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Kohlberg Capital Corporation (NASDAQ:KCAP)

Q1 2008 Earnings Call

May 8, 2008 9:00 am ET

Executives

Chris Lacovara - Chairman and Vice President

Dayl Pearson - President and Chief Executive Officer

Michael Wirth - Chief Financial Officer

Analysts

John Hecht - JMP Securities

Robert Bloomberg - State Capital Advisors

Dean Choksi - Lehman Brothers

Operator

Good afternoon, ladies and gentlemen, and welcome to the Kohlberg Capital Corporation First Quarter 2008 Earnings Conference Call. An earnings press release was distributed yesterday after the close of the market. If you did not receive a copy, the release is available at the company’s website at www.kohlbergcapital.com in the Investor Relations section. At this time, all participants are in a listen-only mode. Following today’s presentation, instructions will be given for the question-and-answer session. (Operator Instructions).

As a reminder, this conference is being recorded today, Thursday, May 8, 2008. This call is also being hosted on a live webcast, which can be accessed at our company’s website at www.kohlbergcapital.com in the Investor Relations section under Events. In addition, if you would like to be added to the company’s distribution list for news events, including earnings releases, please contact Denise Rodriguez at 212-455-8316.

At this time, management would like me to inform you that certain statements made during this conference call, which are not historical, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although Kohlberg Capital Corporation believes that expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained. Factors and risks such as those described in the Risk Factor Section of our 10-K and sections of our Form 10-Q and other SEC documents we have filed during the course of the year could cause actual results to differ materially from expectations.

Now at this time for opening remarks ,I would like to introduce Chris Lacovara, Chairman. Please go ahead sir.

Chris Lacovara - Chairman and Vice President

Thanks very much, and thank you all for joining us this morning for this discussion of our financial results, business activities, and our progress for the first quarter of 2008. As we typically do, I'll begin with some general commentary on our activities for the quarter on the balance sheet, lending activities as well as with our Asset Management Business, Katonah Debt Advisors or KDA. I’ll then turn the call over to Dayl Pearson, our Chief Executive Officer who will discuss our middle market investment activities in more detail and then our CFO, Mike Wirth will provide a brief recap of our first quarter financial results and additional discussion of financial performance. And then at the end, as always, we will open the call for questions.

For the first quarter of 2008, Kohlberg Capital reported earnings per share of $0.45, which represents our fifth consecutive quarter of sequential earnings growth since our IPO in December 2006. All of our earnings per share for the quarter were generated by net investment income, and this is of course consistent with our strategy of not relying on potentially volatile capital gains to support the dividend.

In the quarter, Kohlberg Capital posted a modest 2.8% reduction in net asset value to just under $14 per share, and as it indicates in previous quarters, this reduction was due entirely to the reduced trading value of certain loans inline with general credit market condition. That said, our investment loan portfolio continues to perform quite well and today we have experienced only one single issuer default and have had no realized credit losses.

To start with just a few reminders about our company and our strategy, first of all, long-term investors and we plan to realize the value paid for our loan investments, so unrealized mark-to-market losses of the kind I just mentioned while important do not impact our dividend.

Second, we are not highly levered. As a BDC, we must maintain two-to-one net asset coverage, which equates to a one-to-one debt-to-equity ratio, and this low leverage mitigates the potential effect of default losses on our net asset value and our investment income.

And then lastly, we have significant and very stable liquidity in debt financing, our leverage consists of a single committed formula-based revolver with a five-year maturity, we are not subject to any margin calls. We have substantial excess liquidity under our revolver, which is a revolver of 275 million, which actually gives us enough liquidity to put leverage on the proceeds of our rights offerings, which I’ll talk about in a second.

In terms of our investment activities, our middle market loan portfolio, which represents about 77% of our assets and of course the bulk of our dividend, as I mentioned, we have a strong quality of portfolio of loan securities with approximately 60% senior secured loans. These are at the very top of the capital structure, and a total of 90% senior and second lien secured loans over the course of 2007. And really prior to the IPO, we were actively selecting assets and positioning the portfolio for a potential of an economic downturn and limiting our exposure to economically sensitive sectors.

Dayl will discuss the portfolio in more detail. But again, we are pleased to report that despite the slowing economy, we have only one issuer out of roughly 100 that has had a payment default and only really a few credits on our hard watch list, so we don’t see a rash of default on the horizon. And again, as a reminder, defaults do not equate to losses since these assets typically even if they do default have very very higher recovery rates and I'll talk a little bit about that as well.

