Capital Southwest - Earnings Call - Q4 2021
May 26, 2021
Transcript
Speaker 0
Thank you for joining today's Capital Southwest Fourth Quarter and Fiscal Year twenty twenty one Earnings Call. Participating on the call today are Bowen Diehl, CEO Michael Sonner, CFO and Chris Reberger, VP Finance. I will now turn the call over to Chris Reberger.
Speaker 1
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, Bose.
Speaker 2
Thanks, Chris, and thank you everyone for joining us for our fourth quarter and fiscal year twenty twenty one 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 03/31/2021. 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 light 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 the granularity of hold sizes. As a result of these decisions, we were able to do three important 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 summarize 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 $2.5 Our NAV per share grew 6% to $16.1 versus $15.13 in the prior year period, driven primarily by $20,200,000 in net unrealized and realized gains on the portfolio. I think it is also important to note that our NAV per share of $16.01 as of 03/31/2021 represented a retracement to 99% of its pre pandemic level of $16.74 per share as of December 3139 when adjusted for the $0.50 per share in supplemental dividends we paid out to shareholders during this fifteen month time period.
Considering the unprecedented events of the last fifteen 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 $688,000,000 versus $553,000,000 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 $190,000,000 of unsecured notes, 51,400,000.0 in equity proceeds through our equity ATM program and $15,000,000 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.
In 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 pretax net investment income of $0.44 per share, which exceeded our regular dividend paid for the quarter of $0.42 per share. Including our supplemental dividend of $0.10 per share, total dividends for the quarter were $0.52 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 $0.53 per share for the coming quarter ending 06/30/2021 consisting of a regular dividend increase from $0.42 per share to $0.43 per share and a supplemental dividend of $0.10 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 $688,000,000 as of 03/31/2021. Portfolio growth during the quarter was driven primarily by a total of $77,300,000 in new commitments to six new portfolio companies and one existing portfolio companies company, offset by $23,000,000 in total proceeds from two exits. The portfolio generated net realized and unrealized gains of $2,600,000 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 $89,000,000 in investable capital consisting of $65,000,000 in aggregate principal of unsecured notes and $24,100,000 in gross proceeds through our equity ATM program. Turning to slide eight and nine, 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 tenets 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 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 $58,700,000 or 9% of our portfolio at fair value. Though the equity portfolio currently has performed extremely well with $10,100,000 in cumulative realized 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 as of the end of the quarter, excluding our I-forty five joint venture, grew 8% to $573,000,000 as compared to $531,000,000 as of the end of the prior quarter. Our credit portfolio is currently weighted 88% to lower 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 $77,300,000 of capital invested in and committed to portfolio companies during the quarter. This included $74,500,000 in first lien senior secured debt committed to six new portfolio companies along with $2,500,000 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 $384,000,000 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-forty five 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 on balance sheet upper middle market portfolio excluding our I-forty five 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 one 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 at three and we had no loans rated at 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-forty five portfolio also continued to show improvement during the quarter, as our investment in the I-forty five joint venture appreciated by $1,500,000 Leverage at the I-forty five fund level is now 1.27 debt to equity at fair value. The increase in leverage at I-forty five 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-forty five portfolio was 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.
Speaker 3
Thanks, Bowen. Specific to our performance in the March as summarized on slide 18, we earned pretax net investment income of $8,900,000 or $0.44 per share. We paid out $0.42 per share in regular dividends for the quarter, an increase from $0.41 regular dividend per share paid out in the December. As mentioned earlier, our Board has again this quarter increased the quarterly regular dividend declaring a dividend of $0.43 per share, up from $0.42 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 pretax net investment income is important to our investment strategy.
Over the past twelve 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 $0.10 per share and again our Board has declared a further $0.10 per share supplemental dividend to be paid out during the June. 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 03/31/2021, our estimated UTI balance was $0.92 per share. Our investment portfolio produced $17,200,000 of investment income this quarter with a weighted average yield on all investments of 10.2%.
