Q3 2020 Earnings Call
You for your patience.
[music].
Thank you for joining todays capital southwest third fiscal quarter 2020 earnings call.
Participating on the call today, our Bowen Diehl CEO, Michael Sarner CFO.
Chris Reed Berger, Vice President Finance I would now I'll turn the call over to of course rubber.
Thank you.
Back 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 managements expectations assumptions and believe they are not guarantees of future results and are subject to numerous risks uncertainties and assumptions that could cause actual results could differ materially from such thing.
For information concerning these risks and uncertainties.
Capital southwest publicly available filings with the FCC. 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'll now hand, the call off to a president.
Chief Executive Officer Bowen Diehl.
Thanks, Chris. Thank you everyone for joining us for third quarter fiscal year 2020 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 Dot capital southwest Dot com.
We're pleased to be ready this morning to announce our quarterly results for the third fiscal quarter ended December 31st 2019.
On the core we continue to advance our credit strategy, achieving the final step in transitioning the BDC to solely a middle market lender with successful Salem media recovery.
Which as a reminder, does business under the banner spot C.
The sale was a great outcome for capital southwest as we realized a significant capital gain while strengthening the company's position as a more traditional yield oriented BDC by removing the potential NPV per share volatility from holding such a large equity investment in the portfolio.
As you walk we were call we've been discussing the potential sale for several quarters and will provide further details later in my prepared remarks.
We're excited to have achieved the final step and look forward to continuing the pursuit of our core investment strategy of building a predominant way lower middle market portfolio, consisting largely of first lien senior secured debt with equity co investments across the loan portfolio, where we believe significant equity upside opportunity exists.
Executing the 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.
In December quarter laid out on slide six we generated 44 cents per share a pre tax net investment income and paid out a regular dividend of 40 cents per share during the quarter.
We also paid out 10 cents per share in a quarterly supplemental dividend funded by our sizeable undistributed taxable income balance where you'd <unk>.
Which was generated by excess income in capital gains accumulated from our investment strategy today.
The realized gain on sale and the meat of media recovery allowed us to add to approximately 50 cents per share to our etiology, bringing the total balance to approximately 27.6 million for a $1.48 per share as at December 31st 2019.
We believe this provides visibility to the to the continuation of the quarterly supplemental dividend program well into the future.
During the quarter. We also paid out a special dividend a 75 cents per share, which was the distribution of a portion of the media recovery realized gain.
Total shareholder dividends for the quarter, where a dollar and 25 cents per share.
We're also pleased to announce that our board has declared an increase to our quarterly regular dividend to 41 cents per share.
Our board also declared another quarterly supplemental dividend of 10 cents per share, bringing our total dividends paid to shareholders to 51 cents per share for the March quarter.
During the December quarter, we grew our portfolio on a net basis to 559 million.
539 million as of the end of the September quarter originating approximately $92 million and investments for the quarter. The vast majority of which were deployed in the lower middle market.
From a capitalization perspective, we continue to de risk the balance sheet by diversifying capital sources and maintaining liquidity during the quarter, we raised an additional $10 million on our existing five year five in three each person institutionally place bond due 2024.
The aggregate principal amount for this debenture is now 75 million.
In addition, we raise 13.8 million in gross proceeds through our equity ATM program during the quarter selling over 623000 shares at a weighted average price of $22.07 per share representing a 21% premium to the September 2019, net asset value for sure.
We're pleased to report that since the initiation of our equity into ATM program capital Southwest has sold over 1.3 million shares at attractive premiums to book value raising approximately 29 million in gross proceeds.
Our equity ATM program continues to provide a steady flow of equity equity capital raised ought to just in time basis in lockstep with our ability to thoughtfully put the capital to work.
Including cash Undrawn commitments on our balance sheet credit facility, we have dry powder of $190 million at quarter end available available to deploy and future investments.
This dry powder when invested represents a 34% increase in our portfolio investment assets.
Turning to slide seven eight 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.
Turning to slide nine as a reminder, our investment strategy has remained consistent since its launch in January 2015.
We continue to focus on our core lower middle market lower middle market, while also maintaining the ability to invest in the upper middle market went into attractive risk adjusted returns exist.
In the lower middle market, we directly originate opportunities consisting of debt investments in equity co investments building out building out a well performing and granular portfolio of equity co investment is important to driving and 80 per share growth in aiding in the mitigation of any future credit losses.
Overall, we believe that maximizing the top end of our deal origination funnel is in both markets is critical to generating strong credit performance overtime as it ensures that we consider a wide array of deals, allowing us to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic side.
Hello.
We continue to find superior risk adjusted return opportunities in the lower middle market.
Well, we can land at lower leverage and loan to value levels, while maintaining tighter covenants and other terms in the loan documents.
Over the past several quarters. This has been especially true as the upper middle market has been a primary source of any volatility in our portfolio.
Turning to slide 10, our on balance sheet credit portfolio. Excluding I 45 grew 18% during the quarter to 456 million as compared to 387 million as of the end of the prior quarter.
