Capital Southwest Corporation

Thank you for joining today's Capital Southwest third quarter fiscal year 2021 earnings call. Participating on the call today are Bowen Deal, CEO, Michael Sarner, CFO, and Chris Reberger, VP Finance. I will now turn the call over to Chris Reberger.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information, and management's expectations, assumptions, and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties, and assumptions that could cause actual results to differ materially from such statements. For more information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances, or any other reason after the date of this press release except as required by law. I will now hand the call off to our President and Chief Executive Officer, Bowen Deal.

Thanks, Chris. And thank you to everyone for joining us for our third quarter fiscal year 2021 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We are pleased to be with you this morning to announce our results for our third physical quarter ended December 31, 2020. I want to first say that I hope everyone, their families, and their employees continue to be safe and well. In summary, this quarter was exceptional in virtually all areas. Strong originations, strong capital raises, and strong portfolio performance. As we reflect back on 2020, we were very impressed by how the vast majority of our portfolio management teams and financial sponsors managed our portfolio companies, prioritizing the health and safety of their employees, realizing cost efficiencies were needed, and now recovering nicely from the worst effects of the pandemic. While the pandemic is not yet completely behind us, as we look back to where we were in March of 2020, with so much economic uncertainty and market volatility, we are very grateful for all the work done by the team here at Capital Southwest, and the teams at both our portfolio companies and financial sponsor clients. The pandemic has impacted so many people and companies in a variety of ways, and we are humbled by how well the portfolio has held up through this difficult time. The way our deal team has been able to continue to source, diligence, and originate high-quality assets while continuing to actively monitor our existing portfolio over the past year has corroborated my confidence in them and also in the strength and quality of the assets. During the quarter, our portfolio continued to improve, as evidenced by $7.1 million of net appreciation across the portfolio. For the quarter, we had two loans which had investment rating upgrades. We had no investment rating downgrades, and we had no new loans placed on non-accrual. Overall, as of the end of the quarter, we had only one loan on non-accrual, the junior most tranche of our loan to AG Kings, which had a fair value of $739,000. Substance to quarter end, the sale of AG Kings to Albertson's Ackley Markets has closed. Now we're resolving this last non-accrual asset for Capital Southwest. As a well-capitalized first lien lender with ample liquidity, Capital Southwest continues to be in a favorable position to seek attractive financing opportunities and to provide financial support for the growth of our portfolio companies. Executing our investment strategy under our shareholder-friendly, internally managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable long-term value through recurring dividends, capital preservation, and operating cost efficiency. On slide six of the earnings presentation, we have summarized some of the key performance highlights for the quarter. During the quarter, we generated pre-tax net investment income of 52 cents per share, which more than earned both our regular dividend paid for the quarter of 41 cents per share and our supplemental dividend for the quarter of an additional 10 cents per share. Total dividends for the quarter of 51 cents per share represented an annualized dividend yield on the quarter end stock price of 11.5%, and an annualized yield on net asset value per share of 13%. I'm also pleased to announce that our board has increased our total dividends to 52 cents per share for the coming quarter ending March 31, 2021, consisting of a regular dividend increase from 41 cents per share up to 42 cents per share and a supplemental dividend of 10 cents per share. Our decision to increase the dividend emanates from our confidence in the current earnings power of our portfolio as a result of the reduction in our cost of capital and our ability to continue to improve our operating leverage as we grow the portfolio. During the quarter, we grew our investment portfolio on a net basis by 3% to $649 million as of December 31, 2020. Portfolio growth during the quarter was driven primarily by $57.5 million in total new commitments to three new portfolio companies and three existing portfolio companies, offset by $28 million in total proceeds from three exits. Subsequent quarter end, we added additional investment activity, which spilled over into the new year, closing an additional $33.5 million in commitments. I will review our investment activity in a bit more detail in a moment. On the capitalization front, we were quite busy during the quarter. We successfully raised over $96 million in investable capital during the quarter, consisting of $75 million in aggregate principal in a new 4.5% institutionally placed unsecured bond and $21.1 million in gross proceeds through our equity ATM program. During the quarter, we also received $15 million of additional commitments to our revolving credit facility, which now stands at a total of $340 million in total commitments from 11 banks. In addition, subsequent to quarter end, we paid off the remaining balance on our 5.95% December 22 baby bonds. Turning to slides 7 and 8, we illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage, and value creation since the launch of our credit strategy. In fact, specific to slide eight, as of December 31, 2020, we hit a new all-time high in total value creation for our shareholders. We believe the strength of our investment and capitalization management strategies have been demonstrated through the pandemic based on the solid performance of our company and our portfolio. And now we are