Q3 2021 Capital Southwest Corp Earnings Call
Ladies and gentlemen, todays conference is scheduled to begin shortly please continue to standby. Thank you for your patience.
[music].
Thank you for joining today's.
Capital Southwest third quarter fiscal year 2021 earnings call participating.
Participating on the call today are Bowen Diehl, CEO, Michael <unk>, CFO and Crispy Berger VP Finance I would now turn the call over to Chris be Burger.
Thank you.
I'd like to remind everyone that in the course of this call we will be making certain forward looking statements. These statements are based on current conditions currently available information and management's expectations assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks uncertainties and assumptions that could cause actual results to differ materially.
From such statements.
For more information concerning these risks and uncertainties day capital southwest 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'll now hand, the call off to our President and Chief Executive Officer Bowen Diehl. Thanks.
Thanks, Chris.
Thank you to everyone for joining us for our third quarter of fiscal year 'twenty 'twenty one earnings call.
Throughout our prepared remarks, we will refer to various slides on our earnings presentation, which can be found on our website at www Dot capital southwest Dot com.
We're pleased to be with you. This morning to announce our results for our third fiscal quarter ended December 31, 2020 I.
I want to first say that I hope, everyone and their families and their employees continue to be safe and well in.
In summary, this quarter was exceptional in virtually all areas strong originations strong capital raises and strong portfolio performance.
Every day, we reflect back on 2020, we were very impressed by how the vast majority of our portfolio management teams and financial sponsors managed our portfolio of companies prioritizing the health and safety of their employees.
Realizing cost efficiencies, where needed and now recovering nicely from the worst effects of the pandemic.
While the pandemic has not yet completely behind us as we look back to where we were in March of 2020, with so much economic uncertainty and market volatility. We are very grateful for all the work done by the team here at capital southwest and the teams at both our portfolio of companies and financial sponsor clients.
The pandemic was impacted so it has impacted so many people and companies in a variety of ways and we are humbled by how well the portfolio has held up through this difficult time.
The way our deal team has been able to continue to source diligence and originate high quality assets, while continuing to actively monitor our existing portfolio over the past year has corroborated my confidence in them and also in the strength and quality of the assets.
During the quarter, our portfolio continued to improve as evidenced by $7 1 million of net appreciation across the portfolio.
For the quarter, we had two loans, which had investment rating upgrades, we had no investment grade rating downgrades and we had no new loans placed on non accrual.
Overall as of the end of the quarter, we had only one loan on non accrual the junior most tranche of our loan to AG Kings, which had a fair value of $739000 subs.
Substance of quarter end, the sale of AG Kings to Albertsons Acme markets has closed now resolving this last nonaccrual asset for capital southwest.
As a well capitalized first lien lender with ample liquidity capital southwest continues to be in a favorable position to seek attractive financing opportunities and to provide financial support for the growth of our portfolio companies.
Executing our investment strategy under our shareholder friendly internally managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable long term value through recurring dividends capital preservation and operating cost efficiency.
On slide six of the earnings presentation, we have summarized some of the key performance highlights for the quarter.
During the quarter, we generated pre tax net investment income of 52 per share, which more than earned both our regular dividend paid for the quarter of <unk> 41 per share and our supplemental dividend for the quarter of an additional 10 per share.
Total dividends for the quarter of 51 cents.
Per share represented an annualized dividend yield on the quarter end stock price of 11, 5% and on.
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 <unk> 52 per share for the coming quarter ending.
March 31, 2021, consisting of a regular dividend.
And our regular dividend increase from 41 cents per share up to 42 cents per share and a supplemental dividend of <unk> 10 cents per share.
Our decision to increase the dividend emanates from our confidence in the current earnings power of our portfolio as a result of the reduction in our cost of capital and our ability to continue to improve our operating leverage as we grow the portfolio.
During the quarter, we grew our investment portfolio on a net basis by 3% to 649 million as of December 31, 2020.
Portfolio growth during the quarter was driven primarily by 57 5 million in total new commitments to three new portfolio companies and three existing portfolio companies offset by $28 million in total proceeds from three exits.
Substance subsequent to quarter end, we added additional investment activity, which spilled over into the new year closing, an additional $33 5 million in commitments.
I will review our investment activity in a bit more detail on a moment.
On the capitalization front, we were quite busy during the quarter, we successfully raised over $96 million in investable capital during the quarter, consisting of $75 million in aggregate principal and a new four 5% institutionally placed unsecured bond and $21 1 million in gross proceeds through our equity ATM program.
During the quarter. We also received $15 million of additional commitments to our revolving credit facility, which now stands at a total of $340 million in total commitments from 11 banks.
In addition, subsequent subsequent to quarter end, we paid off the remaining balance on our 595% December 'twenty two maybe.
Baby bonds.
Turning to slide seven and 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.
In fact specific to slide eight as of December 31, 2020, we hit a new all time high and total value creation for our shareholders.
We believe the strength of our investment in capitalization management strategies have been demonstrated through the pandemic based on the solid performance of our of our company and our portfolio.
And now we are pleased to announce on increase in our regular dividend this quarter.
