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Edited Transcript of GARS earnings conference call or presentation 9-Mar-17 8:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 Garrison Capital Inc Earnings Call

New York Mar 9, 2017 (Thomson StreetEvents) -- Edited Transcript of Garrison Capital Inc earnings conference call or presentation Thursday, March 9, 2017 at 8:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joseph Tansey

Garrison Capital Inc. - CEO

* Mitch Drucker

Garrison Capital Inc. - Chief Investment Officer

* Brian Chase

Garrison Capital Inc. - CFO

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Conference Call Participants

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* Brian Hogan

William Blair & Company - Analyst

* Christopher Testa

National Securities - Analyst

* Allison Taylor Rudary

Oppenheimer & Co. - Analyst

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Presentation

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Operator [1]

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Welcome to today's Garrison Capital Incorporated fourth-quarter ended December 31, 2016 earnings call. For the fourth quarter ended December 31, 2016, earnings presentation that we intend to refer to on the earnings call, please visit the Investor Relations link on the homepage of our website at www.GarrisonCapitalBDC.com and click on the fourth-quarter Events.

As more fully described in that presentation, words such as anticipates, believes, expects, intends, and similar expressions identify forward-looking statements. Actual results could differ materially from those implied or expressed in our forward-looking statements for any reason and future results could differ materially from historical performance. You should not rely solely on the matters discussed in today's call as the basis of an investment in Garrison Capital. Please review our publicly available disclosure documents for further information on the risks of an investment in our Company.

Questions will be taken via the phone during the Q & A session at the end. It is now my pleasure to turn the webcast over to Mr. Joseph Tansey, CEO. You may begin.

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Joseph Tansey, Garrison Capital Inc. - CEO [2]

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Thank you. Good afternoon, everybody. Thank you for joining the call. I'm joined by Brian Chase, our Chief Financial Officer; and Mitch Drucker, our Chief Investment Officer.

On Tuesday evening, we issued our earnings report and press release for the fourth quarter and full year-ended December 31, 2016. We also posted the supplemental earnings presentation to our website which is available for reference through out today's call.

Following my broader comments, Mitch will highlight our investment activity during the quarter and discuss the portfolio in greater detail. Brian will then discuss our financial performance before we open up the lines for Q&A.

During the fourth quarter, our portfolio again suffered modest losses which resulted in book value decline of approximately 1% or (inaudible) cents per share. Decline of book value can be attributed to two credits that Mitch will discuss in greater detail, which took turns for the worse during the quarter.

We are growing closer to a resolution of a handful of legacy assets outlined on previous calls. Mitch will touch on a couple of these positions and will remain optimistic around recovery consistent with our current valuation expectations.

Our rigorous asset management and work out platforms will help yield the best possible conclusion to these situations. However, we remain confident in the credit stability of the rest of our portfolio. We saw some broad appreciation in value as a result of tighter credit spreads in the market.

With regard to new origination landscape we continue to focus on quality and have been selective in determining which new deals to pursue during the fourth quarter. Both existing positions and new opportunities we are focused on enhancing shareholder value and committed to providing consistent returns for 2017.

I'll now turn it over to Mitch who will provide additional color on the loan market and our activity during the quarter.

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Mitch Drucker, Garrison Capital Inc. - Chief Investment Officer [3]

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Thanks, Joe. Overall loan volume remained weak due to a number of challenges confronting the market. New acquisition financings in our marketplace continued to be lower than historical levels.

[Sponsors excited] a combination of uncertainty heading into the election and a disconnect with sellers on valuation. These trends are consistent with those in the broader leverage finance market. At the same time, a number of existing and new managers have raised private lending funds focused on the middle market as investors search for yield premiums.

While most of the new funds being raised have targeted the upper middle market, liquidity trickled down to the lower middle market in search of deal flow. This dynamic has lead to more aggressive structures coupled with tightening spreads.