Now another part of our balance sheet, we do make investments in Collateralized Loan Obligation or CLO fund. This represent approximately 12% of our balance sheet assets. Again, these are funds that invest in corporate loans, primarily almost 100% of the assets in the underlying funds are the senior secured loans, the top of the capital structure, there are no underlying investments in CDOs, mortgage-backed papers, it’s entirely corporate leverage loans.

At the end of the first quarter, we had approximately $57 million at fair value invested across nine CLO funds. Most of them are managed by our wholly-owned portfolio company, Katonah Debt Advisors or KDA, the Asset Manager, a few funds that are managed by very well-known third parties. The investments in CLO, CLO Funds, CLO and securities, typically have low-to-mid teens targeted cash yield or cash returns, but the actual results due to strong performances of the fund is quite a bit higher. So, the portfolio is generating average cash yield of 28%, which raises the overall average yield on our balance sheet, and quite frankly it takes pressure off of us to do corporate mezzanine, which can have a significantly higher risk profile.

All of these investments -- almost all of these investments are funds managed by KDA. As I said, we can actually monitor the performance of the underlying investments. We can actually also do that for the funds that are managed by third parties. And again despite the slowing economy, the underlying loans in the CLO Funds continue to perform quite well, they are again almost all senior secured loans and have experienced de minimus issuer default.

Last point I'll make about our CLO investment activities, you saw in the Q that we did actually close another CLO Fund in January called Katonah 2007-1 really because it was originally slated for last year. At the time we closed that the balance sheet Kohlberg Capital purchased 29 million of equity securities in that fund on which we expect to return inline with the returns on our other securities. And, it really was a very good thing for the company because we are really one of the very few asset managers that was able to close the CLO fund in this market, which is a testament to our ability to support the deal of capital, but also the strong reputation of Katonah Debt Advisors, and we do expect to continue to do CLO Funds.

Total CLOs represented about 12% of our balance sheet investments. Our target long-term is stable at 10% net number, the 12% will probably fall as we continue to grow middle market portfolio.

Last part of our company Katonah Debt Advisors, this is our wholly owned asset management company. We value that investment at the end of the quarter at approximately $63 million, so it represents about 13% of our balance sheet assets. A reminder, KDA Managers Corporate Loan Funds, CLO Funds as I mentioned, it does not invest in those funds nor does it have any liability for the fund assets. It really just receives recurring management fee and incentive fees and it’s highly profitable and therefore it actually can distribute its excess profits off to Kohlberg Capital and contribute to the KCAP dividend.

At the end of the quarter, Katonah Debt Advisors had about 2.3 billion in AUM that was up roughly I think 150 million from the end of the year. Part of that -- a large part of that was really just the ramp up of the Katonah 2007-1 fund as we got that fund to full investment. We also have warehouse approximately $218 million of investments that will be used to see two additional funds that we expect to close in the balance of 2008. This is under an engagement with Bear Stearns, obviously they are going through a transition. So, we are in discussions with JP Morgan about taking these two planned funds to market during the balance of the year.

The other point I would make we've gotten the question before, obviously the CLO market has really slowed down in the second half of 2007 and 2008, really more big as problems in the CDO market than any problems in the loan space, corporate loan space. And people ask well, "How you are going to continue to grow?" and the point we’ve made is that there are lots of non-CLO Fund structures, particularly lower leverage structures that actually give the manager a little bit more flexibility. We are actually working on a couple of funds now, one in particular where KCAP and Katonah Debt Advisors are working with an investor to structure a low levered fund, which would invest in broadly syndicated loans that are trading at discounts to par. KDA would actually manage the fund, but this fund would require any investment from Kohlberg Capital, the investor brings all the equity and the debt with them, so we would just secure a long-term management contract and grow our AUM.

Last the point I wanted to talk about was the capital raise. We did complete our one-for-six rights offering. The rights offering was very well received and substantially oversubscribed and we are very pleased that as part of that we were actually able to bring in some new institutional investors. We sold approximately 3.1 million shares to the rights offering with gross proceeds of slightly over $28 million. So with available leverage that gives us roughly 50 to $60 million of fresh capital that we can use to take advantage of the much higher loan spreads available for investors in today’s market.

The rights offering will be slightly dilutive to NAV. We estimate the dilution at about 5%, but we expect it to be accretive to earnings and to the dividend, again because of the very high reinvestment spreads that we expect to enjoy.

And before I turn the call over to Dayl to take us through the portfolio activities in more detail, I just want to address a few areas where we think there may be a lack of understanding about our company and really the impressions about BDCs in general. This is really based on questions that Dayl and Mike and I got in the recent rights offering road show as well as some published reports on KCAP and other BDCs.

