Capital Southwest Corp Q4 FY2022 Earnings Call

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 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 issuing a 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 fourth quarter and fiscal year 2020 earnings call. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio, as we continue to diligently execute our investment strategy as stewards of your Capital. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. I'll start by saying that during tumultuous times like we have seen recently in the public markets, it's reassuring to have a portfolio heavily weighted to first lien senior secured debt, built with a full cycle underwriting mentality that we have deployed over the past seven years since the launch of our credit strategy. It is also reassuring that ninety percent of our credit book is in sponsor-backed companies, which provides these companies with potential capital and operating support if needed. On the capitalization front, we have been diligent about maintaining over half of our liabilities in unsecured debt while consistently raising equity through our cost-efficient equity ATM program. Finally, we are well-positioned for a rising interest rate environment, with ninety-eight percent of our debt assets in floating rate securities and only thirty-eight percent of our liabilities in floating rate securities. Now turning to slide six of the earnings presentation, we will begin with a summary of the key performance highlights for the fiscal year. Total return to shareholders for the fiscal year was eighteen percent, which consisted of share price appreciation of seven percent and total dividends paid during the year of two dollars and fifty-two cents. Our NAV per share grew five percent to sixteen dollars and eighty-six cents from sixteen dollars and one cent in the prior year, driven primarily by over seventeen million dollars in net realized and unrealized gains in the portfolio. During the fiscal year, we grew our total portfolio at fair value by thirty-six percent year-over-year from six hundred eighty-eight million dollars to nine hundred thirty-seven million dollars in the prior year while increasing our pretax net investment income by six percent to one dollar and ninety cents per share from one dollar and seventy-nine cents per share in the prior year. Furthermore, we strengthened our balance sheet capitalization during the year through the opportunistic issuance of one hundred fifty million dollars of senior unsecured notes at three point three seven five percent, approximately one hundred million dollars in equity proceeds raised through our equity ATM program, and eighty million dollars in SBA debentures on which we are currently drawing. Moreover, in May, we received forty-five million dollars in additional commitments on our ING-led revolving credit facility. This now brings the credit facility commitment to three hundred eighty million dollars. Michael will provide further detail on this later in our prepared remarks. On Slide 7 of the earnings presentation, we have summarized some of the key performance highlights for the fourth quarter of fiscal year. During the quarter, we generated pretax net investment income of fifty cents per share, which more than covered our regular dividend paid during the quarter of forty-eight cents per share. As previously announced, our Board has declared a special dividend of fifteen cents per share for the June quarter, which will be in addition to the forty-eight cents per share regular dividend also declared for the June quarter. This special dividend of fifteen cents per share is a result of another successful equity exit and demonstrates our continued track record of distributing realized gains to our shareholders through special dividends. During the quarter, acquisition and financing activity in the lower middle market continued to be strong, albeit slightly below the record activity we saw in the December 2021 quarter. On a net basis, we were able to grow our investment portfolio by approximately sixty million dollars or six point eight percent to nine hundred thirty-seven million dollars. Portfolio growth during the quarter was driven by one hundred three million dollars in new commitments, consisting of investments in three new portfolio companies totaling fifty million dollars, two refinancing transactions totaling forty-one million dollars, and add-on commitments in eight existing portfolio companies totaling twelve million dollars. This was offset by forty-nine million dollars in proceeds from forward debt prepayments during the quarter. On the capitalization front, we raised twenty-five point two million dollars of equity through our ATM program, at an average price of twenty-four point twenty-seven dollars per share, representing an average of one hundred fifty percent of the prevailing net asset value per share. Additionally, we received approval for an additional forty million dollars of leverage from the FDA, increasing our total average commitment from the SBA to eighty million dollars. As a reminder, the total leverage expected from our current SBIC license is one hundred seventy-five million dollars. On Slide 8 and 9, we illustrate our continued track record of producing steady dividend growth, consistent dividend coverage, and value creation since the launch of our credit strategy. We believe the solid performance of our portfolio and our company's sustained access to the capital markets demonstrate the strength of our investment and capitalization management strategy. Maintenance and growth of both NAV per share and shareholder dividends remain a core tenet of our long-term investment objective of creating long-term value for our shareholders. Turning to Slide 10 and NAV per share. 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 arise. In the overall market, we directly originate and lead opportunities consisting primarily of first lien senior secured loans with smaller equity co-investments made alongside many of our loans. We remained in the quarter, our equity co-investment portfolio consisted of forty-one investments with a fair value of eighty-five point two million dollars, which included twenty-five point one million dollars in embedded unrealized appreciation or approximately one dollar and one cent per share. Our equity portfolio, which represents approximately nine percent of our total portfolio at fair value as of the end of the quarter, continues to provide our shareholders with attractive upside from growing the lower middle market businesses. To illustrate on Slide 11, our on-balance sheet credit portfolio as of the end of the quarter, excluding our I-45 Senior Loan fund grew seven percent to seven hundred ninety-four million dollars, as compared to seven hundred forty-five million dollars as of