pleased to announce an increase in our regular dividend this quarter. We believe that the maintenance and growth of both net asset value and dividends per share are paramount to creating long-term value for our shareholders. Turning to slide nine as a refresher, our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market while also maintaining the ability to opportunistically invest in the upper middle market when attractive risk-adjusted returns exist. In the lower middle market, we directly originate and lead opportunities consisting primarily of first lien senior secured loans with smaller equity co-investments made alongside our loans. This combination is powerful for a BDC as it provides strong security for the vast majority of our invested capital while also providing NAV upside from these growing businesses. Building out a well-performing and granular portfolio of equity co-investments is important to driving growth in NAV per share, while aiding in the mitigation of any credit losses over time. As illustrated on slide 10, our on-balance sheet credit portfolio as of the end of the quarter, excluding our I-45 joint venture, grew 2% to $531 million, as compared to $521 million as of the end of the prior quarter. Our credit portfolio is currently weighted 86% to lower middle market loans, up from 82% last quarter, as a result of one loan prepayment in the upper middle market and six loan originations in the lower middle market during the quarter. Ninety-nine percent of the debt originations for the quarter were first lien seniors secured, and as of quarter end, 91 percent of the credit portfolio was first lien seniors secured. On slide 11, we lay out the $57.5 million of capital invested in and committed to portfolio companies during the quarter. This included $45.4 million in first-ling senior secured debt committed to three new portfolio companies, along with $2 million invested in equity co-investments alongside two of the new portfolio loans. We committed an additional $9.8 million in first-ling senior secured debt to two existing portfolio companies, which in both cases was utilized to fund strategic acquisitions. Turning to slide 12, as I noted earlier, Substance to quarter end, we have thus far invested $33.5 million of capital in two new portfolio companies. We believe our ability to cultivate strong sponsor relationships in the market and be a long-term dependable partner to our sponsors and portfolio companies has translated to enhanced deal activity and the ability to win more deals that fit our investment strategy. These relationships are also key to putting us in a position to make small equity co-investments in growing lower middle market companies alongside many of these sponsors. Turning to slide 13, we had two lower middle market exits this quarter, our equity investment in Tenuity and our first lien senior secured loan to Coastal Television. In the upper middle market, we exited our first lien senior secured loan to iEnergizer The exit of our equity investment in tenuity was especially notable as it generated a realized gain of $8.1 million on an initial capital outlay of $1.4 million. This resulted in an IRR of 73.2% and a multiple on invested capital of 6.8 times. Mountain Gate Capital, tenuity sponsored during our hold, and the tenuity management team did an exceptional job growing this business both organically and through acquisitions. and positioning it for a sale that generated an outstanding result for all parties involved. We are grateful to have had the opportunity to support the growth strategy for this company and its sponsor over the past four years. This continues our track record of successful exits. To date, we have generated a cumulative weighted average IRR of 16.8% on 35 portfolio exits, representing approximately $336 million in proceeds. On slide 14, we break out our unbalanced sheet portfolio as of the end of the quarter between the lower middle market and the upper middle market, again, excluding our I-45 joint venture. As of the end of the quarter, the total portfolio, including equity co-investments, was weighted approximately 86% to the lower middle market and 14% to the upper middle market on a fair value basis. Our portfolio of 39 lower middle market portfolio companies has a weighted average leverage ratio measured as debt to EBITDA through our security of 3.8 times. Leverage in EBITDA improved across a solid majority of the lower middle market portfolio for the quarter. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately two-thirds of our portfolio companies. Our on-balance sheet upper middle market portfolio, excluding our I-45 joint venture, consisted of 11 companies with an average leverage ratio through our security of 3.6 times. We were also pleased with the leverage and EBITDA improvement across the upper middle market portfolio. Turning to slide 15, we have laid out the rating migration within our portfolio for the quarter. During the quarter, we had two loans upgraded while having no loans downgraded. As a reminder, All loans upon origination are initially assigned an investment rating of two on a four-point scale, with one being the highest rating and four being the lowest rating. The upgrades consisted of loans to two portfolio companies, one previously rated a three and one previously rated a two, which were upgraded to a two and to a one rating respectively, both based on improved EBITDA performance and deleveraging. I'll also note that the number of loans in each category, as of December 31, 2020, included new portfolio company originations during the quarter, each rated a 2, while removing portfolio companies exited during the quarter. Specifically, one of the portfolio companies exited during the quarter was rated a 1, and one exit was rated a 2. As of the end of the quarter, over 90% of our investment portfolio at fair value was rated in one of the top two categories, either a 1 or a 2. We had six loans representing 9.6 percent of the portfolio at fair value, rated a three, and only one loan, our junior-most loan tranche to AG Kings, representing 0.1 percent of the portfolio at fair value, rated a four. As illustrated on slide 16, our total investment portfolio continues to be well diversified