going to be closer to the actual numbers but directionally, if we were reaching a point where we were not having realized losses, that our realized income was positive, that would start to also signal when we're really running out of tax attributes. So if you look at NOI plus realized gains and losses and if that number starts being positive versus negative, then that starts to signal, I think, when we are moving towards burning through the tax attributes.

Operator

Your next question comes from the line of Greg Mason with Stifel, Nicolaus.

Greg Mason - Stifel Nicolaus

Gentlemen, could you discuss, were there any new non-accruals in the quarter? As we look at the $663 million of non-accruals across last quarter, I believe Orchard Brands was about $300 million of that which got restructured. So we expected the number to fall into kind of like the $370 million range. And it was $519 million this quarter, so were there additional loans that went on non-accrual this quarter?

John Erickson

Yes. There were actually a couple that did go on this quarter.

Greg Mason - Stifel Nicolaus

So would kind of the math work to be, call it $150 million-ish roughly in cost bases, would that be in the ballpark?

John Erickson

I think that strikes me as high.

Malon Wilkus

Yes, I'd tell you, on cost basis we had about $84 million being out during the quarter because of new loans being put on non-accrual. In addition to Orchard Branch coming off of non-accrual, and you also had other loans coming off non-accrual related to better performance. So you had about $141 million drop in non-accrual that cost quarter-over-quarter, and about $84 million was added to the difference of when it came off non-accrual in the Orchard Brands restructuring or just improvement in the portfolio.

Greg Mason - Stifel Nicolaus

Okay, great. And John, as you talked about kind of the potential future losses, does de-RIC-ing change what could be classified as a capital loss versus an ordinary loss? I believe in the past you said that there was kind of a debt loss that was ordinary, if there was an equity loss it was a capital loss. Does that change at all under not being a RIC?

John Erickson

No. The RIC code doesn't have any provisions that are really different than regular lenders who are following a lot of tax provisions that typical lenders follow.

Greg Mason - Stifel Nicolaus

So following up on Vernon's question, as we think about debt investments that could be ordinary losses looking at the non-accruals kind of fair value versus cost, would that be a way to estimate future operating losses that could be harvested?

John Erickson

It's a proxy, but there are new ones in the tax law, some debt investments can actually end up being capital. So, it's a proxy.

Operator

Your next question comes from the line of Jared Cohen with Fortress.

Jared Cohen - J.M. Cohen & Co.

Another good quarter of NAV growth, but the valuation discounts of ACAS continues to grow, or just at least hasn't shrunk, and right now a little bit below high 60s as a percentage of book. So I just want to reiterate, I think it was Joel's questions, your balance sheet looks relatively strong versus all your peers. You guys, on average over the last 4 quarters, have generated about $300 million of realizations per quarter. And based on your guidance for operating loss next quarter, it sounds like more expected realizations, some more cash coming to the business, almost $200 million of cash on the balance sheet today. For the life of me, I can't think of perspective investments that beat this 30%, 35% potential investment opportunity of purchasing stock back. And I understand, Malon, what you're talking about, about ROEs looking backwards, but I think it has to be an opportunity cost of future investment opportunities. And I really just want to try to engage a little more discussion as to how you guys can think about potential share repurchases here.

Malon Wilkus

Keep in mind, when we make an investment, for instance, a one-stop buyout, the equity portion of that investment, we're expecting 20% to 30% rates of return. And on the mezz, we're expecting probably 14% to 17% returns. The senior, we actually -- together with the fee income on it when we syndicate it, we expect fees and returns, though not as high as the other 2. So we do feel that there are good uses of our capital in making new investments, whether it be mezzanine investments or our one-stop buyouts. In addition, we had been most particularly focused on our portfolio companies that also tend to need capital. This last quarter they didn't really need any, but they are growing, and that's where you get some extremely high growth rates on your investment and we continue to support them. Now when we accumulate cash -- and by the way, it's a $350 million or $200 million or $150 million one-stop buyout, we have to accumulate cash on our balance sheet in advance of doing that transaction. And so yes, we are generating realizations, I think we ended this quarter -- can someone tell me how much cash on the balance sheet. I think $175 million or so. We do anticipate our cash to build, but at some point, it will be at levels where we cannot only do the investing that fulfills the opportunities that are before us, but also allows us to consider either a paydown of the $700 million of the debts at June 2013, which produces as, we mentioned before, a risk-free 9 3/4% return. Or to do some combination or one or the other of the stock buyback or possibly dividends. And that's all that -- we indeed will consider all of those. But up until now, we've had good uses of our capital. In the first quarter, we paid down $300 million of debt, we felt that, that was the first and best use of that $300 million. Had we had more mezz or buy opportunities in the first quarter, we actually could use some of that $300 million for that purpose. But we didn't, and so instead we paid down the debt. Now at this level where the debt is at $700 million and is not due until the end of 2013, might we more strongly consider the options that you have been suggesting. Absolutely, yes, indeed we would.