First, this is a big question we get, management does not believe that our current NAV corresponds to any reasonable expectation of future realized losses. Since our IPO, we’ve recognized roughly $30 million reduction on NAV, roughly $1.65 per share, as a result of reduced trading values of loans really over the last three quarters with the credit crunch. However, to actually have a realized loss of that magnitude, again because of the high recovery rates on the assets, we would basically have to have 75 to $100 million of our loan portfolio default, which represents 20 to 25% of the portfolio. I mean frankly even if we had been throwing darts at the market, you'd have a hard time particularly when we have a very diverse portfolio and very small position size is to have that kind of default rate.

Similarly, our stock traded at 25% discount to this already discounted NAV, and there have been some suggestions or questions about whether our NAV may decline further inline with this discount over the balance of 2008 and 2009 based on what everybody expects will be an increase in corporate loan default. I certainly agree that corporate loan defaults are likely to increase particularly if there is a real economic recession, but again I think that that expectation of big further decline is somewhat flawed because again it doesn’t really translate how you get to that reduced NAV into an actual default scenario. So again, for NAV, it actually catch up to our share price, we would need something like a third of our portfolio to default and with a loss factor of around 50%. I mean, even the worst years, we’ve seen in the loan space and even if we bought market averages, default rates peaked around 8% in the last couple of cycles and the recovery rates for our mix of assets were 60 to 70%.

So again, we are not sitting here and saying there aren't going to be more defaults and that we won’t take hit, so although we haven’t had any default losses to-date, but the magnitude of what would have to go on with our balance sheet, it just doesn’t really get you either to our current NAV let alone and NAV that’s another 20 or 25% lower.

Another point I would make is there is some effort by investors to associate the quality of BDC portfolios and are likely to have future defaults with vintage i.e., when loans are put on the books. It's certainly correct to say that on average loan structures were riskier and loan pricing was tighter in the ‘06 to ‘07 timeframe when KCAP started to assemble its portfolio, but this attempt to draw conclusions about the portfolio just from vintage is again kind of flawed, because of inputs that we assumed that we just bought the market and doesn’t really give us any weight for credit selection. Their number statistics I could cite, but in particular we had 95% turndown rate during that period. So, even if we were right some of the time because we bought so little of the market, we didn’t do a lot of the highly leverage structures, we didn’t do covenant life, we didn’t do cyclical industries with high leverage, I don’t think you can just say, just because we were participating in the loan market in those years expect a huge rise in default.

I’d also point out that we went public, our loan portfolio had an average spread of about 350 over LIBOR, which is a clear indication that we were really investing in appropriately priced assets and not buying some of the cheap covenant light paper that was out in the market.

Last point I would make is some investors have -- I think there’s been some confusion about EPS dilution either from the rights offering or whether we are over-distributing net offering income and mainly to return capital to maintain our dividend, I’ve already talked about the rights offering and why we expect that to be accretive over time. I’d also point out that our first quarter dividend of $0.41 was quite a bit less than our $0.45 earnings per share. So, we do have a little cushion for future quarters in 2008.

The other point I would make is that we have not been over-distributing all of our EPS has been covered by net operating income, which includes earnings from KDA and the amount of distributable income derived from KDA is a function not of what it earns but what it distribute up to KCAP. And for Q1 and during last year, KDA actually distributed much less than its actual income for the quarter leaving an undistributed accumulating earnings cushion for future quarters. So again, if there is anything undistributed, it’s actually down at the KDA level, but that represents additional future earnings, not over-distribution at the parent. Mike is going to talk a little bit more about this in his comments.

So with that, let me turn it over to Dayl Pearson, who will take us through the portfolio in more detail.

Dayl Pearson - President and Chief Executive Officer

Thank you, Chris. At the end of the first quarter, our debt securities, not including our CLO investments, totaled approximately $363 million as with the past first lien loans represented. The majority of this is 59%, second lien loans represented another 30% and only 11% of our loans were in mezzanine unsecured loans and bonds. So over 89% of that $363 million is in secured assets.

We continue to hold a high percentage of first lien loans that are basis as I said, in the environment over the second -- fourth quarter of last year or first quarter of this year, we actually saw much greater relative value in the first lien loans is that spread widened out market dramatically than mezzanine spreads and bond spreads did. We are starting to see those other securities also see some widening in spreads and those have started to look pretty more attractive on a risk return basis, but we will be cautious moving forward in terms of balancing our portfolio appropriately for risks.