across industries with an asset mix which provides strong security for our shareholders' capital The portfolio remains heavily weighted towards first lien senior secured debt, with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio in one subordinated debt investment. Turning to slide 17, the I-45 portfolio also continued to show improvement during the quarter, as our investment in the I-45 joint venture appreciated by $2.2 million. Leverage at the I-45 fund level is now 1.07 times debt-to-equity at fair value, which is substantially improved from the peak leverage of 2.51 times debt-to-equity at March 31, 2020. As of the end of the quarter, 94% of the I-45 portfolio was invested in first-lane senior security debt with a diversity among industries and an average hold size of 2.6% of the portfolio. I'll now hand the call over to Michael to review the specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the December quarter, as summarized on slide 18, we earned pre-tax net investment income of $10 million, or 52 cents per share. This was a 23 percent increase from the $8.1 million, or 44 cents per share, earned during the prior quarter. We paid out 41 cents per share in regular dividends for the quarter, flat from the 41-cent regular dividend per share paid out in the September quarter. As mentioned earlier, our Board has declared an increase to our regular dividend from 41 cents to 42 cents per share to be paid out during the March 31 quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax net investment income is important to our investment strategy. This track record is demonstrated by our 107% regular dividend coverage over the past 12 months, and 108% cumulative regular dividend coverage since the launch of our credit strategy. During the quarter, we maintain our supplemental dividend at $0.10 per share, and again our board has declared a further $0.10 per share supplemental dividend to be paid out during the March quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of December 31, 2020, our estimated UTI balance was $1.09 per share. Our investment portfolio produced $19 million of investment income this quarter with a weighted average yield on all investments of 11.2%. This represents an increase of approximately $2.4 million from the previous quarter. The increase in investment income was driven partly by an increase in debt investments outstanding as well as a distribution of $1.2 million from one of our lower middle market portfolio companies, as part of a dividend recapitalization. This is a prime example of the benefits of investing equity with the portfolio companies where the growth story is compelling. As Bowen mentioned, we had no new non-accruals as of the end of the quarter and our weighted average yield on our credit portfolio was 10.6% for the quarter. As seen on slide 19, our operating leverage was flat for the quarter at 2.6%. Operating expenses were slightly elevated this quarter due to the accrual for our annual bonus program. The final payout for our annual bonus will be determined and approved by the Board based upon their review of company performance for the full fiscal year 2021. Based on both our strong NII performance and continued improvement in our overall portfolio, we have accrued the annual bonus above our annual target, giving our Board the flexibility, if they so choose, to pay out bonuses in excess of our stated targets. All that said, We do expect that our run rate operating leverage going forward will be below our target of 2.5 percent. Turning to slide 20, the company's NAV per share as of December 31, 2020, was $15.74, as compared to $15.36 at September 30, 2020. The main driver of the NAV per share increase was $7.1 million of appreciation in the investment portfolio, much of which was in our equity portfolio. On slide 21, we laid out our multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to de-risk our liability structure while ensuring that we have adequate investable capital throughout the economic cycle. During the quarter, we raised an aggregate principal of $75 million in 4.5% unsecured notes due to 2026 and paid down $20 million on our 5.95 percent baby bond due 2022. We believe the execution on our new $75 million issuance is corroboration of the market's acceptance of our investment strategy and their confidence in our portfolio and track record. This capital raise provided us the flexibility to fully repay the outstanding balance of $37.1 million on our 5.95 percent baby bonds subsequent to quarter end. while also providing the company cost-competitive and flexible capital to fund future investments. Our debt capitalization today includes a $340 million on-balance sheet revolving line of credit with 11 syndicate banks maturing in December 2023, a $125 million institutional bond with over 25 institutional investors maturing in 2024, the aforementioned $75 million institutional bond with six institutional investors maturing in 2026, as well as a $150 million revolving credit facility at I-45 with four syndicate banks maturing in 2024. Finally, as we mentioned last quarter, we continue to work with the U.S. Small Business Administration toward becoming officially licensed as an SBIC. We received our green light letter in July 2020 and have submitted our final application for licensure. Due to the disruptions around the election and transition between administrations, the pace of processing application approvals by the SBA slowed considerably over the past few months. We continue to expect to complete this process soon and will keep you apprised of progress where appropriate. Overall, we are pleased to report that our liquidity is strong, with approximately $187 million in cash and undrawn commitments as of the end of the quarter, with ample borrowing-based capacity and covenant cushions on our senior secured revolving credit facility. As of December 31, 2020, approximately 59% of our capital structure liabilities were unsecured and subsequent to the pay down of our December 2020 notes, our earliest debt maturity is now in December 2023. Our balance sheet leverage as seen on slide 22 ended the quarter at debt to equity ratio of 1.22 to one. I will now hand the call back to Bowen for some final comments.

