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Triangle Capital Corporation (NYSE:TCAP)

Q2 2012 Earnings Call

August 2, 2012 9:00 AM ET

Executives

Garland Tucker – Chairman, President and CEO

Sheri Colquitt – VP, IR

Steven Lily – CFO and Secretary, Treasurer

Analysts

Robert Dodd – Raymond James

Mickey Schleien – Ladenburg Thalmann & Co.

John Heck – Stevens

Greg Mason – Stifel Nicolaus

Vernon Plack – BB&T Capital Markets

John Ellis – Private Investor

Bob Martin – Individual Investor

Operator

At this time, I would like to welcome everyone to the Triangle Capital Corporation’s conference call for the quarter ended June 30th, 2012. All participants are in a listen-only mode.

A question-and-answer session will follow the company’s formal remarks. Today’s call is being recorded and the replay will be available approximately two hours after the conclusion of the call on the company’s website at www.tcap.com under the Investor Relations section.

The hosts for today’s call are Triangle Capital Corporation’s President and Chief Executive Officer, Garland Tucker and Chief Financial Officer, Steven Lily.

I would not like to turn the call over to Mr. Garland Tucker.

Garland Tucker

Good morning, everyone and thank you for joining us for joining us for our second quarter 2012 earnings call. Before we begin, I would like to ask Sheri Colquitt, our Vice President of Investor Relations to provide the necessary safe harbor disclosures. Sheri?

Sheri Colquitt

Thank you, Garland. Good morning. Triangle Capital Corporation issues a press release yesterday afternoon with details of the company’s quarterly financial and operating results. A copy of the press release is available on our website.

Please note that this call contains forward-looking statements that provide other than historical information including statements regarding our goals, [inaudible], strategies, future operating results and cash flows.

Although we believe these statements are reasonable, actual results could different materially from those projected in forward-looking statements. These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks including those disclosed under our section titled, "Risk Factors and Forward-Looking Statements" and our annual report on Form 10K for the fiscal year ended December 31, 2011 and quarterly report on Form 10Q for the quarter ended June 30, 2012. These are filed with the Securities and Exchange Commission.

TCAP undertakes no obligation to update or revise any forward-looking statements. And now, I’ll turn the call back over to Garland.

Garland Tucker

Okay, thank you, Sheri. And again welcome to everyone for today’s call. We are very pleased once again to have strong quarterly results to discuss with you. Before we get into the substance of today’s calls, I’d like to note that Brent Burgess, our Chief Investment Officer is unable to be with us as he’s traveling.

Aside from Brent’s absence, we will follow our customary format which is for me to discuss some highlights for the quarter and then for Steven to provide more detailed information about our financial results and liquidity, our capital market’s activity and our investment activity during the quarter.

At the conclusion of these prepared remarks, Steven and I will be happy to answer any questions that you may have.

First, most of you probably saw that we increased our quarterly dividend to $0.50 in June which was a year-over-year increase of $0.06 per share or 13.6% over the second quarter of 2011.

Obviously, we were very pleased with such a meaningful dividend increase and we’re equally pleased that our net investment income of $0.52 per share was once again comfortably in excess of our dividend.

As you know, one of our fundamental operating strategies is to earn the dividend. And by that we mean our net investment income needs to exceed our dividend on a long-term basis.

As of June 30, 2012, our accumulative dividends paid on a per share basis since our IPO totaled $8.48 and our accumulative net investment income per share for the same period totaled $8.77. These results indicate continuing success in achieving this important dividend coverage ratio.

Another very significant operating metric is our efficiency ratio which we calculate as SG&A expenses as a percentage of total investment income. For the quarter ended June 30, 2012, our efficiency ratio was 17.2%. TCAP continues to have one of the very best efficiency ratios in the BDC industry. As internally managed BDC, we have demonstrated that as our company grows, a greater percentage of each incremental dollar of revenue can fall to the bottom line as dividends.

In addition, our low efficiency ratio demonstrates our commitment to operating in the most cost effective manner possible. From a macro basis, we believe the BDC business model is continuing to earn a reputation as a yield oriented, investor friendly vehicle which can provide investors with the certainty of current income and the potential for long-term capital depreciation.

Like other yield driven industries which developed over multiple market cycles, most notably [inaudible] and MLPs, we believe that well-managed BDCs can provide investors an excellent return over a long period of time.

Turning briefly to our operating highlights from an investment perspective, the second quarter was very active for us. We closed seven-year portfolio company investments totaling $112.5 million and we have announced five-year investments subsequent to quarter ending totaling $42 million.

Our portfolio continues to perform well with an average debt yield of 15% and with $3.6 million in realized long-term gains during the quarter bringing our total net long-term gains since IPO to $10.4 million.

So before I hand the call all to Steven, I’d like to close by saying that we continue to believe that the low middle market is an exceptionally attractive place to operate. And that Triangle is well positioned to continue to deliver attractive returns to our shareholders by focusing on what we do best finding high quality businesses where we can add value both from an operating and a financial perspective.

And with that, I’d like to turn the call over to Steven.

Steven Lily

Thanks, Garland. During this portion of the call, I’ll discuss our financial results for the quarter and I’ll also touch briefly on our capital markets and investment activities since our last call.

