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Gladstone Capital Corp. (NASDAQ:GLAD)

F2Q08 (Qtr End 03/31/08) Earnings Call

May 6, 2008 8:30 am ET

Executives

David Gladstone - Chairman and CEO

Chip Stelljes - President and CIO

Gresford Gray - CFO

Analyst

Greg Mason - Stifel Nicolaus

Troy Ward - Stifel Nicolaus

Henry Coffey - Ferris, Baker Watts Inc.

Vernon Plack - BB&T Capital Markets

John Stilmar - FBR Capital Markets

Kenneth James - Robert W. Baird

Daniel Furtado - Jefferies & Company

Operator

Greetings ladies and gentlemen and welcome to the Gladstone Capital second quarter 2008 Earnings Call. At this time, all participates are in a listen-only mode. A brief question-and-answer session will follow the formal presentation.

(Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Mr. David Gladstone, Chairman and CEO of Gladstone Capital. Thank you, Mr. Gladstone, you may now begin.

David Gladstone

Well thank you, Jackie and thank all you nice people for showing up this morning. This is the quarterly conference call for Gladstone Capital, NASDAQ trading symbol GLAD. This is our second quarter, we're always happy to talk to shareholders. We enjoy these moments that we have. We wish we had a lot more moments like this and I hope you all will sign up for e-mail notices so you get the information coming directly to you from our company and please remember that you have an open invitation that if you are in the Washington D. C. area, come by and say hello we are in the McLean, Virginia, just outside Washington. We may not have time to meet with you, but certainly we would want to shake your hand and wish you well if you come by and see us.

I do need to read statement about forward-looking statements. This conference call may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Security Exchange Act of 1934 including statements with regard to the future performance of the company. These forward-looking statements inherently involve certain risks and uncertainties even though they are based on the current plans and we believe those plans to be reasonable.

There are many factors that may cause our actual results to be materially different from any future results that is are expressed or implied by theses forward-looking statements including those factors listed under the caption risk factors that are filed in our 10-K and Q and our prospectus as filed with the Securities and Exchange Commission and can be found on our web site at www.gladstonecapital.com and also on the SEC web site. The company under take no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

This morning we are going to start something new, a new way of reporting to you as our shareholders so you can hear from some of the people at your firm other than me. Of course I am not going anywhere, but you should know that there are a lot of good talented people here at the company and shareholders should hear from them too. We will start with our production and our pipeline report and hear from our President and Chief Investment Office, Chip Stelljes, so Chip take it away.

Chip Stelljes

Thanks, David. Our production for the second quarter was disappointing with only 20.5 million in new investments closed. While the longer term prospects in our pipeline are strong the continued instability of the financial and lending markets that we are all seeing is making closing new investments more difficult and time consuming.

Of the $20 million that we did invest in this quarter, $14 million was to one new portfolio company, the remaining $6 million went to existing portfolio companies in the form of additional investments or draws on their revolvers. We received about $3 million back in the normal amortization and pay downs of revolvers during the quarter for a net production of about $17 million. Some transactions were delayed. We hope we can get back on track to close those deals this quarter.

At the end of March-quarter our investment portfolio was valued at about $413 million and on a cost basis of about $442 million and although the portfolio was depreciated, it's still valued at 93% of cost. And, we don't like the lower valuation of the portfolio during the quarter but given especially that it had strong performance that we remain confident that the devaluation is really reflective of the broader market for loans rather than any substantial change in our portfolio and we expect that most of the portfolio to continue paying as agreed with few problems through the third quarter.

The record, since inception we have made loans to approximately 126 companies. We have been repaid or exited from 61 of those. The average return of the exits has been about 13% for our syndicated loans and 16% for non-syndicated loans. At the end of the quarter we had two loans that were past due, one, with a cost basis of about $1.6 million and the other with a cost basis of about $6.6 million. We are in control of both of these companies now and working aggressively to stabilize the two investments and improve their profitability.

To date all of our realized investments have had a positive IRR. So we think the program we set up when we founded this company is working as planned and we don't feel it's necessary to really make a change to the strategy. We're continuing to look for high quality investments in solid small businesses with really talented management teams and strong institutional equity backing. After the quarter end, we have not yet invested in any new non-syndicated loans. We have added about $2.3 million in additional investments in existing portfolio companies and we have a few deals that should close soon.

Now, the pipeline for new investments is as strong as it has ever been, and we have a noticeable increase in opportunities coming to us. Banks are calling us and are the LBO funds. The market has really come our way in regard to pricing and structure given the credit crunch. We intend to make some strong loans during this time frame and while our new investments this quarter were behind schedule, our pipeline is larger than it has been in the history of the company. So, we just have to convert them to new investments. The equity we've raised and the additional debt capital available provide the company with the ample funds we need to pursue the pipeline opportunities. We still expect a good year for new assets on the books.

With that I will turn it back over to David.

David Gladstone

Okay. Now I'd like to turn to the financial numbers, and for that we will hear from Gresford Gray our CFO. Gresford, go ahead.