We believe that the maintenance and growth of both net asset value and dividends per share are paramount to creating long term value for our shareholders.
Turning to slide nine as a refresher our investment strategy has remained consistent since its launch in January of 2015, we continue.
To focus on our lower on our core lower middle market on a core lower middle market, while also maintaining the ability to opportunistically invest in the upper middle market when attractive risk adjusted returns exist.
In the lower middle market, we directly originate and lead opportunities consisting primarily of first lien senior secured loans with smaller equity co investments made alongside our loans.
This combination is powerful for our BDC as it provides strong security for the vast majority of our invested capital while also providing a be upside from these growing businesses.
Building on a well performing and granular portfolio of equity co investments is important to driving growth in NAV per share while aiding in the mitigation of any credit losses over time.
As illustrated on slide 10, our on balance sheet credit portfolio as of the end of the quarter, excluding our I 45 joint venture grew 2% to $531 million as compared to $521 million as of the end of the prior quarter.
Our credit portfolio is currently weighted 86% to the lower middle market to lower middle market loans up.
Up from 82% last quarter as a result of one loan prepayment in the on the upper middle market and fixed loan originations in the lower middle market during the quarter.
99% of the debt originations for the quarter were first lien senior secured and as of quarter end, 91% of the credit portfolio was first lien senior secured.
On slide 11.
We lay out our 557 5 million of capital invested in and are committed to portfolio of companies during the quarter.
This included $45 4 million in first lien senior secured debt committed to three new portfolio companies.
Along with $2 million invested in equity co investments along two alongside two of the new portfolio loans.
We committed an additional $9 8 million in first lien senior secured debt to two existing portfolio companies, which in both cases was utilized to fund strategic acquisitions.
Turning to slide 12, as I noted earlier subject to quarter end, we had thus far invested $33 5 million of capital in two new portfolio companies.
We believe our ability to cultivate strong sponsor relationships in the market.
And be a long term dependable partner to our sponsors and portfolio companies has translated to enhanced deal activity and the ability to win more deals that fit our investment strategy.
These relationships are also key to putting us in a position to make small equity co investments and growing lower middle market companies alongside many of these sponsors.
Turning to slide 13, we had two lower middle market exit this quarter.
Our equity investment into annuity and our first lien senior secured loan to coastal television.
In the upper middle market, we exited our first lien senior secured loan to I Energizer.
The exit of our equity investment in <unk> was especially notable as it generated a realized gain of $8 $1 million on an initial capital on capital outlay of $1 4 million.
This resulted in an IRR of 73, 2% and a multiple on invested capital of six eight times.
Mountain Gate capital to annuity sponsored during our hold and the Tenuity management team did an exceptional job growing this business, both organically and through acquisitions and.
And positioning it for a sale that generated an outstanding result for all parties involved.
We are grateful to have had the opportunity to support the growth strategy for this company and its sponsor over the past four years.
This continues our track record of successful exits to date, we have generated a cumulative weighted average IRR of 16, 8% on 35 portfolio exits representing approximately $336 million in proceeds.
On slide 14, we break out our on balance sheet portfolio as of the end of the quarter between the lower middle market and the upper middle market again, excluding our I 45 joint venture.
As of the end of the quarter with total portfolio, including equity co investments was weighted approximately 86% from the lower middle market and the 14% to the upper middle market on a fair value basis.
Our portfolio of 39, lower middle market portfolio companies had a weighted average leverage ratio measured as debt to EBITDA through our security of three eight times.
Leverage and EBITDA improved across a solid majority of the lower middle market portfolio for the quarter.
Within our lower middle market portfolio as of the end of the quarter, we held equity ownership in approximately two thirds of our portfolio companies.
Our on balance sheet upper middle market portfolio, excluding our I 45 joint venture consisted of 11 companies with an average leverage ratio through our security of three six times.
We were also pleased with the leverage and EBITDA improvement across the upper middle market portfolio.
Turning to slide 15.
We have laid out the rating migration within our portfolio for the quarter.
During the quarter, we had two loans upgraded while having no loans downgraded.
As a reminder, all loans upon origination are initially assigned an investment rating of two on a four point scale with one being the highest rating and four being the lowest rating.
The upgrades consisted of loans to two portfolio companies. One previously rated a three and one previously rated a two.
Which were upgraded to a two to a one rating respectively. Both based on improved EBITDA performance and deleveraging.
I'll also note that the number of loans in each category as of December 31, 2020 included new portfolio company originations during the quarter Fitch rated at two while removing portfolio companies exited during the quarter specifically one other portfolio companies exited during the quarter was rated a one and one exit was rated at two.
<unk>.
As at the end of the quarter over 90% of our investment portfolio at fair value was rated in one of the top two categories, either a one or two.
We had six loans, representing nine 6% of the portfolio at fair value rated a three and only one loan or junior most loan tranche to AG kings, representing <unk>, 1% on the portfolio at fair value rated a four.
As illustrated on Slide 16, our total investment portfolio continues to be well diversified across industries with an asset mix, which provides strong security for our shareholders' capital.
