Q4 2021 Capital Southwest Corp Earnings Call

Today's conference is scheduled to begin shortly please continue to standby and thank you for your patience.

[music].

Thank you for joining today's capital southwest fourth quarter and fiscal year 2021 earnings call.

On the call today are Bowen Diehl, CEO, Michael <unk>, CFO and Chris from your broker VP Finance I would now turn the call over to Christopher your broker.

Thank you I would like to remind everyone that in the course of this call we will be making certain forward looking statements.

These statements are based on current conditions currently available information and management's expectations assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks uncertainties and assumptions that could cause actual results to differ materially from such statements for information concerning these risks and uncertainties see cash.

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 will now hand, the call over to our President and Chief Executive Officer.

Thanks, Chris and thank you everyone for joining us for our fourth quarter and fiscal year 2021 earnings call.

Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www Dot capital southwest Dot com.

We are pleased to be with you. This morning to announce our results for the fourth quarter and fiscal year ended March 31.2021.

I wanted to first day, I hope, everyone and their families and their employees continue to be safe and well.

We are hopeful that the economy will continue to take steps forward as businesses and communities continue to return to pre pandemic levels.

While the aftermath of the pandemic continues to impact certain parts of the U S and world economies. We are grateful for all the work done by our employees as well as the sponsors owners and employees of our portfolio companies.

I am pleased to report that this year was another stellar year for capital southwest as we continued to steadily grow all aspects of our company, including investment assets capital availability and flexibility and investment income.

If we reflect on the year and the unprecedented storm that hit the economy vis vis the Covid pandemic. We noted some fundamental decisions made in prior years reflective of our force economic cycle management philosophy.

That allowed us to perform well during the unprecedented black Swan event that we all experienced in 2020.

First we have been intent to always have ample liquidity, which in our case means ample revolver availability in a prudent amount of outstanding unfunded portfolio company commitments.

Second we maintained a flexible leverage structure on our balance sheet with over 50% of our liability structure in the unsecured covenant light bonds going into the pandemic.

And third and perhaps most importantly, we have maintained our discipline in building a high quality almost exclusively first lien credit portfolio with diversity in industries in the granularity of hold sizes. As a result of these decisions we were able to do 3 important.

In this fiscal year.

First we had more than ample liquidity to support portfolio companies that needed. It while also continuing to fund new deals that we're able to be underwritten in the pandemic environment.

Second we were able to more than cover dividends to our shareholders and third when the inevitable stock market volatility presented itself, we were able to repurchase a material amount of our stock.

Beginning on slide 6 of the presentation, we summarize some of the key performance highlights for the fiscal year.

Total return to shareholders for the fiscal year was 119%.

With which consisted of share price appreciation of 94% and total dividends paid during the year of $2.5.

Our NAV per share grew 6% to 16 O 1 versus $15.13 in the prior year period, driven primarily by $20.2 million in net unrealized and realized gains on the portfolio.

I think it is also important to note that our NAV per share of <unk> 16 O..1 as of March 31, 2021 represented a retracement to 99% of its pre pandemic level of $16.74 per share as of December 31, 2019, when adjusted for the 50 cents per share in supplemental dividends, we paid out to <unk>.

Shareholders. During this 15 month time period.

Considering the unprecedented events of the last 15 months, we are extremely proud of the team and what they have accomplished.

During the fiscal year, we grew our total portfolio at fair value by 24% year over year to $688 million versus $553 million in the prior year and increased our pre tax net investment income by 7% to $1.79 per share from $1.68 per share.

They're in the prior year.

Furthermore, we strengthened our balance sheet during the year through the issuance of $190 million of unsecured notes.

$51.4 million in equity proceeds.

Our equity ATM program.

$15 million in additional commitments obtained on our <unk> revolving credit facility.

Additionally, we announced in April that we had been formally approved into the Spi C program and have officially received our S. P I see license.

Michael will provide further detail on this later in the prepared remarks.

And a well capitalized first lien lender with ample liquidity capital southwest continues to be in a favorable position to seek attractive financing opportunities grow our asset base and continue to grow earnings and increase dividends for our shareholders.

Executing our investment strategy under our shareholder friendly internally managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable long term value through recurring dividends capital preservation and operating cost efficiency.

On slide 7 of the earnings presentation, we have summarized some of the key performance highlights for the quarter.

During the quarter, we generated pre tax net investment income of 44 cents per share, which exceeded our regular dividend paid for the quarter of <unk> 42 per share.

Including our supplemental dividend of 10 cents per share total dividends for the quarter were 52 cents per share, which represented an annualized dividend yield on the quarter in stock price of 9.4%.

And an annualized yield on net asset value per share of 13%.

I'm also pleased to announce that our board has increased our total dividends to <unk> 53 per share for the coming quarter ending June 32021.

Consisting of a regular dividend increase from 42 per share to <unk> 43 per share and a supplemental dividend of 10 cents per share.

Our decision to increase the dividend emanates from our confidence in our current earnings power of our portfolio as a result of portfolio growth continued reductions in our cost of capital and our ability to improve our operating leverage efficiency by actively managing operating costs, while growing the asset base.

During the quarter, we grew our investment portfolio on a net basis by 6% to $688 million as of March 31.2021.

Portfolio growth during the quarter was driven primarily by a total of $77.3 million in new commitments to 6 new portfolio companies and 1 existing portfolio companies.

<unk> offset by $23 million in total proceeds from 2 exits.

The portfolio generated net realized and unrealized gains of $2.6 million during the quarter and we currently have no investments on non accrual.

On the capitalization front, we were quite busy during the quarter, we successfully raised over $89 million in investable capital consisting of $65 million in aggregate principal of unsecured notes and $24.1 million in gross proceeds through our equity ATM program.

Turning to slide 8 and 9 we illustrate our continued track record of producing a strong dividend yield consistent dividend coverage and value creation since the launch of our credit strategy.

We believe the strength of our investment and capitalization management strategies was demonstrated by the solid performance of our company and our portfolio through throughout this unprecedented period.