John Erickson

Yes. Look, we run a 5-year model on the company and we do run scenario analysis with or without stock buybacks, so it's something that we have focused on. And we do have our view on the future that we obviously can't share our model with the market, but we do believe that we are making a very good economic decision. I think that some other things that factor in that model, for example, as I've talked about, changing the credit rating of the company, right? If you were to assume that we could borrow in the future at a investment grade rate versus a below investment grade rate today, those things all factor into our thinking in our model. And I do think we have some good opportunities to invest the capital, as well as to ultimately look to get a better cost of capital in the balance sheet. So those things factor into the equation that maybe you all or others haven't looked at the same way we have within our model.

Jared Cohen - J.M. Cohen & Co.

And I can appreciate that, and we don't have access to your guys's model. But I think what you're hearing from shareholders on the call today is on an opportunity cost perspective, greater than 30% discount to book as to where your shares are trading, represents probably the best investment opportunity, at least that your shareholders and owners can see. So, that's just our thoughts.

Malon Wilkus

No, we appreciate that.

Operator

Your next question comes from the line of Daniel Kim with JPMorgan.

Richard Shane - JP Morgan Chase & Co

Guys, it's Rick. I got down stuck the call [ph], so I dialed in as Daniel. I really just want to sort of echo just the last comments which is that, Malon, you made the comments that circumstances change. And if we look at what's happened over the last 2 years, there was a very strong correlation, NAV improved, stock price improved, discount narrowed. And it strikes me that perhaps you've reached an inflection point where the business is delevered to the point where continuing to deliver no longer benefits bondholders and equity holders in the same way. And again, much of this conversation has sort of been very binary in terms of what the strategies are. Isn't there a middle ground here in terms of looking at all these different options and continuing to satisfy your ability to continue to grow the company, support your existing investments, provide capital to new investments, protect bondholders and also reward and share in the NAV growth with your equity holders?

Malon Wilkus

Look, we understand that and that's what we've been discussing. And like we said, we are not close minded about that. But we'll point you out to Slide 73, it's the last slide in the presentation and I think it might now be up. We're showing that we've actually improved our price-to-book virtually every quarter since the third quarter of '08. And it's not a perfect line upward, but it has been quite methodically moving up closer and closer to the 1x price-to-book. Now clearly, today we're down, and we understand that and appreciate it, and we will take that into account. But if we continue to produce some great earnings quarter-after-quarter and have a great return on equity quarter-after-quarter, we do believe that it will get reflected in our stock price. And so far, since the fourth quarter of '08, it has been doing that, or I should say the second quarter of '09, it has been doing that. But as we said, we're not close minded about these things. We will evaluate it as it goes and the environment changes. And most particularly, as I pointed out, I care a lot about this, is that we have been effective at delevering, we are substantially less levered today. And I do think the market needs to evaluate that leverage not just comparing BDCs as if they were the same. We are not the same as the rest of the BDCs. We have a lot more equity stakes on our balance sheet and those equities put us deeper down into the capital structures of our portfolio company. And so, a certain leverage for the average BDC might not be the right leverage for us at American Capital. So I feel much better about being at 0.4:1 debt to equity today than I did where we are at many quarters ago. And that does change our point of view about what our options are.

Richard Shane - JP Morgan Chase & Co

Okay. I think that's totally fair. And again what you've described in the past is very consistent with -- entirely consistent with our pieces on the stock. I do just want to emphasize that I think that perhaps we're reaching an inflection point, and I think the market is making a commentary on that today. And I'll leave it at that.

Operator

Your next question comes from the line of Matthew Howlett from Macquarie.

Matthew Howlett - Macquarie Research

Just one more thing on the potential return on capital, the share repurchase authorization is not currently in place. Is that correct?

Malon Wilkus

That's not true. Sam, would you describe that for us, please?

Samuel Flax

Under the forwarding [ph] act we can only do repurchases if we have provided a written notice to stockholders within the last 6 months. Such a notice was in our proxy statement, which was issued in late March or early April. So we are within that 6-month period.

Malon Wilkus

If we see that 6-month period, Matthew, we have to, prior to doing any share buybacks, we would have to inform our shareholders generally in the form of a letter and generally would take a week or 2 weeks after the sending of that letter before we could initiate a share buyback. But in that 6-month period, we're free to do a buyback if we chose to.

Matthew Howlett - Macquarie Research

Great. And the proxy was in May, right? Is that correct?

Samuel Flax

No, it's the date of the proxy, which I don't have off the top of my head. But it's late March, early April.

Matthew Howlett - Macquarie Research

Just switching to the ECAS, on their CLO, it looked like it was a pretty successful sale of the AAA securities. First, were you pleased with the execution there? And then 2, is that the game plan for American Capital next year to issue that market.