Gresford Gray

Thank, David. Our balance sheet is strong and at quarter-end we had approximately $123 million borrowed on our line of credit and about $301 million in equity. So we have less than 1 to 1 leverage. This is a very conservative balance sheet and the risk profile is low. No w turning to the income statement for the March-quarter, net investment income which is before appreciation, depreciation, gains or losses was about $6.4 million versus $5.7 million for the same quarter last year, an increase of about 12%.

On a per share basis, net investment income for the quarter was at about $0.33 per share as compared to $0.47 for the same quarter one year ago. This was a per share decrease of about 30%, attributable to the dilution from share issuances during the quarter or in other words, an additional $7.4 million weighted average shares outstanding as compared to the same period of the prior year. This decline should be removed as the company, as the money from our last public offering is put to work. As all of you know, net investment income is the most important number to us because it is the number that is closest to our taxable income and that taxable income is the income we use to pay our dividends. So this is the one to watch.

Now, let's turn to unrealized and realized gains. This is a mixture of appreciation, depreciation, gains and losses. We like to talk about two categories in this section. First, gains and losses because they are cash items and second, we talk about appreciation and depreciation which are noncash items. For the quarter ended March, we have a small capital gain of about $1,000 from proceeds on our interest rate cap agreement and no capital losses.

The unrealized depreciation, i.e. the non-cash item reported during the quarter ended is primarily determined by our use of opinions of value on our loans that we received from Standard &Poor's Securities Evaluations or S&P. Who does a good job of setting the price on the loans they price. They have good experience in this area because they follow thousands of loans. We asked S&P to value all of the loans in our portfolio that don't have a readily determinable market value every quarter. S&P givers us an independent opinion of the exact dollar value for each loan we ask them to review.

This eliminates the worry our shareholders may have that we are not writing down poor performing loans. Because this is a valuation opinion from our independent third-party, you will see a lot of volatility in this number. At this time last year, our portfolio was just slightly below par whereas this March our portfolio is valued at a depreciated amount due mainly to the general instability of the loan markets. You will see that overall our portfolio held its value at about 93% of par, further demonstrating our investment quality.

For the quarter ended March 31st, our assets had a net unrealized depreciation of about $18.3 million as compared to the prior year which had a net unrealized depreciation of $1.7 million. As you know, depreciation does not have an impact on the ability of the company to pay distributions to shareholders. All of our loans except two are paying as agreed but S&P thought they were in need of some depreciation due to market conditions.

Now, turn to net increased or decrease in net assets resulting from operations. This term is a combination of net investment income, appreciation, depreciation, gains and losses. It adds up everything, kind of like adding up all the apples, oranges and tomatoes.

For the March-quarter we had a net decrease in net assets resulting from operations of about $11.9 million versus a net increase of about $4.1 million last year this time. This March-quarter, we are at about anything negative $0.61 per share versus last year at positive $0.33 per share. For the quarter that just ended, this difference is related to the depreciation of the portfolio this time versus the smaller depreciation of the portfolio last time. Investors should expect this kind of volatility in the portfolio.

Now I am turning it back over to David.

David Gladstone

Okay. Thank you, Gresford and thank you for that good report. Both you and Chip did very good. I want to remind the listeners that valuations are really just best guesses of what the loan could be sold for if we had an orderly sale. There are in essence a general valuation. You want to know that the value of the loan, if you wanted to know the true value of a loan you would need to hire an appraisal company to come in and conduct a full appraisal of the company and the loan. That could cost you 5 to $25,000 for each loan that we have for getting a very accurate appraisal.

We can't justify spending that much money for shareholders to get a valuation and we would have to do it every quarter. So what we do is we engage Standard & Poor's and they use their more general technique to value the loans and that gives us the values that we are looking for. I think it is reasonably accurate for the portfolio, although I must tell you I was surprised that how much depreciation the folks at S&P came up with this time. They are just following the trends in the general marketplace. So I probably should have expected it.

Paid-in-kind or PIK interest, I always mention that, that's the income that you have to accrue for the books and for tax but you don't receive it in cash until much later some times not at all. And, we call this kind of income, phantom income, because the company that is your company doesn't really receive the cash, but has to pay out the noncash income. We have very little of that and this very important point because there are other BDCs that have very large portion of their income from non-cash sources and that non-cash income has to be paid out as a dividend even though the money has not been received.

So they must go to the bank and borrow the money in order to pay their dividend. We strive very hard here at the company not to have any paid-in-kind or original issue discount. And, I must admit this is a very conservative way to run our business and we'd show a lot more earnings if we would just go into PIK Income.

During the previous quarter ending December, one of our investments had a provision in their small $500,000 loan agreement that gave them the ability to capitalize their monthly interest payment and this company that we took over is just one of the ones that we took over, PIK interest here is about 4,000 a month. There is really no other investments in the quarter ending March that had a similar provision. We had about $16,000 in capitalized interest. So as you can see, the amount of PIK Income, we refer to this capitalized interest as PIK Income, we have very little of that in our portfolio.

Loan ratings, this is our internal loan rating, quarter remains relatively unchanged. The risk rating system we use for our non-syndicated loans had an average of 7.5 on our scale of zero to ten versus last quarter it was at 7.1 for the same period last year, quarter. This portfolio is a little less risky, according to our risk rating model and this measures the probability of default. And, the risk rating we use for unrated syndicated loans had an average of 6.3 up this quarter versus an average of 6.2 for the prior year at March 31st, in ending quarter.

