Gladstone Capital Corp (GLAD) 2005 Q4 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Gladstone Capital fourth-quarter earnings conference call. At this time all participants 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. Thank you, Mr. Gladstone, you may begin.

Thank you for opening today's call and also thanks to all the participants out there for joining us today. This is the end of the fiscal year for Gladstone Capital, our year-end call as well as the fourth quarter. And since this is a call I'll need to read the obligatory warning about forward-looking statements.

This report that I'm about to give may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934 including statements with regard to future performance of the Company. These forward-looking statements inherently involve certain risks and uncertainties even though they are based on the Company's current plans that our believed to be reasonable as of today.

There are many factors that may cause the Company's actual results to materially different from any future results expressed or implied by the forward-looking statements, including those factors listed under the caption "risk factors" of the Company's 10-K as filed with the Securities and Exchange Commission and that filing can also be found on our website at www.GladstoneCapital.com. The Company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise. In addition, today's call is webcast and it will be available for replay on the Internet through the link on our website and you can also go to www.investorcalendar.com if you want to listen to it.

The year ending September 30, '05 was a reasonably good year for our company. We recorded about $144 million in new loans, the dividend increased by about 11% on an annual basis and net investment income was up by 30%. We're proud of the achievements but we need to exceed those in 2006 and do a better job.

At the end of our fiscal year, September 30, our portfolio consisted of 28 companies with an investment cost of about 205 million. Fiscal 2005 new loan production was good at about $144 million of new loans to 23 different companies. During the year we received principal repayments of nearly $88 million; those repayments were our biggest problem during the year.

With so many hedge funds out there driving the second lean marketplace we saw a lot of refinancings by hedge funds that are doing deals that, quite frankly, are just too liberal in terms and conditions for us to contend with so we didn't participate in those. I'm only thankful that the hedge funds don't do smaller loans at $5 or $10 million to small businesses; that marketplace continues to chug along at its normal pace.

Since inception we've invested in 49 companies with 21 of those having paid off. The average return on investment for exits has been about 15%; we think that's very good when you're dealing with senior and second lien loans rather than mezzanine so the risk-adjusted return we think at 15% is a good number.

Weighted average yield on our portfolio at fiscal year-end was about 12.23% before giving effect of PIK interest. If you put the PIK interest in there it's about 12.36%. As of today we have no loans that are behind in their payments; but subsequent to the fiscal year end we have exited from two individual investments that I want to discuss because those numbers are in the September 30 numbers. The depreciation for both of those deals are depreciated down to that amount that we sold them for.

The first loan that we sold was a $16.5 million loan that we sold after quarter end that was to Marcal Paper. That's a successful paper production company up in New York that we sold our position, a small loss of about $127,000. If you deduct that loss from the substantial returns over the period the IRR was approximately 18%, so it was a winner for our portfolio even though we took a small loss at the end of the year. That depreciation on that loan was in the March 30 -- in the September 30 numbers so you'll see that in our analysis.

We got out of that deal mainly because the capacity is so abundant in the paper industry that we felt that the next recession that comes along there might be a substantial problem so we decided to exit from that. The most difficult one for us after quarter end was ARI; that's a company that's a seller of remanufactured auto parts. This company had some recent major setbacks and we sold our loan to a distressed debt buyer. As a result of that sale we had a depreciation on that loan and that also was put into the September 30. We sold it for about $0.72 of face value.

Over the period of time we started out with a fairly large loan there and as that company continued to grow and use more money to refinance its growth we continued to lower the amount that we had until the point in time the last refinancing as they bought a larger company we were down to about $4 million. So we sold it for $0.72 on the dollar. Got out of that one. The IRR on that deal from beginning of our engagement with ARI to present, until the time we sold it, was about 12.4%. So all in, even though we took a loss at the end, was 12.4% IRR. Again, not bad for a company that had some real problems at the end.

Currently that company has gone into chapter and I'm not sure how it's going to come out. So we feel very good that we took the $2.8 million or $2.9 million that we got out of the transaction and put it back to work. That money was not working for us in the last quarter ending September 30th and now is back to work for us. And so, we're happy to be out of that one. With those off our balance sheet we think the balance sheet is relatively strong now. We have about $150 million in equity and about 53 million at September 30th in borrowings. So a very conservative balance sheet as of today.

Today also I'm talking about per share numbers. We're referring in our per-share discussions about weighted average fully diluted common shares numbers for the period ending September 30; we had net investment income which is before appreciation, depreciation gains or losses for the quarter ending September 30 was about 3.8 million versus $2.5 million for the quarter last year. Net investment income was about $0.33 a share for the quarter compared to $0.24 for the fourth quarter one year ago. We continue to grow and are diligently working to put loans on the books and so we'll just have to see how the next year turns out.