Investment income was $1,900,000 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 PIK as a further contribution to the company's working capital need. The cash interest converted was approximately $1,000,000 which all fell in the March. 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 twenty twenty one. Going forward, we will report operating leverage on a rolling four quarter basis as we believe this is more informative metric for our shareholders due to the quarterly fluctuations in our operating expenses. For fiscal year twenty twenty two, we expect operating leverage to be between 2.12.3%. Turning to slide 20. The company's NAV per share as of 03/31/2021 was $16.1 as compared to $15.74 at 12/31/2020.
The main driver of the NAV per share increase was $2,600,000 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 derisk our liability structure, while ensuring that we have adequate investable capital throughout the economic cycle. During the quarter, we raised an additional $65,000,000 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 $340,000,000 on balance sheet revolving line of credit with 11 syndicate banks maturing in December 2023, a $125,000,000 institutional bond with 25 institutional investors maturing in 2024 and a $140,000,000 institutional bond maturing in 2026. In addition, we have $150,000,000 revolving line of credit at I-forty five also maturing in 2026. In March 2021, we amended our I-forty five credit facility, lowering our cost of capital to LIBOR plus two fifteen 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 $16,000,000 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-forty five investment going forward.
Finally, as we have alluded to on prior calls, we have now officially received our SBIC license from the U. S. Small Business Administration. Our initial equity commitment to the fund is $40,000,000 and we have applied for $40,000,000 of fund leverage, which is also referred to as one tier of leverage. We would expect to fund this initial $80,000,000 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 $175,000,000 in SBIC debentures, while contributing our $87,500,000 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 $249,000,000 in cash and undrawn credit facility commitments as of 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 one. I will now hand the call back to Bowen for some final comments.
Speaker 2
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 and A.
Speaker 0
Thank you. Our first question comes from Devin Ryan with JMP Securities. Your line is open.
Speaker 4
Okay, great. Good morning, everyone.
Speaker 3
Good morning.
Speaker 4
I guess first question here, clearly as the credit backdrop stabilized, I'd to maybe get some more color on appetite for growing assets in the I-forty five senior loan fund? And also if you can just remind us how you guys are thinking about kind of target leverage target leverage profile in that portfolio?
Speaker 2
Yes. I think 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 I-forty five fund is going well.
It's performed much better now from a market core perspective. Its primary asset class is a syndicated market. So we work very hand in hand with Main Street. We're great partners. They're great partners to us and lead to them.
And so we're kind of looking at the market as we go forward. So our growth in that fund or the pace of growth in that fund is really candidly just a function of the assets that we see and in the syndicated world and to a lesser extent the kind of large club world. And so I'll let Michael comment on leverage targets etcetera, but 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 the windshield and looking forward to windshield in the market and the deals that we see to put in there.
Sure.
Speaker 3
I think from a leverage perspective, I think on a steady state basis, we're probably going to be running leverage between one point three and one point five. I think what you saw during the pandemic, leverage wrote up over two times and we put in equity capital to delever 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 165,000,000 in assets. I think we're going to look to grow that to about $200,000,000 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.
Speaker 4
Okay. Terrific. Great color there. Just a 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?
Speaker 3
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 are approaching $800,000,000 in assets. I think as we approach $1,000,000,000 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 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 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 we're also our leverage level is prudent. One thing on that Michael had me in
Speaker 2
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 grade rated candidate and a strong one, but it's there is a size kind of fairway that you need to be on.
So
Speaker 4
Yes. Okay. Terrific. I appreciate it's a process, but you guys making progress. So I'll leave it there, but thanks for taking my questions.
Speaker 3
I appreciate it.
Speaker 0
Our next question comes from Kyle Joseph with Jefferies. Your line is open.
Speaker 5
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, just kind of want to get a sense for investment activity quarter to date as well as repayment activity.
Speaker 2
Yes. So 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, may be late in the quarter on an average kind of timing of closing.
And so it's I think it's going to be positive for this quarter, but it also it's probably very positive for the September quarter. So just because the timing matters. So I think that we're pretty pleased with the activity. And so we'd expect it to be pretty solid. Anything you want to add?