Credit quality as Chris mentioned continues to be good. As he mentioned, we have one issuer who is in default and that issuer -- one of the things we like about that loan is the fact that there is a very significant asset value and we do think that the recoveries in that issuer will be fairly substantially should there be any losses and should there not be resume paying there interest. And again, we continue to be very rigorous in terms of not only our revaluation of new credits, but in managing the portfolio and try to see any early signs of distress. Our hard watch list has not changed since beginning of the quarter, and most of these names have stabilized with significant investments coming from sponsors to either pay down debt or add additional liquidity where necessary, and we really don’t see any other of our loans migrating to hard watch list in the near term.

Again, middle market investments are diversified across 26 industries and 86 different entities, made almost 100 different loans, specific loans. The average balance per [exposure] is still less than $5 million and our top 10 exposures within that portfolio, which excludes our best and obviously in KDA represent approximately 18% of total investments and we think that is a very well diversified compared to other BDCs, and we do think diversity particularly as it relates to across industries, which eliminates correlation of defaults is credit quality and the current credit environment.

Our yield as of March 31 was approximately 5.1% of our LIBOR, which compares favorably to the 3.5% of our LIBOR that we had at IPO. In addition, a lot of the loans as we have new loans coming on, or if we have amendments to current loans, LIBOR floor have been inserted, so for taxes it gets further downside and LIBOR going forward. That and the fact that our liabilities are also based upon LIBOR, which we really don’t have a significant exposure to LIBOR at risk.

Approximately 7.5% of our debt securities are fixed rate, and the average fixed rate is little under 12%. Again, as we say every time we can, we do not have any RMBS or ABS loan exposure, consumer lending or lenders.

The current pipeline is continuing to grow. It was a bit slow in the first quarter. We do see middle market activity picking up unlike the large market that continues to be frozen by this enormous backlog or shrinking backlog of syndicate loans. The middle market M&A activity loan is somewhat lower continues to be fairly healthy. The new deals we are looking at tend to have significantly lower leverage and significantly higher spreads than what we saw a year ago and again our turned out rate is we expect to continue to be in excess of 90%.

At March 31, net unrealized losses or the difference between the cost basis and fair value of our total investment portfolio totaled approximately $560,000. During the quarter, the value of our investment in Katonah Debt Advisors increased to approximately $63 million with an unrealized gain of approximately 3.9 million. During the first quarter, unrealized losses on our debt and equity securities totaled $8.9 million with an additional net unrealized loss in our CLO securities of approximately 2.8 million. This is due primarily to general reduction of trading values in the first quarter especially January and February the loan market was very weak, it was a little bit of a gain, so in March as this continued to gain during the month of April and then into May. So again, these unrealized losses as Chris mentioned relate to the -- really to the credit crunch and the lack of liquidity in the credit markets and really are not tied to credit quality based upon our portfolio.

During the first quarter and during the early part of the second quarter continue to see all of our loans to pay down, pay down at par or even above par we had two loans in March to pay down at 101, and we have a loan, which we will repay in May, we think it quantifies as there was call protection in those loans, other loans continue to pay at par.

Since quarter end, we think that our marks probably have increased somewhat perhaps as much as $1 million due to the fact that the trading values of loans have come back some. But again, giving the lack of liquidity in those markets, we are not sure those are based upon marks very often and not necessarily on traded values. Again as we’ve noted, all of our loans except for one issuer continue to be current on our interest and principal payments and all of the CLO Funds on which the company holds investments maintained their original credit ratings. There were no downgrades of any securities and any of the CLOs that were invested in, and they continue to generate very healthy cash returns.

We’ve seen the impact of the current economic slowdown and anticipate there may be further default, but we anticipate those will be few. What we have generally seen in our portfolio are performances they are off budget, flat to up less than we expected, in some cases down slightly. But again given the fairly conservative leverage in most of our investments, those don’t really create any short-term or medium-term liquidity issues.

And again -- so in closing, I'd just like to say, the portfolio quality remains very strong and I emphasize again, the substantial amount of our portfolio resides in first lien loans and most of the rest of the portfolio resides in second lien loans, so 90% of the portfolio continues to be secured.

At this point, I will turn the call to Mike Wirth to discuss our financial results for the quarter.

Michael Wirth - Chief Financial Officer

Thank you, Dayl. Good morning everyone. For the first quarter of 2008, we reported net investment income excluding unrealized gains of $8 million, $0.45 per share as compared to $4.9 million or $0.27 per share for the first quarter of 2007. Net investment income excluding unrealized losses is also one of the benchmarks used to determine our quarterly dividend. For the first quarter of 2008, we paid $.0.41 per share dividend as compared to $0.29 for the first quarter of ‘07. For the first quarter our net investment income excluding unrealized gains or losses covered our dividend payments with no return of capital.

