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Edited Transcript of GLAD earnings conference call or presentation 2-May-19 12:30pm GMT

Q2 2019 Gladstone Capital Corp Earnings Call

MCLEAN May 8, 2019 (Thomson StreetEvents) -- Edited Transcript of Gladstone Capital Corp earnings conference call or presentation Thursday, May 2, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David John Gladstone

Gladstone Capital Corporation - Chairman & CEO

* Erich Hellmold

Gladstone Capital Corporation - Assistant General Counsel

* Nicole Schaltenbrand

Gladstone Capital Corporation - CFO and Treasurer

* Robert L. Marcotte

Gladstone Capital Corporation - Executive MD and President

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Conference Call Participants

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* Christopher Robert Testa

National Securities Corporation, Research Division - Equity Research Analyst

* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Gladstone Capital Corporation's Second Quarter Ended 03/31/2019 Earnings Call and Webcast. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. David Gladstone. Sir, you may begin.

Once again, speakers, you may begin your conference.

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David John Gladstone, Gladstone Capital Corporation - Chairman & CEO [2]

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Good morning. Thank you, Jimmy. Nice introduction. Hello, everyone. This is David Gladstone, Chairman, and this is the quarterly earnings conference call for the quarter ending March 31. We're happy to talk with all the shareholders and analysts and welcome the opportunity to provide an update for our company and the investment portfolio.

We're now going to do something a little bit different. We're not going to go into the history of the company and you can get that obviously from the website at gladstonecapital.com. And we're going to just do the current situation of your fund and give you some idea of what we think is going to happen in the future.

But first before we begin, I'll talk to the associate counsel here. He's going to make a statement regarding certain forward-looking statements. So Erich Hellmold, go ahead.

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Erich Hellmold, Gladstone Capital Corporation - Assistant General Counsel [3]

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Thanks, and good morning. Today's report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based upon our current plans, which we believe to be reasonable.

Many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors in our forms 10-Q, 10-K and other documents that we file with the SEC. Those can be found on our website, www.gladstonecapital.com, specifically the Investor Relations or on the SEC's website at www.sec.gov.

We undertake no obligation to publicly update or revise any of these forward-looking statements whether as a result of new information, future events or otherwise except as required by law.

Please take the opportunity to visit our website www.gladstonecapital.com and sign up for our e-mail notification service. We can also be found on Twitter @GladstoneComps and Facebook, keyword: The Gladstone Companies.

Today's call is an overview of our results, so we ask you to review our press release and Form 10-Q, both issued yesterday for more detailed information.

Again, those can be found on the Investor Relations page of our website.

Now I'll turn it over to Gladstone Capital's President, Bob Marcotte.

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [4]

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Good morning, and thank you all for dialing in today to spend a few minutes with us this morning.

Without further ado, let's get into the headlines for Gladstone Capital for the quarter ended March 31, 2019.

Originations on the quarter were down as is typical for the first calendar quarter of the year and appear to be on par with the lower level of transaction activity across much of the middle market for the period. For the quarter, we closed one small syndicated investment of $3.3 million. Exits and repayments were elevated per our earlier guidance and came in at $49 million. Exits included the sale of United Flexible, which generated a $2.1 million realized gain on our equity investment and a net paydown of $10.9 million associated with the consolidation of our investments in Impact! Chemical and WadeCo Specialties, which were merged into empirical -- Imperative Chemical, which also net -- reduced our net energy exposure in the process.

And while investments declined $43.4 million as of the end of the quarter, since the end of the quarter we have closed 2 additional investments totaling $40 million with another $10 million investment expected to fund shortly. So the dip was relatively temporary and we are well on our way ting continue to scale our earning asset base.

Interest income declined 5% on the quarter to $11.1 million from the prior as a result of the decline in average yield on our interest-bearing portfolio to 12%. The impact of 2 small investment positions being placed on nonaccrual status and the restructure of a third investment as the average interest-bearing investment portfolio was essentially unchanged from the prior quarter.

Prepayment fees, exit fees and dividend income rose on the quarter to $1.4 million, which lifted total interest -- total investment income to $12.5 million, which was $600,000 or 5.1% higher than the December quarter.

