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Executives

Steve Tunney – Co-Founder, President and CEO

Tod Reichert – Chief Compliance Officer, SVP and Corporate Secretary

Michael McDonnell – CFO and COO

Analysts

Troy Ward – Stifel Nicolaus

Bob Jordan – SARG Management [ph]

John Stilmar – FBR Capital Markets

Mark Cooper – Wells Capital

Jim Stone – PSK Advisors

Robert Nam [ph] – Ironsides [ph]

David Rothchild – Raymond James

Rick Sherman – Oppenheimer

Rick Firon [ph] – Advertise Capital Partners [ph]

MCG Capital Corporation (MCGC) Q2 2008 Earnings Call Transcript August 7, 2008 10:00 AM ET

Operator

Good day and welcome everyone to the MCG Capital Corporation second quarter 2008 earnings conference call. Today's call is being recorded. With us today is MCG Capital's Co-Founder, President and Chief Executive Officer, Mr. Steve Tunney and Chief Operating Officer and Chief Financial Officer, Mr. Mike McDonnell.

At this time, I would like to turn the call over to Mr. Steve Tunney. Please go ahead, sir.

Steve Tunney

Good morning everyone. First, before we get started, I would like to have Tod Reichert, our Chief Compliance Officer provide the necessary Safe Harbor disclosures. Tod?

Tod Reichert

Thanks, Steve. Today's call is being recorded and webcast live through our Web site at www.mcgcapital.com. A replay of the call will be available on our Web site and an audio replay will be available through August 22, 2008. The replay information is included in our press release announcing this call and it's posted in the investor relations section of our Web site. This recording is the property of MCG Capital Corporation and cannot be used or reproduced without the prior consent of MCG.

Before we begin this morning, we would like to remind you that various remarks that we may make during this morning's call regarding MCG's future expectations, plans, and prospects constitute forward-looking statements for purposes of the safe harbor protection under applicable securities laws.

These forward looking statements involve risks and uncertainties that may cause actual results and/or performance to differ materially from any future results, performance or achievements discussed in or implied by such forward-looking statements.

The risks and uncertainties include but are not limited to expectations regarding our results of operations; general and administrative expenses; our ability to strengthen our capital base; the carrying value of investments in our portfolio; the performance of our portfolio companies; our ability to recover unrealized losses; our ability to access alternative debt markets and additional capital; our ability to monetize assets and the related timing of such monetizations; our asset originations; the timing and sufficiency of cash for future operations; our ability to increase our asset coverage ratio; general economic factors; regulatory matters; and other factors outlined in MCG's annual and quarterly reports which are on file with the Securities and Exchange Commission.

In addition, any forward-looking statements represent our views only as of today and should not be relied representing our views as of any subsequent date. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change and therefore you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

Now during this call, we will be referring to non-GAAP financial measures including distributable net operating income also referred to as DNOI. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in MCG's second quarter 2008 earnings release and in the investor relations section of our Web site at www.mcgcapital.com under the heading non-GAAP financial measures.

I now introduce you to Steve Tunney, our CEO and President.

Steve Tunney

Thank you, Tod, and again, I welcome everyone. Hopefully, by now, you've had a chance to review our second quarter earnings report which was issued last evening. Obviously, we are not pleased with the results and the results were unexpected. Therefore, this morning we'll also announce several steps we are taking to ensure the strength of our capital base and to right size our operation relative to the current operating climate.

First, let me review the second quarter. For the quarter, we lost $0.96 per share with net valuation write-downs of $82 million. The valuation write-downs were concentrated in two portfolio companies.

We recorded a $32 million unrealized loss on Cleartel Communications as we've written off the balance of our investment. Cleartel has continued to miss our expectations and accordingly, we do not believe that we will receive any recovery on our investment.

Additionally, we have taken a $32 million unrealized loss on Jet Plastica Investors LLC, a bulk cutlery manufacturer which is a control investment of MCG. This unrealized loss is a result of a performance miss tied primarily to an unprecedented increase in their raw materials costs which was caused by the recent run up in the price of oil. While this valuation decrease is disappointing, we are optimistic that over time it can be recovered as it is our expectation that Jet Plastica will eventually be able to recoup this raw material cost increase and improve its results.

For the quarter, revenue was $31.1 million, a 38% decrease from Q2 2007. Net operating income decreased 54% to $13 million or $0.18 per share while DNOI was down 51% to $14.8 million or $0.20 per share.

These amounts were in line with our expectations for this quarter. The decrease from 2007 levels is primarily attributable to our no longer recognizing dividend income on our Broadview investment, a decrease in fee income due to lower originations, and exceptionally high levels of fee and dividend income in the 2007 quarter related to an asset sale that occurred last year.

As we mentioned in last quarter's call, we are no longer accruing income on our Broadview investment because the company is fully valued at our current carrying value. We don't anticipate recognizing any additional dividend income at this time.

We believe Broadview is a strong component of our portfolio and we continue to support Broadview. However, any liquidity regarding our investment in Broadview will be subject to among other things future market conditions.

Although our current facilities are adequate for our operations, we have thus far been unsuccessful in our recent efforts to secure additional financing facilities for growth. We were working diligently with two banks on two facilities aggregating $350 million.

However, in both instances, the banks were unable to complete the transactions due to the worsening market conditions. Therefore, we anticipate asset originations in 2008 will be minimal.

Until we improve our asset coverage ratio to our desired target level of at least 235%, we intend to be very selective in our asset originations. The current market environment is extremely challenging.

As we started the year, we had a reasonable expectation that we would have access to both the debt and equity capital markets and that we would be able to monetize several equity investments to support our expected dividends. Unfortunately, given the turmoil in the capital markets, we have not been able to meet these expectations.

While we have been able to accomplish a few capital market initiatives, they were completed with lower than expected proceeds and at a much higher cost than anticipated.

Further, asset monetizations have been hampered by the current market environment. Therefore, we are building our plans around the assumption that there will be no access to the capital markets for the balance of 2008 and into 2009 and monetizations will be significantly reduced.

