Saratoga Investment Corp. (NYSE:SAR) Q1 2024 Earnings Call Transcript

Saratoga Investment Corp. (NYSE:SAR) Q1 2024 Earnings Call Transcript July 11, 2023

Operator: Good morning, ladies, and gentlemen. Thank you for standing by. Welcome to Saratoga Investment Corp.’s 2024 Fiscal First Quarter Financial Results Conference Call. Please note that today’s call is being recorded. During today’s presentation, all parties will be in a listen-only mode. Following management’s prepared remarks, we will open the line for questions. At this time, I’d like to turn the call over to Saratoga Investment Corp.’s Chief Financial and Compliance Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Henri Steenkamp: Thank you. I would like to welcome everyone to Saratoga Investment Corp.’s 2024 fiscal first quarter earnings conference call. Today’s conference call includes forward-looking statements and projections. We ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required to do so by law. Today, we will be referencing a presentation during our call. You can find our fiscal first quarter 2024 shareholder presentation in the Events and Presentations section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night.

A replay of this conference call will also be available. Please refer to our earnings press release for details. I would now like to turn the call over to our Chairman and Chief Executive Officer, Christian Oberbeck, who will be making a few introductory remarks.

Christian Oberbeck: Thank you, Henri, and welcome, everyone. Saratoga’s 10% and 104% increases on adjusted net investment income per share, as compared to last quarter and last year’s first quarter respectively outpaced our recent and significant dividend increases and reflects growth in AUM and margin improvement from rising rates on our largely floating rate assets in contrast to the largely fixed rates paid on our financing liabilities. Higher and rising interest rates and a general contraction of available credit of producing higher margins on our portfolio and importantly an abundant flow of attractive investment opportunities from high quality sponsors at increasingly improving pricing, terms, and absolute rates. We believe Saratoga continued [Technical Difficulty] well positioned for potential future economic opportunities and challenges.

Saratoga’s credit structure with largely interest-only covenant free long duration debt, incorporating maturities, primarily two to 10-years out, positions us well, particularly well for rising and potentially higher for longer interest rate environment, coupled with market volatility. Most importantly, at the foundation of our performance is the high quality nature and resilience of our approximately $1.1 billion portfolio marked down just 0.9% overall. our core BDC portfolio, excluding our CLO and JV, is up 1.3% versus cost, reflecting the strength of our underwriting in our solid growing portfolio companies and sponsors in well selected industry segments. This quarter’s unrealized depreciation of $16.3 million reflects the interest rate, market, and economic volatility in the current environment across our diverse assets, including both our core and broadly syndicated loan portfolios with approximately two-thirds of the markdown in this BSL or broadly syndicated loan space.

As an example of the volatility in our markets, the unrealized reported losses in the BSL portfolio would be nearly one-third recovered if that portfolio were marked as of today. Our portfolio strength is further manifested in our many key performance indicators this past quarter, including: first, following sequential quarterly adjusted NII per share increases of 33% in Q3 and 27% in Q4, adjusted NII increased another 10% in Q1, almost doubling from $0.58 to $1.08 per share over the last three quarters. Second, current assets under management grew to approximately $1.1 billion. Third, dividend increases to $0.70 per share, up 32% from $0.53 per share in Q1 last year, up 1.4% from $0.69 per share last quarter and over earned by 54%, as compared to this quarter’s $1.8 per share adjusted NII.

And fourth, $77.5 million in long-term fixed rate callable capital recently raised in volatile markets to support record growth, while maintaining our BBB plus investment grade rating. While being increasingly discerning in terms of new commitments in the current environment, this quarter demonstrates a robust pipeline. We originated seven new portfolio company investments in this fiscal quarter and 20 follow-on investments in existing portfolio companies we know well with strong business models and balance sheets. Originations this quarter totaled at a $140 million with $11 million of repayments and amortization. Our credit quality for this quarter remained high at 96.5% of credits rated in our highest category with still only one credit on non-accrual.

With 85% of our investments at quarter end and first lien debt, and generally supported by strong enterprise values and balance sheets in industries that have historically performed well in stressed situations, we believe our portfolio and leverage is well structured for future economic conditions and uncertainty. Saratoga’s annualized first quarter dividend of $0.70 per share and adjusted net investment income of $1.08 per share imply a 10.2% dividend yield and a 15.7% earnings yield based on its recent stock price of $27.43 per share on July 7 2023. The over earning of the dividend by $0.38 this quarter or $1.52 annualized per share increases NAV, supports the increased dividend level and growth and provides a cushion against adverse events.

To summarize the past quarter on slide two. First we continue to strengthen our financial foundation this quarter and as indicated by our strong Q1 portfolio performance and credit quality, both this quarter and life to date since Saratoga took over the management of the BDC. Second, our assets under management increased to approximately $1.1 billion this quarter, a record level. Third, in volatile economic conditions such as we are currently experiencing, balance sheet strength, liquidity, and NAV preservation remain paramount for us. Our capital structure at year-end was strong. $337.5 million of mark-to-market equity supporting $571 million of long-term covenant free non-SBIC debt, $202 million of long-term covenant free SBIC debentures and $35 million long-term revolving borrowings.

Our total committed undrawn lending and discretionary funding facilities outstanding to existing portfolio companies are $143 million with $84 million committed and $59 million discretionary. Our debt maturity schedule ranges primarily from two to 10-years out, providing a solid credit structure at a fixed cost and with favorable terms positioning us well for both a rising rate environment or should overall economic challenges arise. And at quarter end, we had $231 million of investment capacity available to support our portfolio companies with $148 million available through our newly approved SBIC III fund. $30 million from our expanded revolving facility and $53 million in cash. Finally, based on our overall performance and liquidity, the Board of Directors most recently declared quarterly dividend of $0.70 per share, which was paid on June 29, 2023 was our largest quarterly dividend ever.