Thanks, Michael. And thank you, everyone, for joining us here today. Capital Southwest continues to perform very well and consistent with the vision and strategy we communicated to our shareholders six years ago. Our team has done an excellent job building both a robust asset base, reputation, and deal origination capability, as well as a flexible capital structure that prepares us for difficult environments like the one we experienced in 2020. In fact, performance through difficult environments like 2020 demonstrate the investment acumen of our team at Capital Southwest and the merits of our first lien senior secure debt strategy. We feel very good about the health of our company and portfolio, and we are excited to continue to execute our investment strategy going forward. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance, and creating long-term sustainable value for all our stakeholders. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

Thank you. To ask a question, you'll need to press star 1 on your telephone. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from Devin Ryan of JMP Securities. Your line is open.

Hi, this is Kevin Fulton for Devin this morning. First question, the stock is trading at a healthy premium to NAV, and as we saw last quarter, you were fairly active in selling shares under the ATM program. Can you provide some high-level thoughts around how you balance raising equity in the current environment and how active we can expect equity issues to be over the next few quarters?

Yeah, look, that's a good question. I would say the ATM program, one of the things we like about the ATM program, on top of it being a very inexpensive way to raise equity, 2% spread to trade. But you can also manage the BDC's leverage over time vis-a-vis the pipeline, how much activity we have coming down, liquidity we have in our portfolio, the quantum of unfunded commitments, a whole host of variables go into the ultimate equation, which is how much equity we think we need to raise. And we always want to stay out in front of and prepare ourselves for hiccups in the night from the economy or what have you. So not an exact answer to your question as to how much we plan to raise, but one of the reasons we raised so much equity this last quarter was that we had a lot of investment activity, and we weren't able to raise a lot of equity in the prior two quarters before that during the pandemic. So it's really a lever that we pull to manage leverage, and we're looking at, again, we're looking at activity in the portfolio, liquidity of the company, and unfunded commitments on our balance sheet that we need to be ready to support.

Yeah, I'd also say, Kevin, just from a modeling perspective, I think we expect, on an average, probably when our stock's been trading well, to raise around $15 million, I would say, on a quarterly basis. Now, this past quarter, as Bowen said, We had higher deal origination volume, so we raised a bit more at 21 million. Sometimes it will be slightly less, but I think 15 is about the right size on a go-forward.

Okay, great. That's helpful. And then kind of another big-picture question. You have a pretty robust deal-making environment currently, fairly significant unused debt capacity, and as mentioned, the ability to issue equity under the ATM. Can you talk about the potential for growth of the investment portfolio in 2021? Sure.

Yeah, I mean, right now, I mean, deal flow right now is certainly strong. You know, our team is really hitting its stride on just deal origination activity. You know, we're still closing about, you know, about 2% of the deals that we review. It's about, over the last 20 years of my career, that's kind of about the number. You know, sometimes a little higher, sometimes a little lower. You know, I think that, you know, having gone through the pandemic and deal sources, sponsors see how we behave. And we're very commercial and reasonable. We don't roll over. We expect fair outcomes. If we contribute capital to the company, we expect the sponsor to do the same. So it's a very commercial and balanced approach. But candidly, one of the ways that we manage an anticipated downturn is structuring deals up front better and more responsible. In other words, you don't go to a very strong sponsor relationship who maybe wants more debt on a deal than we think is prudent for the potential volatility of the business, we don't win those deals, candidly, because we think about it up front. Look, if we're going to over-lever something, we don't want to have a tough conversation with a really good sponsor of ours. So part of kind of being able to manage commercially and responsibly and through a pandemic environment is the structuring and stuff you've done up front. So now we come out of this, come out of the pandemic, Candidly, I think our team has developed a lot of street credibility and comfort and track record when people are considering us as the financing partner. So it's not always being the lowest-priced deal. You've got to be in the zip code of market pricing, but you don't have to, like, low-price every deal you look at if you develop that reputation and how you conduct yourself when things bump in the night. I think that's what's attributing, to some extent, our deal flow and the quantum of deals we see and the quantum of deals we win. So, you know, look, I expect, you know, deal flow to continue to be, you know, solid throughout this year. But we'll see. You know, we'll see.

Yeah, I mean, just probably putting some numbers to it. I think that we project internally to do around 40 to 50 million in originations each quarter and expect to see between, you know, 15 and 20 million come back. Sometimes we do a little bit more on the origination side, and obviously sometimes you'll see a run on prepayments as well, but essentially somewhere in that 20 to 30 million net portfolio growth a quarter.

Okay, that's very helpful. And then lastly, touching on prepayments, what visibility do you have around that 20 prepayments?

Yeah, you know, I think we obviously we get within a quarter. In the beginning of a quarter, we probably have some level of visibility that I'd say for this quarter, we know that there's a limited amount of activity going on, and so we're not expecting probably something on the low end of that range of repayments. As the interest rate environment goes up and down, obviously you see that change. But I think right now you've seen a lot of repayments come back with people kind of settled into where the market is at the moment. So I wouldn't expect a whole rash in the next three to six months.

Okay. That's it for me, and thanks for taking my questions, and congratulations on a great quarter. Thanks, Kevin. Thanks.

Thank you. Our next question comes from Mickey Klein from Lattenberg Thelman. Your line is open.

Good morning, Bowen and Michael. Hope you're well. I want to ask a high level question about this year. So when we think about the pace of vaccinations and the recent mutations of the COVID virus, it looks like the pandemic will or could go on longer than we had hoped and that it could continue to stress companies in some industries. So apart from your software-related investments, how do you feel about your borrowers' availability, your borrowers' ability to carry them through the pandemic, particularly with respect to liquidity?

