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American Capital Strategies, Ltd. (NASDAQ:ACAS)

Q1 FY08 Earnings Call

May 07, 2008, 11:00 AM ET

Executives

Amanda Cuthbertson - Director, IR

Malon Wilkus - Chairman, CEO and President

John Erickson - EVP and CFO

Ira Wagner - EVP and COO

Analysts

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Troy Ward - Stifel Nicolaus

Vernon Plack - BB&T Capital Markets

Carl Drake - SunTrust Robinson Humphrey

Jim Shanahan - Wachovia

Jim Ballan - Bear Stearns

John Neff - William Blair & Company

Daniel Furtado - Jefferies & Company, Inc.

John Stilmar - Friedman, Billings and Ramsey

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the American Capital First Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. [Operator Instructions]. As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Amanda Cuthbertson. Please go ahead.

Amanda Cuthbertson - Director, Investor Relations

Thanks Roxanne and thank you for joining American Capital's first quarter 2008 earnings call. Before we begin, I would like to review the Safe Harbor statement. This conference call and corresponding slide presentation contains statements that, to the extent they are not replications of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those 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, and the telephone recording can be accessed through May 21st by dialing 800-475-6701. The replay code for the replay is 918-891.

To view the Q1 slide presentation, please go to our website americancapital.com, and click on Q1 2008 shareholder presentation link in the upper right-hand corner. You can select conference call options 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 click F5 to refresh.

As a quick reminder, we just wanted to point out that we will be hosting our American Capital Equity Investor Conference on May 19th and formal comments will begin at 9:30 Eastern Time. Registration has closed, but the webcast will be available and can be accessed on our website.

And with that, I will turn the call over to Malon Wilkus, Chairman and CEO of American Capital.

Malon Wilkus - Chairman, Chief Executive Officer and President

Amanda, thank you so much. And I appreciate everyone joining us today. With me today is John Erickson, our CFO; Ira Wagner our COO; and we're going to try to get through this quickly so that we can take questions. But I do want to say that I think most of our analysts are probably tired of hearing it, but I think our shareholders are loving it that it's a great time to be levered less than one to one debt to equity. And as you see all of the troubles in the financial institutions today, I think people and our shareholders are realizing more and more, it’s to those firms that are properly capitalized that the opportunities are available.

So going to slide four, the key takeaways for this quarter is that we have had… this is an outstanding investment environment and that's why we love being levered when we invest in one to one because we can take advantage of it. And our investment portfolio is performing quite well. Commercial credit remains excellent. Defaults remain low and credit crunch has improved pricing, which should be over the next several years to be accretive to future NOIs and realized earnings and dividends.

We had $1 billion in the first quarter of unrealized depreciation and so I want to make sure you take away from this is that 147 million is due to the performance on our private finance portfolio and the balance is due to declining public trading prices, widening spreads and the implementation and adoption of FAS 157. And that quotient totaled $180 million of the total $1 billion amount. But we believe a lot of that declining public trading prices, widening spreads, those will eventually work back through the system and we will talk a lot more about that in a couple of minutes.

This is a great time to have a seasoned portfolio, so we are experiencing great liquidity and that's because we have substantial control over a large portion of our portfolio and it’s generating significant levels of liquidity, $931 million in the first quarter.

Just wanted to review our dividends. Again, we have reiterated our $4.19 in dividends for 2008, a 13% increase over '07. Almost half of that dividend we are forecasting to be paid from income that we earned in 2007 that we rolled over into 2008. That means the income we are earning in 2008, we will be able to roll over a very large amount of that into '09. We also want to make clear. We are forecasting that our 2008 realized earnings will exceed our 2008 dividends. So we expect to perform this year for our shareholders.

The second quarter forecast is for $0.68 to $0.75 in NOI per diluted share, though we also expect our realized earnings will exceed $1.10 per diluted share. And that would not only then cover our second quarter dividend, but a slight amount that we didn't cover in the first quarter with realized earnings. And then we wanted to reiterate our forecast that over $500 million of 2008 taxable income will be rolled over into 2009 to cover the 2009 dividend and that’s versus the $360 million that we rolled over from last year to this year. So again we expect to be performing in an outstanding way this year.

Moving to slide seven, we paid $1.01 in the first quarter, a 13% growth. Our realized earnings per share was 93% of that Q1 dividend, so it is virtually covered by our realized earnings. And the forecast is that our first quarter dividend will be paid from ordinary income for tax purposes and rolled over tax… income that was rolled over from '07.

For the second quarter dividend, which we declared now at $1.03, $0.70 of that will be paid from net long-term capital gains rolled over from 2007 and that will be taxed by the way at a 15% capital gains rate and John wanted me to remind everyone that if I have your shares lent out and that they are on borrow and that’s quite possibly the case if you have it in a margin account, then the income that you will get to replace that dividend will generally be taxed at ordinary rates. So if you want that capital gains tax rate, you might want to take it off borrow. And then you can see our forecast for the rest of the year, adding up to the $4.19 dividend.

And on slide eight, you can see a wonderful growth rate in our dividend. You can see how well we performed growing our dividends in the last recession. And we see no reason why we won’t continue to perform well. In this recession, it can be [inaudible] we are in line and we’ll move into when we expect to perform.

So let's move on to slide 10 to our financial highlights. We had good realized earnings, $0.77 NOI per diluted share, that’s a 5% increase. It came on the high end of our $0.73 to $0.78 guidance and it represents 11% trailing 12 months return on equity. We had $0.94 in realized earnings, 15% increase over Q1, a15% LTM return on equity, and in part, driven by $33 million of net realized gains. And so for both NOI and realized earnings, we had a very nice growth rate over prior year’s performance.

Now we did have a $4.16 loss on the bottom line due to $964 million of net gains and net depreciation. So we had a very large amount of depreciation for the first quarter and I'm going to talk more about that in the next couple of slides. That brings us down to $28.16 NAV, that’s a $4.72 decrease in our NAV over fourth quarter '07, but only a 7% decline from Q1 2007. So since we went up a little bit in 2007 in terms of depreciation and it’s come back down to the levels not too dissimilar from Q1 of '07.

Moving to slide 11, you can see, as your leader here, you look at the gains, but let's talk about the depreciation and appreciation, so the unrealized portion of this total. So we had a total negative amount of appreciation, depreciation gains and losses at $964 million, but the part I am going to focus in on is the 977 million of deep unrealized depreciation. And you can see this broken down on slide 12.So starting with our private finance portfolio, this is where we fund our own buyout and we provide one-stop buyouts and then we also do one step financings or the other private equity firms doing buyout. Here we have 327 million of net depreciation. In context, that’s on a 8.4 billion of assets. The depreciation of the 180 million was from changes in the accounting policies when we implemented FAS 157. And then in addition there were declines in cash flows at certain portfolio companies and declines in trading multiples that a comparable public company multiples of certain of our portfolio companies. So setting aside the FAS 157, we think our portfolio actually performed quite now considering the environment, but there are some specific companies that have underperformed.

Turning to European Capital Limited, we had 123 million of depreciation there due to decline in the quoted market price. We value that based on the quoted market price plus a control premium and in the first quarter, consulted with the SEC staff on the use of the control premium. There was… and this depreciation at European Capital would have no impact on American Capital's revenues, NOI or realized earnings.

As you all know, we have a portfolio company called American Capital, LLC which is the alternative asset fund manager which handles all the asset management business that American Capital is involved in. There, we had $140 million of depreciation and that's due to declines in training multiples of comparable public companies that reflect substantial declines in this last quarter. And it was also due to some decline in the projected management fee.