As most of you know yesterday after the market closed, we filed our earnings release and 10Q. During the second quarter, we generated a total investment income of approximately $22 million which represented a 34% increase over the $16.4 million of total investment income during the second quarter of last year.

The increase in investment income was primarily attributable to a year-over-year increase in the size of our investment portfolio. Of the $22 million of total investment income or total revenue, approximately $1 million was related to one-time fees which on the per share basis are very much in line with our historical experience.

Our total operating expenses during the second quarter of 2012 totaled $7.9 million consisting of interest expense and other financing fees and G&A. For the three months ended June 30, interest in other financing fees totaled $4.1 million as compared to $2.8 million for the second quarter of 2011.

The increase of $1.3 million was primarily due to a $1.2 million increase and interest in financing fees related to our senior notes or baby bond issuance – issue which was done in March of this year.

The $331,000 increase in general and administrative expenses was primarily attributable to increase salary and compensation cost as well as increase in non-compensation cost which were driven in part by an expansion at our operating team which increased from 17 professionals during the second quarter of last year to 21 professionals during the second quarter of this year.

Net investment income for the quarter is $14.1 million or $0.52 per share as compared to recurring NII of $0.46 during the second quarter of 2011. As you would recall on the second quarter of 2011, we recognized approximately $0.09 of one-time non-recurring fees which we called out to the market at that time.

During the second quarter of 2012, we recorded total realized gains of approximately $3.6 million associated with the exit from four portfolio investments. During the quarter, we recorded net unrealized appreciation within the portfolio of approximately $1 million.

As a result of our operating activities, our net increase and net assets from operations was $15.6 for the pre [ph] launch ended June 30, 2012 or $0.57 as compared to $14.5 million or $0.78 per share for the period ended June 30, 2012.

At quarter end, our total investment portfolio had a fair market value of approximately $598 million representing an increase of approximately $189 million from June 30, 2011. And finally our net asset value per share as of June 30, 2012 was $15.21 representing an increase of $0.53 per share since June – or excuse me – since December 31, 2011.

From a liquidity standpoint as of June 30, 2012 we had approximately $94 million of cash on hand, $75 million available under our existing senior credit facility and a little more than $10 million of undrawn SVA debentures for a total liquidity amount of $180 million.

You may recall that during the first quarter of 2012, we completed common stock offering with $77 million in net proceeds and a public bond offering with $67 million in net proceeds.

Those transactions put us in a very strong liquidity position going in to the second quarter where at the time, we had a very robust investment pipeline. As a result, we were able to fund our investment activity during the second quarter while still maintaining more than adequate liquidity from a balance sheet standpoint.

In our first quarter earnings call, we mentioned that we were in the early stages of potentially expanding our $75 million senior credit facility. That process is continuing and we believe we will be in a position to announce an expansion to our senior credit facility sometime this fall likely before our third quarter earnings call in early November.

The contemplated expansion of our senior credit facility is expected to provide us with additional attractively priced capital that we believe will provide us with sufficient liquidity to continue executing our business plan.

I should note that from a balance sheet perspective, Triangle has reached a size where it is appropriate to include at least some amount of what we would call permanent bank financing in our capital structure.

So I think you can reasonably expect to see that as part of our expanded senior credit facility. However, I will reiterate a comment that I made last quarter which is to say that we are still very focused on maintaining our conservative credit profile which we believe is a hallmark of any prudently capitalized BDC.

This is the point of the call when I would normally turn, thanks over to Brent for some color surrounding our investment activities for the quarter. So in his absence I’ll give you a high level overview of our activities. And then Garland and I will be happy to answer any specific questions you have.

As Garland mentioned, the seven new investments we made during the second quarter totaled just over $112 million and the five new investments that we’ve announced also going to quarter end totaled $42 million. So I won’t spend much additional time on these other than to say that the 12 new investments were made across 10 different industries.

Including the effects of our recent investment activity, we currently have 74 portfolio companies across 30 industries which we believe provides us with significant diversification from an operating standpoint.

I would also note that our two second quarter – that two of our second quarter investments, TrustHouse Services Group and Plantation Products were recapitalizations of companies that have been in our investment portfolio since 2008 and 2010 respectively and both of these instances, our portfolio companies have the opportunity to make attractive acquisitions which provided us an opportunity to invest additional capital.

These companies are well known to us and we have been very pleased with their performance since inception and we are excited about their prospects going forward.

The weighted average yield on our debt investments was 15.0% as of June 30, 2012 as compared to 15.1% as of March 31, 2012 which is perhaps the best indication that our investment structures continue to be relevant to companies in our target market.

We continue to be very pleased with the performance of our investment portfolio as well as the portfolio’s overall credit quality. And during the first half of the year, we removed one company from non-accrual status, American-De Rosa Lamparts of $5.4 million investment and placed that company back on full accrual due to its improved operational status. We also placed one smaller company, Equisales a $3.2 million investment on non-accrual status during the second quarter.

