Capital Southwest Corporation

Thank you for joining today's Capital Southwest fourth quarter and fiscal year 2021 earnings call. Participating on the call today are Bowen Deal, CEO, Michael Sonner, 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 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 over to our President and Chief Executive Officer, Bo.

Thanks, Chris, and thank you, everyone, for joining us for our fourth quarter and 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 the fourth quarter and fiscal year ended March 31, 2021. I want to first say I hope everyone, their families and their employees continue to be safe and well. We are hopeful that the economy will continue to take steps forward as businesses and communities continue to return to pre-pandemic levels. While the aftermath of the pandemic continues to impact certain parts of the U.S. and world economies, we are grateful for all the work done by our employees as well as the sponsors, owners, and employees of our portfolio companies. I'm pleased to report that this year was another stellar year for Capital Southwest as we continued to steadily grow all aspects of our company, including investment assets, capital availability and flexibility, and investment income. As we reflect on the year and the unprecedented storm that hit the economy vis-a-vis the COVID pandemic, We noted some fundamental decisions made in prior years reflective of our full economic cycle management philosophy that allowed us to perform well during the unprecedented black swan event that we all experienced in 2020. First, we have been intent to always have ample liquidity, which in our case means ample revolver availability and a prudent amount of outstanding unfunded portfolio company commitments. Second, we maintained a flexible leverage structure on our balance sheet with over 50% of our liability structure in the unsecured covenant-like bonds going into the pandemic. And third, and perhaps most importantly, we have maintained our discipline in building a high-quality, almost exclusively first lien credit portfolio with diversity in industries and a granularity of hold sizes. As a result of these decisions, we were able to do three important things in this fiscal year. First, we had more than ample liquidity to support portfolio companies that needed it, while also continuing to fund new deals that were able to be underwritten in the pandemic environment. Second, we were able to more than cover dividends to our shareholders. And third, when the inevitable stock market volatility presented itself, we were able to repurchase a material amount of our stock. Beginning on slide six of the presentation, we summarized some of the key performance highlights for the fiscal year. Total return to shareholders for the fiscal year was 119%, which consisted of share price appreciation of 94%, and total dividends paid during the year of $2.05. Our NAV per share grew 6% to $16.01 versus $15.13 in the prior year period, driven primarily by $20.2 million in net unrealized and realized gains on the portfolio. I think it is also important to note that our NAV per share of 1601 as of March 31, 2021, represented a retracement to 99% of its pre-pandemic level of 1674 per share as of December 31, 2019, when adjusted for the 50 cents per share in supplemental dividends we paid out to shareholders during this 15-month time period. Considering the unprecedented events of the last 15 months, we are extremely proud of the team and what they have accomplished. During the fiscal year, we grew our total portfolio at fair value by 24% year-over-year to $688 million versus $553 million in the prior year and increased our pre-tax net investment income by 7% to $1.79 per share from $1.68 per share in the prior year. Furthermore, we strengthened our balance sheet during the year through the issuance of $190 million of unsecured notes, $51.4 million in equity proceeds through our equity ATM program, and $15 million in additional commitments obtained on our ING-led revolving credit facility. Additionally, we announced in April that we have been formally approved into the SBIC program and have officially received our SBIC license. Michael will provide further detail on this later in the prepared remarks. As a well-capitalized first lien lender with ample liquidity, Capital Southwest continues to be in a favorable position to seek attractive financing opportunities, grow our asset base, and continue to grow earnings and increase dividends for our shareholders. 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 seven 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 44 cents per share, which exceeded our regular dividend paid for the quarter of 42 cents per share. Including our supplemental dividend of 10 cents per share, total dividends for the quarter were 52 cents per share, which represented an annualized dividend yield on the quarter end stock price, of 9.4% 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 53 cents per share for the coming quarter ending June 30, 2021, consisting of a regular dividend increase from 42 cents per share to 43 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 portfolio growth, continued reductions in our cost of capital, and our ability to improve our operating leverage efficiency by actively managing operating costs while growing the asset base. During the quarter, we grew our investment portfolio on a net basis by 6% to $688 million as of March 31, 2021. Portfolio growth during the quarter was driven primarily by a total of 77.3 million in new commitments to six new portfolio companies and one existing portfolio company, offset by 23 million in total proceeds from two exits. The portfolio generated net realized and unrealized gains of $2.6 million during the quarter, and we currently have no investments on non-accrual. On the capitalization front, we were quite busy during the quarter, we successfully raised over $89 million in investable capital, consisting of $65 million in aggregate principal of unsecured notes and $24.1 million in gross proceeds through our equity ATM program. Turning to slides 8 and 9, 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. We believe the strength of our investment and capitalization management strategies was demonstrated by the solid performance of our company and our portfolio throughout this unprecedented period. Maintenance and growth of NAV per share and shareholder dividends remain as core tenants of our long-term investment objective of creating long-term value for our shareholders. Turning to slide 10 as a refresher, our investment strategy has remained consistent since its launch in January 2015. We continue to focus on our core lower middle market lending strategy 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. We believe that 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 equity investments in 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. Today, our equity co-investment portfolio consists of 29 investments totaling $58.7 million, or 9% of our portfolio at fair value. Though the equity portfolio currently has performed extremely well with $10.1 million in cumulative appreciation, some lingering effects of the pandemic aftermath still persist, leaving us very excited about the potential upside of this equity portfolio moving forward. As illustrated on slide 11, our on-balance sheet credit portfolio is at the end of the quarter, excluding our I-45 joint venture. grew 8% to $573 million as compared to $531 million as of the end of the prior quarter. Our credit portfolio is currently weighted 88% to lower middle market loans, up from 86% last quarter. For the quarter, 100% of the debt originations were first lien senior secured, and as of the quarter end, 92% of the credit portfolio was first lien senior secured. On slide 12, we lay out the $77.3 million of capital invested in and committed to portfolio companies during the quarter. This included $74.5 million in first lien senior secured debt committed to six new portfolio companies, along with $2.5 million invested in equity co-investments alongside two of the new portfolio loans. Turning to slide 13, we continued our track record of successful exits with two this quarter. a first lien senior secured loan to Environmental Pest Service, and the remainder of our expected proceeds from the sale of AG Kings to Acme Markets. To date, we have generated a cumulative weighted average IRR of 15.5% on 38 portfolio exits, representing approximately $384 million in proceeds. On slide 14, we break out our on-balance 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 88% to the lower middle market and 12% to the upper middle market on a fair value basis. Our portfolio of 44 lower middle market companies has a weighted average leverage ratio measured as debt to EBITDA through our security of 4.2 times. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately 60% of our portfolio companies. Our unbalanced sheet upper middle market portfolio, excluding our I-45 joint venture, consisted of 10 companies with an average leverage ratio through our security of four times. Turning to slide 15, we have laid out the rating migration within our portfolio again this quarter. During the quarter, we had one loan upgraded from a two to a one, while having one loan downgraded from a two to a three. 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. As of the end of the quarter, we had 56 loans representing 91% of our investment portfolio at fair value, rated in one of the top two categories, a one or a two. We had seven loans representing 9.2% of the portfolio at fair value rated a three, and we had no loans 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 5% 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 $1.5 million. Leverage at the I-45 fund level is now 1.27 debt to equity at fair value. The increase in leverage at I-45 was mainly driven by an equity distribution to the JV partners during the quarter, which represented most of the capital contributed to the JV during the height of the COVID-related market disruptions. Michael will talk more specifically about this in a moment. As of the end of the quarter, 95% of the I-45 portfolio is invested in first lien senior secured debt with diversity among industries and an average hold size of 2.8% of the portfolio. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance in the March quarter, as summarized on slide 18, we earned pre-tax net investment income of $8.9 million, or 44 cents per share. We paid out 42 cents per share in regular dividends for the quarter, an increase from the 41-cent regular dividend per share paid out in the December quarter. As mentioned earlier, Our board has again this quarter increased the quarterly regular dividend, declaring a dividend of 43 cents per share up from 42 cents per share last quarter to be paid out during the June 30 quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax net investment income is important to our investment strategy. Over the past 12 months, we maintained our strong track record of regular dividend coverage with 108% for the year and 107% cumulative since the launch of our credit strategy in January 2015. During the quarter, we maintained our supplemental dividend at 10 cents per share. And again, our board has declared a further 10 cents per share supplemental dividend to be paid out during the June quarter. As a reminder, the supplemental dividend program allows for shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of March 31, 2021, our estimated UTI balance was 92 cents per share. Our investment portfolio produced $17.2 million of investment income this quarter, with a weighted average yield on all investments of 10.2%. Investment income was $1.9 million lower this quarter, due primarily to last quarter's investment income, including significant non-recurring dividend and fee income. In addition, during the quarter, we had one portfolio company put in place a new revolving credit facility to finance working capital build as the business recovers from some operating challenges. In conjunction with the revolving closing, the term loan lender group agreed to convert three-quarters of cash interest to PIC as a further contribution to the company's working capital need. The cash interest converted was approximately $1 million, which all fell in the March quarter. There were no non-accruals as of the end of the quarter, and our weighted average yield on our credit portfolio was 10.8% for the quarter. As seen on slide 19, our operating leverage continued to improve, decreasing to 2.4% for fiscal year 2021. Going forward, we will report operating leverage on a rolling four-quarter basis, as we believe this is a more informative metric for our shareholders due to the quarterly fluctuations in our operating expenses. For fiscal year 2022, we expect operating leverage to be between 2.1% and 2.3%. Turning to slide 20, the company's NAV per share as of March 31, 2021 was $16.01 as compared to $15.74 at December 31, 2020. The main driver of the NAV per share increase was $2.6 million of net appreciation in the investment portfolio, much of which was in the equity portfolio. On slide 21, we lay 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 additional $65 million in aggregate principal on our existing 4.5% unsecured notes due 2026. We sold the notes at a premium to par of 102.1%, which resulted in an approximate yield to maturity of 4% at issuance. We believe the execution on this additional issuance is further corroboration of the market acceptance of our investment strategy and their confidence in our portfolio and investing track record. 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 25 institutional investors maturing in 2024, and a $140 million institutional bond maturing in 2026. In addition, we have a $150 million revolving line of credit at I-45 also maturing in 2026. In March 2021, we amended our I-45 credit facility, lowering our cost of capital to LIBOR plus 215 basis points, and extending the maturity of the facility to 2026. In conjunction with the credit facility amendment, we distributed to the JV partners a majority of the $16 million of capital contributed to the JV during the height of the COVID-related market disruptions and amended the economic arrangement among the JV partners, which should result in increased returns to Capital Southwest on its I-45 investment going forward. Finally, as we have alluded to on prior calls, We have now officially received our SBIC license from the US Small Business Administration. Our initial equity commitment to the fund is $40 million, and we have applied for $40 million of fund leverage, which is also referred to as one tier of leverage. We would expect to fund this initial $80 million of SBIC capital commitments over the next six to nine months, at which point we will apply for a second tier of leverage. Over the life of the fund, We plan to draw the full $175 million in SBIC debentures while contributing our $87.5 million in fund equity. We are excited to be part of this program and believe it will be a natural fit with our investment strategy. Overall, we are pleased to report that our liquidity continues to be strong with approximately $249 million in cash and undrawn credit facility commitments as at the end of the quarter. As of March 2021, Approximately 69% of our capital structure liabilities were unsecured. Our earliest debt maturity is now in December 2023. Our balance sheet leverage, as seen on slide 22, ended the quarter at a debt-to-equity ratio of 1.13 to 1. 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 over six years ago. Our team has done an excellent job building a robust asset base, deal origination capability, as well as a flexible capital structure that prepares us for all environments throughout the economic cycle. We believe that our performance through difficult times like we all experienced during 2020 truly demonstrates the investment acumen of our team at Capital Southwest, and the merits of our first lien senior secured debt strategy. We feel very good about the health of our company and the 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 continues our prepared remarks. Operator, we are ready to open the lines for Q&A.