We continue to heavily emphasize first lien senior secured debt lending and again this quarter. The vast majority of our originations were in a lower middle market.
As of the ended the quarter, we had 81% of our on balance sheet credit portfolio investing invested in the lower middle market.
Companies, well, having 90% of the credit portfolio in first lien senior secured debt.
On slide 11, we lay out the capital invested in and committed to new lower middle market portfolio companies during the quarter.
This included 86 million in first lien senior secured debt invested in five companies and almost 4 million and equity co investments invested in three of them.
We also committed 3.3 million of additional capital to four existing portfolio companies during the quarter, bringing our total capital deployed for the quarter to over 92 million.
All of the new portfolio company loans were first lien senior secured with one being alone in which a bank lender printed participated as a first out in a first off position.
The weighted average yield to maturity on new debt originations funded this quarter was 9.9%.
We're pleased with the pipeline as it stands today and expect that several additional deals currently in diligence should close during the March quarter.
Again, the vast majority of this perspective investment activity is in the lower middle market.
On Slide 12, we show a summary of the exits during the quarter. The sale of me recovery generated $51 million net proceeds realizing a gain of 44.3 million and an hour of 11.8% measured back to the original acquisition and 1997.
During the quarter, we also realized a full read prepayment of our subordinated debt investment in Chandler side.
Chandler is performing well and we remain invested in an equity co investment position that is appreciated in value since closing.
The subordinated debt exit generated an hour or 14%.
This continues our strong track record of successful exits as we have now had 29 portfolio exits since launching our credit strategy back in January 2015.
Generating 267 million of proceeds and the cumulative are a 15.4%.
On slide 13, we breakout our on balance sheet portfolio, excluding I 45 between the lower middle market and the upper middle market as of the ended the quarter. The total portfolio, including equity co investments was weighted approximately 83% to the lower middle market and 17% to the upper middle market on a fair value basis.
We had 32 lower middle market portfolio companies with an average hold size of 12.6 million weighted average EBITDA of 7.9 million weighted average yield of 11.6% in a leverage ratio measured as debt to EBITDA through our security of 3.6 times.
Within our lower middle market portfolio as of the ended the quarter, we held equity ownership in approximately 69% of our portfolio companies.
Our on balance sheet upper middle market portfolio consisted of 11 companies.
With an average hold size of 9.2 million.
The weighted average EBITDA of 65.2 million.
The weighted average yield of 7.4% and a leverage ratio through our security of 4.6 times.
As in the past couple of quarters, we should note that our on balance sheet upper middle market metrics are shown excluding our investment in American addiction, because the EBITDA, while improving on a run rate basis remains at a level that would skew the aggregate portfolio leverage ratios to a degree that would obscure the ratios of the remainder of the upper middle market portfolio.
American addiction remains a three on our internal rating system and remains on nonaccrual have you been placed on non accrual during the September 2000 2019 quarter.
As a reminder, all investments upfront origination are initially assigned and investment rating of too on a four point scale with one being the highest rating and for being the lowest rate. It is.
As of the in the core of the 44 loans in the portfolio. We had three were the highest rating of one representing 11% of the credit portfolio at fair value.
We had 36 loans rated a two representing 84% other credit portfolio at fair value.
We had four loans rated a free representing 4% of the credit portfolio at fair value and we had one loan ready before which represented 1% of the portfolio at fair value.
The loans rated a three in the portfolio all in the upper middle market.
Include American addiction.
American Teleconferencing, which does business with Premier global.
And Delphi intermediate, which does business as Delphi behavioral health.
Delphi was downgraded from a two to a three during the September quarter enjoyed American addiction on non accrual status during the December quarter.
Both American addiction, and Delphi or in the business of providing addiction treatment services to patients across the country.
Well it would be inappropriate to discuss in detail the status of each company on a public call I will say that the two businesses faced similar challenges due in part to the addiction industry increasingly migrating to an in network insurance reimbursement model.
While this results in reduced reimbursement rates. It also results in a greater opportunity for each company to provide high quality care to a larger number of patients.
Due largely to these challenges cash flow at both companies has decreased to materially in the short term.
That said, we believe that both situations are rapidly moving to balance sheet restructurings and in both cases, we believe that the restructurings will benefit each company in their respective missions to provide the highest quality care to their patients.
We also believe that these restructurings will provide the respective lender groups the opportunity to realize appreciation and recovery of their investments as the business is complete the transitions and grow their respective patient basis.
We continue to believe that the challenges facing both companies, our addressable and our unrealized depreciation each is recoverable.
As a result of these restructurings if and when they occur we would expect that a portion of capital southwest first lien loans currently held in each company would be reinstated as first lien debt on each business with the resulting interest in that portion of coming back on accrual.
The remainder of capital southwest position in each company would then be equity, which we anticipate will be the source of recovery of the unrealized depreciation that exist today.
Our loan ran at a four also in the upper middle market portfolio is educating.