For the 12 months ending September 30, our net investment income was about $17 million versus $13 million for the 12 months of the prior year. So for this 12-month period we had about $1.49 per share and net investment income compared with $1.29 last year or an increase of about 15%. So it's been double-digit growth for this year and we certainly hope that we can do that again in 2006.

Net investment income is the number that's closest to our taxable earnings and that tax number is the number that we use to pay our distributions to shareholders. So we view that as the most important number and think that's one that shareholders should look at quite closely.

Now switching over to unrealized and realized gains. We had a mixture -- this is a mixture of appreciation, depreciation, gains and losses. The total was down by 184,000 for the three months and for the 12 months it was $735,000. ARI and Marcal, the depreciation for those as they were depreciated during the year are in that number. However, it should be noted that today all of our companies are paying as agreed and we feel relatively comfortable with our portfolio now that we've exited from that one bad deal.

Bottom-line, now we turn to net increase and net assets from operation, this is a term that combines net investment income, appreciation, depreciation, gains and losses. For the quarter the net increase in assets resulting from operations was about $0.20 compared with $0.07 for the fourth quarter a year ago. For the 12 months it was 15 million versus 10 million for last year. This is $1.33 versus $1.02 12 months ago. So again, showing positive increases; however, the fourth quarter is the one that hasn't gone up as much as we expected.

I'll mention it again; as of today all of our companies are paying on time as agreed. The portfolio is stronger now that we've gotten rid of the one loan that we felt was really in trouble. I always stop at this point in time and talk about the marketplace. Since last we talked to you the senior and sub debt marketplace, or second lien marketplace, which for these large middle market companies that we invest in from time to time, that marketplace is driven by the capital markets run by Wall Street and the money continues to flow into that. It's about 70% hedge funds these days.

Companies that are receiving ratings from the rating agencies have continued to get relatively low financing. If you look at it from a perspective of LIBOR, which is the London Interbank rate which most people say is the leading indicator of short-term rates, any senior syndicated loan of $150 million or more can get a rating today -- can borrow money at about 2.5% over LIBOR. Right now the three-month LIBOR rate is about 4.5% and if you add that to the 2.5 they're borrowing at about 7% these days. That tends to be a historically lower-level than in the past and so that marketplace continues to have strength.

We believe that low rates will continue to move up a little bit. LIBOR traditionally has been 5 or 6%. We expect it to continue up and get to that point so that companies are paying at about 7.5 or 8%. If you look at the marketplace today, we think that you're pretty much at the average for the last ten years and so businesses are paying nearly -- a little bit lower, but nearly what they've been paying and this means that the marketplace is relatively normal today.

For our smaller companies where we are lending $5 or $10 or $15 million the world is certainly different there. There's no pressure from the syndicated loan marketplace. Syndicated loans rarely dip below $100 million and certainly we've never seen one doing $5 or $15 million. So the small marketplace that we invest in is not seeing much competition; there are a few banks there, but small loans have more risk and so the bank lenders aren't there. We compete mostly for these loans with small private lenders like mezzanine loan funds in the smaller business development company.

Pipeline of loans for the smaller loan is pretty good today; our criteria remains fixed. And just to reiterate something that I've said many times before, we will not change our lending standards to make our loan production increase. Investing in a lot of poor credit is something that's not on our agenda and our goal is to keep our portfolio strong, investing in profitable portfolio companies at good returns. Rather than trying to grow the asset base I'd rather grow it slowly and have a solid base than grow at a fast rate.

On the front of fixed versus variable we are currently doing only variable-rate loans, every now and then we do a smaller fixed-rate loan. But as we look at the Federal Reserve that's increasing interest rates we worry about that and so we're emphasizing variable-rate loans now. For our fixed-rate loans we do have a rate cap in place to cover our fixed-rate loans. So some people refer to that as a derivative and you'll see that appear in our line item as it appreciates or depreciates it's right there on the income statement.

So as of today with our rate cap in place and doing mostly variable-rate loans we're not too worried about rising interest rates as they continue to go up. We're also -- as you know, we're concentrating more on senior debt and second liens as opposed to junior subordinated debt. Currently the portfolio is about 45% in senior debt and approximately 50% in senior subordinated or second lien and approximately 5% in junior debt. So we have a very high-class portfolio compared to some of the other portfolios you may look at at other business development companies.

Our outlook today, we're still worried about the cost of oil. It's rippling through our economy. We see our small businesses having to increase their cost based on that and have to pass it on to their customer. We see other commodities are creeping up as well and those continue to worry us as they run through the economy. We're hoping that it won't cause too much inflation. The amount of money being spent by America on the war in Iraq is certainly hurting us as a country and adding to the fueling interest rates that have moved up. So we worry about that money going out, hopefully that will be curtailed some in the coming year.

We do see pork barrel spending by federal and state governments is just way off the charts and we wish there was something going on there that we could do something about it but we can't. We've never seen Republicans and Democrats agree on something so readily as they do today, but when they come together to start spending the parties are in high agreement. And of course that money comes out of the paychecks of the middle-class hard working Americans who can ill afford it at this time.

