Oaktree Specialty Lending Corp (OCSL) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Fifth Street Finance Corporation second quarter earnings 2010 call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions on how to participate will be given at that time. (Operator Instructions). As a reminder, today's call is being recorded. At this time, I would now like to turn the conference over to your host, Ms. Stacey Thorne. You may begin.

Thank you, Joe. Good afternoon, and welcome everyone. My name is Stacey Thorne and I am the Head of Investor Relations. This is a conference call to discuss the results for Fifth Street Finance Corp. second quarter ended March 31st, 2010. I have with me this afternoon Leonard Tannenbaum, CEO, Bernard Berman, President, and William Craig, Chief Financial Officer.

Before I begin, I would like to point out that this call is being recorded. Replay information is included in our May 5th press release and is posted on our website. Please note that this call is the property of Fifth Street Finance Corp. Any unauthorized broadcast of this call in any form is strictly prohibited.

Before we go into our earnings, I would like to you call your attention to the customer Safe Harbor disclosure in our May 5, 2010 press release regarding forward-looking information. Today's conference call includes forward-looking statements and projections and we ask you refer to our most recent filings with the SEC for important factors that would cause actual results to defer materially from these forward-looking statements and 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 or call Investor Relations at 914-386-6811.

The format for today's call is as follows. Len will provide an overview. Bernie will provide an update on the SBA and other lending facilities. Bill will summarize the financials, and then we will open the line for Q&A. I'm now going to turn it over to our CEO, Leonard Tannenbaum.

Thank you, Stacey. From an economic standpoint we have moved from stable to increasing EBITDAs. These initial indicators of a rising economy are seen across several industry groups. During the economic decline, many of our companies experienced stress and we reacted quickly by marking down the portfolio to reflect the changing values. We also prudently lowered the investment ratings to categories three, four and five, as the situation continued to worsen.

This past quarter reflects a significant change upward in our portfolio. Though we follow a policy of not marking up our debt investment significantly above par, we did experience a significant increase in our category one rated investments. While these securities are clearly improving, we do not see any near term risk of refinancing in general, due to substantial prepayment penalties and exit fees in many of them. Over time, however, this category should reflect investments with a higher likelihood of refinance risk, which in the short term will accelerate our earnings growth. We are also witnessing the fast ramp in mergers and acquisitions activity that we had forecasted in the past few months. As both strategic investors in private equity firms increase their activities, we expect loan demand in middle market to accelerate. We believe that this will continue to grow throughout the year, and will peak in the fourth quarter.

Our plan is to have ample capacity for the wave of deal flow that is coming. From a credit line perspective we have successful negotiated our ING commitment, which Bernie will discuss shortly. We also believe that our partners at Wells Fargo along with several additional credit partners will provide ample liquidity for Fifth Street to grow our portfolio through leverage in addition through our SBA facility. We hope to make several announcements in this regard in the coming months.

Despite recent IPOs in the BDC sector, there continues to be a limited amount of our competitors that can complete a transaction for private equity sponsors without any syndication risks and withhold sizes of $30 million to $50 million. This provides us with some additional pricing power and the ability to continue to be a major lender in the middle and lower middle markets. We firmly believe that it's still the preference for private equity sponsors to partner with a trusted lender, rather than rely on a syndicate group to complete transactions.

Increased mergers and acquisitions activity, coupled with the banks expanding their credit lending, have allowed us to largely refinance out of CPAC, one of our previously underperforming investments. The price received also continues to validate our valuations in the portfolio, as CPAC was at one time marked as low as $1 million, with the most recent valuation at $4.5 million. We received $5 million in cash and a $1 million note for CPAC exceeding our most recent valuation. It has been proactive portfolio management and the partnership approach with our private equity firms that have allowed us to successfully navigate a very challenging environment.

The addition of several team members have enhanced our ability to monitor and manage the existing portfolio. I am pleased to report the categories three, four, and five rated securities account for only approximately 5% of the portfolio. Our second fiscal quarter ended as of March 31st, 2010, was below trend from an origination standpoint. During the past quarter, we originated $33 million worth of funded deals. However, 100% of them were first lien loans. However, we have already closed I think in the first five weeks of this quarter, on $46.5 million of deals, of which $40.5 million were funded at close.