The loan has remained on non accrual for the past several quarters.
Not much has changed with respect to disposition, but the lender group continues to work with a company on strategic alternatives for the business. We will attempt to update you on future calls to the extent, we can comment on the company status.
As illustrated on slide 14.
We have established a portfolio well diversified across industries.
Despite the few idiosyncratic issues, we are dealing with in the upper middle market portfolio. Today, we believe the portfolio is well positioned for late in the economic cycle.
Further our portfolio asset mix should provide strong security for our shareholders capital.
The portfolio remains heavily weighted towards first lien senior secured debt with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio and subordinated debt investments.
As shown on slide 15 as of the ended the quarter. The portfolio was 93% first lien with diversity among industries and an average hold size of 2.2% of the portfolio.
Yeah, I 45 portfolio had weighted average EBITDA of approximately 65 million.
Our weighted average coupon of LIBOR, plus 6.3% weighted average leverage through the I 45 security of 4.5 times.
We also excluded American addiction from these ratios for the Affirmations Afro mentioned reasons.
Ill now hand, the call over to Michael to review the specifics of our financial performance for the quarter.
Thanks, Boeing as seen on slide 16, our investment portfolio produced $60 million of investment income this quarter with a weighted average yield on all investments of 10.7%.
This represents an increase of approximately $800000 from the previous quarter.
The increase in investment income was primarily attributable to an increase in average debt investments outstanding and a transaction fee received in connection with the sale of media recovery.
Offset by decreases in dividend income revolt, I, 45, and media recovery and Delphi being placed on nonaccrual during the quarter.
As of the ended the quarter there were three assets on nonaccrual with a fair value of $18.2 million, representing 3.3% of our total investment portfolio at fair value.
The weighted average yield on our credit portfolio was 11.3% for the quarter.
Excluding interest expense, we incurred $4 million in operating expenses for the quarter, which was $150000 less than the previous quarter.
For the quarter, we arent pretax net investment income of $7.9 million or 44 cents per share.
This compared to 42 cents per share during the prior quarter.
We paid out 40 cents per share in regular dividends for the quarter flat from 40 cents regular dividend per share paid out in the prior quarter.
We have continued our consistent track record of meaningfully covering our regular dividend with pre tax and III as demonstrated by our 109% regular dividend coverage over the last 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy.
As Bowen mentioned earlier, we also paid out a supplemental dividend of 10 cents per share during the quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in a successful exits of our investment portfolio through distributions from our yutai balance overtime.
Due to successful sale of MRI, we were able to replenish argue CCI balance to a level of $1.48 cents per share as of December 31, 2019, which we believe provides visibility to the continuation of our some supplemental dividend program well into the future.
The program will continue to be funded from Yutai earned from realized gains on both debt and equity as well as undistributed net investment income earned each quarter in excess of our regular dividends.
In addition, we declared and paid a special dividend of 75 cents per share as we distributed a portion of the realized gain from the media recovery sale.
On slide 17, we illustrate our operating leverage which as of the ended the quarter was 2.7%, which puts us near our initial target operating leverage of two sub 2.5%.
We are fully committed to actively managing our operating costs in lockstep with portfolio growth and have our longer term sights set on achieving target operating leverage up 2% or better.
But senior professionals and corporate infrastructure largely in place.
Operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure.
Flipping over to slide 19, the company's NPV per share as of December 31, 2019, with $16.74 as compared to $18.30 at September 32019.
Given the number of moving parts this quarter and the fact that much of the any push any be procure per share change with a reset of NPV per share as a result of the final step in the transition of the BDC to a middle market lender achieved through the sale of media recovery, we thought we would take a minute and walk through the components of the quarter over quarter change.
Moving from left to right. We continued our trust strong track record of fully covering our regular dividend with Eni earned during the quarter, while systematically distributing our undistributed taxable income overtime.
With respect to the investment portfolio, we saw unrealized appreciation in the upper middle market, partially offset by unrealized appreciation in the lower middle market portfolio.
Finally, with respect to the sale of media recovery, we paid a special dividend to shareholders of 75 cents per share distributing a portion of the capital gains from the sale to our shareholders.
For the portion of the capital gains we retain.
We paid 19 cents per share tax on the retained capital.
Shareholders will receive a form 20 439 and the letter from US with further explanation of the resulting tax credit and step up on their cost basis, which we expect to be 71 cents per share for shareholders of record as of December 31 2019.
Finally, we recognized book depreciation from the sale of media recovery of 23 cents per share there were three components to the 23 cents per share.
First nine cents per share was driven by frictional transaction costs from the sale process, including investor banker fees legal and accounting expenses and a closing working capital adjustment pursuant to the purchase and sale agreement with the buyer.
Second eight cents per share where the GAAP required book discounts applied to the potential earn out and escrows associated with a company sale to account for the fact that each is a future that.
If we receive both and fall right. It will result in capital southwest receiving an additional 1.5 million in recognize proceeds from the transaction.