As we've taken stock of our results for the first half of the year and looking forward, we see a continuing downward trend in the financial sector. We think it is time to take some definitive measures to ensure the strength of our capital base and to right size our operations relative to the current operating climate. Accordingly, we are taking the following steps.

As we have already met our estimated statutorily required distributions for 2008, we currently do not plan to pay any additional dividends for the remainder of the year. We expect to resume making distributions in 2009.

We are reducing our headcount by 27% through a combination of terminations and recent attrition, the senior executive team will not receive any bonus compensation for 2008, other incentive compensation and expenses will be reduced.

The company will implement a retention program comprised of a repurpose bonus plan and selective restricted stock grants for certain employees. Both of these programs will exclude the senior executive team.

By eliminating the dividend for the balance of 2008, we expect to preserve $40 million in capital. In addition, the expense reductions are anticipated to save $12 million to $14 million through December 2009.

From a business plan perspective, over the next 24 months, we have targeted $150 million to $200 million in assets that if market conditions permit, we expect to monetize and redeploy from non-yield oriented equity investments into high yield cash paying debt investments. If we are successful in making this transition, it will have the effect of reducing our mix of equity investments from 34% to 22% of total investments.

As a result of this redeployment and the cost reduction program, we intend to significantly increase our cash basis earnings per share which we would expect to be the foundation for our future dividends. We intend to set our future dividends off of the cash earnings of the portfolio.

We do not take lightly the decision to curtail the dividend for the balance of 2008. However, we are making this decision to strengthen our capital position which we believe is in the best interest of our shareholders.

We believe we are moving the pressure to liquidate assets in an unfavorable environment and in order to maintain the dividend is the right decision to make.

Further, we think the most cost effective capital we can raise is the capital that we generate through the retention of earnings. We are more focused on realizing on a net asset value of $10.31 per share and see it reflected in the stock price than making a dividend payment for the balance of 2008. We believe our current (inaudible) but we intend to build an additional cushion to enhance our ability to deal with the unexpected circumstances that the current market environment is sure to throw at us.

Currently, we have approximately $100 million of cushion under the BDC asset coverage test. We believe that we are adequately covered, but intend to build more room by increasing our asset coverage ratio target to at least 235%. We are taking these steps as a precautionary measure which we think is prudent in the current market environment.

On our last earnings call, several investors inquired as to whether we should implement a stock buyback program. The accretive aspects of such a plan especially at these levels are attractive. However, our first priority is to achieve our target liquidity and BDC asset coverage levels.

Once we achieve these objectives, we may revisit such a plan in the future. This has obviously been a tough quarter for us. We believe that we are appropriately taking measures that will ultimately deliver value to our shareholders. We do not take lightly the challenges that we face but we are confident that we are positioning ourselves to execute and create value from our portfolio.

We believe our stock in relation to our net asset value is undervalued at this time and we need to demonstrate that through asset realizations. We've been through tough times before. We believe that our performance will improve and the returns for our shareholders will follow.

With that, I will turn the call over to our COO and CFO, Mike McDonnell for a financial overview of the quarter. Following Mike's presentation, we will both be unavailable to address any questions you may have about our performance. Mike?

Mike McDonnell

Thanks, Steve, and good morning, everyone. For those of you who are listening along the webcast, we have posted some slides and they should be available on our Web site, and I will step through those slides and make some comments some of which will be a reiteration of some of the points that Steve just made.

If you look at slide #3, our revenue for the second quarter of 2008 relative to the second quarter of '07 is about $19 million down. That is due to the reasons that Steve cited. We are no longer accruing dividends on our Broadview investment, that's about an $8 million differential, and then we also had a significant amount of fees and so forth associated with originations and an asset monetization that occurred during the second quarter of '07 which also contributed to that diminution as well as the rates of LIBOR dropping a bit from the second quarter of '07 to the second quarter of '08.

We were able to squeeze out some costs below the revenue line and thus the DNOI and balances are about $15 million less versus the $19 million drop in revenue. Obviously, the net income or the loss for the quarter is somewhat disappointed about, it's driven by the marks, and I'll talk a little more specifically about that as we step through the slides.

Subsequent to June 30th of 2008, we've had a few key events. One is that we have repaid our Merrill Lynch warehouse in full on August 4th. That's a good ending to an unfortunate situation that we found ourselves in along with Merrill Lynch when the CLO market basically disappeared very, very rapidly during the summer and fall of last year, and we have successfully navigated our way through that warehouse and have replaced all of the collateral that was in that facility and repaid Merrill Lynch in full on August 4.

Also, during the early third quarter, we sold our position in JUPR Holdings for approximately $23 million. This sale results in a gain of about $6 million, a realized gain of about $6 million in the third quarter of 2008.

This gain will not have any P&L impact in the third quarter because we marked it as of June 30th to this transaction, but it obviously provides $23 million of liquidity and a nice realization in the third quarter of '08. This investment ends up providing a total investment IRR of 28.3% and an equity IRR of 31% for us.

Also in late July, our portfolio company, TNR Holdings Corp. which is a company that has been struggling. We've had a non-accrual status for quite some time, was able to complete a transaction, that's a very good transaction for that company.

NCR Corporation has invested $15 million into TNR, entered into a partnering arrangement with them. That provides TNR with a good amount of capital and a very good strategic partner to work with going forward.

As Steve mentioned during his script, we've taken some very significant steps with respect to distributions in corporate restructuring that we've laid out on slide #5. We've eliminated distributions for the remainder of 2008 which will preserve about $40 million of capital that we expect to reinvest in our business and that will also enhance our liquidity. We do expect to resume making distributions in 2009.

We are a BDC, we are required to distribute our taxable income which helped '08 where we have met our estimated annual distribution requirements and we felt as though not paying dividends for the balance of the year was the prudent thing to do at this time for reasons that Steve articulated.

