Saratoga Investment Corp. (SAR) Q3 2008 Earnings Report, Transcript and Summary

Good day and welcome, everyone, to the GSC Investment’s third quarter fiscal 2008 financial results conference call. This call is being recorded. At this time for opening remarks I’d like to turn the call over to Chief Financial Officer, Mr. Rick Allorto. Please go ahead, Sir.

Thank you, Trisha. And thank you for joining GSC Investment Corp.’s third quarter 2008 earnings call. Before we begin I would like to read a brief statement. This earning call contains statements that, to the extent they are not resuscitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbour protection provided by the reform act. Actual outcomes and results could differ materially from the forecast due to the impact of many factors. We do not undertake to update our forward looking statements unless required by law. A replay of this call will be available 1:00 p.m. today through Friday, January 25th. Please refer to our earnings press release for details. The third quarter shareholder presentation is available in the investor relations section of website, www.gscinvestmentcorp.com. With that I would like to turn the call over to Tom Inglesby, CEO of GSC Investment Corp. Tom?

Thanks, Rick. I would like to thank everyone for joining us on this earnings call. We welcome the opportunity to speak with our investors and to discuss our financial performance. I will begin with an overview of the highlights for the quarter. I will then turn it over to Rick Allorto, our CFO, who will provide you with a more detailed review of our financial results. We are pleased with the results that we were able to generate during a quarter which featured especially challenging market conditions as loan prices approached their summer lows again in November. The market has been pressured by large new-issue transactions, year-end dealer selling, and decreased purchases at year end from non-traditional loan investors, such as hedge funds and mutual funds. In particular, loans with weak covenants and aggressive capital structures have been affected most significantly. Despite these conditions, we remain confident in the overall credit quality of our portfolio. The company’s adjusted net investment income for the quarter ended November 30th was $3.1 million or $0.37 per share, which was ahead of the consensus estimate of $0.36 per share. During the quarter the company had a $1.7 million realized gain on sales investments and net unrealized depreciation on investments of $3.6 million resulting in an adjusted net loss on investments of $2 million or $0.24 per share. At November 30th the company’s net asset value was $13.51 per share. Our net asset value has decreased approximately 2% from the prior quarter primarily due to unrealized changes in the market value of our investments. The company paid a dividend of $0.38 per share for the third quarter on December 3rd. Based on Yesterday’s closing price and our quarterly dividend payout, our stock has an implied annual dividend yield of approximately 14%. We were able to fund the entire quarterly dividend from net investment income. Additionally, on December 28th we declared a special dividend of $0.18 per share payable on January 28th, 2008. This special dividend is a partial distribution of realized capital gain. Since our IPL in March we have declared $1.16 in dividends through December. The dislocation in the credit markets was primarily responsible for a $2 million unrealized loss for the quarter. We carry our investments at fair value. While marking our portfolios at fair value may result in significant price volatility, we take comfort from the fact that our portfolio is primarily based on market and third-party valuation. As of November 30th the company’s portfolio consisted of $199.7 million in aggregate principal amount of investment. Of these, 17.5% of the assets are liquid, 18.7% are valued by an independent valuation firm, 30% are valued on market quotes, and 33.8% of these assets are illiquid. The company has 43 investments in 36 portfolio companies with a median investment size of $4.3 million and a median portfolio company exposure of $5.2 million. The portfolio was comprised of 14% first lean term loans, 42% second lean term loans, 23% senior secured notes, 14% unsecured notes, and 7% structure finance securities and equity limited partnership interests. The weighted average current yield is 11.8% with an average maturity of 4.7 years. Since the last quarter we have added two names to our watch list. We continue to be pleased with the construction and performance of the portfolio. Over 80% of the portfolio is in senior secured loans and notes. The credit market dislocation resulted in declines in most of the markets in which we source investments. The standard reports composites for loan prices recovered in October and early November only to again match the lows of July and August by the end of November. The composite price index ended the month of November at 94.7, which was below the August level of 95.6. Middle market loan activity has slowed since the credit dislocation. The occasional primary deals that have come to market have cleared, generally due to off-market demand from regional banks. During the quarter these loans were by and large being priced around LIBOR plus 375 to 400 basis points with modest up-front fees. The challenging credit markets have presented an increased number of investment opportunities spread in the secondary market, particularly in senior secured loans have widened significantly. During November, in order to take advantage of these widened senior secured loan spreads, we engaged an investment bank to structure and raise a collateralized loan obligation fund. This CLO priced on December the 21st and is expected to close by the end of January. The CLO provides us with an efficient structure to purchase a diversified pool of first lien senior secured loans which we think, on a risk adjusted basis, are attractive. The CLO will be approximately $400 million in size and GSC Investment Corp. will purchase all of the equity in the fund. GSC Investment Corp. will serve as Manager of the CLO and will retain all management fees from the CLO. In managing this fund, GSC Investment Corp. will leverage the competencies of GSC Group’s corporate credit group, a leading US CLO manager with 12 corporate investment vehicles under management, including seven CLOs. With that I will now turn the call over to Rick Allorto, our chief financial officer, to review our financial results. Rick?

