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Allied Capital Corporation (ALD)

Q3 2007 Earnings Call

November 7, 2007, 8:30 AM ET

Executives

William L. Walton - Chairman and CEO

Dale Lynch - Director, IR

Joan M. Sweeney - COO

Penni F. Roll - CFO

Michael J. Grisius - Managing Director

Robert D. Long - Managing Director

Analysts

Sanjay Sakhrani - Keefe, Bruyette & Woods

Henry Coffey - Ferris, Baker Watts

Scott Valentin - Friedman, Billings, Ramsey

Vernon Plack - BB&T Capital Market

Presentation

Operator

Good morning. My name is Julie and I will be your conference operator today. At this time, I would like to welcome everyone to the Allied Capital Third Quarter 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you.

I will now turn the call over to Mr. William Walton. Sir, you may begin your conference.

William L. Walton - Chairman and Chief Executive Officer

Great, thank you, Julie. Good morning everyone and welcome Allied Capital’s third quarter 2007 conference call. I am joined today by Joan Sweeney, our Chief Operating Officer; Penni Roll, our Chief Financial Officer; Dale Lynch, our Director of Investor Relations; and we also have with us Mike Grisius and Rob Long, Managing Directors in our Private Finance Group.

Dale, would you open the discussion today with the required conference call information and a discussion about forward-looking statements.

Dale Lynch - Director, Investor Relations

Sure, thanks, Bill. Today's call is being recorded and webcast live through our website at www.alliedcapital.com. An archive of today as webcast will also be available on our website as will an audio replay of the conference call. Replay information is included in our press release today and is posted on our website. Please note this call is the property of Allied Capital. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

And I would also like to call your attention to the customary safe harbor disclosure in our press release today regarding forward-looking informing. Today's conference call includes forward-looking statements and projections and we ask you that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings please visit our website or call investor relations at 888-253-0512.

For today's conference call, we provided a companion slide that complements our discussion and lays out many of the numbers we will discuss. These slides are available in the presentations and reports section of the investor resources portion of our website. We'll make reference to these slides throughout the call. Finally, as always there will be Q&A after the presentation.

With that I will turn it back to Bill.

William L. Walton - Chairman and Chief Executive Officer

Thank you, Dale. Our results for the third quarter of 2007 were mixed. On the one hand, the third quarter was one of the best capital gain quarters in our history with $212 million of net realized gains, net investment income, and net realized gains together totaling $231 million or approximately $1.49 a share. On the other hand, we recorded unrealized depreciation in the portfolio of $149 million or $0.96 per share, excluding the effect of exit reversals. And therefore, overall, we reported a net loss for the quarter.

The primary reason for the increased level of unrealized depreciation in the portfolio of this quarter was due to some changes we are making in our portfolio company, Business Loan Express. After an extensive evaluation of strategic alternatives for BLX, we have concluded that it needs to make a shift in its business emphasis to focus on conventional small business loans and small commercial real estate loans. BLX will significantly de-emphasize government guarantees lending going forward. We believe that the difficulties BLX is experiencing in government guaranteed lending has made that portion of its business too capital intensive.

It’s with mixed emotion that we made this decision. We remain a big supporter of the mission of the small business administration and of the program, and we commend Bob Tannenhauser for his hard work and commitment to building American small businesses and promoting the social goals of the small business administrations programs. This decision was taken mainly because BLX cost structure and capital requirements have become sub optimal.

The strategy shift is significant and we expect that BLX will reduce loan origination volumes by about 30% in the sort-term. Consequently, we wrote BLX down by $84 million this quarter largely because of this repositioning. We expect that volumes and value will rebuild over time, but through a different product mix. To affect this change in strategy Bob Tannenhauser, BLX’s current CEO, will take on the role of Chairman for an interim period and John Scheurer who has successfully built two commercial mortgage loan investment businesses for Allied Capital will step into the role of interim CEO.

Just to remind you, John’s first major role at Allied Capital was as President of our publicly traded Allied Capital Commercial Corporation, a commercial mortgage REIT. Afterwards, John also recommended that we get into the CMBS investing in the fall of 1998 when debt capital markets collapsed. We exited as you might recollect the business in 2005 when we believe that spreads and sub-ordination levels have become unattractive. We made an internal rate of return of over that 24% on our CMBS investment and realized gain of about $228 million when we sold the portfolio, thanks to John.

We believe that there is significant opportunities to build and grow BLX as a conventional small business and commercial real estate vendor. John is actively working to add commercial mortgage industry veterans to expand BLX’s commercial real estate platform. We think John is the right guy to lead BLX through this change in strategy and we have the requisite resources to support the company through this transition.

It is important to note that unrealized depreciation is just that. In many cases, this depreciation results from changes in current market multiples, particularly in the financial services sector or from portfolio company circumstances that are not significant business model issues. For those assets where we need to affect change to increase value like BLX or Hot Stuff Foods, which has been hit by rising food costs and higher gasoline prices, we believe that we are already implementing the necessary strategies.