The portfolio remains heavily weighted towards first lien senior secured debt with only 6% of the portfolio in second lien senior secured debt and only 2% on the portfolio and one subordinated debt investment.
Turning to slide 17, the <unk>.
I 45 portfolio also continued to show improvement during the quarter as our investment in <unk> 40 in the I 45 joint venture appreciated by $2 2 million.
Leverage at the I 45 fund level is now 1.07 times debt to equity at fair value.
Which is substantially improved from the peak leverage of 251 times debt to equity at March 31, 2020.
As at the end of the quarter, 94% of the I 45 portfolio was invested in first lien senior secured debt with a diversity among industries at an average hold size of two 6% of the portfolio.
I'll now hand, the call over to Michael to review the specifics from our financial performance for the quarter.
Thanks, Paul on specific to our performance for the December quarter as summarized on Slide 18, we earned pretax net investment income of $10 million or <unk> 52 per share.
This was a 23% increase from the $8 $1 million or <unk> 44 per share earned during the prior quarter, we paid out <unk> 41 per share in regular dividends for the quarter flat from the 41 regular dividend per share paid out in the September quarter.
As mentioned earlier, our board has declared an increase to our regular dividend from <unk> 41 to <unk> 42 per share to be paid out during the March 31 quarter.
Maintaining a consistent track record of meaningfully covering our regular dividend with pre tax net investment income is important to our investment strategy. This track record is demonstrated by our 107% regular dividend coverage over the past 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy.
During the quarter, we maintain our supplemental dividend at <unk> 10 per share and again to our board has declared a further 10 per share supplemental dividend to be paid out during the March quarter.
As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance.
As of December 31, 2020, our estimate of UTI balance was $1 nine per share.
Our investment portfolio produced $19 million of investment income this quarter with a weighted average yield on all investments of 11, 2%.
This represents an increase of approximately $2 $4 million from the previous quarter.
The increase in investment income was driven partly by an increase in debt investments outstanding as well as a distribution of $1 2 million from one of our lower middle market portfolio companies as part of a dividend recapitalization. This is a prime example of the benefits of investing equity with the portfolio companies with a growth story is compelling.
As Bowen mentioned, we had no new non accruals at the end of the quarter and our weighted average yield on our credit portfolio was 10, 6% for the quarter.
As seen on slide 19, our operating leverage was flat for the quarter at two 6% operating.
Operating expenses were slightly elevated this quarter due to the accrual for our annual bonus program. The final payout for our annual bonus will be determined and approved by the board based upon their review of company performance for the full fiscal year 2021.
Based on both our strong NII performance and continued improvement in our overall portfolio, we have accrued the annual bonus above our annual target, giving the board the flexibility if they so choose to pay out bonuses in excess of our stated targets. All of that said, we do expect that our run rate operating leverage going forward will be below <unk>.
Our target of two 5%.
Turning to slide 20, the company's NAV per share as of December 31, 2020 was $15 74 as compared to $15 36.
September 32020.
The main driver of the NAV per share increase was $7 1 million of appreciation in the investment portfolio much of which was in our equity portfolio.
On slide 21, we 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 aggregate principal of $75 million and four 5% unsecured notes due 2026 and paid down $20 million on our 595% baby bond due 2022.
We believe the execution on our new $75 million ish issuance is collaboration of the margin market acceptance of our investment strategy and their confidence in our portfolio and track record.
This capital raise provided us the flexibility to fully repay the outstanding balance of $37 $1 million on our 595% maybe bonds subsequent to quarter end, while also providing the company cost competitive and flexible capital to fund future investments.
Our debt capitalization today includes a $340 million on balance sheet revolving line of credit with 11 Syndicate banks maturing in December 2023.
A $125 million institutional bond with over 25 institutional investors maturing in 2020 for the aforementioned $75 million institutional bond with six institutional investors maturing in 2026, as well as a $150 million revolving credit facility at I 45 with.
<unk> syndicate banks maturing in 2024.
Finally, as we mentioned last quarter, we continue to work with the U S small business administration towards becoming officially licensed as an SBA IC we.
Our Greenlight letter in July 2020, and have submitted our final application for licensure.
Due to the disruptions around the election and transition between administrations the pace of processing application approvals by the SBA slowed considerably over the past few months, we continue to expect to complete this process soon and we'll keep you apprised of progress where appropriate.
Overall, we are pleased to report that our liquidity is strong with approximately $187 million in cash and undrawn commitments as at the end of the quarter with ample borrowing base capacity and covenant cushions on our senior secured revolving credit facility.
As of December 31, 2020, approximately 59% of our capital structure liabilities were unsecured and subsequent to the pay down of our December 2020 notes. Our earliest debt maturity is now in December 2023, our balance sheet leverage as seen on slide 22 ended the quarter at debt to equity ratio.
So of one to two to one I will now hand, the call back to Bowen for some final comments.
Michael and thank you everyone for joining us here today capital southwest continues to perform very well and consistent with the vision and strategy, we communicated to our shareholders six years ago our.
Our team has done an excellent job building, both a robust asset base reputation and deal origination capability as well as a flexible capital structure that prepares us for difficult environments like the one we experienced in 2020.