Third and finally pursuant to a management services agreement in place between capital Southwest and media Cranberry capital southwest receiving success fee upon closing the sale, which approximated six cents per share.
The success fee was recorded as fee revenue rather than sales proceeds for purposes of Eni in any be per share.
Our total pretax and high return on equity for the quarter with 9.5%.
On slide 20, we lay out our multiple pockets of capital as we mentioned on prior calls a strategic priority for our company is to continually evaluate approaches to de risk the liability structure at the company, while ensuring that we have adequate investable capital throughout the economic cycle.
To that end, we raised an additional $10 million on our October 2024, institutionally placed bond, which has a coupon on five in three 8%.
As bone mentioned earlier during the quarter ended December 31, 2019, we sold 623111 shares of capital southwest common stock under the equity ATM program at a weighted average price of $22.07 per share raising $13.8 million of gross.
Proceeds.
Cumulative to date, we have sold 1.313 million 588 shares of capital southwest common stock under the equity ATM program at a weighted average price of $22.07 raising 28.7 million of gross proceeds.
Our balance sheet leverage ended the quarter at a debt to equity ratio of 0.8 to one.
We're pleased to report that of liquidity is strong with significant dry powder and the earliest debt maturity at December 2022.
I'll now hand, the call back to Bowen for some final comments.
Thanks, Michael and thank you everyone for joining us today capital southwest has grown in the business and portfolio of developed consistent with the vision and strategy, we communicated our shareholders five years ago.
Our team have done an excellent job building, a robust credit portfolio generating attractive returns for our shareholders. While also demonstrating our extensive credit experience and managing our loan portfolio as it matures and seasons.
Everyone here capital southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long term sustainable shareholder value.
This concludes our prepared remarks, operator, we're ready to open the lines for QNX.
Thank you as a reminder to ask a question you will need to press star one on your telephone.
Draw your question press the pound key please standby well we compound the culinary roster.
And our first question comes from the line of Tim Hayes from B. Riley FBR. Your line is now open.
Hey, good morning, guys and congrats on officially completing the portfolio transition.
My first question if phone would you just mind expanding on your decision to raise the regular quarterly dividend on an after tax basis, Eni is a little bit lower than the 40 cents regular dividend this quarter and I know you had the excise tax accrual, but you also had the onetime success fee Joe investment income higher.
Gross is really strong what is this a case, where it was backend weighted and you expect growth well have a much more profound impact on next quarter's results just any color around that should be helpful.
Sure. Thanks My question.
It's all of those things and so let me, let Michael comment on that on the component.
Oh sure. So I think in looking at the 12 31 run rate. If you exclude the nonrecurring MRI fees were about 1.7 million and then you add back the impact of the 85 million in originations during the quarter for a full quarters accrual our run rate for the 12 31 quarter would be 40 cents per share.
Sure. So that doesn't include looking for originations that have closed this quarter to date, where that will close between now and the end of quarter.
Okay.
Got it.
Helpful and then as it relates to Delphi, what exactly triggered the company being added to non accrual. This quarter was there new information you gathered which increased the likelihood of impairment or did they actually stopped paying interest and or principal on the loan.
So.
There they stopped paying interest on alone so it's picking but not going through our income statement, so Todd non accrual.
But it just basically deterioration that EBITDA.
And so based on that and the fact that we weren't receiving cash interest we made a judgment call to put it on non accrual.
Okay.
And then I've always said Tim It was it was picked into the principal balance and I think though and discusses.
Potential restructuring so that value will be part of that restructuring process.
Right and that was I guess my follow up question on that was can you maybe I know this might be difficult to answer but is there just any rough timeline around the restructuring process that you can give us.
I would say that like like I said in my prepared remarks, I mean, both of them are rapidly moving that direction. So.
I'd say probably should expect.
That Delphi, probably gets done faster than a sees a little simpler given its private Macy's public.
But but but they're both moving on a pretty quick timeline and that's going to be good like I said in my prepared remarks, that's going to be good for both companies.
Because ultimately the company's exists to provide high quality health care to their to their patients and that's what's going to ultimately support the capital structure. So.
But the pace is fairly quick in both cases.
Okay.
And then.
On the 9 million net depreciation on upper middle market investment.
Much of this was the JV and was it largely with remarks, largely fundamental unrelated to company performance or were there any technical factors that drove these fair value marks so.
So it's about half and half.
Between the JV and balance sheet and at the JV or I should say and on the balance sheet.
Is 5.4 on the balance sheet of depreciation and Thats view, if you looked at the for companies that I've mentioned, we've talked about the depreciation between those four is 5.4 million. So.
Okay. All the other companies were kind of pluses and minuses.
And then on on the on I 45.
Was it was four and a half million of total depreciation and 3.2 million of that is essentially four credits, including a C. Therefore credits in 45 that I would say are having credit or operational challenges and then.
The Red Thats four out of 46 loans.