Thanks, Tom. GSC Investment Corp.’s net income for the quarter ending November 30th was $1.1 million or $0.13 per share. Our adjusted net investment income was $3.1 million or $0.37 per share and our adjusted net loss on investments was $2 million or $0.24 per share. As of November 30th, stockholders equity was $112 million and we ended the quarter with a net asset value of $13.51 per share. Our total investment income for the quarter ended November 30th was $5.9 million and our total operating expenses for manager reimbursement for the quarter were $3.5 million. Our expenses consisted primarily of $1.4 million in interest and credit facility expenses, $855,000 in base management fees, $233,000 of incentive management fees, $384,000 in administrator expenses, and $643,000 in general and administrative expenses. On a quarter-over-quarter basis our expenses increased by $443,000, which is primarily attributable to services provided by our administrator. However, pursuant to the terms of the administration agreement, the company is required to reimburse the administrator until we achieve a certain asset level and, therefore, an offset has been recorded in the expense reimbursement resulting in zero impact on net income. Our incentive management fee is comprised of two components. First, equal to 20% of our total pre-incentive fee net investment income above a 7.5% annual hurdle rate, and a second equal to 20% of our net capital gains and net unrealized depreciation on investment. During the quarter we recorded $233,000 of incentive management fees related to the 7.5% hurdle rate and zero was recorded related to the capital gains incentive fee. Our manager has agreed to reimburse the company for operating expenses to the extent that total annual operating expenses exceeded an amount equal to 1.55% of stockholders equity. The expense reimbursement excludes base and incentive management fees and interest and credit facility expenses. For the quarter we recorded $674,000 in expense reimbursement based on our total estimated annual operating expenses. This includes the waiver of the $384,000 administrator expenses previously noted. For the quarter we had $1.7 million in net realized gains from the sale and redemption of investments and the fair value of our portfolio decreased by $3.6 million. As of November 30th we had borrowed an aggregate of $84 million under our credit facilities and had $22 million of undrawn commitments remaining. Subsequent to the third quarter, in December we consolidated our credit facilities and wrote off the remaining $296,000 of unamortized deferred financing costs. This is a non-cash charge. The consolidation of our financing facilities provides us with increased availability under the revolving facility, which is priced at commercial paper rate plus 70 basis points and does not expire until April 2010. On December 28th we declared a special dividend of $0.18 per share payable on January 28th. The special dividend is a partial distribution of the cumulative $3.1 million of realized capital gains through November 30th. The balance will be distributed as required under the BDC rule. This concludes my review of our financial results. I will now turn the call back to Tom for some closing remarks.

Thanks, Rick. I would like to recap briefly some of the points that we have made on this call. First, we continue to be pleased with the performance of our portfolio, particularly in this challenging credit market. Our adjusted net investment income of $0.37 per share exceeded analyst estimates. We were able to fund our quarterly dividends of $0.38 per share entirely from net investment income. Additionally, we had net realized gains for the quarter of $1.7 million. Through the end of November our cumulative net realized gains were $3.1 million or $0.37 per share. Second, we are pleased with the asset quality of our portfolio. We had 43 investments in 36 portfolio companies with a median investment size of $4.3 million. Over 80% of the portfolio consisted of secured loans and notes with an average yield of 11.8%. Third, we believe the challenging credit market will continue to present attractive opportunities for the company. Spreads remain attractive on a relative basis while covenants and terms on most fixed income investments continue to tighten. In particular, the CLO will provide us with an efficient structure to purchase first lien senior secured loans where the market dislocation has been the most severe. This concludes our remarks. Operator, we would now like to open the call to questions.

