MidCap Financial Investment Corp (MFIC) 2008 Q2 法說會逐字稿

Good morning and welcome to Apollo Investment Corporation Second Fiscal Quarter 2008 Earnings Conference Call. At this time, all participants have been placed on a listen-only mode. The call will be open for question-and-answer session following the speakers' remarks. (OPERATOR INSTRUCTIONS).

It is now my pleasure to turn the call over to Mr. John Hannan, Chairman and Chief Executive Officer of Apollo Investment Corporation. Mr. Hannan, you may begin your conference.

Thank you and good morning everyone. I would like to welcome you to our September 2008 quarterly earning's conference call. I'm joined today by Jim Zelter, Apollo Investment Corp's President and COO, Patrick Dalton, the Executive Vice President and Chief Investment Officer of Apollo Investment Management, and Richard Peteka, our CFO. Rich, before we begin, would you start off by disclosing some general conference call information including comments about forward-looking statements.

Sure. Thanks, John. I would like to remind everyone that today's call is being recorded.

Please note that the call is a property of Apollo Investment Corporation and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay information for the call is available in our earnings press release. I would also like to call your attention to the customary Safe Harbor Disclosure in our press release regarding forward-looking information. Today's conference call may include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.apolloIC.com or call us at 212-515-3450. At this time, I would like to turn the call back to our Chairman and Chief Executive Officer, John Hannan.

Thanks, Rich. AIC's successful access to equity capital market in September provided us with substantial liquidity at an opportunistic time for investors. With many banks and other lenders dealing with credit issues, liquidity constraints, and overcommitments, AIC is extremely well positioned with strong conservative underleveraged Balance Sheet and substantial access to capital. Our core business continues to be driven by middle market sponsors but as we discussed in the past, it is complemented by a deep relationships with commercial and investment banks. Through these relationships, we manage a healthy pipeline of potential investments and continue to invest selectively in the highest quality assets that we can find. For the quarter ended September 30th, we invested approximately 454 million in seven new investments and five existing portfolio companies.

This brings our total invested capital since we founded the company to over 4.6 billion in 106 portfolio companies. Approximately 4 billion in assets currently allows us to invest meaningfully across many businesses. We now have the scale to offer financing solutions to middle market and large cap financial sponsors. And with our firm's global credit and industry expertise, we have significant opportunities available to us. From time to time, we have accessed a secondary market opportunities and we are taking advantage of that. Accordingly, our franchise, together with ample liquidity and thoughtful flexible business plan, affords us the ability to invest across many different markets. Now, let me turn the call over to Jim Zelter to go through the market and our portfolio in more detail. Jim?

Thanks, John. Quarter ended 2007 can best be characterized by significant volatility in the global financial markets. The turmoil in the U.S. subprime mortgage market eventually led to a major dislocation in the overall credit markets. Large LBO deals in the market backed up and banks focused internally on their own Balance Sheet issues. We all saw liquidity dry up as well. This left many very good companies without access to the inexpensive capital that characterized the U.S. credit markets over the last few years. We at Apollo are always prepared to provide liquidity across market cycles and be opportunistic in this type of environment. Our favorable liquidity position in this market has indeed afforded us many opportunities including the ability to do business with new sponsor relationships. Since our IPO and through September 30,2007 AIC has now done transactions with more than 55 financial sponsors, many of them choosing to do repeat business with us.

These relationships continue to develop and afford us a pipeline of investment opportunities and business with these sponsors allow us to utilize our deep credit and industry expertise for diligence, structuring and underwriting through which our shareholders benefit by our investment teams gaining improved access to the company management. During more challenging times like these, more than ever, our debt sponsor care who they have in their capital structure and seek long-term relationship-driven business partners. As John noted, we closed our second quarter having invested 454 million across seven new and five existing portfolio companies. The quarter also saw prepayments and other exits totaling 142 million. These prepayments generated call premiums contributing to our strong top line results. And ultimately increased our already substantial harvested taxable income available for future dividends. Since our IPO in 2004, our total invested capital now exceeds 4.6 billion across 106 portfolio companies and has yielded a gross IRR exceeding 21%. At September 30, 2007, our portfolio consisted of investments in 67 different companies and was invested in 53% in subordinated debt, 6% in preferred equity, 17% in common equity and warrants, and 24% in senior secured loans measured at fair value. During this last quarter, we were active investors. Opportunities came from both new and existing middle market sponsors as well as from commercial and investment banks. As part of the Apollo franchise, we are afforded to be a benefit of Apollo's overall relationships with those banks and their capital market and leveraged finance teams to source both primary and secondary opportunities. Furthermore, we continue to focus on opportunities where the Apollo experience offers us the proprietary information edge.

Our investments during the quarter focused opportunistically on larger companies. Accordingly, our average investment in new portfolio companies exceeded 58 million during the quarter and our overall portfolio company investment now stands exceeds 47 million at September 30th. Let me take you through some of our activity for the quarter. We invested approximately 122 million in Asurion corporation. Asurion is the leading provider of wireless cell phone hand set warranty protection programs. Asurion was purchased by Madison Dearborn, Providence, and Welsh Carson Anderson and Stowe. Alongside KKR, we invested 65 million in common equity to support the leveraged buyout of First Data. First Data is the leading global transaction processing franchise providing payment processing services in electronic commerce to merchants and card issuers. We invested approximately £36 million in the subordinated debt of Alliance Boots. Alliance Boots plc is a U.K. based pan-European pharmaceutical retailer and wholesaler with leading positions in both retail pharmacy and the pharmaceutical distribution markets in Europe. KKR is the lead sponsor. Hydrochem Industrial Services is a leading provider of industrial cleaning services in the U.S. We invested 54 million in the company, and it was purchased by Harvest Partners as the sponsor. We invested 47 million in the ServiceMaster Company. ServiceMaster is the leading provider of outsourced lawn care, termite, pest control and Home Warranty Services to residencial and commercial customers.