We anticipate originations to continue to grow throughout the year, with an expected large fourth quarter. In February, our SBIC subsidiary received its SBA license, which Bernie will talk more about later. We are also encouraged by a movement of a bill in Congress which if passed, will hopefully expand the capacity of our SBIC's subsidiary's SBA license by another $100 million. The SBA capital is very advantageous and should create earnings momentum into next year as the leverage is deployed. The investing environment is changing, as I highlighted in our recent monthly newsletters. We were fortunate that currently 75% of our portfolio took advantage of the higher risk return environment, as we were one of the few BDCs that had ample capital to invest during the credit dislocation.

We expect our primary credit dislocation portfolio to generate strong returns as the economy recovers. We continue to be focused on the potential for inflation to spike at any time, given the very pro-liquidity stance of the Federal Reserve. The increase in floating rate loans with floors should begin to serve as a hedge against a substantial increase in interest rates over the coming years. All of the deals so far closed since March 31st are floating rate with floors of at least 9%, bringing the current percentage of our debt portfolio with floating rates to approximately 24%. Our SBA leverage will also serve as a hedge against rising inflation interest rates as the interest rate on that piece of debt is fixed for 10 years when it is fixed.

We expect our first tranche of debt to fix in the September time frame as SBA securitizations tend to occur about twice a year, in March and September. We will continue to use financing partners to provide diversification in the portfolio. Our pipeline of loans remains strong, at approximately $1.4 billion. We continue to expect a high conversion of our pipeline to signed term sheets due to our ability to commit to the entire loan without syndication risk by utilizing both our credit lines and the SBA facility as well as the desire for sellers to close by the end of the year due to the anticipated increase in the tax rates next year. We believe that these events, coupled with our strong brand and relationships, allowed us to capture premium pricing over the market.

We believe the opportunities in the middle market are large and growing even as lenders begin to return to the middle market. We plan on continuing to take advantage of this environment to gain market share with top quartile private equity sponsors as well as to capture strong risk adjusted returns. I am pleased to announce that we exceeded our goal that we set last year of having 65% of the portfolio in first lien loans with first lien loans currently at approximately 71% of the portfolio. Which includes the deals closed during the past five weeks. Over 90% of the pipeline contains first lien one stop loans, so that this percentage may experience a future increase. This gives us one of the most secure portfolios of any BDC.

With that said, our current target is for about two-thirds first lien and one-third second lien loans and we are actively looking for selective opportunities in second lien. We do not plan on investing in unsecured, PIK toggles or many of the vehicles we which believe generate a higher default rate and lower recovery in an economic decline. Our strong first lien position, coupled with further diversification and expansion of assets, should position Fifth Street favorably to reduce its cost of capital over time.

Our Board of Directors declared a dividend this quarter of $0.32, an increase of 6.7%. The $0.32 dividend is up from $0.30 in the previous quarter and $0.27 in the quarter before that. Due to the increased pace of originations, along with the use of leverage, we anticipate the dividend should continue to increase during 2010. We have announced several key hires to our team which has greatly broadened our platform and expertise. As a leading player in the middle market, we are able to attract talent that serves as a key source of enhancement to our underwriting, origination, and portfolio management teams.

I will now hand the call over to our President, Bernie Berman.

Thanks, Len. We were very pleased that our SBIC subsidiary received its license from the SBA as of February 1.

We also received a leverage commitment from the SBA in the amount of $75 million. As we reinvest that leverage, we expect to receive a commitment for an additional $75 million. In April, our SBIC subsidiary drew $17.5 million of leverage, which we invested on May 3rd. Our SBIC subsidiary has now funded $92.5 million of investments, of which $75 million was invested using our equity contribution, and $17.5 million was invested with leverage.

Until our borrowing rate is fixed, which we expect to happen in September, we are paying interest on our drawn leverage at a rate of LIBOR plus 30 basis points per annum plus applicable fees. The most recent coupon on SBIC pooled debentures from March of this year was 4.108%, and that rate is fixed for 10 years. Even with the additional fees that we are required to pay, that is a very attractive rate for 10 year fixed rate leverage. Under SBA regulations, we are allowed to access up to $37.5 million in leverage, prior to our initial examination by the SBA. That leaves us with $20 million in available SBA leverage prior to our exam. Our exam is tentatively scheduled to begin around June 30, so we expect to have access to leverage beyond the current $20 million capacity early next quarter.