Speaker 6
Yeah. I think just
Speaker 3
on the from a net growth perspective, we're also probably we're to see probably 30,000,000 to $35,000,000 in prepayments coming back over the next sixty days. And these are deals that we actually were aware of over the last probably one hundred and twenty 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.
Speaker 5
Yes, yes. Very helpful. Thanks for that. And then with the SBIC, 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?
Speaker 3
Sure. So from an economic perspective, you expect us to really be in the really the 1,200,000,000.0 to 1.35 economic leverage. 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 one point zero as it's fully deployed. So nothing really changed there.
I think you'll see continually a conservative spend.
Speaker 5
Got it. And then last one for me. Obviously, no NPAs. 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?
Speaker 2
Yes. 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 sit 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, especially like this quarter when we tested LTM at February, so that LTM period is March 2020 to February. So obviously that's a period that has 100% of the COVID effect and much less of the recovery effect.
And so I'm making the distinction between run rate and LTM. And so I think the LTM quarter over quarter is 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 is across the portfolio except for half a handful of companies that are still just kind of struggling, but it's definitely on the uptrend.
Speaker 5
Got it. Thanks very much for answering my questions and congrats on a solid year.
Speaker 3
Thank you.
Speaker 0
Our next question comes from Bryce Rowe with Hovdey. Your line is open.
Speaker 7
Thanks. Good morning. A couple of questions here Bowen and Michael. Wanted to kind of touch on pricing in the market. Obviously, we've heard from many of the BDCs that pricing is back to pre COVID levels or in some cases maybe even tighter.
Can you and it looks like this quarter you had a weighted average yield of about 8.8 on the newer investments with a spread of seven to 10% from a yield perspective. Just curious kind of do you expect pricing to stay in this ballpark in this zip code? Or are there is there are you seeing some potential for continued kind of movement to and through pre COVID?
Speaker 2
Yeah. Thanks for the question, Bryce. I would say, first of all, there's lots of liquidity in the market. We all know that. The market is has from an activity perspective returned in my 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 come down slightly maybe 50 basis points in the next six to twelve months based on kind of what we're seeing based on LIBOR being 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 twelve months. Now, don't look if you look at the 8.8%, let 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, kind of it's deal specific, it's mix specific quarter over quarter and it kind of is low kind of lows of 9.5 If you look out over the last several quarters low of 9.5% and high of 10.5%, it kind of fluctuates up and down. And so the landing zone of our yield is not we don't believe is 8.8%. So it's a little bit quarter specific. Think it does flow kind of quarter to quarter in those ranges.
And so and then as a first lien 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.
There are various things. There's always some level of economic enhancement when you think about the entire first lien portfolio. And that will always be a case. And so that tends to make up the difference and get you kind of into the mid-10s kind of yield, if that makes sense. So 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%, mean not even close.
So I think it's and our cost of capital we think is dropping faster than the yields are dropping. That's been good for us.
Speaker 3
Right. And so if you think about it from margin, right, will 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. So as rates rise over the next maybe that takes twelve to eighteen months before you start seeing that you'll see our net interest margin actually start improving as well as 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
Speaker 2
that about our business. 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. The deep end is a little more story credits and the shallow end is lower loan to value safer credits. Well, the lower end has lower yields and the higher 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 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 Mike getting that track record built, the diversity of sources of capital and ultimately your cost of capital down so that you can get equal or better net interest margins on a safer asset portfolio.
That's strategically very important to us.
Speaker 3
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 4.9% years ago to our run rate LTM right now is 2.4%. But this particular quarter our operating expense was 2%. So you're seeing our expenses are growing at a lower clip than our assets are growing. So there's also that in terms of our net
Speaker 2
interest margin. And that also gives you the ability to get net interest margin at the shallow end of the pool if you will.
Speaker 6
Yes. So hopefully that's helpful.
Speaker 2
How we think about the world.