Now, let me turn the discussion to the private equity market in the third quarter. Private equity and related debt markets remain influx, while we are starting to see better terms in pricing, our third quarter deal flow reflected the fact that many transactions were structured pre-correction, and quite frankly were not all that attractive. We invested $560 million in private financed assets during the quarter, which was more than the second quarter, but given our talented resources, we are capable of investing far more. If terms in pricing continue to improve, we intend to increase the origination volumes accordingly.

As Rob will discuss later in the call some of today’s best investments are in the senior loan market where the supply and demand imbalance is greatest. We have seen a number of investment opportunities in what we call stranded CLO vehicles where the assets and managers are strong, but the capital markets are preparing the completions of their financings.

Another area that looks promising is providing one stop debt financing of companies with EBITDA between $15 million to $50 million. To serve this market, we are partnering with GE Commercial Finance to create a $3.6 billion unitranche fund that is scheduled the launch in the fourth quarter. This fund will focus on unitranche facilities for these larger companies that we believe this fund will provide a one stop financing solution that will meet a big market need. We believe that this fund has a lot of potential and we look forward to working with GE in this important endeavor. The addition of this fund will add to our region of middle market financing and will increase our assets under management.

Obviously, reporting a net loss in the third quarter is not great news. Nevertheless, we believe that the quarter was productive on many fronts. We made some very good new investments, we have repositioned BLX to what we hope will be substantial future growth. Credit spreads and acquisition multiples are improving, and we are encouraged by prospects for the unitranche fund. Most importantly, we have already realized significant gains this year and combined with the net investment and common spillover income we have, we believe dividend visibility is good.

Now, Joan, will you take us through the third quarter results in detail?

Joan M. Sweeney - Chief Operating Officer

Thanks Bill. Let’s start the discussion with a review of the September 30, 2007, balance sheet. Please turn to our summary balance sheet, which is on slide three of the companion deck.

We ended the quarter with total assets of $4.9 billion, total debt of $1.9 billion, and total shareholder’s equities of $2.8 billion. We invested $577.5 million in the quarter. We also had a number of portfolio exits during the quarter. After exits and net valuation changes, our portfolio was valued at $4.3 billion as of September 30, 2007, as compared to $4.5 billion at June 30, 2007. The yield on our interest-bearing portfolio at September 30, 2007, was 11.9%, up from 11.6% at June 30, 2007. We closed the quarter with cash and money market investment, including our liquidity portfolio of $306 million. At the end of the quarter, we had $859 million available under our revolving line of credit. As you can see, we expect to have ample liquidity for new investments as they move into the fourth quarter.

At September 30, 2007, our debt to equity ratio was 0.7:1. However, if you adjust for the liquidity portfolio and cash and investments in money market securities, our debt to equity ratio was 0.58:1. Because of our portfolio exit activity and the substantial net realized gains we experienced, it is important to note that we ended the quarter with undistributed earnings of $606 million, up from $476 million at the end of the second quarter. However, as we realized gains, the unrealized appreciation associated with those gains is reversed. In addition, we experienced unrealized depreciation in the portfolio this quarter. Overall, the balance of net unrealized depreciation in the portfolio increased to $395.2 million at September 30, 2007, up from $68.1 million at June 30, 2007. Penni will discuss the net changes in appreciation and depreciation later on the call.

Now let’s move to a discussion of our earnings. For this discussion, please turn to slide four. Interest and dividend income for the quarter end of September 30, 2007, was $105.7 million that’s compared to $102.8 million in the second quarter of 2007. Fees and other income was $12.7 million for the quarter, that’s compared to $14.9 million in the second quarter. This quarter’s fees and other income included fees associated with new investment origination activity of $7.3 million, fees from portfolio companies were $5.2 million, and prepayment premium of $0.1 million. Prepayment premium were $3.3 million lower in the third quarter than in the second quarter.

Total operating expenses were $88.9 million in the third quarter of 2007 as compared to $87 million in the second quarter and $69.1 million in the first quarter of 2007.

I want to walk through certain expense items on slide five where we have provided an analysis of the year-to-date operating expenses. Interest expense was $33.7 million for the third quarter of 2007, which was fairly level with the $34.3 million expense for the second quarter as it would be expected considering our level of outstanding debt was similar for those quarters. You will recall that in the second quarter of 2007, we experienced a $2.4 million expense associated with the mark-to-market component of our individual performance award or IPA and stock option expense. The IPA mark-to-market component, which caused second quarter expenses to be higher than expected actually was a benefit in the third quarter of $2 million resulting from stock price appreciation. Therefore, the IPA mark-to-market resulted in $4.4 million non-cash decrease in expense from the second to the third quarter.

Also in the third quarter, employee stock option expense returned to a more normal level of $3.9 million as compared to the unusual expenses we saw in the second quarter. These expense reductions, however, were offset by an accounting entry we were required to make associated with the tender offer that was completed in July. Under the tender offer a $10.3 million invested in the money options were cancelled in exchange for an option cancellation payment. The total option cancellation payment was $105.6 million, of which $52.8 million were paid in cash and $52.8 million was paid through the issuance of 1.7 million unregistered shares of the Company’s common stock.