In fact performance through difficult environments like 2020 demonstrate the investment acumen of our team at capital southwest and the merits of our first lien senior secured debt strategy.
We feel very good about the health of our company and portfolio and we are excited to continue to execute our investment strategy going forward.
Everyone here at capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long term sustainable value for.
For all our stakeholders.
This concludes our prepared remarks, operator, we're ready to open the lines up for Q&A.
Thank you to ask a question you will need to press star one on your telephone to withdraw your question. Please press the pound key please standby, while we compile the Q&A roster.
Our first question comes from Devin Ryan of JMP Securities. Your line is open.
Hi, This is Kevin Holt Hunter Devin this morning.
First question the stock is trading at a healthy premium to NAV and as we saw last quarter you were fairly opted in volume shares under the ATM program.
Can you provide some high level thoughts around how you balance raising equity in the current environment and how active we can expect equity issuance to be up next few quarters.
Yes, that's a good question I would say the ATM program one of the things we like about the ATM program on top of it being a very inexpensive way to raise equity 2% spread to trade, but you can also.
You can manage the bdc's leverage.
Over time vis vis the pipeline what activity how much activity, we have coming down liquidity liquidity, we have on our portfolio.
Quantum of unfunded commitments, a whole host of kind of <unk>.
Variables go into the ultimate equation, which is how much equity we think we need to raise and we always want to stay out in front of and prepare ourselves for hiccups in the night from the economy or what have you. So.
So not an exact answer your question as to how much we plan to raise but one of the reasons. We raised so much equity. This last quarter was that we had a lot of a lot of investment activity.
And we weren't able to raise a lot of equity in the prior two quarters before that during the pandemic.
So it's really a lever that we pull to manage leverage and we're looking at again, we're looking at activity in the portfolio.
The liquidity of the company and unfunded commitments on our balance sheet that we need to be ready to support yes. I'd also say, Kevin just from a from a modeling perspective I think we expect on an average probably would be when our stock's been trading well to raise around 15 million I would say on a quarterly basis now something this past quarter as Bowen said.
We had higher deal origination volume so we raised about a bit more at $21 million, sometimes it'll be slightly less but I think 15 is about the right size on a go forward.
Okay, Great. That's helpful. And then kind of another big picture question, you have a pretty robust steelmaking environment currently.
Significant unused debt capacity and as mentioned the ability to issue equity under the ATM can you talk about the potential for growth of the investment portfolio in 2021.
Yes, I mean, right now I mean deal flow right now is certainly strong.
Our team is really hitting its stride on on.
On deal origination activity.
We're still closing about about 2% on the deals that we that we review its belt over the last 20 years of my career, that's kind of about the number you know sometimes higher sometimes a little lower.
Sure.
I think debt.
Having gone through the pandemic.
And deal sources sponsors see how we behave.
We're very commercial and reasonable we don't rollover, we expect fair outcomes, we contribute capital to the company, we expect the sponsor to do the same so.
So it's a very commercial and balanced approach, but candidly one of the ways that we manage and anticipated downturn is structuring deals upfront.
<unk> more responsible in other words, you don't go to a very strong sponsor relationship who maybe wants more debt on a deal than we think is prudent for the potential volatility of business we.
We don't.
We don't win those deals candidly, because we think about it upfront look we're going to over lever something we don't want to have a tough conversation with a really good sponsor of ours. So part of kind of being able to manage commercially and responsibly and through a pandemic environment is the structuring and stuff you've done upfront. So now we come out of this to come out.
Of the pandemic.
Candidly I think we've our team has developed a lot of the street credibility and comfort and track record when people are considering us as the financing partner.
So it's not always being the lowest price the deal you got to be on the ZIP code of market pricing, but you don't have to like low price every deal. When you look at if you develop that reputation and how you conduct yourself when things bump on the night. So I think that's what's attributing to some extent our deal flow and the quantum of deals we see in the Quadro deals we win.
Sure.
So look I expect deal flow to continue to be.
Solid throughout this year, but we'll see we'll see.
But yes, I mean just.
Putting some numbers to it I think that we project internally to do around $40 million to $50 million in originations each quarter and expect to see between 15 and $20 million come back.
Sometimes we do a little bit more on the origination side and obviously the use sometimes you'll see a run on prepayments as well, but essentially somewhere in that $20 million to $30 million net portfolio growth a quarter.
Okay that color.
Very helpful. And then lastly, touching on prepayments what visibility visibility you have around that pension payments.
Yeah.
I think we obviously we get.
Quarter and the beginning of the quarter, we probably have some level of visibility.
I'd say for this quarter, we know that there is limited amount of activity going on and so we're not expecting so probably something on the low end of that range and repayments.
The interest rate environment goes up and down obviously, you see that change, but I think right now you'd see it you've seen a lot of repayments come back when people kind of settled into where the market is at the moment. So I wouldn't expect a whole rash in the next three to six months.
Okay. That's it from me and thanks for taking my questions and congratulations on a great quarter. Thanks.
Thanks, Kevin.