Maintenance and growth of our NAV per share and shareholder dividends remain as core tenets of our long term investment objective of creating long term value for our shareholders.

Turning to slide 10, as a refresher our investment strategy has remained consistent since its launch in January 2015.

We continue to focus on our core lower middle market lending strategy, while also maintaining the ability to opportunistically invest in the upper middle market when attractive risk adjusted returns exist.

In the lower middle market, we directly originate and lead opportunities consisting primarily of first lien senior secured loans with us with smaller equity co investments made alongside our loans.

We believe that this combination is powerful for our BDC is it provide strong security for the vast majority of our invested capital while also providing an upside from equity investments in these growing businesses.

Building out a well performing and granular portfolio of equity co investments is important to driving growth in NAV per share while aiding in the mitigate mitigation of any credit losses over time.

Today, our equity co investment portfolio consists of 29 investments totaling $58.7 million or 9% of our portfolio at fair value.

Though the equity portfolio currently has performed extremely well with $10.1 million in cumulative.

<unk> appreciation some lingering effects of the pandemic aftermath still persist, leaving us very excited about the potential upside of this equity portfolio moving forward.

As illustrated on slide 11, our on balance sheet credit portfolio as of the end of the quarter, excluding our I 45 joint venture grew 8% to $573 million as compared to $531 million as of the end of the prior quarter.

Our credit portfolio is currently weighted 88% to the lower middle market lower middle market loans up from 86% last quarter for.

For the quarter, 100% of the debt originations were first lien senior secured and as of quarter end, 92% of the credit portfolio was first lien senior secured.

On slide 12, we lay out the $77.3 million of capital invested in and committed to portfolio of companies during the quarter.

This included $74.5 billion in first lien senior secured debt committed to 6 new portfolio companies.

Along with $2.5 million invested in equity co investments along 2 of alongside 2 of the new portfolio loans.

Turning to slide 13, we continued our track record of successful exits with 2 this quarter a first lien senior secured loan to environment has service and the remainder of our expected proceeds from the sale of AG Kings to Acme markets.

To date, we have generated a cumulative weighted average IRR of 15, 5% on 38 portfolio exits representing approximately $384 million in proceeds.

On slide 14, we breakout our on balance sheet portfolio as of the end of the quarter between the lower middle market and the upper middle market again, excluding our I 45 joint venture.

As of the end of the quarter, the total portfolio, including equity co investments was weighted approximately 88% of the lower middle market and 12% to the upper middle market on a fair value basis.

Our portfolio of 44, lower middle market companies has a weighted average leverage ratio measured as debt to EBITDA through our security of 4.2 times.

Within our lower middle market portfolio as of the end of the quarter, we held equity ownership in approximately 60% of our portfolio companies.

Our on balance sheet upper middle market portfolio, excluding our I 45 joint venture consisted of 10 companies with an average leverage ratio through our security of 4 times.

Turning to slide 15, we have laid out the rating migration within our portfolio again this quarter.

During the quarter, we had 1 loan upgraded from a 2 to a 1 while having 1 loans downgraded from a 2 to a 3.

As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4 point scale with 1 being the highest rating and 4 being the lowest rating.

As of the end of the quarter, we had 56 loans, representing 91% of our investment portfolio at fair value rated 1 in 1 of the top 2 categories of 1 or 2.

We had 7 loans, representing 9.2% of the portfolio at fair value rated a 3 and we had no loans rated a 4.

As illustrated on Slide 16, our total investment portfolio continues to be well diversified across industries with an asset mix, which provide strong security for our shareholders' capital.

The portfolio remains heavily weighted towards first lien senior secured debt with only 5% of the portfolio in second lien senior secured debt and only 2% of the portfolio in 1 subordinated debt investment.

Turning to slide 17, the I 45 portfolio also continued to show improvement during the quarter as our investment in the I 45 joint venture appreciated by $1.5 million.

Leverage at the I 45 fund level is now 127 debt to equity at fair value.

The increase in leverage at I 45 was mainly driven by an equity distribution to the JV partners during the quarter, which represented most of the capital contributed to the JV during the height of the Covid related market disruptions.

Michael will talk more specifically about this in a moment.

As of the end of the quarter of 95% of the I 45 portfolio was invested in first lien senior secured debt with diversity among industries and an average hold size of 2.8% of the portfolio.

I will now hand, the call over to Michael to review the specifics of our financial performance for the quarter.

Thanks, Bowen specific to our performance in the March quarter as summarized on Slide 18, we earned pretax net investment income of $8.9 million or <unk> 44 per share we paid out 42 per share in regular dividends for the quarter, an increase from 41 <unk> regular dividend per share.

Paid out in the December quarter.

As mentioned earlier, our board has again this quarter increased our quarterly regular dividend declaring a dividend of <unk> 43 per share.

Up from 42 per share last quarter to be paid out during the June 30 quarter.

Maintain a consistent track record of meaningfully covering our regular dividend with pre tax net investment income is important to our investment strategy over the past 12 months, we maintained our strong track record of regular dividend coverage with a 108% for the year and 107% cumulative since the launch of our credit strategy in January 2005.

<unk> during.

During the quarter, we maintained our supplemental dividend at <unk> 10 per share and again to our board has declared a further 10 cents per share supplemental dividend to be paid out during the June quarter. As a reminder, the supplemental dividend program allows for shareholders to meaningfully participate in the successful exits of our investment portfolio through.

<unk> from our UTI balance.

As of March 31, 2021, our estimated UTI balance was <unk> 92 per share.

Our investment portfolio produced $17.2 million of investment income this quarter with a weighted average yield on all investments of 10, 2%.

Investment income was $1.9 million lower this quarter due.

Primarily to last quarter's investment income, including significant nonrecurring dividend and fee income.

In addition, during the quarter, we had 1 portfolio company put in place a new revolving credit facility to finance working capital build as the business recovers from some operating challenges in conjunction with the revolving closing the term loan lender group agreed to convert 3 quarters of cash interest to pick as a further contribution to the comp.

These working capital need.

The cash interest converted was approximately $1 million, which all fell in the March quarter.