The cash component of the payment of $52.8 million reduced our NAV, but the stock portion of the payment has no effect on NAV. Because the weighted average market price at the commencement of the tender offer on June 20, 2007, was higher than the market price of our stock at the close of the offer on July 18, we needed to record an accounting expense under FAS 123R of $14.4 million with the corresponding increase to additional paid in capital. This expense did not result in any increase in the consideration to participate in the tender offer and had no effect on our net asset value as the expense was offset by an increase to paid in capital. The accounting expense, however, increased our employee stock option expense and operating expenses, thereby decreasing our net investment income by $14.4 million or $0.09 per share.

And the expected administrative expenses were lower in the third quarter. The second quarter included a one-time expense of $2.5 million in placement and other fees paid to raise the senior debt fund. Income tax expense increased significantly during the quarter, primarily due to excise taxes, which increased by $5 million or $0.03 per share in the third quarter as compared to the second quarter. As I noted earlier, we had significant exits and gains this quarter. As a result excise taxes increased.

So, looking at our expenses for the quarter, overall, you can see that the option cancellation expense and excise taxes caused expenses to increase by $19.4 million or $0.12 per share. The increase in the item was partially offset, however, by the sum decrease IPA mark-to-market expense and stock option expense and the absence of one-time senior debt fund expenses, which totaled $12.5 million or $0.08 per share. After the changes in these expense items, our core operating expense have remained fairly constant throughout the first three quarters of the year. Net realized gains for the quarter were $212.4 million or $1.37 per share. Gross gains totaled $275.8 million for the quarter, while gross losses were $63.4 million.

On slide six, we have broken down our year-to-date net realized gain activity. As we mentioned before 2007 has been a great time to be a seller of investments. Our portfolio companies have continued to attract the interest of buyers and we have capitalized on the vibrant market and the purchase rate multiples we have been able to achieve. Year-to-date 2007, we have seen realized gains of $396.4 million and realized losses of $81.5 million for total net realized gains of $314.9 million.

Now, let’s go back to the income summary on slide four. Net investment income and net realized gains totaled $230.7 million for the third quarter of 2007 or $1.49 per share. For the nine months ended September 30, our net investment income and net realized gains totaled $397.9 million or $2.57 per share. Net unrealized depreciation for the third quarter totaled $327.2 million or $2.11 per share as we exited and realized net gains as well as experienced depreciation in the portfolio. Penni will provide more information on the components of this number in a moment. As you can see our net investment income and net realize gains for the quarter were strong and it was the changes in the valuation in the portfolio that causes to experience an overall loss of $96.5 million or $0.62 per share.

Please turn to slide seven to walk through the changes in NAV. At the end of the third quarter, our net asset value per share was $17.90, a decrease of $1.22 per share since December 31, 2006. For the nine months ended September 30, 2007, net investment income plus net realized gain increased NAV by $2.57 per share, while dividend paid shareholder to decrease NAV by a $1.92 per share. So, our net investment income and net realized gains have more than supported our current level of dividends. However, NAV decreased by a $1.57 per share as a result of reversal associated with exit, and by $0.19 per share due to net unrealized depreciation in the portfolio.

In addition, the cash portions of the option cancellation payment of $52.8 million decrease NAV by $0.34 per share. Capital share transaction increased NAV by $0.23 per share. As we exit from portfolio investment and as the portfolio changes in value, NAV will continue to vary from quarter-to-quarter.

With that I’ll turn the discussion back to Bill.

William L. Walton - Chairman and Chief Executive Officer

Thank you. Penni, would you walk us through results of our valuation process and portfolio quality statistics and want you to give us an update on status of our spillover income?

Penni F. Roll - Chief Financial Officer

Thanks, Bill. First, let me discuss the changes in the value in the portfolio, and for this discussion please turn to page to nine in the slide deck.

For the quarter ended September 30, 2007, net change and unrealized appreciation or depreciation was a decrease of $149.1 million. The reversal of previously recorded unrealized appreciation associated with the realization of gains totaled $243.9 million. The reversal previously recorded unrealized depreciation associated with the realization of losses totaled $65.8 million. As we have routinely said changes in values can vary substantially from quarter-to-quarter. Therefore, quarterly comparisons may not be meaningful. Excluding the effects of reversal due to the gains and losses, we have recorded net unreleased depreciation of only $29.3 million for the nine months ended September 30, 2007.

Our investments and financial services companies and our CLO/CDO investments contributed to most of the $149.1 million depreciation in the third quarter. Net unrealized depreciation for financial services investments totaled $127.4 million In addition, most of our net unrealized depreciation came from equity investments as opposed to debt investments. As I’ll discuss in a moment, the overall credit quality of our portfolio remains good.

