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American Capital Strategies, Ltd. (ACAS)

Q3 2007 Earnings Call

October 31, 2007, 11:00 AM ET

Executives

Amanda Cuthbertson - Director, IR

Malon Wilkus - Chairman, CEO, and President

John R. Erickson - EVP and CFO

Ira J. Wagner - EVP and COO

Analysts

Sanjay Sakhrani - Keefe, Bruyette & Woods

James Shanahan - Wachovia Securities

Carl Drake - SunTrust Robinson Humphrey

Vernon Plack - BB&T Capital Markets

Scott Valentin - Friedman, Billings, Ramsey & Company

Richard Shane - Jefferies & Company

James Ballan - Bear Stearns

Christopher Brendler - Stifel Nicolaus & Company,

John Neff - William Blair & Company

Unidentified Analyst

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the American Capital Third Quarter Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session, and instructions will be given at that time. [Operator Instructions]. As a reminder, the call is being recorded.

I would now like to turn the conference over to your host, the Director of Investor Relations, Ms. Amanda Cuthbertson. Please go ahead.

Amanda Cuthbertson - Director, Investor Relations

Thank you and thanks for joining American Capital third quarter 2007 earnings call this morning.

Before we begin I will review the Safe Harbor statement. This conference call and corresponding slide presentation contain statements that to the extent they are not recitations of historical fact 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 forecast, due to the impact of many factors beyond the control of American Capital. We do not undertake to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our website shortly after the call and the telephone recording can be accessed through November 14th by dialing 800-475-6701 and the replay passcode is 889559. All of this information is also available in our press release.

To view the Q3 slide presentation that management will be using this morning on the call, please turn to our website americancapital.com, click on the Q3 2007 shareholder presentation link in the upper right corner. Select the Conference Call option if you want to view the streaming slide presentation or the webcast option for both slides and audio. If you have any trouble with the webcast during the presentation, please hit F5 to refresh.

And with that, I'll turn it over to Malon Wilkus, Chairman and CEO of American Capital.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Thank you, Amanda, and thanks everyone for joining us today. I think we have an interesting presentation and a excellent quarter, and we will try to save a lot of time for questions.

Joining me here today is John Erickson, our CFO; Ira Wagner, our Chief Operating Officer; Tom McHale, our Heads of Corporate Finance; and Rich Konzmann, Senior Vice President of Accounting and Recording.

So, let’s start with slide four. We had a 78% dividend payout ratio of over the last 12 months, realized earnings ending in the third quarter. And so, as usual now for a very long time, our realized earnings is more than covering our dividends. We declared for the fourth quarter a $1 dividend, which is a 14% growth over the fourth quarter of ’06, a $0.04 increase over our prior guidance, and an $0.08 increase over the third quarter dividend. And we anticipate this will be paid from ordinary income for tax purpose. That brings to $3.72 our dividend have been paid and cleared for 2007, and that’s an 12% increase over the 2006 dividend, all of it is forecast to be paid from ordinary taxable income. And in addition, our forecast 2007 ordinary taxable income is to exceed the dividend and be retained for future dividends. So, we’ve had an excellent year of ordinary taxable income and we are forecasting the full year to be outstanding that will exceed the dividend and we will spillover some of that dividend for future or some of that taxable income for future dividends.

If you go to slide five, we’ve… in addition chosen to change our dividend policy with respect to long-term capital gains. Previously the Company permanently retained long-term gains by paying a 35% tax per… for shareholders and treating gains as a deemed distribution. Our net long-term capital gain earned during the tax year ending in 2007 will be paid as part of the 2008 dividend and American Capital will pay 4% excess tax on those gains in 2007. So, we are spilling over some of our long-term… actually all of our long-term capital gains into 2008 for the payment 2008 dividends.

And starting in 2008, a portion of American Capital’s dividends will be from that long-term capital gains and this change will likely require more cash dividends than under the previous policy. Then the market… the reason for doing this is that we believe the market value is the size, the growth, and the predictability of dividends measured in part by the amount of taxable earnings retained for future dividends, and this policy will allow us to retain more taxable earnings for the future dividends and shareholders benefit from this change.

Going to slide six. We are really announcing an outstanding dividend increase for 2008. American Capital forecasted that both it’s 2008 ordinary taxable income and it’s 2008 net long-term capital gains will exceed it’s 2007 amount. So, in both cases, we think these are going to exceed our amounts that we experienced in 2007, and so, we are forecasting $4.19 total dividend per share for ’08. That’s a 13% increase over 2007 dividend that has been paid and declared. And we are forecasting these dividends to be paid from ordinary taxable income and net long-term capital gains from taxable use ending in 2007 or 2008. So, we are spilling some of our 2007 over… we will take both for 2007 2008 and use it in part to pay the dividend and we actually anticipate will spillover additional amounts from 2008 into 2009.

The 2008 quarterly dividend per share forecast of… it is… on a quarterly basis $1.01 for the first quarter, which is a 13% increase over the ‘07 dividend and $1.03 for the second quarter also a 13% increase, $1.05 for the third quarter of 14% increase, and $1.10 for the fourth quarter of ’08, a 10% increase over ‘04 collectively that all is 13% increase over the ‘07 dividend. We think that should be considered really an outstanding development for shareholders at American Capital.

And you can see this on slide seven. You can see an outstanding history of dividend, this doesn’t take you back the whole 10 years since we went public, but if it did, you would see increase in the dividend every single year since we went public. And you can see the forecasted guidance dividend in ‘08 and those should be viewed as quite substantial. And interestingly, currently based on the fourth quarter $1 dividend that we declared and on based on our stock price yesterday, we are trading a 10% dividend yield. With 13% growth rate added to that yield, should give us a 23% total return by the end of 2008, assuming that we continue to trade at a 10% dividend yield at the end of 2008, based on the fourth quarter dividend at that time. So, a 23% dividend yield, which is already structured into our… I am sorry… 23% total return that’s already structured in dividend yield and based on guidance with respect to our growth rate of the dividend. And we would think that that would be viewed quite positively in the market.

Moving to slide eight, we had outstanding realized earnings for the quarter. Let’s start with our NOI. We had $0.82 per share, a 5% increase over the third quarter of ’06. And that’s versus our guidance of $0.79 to $0.83 per basic share. So, we solidly performed as we expected. On our trailing 12 month basis, our NOI, return on equity is 11%, which is really excellent. And then moving onto our realized earnings, we had $1.20, a 5% increase over the third quarter of ’06. A 16%... last 12 months, return on equity and it’s 130% of our third quarter ’07 dividend of $0.92. On an LTM basis, our realized earnings is 129% of our $3.60 dividend. And over the last three years, our realized earnings was 126% of a $9.92 in dividends. So, we have for quite some time… then earnings substantially more realized earnings than we pay out the divided. And our change in dividend policy will now allow us, number one, to reserve more earnings that can be used to cover future dividends on a temporary basis. We are paying a 4% excise tax on spillovers. And that… and keep in mind we have been doing that and so we anticipate we will be able to do that only a few more quarters in terms of building up that reserve. And then, we will be compelled to it out based on this policy and a nice part of it with that reserve, we believe we can make it very steady, highly predictable, and without much fluctuations, and certainly, we are confident enough to forecast the dividend guidance that we did for 2008.

Our earnings per basic share for the quarter was $0.11, and on LTM basis, our return on equity was 24%, so an outstanding return on equity and just put that $0.11 in context, if you averaged our Q2 earnings per basic share, in our Q3, we have had $2.44 in earnings, that would still be outstanding earnings higher than any period, any quarter in the past.

And if you go to the next slide, let’s talk about the reason that the realized gains was at $1.20 and then our earnings dropped and the difference, of course, is the net appreciation, depreciation gains and losses. Well, for the quarter, we had excellent gains at $71 million. It was comprised of a loss in our CDO and CMBS at $22 million. And I should point out that over time we believe we have securities in the… residual pools of CDOs and CMBS which will, we think have a… give us an opportunity to recoup those losses. Our portfolio of Company had a $92 million in gains, and then we have interest rate derivatives and taxes on realized gains that very much equal themselves. So, about $71 million of net realized gains, an excellent period of gains for us.

