Capital Southwest Corp (CSWC) Q3 2020 Earnings Call Transcript

Thank you for joining today's Third Fiscal Quarter 2020 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, Vice President, Finance. I will now turn the call over to Chris Rehberger.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information, and management's expectations, assumptions, and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties, and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements whether as a result of new information, future events, changing circumstances, or any other reason after the date of this press release, except as required by law. I will now hand the call off to our President and Chief Executive Officer, Bowen Diehl.

Thanks, Chris, and thank you everyone for joining us for our third quarter fiscal year 2020 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation which can be found on our website. We are pleased to be with you this morning to announce our quarterly results for the third fiscal quarter ended December 31, 2019. During the quarter, we continued to advance our credit strategy, achieving the final step in transitioning the BDC to solely a middle market lender with the successful sale of Media Recovery, which does business under the banner SpotSee. The sale was a great outcome for Capital Southwest as we realized a significant capital gain while strengthening the company's position as a more traditional yield-oriented BDC, by removing the potential NAV per share volatility from holding such a large equity investment in the portfolio. As you likely recall, we've been discussing the potential sale for several quarters, and we'll provide further details later in our prepared remarks. We are excited to have achieved this final step and look forward to continuing the pursuit of our core investment strategy of building a predominantly lower middle market portfolio consisting largely of first lien senior secured debt with equity co-investments across the loan portfolio where we believe significant equity upside opportunity exists. Executing this 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. During the December quarter, we generated $0.44 per share of pre-tax net investment income and paid out a regular dividend of $0.40 per share during the quarter. We also paid out $0.10 per share in a quarterly supplemental dividend funded by our sizable undistributed taxable income balance, which was generated by excess income and capital gains accumulated from our investment strategy to date. The realized gain on the sale of Media Recovery allowed us to add approximately $0.50 per share to our undistributed taxable income balance, bringing the total balance to approximately $27.6 million for $1.48 per share as of December 31, 2019. We believe this provides visibility to the continuation of the quarterly supplemental dividend program well into the future. During the quarter, we also paid out a special dividend of $0.75 per share, which was the distribution of a portion of the Media Recovery realized gain. Total shareholder dividends for the quarter were $1.25 per share. We were also pleased to announce that our Board has declared an increase to our quarterly regular dividend to $0.41 per share. Our Board also declared another quarterly supplemental dividend of $0.10 per share, bringing our total dividends paid to shareholders to $0.51 per share for the March quarter. During the December quarter, we grew our portfolio on a net basis to $559 million from $539 million as of the end of the September quarter, originating approximately $92 million in investments for the quarter, the vast majority of which were deployed in the lower middle market. From a capitalization perspective, we continue to derisk the balance sheet by diversifying capital sources and maintaining liquidity. During the quarter, we raised an additional $10 million on our existing 5-year 5.375% institutionally placed bonds due 2024. The aggregate principal amount for this debenture is now $75 million. In addition, we raised $13.8 million in gross proceeds through our Equity ATM Program during the quarter, selling over 623,000 shares at a weighted average price of $22.07 per share, representing a 21% premium to the September 2019 net asset value per share. We are pleased to report that since the initiation of our Equity ATM Program, Capital Southwest has sold over 1.3 million shares at attractive premiums to book value, raising approximately $29 million in gross proceeds. Our Equity ATM Program continues to provide a steady flow of equity capital raised on a just-in-time basis in lockstep with our ability to thoughtfully put the capital to