Our next question comes from Mickey <unk> Wang from Ladenburg Thalmann. Your line is open.
Good morning, Bowen, and Michael I Hope you're well.
On the ESCO high level question.
This year, so when we think about the pace of vaccinations in the recent mutations of the Covid virus it looks like depend on mix.
Could go on longer than we had hoped and that could continue distressed companies in some industries.
So apart from your software related investments.
Do you feel about your borrowers availability.
Your borrower's ability to carry them through the pandemic, particularly with respect to liquidity.
Yes, it's interesting I mean.
Just personal view of this.
The things you said are are correct.
The panamax not behind us the vaccines out there.
We'll see how well the vaccine works how many people take the vaccine all those kinds of things and you've got new strains on lots of unknowns.
But I think at some level and speaking of our portfolio.
People the companies are kind of.
For the most part they've kind of found their stride. So aside from a complete panic lockdown, where everybody goes back to that everybody goes back to the living rooms et cetera.
Aside from that I mean, I feel like our portfolio has kind of found its stride now if the pandemic sticks with us really on a 12 to 18 months.
If I had a concern about that it's more of it's just going to be.
Muddy quick sand for companies that are trying to grow.
So progress in growth could definitely be affected and that's really our equity portfolio right upside of the equity portfolio that could stretch out. So that's a concern from a credit perspective, and a security of our capital perspective.
I feel pretty good about that now moving I would point out is.
The vast majority of our companies are small businesses and many of them many of them have spic's in the capital structures in some way and candidly, we would expect to be an FDIC.
Having FDIC relatively soon and so there is the PPP money that debt that's.
Thats out there.
And so that's.
Looking across our portfolio I don't really see any companies that are like G or the difference between survival and not survival as the PPP loan, but I do think that helps kind of bridge noise across the portfolio might come from the pandemic.
Thank you for that but that's really helpful.
I wanted to ask you about.
American addiction. It has obviously exited bankruptcy.
And if I'm not mistaken you're the.
The new chairman of the company.
How do you feel about that specific companies prospects and is it benefiting from the pandemic.
What's the long term sort of exit strategy for AAC.
Yes.
<unk>.
You know I was involved with our addiction treatment business for 10 year eight years, a while ago my former firm and so I have some experience from the space and the firm the meadows to affirm it had some push out there and it's very successful company.
And so they wanted they asked me to be chairman. So they could put me in the press release and said that the employees would see okay someone on the board actually his industry experience that type of thing so.
What's not happening is I'm not running the company, but what is happening as I am on the board, which I'm happy to do I don't want to do a lot of those things across the portfolio, but im happy in this instance, I am I am pretty positive on on that platform. It's got an incredible asset base network of facilities. They do really really good work.
Saving lives in the addiction area and they do a really good job at it. So it's just been in a tough restructuring and bankruptcy, which we're now clear of and so now it's kind of Sunshine ahead, I'm pretty positive on the on the upside on that business from where we are today just given the just the quality of their network on the AD the things the building block.
That the company has to work with to really recover from where they are on a valuation perspective today. So I would say clearly the pandemic and Lockdowns have created stress in society and when stress in society increases.
A lot of folks struggled with medicating around stress and that obviously results in alcoholism and drug addiction, which are very very unfortunate things and really need to be helped helped.
People lose lives.
From that and so to be able to help.
For those people is obviously a great mission.
And it's one that can be done profitability and one that you can build a really good business around so I think so from that perspective, you do have a tailwind across the addiction treatment space from that stress.
But that said you know when these are these are facilities people live there, while they're going through addiction, and so COVID-19 and COVID-19 protocols, and quarantines and Lockdowns et cetera are all things that you would imagine you could imagine go on so you've got headwinds from the from those types of things, but you have tailwind from from the <unk>.
Just the general stress on the society.
And so I feel pretty I feel actually great about the upside of that business going forward.
So.
Bowen do you expect a roll ups to occur in that industry.
ACB on <unk>.
Or do you expect them ultimately to be acquired by by someone else looking to grow yes.
Yes, so I would say first of all the majority of the upside of just EBITDA growth from.
From the business and.
Signing new network contracts filling the beds that arent filled.
Organically, the economics of adding a few beds to an existing facility.
ROI of that is staggering actually if you can if you can but if you can fill them. So so theres just not a lot it doesn't cost a lot it's like adding on on a wing on a hotel or something or not even that.
It's yes, it's kind of like a hotel, adding on beds and then net recurring or the recurring economics. If you can fill those beds is really attractive. So theres a lot of organic growth. There's a lot of recovery type growth of recovering from.
Where it is today.
And then we may make acquisitions, I think that AAC could absolutely be acquired at some point there.
There are definitely larger platform from the space.
We had a lot of interest in the bankruptcy auction just not at valuations that made a lot of sense candidly a lot of voters swarming around in a bankruptcy theres a lot of noise.
And that people trying to take advantage in Canada, we had a lender group now on industrial group debt.
Seal on upside so we just credit bid and took over the company and that's now where the owners and so so those people are still out there those big platforms are still out there theyre. Just we'll just we're just going to do the things we want to do with the business or the management team with the business and then well it.