Clayton, Dublier & Rice took ServiceMaster private this past summer. Pacific Crane Maintenance Company LP is the nation's largest full service provider of maintenance and repair services to on-dock equipment within every major sea port on the West Coast. We invested 38 million to support Brockway Moran's buyout. Including the 38 million is a $4 million equity co-invest. And finally, Laureate Education, a leading provider of international higher education through counterspace and online universities. Our approximately $14 million of financing was used to support the buyout of Laureate by its CEO Doug Becker and a consortium of private equity investors led by KKR and Sterling. Lastly, we opportunistically invested approximately $41 million in the secondary market in names we currently hold, such as GNC, Infor Global, KAR car holdings, and Thomson Learning and finally, TransFirst Holdings as well. These were all done at discounts to original purchase prices. Ultimately, our investment portfolio as of September 30th consisted of 67 companies with a market value of 3.2 billion. And while we experienced a decrease in the net unrealized appreciation during the quarter due to various mark-to-market quotes as the overall bank and markets created off during the quarter, the overall fundamentals and credit quality of our portfolio remained solid. That said, as noted in our 10-Q, we did have one exception. We placed Lexicon Marketing on a non-accrual status late in the quarter. We continue to work with the sponsor on this investment in order to maximize shareholder value. Of the 106 portfolio companies invested since the IPO, this is our second investment on non-accrual.

By the quarter end, the weighted average yield on our debt portfolio rounded down to 12.7% as compared to 12.8 at the quarter ended previously. The weighted average yields on our subordinated debt and our senior loan portfolios were 13.1 and 11.9 respectively, both unchanged from the prior quarter. The nominal impact up to our debt portfolio during the quarter was derived primarily from prepayments of higher yielding assets, increasing credit risk premiums and declining market and bench mark rates. Before I turn the call over to Rich, let me say that the investment team and I are excited about the resilience of our portfolio and what we believe lies ahead, an oppotune environment that we have not seen since the summer of 2002. Of course, we will continue to navigate ahead with our investment discipline and our focus on principle protection. With that I'll turn it over to Rich Peteka, our CFO.

Thanks, Jim. We closed our books on September 30th with a net asset value of $18.44 per share, down $0.65 or 3.4% from our NAV of $19.09 per share at June 30th. This was largely a result of a decrease in net unrealized appreciation during the quarter due to the various mark-to-markets as Jim noted, as well as the write-down of value in our investment in Lexicon Marketing. Year-over-year, our September NAV increased $2.30 per share, from $16.14 per share or 14.3% since last September. Gross investment income for the quarter totaled 86.1 million. This compared to 88.9 million for the quarter ended June 30th, and 63.9 million for the comparable quarter a year earlier. Accordingly, and excluding the 10 million non recurring structuring fee we received on Innkeepers last quarter, our gross investment income increased 9% quarter-over-quarter and 35% from a quarter a year ago. Net operating expenses for the quarter totaled 24.4 million, of which 7.5 million was management and net performance based incentive fees, 15.1 million was interest expense, and 1.8 million was general and administrative expenses.

This compares to the June quarter of 34.2 million in net operating expenses, of which 23.8 million was management and net performance based fees, 7.6 million was interest expense and 2.8 million was G&A. For the comparable September quarter a year earlier, net operating expenses totaled 30.1 million of which 20.4 million was management and net performance based incentive fees, 8.2 million was interest expense and 1.5 million was G&A. Certain expense increases for the quarter such as those for base management fees and interest expense due to the growth of our investment portfolio were offset during the quarter by a reduction in net accrual for net realized capital gains based incentive fees previously accrued. Accordingly, net investment income was 61.6 million or $0.58 per share for the quarter, as compared to 54.8 million or $0.53 per share for the quarter ended June and 33.8 million or $0.41 per share for the comparable September quarter a year earlier. Apollo Investment Corporation's GAAP net investment income continues to represent only a portion of our taxable income included in quarterly dividends. Taxable income also includes net realized gain and commitment and other upfront fees we receive on investments that we are advertising over their respective terms of their loans among other things. As Jim mentioned earlier in the call, our investment sales and prepayments totaled 142 million. Net realized losses totaled 0.9 million as compared to net realized losses of 20.7 million a quarter ago and net realized gains of 29.7 million for the comparable September quarter, '06. Also during the quarter, we experienced a net decrease in unrealized appreciation of 83.9 million.

This again was largely due to the mark-to-market quotes largely and the write-down on our value of Lexicon Marketing. This compares to a net increase in appreciation of 144 million last quarter and a net increase of 17.7 million from the September quarter a year earlier. As a reminder, every one of our portfolio company investments is valued each quarter using independent third parties. At September 30th, net unrealized appreciation stood at 152 million. This compares to net unrealized appreciation of 236 million at June 30th and 98 million a year earlier. All totaled, our quarterly operating results decreased net assets by 23.2 million, or $0.22 per share, versus an increase of 177.7 million or $1.72 per share for the quarter ended June 30th. And 81.3 million or $1 per share for the quarter ended September 30th, 2006. Now, let me turn the call back to John.