For net unrealized depreciation, we… let me just skip down to European Capital. We had $49 million of losses associated with our investment in European Capital. That was based on the stock price, because it’s public trading stock, but since it trading on our minority discount basis, we require to use a control premium to value it. And so, applying the control premium, we had a $49 million loss. That was offset by a foreign currency translation of $29 million. So, our investment in European Capital pretty much… just a small amount of… I get really zero appreciation or depreciation.

Moving back to the reversal of the prior… appreciation associated with the realized gain, so $71 million of realized gains does require us to go back and reverse out the appreciation and associated with the realized gains and that’s $34 million in part because not all of these gains were… a level that we actually exited at. And then we have interest rate derivatives that are used… they are in the form to the most part of the simple interest swaps that locked in our interest rates when we do the various borrowings. They are required by… to the most part by loan agreements, and over time, as we… as interest rate move and as we end up collecting on our assets and we are paying loans, these derivatives generally will work their way down to a zero, neither appreciation or gains… or neither appreciation or depreciation.

But for the period with moving interest rates and spreads widening, we had a $55 million depreciation on those derivatives. For our CDOs and CMBS we have $54 million depreciation I want to point out that for our CMBS portfolio we had about a $100 billion of commercial mortgages backing our investment there or part in where of that $100 billion we’ve had zero losses in those commercial mortgages, not one dime of losses and the portion on non-accrual is 15 basis points and that’s before recovery in the NO phase, that’s an effective key word to openly experience a loss. We would expect substantial recoveries and so beats the commercial mortgage, our commercial mortgage backed securities, our pool of assets which we spent a tremendous amount of time underwriting where we actually go out, visit, virtually every facility, we feel is performing extremely well. With respect to our CDO portfolio it has earned us about a 16% IR expense or investment. It’s also performing extremely well. But in both cases we are compelled to mark-to-market these assets at fair value based on trading values and of course there is been a liquidity crunch and it’s hard for some of these assets or these kinds of assets to have sufficient interest in buyers for them. It’s a lot of course due to the problems in the sub prime arena but just to reiterate while we are on it, we have no residential sub prime investments to speak of. And then we also had $10 million of depreciation of our portfolio companies. So, with respect to our one stop buy out assets, sponsored finance assets and our direct investments they have been performing extraordinarily well with a combination of realized and unrealized gains of about $60 million or $70 million or stay about $80 million for the quarter.

Let’s move on to slide 10. Our credit quality is excellent, we had 5.5% past due to non-accrual loans the total debt, face value a 1.5% at fair value we think these are excellent statistics. We had a 33% IRR on equity investments since our inception so our equity investment is performing… our equity investment is performing extraordinarily well and of course that has been collaborated by the recent sale of equity stakes in 80… all 80 bar equity investments and our net asset value increased to $6.96 over the third quarter of ’06, that’s a 25% increase and, though, indeed it did drop a little this quarter, if you go I guess I got a slide later I’ll speak to that point.

So let’s go slide 11. We updated our 2007 forecast and I think everyone has reviewed this. I will just jump to the bottom because we pretty much I think are still very much on what we had originally forecast for the beginning of the year. We have made some adjustments but we feel very good about being able to perform and that performance has been consistent all year long. For the fourth quarter NOI, we are forecasting $0.79 to $0.84 and NOI per basic share.

And then moving on to slide 12 you can see our net asset value today is at $34.92, it did dip down signing out from the prior quarter, but you could see it is dramatically up from even three quarters ago and dramatically up over the last year. So, I think it’s worth pointing out that we are currently trading at 1.2 times book which is as you can see from this next slide the lowest price to book that we have traded at in our history and we think this is a… just a tremendous time to be a buyer of American capital.

Now there has been a lot of talk about the liquidity crunch but that’s not happening at American capital. We had $1.5 billion of realizations in the third quarter, $900 million, just close to a $1 billion of it came to principal payments and loan sales, $400 million of it came from selling CMBS assets to the fund we manage AC CRECO [ph] we had a $110 million of equity assets and from those assets we reached the $70 million of net of portfolio realized gains as I mentioned earlier.

So tremendous liquidity of our portfolio and going to slide 15 we also had tremendous capital raising success in the third quarter, raising $2.3 billion from the end of the second quarter to-date, $380 million of that was from a common stock equity raise, and part of that being done through in equity forward program. We had and of course that’s permanent capital, we had $550 million of public debt that we raised at a fixed rate of $685 million and maturing in 2012 and are BBB rated. We did a $338 million on balance sheet terms securitization, that’s at LIBOR plus 47 basis points. Mind you we are taking LIBOR plus 47 basis points and investing it in assets that have over the last 10 years enjoyed it 18% IRR. There is no… I know of no firm which in the world of finance with spreads that dramatic. That was our 10th securitization, we pioneered these securitizations, no other buyout and private equity firm in the world does it. We have… raised $402 million in proceeds selling our CMBS assets to the ACAS CRE CDO and on October, I think it was October 3rd or so of ’07, we sold $585 million or raised $585 million from American capital equity, two, it’s a… we sold $488 million of 17% stakes of each of our equity stakes of 80 portfolio companies. So there were six investors and that led by AIG and they spent months underwriting our equity, meeting our management teams, meeting all of our investment teams and poring over our valuations and our due diligence and chose to invest for a total $585 million in this fund. That fund we should have pointed out here is a 2 and 30 fund, 2% management fee with a 10% to 30% carried interest, It really, an outstanding capital raise and it is because of the quality of our underlying assets and this purchase really corroborates our valuations, the quality of our assets and it all the way down to the most risky portion of our portfolio and I think this should be a comfort to our shareholders that the quality of our assets are very top bar none. Finally we did increase our secured credit facility $50 million.

So, on slide 16, it is a great time to be one of the best capitalized financial institutions with less than one-to-one debt to equity and this is a slide we showed last quarter, you can review it at your leisure but it conveys why we believe that this environment is outstanding for us.

We go to slide 17. You can see that our pricing in the second quarter, I am sorry in the third quarter has materially improved over the pricing that we did it very staunchest on… on a last 12 months basis ending the second quarter. So, since this credit crunch occurred, and liquidity crunch, we have been able to increase our pricing on senior debt by one whole percentage point. On our sub debt, 30 basis points but that is quite understated because most of the financing that we did and sub debt we priced before the end of the second quarter and we held fast and with our commitments on pricing and win ahead and funded, but in the fourth quarter I believe to see a substantial increase in pricing on our sub debt, we think we are getting a 150 to 200 basis points better pricing on sub debt and then you can also see, that pricing on equity has also improved, though I must say this is a little inconsistent with other industry data points. There seems to be a lot of evidence that in the merger and acquisition arena, pricing on equity has either held constant with quite possibly dropped a little bit from the pre end of Q2 period. So that will remain to be seen while we are very happy we have got outstanding pricing for our equity in the third quarter.

Now lets skip over, we will skip a bunch of slides as I do want to get to questions, I want to skip to slide 27 and just to put our cash due and non-accruing loans in perspective, we did have a 5.5% past due to non-accruing loans but if you can see a trend in the last two months or so, they are based on this chart, then you have more enlightenment than I do. So I think our assets are performing extremely well and I think you can see that in this chart.

On slide 28, you can also see that we are having very good investment opportunities. There has been a dramatic increase of investment opportunities over many years now and though there was a decline quarter-over-quarter of investment opportunities the trend is still dramatically up and year-over-year is dramatically up and so we still think we have tremendous opportunities in that arena. We can talk more about that if you like to in the Q&A session.

I would like to take another slide 35 and this is our static pool performance. We break it down between our equity investments which is in gold and all of our investments which is in blue on a static pool basis and you can see that we have performed consistently, in good times, in bad times and interest rate rising and interest falling and during recession and during all sorts of periods. And in the aggregate over 10 years our total assets have enjoyed a 18% compounded annual return. That is why we performed for our shareholders year in and year out producing 21% compounded annual returns and we see no reason why we can’t maintain, in fact we are a better and better firm every year. We see no reason we can’t maintain this kind of performance. For our equity stakes alone, we reaped a 33% compounded annual return over 10 years and those returns are even better if you just look over the last five years.