The other 42 loans are either doing fine doing great or just kind of bumping along so the equity guys are working very hard to get their returns, but but the lift the loans themselves are.
Our probably fine, but theres four out of 46 that are having some level of.
Conversations and operational challenges.
I hope that kind of gives you. Some general color, yes noted that it does thanks, and just broadly would you say how would you describe kind of sponsor behavior. They are they being supportive in working with companies again distressed companies to try to restructure investments are just inject liquidity to help but for a better outcome are you seeing sponsors.
Hey, you kind of debt some of the I don't want to call them losers the ones that are struggling a little bit more and focusing on winners are.
Maybe you could just some color on that would be helpful. Yes. So I think sponsors are making.
For the most part smart informed decisions.
And not just throwing good money after bad so you know across our portfolio over the last year year and a half timeframe when we have.
The vast majority of the time sponsorship supported the companies and Thats, a rational thing for them to do and every one of those instances.
You know there are couple of them one that one in particular to where the sponsors made the decision to.
To hand, the keys over to the first lien lender I.E. restructured balance sheet as I referenced earlier.
And so and so in that case I think that was probably a rational decision in the right thing to do for the business.
And frankly, the right thing to do for the senior lenders and so.
I'd say generally I think we've seen sponsors make.
Smart decisions, but in virtually every case.
That right decision was to support the business.
And frankly keep the first lien lenders happy which is what we want them doing.
Okay got it thanks for the color there I'll hop back in the Q.
Thanks, Tim.
Thank you. Our next question comes from the line of Mickey Schleien from Ladenburg. Your line is now open.
Good morning bone and Michael.
Wanted to ask about deal flow I've been hearing that the volatility in the more liquid markets in the fourth calendar quarter led larger borrowers to gravitate toward.
Correct lenders.
Instead of the syndicated market and that caused larger lenders, including larger bdcs to focus more on bigger deals and that may have resulted in more opportunities for for smaller bdcs.
Was that a trend that you saw in did that impact your deal flow during the quarter.
Well, we certainly saw.
Slowdown of general activity in the syndicated market, so that would be consistent with that comment.
And we've done we've looked at some larger club deals, which I think is also consistent with that.
That is in it as a general matter you know the number of upper middle market deals that weve been excited about and been.
No.
Been low and so enhance you see I 45, you know not not growing because it's been refund capitals been refinanced and.
Below number of new deals really that we've been looking at in the bunch of activity and I 45 slow so you'd slower. So you can see that there.
But I would say.
I'd say virtually everything you just said was.
Certainly consistent what we're seeing.
And I think you mentioned in your prepared remarks that at least so for the first calendar quarter looks pretty busy and that's usually a slow quarters. So.
Is there something specific going on this quarter.
That's leading to that volume.
Spillover from deals that just didn't get done in the fourth quarter.
Yes, I mean, the lower middle market honestly is is we I've always said, it's lumpy and it's frankly kind of random.
So I would say the if you look across our pipeline and I look down the list and I see deals that weve.
Signed up and that were there essentially I would say our ours, if we want them.
Kind of category, it's above average.
And so.
In the December quarter was obviously very strong quarter originations, but the quarter or two but below before that were below average and so.
So.
I mean.
Just thinking align the deals that were working on I wouldn't say that it's.
Albeit.
Strains that if I were working on them in the March quarter. So, it's a little bit random I would just say that the the pipeline this quarter is above average.
You know may not be last quarter's volume, but it's going to be we would expect it to be above average.
Probably causing towards the latter half a quarter.
Okay, I appreciate that and just.
A follow up on a C and I know you're limited as to what you can say, but.
Third there has been news about extension of the forbearance agreement and some additional capital provided by the lenders did you participate in that additional injection of capital into AC.
We did I mean, our pieces small because there's a 400 million dollar loan that we all split split the incremental capital. So our dollars are small but we.
We participated in that incremental capital has very outsized economics and so it.
Directly first first priority secured by the real estate, so its and frankly other people are going to put it in if we don't put the rational thing to do it but fortunately the numbers for us are relatively small.
Okay and I just wondered confirmed there is real estate in the collateral.
That's correct.
Okay.
That's it for me. This morning, Thank you for your time.
Thank you. Our next question comes from the line of Kyle Joseph from Jefferies. Your line is now fan.
Hey, good morning, guys and thanks for taking my questions. Most most have been.
Answered but.
I just wanted to get a sense it sounds like the lower middle market continues to be very attractive in your maybe a little disappointed with some of the investments in the upper middle market I want to get a sense or what's what's driving that is it have you seen things in the upper middle market get more competitive.
Yeah, what can you explain the discrepancy there.
Yes, I mean, if you look at our these kind of break into its components I mean, there's 5.4 million of depreciation in the upper middle market. That's that's you can take the depreciation on Delphi They see it Agee kings and add those together its 5.4 million. So thats the story in the upper middle market and frankly, the credit Guy I look at myself and go we just made back.
Add choices on those loans I mean, those loan me wish we hadn't done them.