It could absolutely be acquired.
A couple of years.
That's clearly an exit strategy.
Okay. Thanks for that for them on my last question.
Just to touch on on see PK. It also emerged from bankruptcy.
I assume the balance sheets a lot.
Healthier now, but I was in I was walking near my my home recently and I saw that my local C. PK was close so.
I have read I think that the footprint has shrunk.
In terms of strategy for PK in this pandemic environment.
Are you looking sort of to manage that business through the pandemic.
Status quo or do you expect some growth opportunities to occur.
What's the outlook in general for PK in the environment that we're in.
Yes so.
CDK is different in the sense that we're not on the board.
They're so we're we're a smaller investor I guess in that in that platform. So I'll give you my impressions and kind of what we what I can tell you about what we hear and see major.
Major teams doing a great management team there is excellent.
And they had this business.
And much much better pre COVID-19. They started I think in mid 19.
And the business has kind of had a difficult time no reason other than just kind of difficult on the management team came in just did fantastic and then Covid hit obviously, it's a restaurant.
And so that struggle they went out and during the bankruptcy process and negotiated leases and the realtors or the lessors that were landlords.
There are certain landlords it just that they decided it wasn't worth.
Keeping net lease and took the excuse to get out of the lease and candidly in my neighborhood RC PK closed as well.
But there's a bunch of <unk> around around Dallas.
And Theyre doing theyre doing fine. The one we did close candidly that was probably a really expensive lease and so.
And so the.
Yeah.
On network of footprint of restaurants, yes decreased as one would expect in a bankruptcy process, it's a chance to clean out leases that are.
That are less profitable.
But if you look across the network I mean, I would tell you just thematic Lee the ones that are open sales, it's pretty interesting how well they are doing versus kind of pre COVID-19 revenues I mean, there it's.
It's got a couple of things, it's got a licensing business with Nestle in grocery stores at Sky. It's obviously, a pizza business and so it's got delivery. That's obviously natural for people to order pizza delivery. So those are some things that helped the business and the management team's done great they've been as far as creativity on keeping expanding patios and doing things creatively.
<unk>.
Need to get past the pandemic before this thing takes off.
But they've done a really good job managing it.
Cash flow positive so we're not haven't thinking about funding it.
We're going to have to wait a bit before it to get out of the malaise of the pandemic, but.
It's going to be it's going to be fine I mean, I really do I think there's a fair amount of upside on that business going forward. It's just a question of pace at which we see the upside these would be the pandemic and timing, but it did.
You look at the net debt the Kpis.
Performance indicators that we look at there's a lot of things about it better.
You just view, where you jump off the page if I get the pandemic would only go past. This thing is in fantastic shape. It's the reaction you have to it. So so we feel pretty good about it timing is somewhat dependent on.
Yes.
The pandemic so.
Okay, I appreciate that and I understand that's it from me. This morning. Thank you for your time.
Thanks Vicki.
And our next question comes from Kyle Joseph of Jefferies. Your line is open.
Hey, good morning, guys, congrats on nice quarter and thanks for taking my questions.
I wanted to talk about net interest margins and the outlook going forward obviously, it's it's.
It's an active deal environment, just talk about spreads.
And where we are versus call it year ago levels.
And then on the cost of funds side talk about what the liability management.
You guys have done recently could how that could help on the cost of funds side.
Yes, sure Walter I'll, just comment on the on the asset side. The spreads I mean, we're kind of back to pre COVID-19 spreads. So we're not.
It's not.
Theres not a we don't see a whole lot of Covid premium out there, maybe a little bit of a premium in the sense that leverage people look at the pandemic in the rearview mirror and leverage assets are slightly lower than they were a year ago. So from my perspective that is a risk element that that's in our favor.
Generally, but the spreads are on the loans, we do our kind of back to pre COVID-19 levels, but our cost of capital, which I'll, let Michael comment on has come down so.
We feel pretty good about the asset liability relationship you want to talk about that yeah. So obviously, we raised $75 million on that four 5% institutional bond.
Which took out if you think about over the last two quarters, we've taken out the entire.
Essentially I think we had $60 million left on that bond. So we've converted it from four $5 95 down to four five so that's about a 150 basis points, which.
Annualize that that's.
Really about $800000 a year, so about a penny a quarter. So that's going to be helpful. I think going forward.
<unk> is still hanging out there the notion would be between $340 million on the credit facility, which is about two and three quarters all in.
And we should expect to see the SBA, if and when that comes to pass at a similar cost. So you'll have three fourths of the portfolio sub three and then you'll have that on net for five plus the 75, we have at around 5%. So that kind of a blend right now is around four 5% and we think we.
We're going to be coming down to four on a quarter.
Probably in the next year.
Got it very helpful.
Excuse me and then obviously your credits churning in the right direction and Youre in your books in good shape, but just trying to peel back the onion, a little bit can you give us a sense for revenue and EBITDA trends in the fourth quarter and how those compared to the third quarter and.
Either in terms of growth or contraction.
On kind of early performance year to date.