As our, we do have some rated syndicated loans, there's not a lot of them. They had an average rating of triple C plus CAA 1 versus a rating of B minus/B-3 for the prior year ending March 31st. So some of our syndicated loans were marked down and, again, that's a result of the general market conditions that is out there today. Our risk rating system gives you a probability of default rating on a scale of zero to ten with zero of course representing either default or high probability of default and a ten meaning not likely to default. The risk we say, here in the portfolio is staying relatively low according to the scale. We are quite satisfied with the current portfolio mix of risk and hope it continues along that line.

As mentioned before and as most of you know we sold from our shelf registration an additional 3 million shares of common stock on February 5th, at a price of $17 a share. In February, the underwriters exercised the option to buy another 450,000 shares of common stock at the same price. This yielded us to the company approximately $55 million of net proceeds of equity for the company that we can invest. We used it initially to repay the borrowings outstanding on our line of credit and are drawing down that line of credit in order to increase the portfolio.

The deals we had in the pipeline that we thought we're going to close when we raised that money haven't come to accretion although, one almost closed in time to report it. I think it will close this week or certainly next week. However, our pipeline as mentioned by Chip before is larger now than it has been at any time and certainly even larger than January when we decided to raise the money. I expect us to have a good quarter this quarter but as always, I must remind you it is hard to judge when these deals are going to close. Chip and his team are working hard as all of us are here at the company to get some good deals in the door and close them and I think it will happen this quarter and next.

Depreciation for this March quarter and last quarter, I mean, I expect some of this depreciation will come back through as the market gets better. From our vantage point, the portfolio is still fine, but if you use an outside party to set your numbers then you have to accept them. We can't somehow say 'J' I don't think this is right or that's right, we have to stick with the numbers S&P has put up for us. Let's see how the June quarter turns out this time. I have a feeling that some of the depreciation has gone through, will turn around and come back through as appreciation, so you will see some changes in the June-quarter and certainly by September things should have changed.

Subsequent events, we have added one more bank to our credit line for $50 million. This should help us weather the storm as the market continues to have a lot of illiquidity in it. Those folks from the bank spent a lot of time looking over everything before they made their commitment. That's a passive feeling I guess from shareholders that somebody else is looking at us and saying it's good enough to lend another $50 million to. Since I talked to you last quarter the senior and subordinated debt market place, the syndicated loan the large middle market company's has had tremendous liquidity problems. For a while the market was actually closed and that is there were no buyers for these loans and so it was hard to get quotes from anybody. But now there's some new transactions going on.

Some of the old loans are getting sold and marketplace is starting to go revise as, revive as you all would expect. As you know, we purchased some of these first and second lien loans when the companies issued them. We have about $75 million on our cost basis in senior and second lien syndicated loans. For the senior syndicated loans of about $200 million or larger, rates have changed dramatically, they were 2, 2.5% over LIBOR. Now it seems that they're 400 to 500 basis points over LIBOR or 4 to 5% over LIBOR, because the new loans that are going out are much better rate this causes the old loans to be lowered in market price, but remember if we hold these loans until they mature and they pay off, we will get 100% with no losses.

All of these syndicated loans are paying as agreed so we are in pretty good shape today. LIBOR, just to remind you is the London Interbank rate which is recognized as the leader indicator of short-term rates and we tied our loans to that and almost all of the senior syndicated loans that come out are tied to LIBOR. LIBOR's norm is in the 5 or 6% range but today it's about 2.7, 2.8%. So money is relatively low cost even when you are adding 4% to it. You are talking about 6 or 7% total cost of money for these mid market companies. So, money is relatively cheap. The difference of course is they're not a lot of lenders, so while money is low cost, there are very few lenders out there making these kinds of loan.

The demand for loans in the big capital marketplace by non-bank lenders like hedge funds and bond funds for rated loans is very low. There are just very few buyers out there in the marketplace today. So, somewhere along the way that market place will pick up and change and things will come back but it is going be a while. For our small companies that is these are the loans in a very different part of the market place, these are small markets where we invest a lot of our money, we are seeing some competition but not a lot from some banks. Banks have gotten very strong in terms of their credit criteria. Many banks have tightened up their credit standard such that it is very hard to get a loan from them at all.

Most banks don't make the kind of loans that we make that is the longer term loans. We have to compete for our loans with other small private lenders like mezzanine loan funds and a few hedge funds that are still out there in the small marketplace. We do compete with some of the small business development companies that are out there. Our loan request pipeline is very strong. We see a very strong outlook and it may materialize into more loans for us and we will just have to see what that looks like next quarter. We do concentrate on variable rate loans that won't hurt us when rates increase or decrease. We try to keep everything variable so the spread stays the same and while our rates are variable we often have minimum that we charge such that our interest rate stops at 9 or 10% and doesn't go any lower when Mr. Bernakey and the others at the Federal Reserve decide to lower interest rates.

