Oaktree Specialty Lending Corporation (OCSL) Q2 2010 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fifth Street Finance Corp. Second Quarter Earnings 2010 Call. [Operator Instructions] At this time, I would now like to turn 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 31, 2010. I have with me this afternoon Leonard Tannenbaum, CEO; Bernard Vernon, 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 5 Press Release and is posted on our Web site. Please note that this call is the property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call of any form is strictly prohibited. Before we go into our earnings, I'd like to call your attention to the customary 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 that you refer to our most recent filings with the SEC for important factors that would cause actual results to differ 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 Web site or call Investor Relations at 914-286-6811. 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 up 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 investments 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're also witnessing the fast ramp in mergers and acquisitions activity that we've forecasted in the past few months. As both strategic investors and private equity firms increase their activities, we expect loan demand in the 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 successfully renegotiated our ING commitment, which Brian 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 to our SBA facility. We hope to make several announcement in this regard in coming months. Despite recent IPOs in the BBC sector, there continues to be a limited amount of our competitors that can complete a transaction for private equity sponsors without any syndication risk and with whole 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 the credit lending have allowed us to largely refinance out of CPAC. 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 a enhanced our ability to monitor and manage the existing portfolio. I am pleased to report that categories three, four and five rated securities account for only approximately 5% of the portfolio. Our second fiscal quarter ended as of March 31, 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 the movement of a bill in Congress that if passed will hopefully expand the capacity of our SBIC 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 highlight in our recent monthly newsletters. We were fortunate that currently, 75% of our portfolio took advantage of a higher risk return environment as we were one of the few BDCs that have 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 anytime, 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 the substantial increase in interest rates over the coming years. All of the deals so far closed since March 31 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 timeframe, as SBA securitizations tend to occur about twice a year, in March and September. We will continue to use financing partners to provide diversification of the portfolio. Our pipeline of loans remain 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 that 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've exceeded our goal that we set last year of having 65% to 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 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 2/3 first lien and 1/3 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 which we 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 in 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've 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'll now hand the call over to our President, Bernie Berman.

Thanks, Len. We were very pleased that our SBIC subsidiaries received its license from the SBA as of February 1. We also received the leverage commitment from the SBA in the amount of $75 million. After we invest 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 3. 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 at our drawn leverage at a rate of LIBOR plus 30 basis points per annum plus applicable fees. The most recent coupon on SBIC pool 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 still 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 but we expect to have assets 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 is terminated. We did this because the deal with 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 had originally negotiated. We expect the 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, Will Craig.

Thanks, Bernie. With respect our balance sheet as of March 31, 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 $40.1 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 depreciation of $1.2 million and $2.9 million of realized loss. For the three months ended March 31, 2010, we recorded net unrealized depreciation of $2.2 million and $2.8 million of realized loss. For the quarter ending 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 31, 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 an interest at floating rates. Again, as Len previously noted, the percentage of our debt portfolio for floating rate 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 ending March 31, 2010, we invested $33.2 million across one new and five existing portfolio companies. With respect to our ratings at March 31, 2010, the distribution of our debt investments on the one to five scale rating at fair value was as follows: The percentage of one in two rated securities for the quarter ended March 31, 2010 was 94.9% in comparison to 93.3% as of December 31, 2009. We are closely monitoring all of our investments and continue to provide managerial assistance as proactively as possible.

Thanks, Bill. As a reminder, for the month that Fifth Street does not report quarterly earnings, we generally release a monthly newsletter. If you'd 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@fifthstreetcaps.com. Alternatively, e-mail alerts can be set up through the shareholder tool link under the Investor Relations tab on our Web site, www.fifthstreetfinance.com. Thank you for participating on the call. I will now turn it over to Joe to open the line for questions.

[Operator Instructions] Our first question comes from Greg Mason with Stifel, Nicolaus. Greg Mason - Stifel, Nicolaus & Co., Inc.: 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 amounts. Can you give us an update on where you are for that remaining amount of debt capital?

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. That leaves $20 million more available to us at this moment. And 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.