Yes, I would say generally EBITDA on revenue in the portfolio for the for a strong majority of the companies.
It was positive kind of low single digits.
And.
Let's look pretty good I mean deleveraging of the portfolio is good we've got a handful of names that are kind of bumping along but from where we sit from a first lien perspective.
That just means that they bust the covenant here there we get discharged economics.
And but there's plenty of cash flow to service our debt and that type of thing. So that's part of being a first lien lender. That's a benefit you get as things bump along a little bit.
But.
On a very strong majority of the companies were last.
Last quarter and this quarter were positive.
Got it and then one last one from me just talk about your appetite for continuing the special obviously you guys have that.
Strong UTI balance, but kind of the outlook for that going going forward, given where the base went to as well as the overall strong portfolio performance.
Yes, so I mean, it's.
We're continuing to until the board decides otherwise we're continuing the supplemental dividend program like we stated.
Liquidity quit anything right.
UTI is not going anywhere so we distributed overtime. So its liquidity thing for us to have the capital to do it which we have plenty to do we manage it that way.
And so.
Our goal was to create a program that the market can rely on and then obviously.
Just the stock accordingly, but.
As of now we're continuing to pay it.
I would say that you would need to really look at them independent of one another so the UTI balance is going to dictate price Bowen said, whether the submental different and is approved by the board on a quarterly basis, and obviously, we have about two and a half years of runway. There. So plenty of time to channel to make a decision on how we play that out over time, but on the regular dividend and.
All of the things, we're talking about we're having a growing portfolio our cost of debt is coming down.
Operating leverage even though it was around two six this quarter the run rate for operating leverage is really around two two.
On a normal course, so all that being said we think that this is the first of several dividend increases.
Really over the next several quarters and so you should expect to see growth on a regular and supplemental should continue along the way.
Got it very helpful. Thanks for answering my questions.
Thank you. Thank you. Our next question comes from Robert Dodd of Raymond James Your line is open.
Hi, guys congratulations on the quarter Bowen, if I can go back to that.
The spread issue I mean, obviously.
You said, no COVID-19 premium anymore, which.
Is that surprising, but it's less which is down.
Could you give us any kind of on.
Today, if you work work.
Our risk adjusted total return expectation when you're looking at doing a deal is that wider today still than pre COVID-19 on this all of that.
Back to weighted as well with this.
No Covid premium is the lower leverage not enough to.
To kind of.
Make you raise your expectations for total return is going to be over the life of a.
On incremental loan or is it.
Yes, it's an interesting question I would I would say this I mean I think generally speaking the models. We're looking at now or has from a debt perspective.
Have you kind of the same.
Debt returns with a difference that I wanted to make here a second that's important.
But the debt returns are all anticipated returns on your debt, which is spread and LIBOR in OID upfront and prepayment penalties if they pay early those types of things is all generally the same.
One of the things that your equity returns might be higher because some of the businesses performed really well during COVID-19, but theres still kind of down from COVID-19 or and so we.
We can underwrite.
Founders wants to go ahead and de risk their personal situation and rollover, maybe even more equity because the valuations may be youre down in certain instances and so as we look forward the equity upside in.
In a company like I, just described might actually be higher than it was a year ago, where everything is up into the right and theres no problems in the world.
Whenever theres no problems in the world that means the problems coming right. So.
So there are situations that we definitely seen where the equity returns. If we had done the deal a year ago would probably be anticipated on a base case equity return might be less and so that's the difference.
I would say is our cost of capital as we have always said you know the range of the range of.
Pricing in the lower middle market is a range on some of that competition, but some of that's just things like leverage but also loan to value.
Company Thats Youre lending, 30% loan to value is kind of on a cash flowing higher margin business is going to have a lower pricing than something you're 50% loan to value with maybe lower margin and so but it is going to price cheaper. So so like there is a C.
Safe into the lower middle market, and a little bit less safe into the lower middle market right. There's a range right that should be all that surprising and so as we manage our capitalization to get our cost of capital now we can play more.
In the safer and on the lower middle market and so it's a lower loan to value, but maybe tighter spreads, but then one of the big as you know one of the big drivers of long term. All in returns is principal loss rates right. So yes, so I think that as we invest maybe slightly lower spreads in a safer and.
The market was lower loan to value higher margin businesses.
You asked me about my anticipation I mean, the more we do in that I anticipate.
Materially less long term credit losses, So look I think I think our track record of our team is excellent.
But credit losses are and expense of our business right. I mean your expenses your business right. If it's a spread business, but we have three buckets right. One is the cost of our capital. We're borrowing another is our overhead that's operating leverage you hear about every quarter and in the third cost as losses over time, so you're always trying to gain efficiency by decreasing.
All three of those buckets and so one of the buckets as losses over time, so as we do slightly safer loans Aida is slightly lower spreads yes, my anticipated all in return over time increases.
And we are also excited by.
Putting together Robert portfolio of Sip of those credits that phone. Just described it's also been enhance our investment grade portfolio right in terms of going to the rating agencies, which in time would mean, we'll actually be able to reduce our cost of capital even further by putting together that high quality portfolio, but hopefully that's helpful on out.