There were no non accruals as of the end of the quarter and our weighted average yield on our credit portfolio was 10, 8% for the quarter.

As seen on slide 19, our operating leverage continued to improve decreasing to 2.4% for fiscal year 2021 going forward. We will report operating leverage on a rolling 4 quarter basis. As we believe this is more informative metric for our shareholders due to the quarterly fluctuations in our operating expenses for <unk>.

Full year 2022, we expect operating leverage to be between 2.1% and 2.3%.

Turning to slide 20, the company's NAV per share as of March 31, 2021 was $16 per <unk> as compared to $15.74.

At December 31, 2020.

The main driver of the NAV per share increase was $2.6 million of net appreciation in the investment portfolio much of which was in the equity portfolio.

On slide 21, we lay out our multiple pockets of capital as we have mentioned on prior calls a strategic priority for our company is to continually evaluate approaches to derisk, our liability structure, while ensuring that we have adequate investable capital throughout the economic cycle during the quarter, we raised an additional $65 million in aggregate.

Principle on our existing 4.5% unsecured notes due 2026, we sold the notes at a premium to par up 102, 1%, which resulted in an approximate yield to maturity of 4% at issuance we.

We believe the execution on this additional issuance is further collaboration of the market acceptance of our investment strategy and their confidence in our portfolio and investing track record.

Our debt capitalization today includes a $340 million on balance sheet revolving line of credit with 11 Syndicate banks maturing in December 2023.

$125 million institution.

And with 25 institutional investors maturing in 2024, and a $140 million institutional bond maturing in 2026. In addition, we have $150 million revolving line of credit at I 45 also maturing in 2026.

In March 2021, we amended our I 45 credit facility lowering our cost of capital to LIBOR, plus 215 basis points and extending the maturity of the facility to 2026.

In conjunction with the credit facility Amendment, we distribute to the JV partners a majority of the $16 million of capital contributed to the JV during the height of the Covid related market disruptions and amended the economic arrangement among the JV partners, which should result in increased returns to capital southwest on its a high 45 investment going.

Forward.

Finally, as we've alluded to on prior calls we have now officially received our Spic's license from the U S. Small business administration, our initial equity commitment to the fund is $40 million and we have applied for $40 million of fund leverage which is also referred to as 1 tier of leverage.

We would expect to fund this initial $80 million of Spic's capital commitments over the next 6 to 9 months at which point, we will apply for a second tier of leverage over.

Over the life of the fund we plan to draw the full $175 million in Spic's debentures, while contributing or $87.5 million in fund equity. We're excited to be part of this program and believe it will be a natural fit with our investment strategy.

Overall, we are pleased to report that our liquidity continues to be strong with approximately $249 million in cash and Undrawn credit facility commitments as at the end of the quarter.

As of March 2021, approximately 69% of our capital structure liabilities were unsecured our earliest debt maturity is now in December 2023, our balance sheet leverage as seen on slide 22 ended the quarter at a debt to equity ratio of 113 to 1 I will now hand, the call back to Bowen for some <unk>.

Final comments.

Thanks, Michael.

Thank you everyone for joining us here today.

Capital Southwest continues to perform very well and consistent with the vision and strategy, we communicated to our shareholders over 6 years ago.

Our team has done an excellent job building, a robust asset base deal origination capability as well as a flexible capital structure that prepare it prepares us for all environments throughout the economic cycle.

We believe that our performance through difficult times like we all experienced during 2020 truly demonstrates the investment accurate acumen of our team at capital southwest and the merits of our first lien senior secured debt strategy.

We feel very good about the health of our company and the portfolio and we are excited to continue to execute our investment strategy going forward.

Everyone here at capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long term sustainable value for all our stakeholders.

This continues our prepared remarks, operator, we are ready to open the lines for Q&A.

Thank you to ask a question you will need to press star 1 on your telephone towards draw. Your question press the pound key please.

Please stand by while we compile the Q&A roster.

Our first question comes from Devin Ryan with JMP Securities. Your line is open.

Okay, Great Jack good morning, everyone.

Good morning.

I guess first question here clearly.

The credit backdrop stabilized book.

You may begin.

More color on appetite for growing assets in the I 45, senior loans funds and also if you can just remind us how you guys are thinking about kind of target leverage.

Net leverage profile in the portfolio.

Yes, I think I'll make this as Bowen. Thanks for the question I'll make a comment on the market and I'll, let Michael comment on the leverage target.

<unk> 45.

Funding is going well it's per.

It's performed much better now from a market Corp perspective.

Its primary.

Asset class in the syndicated market so.

We work very well hand in hand with main street with Great partners. They are great partners to us and we to them and so we're kind of looking at the market as we go forward. So you know.

Our growth in that fund or the pace of growth in that fund is really candidly just function of the assets that we see.

And in.

In the syndicated world and to a lesser extent the kind of large club world.

So.

I'll, let mark I'll, let Michael comment on the on the leverage targets et cetera, but.

We're managing leverage in the fund and we certainly have capital to put in the fund to grow at main Street clearly has capital to put in a funding growth. So it's really just a function of.

The windshield and looking forward the windshield on the market and the deals that we see to put in there.

I think from a leverage perspective, I think on a steady state basis, we're probably going to be running leverage between 1.3 and 1.5 I think what you saw during the pandemic.

Leverage wrote up over 2 times and we put it in equity capital to Delever down to closer to 1 times because we thought that was the prudent thing to do at the time.

So right now we have about $165 million in assets I think we're going to look to grow that to about $200 million in assets, which would get us closer to like 1.5 times.

We have a pathway to do that in the next 2 quarters.

Okay terrific great color there.

Follow up on the liability side, you continue to make progress.

Could you kind of alluded to dissipate on the prepared remarks, but can you.

Can you just remind us kind of.

Pathway from here to kind of that investment grade rating in your view, maybe what else needs to happen to achieve that.

It's a good question and we've been talking about it for a while I would tell you right now I think there's a size bias and so we're approaching $800 million in assets I think as we approach a $1 billion in assets I.