We've also reduced our headcount by 27% through terminations and non replacement of some vacancies, eliminated bonus compensation for our senior executive team. We've also reduced some staff incentive comp and G&A expenses.

And overall, we expect that these reductions will result in an annual savings through 2009 of approximately $12 million to $14 million. So the remaining six quarters between now and the end of 2009, if we are at the lower end of that range that should provide roughly $2 million per quarter in savings and it will be our goal to try to run our SG&A at roughly 2.5% to 3% of our asset balances during that time frame. That will be a bit dependent on the level of assets that we maintain.

On slide #6, notwithstanding the marks, we still have a very strong balance sheet. We've got $780 million of equity capital behind $1.4 billion of total investment. Our debt-to-equity ratio of 0.89 to 1 is admittedly higher than where we would like to be that has been impacted by the marks that we took as of June 30. Our asset coverage ratio is at 210% as of June 30.

And as Steve mentioned, it's our goal to drive that back up to 235% which is roughly a 0.75 to 1 ratio which we think is a prudent level in the current market environment. We have made some progress on this subsequent to the end of the quarter due in part to the JUPR monetization and we are currently sitting at about 213%.

We've also got yields in a decent spot. If you look at the chart, you can see as of 12/31/07, they've gone from 12.5% as of that date to 11.5% as of June 30th '08. However, there has been about a 2.3% drop during that time period in LIBOR. Our spreads have actually increased by about 1.2% from one period to the other and that's somewhat impacted by the timing of when LIBOR resets, but the spreads have widened during that time frame.

Our NAV per share obviously has been impacted by the rights offering that we closed in April as well as the losses and the dividends that we've declared during the first half of '08 and sits at $10.31 as of June 30, 2008.

Some selected operating data, I've touched on many of these points. The salaries and benefits obviously a significant reduction there in the second quarter as we've reduced our estimated incentive compensation levels. The G&A did spike a bit during the quarter.

My expectation is that will go down as we head into the third quarter and beyond, that should go down a bit. There were some costs associated with some of those debt facilities that we were working on that didn't materialize that we charged off the G&A during the second quarter of 2008.

From a revenue standpoint, obviously, we had a significant drop from the first quarter of '08 to the second quarter to the tune of about $13 million, that's due in large part due to the Broadview where we accrued about $8 million of dividend income in the first quarter and none in the second quarter.

It was also a bit impacted by nonaccruals a bit as well as the dropping LIBOR, the dropping LIBOR, we are able to recover lot of those revenue drops, on the interest expense line, you may have noticed on the previous slide that our interest expense was down a bit as well.

EPS breakdown, we try to present this slide to give you a feel for the run rate of the business. I think the second quarter of '08 is basically a spread income sort of quarter really nothing in the way of advisory fees or accelerations or nonrecurring given the lack of originations and pay downs, there's about $0.01 in there. The $0.13 drop in net operating income that you see from the first quarter of '08 to the second quarter of '08, about $0.11 of that is related to the Broadview dividend.

Gains and losses, we have a slide, slide # 10 that lays out the $82 million. Cleartel and Jet Plastica are the two biggest drivers of that. There was about $64 million or $65 million associated with those two companies, and the rest of the losses are all sort of smaller amounts that just add up to a big number when you roll it (inaudible).

Our ROE obviously disappointing, that's driven by the losses was negative 5.88% for the 12 months trailing as of Q2 2008. I want to talk a little bit about the debt facilities, make a couple of points here. The debt facilities that we have we believe are adequate to support our existing business.

As Steve mentioned, we were working on a couple of growth facilities that we were unable to complete. That said, in terms of the existing business, I think we were in good stead with all of our lenders and that we've got good facilities in place.

The 2006 at one [ph] securitization which has a little over a third of our balance sheet placed and it continues to perform extremely well. That is long-term capital that is match funded to the repayment of the assets.

The Merrill Lynch warehouse, as I mentioned previously, we have now repaid in full and that is completely behind us. The SunTrust warehouse has $190 million drawn as of June 30th, which leaves another $60 million of room in that facility. It's a $250 million facility.

That facility, while it is renewable annually at the discretion of the lender, to the extent that the lender does not renew that facility, it goes into an amortization mode, it's not a bullet maturity so we do view that as long-term capital.

Our one short-term facility is the unsecured revolver. That's led by SunTrust Bank. We had $22 million of outstandings on a $70 million facility as of June 30th. That balance as of today sits at $8 million on $70 million, and in that facility, which is again led by SunTrust, we have Bank of Montreal, Chevy Chase Bank and Sovereign Bank, they are all very good, they understand our business very well. And they are folks that we enjoy working with very much.

The private placements we've got maturities in October of 2010 and 2012, the SBIC is a facility that we do expect to begin originating assets into once we receive exempted relief from the SEC which we hope to complete at some point in the future and we will utilize that facility for growth going forward once that's received.

From an origination and pay down summary, not a whole lot to report there. We had about $41 million of originations and advances and about $40 million of pay downs. Obviously, the pay downs are slow in the current environment and we are just not originating much given our current situation.

Portfolio distribution by asset class, rough numbers about a third between senior, subdebt, and equity. Our equity portfolio is about 34.6% of the total portfolio as of June 30th.

As Steve mentioned, to the extent that we are able to monetize some equity investments and redeploy those into cash yielding debt investments, you would see that equity balance as a percentage of the portfolio begin to decline and likely see a lot of that movement to the subdebt categories.

Portfolio distribution by industry. We currently sit at about 18.7% of the portfolio in telecommunications or other communications. Industries, none of our other industries are more than 10%. (inaudible) is the second largest at 9.2%.

Our portfolio investment ratings, we talk about these each quarter. This is – these are ratings that are determined by our board. We rate our investments on a 1 through 5 scale. There is not a whole lot of migration in terms of the percentage mix from one quarter to the other.