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

Okay, great. Good morning, everyone. Morning. I guess first question here, clearly, as the credit backdrop stabilized, we'll have to maybe get some more color on appetite for growing assets in the I-45 Senior Loan Fund? And also, if you can, just remind us how you guys are thinking about kind of target leverage and target leverage profile in that portfolio.

Yeah, I'll make a – this is Bowen. Thanks for the question. I'll make a comment on the market, and I'll let Michael comment on the leverage target. But, you know, the I-45 fund is going well. It's performing much better now from a market quote perspective. You know, it's primary asset class in the syndicated market. So, you know, we work very hand-in-hand with Main Street. We're great partners. They're great partners to us and we to them. And so we're kind of looking at the market as we go forward. So, you know, our growth in that fund or the pace of growth in that fund is really, it can only function on the assets that we see in the syndicated world and to a lesser extent the kind of large club world. And so, you know, I'll let Michael comment on the leverage targets, et cetera. But, you know, we're managing leverage in the fund, and we certainly have capital to put in the fund to grow it. Main Street clearly has capital to put in the fund and grow it. So it's really just a function of, you know, the windshield and looking forward to the windshield and the market and the deals that we see to put in there. Sure.

I think from a leverage perspective, I think on a steady state basis, we're probably going to be running leverage between 1.3 and 1.5. I think what you saw during the pandemic, leverage rode up over two times, and we put in equity capital to de-lever down to closer to one times because we thought that was a prudent thing to do at the time. So right now we have about $165 million in assets. I think we're going to look to grow that to about $200 million in assets, which would get us closer to really 1.5 times. And we probably have a pathway to do that in the next two quarters.

Okay, terrific. Great color there. Just to follow up on the liability side, you continue to make progress, and you kind of alluded to this a bit on the prepared remarks, but can you just remind us kind of the pathway from here to kind of that investment grade rating, and in your view, maybe what else needs to happen to achieve that?

You know, it's a good question, and we've been talking about it for a while. I would tell you right now I think there's a size bias. And so we're approaching $800 million in assets. I think as we approach a billion dollars in assets, I think that's when we would start approaching the rating agencies, because what we've tried to do over the last six years is really diversify our sources and products on the liability side. So it started with growing that credit facility over time from three lenders to 11, doing the baby bond, and then having two institutional deals done, and now adding to it the SBA. really sort of kind of solidifies, we believe, that plus trading above book and having the ability to raise equity on the ATM program. And then I guess lastly, I think the other thing that the rating agencies look at is repayments and liquidity coming out of the portfolio, which now we see that in a steady state now that we're a stronger, a larger company and more mature. So I think all that being said, I think it's really just a little bit more of time and to continue to perform and make certain that, you know, we're also our leverage level is prudent.

You know, one of the things on that, Michael had me in front of each of the rating agencies six years ago, five, six years ago when we started. And my goal was not to be an investment grade company five or six years ago, but my goal was to solidify in our mind very thoroughly what our resume needed to look like when we did get to the size and we were a candidate. And so we've been thinking about that for years. And Michael just articulated kind of the resume. But we think we've built that resume. Of course, it's all based on track record as well, as Michael alluded to. But we think we have the resume to be an investment-rated candidate and a strong one, but there is a size kind of fairway that you need to be on.

Yeah. Okay, terrific. I appreciate it's a process, but you get to see you guys making progress. So I'll leave it there, but thanks for taking my questions. Appreciate it.

Our next question comes from Kyle Joseph with Jefferies. Your line is open.

Hey, good morning. Thanks for having me on and taking my questions. Just given where we are in the second quarter or your fiscal first quarter, I just kind of want to get a sense for investment activity quarter to date as well as repayment activity.

Yes, I would say the pipeline is very strong right now. Our activity has been strong. We would expect... to have a pretty robust quarter from an origination perspective this quarter. Now, it may be late in the quarter on an average kind of timing of closing. And so, you know, so it's, you know, I think it's going to be positive for this quarter, but it also is, you know, probably very positive for the September quarter. So, you know, just because that timing matters. So I think that, you know, we're pretty pleased with the activity. And so we'd expect it to be pretty solid. Anything you want to add?

Yeah, I think just from a net growth perspective, we're also probably going to see probably 30 to 35 million in prepayments coming back over the next 60 days. And these are deals that we actually were aware of for the last probably 120 days. So they're probably just winding down their processes. But we're not seeing much behind them. So I think on a net basis, you can kind of get the picture.

Yep, yep, very helpful. Thanks for that. And then with the SBIC, you know, obviously that's excluded from regulatory leverage calculations. Any change to your sort of target leverages in terms of how we should think about total versus BDC leverage? Sure.