And now let’s go to one final chart before our summary. Chart 38. We keep thinking about our return on equity and the fact that over the last five years it has been at a 20% return on equity. Our performance has been at a 20% return on equity so we went and looked at every public company of $1 billion of more in market cap that had a return on equity within 2 percentage points of that 20%. And there were several hundred of them and the average price to book for those companies were up 4 times, price to book and we are trading at 1.2. The average price to earnings was at 21 times and we are trading at five times. Now, you might say while our price to… our return on equities in part includes appreciation that haven’t been realized and so… if you strip that out and just look at our realized return on equity. Our realized earnings return on equity which is at 14.6% and again we look at every public company that has a return on equity within 2 percentage points of that, either up or down and they traded at five times the average price to book… they… while we are at 1.2. Price to earnings, they were at 27 times while we were at nine times. So, we are… we still believe that we present an extraordinary opportunity to the marketplace because of the quality of our underlying assets and how they perform and how that translates ultimately to the returns that we can provide to our shareholders.

And so if you turn to our summary side 39, we are in an outstanding investment environment. We are forecasting $4.19 in dividends, a 13% growth rate on top of our 10% yield to-date or 23% total return if we are trading at the same to percent yield at the end of next year. We think that’s a no brainer return, an incredible return and keep in mind there could be other extraordinary and keep in mind… half of that return is going to be in cash dividends that the market can’t reprice and we can’t restate. The capital market conditions have resulted in two competitors for us so this is a great time for us. The credit tranches increase spread. So, it should improve our NOI and subsequently our dividend. The commercial credit markets remain excellent. I should say commercial credit remains excellent. Defaults remain extremely low and as I pointed out in commercial mortgage backed securities, we’ve had zero losses. So, we think this is a great time to have permanent capital. We think it is a great time to be levered less then one-to-one and so we are continuing to rationalize this industry. We have been investing in sub debt and equity in the middle market.

And with that, let me open it to questions.

Question and Answer

Operator

[Operator Instructions]. And our first question comes from the line of Sanjay Sakhrani of KBW. Please go ahead.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Hi. Thanks for taking my question. Just a quick question on the ’08 dividend guidance, how much of the dividends are expected to be paid out of ’08 capital gains?

Malon Wilkus – Chairman, Chief Executive Officer and President

The ’08 dividend?

Sanjay Sakhrani – Keefe, Bruyette & Woods

Yes.

Malon Wilkus – Chairman, Chief Executive Officer and President

Well, you could see that our ordinary taxable income has doing… been doing a superb job of covering our dividend and we don’t see any reason why that won’t continues. So, but on the other hand since we are spilling over the capital gains and we can only do that for so long. We will have to use a chunk of the capital gains to pay the dividend. We will report that but we will spill over then the net operating income over in 2009. So we expect to have outstanding coverage by our taxable income of our dividend in ’08.

John Erickson – Executive Vice President and Chief Financial Officer

Yes. I mean, we didn’t give detailed guidance on this but you’ll be able to see that our ’07 capital gains that are been spilled over are significant. So, based on the… where we set the dividend if we pay the level that we’ve set. You could really see with the numbers that is not an easy any of the ’08 capital gains to pay that level of dividend. I mean, what is been happening is over the past the three years, we’ve been distributing less then our realized earnings as I think Malon mentioned on the call. You know the realized earnings have been running 26% higher than our dividend and so I think that if you look we grew the dividend from ’06 to ’07 12% without using capital gains and you could in fact look at this increase of 13% as being modest of not over flowing capital gains and they are not really relying heavily on future capital gains because of just increase of the growth rate by 1% to some extent with the modest if your similar earnings can change to grow next year they have this year. So there is really not a reliance in looking out towards ’08. We feel like with the spill over and we start spilling our rate is probably two years ago. We’ve already built up over two quarters pushing with this spilling over the capital gains. We’ve got plenty of push into cover that the dividend forecast without having to really rely on ’08 capital gains.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Okay, okay. That’s what I was getting at and just to clarify Malon, to the extent that you guys have realized losses that would hit up against sort of the spill over. Is that right?

Malon Wilkus – Chairman, Chief Executive Officer and President

No. I think that the spill over is going to get locked in and then the realized losses would hit against future capital gains. So and if you look at the portfolio in total, we have plenty of unrealized appreciation to buffer us. So, obviously we will have realized losses but total we are projecting the realized gains will be positive net which is… if you look at portfolio there in terms where it is valued, that is a pretty easy assumption to make.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Okay. Got it. Just second question, just on the asset management initiative, I mean are there any other funds that… or I guess what are the other funds that are imminent? I guess what I’m getting that is sort of what the yield drag is from the non-core assets that are being incubated?

Malon Wilkus – Chairman, Chief Executive Officer and President

We did a extensive analysis of that and we really aren’t having much of the drag on the NOIs as result of the development of our funds under management, in part because it’s really integrated very much into our capital raising capabilities. So our finance department is… has for many years been meaning to raise capital quite periodically and really the capital or the asset management strategy is simply a capital raising concept and so this is… our department there is a permanent department. It is substantial. We are continuing to hire there, so we can tap into all sorts of capital around the world and not just the public markets and you can see the result of that is that we’ve been rolling out a wonderful set of funds under management and if you look at the slide 49, you can see that we now have 6 funds under management. They all are earning us fee income and to the most part they all have carried… some kind of carried interest that gives us some upside. We think for most part, most of these upside will occur down the road but the fee income is helping to produce some wonderful asset management fee income that is highly steady, predictable and growing.

John Erickson – Executive Vice President and Chief Financial Officer

And one other thing if there always a drag related with growth whether it is creating a fund in hiring a team that helps generating assets or whether it is just opening another office just putting assets on American Capital’s books. We’ve had that drag essentially for 10 years in our numbers and we don’t expect that drag to go away. So trying to kind of separate or isolate it is a very difficult task but essentially any time we open a new office or any time we decide to go into a new vertical and hire a team that is dedicated to or any time we decide to set up a fund and hire a team that is going to be dedicated as funds. There is some absolute drag that you experience but that’s really been baked into our numbers for 10 years and as long as you assume that then we are going to continue to grow. We would continue to have a similar kind of drag in the numbers because we… there is no question that at any point in time, we have employees that have been hired but are not yet generating revenues or are fully accretive in terms of the ROEs they are generating. So we want to reduce and to put some asset on the books. It takes a while for the ROE to get up to the level that American Capital overall is enjoying.

Malon Wilkus – Chairman, Chief Executive Officer and President

And I guess where I was getting at is the core sort of middle market investments or debt investments are probably generating a higher yield than let’s say the CMBS portfolio.

Sanjay Sakhrani – Keefe, Bruyette & Woods

No. I mean if you were to isolate those investments. I mean, I would think that there would be a drag on the yield, right?

Malon Wilkus – Chairman, Chief Executive Officer and President

Yes. That was probably true up until we did the CDO and up until we remarked the CMBS assets but at this point in time certainly based on fair value that’s not true and even based on historical cost. We are generating a fairly positive yield. So really that dynamic changed effective with the CDO transaction. It really helped us get the yield to where we wanted it to be plus I guess, we talked about in the second quarter, we started changing the pricing on the CMBS as early as April and that’s already starting to flow through though the price increases continue all the way in through August. So, starting in April, we are raising prices and even as we did… CMBS transactions in July and August, so prices continue to widen out and today we think that we are essentially indifferent to whether we put in a CMBS transaction or to put a sub debt transaction because your CMBS transactions on current yield basis are in the mid teens.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Okay. Great. Thank you very much.

Malon Wilkus – Chairman, Chief Executive Officer and President

You’re welcome and just to point out on the slide 49, we have a whole variety of additional funds and development to the… continue to expand our alternative asset management business.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Hey, great.

Malon Wilkus – Chairman, Chief Executive Officer and President

Thank you.

Operator

Okay. Thank you. And the next question comes from the line of James Shanahan of Wachovia. Please go ahead.

James Shanahan – Wachovia Securities

Thank you very much. Good morning.