And that was Bernie. This is Len. I just wanted to add to that we asked the SBA to move the timetable in the report review, and they were very accommodative by allowing us to be reviewed at the end of June. So we appreciated that. Greg Mason - Stifel, Nicolaus & Co., Inc.: 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?

I just sat on a panel at ACG InterGrowth that in conjunction with a number of other lenders, senior lenders, junior lenders, et cetera that were top in our space 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 as the investment banks basically, especially the middle-market investment banks, almost at capacity. In terms of new deals, books out, etcetera. So I'm keeping closely abreast of the market from all the other CEOs from 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&A 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's a healthcare bill with potential tax increase to the rich, we saw at December approximately $150 million in signed term sheets, which we closed all of those deals. This fourth quarter could be multiples of that. Greg Mason - Stifel, Nicolaus & Co., Inc.: So as you're kind of thinking about you 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 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 we need 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 of our credit lines at a reasonable bond costs. And access in the next quarter to the SBA to the balance of or 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.

Our next question comes from Chris Harris with Wells Fargo.

Taking a look at some of 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 remainder of the year or do you think it might get pressured somewhat as more competition heats up?

Weighted average yields of the new deals was almost over 13 3/4%, with the cash yield of approximately 13%. So we're actually really proud that weighted average yields really held up very well. As I've 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 that all of 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 the 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 was 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 is still is valued by the private equity firms.

In the past you've 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 is that kind of gone away?

The bank that came into our market, I asked the panelist that I was on the panel with yesterday, has certainly taken a step back from their aggressive postures. But there's definitely other players in the market. Look we've operated in the 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 were able to achieve pricing in excess of 200 basis points I think we were able to get today. You can see that by the very good pricing of our December deals. But however, I still think we're in a normal market, and this is a market we're very used do with competitors we're very used to competing against. Right now, we're not seeing any rational players in the market, and that's a good sign.

Shifting gears back to the SBA here for a minute. Bernie, it's 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 pick up the phone and call them or do you have to go through some detailed, lengthy application process? Maybe you can just 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.

Can you guys remind us what your excess distributable income was as of the end of this quarter?

In terms of dollars or expense per share?

Either would be fine.

We're looking up the number here. We're actually under distributed by about $1.2 million.

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

Leonard 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's 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 deal or fourth deal. I really would like to concentrate our relationships to 10 or 20 top PE firms and get a true partnership across their platform rather than scatter it among many, many different relationships. So I'm pleased with adding some of the new relationships we added which are fund sizes between $200 million and $500 million, primarily, are really terrific relationships and I'm really pleased to have added them.

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

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

Yes.

How much amortization are you structuring into new first lien loans?

I think one of the interesting things as you invest first lien in the platform and concerns the private equity sponsors is amortization. I think almost every first lien one-stop loan we've been doing the market. Steve's nodding yes so that 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 yet we realize the importance of amortization in the APs 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, a little less, sometimes, a little more. But that's a good rule of thumb to use for year one. And yes, these are primarily -- it's not all five-year loans. With a BPs that's a bullet and APs that amortizes.

Just as a follow 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 just to pay out that extra $0.03 per share.

We've mapped 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 in 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 of days ago, the discussion was around origination, closed deals, etcetera, because as you know, the points up front go into distributable income immediately even though they are amortized over the life of the loan is one effect of this. And the other thing is we are starting to see the early sign of recycle-ability and recycle-ability will create additional distributable income as well as exit fees which we really to date have not recognized much of get realized prepayment penalties, get realized in other things. Which yes, accelerates income in the short term but also really accelerates distributable income. So the board took a look at the forecast over the next four quarters and determined that $0.32 was a appropriate and yet conservative number, which still allows us room to increase it further during 2010 if originations keep pace with our forecasts.

Our next question comes from Jasper Birch [ph] with Macquarie.

Just to start off, I just want 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?

They need to be originated at the SBIC.

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 the SBIC funding is going to be fixed rate, how are you looking at running a matchbook and locking in yields? Is that something that you are considering or do you really like the floating rate play right now?

Look with LIBOR near zero, it's very difficult to think of LIBOR going down much. So all of our loans so far or most of our floating rate loans have floating rate loans 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 is positioning itself for the opposite, which is an eventual increase in interest rates and doing our book corporately [ph]. 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.