Yeah, it's interesting. I mean, you know, just personal view of this, I mean, you know, the things you said are correct. You know, the pandemic's not behind us. You know, the vaccine's out there. It's You know, we'll see how well the vaccine works, how many people take the vaccine, all those kinds of things, and you've got new strains and lots of unknowns. But I think at some level, and speaking to our portfolio, you know, people, you know, the companies are kind of, they've found, for the most part, they've kind of found their stride. So aside from a complete panic lockdown where everybody goes back to the, everybody goes back to the living rooms, etc., You know, aside from that, I mean, I feel like our portfolio has kind of found its stride. Now, you know, if the pandemic sticks with us for another 12 or 18 months, you know, if I had a concern about that, it's more of it's just going to be, you know, muddy quicksand for companies that are trying to grow. And so progress and growth could definitely be affected. And that's really our equity portfolio, right? Upside of the equity portfolio, that could stretch out. So that's a concern from a credit perspective and a security of our capital perspective. you know, I feel pretty good about that. Now, the only thing I would point out is, you know, the vast majority of our companies are small businesses, and many of them have SBICs in the capital structures in some way, and candidly, we would expect to be an SBIC, you know, or have an SBIC relatively soon, and so there is the PPP money that's out there, and so that's, you know, I don't Looking across the portfolio, I don't really see any companies that are like, geez, the difference between survival and not survival is a PPP loan. But I do think that helps kind of bridge noise across the portfolio that might come from the pandemic.

Thank you for that, Bowen. That's really helpful. I want to ask you about American Addiction. It has obviously exited bankruptcy. And if I'm not mistaken, you're the new chairman of the company. How do you feel about that specific company's prospects? And is it benefiting from the pandemic? And, you know, what's the long-term sort of exit strategy for AAC?

Yeah, so AAC, you know, I was involved with an addiction treatment business for 10 years or eight years a while ago at my former firm. And so I had some experience in the space. And the firm, the Meadows, is a firm that had some posh out there and It's a very successful company, and so they wanted to ask me to be chairman so they could put me in the press release so that the employees would see, okay, someone on the board actually has industry experience, you know, that type of thing. So what's not happening is I'm not running the company, but what is happening is I am on the board, which I'm happy to do. I don't want to do a lot of those things across the portfolio, but I'm happy in this instance. I am pretty positive on that platform. It's got an incredible asset base. network of facilities. They do really, really good work saving lives in the addiction area, and they do a really good job at it. So it's just been in a tough restructuring and bankruptcy, which we're now clear of. And so now it's kind of sunshine ahead. I mean, pretty positive on the upside on that business from where we are today, just given the quality of their network and the building blocks that the company has to work with to really recover from where they are on an evaluation perspective today. So I would say, you know, clearly the pandemic and lockdowns has created stress in society. And when stress in society increases, you know, a lot of folks struggle with medicating around stress. And that obviously, you know, results in alcoholism and drug addiction, which are very, very unfortunate things and really need to be helped. And, you know, people lose lives from that. And so, you know, to be able to help those people is obviously a great mission. And it's one that can be done profitably and one that you can build a really good business around. So I think, you know, so from that perspective, you do have a tailwind across the addiction treatment space from that stress. But that said, you know, when, you know, these are facilities. People live there while they're going through addiction. And so COVID and COVID protocols and quarantines and lockdowns, et cetera, are all things that you would imagine, you could imagine go on. So you've got headwind from those types of things, but you have tailwind from the general stress in the society. And so I feel actually great about the upside of that business going forward.

Bowen, do you expect roll-ups to occur in that industry? And would AAC be an acquirer, or do you expect them ultimately to be acquired by someone else looking to grow?

Yeah, so I would say, first of all, the majority of the upside is just EBITDA growth from the business and, you know, signing new network contracts, filling the beds that aren't filled. You know, organically, the economics of adding a few beds to an existing facility, the ROI of that is staggering, actually, if you can fill them. So, So there's, you know, it's just not a lot. It doesn't cost a lot. It's like adding on, you know, a wing on a hotel or something or not even that, like a, you know, it's, you know, it's, yeah, it's kind of like a hotel, adding on beds. And then the recurring economics, if you can fill those beds, is really attractive. So there's a lot of organic growth. There's a lot of recovery type growth or recovering from, you know, where it is today. And then we may make acquisitions. You know, I think that AAC could absolutely be acquired at some point. There are definitely larger platforms in the space. You know, we had a lot of interest in the bankruptcy auction, just not at valuations that made a lot of sense. Candidly, a lot of vultures swarming around in a bankruptcy. There's a lot of noise in that, people trying to take advantage. In Canada, we had a lender group, now an investor group that, you know, see a lot of upside. So we just credit bid and took over the company and that's now we're the owners. And so, so those people are still out there. Those big platforms are still out there. They're just, you know, we'll just, we're just going to do the things we want to do with the business or the management team with the business. And then we'll, it could absolutely be acquired in the next couple of years. I mean, that's, that's, that's clearly an exit strategy.