At March 31, 2008 we had three fixed rate loans at a cost basis of about $16.5 million or approximately 4% of the portfolio on a cost basis. We have in place an interest-rate cap to cover any fixed rate loans that this is commonly called a derivative and it keeps us from getting hurt should rates go against us very bad. Capital and rate will protect us I think against any increase, but I really don't expect any increase in interest rates during the near-term.

We continue to worry about the cost of oil, our economy it is very hard to think of this economy standing up to $120 a barrel cost. I am also reminded that many Europeans pay twice as much for gasoline and oil that we do because the taxes on their gas and oil over there and they seem to survive and the euro is doing well. So, maybe I am being too pessimistic when it comes to oil prices but with all the problems in the oil world especially in the Middle East, high oil prices are going to continue to take money out of the pockets of our middle class citizens. They just don't have the money for restaurants or to buy durable or nondurable goods. So, there's not a lot of money out there and certainly they're not saving for a rainy day. So it has put a real crimp on the economy.

We are no longer worried about inflation. I think it will be back in maybe '09 and certainly by '10 given all of the spending going on but it is not in the cards right now. The amount of money being spent on the war in Iraq certainly hurts our economy; all of the team here at your company support our troops in Iraq and Afghanistan. They're certainly our true heroes in this period in history. My hats are off and we think highly of anybody that risks their lives for us. We want them all to come home safe, but nonetheless the money that we are spending in Iraq and Afghanistan is costing us a great deal in terms of our economy.

And, worst of course I mention every time, because it's a major problem I see for the next 20 years is the spending of Federal, State and Local Governments. They are in my estimation simply out of control; they don't mind spending our money on virtually anything. All of this excess taxing and excess spending causes a great deal of dislocation in the economy and it absolutely kills the dollar in terms of other currencies like the euro.

Trade deficit with China continues to be one that's very difficult for us. China continue to subsidize their industries to the disadvantages of our businesses and every time we look at an investment we have to ask ourselves what's the possibility that China will come into this market place and hurt our local company that we are investing in so we avoid anything that would have a competitive disadvantage with China.

The downturn in housing industry has been a disaster for many people that are in home building and home mortgage business. We are in neither and don't have any exposure to that and haven't for years and years. No one knows how many home mortgages we'll fail, but we originally thought it would be about $200 billion we have revised our estimate up to about $400 billion. I still don't think that is enough to cause a downturn that's significant. Sure we're going to have some problems, but it is not case that it is enough to cause a slowdown certainly but not enough to cause a recession.

First quarter did not fall enough to be called a recession at least they may revise the numbers and get it into that category. But as we all know, we are all feeling the slowdown in our portfolio companies as well as in all of the businesses that we look out. Housing problem so the experts say is probably not going to turn around for at least a year, so housing prices continue to fall. If you remember they went up a lot. So it is pretty appropriate they come back down to a price that's more realistic. Also much of the housing trade is out of work, that is the individuals in that but they're not showing up in the Government statistics because many of them were here without visas. I'm not sure we have a good number on the unemployment rate. Many of those people have gone back to Latin America and certainly the money flow from the United States back to Latin America has, is down substantially. I have read some numbers that is down by as much as 50%, because those people who were wiring money back home obviously don't have the money to wire back anymore.

In spite of the downturn, those negatives that I keep mentioning and the industrial base of the U.S., still is incredibly strong. The small businesses that kept their cost low, they have not gone out on the limb and built their businesses on speculation. Manufacturing is not operating at full capacity and they're just not going out there and taking the risk. So, the slow down in the manufacturing side has been not as painful as it was in 2001. The backlog that has come down and their slow on hiring and you can see that in everyone of these companies that we look at, but the recession is not as bad as we all thought it was going to be.

I think the quarter ending June, may show the recession but probably not a big amount. Our dividends, we did hold our dividends at $0.14 per month per share for the quarter ending June 30, 2008. But the run rate is still $1.68; we will see how our second half plays out. I think it should turn around pretty strong and hopefully we can spend some time talking at our Board meetings about increasing the dividend.

At this dividend rate and with the stock price closed yesterday at about 1906, the yield on the stock is 8.8%. That’s a really solid 8.8 given the strength of the portfolio. The stock came down just like all of the stocks in the financial area did and we will just have to see if we can start pushing hard to get that stock price back up. I am going to end now but please go to the website and sign up for the e-mail notification service. We don't send out junk mail. We would like for you to be on our mailing list so you get all of the information that's coming out about the company.

In summary, as far as we can see the outlook is still okay. We can't see more than a couple of quarters out, but we are just being careful and we are stewards of your money. We want to stay the course and continue to be conservative in our investment approach and hope this quarter comes out a lot stronger than last quarter. And, Jackie, if you will come back now and tell these folks how they can ask question we will open it up for some questions.

Question-and-Answer-Session

Operator

(Operator Instructions). And your first question is from Greg Mason of Stifel Nicolaus.

Greg Mason - Stifel Nicolaus

Hi, good morning, gentlemen I have a couple of questions and Troy Ward has a question. First on your originations, clearly the language in the conference call and the press release indicates you guys are disappointed having through four months done about $23 million of originations, what's happened? We have been hearing that it's a great time to invest, lots of investment opportunities, what happened to cause you to be disappointed in your originations? Why didn't they come through?