Malon Wilkus – Chairman, Chief Executive Officer and President

Good morning.

James Shanahan – Wachovia Securities

My first question I guess from your earlier response, it doesn’t sound like you are willing to provide the exact dollar value or retained long term capital gains at sub 30 that’s available to support the dividend.

Malon Wilkus – Chairman, Chief Executive Officer and President

Well, I think the… we will have a number in the queue. It’s going to be at about $140 million. I just don’t want to give an exact number at this time but Rich said this at the press release 142 million is what we're spilling it over at this time.

James Shanahan - Wachovia Securities

And regarding ACAS equity, you sold a 70% interest in all your equities investments and that was at a 3% discount to, I think you said the June 30 carrying value. Now this was announced in October but in this market value comp or level 1 input if you will be impacted the fair value of any of your equity investments for the September quarter?

Malon Wilkus - Chairman, Chief Executive Officer, and President

If you look at the slide. Let’s turn to that slide. That shows the individual assets and composition of the depreciation and net gains. We had wonderful gains on the portfolio so he third line there of $92 million of gains for the portfolio. In Q3, but then we had all of $10 million of portfolio company depreciation. So if there was modest changes to the portfolio company's and it is those, it is the equity in those company's which would be sold in that transaction and so I think we are in great shape it’s nowhere near that $10 million is virtually zero on that volume of assets.

John R. Erickson - Executive Vice President and Chief Financial Officer

I think we could exit at those level 3 data and I think it played a roll in the evaluations yet, in looking at how that transaction was negotiated they were working on Q2 portfolio company data and they were pricing the transaction in the August, September time period. I think the price had been essentially kind of agreed to early in September and they did not have third quarter portfolio company performance data so we had to consider that in our valuation but obviously we also what data they were working on and what the time frame was that they were making that assessment. So when you… certainly during the third quarter I think everyone in the middle of the quarter thought that the quarter would end with public companies being weighed down. But indeed that’s what happened and the public comps were generally quite solid from the beginning of the quarter to the end and in fact our data in the aggregate from our entire portfolio shows revenues and EBITDA increasing. So we think the structure an excellent transaction with respect to American Capital and equity too

Malon Wilkus - Chairman, Chief Executive Officer, and President

One other point. We didn’t sell 100% free and clear interest in those portfolio company's because in essence we retained a management agreement that paid us 2% up to a 30 % carry and so the way GAAP will account for that, it was a fourth quarter transaction the way GAAP will account for that is they will… GAAP will require us to put some value on the management contract retained which will be addition proceeds and the 3% discount does not take into account then the value of the management contract received which will be additional proceeds so when we're done with the fourth quarter valuation and with valuing those proceeds we’ll give a detail break out in Q4 what the actual realized gain or loss for that transaction would be. I mean like we expect at this point to be a realized gain.

John R. Erickson - Executive Vice President and Chief Financial Officer

Yes. Keep in mind that, I think we announced there’s $10 million of revenues flow into the asset management company as a result of the transaction on an annual basis. So the combining that together with the discount frankly it’s a superb transaction for our shareholders.

James Shanahan - Wachovia Securities

Currently Ecast evaluation I appreciate that your generosity with your time. The Ecast valuation, it has deteriorated further since September and should I understand that to mean that any incremental further weakening in the share price of Ecast offset by an increase or improvement in the currency translation would basically be accrued to the control premium?

Malon Wilkus - Chairman, Chief Executive Officer, and President

That remains to be seen. We will have to value that at the end of each quarter obviously. But I think what is occurring is from a control perspective one opportunity of the control investor is the ability to liquidate the assets and that’s something that a minority investor doesn’t have the advantage of but it’s certainly in the power of the control investor. And so the net asset value of European Capital does represent a very powerful indicator of value.

John R. Erickson - Executive Vice President and Chief Financial Officer

Yes. I would say that we spend a tremendous amount of time on that valuation this quarter also consulting with numerous advisors including obviously consulting with national people at Earnest and Young consulting Houlihan Lokey and also consulting with the FAS 157 advisor that we had engaged previously and as you know the FAS. We spending a lot of time providing some guidance insights on 157 right now so I don’t know that we want to give any color on what may happen in the future and I think there’s still some flux around 157 how that, what kind of ultimate guidance that may come out. But, for this quarter suffice it to say we spend extensive amounts of time with our advisors concluding on the valuation methodology and it just depends on what ends up coming out of 157as to how that might impact in the future.

James Shanahan - Wachovia Securities

Thank you.

Malon Wilkus - Chairman, Chief Executive Officer, and President

You're welcome. Thank you. Next question please.

Operator

Thank you and the next question comes from the line of Carl Drake of SunTrust, Robinson, Humphrey. Please go ahead.

Carl Drake - SunTrust Robinson Humphrey

Thank you. Good afternoon. A couple of questions. In the quarter there was a reduction in fee income that came I believe tied to origination volume and also operating expenses that declined nicely with that. Maybe you could touch on little bit of the break out, what happened there and also the breakout of the $44 million in the fee income.

Malon Wilkus - Chairman, President, and Chief Executive Officer

Yes. Ira, why don’t you speak to that.

Ira J. Wagner - Executive Vice President and Chief Operating Officer

Sure. As we've said many times in the past. The fee income is lumpy quarter-to-quarter. Predominantly tied to the volumes of ACAS buyouts business. And the buyouts business is inherently lumpy quarter-to-quarter of the second quarter of this year was very robust and I think we did five transactions or five or six in the second quarter of the year and the third quarter was significant lower in a couple of transactions which you saw on slide 23 at $586 million and a large part of the fee income is tied to that buyouts business, so that’s why it’s lumpy quarter-to-quarter related to the buyouts business.

Carl Drake - SunTrust Robinson Humphrey

And the operating expense are also tied somewhat to that?

Malon Wilkus - Chairman, Chief Executive Officer, and President

It’s a pretty good decline quarter-to-quarter.

John R. Erickson - Executive Vice President and Chief Financial Officer

The relationship between compensation but there are, some elements are certainly tied to it for example. Write offs for dead deals and that sort of thing that varies from quarter-to-quarter depends on what you're working on and what happens.

Malon Wilkus - Chairman, Chief Executive Officer, and President

That would be the bulk of our business. Now that M&A market has dropped off, but not nearly to the extent that the big LBO transactions have dropped off. So we are continuing to see a very robust deal flow in the middle markets for both the buyouts side of the business as well as sponsored finance side of the business. In fact on the sponsored finance side of the businesses the deal flow is picking up as some other investors have dropped out of the market and its investors like ourselves who are the long-term investors that are… That the other private equity funds are turning to, to fund the transactions that they have. So the middle market contributions to be very active. There’s still plenty of transactions in the marketplace. It’s really the big LBO business that you've seen the really dramatic fall-off and that’s a very, very small part of our business.

John R. Erickson - Executive Vice President and Chief Financial Officer

I think, it’s worth pointing out there’s been a lot of commentary that the M&A business is going to drop off and therefore we won’t be able to do a lot of new buyouts and we won’t be able to sell a lot of companies that we have been doing in the past and we're just not seeing that, there is, quarter-over-quarter the second quarter was an extraordinarily high quarter in volume of M&A activity and yes, we're down from that. But, year-over-year it’s still dramatically up. There’s great opportunities out there. We do think it’s harder for some buyout firms to do deals because it’s harder to get debt financing but it’s not impossible and of course our one stop financing that we offer to other private equity firms is in great demand right now. And then our one stop buyout has tremendous power in this environment where everybody wants more confidence of getting to a closing. Because some of the big buyout firms, weren’t able to provide confidence. I mean they failed in being able to perform, when they had committed to a buy out. We, our one stop buyout capability really eliminates that risk and it gives us great opportunities. But we think we will have still an excellent environment. It certainly is, from what we see in the next quarter, what we're seeing right now and what we would anticipate in the next quarter that we will have substantial M&A volume of opportunities. Now opportunities are one thing, closing is another. We closed up 1.5% I think this last quarter of the deals that we looked at so that’s why it can be so lumpy. And then two, is that we have a number of company's for sale and we quite often just think that they will be sold and with a great outcome. So we think a lot of the speculation about some substantial declines is not appropriate.