In the financial services sector, the largest contributor to deprecation was our investment in BLX, which we’ve reduced in value by $84.1 million this quarter. Under its new business plan, BLX intends to reduce its annual loan origination volume by about 30% in the next fiscal year, and then over time, it plans to rebuild its loan origination volume in conventional and commercial real estate loans

The inherit risk and repositioning the business combine with the reduction and loan origination volume in the projection period used to value BLX, resulted in a decrease in the value of our investment. In addition, the value is negatively impacted by a reduction in the value of residual interest and a net book value of the Company. The BLX remains on non-accrual status, its value has been written down to $136.7 million. It is only a nominal contributor to our net investment income and only 2.8% of our assets at September 30.

Turning now to slide 10, you can see that in the third quarter, 49 private finance investments experienced the unrealized appreciation in value and 50 private finance investments experienced unrealized depreciation in value. Nine investments represent about 80% of the appreciation and eight investments represent about 80% of the depreciation.

Let’s move on now to slide 11 and the valuation process. We continue to receive third party evaluation assistance for our private finance portfolio this quarter. We receive third party assistance for 92.1% of the portfolio for the third quarter of 2007. Other remaining 7.9% of the portfolio, 7.2% represented deals closed during the third quarter. You will be able to review the changes in portfolio evaluation in more detail in our third quarter Form 10-Q.

Now, turning to slide 12, you can see that this quarter’s realized gains have added to our impressive realized gain track record. We have harvested $1.9 billion in gross realized gains since the merger of the five Allied Capital companies in December 1997. Net of the $427 million in gross realized losses during that period, we have earned $1.4 billion in that realized gains.

Now, let’s turn to slide 13 and discuss portfolio quality. At September 30, workout assets graded 4 and 5 totaled $142.9 million or 3.3% of the total portfolio value as compared to $177.5 million or 4% at June 30. Loans and debt securities not accruing interest totaled $250.1 million or 5.8% of the portfolio value at September 30, as compared to $298.1 million or 6.7% of the portfolio value at June 30 2007. Our credit quality continues to be stable and within historical ranges.

I would like to move now to a discussion of our taxable earnings and spillover income. We have now paid or declared all 2007 dividends, including a declared fourth quarter dividend of $0.65 per share and an extra cash dividend of $0.07 per share. Almost all of 2007 dividends will be paid from 2006 taxable income. Thus, substantially all of our taxable income earned in 2007 will spillover into 2008 dividend payments. For the nine months ended September 30, 2007, net investment income and net realized gains totaled about $400 million and these two items are the primary components of our taxable income. In addition to spillover taxable income, we have an estimated $222 million in deferred taxable income resulting from installment sale gains. These gains maybe deferred for tax purposes until the installment notes are sold or collected in cash.

I want to point out that we experienced numerous temporary and permanent differences in the recognition of book and taxable income and as a result today our tax undistributed earnings exceed our book undistributed earnings. I encourage you to read our tax disclosure in our 2006 Form 10-K and our third quarter Form 10-Q for a more detailed discussion of our taxable earnings.

And with that I will turn things back to Bill.

William L. Walton - Chairman and Chief Executive Officer

Thank you, Penni. Now Mike and Rob, would you give us an update on middle market investing climate and what we did in the third quarter?

Michael J. Grisius - Managing Director

Sure Bill. First, let me summarize this quarter’s investment activity and then I am going to provide you with some market color. Later I will pass it on to Rob to expand on the market discussion and our view going forward.

Please turn to slide 14. We invested $577.5 million in the third quarter of 2007 and had principal collections related to repayments or sales of $351.1 million.

Turning to slide 15, you will see that we continue the balanced approach to investing in the third quarter with our emphasis on making investments where we can lend money and generate current interest income. During the quarter, we originated senior loans of $151.5 million, unitranche debt of $47 million and subordinated debt of $247.5 million. We made new equity investments of $130.1 million.

Our weighted average yield on senior debt was 11%, while our weighted average yield on subordinated debt investments was 12.8% in the third quarter as compared to 10.3% for senior and 12.6% for sub-debt in the second quarter. The unitranche investments we originated in the third quarter yield at 11%, that’s compared to 10.6% for the second quarter. We are seeing more interest in both mezzanine and unitranche debts securities as the debt capital markets contract.

Looking at our business from a different perspective, capital invested in debt investments and minority equity co-investments totaled $376.2 million and capital invested in buyout investments totaled $199.9 million. In terms of security type, we invested $446 million of debt and $130.1 million in equity for a 77%… 23% mix.

Let me talk a little bit about the nature of some of our new investments this quarter. Our biggest investment for the quarter was $94.1 million to support the management lead recapitalization of Higginbotham & Associates. Higginbotham is a leading middle market insurance brokerage and risk management firm with more than 300 regional and national carrier partnerships. Our investments include senior and subordinated debt as well as non-voting common equity.

Also during the third quarter, we completed the buyout of Worldwide Express Inc. for $15.7 million. Worldwide Express is a leading reseller in the U.S. of DHL Express and ground shipping services to the small and medium sized business market. Our investment took the form of subordinated debt and equity. We also made some significant debt investments this quarter including $41.4 million to support the buyout of CK Franchising Inc. or Comfort Keepers, a leading franchisor in the non-medical, In-Home care market for seniors and other adults needing care. And $30 million to support the buyout of Bojangles', the nation’s sixth largest chain of chicken quick service restaurants with 145 owned and 241 franchised units.