We believe an important distinction in the quality of our earnings and the result of dividend is that they are more dependent on net interest is that or that they are more dependent on net interest and dividend income rather than on capital gains on sales of investments. We believe that the income stream on interest and dividends is well predictable, well recurring and less volatile than relying on capital gains to earn the dividend, particularly in the current market environment.

I will now highlight the components of our net investment income. Total gross investment income, which consists of interest, dividend and fee income, was $14.3 million for the three months ended March 31, 2008. For the three months ended March 31, 2008, Katonah Debt Advisors, our wholly owned portfolio company, and after-tax net income of approximately $1 million. Of this 1 million, the quarterly earnings Katonah Debt Advisors $350,000 was distributed in form of the dividends to KCAP and those contributed to KCAP’s gross investment income for the quarter. The remaining $600,000 of undistributed net income of Katonah Debt Advisors for the quarter is part of a $2.9 million of accumulated undistributed net income of Katonah Debt Advisors. This undistributed net income which we paid on distributing in future quarters will that contributes to KCAPs earnings and dividend distributions at that time.

We realized a $726,000 loss on the sale of selected investments during the quarter which is offset by $1.1 million in restructuring and other fee income. Now they are certain such realized loss is due to sale that current trading levels and not due to credit losses on defaulted assets. As we were able to predict the high level of other fee income during the quarter, we thought it advantageous to offset such revenues and recognize some realized trading losses in order to reposition the portfolio with higher yielding assets. Such high level of structuring and other fee income is expected to be substantially less in future quarters, as they typically range between the $100,000 to $200,000 range per quarter.

Total expenses including interest expense of $5.6 million for the first quarter, non-interest expense for the quarter was $2.2 million. Non interest expense consist mainly a compensation expense, professional fees, and administrative costs.

Interest expense for the quarter was $3.3 million or weighted average debt balance of $255 million for the quarter. Weighted average interest rate on average outstanding borrowings was 4.1% for the quarter, and the company is in compliance with all its debt covenants. The company had an outstanding balance of $250 million on its term borrowing facility at quarter end. The company’s assets and debt coverage was approximately 2.1 as of quarter end and consistent with the coverage requirements of the BDC. We are closer to the 2.1 asset to debt coverage of some of our peers, it is important to note that our facility is a fully committed term facility expiring October 1, 2012, with no internal manual renewals or resets and is not subject to margin cost. As a result, we do not need to provide a large cushion for short-term liquidity re-pricing or renewal facility.

Our net increase in stockholders equity from operations for the quarter, which is our net investment income, includes the unrealized gains and losses were $195,000. Net unrealized losses for the quarter related to the decrease in market value of investments of approximately $7.9 million. As a result, our net asset value at the end of the first quarter was 1398 as compared to 1438 at the end of 2007.

Our total investment portfolio at quarter end was valued at approximately $488 million, with net unrealized depreciation over our cost basis of approximately $560,000.

Our first quarter dividend of $0.41 per share, which was paid on April 28, represented an annual yield of 10.9 on our IPO price of $15.00 and over 16% on current stock trading levels. We expect the dividend to rise in future quarters as we increase our portfolio, add leverage and increase the net income of Katonah Debt Advisors, and to distribute -- and the distribute more income from Katonah Debt Advisors in the form of the dividends to KCAP.

As noted before, our net investment income inclusive of Katonah Debt Advisors net income and realized gains sufficiently cover our dividend payments. So long as our dividend distributions to shareholders do not exceed GAAP net investment income and realized gains, there should be no GAAP return of capital which would lower net asset value per share.

Before I turn the call over for questions, I would like to discuss the impact of FAS 157 on our asset valuations. Generally, since we’ve always had the fair value of our asset FAS 157 has not radically changed our approach to asset valuation in thinking the most objective input on which they determine value. However, FAS 157 does impact the documentation of such valuations and requires that we disclose in our financial statements a higher valuation methodologies know as levels 1, 2, and 3.

Generally level one assets, are those whose values are reported in the active markets such as publicly listed equities and securities. And generally, level two assets for those assets not in an active market but they fall significant valuations inputs were identical to similar assets being what’s called market observable.

