BlackRock Kelso Capital Corporation Q1 2008 Earnings Conference Call

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BlackRock Kelso Capital Corporation (NASDAQ:BKCC)

Q1 2008 Earnings Call

May 8, 2008 4:30 pm ET


James R. Maher - Chief Executive Officer

Michael B. Lazar - Chief Operating Officer

Frank D. Gordon - Chief Financial Officer and Treasurer

Vincent B. Tritto - Chief Compliance Officer and Secretary


Jay Aston – Neuberger Berman

Jim Shanahan - Wachovia Capital Markets, LLC

Bradley Ball - Citigroup Global Markets, Inc.

George A. Sacco - J.P. Morgan Securities, Inc.

Jim Shanahan - Wachovia Capital Markets, LLC


Welcome to the BlackRock Kelso Capital Corporation investor teleconference. Our hosts for today’s call will be Chairman and Chief Executive Officer, James R. Maher; Chief Operating Officer, Michael B. Lazar; and Chief Financial Officer, Frank D. Gordon. (Operator Instructions)

James R. Maher

Welcome to the BlackRock Kelso Capital Corporation first quarter 2008 earnings conference call. I’m joined today by Mike Lazar, our Chief Operating Officer, and Frank Gordon, our Chief Financial Officer.

We’ll begin by having Frank talk about some general conference call information, including forward-looking statements.

Frank D. Gordon

Before we begin our remarks today, I’d like to point out that during the course of this conference call, we may make a number of forward-looking statements. We call to your attention the fact that BlackRock Kelso Capital’s actual results may differ from these statements. As you know, BlackRock Kelso Capital has filed with the SEC reports which list some of the factors which may cause BlackRock Kelso Capital’s results to differ materially from these statements. Finally, BlackRock Kelso Capital assumes no duty to update any forward-looking statements.

I would now like to turn the call back over to James.

James R. Maher

We’re delighted to have the opportunity to speak with you this afternoon. We’re pleased with our first quarter of 2008. We continue to deliver on our goals of becoming a premiere provider of capital to middle market companies, and providing an attractive return to our stockholders.

Since our inception in July 2005, we filled a strong team of investment professionals and have an extension outreach program to access middle market companies. We have a well-diversified investment portfolio of more than $1.1 billion in assets. At quarter end, our weighted average yield on investment capital was 11.5% on an annualized basis.

While the first quarter was certainly a difficult one from the credit markets and for financial services companies, BlackRock Kelso Capital completed a solid quarter on March 31. We continue to utilize our direct sourcing model with high credit underwriting standards to structure sound investments in middle market companies.

We view the recent turbulence in the credit markets as an opportunity for BlackRock Kelso Capital to apply our thorough investment selection process to enhance the risk adjustment returns of our investment portfolio. As a business development company, our balance sheet leverage is limited to one-to-one and BlackRock Kelso Capital had a balance sheet leverage of approximately 0.66 to one on March 31. As a reminder, we do not make and have not made any mortgage or real estate loans and do not own any CDOs or CLOs securities.

Yesterday, our Board of Directors declared a second quarter dividend of $0.43. This dividend will be paid on June 30th and represent a 13.7% annualized yield on our net asset value and over 14% based on yesterday’s closing price.

Since inception, dividends have been derived from taxable income and net capital gains. Net investment income for the first quarter was $0.44 a share. Mike and Frank will discuss more of our financial results shortly. We continue to be pleased with our investment opportunities that have resulted from our direct calling efforts. As a result of this effort, we invested $94.6 million during the first quarter. We examined more than 100 investment opportunities during the quarter and well over 1,100 opportunities since our initial funding in July 2005. We attribute our success to our terrific investment team. We’re particularly proud to have accomplished this during the quarter that exhibited lower overall transaction volume for sponsored-led leverage buy-outs.

Activity in the middle market, which we define as companies with EBITDA between $10-50 million, slowed significantly in the second half of 2007 and remained slower than it was, or significantly slower than it was, at this time last year.

Not withstanding the reduction in volume, we continue to see many opportunities today that are of a higher quality. We believe that the changes in the environment of syndicated loans and public high yield debt have produced opportunities for higher returns and reduced leverage. This environment continues to provide a great opportunity for BlackRock Kelso Capital.

We believe that our portfolio is well positioned for the current economic environment. On March 31, our net portfolio consisted of 62 companies and was 68% invested in senior secured loans and senior notes. At the end of the first quarter, only 4% of our portfolio was invested in equity securities. The remainder of our portfolio, or approximately 28%, was invested in unsecured or subordinated debt securities.