David Gladstone

Chip will answer that. He's on the firing line everyday for that.

Chip Stelljes

I think a couple of things happened. First of all timing has changed dramatically. I think number one, a lot of the letters of intent that were signed six months ago had had to be renegotiated based on the availability of capital both equity and debt. So we had some timing differences and some deals that just fell apart. Now that being said we've had a lot of new deals added to the pipelines? Secondly, I think, as we looked at the capital markets and the opportunities, we sort of raised our bar on the kind of returns that we wanted to see, given where our stock was trading and our cost of capital. So, some of the things that we looked at is potentially being attractive, six or eight months ago we decided that they weren't nearly as attractive. We would like to add new ones. I am surprised we didn't close more from a backlog standpoint I'm not surprised from the current dislocation of the market. We are seeing a lot of deals getting re-traded and renegotiated. It is a great time if you can get them closed but this business to me has always been a yearly business, but we have to report on quarter-by-quarter. So, a deal as David said, that should of closed before the quarter closes three days later and it doesn't look like it was a good quarter but on the other hand you have a quarter that now is accretive for a deal that accretive for the entire quarter. So I think it is partially timing, partially market, but I still feel like it is going be a good time to invest. We just to get some of these deals across the finish line.

David Gladstone

And Greg, we saw--- This is David Gladstone again. Greg, we saw the some of our good sponsors decided not to go forward in some of their deals. They had priced them at one price and then decided that it wasn't good enough given the current circumstance in the marketplace and given the pricing of the debt, the senior lenders are charging more. We are charging more and it took away from that and some of the sponsors also had their sellers, they couldn't get to the finish line quick enough, would walk from the deal because they were feeling that they weren't getting enough for their company. So there has been a mixture if there. We do have a lot of closing in the pipeline and hopeful that we will make you happy in June. Now we will take the next question. Greg, do you have another one?

Greg Mason - Stifel Nicolaus

Yes, on your credit reimbursement of the incentive fee, can you talk about how that unwinds, what the timing of it is, how do you decide how much you are going to reimburse versus start actually recording that as an expense?

David Gladstone

We do this very every quarter and we make this promise every quarter that we are always going to give back enough of the fee to make sure we never have a problem meeting the dividend. So, that said, we give all of the incentive back, fee back right now, because that's what is needed in order to make the dividend. A problem of course in getting out of that circular problem of having to give it back every quarter is the fact that we placed a lot of new shares on the books and those new shares have to be fed with the same amount so that we are paying in dividends has to be paid on each one those. So, every time we raise money we make the bar higher in order for us to get to the incentive comp and the only way to do that is to have some very good capital gains down the road of which we have got a couple that we hope will happen and also, as you know, we don't record on the P&L or the balance sheet. The PIK Income that we have coming in from our success fees, these success fees are exactly like paid-in-kind income, except that we don't accrue them, we don't have to pay them out until we receive the cash. And there's an excess of $3 million or so sitting there and continues to buildup. So somewhere along the way these companies will pay off their loans and or the businesses will be sold and will be cashed out at that point in time and those moneys will come in and given the size of those and the projections that should solve the problem. So, we are waiting for a turn around in the economy and some sales of these businesses in order to generate enough income to work us out of that problem.

Greg Mason - Stifel Nicolaus

Great, and then Troy Ward had one question.

Troy Ward - Stifel Nicolaus

Quickly, David, on FAS 157, obviously this is the first quarter of implementation and of course you are one of the first out with your earnings, in your conversations with S&P can you give us the impression of 157, their interpretation and were you at all surprised with their interpretation.

David Gladstone

Actually, our depreciation had nothing to do with 157. As you can imagine, in our company, we have not had a problem with 157 because we don't have the disparity between market and what the internal numbers are coming out simply because Standard & Poor's, an independent third-party is giving us that number and so that number goes into our portfolio. As I understand, the problem in some of the companies and I guess we have all read the article that came out yesterday is that some companies used total enterprise value to value their loans and total enterprise value would be different from a price that might be derived in a market. That disparity is what is probably going to hit a lot of people in the first quarter. Just so you know also Troy, this company was not required to adhere to 157 in the first quarter even though we are adhering to 157 in the first quarter. We didn't have to. We were already there. So as a result, we won't have, it won't change anything for us. And I think, we've had this question several times, is 157 going to change your ways. The answer is no, because we are already adhering to go 157 and have since the inception. You will hear us talk about 157 in the June-quarter for Gladstone Investment gain because we will have to adhere to it for the first time there. That will be the first company that comes up. As you know, many of the companies that have a December 31st year-end are going to report their first quarter and there may be some surprises from some of them.

Troy Ward - Stifel Nicolaus

Great. Thanks for that clarification. Quickly on the credit within the portfolio, we saw several of the investments go from typically from previous quarters maybe a mark of 3 to 4% and we understand the 93% on the whole portfolio is an average and you are going to have some above and below, but it seemed like there was a big grouping in that 12 to 15% mark. Is that, is that just a function of the market and not a, any underlying credit issues?