What I do want to point out is that we did have some net drops in these categories which are offset in some cases by the marks that we have taken. This table is presented on a fair value basis. So the net of all that is that there is not a whole lot of migration percentagewise. But I do want to point out that we did have some drops during the quarter.

And from a nonaccrual perspective, while the percentage did go down by about a point, there were five investments that we moved onto nonaccrual status during the quarter and basically the math on that is that the five that we moved in increased the percentage by about 2% and then the marks that we took primarily Cleartel on the debt side, dropped that percentage by about 3% and net to about 1% down on a fair value basis.

From a valuation perspective, we continue to utilize third-party firms to provide additional data points in determining fair value of our investments. And as of June 30, 2008 on a trailing 12 month basis, 85% of the total portfolio and 83% of the total equity portfolio has been valued or reviewed by independent third parties.

In summary, we had DNOI of $0.20 per share, net operating income of $0.18 per share and a loss per share of $0.96 for the second quarter of '08. We paid dividend during the second quarter of $0.27. We had $41 million in originations and advances, $40 million in pay downs.

We did enter into a one year $70 million of in line of credit facility effective May 30th. SunTrust provided the annual renewal of its liquidity facility that supports our commercial loan funding trust which is a $250 million secured warehouse facility and that renewal will run through April 30th of 2009.

We completed rights offering in April of '08 which resulted in net proceeds of approximately $58 million. We increased our commitment to Solutions Capital which is our SBIC subsidiary.

That should increase the maximum borrowing capacity from $100 million to $130 million that can be used upon SBA approval to provide debt and equity capital to qualifying small businesses. We repaid Merrill Lynch in full on August 4. We sold JUPR for $23 million, as I mentioned previously, and then we also had the TNR transaction that closed during July of 2008.

And with that, I think we will open it up for questions.

Question-and-Answer Session

Operator

(Operator instructions) We'll go first to Troy Ward with Stifel Nicolaus.

Troy Ward – Stifel Nicolaus

Good morning, gentlemen.

Mike McDonnell

Good morning, Troy.

Troy Ward – Stifel Nicolaus

On slide #12 on the debt facility summary, could you give a little additional color? I know you talked about the SunTrust warehouse bullet or amortizing unwind and it's amortizing which is good. Can you talk about the revolver that's due in May of '09, how – what that would look like if it's not renewed?

Mike McDonnell

Yes, I mean it's somewhat dependent on where we sit in the spring of '09. And like I said, we've got good relationships with four very good partners, but that facility is one that we do rely heavily on currently. And it is our goal between now and the time that that would come up for renewal to manage our liquidity very carefully and put ourselves in a spot where we are not over-relying on any one facility.

Steve Tunney

To specifically deal with it, at maturity, if it were not renewed, we would just have to pay-off the balance in full at that date.

Mike McDonnell

And we are sitting with about $8 million drawn right now on the 70.

Troy Ward – Stifel Nicolaus

And then the SBIC, obviously, that is a clear positive something that you haven't utilized to its full. It sounds like you are in the process of getting the right approvals. I know there is a lot of steps and a lot of hoops to jump through with the government in this plan. Where are you in that process to getting this additional available capacity in the SBA program?

Steve Tunney

One of the principal – there is two things. Number one, there is an audit that needs to be completed. They do an audit after you establish the SBIC just to make sure all of your control procedures in place. And until you complete that audit, you are limited to a half a turn of leverage against your capital commitment. We would expect that audit to be completed in the near term. It's scheduled and, but it is subject to the government doing their audit. And then the second thing I would tell you is that we will not access this in earnest until we receive exemptive relief. As I've said on prior calls, last August, I believe it was, we filed for what is called exemptive relief where the leverage of the SBIC would not count as a senior security of the BDC for purposes of the asset coverage ratio. The reason why we would wait until we receive that is we want to maintain a lot of cushion in that BDC asset coverage test. Presently, we are at $100 million as we sit today. And if we get that exemptive relief to the extent that we would use borrowings under that facility, it would not create pressure on that cushion after we receive that exemptive relief.

Troy Ward – Stifel Nicolaus

Right. And we are aware of at least one or two others that have received that exemptive relief. Is your estimation that, that is just a timing issue?

Steve Tunney

Yes, it's a timing issue.

Troy Ward – Stifel Nicolaus

Great. And then quickly, I think you said there was five new investments on nonaccrual. What are the total number of investments on nonaccrual? Is that pieces of portfolio companies or when you put it one on nonaccrual, does the whole investment in that portfolio company fall into the nonaccrual bucket?

Mike McDonnell

No. It's instrument by instrument. So we do have instances where you might have a subdebt investment that's on nonaccrual status and you might have a senior debt investment in the same company that is not on nonaccrual status. So it's sort of an instrument by instrument determination.

Troy Ward – Stifel Nicolaus

That's what I assumed. And so the – you said five new investments, is that five new instruments or five new portfolio companies?

Mike McDonnell

Five new instruments would be the way to look at it.

Troy Ward – Stifel Nicolaus

Good. And then, Steve, can you comment quickly and then I will let somebody else hop on. About the apparent disconnect between the credit quality in your portfolio if you look at slide 17, 80% to 85% of the portfolio is rated in number one and/or number two which obviously your board feels very high probability of gains and/or complete repayment. But yet we sit here at, call it 25% of book value in the market valuation. Can you comment on that and where you think the disconnect is happening?

Steve Tunney

I think first and foremost, the announcement with respect to the dividend is probably the primary driver of that. The fact that we decided to – number one reduce our dividend earlier in the year and then the situation we find ourselves in right now where we fully paid out our earnings in the form of the dividends that we've made to date is creating a lot of that disconnect and pressure. And I would think further still people's questions about valuations in the sense of we do have a high level of level three assets and there's a lot of volatility or downward pressure on asset valuations, and so that creates a further disconnect.

Troy Ward – Stifel Nicolaus

And can you comment, just because I know this is a – I'm sure you've gotten and I know we are going to get over the next several days is liquidation of this portfolio. How would that be viewed and what's the possibility of that in this market?