So from an economic perspective, you expect us to really be in really the 1.2 to 1.35 economic leverage range. And I think as we ramp the SBIC, I think regulatory leverage will inevitably be around one times, and I would say 0.9 to 1.0 as it's fully deployed. So nothing really changed there. I think you'll see a continually conservative bend.

Got it. And then last one for me, obviously, no MPAs. It sounds like the portfolio performance has been really strong. But can you give us a sense for maybe REV and EBITDA growth trends and how those have trended kind of into the quarter, particularly as we start to comp against COVID-impacted markets.

Yeah, so it brings up an interesting point. So if you look at kind of run rate, EBITDA, and revenue growth across the portfolio as we see here today, I'd say it's positive because the portfolio is, and the economy, candidly, is from a run rate perspective opening up. businesses are growing, returning to pre-pandemic levels. Now, from an LTM perspective, you know, especially like this quarter when, you know, we tested LTM at February of 21. So that LTM period is March of 20 to February of 21. So obviously that's a period that has 100% of the COVID effect and much less of the recovery effect. And so, you know, so I'm making the distinction between run rate and LTM. And so I think, you know, the LTM quarter over quarter is, you know, still, I guess I'd say down across the portfolio, although we have a couple of handful of companies that are kind of, we just blew right through the COVID pandemic due to their business models. But the run rate as we kind of see here today is clearly across the portfolio, you know, except for a, half a handful of companies that are still just kind of struggling. But it's definitely on the uptrend.

Got it. Thanks very much for answering my questions, and congrats on a solid year. Thank you.

Our next question comes from Bryce Rowe with Cosity. Your line is open.

Thanks. Good morning. A couple questions. A couple of questions here, Bowen and Michael. You wanted to kind of touch on just pricing in the market. Obviously, we've heard from many of the BDCs that, you know, pricing is back to pre-COVID levels or in some cases maybe even tighter. And it looks like this quarter, you know, you had a weighted average yield of about 8.8% on the newer investments. you know, with a spread of 7% to 10% from a yield perspective. Just curious, kind of, do you expect, you know, pricing to stay in this, you know, in this ballpark, in this zip code? Or are there, you know, are you seeing some potential for continued kind of movement to and through pre-COVID?

Yeah, thanks for the question, Bryce. I would say, first of all, you know, There's lots of liquidity in the market. We all know that. The market has, from an activity perspective, returned, certainly from a price perspective, kind of back to kind of pre-pandemic levels. Leverage pre-pandemic, post-pandemic, I still think it's slightly lower post-pandemic, but pricing is definitely back. When you look at our 8.8, I'd caution you from getting – I think yields in our portfolio will – will come down slightly, maybe 50 basis points in the next, no, six to 12 months, based on kind of what we're seeing, based on LIBOR being down. But you have to keep in mind, our cost of capital has come down quite a bit. As we start layering in the SBIC, I think the net interest margin will be very robust, even with a slight kind of 50 basis points kind of retracement over the next kind of six to 12 months. Now, if you look at the 8.8, let me put that in perspective. If you take out the 7.1%, that's actually a first-out loan that we did, kind of 1.3 times leverage kind of number. And if you take that out, it's closer to 9.5%. And I would tell you that our pricing on our deals, I mean, it's deal-specific, it's MIPS-specific quarter over quarter, and it kind of is low, kind of lows of 9.5%. You look out over the last several quarters, low of 9.5% and high of 10.5%. you know, it kind of fluctuates up and down. And so, you know, the landing zone of our yield is not, we don't believe it's 8.8%. So, it's a little bit quarter specific. I think it does flow kind of quarter to quarter in those ranges. And so, and then, you know, as a first ring lender, we always have a portion of our portfolio that underperforms. That's just the nature of any lender and certainly a non-bank lender. And so, The beauty of a first lien lender is that when companies underperform, a lot of our loans have grids. So interest rate floats up. We get additional interest in default interest, various things. There's always some level of economic enhancement when you think about the entire first lien portfolio. And that will always be the case, and so that tends to make up the difference and gets you kind of into the mid-tens kind of yield, if that makes sense. So I'm trying to relate the 8-8 to... The fairway we live on, I don't think the fairway has gone from 10.5 to 8.5. I mean, not even close. So I think it's – and our cost of capital, we think, is dropping faster than the yields are dropping. So that's been good for us.

Right. I'm sorry if you think about it from the next margin, right? It'll be fixed rate draws on the SBA, but you also look at what we've done to date. We have two-thirds of our liability structure that's fixed rate draws. So as rates rise over the next, maybe that takes 12 to 18 months, before you start seeing that, you'll see net interest margin actually start improving, as well as, you know, the impact on the assets as well.

The other thing, Bryce, I'll just throw out one more comment. It's important to appreciate, it's important to know that about our business. You know, we primarily in the lower middle market. The lower middle market, I think of it as kind of a pool. It's got a deep end, it's got a shallow end. You know, the deep end is, you know, a little more storied credits, and the shallow end is lower loan-to-value, safer loans, Well, the lower end has lower yields and the deep end has higher yields. And a portfolio is a mix of all that. So as your cost of capital comes down, you can get nice net interest margins on the shallow end of the pool. So you can have some of your overall portfolio yield migrate down as you drop your cost of capital down. And then our job as credit managers is to make sure we're not putting shallow end pricing on deep end deals, if you know what I mean. And that's our job and that's art of what we do. But it is a very real dynamic and one of the key reasons why, you know, getting that track record built, the diversity of sources of capital, and ultimately your cost of capital down so that you can, you know, get equal or better net interest margins on a safer asset portfolio. That's strategically very important to us.