David Gladstone

There is the credit issues are the same as they were in the last couple of quarters. We still have the same two problems that we've had before and I can't explain it other than the fact I think that folks at S&P are becoming very, very conservative given their past performance in some of the sub-prime loan pools and they want to make sure that they hit the mark and quite frankly, they are responding to go a market place that has had very, this quarter ending, the quarter ending March. So from January to March there was a very dramatic change in the senior syndicated loan marketplace in terms of depreciation and pricing that was out there. Virtually no one showed up for a lot of the pricings and enormous number of pools came to marketplace. We probably saw and just guessing of the top of my head now, $4 to $5 billion worth of loan pools that were being liquidated and dumped into the marketplace, driving prices down pretty strong. While I would love to buy some of those, the overall yield was in the 11 or 12% range and we just felt it was unwise for us to load up on those at that time and they were being sold as pools rather than individual loans and those pools have just been bought and sold in the marketplace and I don't know how much more of that is coming. But there is still a lot of hedge funds that have been taken over by their lenders and their portfolios is being liquidated. So we would expect over the next year period a fairly robust amount of loans coming to marketplace and hopefully they'll be some company's be set up to grab those and they're still awfully good loans. They are just being pushed down by the bulk of a number of loans coming to market that don't have enough buyers.

Troy Ward - Stifel Nicolaus

That's great color. Thanks, David.

David Gladstone

And Troy, just to mention it, thanks much for all of the write up you did on BDC's, we were impressed with the report that you came out with. Next question?

Operator

Thank you. Our next question is coming from Henry Coffey Ferris, Baker Watts Inc.

Henry Coffey - Ferris, Baker Watts Inc.

Yes, David, Henry coffee. How are you? I appreciate a lot of the comments. And some of the stuff you clarified. Basically you have been practicing 157 or market-based accounting since the fund started; right?

David Gladstone

That's true and in addition to that, we started looking at 157, our auditors pointed to us I want to say two years ago when it was still in draft form. We made commenting on it and have been adhering with 157 every since.

Henry Coffey - Ferris, Baker Watts Inc.

The, your loan yields which are now sort of in the 10% area, does that improve as you put new loans on the books or is that sort of the benchmark cost for your borrowers right now?

David Gladstone

In capital it should improve, the deals we are closing are higher than that. And, so overall you should see an increase although it is incremental you have got a portfolio that's pretty large. So putting another 40 or $50 million on the books at a higher rate is not going to move the needle that much.

Henry Coffey - Ferris, Baker Watts Inc.

And second question, what is your incremental borrowing cost?

David Gladstone

I've read it some advisors like 5.9%. About 6%. Yes, about 6%.

Henry Coffey - Ferris, Baker Watts Inc.

And then, in terms of new production for the next couple of quarters, are you willing to put a number out there?

David Gladstone

Well, I flog Chip everyday on that and he gives me some numbers but I am not willing to put those out to the public. Thank you, though.

Henry Coffey - Ferris, Baker Watts Inc.

Great. Thank you much.

David Gladstone

Next question, please, Jackie.

Operator

Thank you. Our next question is comes from Vernon Plack of BB&T Capital Markets.

Vernon Plack - BB&T Capital Markets

Hey, good morning. Most of my conversions have been answered, just had one regarding the professional fee expense line. I know that number went up four fold compared to last year and was just hoping maybe to get a little more color on that.

David Gladstone

Yes. Professional fees the accounting number in that, and counting and legal words in that, the accounting number didn't go up by that much. It was not that high. So, unless somebody has a different idea, I think that most of it came from---

Gresford Gray

It was from the stock offerings we did.

David Gladstone

Okay. Actually in putting together the stock offerings it went through that number.

Vernon Plack - BB&T Capital Markets

Okay.

David Gladstone

Every time you raise money these lawyers have to opine and they charge a lot to opine, so it costs us a bit to get these things done.

Vernon Plack - BB&T Capital Markets

Okay. Thank you.

Operator

Thank you. Our next question is coming from John Stilmar of FBR Capital Markets.

John Stilmar - FBR Capital Markets

Good morning, David and gentlemen. Thank you very much for taking my question. I am -- don't mean to beat a dead horse but want to go back to Chip's comments earlier with regards to the closing of the pipeline and his answer to the previous question which sort of talked about a six months lead time. Can you talk about, is that typically about a six months lead time and sort of where we are in the pipeline or where we are in sort of the pipeline for when those deals were originally negotiated and secondly, you talked a little bit about sponsors pulling out. There seems to be a pretty strong amount of middle market and mezzanine financed money that's out there still today. Are you seeing that money itself is starting to re-price and multiples are starting to change or what are some of the dynamics there we might think of in changes from last quarter?