Carl Drake - SunTrust Robinson Humphrey

So, your view of the economy, taking those comments is pretty optimistic looking out into 08 in terms of multiples steady on, in terms of purchase multiples despite the credit crunch?

Malon Wilkus - Chairman, Chief Executive Officer, and President

Well the data we've been looking at quite a bit of data on this both our own internal data as well as outside data and if you strip out the large deals and just pay attention to the middle market. Spreads been widening on senior debts. Spreads have widened on sub-debt materially, but purchase multiples have not really changed and that would imply that returns to equity is probably a little lower… the likely returns to equity probably have dropped a little bit. But keep in mind, returns on equity, in the world of private equity, at least, for the top quartile, private equity has been extraordinary. And we have proven that and you can see it from our numbers with extraordinary returns on our equity. Now if those were 2 percentage points less, I don't think it would impact our ability to raise capital, nor I don't think that would be the case for the top quartile of private equity. So, there is still a lot of capital out there for private equity to buy companies, and of course, keep in mind, private equity represents maybe only 40% of the buyers out there or 30% worldwide most of the buyers are strategic buyers.

John R. Erickson - Executive Vice President and Chief Financial Officer

Yes, and I would also say that the return of equities have only dropped if you assume that the cost of financing is going to remain over the next five or six years where it is today. If you assume that it’s going to… will get out of this credit cycle and the fancy market gets a little tightened up some… I backed it some of the equity sponsors are assuming that they can refinance later on a lower cost to debt capital and really not probably impact directly returns that much.

Carl Drake - SunTrust Robinson Humphrey

Okay. I appreciate the discussion.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes, that’s not our view. That’s not what we are doing, but that's’ what I think…

John R. Erickson - Executive Vice President and Chief Financial Officer

One of the reasons you are not seeing the equity multiples or the equity changing much in value.

Carl Drake - SunTrust Robinson Humphrey

Okay. Thank you.

Malon Wilkus - Chairman, Chief Executive Officer, and President

You’re welcome.

Operator

Okay. Thank you. And the next question comes from the line of Vernon Plack of BB&T Capital Markets. Please go ahead,

Vernon Plack - BB&T Capital Markets

Yes. Thanks. The… debt to equity ratio at the end of the quarter is… was substantially lower than it has been for quite some time. I am curious in terms of thoughts on managing that going forward, should we expect you to leverage back up or what are your thoughts?

John R. Erickson - Executive Vice President and Chief Financial Officer

Yes, I think that we will certainly leverage back up. I think we had very active quarter for capital rising and for capital coming back. If you added up the slides Malon covered in terms of repayment and capital raises, that's almost $4 billion that we had of liquidity in the quarter on $11 plus billion invest on the balance sheet. So, that's quite substantial. And that was not unintentional. Obviously, in a market of credit disruption, we want to be a little more conservative and really raise some capital ahead of needs, and so, I think that puts our balance sheet in a great position to be opportunistic in this market.

Vernon Plack - BB&T Capital Markets

John, you all were actually coming closer to 0.9 to 1. Do you expect to migrate up to that? Or is a lower number probably more appropriate at this time?

John R. Erickson - Executive Vice President and Chief Financial Officer

It depends on closings. We are very active in terms of pursuing transactions and it’s possible that we could up to 0.9 to 1, but it’s also possible that if we don't close on a transaction here or there, we won’t. I think we want to remain well funded, and we are going to make sure that we got plenty of capital to pursue the opportunities.

Vernon Plack - BB&T Capital Markets

Okay. Great. Thanks John.

Operator

Okay. Thank you. The next question comes from the line of Scott Valentin of FBR Capital Markets. Please go ahead.

Scott Valentin - Friedman, Billings, Ramsey & Company

Thanks for taking my question. It has to do with the control premium and just… I am trying to make sure I get the mechanics behind it correct. I guess that the fact that the ACAS is trading below NAV because you own a good chunk of the Company, you have chosen to evaluate at an NAV basically on the assumption that you can liquidate the Company and recover NAV. At some point in the future if things… when things turnaround and ACAS were to trade at a premium would you then be locked in and say, okay, VAV is liquidation value or would then you go with the higher stock price on the assumption you could sell through the open market at a higher price?

John R. Erickson - Executive Vice President and Chief Financial Officer

The methodology is price times quantity plus… one plus the control premium. So, price times quantity is one of the inputs in that equation.

Malon Wilkus - Chairman, Chief Executive Officer, and President

And 157 does require you to look toward the best market to optimize value.

Scott Valentin - Friedman, Billings, Ramsey & Company

Okay. I am just trying to… a handle for forward looking… when we do our estimates and do you think that, just what can we uses kind of a factor, is there a factor use or is it just going to vary from quarter-to-quarter.

John R. Erickson - Executive Vice President and Chief Financial Officer

Scott, if the stock will be trading well north of NAV. We wouldn’t say that likely exit would be to liquidate the Company. We would say we want to build the stock, and that the philosophy. You may see control premium. We reduced over time if the stock is well north of NAV because you are going to be very liquid market for the stock above NAV.

Scott Valentin - Friedman, Billings, Ramsey & Company

Okay. And just a follow-up question. On the dividend policy going forward, the payout on long-term gains, does that eject more volatility into the dividend? I mean if you guys start paying--?

Malon Wilkus - Chairman, Chief Executive Officer, and President

Just the opposite I mean that's the thing I find so interesting. All of a sudden we added more capital to the potential could… that can fund the dividend. So, historically, for 10 years now, we have only funded the dividend with ordinary taxable income. Now we have announced that we are going to add another stream of cash flow of earnings that could fund the dividend and now people are thinking it’s going to become more volatile. Well, that would be the case if we took it to the max, but we have never taken the dividend to the max. We have always have earned dramatically more realized earnings than we have had paid out as dividends. And we intend to continue to do that. We plan to actually have the dividend be more consistent to provide more confidence in the dividend by building up the reserve to the extent that that the tax laws allow, and that's quite meaning full. It’s not… you can’t do it forever, but it’s very, very meaning full amount. We think we can get three maybe four quarters of reserves and then that reserves will go up and down, depending on some lumpiness of our taxable income. And so we just think we’ve up… so keep in mind, our real life return on equity for five years has been 16%, right. 16% and yet our dividend growth is… this quarter… the year was 12%, this year for ’08 we forecasting 13%.

So, we are still reserving our 3% of our return on equity that we are not paying out. Now alternately with this policy, we will have to… if we continue to have 16% return on equity for the next five years, within about a year, we are going to have to go to a 16% payout rate. And… but we will still have a lot of reserves so that if it dipped below 16% ROE that we will have a period… a year, probably a whole year of capacity to absorber that dip. And so, this is… I mean I think folks don't realize how much more we could have paid out as a dividend over the years, if a lot.

John R. Erickson - Executive Vice President and Chief Financial Officer

Just to the excess realized earnings over the dividends for the last three years was like $0.45 in ’05 and $1.10 in ’06 and $0.79 in ’07. And so there’s been substantial earnings. And the other thing is to keep in mind is our portfolio is extremely granular. It's not as though we have three or four companies where we are expecting all of our capital gains to come from and so either you sell or you don't. We have a granular portfolio of equity investments where we have a number of companies that we are planning to put up for sale in the near-term that have good unrealized appreciation and they will be more companies in ’09 and more companies in 2010. So it’s going to be a regular harvest moon. Certainly, we can go through a recession or a tough environment, but that's why two years ago we started the bank the dividend pay in excess tax and that's… we put ourselves in a position to absorb a downturn. So, I would echo Malon's sentiment we have actually been very conservative and have plenty of excess capacity, so that we don't have the… we don’t want to payout a 100% of everything, so you do start to see the dividend having to move up and down with the realized earnings. We are going to it as a conservative level where we’re continue to spillover in banks and then if you do have a negative environment, you get the ability to keep that dividend going at the same rate and eat into the spillover earnings that you would have had for the following year.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes one thing I have always been surprised at is that relative to the other BDCs, we have had one of the best coverages of ordinary taxable income to our dividends. And we have managed to that where it seems at least in some cases BDCs have not concentrated on their ordinary income and use gains to make their dividends, but so even… so there’s two… you can think of it there’s two kinds of companies one like finance companies in the BDC world, where all they really have is ordinary taxable income to cover their dividend, we have really been highly competitive with them it terms of how we have covered the dividend plus we have done the banking of our gains. But we have not created a set of assets where we were looking for homeruns from several of our portfolio companies so that we could cover the dividends. We have had very confident, very regular harvesting of gains. And by the way, we have also have taken our lumps as rapidly as we can and we think it’s appropriate and so there’s not a lot of depreciation on our balance sheet relative to other firms out there because we have recognized those deprecations through loses even in this last quarter. We had $92 million of portfolio company net gains if you want to take that chart I don’t quite know the number off the top of my head, but we had significant amount if losses that we recognized and in the third quarter as well. And we keep doing that quarter-after-quarter, so we have a very clean balance sheet today.