Trade deficit with China still a very big item on our list as we watch what's going on there. China continues to subsidize their industries and I don't mean to single out China -- most of Asia and India have the same approach. And I'm sure the large retail giants in the United States are lobbying Congress not to act against this, those who are subsidizing their industries, but it's pretty hard to sit back and watch these large retail companies who are buying in foreign countries from subsidized producers, it's not good for our economy and we wish Congress would wake up and do something about that.

Nonetheless, for those in the industrial base in the United States that are small businesses or medium-size businesses that don't have to compete directly with the subsidized products, they have kept their costs low and their profits are getting stronger and they just continue to get better every year. So those that are not in competition with the manufacturing facilities that are being subsidized in Asia are continuing to build backlog in hiring people. They've gotten very strong; 2005 was a very good year for them and 2006 looks like it's going to be an even stronger year. And I think that should continue to translate into stronger growth for our portfolio companies as well as new companies that we look at.

One little interesting twist that we're looking into now, we've been reviewing our taxes -- we see that some of our taxes -- some of our tax returns, we have to look at them again and we'll look at the 1099 this year. Some of our fees may have been capital gains and so we're going to look at that and try to come back to you with some kind of announcement once we've sorted it all out.

But it may be that for our dividends that when we do our 1099 this year in January and send it out to you, rather than ordinary income -- and I know we've been cuing you up for everything that we've been sending you in our dividends to be ordinary income -- I think some of it now because, as we look at it, prepayment penalties may be counted as capital gains for tax purposes. Not for GAAP and not for reporting, it will continue to be the same but there may be adjustment and we'll have to start tracking that a lot better and making sure that it gets reported correctly. So we'll be back to you once we've straightened that out with the tax folks that we deal with.

Shelf registration is still out there, we'll update it. We don't need the money today but we may in the future. So as a result don't be surprised if you see us updating the shelf registration. We don't have any plans to come to the marketplace in the near term. And special stockholders meeting -- as you know, on December 2nd our stockholders approved an amended and restated investment advisory and management agreement with our advisor. The new contract will be implemented probably around the first of the year, October 1, 2006. There's really no change in the team that's working on investments out there for you today so don't look for any change there. It's just that we're going to remove all of our stock options and go to an incentive fee payment rather than relying on stock options.

Please do take a moment and go to our website, it's changed a great deal. Kelly Sargent who worked on that has done a really great job in updating that. There's a lot of good information there. Please also sign up for our e-mail service so that you get e-mails on all the information that we produce and send out.

In summary, 2005 was a good year. We don't like the fourth quarter and we think 2006 will be a good one too. All of these quarters are always lumpy. We have good quarters and we have slow quarters. Fourth quarter and maybe even the first quarter of this year may be as lumpy as any we've seen. So we just have to continue to stick to our knitting and do what we think is best for the Company.

We did increase the dividend this year; the monthly dividend at the beginning of the year was $0.12 per share per month. We increased that; now we're up to 13.5 so that was a 12% increase. I think we can increase the dividend again in this year, just have to wait and see how things play out. Now the run rate is at about $1.62 and so we're trading at about 23 today and that gives you a 7% yield. If you had been in the deal for -- since the days of -- the original day it would have been a wonderful 10.8% return, so it's been good.

We feel pretty good about what's going on in the marketplace today and look forward to the future being very strong. I understand some people are unhappy with the fourth quarter and we'll just have to see how it sorts out, but we're feeling very bullish about '06. Now comes the part where the listeners get to ask questions. Operator, would you please let the callers know how they can ask questions?

(OPERATOR INSTRUCTIONS). John Maier, UBS.

Do you think you can talk a little bit about the dividend and how you determine the dividend? Because currently you're under earning it based off net investment income. So you talked about increasing it in 2006 possibly, so I just kind of want to understand the methodology there?

The increases will come from adding new loans to the portfolio, obviously that's the way you grow the dividend. But the composition of the dividend is the thing that I was trying to mention on the tax side. That really doesn't determine whether you increase it or decrease it, it's just how you explain it to your shareholders. And we're believing now that prepayment penalties and prepayment fees are probably going to be counted as capital gains for tax purposes, so it'll change the composition of the tax.

And as we grow the dividend, each year we have people who don't believe in us and don't believe we're going to grow it and they sell the stock and it goes down and then we deliver and I think we will deliver again this year. But it's all about production and putting loans on the books that will deliver that extra dividend for this year.

Just a follow-up question. In terms of net new investments for the quarter, I counted $8 million, does that sound about right?

I think it's a little higher than that. They want to know what the net new investments were for the quarter, was it about 17 or --?

(indiscernible) gross was about 17.

Gross was about 17 and -- for the quarter what was the net?

For the quarter ending --.