Speaker 7
No, 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 of quarters with some more active use of the ATM. So I guess my question is, do we think about this pace 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 of quarters in anticipation of the SBIC license coming online and having to get ready to capitalize that?
Speaker 2
Yes. I'm going make a general comment. I'll let Michael comment as We view the ATM is a great instrument a great tool for an internally managed BDC like us. You keep your track record strong. The internal we all know the benefits of the internal managed model.
We talked about the operating leverage of various things. If you 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 etcetera. And so first lien portfolio can we believe can hang out a little bit higher leverage than a second lien portfolio etcetera.
But you're using that ATM to govern that leverage. Now we're not opportunistically doing it necessarily. We're thinking about leverage in the pipeline and the ATM can be great because we can raise equity at 1.5 kind of spread to trade and we can do it more in lockstep with putting the dollars to work. And so the and we deserve the multiple, right, and that's a function of track record and consistency and we hold that very dear, it's very important to us. 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 minimizes and theoretically eliminates the NII dilution from it if you're putting it to work.
So anything else Michael you'd add?
Speaker 3
Yes. Mean I would say that on a for the next twelve months, I think on an average you probably would expect to see us raise on average $15,000,000 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 with our earnings timing relative to quarter end, you have a sense what your pipeline looks like. And so when you open the ATM opens up like it will 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 will 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 then you might see it closer to the lower end of the range.
Speaker 7
Great. Good answers. I appreciate all the perspective.
Speaker 3
Thanks, Bryce. Thanks,
Speaker 0
Our next question comes from Sarkis Sherbetchyan Riley Securities. Your line is open.
Speaker 8
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 $80,000,000 capital to commit next six to nine months and plan to draw $175,000,000 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 the rest of the BDC?
Speaker 3
Well, we're anticipating starting to contribute assets to the SBIC in the next few weeks. Our first asset will probably go 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 paperwork to get completed. But once that occurs, we'll be basically funding our first $40,000,000 and then we'll be drawing $20,000,000 of capital, so a half tier.
You have to ask for an examination by the FDIC just to review your and records at that point and then they release the additional $20,000,000 So I'd say we see that $80,000,000 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 FDIC. So in terms of putting the capital work over the entirety of the program, so six to nine months for the first eighty, we probably anticipate it will be in the three to four years before we fully utilize the 175,000,000 And then obviously we'll be replenishing that as repayments come in over the ten year life.
Speaker 8
Great. Thanks for that. And in the last quarter's call, mentioned kind of a net origination growth per quarter and kind of the $20,000,000 to $30,000,000 zip code. And it sounds 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?
Speaker 3
Yes. 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 we've certainly had a grew foothold in markets around the country.
I would tell you that at the low end of the quarters or about maybe we should expect 40,000,000 or $50,000,000 of originations and the high is 75,000,000 plus. We kind of anticipate somewhere in the 10,000,000 to $20,000,000 in repayments a quarter. So the net is somewhere in the middle there. Do want
Speaker 6
make No.
Speaker 2
I think that's right. I think it's the net might be a little bit higher than we said last quarter, it's not too far off.
Speaker 8
That's all for me. Thank you.
Speaker 3
Thank you.
Speaker 0
Our next question comes from Robert Dodd with Raymond James. Your line is open.
Speaker 6
Hi, guys. A couple of questions. First on I-forty five. You mentioned, I think, Michael, you amended the agreement. Does that bring basically your economic share into line with your ownership share?
Or is some other delta in terms of amending that agreement with Maine?
Speaker 2
Yes. No, essentially that's it moved that direction as you said Robert. I mean, it's we just changed the relative economics to reflect the maturation of our firm. So it's not any more complicated than that. Mean the relationship goes really well, it's kind of basically we did and it was kind of time for that.
Speaker 6
Yeah, yeah. Understood. Then just one more on that. Mean, you amended the revolver. It's now down to two fifteen basis points.
That looks pretty was 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 or and obviously your comments where you expect the returns to be higher in the future so this quarter?