They were structured well you know the structure of the restructuring is going to work out fine in the long run, but certainly we wish we never made those loans right I mean, but its but thats not a zero defect business and so those are that that's the upper middle market story. So far we do think that loan as weve really referenced.
Really pretty consistently over the last several years the upper middle market is a market where it is more competitive theres more people willing to lend to larger companies and so you have large higher leverage ratios on average.
Higher loan to value on average.
The lower yields on average across and so when there's a problem you have less degrees of freedom.
So thats the nature of the upper middle market, so as far as beginning more competitive or less competitive kind of been that wafer for so certainly a few years now.
On the lower middle market side, our story is different I mean with $370 million loan portfolio depreciated by 140 Grant this quarter.
That's basically flat and then our.
Lower middle market equity portfolio appreciated by 2.9 million.
And so it's that portfolio is working as designed its first first lien with equity co investments and that was equity co investments.
The winners are far outpacing any any depreciation in the equity portfolio and so it's working like as designed.
Hopefully that some got it and that's good segue to my next question said anything about that the pipeline between.
Upper and lower Middle market, Oh, I guess is kind of a three part question, but talk about yield trends, you're seeing in the upper and lower middle market and what that means for your portfolio more broadly.
Yes, I would say that the sandbox. If you will have loans, you know, India lower middle market yields are basically.
Basically generally the same and I think generally saying, there's there's a range of.
Yes deals and within a market right. So you have you'll have loans that are very high margin recurring revenue type businesses, where were making a relatively low loan to value kind of kind of loan and those are going to have tighter spread.
Maybe sponsored right. So then so that's going to be havent tighter spread than a deal that that has a maybe a slightly higher loan to value maybe less less.
Less recurring base business.
Maybe a sponsor that's not as large of a fund or maybe doesn't have specific sector expertise as the other not that those are negatives, but that would be that would be a higher yield deal. So there's going to be ranges of yields and so if you look quarter to quarter.
We're going to do some of all of that as we move to target leverage you know our cost of capital is coming down and frankly as we lever up the BDC one should expect that we do safer safer deals and so you may move from one edge that same sandbox to the other.
Edge of that sandbox.
But I would say that over the last.
Several quarters.
No I don't I really haven't seen the sandbox itself move all that much I mean, it's been competitive for a long time.
The upper middle market has been more competitive in the lower middle market for the for a long time.
Hi, long time meeting a couple of years I mean, it's been the same theme, but we don't see like this quarter, we didnt see the Sandboxes I defined it change change all that much.
Appreciate it that's good color and that's it for me Thanks, a lot for answering my questions.
Thank you Sir our next question comes from the line of Bryce Rowe from National Security. Your line is now open.
Thanks, Good morning, guys.
I want to us.
Hey, Michael I wanted to ask you about the source of dividend income here.
This quarter, obviously, you had I 45 dividend.
But curious what what the other portion of that that dividend income was.
The other portion was a stub dividend from MRI for about 500000 that was paid out of the proceeds before close okay.
That's helpful.
Okay.
And then.
But when you talk about the pipeline being maybe above average and can be quite random in terms of.
The lower middle market.
I'm curious, what you're seeing from maybe a repayment visibility perspective.
Obviously this past quarter was dominated by the proceeds from from in MRI, but just wondering if you have any any visibility into repayments over the next quarter or too.
Yeah, I, just think I'm I'm looking at Michael thinking about that I think prepayments are kind of obviously you know there kind of.
Constant aspect of our business model, but we don't really have large flight right now because ability on large prepayments coming in the next quarter for two that means that we away maybe one phone call away from seeing that some of our companies, but we don't have any in prepayments I would expect the prepayments over the next quarter to be.
Repeal and in the lower middle market, certainly a relatively light right now and we did have we didn't have to what we'd call a plus performers that the potential for refinancing existed and I think we've worked through that where we're going to stay in as a lender. So thats part of the reason, we say, we don't see any visibility right now for additional repayments.
Okay. Okay.
Okay and then if you guys can I don't know if you can speak it its or not the.
The earn out that you mentioned with MRI, what kind of.
Im frame are we talking about there.
So the earn out will be tested on a 932020 fiscal year that's that.
Thats MRI fiscal year basis, so be earnings performance for that year.
Excellent okay. Thanks appreciate the answers.
Thanks, Brett Thanks.
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Thank you. Our next question comes from the line of Christopher York from JMP Securities. Your line is now fan.
Good afternoon, guys. Thanks for taking my questions.
So Michael or Bill when I noticed a decent pick up in the weighted average leverage to your security upper middle market.
That's that's what the churn from 3.7 to 4.6, so could you maybe just.
Comment on what drove that big increase.
Yes. Thanks.
All Delphi basically so if you take Delphi out the 4.6 is 3.6.
Very good Okay, and then in I 45, we also have a decent increase there I would have to look at that Q.
And Thats why Delphi in I 45 as well.