Saratoga investments first quarter demonstrated strong performance in our key performance indicators, as compared to the quarters ended May 31, 2022 and February 28, 2023. Our adjusted NII is $12.8 million this quarter, up 101% from last year and up 11% from last quarter. Our adjusted NII per share was $1.08 this quarter, up 104% from $0.53 last year and up 10% from $0.98 last quarter. Latest 12-months return on equity is 7.2%, up from 6.9% last year and unchanged from 7.2% last quarter and beating the industry average of 1.5% and our NAV per share is $28.48, down 0.7% from $28.69 last year and down 2.4% from $29.18 last quarter and substantially ahead of the latest 12-months industry average of a negative 7.3%. Henri will provide more detail later.

As you can see on slide three, our assets under management have steadily and consistently risen since we took over the BDC almost 13-years ago, and the quality of our credits remains high with only one credit on non-accrual, the same as last quarter. Our management team is working diligently to continue this positive trend as we deploy our available capital into our growing pipeline, while at the same time being appropriately cautious in this volatile and evolving credit environment. With that, I would like to now turn the call back over to Henri to review our financial results as well as the composition and performance of our portfolio.

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Henri Steenkamp: Thank you, Chris. Slide four highlights our key performance metrics for the fiscal first quarter ended May 31, 2023, most of which Chris already highlighted. Of note, across the three quarters shown on the slide, weighted average common shares outstanding were relatively unchanged, so per share numbers are comparable. Adjusted NII increased significantly this quarter, up 85.4% from last year and up 7.2% from last quarter, primarily from: first, the impact of higher interest rates both base rates and spreads with a weighted average current coupon on non-CLO BDC investment increasing from 8.5% to 12.7% year-over-year and from 12.1% last quarter; second, average non-CLO BDC assets increasing by 22.2% year-over-year and by 5.7% since last quarter; and third, other income this quarter including both the structuring and advisory fees generated from the higher level of Q1 originations, as well as a $1.8 million dividend received from the Saratoga joint venture.

This was partially offset by increased base and incentive management fees generated from higher AUM and earnings, and increased interest expense resulting from the various new notes and SBA debentures issued during the past quarter and year. Adjusted NII yield was 15.0%. This yield is up from 13.6% last quarter and 7.3% last year. Total expenses this quarter, excluding interest and debt financing expenses, base management and incentive fees, and income and excise taxes, increased from $2.0 million to $2.3 million, as compared to last year’s Q1 and remained unchanged from Q4. This represented 0.8% of average total assets on an annualized basis, down from 0.9% at Q1 last year, and unchanged from last quarter. Also, we have again added the KPI slides 27 through 30 in the appendix at the end of the presentation that shows our income statement and balance sheet metrics for the past nine quarters and the upward trends we have maintained, including a 52% increase in net interest margin over the past year.

Moving on to slide five, NAV was $337.5 million as of this quarter end, a $9.5 million decrease from last quarter and a $7.7 million decrease from the same quarter last year. This quarter, the main drivers were $60 million of net investment income, offset by $16.3 million of net realized and unrealized losses and $8.2 million of dividends declared. In addition, during Q1, $1.1 million of stock dividend distributions were made through the company’s DRIP plan offset by $2.2 million of shares repurchased at an average price of $24.36. This chart also includes our historical NAV per share, which highlights how this important metric has increased 16 of the past 21 quarters. Over the long-term, our net asset value has steadily increased since 2011, and this growth has been accretive as demonstrated by the consistent increase in NAV per share.

We continue to benefit from our history of consistent realized and unrealized gains. On slide six, you will see a simple reconciliation of the major changes in adjusted NII and NAV per share on a sequential quarterly basis. Starting at the top, the primary driver of the $0.10 increase in adjusted NII is the $0.15 increase in non-CLO net interest income. While on the lower half of the slide, NAV per share decreased by $0.70, primarily due to the $0.69 dividend recognized in the quarter with GAAP NII and unrealized depreciation basically offsetting each other. Slide nine outlines the dry powder available to us as of quarter end, which totaled $231.2 million. This was spread between our available cash, undrawn SBA debentures, and undrawn secured credit facility.

This quarter end level of available liquidity allows us to grow our assets by an additional 21% without the need for external financing with $53 million of pro forma quarter end cash available, and thus fully accretive to NII when deployed and $148 million of available SBA debentures with its low cost pricing also very accretive. We remain pleased with our available liquidity and leverage position, including our access to diverse sources of both public and private liquidity, and especially taking into account the overall conservative nature of our balance sheet. The fact that almost all our debt is long-term in nature with almost no non-SBIC debt maturing within the next two years. And importantly, that almost all our debt is fixed rate in this rising rate environment.

Also, our debt is structured in such a way that we have no BDC covenants that can be stressed. And with available call options in the next two years on the debt with higher coupons important during such volatile times. Now, I would like to move on to slides eight through 12 and review the composition and yield of our investment portfolio. Slide eight highlights that we now have $1.1 billion of AUM at fair value and this is invested in 56 portfolio companies, up by seven from last quarter, one CLO fund and one joint venture. Our first lean percentage is 85% of total investments, of which 29% is in first lien lost out positions. On slide nine, you can see how the yield on our core BDC assets, excluding our CLO, has changed over time especially this past year.