Please turn now to slide 16. Through September 30, we have reduced potential deal flow of approximately $67 billion and new investments have totaled $1.2 billion. We have closed approximately 1% to 2% of what we have seen so far in 2007, a decrease from approximately 3% close rate in the past few years. We have remained very selective during a time where the markets have been very aggressive. When we talked to you last, we believe that we are entering a period where deal opportunities would be more rationally structured and priced and where Allied Capital’s strong balance sheet would enable us to capitalize on a weaker debt market. The middle market financing space has remained fairly competitive but we are seeing better structures and pricing. Nonetheless the environment for middle market deals in the third quarter remained somewhat unsettled we saw many deals that were originated pre correction and as a result did not look all that attractive from a debt or equity perspective.

And in addition as you can see in slide 18, the purchase price multiples for deals closed in the third quarter were at an all time high. This makes sense when you consider that these deals were most likely price pre correction. We are starting to see better leverage levels and better debt pricing but a correction in purchase price multiples may take some more time.

Let me turn the discussion over to Rob to expand on the market and our business review.

Robert D. Long - Managing Director

Thanks, Mike. To follow up on Mike and Bill’s comments the third quarter offered some good and some not so good investment opportunities but the market we see emerging does appear to be a better market for us. Leverage on new deals, deals that have been negotiated since July has come down and pricing on senior debt has improved by as much as 75 basis points to 100 basis points. In addition structural deal terms have improved, particularly covenants. So-called covenant light deals, which we don’t do are no longer a competitive factor for us. Secondly debt is less plentiful due to the sharp pull back of the syndicated loan market since August and subordinated debt opportunities are increasing. Subordinated debt pricing has remained relatively unchanged but what has changed is that there are more mezzanine opportunities to pursue. Consistent with a more sober credit environment we are currently seeing a greater number of attractive opportunities than we did in the first half of 2007.

As Mike reviewed earlier our investment pace increased in the third quarter and our current pipeline is full. We are also seeing a number of attractive opportunities to finance standard structured loan portfolios at attractive yields of as much as 20% for the junior tranches. The credit quality of these pools is good and the managers are experienced. We have also taken this market opportunity to form a private fund with GE Commercial finance to provide larger unitranche financings. The reduced liquidity in the market for syndicated loans has increased the attractiveness of the unitranche product, which offers greater certainty of execution for borrowers. We expect this fund will be launched in the fourth quarter and is planned to have $3.6 billion of capital commitments. Allied Capital will provide a commitment of approximately $500 million of the junior capital to the fund. The fund will be jointly managed by Allied Capital and GE, GE is obviously a key player in the middle market debt space and we are delighted to have the opportunity to invest in and co-manage this fund with such an impressive partner. We will provide more information on the fund when it is formally launched.

To summarize, as an investor we see that conditions have improved in the middle markets through our own investment activity and through investments in managed funds such as the Allied Capital Senior Debt Fund and the New Unit Tranche fund. We will continue to build our portfolio with investments that generate attractive returns. And with that I will turn it back to you Bill.

William L. Walton - Chairman and Chief Executive Officer

Thanks Rob. Before we open the line for questions let’s review the dividend for the remainder of 2007. We disclaimed the fourth quarter dividend already at $0.65 per share and an extra cash dividend for 2007 of $0.07 per share. Since as Penni mentioned substantially all 2007 dividends were paid from 2006 taxable income, we have good visibility as per the composition of these dividends. We estimate that 70% of the 2007 dividend will come from capital gains income, but the remaining 30% expected to be tax sales ordinary income.

Let me summarize a few takeaways from today’s call. First the portfolio has generated significant net investment income and net realized gains. We have substantial undistributed earnings for future dividend payments. Second, while we recorded roughly 3.5% unrealized portfolio depreciation in this quarter we believe that as we execute uncertain turnaround strategies we will see improvements in values of these depreciated assets.

Finally, as Rob and Mike talked about middle market private equity structures and prices are improving. In addition, in keeping with our innovative opportunistic business model we have created new products to adapt to changing markets such as the new unitranche fund.

Julie, can we now open the line for questions?

Question and Answer

Operator

[Operator Instructions]. We will pause for just a moment to compile the Q&A roster. The first question comes from the line of Sanjay Sakhrani with KBW.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Hi, thanks. Penni mentioned that a lot of the depreciation came from the equity investments, could you maybe elaborate just on the additional $65 million of depreciation you guys saw so, aside from BLX?

Penni F. Roll - Chief Financial Officer

Sanjay, it’s Penni. We’re going to have more detailed discussion in the 10-Q as you know, we list all of our investments by portfolio company. So you’ll get a chance there to see the individual companies that experienced additional depreciation. But if you look at the equity depreciation, the bulk of it … you think about our companies where we have an enterprise value, valuation methodology you want to follow the value to the debt and then to the equity given our buyout portfolio and the equity positions we have, it seems to make sense that you’d see more movement in the equity layer of the capital structures.