I think that's when we would start approaching the rating agencies, because what we've tried to do over the last 6 years is really diversify our sources and products on the liability side. So it started with growing that credit facility over time from 3 lenders to 11.

The baby Bond and then having to institutional deals done and now adding to it the SBA.

Really sort of kind of solidifies, we believe that plus trading above book.

And having the ability to raise equity on the ATM program and then I guess lastly, I think the other thing is the rating agencies look at us.

Repayments in liquidity in the coming off the portfolio, which now we see that in a steady state now that were stronger.

A larger company and more mature so I think all of US all that being said I think it's really just a little bit more of time and to continue to perform and mixed certain net we're also our leverage level is prudent.

1 of the things on that Michael Michael had me in front of each of the rating agencies 6 years ago 5.6 years ago. When we started and my goal was not to be an investment grade company 5 years 6 years ago. My goal was to solidify in our mind very thoroughly what our resume needed to look like when we did get to the size and we were a candidate.

And so we've been thinking about that for years and Michael just articulated kind of the resume but we think we've built that resume of course, it's all based on track record as well as Michael alluded to but we think we have the resume to be an investment grade rated candidate and a strong 1 but there.

There is a size kind of fairway that you need to be on.

Okay terrific I appreciate it's a process, but you could see you guys, making progress so I'll leave it there, but thanks for taking my questions.

Got it.

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

Hey, good morning, Thanks for having me on and taking my questions.

Just given where we are in the second quarter or your fiscal first quarter, just kind of want to get a sense for.

Investment activity quarter to date as well as the repayment activity.

Yes, I would say the pipeline is very strong right now.

You know our activity has been strong.

Would expect.

To have a pretty robust quarter from an originations perspective this quarter now maybe late in the quarter.

On an average kind of timing of closing.

And so so.

Yes, I think it's going to be positive for this quarter, but it also.

Probably very positive for the September quarter.

So just because of timing matters. So I think we're pretty pleased with the activity.

And so we would expect it to be pretty solid and you want to add.

Yes, I think just from.

From a net growth perspective, we're also probably see probably 30% to $35 million in prepayments coming back over the next 60 days.

And these are deals that we actually were aware of over the last probably 120 days, so theres, probably just winding down their processes.

We're not seeing much behind them.

So I think COVID-19 from a net basis, you can kind of get the picture.

Yes, yes very helpful. Thanks for that.

And then with the SBA.

Obviously, thats excluded from regulatory leverage calculations.

Any change to your sort of target Leverages in terms of how we should think about total versus.

BDC leverage.

So from an economic perspective, you can expect us to really be in really the 1.2 to 135 economic leverage.

And I think as we've ramped the CIC I think regulatory leverage will inevitably be around 1 times and I would say 9 to 1 point.

As it's fully deployed so nothing really changed there I think youll see continually conservative bend.

And.

Got it and then last 1 from me obviously.

No NPA and it sounds like the portfolio performance has been really strong, but can you give us a sense for maybe Rev and EBITDA growth trends.

And how those have trended kind of into the quarter, particularly as we start to comp against Covid.

Covid impacted.

Yes, so it brings up an interesting point. So if you look at kind of run rate EBITDA and revenue growth across the portfolio as we sit here today I'd say, it's positive because the portfolio is is in the economy candidly as a run rate perspective opening up.

Businesses are growing returning to pre pandemic levels now from an LTM perspective, especially like this quarter when we tested LTM at February of 'twenty 1.

That LTM period as March of 'twenty, 2 February of 'twenty..1 so obviously, that's a period that it has.

100% of the Covid effect and much less.

The recovery effect and so on.

I'm, making a distinction between run rate and LTM.

And so I think the LTM quarter over quarter.

Still I guess I'd say down across the portfolio. Although we have couple of handful of companies that are kind of we just blew right through the blew right through the Covid pandemic.

Their business models, but.

But the run rate as we kind of seen here today is clearly is across the portfolio.

Except for a half a handful of companies that are still just kind of struggling.

But it is definitely on the upturn.

Got it thanks very much for answering my questions and congrats on a solid year.

Yes.

Our next question comes from Bryce Rowe with comedy your line is open.

Thanks.

Good morning.

Uh huh.

Couple of questions here, Bohn and Bowen and Michael.

Wanted to kind of touch on just pricing in the market obviously, we've heard.

From for many of the Bdcs that.

Pricing is back that.

Back to pre COVID-19 levels or in some cases, maybe.

Maybe even tighter.

Can you and it looks like this quarter you had a weighted average yield of about 8.8% on the newer investments.

With a spread of 7.7% to 10% from a from a yield perspective, just curious kind of do you expect.

Pricing to stay in this and this.

In this ballpark in this Zip code.

Or are there is there.

Is there are you seeing some some potential for continued kind of movement to and through pre COVID-19.

Yes. Thanks for the question price I would say first of all.

There's lots of liquidity in the market, we all know that.

The market is has from an activity perspective.

Returned.

Certainly from a price perspective kind of back to kind of pre pandemic.

Leverage pre pandemic post pandemic I still think it's slightly lower post pandemic.

But pricing is definitely back when you look at our 8.8 I'd caution you from getting deal I think yields I think yields in our portfolio will will come down slightly maybe 50 basis points from the next 6 to 12 months based on kind of what we're seeing based on LIBOR being down.

But you have to keep in mind, our cost of capital has come down quite a bit as we start as we start as we start.

Art layer in the <unk> I think the net interest margin will be very robust, even with a slight kind of 50 basis points kind of retracement over the next kind of 6 to 12 months now.

Look at the $8.8 live with that in perspective, if you take out the 7.1% that's actually a first out loans that we did kind of 1.3 times leverage kind of number.

And if you take that out it's closer to 9 and a half and I would tell you that that our pricing on our deals I mean, it kind of its deal specific it's mix specific quarter over quarter and economy is low Cal lows of 9 and a half you look out over the last several quarters low of 9 and a half and Hyatt 10 and a half.

It kind of fluctuates up and down and so.