This quarter, our core BDC yield was up another 60 basis points to 12.7%. And the full impact of the rising rate environment through today is still not yet fully reflected in our earnings, as you will see on the next slide. The CLO yield decreased further to 6.5% from 7.4% last quarter, reflecting current market performance. The CLO is performing and current. Slide 10 shows how at the end of Q1, the average three months SOFR used in our portfolio was 498 basis points versus at quarter end when three months SOFR closed at 529 basis points and versus today at approximately 528 basis points. Despite the small decrease recently, with 99% of our interest earning assets using variable rates earnings will continue to benefit from these higher rate levels in Q2 and Q3, while all but $35 million of our borrowings is fixed rate and will not be impacted by these increases in base rates.

There is uncertainty about the future of rates, but we stand to continue to gain as rates rise. That said, there will be a lag in the effect this dynamic has on our earnings due to timing, up rate resets and invoicing terms. Slide 11 shows how our investments are diversified through the U.S. And on slide 12, you can see the industry breadth and diversity that our portfolio represents, spread over 42 distinct industries, in addition to our investments in the CLO and JV, which are included a structured finance securities. Of our total investment portfolio 8.9% consists of equity interest which remain an important part of our overall investment strategy. For the past 11 fiscal years we had a combined $81.6 million of net realized gains from the sale of equity interest or sale or early redemption of other investments.

This consistent realized gain performance highlights our portfolio credit quality, has helped grow our NAV and is reflected in our healthy long-term ROE. That concludes my financial and portfolio review. I will now turn the call over to Michael Grisius, our Chief Investment Officer, for an overview of the investment market.

Michael Grisius: Thank you, Henri. I’ll take a few minutes to describe our perspective on the current state of the market and then comment on our current portfolio performance and investment strategy. Not too much has changed since our recent update in May. For the most part, lenders are staying cautious though competition for premium quality credits persists. Liquidity continues to remain abundant after the large scale fund raisings of last year, but lenders and especially banks remain more risk sensitive backing off historically volatile sectors and taking a harder stance on the use of capital. Lenders are requiring greater equity capitalizations regardless of the enterprise multiple and in some cases have reduced their pace of deployment, as well as their hold positions.

All these factors are positive for us as we have been seeing more attractive opportunities come our way and have a very actionable deal pipeline. Leverage levels appear to have come down at the margin, but remain full for strong credits. Absolute yields continue to grow with SOFR increasing another approximately 30 basis points during our first fiscal quarter and have remained there. The spread widening we have been experiencing in recent quarters appears to have stabilized and for highly desirable credits, we have seen some lenders offer tighter spreads to win mandates. Lenders in our market remain wary of thinly capitalized deals and for the most part are staying disciplined in terms of minimum aggregate base levels of equity and requiring reasonable covenants, particularly given the concerns around potential economic recession.

The Saratoga management team has successfully managed through a number of credit cycles and that experience has made us particularly aware of the importance of: first, being disciplined when in making investment decisions; and second, being proactive in managing our portfolio. We’re keeping a very watchful eye on how continued inflationary pressures and labor costs, supply chain issues, rising rates, and slowing growth could affect both prospective and existing portfolio companies. A natural focus currently is on supporting our existing portfolio companies through follow-ons. Our underwriting bar remains high as usual, yet we continue to find opportunities to deploy capital. First-half of calendar year 2023 was a very strong deployment environment for us.

Follow on investments in existing borrowers with strong business models and balance sheets continued to be a healthy avenue of capital deployment as demonstrated with 39 follow on so far this calendar 2023, including delayed draws. In addition, we have invested in nine new platform investments this past calendar year and in another eight new investment platforms so far this year. Portfolio management continues to be critically important and we remain actively engaged with our portfolio companies and in close contact with our management teams, especially in this volatile environment. All of our loans in our portfolio are paying according to their payment terms except for our Nolan investment that remains on non-accrual. As we have moved to pick interest for a period of time.

Nolan is our only non-accrual investment across our portfolio. After recognizing the unrealized depreciation on our overall portfolio this quarter, Saratoga’s overall assets are now slightly less than 1% below cost basis with our core non-CLO portfolio 1.3% above cost. We believe our strong performance reflects certain attributes of our portfolio that bolster its overall durability. 85% of our portfolio is in first lien debt and generally supported by strong enterprise values in industries that have historically performed well in stress situations. We have no direct energy or commodities exposure. In addition, the majority of our portfolios comprise the businesses that produce a high degree of recurring revenue and have historically demonstrated strong revenue retention.

Our approach has always been to stay focused on the quality of our underwriting. And as you can see on slide 14, this approach has resulted in our portfolio performance being at the top of the BDC space with respect to net realized gains as a percentage of portfolio at cost. We are one of only 14 BDCs that have had a positive number over the past three years, currently fifth overall. Our internal credit quality rating reflects the impact of current market volatility and shows 96.5% of our portfolio at our highest credit rating as of quarter end. Part of our investment strategy is to selectively co-invest in the equity of our portfolio companies when we’re given that opportunity and when we believe the equity upside potential. This equity co-investment strategy has not only served as yield protection for our overall portfolio, but also meaningfully augmented our overall portfolio returns as demonstrated on this slide and a previous one.

And we intend to continue this strategy. Now looking at leverage on slide 15, you can see that industry debt multiples have come down this year from their historically high levels. Total leverage for our overall portfolio is 4.9 times excluding Nolan and Pepper Palace, while the industry is now around 5 times leverage. In addition, this slide illustrates the strength of our deal flow and our consistent ability to generate new investments over the long-term, despite ever changing and increasingly competitive market dynamics. During the second calendar quarter, we added another four new portfolio companies and made 20 follow-on investments. Despite the success we’re having investing in highly attractive businesses and growing our portfolio, and the increased deal flow we are seeing, it is important to emphasize that as always we’re not aiming to grow simply for growth sake.