As a result of these factors, deal flow in our pipeline, and those consummated by our competitors, do not meet our risk-adjusted return hurdles. These conditions have persisted into the first quarter of 2017.

With reduced yield premiums for lower middle market deals, we have currently experienced better relative value in the upper middle market. We consider the upper middle markets to be companies that borrow between $100 million and $300 million. These deals can either be clubbed up or syndicated by the arranger.

Four deals closed in the fourth quarter and first quarter to date have fallen into this size range. While yields on these deals are lower than our historical averages, we view this business as more prudent in the current environment. We anticipate that as overall deal activity picks up as election uncertainty fades, we will once again see solid opportunities in the lower middle market with enhanced deals.

We will continue to take a cautious and selective approach to the market. While the market is anticipating a prolonged economic cycle, we've incorporated the potential for a recession into our valuation of all new opportunities. We will focus on investments in stable and mature industries with solid sponsors and structures.

One of the virtues of sourcing in the lower middle market is that it is inefficient and fragmented. Our SBIC license, lower fee structure and reduced dividend level, which Brian will discuss, will afford us the flexibility to pursue higher quality deals and tighter pricing levels. We are also well positioned to capitalize on sporadic volatility, which typically leads to opportunities in larger club transactions, rescue financings and attractive S-based lending situations.

New purchases and portfolio add-ons totaled $18.6 million for the fourth quarter, this consisted of two sponsor deals and both were classified as core loans. The weighted average yield of the upper middle market deals was 8%, this is below our historical averages, but at the high end of deals priced in the upper middle market. These deals both had a concentration of alternative lenders in lending syndicate.

The first situation entailed a term loan refinancing for a manufacturer of branded filtration and ignition replacement products sold into the light vehicle aftermarket. The second deal was an acquisition term loan for a provider of data migration software to large quantity conversions and infrastructure optimization. Both of the transactions were first lien deals bringing the overall percentage of first lien deals in the portfolio up to 97%. A brief description of the two deals can be found on page 4 of the presentation.

Additions to the quarter were offset by $42.8 million of repayments during the quarter, with an average weighted yield of 11.5%. Approximately $9 million of repayments were due to the sale of transitory positions. Transitory assets consist of purchases made in the liquid secondary market with our excess liquidity.

As spreads have tightened, we realized overall gains on the sale of these positions. Transitory assets at quarter end totaled $9.9 million.

Another $25 million came from full repayments including prepayment and exit fees on three core accounts. These three accounts had yields of 12% or higher. Two of the accounts were refinanced in the aggressive market and the other was a sale of a business which led to the full payout of our only mezzanine position.

The balance of repayments came from normalized amortization and excess cash flow repayments. While we expect further repayments in Q1 due to aggressive market activity, additional repayment and exit fees are expected to accompany these repayments.

Softness in volume for the period led to a reduction in assets quarter over quarter. The weighted average yield on the remaining portfolio is down slightly to 10.9%. We will continue to remain focused on portfolio retention by servicing our clients' needs through acquisition financing support, or rate accommodations when justified.

I'd like to take a few minutes now to discuss the credit quality of our portfolio. Of the four situations that have led to credit losses over the last year, only one of the four -- Forest Park San Antonio -- remains on nonaccrual status.

During the quarter, we added one of our energy deals to the nonaccrual list and nonaccruals as a percentage of fair value now stands at 2.5%. While this is an increase from the previous quarter, it is down from a peak of 5.9% at the end of Q4 2015. In addition, in Q4 2016, we marked up the fair market value of certain loans whereby performance has improved or spreads in purchase positions have tightened.

Net incremental realized and unrealized losses totaled $2.1 million for the quarter. Negative credit-related adjustments on the energy position put on non-accrual status totaled $3.2 million, and a write-off of our speed commerce equity position totaling $1.7 million drove the increase.

The energy investment was made to an exploration and development company that had experienced a decrease in value in gas-related production reserves over time. Prior to year-end, the Company had several third parties interested in contributing capital to the Company. The position was written down to liquidation value, as prospects for an outside capital raise fell away at year-end.