Thanks for that. My last question, just to touch on, on CPK, it also emerged from bankruptcy and, I assume the balance sheet's a lot healthier now. But I was walking near my home recently, and I saw that my local CPK was closed. So I have read, I think, that the footprint has shrunk. So in terms of strategy for CPK in this pandemic environment, are you looking sort of to manage that business through the pandemic and status quo or – Do you expect some growth opportunities to occur? You know, what's the outlook in general for CPK in the environment that we're in?

Yeah, so, you know, that CPK is different in the sense that, you know, we're not on the board there. So we're a smaller, you know, investor, I guess, in that platform. But I'll give you my impressions and kind of what I can tell you about what we hear and see. The manager team there is excellent. And they had this business – doing much, much better, you know, pre-COVID. They started, I think, in mid-19, and the business was kind of had a difficult time, no reason other than just kind of difficult, and the management team, you know, came in, just did fantastic, and then COVID hit. Obviously, it's a restaurant, and so that struggle, they went out during the bankruptcy process and negotiated leases, and the realtors or the lessors that were landlords, there were certain landlords that just, you know, that they decided it wasn't worth keeping that lease and took the excuse to get out of the lease. And candidly, in my neighborhood, our CPK closed as well. But there's a bunch of CPKs around Dallas, and they're doing fine. The one that closed, candidly, that was probably a really expensive lease. And so the network of footprint of restaurants, yes, decreased, as one would expect in a bankruptcy process. It's a chance to clean out leases that are less profitable. But if you look across the network, I mean, I would tell you just thematically, the ones that are open, it's pretty interesting how well they were doing versus kind of pre-COVID revenues. I mean, they're It's got a couple of things. It's got a licensing business with Nestle in grocery stores. It's obviously a pizza business, and so it's got delivery. That's obviously natural for people to order pizza delivery. So those are some things that help the business. And the management team has done great. As far as creativity on expanding patios and doing things creatively, we need to get past the pandemic before this thing takes off. But they've done a really good job managing it. You know, it's cash flow positive, you know, so we're not thinking about funding it. You know, we're going to have to wait a bit to get out of the malaise of the pandemic, but it's going to be fine. I mean, I really do. I think there's a fair amount of upside in that business going forward. It's just a question of pace at which we see the upside, these are the pandemic and timing. But if you look at the KPIs, the performance indicators that we look at, There's a lot of things about it that are – you jump off the page. It's like if the pandemic would only go past, this thing is in fantastic shape. That's the reaction you have to it. So we feel pretty good about it. Timing is somewhat dependent on the pandemic.

Okay. I appreciate that. I understand. That's it for me this morning. Thank you for your time.

Thanks, Vicki.

Thank you. And our next question comes from Kyle Joseph of Jefferies. Your line is open.

Hey, good morning, guys. Congrats on a nice quarter, and thanks for taking my questions. I wanted to talk about net interest margins in the outlook going forward. Obviously, it's an active deal environment. Just talk about spreads and where we are versus, call it, year-ago levels. And then on the cost of funds side, talk about what the liability management is. you guys have done recently, how that could help on the cost of funds side?

Yeah, sure. Well, I'll just comment on the asset side, the spreads. I mean, you know, we're kind of back to pre-COVID spreads. So we're not, you know, it's not, you know, there's not a, we don't see a whole lot of COVID premium out there. Maybe a little bit of premium in the sense that leverage, you know, people look at the pandemic in the mirror of your mirror and leverage asks are slightly lower than they were a year ago. So from my perspective, that is a risk element that's in our favor. generally, but the spreads on the loans we do are kind of back to pre-COVID levels. But our cost of capital, which I'll let Michael comment on, has come down. So we feel pretty good about the asset-liability relationship. Do you want to talk about that?

Yeah, so obviously we raised $75 million on that 4.5% institutional bond, which took out, if you think about it, over the last two quarters, we've taken out the entire, potentially, I think we have $60 million left on that bond. So we've converted it from 5.95 down to 4.5, so that's about 150 basis points, which if you annualize that, that's really about $800,000 a year, so about a penny a quarter. So that's going to be helpful. I think going forward, the SBA is still hanging out there. The notion would be between $340 million on the credit facility, which is about two and three quarters all in, and we should expect to see the SBA, if and when that comes to pass, at a similar cost. So you'll have three-fourths of the portfolio, you know, sub-three, and then you'll have that bond at four and a half plus the 75 we have at, you know, around 5%. So kind of your blend right now is around 4.85%, and we think we're going to be coming down to, you know, like four and a quarter probably in the next year.

Got it. Very helpful. And then obviously your credit's trending in the right direction and your book's in good shape, but just trying to feel back the onion a little bit. Can you give us a sense for revenue and EBITDA trends in the fourth quarter and how those compare to the third quarter, either in terms of growth or contraction and kind of early performance year to date?

Yeah, I would say generally EBITDA on revenue in the portfolio for a strong majority of the companies was positive, kind of low single digits. And, you know, it looked pretty good. I mean, deal leveraging in the portfolio is good. We've got a handful of, you know, names that are kind of bumping along. But, you know, from where we sit from a first lien perspective, it's, you know, that just means that, you know, they bust a covenant here or there. We get to charge economics and you know, but there's plenty of cash flow to service our debt and that type of thing. So that's part of being a first lien lender. That's a benefit you get as things bump along a little bit. But, you know, a very strong majority of the companies were, you know, last quarter and this quarter were positive.