Thanks, Rich. Let me just wrap up by saying that AIC will continue to stay the course. Our primary objective remains to generate high current income, capital appreciation, through senior and subordinated debt investments and by making select equity investments, generally in middle market companies. That said, we continue to be opportunistic and add to investments whenever we see opportunities that make sense. Larger companies typically have the wherewithal to better withstand market cycles with stronger and larger balance sheets, more seasoned management teams and more diversified businesses. Furthermore, we'll continue our focus on principle preservation. We are not chasing yield. Current fiscal year top line earnings to date have exceeded our current year's dividends to shareholders and have allowed us to increase our already significant dividend availability. We also continue to enjoy significant absolute returns in net unrealized appreciation. Based on our recent common stock trading levels, we are trading in excess of a 10% dividend yield, a very impressive number. Looking ahead, expect us to continue to manage our portfolio for continued improvement in security, structures, terms and conditions. Also, expect us to remain disciplined and not just chase yield. At this point, I would like to close and open up questions to the audience. Thank you.

Thank you. [OPERATOR INSTRUCTIONS]. We'll pause for just a moment to compile the Q&A roster. Our first question comes from Carl Drake of SunTrust Robinson. Please go ahead.

Good morning. Thanks for the comments on the market and the strategy. The question is in terms of going forward, your focus is on larger companies, clearly. What types of yields are you seeing on the larger companies and what type of structures, less leverage, maybe you could comment a little on that, what we might expect going forward?

Hey, Carl. It's Jim. I think that we're seeing is certainly if you look at our second lien paper right now is coming out. A few months ago before the September -- before the June quarter, you saw pricing on some second lien paper with a LIBOR plus a 500 handle on it or 525, certainly that market is backed up to a LIBOR 700, 750 level, before we even start looking at paper, quite frankly as a starting point. You know, in terms of some of the classic mezz paper that we're looking at in our portfolio, we're certainly looking at yields in excess of 12% as a starting point. As Rich said and John said, we're also looking at getting and we are achieving what we think are some better call protection in some of our paper.

You saw the marketplace move to non call six months. Certainly, some of the newer paper we're buying either at discounts, which by definition gives us some call, better call protection or otherwise, really allows us to have better call protection as well. So we're seeing a repricing in the market. It's obviously there's some secondary benchmarks as well. But I would say north of 12% and I'll have Patrick add a comment or two if you want to.

I think, Carl, thank you for the question. We watch this every day. We're looking at relative value between the different markets that we operate in, in the public secondary markets or the private mezz markets making sure that we're focusing on the risk adjusted returns. Obviously, looking for duration in great companies is what we're focused on as well and that's becoming more available in this market.

Next question on just overall macro view on the economy. You're in a good position to see, you obviously had some indirect impact in a few credits from housing or home building. Aside from that, what else are you seeing out there in the economy? What type of expectation do you have for the portfolio?

We're seeing a lot of -- this is not like 2001, 2002 where you definitely saw the immediate impact of the credit cycle on all parts of the economy. Some parts are doing well. We're on a multi-speed economy. Certainly the global growth is having some effect on that. To the domestic economy. Home building and consumer and second and third derivatives are what's affecting the home building market in terms of employment, local employment in certain regions.

You are seeing some degradation, but there's a lot of mixed signals out there. Earlier this summer, we would have said the recession is 8020, we're not seeing it. Certainly what's going on in the mortgage space is a higher number right now. But we're not seeing that cover all the industries by any means. There are some real strengths in the economy as well.

Yes. And what we're also saying is the larger companies do have some export business and those markets we all know are strong so we're encouraged by that.

Okay. That's helpful. And then the last question on realized gains, the outlook there. You know, in an environment like this you've got some substantial unrealized appreciation on the Balance Sheet. There are some reports about Goldman as the sponsor of Prysmian selling a portion or investment that you might be able to tag along with that. Maybe you could talk about the outlook for harvesting some realized gains.

Sure, Carl. Patrick again. We're very encouraged. It was announced yesterday that Pirelli and Goldman Sachs have announced the sale of approximately 22% stake in the business. We are part of that Goldman Sachs group. We do have tag-along rights. Expect us to exercise those rights. It is also publicly disclosed. The remaining stake is subject to a 90 day lock-up going forward.

Okay. Okay. Thank you very much.

Thank you. Our next question comes from Sanjay Sakhrani of KBW. Please go ahead.

Hi, thanks. Pete, just a follow-up question on that Prysmian question. I think it was noted that Goldman Sachs was going to even sell a greater amount than that. I think it is like 40%. Could that 22% was a Korean sale. Then there was another accelerated sale in the market. Is that something that you guys are a part of as well?

It is actually -- it is publicly disclosed, 12% was sold to institutional investors and approximately 9.9% was sold to the Korean investor.

So, it's 22% of the entire stake?

Yes.

Okay. Got it. And then just taking your comments on the yield and how they've sort of accreted in the marketplace, do you think that this quarter was sort of a trough in terms of NOI?