David Gladstone

While, the marketplace is in flux and it has been in flux and it has been in flux for about six months. And quarter ending March was one in which there were lots of changes going on in the marketplace. Number one, the banks had tightened up dramatically. So that's good for us usually except that when the banks tighten up they offer less money and they charge more. We charge more so when a sponsor is looking to purchase something they now have to drop the price pretty significantly, in order to make the numbers work. A lot of the sellers at that point say to themselves well I understand that your cost Mr. Sponsor has gone up and therefore you want to pay me less, but I am not willing to sell my business for less and one of the two parties then walks away and deal dies. So, that does happen and has happened for deals that were priced as far as the June-quarter of last year some on the turn around. We don't see that happening in the new deals that get priced now because everybody already knows this pricing mechanism that's going on. So the deals that we are closing today are mostly the newer deals that have been priced according to the current market even though the market for a March ending quarter was substantial change in the marketplace again. And, I want to impress upon you that when the down downturn started in June of last year and you saw the quarter ending September it wasn't nearly as bad as everybody thought it was at that point in time. Come December people had started to see that the downturn was bigger than they thought and the realization came very strong in the March-quarter ending '08 and that was sort of the quarter that everybody said to themselves the world has really changed and we need to change the way we were looking at the world and a lot of things were in flux during that period of time. Chip, do you want to add anything to that?

Chip Stelljes

Well a couple of things. One is you are right, the deals are taking closer to long because of the factors that David mentioned. There are some more moving parts. So the gestation period has gotten longer. I think, the answer to your final question sort of there is a good deal of Mez-money but not nearly the amount of Mez money there was prior to August of last year. So I think we are seeing clearly 200 plus type basis point increase in pricing and half a turn to a turn less of leverage in the second lien sort of structure. They may expand back as more mezzanine money comes in. But right now we still that that the pricing and the lower multiples of debt are going to stick with us for a while. So, we are going to do our best to take advantage of that.

David Gladstone

The Mezzanine money out there as Chip mentioned is not a lot and you can understand why. About a year or maybe it has been a year and a half ago, we went to the marketplace trying to set up a private fund that would do co-investment with our other funds and given the fact it was yield oriented rather than equity oriented that is more a Mez-fund than equity fund, we found almost no takers. So Mez funds weren't raised in last couple of year simply because they couldn't promise the kind of returns equity funds could and the pension funds and insurance companies that buy those limited partnership interests were not very interested in that type of investing. I don't know that the marketplace has changed any since then, but there's certainly a lot less mezzanine money around than it was three or four years ago.

John Stillmar - FBR Capital Markets

Wonderful. Thank you guys for that. And, the last question is more of, as we start thinking about market values of securities and there is certainly a market values consider the illiquidity that certainly out there not necessarily the credit risk solely and I think that is your point, David, but how do we as analysts or investors start think or look at different indices. I mean it looks like you had a, only a single-digit pull back in term of your pricing whereas you sort of move up into you the larger single digit or larger markets. The pricing changes have been a little bit more severe. How do, are you experiencing less of sort of the illiquidity discount or how should we as analysts and investors, what kinds of benchmark should we look to kind of think about just sort of general market pricing that can exist as S&P sort of universally thinks about your portfolio.

David Gladstone

Yeah, I think S&P, and I don't know this for sure, I am just guessing S&P looking at the general marketplace and then coming in pricing our loans based on the general marketplace. The general marketplace dropped dramatically between January and March this year and there's really no indices you can go look at. There is the indices for senior syndicated loans but it is like the S&P 500, every time some loan is not doing as well or it is very seasoned they take it out and replace it with another one. The index today is about $0.99 and where as if you and it's called, I think index number 10 now that they're working on. If you go back and look at index number five, I think it would be lower than the $0.93 on the dollar that we have, but they replace all of the poorly performing loans in the index with better performing loans and anything that gets to a, has paid down some, they take it out as well. So there is a, not an indices that you can look up that I know out there. There may be some place that is similar but that makes it frustrating for folks like you because you can't anticipate what the folks at S&P might mark our loans to. And quite, frankly, neither can we. So, we were surprised this quarter with the general mark down. I think, I remember the sheet that I looked at when we were in the Board meeting, I think every single loan that we had with the exception of one or two was marked down somewhat, some of them are small amount and some of them larger amount, all the way down they were nothing but read negatives all the way down on the valuations this quarter. And, obviously our portfolio is not doing bad and we don't have that many problems in the portfolio. So, you would expect it not to go down much at all. And, had we've been using our own internal technique probably would have gotten lot less devaluation than S&P put on it. But S&P is reacting to what is going on in the marketplace and the marketplace for senior syndicated loans has been pretty grizzly and that shadow is cast on all of our loans when they come into review it. Any other questions?

John Stilmar - FBR Capital Markets

No. Thank you so much. I appreciate it.

Chip Stelljes

Okay, next question.

Operator

Thank you. Our next question is from Kenneth James of Robert W. Baird.

Kenneth James - Robert W. Baird

Hi, good morning.

David Gladstone

Good morning.

Kenneth James - Robert W. Baird

I think most, everything has been covered but I wanted to see if I can get more color on the success fees. You referenced the $3 million of success fees I am curious maybe how many deals comprises that $3 million. I know you have a $500,000 fee, you're saying you are going to recognize in the second quarter. Pretty much all that size, trying to get a feel for the total number of potential deals it would take to unlock them all?

David Gladstone

I don't know the average on. Anybody got guess on where it might be on the success fees, how many loans? I know most of the loans that we have that we negotiate on the small side either have a success fee or some kind of exit fee. So we have money building up. How much it is per loan I haven't done the calculation, let's see if we can run that to ground and maybe post it on our web site for you.