Scott Valentin - Friedman, Billings, Ramsey & Company

Okay. And just one quick question. You mentioned you are not really seeing the pricing multiples come down on transactions. But have you seen any stress on EBITDA, any of your portfolio companies given I mean the economy had to slowdown I guess the outlook that it may go down, and certain sectors are seeing a slowdown. Have you seen any of it?.

John R. Erickson - Executive Vice President and Chief Financial Officer

Let me Ira to speak to that.

Ira J. Wagner - Executive Vice President and Chief Operating Officer

I think your question has to do with performance of the portfolio and what we have seen in the portfolio, overall, is that we have seen growth in the portfolio both in revenues and in EBITDA year-over-year. So, in general, the portfolio is performing quite well, and we have had a few companies that have predominantly been exposed to the housing and construction industry that have suffered along with the housing industry but that’s a pretty small part of our portfolio. So the predominance of our portfolio is performing quite well.

Malon Wilkus - Chairman, Chief Executive Officer, and President

We did state in the press release that the earnings and EBITDA for the balance of portfolio was up in the third quarter. So it was really that the non-accruals did come from the housing and construction sector.

Scott Valentin - Friedman, Billings, Ramsey & Company

Okay. Thank you.

Operator

Thank you. And the next question comes from the line of Richard Shane of Jefferies. Please go ahead.

Richard Shane - Jefferies & Company

Thanks guys for taking my question. Most of them have been answered. One sort of technical question. Related to the change in the tax policy on the capital gains, is there going to be any credit going forward associated with that. Is some of these gains are re-characterized or is that what is past is past?

John R. Erickson - Executive Vice President and Chief Financial Officer

I’m not sure. Are you talking about 2006 transactions or are you talking about the ’07 year?

Richard Shane - Jefferies & Company

Anything going forward. Is there any anomaly that we should expect in 2008 related to this. I mean I don’t even know necessarily what the change could be but when you make a tax policy change, do you have for example, credits for taxes if the 35% rate that you paid previously?

John R. Erickson - Executive Vice President and Chief Financial Officer

No. I mean, so for 2006, we did have a deemed distribution. We paid the 35%, so in terms of our tax return that’s done and behind us. There is no recapture or there is no way to go back to that, that’s a done item. So this only relates to capital gains earned in the 2007 taxable year.

Richard Shane - Jefferies & Company

Okay. And that is what I was driving at.

John R. Erickson - Executive Vice President and Chief Financial Officer

Yes.

Richard Shane - Jefferies & Company

The second question and again you guys have talked about this a couple of different times and I apologize for not understanding that but you talk about the fact that 80 portfolio companies, equity positions were sold in the fund too. What was excluded, I’m assuming that the equity position at any of your management companies, were excluded and the reason I’m trying to do this I’m just trying to reconcile the equity values on your balance sheet with the implied equity value of the portfolio companies that you transferred.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes, Rick, we would have been excluded European capital or investing the management companies. Investments in equity of CDOs and there may be there’s about a handful of just were we were last year, middle market investments that were excluded for variety of tax or legal structuring issues

John R. Erickson - Executive Vice President and Chief Financial Officer

Primarily equities that had been written down to zero already and so for tax reasons and other, we did not transfer that.

Richard Shane - Jefferies & Company

Got it. And so…

Malon Wilkus - Chairman, Chief Executive Officer, and President

Virtually all of our… what you would take if our historically…

John R. Erickson - Executive Vice President and Chief Financial Officer

Private equity same market portfolio.

Richard Shane - Jefferies & Company

Great. Okay. Thank you guys very much.

Malon Wilkus - Chairman, Chief Executive Officer, and President

There was no… just to make it clear, there was no selective picking from our portfolios, none of that.

Richard Shane - Jefferies & Company

Understood and again it looks to me like the big difference is just the management companies and E-caps in your equity positions there.

Malon Wilkus - Chairman, Chief Executive Officer, and President

That’s right, yes.

Richard Shane - Jefferies & Company

Great. Thank you, guys.

Malon Wilkus - Chairman, Chief Executive Officer, and President

You’re welcome.

Operator

Okay. Thank you. And the next question comes from the line of Jim Ballan of Bear Stearns. Please go ahead.

James Ballan - Bear Stearns

Great. Thanks a lot. Just following up on actually a number of questions that have already have been asked. Along with the de-leveraging that we saw sequentially this quarter and if you take out the sort of call it the strategic equity positions, it looks like you are actually equity exposure is also lower. And so, I wanted to get your thoughts on as you re-lever and as you put this always quite a little work that you have raised. What your thoughts in terms of re-opting the private equity portion of portfolio versus what looks like you have done in the last couple of quarter which has been more of emphasis on senior debt and now that your senior debt is how your better spreads are. So, I mean maybe another way of asking it is where in the capital structure do you see the greatest risk reward today on a relative value basis and how does that jive with your thoughts on where credit quality is going, going forward?

Malon Wilkus - Chairman, Chief Executive Officer, and President

That’s such an interesting question. I ask myself, we have investor committee meetings virtually every day of the week and when I look at one investment opportunity to the next keep in mind, we can go up and down the balance sheet. So we are constantly rejecting securities that one level of a respected portfolio company and by accepting it at another level. So, it is a natural day-to-day occurrence for us to be saying this is not a proper risk reward profile but this is and we’ll bid on that and we won’t bid on the other. In within one company, within one industry within one region, within different sectors, we do that between energy and medical products, financial institutions. We are prepared to look wherever the right risk reward is and honestly I can’t say where the patterns are. I’ve been asked this question many times and when I’m done making an investment, at the end of the week we maybe decided on making 10 different investments that week. I’m not sure which one will be better than the other and I generally couldn’t tell you but what I will say is it right now, obviously we demand a lot for any company within housing for anything that’s having been to do with residential construction. We demand dramatically better companies if we think, it’s in a cyclical industry. We’ve always been doing those things and we continue to do it and bidding on where we think the world is and what is happening in our portfolio and the advice that we are getting from our CEO’s of portfolio companies and so forth. We are constantly shifting our views by industry, by companies, by tranche within the company and so forth. Ira, do you want to add something to that?

Ira J. Wagner - Executive Vice President and Chief Operating Officer

No. I think it’s very much a deal-by-deal basis and we look at every, we underwrite every transaction and everything that’s on the balance sheet and then we make decisions about where we think we should be invested on that balance sheet and there is a lot of as we’ve said the spreads in the debt markets have gone up. So we are seeing a lot of opportunities in the mezzanine business but we are still seeing a lot of what we consider to be good in equity investments so, its really very much deal-by-deal.

James Ballan - Bear Stearns

Okay. I mean just on… there is a lot of economists out there who are predicting a slow down or possibly recession. I mean can you just… obviously your unique visibility into that. I mean is there anything you point out?