Speaker 3
Yes. So I would say that Sure. I-forty five this quarter, I think I would tell you that the repayments that came in, were plentiful, came in early during the quarter. And then the originations, honestly, that we've actually closed, but haven't even settled. So the settlement process for some of these credits takes a bit of time.
So we're looking probably at I think 15,000,000 to $20,000,000 of originations that will probably settle in this June. So I think it's just a bit of a mismatch, right, for in terms of the impact to the dividend. To your second question, we do expect there to be a bounce back in this following quarter.
Speaker 2
That's a good question, Robert.
Speaker 6
Got it. Thank you. And then just a more broad one. I mean, in the comments you said equity ownership in 60% of the portfolio companies. I mean, is the target to take that I mean, obviously, it will vary quarter to quarter.
I mean, the 61% this quarter there were only two that got equity. So, obviously, lower than a 60% run rate. But would you expect that 60% to go up over time? Or are you happy kind of at 60% across long term? Or any color you can give us on that?
Speaker 2
Yes, it's an interesting question. I would tell you that we don't look at I mean, it's obvious, but we don't look at, okay, we want a certain percentage of our portfolio companies to that we want equity in. I mean, we're looking at it more from two things. Top level looking at it saying, the equity we'd like it to be 8% to 10% of the portfolio overall kind of works for the business model. And then it's question of deal by deal.
Do we like the equity story The equity story and the valuation thereof of the equity story and whether we think there's equity get the equity story or we think there's adequate returns on the equity. We take a view of the sponsor whoever is taking another view that doesn't necessarily always blend. And those on the call 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 two dynamics between the two are very different.
Something to be a really interesting cash flowing business, but it's like gee whiz how do you grow it? How do you scale it? That kind of thing which is not the lenders problem, that's the equity holders 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. And so where it all lands 60% I mean my guess is it's I'm guessing here, but I'm guessing it's probably 60% to probably around two thirds plus or minus over time of the deals of our portfolio loans will have an equity piece next to it. I'd probably say it's probably very rough rule of thumb. So 60%, 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.
Speaker 6
Got it. Got it. Because I mean obviously your realized IRRs to date of north of 15%, I presume that would be a challenge to sustain from debt only, right? So equity is kind of required to yeah, I think that's probably
Speaker 2
true from theoretical perspective. I also think that we're lending to the lower middle market. Are smaller businesses and the good news about the smaller businesses, lot of them are growing pretty interestingly. I mean, and so it's not like these large companies that are trying to grab two points of market share, etcetera. I mean, these are businesses that have 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 are generate KPIs that are 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.
Speaker 3
The other thing I would note too Robert is that we have 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 push on them and those might see some significant recoveries in equity as well.
Speaker 2
That's The reality is that's recovering form of principal. But if you think about it from where NAV is today that's all upside. So you look at it both ways, right? So we think that's something that we're pretty bullish on honestly.
Speaker 6
Understood. If I got one last housekeeping one. On the tax side, I mean the tax in the I mean obviously there was the onetime write off last quarter. But this quarter even so the tax looks elevated relative to what I would expect excise tax to be. So that 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?
Speaker 3
Sure, sure. So 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, there was majority of it was last quarter. There was an additional $425,000 because the previous number was off of provisional return and the final tax return was done in April.
Got it. So there's 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.
Speaker 6
Got it. I appreciate it. Thank you.
Speaker 0
Our next question comes from David Miyazaki with Consolence Investment Management. Your line is open.
Speaker 9
Hi, good morning gentlemen. First of all, a couple of comments. I really appreciate that you guys years ago set out to tell us what you're going to do and years later you're not 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 NII dilution after equity issuance. It's just very helpful. And congratulations on getting the SBIC over the line.
Speaker 2
Thanks, Kevin.
Speaker 6
Just as kind of yeah, so
Speaker 9
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 is 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 from about $10,000,000 on the lower middle market exposure and $70,000,000 in the upper middle market.
I'm just curious is what are your thoughts? The basic theme 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?
Speaker 2
Well, first, hey, Devin, 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 think we know that. So there's just Sure.