One of the… I guess the larger sector where we have declines with our Structured Products business, where we are invested in CLOs, CDOs and CMBS. There we had $361 million of depreciation and that's due primarily to widening investment spreads. And I’m going to give an example of that in a minute, we will actually look at those spreads. The assets are performing as underwritten and we have seen no impact on our revenues, NOI or realized earnings as a result of this depreciation. And then we had interest rate derivatives where we have $73 million of depreciation. A large portion of those derivatives were required as a result of our securitizations, on balance sheet terms, securitizations and some of our other bank loans.

Let's go to side 13. American Capital, as you know, invests primarily in illiquid assets and they have no trading markets. And under FAS 157 those are considered level 3 assets. American Capital generally holds or we intend to hold those assets to settlement or maturity, and that has been the case for 10 years that we have been in business as a public company.

Well, in March of this year, the SEC staff published a letter on MD&A disclosure, this is for the 10-Qs and 10-Ks, the management discussion that you typically put in those... in the K and Q. And what the SEC has asked is that companies to consider disclosing certain level 3 assets. And I’ll just close here, whether you believe the fair values diverge materially from the amounts you currently anticipate realizing settlement or maturity. And then if so, disclose why and provide the basis for your views and that’s unquote there. So American Capital expects $656 million… differences between our realizable values and our GAAP fair values that flow back through our income statements and balance sheets in the future.

And we wanted to walk you through that on the next couple of slides and I want to give you an example on it on slide14. And this is an example of the GAAP fair values and realizable fair values. So, for instance, we have a commercial real estate collateralized debt obligation that we are invested in. It’s called a CRE CDO. And we have invested $220 million in this. It’s backed by the way by collaterals that have $69 billion of commercial mortgages underlying it.

Well we, under GAAP and under this bond yield trading analysis, method evaluation, have written this down to $11 million of fair value on the $220 million that we invested. And that’s base in this last quarter on current market prices and third party quotes. Now I can tell you there is virtually no market. And when you attempt to... if we were to attempt to sell or buy, buying these kinds of assets in the market, we doubt seriously whether we could actually buy any, because the market is slow incredibly sooner than trading. In fact there was never a market for these kind of assets in the past and there has only been in the period time in the last few quarters, institutions under great financial distress themselves have started to make or try to sell some of these kind of assets and they are willing to do it at huge discounts even though they may be performing just fine.

Well in our case our CRE CDO investment is performing as underwritten and it’s currently producing $8 million of cash flow. We got it in the first quarter $8 million, we got it in the fourth quarter of last year. We got in the third quarter last year. We got… and we expect to get $8 million in this current quarter and we expect to get it indefinitely. We are experiencing virtually no losses on the $69 billion of commercial mortgages that are underlying in the CRE CDO collateral. And actually on that $69 billion, $460,000 has been lost and some of [inaudible] in these securities. That $460,000 on $69 billion, it's a... I don't know it's a fraction of basis.

So American Capital actually anticipates receiving $220 million upon settlement or maturity assuming, by the way, say, will indeed the credit losses through a recession on the underlying assets. Yet we still expect, based on assumptions including recessions that we will get $220 million back. And that's why we've reported as... we've been asked to consider to do so that we expect that we will get our entire cost basis back with investment even though we valued it on a GAAP basis at $11 million.

Now, actually we have a couple of charts that shows the reasons why some of this is happening. Chart 26 can show you how the pricing on these kind of assets has gone up dramatically or I should say the pricing has gone down dramatically. The yield expected you see it on the assets underlying in these portfolios had gone up dramatically, and you can see it was at the 7% to 10% levels from BBB- to B-. And quarter-by-quarter over the last year, it's been rising and in the fourth quarter of last year, it was at the 15% to 23% level, and then it’s jumped up to 25% to 30% levels of expected yield. And to get those kind of yields on these sets of assets, you have to depreciate them dramatically.

And then I just wanted to show you another slide, slide 32, which shows you that the assets that underlie our investment in CRE CDO and our other commercial mortgage-backed securities investments, they are performing wonderfully well. Actually, they are performing according to plan, but when you compare them to other assets... other fee investment classes out there such as the 2000 to 2005, or the 2006 to 2007 coverts with respect to delinquencies, our portfolios are performing very, very well and distinctly better.

So let's go back then to this general discussion. So going from slide 14 now to slide 15, you can see that on slide 15, our private finance portfolio shows $132 million. This is in the upper right-hand corner, the difference between the realizable value and the GAAP fair value and we would expect that would flow back into income in the years ahead.

Structured Products portfolio is where we see the greatest difference and that makes sense, because there has been great disruption in Structured Products around the world. And so people are pricing them way down even though many of them, including the ones that we have in our portfolio, are performing extraordinarily well. So $530 million difference there. We expect that would also flow back in through income as years go by. And in fact, for the second quarter of this year, we have already seen spreads to tighten on commercial mortgage-backed securities. And so we may actually see if that holds up through the end of the quarter, we may actually see that, some of that to start appreciating this quarter.

Going to slide 16 then, I guess I’d leave behind that whole discussion and through your hot questions, we will open it up shortly for those questions. Slide 16, I just wanted to remind folks that we are one of the few firms raising equity on an accretive basis at a premium to book. We raised $317 million and also I want to remind you Fitch, S&P and Moody’s have graded us as investment grade, and they reaffirmed, Fitch did at least in April cap ratings.

And at slide 17, I just... if you could look at this on your own, the debt maturity scheduled for us is outstanding. We just have, just no questions concerning our liquidity. And in fact if you look on slide 19, you can see we continue to have excellent performance in syndicating our senior debt as we originated. And slide 20 shows you that on a trailing 12-month basis, we are having… continue to have outstanding realizations of our prior-year assets. So 57% turnover of our assets in the last 12 months, and we had $4.9 billion of capital coming back to us in the last 12 months. Tremendous amount of liquidity, again, we have more liquidity coming back to us than almost all of the firms that we compete with have as capital.

So now, I would like to open it up to questions.

Question and Answer

Operator

[Operator Instructions] And our first question is from Sanjay Sakhrani. Please go ahead.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Sorry, can you hear me now?

Malon Wilkus - Chairman, Chief Executive Officer and President

Yes, we can hear you.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Thank you. I was just wondering can you get a sense of how much of the total portfolio is quoted now? And is it fair to assume that most of the negative marks we're seeing on the non-control side?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, how much of the portfolio is quoted?

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Yes. Are they probably quotes on the investments that within the portfolio?

John Erickson - Executive Vice President and Chief Financial Officer

Yes. I mean, ECAS is really the only thing in the public quote. Everything else is not quoted. On the second lien portfolio, you can find some pricing services and some numbers out there, but essentially the portfolio is not quoted.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Okay. And then do we have the breakout between level 1, 2 and 3?

John Erickson - Executive Vice President and Chief Financial Officer

Essentially, we're all level 3, because even European Capital where it is quoted, that’s because we use a control premium. I think you should note that we did review our use of the control premium with the SEC this quarter as we stated last quarter that we would. And because we use a control premium, it’s actually level 3 rather than level 1. So effectively our portfolio is a level 3 portfolio.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Okay. And most of the adjustments made on the non-control side or were there control investments that were also--?