Sanjay Sakhrani - Keefe, Bruyette & Woods

So is it mainly just sort of function of multiples coming down?

Penni F. Roll - Chief Financial Officer

It’s a combination of multiples coming down and an addition to the ones we specifically talked about some more portfolio companies specific depreciation like with BLX.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Okay. All right. Great. And just if we sort of think into next year, I mean how should we think about the mix of investments and maybe just balance your growth. I know it’s sort of looking ahead but just any indication will help.

William L. Walton - Chairman and Chief Executive Officer

Well I think… it’s going to be an interesting question about balance sheet growth. We’re very optimistic about the unitranche fund. We think this is going to fill a fairly significant hole in the market. And so our piece of that is about $500 million and we hope to deploy that pretty rapidly and that piece of paper has very attractive yields. We hope if it goes through as projected and then I think, we’re also hopeful that we’ll continue to see some downward movement in acquisition multiples, so we want to be active in the buyout business. And with debt pricing and structures improving, we think that might be attractive on balance sheet. So we’re cautiously optimistic that we should see some significant balance sheet growth during 2008.

William L. Walton - Chairman and Chief Executive Officer

I might add that in the last five months our pipeline of deal flow has been running about 25% ahead of the year earlier period. So if you look at us over the last seven quarters. You will see that the first half of ’07 was about the slowest period for new assets because that was the worst time in the market to be adding assets. Now that the market has re-priced we are not surprisingly seeing a nice increase in flow. So I think we feel good about next year’s asset growth.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Okay, just I mean, and just final question on this unitranche fund, I mean how would the structuring work? I mean you guys would collect a fee and carried interest or how would about structure? So work in terms of how it would translate into income statement?

William L. Walton - Chairman and Chief Executive Officer

Sure, it’s structured not unlike a CLO and if there is a junior capital that receives the flow through of excess cash flow from more senior securities. So as we ramp up the assets in the fund there will be more excess cash flow to distribute to the junior equity securities. And as you think about it, it’s something that will probably also resemble the COO junior notes as far as the return profile.

William L. Walton - Chairman and Chief Executive Officer

Our investment is in the junior notes. So the current return that will get off that investment is substantially higher than what we get off our standard unit tranche product that we put… that we have out today.

Joan M. Sweeney - Chief Operating Officer

In addition to that we anticipate we will receive the management fee as well for co-managing the fund with GE.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Okay and GE contributing a like amount?

William L. Walton - Chairman and Chief Executive Officer

Like not so it’s still up in the air.

Michael J. Grisius - Managing Director

Their focus is more on the senior debt side of the balance sheet here so our focus is more on the junior securities and their focus is more on the senior securities.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Okay I got it. Right, thank you.

Operator

Your next question comes from Henry Coffey with Ferris, Baker Watts.

Henry Coffey - Ferris, Baker Watts

Yes. Good morning. Couple of questions here, the… I got the information on BLX. How much did you have to write down your own CDO/CLO preferred… the preferred and the subordinated notes that you hold.

William L. Walton - Chairman and Chief Executive Officer

Annie is working at the Q.

Michael J. Grisius - Managing Director

Which hasn’t been published yet.

Joan M. Sweeney - Chief Operating Officer

Bear with us on that Henry…

Henry Coffey - Ferris, Baker Watts

Let me jus ask a couple of other questions. In terms of unscrambling the numbers this slide you provided here extremely helpful. Most… just to kind of summarize most of the employee stock option expense items are all non-cash to begin with and not include in taxable earnings.

Joan M. Sweeney - Chief Operating Officer

Well it’s interesting. From a GAAP perspective stock option expense comes in accordance with that B 123R.

Henry Coffey - Ferris, Baker Watts

Right.

Joan M. Sweeney - Chief Operating Officer

Tax perspective. The tax deduction occurs when the stock option is actually exercised but that’s limited under section 62M of the code so not all of the stock option expense or sorry I guess I should say some of the stock option expense never runs through the tax earnings because it can’t, it’s not allowed to be deducted.

Henry Coffey - Ferris, Baker Watts

If we were to throw GAAP out of the window which is hoping I would be happy to sponsor, Joan would it be fair to… looking at your operating earnings to exclude the excise tax as well as some of the other stock option expense and then what about the IPA charges?

Joan M. Sweeney - Chief Operating Officer

The IPA charges again are really, very, there’s lot of noise because of the market value of the stock.

Henry Coffey - Ferris, Baker Watts

Right, right.

Joan M. Sweeney - Chief Operating Officer

Income statement so that’s why on the slide we broke out IPA expense as it is and then we have the mark-to-market separately because the expense as it is real legitimate sense we are making a cash contribution to a trust and the trust is buying shares at Allied Capital’s expense so I think you got to count that expense but the mark-to-market change is a… very volatile and moves around and it’s non-cash. For the excise tax that’s clearly a cash expense but…

Henry Coffey - Ferris, Baker Watts

It’s not tied to operating results.