So there isn't a meaningful higher yield on fixed rate assets right now?

Yes, we probably could capture a little 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 or 25% of assets. And so you can continue to see over the next couple of quarters that number progress towards 50%.

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?

We certainly are seeing an active second lien loan market and 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 and to 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 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 a trusted lender like us is their preference.

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. It looks like your leverage ratio is either flat or going up a little bit. I'm 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 one certainly did go up a bit but the amount of category ones went up a lot. Just in perspective at September 30, 2009, our one rated securities had a fair value of $22.9 million. Today, they're $69 million. And category two has gone from a 248 to 368. So you've added a lot to the portfolio. Category two is 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 30, 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 you watched 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 it we hope predicts.

Is the leverage ratio is just that's the EBITDA?

Yes.

And is that just quarterly or is that trailing?

Quarterly.

Our next question comes from Casey Alexander at Gilford Securities.

I was just wondering, how many companies, 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 and we've endeavored and I think achieved, in general, to be the one of most transparent BDCs. We were asked to disclose our non-accruing PIK and non-accrual securities which we did disclose in the Q. We plan on disclosing each quarter. But that's the only ones that we disclosed. Our under performers.

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

Len, you described 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, 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 are in a quarterly basis, right? Now with EBITDA increasing, in general, and I would've 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 was a director at AlixPartners, was key. And one that we hadn't announced but we'll put out an announcement is the addition of Chad Blakeman into co-head underwriting. And Chad's got 15 years experience in credit quality and has managed over a billion dollars in credit and is extremely terrific in process and underwriting. So we're pleased to have him. So up until now, I would have said people. I feel 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. It's 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 and 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. And so if it 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.

You actually had a good amount of capacity between your credit lines and the SBA and cash in the balance sheet. So that's terrific. I wanted to also ask about the $1.2 million undistributed income. Is that just for this year, or does that include spillover from previous year?

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 31, it's a difficult to be able to match your distribution plans for that. So a little bit of income spilled over from last year into this year?

Just along those lines. Your taxable or distributable income in the first two quarters of your fiscal year have been considerably higher than the GAPP income. Do you think that's something that will continue into the second half of your fiscal year?

I think you'll see the 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.

Our next question comes from Arren Cyganovich with Ladenburg.

I was wondering if you could talk about the credit quality. It looked like it improved somewhat this quarter. Looked like you had and again three non-accrual PIK investments that fell to two and still have two on cash non-accrual. 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 when only 5% of our securities are in categories three, four and five. And that's the lowest number it's been since I can remember. It's been quite a while. The reason that we had one less non-accrual is of course is we sold CPAC or primarily sold CPAC. We did receive a note. At the same time, we received a note the equity sponsor injected an additional $2.5 million of equity. So we feel very good about our last $1 million note and that's rated a category two. And yes, in general, the credit quality is improving. I don't know that -- I think in the previous monthly newsletters I might've said that Premier Trailer, which is one non-accruing category five, marked down approximately 50%. Security is currently undergoing an option 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 books 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.

And 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 a around 8% of your portfolio right now. Is this something that kind of sticks out as a potential area of focus for drawing that in the future?

Steve's saying 10 to 12 companies. If you want the exact numbers, we figure out the exact numbers but over a number of companies for sure. We monitor them closely. He's saying 13 now. We monitor the companies closely and we watch what we expect to draw. Look there's a couple of them. It's frequent we draw and pay back their credit lines. Most of them these are unfunded revolvers that they just feels more comfortable than unfunded revolver and some of the -- a few of them are secured by letters of credit, or backing up letters of credit or or things like that. So we pay close attention to our unfunded commitments and are expected draws against them and we have a nice history with the draws and expected the draws and the ability to predict them.

I'm seeing no further questions on the phones.

Thank you, everyone, for attending on a Friday afternoon. We better not have future calls on Friday afternoons. That wasn't the intention. But ACG InterGrowth which is our largest conference was a primary reason for being on a Friday afternoon and we look forward to continuing to execute and follow our policy of promise and deliver. So thanks for attending.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone have a great day.