On the ING facility, last week we notified ING that our obligations and their commitment under the commitment letter which we announced in February had terminated. We did this because the deal we negotiated at that time was no longer a market deal. We have since reached agreement with ING on new terms as we announced this morning and we expect to close the credit facility within the next 30 days. The pricing on the facility will be much lower than the pricing we had originally negotiated. We expect pricing to be in the range of LIBOR plus 3.5% per annum, to LIBOR plus 3.75% per annum, with no LIBOR floor.

We are pleased that our partners at ING and the other participating banks have been so flexible and we look forward to working with them. We expect the initial closing will be somewhat larger than the $65 million we have been targeting and the maximum size of the facility will remain at $150 million. We also have had very productive conversations with Wells Fargo about expanding their facility and lowering the pricing on their facility. We are optimistic that we'll have an expansion of the Wells facility within the next few weeks.

I'm now going to turn it over to our CFO, Bill Craig.

Thanks, Bernie. With respect to our balance sheet, as of March 31st, 2010, total assets were $490.8 million, which included total investments of $460.9 million at fair value, and cash and cash equivalents of $23.5 million. Since March 31, we have used substantially all of our cash balance to fund investments. Liabilities were $6.4 million, and stockholders' equity was $484.4 million, and our net asset value per share at March 31, 2010 was $10.70.

With respect to our operations, total investment income for the three months ended March 31, 2010 was approximately $17.9 million, which was comprised of $14.1 million of cash interest income, $2.3 million of PIK interest, and $1.5 million of fee income. Total investment income for the six months ending March 31, 2010, was approximately $31.1 million, which was comprised of $24.4 million of cash interest income, $4.3 million of PIK interest, and $2.4 million of fee income. For the three months ended March 31, 2010, we recorded net unrealized appreciation of $1.2 million, and $2.9 million of realized loss. For the three months ended March 31, 2010, we recorded net unrealized appreciation of $2.2 million, and $2.8 million of realized loss. For the quarter ended March 31, 2010, our weighted average yield on investments was 15.0%, which included a cash component of 12.7%.

Our average portfolio Company investment at March 31st, 2010 was $14.9 million. At March 31, 2010, our portfolio consists of investments in 34 companies. At fair value, 98.8% of our portfolio consisted of debt investments, 68.9% were first lien loans, and 29.9% were second lien loans. As Len previously noted, our first lien percentage has grown to approximately 71%, when we include the deals closed in the last five weeks. At March 31, 2010, approximately 18% of our debt investment portfolio at fair value bore interest at floating rates. Again, as Len previously noted, the percentage of our debt portfolio with floating rates is approximately 24%, including the recent deals.

All of our floating rate loans carry a minimum interest floor of at least 9%. During the quarter ended March 31, 2010, we invested $33.2 million across one new and five existing portfolio companies. With respect to our ratings at March 31st, 2010, the distribution of our debt investments on the one to five scale rating at fair value was as follows. The percentage of one and two rated securities for the quarter ended March 31, 2010, was 94.9%, in comparison to 93.3% as of December 31st, 2009. We are closely monitoring all of our investments, and continuing to provide managerial assistance as proactively as possible.

Thanks, Bill. As a reminder for the month, Fifth Street does not report quarterly earnings. We generally release a monthly newsletter. If you would like to be added to our mailing list and receive these communications directly please either call me at 914-286-6811, or send a request e-mail to IR@FifthStreetCap.com. Alternatively, e-mail alerts can be set up through the shareholder tool link under the Investor Relations of our website, www.FifthStreetFinance.com. Thank you for participating on the call. I will now turn it over to Joe to open the line for questions.

Thank you. (Operator Instructions). Our first question comes from Greg Mason with Stifel Nicholas.

Great. Good afternoon. Len, on on the SBIC, as I understand it, you were able to draw $37.5 million but then you have to go back and get additional approvals from the SBA to draw the remaining amount. Can you give us an update on where you are for the remaining amount of debt capital.

Hi, Greg. We actually got an initial commitment for $75 million of which we were immediately able to access $37.5 million and we've drawn $17.5 million of that. So that leaves $20 million more available to us at this moment. After we have the exam in June, we should very quickly have access to the remaining $37.5 million of that initial $75 million commitment. And then we can go back and ask for the last $75 million.

That was Bernie. And I just want -- this is Len. I just wanted to add to that that we asked the SBA to move the timetable for the review and they were very accommodating by allowing us to be reviewed at the end of June, so we appreciated that.