Thank you. (Operator Instructions). We’ll go first to Henry Coffey with Ferris, Baker, Watts. Henry Coffey – Ferris, Baker, Watts, Inc.: Good morning, guys. Congratulations on a strong quarter. A couple of questions. The realized, the unrealized losses that you reported, without pure just market-to-market adjustments against the syndicated loan bids or what was the source of those changes?

Henry, they were primarily market-to-market losses. There were a few companies that had slightly weaker results during the quarter and they had quotes of some sort in the markets which were lower and we marked them down to those quotes. We added two names to our watch list during the quarter. But the bulk of the, by far the largest portion of the market-to-market was reflected on the climb of the market in the latter of November. Henry Coffey – Ferris, Baker, Watts, Inc.: How do you stand in terms of how many companies you do have on the watch list and things like loans that are just delinquent or loans that are in default of significant covenants?

We have no loans we’ll not accrue. We have one loan which is in its grace period where we expect the loan to make its payment by the middle of January. But (inaudible) and they did not make the payment. We have three companies on our watch list. Henry Coffey – Ferris, Baker, Watts, Inc.: And that one loan that didn’t make your payment, you’re looking for a cheque this January?

Yes, yeah. We recently spent a significant amount of time with the company. They have an equity sponsor. We expect the equity sponsor to put money into the company. The company has a temporary issue with their costs and they expect it to be resolved. They expect the company to improve during the year. Henry Coffey – Ferris, Baker, Watts, Inc.: Now, the CLO, obviously that’s going to be a good way to deploy capital. Where does the cash for making that initial investment come from? The liquidation of current holdings or are you going to sell loans into the fund or how is it going to work?

I would say, speaking generally, we have been husbanding our cash during the end of the quarter to come up with the cash necessary to make the investment. Henry Coffey – Ferris, Baker, Watts, Inc.: And how much cash are you going to put into that? Approximately. Or how much, what is the size of your investment in this fund going to be?

When it closes it will be approximately $30 million and that will be in a portfolio that would have at least 100 investments or so. Henry Coffey – Ferris, Baker, Watts, Inc.: Excellent. Well, thank you. Good quarter and this new vehicle should help you grow a little bit more.

Thanks, Henry.

Again, that’s *1 for questions. We’ll go to Evan Marks with Aubin (sic) Asset Management. Mr. Marks, your line is open. Please check your mute button. Evan Marks – Aubin (sic) Asset Management: Yes. I’m sorry. Good job, fellas. Happy New Year. Question. With respect to the fees that will be earned from the new COO, who’s the beneficiary of the fees? Does it go directly to the manager or will the shareholders benefit from that as well?

It’s going to go to GSC Investment Corp. And it’s just like all the other income at GSC Investment Corp., we’re required to distribute our net income. This will be revenues of the company and whatever net income we generate after expenses in the company will be distributed to investors as pursuant to the structures of the BDC. Evan Marks – Aubin (sic) Asset Management: Thank you. In a follow up question from the previous caller, with respect to your equity contribution to the CLO, exactly what are the sources of funds to fund the 30, my recollection is that your cash, your current cash position was a little bit short of your required equity contribution.

We have been, sort of, I’d say optimizing our portfolio during November and December and coming up with cash to make this particular investment. There are some investments in the BDC which will be sold into the CLO, which we’ll be providing cash that way as well. Evan Marks – Aubin (sic) Asset Management: M-hm. Okay. Very good. And post closing, how much headroom do you anticipate having on your untapped credit facility?

Our objective is to be fairly fully invested. So we think we’ll be fairly fully invested. It’s kind of hard to give you a precise answer because we get unexpected pay downs from investments and the like, but generally speaking we’re structuring this so we can be fairly fully invested. Evan Marks – Aubin (sic) Asset Management: But all things remaining equal, you would imagine that you would pull down the remaining $20 million on the credit facility more or less in order to fund your investment in the new CLO?