Malon Wilkus - Chairman, Chief Executive Officer, and President

Well, we think two things about it. Number one, we have certainly, we are also are of the view, we are not economists here but we are also of a view that the other recession probably has gone up and believe me we care about that a great deal and we are asking all of our investment teams to assume a worst scenarios for our base case to decide whether to make an investment or not. So we have moved up with on to our most companies that we review. We usually have recessions and forecasts. We move those… in this last year we’ve moved that up to an earlier period and to some degree made them more severe. Now, that’s not true for every company because some companies are actually quite recession resistant we believe but…

John R. Erickson - Executive Vice President and Chief Financial Officer

Well in fact if you look at the bi-ops that we’ve done so far this year, I think we selected some larger companies that we feel like aren’t completely correlated economy that have some stability and lower beta in terms of their earnings, first is what would happen in a recession.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Well also I think it’s interesting. I’m not sure many other firms do this but if we like the company that we think it’s a dramatic, it’s a wonderful company and has tremendous growth and maybe probably has very little exposure to any economic cycles. We may pay a very high multiple for that company, but we might also assume an exit multiple that’s a chunk below, substantially below our entry multiple and not assume that we’ll be in the same kind of multiple environment when its time to exit when we entered. And so we passed our assumptions all the time and put great demands on what we believe we should maybe investing in. Now, keep in mind the reason our volume is so high is we're simply the biggest firm in the world in the middle market and by a very substantial major. We can have our 14 offices and we have the largest deal flow and more importantly we get the cream of the crop. We don’t have to always be the highest bidder, because when you can do a one stop buyout and none of your competitors can. We have the lowest cost of capital in the industry. We have these huge advantages. So the reason our volume… people keep asking why did we do all that volume in the last year ending in the second quarter. Because, we saw fabulous companies. They were great companies and by the way if you… we looked at the assets that we invested in, the investments we made in the first and second quarter of this year and they actually appreciated about $30 million by the end of the third quarter. So those assets are performing for us. They are excellent companies.

James Ballan - Bear Stearns

Okay. Terrific. Thanks a lot.

Malon Wilkus - Chairman, President, and Chief Executive Officer

We just want to be in the enviable roll of seeking the very best opportunities out there.

James Ballan - Bear Stearns

Great. Thanks a lot Malon.

Malon Wilkus - Chairman, President, and Chief Executive Officer

You're welcome.

Operator

Thank you. The next question comes from the line of Chris Brendler of Stifel Nicolaus. Please go ahead.

Christopher Brendler - Stifel Nicolaus & Company,

All right. Thanks. Good afternoon. A couple of questions. A pretty large number of senior debt sales this quarter. Can you just talk about that and do you actually get that gain income when you sell those and where does that show up?

Ira J Wagner - Executive Vice President and Chief Operating Officer

Sure. This is Ira. Let me talk about the large volume of senior debt sales in the third quarter is indicative of the success of our ability to underwrite the senior debt and then syndicate is and sell it off to other investors. So we have been very successful in doing that both within our own buyouts as well as in the in the one stop financing deals that we do for other private equity firms. So our syndications desk in New York has been, we've been extremely good at structuring transactions that will fit the marketplace and then successfully syndicating that paper out to other investors and that almost billion dollars that you saw in the third quarter of senior debt sales is indicative of that. So its, really another example of where the middle market is different then the big LBO business where we've been able to do it quite successfully for our sized transactions as compared to the other people in the big LBO business that had to do much bigger numbers, to much larger numbers of investors. That’s been very difficult environment for them and we've been able to be very successful at it in our, for our middle market space.

John R. Erickson - Executive Vice President and Chief Financial Officer

Going into the accounting for that, there is a small portion that we generate or realize a gain because we have a, some portion of the loan fee is a discount fee of OID on that portion of the loan and see a little bit of realized gain from that portion. But the bulk of the income of the transaction would be, the portion of the loan fees that we actually keep in the syndication process, which would be fee income.

Christopher Brendler - Stifel Nicolaus & Company

Okay. And then Ira is that market still as robust as it was in the third quarter?

Ira J Wagner - Executive Vice President and Chief Operating Officer

No. as I've said earlier. It is off a little bit but its not off very much at all and it still is extremely robust and as Malon said with our market coverage with offices all over the country and all over the world. Our penetration into that market is very high. So it’s a very… remains, continues to be a very large fragmented marketplace even if it’s a little bit off from where it used to be. Even three months ago it is still a very robust with lots of transactions in the marketplace every quarter.

Christopher Brendler - Stifel Nicolaus & Company

And then. A couple of questions related to the CMBS business. In the CRE CDO that you did, do you think you could name all--?

Ira J Wagner - Executive Vice President and Chief Operating Officer

Perhaps I could. Before we move from that I would like to say one more thing about it. Think about this, we're virtually the only firm that syndicates senior assets, that is also investing in the equity of the same company and the sub debt of the same company and in fact holding some of that senior for some of our structured CDO vehicles that we're managing. So everybody else is trying to syndicate those assets are essentially saying I don’t want them. We're saying look we are fighting for you as an equity investor, a sub debt investor and as I, as a firm preparing to sue with you in that senior. And so we have far, there are far more people wanting to buy our senior assets in syndication that there is for other firms out there. We are the perfect firm syndicate senior. The perfect firm to syndicate senior. And keep in mind, if for any reason we can't syndicate it. If all of a sudden the world gets worse somehow and we can't syndicate it. Well we just in our balance sheet. You folks should be happy about that, if that happens you should be writing good things about it.

Christopher Brendler - Stifel Nicolaus & Company

I think it’s wonderful and that’s been a look for a long-time. You originated one stop and get rid of the lower end of the seniors, perfect.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes, we have made wonderful fees on that.

Christopher Brendler - Stifel Nicolaus & Company

Any sense of what those fees are?

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes, there’s a significant fee income from the underwriting to the syndication. It was significant. I think in ’06, it was 10. I would be something North of a 100 basis points on the total number on the senior debt.

John R. Erickson - Executive Vice President and Chief Financial Officer

Right

Christopher Brendler - Stifel Nicolaus & Company

Great. Thanks. On CMBS business can you just talk about what drove the realized loss and I’d like to know just you imagine that superior [inaudible] performance you're seeing in your portfolio but yet we're seeing a pretty heavy sell off in CMBS bonds especially [inaudible] I think about a 300 basis points riding the lower range traunches. How does that impact your thinking and how does it impact your perspective valuation of that portfolio ?

Ira J Wagner - Executive Vice President and Chief Operating Officer

Yes the realized loss Chris is related to the sell of the bonds in [inaudible] into the CDL so we sold [inaudible] loss on the sale based on the expected returns that we were putting on to the underlying retained pieces

Malon Wilkus - Chairman, President, and Chief Executive Officer

Yes and that we announced I guess in July. We did a transaction announced that it was a regular realized loss. I think in terms of the sell off in CMBS. We are an active CMBS investor and part of what we're doing is, I mean when we're looking at the required returns. We're an active buyer of CMBS investments and so we've been very close to the market. And in terms of our experience we saw the… we helped drive the spreads running after from April till August. Since then in terms of where we have been bidding and winning and losing deals we have a very good sense of where the current spreads are. Now, in terms of specific bonds and I don’t think you see a lot of the non-rated tranches out in the market. I think what you are seeing are probably BBB and maybe some BB and other parts of the capital structure so…

Malon Wilkus - Chairman, Chief Executive Officer, and President

Let me go at it another way. The tranches that we are investing in, in the CMBS is the last out of the equity tranche and it’s virtually not traded at all so you can’t look for trading Marks to the terms in the valuation there but we are making new investments and so are our competitors. There’s only a handful… we really only have a handful of competitors in that arena but we know, generally speaking some of the pricing that they are in investing at and so if spreads widen any existing set of CMBS that we have in our portfolio, will get appreciated, almost invariably. And not because we think there has been a change in the risk of with respect to our forecast of loss rates, but simply because the market is requiring a re-pricing… just as off interest rate change and a bond value has been changed. So, keep in mind, we intend to hold those equity stakes to their complete repayment, and those… that in many years and we think we have outstanding IRRs in those, great cash flows, it’s all cash… wonderful cash flowing, there is no non-cash income, there is no equity risk, the way you think of in other equities. So, this is… we think these are great assets, but they are subject to these periodic depreciation or appreciation. That will happen they will go up and down, but as we get closer and closer to their full maturity, they should counted… assuming our forecast on lost rates was correct they will come to zero and all we will have is our income and our income will should be in the mid to high teens. And so, we are with real with these opportunities, in fact, as spreads have widened, we just are happier and happier with this business, we think there is great opportunities there.