Joan M. Sweeney - Chief Operating Officer

But it’s not tied to operating… yes, net investment income in most of that comes from the fact that we have generated so much net realized gains that’s increasing our tax burden because we are not paying those out in the year, we are paying them out by the time tax return is filled by the following year.

Penni F. Roll - Chief Financial Officer

But that is a non-deductible excise tax is paid. So we do not get a tax deduction for that.

Henry Coffey - Ferris, Baker Watts

Yes. And where as the tax is $2.2 million and expense is legitimate, a deduction of operating expenses.

Penni F. Roll - Chief Financial Officer

It is. But like with any deferred compensation plans. The deduction, you take, is actually taken when the assets are distributed out of plan. So, there is a timing difference related to that.

Henry Coffey - Ferris, Baker Watts

I’m looking at the both at the line item below the excise tax.

Penni F. Roll - Chief Financial Officer

Okay. Right, excise tax

Henry Coffey - Ferris, Baker Watts

That’s tied some of your operating subs.

Penni F. Roll - Chief Financial Officer

Yes. That’s tied what happens going on at AC Corporation which is a taxable C Crop.

Henry Coffey - Ferris, Baker Watts

Okay. That is right. And the mark-to-market on the Callidus subordinates.

Penni F. Roll - Chief Financial Officer

I’ll come back to that. So…

Henry Coffey - Ferris, Baker Watts

I’ll get… I can dig that out your Q comes up pretty soon, I assume.

Penni F. Roll - Chief Financial Officer

No. I have the numbers right here, not a problem. So, moving to just evaluation of our Callidus CLO, CDO investments for the quarter. We mark those down at $5.9 million for the quarter. The market yields we use to value those preferred share income notes which is more of the equity components of those investments was 20% to 21% for the quarter with the exception one of the notes where we used as market yield of 15.9% because of the characteristics of that specific insurance. So, the market yield did go up and as the result the value of those investments declined for the quarter.

William L. Walton - Chairman and Chief Executive Officer

Let me elaborate on that. All of the collateral in the CLOs are corporate debt securities. There are mortgages and no commercial mortgage securities. It’s all corporate debt securities. But it is important to note that if you go back before the re-correction of the market 15% was the typical yield of this type of an instrument and as Penni said, we now mark them as if there was 20% yield. But in fact, our performance has been up significantly above plan for the preponderance of our funds and in fact you will see the Q that we have a current number of 0.2% of all the assets are in a default condition and the traditional CLO map uses 2% annual default rate. So, our default experience has been quite extraordinary. And as a result, the yields on these are above their regionally expected yield. So that…

Henry Coffey - Ferris, Baker Watts

Maybe the interest income coming in?

William L. Walton - Chairman and Chief Executive Officer

Correct. So write-down is not as big as you would think because the interest income off of this vehicle is ahead of plan.

Henry Coffey - Ferris, Baker Watts

And what was the number Penni on… I can’t calculate it.

Penni F. Roll - Chief Financial Officer

The write-down for the quarter?

Henry Coffey - Ferris, Baker Watts

Yes.

Penni F. Roll - Chief Financial Officer

$5.9 million.

Henry Coffey - Ferris, Baker Watts

So, that was much less than we would have thought because of what you are saying that the incoming in is stronger.

William L. Walton - Chairman and Chief Executive Officer

Correct.

Henry Coffey - Ferris, Baker Watts

And then finally, I am assuming do have… if you were looking at liquidating BLX and simply selling all the assets, how would that compare to your carrying value.

William L. Walton - Chairman and Chief Executive Officer

Well, I think, I think we have got it marked with the place where we think it’s…

Penni F. Roll - Chief Financial Officer

What we would get on the current sale.

William L. Walton - Chairman and Chief Executive Officer

Yes what we would get on the current sale. So… and I think that the thing that is interesting about BLX is we have had this real estate investing capabilities and John Scheurer’s team. And we have had this asset that has been under exploited since we sold to CMBS portfolio and it wasn’t real to attract… get back into the business we all had some non-compete issues, and it just sort of dawned on us why don't we just focus on doing this through BLX as a much simpler business supposed to be in and something we know really well and John has extensive relationships in the industry to bring to the table, but remember BLX has also got a terrific origination platform and a lot of terrific people that are already out there doing deals, and I have got a significant pipeline of conventional real estates that we think is very attractive. And so it really became a question for us to just, what’s a simpler business for us to be in and that’s the reason we took the decision.

Henry Coffey - Ferris, Baker Watts

Well it makes a lot of sense and the information you are giving here its helping us to kind of unlock the numbers and it looks like a very strong quarter so thank you.

William L. Walton - Chairman and Chief Executive Officer

Thanks.

Operator

You next question comes from the line of Scott Valentin with FBR Capital Market.

Scott Valentin - Friedman, Billings, Ramsey

Good morning and thanks for taking my question. You mentioned in the capital structure to see a loan portion was looking very attractive. Could you maybe provide some color on spread maybe for the different capital structure tranches? Maybe where you are seeing spread wide down too. We have heard quite varying degrees spread widely from some of your colleagues or your peers.