Borrowings -- borrowing-related cost rose by $200,000 on the quarter with the full quarter impact of our 6 1/8% senior note issue and our -- and the cost of that relative to our line of credit borrowings and an increase in commitment fees associated with the lower utilization of our credit line during the quarter.

Net investment income was up slightly at $6 million or $0.21 a share as operating expenses declined. However, net management fees rose compared to the prior quarter as invite -- adviser fee credits declined with the reduced level of new origination fees.

Net assets from operations rose to $9.3 million or $0.33 a share as a result of the $3.3 million of net portfolio appreciation on the quarter. And net asset value rose by $0.13 a share or 1.6% to $8.11 per share as of March 31.

With respect to the overall portfolio, the asset mix at the end of the quarter shifted slightly with the prepayment activity as senior secured assets dropped 5% to 49% of our investment portfolio at fair value, while the second lien investments rose to 38%. However, with the recent and pending fundings, the senior secured balance will increase above 50% again.

During the quarter, our investments in Meridian Rack & Pinion and New Trident were placed on nonaccrual status. These investments represent an aggregate cost of $8.5 million or 2.4% of all debt investments and an aggregate fair value of $2.5 million or 0.7% of the fair value of the portfolio.

Meridian was negatively impacted by Chinese import tariffs and we anticipate will be restructured and returned to earning status. However, New Trident filed bankruptcy during the quarter and we expect our second lien investment will be converted to equity.

We completed the restructure of our senior secured position in LWO Acquisition, which is a printed circuit board manufacturing business, which included converting $9.7 million of our exposure to a success-based fee term loan. And consistent with the restructure, this investment has been reclassified as a control investment and the fair value of our debt decreased by $4.4 million to $5.3 million or 34% of cost at the end of the quarter. The balance of the underlying portfolio performed well and if you exclude LWO, the net appreciation for the quarter was $7.7 million.

With respect to the near-term outlook, the combination of the recently closed investments and the current investment backlog are expected to support a higher average investment balance and lift our core net interest income via higher financial leverage and lower average financing cost going forward.

For planning purposes, we're now discounting any potential uptick in net interest income on our floating rate assets given the reduced likelihood of any future Fed rate increases at the moment.

Lastly, we continue to monitor the possibility of future spikes in prepayment activity as our borrowers contemplate selling out in the face of elevated market valuations.

That said, we would expect exit or prepayment fees to mitigate much of the interest income impact until the proceeds are reinvested as occurred in the last quarter.

And now I'd like to turn it over -- the call over to Nicole Schaltenbrand, our CFO for Gladstone Capital, to provide a more detailed update on the financial results for the quarter.

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Nicole Schaltenbrand, Gladstone Capital Corporation - CFO and Treasurer [5]

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Good morning, everyone. During the March quarter, total interest income declined by $600,000 or 5.5% from the prior quarter driven mainly by the 30 basis point decline in the average yield on the investment portfolio and the nonearning and restructured investments discussed earlier.

Other income rose by $1.2 million to $1.4 million from $200,000 last quarter driven by exit fees and prepayment fees received associated with the payoff of Merlin and dividend income received from a number of our other portfolio companies.

Total investment income rose $600,000 or 5.1% to $12.5 million on the quarter. Total expenses for the quarter increased by $600,000 driven mainly by the $200,000 increase in financing expenses associated with the 50 basis point increase in average borrowing costs, with the full quarter impact of our 6 1/8% senior notes and the $15.4 million reduction in average credit facility borrowings during the quarter and the resulting higher unused credit facility commitment fees.

Net management and incentive fees rose by $500,000 for the period as base management fee credits declined with the reduced level of originations and associated fees. Other expenses declined by $100,000 and totaled 78 basis points on average assets on the quarter.

For the quarter ended March 31, net investment income was $6 million or $0.21 per share and covered 100% of our shareholder distribution.

Moving over to the balance sheet. As of March 31st total assets were $396 million consisting of $388 million in investments at fair value and $8 million in cash and other assets.

Liabilities declined by $49 million to $162 million and consisted of $52 million in borrowings on our credit facility, $55.5 million of our 6 1/8% senior notes and $52 million of our Series 2024 Term Preferred Stock.