Len, could you give us a little more color on the investment opportunity, you particularly talked about a wave coming in the fourth quarter. Do you have any ideas in your mind on how much origination potential there is and how much capacity do you need going into the fourth quarter to do those deals?

Yes, I just sat on a panel at ACG Intergrowth that in conjunction with a number of other lenders, senior lenders, junior lenders, et cetera, and we all unanimously agreed that because the tax rate increases next year, the fourth quarter was going to be very, very large. All of us are seeing in the investments banks, basically, especially the middle market investment banks, almost at capacity in terms of new deals, books out, et cetera.

So I'm keeping closely abreast of the market from all the other CEOs, for many of the other CEOs and number of other market leaders and I feel confident that this will be one of the biggest fourth quarter M&As in history, maybe. Having said that, it's very difficult to gauge the amount of the fourth quarter but I feel like from last year's experience where there was a healthcare bill with potential tax increase to the rich, we saw in December $150 million, approximately $150 million in signed term sheets which we closed all of those deals. This fourth quarter could be multiples of that.

So as you're kind of thinking about your capital budgets, how much capacity do you want to have going into that fourth quarter?

The goal has always been to be able to have enough capacity to fulfill the needs from our private equity sponsor partners and so the good news about being 100% origination shop and having approximately 120 day lead time from the time we get a deal to the time we close a deal, we're able to plan pretty well for capital needs. So you can definitely judge as an analyst or as a shareholder how much capacity at any given time by our announced term sheets, signed term sheets and pipeline. And right now we're already seeing the M&A build and we're fortunate to hopefully as Bernie said and I said, have an expansion to our credit lines at reasonable borrowing cost. And access in the next quarter to the SBA, to a balance of the SBA leverage and hopefully eventually the last $75 million. So I feel like we're definitely taking the right steps to be prepared but we're closely monitoring the signed term sheets and needs of our private equity sponsors.

Great. Thanks, guys.

Our next question comes from Chris Harris with Wells Fargo.

Great. Thanks a lot. Taking a look at your recent transactions here, if my math is correct it looks like the weighted average yield on these deals is about 12%, which I think is in line with the deals that were done in December. I'm just curious, do you think that yield can hold for the remainer of the year, or do you think it might get pressured somewhat as competition heats up?

So, we're actually going to give you an answer that we normally wouldn't give. Weighted average yield of the new deals was almost -- was 13.75% with a cash yield of approximately 13%. We're actually proud that weighted average yields held up really well.

As I said for a while, we expect the 14.9% or 15% weighted average yield that we currently have to drop towards 14% and I wouldn't be surprised at all if that happened over time. One of the mitigants to that happening is often our securities there's an A piece and a B piece. The B piece is a higher interest rate piece and the A piece amortizes. So over time, the weighted average yield should all originations remain static, goes up, because the higher interest piece stays in place, the lower interest piece gets amortized.

That's offset by recent deals where weighted average yield is below the 15% number. So I do believe it's going to continue to decrease and that's what should be expected. But we are capturing a premium in the market for our services and we're capturing a premium in the market for our first lien one stop and for our hold size and I think that that still is valued by the private equity firms.

Okay. Then kind of along the same lines, in the past you talked about some banks kind of stepped in your market and really got aggressive. Are you still seeing a lot of activity from the banks or has that kind of gone away?

The bank that came into our market, I asked the panelists that I was on the panel with yesterday has certainly taken a step back from their aggressive postures. But others -- there's definitely other players in the market. Look, we operated in a competitive market for probably 10 of the 12 years. It's clear that the 2008 and 2009 vintages were severely less competition. Which is why we're able to achieve pricing in excess of 200 basis points I think of what we're able to get today. You can see that by the very good pricing of our December deals. However, I still think we're in a normal market and this is a market we're very used to with competitors we're very used to competing against. Right now we're not seeing any irrational players in the market and that's a good sign.

Okay. And then shifting gears back to the SBA here for a minute, Bernie, this is probably a good question for you. You mentioned you have to ask for the remaining $75 million commitment. What do you mean by ask for? I mean, is that simply just pick up the phone and call them or do you have to go through some detailed, lengthy application process. Maybe if you could tell us a little bit about how that works.