A landing zone of our yield does not we don't believe is 8.8%. So it's a little bit quarter specific I think it does flow kind of quarter to quarter in those ranges.

So and then as a first lien lender we always have.

A portion of our portfolio that Underperforms, that's just the nature of any lender and certainly a non bank lender and so the beauty of a first lien lender is it wind companies underperform a lot of our loans have grids. So interest rate floats up we get additional interest and default interest there are various things there's always some level of <unk>.

Economic enhancement and when you think about the entire first lien portfolio and that will always be the case and so that tends to make that tends to make up the difference and gets you kind of into the mid teens kind of kind of yield.

If that makes sense, so I'm trying to relate the 8.8.

The fairway, we live on I don't I don't think the fairway has gone from $10.5 to 8 and a half I mean, not even close.

I think it's in our cost of capital, we think is dropping faster than the yields are dropping so.

That's been good for us right and I'm, sorry, if you think about it from net margin rate it'll be fixed rate draws on the SBA, but you also look at what we've done to date, we have 2 thirds of our liability structure thats fixed rate so as rates rise over the next maybe that takes 12 to 18 months before you start seeing that Youll see our net interest margin actually start improves.

<unk>.

As well as the impact on the assets as well the other thing Brian. So I'll just throw out 1 more comment it's important to appreciate is important to note that about our business.

We primarily in the lower middle market, the lower middle market I think of it as kind of a pool, it's got a deep in its got a shallow and deepens day.

A little more storied credits Michelle low end is lower loan to value safer credits, while the lower end has lower yields and higher and the deepened has higher yields in our portfolio is a mix of all that so as your profit.

Comes down you can get nice net interest margin on the shallow end of the pool. So you cannot you can have some of your overall portfolio yield migrate down as you drop your cost of capital down and then our job as credit managers is to make sure we're not putting shallow and pricing on <unk>.

And deals if you know what I mean, and that's our job and that's art of what we do but it is a very real dynamic and 1 of the key reasons why you know my getting that track record built the diversity of sources of capital and ultimately your cost of capital down So that you can.

Net equal or better net interest margin on a safer asset portfolio that is strategically very important to us and then not to beat a dead horse, but the other part is our cost structure. So you've seen our operating leverage come down from 4.9% years ago to run rate LTM right now is 2.4%, but this particular quarter or.

Operating income operating expense was 2% so youre seeing our expenses are growing at a lower clip than our assets are growing. So there's also that in terms of our net and that also gives you the ability to get net interest margin at the shallow end of the pool, if you will.

Yes.

I'll get out how we think about the world. So that's perfect perfect perspective, and maybe leads into the next question. So.

You've seen now.

This bump in your stock price and your price to NAV valuation, obviously took advantage of it.

The last couple of quarters with with some more active use of the ATM. So I.

I guess my question is do we do we think about this pace of.

ATM usage being kind of more normal now that you've got the multiple that you have.

Or have you have you tried to be more opportunistic the past couple of quarters in anticipation of that.

The Spic's license coming on online and have it.

Doug.

Get ready to capitalize capitalize that I'm.

I'm Gonna make a general comment I'll, let Michael comment as well.

We viewed the ATM is a great interest from a great tool for our internally managed BDC like us.

Keep your track record strong the internally, we all know the benefits of the internal managed model, we talked about the operating leverage of various things.

If we can raise equity capital as a function of the originations that we're doing so the equity to US is is moderating and governing the leverage on the vehicle.

And the leverage on the vehicle is a function of asset quality first lien versus second lien et cetera, and so first lien portfolio can we believe can can hang out a little bit higher leverage than our second lien portfolio et cetera, but youre using that ATM to govern net leverage now so we're not opportunistically doing it necessarily worth.

Thinking about leverage in the pipeline and the ATM can be great because we can raise equity at a 1.5%.

Kind of spread to trade and we can do it more in lockstep with putting the dollars to work and so the and if we're in if we deserve the multiple right and that's a function of track record and consistency and we hold that very dear.

Important to us.

We have a premium multiple then that those that ATM program is accretive to NAV per share, but it's also being put to work very quickly if it's being done in conjunction with the pipeline.

And theoretically eliminates the NII dilution from it if youre, putting it to work so anything else Michael you bet I would say look on it.

For the next 12 months I think on average you probably would expect to see us raise on average $15 million a quarter, but having said that the way Bowen just described right. We kind of think about it as sort of like the collection. The break that we're trying to make certain that we stay in that leverage range.

And since with our earnings timing relative to quarter and you have a sense what your pipeline looks like and so when you open the ATM opens up like it will in 2 days from today, well sort of know where we want to land based on the originations and therefore, how much equity will want to raise.

So for this quarter, obviously with it being robust you can maybe anticipate a more.

But in other quarters, where we're indicating origination slightly lighter or prepayments are higher.

Then you might see it closer to the lower end of the range.

Great.

Good answers I appreciate all the perspective.

Thanks, Brian.

Okay.

Our next question comes from Sarkis, <unk> with B Riley Securities. Your line is open.

Hey, good morning, and thank you for taking my question here.

Just wanted to quickly touch on the SB IC.

License It I think you mentioned.

Initial 80 million capital to commit next 6 to 9 months and plan to draw $175 million on the debentures. So.

Just wanted to get a sense for from the net originations like how quickly do you plan to tap into the to the Spic's side versus.

The rest of them.

The BDC.

I mean, we're anticipating starting to contribute assets to the FDIC in the next few weeks our first assets will probably go in the next 2 or 3 weeks. So we will initially put equity to work, we're still waiting for approval on the leverage applications, which is just a.

Paperwork to get completed but once that occurs.

Basically funding our first $40 million and then we will be drawing $20 million of capital so a half tier.

You have to ask for an examination by the FDIC just to review your books and records at that point and then they released 2 additional 20, so I'd say, we see that $80 million and if you think about the way we will allocate assets, we'll be putting essentially approximately 50% of an asset originated assets into our credit facility and 50% in the SBA.

I see.

So.