And not to beat a dead horse, but the other part is our cost structure. So, You've seen our operating leverage come down from, you know, 4.9% years ago to, you know, our run rate LTM right now is 2.4%. But this particular quarter, our operating expense was 2%. So you're seeing, you know, our expenses are growing at a lower clip than our assets are growing. So there's also that in terms of our net interest.

And that also gives you the ability to get net interest margin at the shallow end of the pool, if you will.

Yeah.

So hopefully that's helpful. That's kind of how we think about the world.

Yeah, that's perfect perspective. And maybe leads into the next question. So you've seen a nice bump in your stock price and in your price to NAV valuation, obviously took advantage of it the last couple quarters with some more active use of the ATM. So I guess my question is, do we think about this case of ATM usage being kind of more normal now that you've got the multiple that you have or have you tried to be more opportunistic the past couple quarters in anticipation of the SBIC license coming online and having to get ready to capitalize that?

Yeah, I'm going to make a general comment. I'll let Michael comment as well. The APM is a great tool for an internally managed BDC like us. You keep your track record strong. We all know the benefits of the internal managed model. We talked about the operating leverage of various things. And if we can raise equity capital as a function of the originations that we're doing. So the equity to us is moderating and governing the leverage on the vehicle. And the leverage on the vehicle is a function of asset quality, first lien versus second lien, et cetera. And so a first lien portfolio, we believe, can hang out a little bit higher leverage than a second lien portfolio, et cetera. But you're using that ATM to govern that leverage. Now, so we're not opportunistically doing it necessarily. We're thinking about leverage and the pipeline. And the ATM can be great because we can raise equity at a, you know, one and a half percent, you know, kind of spread to trade. And we can do it more in lockstep with putting the dollars to work. And so the – and if we deserve the multiple, right, and that's a function of track record and consistency, and we hold that very dear – That's very important to us. And we have a premium multiple. Then that ATM program is accretive to NAV per share, but it's also being put to work very quickly if it's being done in conjunction with the pipeline. So that minimizes and, you know, theoretically eliminates the NII dilution from it if you're putting it to work. So anything else, Michael, you'd add?

Yeah, I mean, I would say, look, for the next 12 months, I think on an average, you probably would expect to see us raise, on average, $15 million. a quarter. But having said that, the way Bowen just described this right, we kind of think about it as sort of like the clutch and the brake, that we're trying to make certain that we stay in that leverage range. And since, you know, with our earnings timing relative to quarter end, you have a sense what your pipeline looks like. And so when the ATM opens up, like it will, you know, in two days from today, we'll sort of know where we want to land based on the originations and, therefore, how much equity we'll want to raise. So for this quarter, obviously, with it being robust, you can maybe anticipate a more. But in other quarters, we're indicating originations might be lighter or prepayments are higher than you might see it closer to the lower end of the range. Great.

Good answers. I appreciate all the perspectives.

Thanks, Bryce.

Thanks, Bryce.

Our next question comes from Sarkisht. Sherbetian with B. Rowley Securities. Your line is open.

Hey, good morning, and thank you for taking my question here. Just wanted to quickly touch on the SBIC license. I think you mentioned an initial $80 million capital to commit next six to nine months and plan to draw $175 million on the debentures. So just want to get a sense for from the net originations, like how quickly do you plan to tap into the SBIC side versus, you know, the rest of the BDC?

We're anticipating starting to contribute assets to the SBIC in the next few weeks. Our first asset will probably go in in the next two or three weeks. So we'll initially put equity to work. We're still waiting for approval on the leverage application, which is just a, you know, paperwork to get completed. But once that occurs, you know, we'll be basically funding our first $40 million, and then we'll be drawing $20 million of capital, so a half-tier. You have to ask for an examination by the SBIC just to review your books and records at that point, and then they release the additional $20. So I'd say we see that $80 million. And if you think about the way we'll allocate assets, we'll be putting essentially approximately 50% of an asset, originated asset, into our credit facility and 50% in the SBIC. So, in terms of putting the capital work over the entirety of the program, six to nine months for the first 80, we probably anticipate it will be in the three to four years before we fully utilize the 175, and then obviously we'll be replacing that as repayments come in over the 10-year life.

Great. Thanks for that. And in the last quarter's call, you mentioned kind of a net origination. growth per quarter and kind of the $20 million to $30 million zip code. And it seems like you guys did a really nice job here in this past quarter, and it sounds like that maybe continues here in this quarter. Is that kind of the right zip code to think about from a growth perspective, or would you think originations and kind of prepays go to more, let's say, normalized levels? Any comments around that?

Yeah, you know, it seems like – and I think we would amend that based upon the staff we have. We've had seasoned professionals. We've added staff. And I think, you know, we've certainly had a – grew a foothold in markets around the country. I would tell you that, you know, at the low end of the quarters, or about maybe we should expect 40 or 50 million of originations, and the high is, you know, 75-plus, we kind of anticipate somewhere in the 10 to 20 million in repayments a quarter. So the net is somewhere in the middle there.

Yeah, I think that's right. I think the net might be a little bit higher than we said last quarter, but it's not too far off.

Fantastic. That's all for me. Thank you. Thank you.

Our next question comes from Robert Dodd with Raymond James. Your line is open.

Excuse me. Hi, guys. A couple questions first on I-45. You mentioned, I think, Michael, that you amended the agreement. Does that bring, basically, your economic share into line with your ownership share, or is there some other delta in terms of amending that agreement with Maine?

Yeah, no, essentially, it moved that direction, as you said, Robert. I mean, we just changed the relative... economics to reflect the maturation of our firm. And so it's not any more complicated than that. I mean, the relationship goes really well, but that's kind of basically what we did. And it was kind of time for that.