We think we’ll be, we’ll be pulling down money from the credit facility in order to fund the CLO, along with disposition through the portfolio and along with contribution of assets for the BDC into the CLO. Evan Marks – Aubin (sic) Asset Management: Okay. And then operating your business, do you anticipating meeting a certain amount of residual untapped amount in the facility in order to deal with unanticipated events in the portfolio?

No. I don’t think we’re going to be completely fully drawn, although I hate to make a precise prediction, but we don’t envision any effect on the operations of our business portfolio for making this particular investment. Evan Marks – Aubin (sic) Asset Management: Okay. And the new CLO is going to be comprised exclusively or only partially of first and senior pieces of debt?

The CLO will be obligated to be at least 90% first lien senior secured investment. We’ll have a small bucket in which to purchase structured financial securities for smaller loans. Evan Marks – Aubin (sic) Asset Management: Okay. Listen, I reiterate my congratulations. Good job, guys.

Thank you very much. Appreciate it. Evan Marks – Aubin (sic) Asset Management: Thank you.

Once again as a reminder it’s *1 for questions and please make sure your mute function is turned off. We’ll next go to Elliott Burke with Ironsides (sic) Partners. Elliot Burke – Ironsides (sic) Partners: Yeah, hi. Thanks. I wanted to ask you about the debt part of your balance sheets. The credit facility. So following the reorganization of it post quarter, when does it mature, when do you need to renew it? I would basically, the point of my question is to kind of ask you how secure you feel about you’re funding in terms of the credit facility and where you’re going to go with that.

Sure, Elliot. We had two facilities. One was a term and the other was a revolver. We consolidated the term facility into the revolving facility and now we have a $100 million revolving facility and that revolver, the ability to draw on that revolver expires in April 2010. Elliot Burke – Ironsides (sic) Partners: And prior to April 2010, presumably you have certain covenants with respect to the credit facility. I assume you’re not, given that your financial performance, your share performance has been good, has been fine, I assume you’re kind of not (inaudible) any covenants on that? Is that fair to say?

That’s correct. Elliot Burke – Ironsides (sic) Partners: Okay. And so assuming that you don’t (inaudible) those covenants prior to April 2010, do you lenders have any ability to kind of pull that credit facility?

No, they do not. That is fully committed to the facility for that period. Elliot Burke – Ironsides (sic) Partners: Okay. So the next topic I wanted to ask you about was the CLO fund. When you launch this will you be consolidated this on your balance sheet to this count towards the debt equity limits for BDCs? How does that work?

For financials, for GAAP financial statement purposes, no we will not be consolidating it. It will show up as an investment. But just the equity piece will show up. Elliot Burke – Ironsides (sic) Partners: And will you have, how will your piece, will that be a minority of the equity of the CLO fund? Is that a fair characterization? What exactly does your investment comprise?

We’re putting up $30 million, which would comprise all of the equity. Elliot Burke – Ironsides (sic) Partners: Okay.

So the GSC Investment Corp. will receive all of the equity distribution, as well as all of the management fees from the CLO. Elliot Burke – Ironsides (sic) Partners: Okay. So that, why, given that you own all the equity, why don’t you need to consolidate that? Out of curiosity.

Those are the specific accounting rules as an investment company. The rules state that you do not consolidate your investment portfolio. Elliot Burke – Ironsides (sic) Partners: Okay. It’s considered kind of a portfolio company.

Yes, it is. Elliot Burke – Ironsides (sic) Partners: Okay. And similarly, I assume, it doesn’t count towards the two-to-one leverage rules for BDCs. Is that –

That’s correct. That’s correct. Elliot Burke – Ironsides (sic) Partners: Okay. Great. And so my last topic that I wanted to ask you about was, obviously the shares are well below book value now. You can’t issue shares below book value. You could presumably do a rights offering, but the share place is so low I would hope you wouldn’t do that. I’m kind of curious what your thoughts are with regard to capital, the capital situation, kind of where you go forward. The CLO fund will obviously help to a certain extent, but kind of where do you go from here with the shares where they are now?