Net assets rose by $7.5 million since the prior quarter end with $3.3 million of net realized and unrealized portfolio appreciation and common stock issuance under our ATM program for net proceeds of $4.2 million.

For the quarter, we issued 460,000 common shares at a weighted average price of $9.24 under our ATM program. NAV per share rose by $0.13 to $8.11 as of March 31 compared to $7.98 as of the prior quarter end.

While our leverage as of March 31 was down materially at 69% of net assets, pro forma for the deals closed since the end of the quarter and additional common issuance proceeds from our ATM program of $3.5 million, our leverage has increased to approximately 85% post quarter end. And we currently have approximately $74 million of availability under our line of credit.

And now I'll turn it back to David to conclude the presentation.

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David John Gladstone, Gladstone Capital Corporation - Chairman & CEO [6]

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All right. Good report, Nicole, Bob, Erich. I think we did a good job of informing our stockholders even though this is a little bit shorter than we normally do. I hope you all like the way we're doing our presentations now.

Just to conclude, in summary our company had a good quarter generating realized gains and a significant fee income and lifted the investment income enough to cover the dividend again this quarter. Since the end of the quarter, the team has been very successful in reinvesting almost all of the prepayments that were proceeds from the last quarter and got some good lower middle market businesses financed with that money. It's well positioned now, I think, to grow over the balance of the fiscal year ending September 30, 2019, and looks like it's going to be a good, good period for us.

Gladstone Capital has remained committed to paying shareholders cash dividends and so in April, the Board of Directors declared our monthly distribution of common stock to $0.07 per common share for April, May and June, which is an annual rate of $0.84 per share. The Board will meet again in July to determine the monthly distributions of common shareholders for the following quarter.

At the current distribution rate, the common stock with a common stock price that closed at $9.50 yesterday, distribution is a run rate of about 8.84% per share. That's a great yield for a good, strong company like this.

In summary, the company sees the improved position in the private business and the middle-sized businesses that we invest. Many of these are owned by middle-sized buyout funds looking for experienced partners that can put the money in and be their co-investor in those companies. This gives us a chance to make attractive in interest-paying loans to support our ongoing commitment to pay cash distributions to shareholders.

We got a great team here and they're going to do a good job for you in this next quarter. And so operator, if you'll come on now and give the callers how they can ask questions about the comments.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Mickey Schleien with Ladenburg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [2]

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I'd like to start by asking about the decline in the portfolio's average yield. I'm curious if you use the forward curve to calculate the yield, and were changes in the curve what caused the decline?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [3]

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No. We don't calculate on a forward-curve basis. It's based on what's the actual LIBOR at the time and obviously, LIBOR has gotten a little bit lower in the course of the last 90 days, Mickey. I would say the average -- if you look at the footnotes, I think the average is roughly the same. There's a very slight change in the aggregate. We kind of peaked at the last quarter, as you may recall, we closed a lot of deals towards year-end. Some other deals paid off as we got into this quarter. So the average was slightly different. Most of the underlying yield change was due to 2 factors: one is the definite mix shift in some of the older assets rolling off and newer assets being more effective in driving the yield; and secondly, as we cited, some of the non-earning assets had an effect on the average yield as well. So I would say the bigger proportion is probably the latter than the former.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [4]

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That's really helpful, Bob. Thank you for that. Just a couple more questions. What was the catalyst for the impact in WadeCo merger? And how do you feel about the company's outlook, the merged company's outlook in the current environment?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [5]

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As we've discussed our energy portfolio in the past, both of those companies were in the chemical distribution business and both were owned by the same sponsor. One was distributing chemicals to the production of wells in the Permian, which obviously continues to grow. The other was acquired and built up as distributing chemicals to the pipelines that service the Southwestern markets. Given the overlapping nature of the business and given the combination of vendor supply and the general consolidation that's going on in the energy complex in the Southwest, the company felt efficiency and scale would be more relevant for the business. When you put those 2 businesses together, you're talking about a business that's approaching several hundred million dollars in revenue and certainly a far more substantial cash flow and operating profitability.