In terms of putting the capital to work over the entirety of the program. So 6 to 9 months for the first 80, we probably anticipate it will be in the 3 to 4 years before we fully utilized the 175 and then obviously we will be.

Replenishing that as repayments come in over the 10 year life.

Great. Thanks for that and in the last quarters call you mentioned kind of a net origination.

<unk> growth per quarter, and then kind of the 20 million to $30 million ZIP code and it sounds like it seems like you guys did a really nice job here in this past quarter and then it sounds like that maybe continues here in this quarter is that kind of the right.

ZIP code to think about from a growth perspective, or would you think originations and kind of prepays.

Go to more let's say normalized levels any comments around that.

Yes, it seems like I think we would amend that based upon the staff. We have we have seasoned professionals we've added staff.

And I think we certainly had a growth.

Crew foothold in markets around the country I would tell you that the low end of the quarters or about maybe we should expect 40 or $50 million of originations from the high as 75 plus.

We kind of anticipate somewhere in the $10 million to $20 million in repayments of quarter. So the net is somewhere in the middle there.

That's right.

The net might be a little bit higher than we said last quarter, but it's not too far off so.

Yes.

Fantastic Thats all from me. Thank you.

<unk>.

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

Hi, guys.

Couple of questions first on I 45.

You mentioned I think Michael.

You amended the.

The agreement does that bring basically your economics.

Economic share into line with your ownership share of at least some of that.

Delta in terms of amending the agreement with me.

Yes, essentially thats moved that direction as you said Robert.

We just changed the relative economics to reflect the maturation of our firm and and.

And.

And so it's not any more complicated than that.

A relationship that goes really well it looks kind of book basically what we did and it was kind of time for that.

Yes, understood and then just 1 more on that I mean, you.

Yet you amended to evolve which net.

250 basis points.

That looks pretty good there any 1 time expenses or anything like that in this quarter. It looks like the lowest dividend I mean lowest dividend from the JV since probably 2016 I think.

Was there anything unusual and obviously your comments, where you expect to it tends to be high in future. So at this point, so I would say that.

Sure.

Our I 45, this quarter I think I would tell you that the repayments that came in which were plentiful.

Came in early during the quarter and then the originations honestly that we've actually closed but haven't even settled so the settlement process for some of these credits takes a bit of time. So we're looking probably at I think $15 million to $20 million of origination that will probably settle in this june quarter.

I think just a bit of a mismatch right for in terms of the actual to the dividend. So to your second question. We do expect there to be a bounce back in this following quarter with Covid.

Question well got it.

Thank you.

And then just a more broad 1.

In the comments.

Owners equity ownership in 60% of the portfolio companies.

<unk>.

Is the target to take that I mean, obviously, it will vary quarter to quarter I mean, the 6 new ones. This quarter that were only 2 got equity so obviously lower than the 60% run rate.

Would you expect that 60 to go up over time or are you happy kind of.

60 across.

Long term or any any color you can give us on that.

Yes, it's an interesting question I would tell you that we don't look at I mean, maybe it's obvious but we don't look at okay. We want.

A certain percentage of our portfolio companies to do we want equity in I mean, we're looking at more from 2 things top level looking at it saying, okay. The equity we'd like it to be.

8% to 10% of the portfolio. The overall kind of works for the business model and then it's a question of deal by deal do we like the equity story or not I mean, we don't necessarily have an equity story and the valuation thereof, the equity story and whether we think there is equity.

We get the equity story, we think there's adequate returns on the equity.

Take a view of the sponsor or whoever is taking another view that doesn't necessarily always blend.

And those on the call or around that have done credit before you do see often times deals where you liked the credit story more than the equity story I mean, the dynamics between the 2 are very different.

Really interesting cash flowing business, but it's like Gee with how do you grow it how you scale it that kind of thing which is not the lenders problem. That's the equity holders problem and so we don't always like the equity story doesn't mean, we hate the equity story.

But.

But we don't always loved the extra <unk> and the other thing I would say is is that if a if a private equity firm is a larger firm riding a smaller check in a deal sometimes it's hard for them to to to share the equity.

They want an outsized carry if we invest in equity and that starts to deteriorate. The equity story to us if we have a huge carry going out so.

A number of factors.

And so where it all lands you know, 60% I mean, my guess is I'm guessing here, but I'm guessing, it's probably 60%.

Probably around 2 thirds, plus or minus overtime of the deals of our.

Our portfolio loans will have an equity piece.

Next to it at price.

It's probably.

Very rough rule of thumb so 60%.

I know when I looked at that number and thought about the average as I thought that sounded a little bit low and if it was above 75% I feel like that was a little high so its probably 2 thirds over time on average.

Got it got it because I mean, obviously.

Realized I asked a day north of 15%.

That would be a.

Challenge to sustain from debt.

So equity is kind of look what to what.

Yes, I think for yourselves.

Thats, probably true from theoretical perspective, I also think and remember we're lending to the lower middle market. These are smaller businesses and the good news about the smaller businesses a lot of them are growing.

Pretty interestingly and so it's not like these large companies that are trying to grab 2 points of market share et cetera.

Businesses that have.

New newer ideas newer business models grabbing market share at a pretty high rate.

Private equity firm is putting basic institutional ish things in place like ERP systems that are generate kpis. There that they can help the founder manage the business better and grow it better adding marketing people because the small company has to marketing people and you look at that go day ought to have 10, just obvious without certain industry.

They ought to have 10, well those are big growth drivers and you don't see that as much in larger companies and you see it in this lower middle market quite often and so the equity is important if we like it it's an important piece of the business model, but it does it does enhance returns overtime for sure and the other thing I would go to Robert is that we have we've actually in some of the companies that have stumbled.

During.

Covid like AAC.

Or Delphi right.

CDK, we'd be able to pick up equity in the restructures and so those assets actually we we haven't kind of.

Push on them.

And those might see some significant recoveries in equity as well. So that's the reality is that's recovering former principal but if you think about it from where it is today that's all upside.

So.

If you look at it both ways right and so we think that that's something that we're pretty bullish on honestly.