We’re going to search for every viable way to raise capital under the rules established for BDCs, recognizing that shares cannot be issued under book value without the consent of the shareholders. And we’re going to do our best in the interim to optimize our dividends and increase it. Every investment decision we take, subject to risk appropriate standards, has been made with that in mind. Elliot Burke – Ironsides (sic) Partners: Okay. Would you consider, I mean, I’m curious of what your thoughts on selling shares where they are now. Would you, I mean, is that something – For me personally as a shareholder that’s not something I would look favourably even if it was done through a rights offering. Do you have any thoughts with regard to that?

Well, we want to make sure that anything we do is (inaudible) the investors. We discussed the issue and problem of our share being below book value with our board of directors right now and I’d say the consensus from everyone at GSC, including our board, is we’ve got to be very careful that anything we do is (inaudible). So by no means do we have any plans to do a rights offering. We’re certainly aware that they’ve been done in the past. If I thought a rights offering would be a (inaudible) then we could generate enough income from the investment (inaudible) book value then that’s something that we would theoretically consider taking to shareholders, absolutely. Elliot Burke – Ironsides (sic) Partners: Okay.

We absolutely expect any shareholder – and I’m a large shareholder myself – to ask and to demand that that investment be (inaudible). Elliot Burke – Ironsides (sic) Partners: And when you say shareholder consent, do you have to get specific shareholder approval for that? What do you mean by consent? Do you know the rules there? I’m not aware of whether you actually need to get shareholder approval. I think you probably just, I’m not 100% sure, but in the past I think people have just done rights offerings. Anyway, basically I’m happy you’re not planning rights offering. I’d definitely be strongly against it. The IPO is at $15 a share and the shares are $10 now. Even if there were rights offering people shouldn’t be thrilled with seeing more shares sold at $10. That would be a bad thing. So I would hope you wouldn’t do a rights offering. I guess actually I do have one more question. Do you, have you been blacked out with regards to insider buying since, say, early November? Because I haven’t seen any insider purchases since then and I’m a little bit curious. Will the window open up again? I would hope to see more insider purchases with the shares where they are now. Where does that stand?

Our policy that we have implemented is to have the trading window for insiders open for a two-week period shortly after we file our Q. We hope and expect the window will open next week.

I would also note that the manager of GSC Investment Corp., GSC, not all employees of GSC are listed as insiders to GSC Investment Corp. So the (inaudible) and substantial purchases by senior persons at GSC that aren’t part of GSC Investment Corp., that wouldn’t show up in the file. Elliot Burke – Ironsides (sic) Partners: Okay. That’s good to know. But I mean, there were some not insignificant purchases in early November and it looks very favourably on further insider purchases when the window is open. So thanks very much.

We’ll go next to Jim Shanahan with Wachovia. Jim Shanahan – Wachovia Capital Markets: Hi, there. Good morning. Thanks for taking my call. I apologize in advance. I did dial in late, so some of this may be repetitive. And I also am new to the story. But regarding your disclosure of watch list assets, just to be clear, you talked about there was a loan that’s in a grace period. Is that loan also one of your watch list assets?

No, it’s not. Jim Shanahan – Wachovia Capital Markets: Okay. And can you describe of the three loans that are on your watch list, and I don’t know if you’re in a position to identify those particular investments or if you’re more comfortable can you just talk about what kind of, what is the nature of their businesses and what, why the reason why they’re on the watch list?

Sure. There’s, one company is called Eurofresh (sic). It’s a senior note. There’s not, very little leverage ahead of it. They’ve had, they grow tomatoes, greenhouses. They’ve got operating issues and cost overruns. They’re coming up on their interest payment date and the senior note is quoted in the secondary market at a fairly significant discount to par. That said, we’re at a very attractive place in the capital structure in our judgement and the company, we understand the company to be taking steps, if possible, to make the payment. So we put it on our watch list not knowing whether or not they will go into default or not. We again think the notes are very attractively priced to retain their value under any one of various forms. Whether it’s buyer restructuring. Jim Shanahan – Wachovia Capital Markets: But that particular investment isn’t one that you’ve classed here as a senior secured bond, but you still feel good about where you are as an unsecured creditor?