Our underwriting process is focused on investments in low capital intensive, high free cash flow businesses. Our transactions are structured based on our underwriting credit cases which factor in the facts of recessionary environments on each of the company’s cash flow forecast. In despite the conservative positioning and strong underlying credit quality of our portfolio, we were certainly not immune from the impact that marks on our portfolio during the first quarter.

We believe that being actively involved in the due diligence structuring of the assets that we acquired provides us with a conservative portfolio. The terms of the loan in which we are invested are conservatively structured with adequate covenant, security and other protections. We continue to make investments where we are able to play an active role either as the sole or lead investor or as a member of a small club of investors. Investments made in these lead or club transactions represent approximately 70% of the assets in our portfolio today. More than 90% of the capital we invested during the first quarter was invested in fixed rate securities and more than half of the capital was invested in senior secured loans.

We’re pleased with our results for the first quarter. We continue to demonstrate our ability to originate and structure investments in the middle market companies. These investments produce high-risk adjusted returns with high reoccurring yield and opportunities for higher total returns from structuring and prepayment fees and from equity investments. Mike Lazar will now review our portfolio and investment activities in more detail.

Michael B. Lazar

We’re pleased to report that BlackRock Kelso Capital Corporation invested a total of approximately $94.6 million in eight companies during the first quarter. Four of these investments involved companies with which BlackRock Kelso Capital had previously completed a transaction. Their investments included a $15 million fixed rate senior loan to sponsor buyout in a healthcare sector, a $35 million fixed rate senior loan to a privately held vertically integrated transportation infrastructure company, and $15 of subordinated fixed-rate debt to a consumer financial services company. We were able to find and capitalize on these investment opportunities as a result of our active origination program, our access to sponsors and management teams, our thorough due diligence process, and the resources of our partners.

In a current market environment, we’re finding that by being selective, we’re able to make new investments not only at higher yields but also at lower levels of leverage. We experienced $28 million of portfolio runoffs during the first quarter. We’re pleased that we collected prepayment and related fees in connection with three of our four repayments during the quarter. Substantially all of our repayments were of floating rate loans.

The fair market values in our GAAP financial statements are derived by dealer quotations for those securities that are quoted and by engaging third-party valuation firms to perform valuations on all non-traded portfolio investments. These valuations are performed on a company-by-company security-by-security basis for every investment every quarter. Our valuation procedures have been consistent with FAS 157 requirements since our inception and as a result, there is no adverse effect in our March 31 financial statements due to the adoption of FAS 157 under GAAP.

During the first quarter, BlackRock Kelso Capital was required to adapt FAS 159. FAS 159 gives us the option to fair value the company’s financial liabilities and its financial statements. Although the company did not elect to reduce to fair value with the liabilities on our balance sheet, we believe that if we did sell, our NAV per share would be higher.

As you know, conditions in the corporate credit markets changed dramatically during the second half of 2007, as a resulting part of the events in the subprime mortgage sector. In the first quarter of 2008, the condition of the credit markets generally deteriorated even further than it had in late 2007. Total portfolio unrealized depreciation during the quarter was approximately $62.7 million. At quarter end, our net asset value per share was $12.60. We believe the declines in valuation of our investments are due primarily to instability of the credit markets and changes in the current interest rate environment. The unrealized depreciation on investment did not have an impact on our ability to pay distribution to our stockholders.

Slightly less than half of the dollar value of our portfolio is valued by dealer quotes. Quotes on this portion of the portfolio were down approximately $47.9 million. Most of the loan quotes that we received are not based on actual trades but instead on dealer’s relative value estimates. As we hold most of our investments to maturity, we anticipate that for investments in companies with added fundamental performance, we will not ultimately realize losses in value.

The largest portion of the increase in unrealized depreciation for non-quoted or appraised investments relate again to one portfolio company, Tygem Holdings, that has significantly underperformed its plan and its historical results due to several company specific and market events. BlackRock Kelso Capital continues to be actively involved in working out recovery plan, taking an active role on the company’s Board of Directors. In the aggregate, the value reflected in our financial statements for this company is carried at less than one third of its costs.

While we have seen some companies with credit issues during the first quarter, we find the condition of the portfolio to be strong today. Our investments are well diversified and our largest exposures are to companies that provide business and other services to media and other companies and to consumer products companies. Overall, these industries represent just under half of the total portfolio.