John Erickson - Executive Vice President and Chief Financial Officer

I mean every quarter we do our control investments, right. But I think the key here is that the corporate control investments, there really wasn't a change under 157. We continue using basically the enterprise value waterfall approach, whereas on the non-control debt, we concluded, despite spending tons of time with the FASB that we really had to create a hypothetical market and hypothetical bond yield, it could not use an enterprise value approach, which should be in the historical valuation methodology. And so basically we’ve come up with a hypothetical market, which does the non-control debt investments under a bond yield approach. So essentially we had to look being non-control debt deals as though we were originating it today and pricing it today. So if we originated non-control debt last year and had priced it at 11% interest rate and today, we were priced it at 12%, that creates a mark-to-market difference. Even though it's a good credit, we expect to collect it and we are only going to collect it through really a sale of the company or a recapitalization of the company, which is historically how we've collected the principal on our investments.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Okay. And just to be clear, I mean you guys feel that all the adjustments that were necessary to be made have been made. And I guess I'm just specifically on that control premium, you guys mentioned that you talked with the SEC about it, that's all squared way and they are okay with the control premium on a go forward basis?

John Erickson - Executive Vice President and Chief Financial Officer

We would be saying that they… if they objected to our accounting force, they would have told us and we had written the [inaudible] verbal discussions with them.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Okay.

Malon Wilkus - Chairman, Chief Executive Officer and President

In another comment earlier that we made all the adjustments that we needed to make. Keep in mind, we’ve properly reported under GAAP at all times in the last 10 years, including the fourth quarter of last year and of course this quarter because FAS 157 went it to effect this quarter. We abided by its provisions and we think we are properly stating our assets according to GAAP.

John Erickson - Executive Vice President and Chief Financial Officer

Right, I mean the big drivers this quarter, I mean we've isolated the FAS 157 adjustment right, and so the big drivers really where the -- the increasing spreads on the Structured Products, which is the one chart Malon already referred to, where despite in the third quarter and fourth quarter of last year, the Structured Products’ spreads widening out, they widened significantly in the first quarter, and really all the way through March, we were completely shocked with some of the levels that the brokers were quoting at the end of March. The CRE CDO is a good example of that. And in fact what we did after getting all those March 31st quotes, we turned to our CMBS team and told to go start buying as much as they could at these levels. And we found that in April as we started trying to buy them, the spreads started tightening up. So if we were sitting at the end of the April, if the spreads that we have at the end of April hold through to the end of June, we would expect to, absent any other credit events, we would expect to actually start appreciating the Structured Products portfolio. So, it looks like right now that March might have been the low point there. The other big driver of the depreciation obviously is European Capital and the change in the stock price, which caused further depreciation as well as depreciation in the manager, which was multiple driven and earnings driven. So, really the FAS 157 mark-to-market this quarter was not the most significant driver of value changes.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Okay, great. I had a couple of other questions. Just on the yield compression, I saw the yield was down almost 80 basis points sequentially. I was wondering if you could just talk about that. And then just finally on the office closings and the restructuring of the branch offices, I was wondering are there any implications from a cost perspective? I mean I’m assuming it's not accretive to the NOI. Thanks.

John Erickson - Executive Vice President and Chief Financial Officer

Yes, first of all, on the yields obviously we have a fair amount of LIBOR-floating assets and debt and so you are going to see the effective interest cost dropping as well the effect of yield on the assets so you have any probably where a LIBOR dropped pretty significantly from December 31st to March 31st. And so, that’s the impact you're seeing there. On the cost side, there will be… the restructuring would have some accretive impact in the third and the fourth quarter, we’ll have some costs in the second quarter from that.

Sanjay Sakhrani - Keefe, Bruyette & Woods Inc.

Got it. Thank you very much.

John Erickson - Executive Vice President and Chief Financial Officer

Great.

Malon Wilkus - Chairman, Chief Executive Officer and President

Thank you.

Operator

Our next question is from Troy Ward with Stifel Nicolaus. Please go ahead.

Troy Ward - Stifel Nicolaus

Thank you. Good morning, gentlemen.

John Erickson - Executive Vice President and Chief Financial Officer

Hey, good morning.

Troy Ward - Stifel Nicolaus

Hey, quickly on the expenses here in this quarter. Can you speak to… they came in under, can you speak to what was there in the slower bonus accruals and such?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, we did not hit our internal forecast so we didn't pay a bonus for the first quarter. Right now for the second quarter, for example, our internal forecasts would be pointing towards a bonus payment. So that’s baked into the second quarter forecast, but we did not pay a bonus in the first quarter.

Troy Ward - Stifel Nicolaus

Can you kind of give us a magnitude of the change, Q1 versus Q2 and what wasn't there and what will be in Q2?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, I'd rather not because that number moves right. So it's possible we don't hit our targets for Q2 and then we don't end up having the bonus. So I think you'll see historically our compensation costs vary. I mean there is a lot of fact in the quarterly variances. First of all, transactions fees vary from quarter-to-quarter, incentive fees and then even our leverage. So trying to get behind the NOI forecast is not that simple and compensation does have an impact of the NOI forecast for Q2. But also leverage rates, so when we are selling these companies, we get a $400 million payment back on a company. We are deleveraging for a period time and then we are taking some time to put that money back out. And you will see that one of the impacts in the lower NOI really since Q3 of last year has been the fact that we have been deleveraging because of this environment wanting to maintain flexibility and not run our leverage up to the levels we had during a better credit environment.

Troy Ward - Stifel Nicolaus

Well, okay. But are the bonus accruals specifically, are they going to be more tied to realized gains similar to what the guidance you put out in--?

John Erickson - Executive Vice President and Chief Financial Officer

There is a lot of factors and it’s certainly not tied to anyone factor. For example, the success we have in raising a third-party fund or raising capital also ties into the different metrics. So we can't give you one metric and say that you can... it sounded like the investment banking world when you say, well, basically we will take the 50% of revenues and run a bonus… compensation number. We've got more complex factors that go far outside of just realization. Obviously, when someone generates a large gain, that that's a factor and certainly in terms of personal performance.

Troy Ward - Stifel Nicolaus

Okay. Moving on, on the guidance given on the balance sheet, I think you said year-end $12 billion expectation. Just looking at where you sit at the end of Q1, it’s approximately $1.8 billion growth, but looking at the amount of equity above the debt right now, it’s… you don’t call it 1.5 and then in the guidance you also mentioned that you don't expect to raise equity. What's filling the gap there between the balance sheet growth and the apparent lack of leverage to get there?

Ira Wagner - Executive Vice President and Chief Operating Officer

As you know I already had mentioned I think the Structured Products portfolio alone I think has appreciated to the point time through April. I think you’re probably discounting what might end up having in terms of the overall portfolio in terms of appreciation. Don't forget, if we take a non-control debt and we write it down to $0.88 or whatever, and then they pay us off, that's just like appreciation. So I think we're comfortable with that $12 billion number is pretty realistic.

Troy Ward - Stifel Nicolaus

Okay. Okay. And then finally one more, if you're looking at the 2000, the static pool data for the 2000 vintage… 2007, the higher debt-to-EBITDA, the lower EBITDA margins, and then also, the amount of current investments on non-accrual of 114 written down to 16 with face. How should we look at the vintage based on those metrics, and what it is versus historical performance at other vintages?

Malon Wilkus - Chairman, Chief Executive Officer and President

I think the 2007 market conditions were challenging in terms of yields on the non-controlled debt investments, and so you will see yields would be a little bit lower than you'd see in the marketplace today, but as we've talked about through numerous quarters, and in terms of the non-accrual, it's very specific to a couple of underperforming companies. So we just have some specific issues from some of the '07 companies, which we are working on to try to improve going forward and we’re hopeful we're going to see improvement in those companies going forward. But the market conditions in general in '07 were a lower yield environment than you had in prior years and what you have today and have seen since the middle of '07 as the market conditions and yields have improved.

Troy Ward - Stifel Nicolaus

Thanks. Yeah going forward, how do you think from a credit quality perspective, on the non-accruals that vintage versus what you expected in respect to the other historical portfolio?