We think we can have influence in the restructuring. If it were to go to a restructuring. And again, we don’t have any reason to think it will. We’re just an outside investor waiting to see what happens. What we know is the bond trades at a discount in the secondary market. Jim Shanahan – Wachovia Capital Markets: Okay.

Second company is a senior secured loan which has some potential liquidity issues and there’s possibilities they’re going to have to restructure as well. That’s a loan that’s quoted in the, I think quoted in the low 80s in the secondary market. Again, not know whether or not they’re going to make the next payment we think we’ve put that on our watch list as well. We think, again, we think we’re very attractively positioned in the capital structure if we have to go through a restructuring. On the third name, it’s just a very small position. Around $100,000 or so in an unsecured bond trading in the low 60s. Jim Shanahan – Wachovia Capital Markets: What is the size of the second investment that you identified?

Approximately $6.5 million at par. Jim Shanahan – Wachovia Capital Markets: Six-point-five million at par. And one final question, please. I appreciate your generosity with your time. What percentage of your total portfolio is quoted in the secondary market?

We did have that in our comments. Jim Shanahan – Wachovia Capital Markets: I apologize. I missed your comments.

That’s okay. Jim Shanahan – Wachovia Capital Markets: I can listen to the replay. That’s fine.

No, no, no. It’s ... 17.5% of the assets have liquid quotes and 34% of the, excuse me. Thirty percent of the assets have market quotes and then about 18% of the assets are liquid. So they’re quotes every day. So about half of it is quoted and then additionally we went ahead and had a third party give valuations for an additional 19% of the portfolio. So of the portfolio this time, close to half was quoted and close to two-thirds has some sort of third party valuation. Jim Shanahan – Wachovia Capital Markets: Thank you for that. A quick follow up. What can you say about the market volatility since November 30th? I mean, it’s about six weeks ago now. Have things gotten incrementally, are the bonds generally wider from that point among the names that you own?

No, the market has not recovered. It’s interesting, I would have thought anecdotally that the market has come, has gone even a little lower generally since the end of November, although the last S&P loan index that I saw stopped before Christmas and showed it flat to slightly off. So that’s not consistent with how I would have viewed the loan market since the end of November. Jim Shanahan – Wachovia Capital Markets: Okay. Thank you very much.

And once again as a reminder, *1 for questions. We’ll go next to John Ellis. Jonathan Ellis – Merrill Lynch: Hello?

Hi, John. Jonathan Ellis – Merrill Lynch: Hi. Concerning the CLO fund, once it’s up and running what kind of overall leverage for the company do you expect?

The investment is not consolidated at BDC. Jonathan Ellis – Merrill Lynch: Yeah, I understand it’s not going to count in the one-for-one limitation. So that’s my question.

Is that your question? Jonathan Ellis – Merrill Lynch: My question is what’s your overall leverage going to be once this is up and running?

The CLO will have about $400 million of assets and the equity investment that we’re providing is about $30 million. Jonathan Ellis – Merrill Lynch: Okay. All right. I can figure that out. Now that you’re husbanding cash, where is that coming from to set this CLO up?

We had some redemptions and we’ve been able to take some assets from the BDC and sell it into the BDC CLO. Jonathan Ellis – Merrill Lynch: Is this affecting the funds that you’re required to pay out eventually to shareholders?

Not at all. Also, we were careful about draw down on our portfolio the beginning of November, particularly as the market became less liquid and didn’t (inaudible), so we have some availability on our credit ability as well. Jonathan Ellis – Merrill Lynch: Right. Have you given any dividend at guidance?

We have not given dividend guidance. Jonathan Ellis – Merrill Lynch: Okay. So will you give any dividend guidance? And if so, when?

At this time we’re not prepared to give dividend guidance. Jonathan Ellis – Merrill Lynch: Okay. Thanks. I’m pleased. I’m waiting. Thank you.

Thank you.

And again, *1 for questions, please. And gentlemen is appears we have no further questions at this time.

Ladies and gentlemen, thank you again for joining us on this call. Please feel free to contact us if you have any questions. We look forward to seeing you on our next call.

Thank you, ladies and gentlemen, for your participation. This does include today’s conference call. You may disconnect now any time.