As a result of this activity, our non-accrual rate as of June 30, 2012 represented 0.5% of our total portfolio on a fair value basis and 1.6% of our portfolio on a cost basis. Our high level thoughts [ph] on the general investment climate are that the lower-middle market will continue to remain active during the second half of the year as generational sellers seek to lock in games ahead of the presidential election and also potential tax uncertainties which clearly lie ahead.

So in conclusion as Garland mentioned at the outset of the call, we continue to believe that the lower middle market is a very fragmented but also a very large segment of the market where we can continue to increase our market share by offering investment structures which are attractive both to financial sponsors and high quality management teams.

And with that, I’ll turn the call over to Garland for any concluding comments before we take questions.

Garland Tucker

Good. Thanks, Steven. I think the most meaningful comment I can make at this point is to assure you that we intend to continue doing just what we have been doing. In very simple terms, we invest in companies that have reasonably conservative capital structures that generate steady cash flow and which have exceptional management teams with significant ownership.

We read the same headlines that you do about the uncertainty of the financial markets in Europe and the continuing economic struggles in the US. However, we believe the subordinated debt investments in the lower middle market continue to offer very attractive risk adjusted returns and historically the fluctuations in interest rates for our type of financing have been much less volatile than those experienced by the broader debt markets.

So again, we had another great quarter and we very much hope that our call in November will be equally as positive.

With that, operator, you can now open the call up for questions.

Question-and-Answer Session

Operator

Okay, thank you. (Operator Instructions) And our first question comes from Robert Dodd of Raymond James. Please go ahead, your line is open.

Robert Dodd – Raymond James

Thank you. Hi, guys. Excellent quarter. I’ll ask on the deployments number obviously through the last four months if we include the July numbers, you put $160 million in capital [inaudible]. I mean you still got liquidity, but how much of that do you think is – things that have been in the pipeline a long time and of just all being pulled forward maybe from the back end of the year.

And obviously what I’m trying to get at is, what kind of run rate can we expect because I assume it’s not the level we’re seeing – you’ve seen very recently?

Steven Lily

Robert, thanks. It’s Steven. Yes is the short answer to your question, they’re worst. And in certain quarters, sometimes things get delayed and in certain quarters, things, as you indicated, get pulled forward. And I think we certainly experienced some of that in the last four months as you indicated.

Clearly when went to the equity markets in the first quarter and also the bond market in the first quarter, we, as I mentioned on the call, had a fairly robust pipeline and those things had cycled through.

As we look at the second half of the year, as you know, we don’t – yes, we really do try to shy away from giving specific forecast because frankly it’s just difficult if not possible for us to know ourselves.

But one thing I think that – excuse me – you might allow in your forward estimates would be as we move through the second half of the year, given the size of the portfolio now, we would – it would certainly be reasonable to expect some repayments would occur between now and the end of the year, honestly very difficult for us to handicap the timing of those. But we probably have a little less of that activity over the last three or four quarter than we normally would expect.

So deployments have been significantly an excess of repayments for the last several quarters and at some point that needs to probably balance out in a portfolio.

Garland, would you add anything to that?

Garland Tucker

Yes Robert, I would just say that the – I guess the caveat we give every quarter is that it’s very difficult to project net deployment levels and that caveat would be just as [inaudible] this quarter as any other quarter for the reasons that Steven has given.

Even when net deployments are as robust as they’ve been this year so far, we’re still only dealing with just a relative handful of deals and it doesn’t take much movement in either directions – either direction with a number of deals or in repayments to change that number.

So the answer to what the future deployment reg looks like is unfortunately, we honestly won’t know until we get there.

Robert Dodd – Raymond James

Understood guys. On pricing, like you’ve always been very stable, I mean you’re talking about 15%, 15 and 1 a year ago [ph]. I mean are you seeing any change in other terms. I mean I’m just a little surprised it’s been so solid given as you’ve talked the analyst day, you’ve moved your mix towards slightly bigger private equity partners and obviously there’s a pricing seems to be sticking very, very well.

Are you seeing changes on multiples or covenants or anything else or upfront fees [ph]? I mean is there anything else sticking around or is all that sticking as well?

Steven Lily

Well, it’s probably good, Robert that Brent is not with us today with that question because he would probably tell you how in the transactions that he looks at from an early stage basis with many of our investment professionals that things are all over the map.

But it is true as transactions have moved through the investment funnel if you will hear that we’ve been very thankful that we’ve been able to maintain the pricing that we have and also maintain the equity positions that we have and investments we’ve made.

I don’t think we’ve seen any noticeable change certainly upfront fees in terms of moving away from the sort of all norms of about 2% plus or minus. And in covenants, we haven’t seen any meaningful change there either.

So it’s, again the percentage of investments on which we close as compared to all of the ones that we look at and evaluate is, as you well know, very, very small sort of a single digit percentage. So that does help us I think in terms of what actually gets into the portfolio.

Robert Dodd – Raymond James

Okay, great thank you. The last question if I can on credit. Equisales, I mean can you give us an indication? Obviously it’s gone on to non-accrual now. It looked a little stress last quarter. Can you give us an idea here if you’ve got any probably that coming back onto accrual or what the timeline is going to be?

And then same kind of question, I mean looking at to us, to me looked a little stressed last quarter. And Venture Technology Group did [inaudible] markup this quarter, so things have clearly improved there. Can you give any more color on that?