We're adding it up. Do you have another question while we wait?

No, that's about it.

Why don't we take the next question and we'll come back to you on that during the call.

Thanks, David.

Scott Valentin, Friedman Billings Ramsey.

Thanks for taking my question, David. You gave some good color on origination volume. I guess I was hoping to get a little bit more given you gave some first-quarter insight and it looks like the first quarter, as you mentioned, (indiscernible) relatively low in terms of origination volume. Is it purposeful on your part? Are you just pulling back a little bit? You mentioned some aggressiveness in terms of pricing out there from the competition? Is that a reason why you're not seeing the volume because you're being more disciplined or is it just the volume of flow you're seeing, the number of deals you're seeing is lower?

And secondly, $10 million in loan participations this quarter, is that going to be used as kind of a plug to help the portfolio grow instead of the direct investments?

Hard to answer a question like that, but let me start back. The pipeline today is still very strong; we're seeing an enormous number of opportunities. There are two things that go on during this period of time, first of all we see deals that are priced in the way that people who are looking for the money don't want to pay what we think is a fair price and they find money other places and in the second lien marketplace we see deals being done by folks that are off the charts and in some of the smaller deals we see the same thing of people pricing deals at rates that don't make any sense.

And so from that standpoint the discipline is there. We're not going to do that. Every time I've done that in the past and I've done it and so has everybody else in this business, it just comes back to bite you within six months or a year. If we think that at this point in time the economy is at a normal level and can either go better or worse it's really not the time to start exploring deals with strange terms and conditions. So I'd say from an origination standpoint we are seeing everything in the marketplace. It's not a situation where we are being excluded. We see them all and we do the deals that we think are best.

The pipeline right now of things that have not closed is very strong and we expect to have good announcements during the next 60 to 90 days. But we can't count on that and we can't give you any color on it because, quite frankly, those deals can fall apart and sometimes do. We have a large number of letters out and so we just have to wait and see how those come together.

This business for the last 25 years has been the same way. We get sporadic movements up and down in terms of our loan volume and those who have stuck with us have made money and those who have believed that we are lagging behind have sold their stock and gone on to better things. So that's about all I can say about it, Scott. There really isn't a good answer for it.

Okay. And maybe if you could address the syndication part. Is that a new area for you guys or are you just using it kind of as short-term --?

No, we've always liked the second lien. There are a number of transactions that will come to marketplace from LBO funds that we know and they're doing the larger transactions that we will take a $5 or $10 million participation in. And we like that second lien marketplace and have played in it from time to time and today there are still some good deals there. But given the fact that the amount of money that is in hedge funds today and what they're doing in that marketplace it's rather frothy and so we're being exceedingly careful to make sure that we don't bite off something that's going to come back to hurt us a little later on.

Okay. And if you could maybe address the credit side. You mentioned I think all your loans or all your investments are performing, but the loan rating seemed to have dropped. I was curious maybe if you could talk about that?

Yes, the loan ratings dropped primarily because the second lien loans that we do are larger loans and we are willing to go down the rating system a small amount there. So they've dropped maybe I want to say 4/10 of 1% -- I'm trying to remember the number. They've dropped from about 7.1 down to 6.7 on our rating system. And so I wouldn't take that as a deterioration of the portfolio as much as I would we're switching some of our portfolio over to second loans that are of larger companies which risk rating wise, we don't have a section in our risk rating model that looks at large versus small.

We should, but we've never seen anybody do that. And so as a result we just -- a small company borrowing $5 million is risk rated the same way you'd risk rate a company that's borrowing $100 million in which we're participating in that. And we're willing to take a little higher risk on those deals because the larger companies tend not to get into as much trouble as the smaller companies over time.

Okay, thanks very much.

Vernon Plack, BB&T Capital Markets.

My question really is very related to the other questions. And not to be redundant, but just looking at new investments over the last several quarters, in the first quarter of '04 new investments were 47 million; the next quarter it was 45 million, then you went to 35 million. The fourth quarter this year was almost 18 million and it looks like so far what you've announced for the first quarter of '06 is I think around 13 million. And it just makes me wonder, is there any thought -- you say the pipeline is full, but it kind of makes me think is the Company set up and are you really seeing enough qualified deal flow?

Well, we see it, Vernon, but the problem has been pricing. And just like everybody else is looking for things out there, your worst nightmare in life is when you overpay for things and have to hope that during the next year or two that they can pay down the debt and come back into compliance with our underwriting standards.

We know folks and we see it going on every day in which people are doing just that, they're hoping that within an 18-month or two-year period they will be able to look at the loan and say it's well within the guidelines of good credit, but they certainly aren't on day one. We see people doing deals today in which they start out in the subordinated debt, that is the deepest piece is on PIK meaning they're not paying anything. And then the coverage ratio on the second lien and the first lien is 1 to 1.