Yeah, understood. Then just one more on that. I mean, you amended the revolver. It's now down to 215 basis points. Were there any one-time expenses or anything like that in this quarter? It looks like the lowest dividend... I mean, lowest dividend from the JV since probably 2016, I think. Was there anything unusual? And obviously your comments where you expect the returns to be higher in the future.

Yeah, so I would say that, sure, for I-45 this quarter, I think I would tell you that the repayments that came in, which were plentiful, came in early during the quarter. And then the originations, honestly, that we've actually closed but haven't even settled. So, you know, the settlement process for some of these credits takes a bit of time. So we're looking probably at, you know, I think $15 to $20 million of originations that will probably settle in this June quarter. So I think it's just a bit of a mismatch, right, in terms of the dividend. So to your second question, we do expect there to be a bounce back in this following quarter.

That's a good question. Go ahead. Thank you. Just a more broad one. I mean, you know, in the common sense, equity ownership in 60% of the portfolio companies. I mean, is the target to take that high? I mean, obviously, it will vary quarter to quarter. I mean, the 60 ones this quarter, there were only two that got equity, so obviously lower than a 60%. But would you expect that 60% to go up over time, or are you happy kind of, Act 60 across, you know, long-term or any color you can give us on that? Yeah, it's an interesting question.

I would tell you that we don't look at, I mean, maybe it's obvious, but we don't look at, okay, we want a certain percentage of our portfolio companies that we want equity in. I mean, we're looking at it more from two things. Top level looking at it saying, okay, the equity we'd like it to be, you know, 8% to 10% of the portfolio overall kind of works for the business model. And then it's a question of deal by deal. Do we like the equity story or not? I mean, we don't necessarily – or the equity story and the valuation thereof of the equity story and whether we think there's equity – you know, we get the equity story or we think there's adequate returns on the equity. You know, we take a view of the sponsor or whoever is taking another view. That doesn't necessarily always blend. And those on the call or around that have done credit before – you do see oftentimes deals where you like the credit story more than the equity story. I mean, the dynamics between the two are very different. Something would be a really interesting cash-flowing business, but it's like, gee whiz, how do you grow it? How do you scale it? You know, that kind of thing, which is not the lender's problem. That's the equity holder's problem. And so we don't always like the equity story. It doesn't mean we hate the equity story, but we don't always love the equity story. And the other thing I would say, is that if a private equity firm is a larger firm writing a smaller check in a deal, sometimes it's hard for them to share the equity, or they want an outsized carry if we invest in equity, and that starts to deteriorate the equity story to us if we have a huge carry going out. So there's just a number of factors involved. And so where it all lands, you know, 60% – I mean, my guess is it's – and I'm guessing here, but I'm guessing it's probably 60 to, you know, probably around two-thirds plus or minus over time of the deals of our portfolio loans. We'll have an equity piece next to it. I'd probably say it's probably a very rough rule of thumb. So 60%, you know, I know when I looked at that number and thought about the averages, I thought that sounded a little bit low. And if it was above 75%, I'd feel like that was a little high. So it's probably two-thirds over time on average.

Got it, got it. Because, I mean, obviously you're realized IRRs today of north of 15%. I presume that would be a challenge to sustain from debt only, right? So equity is kind of required to... Well, yeah, I think that's... Yeah, I think that's probably...

from a theoretical perspective. I also think that, remember, we're lending to the lower-middle market. These are smaller businesses, and the good news about the smaller businesses, a lot of them are growing pretty interestingly. I mean, you know, and so it's not like these large companies that are trying to grab two points of market share, et cetera. I mean, these are businesses that have, you know, newer ideas, newer business models, grabbing market share at a pretty high rate, The private equity firm is putting basic institutional-ish things in place like ERP systems that generate KPIs that they can help the founder manage the business better and grow it better, adding marketing people because the small company has two marketing people, and you look at that and go, they ought to have 10. It's just obvious with that certain industry they ought to have 10. Well, those are big growth drivers, and you don't see that as much in larger companies, and you see it in this lower middle market quite often. And so the equity is important if we like it. It's an important piece of the business model, but it does enhance returns over time for sure.

The other thing I would note too, Robert, is that we've actually, in some of the companies that have stumbled during COVID, like AAC or Delphi or CPK, we've been able to pick up equity in the restructures. And so those assets, actually, we have kind of bullish on them. and those might see some significant recoveries in equity as well.

You know, the reality is that's recovering former principal, but if you think about it from where NAV is today, that's all upside. So, you know, you can look at it both ways, right? And so we think that's something that we're pretty bullish on, honestly.

Understood. If I got one last housekeeping one. On the tax side, I mean, the tax in the – I mean, obviously there was the – the one-time write-off last quarter, but this quarter even so that the tax looks elevated relative to what I would expect excise tax to be. So it seems like there's something more in the tax in the NII line than just excise. Can you give us any color on what that is?

Sure, sure. And you're right. The excise tax actually of the $850,000 is only $50,000, and that's a run rate number going forward. We did have, as part of the write-off of CSMC, as you noted, the majority of it was last quarter. There was an additional $425,000 because the previous number was off of a provisional return, and the final tax return was done in April. Got it. So there was another $425,000. And then the last one we had, and that was obviously one time in nature, and then we had another one-time expense as well for one of our portfolio companies paid a dividend, cash dividend, And so from a tax basis, it reduces your cost basis and therefore increases your unrealized gain, and therefore we had to increase the income tax accrual. So that was $375,000. And so that's essentially $800,000 of the $850,000 were one time in nature, and both of them are non-cash. Got it. I appreciate it. Thank you.

Thank you. Our next question comes from David Miyazaki with Confluence Investment Management. Your line is open.