Well, I don't want to talk about a trough. I think what we are seeing is we are seeing a repricing in the marketplace. And we have three -- we've sort of pursued three broad strategies for the quarter. Obviously first and foremost, looking at opportunities that we already own to be opportunistic in buying those at some discounts. Obviously there are some deals that have been hung up on Wall Street's inventory and we looked at all of those and we're very selective and chose a couple and then also in the repricing of the classic mezz market.

We don't want to reach yields. We want the same type of yield spectrum to be able to buy a better risk adjusted asset. So, We want to buy a larger company with more diversity at that same yield level. So, I guess I'm not saying where they're going to trough in terms of our overall business but that is a strategy on an individual by individual investment.

I think what we're also doing, Sanjay, is investing in the future. Because with call protection you get premiums when people take you out so the yield is just one component of our return. So, as we're getting better call protection in the marketplace, when those companies do exit they generally exit at a premium.

Do you think you can elaborate a little bit more on these opportunistic purchases of this paper, the First Data and Alliance Boots?

Well, as I laid out in my commentary, we really purchased 41 in the secondary market on names like GNC, Infor Global, KAR, Thomson Learning and TransFirst, certainly a name like a ServiceMaster was one that was much noted in the papers and the structure of the security that we purchased we thought was in a major discount to par and we thought that between the coupon and the overall structure of the asset as well as the discount, that gave us well in excess of what we think is our base case returns to maintain our dividend. So, again, We looked at many, many of those. A lot of them as you probably know are in the senior debt component of companies so a lot of the hung merchandise is senior debt that is issued at LIBOR plus 300 at a discount of 3 or 4 or 5 points to par. That wouldn't fit into our yield bogie.

We need to make sure we're buying subordinated paper with high coupon and a substancial discount that's well in excess of our dividend and our cost of capital. So, a lot of the headlines have really been on the senior loans. We've not taken advantage of those. We've been taking advantage of the opportunities in the mezzanine or the subordinated tranches that were hung.

Got it. Thank you.

Thank you. Our next question comes from Chris Brendler of Stifel Nicolaus. Please go ahead.

Hi, thanks. Good morning. Can you talk about the mark-to-market process? I understand that you use quotes when available but it's pretty choppy conditions out there. I actually thought your portfolio marks held up relatively well given all the pressure on high yield. Can you talk about what percentage of the book was marked based on a public quote and any underlying trend you see by sector in terms of where the most pressure is and how you're exposed to it?

Let me answer this. Hi Chris, this is Richard. I'll answer the first part of that. Our portfolio, given the environment, there were some traditional mezzanine notes out there that were done with us where there were other investors in the tranche. We started to see a few of those start to trade in this last quarter. I think there were some people trying to make a mark or try to make a buck, one way or the other. Some of those things what we had, a third evaluation from value in the past, all of a sudden started to become quoted.

So, between that and our diversity into larger companies, bigger deals, bigger companies, over the quarter our percentage of quoted investments absolutely did grow. And I think we're prior we were probably closer to a third of our portfolio being quoted, I would tell you at September 30th, that number is closer to a half now.

Okay. I'm looking at this fair value.

That's on a dollar basis.

I'm looking at these numbers, a lot of these subdebt notes actually held up pretty well. Just given all the pressure on the high yield market that I see from afar, I thought it was actually pretty good performance if you are using quotes here. Can you just sort of comment on maybe by industry, a lot of the sectors you're in not as impacted by the overall market conditions.

A great question. I think we spent our time really focusing on the very best companies and good industries. We are across industries. We're seeing some. We've taken advantage of some opportunities in industries like retail which has been hurt pretty badly but there are a couple of companies in that space that are category killers that we'll look at. We have a very strong retail practice at the firm and so we have good knowledge.

It's really within the industries, we're not doing home building, we're not looking at building products aggressively today because those have been -- you have seen them being hurt. What we're looking at is companies that are large that are not going to go away that have plenty of free cash flow that can withstand the environment that's ahead of them and the market generally reacts across sector and then it starts to differentiate by company within the sector and some of the names fortunately that we've invested in are performing their relative competitors.

Okay. Just one quick follow-up. I think it was already asked but just sort of how do you feel about like my concern, I guess, not just for your company but for the financial sector in general is that liquidity has been removed in the last several months, it continues to be very difficult today and in the housing market just continue to get worse, how do you feel about the outlook going into '08? This is obviously a good time to be putting money to work? Are you worried on the value trap and how selective are you being by industry?

Well, that is a great question. First and foremost, whenever you get to an environment like this, our first focus is on assets we already own. Obviously, we're spending a tremendous amount of time, going out, spending time with the companies we have great assets to and understanding what is going on with our inherent portfolio. That's first and foremost. The second thing, as John mentioned, we do have liquidity right now and we typically as we have said since day one, there is no set investment pace here. It's an investment by investment and certainly what we think is going on right now is our positioning in the market by a provider, a mono line provider of mezz product to the sponsors large and middle market, there are -- there is a sweet spot, if you would, north of 50, under 3 to 400, where our space we believe is a better space. Higher quality companies, less providers of that capital. So yes, we are incredibly selective.

We continue to be. You know, the tone you're hearing here is larger investments on larger companies. We think that this makes sense at this point in time in the cycle and we'll continue to do so. But with the issues you see going on right now amongst a lot of of other financial institutions, we think by definition that has to play into our advantage by as a capital provider in this space.

Excellent. Thank you.

Our next question comes from Jim [inaudible] of Bear Stearns. Please go ahead.