Malon Wilkus - Chairman, Chief Executive Officer and President

Well, I'm going to want to – I wanted to point out is that the IRR on the equity-only components of that portfolio is still now at 18%. It's not greatly off from our average for the last 10 years. And so, I think I've have been reading a number of analysts kind of trying to point out that somehow that we invested it very expensive times and so forth. If you look at the amount of assets that we have in that portfolio today, it's already substantially down as a result of tremendous amount of liquidity becoming off of it. So, we and we're getting… experiencing wonderful gains in the liquidity that we have been getting overall. So I think you might be making too much of this concept that this portfolio is going to be somehow worse than another portfolio. I'm honest that I got to say we are much closer to us than you are, and I honestly can't do that. I can't look at that portfolio and say somehow that is worse than another static pool of the year before. Let me ask Ira.

Ira Wagner - Executive Vice President and Chief Operating Officer

I think, in general, that portfolio, the companies in that portfolio are performing very well. We just have a couple of situations that are more challenging and difficult. So it's not across the board, it's much more specific which we are working on in order to improve.

John Erickson - Executive Vice President and Chief Financial Officer

And unfortunately they are actually in the sponsored finance part of the portfolio. I think the buyouts I feel extremely confident that we made outstanding buyouts that so far proving to perform very well through the economic cycle. I think that arguably with where we are today, we have not seen a real downturn. Somehow a little bit surprising to me that we may be in a recession, but it's not really showing up and certainly within our buyout portfolio, we feel like it’s really not showing up in a meaningful way. The buyouts we did in the first half of '07 I would characterize as performing very well.

Malon Wilkus - Chairman, Chief Executive Officer and President

And just to remind you the exits in prepayment for the '06 static pool is virtually… almost half of the original investment. And for '07, it is $1.5 billion on the $6.6 billion that we invested already, so tremendous liquidity also off of those pools. If you somehow have the view that these are ugly investments, believe me, uglier investments are harder to exit than good performing companies.

Troy Ward - Stifel Nicolaus

Thanks. That's great color, thanks. And then one final one and I will get back into queue. What are you looking at in the current market kind of the mix that you are focused on may be between buyout and sponsored finance deals?

Ira Wagner - Executive Vice President and Chief Operating Officer

Well, we continue to look at all kind of transactions. As you know, the private finance portfolio, the volume of business that we do is very much a function of the M&A market, so the M&A markets are down significantly in '08 compared to '07. And so the volume of transactions in the marketplace is well down, and we are, on top of that, being extremely selective in the transactions that we do. So the conversion ratio of everything we are looking at into what we are actually doing has actually gone down as well recently. So there is still a lot of deal flow but not nearly as much as there used to be and we are being extremely selective. We do have a lot of good opportunities on both the buy outside and the debt side, particularly on the debt side, where you've got transactions that would have been done in prior years through a syndication process arranged by Wall Street investment banks and that market is pretty much disappeared with the disappearance of the CLO business. And so you've got a lot of mezzanine opportunities that are coming back into the market for very large transactions, and we're seeing quite a few of those, which we see as being very attractive large mezzanine transactions. So we continue to look at both things, but it's a much lower volume kind of marketplace than you've seen in the last couple of years.

Troy Ward - Stifel Nicolaus

Good color. Thanks.

John Erickson - Executive Vice President and Chief Financial Officer

Let me go back to make one more comment, going back to the question of '02 guidance and the change in NOI. Our internal calculations show that the March equity raise is going to cost us about $0.03 a share in the second quarter once you [inaudible] the deleveraging point. We’re certainly putting that money to work at good spread, but having done that raise in March in increasing the shares outstanding, it’s attributing about $0;03 per share to the lower results. I mean over time, as I said, we'll certainly put that money to work and have good returns on it.

Malon Wilkus - Chairman, Chief Executive Officer and President

Next question please.

Operator

Our next question is from Vernon Plack with BB&T Capital Markets. Please go ahead.

Vernon Plack - BB&T Capital Markets

Thanks very much. And the commercial real estate CDO is a great example. And John, I think you alluded to… you probably answered part of my question already, but just curious in terms of if you look at pricing at current levels and given the returns available, can we expect? I know you've seen some pricing recovery there, but can we expect the Structured Products' part of your portfolio to grow more than the rest of the portfolio?

John Erickson - Executive Vice President and Chief Financial Officer

No, look, we've got certain guidelines within all the Reg BDC rules, so we can’t grow just proportionately. But what I can say is we think there of phenomenal values in the Structured Products doing it today. I mean you would not believe the kind of spreads you're getting on ever A-rated bonds. The banks had really had a bunch of this stuff hung up on their balance sheet, and they remain hungry to sell it. And so, we, with the March bids, we have an aggressive program to buy those assets and we're buying some. And when you can underwrite the underlying collateral the way that we can, it makes a ton of sense.

Vernon Plack - BB&T Capital Markets

Okay. And this may be connected, but I know that your forecast is for more externally managed assets rather than managed… rather than assets on your balance sheet. And what I was looking for perhaps maybe just a little bit more color in terms of the opportunities that you think that you can take advantage of? And can we see the Structured Products' portfolio grow more off balance sheet, if that's possible? Just trying to get some color where you see the opportunities?

Malon Wilkus - Chairman, Chief Executive Officer and President

Turn to slide 34, you can see the loans that we have under management.

Vernon Plack - BB&T Capital Markets

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

And ones that are in development, and that's really showing you the areas that we are working in right now to develop new funds.

Vernon Plack - BB&T Capital Markets

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

We can't really say a lot more about them, because in some cases there are actually under... in some process.

Ira Wagner - Executive Vice President and Chief Operating Officer

What I will say is...

Vernon Plack - BB&T Capital Markets

Sure.

Ira Wagner - Executive Vice President and Chief Operating Officer

Our sentiment on the Structured Products I think in recent conversations we’ve had with investors, I think they share that sentiment. I think investors are looking for some credit-sensitive investment opportunities and our expertise in the real estate I think is an area where we can find a way to think about packaging that up before investors that want some exposure in that area and you can’t do it directly.

Vernon Plack - BB&T Capital Markets

Sure. And last question in terms of the mix of new business at least for the foreseeable future, can we expect a higher level of subordinated debt?

Ira Wagner - Executive Vice President and Chief Operating Officer

We continue to pursue every subordinated debt investment that meets our credit quality and the quality standards that how we look for. And as long as we can find one, so it will meet our quality standards, you'll see us putting them on the books. So well I’ve said, we've got some opportunities with much larger transactions than we've typically had in the past and we're hopeful that some of those are going to come to fruition.

John Erickson - Executive Vice President and Chief Financial Officer

Yeah, we’ve actively been working on a number as we’ve had sponsors coal [inaudible] had not called us in the past and we have a number of them in our backlog right now that you can do anything, you just never know what's going so close.

Vernon Plack - BB&T Capital Markets

Sure. Thanks very much.

Malon Wilkus - Chairman, Chief Executive Officer and President

Vernon.

Vernon Plack - BB&T Capital Markets

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

If you look at slide 29.

Vernon Plack - BB&T Capital Markets

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

And that kind of… this is broken down by tranche as opposed by product category.

Vernon Plack - BB&T Capital Markets

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

The way you were asking your question.

Vernon Plack - BB&T Capital Markets

Okay.

Malon Wilkus - Chairman, Chief Executive Officer and President

And I think we have some other slides in the presentation showing exactly, but it takes a lot of effort, a lot of... it takes some numbers of quarters to make a big dent in $11 billion balance sheet.

Vernon Plack - BB&T Capital Markets

Sure.