Speaker 5
The rating agencies
Speaker 6
say that too, right?
Speaker 2
Yeah, right. And so the bigger companies so therefore there's more capital available. There's just more big insurance companies etcetera. Everybody's like okay, well, we'll invest, but it needs to be at least he's still in the blank. I mean, well, we'll do it, but it's got to be at least 25,000,000 in EBITDA or at least 10,000,000 in revenue.
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 they're bigger companies, but I wouldn't say, 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.
There's less so the second way name 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 leverage is lower, covenants are real and documents are tight. You don't see Cub Light loans in our world. And so it's those are all reflective. So yes, they're smaller companies, but we think the risk adjusted returns which takes into account the company quality, the growth and the credit structure and integrity of the documents in the thing are just more attractive.
Now that's why you see the majority of our vast majority of our portfolio in the lower middle 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, do think there are credits from time to time in the upper middle market that makes sense. Now the other thing is in the lower middle market, we lead the vast majority on 80% plus of the credits in the lower middle market. We originate and lead.
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 can't really make decisions. You just sit on committee calls ad nauseam, right? And 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 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 of 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, 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, I'll also say as we grow, we'd like to look at this number, I think so 80% to 85% of our portfolio are deals that we lead, we originated in lead, okay. And of that, the last time I looked at the stat, which was maybe a quarter or two ago, but I don't think it's that much different. Over half of that piece that we lead, we 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 to keep them 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 we're I'm very reluctant to go and compete with the large 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 doing deals out in a larger percentage of our portfolio being outside the lower middle market. Hopefully that's helpful.
Speaker 3
And David one thing I would add to that. Our viewpoint on the lower middle market is as Boen 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 the I-forty five fund kind of shrink over time. And that's just our viewpoint on the upper middle market became it was frothy and it wasn't a place for us to find value.
Speaker 2
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 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.
Speaker 3
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.
Speaker 6
Right. So
Speaker 9
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 seeing an erosion in operating fundamentals. Is it fair to say that your experience has not really based upon your individual lending decisions has not really been adversely affected by the fact that your companies are smaller versus larger?
Speaker 2
Yes. 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 larger loan portfolios don't necessarily are not necessarily the risk adjusted returns candidly are not we think not as attractive as a general matter. And so candidly when things bump in the night, we like to be the decision maker. 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. They're talking to us and we can make decisions and we have I guess we have leverage in those conversations.
We make decisions on being commercial and being reasonable and maintaining our reputation and all that. The point is we get to control those situations. When you're I think it's what you're asking, Dave. And when you're in a larger lender group, 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 be in that I would rather have that loan book that kind of loan book where I can make real decisions.
Speaker 9
That's helpful. So I mean one of the things that 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 to the extent that your asset yields decline, your NIM can remain intact. It's just kind of helpful for you to just 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.
Do you 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?
Speaker 2
I think you always said, I know you know this David. Mean you have to remember that we're not there's no incentive here for us to scale just to scale. That's not we don't have a management contract that doubles in size if we double the assets. There's no 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 hold larger 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. So I want to grow for those reasons not just to scale. And so like you mentioned cost of capital tempting you to get in the upper middle market. I'm just telling you that is absolutely not the case here because what are you going 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. I mean 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 deck that comes down.
As we talked about, there's three costs to this business. And we're taking our costs and we're re lending 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, 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, right? 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 net our margin in our business. And so, we'll grow operating costs, but we don't think of it as scaling. We think of it as growing proportional to or at a slower rate than asset growth, because that's where the efficiency comes in.
Speaker 9
Well, greatly appreciate that answer. It's certainly what I wanted to hear. I like the focus that you have. And 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, your answers and congratulations on a good year.
Speaker 2
Thanks, Dave.
Speaker 9
Thanks, Dave.
Speaker 0
Thank you. This concludes the question and answer session. I'd now like to to turn the call back over to Bowen Diehl for closing remarks.
Speaker 2
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.
Speaker 0
This concludes today's conference call. Thank you for participating. You may now disconnect.