Steve Tunney

We are not putting out the shingle to say we are selling the portfolio. I mean part of the reason for backing away from the dividend is to do the very opposite. I think that putting a shingle out to liquidate everything in this environment is not the way to go about it. What we want to do is go about monetizations in a normal prudent manner without pressure. And so we've eliminated all that pressure to do that. We have adequate coverage from an asset coverage ratio, we have adequate liquidity in the company, we are going to continue to improve those numbers to keep that kind of pressure off having to do something like that. And then the monetizations will happen in their normal course. We will look for opportunities to create exits in both the debt and equity portfolio and we do have some expectations that we will see some monetizations over the next few quarters that will demonstrate that the NAV is good.

Troy Ward – Stifel Nicolaus

Great. Thanks, gentlemen.

Steve Tunney

Thank you.

Operator

And we'll go next to Bob Jordan with SARG Management [ph].

Bob Jordan – SARG Management

Hi, SARG Management. Hi, Steve. I think the last 6.5 years we've gone from a book value per share of about 1246 to approximately 10 – approximately (inaudible) right now. We haven't yet seen the down part of the credit cycle. Let's assume that NAV is good here and I'm not – what would the process be if shareholders wanted to promote an orderly runoff of the portfolio? Not a liquidation, but let's say a runoff, give time to realize value we haven't seen the creation of value that one really might expect over a full cycle here.

Steve Tunney

I think that the creation of NAV in a BDC environment is tied to retention of gains or something of that nature. The model itself is distribute out all the earnings, so the way that you grow NAV in a BDC is either have a capital gain and retain it or accretive share issuances above book value. And to the extent that you have any losses, you obviously go backward. So the models of BDC isn't about turning an NAV from 10 to 40 over a short period of time as you would in a C Corporation which is retaining the gain. So that's the first comment on the performance. But from an orderly liquidation, that's not the plan that we have at this time. We have right sized the operations of our business to operate in this environment and we do think that as this environment plays out, we will get back in the business of making investments and generating returns for our shareholders.

Bob Jordan – SARG Management

But can you tell me what the process would be if one wanted to suggest that taking a slightly different course, bit more conservative course?

Steve Tunney

I perceive your comment but it's not something I intend to pursue on this call.

Bob Jordan – SARG Management

Different – totally different subject, just on commitments at the end of the first quarter I think there was 68.2 million outstanding commitments. Have you been able to reduce those a bit as we move into a tougher credit cycle or do they stand at roughly similar levels?

Mike McDonnell

They haven't moved a whole lot since June 30th. What I would point out to you is that lot of those commitments are in companies that we control and that's something that we can manage pretty closely.

Operator

We'll go next to John Stilmar with FBR Capital Markets.

John Stilmar – FBR Capital Markets

Good morning, guys. How should we be thinking about the balance sheet? Or we – I know Steve you said you are not – we aren't necessarily in runoff mode but at the same point in time, we are talking about increasing the sort of asset coverage in and of itself. Should we be thinking over the next several quarters that asset to values or that you will not be growing the portfolio that we really should be starting to think about a portfolio that comes down and then using free cash to retire debt and free up capacity?

Steve Tunney

Yes. That is the way to think about it.

John Stilmar – FBR Capital Markets

And should – on the loss principal payments this quarter were up $15 million. You are saving about $13-ish, what's called $15 million. So is it really only $30 million a quarter or should that be sort of in the plan? Is that sort of how we should be thinking about it?

Steve Tunney

I mean the $15 million is about a normal quarter run rate. That $15 million for the quarter wasn't just amortization. We did have I believe one loan–?

Mike McDonnell

Our total payoffs were $40 million for the quarter total. Obviously, payoffs are down from where they were several quarters ago. And that is one of the hardest things in the model to predict. I would be hopeful that we would see maybe perhaps a bit of an uptick to what we saw in the second quarter, and then we would run the model exactly as you suggested where you are using the proceeds to repay debt and you are not redeploying all of those dollars.

John Stilmar – FBR Capital Markets

And then to move back into the world of CLECs, obviously, the news PAETEC, the public comp I guess to Broadview and to maybe a lesser extent, Cleartel, announced sort of broad based problems. Some of it were company specific, but I think some of it was more micro concerned. I also noticed that Cleartel, you took an incremental write-down I think on the remaining $32 million that you had in that business. Can you talk to me about macro trends that are happening in the CLEC business, first of which? And then second of which how either those macro trends might be applied to each one of those portfolio investments? And then more specifically with regard to Broadview, how should we be thinking about that in terms of a risk factor to equity on a go-forward basis?

Steve Tunney

Broadview is in registration, so I'm really limited about getting into the specifics of Broadview. But, I would say on a macro basis, not all CLECs are seeing the same downward pressure as PAETEC to the extent that they are seeing it. So different companies are having different experiences with regards to that, and I would think that PAETEC perhaps has gotten impacted a little more than perhaps they historically would have because of the large base of business that they got in the McLeod acquisition. The McLeod's customer base is a much smaller customer base than they have historically been involved with, with their core business in either PAETEC or US LEC. And I would say Broadview's customer base is much more up market versus McLeod's.

John Stilmar – FBR Capital Markets

And then how that extends to Cleartel?

Steve Tunney

Cleartel at zero value, there really will be no further really impact on Cleartel. But Cleartel's business is very much down market, so they've been experiencing a lot of macro pressure. About two-thirds of their business is residentially focused, and so we all know what's going on with the consumer. There is a lot of pressure on the consumer, and a big part of that residential base is actually a Hispanic target market in South Florida. And so the Florida (inaudible) is really hurting, so they are really feeling it in both their residential portion of their portfolio and the business portion of their portfolio.

John Stilmar – FBR Capital Markets

That's very helpful. And then lastly as we start thinking forward about MCG, I know it's a one point in time you guys may have had other kind of – let's call it, taxable losses that may not have been pulled through the tax income line. And I was wondering if there was any call it aside from selling assets that are below current market NAV or taking realized losses. Is there any way that from a tax perspective you might have in 2009 to incrementally lower your taxable income to minimize that payout other than just standard NOI or selling companies below the cost basis?