Kenneth James - Robert W. Baird

Okay. I was just curious as to what your degree of confidence or expectation as of that $3 million would be recognized not necessarily even this year, but you know over the course of the next six quarter say by the end of FY '09 or is that amount of money that could potentially carry on through even further than that.

David Gladstone

Here is the calculus. The calculus that you look at is will the company be sold. These success fees are based on the sponsor who is an LBO fund, selling the business at some point. Right now of course it is not the appropriate time to sell a business. You can't get the top dollar for it, so many of the sponsors are holding on to their companies and not exiting. But, there will be a lot of pressure for them to sell their business because they are limited partnerships and have to return the money at some point in time and it will be a lot of pressure over the next couple of years to sale some of those businesses anyway even if the marketplace is bad. And every time they sell a business the success fee is due and we get paid just like you had a warrant or some other equity ownership in the company. And, I can't predict when that is going to happen. But I know it happens just like clockwork every year, some amount gets sold and so we are counting on that occurring. Do you have any comments on that, Chip? Do you know any?

Chip Stelljes

No, I think if you take all of the senior syndicated loans, all the syndicated loans out, you take most of the senior broadcast and our radio loans out, most of the other transactions are going to have some level of success or exit fee on them. When they will realize as David says, it is very difficult to figure out who's going to sell a company or who is going to refinance their debt and volunteer to repay those exit fees. But they tend to kind of come in when they come in. We would love to recognize them but it wouldn't be the right thing to do. So, we haven’t done it. We will recognize them when they come in.

Kenneth James - Robert W. Baird

Okay. Thanks.

David Gladstone

Okay. Next question, please.

Operator

Thank you. Our next question is coming from Daniel Furtado of Jefferies & Company.

Daniel Furtado - Jefferies & Company

Morning, guys. Nothing earth shattering here, I'm just trying to get a handle on the advance rates on the line of credit as well as the spread to LIBOR.

David Gladstone

Advance rate you're meaning, I am not sure.

Daniel Furtado - Jefferies & Company

What percent of the investment you can fund? Is that an un-secured line where you can fund a 100% of the investment or you've like a 70% advance rate for like senior and 50 for equity or something along those lines.

David Gladstone

Yes, its--. It is our line of credit with the bank and how much we can draw down. It is usually based on about 50% loan to value. So, if we put a loan and therefore $1 million, we should be able to borrow $0.5 million. If you remember our problem in our industry is that we can't leverage more than 1 to 1 anyway. So, we set our bank loan up that way. We are in the final stages of negotiating our closing this month with the folks at Deutsche Bank and the other banks that are part of it, so you should see an announcement in the not too distance future with regard to that the line has been renewed.

Daniel Furtado - Jefferies & Company

Okay. And then the spread to LIBOR has that changed from previously?

David Gladstone

Oh yes. The spread to LIBOR is going to go from about 1.2 to about 2.5.

Daniel Furtado - Jefferies & Company

Okay. Perfect. Thank you very much, David.

David Gladstone

Okay. Next question.

Operator

Thank you. (Operator Instructions).

David Gladstone

No other questions?

Operator

Thank you, Mr. Gladstone. We did have another question coming from Greg Mason of Stifel Nicolaus.

Greg Mason - Stifel Nicolaus

One final question here, on your interest rate sensitivity analysis that you provide in your Q, is that based on a 1% change on the 3.6% average LIBOR during the quarter or at the 2.7% rate at the end of the quarter? The reason why I am asking is has the change in LIBOR from your average rate of 3.6 down to the current rate 2.7, 2.8 has that impacted your portfolio margins at all?

Gresford Gray

Yes. This is Gresford. In answer to your first question, what's based on the average LIBOR during the quarter? And for your second question, based on the size of our portfolio, the sensitivity hasn't changed substantially.

David Gladstone

And Greg, just so you know, we have floors on many of your loans so they stop at anywhere from 9.5 to 10%. They get hung up at a higher rate even though we are paying less on your line of credit. So the spread is positive for us.

Greg Mason - Stifel Nicolaus

Okay. And when you say they're locked in at 9%, what does that implied for a LIBOR rate lock in.

David Gladstone

Well, think about it this way. If we might be charging on a second lien loan LIBOR plus 7, and obviously at LIBOR plus 7 that's 9% today with LIBOR assuming LIBOR was around 2, it's not 2 but it's about 2.7. But, the point being is the minute it drops below the floor of 10%, they still have to pay 10% because that's the minimum they have to pay. And, while our rate is locked into LIBOR, let's say it's 2.5% over LIBOR, we continue to move down in our cost of funds. Am I explaining it correctly or I'm missing something?

Greg Mason - Stifel Nicolaus

No, that makes sense. All right. Thanks, guys.

David Gladstone

Any other questions.

Operator

Thank you, Mr. Gladstone. There are no further questions at this time.

David Gladstone

All right. Thank you all again and I hope to see you in, well end of June. Thanks again.

Operator

Ladies and gentlemen that does conclude the teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Gladstone Capital Corp. F2Q08 (Qtr End 03/31/08) Earnings Call Transcript
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