Got it. And then one last one from me, just talk about your appetite for continuing the special. Obviously, you guys have a a strong UTI balance, but kind of the outlook for that going forward, given where the base went to, as well as the overall strong portfolio performance?

Yeah, so, I mean, you know, it's, you know, we're continuing to, you know, until the board decides otherwise, we're continuing the supplemental dividend program, like we stated. You know, it's a liquidity thing, right? There's The UTI is not going anywhere, so we distribute it over time. So it's a liquidity thing for us to have the capital to do it, which we have plenty to do. We manage it that way. And so our goal was to create a program that the market can rely on and then obviously can price the stock accordingly. But as of now, we're continuing to pay it.

Yeah, and I would say that you need to really look at them independent of one another. So the UTI balance is going to dictate, as Bowen said, whether the supplemental dividend is approved by the board on a quarterly basis. And obviously we have about two and a half years of runway there, so plenty of time to make a decision on how we play that out over time. But on the regular dividend, all the things we're talking about, we're having a growing portfolio, our cost of debt is coming down. Our operating leverage, even though it was around 2.6 this quarter, The run rate for operating leverage is really around 2.2 on a normal course. So all that being said, we think that this is the first of several dividend increases, probably over the next several quarters. And so you should expect to see growth on the regular, and sub-medal should continue along the way.

Got it. Very helpful. Thanks for answering my questions.

Thank you.

Thank you. Our next question comes from Robert Dodd of Raymond James. Your line is open.

Hi, guys. Congratulations on the quarter. But if I can go back to the spread issue, right? I mean, obviously, you said, you know, no COVID premium anymore, which I don't think is that surprising. But if leverage is down, can you give us any comment today if you work a risk-adjusted total return expectation when you're looking at doing a deal? Is that wider today still than pre-COVID? Or is all of that evaporated as well with this no COVID premium? Is the lower leverage not enough to kind of make you raise your expectations for what total return is going to be over the life of an incremental loan? Or is it? Yeah, it's an interesting question.

I would... say this. I mean, I think generally speaking, the models we're looking at now are, you know, from a debt perspective, you know, have, you know, kind of the same debt returns with a difference that I want to make here a second that's important. But the debt returns are, you know, all, you know, anticipated returns on your debt, you know, which is spread and LIBOR and OID up front and prepayment penalties if they pay early, those types of things, is all generally the same. One of the things that, you know, your equity returns might be higher because some of the businesses, you know, performed really well during COVID, but they're still kind of down from COVID. And so, you know, we can underwrite, you know, the founders wants to go ahead and, you know, de-risk their personal situation and roll over maybe even more equity because the valuations maybe are down in certain instances. And so as we look forward, the equity upside in a company like I just described is might actually be higher than it was a year ago where everything is up and to the right and there's no problems in the world. You know, whenever there's no problems in the world, that means the problem's coming, right? And so there are situations that we've definitely seen where the equity returns, if we had done the deal a year ago, would probably be anticipated. A base case equity return might be less. And so that's a difference. I would say, you know, as our cost of capital, as we have always said, you know, the range of The range of pricing in the lower-end markets, a range. Some of that's competition, but some of that's just things like leverage but also loan-to-value. A company that you're lending 30% loan-to-value and a cash-flowing higher-margin business is going to have a lower pricing than something you're 50% loan-to-value with maybe a lower margin. And so – but it's going to price cheaper. So, like, there's a safe end of the low-orbital market and a little bit less safe end of the low-orbital market, right? There's a range, right? That shouldn't be all that surprising. And so as we manage our capitalization and get our cost of capital down, we can play more in the safer end of the low-orbital market. And so it's a lower loan-to-value but maybe tighter spreads. But then one of the big, as you know, one of the big drivers of long-term all-in returns is principal loss rates, right? So I think that as we invest maybe slightly lower spreads in a safer end of the market with lower loan-to-value, higher margin businesses, you know, you asked me about my anticipation. I mean, you know, the more we do in that, I anticipate materially less long-term credit losses. So, look, I think our track record of our team is excellent. You know, but credit losses are an expense of our business, right? I mean, your expense is your business, right? It's a spread business, but we have three buckets, right? One is the cost of our capital we're borrowing. Another is our overhead. That's operating leverage you hear about every quarter. And then the third cost is losses over time. So, you know, you're always trying to gain efficiency by decreasing all three of those buckets. And so one of the buckets is losses over time. So as we do slightly safer loans, i.e. slightly lower spreads, yes, my anticipated all-in return over time increases.

And we also expect you, by putting together, Robert, a portfolio of those credits that Bone just described, it's also going to enhance our investment-grade portfolio, right, in terms of going to the rating agencies, which in time would mean we'll actually be able to reduce our cost of capital even further by putting together that high-quality portfolio.