Thanks a lot. I want to follow up a little bit more on just the direction of the portfolio. I mean, I hear what you're saying about doing bigger deals. I mean, is it fair to say that you're increasing your private equity exposure here and that given that increases there and also just more investment in existing companies, that you're moving toward a more concentrated portfolio and how does that jive with sort of your outlook on the economy for next year?

Well, first of all, In terms of our equity exposure as we talked about last time, the zip codes that we're in right now is where we're going to be staying. We really want to make this a lion's share majority of the portfolio is a debt portfolio, throwing off current income for our shareholders. The amount of equity component is how you're going to see it in the overall scope of situations of the overall portfolio. In terms of existing investments, I mean, investments that you already own and know and have done deep due diligence on, if we find opportunities to be selective and take advantage of what we think is a technical selloff, we're going to continue to do that because, again why spent the time and energy on a new company we don't have that access in dialogue, We would rather really spend more capital on names we know. But you are not going to see us -- the size of our portfolio, our 67 plus investments right now, we want to be diverse. We don't want to have a portfolio with two to 300 investments but you're certainly not going to see us go down in terms of 30 or 40 investments. That's not the path we're going.

We're really trying to have investments in excess of $50 million grow on a very selective basis. We think that's prudent because we get the size of our portfolio, but certainly prudent in the environment we're getting into. I would ask Patrick to add any comments on that as well.

I completely agree with that. I think what we're really looking at is -- we want to make sure we have the resource to monitor every company, every day and every quarter. So we know what we own and so we're not going to have several hundred companies in this portfolio. As we become a larger business, we have the capacity to increase our average investment size in larger companies and therefore can be relevant to the sponsors and to the banks we're partnering with. And so you should not expect that we'll either decrease the number of companies or significantly increase the number of companies over the short term.

One thing I would add is, while some transactions took the form of somewhat syndicated in the process, I think we found during the quarter that a firm like ourself can take a very active role in structuring a transaction to our benefit in terms of convenance, in terms of coupon, in terms of covenance and we found that in the few of our cases and we will continue to do even though those who come from what we would consider a syndicated process where a year ago you had very little voice. We are finding ourselves having a greater voice in these transactions we like and can take a lead rolling.

So with the fact that you have sort of more syndicated investments here, I mean, is that sort of just a function of what was going on in the market over the last few months and maybe you'll go back to more -- where you're more negotiated deals.

That's when we saw the most opportunity. The syndicated market over the last few years have been very robust. We turned down most of the deals, if not a significant portion of those that we saw, given that allocations were small. You couldn't make covenant changes. Prices were tight. Leverage was high. When the market backs up and the banks are holding loans on their books, you can buy them at discounts.

If they're trying to bring a deal to market, you can work with the banks and the sponsor. Because we've got sponsor relationships. They want successful execution as well. By tweaking the structure of the documents and the pricing or the duration, you're able to come to terms at a mutually agreeable to both parties and that's what we were able to do over the last quarter.

See you guys next week.

Thank you.

Thank you. Our next question comes from Scott Valentin of FBR Capital Markets. Please go ahead.

Good morning, thanks for taking my call. Regarding the unrealized appreciation you mentioned most of it was mark-to-market. Can you talk about maybe the underlying performance such as EBITDA or revenue items of some of the companies in your portforlio. You're seeing net improvement in EBITDA. Are you seemed stabilized. Some investors are fearful that you're seeing credit deterioration in the portfolio as opposed to straight mark-to-market.

What we do each quarter is we go through our portfolio. We rate the portfolio. We've consistently been rated a two. It remains a two average rating on the portfolio. So, that's encouraging. There are some highlights and there are some issues that come every quarter. We are, as mentioned the middle market in the U.S. is not growing at the clip, it was growing a couple years ago in general. But we're not seeing a deterioration.

As a primarily a debt investor, business that goes sideways or flat are good if you're going to read cash flow. We're saying that we continue to see that in the portfolio. We're watching very closely. A lot of press when the economy is going. We seek to pick the best companies in the space that can increase market share and down markets and improve cost control that they need to and can be resilient in the marketplace. We're not seeing significant deterioration in the quality of the portfolio, as evidenced by our average rating still to two.

Just a follow-up question. This quarter's originations are a little bit stronger than I thought. How do you balance the opportunity you see with better product out there, better returns, with maybe holding off and waiting for to widen even further and provide better opportunities in the future?

Well, I would say there's three things. I sort of mentioned it before but the opportunities that he with saw in the portfolio were really three paths, one was the distinct portfolio. The second was the yields that were somewhat hung on Wall Street inventory. Those were immediate and opportunistic. The third, our traditional mezz, those take longer to develop, a longer due diligence process and I think over time, you'll see us -- That will be the driver of our business.

But certainly we want to make sure we took advantage of the select opportunities right now and again, as I mentioned earlier, of the deals that were somewhat hung on the investment banks, we looked at well in excess of probably 35, 40 transactions and invested in less than a handful. It's a constant balance. We're always making sure we have a liquidity in the outlook. But these are the times like investors like us, we think we'll look back on the investments that have made in a true manner will pay great dividends for us in time.

Thanks very much.

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

Good morning and thank you. I think most of my questions have been answered. I don't think this has been asked yet or commented on. Given your focus on mezz and that you're primarily a debt shop as well as the obvious desire to generate capital gains, in today's market there's been talk perhaps a return to a larger return to warrants. Could we see your warrant position increase relative to the rest of the portfolio?