I can't imagine anybody doing a deal like that and holding their breath for 18 months or 24 months and saying to themselves, gee, I feel that this is a good deal to do. At some point in time a couple of those are going to hit the wall and then the marketplace will turn around and begin to look at things on a normal basis. I'm just not willing to take those kinds of risks with my shareholders' money and we're going to hold the line.

Now, is 18 million a number that we think is a reasonable number to have in a quarter? Of course not. We build our projections on $30, $40 million a quarter and I think before the end of '06 we will crank out a good amount of loans and we cranked out about $144 million next year. I'm hopeful that we can exceed that this year and you'll have to wait and see.

This is a very lumpy business. Quarters tend to go up and down and I've been on the call when I was running American Capital explaining that we didn't do anything this quarter worth while and the same thing for when I was running Allied, we have lumpy quarters. So you're just going to have to put up with a fella who holds to his credit standards and will only do those deals that we think are best for the Company.

Could you help me reconcile -- I see new investments going down and your comments regarding pricing, but you also (technical difficulty) small loans, the $5 to $10 million loans which is where you do a lot of your business, that there's been no real change in that marketplace -- or at least I thought you said that earlier in the call. Just trying to -- having trouble reconciling that with (technical difficulty) results are actually coming in.

We've got a good pipeline of small-business loans but they are backed up and trying to get closed. So we'll have to see whether they get through the hoop or not. And in the small business world there is an abundance of opportunities, but you'll have people -- for example, we had a commitment to a small business that was being brought and the owner just decided he didn't like the price he was getting for the buyer of the business and decided to pull it off the marketplace.

So things happen and we just have to live with it. And Vernon, I can't give you much more flavor than that. The marketplace is very fluid. It changes within days and you just have to ride with the marketplace and play it the way you see it.

Sure. Last question, David, refers to the dividend and -- this is over simplistic, but the gap between the dividend and net investment income, the $0.33, roughly $0.33 in the quarter, the dividend is 40.5 cents in the quarter. It looks like the first quarter, at least from what I can see, is probably going to be a challenging quarter as well. And I wonder about you being able to close the gap there. And it also makes me wonder if in fact we may be faced with a situation where the dividend could perhaps because cut for '06? Any thoughts there? Am I being too conservative in my thought process?

I think you're being overly conservative. We have not cut a dividend in the past, so do not believe we are going to do it this year either. I don't think it is much of a challenge. I think you will see it rally and come back in terms of things. Unfortunately, we have a number of businesses in which we have success fees that are probably going to get sold in '06, and the success fees will come in and pay for a lot of the dividends as well. As you know, we had about -- I think it was 1.1 million in success fees and 1.2 million in success fees for '05. And so as the portfolio matures and these smaller loans where we do have success fees, hopefully those will roll through and take up some of the slack that you're worried about.

Thank you, David.

Rich Shane, Jefferies & Co.

This is actually Rohit (ph) for Rick (indiscernible). I've actually got two questions, one related to credit quality. At the end of the third quarter you reported 189,000 (inaudible), and then on the call you had indicated that you were going to write that back up in the fourth quarter. Did that happen?

It did not. That was the one that we thought was -- and ARI was a very volatile situation. We had new money standing by ready to go in. At the time we thought the company that owned -- the fund that owned it was going to put up additional money. And in addition to that we had senior debt that was going to come in and we thought it was all going to be recapitalized. After the end of the quarter, this fourth quarter, what happened is a distressed debt hedge fund bought the senior debt, began to foreclose on the company and tried to push out all of the guys that were in the lower credit lines and, as a result, ended up pushing the company into bankruptcy.

So that was the company that we thought was going to be cured by the new money that had teed up to come into it. And as a result of the fairly aggressive action taken by the distressed debt fund, that company ended up going into Chapter 11. It was a very sad event before the equity sponsor as well as all of the subordinated debt people. We were lucky enough to get out at $0.72 on the dollar.

And the loss on both the sale of the loan and on ARI, did that make up the entire balance of the depreciation for this quarter?

No, I think there are some pluses and some minuses. There was some appreciation and depreciation in there that ran through the portfolio. For example, we had one of our companies that was affected by Katrina and Standard & Poor's depreciated that pretty substantially and that went through there and there were some appreciations. But now that company, which is a wireless company, has gotten back up and is broadcasting and their revenues are coming back up. So we're hopeful when S&P looks at that at December 31st that they will appreciate it back up again. So there were lots of pluses and minuses in there.

And I guess there is no delinquency in the portfolio right now.

No, everybody is paying as agreed, so we're happy today.

Okay, great. Thank you.

Joel Houck, Wachovia.

David, the last two fiscal years it looks like the net loss investments have been about 4.5 million and that obviously makes it very difficult to grow book value. Have you given any thought to perhaps moving -- taking on perhaps more warrant equity positions so that in the event you have winners there's a better balance over time that could maybe accrete book value? Because the way it looks now is that the investment process is kind of slightly dilutive to the NOI or the net investment income at least over the last two years in what's been a pretty good M&A and healthy M&A environment?