No. It's not so the leverage on I 45 went from 4.3 last quarter 4.5.
During the quarter, we had $9.3 million paid down or prepaid on companies, where the leverage was.
Mid two and a half kind of two and a half times EBITDA basis, because of the performance and we put two credits on that were new deals new issues and they were kind of in the low four times like 4.2 to 4.3 type leverage.
And so that's basically that's basically the change.
That's great color okay.
And then see that I 45 dividends decreased 400 say sequentially no given the decline in the portfolio. There is this a level recurring dividend that we should be expect.
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Yes based upon the number of credits that are in the portfolio right now and the cash yield I think that the 2.1 is a good run rate number going forward.
Okay.
And then maybe taking a step back given the competition that you described from wind in the upper upper middle market losses experienced here in the upper Middle market has this cause you to reconsider the dual prong strategy or allocating capital between the strategies.
Now let me our strategy from the beginning its been core market lowered aftermarket opportunistic market upper middle market and so.
Right now, it's very competitive I think a set in really over the last couple of years I mean, finding value in the upper middle market has been certainly much more challenging in our view than finding value value from a credit perspective in the lower middle market. So.
Or said differently risk adjusted returns and so.
And so I don't that strategy hasn't changed.
And so given what I just said in our core business lower middle market. We've had a lot of our deal teams have done a great job originating.
Deals and we kind of we're kind of tracking closing about 2% of the deals. We look at so so they've done a great job originating opportunities for us to look at and so there is so I look at that I'm like Okay. There's demand for our lower middle market, our balance sheet, the lower middle market.
In value is more challenging defined in the upper middle markets that meet doesn't exist I mean, I mentioned earlier, we did two deals this quarter. So it's not like it doesn't exist or two deals like 45.
But it's just more challenging so that hasn't changed I mean now we've we've.
Got three so couple of situations that in the upper middle market that are obviously credit challenge and being restructured that's just noise thrown on top of the strategy that strategy statement that I laid out but the strategy I wouldn't say is changed but where we're putting our money and where we're allocating capital.
He is going to ebb and flow based on the risk adjusted returns we see in those markets and so I still think it's important for us to maintain certainly the lower middle market and we.
And you we've talked quite a bit about why we like to lower middle market, but we want to maintain the ability to look at to consider.
And evaluate the upper middle market, because we do think theres opportunities and as we've always said you know when things move in the market.
Upper middle market moves from a quote perspective, it doesn't necessarily immediately result in asset you could buy but it certainly moves around with Coop Wall Street Journal, if you will and so it's going to be opportunistic for us in the future. So we're going to still continue to look at it maintained that capability maintain those contacts in the market.
But it's just it's right now it's it's just it's hard we it's harder to find.
Value if you will in that market.
Sure it's great context.
And then last one from me maybe two part question, but when you said that.
You may have not made some of the upper middle market investment.
If you were approach to potentially invest today, maybe could you describe some with the characteristics that led you to say that and then secondly, what gives you such confident that there is recoverable value some of the unrecognized depreciation.
Given that your ability to control the outcome of the part of the syndicate.
Yes.
Bill or let deal.
Yes, so first of all anytime you make an investment or an investor buys a stock. It doesn't go value. My question you wished you've never done it right. So thats a general comment I would say with respect to those industries I mean, the addiction treatment industry, which is most of the story here right. So we will talk I'll come back at Kings and a minute but addiction.
Industry. Unfortunately, the opioid a drug epidemic in this country is growing and that we I think we all would agree on that and it's certainly not a positive but people need help and been lives are being saved in that industry. So it is an industry that unfortunately or fortunately depending on your perspective is growing.
But with that comes increased cost and so payers are in Korea had to bear that burden and so the industry is moving making a transition from outer network in network. Both of these businesses had had a portion of their business out of network.
And then there's number of different challenges management or otherwise, but that's that's.
A large piece of it and so do I wish we never invested in the lower end addiction treatment industry, No I can't say that I mean.
One of my former one of my better investments I made at my former from within the addiction treatment business and so we like that industry. We think it gets to your Recoverability question. I mean these are Bible platforms, we still believe and certainly I guess I suppose theoretically that could change, but we think these are Bible. These are viable platforms.
In a growing industry that is going through a transition. So I still view that certainly the vast majority of that have that if not all of that.
Unrealized depreciation.
It should be recoverable and so that's kind of why said that and so.
So no I don't I don't think that addition industry as a horrible placed invest in all out it's just it's just.
It's those factors I just laid out and then on the grocery solid the grocery business as it is a very competitive business. I mean, we know that any people don't stop eating and so thats. Good theres always a chance theres always a does a.
Consumer staple type product.
But it's one that's increasingly larger and larger competitor competitors.
Our opening up stores and more and more geographies and so it's it's just a net that pace is moving faster than.
Frankly, we anticipated several years ago, we made that loan.
And so so thats.
That unrealized depreciation is going to be harder to recover and that's why it's a four not three.
And so it's a different situation.