Steven Lily

Did you want to get a go?

Garland Tucker

Robert, this is Garland. I’ll give you just a word on Equisales. The Company continues to have problems. I think the starting point is the size of the investment as a matter of fact that originally it was a $6 million investment. And I think [inaudible] we prepaid on half of it, so it’s fortunately down to a relatively small number.

But the company continues to have problems. We don’t know what the outcome is. Their senior bank is working constructively with the sponsor and the company to try to – to pull out of the operating hole that they’re in. But at this state, it’s too early to tell.

Their business, basic business model remains the same and it could turn out to be just fine, but at this stage, we honestly don’t know. In fact you’re correct in – I mean the message that we’re sending back on non-accrual as it continued to have problems and we don’t know the outcome at this day. But we’re happy that the size of the investment is what it is.

Steven Lily

Yes, Robert. And then on Venture Technology Group, you’re accurate in the slightly positive this quarter, yes, still in the same zip code I think I would say in terms of relative fair value today versus cost.

And that company as we mentioned on the last call lost their sort of biggest customers soon after the investment was made. No fraud or anything like that. It’s just one of those things that can and does happen sometimes on a customer that delayed the large project.

But we’ve been doing the right things so to speak and still producing some cash flow. So we’ve obviously getting paid and hope that will continue. But it’s just one of those situations that you try to work through.

But thankfully that’s not a large investment for us either from a total portfolio standpoint, but we are – it is likely better this quarter than it was last quarter. So we’re thankful for that.

Robert Dodd – Raymond James

Okay, got it. Thank you.

Steven Lily

Great. Thank you, Robert.

Operator

Thank you. Our next question is from the line of Mickey Schleien of Ladenburg. Please go ahead, your line is open.

Mickey Schleien – Ladenburg Thalmann & Co.

Good morning and thank you for taking my questions. I have two. The first one is how much downside in cash flow do you think your portfolio companies can withstand at the down cycle of the economy without putting your sub debt servicing at risk?

And what level of GDP contraction would it take to get there?

Steven Lily

Mickey, its Steven. I’ll try to give – that’s a – for a call like this, it’s a very, very precise question. So forgive me if the outsets answer you a bit in generalities. As we said before the average fix charge coverage that our portfolio companies have is – has really since our IPO has been basically plus or minus, 1.5 times.

And the things that would impact in a downturn, the company’s ability to maintain that would be frankly more of the what the amortization is of senior debt that might be in front of us in the capital structure.

And as you well know, certainly if there is a – if there’s downward pressure, many banks would work with their clients and their customers to alleviate some of that amortization. So lots of things can happen and truly is a case-by-case basis.

But we like the fact that we enter our investments with such a strong fix charge coverage ratio. So I think as you look back at our credit quality versus perhaps some others in the space, we’ve had a really nice low non-accrual rate and high repayment and then gain rate as well.

In terms of overall GDP and how that might impact our specific portfolio, that’s just unfortunately I think tough, if not impossible for us to really connect those dots, of how these companies – how these companies function in their respective markets.

But when we run our downside cases before we make investments, we run scenarios where typically we would cut EBITDA by somewhere in the 40% to 50% range and look at what happens.

And in those situations we – it’s clearly not always a pretty picture but it’s one where we think we can get our money out over time and have certain covenant discussion and those types of things. It would be bumpy, but we’d protect principal.

So all those things combined made us feel pretty good about the portfolio. Probably the best way to look at it, I would say is from a historical basis of what we went through in the portfolio and the results we generated through the downturn.

Does that help answer your question? I know I didn’t get all the way there on the GDP piece.

Mickey Schleien – Ladenburg Thalmann & Co.

No, no, no. That’s very helpful. And just a one quick follow up. You know your company really is quite different from most of the other BDCs that at least that I covered with respect to the amount of operating leverage that you’ve been delivering.

But you have a very solid year so far and a lot of growth. And I’m just trying to get a handle on how much more operating leverage could there be in the sense of with this pace [ph] of portfolio growth, clearly I think you would need to continue to add employees.

And can we expect this in a leverage ratio to continue to improve or are we at some sort of maximum level at these current ratios?

Steven Lily

Well, I’ll give you a quick thought there and then Garland may well add something too. But first just in terms of investment phase, we did have one of those quarters where everything kind of went right so to speak in terms of timing.

But if you were to compare back to the first quarter for example of this year, we only closed about, on a net basis, $30 million of – or excuse me – $40 million of investments on a total gross basis.

So it was – I wouldn’t expect this investment pace to continue for us at the same right that it did in the second quarter.

In terms of operating leverage, we really do believe that the internally structured model or the internal BDC model is not only just more shareholder friendly, but it’s frankly just we think of much better way to operate so you can experience that type of operating leverage that you mentioned in your question.

Clearly we’re running sort of mid 60s in terms of percent or NII margin. But the example we [inaudible] around sometimes internally if you make a $10 million investment at 15% interest, then you got $1.5 million a year of revenue off of that investment. Even if you were to go higher one person for each new investment that we make and pay that person $500,000 a year, then you got a 65% cash flow margin on those incremental investments. And you don’t – clearly don’t need to staff at that level.