There's an application process, but it's nothing like the licensing process, which was long and detailed. It's more in the way of just a few pages of paper. And that's just a formality. The maximum leverage is $150 million, but they typically don't commit it to you all at once. In this case, they committed half of it up front and then we'll simply go back and ask for the rest when that $75 million is invested or allocated.

Okay. And last question, then I'll hop off here. Can you guys remind us what your excess discontributable income was as of the end of this quarter?

In terms of dollars or cents per share?

Either would be fine.

We're looking up the number here. Yes, it's actually -- are we back on? We're actually underdistributed by about $1.2 million.

Okay. Thank you.

Our next question comes from Jason Arnold at RBC Capital Markets.

Hi. Good afternoon, guys. Len, I was just curious if you could talk a little bit about the opportunities you're seeing to add new PE sponsor relationships or expand upon current relationships as you add on some scale and new hires as well.

I think there is definitely opportunity to expand relationships and we recently expanded to a number of new ones. We're now looking at our second deals with many of those sponsors, and in the case of a couple of our larger relationships, our fifth or fourth deal. I really would like to concentrate our relationships to 10 or 20 top PE firms and get a true partnership and across their platform, rather than scatter it among many, many different relationships. I'm pleased with adding some of the new relationship we added which are fun sizes between 200 and 500 million primarily, really terrific relationships. I'm really pleased with adding them.

Thank you very much.

Our next question comes from David Chiaverini with BMO Capital Markets.

Good afternoon. Couple questions. Going to the SBIC, how much have you put into that? Did you put in $75 million of equity?

Yes.

Okay. And how much amortization are you structuring into new first lien loans?

That's a good question. I think one of the interesting things as you invest first lien in the platform is -- and concerns the private equity sponsors, is amortization. Amortize I think almost every first lien one stop loan we've been doing in the market. Steve's nodding yes, so it must be the right answer. We typically start amortization relatively low, on the order of 10%, or so and we ramp it over time. We want to give our sponsors a chance to grow the Company and use the cash for that purpose. But yes, we realize the importance of amortization in the A piece and each one of our loans has it.

So it's 10% the first year and then it ramps up and these are typically five year loans?

Well, I mean, 10% is sometimes, sometimes it's a little less, sometimes a a little bit more but that's a good rule of thumb to use for year one and these are all -- these are primarily if not all five year loans with a B piece that's a bullet and A piece that amortizes.

Okay. Great. And then I guess as a follow-up to the earlier question about the $1.2 million of excess undistributed income, is that why you elected to increase the dividend to $0.32 even though distributable income was $0.29, was to pay out that extra $0.03 per share?

We map our dividend over the year. The idea is to distribute back the cash that we receive, so even in a lot of the cases where there's PIK interest, there's amortization of the same securities so we're always getting the cash which the cash covers the dividend. As we approached the Board for the dividend a couple days ago, the discussion was around origination, closed deals, et cetera. As you know, the points upfront go into distributable income immediately, even though they're amortized over the life of the loan, is one effect of this.

The other thing is we are starting to see the early signs of recyclability and recyclability will create additional redistributable income. Get realized prepayment penalties, get realized in other things. Yes, accelerates income in the shower . The Board took a look at the forecast over the next four quarters and determined that $0.32 was an appropriate and yet conservative number which still allows us room to increase it further during 2010 if originations keep pace with our forecasts.

Okay. Thanks for the color on that.

Our next question comes from Jasper Birch with Macquarie.

Good afternoon, everyone.

Hi, Jasper.

Hi, how are you? Just to start off, I just want to make sure and think about this right. Sorry about that. My phone was off. Just to make sure I'm thinking about this right, you can transfer assets into the SBIC or do they have to be originated at the SBIC?

No, they need to be originated into the SBIC.

Okay. And then in terms of just looking at -- I know you guys are doing mostly floating rate or almost all floating rate assets right now and that totally makes sense, given that there's only one way for interest rates to go, but just looking down the road in terms of -- I mean, the SBIC funding is going to be fixed rate. How are you looking at running a matched book and locking in yields? Is that something you're considering or do you really like the floating.

With LIBOR near zero it's very difficult to think about LIBOR going down much. So all of our loans so far, or most of our floating rate loans have floating rate floors of three and the ability to hedge naturally against an increase in LIBOR makes a lot of sense. Fortunately on the way down, we did a lot of fixed rate loans. That protected us as LIBOR decreased and so now Fifth Street's positioning itself for the opposite, which is the eventual increase in interest rates and doing our book appropriately. Yes, you're right, the fixed rate leverage that the SBIC affords us provides additional protection as interest rates increase. But that should just be flow-through of earnings to our shareholders.