On a combined basis, our feeling is it's much stronger company in part at this point because the chemical -- the pipeline business, Mickey, as you may know is going through a surge in trying to add take-off capacity out of the Permian Basin. And so with those new pipelines coming on, the business is going to be surging on that side of the business. As a result of that, the pure working capital needs of the company on a consolidated basis were well in excess of what we continue to support. So the decision was made to support the growth of the business and the performance of the business that we allowed them to bring in a senior secured working capital line supported by the underlying assets and we downsized our position. The leverage in fact didn't really change, it just provided the flexibility for the company to continue to grow. So we feel pretty good about both the nature of the consolidation, the consistency of the overlap and the ownership, the outlook for the businesses and the leverage profile of a much larger business that we're now financing. And our energy exposure dropped in the process, kind of a win all around.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [6]

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And Bob, given the scale of the combined company, how likely do you believe it could be -- that you'll be refinanced out of the new entity's balance sheet?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [7]

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Having just closed that, I don't think it's likely at this point. I think they are very happy. We've been a strong supporter. As you can look in our history, we've been in these businesses for a number of years. We have a very strong relationship with this company. So we're not likely to expect to see that. We were accommodating the growth of the business and I think they view us as a supportive partner. So I don't think that's likely to happen.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [8]

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Okay. And lastly, could you just discuss a little bit about the outlook for LWO? Given the decline in the valuation. And that's it for me this morning.

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [9]

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Sure. Thanks, Mickey, for calling in. LWO is a business that is, as I said, in the printed circuit board manufacturing side of things. We believe, and all indications are, that that's a sector that continues to grow. Digitization and distribution of both technology and integration of that kind of printed circuit board in our -- in all products is continuing to increase. So the opportunities are out there. It is a business that requires a very exacting level of management and oversight. And some of the operating performance gaps were -- became evident over time. The business did bring in some more expert operating individuals to take on that side of the business late last year, but the market is certainly challenged. And so we feel that the markets there, they are beginning to add the resources that are necessary to operate it in the way that it needs to be run. It's a contract manufacturing business and if you don't run tight, you can lose money.

And lastly having taken the moves that we have, we've also stepped in and are working with the management team with some external resources to address the operating issues that they have. So we still feel positive on the outlook. We have core elements that we're happy with and we're supplementing those resources. So we feel pretty positive. It is not going to be a fast turn. These are businesses that have backlogs that will take a while to work through the contract framework, but the overall momentum in the sector should allow us to turn it. It will probably be sometime or a number of quarters before we can report any significant movement there. But it's one we still feel pretty positive about and are currently spending a fair bit of time on.

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Operator [10]

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(Operator Instructions) Our next question comes from Christopher Testa with National Securities Corporation.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [11]

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Bob, you've mentioned Meridian went on nonaccrual. It was impacted by Chinese tariffs. Would the -- would I guess the event that would bring this back on accrual status be the lifting of those tariffs? Or do you think that this is something that can go back on accrual status even if the tariffs remained?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [12]

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The business -- the tariffs were kind of a temporary phenomenon...

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David John Gladstone, Gladstone Capital Corporation - Chairman & CEO [13]

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That's $600,000.

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [14]

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Yes, it was both a working capital and a cost. They've now moved to accommodate some of those things. I would expect it could come off without -- this is a business that had a working capital line in it and given the seasonal working capital needs, the business over the winter months doesn't do a ton of auto repairs. Demand for those parts is not much. So between the tariff consuming some of the working capital late last year and the seasonal down swing, it was not in a position to fully service the debt. I would expect with the upswing in the seasonal combined with the adjustments that have been made all likelihood is that, that could be returned in a shorter period.