work. Including cash and undrawn commitments on our balance sheet credit facility, we had dry powder of $190 million at quarter end available to deploy in future investments. This dry powder, when invested, represents a 34% increase in our portfolio investment assets. Turning to slides 7 and 8, we illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage, and value creation since the launch of our credit strategy. Turning to Slide 9 as a reminder, our investment strategy has remained consistent since its launch in January 2015. We continue to focus on our core lower middle market while also maintaining the ability to invest in the upper middle market when attractive risk-adjusted returns exist. In the lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a well-performing and granular portfolio of equity co-investments is important to driving NAV per share growth in aiding in the mitigation of any future credit losses. Overall, we believe that maximizing the top end of our deal origination funnel in both markets is critical to generating strong credit performance over time, as it ensures that we consider a wide array of deals, allowing us to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic cycle. We continue to find superior risk-adjusted return opportunities in the lower middle market, where we can land at lower leverage and loan to value levels while maintaining tighter covenants and other terms in the loan documents. Over the past several quarters, this has been especially true as the upper middle market has been a primary source of NAV volatility in our portfolio. Turning to Slide 10, our on-balance sheet credit portfolio, excluding I-45, grew 18% during the quarter to $456 million compared to $387 million as of the end of the prior quarter. We continue to heavily emphasize first lien senior secured debt lending, and again this quarter, the vast majority of our originations were in the lower middle market. As of the end of the quarter, we had 81% of our on-balance sheet credit portfolio invested in lower middle market companies while having 90% of the credit portfolio in first lien senior secured debt. On Slide 11, we lay out the capital invested in and committed to new lower middle market portfolio companies during the quarter. This included $86 million in first lien senior secured debt invested in 5 companies and almost $4 million in equity co-investments invested in 3 of them. We also committed $3.3 million of additional capital to 4 existing portfolio companies during the quarter, bringing our total capital deployed for the quarter to over $92 million. All of the new portfolio company loans were first lien senior secured, with one being a loan in which a bank lender participated as a first-out position. The weighted average yield to maturity on new debt originations funded this quarter was 9.9%. We are pleased with the pipeline as it stands today and expect that several additional deals currently in diligence should close during the March quarter. Again, a vast majority of this prospective investment activity is in the lower middle market. On Slide 12, we show a summary of the exits during the quarter. The sale of Media Recovery generated $51 million in net proceeds realizing a gain of $44.3 million and an IRR of 11.8% measured back to the original acquisition in 1997. During the quarter, we also realized a full prepayment of our subordinated debt investment in Chandler Signs. Chandler is performing well, and we remain invested in an equity co-investment position that has appreciated in value since closing. The subordinated debt exit generated an IRR of 14%. This continues our strong track record of successful exits, as we have now had 29 portfolio exits since launching our credit strategy back in January 2015 generating $267 million in proceeds and a cumulative IRR of 15.4%. On Slide 13, we break out our on-balance sheet portfolio excluding I-45 between the lower middle market and the upper middle market. As of the end of the quarter, the total portfolio including equity co-investments was weighted approximately 83% to the lower middle market and 17% to the upper middle market on a fair value basis. We had 32 lower middle market portfolio companies with an average hold size of $12.6 million, a weighted average EBITDA of $7.9 million, a weighted average yield of 11.6%, and a leverage ratio measured as debt-to-EBITDA through our security of 3.6 times. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately 69% of our portfolio companies. Our on-balance sheet upper middle market portfolio consisted of 11 companies with an average hold size of $9.2 million, a weighted average EBITDA of $65.2 million, a weighted average yield of 7.4%, and a leverage ratio through our security of 4.6 times. As in the past couple of quarters, we should note that our no-balance sheet upper middle market metrics are shown excluding our investment in American Addiction, as the EBITDA while improving on a run rate basis remains at a level that would skew the accurate portfolio leverage ratios to a degree that would obscure the ratios of the remainder of the upper middle market portfolio. American Addiction remains a 3 on our internal rating system and remains on non-accrual, having been placed on non-accrual during the September 2019 quarter. As a reminder, all investments 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. At the end of the quarter, out of the 44 loans in the portfolio, we had 3 with the highest rating of 1 representing 11% of the credit portfolio at fair value. We had 36 loans rated a 2 representing 84% of the credit portfolio at fair value. We had 4 loans rated a 3 representing 4% of the credit portfolio at fair value, and we had 1 loan rated a 4 which represented 1% of the portfolio at fair value. The loans rated a 3 in the portfolio all in the upper middle market include American Addiction, American Teleconferencing, which does business as Premier Global, and Delphi Intermediate, which does business as Delphi Behavioral Health. Delphi was downgraded from a 2 to a 3 during the September quarter and joined American Addiction on non-accrual status during the December quarter. Both American Addiction and Delphi are in the business of providing addiction treatment services to patients across the country. While it would be inappropriate to discuss in detail the status of each company on a public call, I will say that the 2 businesses face similar challenges due in part to the addiction industry increasingly migrating to an in-network insurance reimbursement model. While this results in reduced reimbursement rates, it also results in a greater opportunity for each company to provide high-quality care to a larger number of patients. Due largely to these challenges, cash flow at both companies has decreased materially in the short term. That said, we believe that those situations are rapidly moving to balance sheet restructuring, and in both cases, we believe that the restructurings will benefit each company in their respective missions to provide the highest quality care to their patients. We also believe that these restructurings will provide the respective lender groups the opportunity to realize appreciation in and recovery of their investments as the businesses complete the transition and grow their respective patient bases. We continue to believe that the challenges facing both companies are addressable and our unrealized depreciation in each is recoverable. As a result of these restructurings, if and when they occur, we would expect that a portion of Capital Southwest’s first lien loans currently held in each company would be reinstated as first lien debt on each business, with the resulting interest in that portion of coming back on accrual. The remainder of Capital Southwest’s position in each company would then be equity, which we anticipate will be the source of recovery of the unrealized depreciation that exists today. Our loan rated a 4 also in the upper middle market portfolio is AG Kings. The loan has remained on non-accrual for the past several quarters. Not much has changed with respect to this position, but the lender group continues to work with the company on strategic alternatives for the business. We will attempt to update you on future calls to the extent we can comment on the company status. As illustrated on Slide 14, we have established a portfolio well diversified across industries. Despite the few idiosyncratic issues we are dealing with in the upper middle market portfolio today, we believe the portfolio is well positioned for late in the economic cycle. Further, our portfolio asset mix should provide strong security for our shareholders’ capital. The portfolio remains heavily weighted towards first lien senior secured debt with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio in subordinated debt investments. Shown on Slide 15, as of the end of the quarter, the portfolio was 93% first lien with diversity among industries and an average hold price of 2.2% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately $65 million, a weighted average coupon of LIBOR plus 6.3%, and a weighted average leverage through the I-45 security of 4.5 times. We also excluded American Addiction from these ratios for the aforementioned reasons. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.