Okay. So there's -- so there isn't a meaningful higher yield on fixed rate assets right now?

Yes, we probably could capture a little bit more yield if we were fixing it versus floating it. But I think the prudent thing to do for the shareholders is to continue moving our floating rate assets and I didn't say it during our speech, but maybe I forgot to write it. But our target is to get floating rate assets to 50% of assets. So I think we're one quarter, we're 25% of assets so you should continue to see over the next couple of quarters, that number progress towards 50%.

Okay. Excellent. Just two more quick questions. I know you mentioned that your pipeline's about 90% first lien loans. Is that symptomatic of the entire market, that only fixed rate loans are getting done? Or is that really just the only deals that you're looking at?

You mean first lien?

First lien. Sorry about that.

I think -- this is also very interesting debate on the panel, but we certainly are seeing an active second lien loan market, mezzanine market, as well as a first lien one stop market. Our ability to commit a reasonably large amount of capital to the middle market, to the lower middle market is allowing us to capture premium pricing. And to capture and maintain really great partnerships with our private equity sponsors. So as long as that continues to be true, I'm really happy to continue primarily originating first lien one stop loans. But no, the market is seeing all sorts of different loans. I think the private equity sponsor in the general prefers less lenders than more. They've been burned on syndicated loans in the middle and lower middle market by syndicate members that may have been very difficult to deal with. So I think the fact that they can work with the trusted lender like us is their preference.

Excellent. And then just lastly, I know EBITDAs are going up in the portfolio, but looking at your leverage ratio. that you provide along with your investment ratings, looks like your leverage ratio is either flat or going up a little bit. Just wondering what exactly is going on there?

So the leverage ratio we provide for categories one, two and then three, four and five, the ones certainly did go up a bit but the amount of category ones went up a lot. Just in perspective. September 30th, 2009, our one rated securities had a fair value of $22.9 million. Today, they're $69 million. And category two has gone from $248 million to $368 million. So you've added a lot to the portfolio.

Category two is really probably the most relevant leverage ratio to look at as well as you should see three, four and five, anything really high should probably go into those categories. But category two at September 30th, 2009 actually went down from 4.34 leverage ratio to 4.29. Which is not really down. It's basically flat. And I think that's right. I think if the you watch the Fifth Street index which we publish monthly, it's a very good indicator across the portfolio of our EBITDA and EBITDA movement, so I encourage all of you to watch and monitor the Fifth Street index for changes in the middle market, lower middle market health, which is what we hope predicts.

And then is that -- is the leverage ratio, that's just the debt to EBITDA of the Company?

Yes.

And is that just quarterly or is that trailing?

Bill?

Quarterly.

Quarterly. Great. Thank you.

Our next question comes from Casey Alexander at Gilford Securities.

Hi, good afternoon. I was just wondering how many portfolio investments are now in category one and how many portfolio investments are in category five?

We don't disclose the amount of investments in one, two or three. We did disclose by the way in the Q as asked -- look, we try. We've endeavored. I think achieved in general to be one of the most transparent BDCs. We were asked to disclose our PIK -- our non-accruing PIK and non accrual securities, which we did disclose in the Q. We plan on disclosing each quarter. So those are the -- that's the only ones that we disclose, our underperformers.

Okay. That's all I have.

Thanks, Casey.

Thanks.

Our next question comes from Jim Ballan with Lazard Capital Markets.

Great. Thanks a lot. Say, Len, you described a -- doing what seems to be a very attractive environment that you're operating in right now. Which is consistent with our research as well. But can you talk to me a little bit about what you think your sort of biggest operating risk for the firm is right now? Is it credit quality of the portfolio? Access to capital? Lower returns on incremental investments? Going forward, what do you think of as sort of your biggest operating risk?

This changes on a quarterly basis. Now with EBITDA increasing, in general, and I would have said a quarter ago it was people, but the addition of two key people, which was Casey in September, and Rob in portfolio management, who is a Director at Alex Partners was key and one that we hadn't announced but will put out an announcement is the addition of Chad Blakeman in to Co-Head Underwriting and Chad's got 15 years' experience in credit quality and has managed over $1 billion in credit and is extremely terrific in process and credit underwriting. So we're pleased to have him. But so up until now I would have said people. I feel like the senior team is truly enhanced today.