Reds relate to all in return for that.
Yes, absolutely very helpful. I really appreciate that.
I mean, it's a total return vehicle and it's not just that.
Just the coupon business.
On the portfolio as it stands right. Obviously, we don't have the Q yet right. So when I look at the unrealized depreciation in the quarter can you give us any color on how.
How broad base that wasn't mean there'll be so you had two upgrades.
Did those accounts from most of the unrealized depreciation or is it just is it much more broad than that across the portfolio.
Say it's.
Pretty broad in a sense, but it's mainly on the equity portfolio. So that's why we put that bridge.
Sure.
Slide what slide 20 in the shareholder deck and so we did that kind of football chart going across the page and you can see that.
Change in the equity portfolio being 33, a share for the quarter, that's not that's not a small number for one quarter.
And that's probably it.
Definitely two handfuls of equity investments.
No.
Now we did have the tenuity exit this quarter.
That was materially higher than it was valued at the end of last quarter. So so that contributed to that equity upside as well.
Got it got it and then one last one I've got on AG Kings, Obviously again, we don't have the box.
At the end of the quarter was that.
In line with the market that you had at 12 31, and if you can give us any color on where that Mark was versus 930 since that's the only one.
That's the scheduled investments, we couldnt have right now.
Yes, so so so that our exit was higher than where it was valued last quarter. So that's first thing I would say.
And then the 739000 that's left is basically the last interest I mean, Theres a litigation trust in them.
The final bankruptcy cleanup and Theres, a final working capital adjustment and some final economics, which.
Candidly, we believe it's going to be meaningfully higher than the 740 Grand we haven't valued right now. So we think there's upside in AAV from that perspective, and then our all in recovery at the end of the day it will be about 80 cents on the dollar.
Got it I appreciate it thanks a lot.
Thank you and our next question comes from Sarkis <unk>.
With B Riley's Securities. Your line is open.
Hey, good morning, and thanks, so much for taking my question here.
Just wanted to hit on the point regarding the comments on operating leverage run rate at two 2% on a normal course.
You mentioned in your commentary can you maybe help us understand the timetable that you are anticipating on getting there as well as maybe.
The portfolio or total portfolio size that you would expect to achieve that.
Well I would tell you right now.
Earlier in the script debt, we've had a essentially one time accrual above the annual target rate, which was about 700000. So this quarter the actual run rate for.
Cash compensation would be $1 7 million or <unk>.
Share based compensation run rates, usually around 800000.
And so youre looking usually about $2 $5 million on a run rate basis, right now and based on that asset base, It's a two 2%.
So we would expect additional we've already said, we closed $33 million in.
Assets in January so moving forward on a normal run rate basis, we would expect debt percentage to be somewhere between 2.1 to point to.
Great. Thanks for that and just wanted to hop on page 11, and 12 of the slide deck for the Q3 originations and then the subsequent quarter end originations right. So if I look at the debt spread the weighted average was eight point to almost on the Q3 originations and then if I look at.
The two in quarter end.
It's about 7% is that really just deal specific or is that an indication of what's going on from a tightening perspective, India environment any color there. Please.
Yeah, I know you've got to really its deal specific I mean, if you look down through there I mean like there is a couple of deals that were one in particular is a first out last out structure. So we brought on a first out person first out party.
To take a small piece of the loan so our spread is higher on that.
We've got one of the companies had a 950 spread.
Portfolio company, we've been in for a long time and there is some precedent set as to what the spreads are in that that deal. So it is not completely new deal.
Type thing.
But it's really kind of I'm, just looking down the list, it's pretty deal specific so.
You go on to.
Sure.
I mean, six hundreds of law of larger larger on a club type situations larger company.
And we refer to GAAP, we're actually first out in that in the 600 deal where actually a first out interestingly enough. So.
It's a little bit more deal specific I wouldn't say that the difference between slide 11, and 12 is is directly parallel to some to some.
<unk> trend in the market.
Great. That's helpful. And then I guess last question on me regarding kind of the leverage from I believe.
From an economic leverage perspective, how did your targeted kind of the one three to one four range, assuming you get the FDIC licensure and from a regulatory leverage perspective, it's still kind of being the one to $1. One ZIP code can you kind of give me some color on that yes, I would tell you from an egg.
Economic leverage perspective, we really are targeting between one two and one three even getting the SBA.
Money, one day when that does happen.
We don't plan on levering up economic leverage beyond there. So I think to your point, we probably will show up with one point out of 1.15 on regulatory leverage and stick to one two to one three on.
On our total economic leverage.
Great. That's all from me thanks for the time.
Thanks, Doug with you. Thank you and at this time Im showing no further questions I'd like to hand.
Back to Mr. Bowen Diehl for any further comments great. Thanks, operator, thanks, everybody for joining us we appreciate it.
Hopefully you got a good impression of things are going pretty well here and we appreciate your support and time and look forward to keeping you posted on the business as we go forward.
Ladies and gentlemen. This concludes today's conference call. Thank you for your participation you may now disconnect everyone have a wonderful day.
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