Hi. Good morning, gentlemen. First of all, just a couple of comments. I really appreciate that you guys years ago set out to, you know, told us what you were going to do, and years later you've done what you said you were going to do. Unfortunately, in this industry, there's oftentimes a gap between those two things, so I really appreciate it. Your credit underwriting, the formation of your JV and its growth and its management, your liability management, particularly your use of the ATM and how you characterize its use versus your leverage, all those things help make things a lot easier for us as shareholders to not have to manage through surprises, not have to manage through problems, NII dilution after equity issuance. It's just very helpful. And congratulations on getting the SBIC over the line. Thanks, Jim. Yeah, so you guys have done a great job. And one of the things that we often hear, particularly as BDCs become larger, there's this recognition that the lower middle market is less efficient, pricing is more stable, the terms are more consistent. Whereas the upper middle market gets tugged around by what's happening in the public markets and the big capital flows. And usually you hear these themes based upon how big a BDC is. And managers usually characterize whatever they're doing as to be the best place to be. But you guys are kind of in a unique situation because you're straddling the upper and the lower middle markets. And the difference in EBITDA size that you have you know, from about $10 million on the lower middle market exposure and $70 million in the upper middle market. I'm just curious, you know, what are your thoughts? You know, the basic thing that the larger upper middle market borrowers are the place to be because they're bigger companies with less credit risk versus the opportunities you might see in the lower middle market. You're doing both. But how do you feel about the way that the two sides of the middle market get characterized?

Well, first, hey, Dan, thanks for the question. I would say, first of all, there clearly is a bias across the whole financial markets. Bigger is better, right? I mean, we know that.

And so there's just – Sure, the rating is – you say that too, right?

Yeah, right. And so the bigger – so therefore, there's more capital – there's just more, big insurance companies, et cetera. Everybody's like, okay, well, we'll invest, but it needs to be at least, he's filling the blank. I mean, well, we'll do it, but it's got to be at least 25 in EBITDA or at least 10. That's just all reflective of that bias. And so what is that? That then rolls itself, that manifests itself in two things. First of all, there's less, there's more competition for those larger deals, and therefore the spreads are lower for those larger deals. Now, there are bigger companies that, But I wouldn't say, you know, candidly, they're necessarily more – they're not always necessarily better credits, but they are bigger companies. But there's more capital chasing those deals. So there's less – so the second way it manifests itself is because there's less capital chasing the smaller deals, the documentation and leverage and those types of things that matter to a credit group like us, are much more robust. I mean, leverages lower covenants are real, you know, and, you know, documents are tight. You know, you don't see cove-light loans in our world, you know. And so, you know, so it's, you know, those are all reflective. So, you know, yeah, they're smaller companies, but, you know, we think the risk-adjusted returns, which takes into account the company quality, the growth, and the credit structure and the integrity of the documents in the thing are just more attractive. Now, That's why you see the vast majority of our portfolio in the lower market. I mean, it just fits. We like that asset class. We like the fact we can do an equity co-investment if we like the equity. We have that equity kicker in our portfolio. That's important. Those opportunities don't exist in the larger market. All that said, I mean, we do think there are credits from time to time in the upper middle market that make sense. You know, now the other thing is in the lower middle market, we lead the vast majority, I don't know, 80 plus percent of the credits in the lower middle market. We originate and lead. You know, that's a big deal. I mean, if we're one part of a large bank group in the upper middle market and something goes wrong, you know, you can't really make decisions. You're just going to sit on committee calls ad nauseum, right? And a lender steering committee calls and blah, blah, blah, right? So you don't, you can't, and lawyers and consultants get to make tons of money advising those steering committees. And so, you know, it's tough to watch when something bumps, like an AAC or something like that, right? Something like that. So it's just the nature of that asset class. And so some of it's a function of our size. But candidly, the vast majority, the reason we like the lower middle market is because of the growing nature of those businesses, the quality of the documentation and structures. And candidly, we just think that there's not, we just don't have that large company bias. We don't think the bigger is better positive bias Or small is harder, negative bias overcomes the credit quality and the asset qualities in the space. And so, you know, and I'll also say as we grow, last time we looked at this number, I think, so 80 to 85% of our portfolio are deals that we lead, we originated and lead, okay? And of that, the last time we looked at the stat, which was maybe a quarter or two ago, but I don't think it's that much different, you know, over half or half of that that we lead, we've brought in another lender or two into those deals because we're managing our hold size. And so as we grow, we can hold more and more of the same sandbox of loans that we hold today with the same level or better granularity. So we have a lot of growth potential within the lower market before we ever have to think about moving up market. And I'm very reluctant to go and compete with the large business bigger is better BDCs. They do a fine job in that space, and there's plenty of people and plenty of capital chasing those deals in that market. And so the lower middle market, we've got a lot of growing room in the lower middle market before we're even talking about, you know, doing deals in a larger percentage of our portfolio being outside the lower middle market. Hopefully that's helpful.

And, David, one thing I would add. Our viewpoint on the lower middle market is, as Bowen has said, it's been consistent through the years. I think that our viewpoint on the upper middle market has varied depending on what the market looked like. So if you look at 2016 and 2017, we were very active in the upper middle market portfolio. The market was sort of beaten up and we found some great opportunities. We made some nice returns. Between 2018 and 2020, you saw barely any transactions in the upper middle market from us. You saw you know, the I-45 fund kind of shrink over time. And that's just, you know, our viewpoint on the upper middle market became, you know, it was frothy and it wasn't a place for us to find value.

So it's kind of why we had our original slide six years ago said core market, lower middle market, opportunistic market, upper middle market. It's just the same thing today. I mean, it's, you know, you got to remember, you got to define who you are and what you're good at. And then, but you got to maintain a capability to look at deals and participate in large upper middle market deals when there's when the dynamic exists. And it does exist from time to time. It's just the majority of things we do for sure.