Understood if I got 1 last housekeeping 1 on the tax side I mean the tax.

Obviously that was.

The 1 time write off last quarter, but this quarter, even so the tax.

Looks elevated relative to what I would expect excise tax to be so that it seems like there is something more in the the tax in the NII line than just can you give us any color on what that its.

Sure sure so and you're right the excise tax actually of the 850000 is only 50000 and that's that's a run rate number going forward. We did have as part of the write off from TSMC. As you noted there was a majority of that was last quarter. There was an additional 425000.

The previous number was off of a provisional return in the final tax return was done in April got it. So there's another 425000 and then the last 1 we had and that was obviously 1 time in nature and then we had another 1 time.

<unk> expense as well for 1 of our portfolio companies paid dividend cash dividend.

And so from a tax basis it reduces your cost basis, and therefore increases youre unrealized gain and therefore, we had an increase the income tax accrual. So that was 375000 and so thats essentially 800000 of the 850 were onetime in nature and both of them are noncash.

Got it I appreciate it thank you.

Thank you. Our next question comes from David <unk> with confluence investment management. Your line is open.

Hi, good morning, gentlemen.

First of all just.

Couple of comments.

I really appreciate that you guys years ago sent out too.

Total is what.

We're going to do in years later you are not.

Done what you said you were going to do.

Yes.

Unfortunately in this industry, there's oftentimes a GAAP between those 2 things I really appreciate it.

Your credit underwriting.

The formation of your JV in its growth and its management your liability management.

Particularly your use of the ATM and how you characterize its use versus your leverage all of those things help make things a lot easier for us as shareholders too.

Not have to manage through surprises not have to manage through.

NII dilution after equity issuance.

It's just very helpful and congratulations on getting the Spi C over the line.

Thanks, David.

So you guys have done a great job in 1 of the things that.

We often here.

Particularly as BDC to become larger.

This recognition that the lower middle market is less efficient pricing is more stable that terms are more more consistent whereas the upper middle market gets tagged around by what's happening in the public markets from the Big capital flows and usually you hear these themes based upon how big a BDC is in.

And managers, usually characterized whatever theyre doing is to be the best place to be but you guys are kind of in a unique situation because youre straddling the upper and the lower middle markets and the difference in EBITDA size that you have.

From about $10 million on the lower middle market exposure in the $70 million in the upper middle market I'm just curious.

<unk>.

What are your thoughts the basic theme that the larger upper middle market borrowers are the place to be because they are bigger companies with less credit risk versus the opportunities you might see in the lower middle market.

Both.

But how do you feel about the way that.

The 2 sides of the middle market get characterized.

Well first of all David Thanks for the question I would say first of all there clearly is a bias across the whole financial markets bigger is better I mean, we think we know that.

And so there is just you are the rating is adjusted that too right yes.

And so the bigger come there. So therefore, there is more capital.

Available there was just more of a big insurance companies et cetera, it's like okay, well, we'll invest but it needs to be at least you fill in the blank.

We will do it but it's got to be at least 25 and EBITDA of at least 10.

That's just all reflective of that bias.

So what is that that's been rolls itself that manifests itself in 2 things first of all.

Theres less there is more competition for those larger deals.

And therefore, the spreads are lower for those larger deals and other bigger companies, but I wouldn't say candidly they're necessarily more.

They're not always necessarily better credits.

But they are bigger companies.

But theres more capital chasing those deals so there's less so the second weighted named manifests itself is because there is less capital chasing the smaller deals the documentation and leverage in those types of things that matter to credit group like us are much more robust leverages lower covenants are real you know them.

Documents are tight you don't see Cub light loans in our world.

And so.

It's.

Those are all reflective so yes, there are smaller companies but.

We think the risk adjusted returns, which takes into account the company quality of the growth in our credit structure and the data and the integrity of the documents into thing or just more attractive now.

That's why you see the majority of our vast majority of our portfolio in the lower middle market I mean, it just fits we like that asset class. We like the fact, we can do a equity co investment if we like the equities have that equity kicker in our portfolio.

It's important that those opportunities don't exist in the larger market.

All that said I mean, we do think there are credits from time to time in the upper middle market debt.

Makes sense now the other thing is in the lower middle market. We lead the vast majority are 80 plus percent of the credits in the lower middle market, we originate and lead.

A big deal I mean, if we're 1 part of a large bank group in the upper middle market and something goes wrong.

You can't really make decisions just to sit on committee calls ad-nauseum rate and lender steering committee calls and blah Blah Blah right. So you don't you can't.

And lawyers and consultants get to make tons of money advising the steering committees and so.

It's tough to watch when something bumps like and AAC or someone like that right something like that so it's just the nature of that asset class and so some of it's a function of our size, but candidly the vast majority of the reason, we like the lower middle market.

Is because of the growing nature of those those businesses the quality of the documentation and structures.

Candidly, we just think that there is not we just don't have that large company bias. We don't think we don't think the bigger is better positive bias or small is harder negative bias overcomes the credit quality and the asset quality is in this space.

And so interest I'll also say as we grow.

With last time, we looked at this number I think so 80% to 85% of our portfolio or deals that we leave we originated an elite okay.

And of that.

Last time, we looked at the stack, which was maybe a quarter or 2 ago, but I don't think it's that much different.

Over half or half.

Of that piece that we lead we brought in another lender or 2 into those deals because we're managing our whole types.

And so as we grow.

We can hold more and more of the same same sandbox of loans that we hold today.

To keep with the same level or better granularity. So we have a lot of growth potential within the lower per market before we ever have to think about moving up market and.

I'm very reluctant to go and compete with the large bigger is better bdcs, they do a fine job.

In that space, and there's plenty of people and plenty of capital chasing those deals in that market and so the lower middle market, We've got a lot of growing room.

In the lower middle market before we're even talking about doing deals out in a larger percentage of our portfolio being outside the lower middle market hopefully thats helpful. David 1 thing I would add.

Our viewpoint on the lower middle market as Bowen said, it's been consistent through the years I think that our viewpoint on the upper middle market has varied depending on what the market looked like so if you look at 2016 and 2017, we were very active in the upper middle market portfolio. The market was good a beaten up and we found some great opportunities.