Thanks Bowen. As seen on Slide 16, our investment portfolio produced $16 million of investment income this quarter, with a weighted average yield on all investments of 10.7%. This represents an increase of approximately $800,000 from the previous quarter. The increase in investment income was primarily attributable to an increase in average debt investments outstanding and a transaction fee received in connection with the sale of Media Recovery, offset by decreases in dividend income from both I-45 and Media Recovery and Delphi being placed on non-accrual during the quarter. As of the end of the quarter, there were 3 assets on non-accrual with a fair value of $18.2 million representing 3.3% of our total investment portfolio at fair value. The weighted average yield on our credit portfolio was 11.3% for the quarter. Excluding interest expense, we incurred $4 million in operating expenses for the quarter, which was $150,000 less than the previous quarter. For the quarter, we earned pre-tax net investment income of $7.9 million or $0.44 per share. This compared to $0.42 per share during the prior quarter. We paid out $0.40 per share in regular dividends for the quarter, flat from the $0.40 regular dividend per share paid out in the prior quarter. We have continued our consistent track record of meaningfully covering our regular dividend with pre-tax NII, as demonstrated by our 109% regular dividend coverage over the last 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy. As Bowen mentioned earlier, we also paid out a supplemental dividend of $0.10 per share during the quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in a successful exit of our investment portfolio through distributions from our UTI balance over time. Due to the successful sale of Media Recovery, we were able to replenish our UTI balance to a level of $1.48 per share as of December 31, 2019, which we believe provides visibility to the continuation of our supplemental dividend program well into the future. The program will continue to be funded from UTI earned from realized gains on both debt and equity as well as undistributed net investment income earned each quarter in excess of our regular dividend. In addition, we declared and paid a special dividend of $0.75 per share as we distributed a portion of the realized gain from the Media Recovery sale. On Slide 17, we illustrate our operating leverage, which as of the end of the quarter was 2.7%, which puts us near our initial target operating leverage of sub 2.5%. We are fully committed to actively managing our operating costs in lockstep with portfolio growth and have our longer term sight set on achieving target operating leverage of 2% or better. With senior professionals and corporate infrastructure largely in place, operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure. Flipping over to Slide 19, the company's NAV per share as of December 31, 2019, was $16.74 as compared to $18.30 at September 30, 2019. Given the number of moving parts this quarter and the fact that much of the NAV per share change was a reset of NAV per share as a result of the final step in the transition of the BDC to a middle market lender achieved through the sale of Media Recovery, we thought we would take a minute and walk through the components of the quarter-over-quarter change. Moving from left to right, we continued our strong track record of fully covering our regular dividend with NII earned during the quarter, while systematically distributing our undistributed taxable income over time. With respect to the investment portfolio, we saw unrealized depreciation in the upper middle market, partially offset by unrealized appreciation in the lower middle market portfolio. Finally, with respect to the sale of Media Recovery, we paid a special dividend to shareholders of $0.75 per share, distributing a portion of the capital gains from the sale to our shareholders. For the portion of the capital gains we retained, we paid a $0.19 per share tax on the retained capital. Shareholders will receive a Form 2439 and a letter from us with further explanation of the resulting tax credit and step up on their cost basis, which we expect to be $0.71 per share for shareholders of record as of December 31, 2019. Finally, we recognized book depreciation from the sale of Media Recovery of $0.23 per share. There were 3 components to the $0.23 per share. First, $0.09 per share was driven by frictional transactional costs from the sale process, including investor banker fees, legal and accounting expenses, and a closing working capital adjustment pursuant to the purchase and sale agreement with the buyer. Second, $0.08 per share was the gap required book discounts applied to potential earnouts and escrows associated with the company’s sale to account for the fact that each is a future event. If we receive both in full, it will result in Capital Southwest receiving an additional $1.5 million in recognized proceeds from the transaction. Third, and finally, pursuant to the management services agreement in place between Capital Southwest and Media Recovery, Capital Southwest received a success fee upon closing the sale, which is approximately $0.06 per share. The success fee was recorded as fee revenue rather than sales proceeds for purposes of NII and NAV per share. Our total pre-tax NII return on equity for the quarter was 9.5%. On Slide 20 we lay out our multiple pockets of capital. As we’ve mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to derisk the liability structure of the company while ensuring that we have adequate investable capital throughout the economic cycle. To that end, we raised an additional $10 million on our October 2024 institutionally placed bond, which had a coupon of 5.375%. As Bowen mentioned earlier, during the quarter ended December 31, 2019, we sold 623,111 shares of Capital Southwest common stock under the Equity ATM Program at a weighted average price of $22.07 per share, raising $13.8 million of gross proceeds. Cumulative to-date, we have sold 1,313,588 shares of Capital Southwest common stock under the Equity ATM Program at a weighted average price of $22.07, raising $28.7 million of gross proceeds. Our balance sheet leverage ended the quarter at a debt-to-equity ratio of 0.88:1. We are pleased to report that our liquidity is strong, with significant dry powder and the earliest debt maturity at December 2022. I will now hand the call back to Bowen for some final comments.