Direct energy exposure now includes three deals representing 5.2% of our total investments at fair value. Of the remaining two energy loans, one is an exploration and development company that has a valuable countercyclical plugging and abandonment services business which hedges its overall operating performance. The other is a manufacturer of piping for the energy markets and the loan is fully collateralized with cash and other current assets. This position was marked up to par during the quarter due to a pending repayment.

Speed commerce equities marked down in the fourth quarter to reflect continued revenue decline and slower than expected turnaround to profitability. These losses were offset by aggregate positive market related adjustments of $2.8 million, primarily driven by tightening spreads and positive fair value adjustments on our syndicated loans.

Leverage of the remaining portfolio, after removing the nonaccrual credits, decreased slightly to 3.6 times debt to EBITDA. On the whole, leverage levels for our portfolio remain materially below those in the upper middle and broadly syndicated market.

We utilized a risk rating system that reflects the quality of the balance of our portfolio. A risk ratings range from one for our highest rated companies, to four for the lowest rated. The weighted average risk rating, excluding nonaccruals, showed a decrease in risk to 2.59 times from 2.56 in the previous quarter.

New loans booked during the quarter were booked at ratings of two and three respectively. A combination of credits repaid during the quarter averaging 2.63 and upgrades on credits expected to be repaid in the first quarter of 2017 drove the slight improvement.

Market conditions for new business in the first quarter of 2017 remain challenging. The supply of new loans in the marketplace has remained muted while there has been an increase in liquidity from robust fund raising in a direct lending space. With the election season over and market optimism over anticipated fiscal stimulus, we do expect to pick up in overall loan activity over the coming months.

Our investment focus will continue to be in the sponsor arena, with groups with which we have executed repeat business or have strong relationships. As economic conditions remain fragile in the US, and aggressive loan structures permeate the market, we will be selective and pursue only those deals with reasonable leverage levels and solid business prospects.

Now I'd like to pass the discussion to Brian Chase, our CFO.

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Brian Chase, Garrison Capital Inc. - CFO [4]

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Thanks, Mitch. Our fourth quarter net investment income was $0.31 per share and net income was $0.18 per share. This marks the first quarter where we had positive net income since the second quarter of 2015. We've announced a first quarter dividend of $0.28 per share payable on March 30, 2017.

We continue to manage through a couple of legacy restructuring situations, the majority of which we hope to conclude over the next quarter. We are eager to finalize these and provide visibility into their implications for book value. While we aren't in a position to publicly speculate on the resolution, we believe that the current markets reflect the range and probability of likely outcomes which may result in increase or decrease to our current book value.

It is worth reiterating since our last call that we expect net investment income to out earn the dividend over the course of the year due to the remote chance that we earn any meaningful incentive fee in 2017. Any earnings above and beyond net investment income will build book value and can serve as an offset if any of the restructurings resolve themselves below our current marks. We continue to have ample liquidity to originate and invest in new opportunities, given the robust pace of loan repayments and the unfunded capacity in both the SBIC subsidiary and the CLO revolver.

I'd now like to open up the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions)

Your first question comes from the line of Brian Hogan with William Blair.

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Brian Hogan, William Blair & Company - Analyst [2]

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Good afternoon.

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Joseph Tansey, Garrison Capital Inc. - CEO [3]

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Hi, Brian.

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Brian Hogan, William Blair & Company - Analyst [4]

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My first question is, do you -- in relationship to your portfolio growth, quite frankly, you mentioned you have a lot of repayments and expect a lot of here in the first quarter? And obviously with competition in your lower middle market being challenging, do you intend, or is it your expectation rather, to grow the portfolio in 2017, given all that's going on?

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Joseph Tansey, Garrison Capital Inc. - CEO [5]

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I think we're going to be patient, but yes, I do think markets like this, in our experience, will ebb and flow and you had a real dry-up in M&A of volumes particularly for the sponsors at the same time you had a bunch of new entrants. I think the M&A will pick back up, it feels like.