As the BDC, we are required invest primarily in the debt equity of nonpublic companies for which there is little if any market observable information. For example, what we make by our numerous peer comparables for which to identify certain valuation assumptions the fact that such market observable data will be applied to non market absorbable date such as a private company’s EBITDA indicates as a result most of our investments will most likely be deemed level 3 assets under FAS 157. We believe that investments classify as level 3 for FAS 157 have a further hierarchical framework, which prioritizes and rank such valuations based on the degree of independent and absorbable inputs, objectivity of data, market acceptance of underlying models or methodologies, and the level of judgments required to adjust comparable data. For example, assets in level 3 that are priced by third party pricing service would rank higher in our hierarchy than those values that are determined based on public reply to comparables.

Furthermore evaluations which are heavily dependent on models and have little market activity or other market absorbable data would rank lowest in our level 3 hierarchy. You will be able to see what our level 3 assets are in our 10-Q that will be filed in the next couple of days. Our first quarter 10-Q will be filed no later than May 12, and our annual 10-K is also available at our website, www.kohlbergcapital.com or www.sec.gov.

This concludes our comments. Once again we thank you for your continued interest and support and we will now open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from John Hecht with JMP Securities.

John Hecht

Good morning guys. Thanks for taking my questions. Dayl, you mentioned two loans of pay down since the end of the quarter, can you give us sort of the amount of the pay downs?

Dayl Pearson

There are two loans pay down in March, the total pay downs was about $10 million. We expect to have another prepayment during May, which would be -- it’s going to be small, it’s 2 or $3 million, and we had normal amortization in March. Again, all these pay off at par of around $5 million I believe.

John Hecht

Okay. Have you guys mentioned the spread over LIBOR, at the time the IPOs was 3.50, and I think you referred to a 5 to 10 spread now, is that the mix of spread or is that the spread that if you were to buy assets in the market right now?

Dayl Pearson

As the spread on the par value of our loans.

John Hecht

So, what are spreads right now if you were to buy the same type of mix of assets in the market today, what do you think spreads would be?

Dayl Pearson

Middle market firstly in spreads would generally someway are in the mid to high 4s, 4.50, 4.75 over LIBOR. They would also have a LIBOR floor and that sort of varies from loan to loan, some are between 3% and 4% generally. Second lien loans, there really hasn’t been a lot of settling activity in that market seems to have really, really dried up to some extent. There are few that we see and generally they are sort of that 7.50 to 8.50 range. In mezzanine if compared to when we were assembling the portfolio it would have been towards 6.50 or 7.50. And mezzanine which is probably 12% cash and 2% pick, now probably more 12% cash and 4% pick maybe 5% pick.

John Hecht

Okay. And the -- on the quarter there is a reasonably large pick up in the capital structuring service fees. Obviously part of that was related to this, I imagine the COO you guys structure in the first quarter. What’s a normalized rate for that and is there anything else going on in that line item?

Dayl Pearson

Typically you would see about of that $1.1 million that you saw in the first quarter, about $800,000 was related to a component 2007-1 as you guessed. Typically you would see fee income during any particular quarter ranging anywhere from a $100,000 to $200,000.

John Hecht

$100,000 to what was that?

Dayl Pearson

$100,000 to $200,000.

John Hecht

Okay. And then last question before I get back in the queue is the $350,000 dividend from the KDA is that a -- it appears that that’s a lower than the kind of potential rate of dividend given the assets or the earnings power of that company. But is that reasonable number to assume going forward coming out on a quarterly basis?

Dayl Pearson

The company and the Board will evaluate that on a quarter-by-quarter basis. Again, KDA earned in the first quarter just under $1 million and only distributed 350 up to KCAP. I think part of it would be looking at the, trying to maintain a very nice stable but not growing dividend. So, you may see that 350. I don’t think that 350 is necessarily a run rate per se.

John Hecht

Okay, thank you guys very much to answer my questions.

Operator

Thank you. And we will now move to our next question which will be with Robert Bloomberg with State Capital Advisors.

Robert Bloomberg

Yeah, hi guys. I had a question about -- I noticed there is some insider ownership of the BDC which I would like to see. But there wasn’t much ownership among some of the people like Dayl Pearson and E. A. Kratzman who seem to be managing the day-to-day assets of the firm. And I just wondered if you could comment if the shares are so cheap, when you were trading with this huge discount, why are we not seeing more insight or buying at this point?

Dayl Pearson

All right, I think you did see insight of buying in December when the window was open. You also saw insight there is exercising their rights in the writes off for any and I think of selectively based upon people’s ability to invest, they will invest as the window opens.

Michael Wirth

And actually it has been somewhat difficult at times because we have a very narrow trading window per policy, and often times at least during last year we were in the middle of a registration statement or something like that, which pretty much precluded opening the window or awaits to buy shares.