Robert D. Long - Managing Director

Sure. This is Rob again. If you look at the S&P middle market data, you will see that from June the average spread for institutional loans this is the senior loan asset itself was L plus 267. And as of November 1, it was L plus 350. So, most senior loans are being priced now at about L plus 375, we see some with L plus 400, we see some with L plus 425, we tend to not do the higher price wins for credit reasons, but you can see that there has been roughly a 100 basis point change since June in the asset price of the senior loan. And when you look at the collateralized loan vehicle structures, the backup in the securitization markets has been severe and the pricing on the equity tranche as we talked about is 20% to 21% for new deals now. The notes that are right above those, which are the BB notes that had historically been between L plus 250 and L plus 350 have been trading at L plus 700 to as much as L plus 900 for BB rated note which is quite incredible. But because of the collateral prices have come down or the yields have gone up, the mathematics are still quite attractive. It just they are very, very few buyers of CLO financings today and only the very high quality names can actually execute transactions. So, our investment in Callidus, our portfolio company, is one of those that is able to execute in this marketplace and in the second half of the year, we expect they add approximately $1 billion of assets under management to two new CLO vehicles.

Michael J. Grisius - Managing Director

And I think, the thing I would add to that and what is this mean for the other parts of our business. In addition to spreads widening, the senior lenders are been less aggressive in terms of total leverage and it as compared six months ago where the senior lenders were offering debt at pretty high leverage levels and very thin spreads. It really was squeezing out the opportunity to put mezzanine capital or junior capital to work in a way that made any sense, and of course, the second lean market was very, very active. While the market is less volatile than and certainly last we had a call, I think have settled down somewhat. The lending market has improved quite a bit for us. So, you’ve got senior lenders been less aggressive and pricing their debt securities at wider spreads. The second lean market contracting which gives us an opportunity to step in and do more traditional sub debt that we expect to capitalize on and it also creates an opportunity particularly at the upper end of the market, which ironically is probably experiencing even more volatility and more execution risk. At that end of the market, if we think it provides a great opportunity for this unitranche product that we talked about in the call that were partnering with GE to launch this quarter.

William L. Walton - Chairman and Chief Executive Officer

One additional data point for you, Mike talked about leverage. According to the S&P statistics, as off September 30, the average total leverage was 5.9 times EBITDA. On November 1, two months later that number fell to 4.7 which is 1.2 turn reduction in leverage and that is why we are anticipating a good opportunity to invest with lower leverage and better credit quality than we saw earlier in the year.

Scott Valentin - Friedman, Billings, Ramsey

It sound like the better investment so and more secured, better yield certainly much better environment.

William L. Walton - Chairman and Chief Executive Officer

Correct.

Scott Valentin - Friedman, Billings, Ramsey

Thanks very much.

Operator

[Operator Instructions]. The next question comes from Vernon Plack with BB&T Capital Market.

Vernon Plack - BB&T Capital Market

Thanks. Bill, my question relate to really bigger picture and its strategic in nature. I now a lot of… and on market conditions but how deliberate do you plan on being in terms of the coming more of an asset manager and perhaps managing assets after balance sheet. I am just trying to get a sense of what the Company look like say three years about?

William L. Walton - Chairman and Chief Executive Officer

Well, I think you’ve seen with the senior debt fund and now the unitranche fund that this is something that we think is attractive. Callidus portfolio company already has a fairly significant portfolio. I think what is Rob about…

Robert D. Long - Managing Director

Over 3.5 billion under management today.

William L. Walton - Chairman and Chief Executive Officer

And I think that’s a very important strategic direction for us because there are some assets like the unitranche that wouldn’t really fit on our balance sheet. But through the GE fund it does. So I think we are going to be looking at more things like that. We get some fund ideas as well. I think though we are not … we are using this more strategically so we can offer more products to the serve market and try to keep ourselves highly focused on the business we are in which is financing middle market company sort of 5 million to 50 million some times larger. And so, with these different products, we can do that. We got some other ideas with things that might also serve this market pretty well. And I think as we do that we are going to see managed assets grow where we will see increased fee income from some of this vehicles. We haven’t yet quantified what kind of contribution that might make our bottom line. I mean right now it’s a small amount relative to kind of returns we get from interest income, origination in fee income from new transactions and capital gains, but I think you will see us more and more like that. So, we have combination I think of both balance sheet growth and manage fund growth.

Vernon Plack - BB&T Capital Market

Okay. Thank you.

William L. Walton - Chairman and Chief Executive Officer

Julie, why don’t you… I would like to thank everybody for joining us on the call. And as I say I think you probably heard we think we are very positioned now and have made some fundamental decisions to move into some new directions and feel good about our prospects. So, look forward to talking with you next quarter.

Dale Lynch - Director, Investor Relations

Thanks, Julie.

Operator

Thank you. This concludes today’s Allied Capital third quarter 2007 earnings conference call. You may now disconnect.

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Source: Allied Capital Corporation Q3 2007 Earnings Call Transcript
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