Not super excited about making any other grocery loans quite frankly, so so hopefully you are hearing a different answer to that question then with respect to addiction.
The addiction treatment space.
All three are challenged situations no question about it but the two industries are very different.
Certainly understand that.
Great Thats it for me thanks for the candor and thanks for taking my questions.
Thanks, Chris.
Thank you. Our next question comes from the line of Robert Dodd from Raymond James Your line is now fan.
Hi, guys I'm, just some quick housekeeping ones I think on EMI and then a couple of more detailed ones. Michael you mentioned earlier in the cool 1.7 million success fee for them all related to my is like okay.
I assume that 1.7 includes the half a million dividends because.
Otherwise it be more than utopian Cup.
Thats correct. It was one point does right 1.16 million for the success fee and was approximately 500000 for the stub dividend going it got it and then on the form if I got the number by the 20 429, I know I'm going to get questions about this but when when can you show shareholders expect that.
I think we should have that in the next week and it has full description as did the definition the deem distribution will describe the tax the long term gain and tax treatment it will help them.
By the permission to their tax advisors to get it done correctly got it got it and then the last one on that on the 27.6 million in undistributed income that's adjusted for the deep distribution Mountain that you might you would take.
Yes, that's correct yeah got it okay. Thank you on that.
So just going to I 45.
And looking at that level I mean, the portfolio overseas over the last year.
Looking at page 15, which is very helpful.
It shrunk a little bit let me just gone up you mentioned that the you know you had some low levered repayments should we have so some good assets more or less.
Well assets and we paid should we be worried given me the leverage is going up a point over the course of the year wallet shrinking that there's any adverse selection going on.
In that portfolio about what the the remaining borrowers arm and obviously the more successful aboard the more likely the out to repay early and get out of a portfolio and when the portfolio shrinking do you end up which with a mix that you might know of wanted up.
Well I think clearly as any portfolio certainly loan portfolio the ones that.
Outperform leverage goes down gets repaid earlier. So so then it just academically by definition the lesser quality credits are the ones left in the portfolio. So having said that you know if I look across the loan portfolio.
It's.
It's really kind of four or five loans that I would say that are kind of companies are going through operational issues, one of those being a c., but the other ones aren't aren't on our balance sheet.
They're just unique I 45.
Which is the bulk of the depreciation.
And so you know and that's also affecting the leverage as well.
And so.
I would say other than just yes from a high level you know the portfolio the better quality loans pay off faster and then recycled in newer loans and some of the older loans, but it doesn't mean that what's left is a disaster, but I think that I mean, I mean agreeing with your general comment, but I'm, telling you that that we don't think thats like.
Dramatic issues I 45 got it got I appreciate it and then on the lower middle market. If I can let me.
Very strong originations in the quarter and as you said earlier that can be lumpy, but.
Have you seen anything in the Mark on the lower middle market in terms of.
The borrow as all the company on us as the acts on what they're looking for shifted any that that makes the deals maybe slightly more appealing to you.
Well I mean, there's a lot of variables right I mean the ask.
When I say the asking me every industry is different right every industry every company is different so the different profit levels. The industries have different profit drivers economic theyre different levels of sensitivity to the economic cycle.
And so you know so we look at it and go is the ask.
Appropriate for our view of that industry in that <unk>, So and I don't think I mean, I don't think that sponsors are for a given for a given I mean, they always ask you know they varying levels of aggressive behavior from sponsors write some sponsors are very aggressive they want the last nickeled leverage and others.
Answers are much more measure because ultimately.
Most of their ours is going to be driven by the operational improvements they provide that business and less by the financial engineering.
We do better with the second the latter category is not surprising.
But I don't I again, it's more in general it's the same comments I made with respect to the sandbox and leverage and pricing I mean, the sandbox I don't think is changed but as as we can play in different portions of the of the sandbox. If you will and certainly as we move up in leverage bringing our cost.
Capital down.
It allows us to.
Compete and put assets on the books that generate attractive or are we to our shareholders, which is ultimately whats important.
In maybe a safer side of the sandbox if that makes sense, yes, that's I mean, if it if I cant on that size question, what both on and Husky it.
The target of getting operating leverage so two and a half, but obviously, it's been trending down and then.
Increasing returns to shareholders I mean, what was not necessarily timeframe. When do you think you can get that but so much as what do you think youre asset leverage level needs to be for that sustainably.
For that opex ratio to be self to it.
Yeah honestly, Robert I'd tell you that we think we can achieve it I'd give you the timing in the amount I think we can achieve it in the next two quarters and I think the amounts can be in somewhere in the close to 650 million original of assets on balance sheet.
Got it appreciate it.
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Thank you at this time I'm showing no further questions I would like to turn the call back over to Bowen Diehl for closing remarks.
Thank you operator, and thanks, everybody for joining us today and thanks to all the analyst asked the question those are great questions and we appreciate everybodys support and look forward to giving updates as we move forward.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating you may now disconnect.
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