Christopher Brendler - Stifel Nicolaus & Company

It’s hard to say you don’t think of the commercial real estate--?

John R. Erickson - Executive Vice President and Chief Financial Officer

I am sorry going back to our data point. The non-rated in the single Bs, we bid on and loss transactions in September and October and we bid on one transactions and I think we are very good data where we think those spreads are clearing the market. And then going back to the double B, there is some is trading data on that and they actually I think widening down in August and we had some other trading days suggesting they maybe tightening up a little bit in September. But we do factor all that in due to our valuations and suffice to say that depending on what that data showing at December 31st, will impact where the markets on these go. But as Malon said we are a long-term investor, we are not holding these on our balance sheet to sell. And so, we would not look… we will not be converting those into a realized loss by selling them, so they may appreciate or depreciate based on where they are in December 31. But today you can assume they are providing very attractive returns for us in terms of new generating the earnings we want for our dividend.

Malon Wilkus - Chairman, Chief Executive Officer, and President

And keep in mind, these… since the cash flows still wonderfully, so steadily, and highly predictable, we can lever these assets, so the mid teens returns that we get on the gross assets we can leverage and really compound those returns. So, where we are we are very much appreciate our… one of the leading positions in the CMBS investing arena.

Christopher Brendler - Stifel Nicolaus & Company

Okay. Thanks.

Operator

Okay. Thank you. [Operator Instructions].

Malon Wilkus - Chairman, Chief Executive Officer, and President

Is there any other questions?

Operator

And the next question comes from the line of John Neff of William Blair. Please go ahead.

John Neff - William Blair & Company

Hi, thanks for taking the question. I’ll be quick. You mentioned in the press release that CMBS and CDOs are about 7% of your portfolio which is sort of around $770 million, the net depreciation on those looks like it was $54 million in Q3, which would be roughly a 7% decline in the value there. Am I thinking about that correctly and does that include CMBS assets sold to the CDO?

John R. Erickson - Executive Vice President and Chief Financial Officer

Now you also would add to that to realize loss that you had, and that would… I think the CDO transaction, it’s difficult to benchmark in terms of where that was with the NOI CMBS valuations. But that was one transaction, so then, I think if you look at the depreciation of the balance of the CMBS pool as a separate transaction and measure the depreciation you are looking at core based on what’s invested in the CMBS.

Malon Wilkus - Chairman, Chief Executive Officer, and President

Yes, John, to clarify that $27 million on the CDO transaction at the real estate. You would measure that against the $650 million of cost that we sold in, and then you would measure the remaining appreciation, depreciation or the value of the assets that we hold in the same CMBS and CDOs.

John Neff - William Blair & Company

All right. And then I just… little bit more clarification on the dividend policy, I just want to establish is this… you can talk about sort of building a reserve, are you intending to pay the dividend, pay long-term capital gains on a regular basis through the dividend? Or is it… you mentioned getting I think, Malon, three or four quarter kind of a reserve. Is that the intention and you don’t plan on playing long-term capital gains through the dividend only in the event of having to dip into that reserves that you would build up?

Malon Wilkus - Chairman, Chief Executive Officer, and President

We will be compelled to pay first with long-term capital gains. And it will be ordinary taxable income that we will spillover from year-to-year-to-year. And so, you will see our dividend composed more of long-term capital gains, but you need to pay attention to our total ordinary taxable… I am sorry… total taxable income, and you will see that, frankly, we could have paid it with… you will see I believe that we will… we could have paid that future dividend with ordinary taxable income or almost entirely with ordinary taxable income. But it will get reported has been paid from long-term capital gains to some extent and then ordinary taxable income to another extent. And we will try to keep you apprised of how much we are covering the dividend with realized earnings, just as we have been. I don’t… people don’t… they don’t see written very often, but we’ve dramatically covering the dividend with realized earnings and we don’t see that changing upping our growth rate, keep in mind, we grew 12% last year and we up it to 13%. So, we really haven’t up it very much from our prior growth rate, but we’ve… and you can just compare it to the return on equity. The realized return on equity is 16%. So, by definition, we are keeping 3%. If we have 16% return on equity through 2008, then by definition, we kept 3% return on equity as some… some form of retention, either ordinary taxable income or long-term capital gains.

John Neff - William Blair & Company

All right. Thank you very much.

Malon Wilkus - Chairman, Chief Executive Officer, and President

And then just as I said before, we will get to a point where we can’t bank any more ordinary income and we will be compelled to pay at all out. But since we have so much bank, it will be like four quarters banked, we will be able… even if there is a slowing down of our dividend growth, we will be able to… even that out very nicely because we have so much in reserve.

John R. Erickson - Executive Vice President and Chief Financial Officer

We should just take one last question as we work for more than an hour and a half.

Operator

Okay. Thank you. And our last question comes from the line of Joseph Nickerson of [inaudible] Partners. Please go ahead.

Unidentified Analyst

Hi, gentlemen. Thank you for taking my call. I was just wondering what kind of growth rate we can assume in now… in 2008.

Malon Wilkus - Chairman, Chief Executive Officer, and President

While we are not… we haven’t forecast that and I don’t… we certainly are not going to do at top of our heads now. But we… and keep in mind, the… one of the reasons we had some such outstanding growth in our NAV in the past is because the underlying assets have performed so well and we’ve not paid out as much dividend as our return on equity. Our return on equity not… it’s the bottom line return on equity has been 20% some. 21%, I think in the last 12 months… 24% last 12 months, but it’s been 21% last five years I believe. So, if we continue at those level and our assets have been performing at those levels for a long, long time for 10 years now, we should continue to grow the NAV as well as achieved this very high dividend payout.

John R. Erickson - Executive Vice President and Chief Financial Officer

We typically do our guidance in February of the year, that’s when we put the ’07 NAV guidance. So, if we decide to do NAV guidance for ’08, that’s when you can expect to see it.

Unidentified Analyst

Okay. All right. I guess, I was just a little bit concern because it seems like if I look at this quarter, it was about 2% decline quarter-over-quarter. And if I look at the mid point of your estimate for Q4, it’s another 2% decline since. I presume that’s not the run rate that you are assuming for the full year next year.

John R. Erickson - Executive Vice President and Chief Financial Officer

I think the estimate, we have out there has room to appreciate or depreciate. And so, we have got plus or minus and you should not be assuming that we are looking at it a decline rate on NAV.

Malon Wilkus - Chairman, Chief Executive Officer, and President

And I think we have done it. I think, hope, we’ve made this point clear. There are things simply out of our control, which orderly out of control that could cause depreciation to our assets. You saw that at European Capital, totally out of our control, but it is a good investment on our part. We are making very great… new wonderful dividends also of our investments, European Capital. We think ultimately, it will trade at a premium to book… at a nice premium to book as investors get… to enjoy those dividends and continue to grow. And the same we have say CMBS another asset as well. Their interest rate change and you will see some changes in depreciation or appreciation. That is out of our control, and so, we are… we can’t easily predict NAV. But our dividend is, I think keep in mind, we have always growing our dividend and it’s been a best indicator of all of how our underlying assets have been performing.

Unidentified Analyst

Okay.

Malon Wilkus - Chairman, Chief Executive Officer, and President

By the way if you look at that chart about historical performances, you can see about five years we had a 20.1% return on equity.

Malon Wilkus - Chairman, Chief Executive Officer, and President

All right. Thanks everybody. This has been a good call. We appreciate you taking all this time to listen to how we did for the quarter and what we are thinking about the future. And we will talk again with you about three months from now. Take care now.

Operator

Okay. And ladies and gentlemen, this conference will be made available for replay after 9:30 PM Eastern Time today until Wednesday, November 14th at mid night. You may access the AT&T Executive playback service at any time by dialing 1-800-475-6701, entering the access code 889559. International participants dial 1-320-365-3844. And again, that access code is 889559.

And that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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Source: American Capital Strategies Ltd. Q3 2007 Earnings Call Transcript
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