Yes, that's a good question. We have not seen -- in the market we operate in, which is the larger end of the middle market, we're not seeing warrants today. We would like to see them, obviously. We are seeing warrants of the very small companies that have even more constrained access to capital who need to put warrants because the risks in those returns are needed to be higher. In the market we're operating today, we're not seeing warrants as of yet.

Thank you.

Thank you. Our next question comes from James Shanahan of Wachovia. Please go ahead.

Thank you. Good morning. I missed this. Was it Lexicon that's on non-accrual?

That's right, Jim.

Thanks. As a follow-up, I noticed here with Lexicon and Arbonne there was no mark on either of these investments three months ago and you took about $26 million in marks in the September quarter. Can you give us more detail on what happened over three months to cause such a big reduction in value?

Sure, Jim. It's Patrick. I'll address those two separately. Natural products group was a business that's been performing very well historically, Harvest Partners is the owner of that business. That business had been growing at a very significant clip. It is a network marketing business. Consultants who are recruited buy product and sell product in and have been growing very quickly. We saw evidence over the last quarter that that has kind of matured and when you have a business that relies upon new recruits and international expansion that's forth coming, that can turn pretty quickly.

Our EBITDA today is higher than the EBITDA than we invested in. But when you see a business that was growing so fast slow down, and we think right now we're seeing evidence of stabilization, we're encouraged that became a quote instrument. Only thing in part of hotel security is first lien bank debt. The first lien bank market traited down just in general. The LCDX went down close to 90. Then you add additional deterioration in the quotes, because of that company's -- the loss of growth. We're working very closely with the sponsor on that one and that was a quoted investment. Lexicon is a little bit different story.

They primarily sells English as a second language products to Hispanic immigrants in the U.S. What we have found is over the last few months, a lot of that population was in the construction market. In addition, there's been more stringent immigration rules and laws. So the confidence to spend on what is a $1,200 investment for a consumer into learning English, given that their job security was at risk as well as tighter immigration laws, that business has dramatically changed quickly. The demand size of that business has changed. We are working with Quad-C as a sponsor, they're doing a very good job with management, trying to resize the business, restructure, reorganize to see if they can stabilize to what it looks like, it's like -- That happened very quickly.

That's terrific color. I was also surprised to see a small mark but a mark on Grand Prix Holdings. I think we would all benefit from an update on Innkeepers.

Yeah, Jim. That's one of the investments that are sent out to third parties and you know, essentially the third parties looked at the comps, they used their typical pixie dust. They took all the market data, the unobservable data, the portfolio and financial information and they basically came out that they're going to hold this investment at cost, essentially. And what you're seeing there is that slight value, about $2 million of what looks like depreciation on the common stock. Simply represents the accrued dividends on the preferred that is added to the debt on the company's Balance Sheet.

So it's just a reclassification that we took $2 million on that 12% preferred security on our P&L and that accrued on their P&L as additional debt and therefore with a reduction in equity value. Net, net, it's a flat investment. There's been no change in the investment value on Innkeepers.

Just a comment on the operating performance of the company. The company is doing as planned. We're not seeing the softness that folks may see in the hotel industry. We're very encouraged by the operating results of the business today. And what impact if any do you expect or should we expect from the implementation of FAS 157 and what set of financial statements will we first observe the implementation of that?

I'll answer that. This is Rich. FAS 157 is effective for fiscal years beginning after November. Our next fiscal year starts on April 1st. So it's likely that shareholders are not going to see us become effective on that until our June quarter of '08. That said, as I mentioned earlier in our comments, we value all our investments. We're extremely transparent. About 50% of the portfolio is quoted.

The other half of the portfolio is valued by third parties with a security, there is no quote, there is no liquid market, it's not an active market and these guys are doing their best to create and understand fair value. My expectation would be, although it's not effective for us yet, that you see very little change, probably just some added disclosure in our financial statements. At least that's what we've determined so far.

Our next question comes from Bob Nicholson of Pan Capital Please go ahead.

Thanks. Congratulations on a great quarter, guys. I have two questions. The first is from accounting standpoint, when you calculate the average yield across the portfolio, if you're buying either secondary paper or primary paper at meaningful discounts, so you pick up second lien bank debt at $0.92, that $0.08 OID, is that incorporated in the 12.7% or 12.8% average yield for the portfolio?

Yes it is with an amortization after the maturity date, not to a FirstCall date. Typically we're not going to see things go to maturity in this Market. We don't expect that. But still we're conservative. We're taking that after the full maturity date.

So, an 8.0 OID with an eight year security is --

One point a year.

One point a year regardless of what you anticipate the real economic life of the security to be.

Correct.

Second question has to do with you guys have not provided any guidance in terms of how the growth of the asset base is going to impact the growth of the dividend going forward. And I think everybody on this call can do the simple math of how the strong net origination performance and the flow-through from the secondary offering and the incremental leverage impacts the business. By my math, 312 of net originations this quarter and assuming at least that in Q4. If you flow that through again, you're cost structure and you're cost of debt, You get to a pretty meaningful increase in distributable income for the fourth quarter. Can you give some guidance on what investors should expect?