The pipeline is rebuilding a bit and so I do think that there's actually a better time for better deal flow in -- I'm not going to say it's going to happen today or tomorrow, but over the next six to nine months, certainly we think things will pick up.

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Brian Hogan, William Blair & Company - Analyst [6]

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And the yields -- since you're going a little more larger upper middle market, you said in the quarter the two would put on about 8% yields? Is that what we should expect going forward for replacement so we have a major headwind from the asset yield perspective?

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Joseph Tansey, Garrison Capital Inc. - CEO [7]

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Well I think as Mitch mentioned in his comments, you'll see a mixture of the lower middle market with a little bit higher yield in some of the club situations. So I think the club situation has been, we felt, the best opportunities we saw recently, and you have an increase in that in the mix. But I wouldn't say that's going to exclude the lower middle market deals we expect to see as well.

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Mitch Drucker, Garrison Capital Inc. - Chief Investment Officer [8]

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We were seeing and experiencing deals in the lower middle market that went off at 7% to 8% yield. Whereas in 2014 and 2015, we're booking these sales at 9% to 10%. And now with yields coming down, we experienced lower quality deal flow in general -- like the terms, the structures have gotten very aggressive and some of the business in the lower quality deals where you have industry issues or high loan to values, just didn't make sense for us in the lower middle market. So we saw the better relative value in the upper middle market, as Joe said.

Larger deals tend to be lower loan to value. And some of these credits were nuanced credits, where because maybe it was an industry, or some inconsistency in earnings, we were able to get premium pricing -- but by and large, it was still a lower loan to value situation and a Company that was more marketable regardless of economic conditions.

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Brian Hogan, William Blair & Company - Analyst [9]

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Sure, and you have, if I heard you correctly, about $10 million left of transitory assets? And in addition you have $10 million in unrestricted cash on the balance sheet, giving you $20 million of capital that can lever? What is your appropriate leverage target at this point, given your shift to senior loans and upper middle market and whatnot?

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Brian Chase, Garrison Capital Inc. - CFO [10]

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The total liquidity is around $90 million, because we have fully equitized the SBIC subsidiary as well, so it's another $35 million. We have some cash sitting in the SBIC that we can utilize, we have the transitory assets, we have some cash in the CLO, and we actually an unfunded revolver in there. So we have a lot of liquidity we can put to work over the next year or so.

And in terms of the leverage levels, I think we're appropriately levered right now from a regulatory perspective. I don't think we would be pushing this a lot further. It can go up and down a little bit, maybe we would bring it up a little bit in anticipation of a payoff or something like that happening.

And then obviously the SBIC -- we feel comfortable utilizing all that leverage from a risk management perspective. Obviously that doesn't count towards the regulatory calculation.

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Brian Hogan, William Blair & Company - Analyst [11]

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What was the lost fee income from the nonaccruals -- or lost interest income, I should say?

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Brian Chase, Garrison Capital Inc. - CFO [12]

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Well there was a write-off of interest on the Badlands asset that was around $0.10 or $0.11, but that was accumulated over time. And then sort of on a go-forward basis, obviously we expect that asset is not going to hang around for a very long time. So eventually it will turn to cash and get redeployed.

However, while it is hanging around on nonaccrual, our estimate is $0.03 per quarter.

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Brian Hogan, William Blair & Company - Analyst [13]

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For Badlands?

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Brian Chase, Garrison Capital Inc. - CFO [14]

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For Badlands, correct.

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Brian Hogan, William Blair & Company - Analyst [15]

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And then for the Forest Park San Antonio?

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Brian Chase, Garrison Capital Inc. - CFO [16]

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Forest Park is de minimis -- it's been on nonaccrual for a while. I don't have the calculation, I'd be surprised if it was more than $0.01 or so.

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Brian Hogan, William Blair & Company - Analyst [17]

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And then the status of Forest Park?