I understand, you're saying losses. I think you mean depreciation. We've had about 4.5 million on the 200 million depreciate.

Right, right.

And so we haven't lost it. I would remind you that while S&P -- we love them, they do a great job on valuations and they depreciate these loans -- many times we've disproved them by getting 100 cents on the dollar. In fact, we have one that is currently being refinanced and will be paid off on that loan and they've got it at a substantial depreciation which, again, if I was doing the valuation I'd do it differently, but since S&P is doing it.

So I'm not sure you can look at a portfolio and say it's depreciated by $4.5 million on a $200 million portfolio, that that's a big indicator of trouble in the portfolio. From my perspective I think the portfolio is as strong as it's ever been today and we have very little problems in the portfolio since we've gotten rid of the one difficult loan which was we took the hit on that one. And then the second one, the Marcal, which we worried a lot about, that's now gone. So both of those loans are off our books and we feel like the portfolio is pretty strong today.

So I'm really not worried about net asset value. I think the people who look at net asset value either at our Company or any of the other BDCs, it's really hard to figure it out because we don't have an independent third party at most of those companies. Now S&P is wonderful, but -- and probably as good as any in valuing it, but who knows what the value of these portfolio of companies really is. And we had the scare of a lifetime with ARI moving from what we thought was going to be a repair position into a very negative situation. And life can change in these businesses and we were trying to avoid those kinds of situations by bulking up on low return, higher risk deals.

Most of the other BDCs I think use independent valuation firms, but the Board of Directors ultimately have the final say on valuation. Is it different here at Glad? Can't you override S&P? It's just an opinion ultimately, but isn't your Board the one that is responsible if they feel like S&P is too aggressive they can override it or is that not the case?

I would take exception, I think we are the only group that uses someone that gives us a number. I have looked at the other folks that help others out and what they give them is some kind of range. They say you're within a range rather than a fixed number. S&P actually gives us a number. They'll give you a number of 99 or 98 or 80% of par or 101; they actually give a physical number. A number then is reported to the Board of Directors and the Board can either accept it or reject it. They rarely accept it just at face value.

They go through it and they get us, we do our own review of the loan for them so that they can see how management looks at it. And from time to time they will accept a different number. Now in the past they've accepted only numbers that were less than S&P and in the case of ARI that was originally thought by the folks at S&P to be at one number and we took a lower number. We took the number that we physically sold it for so that $0.72 on the dollar was the number that we used in the September 30 valuation rather than the number that S&P had at September 30.

So we had -- and that loan wasn't sold until about a month afterwards. So there were some significant changes between then so we used that lower number to make the balance sheet more conservative. And I just think we're the only one out there, and I may be wrong, that has anybody to give them an exact number the way that S&P does for us in the BDC world. I'd also make a point that it may be easier for S&P to do that because most of our loans are either senior or second lien pieces which are easier to value than is a mezzanine or a junior subordinated debt piece that most of the other BDCs are investing in.

So I think we're higher in the balance sheet with our loans and investments and, second of all, I think we have a more accurate independent party than do all of the others. And yes, ultimately the Board of Directors is responsible for setting fair value and they do -- I'd say most of the time they accept the value that's given by S&P unless additional negative information comes up and then we use that additional negative information to take it down even further.

I think that's a good explanation. The quarterly results, it looks like the portfolio showed some growth but the decline in net investment income looks like there just wasn't any fee income. So if what you're saying -- I just want a make sure we understand the dynamics going forward, that with a pickup in business and perhaps excess fees that next year as far as you can look for a whole year understanding that business is lumpy -- the year looks in good shape with respect to covering the dividend and that this quarter, in terms of NOI, is more of an anomaly. Is that kind of how you're representing the situation here?

I'm not sure anomaly is the right word. Certainly it's not a strong quarter and I think the next quarter, as we go forward and put more loans on the books, the quarters will be stronger. It's the only way you can look at the world, if you put more loans on you get more income. And so it's highly dependent -- as some of the other questioners have indicated -- it's highly dependent on loan production and that's the one thing that everybody focuses on. We get questions about how's your pipeline. What do think you're going to put on for the quarter?

And it's not easy to project because every deal has 100 items that you're looking at and if you don't get comfortable with the 100 items that are on the list of things for due diligence you end up not doing the deal. And even when you do get comfortable with them there's then the pricing question. There are many good stocks, as you know, Joel, out there today -- good companies, but their stock price is so high that you just don't want to buy into them.

So from our standpoint it's the same thing. We see good companies, good potential borrowers, but the deal that's offered or tried to negotiate is not comfortable to us in terms of risk and reward. And I just think if you look at our portfolio today, the risk/reward on it is so much stronger than some of the others that we compare ourselves to that it's really a difference between night and day. And the proof is in the pudding, we don't have any deals that are today not paying and we've had one since our inception over four years. I think that's a pretty tremendous record looking at what we're doing.