Thanks, Michael. And thank you everyone for joining us today. Capital Southwest has grown, and the business and portfolio have developed consistent with the vision and strategy we communicated to our shareholders 5 years ago. Our team has done an excellent job building a robust credit portfolio, generating attractive returns for our shareholders, while also demonstrating our extensive credit experience in managing our loan portfolio as it matures and seasons. 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 shareholder value. This concludes our prepared remarks. Operator, we are ready to open the lines for Q&A.

Our first question comes from Tim Hayes from B. Riley. FBR. Your line is now open.

And congrats on officially completing the portfolio transition. My first question, Bowen, would you just mind expanding on your decision to raise the regular quarterly dividend? On an after-tax basis, NII was a little bit lower than the $0.40 regular dividend this quarter, and I know you had the excise tax accrual. But you also had the one-time success fee that drove investment income higher. Growth is really strong, but is this a case where it was back-end weighted and you expect growth will have a much more profound impact on next quarter's results? Just any color around this would be helpful.

Sure. Thank you for your question. It involves multiple factors. Now, I'll have Michael provide insights on the components.

Sure, sure. So I think looking at the 12/31 run rate, if you exclude the non-recurring MRI fees, we were about 1.7 million and then you add back the impact of the 85 million in originations during the quarter for a full quarter’s accrual, our run rate for the 12/31 quarter would be $0.40 per share. So that doesn't include looking forward originations that have closed this quarter to date or that will close between now and the end of the quarter.

Okay. Got it. That's helpful. And then as it relates to Delphi, what exactly triggered the company being added to non-accrual this quarter? Was there new information you gathered, which increased the likelihood of impairment? Or did they actually stop paying interest and/or principal on the loan?

So, they stopped paying interest on the loan, so it's picking up but not going through our income statement. So it's not non-accrual but it's just basically deterioration of EBITDA. And so based on that and the fact that we weren't receiving cash interest, we made the judgment call to put it on non-accrual.

As Bowen said, Tim, it was picked into the principal balance and I think Bowen discussed the potential restructuring, so that value will be part of that restructuring process.

Right. My follow-up question is, could you provide any rough timeline regarding the restructuring process?

I mentioned earlier that both companies are progressing quickly in that direction. You can likely expect that Delphi will complete its process faster than AAC, as Delphi is a private entity whereas AAC is public, making it somewhat simpler. However, both are on a relatively swift timeline, which is beneficial for both companies. Ultimately, they exist to deliver high-quality healthcare to their patients, and this focus will support their capital structures. Overall, the pace of progress is quite rapid for both.

Okay. Regarding the $9 million of net depreciation on upper middle market investment, how much of this was attributed to the joint venture, and were the marks primarily driven by fundamental factors related to company performance, or were there any technical aspects that influenced these fair value marks?

It’s split approximately equally between the joint venture and the balance sheet. On the balance sheet, there is a depreciation of 5.4 million, which is the total for the four companies I mentioned. The other companies showed various fluctuations. For I-45, total depreciation reached 4.5 million, with 3.2 million attributed to four credits, including AAC. These four credits in I-45 are facing credit or operational issues, whereas the other 42 loans are performing adequately, some even excelling. The equity teams are putting in significant effort to secure their returns, and while the loans generally appear stable, there are four out of 46 that are experiencing challenges and discussions. I hope this provides some insight.

Yes, it does. Thank you. Broadly speaking, how would you describe the behavior of sponsors? Are they being supportive in working with distressed companies to restructure investments or provide liquidity for a better outcome? Are you noticing sponsors moving away from companies that are struggling and focusing on more successful ones? It would be helpful if you could provide some insights on this.

Yes, I think sponsors are generally making informed decisions and not just wasting money. Over the past year to year and a half, sponsors have mostly supported their companies, which is a logical approach in those situations. There have been a couple of cases, particularly one, where sponsors decided to relinquish control to the first lien lender and restructure the balance sheet as I mentioned earlier. In that instance, I believe it was a reasonable and appropriate choice for the business and the senior lenders. Overall, I think sponsors have demonstrated smart decision-making, with the right action in nearly all cases being to support the business and keep the first lien lenders satisfied, which is what we aim for.

Our next question comes from the line of Mickey Schleien from Ladenburg. Your line is now open.

I wanted to ask about deal flow. I've been hearing that the volatility in the more liquid markets in the fourth calendar quarter led larger borrowers to gravitate toward direct lenders instead of the syndicated market, and that caused larger lenders including larger BDCs to focus more on bigger deals, and that may have resulted in more opportunities for smaller BDCs. Was that a trend that you saw, and did that impact your deal flow during the quarter?

We definitely experienced a slowdown in general activity in the syndicated market. This aligns with what you mentioned, and we have looked at some larger club deals, which is also in line with that observation. Overall, the number of upper middle market deals that we’ve been interested in has been low. Consequently, I-45 is not growing because capital has been refinanced, and there have been very few new deals we’ve been considering in that fund. Therefore, activity in I-45 is slower, which is evident. However, I can confirm that what you said aligns with our observations.

And I think you mentioned in your prepared remarks that at least so far, the first calendar quarter looks pretty busy. And that's usually a slow quarter. So is there something specific going on this quarter, that that's leading to that volume? Or is it just spillover from deals that just didn't get done in the fourth quarter?