Malon Wilkus - Chairman, Chief Executive Officer and President

So it’s probably safe [ph] that we’ll be doing somewhat fewer buyouts, where we're going down all way to the equity, because we think the mezzanine and debt opportunities are so outstanding. And so since we are going up balance sheet, but you're not going to... to the degree that we do that, it’s still not going to make a great dent in this composition of our different tranches as you see on this slide. Nonetheless it will and it will be adding… because that we're going into wider spreads, it will be adding basis points into the spread and that should, as I said, be accretive to NOI and realized earnings and our dividends in the years ahead.

Vernon Plack - BB&T Capital Markets

Thank you very much.

Malon Wilkus - Chairman, Chief Executive Officer and President

You're welcome, Vernon.

John Erickson - Executive Vice President and Chief Financial Officer

Thanks, Vernon.

Operator

Our next question is from Carl Drake with SunTrust Robinson. Please go ahead.

Carl Drake - SunTrust Robinson Humphrey

Hi, good morning. Question is on ECAS. Has there been any change in strategy or plans with ECAS? There have been some press releases, some turn over there. I’m just wondering if you could update us a little bit on what's happening with ECAS and any change in strategy there?

John Erickson - Executive Vice President and Chief Financial Officer

No, there is no change in strategy at European Capital at all. We continue to pursue both buyouts and mezzanine opportunities across the four markets that we are covering. And it’s predominantly mezzanine in a couple of markets, but we also continue to pursue the buyout business in the U.K. market and in France. And so, in any business, you always have some turnover in personnel, and we've had some turnover in personnel at European Capital, but there is no change in the strategy at all.

Malon Wilkus - Chairman, Chief Executive Officer and President

We continue to have four highly productive offices and about 90 to 100 people there.

Carl Drake - SunTrust Robinson Humphrey

Okay. That's helpful. My second question is in terms of non-accruals and delinquencies they're well below past cycles. It seems like the market is discounting obviously a significant credit cycle ahead. What is your take on potential trends in non-accruals and delinquencies, what you're seeing in the economy right now?

Malon Wilkus - Chairman, Chief Executive Officer and President

Our portfolio is performing very well. As mentioned in the past, we've run this aggregate analysis of our portfolio in the most recent analysis of that where we’ve actually weighted it by our investment in these companies, we're seeing approximately 3% growth in revenues and EBITDA growth of around 7%. So, we really think the portfolio overall is performing quite well, though as we mentioned earlier, there are some spots where we've had some troubles, but on our size of portfolio, you always are going to have that. Now, on the other hand, we believe that we are either in a recession or we are heading into a recession and we believe we will have to batten down your hatches. You have to prepare for it. Frankly, we started preparing for a recession in a very thoughtful way starting a year ago. As you know, we raised tremendous amount of capital last year. We did that with our view that the economy was likely turning into a recession. And by the way, the reason we had those views is because we are so diversified that we were seeing the issues developed in the RMBS area I think very early on, even though we don't invest in that area, we are certainly seeing opportunities to invest there. We kept looking at them and we couldn't make sense out of them. We saw the liquidity crisis then come from there and move into other Structured Products and we were certain that it was going to be experienced by private finance and indeed that happened just as we had figured. And so early on, we were raising capital on a... I think it was about a four-month period, where we raised about –

John Erickson - Executive Vice President and Chief Financial Officer

$4 billion.

Malon Wilkus - Chairman, Chief Executive Officer and President

$4 billion I think. And so we don't know if we are in a recession now or not. But we are certainly acting and operating as if we are in one. We are continuing to make adjustments to prepare for it and if it is going to be a long one. We are quite ready for it and we intend to perform for our shareholders, whether it's come or gone. We are intending to perform for the shareholders.

Carl Drake - SunTrust Robinson Humphrey

And you don't see it spilling over into new industry sectors, is it still isolated to the usual consumer housing related sectors?

Malon Wilkus - Chairman, Chief Executive Officer and President

I think it’s fair to say that we have been preparing that it does indeed spill over for quite a long time we have been preparing for that and making sure that we are investing in companies that are not cyclical. Actually, we think we've made some investments in some counter-cyclical companies as well. So those are hard to find. And as you’ve seen, Ira just pointed out, our closing ratio has gone down because frankly we are often outbid. We are more often outbid in the last few years than in the past. And then in due diligence, we more often walk away from deals.

Carl Drake - SunTrust Robinson Humphrey

That's helpful. Last question on operating expenses, on the last cycle you did a good job of cutting costs throughout the cycle. I was wondering if given the level of growth you shared, do you believe that you can keep your operating expenses to assets below 3%? I think you were at 3.3% last year or is it going to be tough to just to maintain it at around that level?

Malon Wilkus - Chairman, Chief Executive Officer and President

I don't know how you are calculating that. We have a different calculation on that, and I don't know what you're trying to get here. We're at… from our calculation of that, we're at 2.1% and it’s just slightly up from the 1.9% of all of 2007. And that by the way, I believe would be one of the lowest, if not the lowest operating expense ratio of any firm in our industry.

John Erickson - Executive Vice President and Chief Financial Officer

Well, that assets under management includes all the asset classes.

Malon Wilkus - Chairman, Chief Executive Officer and President

That's a very good point. [inaudible] And that's probably why you're coming to your conclusion, Carl. If you don't include the other… our assets or funds that we are managing, you’re really not running the right number.

Carl Drake - SunTrust Robinson Humphrey

I got you. Okay. And do you feel like you can maintain that at those levels with--?

Malon Wilkus - Chairman, Chief Executive Officer and President

We do and we also believe that we will size ourselves properly. And so we intend to perform in terms of our realized earnings covering our dividend and we expect to do that one way or the other.

Carl Drake - SunTrust Robinson Humphrey

Okay. Thank you.

Operator

Our next question is coming from James Shanahan with Wachovia. Please go ahead.

Jim Shanahan - Wachovia

Thanks. Almost good afternoon. In the revised forward guidance, again it assumes no new capital will be raised, that was also the case last quarter. Yes, the company did a spot offering at the end of the quarter, I think it actually even closed in March 31. Unless I'm mistaken, that offering was only 3 weeks, 4 weeks after the guidance was issued. Why was it necessary? And if it were opportunistic, should we be prepared for capital raises anyway so long as the price is above book value?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, look, it is opportunistic. I think that what we're saying is we are managing our balance sheet to where we don't have to raise capital. So we have a plan that will allow us originate and make investments without raising capital, but nevertheless, if our stock is trading below book, we have that $500 million repurchase program, and we’ll look to add accretive transactions by buying our stock in. If our stock is above book, we think that we can get good returns for investing the capital, you will see us actually issue equity. So we are prepared for this environment, but obviously to the extent we can raise capital I think that everyone would acknowledge that there are just tremendous opportunities today to invest that capital. Certainly, we are in an environment, where spreads have widened, and so we'd love to be able to raise capital and to outperform our guidance.

Malon Wilkus - Chairman, Chief Executive Officer and President

In the last recession, Jim, we raised capital throughout that last recession. But it would be imprudent of us to not prepare and be capable of operating, whether we raised capital or not. My view of it is, if we perform well, and we performed wonderfully for our shareholders. If we perform well and the believe in us, they will be willing to give us more capital to put to work, and believe me, we've got great places to put it work today. And so, if the market tells us, they think we are a good place to put capital, then we're going to take advantage of that, we are going to raise it. It will only be done accretively. Whereas there is plenty of other firms that you can go to if you want to and the market you can go to where they seem to be prepared to issue equity that's dilutive below book.