I think the credit record is good. I think people are just trying to get a sense for the potential in terms of this NOI to kind of snap back next year. But I guess the most important thing is you still are targeting on a full-year basis higher originations next year versus what you just did. I think I heard you say that earlier?

Well, that's always the goal than to have higher originations. We want to continue to grow the Company. We've brought on three more managing directors to help us and we should see more transactions. We've got more people now than we've had ever before. So as we grow the number of folks and we see more deals it's logical to assume that we're going to do more deals. Whether that actually occurs or not is always the question. Now, we haven't had a situation in which we've ever cut a dividend, so the question about cutting your dividend and reducing your payout is just not on the agenda at this point in time.

What was the income tax expense this quarter? I don't know if you mentioned it earlier or not, it was 70.6 --.

We had -- we had an issue in our subsidiary. We have a subsidiary called Gladstone Capital Advisors where we all used to work and we didn't do the tax return right there and had to redo it. And so that's the additional tax that you're seeing running through there.

So that's just a onetime thing?

Yes, a onetime event and it should be over with. I'm telling you, this tax world is very confusing.

I hear you there. Thanks, David.

(OPERATOR INSTRUCTIONS). Brad Golding, CRC.

Just two quick questions. One is in the case of ARI, and I haven't had a chance to go through your filing too closely, but it appears that in terms of internal grading systems every bond you consider to be between 10 which is a BBB or better and a 5 which is a single B, yet we know that ARI fell apart and you took a loss on the sale and you would have taken a loss had you held the bond.

I'm just curious how that qualifies for a 5. And certainly with the benefit of hindsight maybe it would have been lower and maybe it should have been a 5 on September 30th. But in looking at the grading system, I'd appreciate a little insight in how to look at the lowest bond being a 5 but it did suffer a catastrophic event very shortly thereafter.

Right. June 30, that company was paying as agreed. So it looked fine and things were going along. By September 30, which is -- sometimes happens, I don't remember what the grade was on that but I'm guessing that it was lower than a 5.

It was a 5. According -- if I read this right and if anyone can hop in afterwards, yet, on September 30th the lowest grade was a 5, the highest grade was a 9, the average was 6.7. So I'm looking at some of those 5's and 6's and saying if your average grade is a 6.7 and you're looking at a 5 that had a problem should I be worried here? And I know you haven't had losses but you have sold bonds. Before they turned into losses and I'm starting to get a little nervous.

I understand where you're coming from. At September 30 it's a 5 and the question is why is it a 5 if it's going to the dogs. And I can't answer that. I'll have to go back and look at that exact one, but you're pointing to something I haven't looked at in a while and I'll go back and research it. But the point being is that company moved so quickly from about August 1st to the time it was -- we sold our loan which was at the end of October that it would make your head swim is how fast it moved. It got refinanced and new money came in and then the senior lender sold their loan to this distressed debt group.

Right, and everyone else got squeezed out.

And it went down so quick that it just made our head swim in terms of the way this thing moved.

Understood and I appreciate the fact very much that in terms of pricing you go to S&P and get a point, they come back with a number as opposed to a range -- the other -- because I've got to be honest with you, I don't understand because they give to their valuation firms their valuation and then their valuation firms build off that knowing what their valuation is already. And I think you're running one of the few trustworthy pricing -- you're running one of the few shops that I can fully trust in terms of what's coming back and I greatly appreciate that. My question is really on your internal -- the internal grading system and how to view that?

The real question that you're asking is why was ARI graded a 5, which is probably what it was on September 30. And that valuation, just so you know, the S&P valuation and our valuation that we put together is done on September 5th, so it doesn't done a month later with hindsight.

Understood, and I understand that you mark down S&P's valuation.

No, let me explain that. Whenever S&P did their valuation on September 30, we didn't mark it down on September 30 when the Board met. What happened is the Board met, accepted S&P's valuation on September 30, and then 30 days later or five weeks later we sell our loan at a lower amount than it was done on September 30. So we go back and we say it wouldn't be fair now that we have all this good, strong knowledge we've actually sold it, we can't go to our shareholders and say it was worth ex on September 30. We really need to use the 72% of par that we had at a later date.

So we actually -- the audit committee that meets with PWC, actually revalues that down to the actual sale price so that that devaluation goes through at that point in time. So there's a second guessing, if you will, with later information about what was done by S&P and the Board on September 30. So at September 30, I'd have to go back and look at it, it probably was rated as a 5 -- I would guess that's the number -- for many reasons. That is new money coming in, outlook bright, things looking up, and then all of a sudden, boom, you're in the hopper pretty quick with the hedge fund buying the loan. I think it was at the end of September or maybe at the beginning of October. At any rate it was information not available at the time when we were doing that valuation.