Yes, the lower middle market is indeed unpredictable and can vary significantly. Looking at our pipeline, we have a good number of deals that we can pursue, which is above what we typically see. The December quarter was a strong one for our originations, although the quarters prior were below average. As I assess the deals we are currently engaged with for the March quarter, it remains somewhat uncertain. However, I can confirm that this quarter's pipeline is above average. It may not match last quarter’s volume, but we expect it to exceed average performance and likely close in the latter part of the quarter.

Okay. I appreciate that. And just a follow-up on AAC and I know you're limited as to what you can say. But there has been news about the extension of the forbearance agreement and some additional capital provided by the lenders. Did you participate in that additional injection of capital into AAC?

We did. I mean, our piece is small because there was a $400 million loan that we all split the incremental capital, so that our dollars are small, but we participated in it, and that incremental capital has very outsized economics and so it’s directly first priority secured by the real estate. And frankly, other people are going to put it in if we don't. So it’s the rational thing to do. But fortunately, the numbers for us are relatively small.

Okay. And I just wanted to confirm there is real estate in the collateral, correct?

That's correct.

Thank you. Our next question comes from the line of Kyle Joseph from Jefferies.

Hey, good morning guys and thanks for taking my questions. Most have been answered, but I just wanted to get a sense, it sounds like the lower middle market continues to be very attractive and you're maybe a little disappointed with some of the investments in the upper middle market. I want to get a sense of what's driving that. Have you seen things in the upper middle market get more competitive? Yes, can you explain the discrepancy there?

Yes, if you break it down, there's $5.4 million of depreciation in the upper middle market, which comes from the combined depreciation of Delphi, AAC, and AG King. That's the current situation in the upper middle market. Honestly, from a credit perspective, I see that we made poor decisions on those loans. They were well-structured, and the restructuring will ultimately be successful, but we regret those loans. This is not a zero-defect business, and that's the story for the upper middle market so far. We believe that, as we've consistently mentioned over the past few years, the upper middle market is quite competitive, with many people eager to lend to larger companies. Consequently, this results in higher average leverage ratios, higher loan-to-value ratios, and lower average yields. Thus, when issues arise, we have less flexibility. This has been the trend in the upper middle market for several years now. On the other hand, our lower middle market story is different. We have a $370 million loan portfolio that depreciated by $140,000 this quarter, which is essentially flat. Meanwhile, our lower middle market equity portfolio appreciated by $2.9 million. This portfolio is functioning as intended, featuring first liens with equity co-investments, and the successful investments are significantly outweighing any depreciation in the equity portfolio, operating as designed.

That's a good transition to my next question. As you consider the pipeline between the upper and lower middle market, could you discuss the yield trends you're observing in both segments and their implications for your overall portfolio?

I'd say that the loans in the lower middle market generally yield about the same as before. There are various deals within the market. For example, you have loans from high-margin, recurring revenue businesses that typically come with a lower loan to value ratio, resulting in a tighter spread. Some of these may be sponsored, which can also contribute to a tighter spread. On the other hand, deals that might have a higher loan to value ratio or are less based on recurring revenue, or sponsored by a smaller fund or without specific sector expertise, could yield higher returns. As we look ahead quarter-to-quarter, we will be engaging in a mix of these types of deals while targeting leverage, and our cost of capital is decreasing. If we increase leverage in the BDC, we should anticipate focusing on safer deals. Thus, our approach may shift within the confines of the same market. Over the past several quarters, I haven't noticed significant changes in the market landscape; competition has remained steady, with the upper middle market being more competitive than the lower middle market for quite some time. Overall, this quarter, I did not observe much change in the market as I've defined it.

Our next question comes from the line of Bryce Rowe from National Security. Your line is now open.

Hey, Michael, I wanted to ask you about the source of dividend income here. This quarter, obviously you had I-45 dividend. But curious what the other portion of that dividend income was?

Sure. The other portion was a sub dividend from MRI for about 500,000 that was paid out of the proceeds before close.