John Erickson - Executive Vice President and Chief Financial Officer

And that's really the key part of our guidance, right, that we are prepared to operate without raising dilutive equities. And that's critical, if you look at, as Malon mentioned, the financial services space, there are just a tremendous number of firms we’ve had to issue dilutive equity and we put our balance sheet in our business plan in a position where we are not going to issue dilutive equity, We're going to issue equity accretively or we're going to buy stock back and accretively. We don't want to be diluting our shareholder value.

Jim Shanahan - Wachovia

A very helpful answer, thank you.

Malon Wilkus - Chairman, Chief Executive Officer and President

In that transitionary period, where you move from being able to raise lots of equity, which we were doing in the last several years to going into being able to operate and perform well for our shareholders in the steady state, you'll naturally see a somewhat decline in NOI, and a greater reliance on unrealized gains. But that's just a transitionary period. It won't last long, because as we get this huge amount of liquidity and we already showed you, 50% of liquidity we're putting it into higher spreads and overtime that will show up back into NOI. But as we've already discussed and there is also some internal adjustments that you make. And so that's what we're going through right now. But the bottom line is that we will… we are earning our dividend. We are only paying a dividend that indeed we've earned and actually we're more earning more than our dividend and we're going to roll over more into next year than we did from last year to this year. And I got to say I expect this is… I'm just so proud of what we are doing here, and we don't seem to get much credit toward I have to say.

Jim Shanahan - Wachovia

Well, thank you for clarifying that. And a follow-up if I might, there has been some discussion about one of your portfolio companies where there might be some liability for damages to consumers who utilize the product. And my question is not really about the valuation of the company or those specific issues, but I'm curious as an investor in a company like that, I’m not sure if it makes a difference if you are a control or non-control investor. If there is liability associated with the product or service that's offered by one of your portfolio companies, is it your view that there is... that you, American Capital, has no liability in the event that the plaintiff’s attorneys go after the value of that portfolio company? In other words, can they pierce the corporate bail and go after American Capital or are you protected?

Malon Wilkus - Chairman, Chief Executive Officer and President

That's right. The corporate, they’ll protect us from that. And so it's never... I don't know of a case where an investment company or a private equity firm has become responsible for the portfolio of company's liabilities.

Jim Shanahan - Wachovia

Thank you, Malon.

John Erickson - Executive Vice President and Chief Financial Officer

And keep in mind, I mean this is a public issue. We’ve obviously had portfolio companies that have failed before, and so we're quite comfortable in the way that we operate. That answer holds true.

Jim Shanahan - Wachovia

Okay, thank you.

Malon Wilkus - Chairman, Chief Executive Officer and President

Thank you, Jim.

Operator

Our next question is from Jim Ballan with Bear Stearns. Please go ahead.

Jim Ballan - Bear Stearns

Hi, thanks a lot. It's Jim Ballan. My question is around sources and uses of capital. It looks like the new investments you made in the quarter was about $900 million, and that the realizations was also about $900 million. Now it looks like the debt balance though went down by about 700, so you're sort of equal in and out. And obviously you raised the $300 million in equity, I’m trying to figure the other $400 million. Two answers that I can think of, one is that this is just a timing issue, and that they are just certain investments that maybe were made after the close of the quarter or else maybe it’s just $400 million in managed funds that may have been more inter company. Can you talk about that?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, the European Capital $400 million is a commitment. They are going to draw that, basically it's like a revolver. They are drawing that as they make investments.

Jim Ballan - Bear Stearns

Okay. So it's actually a both. It’s something that will be drawn in the future and it's in the company.

John Erickson - Executive Vice President and Chief Financial Officer

Right.

Jim Ballan - Bear Stearns

All right.

Malon Wilkus - Chairman, Chief Executive Officer and President

But we always report our commitment and in some cases, it takes some months for those commitments to be drawn.

Jim Ballan - Bear Stearns

Okay, great. Terrific, thanks a lot. That's helpful.

Malon Wilkus - Chairman, Chief Executive Officer and President

Sure, any other questions.

Jim Ballan - Bear Stearns

All set for now.

Malon Wilkus - Chairman, Chief Executive Officer and President

Thank you.

Operator

Our next question is from John Neff with William Blair. Please go ahead.

John Neff - William Blair & Company

Hi gentlemen. I was just wondering if you could talk about just looking at over the next several years, are there any circumstances right now that you could envision that would impair your ability to pay and grow the dividend?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, I think we have certainly given the spillover and the way we positioned ourselves. We certainly don't envision a scenario where we can pay the dividend. What I would is when you go through a downturn in recessionary environment, what that does do is it changes your ability to grow the dividend. So we've had a great recent track record of growing the dividend at double-digit rates. But if you go through the last recession, I think we were down at low-single-digit rates. And so the growth rate for '09 and 2010 may change somewhat based on the environment we are in today. And once we can get back into more of a normalized environment in terms of taking our leverage up, raising accretive capital and doing more investing activities, the growth rate will come back, but certainly this environment will change the outlook of the growth rate in '09 and 2010.

Malon Wilkus - Chairman, Chief Executive Officer and President

If you look at slides 46, 47 and… 46 and 47, are we trying to have given the market a tremendous amount of information about this year and actually some about next year that should give tremendous comfort to people about our ability to pay the dividend. And pay the dividends that we are forecasting at these… that has been 13% growth rate in the dividend through '08. And then we are making it clear we expect to roll over of $500 million of ordinary taxable income and taxable gains into '09. And so that’s... I don't know how we can give people more comfort about the dividend than what we are doing.

John Neff - William Blair & Company

Can you talk a little bit about to what extent you have flexibility, the asset management strategy is spinning out various funds. How much flexibility does that gives you in terms of mitigating the BDC leverage requirement at a time when FAS 157 is going to potentially make your equity and your book value a little bit more volatile?

Malon Wilkus - Chairman, Chief Executive Officer and President

The funds that we are managing to the most part aren’t... well, American Capital equity one and two aren’t levered at all. European Capital is levered about one to one. So this is not, that funds under management effort is not a way to do investing at a higher leverage level.

John Erickson - Executive Vice President and Chief Financial Officer

Well, no, what I think in a different environment certainly real estate can carry more leverage.

Malon Wilkus - Chairman, Chief Executive Officer and President

Yes.

John Erickson - Executive Vice President and Chief Financial Officer

Historically, carry more leverage. Arguably today, that situation probably is not true. So, for example, if we did a commercial real estate fund in a different environment, you put more leverage on it, but this environment, you really may not.

John Neff - William Blair & Company

Okay. Thank you. Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

Each fund would be... that we would be managing, our intention is to lever it at say for the appropriate levels for its asset class.

John Neff - William Blair & Company

Right. Right. And what I guess I'm getting at is your ability to implement that asset management strategy, does that give you flexibility in terms of making the investments you want to make at a time where your equity may be more volatile based on the adoption of FAS 157?

Malon Wilkus - Chairman, Chief Executive Officer and President

Yes. We don't see that there is a volatility. Keep in mind that the adoption of 157 had a rather de minimis effect on us, right?

John Neff - William Blair & Company

Yes.

Malon Wilkus - Chairman, Chief Executive Officer and President

But I think what you're saying though is bond trading, the application of bond trading analysis to valuing on our assets. That has indeed had a greater effect, but it's just impacting the NAV and we were making it very clear that we think that a lot of that will flow back into our statements as reappreciation occurs.

John Neff - William Blair & Company

And then last, last question here. The asset management fees, those are assessed on I assume fair market value asset levels. And then if you could just break out for us, obviously structuring and certain advisory fees are down, but could you just give us the pure asset management revenue, may be a quarter... this time last year versus the first quarter '08? Thank you.

Malon Wilkus - Chairman, Chief Executive Officer and President

Yes. If there's any other questions you might want to pop up, because I don't think we have an answer.