We haven't given dividend guidance historically and it's going to be hard for us to say that We are committed to a steady stable and growing dividend. If you look at our 10-Q that was put out at the end of May of '07 it showed over $100 million of harvested realized gains. I've had some analysts tell me that they could look at my GAAP top line income, which exceeds our current fiscal year dividends and say is it unreasonable to say that you are harvested available dollars for dividends has increased so far this fiscal year from last fiscal year and that is not an unreasonable assumption. We are committed to that steady stable and growing dividend. If people do the math, they'll see that our harvested dollars have increased. We feel very good about it the longevity of the dividend.

Okay. Thank you.

[OPERATOR INSTRUCTIONS]. Our next question comes from [Stuart Sterling] who is a private investor. Please go ahead.

Good morning, gentlemen. As a private investor, I'm looking for what you were just talking about, the dividend. If the comment is that the market will return 10% a year over 20 years or 30 years or 40 years, I have it right here in front of me at 10% a year without having to go crazy. Several of the other companies that I've owned, I've been successful with because I've done it for a number of years. And my curiosity is one of the companies already had stated their whole dividend policy for next year, which is hard for me to see with the market turning the way it is. But I'm just wondering if you could make any comment on how you look forward to the dividend itself. Is money put aside for the dividend? I'm sorry I missed part of the call so I don't know if you've already covered this. But I know from last year's earnings, some of the companies are paying the dividend in this year's earnings, et cetera, and keeping capital gains because they've earned the money. I would like, you know, your expertise in what your company plans on doing to the permissible part of the law.

Stuart, let me try and answer that for you. You know, in what we've disclosed publicly. As I just mentioned, you know, we are committed to a steady, stable and hopefully growing dividend stream. We have some pretty significant harvested dividends that we can pay out in the future. You know, we grow our business one investment at a time. We are completely transparent as far as values as well as our P&L. And I think what you wanted to hear, what you want to hear us say is that, you know, if we're in the mezzanine and private equity business, that's not a quarterly business. So, how can I give you dividend guidance years out from now? I mean, we could do that but then we would just be coming back to you each quarter and telling you what's changed since last quarter. We run our business as investors, one investment at a time, keep diligence, bottoms up approach and try and generate a matching amount of income that supports our dividend and we do that primarily through income. And there is some capital gains. So you know, we feel good about the level of our dividend. And you know, we're very committed to managing our business each day and each investment, being cognitive of the cost of capital and trying to make sure that we have enough to pay that dividend. We have not turned capital to date. We will try not to in the future. We are managing our business one investment at a time based on what our cost of capital is and that is primarily that dividend.

So, in other words, what you're basically saying is that you're earning the money that you're paying?

We have so far and we've actually earned in excess of the money that we've been paying.

You're keeping that as part of the investment for the future when you have to -- I know you have to pay it out at a certain point. But you can keep some of it or you can the government, what is it 4% excise tax or something like that.

That's correct.

So you basically answered the question. You're looking forward to keeping the dividend at roughly at 10 to higher percent yield which most of the companies that I invested in. I'm now getting 20 to 30 and 30 to 40 in some of them. So, I look forward to it and why should I kill myself when I have you working for me. I appreciate it.

Thank you.

Best of luck to you.

Thank you. Our next question comes from John Arfstrom of RBC Capital Markets. Please go ahead.

Good morning, guys.

Hey, John.

Question for you, Patrick, I guess. Seems like there's a clear push towards larger deals and larger companies. I'm curious on some of the smaller company deals that are coming across your desk. Are you seeing specific signs of weakness or any erosion in the health of those credits or is this something you look out over the horizon and say it's going to be much better to be in larger companies.

I think it's really our approach looking what's coming on a non-horizon. We're not going to abandon our clients who have gotten us here if they show us a deal that is a smaller sized deal. We're obviously going to have high hurdle rate for acceptance of doing those deals. But what we are trying to do is figure out where the economy is going and repositioning, because we have the capacity now to do that in larger companies.

Okay. Couple more questions. In terms of, Rich, you mentioned that 50% of the portfolio is quoted.

Approximately half.

Approximately half. Okay. Obviously, that increases the volatility in any of these from quarter to quarter. And you know, seems like more of a nuisance, as long as the asset quality is consistent. And I guess the question is, is it safe to look at the various indices that are out there as a a way to gauge the potential change in the NAV from quarter to quarter for at least half of your portfolio or is there something different about what you have that would say that that's not necessarily true?

Well, yes, I mean would argue it's not. We view ourselves as investors and the index is just a portfolio of names. While as Patrick mentioned what was going on in LCDX or the high yield CDX, that's one way someone could back into what a relevant should do. We believe we can -- we have that's not exactly relevant for our businesses. Again, because of the transparency of all the names, you can look them up. Vis-a-vis what you've seen in index. I can't argue with some of the direction. I don't know if the correlation is that correct over time.

Okay. And then Rich, just one more question for you. Lower short term rate means potentially lower funding costs and it sounds like spreads continue to widen. Is it -- can you look at your business model? Is it as simple as that? Is there something that prevents us from looking at it that way?

No, that's just one piece of the calculation, John. There's a couple of things, I think that it's important to note that during the quarter ended September, LIBOR had spiked up pretty dramatically given the banks' constraint Balance Sheet and their lending ability to each other. That's come down significantly now. So, we should see some improvement there. And then the other piece that you want to factor in is the timing of equity raises. Because we have a multi currency revolver and we like to stay as close to 100% hedged as possible as far as exchange rate risk on that portion of the portfolio that's not US dollar denominated. I would say that we would typically in order to maintain that hedge, we would repay, when we do raise equity, U.S. dollar borrowings and so as the correlation changes among borrowings in non U.S. dollars versus U.S. dollars and the fact that we want to maintain our hedge and then we pay down U.S. dollar borrowings, you will see some changes in the cost of capital for us, debt capital on a quarter to quarter basis.