So I think we really do like the leverage that we get, but when you’re running at a mid to high teens efficiency ratio as compared to an industry that operates on that same basis somewhere between 35% and 40% of revenue for G&A as compared to revenue, at some point you’re not going to take much lower.

So we want to be cognizant of that. But Garland I’ll let you add a couple of thoughts too.

Garland Tucker

Yes, no. I think I won’t change anything what Steven said. And I think we’ve got enough of the history that you can look back and see – even though we only have 21 people total now, but percentage wise, that’s grown as the company has grown. And given that we very much intend to stay down in the lower middle market end of the market.

As we have growth opportunities it’s going to mean we will add people. But I think the important thing from a shareholder standpoint is – or two things really when you look back and see that there has been significant operating leverage and with the internally managed model, at least shareholders have a chance to benefit from leverage which they don’t have – operating leverage which they don’t have with the external model.

Our primary commitment is to staff appropriately and to continue the investment quality we’ve had. And in meeting those two objectives, if we can continue to deliver for shareholders some operating leverage, that’s absolutely something we intend to do, but the first two come first.

Mickey Schleien – Ladenburg Thalmann & Co.

Thank you for your time today.

Steven Lily

Mickey, thank you.

Operator

Thank you. And our next question is from the line of John Heck [ph] of Stevens. Please go ahead, your line is open.

John Heck – Stevens

Good morning guys. Congrats at another good quarter. Some of these are a little bit redundant because you commented on the strength in originations this quarter might have been, just at the timing of all the deals came together in a coincidental fashion.

But you had high originations or payment activity was high. Would you tribute this all to this potential tax policy change or is it potential secular trends that are evolving that might just suggest that your overall capital deployment and middle market M&A activity might be just starting to increase in the cycle?

Steven Lily

Well, John it’s hard to say how much is driven precisely due to the election and potential change in the tax laws. It is a conversation people like to have. And so when you sit down with sponsors and you sit down with management teams, it’s usually some portion of the discussion does revolve around that.

But I think for us probably more than that specifically was we just had a very well timed quarter. And as you well know because you’ve followed us for quite some time now. This is, in the last eight quarter, this is overwhelmingly the largest deployment quarter that we’ve had and by fairly wide margins.

So, I think it’s really more timing than anything. We feel very fortunate that we raised money in the first quarter, sort of mid to late in the first quarter. From a timing standpoint, we just couldn’t have been more well-treated from that standpoint.

So it’s just tough to say how much. I mean, certainly there’s some activity and people talk about it, but there’s no way we could say, gosh, 50% of our volume this quarter was due to that, would you say, Garland?

Garland Tucker

Yes, I would just echo what Steven said. I’m not sure we’re in the best – I’m not sure we would recognize secular trends, but I don’t think we’ve seen anything that we think is a strong trend. The quarter turned out to be very good for the reasons Steven mentioned, but they’re all – all those reasons were peculiar to a handful of deals and the fact that we didn’t have substantial repayments.

And we hear all the talk about the apprehension and the tax rates and the uncertainty and all that, but I don’t think we’ve sense that that’s just driving our market.

John Heck – Stevens

Okay, that’s good color. Second on the portfolio trends, obviously stable to positive credit particularly in terms of non-accruals. But can you comment on revenues, EBITDA margin trends? And have you seen any fluctuations lately just with all the mixed economic data we’re getting in any particular companies or sectors that you have invested in?

Garland Tucker

Just overall, it’s been – and you can imagine with 70 companies, we see plenty of variation. We’ve had some with substantial growth and some with some declines. But overall, the portfolio is relatively flat, which I think in this economy – in the overall economy is probably not surprising and maybe it’s fairly reassuring.

John Heck – Stevens

Okay.

Garland Tucker

We have no significant advantages [ph] overall.

John Heck – Stevens

Okay. And then, consistent yields in the portfolio and then just I wonder if you could comment on leverage, the leverage in recent deals, I guess, the last quarter and thus far into this quarter. Has there been any significant changes in those?

Steven Lily

John, it’s Steven. No, there really hasn’t. We think amazing is probably not too strong an expression that if you look back over the originations that we have had on an annual basis, quarterly basis since IPO, our total leverage has averaged between 3, 3.25 times. Again, these are averages, of course, so be a little careful with it.

But fixed charge has been kind of between 1.4, 1.5 and 1.55, and then the most gratifying thing is the average EBITDA in our portfolio of companies has increased from kind of just shy of $10 million on average to something just slightly north of $15 million – yes, $15.1 million or $15.2 million.

So we’re just very pleased to be able to be more relevant to companies in the lower middle market, because our balance sheet is bigger, and also being able to be relevant to companies that are slightly larger than the ones that we were working with at the time, just before and just after the IPO, but still very, very much being in the heart of the lower middle market where we just really enjoy operating.

John Heck – Stevens

Thanks. Appreciate the color.

Steven Lily

Thank you. Appreciate the questions.

Operator

Thank you. Our next question in queue is from Greg Mason of Stifel Nicolaus. Please go ahead.