John Erickson - Executive Vice President and Chief Financial Officer

We don't have an answer, but you may actually, why don’t you call IR and get that answer after the call, because we probably don't have last year's handy. So we will pull that data and you can call us afterwards then.

John Neff - William Blair & Company

Thank you very much.

Amanda Cuthbertson - Director, Investor Relations

Roxanne, we’re pushing past an hour. So why don't we take two more questions.

Operator

All right. Our next question is from Dan Furtado with Jefferies. Please go ahead.

Daniel Furtado - Jefferies & Company, Inc.

Good afternoon. Thank you for your time. Just trying to get a handle on senior management's thoughts as to middle-market activity and when we could potentially see this growing again. I know I’m a little bit in front of the ball here because the space is continuing to contract. But based on the last recession and kind of what you’re seeing here, at what point do you think we start to stabilize and this middle market activity grow again?

Ira Wagner - Executive Vice President and Chief Operating Officer

I think the middle market has been less impacted than the big LBO markets because of its much lower dependence on the syndication of senior debt assets to CLOs and hedge funds. So there is a lot of liquidity on the debt market side in the middle market business, and of course, private equity funds and strategic buyers continue to be active in the marketplace. There is a lot of dry powder in the private equity industry. So I think you'll… the middle market is down but not nearly as much as the big market. And I'm hesitant to predict how long it's going to be at the volume that it is right now. I think as more and more sellers realize, the valuations haven't been terribly impacted that they will bring their companies to market. And you're still seeing that there are healthy valuations for companies that are being traded, just at much lower volumes and you've seen in the past few years. So I would expect that if that continues that you'd see more and more companies come back to market at some point in time when sellers believe that they can still get reasonable prices for their companies.

Daniel Furtado - Jefferies & Company, Inc.

And then, just quickly on... yes, I'm sorry.

Malon Wilkus - Chairman, Chief Executive Officer and President

Hi Dan. You can see on the slide 28, that volumes are definitely down from the peak of the second quarter of '07. But at levels that are still kind of consistent with '06 and that's still clearly down. I don't really want to mislead anybody. The volumes are definitely down. The quality out there is particularly when you are always are thinking about a recession happening in the next day or being in one, the quality is such that we're just simply either walking from deals at higher percentage or else we are out bid frequently. And so, our volume is down I think appropriately so, but the volume of the deals... the deal volume is slightly up from the fourth quarter, but still considerably lower than the second quarter of '07 and at levels that are kind of consistent with '06.

Daniel Furtado - Jefferies & Company, Inc.

That's great color. I appreciate that. And just real quickly if I may, Can I get a thought on how you guys are thinking about long-term asset financing right now? I mean is this like, are we going to convertible bonds. I saw that an idea there? Or do you think you’d probably do more of a plain vanilla type of bond or just.? What are your thoughts when it comes to long-term asset-financing right now?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, the convertible bonds, that’s more of a... just having something available in case we need it, but I think that if you look European Capital, for example, in January did a securitization were basically they sold off the AAA tranche. I think the fact that we only need one to one leverage would allow us to enter the securitization market before like an asset manager trying to do an arbitrage CLO to enter the market, because really we can afford the enter the market by just structuring a AAA securitization of retaining the bonds below the AAA. And so I think we are constantly monitoring market conditions. And when we feel like the conditions are right, that would probably be our first approach to getting financing. I think that it's safe to say that there continues to be excess investment opportunity in secondary assets. And we’d like to see more of that cleared out of the way because that will lead to a tighter spread environment. Certainly, in April, it looks like that we were heading in that direction, but you need more of the secondary assets that are sitting on the Wall Street bank’s books to get cleared out before I think you start to develop an appetite for primary issuance.

Daniel Furtado - Jefferies & Company, Inc.

And so I guess in the meantime, would just focus on the line of credit to fund the assets?

John Erickson - Executive Vice President and Chief Financial Officer

Yes, well, look, we've got the liquidity of our own asset sales and then… so essentially we've been drawing our line of credit, repaying our line of credit and holding our leverage account at the lower levels right now.

Malon Wilkus - Chairman, Chief Executive Officer and President

Just to remind you, we got $4.9 billion back off of our portfolio in the last 12 months. And also we still have some undrawn shares under the equity forward program.

Daniel Furtado - Jefferies & Company, Inc.

Okay. Okay. I was just trying to get an idea of what future like ROEs are looking when you factor in debt costs and stuff like that, but I appreciate the color. It's very helpful.

John Erickson - Executive Vice President and Chief Financial Officer

Great, thanks.

Malon Wilkus - Chairman, Chief Executive Officer and President

Thank you. So is there one final question here?

Operator

And our final question is from John Stilmar with FBR. Please go ahead.

John Stilmar - Friedman, Billings and Ramsey

Hi. Good afternoon. And thank you for allowing me to get in the queue here. Just real quickly, just cleaning up on the FAS 157 marks that you guys took. I noticed that in terms of one of the items in the press release, you talked about public marks at least relative comps of public equities, is it fair for us to say or is it fair for you to say that the public equity markets have had a bigger influence than sort of the private M&A multiples at least in terms of the valuation of some of your equity investments?

Malon Wilkus - Chairman, Chief Executive Officer and President

Yeah, I think that's true. In the private arena, multiples are staying high and we’ve done all sorts of analysis of that.

John Erickson - Executive Vice President and Chief Financial Officer

[inaudible] no better analysis than knowing what multiple you've actually sold something for?

Malon Wilkus - Chairman, Chief Executive Officer and President

Right. So we know that in the middle market, multiples are staying high. And with over [ph] that because we've got lot of portfolio companies and they are performing well. And so as all have seen, we've been getting wonderful gains off of that portfolio, quarter after quarter after quarter after quarter. The public multiples however indeed came down in this last quarter, with respect to our portfolio. And that definitely has an impact and that's what we are alluding to in our earlier comments.

John Stilmar - Friedman, Billings and Ramsey

Okay. That's helpful and as you start talking about realizing gains, it brings up the next question of balance sheet migration, as we start look...

Malon Wilkus - Chairman, Chief Executive Officer and President

By the way, I’m just looking at a chart that just completely supports that comment that I've just made. I mean just a significant decline in public company comps versus the private arena.

John Stilmar - Friedman, Billings and Ramsey

Okay. So we as analysts when we start thinking about maybe marks as you may have in the quarter, should lean a little bit more heavily toward ETFs or public marks rather than sort of the assumed stability if private... if middle market multiples remain firm.

John Erickson - Executive Vice President and Chief Financial Officer

Well, the public marks is one factor. We weighted different methodologies, so that's one factor and that's the factor that's driving it down I think. The data in terms of with the transactions that are getting down in the middle market, another data point that's not declining.

Malon Wilkus - Chairman, Chief Executive Officer and President

And by the way discount rates are not going up. If anything, they are going down, and so when we do discounted cash flow analysis of portfolio companies, including assuming recessions in their future, we also see some maintenance of value as a result. So it's really owing to public company comps that are kind of causing an element of depreciation in the kind of analysis that we do for our controlled companies. Now, keep in mind on the mezzanine investments that we have in non-control companies, that’s being valued on a bond-trading basis, bond yield analysis. And there is where you've seen some of that depreciation that we pointed out in our private finance.

John Stilmar - Friedman, Billings and Ramsey

Okay. That's very helpful. As we start thinking about the balance sheet migration, and what I assume is sort of your ultimate goal is--?