Okay. And then Bowen, you talk about the pipeline being maybe above average and can be quite random in terms of the lower middle market. I'm curious what you're seeing from maybe a repayment visibility perspective. Obviously, this prior quarter was dominated by the proceeds from MRI, but just wondering if you have any visibility to repayments over the next quarter or two?

Yes, I'm reflecting on that, and while prepayments are a consistent part of our business model, we currently do not have significant visibility regarding large prepayments expected in the upcoming quarter or two. While we could potentially hear from some of our companies about this, right now, I anticipate that prepayments over the next quarter will be relatively light, particularly in the lower middle market.

And we did have 2 what we call A plus performers that there a potential for refinancing existed. And I think we've worked through that where we're going to stay on as a lender. So that's part of the reason we say we don't see any visibility right now for additional repayments.

Okay. Can you provide some insight into the earn-out you mentioned with MRI? What kind of timeframe are we discussing?

So the earn-out will be tested on a 9/30, 2020 fiscal year that's MRI fiscal year basis, so with earnings performance for that year.

Thank you. Our next question comes from the line of Christopher York from JMP Securities. Your line is now open.

Good afternoon guys. Thanks for taking my questions. So Michael or Bowen, I noticed a decent pickup in the weighted average leverage to your security in upper middle market investments of about to turn from 3.7 to 4.6. So could you maybe just a comment on what drove that big increase?

Yes, thanks. It's all Delphi basically. So if you take Delphi out, the 4.6 is 3.6.

Very good. Okay. And then in I-45 we also have a decent increase there and I would have to look at the Q, so I've Delphi in I-45 as well?

No, it's not. So the leverage on I-45 went from 4.3 last quarter to 4.5. During the quarter, we had $9.3 million paid down or prepaid on companies where the leverage was mid 2.5 times EBITDA basis because of the performance. And we put 2 credits on that were new deals, new issues and they were kind of in the low 4 times, like 4.2 to 4.3 type of leverage. And so that's basically the change.

Okay. And then I see the I-45 dividend decrease for $100,000 sequentially. Now given the decline in the portfolio there, is this a level of recurring dividend that we should be expecting to continue?

Yes, based upon the number of credits that are in the portfolio right now and the cash yield, I think the 2.1 is a good run rate number going forward.

Okay. And then maybe taking a step back, given the competition that you described Bowen in the upper middle market, losses you've experienced here in the upper middle market, has this caused you to reconsider the dual pronged strategy or allocating capital between the strategies?

No, our strategy has always focused on the core lower middle market, the opportunistic market, and the upper middle market. Currently, it is very competitive. Over the last few years, finding value in the upper middle market has been more challenging from a credit perspective compared to the lower middle market, or in other words, regarding risk-adjusted returns. That strategy has not changed. Our core business in the lower middle market has seen our deal teams do an excellent job of originating deals, and we are closing about 2% of the deals we review. There is still demand in the lower middle market, but finding value in the upper middle market is more difficult. This doesn't mean there aren’t opportunities; for instance, we completed two deals this quarter, but it is just more challenging. We have a few upper middle market situations that are credit challenged and being restructured, which adds some noise to our strategy, but the strategy itself remains unchanged. The allocation of our capital will adjust based on the risk-adjusted returns we identify in those markets. It’s crucial for us to maintain our position in the lower middle market, where we see value. We also want to keep the ability to evaluate the upper middle market because we believe opportunities exist. As always, when market conditions shift, the upper middle market may react, but that doesn't instantly lead to purchasable assets. We will continue to look at the upper middle market, maintain our capabilities, and nurture our market contacts, though it is currently harder to find value there.

And then last one from me, it's maybe a two-part question. But when you said that, you may have not made some of these upper middle market investments if you were approached to potentially invest today. Maybe could you describe some of the characteristics that led you to say that? And then secondly, what gives you such confidence that there is recoverable value in some of the unrecognized depreciation given that your ability to control the outcome as part of a syndicate is less than the kind of deal?