Greg Mason – Stifel Nicolaus

Steven, at the investor day, you talked about a goal of hopefully getting a credit rating in the next 12 to 18 months. I wonder to see if you’ve officially started any of the dialog with the rating agencies yet and if you’re getting any feedback from that aspect.

Steven Lily

Greg, thank you for the question. We have not formally started that process with the rating agencies. We’ve as we mentioned at the investor day done some background or state work, and we would expect in the second half of this year to begin some of those conversations. It’s one of those things that we would certainly hope like many of our brethren in the space that when we are rated, we would have the opportunity to earn an investment grade rating.

But we are certainly gratified with how the bond offering that your firm led earlier this year has traded and I think they’re trading right around 6.5 or 6.625 today. So we’re very pleased with that and what may portend in terms of future cost to capital for us whether we’re rated or not. But it is something we will continue looking at on that same timeline.

Greg Mason – Stifel Nicolaus

All right. Great. And then, just on your last comments of where you’re now looking at companies with EBITDAs of $15 million. Are you seeing any pressure on the amount of equity co-investments you’re able to make in these companies?

You’ve talked in the past that that’s really been one of the keys to your strategy, is having equity in every single investment because you never know which ones are the big winners and losers when you start out. So has that equity changed as you’ve moved out market just slightly?

Steven Lily

It really is not, and again, we should, as a side, be a little careful with averages, on averages, so to speak. And if you have one company with significant EBITDA, that can move the needle obviously for the whole portfolio in terms of how things close and when they close. But we are still very, very much in those four buckets we described at the analyst day and during that presentation on our website of where we like to look with having transactions with larger sponsors, smaller sponsors, just sort of fund less [ph] sponsors or family offices, and we’re triangle in certain cases as the institutional capital in a company.

The blend of those four types of investing activities really gives us the ability to have equity or some type of upside in almost 90% of our portfolio companies. So we’re very much very consistent with that strategy in the second quarter.

Greg Mason – Stifel Nicolaus

Great, thank you. And then one final question, just to make sure I’m thinking about this right. And I know people are talking about operating leverage and can they get better from the 17% efficiency ratio. But even if the percentage doesn’t get better, it would still seem like $0.83 of every $1 is falling to the bottom line. That can still be accretive in growing earnings as you deploy capital. Am I thinking about that correctly?

Steven Lily

Well, I think, partly. But keep in mind you got to have – there is some interest cost there. When we talk about efficiency ratio, that’s G&A only to be consistent with how other companies would report that same statistics. Once you layer in the interest burden for any company in the space, you probably get lower than that. I mean, our NII margin has been uncomfortably in the 60s for years now, and we feel good about that. But it’s not an incremental $0.80 to $0.85 of every $1 and that thing.

Were you going to add something Garland?

Garland Tucker

Yes. I think your thought is right in that even if we’re unable to significantly improve the efficiency ratio of the shareholders, if we’re able to roughly maintain it, that’s a pretty significant benefit to shareholders compared to what an external structure would have delivered to them.

So I guess we’ve been able to deliver the benefits so far if we can just – if we can improve it, that’d be great, but if we can hang on to it, that’s still preserving that significant spread that clearly exists at this point. And certainly, we’d like to – I don’t know any reason why that shouldn’t be a goal. And it is a goal for us to at least continue it.

Greg Mason – Stifel Nicolaus

Great. Thank you, guys.

Steven Lily

Thanks, Greg.

Operator

Thank you. And our next question in queue is from Vernon Plack of BB&T Capital. Please go ahead.

Vernon Plack – BB&T Capital Markets

Yes. We’ve talked a lot this morning about efficiencies and that you continue to grow the business. I know that your portfolio is diversified across the country. Have you thought at all about having a physical presence, an office location in any other areas than Raleigh?

Garland Tucker

Vernon, this is Garland. It’s absolutely something we thought about and talked about from the earliest stages. I wouldn’t at all say that we would never do that. But I can tell you why we have resisted the idea and why we continue to think it’s probably unlikely that we would.

I’d say the first thing is we’ve been able to grow our presence. If you look at the slide that we used in our presentations as our geographical distribution, we arguably have a national reach at this point operating from one office. And the reason we have, I guess, been pretty insistent today on not opening a branch is that, with only currently 21 people, if you were an individual stuck out on a branch, I guess that said internally, I wouldn’t want to be that person out in the branch.

If I were with a company, those are the smallest 21 people I’d want to be physically located where the decisions were made and be a part of the process. And the trade-off is that to have a national reach like we do and operate at Raleigh there’s an awful lot of travel involved and you would eliminate some of that if you had branch offices. What you would give up is the benefit of having the key deal people all around the table once a week, which we think has been very, very important to us in delivering the kind of investments, the kind of credit quality we have.

So I guess I’d go back to the starting point. We would not say we would never do it, but we don’t see it anytime soon and it might well, and hopefully – I would personally hope we would never have one, but I wouldn’t say we would never.

Vernon Plack – BB&T Capital Markets

Okay. And as you continue to grow and expand the business, are there thoughts – I don’t know how you feel about the amount of deal flow that you’re seeing. Are you comfortable with the amount of deal flow? Are there deals that perhaps you’re not seeing that maybe if you perhaps either staffed a little bit better or better connected, per se, in the market place that you would see more deals? Or do you feel as though you’re really seeing all the deals that you need to see at this point?