In the face of this uncertain macro environment, we’re keenly focused on investing in durable businesses with limited exposure to inflationary and cyclical pressures. Our capital deployment bar is always high and is conditioned upon healthy confidence that each incremental investment will be accretive to our shareholders. Slide 16 provides more data on our deal flow previously discussed demonstrating how our team’s skill set, experience and relationships continue to mature and our significant focus on business development has led to multiple new strategic relationships that have become sources of new deals. What is especially pleasing to us is seven of the 13 new portfolio companies over the past 12 months are from newly formed relationships, reflecting notable progress as we expand our business development efforts.

The significant progress we’ve made in building broader and deeper relationships in the marketplace is noteworthy, because it strengthens the dependability of our deal flow and reinforces our ability to remain highly selective as we rigorously screen opportunities to execute on the best investments. As you can see on slide 17, our overall portfolio credit quality remains solid. The gross unleveraged IRR unrealized investments made by the Saratoga Investment Management team is 15.6% on $908 million of realizations. On the chart on the right you can see the total gross unlevered IRR on our $1.1 billion of combined weighted SBIC and BDC unrealized investments is 11%. As of this quarter, we continue to have two yellow rated investments, still only being Nolan Group and Pepper Palace investments.

Nolan has been yellow for a while now since COVID being more dependent on in-person business interaction and has been on non-accrual status since last year. There was no significant change to the market Q1. The current unrealized depreciation reflects the current performance of the company, but does not change our view of the fundamental long-term prospects for the business. The other yellow investment is Pepper Palace. In this quarter, there was an additional $1.1 million unrealized write-down to the mark, leaving the total depreciation of approximately $11 million since investment on our first lien term loan and equity investments. And this markdown reflects the current performance of the company, but they continued to pay interest. We are working closely with the company and the sponsor as they work to improve performance.

This quarter’s $16.3 million net unrealized depreciation can be divided into three primary buckets: first a $11 million of unrealized depreciation on the companies CLO and JV equity investments, reflecting both the volatility in the broadly syndicated loan markets as of quarter end, as well as the reduction in value of certain defaulted assets in the CLO portfolio. Second $3.3 million of unrealized depreciation on the company’s Netreo equity investment, reflecting increased company leverage, reducing the investments total net unrealized appreciation to $5 million. And third, approximately $2 million of net unrealized depreciation across the remainder of the portfolio, most of which reflects current market spreads. Our overall investment approach has yielded exceptional realized returns and recovery of our invested capital.

Moving on to slide 18, you can see our first and second SBIC licenses are fully funded and employed with $3.5 million and $6.5 million of cash available for distributions to the BDC and SBIC I and SBIC II respectively. We are currently ramping up our new SBIC III license with $19 million of cash and $148 million of lower cost undrawn debentures available, allowing us to continue to support U.S. small businesses. This concludes my review of the market. And I’d like to turn the call back over to our CEO. Chris?

Christian Oberbeck: Thank you, Mike. As outlined on slide 19, our latest dividend of $0.70 per share for the quarter ended May 31, 2023 was paid on June 29, 2023. This is the largest quarterly dividend in our history and reflects a 59% and 32% increase over the past two years and by this latest 12-months respectively. The Board of Directors will continue to evaluate the dividend level, at least a quarterly basis, [Technical Difficulty] both the company and general economic factors, including the near-term impact of rising base rates and increased spreads on our earnings. We’re recognizing the divergence of opinions on the future direction of interest rate levels and overall economic performance. Saratoga’s Q1 over earning of its dividend by 53% or $1.08 versus $0.70 per share this quarter provides substantial cushion to the economic conditions deteriorate or base rates decline.

Moving on to slide 20, our total return for the last 12-months, which includes both capital appreciation and dividends has generated total returns of 30%, outperforming the BDC index of 18% for that same period. Our longer term performance is outlined on our next slide 21. Our three and five year returns place us in the top quartile of all BDCs for both time horizons. Over the past three years, our 113% return exceeded the average index return of 61%, while over the past five years, our 67% return more than doubled the index’s average of 30%. Since Saratoga took over the management of the BDC in 2010, our total return has been 695% versus the industry’s 197%. On slide 22, you can further see our performance placed in the context of the broader industry and specific to certain key performance metrics.

We continue to focus on our long-term metrics such as return on equity, NAV per share, NII yield and dividend growth, which reflects the growing value our shareholders are receiving. While NAV per share decreased [Technical Difficulty] 2.4% this quarter, we are only down 0.7% year-over-year, while the BDC industry is down 7.3%. We continue to be one of the few BDCs of grown NAV over the long-term and we have done it accretively, but also growing NAV per share 16 of the last 21 quarters. And our latest 12 months return on equity of 7.2% significantly beats the industry’s 1.5% average. Moving on to slide 23, all of our initiatives discussed on this call are designed to make Saratoga Investment, a leading BDC that is attractive to the capital markets community.

We believe that our differentiated performance characteristics outlined on this slide will help drive the size and quality of our investor base, including adding more institutions. These differentiating characteristics, most of which have been previously discussed, include the maintaining of one of the highest levels of management ownership in the industry at 14%, ensuring we are aligned with our shareholders. Looking ahead on slide 24, we remain confident that our reputation, experienced management team, historically strong underwriting standards, and time and market tested investment strategy will serve us well in navigating through the challenges and uncovering opportunities in the current and future environment and that our balance sheet, capital structure and liquidity will benefit Saratoga shareholders in the near and long-term.