Mike McDonnell

Yes, you are getting into a very complex area, obviously, from a tax planning and structuring standpoint. But, rest assured the losses that we've taken on Cleartel ultimately is something that we're going to try to use to our advantage from a tax planning perspective, big number.

John Stilmar – FBR Capital Markets

Yes. And so as we start thinking about distributions in 2009, should conditions start to worsen, you have the opportunity then to maybe exercise the ability to retain capital or is that where the BDC distribution requirement relative to NOI comes in? Or NOI relative to realized gains so you would be able then to extend those losses into 2009, am I thinking about that correctly?

Mike McDonnell

It really depends on the nature of the loss, capital losses. There are carry-forward provisions that run typically up to eight years. Ordinary losses are not able to be carried forward so it really gets down to a very fact and circumstances kind of analysis.

John Stilmar – FBR Capital Markets

Alright.

Mike McDonnell

Thanks, John.

Operator

We'll go next to Mark Cooper with Wells Capital.

Mark Cooper – Wells Capital

Thank you. Can you remind us what the carrying value of Broadview is?

Steve Tunney

$193 million as of June 30th.

Mark Cooper – Wells Capital

And that's – does that represent the total investment in the company?

Steve Tunney

No, the actual cash investment in Broadview is on the order of $78 million and the difference between that amount and 193 relates to unrealized gains and dividend accruals that have been recorded over time on that investment.

Mark Cooper – Wells Capital

Thank you.

Steve Tunney

Sure.

Operator

We'll go next to Jim Stone with PSK Advisors.

Jim Stone – PSK Advisors

Good morning, gentlemen. Couple questions. First of all, on the 2% that you – of the assets that you moved to nonaccrual, those five items, could you tell us where those were rated before? Were they rated a 1, 2, 3, 4 or 5?

Steve Tunney

What can I tell you? We don't specifically disclose individual ratings. What I can tell you is that none of them were particularly large positions. In fact, a couple of them were more deals that we just participated in with aggregate dollars in – call it $5 million or less. And I don't know that any of them were rated toward the higher end of the scale previously. But I don't want to make any kind of blanket statement in that regard. Most of them were showing some signs of struggle prior to the quarter in which we placed it on nonaccrual for the most part.

Jim Stone – PSK Advisors

I missed the point when you said how many instruments or companies you now have in the nonaccrual status. What is that number?

Mike McDonnell

I don't have that exact number. I will try to pull it out and we could say it later on the call but it is on the order of 10 to 12 call it dozen companies, a dozen instruments, call it.

Jim Stone – PSK Advisors

Now what I am concerned about is the cash flow in those companies and some of the ones that you may have commitments to. If you don't follow through in the commitments, are those a type of a growth company or another type of company where the lack of cash could put them in serious problems?

Mike McDonnell

It depends on the company. What I would say is that for the most part, we've got good debt investments that are paying their interest on time. We do have instances where just because we are putting something on nonaccrual status does not mean that it is nonpaying. There is a GAAP convention where you have a certain level of mark. You have to account for those interest payments as a return of capital but the company is still paying. And I would say at this point based on what we are seeing, what you are asking about is manageable.

Jim Stone – PSK Advisors

Then also I think you mentioned you're looking at selling

$100 million or $150 million worth of assets this year.

Mike McDonnell

No, it was over the next two years.

Jim Stone – PSK Advisors

Over the two years, I am sorry, I misspoke on that. What types of valuations are you looking for to get on those assets and what the belief that those valuations will hold and that you can get those prices?

Steve Tunney

Because we believe we are fairly valued from a market perspective and as I mentioned, I think that we need to demonstrate that to the market through actual monetizations. We do go through a very rigorous valuation process. We have – what is it 85 – 88% that have been independently reviewed by third parties and so we have a high degree of confidence that if allowed to run its natural course, we will realize on those monetizations at the fair value that we are carrying or even possibly better.

Mike McDonnell

Let me just go back to your previous question. A number of companies where we have nonaccruals is 11.

Jim Stone – PSK Advisors

Are any of those companies looking like they might be in serious jeopardy that you would have to write-off more? Or put – I should say put–

Steve Tunney

There is certainly always the potential with that. I think that in this market climate that we are in and as you look forward, I think that additional marks are always going to be a possibility on these companies or companies that are not on nonaccrual based on how this downturn in the company plays out. I would point out that the portfolio as a whole out even though we've taken some rather large marks is doing pretty well. From a loan to value perspective, our companies have about a 53% advance rate against their value. And on an overall basis, there is very healthy growth in both the revenue and EBITDA of these companies, but there is to be no assurances that, that situation will continue as this economic downturn plays out.

Operator

And we'll move next to Robert Nam [ph] with Ironsides [ph].

Robert Nam – Ironsides

Hi, gentlemen. I just was curious, it sounds to me maybe it's a broad question but do you really think you still need 74 employees for what you are doing now?

Steve Tunney

We took a hard look at the level of the company and we resolved that, that is the number and we feel comfortable with where we are. That being said, especially going through, what we have gone through and where we sit from a dividend perspective, we also had to sort of plan for additional attrition that wasn't initiated by the company through people leaving the company. Notwithstanding the fact that we put in a retention program, people may choose to leave. So we have to sort of account for expectations in that as well.

Robert Nam – Ironsides

You mentioned in the call, in your prepared remarks about moving some of the preferred equity investments as they are–

Steve Tunney

Non-yielding equity investments. The move of non-yielding equity investments into cash paying high-yield debt investments.

Robert Nam – Ironsides

And then when – but then in response to some other question from question from one of the previous callers, you said that cash is going to be used to free up the debt in terms of working the balance sheet.

Steve Tunney

We are going to do both.