So I think the biggest risk, what I continue to worry about every week is capacity versus demand. The simple supply and demand equation, where our private equity sponsors are coming to us with relatively large deals, between $30 million and $60 million we have to have the capital to satisfy their needs. And to the extent that we like the credit and it fits within our basic parameter of a sponsor deal with substantial equity with a good sponsor that we believe is top quartile and will be able to raise funds in the future.

If it fits those -- primarily fits those categories, we have to have the capital. So the balance is of course capital available versus capital demanded. And I think that's the biggest issue right now.

Okay. Seems to me you actually had a good amount of capacity between your credit lines an the SBA and cash on the balance sheet, so that's great. If that's the biggest one, that's terrific. Wanted to also ask a little about the $1.2 million in undistributed income. Is that just for this year? Does that include spillover from previous years?

It includes spillover from last year, because there was a number of deals that were originated as I highlighted in December, and a deal that closes December 31st is very difficult to be able to match your distribution plans to that. So a little bit of income spilled over from last year into this year.

Okay. Great. And just along those lines, your taxable or distributable income in the first two quarters of your fiscal year have been considerably higher than the GAAP income. Do you think that's something that will continue into the second half of your fiscal year?

I think you'll see distributable income start to catch up pretty quickly or exceed the dividend rate over the course of the year, especially as you see originations continue to ramp up quarter-over-quarter. As for net investment income, the issue with net investment income of course in the ramp stage as you well know is because the points up front are amortized over life of loan, it's a little bit of a trailing number. But over time, that certainly continues to go up.

Okay. Terrific. Thanks a lot, Len.

Our next question comes from [Aaron Zigonovich] with Ladenburg.

Hi, guys. Just wondering if you could talk a little about the credit quality. Looked like it improved somewhat this quarter, looked like you had -- I think you had three non-accrual PIK investments last quarter. That fell to two. You still have two on cash non-accrual. Just what you're thinking about the portfolio overall Just what you're thinking about the portfolio overall in terms of credit quality and do you have any that are at risk over the near term?

It's definitely an improvement. Only 5% of our securities are in categories three, four and five, and that's the lowest number it's been at since I can remember. In quite a while. The reason that we had one less non-accrual of course is we sold CPAC or primarily sold CPAC. We did receive a note. At the same time we received a note, the sponsor injected an additional $2.5 million of equity. So we feel very good about our last $1 million note. And in fact, that's rated a category two.

And yes, I think in general the credit quality is improving. I don't know that -- I think in the previous monthly newsletters I might have said that premier trailer, which is one non-accruing category five markdown approximately 50% security is currently undergoing an auction process, in which we're hoping for an additional equity investment in the restructuring of the second lien loan, so we're excited by that, and it's a good time to be doing that for that security and we recently placed our other payment non-accrual security which is Lighting by Gregory up for auction with Lincoln International, and book should be going out shortly. And that Company's improved nicely from the bottom and from the recession. So both of our payment non-accrual securities we're hoping for a restructuring in the next three to six months.

Helpful. Thank you. And then lastly, in terms of unfunded commitments that you have on the balance sheet, I think they increased a little bit. I'm assuming largely from new one stop investments. What are your thoughts on how big you want that to get and how to manage that risk going forward? I think it's about $35 million or around 8% of your portfolio right now. Just something that kind of sticks out as a potential area, folks start drawing that in the future.

So the unfunded commitments, first of all, it's diversified across -- I forget how many companies. Steve's saying 10 to 12 companies, and don't -- we can get back, if you really want the exact number, we can try to figure out what the exact number is. Over a number of conditions for sure. We monitor them closely. We monitor -- he says 13 now.

We monitor the companies closely and we watch what we expect to draw versus unexpected. There's a couple of them that frequently draw and pay back their credit lines. Most of them, these are unfunded revolvers that they just -- private equity firm feels more comfortable with an unfunded revolver. A few of them are secured by letters of credit really, backing up letters of credit or other things like that. So we pay close attention to our unfunded commitments and our expected draws against them and we have a nice history with the draws and expected draws and our ability to predict them.

Thank you.

I'm seeing no further questions on the phones.

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