In closing, I would again like to thank all of our shareholders for their ongoing support. I would like to now open the call for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from the line of Mickey Schleien from Ladenburg. Your line is open.

Mickey Schleien: Yes. Good morning. Couple of questions today, the $1.8 million of dividend income from the senior loan fund implies over a 40% ROE on your equity investment in that funded cost, which is obviously really high. I’d like to understand what drove that dividend and what is your target ROE on that investment?

Christian Oberbeck: Well, Henri, you can take that.

Henri Steenkamp: Yes. Mickey, yes, you’re right. So that was let me start with what drove the dividend, obviously, as you know, our joint venture owns CLO investment. And so therefore, the returns are driven by the equity distributions that we received by the CLO into the joint venture. And then the joint venture dividended out some of the return to its partners of which is us and one other partner in a joint venture structure. The accounting is that’s dividend income and so that was our first dividend that we’ve received on that investment. I’m trying to think how best to think of this as a future return. It’s obviously a really strong return, but we continue — we definitely do think of the joint venture return as more similar to our CLO in general, which is high-teen digits or higher.

Mickey Schleien: Okay. So Henri, was there some sort of a catch up in the quarter given that it was the first distribution?

Henri Steenkamp: That dividend represented a three month period. So no real specific catch up, but you’ll always see that the first waterfall distribution is quite a fulsome distribution.

Mickey Schleien: Right, okay. My follow-up question is, I see that the portfolios leverage has increased by almost a full turn over the last year to almost 5 times, as Mike described. So I’d like to ask how your portfolio companies are doing in terms of their revenues and EBITDA. And is it declines in EBITDA that’s driving that increase or is it the market terms that’s driving the increase or a little bit of both?

Michael Grisius: Good morning, Mickey. This is Mike. So it’s a good question. It is not underperformance that’s driving the increase in leverage, it’s really reflecting some of the newer portfolio companies that we feel really good about that have a bit higher leverage profile. And then in terms of the overall portfolio performance, the vast majority of our portfolio is performing very well and we’re watching it very carefully. But at this juncture, the vast majority of our portfolio is up quarter-over-quarter and up at the same quarter over last year.

Mickey Schleien: And Mike, just to follow-up, is the more recent investment activity into perhaps larger companies than you’ve historically done, which may include higher leverage multiples?

Michael Grisius: Well, it’s less about size and I think it’s more about durability of the portfolio companies. So and we always say this right? When we’re looking at the lower end of the middle market, we’re seeking companies that have, kind of, large company characteristics i.e., lots of durability, really strong management teams, et cetera. So for instance, if you do a support and I’ll just use an example of business that’s in the franchising space. It’s a franchisor, not a franchisee. It may not be a terribly big business. It’s not a worldwide name, but it can be a business that has 100 of locations, very successful, real durable cash flow stream, et cetera. That would be a business that would typically command a more fulsome leverage just reflective of the much lower risk profile and the lower volatility that, that is associated with that business.

So in business models like that, which we seek out having a lot of those characteristics, we’re okay with a bit higher leverage profile and most of the increase in leverage is reflective of some of that activity.

Mickey Schleien: And that includes your focus on software deals, right? Where leverage tends to be higher than average or am I mistaken?

Michael Grisius: It would include that for the ones that are underwritten on an EBITDA basis for the same reasons.

Mickey Schleien: Yes.

Michael Grisius: But it would also include some of the other business models that we invest in as well.

Mickey Schleien: Okay. I understand. Those are all my questions this morning. Thank you for your time.

Christian Oberbeck: Thanks, Mickey.

Henri Steenkamp: Thank you, Mickey.

Operator: Thank you. [Operator Instructions] And our next question comes from the line of Bryce Rowe from B. Riley. Your line is open.

Bryce Rowe: Thank you. Good morning. Wanted to start, Chris, with just the dividend and obviously the huge amount of coverage you have of the dividend here this quarter? How should we think about the dividend construct, you know, going forward, I think we’ve probably all of us have thought about this or asked us on previous calls. But clearly, there could be some room to move the dividend higher? Are you expecting possibly to consider a base supplemental construct? Just curious how you and the Board are thinking about it at this point?

Christian Oberbeck: Well, as you can imagine, this is something we think about and discuss quite a bit. I think a lot of the predicting — the future business is very difficult especially these days. And if we look at we kind of look at all these forward interest rate curves that are coming out. And I think if you look at the forward interest rate curve six months ago, they were predicting interest rate cuts this summer, this July. And then you look at it more recently there’s higher for longer and interest rates coming in 2024. So there’s a tremendous amount of volatility. I think we’ve had probably the most predicted recession by really accomplished, intelligent and really successful investors have been predicting an imminent recession for, you know, six months now or something and that has not yet occurred.

And now this debate is a soft landing, hard landing still going on. So there’s so much uncertainty out there and that’s not really our business to try and figure that one out. That’s pretty complicated to figure out. And so what we’re trying to do is we’re trying to establish a sustainable dividend level if, kind of, you know, somewhat of the worst case occurs coming out there, you know, in the future, you know, if the economy comes off and then the interest rates comes down, we want to be in a position where we can sustain this dividend, kind of, through that, that case. Then obviously, if things continue much better, we’re building up a lot of incremental dividends obligation, right, that we would ultimately look to take payout, you know, to our shareholders.