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Joseph Tansey, Garrison Capital Inc. - CEO [18]

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There's a new advisor who was hired to sell the entire hospital. That process was officially re-launched at the beginning of March. So we expect to see a resolution, reasonably quickly. As to the previous process -- it [kind of failed].

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Brian Hogan, William Blair & Company - Analyst [19]

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And what are your expectations to get -- obviously you have it marked at where you have it marked, but is that what you're expecting?

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Joseph Tansey, Garrison Capital Inc. - CEO [20]

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That's what we have been expecting from conversations with the advisors, so we will -- obviously we feel it's reasonable.

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Brian Hogan, William Blair & Company - Analyst [21]

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Thank you for your time.

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Joseph Tansey, Garrison Capital Inc. - CEO [22]

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Thank you.

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Operator [23]

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Your next question comes from the line from Christopher Testa with National Securities.

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Christopher Testa, National Securities - Analyst [24]

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Good afternoon, guys, thanks for taking my questions. Just curious, with the deals you're seeing in the upper middle market, what you're seeing in terms of the covenants and cash flow sweeps available on those deals? And if you could provide detail what you're seeing broadly in the market and the deals you're taking on? That would be great.

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Mitch Drucker, Garrison Capital Inc. - Chief Investment Officer [25]

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The deals that we are participating in are not the ones you're seeing in the broadly syndicated market, where it's extremely tight pricing and covenant light. These tend to be $100 million to $300 million deals. So they're catering, to some extent, to the club market. Maybe it has some institutional money in there, but whatever reason, their nuanced credits -- as I said they aren't drawing full CLO participation.

There could be an industry reason, or some inconsistency in earnings, but we feel that based on the quality of the deal, it's still low loan to value. These deals that we're in we feel are less than 50% loan to value. We've hit the sweet spot on the size range where it's trading at a premium to what you're seeing in the broadly syndicated.

You're anywhere between 6.5% and 8%, they tend to be sponsored deals, they are larger more saleable companies. And in a number of them, we know the sponsor pretty well because we've done deals with them. So we are able to get very decent allocations when they distribute the deal to the market.

But overall what are we seeing in the market, yes, that follow-up question. We're seeing intense competition. That's why we are very selective and cautious. The sponsor business has been down overall in the market.

There's a ton of liquidity in the market due to the fundraising and some of that liquidity has trickled down into the lower middle market. So that's led to tightening at levels we feel just doesn't make sense. And we said, we aren't going to chase that on a risk-adjusted value basis.

From what we're seeing today, we see the upper middle markets having more value. That being said, as we enter the second quarter we're seeing a pick up right now in sponsor volume. Some of the uncertainties have been eliminated -- the election's over, the sponsors have a lot of dry powder to put to work, and some of the small business owners held off until 2017 to sell their businesses because of the anticipated tax cuts -- so the volume is picking up.

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Christopher Testa, National Securities - Analyst [26]

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Okay that's helpful, thank you. Just wondering if there's any inclination on your behalf to potentially set up a joint venture where you could put a higher leverage on these club deals and alleviate some of the capital constraint on the balance sheet?

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Brian Chase, Garrison Capital Inc. - CFO [27]

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I think if you look at our balance sheet, it would be very difficult for us to do something like that. We've effectively created between the CLO and the SBIC. Those are our sort of primary and permanent financing facilities.

If the BDC were ever to grow, then you know something like that could be considered. But right now I would say that our capital structure is fairly locked in.

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Christopher Testa, National Securities - Analyst [28]

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Okay, and just to make sure I understand correctly -- the energy investment that you're expecting work came in on, that's Iracore?

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Joseph Tansey, Garrison Capital Inc. - CEO [29]

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Yes, that's correct.

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Christopher Testa, National Securities - Analyst [30]

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Okay great. That's all for me, thank you.

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Joseph Tansey, Garrison Capital Inc. - CEO [31]

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Thanks, Chris.