Hopefully that's helpful on how spreads relate to all-in return. I hope that's helpful.

Yeah, absolutely. Very helpful. I really appreciate that. Exactly. Right. I mean, it's, it's a total return vehicle. It's not just a, it's not just a coupon business, um, on the, the, the portfolio as it stands. So obviously we don't have the queue yet. Right. So when I look at the, the unrealized appreciation in the quarter, can you give us any color of how broad based that was? I mean, obviously I had two upgrades, um, Did those account for most of the unrealized appreciation, or is it much more broad than that across the portfolio?

I'd say it's pretty broad in a sense, but it's mainly on the equity portfolio. So that's where we put that bridge, slide 20 in the shareholder deck, and so we did that kind of football chart going across the page. And you can see the change in the equity portfolio being 33 cents a share for the quarter. That's not a small number for one quarter. And that's probably, you know, it's definitely two handfuls of equity investments. You know, now we did have the tenuity exit this quarter. You know, that was materially higher than it was valued at the end of the last quarter. So that contributed to that equity upside as well.

Got it. Got it. And then one last one. I forgot. AG Kings, I mean, obviously, again, we don't have the mark. The exit at the end of the quarter was that. about, you know, in line with the mark that you had at 1231 and if you can give us any color on where that mark was versus 930 since that's the only one that, you know, that's the scheduled investments we currently have right now.

Yeah, so our exit was higher than where it was valued last quarter. So that's the first thing I would say. And then the $739,000 that's left is basically the last interest. I mean, there's a litigation trust and a you know, the final bankruptcy cleanup and there's a final working capital adjustment and, you know, some final economics, which, you know, candidly we believe is going to be, you know, meaningfully higher than the $740,000 we have valued right now. So we think there's upside in NAV from that perspective. And then our all-in recovery at the end of the day will be about $0.80 on the dollar. Got it. I appreciate it. Thanks a lot.

Thank you. And our next question comes from Sarkis Sherbetchen.

Hey, good morning, and thanks so much for taking my question here. I just want to hit on the point regarding the comments on operating leverage run rate at 2.2% on a normal course you just mentioned in your commentary. Can you maybe help us understand the timetable that you're anticipating on getting there, as well as maybe the portfolio or total portfolio size that you would expect to achieve that?

Well, I would tell you right now, as I was noting earlier in the script, that we've had essentially one-time accrual above the annual target rate, which was about $700,000. So this quarter, the actual run rate for cash compensation would be $1.7 million. Our share-based compensation run rate is usually around $800,000. And so you're looking usually at about $2.5 million on a run rate basis right now. Based on that asset base, it's a 2.2%. So we would expect additional. We've already said we've closed $33 million in assets in January. So moving forward on a normal run rate basis, we would expect that percentage to be somewhere between 2.0 and 2.2.

Great. Thanks for that. And I just want to hop on page 11 and 12 of the slide deck for the Q3 originations and then the subsequent quarter end originations, right? So if I look at the debt spread, the weighted average was 8.2 almost on the Q3 originations. And then if I look at the two and quarter end, it's about 7%. Is that really just deal specific or is that an indication of what's going on from a tightening perspective in the environment? Any color there, please?

Yeah, no, you've got to really, it's deal specific. I mean, if you look down through there, I mean, like there's a couple of deals that were, one in particular is a first out, you know, last out structure. So we brought in a first out person, a first out party to take a small piece of the loan. So our spread is higher on that. You know, we've got, you know, one of the companies had a 950 spread. That's a portfolio company we've been in for a long time. And there's some precedent set as to what the spreads are in that deal. So it's not completely new deal. type thing. But it's really kind of I'm just looking down the list. It's pretty deal specific. So if you go into 600 is a larger club type situation, larger company. And we're actually first out in the 600 deal. We're actually a first out interestingly enough. So it's a little bit more deal specific. I wouldn't say that the difference between slide 11 and 12 is directly parallel to some trend in the market.

Great. That's helpful. And I guess last question on me regarding kind of the leverage front. I believe from an economic leverage perspective, had you targeted kind of the 1.3 to 1.4 range assuming you get the SBIC licensure and from a regulatory leverage perspective, you'd still kind of be in the 1 to 1.1 zip code. Can you kind of give me some color on that?

Yeah, I would tell you from an economic leverage perspective, we really have targeted, you know, between 1.2 and 1.3. Even getting the SBA money when that does happen, we don't plan on levering up economic leverage beyond there. So I think To your point, we probably will show up with 1.0 to 1.15 on regulatory leverage and stick to 1.2 to 1.3 on our total economic leverage.

Great. That's all for me. Thanks for the time. Thank you.

Thank you. And at this time, I'm showing no further questions. I'd like to hand the conference back to Mr. Bowen Deal for any further comments.

Great. Thanks, operator. Thanks, everybody, for joining us. We appreciate it. Hopefully you got a good impression of things are going pretty well here, and we appreciate your all support and time and look forward to keeping you posted on the business as we go forward.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day.