I think as we mentioned in our last call, the way the BDC requirements for payouts occur, generally, it’s sort of like November’s, right, for us. So you have November of ‘23, you have a certain tax obligation, November ‘24, you have a certain tax obligation. And so we don’t have a requirement by November of 2023 to do anything different than what we, kind of, been doing. November 2024 is different, then that’s when a lot of our supplemental, you know, earnings, you know, incremental earnings would be due. And so we have quite a bit of time and as I’ve just said, you know, if look at over the last six months how outlooks have changed. I think over the last next six months, probably outlooks may change just as much, may not change a lot, we don’t know.

But I think we’re in a very comfortable position in terms of where our dividend is and being able to sustain it over the long run. And the incremental earnings that we have are going right into our equity base and allowing us to do more business. I think as Mike had elaborated in his piece, we had to have a tremendous pipeline and we’re actually turning down very interesting deals, because our bar has been raised even higher. And so the terms, conditions, quality of what we’re seeing is very strong. And so I think the shareholders feel comfortable that, that those incremental earnings are being put to very good use in this current environment.

Bryce Rowe: That’s helpful, Chris. Maybe one more from me. It looks like on the phasing page of the queue that shares outstanding are up a little bit quarter-to-date with the quarter ending August. You know, I assume that, that you’ve been a little bit active on the ATM and I guess the question is, are you all at the adviser level helping to subsidize some of the costs of the ATM?

Christian Oberbeck: Well, I think that’s a very astute observation, Bryce, and I and yes, that is the case. We have sought to raise some more equity and we had some small raises in the past. And yes, the advisor has been involved in assuring that the BDC receives NAV for any shares sold.

Bryce Rowe: Excellent. And with that in mind, Chris, you know, I think we’ve talked about this in past calls as well, but is there a understand, kind of, the nature of your debt outstanding and the higher quality nature of it? Is there a, kind of, a certain, kind of, target debt to equity ratio that you would optimize or that you would ultimately like to be at with the ability to possibly raise equity in the future?

Christian Oberbeck: Well, again, last call we had a very extensive conversation on that. I think our comments from that are still what we think about it. I think we’ve got a balancing act that we’re working on here, which is we’ve got a tremendous pipeline of very high quality investments. We’ve got a very solid liability structure that is really structured to handle a lot of adversity, and right now is paying off super well given the rising rates. And so I think on the downside of leverage, I think we’re very, very well positioned in that we don’t have any covenants. We don’t have any hard maturities that are coming anytime soon that aren’t pretty manageable. And so we’re very well structured on the downside. And I know in terms of leverage, everybody, especially these days are very concerned about the downside.

I think the flip side is the positive, right? I mean leverage is good, and there’s a whole good aspect of leverage. And I think as you can see, our earnings performance, kind of, was way, way ahead of projections by many people looking at us and part of that is because of our leverage. And so we have a very strong — at the heart of it, super strong portfolio. And that portfolio with the rising rates and then the increase and better terms in our newer deals is driving, you know, I mean, our earnings are twice what they were a year ago. Our stock price is in twice what it was — what our earnings are. And so — and our earnings yield is over 15%. So dividend yield, 10%-plus earnings yield, 15%-plus. So from — looking at our portfolio, I mean, we’re performing extraordinarily well.

So going to your question of what is our leverage levels, we just have to balance the fact that we’ve got some statutory requirements. We’ve got some — which is most important to us, credit quality issues, like how do these assets fit within our credit quality perspective? And as Mike said, we’ve got a very high bar, and we’re putting on some tremendously strong credits in this environment. So I can’t give a precise answer, but it’s kind of opportunity driven and risk assessment driven and statutory [Technical Difficulty] looking at all of that at once and trying to do the best job we can to continue our pretty substantial and remarkable earnings performance.

Bryce Rowe: Yes. I appreciate that. It’s great to see the progression in earnings and certainly impressive quarter this quarter and even the last couple. So, I appreciate the comments.

Christian Oberbeck: Thank you.

Operator: Thank you. [Operator Instructions] Our next question comes from the line of Casey Alexander from Compass Point Research. Your line is open.

Casey Alexander: Hi, good morning. And thank you for taking my questions. I’ve got a couple here. First of all, I think Henri mentioned in the prepared remarks, that 29% of the first lien portfolio encompassed last-out position. So I’m not sure that I’ve heard that before. And I think maybe this is for Mike. If you could explain what characteristics are you looking for that you would accept the position that’s a last-out position, kind of, who’s in front of you? It’s kind of unusual in that not a lot of term loans have partial repayments. So I’m sort of interested in the characteristics. And why not have the chart on page eight. The portfolio composition recognize that some of those first lien loans are last-out positions?

Michael Grisius: Good morning, Casey. Let me address the way that we think about last out positions vis-a-vis $1 unitranche positions. Certainly, the bar is higher for those positions, given that we’re in a first lien position, which is kind of the premium spot to be in the balance sheet, albeit behind a first-out lender. So we’re looking at when we make those investments at making sure that from a credit quality perspective, we feel that much more comfortable that that position is one that is sensible and that we’re well protected by the enterprise value of the business. We also structure those deals typically with partners that we scrutinize very carefully and have a great deal of comfort that their rational partners, and we typically structure those, also we’re not typically — always structure those with an agreement in terms of how the loan is administered should there be any challenges or what have you.

And there’s lots of protections around how we structure the deal so that we’re working in partnership with the first-out lender. Generally, and there’s a lot of nuances in terms of how first out last out deals are structured. But the way we structure them is such that we feel very comfortable that the terms are strong, especially relative to some other structures that we’ve seen in the marketplace. And as I said, we’re scrutinizing the partners that we work with to make sure that we’ve got a lot of comfort that they are reasonable in terms of their credit underwriting and that we have a good partnership approach to investing.