Robert Nam – Ironsides

Because I think it is pretty clear when you have a revolver with a maturity in '09, you should run the business assuming that's not going to be there.

Steve Tunney

And that's what we are doing. We're going to do both. I think the first priority is to, to get to the target coverage level of 235% managing liquidity, priority one, keeping the debt levels that are comfortable for us, the redeployment is in large part dependent on exits.

Robert Nam – Ironsides

So where do you think your run rate –

Steve Tunney

From a redeployment perspective, just let me point out, that in the SBIC when we achieve the exemptive relief, we require very little additional capital from us to be able to originate the first $80 million of investments by drawing down on the SBIC. The way the SBIC works is you actually get three turns of leverage on the first third of your capital and two turns of leverage on your next third of capital. So with the assets that we presently already have in the SBIC, I believe it takes about $10 million of additional equity capital to originate about $80 million of investments in the SBIC.

Robert Nam – Ironsides

That sounds reasonable. Now do you have a run rate kind of G&A number that you can identify now that you reduced some of the staff and –?

Mike McDonnell

Just the G&A, not excluding salaries and benefits–

Robert Nam – Ironsides

I meant everything, I mean every non interest expense. What is the number?

Mike McDonnell

I think what we mentioned earlier is we are going to –

Robert Nam – Ironsides

Historically, it has been a lot higher than 3%.

Mike McDonnell

Yes and we are going to target running that at 2.5% to 3% of our average asset base. It's a little bit –

Robert Nam – Ironsides

That's rent, insurance, director's fees, salaries?

Mike McDonnell

That would be salaries and benefits including incentive comp and our G&A.

Robert Nam – Ironsides

Because I think I mean another caller mentioned this and he was maybe being a bit more diplomatic because he is a sell side analyst. But your share price even if it recovers a little bit, call it $3, and let's call your NAV $10. So, if you think – some of your directors think as fiduciaries, what is the right thing to do for your shareholders now? Stop originating, realize the company, put yourself in the run-off, pay back every bit of – pay off the debt and then distribute the cash to shareholders. What is the projected return? What's 10 over 3?

Steve Tunney

It's very –

Robert Nam – Ironsides

It's a 230% return. And I'm not giving us any credit for any of the income that the portfolio might generate and I'm taking a haircut on the NAV. So if you are sitting there as a management team and you have a low risk option to earn your investors a 230% return, call it in a year, call it in two years, what other option should you –?

Steve Tunney

We are doing everything that we can to maximize our returns for our shareholders.

Robert Nam – Ironsides

I think you should give the shareholders a vote and ask them what they want. Your shares are at $3 today. Your NAV is at $10, these are extraordinary times.

Steve Tunney

Yes, they are.

Robert Nam – Ironsides

I just urge you. Thanks for taking my questions (inaudible) but you should put this to a shareholders vote. This is not about management anymore. Thank you.

Steve Tunney

Thank you.

Operator

We'll next to David Rothchild with Raymond James.

David Rothchild – Raymond James

I got to reiterate the guy that just spoke, I agree with him. I'm a stockbroker and I got to tell you, you guys have done a poor job for the investors. In your annual report, you said your dividend was secured $1.76. You do your rights offering and then right after the rights offering, you slash your dividend, and then now you are saying no dividend for the rest of the year. I assume you must be anticipating you are going to have losses for the next two quarters where you are saying no more dividend for the rest of the year.

Steve Tunney

No, what we are saying is we have distributed out all of our statutory required dividends at this – with what we have paid through the first half of the year.

David Rothchild – Raymond James

So you are saying you don't (inaudible) earnings for the rest of the year?

Steve Tunney

I would just point to you that the ground is moving under our feet quite violently and we are responding to the best of our ability to market forces that are quite challenging.

David Rothchild – Raymond James

So you don't anticipate having positive earnings the next two quarters, is what you are saying?

Steve Tunney

We are not providing earnings guidance for the next two quarters. We don't do that.

David Rothchild – Raymond James

As you are getting shares or as you are getting loans paid off, why don't you use that money and buy back shares rather than issue shares at below NAV?

Steve Tunney

In my opening remarks, I pointed out that we first want to hit our liquidity and BDC asset coverage level objectives and then after we achieve those objectives, we perhaps will revisit the idea of doing a stock buyback.

David Rothchild – Raymond James

And I assume you are not going to be issuing any more stock at below book value?

Steve Tunney

That's a pretty good assumption.

David Rothchild – Raymond James

Thank you.

Operator

We'll go next to Troy Ward with Stifel Nicolaus.

Troy Ward – Stifel Nicolaus

Hi, guys, I had a couple of follow-ups. Quickly on slide 4 you talk about July 28 transaction involving TNR and NCR. Can you just walk through where – I looked at the 10-Q and it looks like you have a fair value of about $36 million in TNR at Q1. What – was that all converted into preferred?

Steve Tunney

Yes, there – all that was converted into preferred and then we additionally invested I think additional $2 million in debt in TNR and basically the value that the transaction cleared at validated our value at 630.

Troy Ward – Stifel Nicolaus

That was my next question this is–

Steve Tunney

For the equity value that came in from NCR, validated our carrying value.

Troy Ward – Stifel Nicolaus

And the ongoing capital structure of TNR now, where do you sit in that in relationship to the debt that NCR put in?

Steve Tunney

We are pari passu with them. It's a strip of $6 million of debt I believe and then all of the equity of NCR and MCG is pari passu.

Troy Ward – Stifel Nicolaus

And is that – I mean realize it's only $2 million strip for you but is that cash pay?

Steve Tunney

After one year, it was picked for the first year.

Troy Ward – Stifel Nicolaus

And then one final one, back to the slide on liquidity which is very helpful actually, but can you comment if do you have any covenants related to any of your credit facilities that maybe have a market cap trip up or an asset size? Is there anything like that that you may have in your future that we don't anticipate at this point?