John Erickson

I would say we were pleased with the execution with the backdrop of the market, meaning that for really the first CLO to get done in Europe with mezzanine assets since the downturn, that was the positive. The negative is obviously advanced rates are a lot wider than where they would've been before the market downturn. And so we built the mezz CLO market in the U.S. in 2000 through our BLT issuances at American Capital. We know how that goes, where over time, you hope to see improving conditions and better advanced rates and cheaper costs of capital alone. And if the economy continues recovering, we think that'll be true and I think that securitization is probably the best form of financing for senior and sub-debt middle market assets. So I think both for European Capital and American Capital, the securitization markets are probably the place you want to be. And I think that if you even look at our own balance sheet financing in the BLTs, the positive there is I think that they have performed very well through the recession. They're all deleveraging and amortizing nicely and getting the investors' money back. And so hopefully, when we are ready go back out in the market, they'll remember that we're really -- within the context of all forms of securitization, we're really one of the best forms of securitization in this downturn.

Matthew Howlett - Macquarie Research

So would you consider that market open to American Capital, in other words, I mean, as long as new market conditions stay pretty much flattish, I mean you'd have the access to that market there. Like you said, the issuer reputation is strong enough where you could access that. I only say that because you've seen a few CLOs come off here in the last few months.

John Erickson

Yes. Look, I think that both -- the European Capital transaction, I think somewhat demonstrates that, and I think our own performance is good. We've not been out in the market talking to investors, so I can only assume that the reception would be positive. But I'll say that, as I said, the business performed and then going over the CLO market, we performed well in the CLO market side with the CLO that we managed with Mark Pelletier's group has been really a top desk of our performance. So I do think at the right time, that's a market we would look to access.

Matthew Howlett - Macquarie Research

And then just last question, it's not a big part of your portfolio but the Structured Finance -- the structured products was rearing up a little bit. I was a little surprised with some of the volatility you've seen in the securitization markets sort of with the quarter. But what are you seeing in those deals in terms of to write it up a little bit and how do you feel about you're still well below cost, how do you feel about valuation going forward?

John Erickson

I think in that marketplace we saw, first of all, if you go back over the past 2 or 3 years, the broker quotes on these positions had been what we thought were very poor, and I think that the transactional market and our broker close have certainly improved. So that was just driven based on market data that was telling us that the returns were getting better, and so it was market-driven. I think that also, in some cases, the performance of our CLO equity portfolio has actually been also very strong, I think that we fortunately chose the right managers to back and the underlying performance of most of the CLOs have been very good relative to the market.

Operator

And we have time for one last question. Our last question comes from the line of David Chiaverini with BMO Capital Markets.

David Chiaverini - BMO Capital Markets U.S.

A couple of questions. Assuming you put to work a couple of hundred million in cash on the balance sheet. How much in debt capacity does ACAS have to do additional originations?

Malon Wilkus

With our current debt structure, we don't have a revolver. And so that's one of the issues we kind of referred to in terms of talking about the balance sheet. There's not a revolver on the current structure. And so I think we would need to wait until there's an opportunity to refinance that $700 million to get a revolver in place.

David Chiaverini - BMO Capital Markets U.S.

Okay. And how much of a valuation allowance would ACAS have to record for the deferred tax asset?

John Erickson

You just have to look at the Q. It will all be laid out there.

David Chiaverini - BMO Capital Markets U.S.

Is it your intention to regain a RIC status after utilizing the NOLs?

Malon Wilkus

You know, we really can't comment on our intentions in that respect. What we can tell you is that we think for the next tax year 2012, it makes sense for us and our shareholders to be a C corp. in filing our taxes. And we'll evaluate the value of once again becoming a RIC as we go. We feel like we're completely capable of doing that if it makes sense for our shareholders, and that's what we care about.

David Chiaverini - BMO Capital Markets U.S.

Okay. And as you mentioned earlier in the call how you're aggressively looking at additional buyout transactions. Now doing one-stop buyouts, now that'll put you a bit more offsides on the diversification requirements. So I assume you're going to have to do some sort of transaction. You mentioned doing an ACE 3, you'd do something to that effect the get back to RIC status, I suppose.

Malon Wilkus

There's all sorts of things that come into play there. One of our largest assets is our investment in European Capital. And that is a net asset that fits us into the bucket that doesn't qualify. And so there's a variety of things we can do with European Capital, we could take it public once again, as an example, and continue to manage it as a publicly traded company. We could -- in taking it public, we possibly could do it in various ways including the possibility of distributing it to our shareholders so it could be public. So then there's the numerable ways in which we can address the desire to be once again treated as a RIC protector.

John Erickson

Yes. We've talked about a number tools. I mean, one other tool, for example, to be going into the senior loan market and buying senior loans on repo at the appropriate time. So there are a lot of ways, a lot of tools that you have if you want to get into the clients.

Malon Wilkus

Folks, thank you very much. Thanks so much. Very good set of questions. We appreciate all of your comments and your views. And we will continue to work very hard for you, and so we look forward to talking to you once again 3 months from now.

Operator

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

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