Okay. Thank you.

Thank you. Our next question comes from [Jim Cavallaro] who is a private investor. Please go ahead.

Good morning, gentlemen. A few questions. In reference to your investment ratings, one through five, one and two are pretty good. Four and five, not so good. Being transparent with your shareholders and investors, could you tell us or give us any insight, are there any portfolio companies that are in the four to five rating that we might want to know about?

We historically have -- we have historically talked about our overall portfolio. We feel that the transparency of having our portfolio up that people can look at is the transparency that we think is best practices. But going beyond that is not something that we have done in the past and are not prepared to do in the future.

Let me just add to that, Jim. You've been a long time investor with us and we appreciate that I would say to you to add to Jim's comment in respect to regular FD that if you look at the definitions of those items one through five which are available to you and you look at the fair value and the transparency and the careful transparency and fair value process that we have, you can kind of look. If there's a definition that we expect to lose principal and you see our cost significantly below value on something that is fair valued, it wouldn't be unreasonable for you to consider that that is something that would fall into this definition or that definition. So, there's not many of them that would pretty if you look at. When you look at all the names in the q.

Okay. Thank you. Another question. Approximately what percentage of your portfolio of companies have international exposure in regards to sales?

Primarily we are U.S. investor for companies that are in the U.S. Larger companies do have access to foreign markets for sales. But predominantly, our portfolio of companies are operating and doing most of their sales in the U.S.

Another question. In your opinion, of the -- your opinion of the U.S. heading into a recession, and what impact that would have, if it occurs? Does that concern anyone, and if so, what would you do to?

Sure, we definitely as I said earlier, you know, not getting too long winded here, what happened in June and July from our perspective in the leveraged finance space, was a technical overhang caused by a lot of the subprime ABS fallout. What's happened subsequently to that, we had a very strong reality in the credit markets in September, a little bit of reality I would say is coming home to roost now, especially in the asset backed and you can see the write-downs at Merrell and other places, so there is greater concern about the derivative effect or the exponential effect on this home building and asset backed securities on other types of industries, I mean, we are -- we have been diligently focused on the effect of the potential effect of a recession and how it would affect our portfolio for the last 24 months. This is nothing new to us. We saw credit priced at very, very tight levels historically on any kind of historic analysis over the last two or three years. With that being said, as I said earlier, if you asked me in June or July what I thought the potential recession would be, I would have said, you know, 20%. I think anybody right now who is a student of the markets would say that number is higher and I think what we are also seeing is we see Apollo as a firm and many of our companies in private equity otherwise, there is tremendous global growth going on, not the same as going on in U.S. home building market. My point really is when we think about -- we always assume we are going to have a challenging economic environment. Every investment we make we have very, very harsh down side scenarios to make sure we have adequate recovery and we're getting structurally paid the risk inherent in every deal. So, we assume a recession is going to happen in our down side case with every deal and that's why over a quarter you see us making seven new investments out of a much, much larger pool that we look at. So, we obviously have greater concern about it today with regards to the position of our portfolio that positioned appropriately. But the things you're hearing here about not reaching or yield, larger companies and being continually more selective, those are all the output from our view of the world.

Very good.

Thanks, Jim.

Thank you.

Thank you. Our final question comes from [Lee Pelzo] who is a private investor. Please go ahead.

Hi, guys. I'm just wondering if you're willing to hypothesize, the market's upset over something, you're stock's down 7% this morning. Everything that I've read and heard this morning sounds okay to me. What do you think it is that's frightening the market right now or do you think you're under a little bit of a short attack or are you willing to just speculate as to what's going on?

I've been doing this for excess of 20 years. If we come in every day and focus on our portfolio and find good investments and grow a steady stable dividend, the rest will take care of itself. And what the conjecture is, we have a great dialogue with the analysts. I think they know our company very well.

I'll add to that, just a piece of information I got this morning and that is, when you see the selling come from it's pure retail, people that are coming out of the discount, deep discount brokers that got a bullet explanation of our P&L in one way or the other, that don't really tell the story and that sometimes panics people when they have general market concerns. Just the mechanics of these electronic markets, you have one person panic and it triggers stop loss orders and other things. And then people panic and people pile along. I mean, that's not our business. Again, we're not quality business. We're not a daily business. Our head is down. We're working as we have always. John has mentioned, we're staying the course, we're focused on our dividend every day. We feel good about the portfolio. The condition, the -- and the harvested earnings that support the dividend and it's one day at a time and it's unfortunate that in today's electronic age that we have the type of trading volatility in our stocks. Our business is not that volatile. So, we shouldn't trade that way.

It's not necessarily unfortunate for some of us investors.

There you go. We're a long-term investors.

I think, Rich, to follow-up. Last night, i read some news over the wire that was actually look misleading to me and when I looked at your financials I realized it was basically wrong.

I saw it as well. And it was discount brokers that disseminated some of that stuff.

I see. Okay, thanks, guys.

Thanks for your time, everyone.

Thank you. This concludes today's Apollo Investment Corporation conference call. You may now disconnect and have a great day.