Henri Steenkamp: Casey, and I would just add, although we don’t show it in the chart, I have been always providing that breakout for years now always in my remarks, just to give that color as well. So, it’s not a new disclosure there.

Michael Grisius: And the other thing I’d add, Casey, as well, is that those structures allow us to do some deals that if we try to be in those credits as a pure unitranche provider, we wouldn’t be able to be competitive. So the credit profile, the quality of the credit profile is such that the pricing were it to be a unitranche pricing would be below where we could make it accretive for our shareholders. So these are generally deals that are high-quality deals. The characteristics of them are very strong. And so to be competitive, the overall pricing on a facility like that is quite — is tighter. Doing a first-out last-out gives us an opportunity to create a combined pricing structure that works for the borrower, but gives our shareholders a chance to get premium yields, because we’re leveraging that first-out partners pricing as well.

And so we think it’s a terrific way for us to augment our portfolio in a way that’s balanced and still in a first lien position, but with premium quality credits.

Christian Oberbeck: If I could add as well to that, Casey, that just to, kind of, give a sort of a strategic overview. I think as both Mike and Henri has said, there’s sort of several categories here. One is how do we — as Mike just described, how do we get into really high-quality credit, which may be different pricing. The other is how we stay in. We’ve had a number of deals where we would have lost the deal, because the companies have credit quality, scale, size, enable them to get into a better credit facility pricing-wise than ours-wise. But by bringing in a partner whom we select, we’re able to bring in a senior level lender, which allows the combined package to be much more competitive maybe not as competitive as it could be if they completely went to the market, but allows us to preserve the relationship and the credit positioning.

And then the third is to provide strategic liquidity. We have a number of unit tranches we’re in, and we’ve looked to bring in, again, known partners on known documentation that is our documentation largely that allow us to basically liberate some of the capital in these credits and redeploy. And I think if you look at the most recent quarter, we had seven new relationships and having the capital to do new relationships is very important strategically, because they pay us enormous dividends down the road because we had seven new relationships, but we had 20 follow-on investments. And so all of our new relationships lead to all these follow-ons. And so it’s a combination of capital enhancement for us and staying in much more substantial credits than before.

And then — and Mike and Henri, I think it’s fair to say. I mean, all these people were doing last outs with our relationships we’ve had for many, many years.

Michael Grisius: That’s right. We’ve got long-standing relationships with our first-out partners. Casey, the one thing I would do to — just to reemphasize what Chris mentioned, a perfect example would be the hematera loan that we have in our portfolio. That’s a deal that’s sort of a great example of how we’ve attacked the market. So that get the dollars — I don’t have the exact dollars, but I’m going to say that the original investment there was for the initial platform was less than $10 million between our debt and equity investment, and we did a unitranche, $1 unitranche and a healthy equity co-investment. That company has performed very well. It’s owned by a sponsor relationship that we’ve had for a long time, and it’s a really strong sponsor relationship.

We supported it with follow-on capital for them to do some acquisitions. That investment grew to a pretty healthy size. I can’t remember the exact number. And then most recently, they did a much larger acquisition that would have brought that facility as a unitranche to over $100 million, which is something that was too large for us to carry on our balance sheet. But given the performance of the business, the experience that we had in the deal for at least a couple of years directionally before we upsized it at that point. We were very comfortable with the credit profile. And rather than see that portfolio company exit and not having our shareholders get the benefit of the continued earnings stream. In that case, we brought in a first-out partner, and we’re able to upsize the facility, continue to support the portfolio company, and we also have equity in that investment, and that business continues to perform exceedingly well.

So that’s kind of a — it’s a microcosm of, sort of, how we look at certain deals or how we’re approaching deals in the marketplace and an example of our first-out last-last out scenario.

Casey Alexander: Well, thank you for that. I’m pleased that I could ask a question that would prompt all three of you to participate in the answer. My second question is, can you give some more color on the defaulted assets in the CLO and how that may impact its structure, its requirements and potentially it’s cash flow?

Christian Oberbeck: Well, maybe I’ll start with that, Casey, on sort of on a high level. The CLO has round numbers plus and minus like a couple of hundred credits. And so there’s a lot going on inside the CLO. And then the CLO also has a fairly complex roll up to value, if you will, with waterfalls and things like that. And so it’s not necessarily the easiest thing to predict from a distance, how it behaves and how it operates. But inside of…

Casey Alexander: I guarantee you, it’s impossible to predict for those of us sitting outside of the company.

Christian Oberbeck: Yes, right. And so especially on a quarter-on-quarter basis, and there’s like BB credits are highly desired right now. So those are trading extraordinarily well. Single B are less desirable, because they’re closer to CCC and then CCC credits are not trading very well at all, because people don’t want them. They have baskets that are kind of full. There is supply and demand issues out there where they have a lot of CLO formation in the beginning of the year and then less just recently, and then you combine that with not that much issuance, because the larger buyouts are not happening at the same rate at four, and so you have all these different crosscurrents in the marketplace, which result in sort of different credits and different assets, different pricing, given what goes on.

Like for example, a restructuring credit that might trade at $50 million, we mentioned in our conversation that the whole portfolio has recovered maybe one-third of where it was marked — what it was marked down from May 31. But inside of that, anything trading at $50 million probably didn’t move, right, where something trading in the 90s might have moved up a lot more. And so you have all those dynamics underlying at all. But I think the — it’s hard to, again, take sort of individual pieces of the puzzle and then try and assemble the whole puzzle because there’s like a 1,000 pieces to this puzzle. And so the way we look at it is, we’ve been in the CLO from the beginning. We have a second CLO, which has been added to it. And if you’d look — and we — and the CLO has been through a lot of different markets, right?