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Operator [32]

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(Operator Instructions)

Your next question comes from the line of Allison Taylor Rudary with Oppenheimer.

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Allison Taylor Rudary, Oppenheimer & Co. - Analyst [33]

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Hi, good afternoon, guys. Thanks for taking my question. I guess I'd like to talk about Badlands a little bit? You had put on all of your energy credits after 2014 when prices dropped, and I'm a little surprised to see problems there? Since I thought they would be underwritten to a new stress order?

So when I look at losing that interest stream and going out into 2018 when all of the intensive income economics reset, and given your available liquidity and given what's going on in the market -- I actually see a portfolio run rate that may not get to the new dividend level? So can you talk about and work out the expectation for Badlands, like what happens there?

And then give me a little bit of look forward into the portfolio growth prospects and yield prospects looking out in the next 12 months as we think about 2018?

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Joseph Tansey, Garrison Capital Inc. - CEO [34]

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Sure. I'll hit the Badlands first. Obviously we're disappointed with how things played out there. And it seemed obviously the Company has assets that are in both oil and gas and those markets have not performed the same way, is part of the challenge. With some of the continued challenges in gas prices, in particular.

The Company is close to hiring an advisor to sell the assets. We don't think it will be -- we know there are interested parties to buy the assets. So we think that will move reasonably quickly. So we don't think it will drag on for a super long time but it is a process and they will hire someone to do the sale. I think Brian probably better talk about the portfolio question.

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Brian Chase, Garrison Capital Inc. - CFO [35]

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Yes, as I said in my prepared remarks, for 2017 because we aren't earning an incentive fee, it would be -- there are obviously scenarios where we'd wouldn't cover, but I think they are fairly farfetched scenarios. It's pretty likely that we aren't going to have any issues and in fact we will probably build some book value as a result of over earning.

On an adjusted basis, if it's close, we have a lot of runway between now and the first quarter of 2018. I think if you were to just extrapolate what we did in this quarter and play it all the way through and just assume you're going to do 8% deals forever and move in LIBOR and no portfolio expansion, then you're right.

I think if you see some portfolio expansion, if there is an increase in LIBOR, it looks like next week there will be at least one rate hike, who knows what it will be beyond that. If the yields are greater than 8% but not meaningfully greater, I think you can get there. There are just too many variables right now for us to really speculate on the first quarter of 2018.

But I appreciate the fact that if you were to look at this quarter in isolation, you might ask that question. But we're frankly focused on the next quarter and the quarter beyond that and it's tough to look too far past that.

But look, at the end of the day, if the market will dictate where yields are and we've learned some lessons where you do stuff that have slightly higher rates and you aren't taking the appropriate amount of risk. So we're going to do the good deals that we see, and wherever the market prices them is where the market prices them.

And if that means that the dividend will have to be lower in 2018 -- we aren't managing this to the dividend. We are managing this to do the best deals that we see. So it will be what it will be, I guess at the end of the day. But we think where we sit right now for the remainder of the year, we're in pretty good shape.

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Allison Taylor Rudary, Oppenheimer & Co. - Analyst [36]

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That's helpful color, thanks. A follow-up for me then would be, what is your portfolio sensitivity to another 50 basis point rate hike?

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Brian Chase, Garrison Capital Inc. - CFO [37]

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So with the rate hike that I think the markets are saying are a 96% chance next week, that would be $0.03 for the year. And then every additional 25 Bps on a $400 million portfolio is roughly $0.06 annually.

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Allison Taylor Rudary, Oppenheimer & Co. - Analyst [38]

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Thanks very much. That's it for me.

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Brian Chase, Garrison Capital Inc. - CFO [39]

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Sure.

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Operator [40]

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There are no further questions in the queue at this time.

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Joseph Tansey, Garrison Capital Inc. - CEO [41]

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Great. Thanks, all. I'll talk to you next time.

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Operator [42]

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Ladies and gentlemen this concludes today's conference call. You may now disconnect.