We’re pleased that the performance of our portfolio companies continues to be strong with an overall weighted average rating of 1.31, using our 1-4 credit rating scale. Consistent with year-end, approximately 3.5% of investments at value just rated three or four, with more than 96% of the portfolio rated one or two. As of March 2008, we have three investments on nonaccrual status representing less than 1% of portfolio value. The fair market value of these assets is just over $8 million as of March 31, which represents approximately 30% of their aggregated costs.

In the first quarter, BlackRock Kelso Capital earned structuring and upfront fees and discounts equal to approximately 1.7% relative to new investments. Currently, our ratio of borrowings to net assets is 0.66 to 1; leaving us with sufficient capacity for new investment opportunities in what is now a very attractive investment environment. We borrow under our revolving credit facility at LIBOR plus 7/8 and at March 31, we had availability of more than $100 million.

2008 is off to a good start with an increasing number of attractive investment opportunities for BlackRock Kelso Capital. Middle market deal activity has regained at least some of its strengths and our access to these transactions continues to increase as we continue to add to our investment teams and grow our direct sourcing efforts. We remain focused on finding the best risk adjusted returns in middle market companies where we’re able to play an active role in due diligence and in transaction structuring.

I’d now like to turn the call over to Frank Gordon to review some of the GAAP financial information for the first quarter.

Frank D. Gordon

I would now take a few moments to review some of the detail of our GAAP financial information for the first quarter of 2008. Investment income totaled $35.7 million for the quarter ending March 31, 2008, compared to $25.1 million for the quarter ended March 31, 2007. The increase reflects the growth of our portfolio as a result of the deployment of debt capital under our credit facility and equity capital from our initial public offering in July 2007.

Net expenses for the quarter ended March 31, 2008, were $12.5 million versus $11 million for the first quarter last year. Of these totals for the quarter ended March 31, 2008, $5.2 million was interest and other credit facility expenses. Interest and other credit facility expenses totaled $3.7 million for the corresponding quarter in 2007. In addition, performance based incentive fees totaled $3.7 million for quarter ended March 31, 2007. There were no incentive fees for the quarter ended March 31, 2008.

Expenses net of performance based incentive fees, interest and other credit facility expenses for the quarter ended March 31, 2008, were $7.3 million compared to $4.6 million for the quarter ended March 31, 2007. Overall, the increase in expenses was driven primarily by an increase in base management fees resulting from the growth of our portfolio and an increase in other general and administrative expenses.

Net investment income totaled $23.2 million, or $0.44 per share, for the quarter ended March 31, 2008. Taxable income exceeded our GAAP net investment income during the quarter. For the corresponding periods in 2007, net investment income totaled $14 million, or $0.36 per share.

Total net realized gain or loss for the quarter ended March 31, 2008, was a gain of $0.2 million compared to a loss of $0.2 million for the quarter ended March 31, 2007. For the quarter ended March 31, 2008, the net change in unrealized appreciation or depreciation on our investments foreign currency translations and cash equivalence was depreciation of $62.7 million versus appreciation of $3 million for the quarter ended March 31, 2007. Net unrealized appreciation or depreciation was net depreciation of $120.5 million at March 31, 2008, and net appreciation of $4.6 million at March 31, 2007.

For the quarter ended March 31, 2008, the net increase or decrease in net assets from operations was a net decrease of $39.5 million, or $0.75 per share, compared to a net increase of $17 million, or $0.44 per share, for the quarter ended March 31, 2007. With that I’d like to turn the call back over to Jim.

James R. Maher

Looking forward in the second quarter and the second half of 2008, we continue to be very excited about our business and about our prospects. The portfolio is well diversified, conservatively constructed, and performing well. We remain focused on preservation capital and on providing the best risk adjusted returns for our shareholders.

And finally, I’d like to thank the talented investment team at BlackRock Kelso Capital and our partners at BlackRock and at Kelso for their dedication to the success of BlackRock Kelso Capital Corporation.

Will the operator please now open the call to questions?

Question and Answer Session


(Operator Instructions) Your first question comes from Jay Aston - Neuberger Berman.

Jay Aston – Neuberger Berman

With regards to value of the portfolio, have you all seen any bounce back in April? Obviously, the last couple of weeks of March were incredibly tumultuous and what we’ve heard from some is that some of the relief has created a real bounce back. Have you all seen much of that?