And even before we owned it, it went through the 2008, 2009 crisis. And then we’ve been through all kinds of liquidity, different things, COVID, et cetera. But over the long run, our CLO reduced high-teens returns based on our investments. And so we’ve, kind of, weathered a lot of ups and downs, a lot of different types of markets. And this one, I’m not going to say this is the same as we’ve seen before. And I’m not going to say the whole marketplace has the exact same dynamics, but the structure has been a very successful long-term investment structure for us, and we don’t think any differently. There are some adverse events and some are idiosyncratic. We’ve avoided a lot of traditionally cyclical elements in our CLO, like we don’t have energy investments, for example, which have gone down a lot, gone up and then go down.

I mean, there’s a lot going on there. But then as a general sort of overview of that, we feel that this is a good investment in the long run, although there are periods of time where you have some adverse developments, but the power and the earnings of it has produced fairly consistently high-teens returns for us over the long run.

Casey Alexander: All right. Thank you. That’s all my questions. I appreciate it.

Michael Grisius: Thanks, Casey.

Christian Oberbeck: Well, Casey, I hope you appreciate our presentation was shorter this time.

Operator: Thank you. [Operator Instructions] Our next question will come from the line of Erik Zwick from Hovde Group. Your line is open.

Erik Zwick: Thank you. Good morning, everyone. I wanted to start with the pipeline for my first question. I think last quarter, you mentioned, you kind of described it as robust with many actionable opportunities. And this morning, you mentioned that it continues to grow. So I’m wondering if you could just provide a little color, first in terms of any particular industries where you’re seeing stronger demand or stronger activity? And then second, just if you could categorize how it shapes up in terms of new investment opportunities versus follow-ons?

Michael Grisius: Yes, I’ll try to address that. You’re right, the pipeline that we have remains very robust, and that’s mostly reflective of the business development efforts that we’ve taken on over the last several years. Certainly, deal flow in the market is down relative to historical levels. It continues to be down, although we’re seeing some pickup in that respect. So our actionable pipeline has more to do with, kind of, what we’re doing in the marketplace and our reputation growing and our relationship is growing. But that’s definitely yielding really good opportunities for us. We think it’s a great time to be investing capital. There’s a lot of caution in the marketplace. We think we’ve got certainly among the best teams in the BDC marketplace.

We like being in the lower end of the middle market for sure. We think we get an opportunity to underwrite our deals in a way that the larger market can’t. We get better legal protections as well. We like the verticals that we’re in. And I think as a result of that robust pipeline, we have an opportunity to be highly, highly selective. Now as it relates to sort of the industries that we’re in, we’re generalists. So we’re really just looking for businesses that have really strong characteristics that get us comfortable that they’re going to hold up under most reasonable circumstances that we can think of as we analyze the businesses, but we also have a few verticals that we tend to focus on. And that’s by design, because those verticals are ones where we think that businesses that differentiate themselves and really create a business model where they have an enduring value proposition that they offer for their customers, they can hold up really well and thrive.

And as a result, we’ve sort of gravitated toward — outside of our generalist approach, we’ve gravitated toward a few verticals, and we’re seeing healthy deal flow there, in part because of our, as I said, business development outreach, but in part because those verticals are holding up well and there’s still a fair amount of activity within those verticals, which would be certainly software-related businesses and SaaS businesses that are across a wide variety of industries. We certainly have expertise and a reputation that gives us healthy deal flow in that market. And then outside of that, we’re also focused on health care and education. And so we’re seeing healthy deal flow there. Now because a good portion of our portfolio is invested in those verticals where those businesses are continuing to grow, and they are — have an appetite for more capital.

And that’s where you see a lot of that follow-on activity. But you’ve also seen that we’ve added additional portfolio companies as well, and that’s just reflective of healthy new deal flow that we’re seeing on new portfolio companies.

Erik Zwick: That was all very helpful. And any color in terms of, I guess, kind of, what’s moving more near-term through the portfolio — I’m sorry, through the pipeline and contention close in terms of kind of new opportunities versus follow-ons?

Michael Grisius: It’s a healthy mix. I think it’s really hard to predict that. I think as you’ve seen, our portfolio — our investments in new portfolios are really a reflection of how strong we think the business investment opportunities are. We have historically had some quarters where we actually have not done any new portfolio investments. And it’s just because we haven’t seen anything that’s worthy of investing. And there are other times where we’ve had pretty significant investment activity. Right now, we’re seeing a lot of opportunities, especially ones that we’re delighted to see that fit our SBIC III, which has lots of room to expand.

Henri Steenkamp: Yes, Erik, you will see historically, follow-on has always been a really, really important part of our origination story and our growth story. And I don’t think we expect that to change. But definitely, our focus is SBIC III at the moment as we have a lot of capital to deploy there.

Erik Zwick: Makes sense. And last one for me, really just kind of a maybe a recordkeeping one. Do you have the value of the spillover at the end of the quarter?

Henri Steenkamp: No, I don’t. We disclosed it. It was around $20 million at the end of February, which we disclosed in the 10-K, but we don’t generally disclose it on a quarter-end basis.

Erik Zwick: Got it. Thank you for taking my questions today.

Michael Grisius: Thank you.

Henri Steenkamp: Thanks.

Operator: Thank you. And I’m not showing any further questions in the queue. I’d like to turn the call back over to Christian Oberbeck for any closing remarks.

Christian Oberbeck: Well, thank you all. We very much appreciate the support of all our shareholders, and we look forward to speaking with you next quarter. Thank you very much.

Operator: This concludes today’s conference call. Thank you for participating. You may now disconnect, everyone, have a great day.