There's no doubt that the auto market, the parts market is a very competitive business. So we'll be evaluating alternate -- all alternatives in trying to assess what's the right move on that business. But I don't think it was a permanent impairment and I think your question around the temporary aspect of the tariffs is likely one that we'll be able to overcome in the short term.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [15]

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Got it. And sticking with that theme, I know that you guys have a decent yield manufacturing and that sort of investment on the portfolio. Just wondering, how much of any of that has also been negatively impacted by any tariffs?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [16]

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Well, we've had a while to live with them. Based upon the overall movement in the valuations for the businesses, I don't think that we're really seeing much if anything in the tariff side. We do have a couple of businesses that have some Chinese operations and -- but we never really were a big player in virtual companies, totally reliant on imported products. So off the top of my head and looking down the list of the various portfolio movements, we don't really have anything that is being negatively affected other than that. And frankly, that wasn't a big number. I think as David referenced, it was less than -- it was in the range of $0.5 million for a business that was doing order of magnitude somewhere between 25 and 50 in the total revenue. So it was not an overwhelming issue. It just happened to be a fairly thin, a modest margin and a seasonal business that made it more impactful to that business.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [17]

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Got it. That's great detail. I appreciate it. And just switching gears to New Trident, I mean this had been marked at 0 the past couple of quarters and then a few quarters ago, it was marked 25 or 30, something like that. Just wondering why it took so long to place this on nonaccrual when it was apparently distressed by the marks that it had for several quarters now?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [18]

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Well, the business was being marketed for sale. Certainly, the expectation was that, that was a possibility. Strategic buyers looking for the largest player in the sector that, that business was, would have been, obviously a transformative event. When it became clear that even though there was a new management brought in that, that was not likely to happen, the result was they decided to proceed with the bankruptcy restructuring of the business.

So given the market valuations and multiples in the marketplace, we felt that it was -- as long as they were continuing to pay and as long as that was a viable option, that was appropriate to accrue or at least realize what they were paying us. That obviously ended last quarter.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [19]

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Yes. Okay. I understand that but if people are making active bids for the business or showing interest, obviously some numbers are being thrown out, but it was still again marked at 0. So I'm just wondering why it was marked there? I mean I appreciate the conservatism. I mean it's a good thing that you guys had it marked where it was but I'm just wondering why it wasn't being marked where you were getting bids for this potentially?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [20]

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I think there's a couple of things, one is I think it was marked as 0, correct me if I'm wrong, Nicole, at December. So obviously the financial performance was challenged, so it had been marked at 0 for a long time. And two, obviously, it was another quarter before we took it on -- put it on nonaccrual. So it was a -- I think a conservative view on valuation and it was a "as we're receiving it" scenario. As we're receiving and paying interest with a view that it might be sold, we took the income in. And obviously it's a very modest exposure. So we were not prejudging where the business was going to go when we recognized the income in the December quarter on that investment.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [21]

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Got it. And now that you'll be taking equity in the company, are you looking to sort of rekindle the flame of the -- of selling this business or is this something that you guys are looking to maybe either put in a new manager and help turn it around first before you look to sell?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [22]

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This -- Chris, this is a syndicated deal. It is a large company. It is -- we are a relatively small player. Ares, in fact, is the largest investor at a significant multiple of our exposure. I think that's a question that they might be better positioned to answer since they'll be a more significant equity owner going forward.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [23]

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Got it. Okay. That's helpful. And just last one for me and I'll hop back in the queue. Just how much of the unrealized appreciation during the quarter was from technical from the low market bouncing back versus just idiosyncratic positive developments in the companies?

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Robert L. Marcotte, Gladstone Capital Corporation - Executive MD and President [24]

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That's kind of a tough call. I think when we discussed earnings and results last quarter, I think we said in the neighborhood of roughly $5 million we had attributed to market movement. This quarter as I said, ex the large one item, LWO, we were at 7.7%. So I would guess it -- if I were just using a rough guesstimate, I would probably say 1/2 to 2/3 of it was probably market oriented. There were clearly some very strong performances in the underlying portfolios that ultimately came through their year-end numbers. If I look down from the top, there were definitely a few very strong performers. But I don't have, and it's very difficult when you ask our outside valuation service just to parse the difference between market multiples and earnings performance. I will say, I don't believe that they -- that the middle market necessarily bounced back as much as some of the syndicated market, but it was a very significant contributor to the overall movement for the quarter.

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Operator [25]

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And I'm showing no further questions in the queue at this time. I'd like to turn the call back to David Gladstone for any closing remarks.

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David John Gladstone, Gladstone Capital Corporation - Chairman & CEO [26]

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All right. Thank you very much. We appreciate everybody calling in and we'll see you next quarter. That's the end of this call.

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Operator [27]

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