We made some nice returns.

Between 2018, and 2020, you saw barely any transactions in the upper middle market from us.

Sure.

I 45 fund kind of shrink over time and Thats, just our viewpoint on there from a market became it was frothy and it wasn't a place for us to find value. So it is kind of why we had our original slide 6 years ago said core market lower middle market opportunistic market upper middle market. It's just the same thing today.

We got it you got to remember you got to define who you are and what you are good at and then but you got to maintain our capability to look at deals and participate in large upper middle market deals when there's when the dynamic exists and it does exist from time to time, there's just the majority of things we do for sure and it's the same sort of thought process. We go through with a share buyback program right where it was.

We want to maintain liquidity to find opportunities in the market when they're there sometimes it's in the upper middle market. It seems like it will always be in the lower middle market and then sometimes it's buying back our stock when we feel like we are undervalued.

Alright, so so.

When you think about the thesis that the bigger companies are safer, obviously, that's very dependent upon individual situations and credits.

When you come across credit problems, even before default, but you just kind of seeing an erosion and operating fundamentals.

Is it fair to say that your experience is.

Not really.

Based upon your your individual lending decisions has not really been.

Adversely affected by the fact that you are companies or smaller versus larger.

Yes, so there's lots of different facets of your question. So bigger is safer I would say bigger companies are more established in their relative industry, but loans to bigger companies are not necessarily safer because loans to bigger companies have less looser covenants.

And higher leverage generally.

And so and so.

So larger loan portfolios don't necessarily or not necessarily the risk adjusted returns candidly are not we think not as attractive as a general matter. So.

And so candidly with things bump in the night, we like.

To be the decision maker, if we originate alone and we are controlling that loan.

The sponsor of the owners talking to us, they're not talking to a steering committee.

And to us and we can make decisions and we have I guess, we have leverage in those conversations you know, we make decisions on being commercial and being reasonable and maintaining our reputation and all that but but the point is we get to control those situations. When you are.

It's what you are asking David.

And when Youre in a larger lender group.

You can influence, but it's almost a political influence with the lender group, it's not an actual decision because you can influence the group think and the group think maybe get to the right answer or most often they get to an okay answer that's not the best answer is usually what happens.

But that's a very different dynamic in the lower middle market leverage lower generally documents tighter we have more decision, making authority and power in those loans and so you look across the entire loan book I would rather be in that I would rather have that loan book that kind of loan book, where I can make real real decisions.

That's helpful. So I mean, 1 of the things that.

When you look at the.

The trend of your cost of capital right, it's declining on both on the equity as well as.

On your debt right, which is great and it can help offset.

To the extent that your asset yields declined.

Your NIM can remain intact.

Is it just kind of helpful. For you to do this for me anyway have you describe UV is towards the upper middle market, because you could see how if youre liability constantly cost cap.

Capital was going down that there could be a draw to go into the upper middle market, where the yields are lower.

But you can do it because your cost of capital went down but it doesn't sound like that's really your strategic plan.

Do you.

Couple of the larger Bdcs that are internally managed obviously your friends at main street other ones like Hercules, you've been able to.

Maintained their focus well, while being an internally managed BDC.

Grow.

And you are continuing to focus on the lower middle market. How do you feel about sort of scaling your employee base and your resources to continue focusing on smaller loans, even though your capital base is larger.

I think you always had I know you know this David but I mean, you have to remember that we're not theirs.

There is no incentive here for us to scale just the scale. That's not we don't have a management contracted doubles in size that we double the assets. There's no. There's only 1 incentive here and that is yes.

Yes, we want to grow but theres a lot why do we want to grow where we want to get investment grade credit rating, we want to hold larger we want to bring in other parties may be less so that we can be the sole lender on more of our loan book because that allows us to be to be more reliable to close and in theory, we should be getting even better deals. If we don't have to.

<unk>.

Insert the closing risk associated with bringing in somebody else into our loans. So I want to grow for those reasons not not just to scale and so like you mentioned cost of capital tempting you to get in the upper middle market.

I can just tell you that is absolutely not the case here because what do you guys do it we're going to go out and do a bunch of upper middle market deals, where we don't control any of the loans and we have a bunch of participants were participant and a big chunk of our book.

Solely because our cost of capital went down I mean that.

That would be like that would make no sense and I'm not saying your question made no sense I think the question makes a lot of sense I'm, just trying to make that distinction.

So we're incentivized to grow this vehicle to make it higher quality and more effective in the market operating cost scaling same thing right.

Want to grow of course, we're going to need to grow operating cost dollars overtime as our portfolio growth of course, but we look at the operating leverage because we want we want to grow operating costs.

Lower then we grow assets, which brings the percentage operating leverage that we're always putting in our slide deck that comes down.

As we talked about Theres 3 cost to this business.

And we're taking our costs and we're re lending the money at a higher rate and so what are our costs our cost of financing cost obviously talked about that operating cost, which is our operating leverage as a percentage of assets that comes down that increases our interest our margin at the end of the day and then the third cost as non accruals.

I mean, we're going to have non accruals, we model in non accruals in our future.

We're not going to hang out with zero non accruals forever.

It's just part of our business, but we want that number to be either zero or low because thats a further cost of our business and we want to.

Make that cost efficiency and as we increase net cost efficiency, we're going to enhance our net our margin in our business and so so yes, we will grow operating costs, but we don't think of it is scaling we think of it is growing.

Growing.

<unk>, 2 or at a slower rate than asset growth, because that's where the efficiency comes in.

Well.

I greatly appreciate that answer its certainly what I wanted to hear.

I'd like to focus that you have but I also like the fact that you have the ability.

To take advantage of the opportunities that episodically seemed to come about in the upper middle market.

I appreciate your answers and congratulations on a good year.

Thanks connected.

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

Thank you operator, and thanks, everyone for being with US here today, we love talking about our business and we look forward to.

Giving you guys updates in the quarters to come we appreciate your support.

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

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