Garland Tucker

Vernon, this is Garland again. I’ll answer that and Steven can chime in if he has a different thought. I would say that we’ve certainly to date never been in a position, and I would guess probably never would be in a position, to say we’re satisfied with deal flow because there are times even in the past quarter which is awfully good that we said, well, gee, are we going to have enough deal flow or whatever.

But I think the overall sort of the high-level position we’re in, and then we’ve said this before, but I think it’s really an important point is we feel like we’re in an ideal situation right now. There is no question in our minds that we are infinitely better known as a provider of mezzanine capital in the lower middle market than we were when we went public. There’s no question about it. And we’re better known by sponsor groups.

But the good news is that we – even though from every measure we can see, we’re the biggest, most-active, consistent provider of mezzanine capital to the lower middle market. But even if that’s true, we don’t even come close to dominating our market. So we’ve made real progress in getting our name out there and having these relationships, but absolutely there are deals that we don’t see and that we want to be on the shortlist for every good sponsor, and we’re not yet at that point.

We’ve made a lot of progress and we feel like we’re ahead of everybody else that we view as competition down in our market. But the good news is, we’ve got a lot of runway ahead of us and if we can continue making progress and getting on the shortlist of sponsors, we think we can continue growing.

Steven Lily

Vernon, I’d love to improve on that answer, but I can’t. So what he said.

Vernon Plack – BB&T Capital Markets

Okay, all right. Well, thank you very much.

Garland Tucker

Thanks so much.

Operator

Thank you. Our next question is from John Ellis [ph], a private investor. Please go ahead. Your line is open.

John Ellis – Private Investor

Good morning, gentlemen.

Steven Lily

Good morning, John.

John Ellis – Private Investor

So happy with you that perhaps words can’t express it. I’ve been with you three years. You may remember I visited your company about three years ago. And at that visit, my last question to you was, what you worry about when you go home at night. And your answer was one word, inflation. How would you answer that question today?

Steven Lily

Well, I think the first thing we’d say, John, is we’re thankful that that concern was not realized in the last three years.

John Ellis – Private Investor

Yes, I think we all are, right?

Steven Lily

Yes. Certainly, as you would look at our company and the types of things that we tried to do from a balance sheet management standpoint and a revenue standpoint, we have a balance sheet that today is 100% fixed, at about 5.25% interest rate weighted average, and we have the revenues coming in that are about 96%, 97% fixed at a weighted average debt yield of 15%. So that fixed spread of roughly call it 10 percentage points or 1,000 basis points is really a nice form of ballast for us were we to enter an inflationary environment.

The same headlines that you read are the ones that we read about rates staying low for certainly in the near to intermediate term and the yield curves are relatively flat in the period. So it’s not an overarching concern for us in the near term for the business, but it is certainly, I think, you could tell by our actions, we are trying to be sure that we have a balance sheet that is very well-prepared were that to happen so we don’t get caught kind of looking the wrong way, if you will.

John Ellis – Private Investor

And your average deals is three to five years, right?

Steven Lily

Right. Our average commitment period is approximately five years on a weighted average basis. It’s probably 5.1, 5.15 years. But the average transaction life is between 2.5 to 3 years.

John Ellis – Private Investor

Okay, fine. Does inflation at all on your screen?

Steven Lily

No, at least not mine personally. Garland may have a different answer. I think our government sort of bet the farm at some point our country will need to have inflation as its friend at some sort to get us out of the mess we’re in collectively. But Garland, you may have a different opinion.

Garland Tucker

I think as to what we worry about, I don’t think we worry anymore, but hopefully no less now than we have in the past. I mean, when we’re making investments in smaller companies, which we always have, and we’re shooting from mid to high-teens total returns, I mean, you know by definition we’re taking significant equity-like risks, and that’s been through since we started. It’s true for the mezzanine space.

And so I think the – I guess I would say two things. I think there’s always the danger that somehow inadvertently we take our alpha ball and stop doing what we’ve been doing in the past. And we’re committed not to do that. And then the second thing that’s been a very important part of our strategy and is even more significant today is the diversification of the portfolio over 70 investments over some 30 industries that as we’ve grown that diversification – as the portfolio has grown, that diversification has grown. And we think that’s important.

Right now, credit quality is as good reasonably, I mean, certainly at the very low end of the range of what we’ve experienced or what any BDCs have experienced and for that –

Steven Lily

In terms of non-accrual.

Garland Tucker

In terms of non-accrual. And for that, that could change significantly with just a handful of investments. We don’t see that in the portfolio now, but I hope we continue to worry about it, because it’s something we certainly realized when we make these investments that we’re taking significant risk in order to achieve the significant returns we expect to make.

And so far, we’ve done that prudently and we know the key factors in our strategy and we’re committed not to change those. I think –

John Ellis – Private Investor

So you’re looking out to 2014 as sort of the guarantee by Fed Reserve as the low interest rate environment continuing.

Garland Tucker

Well, I’d say we don’t spend a lot of time thinking about or worrying too much about the macro issues. As I mentioned, I think, in one of my comments that the interest rate on mezzanine investments, really, historically, going way back before we existed and certainly during our life as a mezzanine investor, the rates don’t tend to bounce around like the short-term rates do, and either up or down.