Robert Bloomberg

Do you anticipate buying more share in the future if it continues to trade at this -- I mean, specifically I guess sale and I have noticed that like in case of Mr. Kratzman, he actually has been failed, which I was surprised to see and I wondered if there was a reason for that and going forward do you expect to do more buying?

Dayl Pearson

I mean, I think it’s all sort of comment and I think individual people’s situations actually also dictate buying regardless of buying and selling, regardless of what they see as the opportunity. So, it’s really hard to comment on that. But again, I think there is good level, I think part of the problem frankly is that the level of ownership by the management, which I think is substantial, it’s a little bit dwarfed by the ownership by the corporate facility, it’s just because we received shares in the transaction for assets that we contributed. So, I think all in the board is very satisfied with us. So, buying -- and I would expect people will buy even if the stock remains at these level.

Robert Bloomberg

I also wonder if you could comment a little bit about maybe the differences in how FASB applies to your company versus some of these older BDCs that was started much earlier than you and I am sure. I don’t if you want to mention names, I am sure you know which names I mean.

Dayl Pearson

Well, without mentioning names, I mean, and without jump -- talking about FASB, let me give a little interpretation. I think what you have in some of the older BDCs is a big difference from our company, not so much as the applicability of the rules as how their balance sheets are constructed. Many of the older BDC in order to drive growth have diversified much more heavily into private equity and/or assets management than we have. I mean, our -- but we really -- KCAP really has no private equity portfolio and no equity portfolio at all other than it’s a investment in the KDA affiliate, which is a valuation that’s very stable because the assets and revenues there are lot we apply metrics just to those -- into those numbers. I think what you have with the other BDCs where they have lots of affiliates where they put valuation on those affiliates and regulatory touch we have variable values and then they have large private equity portfolios. There is a lot of volatility particularly in the current economic conditions and even more volatility frankly is applied due to FAS 157. It’s my foresight, FAS 157 really isn’t a big event for our company because we don’t have a lot of hard to value equity assets, but I do think that that’s going to raise some issues for BDCs that have a lot more equity portfolio in individual companies and/or lots of affiliates that they are trying to value.

Robert Bloomberg

As far as the rights offering goes, I didn’t -- may be I missed it, but has the dilution affected that and already factored in or because it was done I guess after March 31, it will be factored in the next quarterly by NAV.

Dayl Pearson

Yeah, that correct, you will see it in -- you will see the NAV impact in the next quarter and the diluted impact if any, the short-term diluted impact if any towards EPS in the next quarter. Those shares will be averaged in the second quarter --

Michael Wirth

That’s right.

Robert Bloomberg

And I would imagine it won’t be very great because the offering we saw wasn’t a large offering?

Dayl Pearson

Exactly, we very consciously raised did a one for six as opposed to one for three, which I guess is the maximum we could have done because of the dilutive impact, because we think the stock is frankly too cheap and to minimize with dilution.

Robert Bloomberg

And I wondered -- do you have any stat on what is the latest -- the expenses as a percentage of classifier at this point, as for BDC?

Dayl Pearson

2.2 for the quarter.

Michael Wirth

That was…

Dayl Pearson

Non-interest expense.

Robert Bloomberg

2.2?

Dayl Pearson

I think that what -- let me double check here. Non-interest expense to average net asset was actually 3.5%, total expense was 8.7 that’s also including interest expense.

Michael Wirth

It’s 2.2 million.

Dayl Pearson

Hey, again it was 2.2 million, that’s right. But as percentage of average net assets it was 3.5%.

Robert Bloomberg

Is that going up or -- it seems like you guys in the past have like somewhere around 2.6 percent or something?

Dayl Pearson

Yeah, typically we are in the 2 range. A part of it is a function of the denominator with values being marked down to market levels. In the end also there is you will see it probably spread out during the course of the year closer to the mid to low 2% range.

Robert Bloomberg

I think like you guys have – I think internally manage BDC then have a better expense structure than it externally one I don’t know if you have any thoughts on that but it seems like you do?

Dayl Pearson

That’s a very interesting question. I mean, some of the larger internally managed ones actually have much higher expense ratios could they have very large origination and credit functions, and the externally managed BDC basically have to operate within their fee structure. So, I’m not sure that the case, our goal is always been to be at the low end even within internally managed BDC because our origination is more kind of the club type where we are not, we don’t have 50 people in branch offices in Dallas and Atlanta beating the bushes for small companies we are using senior relationship for private equities sponsors and other middle market lenders to source and that eliminates a lot of origination cost.

Robert Bloomberg

Well, thank you guys. I don’t want to take any more time. Thanks a lot.

Dayl Pearson

Thank you.

Michael Wirth

Thank you.