If we had been doing the valuation on whatever day we sold it, sometime late October/early November, obviously it wouldn't have been a 5. Events occurred so quickly that it was very difficult for us to get a good fix on that thing anyway, but we followed the appraisal by S&P and felt comfortable with it until all of the events continued to occur. I mean it was like day and night kind of a transition.

Those events are going to happen. We refer to those as really unlikely events to happen that quickly, but when they do we feel like we have to go back and make that adjustment. For example, the same thing with Marcal. Marcal is marked down to the amount at September 30 that we actually sold the loan for. Hindsight is 20-20 in these things, if you've sold it you really need to go back and adjust the depreciation down by that amount that you lost on the loan.

My next question is about the -- and this may be out there and this may not be the correct forum -- but the impact of the change in the management contract on earnings. There's going to be an offsetting amount I understand in equity option grants, but what is the -- do you have any expectations of what that will be in cents a share?

We don't and obviously it's not going to impact '06 because we're not implementing it until October 1, '06. So for this fiscal year there's no impact in terms of a change from that perspective. So it would be in the '07 year. We have not put together something that we can share with the outside. My guess is that it's not going to hurt the dividend. I've stood by that all along in discussions with people. And so from my perspective our goal is to increase the dividend every year.

But earnings and dividend are different.

They're very close. Net investment income, sorry. What are you talking about?

I'm talking about earnings.

Yes, net investment income.

Right, that's fine.

We're both on the same wavelength. I don't think that we're going to lower net investment income by changing to this contract for '07 and in a way that's going to impact the dividend. Now would it have gone up faster? Obviously so if you're paying out more money to the investment advisor. But on a fully diluted basis, that is taking into account all the shares that were out that are going to be removed -- all the options out that are going to be removed, I think the income flow will be stronger after the contract goes into play.

Okay, thank you very much.

Scott Valentin, Friedman Billings Ramsey.

Thanks for taking my follow-up questions. David, you had mentioned before you felt pretty comfortable with the (indiscernible) risk profile of the Company. I think we talked about roughly a 50 basis point contraction in margin this quarter. I was curious if there was any seasonality to that or any one time event that led to that?

I think the thing that causes that for us as we get some of these older loans that pay off that are at higher rates and I think that's where the compression is coming in. We're obviously not putting loans on -- I remember Kozy Shack, for example, a rice (ph) manufacturer, we charged them a fairly hefty rate. We can't get that in today's marketplace without doing highly risky deals which we aren't planning to do. I think that compression that you're talking about is a run-off of older loans at higher rates to newer loans that are replacing them.

That should continue then probably for at least some time --?

Yes, I think that's true, although there aren't that many old loans. We've had so many prepayments over the last year or so that as a result I'm not sure there are that many big loans out there. Marcal was one and that one's gone now. So at the end of the day I think that's what's been driving this. We just need to get the volume up and that's the hardest thing to do. I think all of you have hit on the one issue that we have for this year and that is loan volume.

Okay, thank you.

Vernon Plack, BB&T Capital Markets.

David, how many people do you have at Gladstone management right now?

About 32 people, ten MDs and a lot of associates and a lot of staff.

And how am I to think about that in terms of being -- I know this is a tough question to answer, but being divided up among the different companies that Gladstone management serves?

The only three MDs that really don't produce for either Gladstone Capital or Gladstone Investment are the real estate people. Although they have found deals, we have three MDs that are on the REIT side, they have found deals that we've actually done in Gladstone Capital and so they have been good at presenting and finding deals but they are not closers obviously. So we've gone from three real estate people -- I'm sorry, that's remained the same. We've gone from four MDs to seven MDs on the production side.

And just trying to get a sense for -- the effort involved on the Gladstone Capital side and how that's changed over the past 12 months?

Again, it's just the number of people that are going from the four or five people in MDs to seven or from four to seven, yes.

Thank you.

Anybody else, last questions?

No, sir, I'm showing no further questions in queue at this time.

All right. Did we answer all the questions? Was there anything left out? Everybody get all of their answers because I know we were looking for a couple things. I think we finally got all those answers out.

There is another question queued up from John Maier, UBS.

David, you were going to give that net number, maybe I missed it, for the quarter?

That's what he said, 17 million in new deals but how many paid off. He's looking for the net number in the fourth quarter. I think we didn't understand your question. The gross was right and you were right, John; we were all talking about gross but we were looking for the net new numbers. What did you have in pay-off? Why don't we do this? We'll post it on our website under the Q&A rather than hold everybody up unless you just want to wait, John?

Whatever you want.

For those who want to drop-off they can drop-off and we'll post it on the Q&A. Danya (ph) is looking at the number of quick calculations about $10 million net.

Okay, thank you.

But we'll post it anyway accurately so that you know it on the Q&A. Any other questions? All right, the meeting is adjourned.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.