Yes. First, when you invest or buy stock, it can feel like a mistake if values fluctuate. This applies to the addiction treatment sector, which is where most of our focus lies. The opioid and drug crisis in this country is worsening, and while this is not positive, it's crucial that people receive help, as lives are saved in this field. The industry is unfortunately growing, bringing higher costs that payers must manage. There’s a shift happening from out-of-network to in-network services, and both our businesses have had some out-of-network aspects. There are various challenges, but it's a significant factor. Do I regret investing in addiction treatment? No, I can't say that. One of my most successful past investments was in this area, and we still appreciate this industry. It relates to your question about recoverability; we believe these platforms are still viable in a growing market that's undergoing changes. Therefore, I consider that most, if not all, of the unrealized depreciation should be recoverable. I don’t view the addiction industry as a bad investment; it has its complexities. On the grocery side, however, that sector is quite competitive. People will always need to eat, which is a positive, but there are increasing large competitors opening stores in more areas, and that growth pace has outstripped our expectations from several years ago when we made that loan. Consequently, recovering that unrealized appreciation will be tougher, accounting for its lower rating. I'm not particularly enthusiastic about making more grocery loans right now. While both sectors face challenges, the situations in addiction treatment and grocery are distinctly different.

Our next question comes from the line of Robert Dodd from Raymond James. Your line is now open.

Hi guys. I have a couple of housekeeping items regarding MRI and then some more detailed questions. Michael, you mentioned earlier in the call a $1.7 million success fee related to MRI, which I assume is non-recurring. I take it that the $1.7 million includes the $0.5 million dividend, because otherwise it would exceed your total fee income?

That’s right. $1.16 million for the success fee and it was approximately $500,000 for the sub dividend.

And then, on the form, if I got the number right, the 2429, I know I'm going to get questions about this, but when can your shareholders expect that?

I think we should have that in the next week, it has a full description as the definition of the deemed distribution will describe the tax, the long-term gain and tax treatment. It'll help them provide the information to their tax advisors to get it done correctly.

Got it. And then the last one. On the 27.6 million in undistributed income, that's adjusted for the deemed distribution, right, the amount you were taking?

Yes, that's correct.

I want to discuss I-45 and review that level. The portfolio has obviously shrunk a bit over the last few years. I've noted that leverage has increased. You mentioned that there were some low leverage repayments. Should we be optimistic about the quality of the assets, considering that as we pay down, we anticipate success? Should we have concerns now that leverage has increased by one point over the year while the portfolio is shrinking? Is there any risk of adverse selection regarding the remaining borrowers? Typically, more successful borrowers are likely to repay early and exit the portfolio. When the portfolio is shrinking, does this lead to a mix of borrowers that you may not have preferred from the outset?

I believe that in any portfolio, including a loan portfolio, the loans that perform well tend to see their leverage decrease and get paid off sooner. This means that the remaining credits in the portfolio are generally of lesser quality. As I review our loan portfolio, I notice that there are about four or five loans from companies facing operational challenges, with AAC being one of them. However, the other loans are not on our balance sheet; they are specific to I-45, which accounts for most of the depreciation and also impacts the leverage. Overall, while it is true that higher quality loans tend to be paid off more quickly and replaced with newer loans, this doesn't imply that the remaining loans are problematic. I agree with your observation, but I want to clarify that we do not perceive this as a significant concern for I-45.

And then on the lower middle market, I mean very strong originations in the quarter and as you said earlier, it could be lumpy. But have you seen anything out in the market on the lower middle market in terms of the borrowers or the company owners, is the ask on what they're looking for shifted any that makes the deals maybe slightly more appealing to you?

There are many variables to consider. Each industry and company is distinct, with varying profit levels and drivers, as well as different sensitivities to economic cycles. We evaluate whether the requests align with our perspective on that particular industry and company. Sponsors exhibit different behaviors; some are very aggressive seeking maximum leverage, while others take a more measured approach. Typically, the internal rate of return for the latter group is more influenced by operational improvements than by financial engineering. We tend to perform better with the latter type. This remains consistent with my earlier comments regarding our position in the market. The situation allows us to explore different areas of opportunity. As we increase leverage and lower our cost of capital, we can compete effectively and acquire assets that provide an attractive return on equity for our shareholders, which is ultimately what matters in perhaps a safer area of the market. Thank you operator. And thanks everybody for joining us today and thanks to all the analysts that asked us the questions. Those were great questions and we appreciate everybody's support and look forward to giving you updates as we move forward.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.