Mike McDonnell

We do have covenants in our private placement and in our unsecured revolver we are in full compliance with those covenants as of June 30. And there is not a lot I can say beyond that. There are asset coverage requirements. There are certain levels of cash earnings and so forth and we are in full compliance as of June 30th and they are filed publicly.

Steve Tunney

You can get that information from the SEC filings.

Troy Ward – Stifel Nicolaus

Great. Thanks, guys.

Mike McDonnell

Thanks, Troy.

Operator

We'll go next to Rick Sherman with Oppenheimer.

Rick Sherman – Oppenheimer

Mine is just a comment. You touched on why you felt the stock was where it was relative to the shock of getting rid of the dividend. But I would comment that since your comments from starting from seven or eight months ago where the dividend would be at least that was your wording and other things that basically have happened over the last seven months, part and parcel of the problem is also a credibility problem on the part of management because–

Steve Tunney

I would agree with that statement. I agree with that.

Rick Sherman – Oppenheimer

I think it's fair. So you are going to need to do something on that front to rebuild that credibility now in a major way.

Steve Tunney

I totally agree. And the only thing that I can think of is shut up and perform and what we need to do is demonstrate realizations that clear out at our NAV and execute on that diligently over the next several reporting periods.

Rick Sherman – Oppenheimer

I agree with that and I also think you should try to be as – based on just the last caller who was worried about some other shoe getting ready to drop that basically any and all even though it might be buried in filings, and all the things that could go –

Steve Tunney

I think that what we need to do, the thing is we can't just respond off the cuff. So what I think we will do is we will come up with a way to dig that out so all shareholders benefit from that. And I have to get together with my CFO and Chief Compliance Officer how we go about doing that so that it's front and center for everyone.

Rick Sherman – Oppenheimer

I think that would alleviate some fear if you would basically just get out in front of that issue and just say that look, these are all the things that if the world goes to hell in a hand basket, these are the things that can trigger and what we would be thinking about doing about it.

Steve Tunney

We will look to do something in that regard with our filing.

Rick Sherman – Oppenheimer

Thank you.

Tod Reichert

Operator, I think we will take one more question.

Operator

And our final question will come from Rick Firon [ph] with Advertise Capital Partners [ph].

Rick Firon – Advertise Capital Partners

Good morning, guys.

Steve Tunney

Good morning.

Rick Firon – Advertise Capital Partners

You all had about $15 million in distributable NOI this quarter. What are you expecting? I know you don't give projections on EPS but what are you expecting in terms of DNOI for the next few quarters? Do you think it will be 15 plus with reduction in SG&A or is that about the number we should be thinking about?

Mike McDonnell

That's not something we provide forward-looking guidance on. What I can say is that the revenue is pretty much a run rate sort of quarter without the benefit of fees from origination. And as we said going forward, we are not going to be really originating in earnest. I think that on the SG&A line, as we mentioned previously, we are expecting to save $12 million to $14 million between now and the end of '09 which pulls about roughly $2 million a quarter out and that's kind of the best sort of roadmap that I can give you.

Rick Firon – Advertise Capital Partners

Can you just actually add a little more color to the revenue? What percentage of that was fee generated from originations?

Mike McDonnell

Yes, we have a slide on that. The answer is very, very little, very little.

Steve Tunney

If you look at page 8 of the slide deck, it breaks that out.

Mike McDonnell

Yes, there is roughly a penny or two per share of fees related to originations and fees and so forth.

Rick Firon – Advertise Capital Partners

So the majority of that revenue generation, the $30 million is being thrown off from your portfolio companies?

Mike McDonnell

Yes.

Rick Firon – Advertise Capital Partners

So with a lower SG&A line, you are looking – I mean I know you don't want to comment on it but if one were to run the numbers, you are going to come up with a bigger number than $15 million of DNOI.

Mike McDonnell

Yes, the only thing that I want to caution you on is that we did – if you look at the slide 7 you can see the salaries and benefit line we did reel back that amount quite a bit in the second quarter of '08. So some of that benefit is already resident in the second quarter of '08. The G&A number of $4.5 million should come down.

Rick Firon – Advertise Capital Partners

So again, $15 million is at the low end?

Mike McDonnell

I've said all I can say.

Rick Firon – Advertise Capital Partners

Can you also comment on some of the metrics used for valuing your portfolio companies?

Mike McDonnell

We use a variety of metrics, we use market multiples, we look at comparable transactions, we look at DPF analysis, we look at a variety of different things and apply them to different company metrics which can be revenue, EBITDA, operating cash flow, et cetera.

Rick Firon – Advertise Capital Partners

And what metric would you use for valuing MCGC right now?

Steve Tunney

Percent NAV.

Rick Firon – Advertise Capital Partners

And are you taking a discount to NAV?

Steve Tunney

Right now the stock is trading at a significant discount –

Rick Firon – Advertise Capital Partners

Understood. What do you value MCGC at?

Steve Tunney

Our NAV (inaudible) $10.31. We are focused on the $10.31.

Rick Firon – Advertise Capital Partners

Have you all considered partnering with any other institutions given where you stand with respect to the market vis-à-vis NAV?

Steve Tunney

I can't really respond to that comment.

Rick Firon – Advertise Capital Partners

I guess I'd just like to reiterate on what the other callers have been saying which is there is a lot of BDCs out there that are also being hit pretty hard by the market so you are not alone. But this kind of discount to NAV is you are alone. It's pretty extraordinary. And it would seem that having a bunch of public companies out there which is, as you all know, is the fixed cost to be running a public company, it may make a decent amount of sense to be talking with some of your peers about consolidating. But, anyhow, I hope you can see your stock price move up where you'd consider some things that are little more shareholder friendly.

Mike McDonnell

Thank you.

Steve Tunney

With that thank you very much for the call. And we will see you next quarter.

Operator

Thank you, ladies and gentlemen that will conclude today's conference. We do thank you for your participation and you may disconnect at this time.

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Source: MCG Capital Corporation Q2 2008 Earnings Call Transcript
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