And it's the same sort of thought process we go through with a share buyback program, right? Where we want to maintain liquidity to find opportunities in the market when they're there. Sometimes it's in the upper middle market. It seems like it will always be in the lower middle market. And then sometimes it's buying back our stock when we feel like we're undervalued.

Right. So... When you think about the thesis that the bigger companies are safer, obviously that's very dependent upon individual situations and credits. When you've come across credit problems, even before default, but you're just kind of seeing an erosion in operating fundamentals, is it fair to say that your experience is not really, based upon your individual lending decisions, has not really been adversely affected by the fact that your companies are smaller versus larger?

Yeah, so there's lots of different facets of your question. So bigger is safer. I would say bigger companies are more established in their relative industries, but loans to bigger companies are not necessarily safer because loans to bigger companies have less looser covenants and higher leverage generally. And so, you know, larger loan portfolios don't necessarily or not necessarily, the risk-adjusted returns, candidly, are not, we think, not as attractive as a general matter. So, you know, and so, candidly, when things bump in the night, we like to be the decision-maker. I mean, if we originate a loan and we are controlling that loan, the sponsor or the owner is talking to us. They're not talking to a steering committee. You know, they're talking to us, and we can make decisions, and we have, you know, I guess we have leverage in those conversations. You know, we make decisions on being commercial and being reasonable and maintaining our reputation and all that, but the point is we get to control those situations when you're, I think it's what you're asking, Dave, and, you know, and when you're in a larger lender group, you know, you can influence, but it's almost a political influence with the lender group. It's not an actual decision. because you can influence the group think, and the group think maybe gets to the right answer, and most often it gets to an okay answer that's not the best answer, is usually what happens. But that's a very different dynamic. In the lower middle market, leverage lower generally, documents tighter, we have more decision-making authority and power in those loans. And so you look across an entire loan book, I would rather have that kind of loan book where I can make real decisions.

That's helpful. So, I mean, one of the things that, you know, when you look at the trend of your cost of capital, right, it's declining both in equity as well as on your debt, right, which is great, and it can help offset, you know, to the extent that your asset yields decline, your NIM can remain intact. It was just kind of helpful for me anyway to have you describe your views toward the upper middle market because you could see how if your liability cost and your cost of capital was going down, that there could be a draw to go into the upper middle market where the yields are lower But you can do it because your cost of capital went down. But it doesn't sound like that's really your strategic plan. There's a couple of the larger BDCs that are internally managed. Obviously, your friends at Main Street, the other ones like Hercules, have been able to maintain their focus while being an internally managed BDC. As you guys grow... and you are continuing to focus on the lower middle market, how do you feel about sort of scaling your employee base and your resources to continue focusing on smaller loans, even though your capital base is larger?

I think you always say, I know you know this, David, but you have to remember that there's no incentive here for us to scale, just to scale. We don't have a management contract that doubles in size if we double the assets. There's no incentive. There's only one incentive here, and that is, yes, we want to grow, but there's a why. Why do we want to grow? Well, we want to get investment-grade credit rating. We want to bring in other parties maybe less so that we can be the sole lender on more of our loan book because that allows us to be more reliable to close, and in theory we should be getting even better deals if we don't have to insert the closing risk associated with bringing in somebody else into our loans. I want to grow for those reasons, not just to scale. You mentioned cost of capital tempting you to get in the upper middle market. I can just tell you that is absolutely not the case here because what are you going to do? We're going to go out and do a bunch of upper middle market deals where we don't control any of the loans and we have a bunch of participants. We're a participant in a big chunk of our book solely because our cost of capital went down. That would be like That would make no sense. And I'm not saying your question made no sense. I think your question makes a lot of sense. I'm just trying to make that distinction. And so we're incentivized to grow this vehicle to make it higher quality and more effective in the market. Operating cost scaling, same thing, right? I mean, we want to grow. Of course, we're going to need to grow operating cost dollars over time as our portfolio grows, of course. But we look at operating leverage because we want to grow operating costs slower than we grow assets, which brings the percentage operating leverage that we're always putting in our slide decks. That comes down. You know, as we talked about, there's three costs to this business. You know, and we're taking our costs and we're relending the money at a higher rate, right? And so what are our costs? Our costs are financing costs, obviously. We talked about that. Operating costs, which is our operating leverage as a percentage of assets. If that comes down, that increases our margin at the end of the day. And then the third cost is non-accruals. I mean, we're going to have non-accruals. We model in non-accruals in our future. We're not going to hang out with zero non-accruals forever. It's just part of our business, but we want that number to be either zero or low because that's a further cost to our business. So we want to make that cost efficiency, and as we increase that cost efficiency, we're going to enhance our margin in our business. And so, yes, we'll grow operating costs, but we don't think of it as scaling. We think of it as growing costs. you know, growing proportional to or at a slower rate than asset growth, because that's where the efficiency comes in.

Well, I greatly appreciate that answer. It's certainly what I wanted to hear. I like the focus that you have, but I also like the fact that you have the ability to take advantage of the opportunities that episodically seem to come about in the upper middle market. So I appreciate your answers, and congratulations on a good year.

Thanks, David. Thanks, David.

Thank you. This concludes the question and answer session. I'd now like to turn the call back over to Bowen Deal for closing remarks.

Thank you, Operator. Thanks, everyone, for being with us here today. We love talking about our business, and we look forward to giving you guys updates in the quarters to come. We appreciate your support.

This concludes today's conference call. Thank you for participating. You may now disconnect.