Frank D. Gordon

No, I think if you look at the more actively traded securities, there’s clearly been a bounce back. And if you take a look at our portfolio, it hasn’t bounced back as much because it’s not traded but the quotes have improved, I would say, somewhat but nowhere near as much as the quotes in the broadly traded markets.

James R. Maher

Look at it this way: The actually traded markets.

Michael B. Lazar

Many of the securities that are quoted are quoted on some type of a relative value bases and so because they’re not active, the quotes don’t move and the absence of an actual new FAS typically.

Jay Aston – Neuberger Berman

Are you all seeing any or do you work with, have been financing any of these FAS or seeing any interest from these FAS?

Frank D. Gordon

No, we haven’t financed this FAS to date. It doesn’t mean that we wouldn’t but we haven’t and I don’t think this FAS would work particularly well with the BDC in terms of financing of BDC.


Your next question comes from Jim Shanahan - Wachovia.

Jim Shanahan - Wachovia Capital Markets, LLC

I’m curious if you can walk through what’s happening with the incentive fees. It seems to me that the greater incentive fee income is sufficient to have resulted in incentive fees the last couple of quarters and there hasn’t been any, is that a function of the big unrealized losses that we’re taking and whether there’ll become sort of catch up if the portfolio values rally? And there might be some subtleties about the incentive fees that I’m not aware of.

Michael B. Lazar

The one-word answer to your question is yes. The reason that there hasn’t been any incentive fees has to do with the high water mark component of our incentive fee test. Because of the unrealized depreciation in the portfolio we have not been entitled to any incentive fees to date. There is a trailing four quarters element to this test so it is conceivable that at some point in the future there may be some amount of a catch up payment, although it’s very difficult to guess as to whether or not that would happen and to what extent it would affect our going forward financial results.

Jim Shanahan - Wachovia Capital Markets, LLC

The portfolio is under levered probability there’s some opportunity here to grow the business. They will be favorable for earnings but eventually the incentive fees are going to kick in, and just questioning, if you’re comfortable when diluted EPS relative to dividend hasn’t been an issue in recent quarters but could it be? Are you comfortable with the dividend going forward?

Frank D. Gordon

I think the answer to that, as Mike said, I think it’s very hard to predict the timing and probability of those incentive fees. If they were to all kick in one quarter, it would create a payment that would be greater than, I think, the dividend in that particular quarter. When that occurs, it’s difficult to predict. It’s not likely to occur until very late this year or early next year. And in the intervening period, I think it’s much more dependent on the mix of our fixed rate portfolio and the leverage that we’re able to employ in the portfolio.

Michael B. Lazar

I would add you’ll notice that our net investment income is greater than our dividend and I think Frank mentioned in his remarks that our taxable income is, in fact, greater than our net investment income. So hopefully that will give you some direction as to where we might have some access capacity in our earnings to the extent if there may be incentive fees payable in the future.

Frank D. Gordon

And we continue to have floating rate assets go off of our books. We have some visibility on some assets that are currently floating rate that we expect to refinance in the next quarter or two. And the combination of those events will have an impact also on the dividend, obviously.

Jim Shanahan - Wachovia Capital Markets, LLC

And a follow up question, kind of higher level here, what would you say to the following question that there have been so far relatively limited credit issues impacting the commercial finance market or just middle market companies in general, and that it’s inevitable that credit issues are going to materialize? Then they’re going to accelerate rapidly and how do you feel about what sort of a next 6, 12, 18 months look like in terms of the credit development?

James R. Maher

Well, we structured our portfolio on a basis where we thought we could weather some pretty significant downturns in the economy. We stayed away from cyclical companies and we feel quite comfortable in our portfolio to the general overall view of if you took, not our portfolio, but I think of an overall snapshot of the economy, the economy continues to deteriorate over the next 6 to 9 to 12 months. Well, we will clearly see deterioration in credit. We feel quite comfortable with our portfolio. At some point in time where there’s very significant deterioration in the economy, we will see an impact in our portfolio, but we, based on where we see the economy at the moment, are not seeing that type of impact.

Michael B. Lazar

Our portfolio is very senior and senior secured biased. So in a bad economic environment or if any particular company runs into issues that would cause credit deterioration, at least we are, in the most part, in a position to take an active role and pursue a meaningful recovery. Senior secured loans in the past have had pretty low default combined with pretty high recovery rates. And so, we do have the senior biased portfolio.


We have no further questions at this time.

James R. Maher

Well, thank you all. I look forward to talking to you again in another quarter or feel free to give us a call on the info. Thank you again.

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