And so we don’t – I mean, we do worry about the term of the overall economy, but where the short-term rates happen to tick up a bit, it’s hard to imagine ticking down any from where they are now, but if they happen to tick up a bit, we wouldn’t be – I don’t think it would affect us necessarily too much.

John Ellis – Private Investor

Well, thank you very much for your excellent work. You’re probably the best BDC I own in terms of performance. So I’m not going anywhere.

Steven Lily

Well, thank you, John. Thank you very much.

John Ellis – Private Investor

Good day.

Operator

Thank you. And our next question is from Bob Martin [ph], an individual investor. Please go ahead. Your line is open.

Bob Martin – Individual Investor

Do you parse non-accruals into two categories unlike other BDCs, giving detail on PIK non-accruals? I have no idea if you’re breaking data into two parts that others lump into one or if you’re providing transparencies that others lack. Can you give me some detail?

Steven Lily

Bob, this is Steven Lily. We hope it is the latter, although I’ll confess to you that we have not done a canvassing of the entire industry to see how other people – how everybody else has disclosed that. We do know there are certain folks who choose not to disclose PIK non-accrual.

Really, the litmus test for us is when we draft the 10Q, we try to draft it in a way placing ourselves in the position of the reader and the investor and ask ourselves what questions we would find helpful, what information we would find helpful. So we’re hopeful that it adds a layer of transparency to give, again, anyone reading the Q is much details as possible in the portfolio.

It’s specifically on the company that you mentioned that is on PIK non-accrual home positions, is the name of it. And that account is continuing to pay from a cash standpoint, and we’re thankful for that. But it has had some operational issues. So I think the thing that we take most comfort in is even if that account – and Garland alluded to this earlier in his comment – even if that account were to go on full non-accrual, given the amount by which we are overearning our dividend, we would be able to absorb that loss of revenue, if you will, and still be in a position to earn more than the dividend going forward.

So we hope that we’ve done the right things in terms of taking that into account with our dividend level and also hope that are being as transparent as we can. But I can’t unfortunately comment on what everybody else is doing in the space.

Bob Martin – Individual Investor

Thank you. I’m trying to get apples-to-apples numbers and that’s difficult with BDCs. Did you have OID income that was accrued in Q2?

Steven Lily

We do have OID income that is accrued, really, every quarter for us given the way the accounting rules work. We did not have any what we would call overly significant OID this quarter versus any prior quarter. It’s very much in line with our historical experiences.

And I think maybe what you might be touching on there, Bob, and we appreciate it, is where we to have overly significant one-time fees or non-recurring fees in the form of OID or some other fee, we certainly have historically called that out to the market and we would expect to do so again just trying to think of things that people would find meaningful as they evaluate our performance.

Bob Martin – Individual Investor

Okay. I do want to thank you for your transparency. You provided detail on PIK income dollars received in Q1 and Q2. In Q1, you accrued close to $3 million in PIK income and received less than $600,000, whereas in Q2, you received more than $2 million in PIK income and accrued $3 million. Is that correct?

Steven Lily

Yes, I think those numbers are correct.

Bob Martin – Individual Investor

That variety, that oscillation concerns me. Can you give me some color?

Steven Lily

Sure. Per the accounting rules, we recognize PIK income in what we could call the top part of our P&L or income statement as companies – as that accrues in their interest rate. It is not received in cash at the time, but it does accrue. And then, the reconciling item, so to speak, is what you mentioned, which when companies prepay their PIK or if a company repays all of its principal amount, they then repay the PIK as well because it accrues to additional principal over time.

So it fluctuates on a quarterly basis really based on the repayment activity that we have that we experienced in the portfolio. I can tell you, Bob, it’s something that we track very closely every quarter and every year and we share that information with our board every quarter and every year. And we look at it on this. You just did and that’s why we disclosed it that way both the gross and the net basis.

But we have typically found that the net exposure that we have to PIK interest on annual basis tends to average between $1 million and $2.5 million a year, which is one of the reasons we hold back a little bit extra cash on our balance sheet to be sure that we have sufficient liquidity and sufficient funding, if we enter a period where companies do not repay and therefore bring down that PIK number.

So hopefully we’re doing the right things. It’s we think been a positive boon to us in operating the lower middle market to capture those additional interest rates, but also trying to recognize that PIK income is less certain than cash, but maybe more certain that a potential equity gain. So it has a place in our way of investing, but just want to be sure that we’re tracking it very closely.

Does that help?

Bob Martin – Individual Investor

It does help. Thanks for your answers.

Steven Lily

Great. Thank you so much. I appreciate you participating.

Operator

And with that, I’m showing no further questions in queue. I’d like to turn it back to Mr. Tucker for any concluding comments.

Garland Tucker

All right. Thanks again to everyone for being on the call, and we look forward to talking to you in three months. But in the mean time, if you have any questions, feel free to call Steven, Brent or me or Sheri. Thanks again.

Operator

Again, thank you, ladies and gentlemen, for your participation in today’s conference. You may now disconnect. Have a great day.

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