Malon Wilkus - Chairman, Chief Executive Officer and President

Let me just say a couple of more things about that point. So in the first quarter, for the first time, we did value a lot of our mezz investments and senior loans for that matter, second lien loans by using a bond yield analysis. And keep in mind, we have never traded in or out of those assets in our history. We've never sold a mezz loan to somebody else. We've always been waiting for the companies to repay us off or and they do that, generally speaking. They often do it just out of cash flow. Secondly, they do it, because they go through a change of control transaction or sold and the debt is repaid generally in full. So we also think it is an odd way to value mezzanine assets by using a bond yield analysis. We don't think that gives our shareholders a great insight into its real value, but that is the required GAAP fair value methodology and so that's what we're using and so we pointed out that there was $180 million of depreciation associated with that implementation of FAS 157 this quarter. But we've also pointed out that we expect to get back about $132 million in realizable value at settlement of maturity.

John Stilmar - Friedman, Billings and Ramsey

Okay, perfect. And that's very helpful. Going back to as we start thinking about the balance sheet migration, and what I assume is your goal of investing more heavily in debt over the next couple of years. And we have an equity portfolio then it will be harvested to support your dividend. The question is what does the balance sheet ultimately look like as we start… in the longer-term sort of end of '09? Are we talking about a portfolio that's about 10%, 15% equity and mostly debt? And if that's the case, does that portfolio in and of itself able to constructed to what seems to be an implied 15% ROE, or mid teens ROE itself? Is that only predicated by doing mezz or can you give a little bit thought of what the debt portfolio looks like in order to support a recurring dividend in the outer period?

John Erickson - Executive Vice President and Chief Financial Officer

Yeah, look, I'm not sure you can say over the next couple of years we're going to get more into debt. What you can say is in today's environment where we think we are either in a recession or a recession is imminent, what we're going to do buyouts, we're going to factor that into the buyout, we may not win as many buyouts in this environment, but certainly as the economy recovers, and moves in the other direction, you can assume that we will be active on the buyout side as well. Now one of things that’s changing is a lot of our buyout capital is going to get funded through funds like ACE I, ACE II and even some primary equity funds. So, ultimately the mix of equity on our balance sheet may change, but I think that you might be projecting too much of an imminent mix change. I think that we feel like we always want some equity on our balance sheet to generate realized gains. And so, we're going to always have a mix of debt and equity. I think that you could say this environment that the subject component will grow, but if you go back and look historically through the last cycle, the debt yields went up during the recession and then it kind of… when we were in the recession, we made some great equity investments and then coming out of recession capital gains accelerated and I would expect that to hold true in this environment as well. We'll grow NOI and we'll grow our yields over the course of the next near-term and then when the environment changes, we're going to grow capital gains again.

Malon Wilkus - Chairman, Chief Executive Officer and President

We've got just shy of $4 billion worth of equity stakes. And I know a lot of analysts have thought somehow that's a bad thing, but keep in mind that equity has historically grown at over 10 years on average at 22% IRRs. Over the last five years, it's grown at a 25% IRR. Now, here we're in an environment where multiples have continued to stay up for the middle market, for our middle market companies, and on $4 billion of equity, they even had a 20% growth, you're looking at $800 million of appreciation gains in a year's time, so a huge amount relative to our dividend. Even if you assume, we get half of that, you're still talking about $400 million of appreciation in gains off of our equity. And until multiples decline in the middle market and there seems to be no trend to that happening, our equity portfolio generates some wonderful returns for us, and frankly, I see zero comments about that. Only comments I hear about our equity is that somehow bad for us. When indeed, it's going to be the wonderful thing that will allow American Capital to outperform the typical financial institution. A finance company has no, none of that. So a large amount of gains that we've experienced in the last year, the amount of gains and we've given forecast that the gains this year will be greater than last year. A finance company will have none of that to support, to allow them to support a dividend or to support their earnings. So we are thrilled with the equity stakes that we have and though that might decrease as a percent of our total assets over the next few quarters that can change on a dime and we will find some great opportunities to invest in and invest in it once again, because that's the way to get the kind of 16% return on equities that we provide, the high returns on equity that we have historically performed at versus a typical finance company.

John Stilmar - Friedman, Billings and Ramsey

Great. And just a follow-up, just a data point. I wanted to make sure I wasn't reading something into it. I know it's a small number. But on page 11, the net realized gains was $33 million, but the reversal of prior appreciation looks like it was $46 million. And I was worried that maybe M&A multiples may be contracting or something like that. Am I reading too much into it and what can I infer from both of those numbers if anything?

Malon Wikus - Chairman, Chief Executive Officer and President

Which page, what were you looking at?

John Stilmar - Friedman, Billings and Ramsey

I was looking at page 11 on the smaller presentation, the net realized gain of 33 million and then the reversal of prior appreciation, it's 46 million?

John Erickson - Executive Vice President and Chief Financial Officer

I think based on public stock price declined by the time we exited it.

Malon Wikus - Chairman, Chief Executive Officer and President

Overall we had a great return on and wonderful gains on our ASA investment, including when it was purchased by VeraSun. But for the one quarter where we had a lock-up, we did I think I have a slight loss on it. But I don't know if that's the major thing we're talking about here.

John Stilmar - Friedman, Billings and Ramsey

We can follow-up offline, it seems to be pretty small. And then my final question, John, it's regarding your comments in the press release which said, obviously, we are starting to see spreads tighten in the second quarter and you can certainly look at any sort of high yield index or any sort of Structured Products or CDS spreads, and that would certainly be the case. But are you seeing a spreads tighten in any of your lending products in the middle market, or is that more of a reflection of more broadly syndicated or let's call it more broadly used indices rather than necessarily middle market loans that you're making.

John Erickson - Executive Vice President and Chief Financial Officer

Yeah, my comments to really the Structured Products and the things we're seeing there, I think I'll let Ira speak to the middle market but, you know...

Ira Wagner - Executive Vice President and Chief Operating Officer

Yeah, I think you're also seeing that in the very liquid leverage loans for the big deals. You've seen spreads come in during the month of April, but there hasn't been a significant impact on pricing in the middle market. It's gone up over the course of last year and it continues to be fairly stable at those levels. The middle market always fluctuates a little bit based on the quality of the asset and the company has always a range of pricing on the deals, but since it’s not... nothing is really actively traded. You don't see the impact like you do on the highly liquid leverage loans.

John Stilmar - Friedman, Billings and Ramsey

Great. Thank you guys for allowing me to asking my questions.

Malon Wilkus - Chairman, Chief Executive Officer and President

Yes, thank you, John. And with that we're going to come to an end here, but I would like Amanda just to repeat the announcement with respect to our I guess our shareholder...

Amanda Cuthbertson - Director, Investor Relations

Investment meeting.

Malon Wilkus - Chairman, Chief Executive Officer and President

Investment meeting.

Amanda Cuthbertson - Director, Investor Relations

Yes, we are planning our American Capital's Equity Investor Conference for May 19th. Registrations have closed and we're out of capacity, but we invite all of our shareholders to participate via our webcast, which will be posted on the homepage of the American Capital website. So we hope you all can take a look. Formal remarks start at 9:30 AM. And for any investors or analysts that were left in the queue, we invite you to reach out to the IR team, we're happy to answer any questions that you have.

Malon Wilkus - Chairman, Chief Executive Officer and President

With that folks, thank you very much. We appreciate it and we’ll talk to you again in a quarter.

Operator

Ladies and gentlemen, this conference will be made available for replay after 3:00 PM today until May 21st, 2008 at midnight. You may access AT&T's Executive playback service at anytime by dialing 1-800-475-6701 and entering the access code 918-891. International participants may dial 320-365-3844. Again, the numbers are 800-475-6701 and 320-365-3844 and the access code is 918-891. 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. Q1 2008 Earnings Call Transcript
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