Operator

Thank you. We will now move on to Dean Choksi with Lehman Brothers.

Dean Choksi

Good morning.

Dayl Pearson

We can’t…

Operator

Dean?

Dean Choksi

Hi, can you hear me now?

Dayl Pearson

Yeah, it will be a much better.

Dean Choksi

The investment in Katonah 07-1 was bit larger than your past CLO equity investments, can you kind of talk about the rational for that and what your target and estimates since CLO equity is going forward?

Dayl Pearson

Sure. It was margin I mean typically being we have been doing sort of $5 million to $10 million, the larger size was a function of really a few things, first of all, the investment pumps us out in a big way, because the interest cost in that fund is actually going to end up quite a bit lower than what’s current in the market but of course, they are buying assets in the low 90s at investment spreads that are huge for CLO. So, we actually like the investment. Number 2 in essence some of the capital in there was taking the place of a couple of funds that we had expected to get done in ‘07 and didn’t. So, we actually as our budget suggested that we would have been about $60 million at the year end and we were at about 30. So, we actually had room and again as we said our general goal is to keep that around 10% and that probably we are worried at the end of Q2. The third thing, I was in many ways the most important it was a very opportunistic purchase what happened was Katonah was actually approached by a AAA investor who wanted to do a deal as people may know the difficulty in CLO market now isn’t so much fun in the equity is finding the AAA, we get many AAA investors who are also heavily exposed to sub-prime and ADS and they are out of the market and this AAA investor was willing to underwrite, essentially purchase the entire senior capital structure of the fund at a very low rate.

And so, we will actually at that point we are marketing equity we’re syndicating it, we weren’t sure we could hold that investor or the six to eight weeks it would have taken to syndicate the equity, so, we just said no, we will write the whole check what’s nice is not only good with all of the AAA taken down at closing for cash but the fact that we actually were also able to place almost all of the mezzanine securities with investors and subsequently we are able to sell all of that. So, there were a number of things that came to together where we said we have capacity, it’s a great trade.

The other thing I would say is to satisfy that basically the way we did that was we actually had some lowest spread in a senior security liquid assets on the balance sheet that instead of taking cash we actually contributed those into the funds of the equity fees. So, it’s a very efficient way to raise our average yield on the balance sheet and to buy down the equity of assets that were already on the balance sheet that were appropriate for the fund.

So, last one I would make is that, and this is typically true when we buy the numbers that people see on the balance sheet for the cost of our senior security don’t represent per value, we basically buy the discount to raise our yield and particularly because like any investors if you are buying a lot sluggish and enjoy that. I think in that fund we bought at around 90 and shared that discount with a placement agent. So, it cancels that as a very, very attractive return.

Dean Choksi

Okay, and then on the I guess is the spotted loan I guess they were typically in the middle market kind of how long is that take together recovery and what timeframe would you recognize the loss?

Dayl Pearson

Well, it really depends upon the situation, it can be anywhere from 3 months to 18 months as it works its way through, this is a fairly, this particular situation is actually somewhat larger well, and we would anticipate the fact that if we would have to actually realize a loss wouldn’t be until very late this year or early next year.

Dean Choksi

And, it’s on loan marked at time you are expected recovery value?

Dayl Pearson

Yes.

Dean Choksi

Okay. And then the final question is on the net income from KDA was 1 million, is that inclusive of the $800 or $1,000 restructuring fee?

Michael Wirth

No, because we took a 100% on the equity position, we kind of able chose to put that 800/1000 structure in fee actually at the KCAP level. As, as we took some that as income and basically offset the loss on the asset that we transferred in and then some of we just frankly took it discount on the purchase.

Dayl Pearson

So, it was not a KDA income was almost a $1 million this not include that fee.

Michael Wirth

That’s right.

Dayl Pearson

It’s the question I think John had that $1 million KDA income for the quarter is a lot closer to what we think is the run rate quarterly income of KDA then the 350 that we actually distributed.

Michael Wirth

That’s correct.

Dayl Pearson

And there is 2.8 as I mentioned also there is $2.8 billion undistributed accumulated undistributed income sitting at KDA yet to be dividend out in the future take out.

Dean Choksi

Okay, great. Thanks guys.

Operator

(Operator Instructions). And it appears that we have no further questions for today. And I will turn the conference back over to you for closing remarks.

Chris Lacovara

Great. I will just thank you all for joining us this morning. I will look forward to talking with you in the future.

Operator

Thanks and this ends today’s conference call. Thank you for your participation. Have a great day.

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Source: Kohlberg Capital Corporation Q1 2008 Earnings Call Transcript
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