the end of the prior quarter. For the quarter, one hundred percent of the new portfolio debt originations were first lien senior secured debt. Finally, as of quarter end, ninety-three percent of the credit portfolio was first lien senior secured. On Slide 12, we lay out one hundred thirty million dollars of capital invested and committed to portfolio companies during the quarter. Capital committed this quarter included forty-nine million dollars in first lien senior secured debt committed to three new portfolio companies, including one in which we also invested one million dollars in equity. Finally, during the quarter, we also committed fifty-one million dollars in first lien senior secured debt to nine existing portfolio companies. Turning to Slide 13. We continue our track record of successful exits with four debt investment prepayments. Two of these loan prepayments were refinancings related to acquisitions in which Capital Southwest was able to participate in the new credit facility. In total, these net exits generated over forty-nine million dollars in total proceeds realizing gain of five hundred twelve thousand dollars and generating a weighted average IRR of twelve point nine percent. Since the launch of our credit strategy over seven years ago, we have generated a cumulative weighted average IRR of fourteen point four percent on sixty portfolio exits, representing approximately six hundred ninety-five million dollars in proceeds. As previously mentioned, the market for acquisition and refinancing capital continues to be strong. Our investment pipeline, as we have mentioned on previous calls, remains robust throughout fiscal year 2022 on both volume and quality of deals, and that trend has continued into the June quarter. Given the current activity we are seeing in the market, we expect the June quarter to again be a strong quarter for originations. We are pleased with the strong market position that our team has established in the lower middle market as a premier debt and equity capital partner. On Slide 14, we illustrate some key stats for our on-balance sheet portfolio as of the end of the quarter, again, excluding our I-45 senior loan fund. As of the end of the quarter, the total portfolio fair value was weighted eighty-four point two percent to first lien investments, six percent to second lien, zero point one percent to subordinated debt, and ninety-nine point seven percent to equity co-investments. Turning to Slide 15. We have laid out the rating migration within our portfolio. During the quarter, we had no loans upgraded and one small loan position downgraded from a 2.3. As a reminder, all loans upon origination are initially defined with an investment rating of two on a four-point scale, with one being the highest rating and four being the lowest rate. As of the end of the quarter, we had seventy-one loans representing ninety-five point three percent of our investment portfolio at fair value rated in one of the top two categories, one or two. We had six loans representing four point six percent of the portfolio at fair value rated a three, and one loan representing less than one percent of the portfolio rated at four. During the quarter, we had no new loans placed on non-accrual. As illustrated on Slide 16, our total investment portfolio continues to be well diversified across industries with an asset mix, which provides strong security for our shareholders' capital. The portfolio remains heavily weighted towards first lien senior secured debt, with only six percent of the total portfolio in second lien senior secured debt and only zero point one percent exposure to subordinated debt. Turning to Slide 17, our I-45 fund continued to generate solid performance. As of quarter end, ninety-seven percent of our bio portfolio was invested in first lien senior secured debt. The average EBITDA and leverage across the companies in the I-45 portfolio was seventy-two million dollars and four point two times, respectively. The material decrease in leverage this quarter was due to the exclusion of a loan position in one portfolio company that had negligible fair value in EBITDA. As the stats for each of the December and March quarters excluded this portfolio company, pro forma leverage across the I-45 portfolio would have been four point three times and four point two times in each of the December and March quarters, respectively. The portfolio continues to add diversity among industries at an average hold size of two point four percent of the portfolio. Leverage at the I-45 fund level is currently one point fifty-nine times debt to equity. I will now hand the call over to Michael to review more specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the March quarter, as summarized on slide 18, we earned pretax net income of twelve million dollars or fifty cents per share. We paid out forty-eight cents per share in regular dividends for the quarter, an increase from the forty-seven cents per share paid out in regular dividends in the December quarter. As mentioned earlier, our Board has declared a special dividend of fifteen cents per share for the June quarter, while maintaining the regular dividend for the June quarter at forty-eight cents per share. Maintaining a consistent track record of meaningfully covering our dividend with pretax net investment income is important to our investment strategy. We continue to maintain our strong track record of regular dividend coverage with one hundred five percent for the last twelve months ended March 31, 2022, and one hundred seven percent cumulative since the launch of our credit strategy in January 2015. Our investment portfolio continues to perform well generating seven point seven million dollars in net realized and unrealized gains this quarter, bringing the net realized and unrealized gains on the investment portfolio over the past four quarters to seventeen point three million dollars. As Bowen mentioned, going forward, we intend to distribute special dividends to our shareholders as we monetize the unrealized appreciation in the portfolio. As of March 31, 2022, our estimated UTI balance was forty-seven cents per share. Our investment portfolio produced twenty-one million dollars of investment income this quarter with a weighted average yield on all investments of nine percent. Total investment income was one point three million dollars lower this quarter due primarily to a decrease in one-time fees paid on debt repayments in the December quarter. There continue to be three loans on non-accrual with an aggregate fair value of fourteen million dollars or one point five percent of the investment portfolio as of the end of the quarter. We did not place any new loans on non-accrual during the quarter. The weighted average yield on our credit portfolio was nine point three percent for the quarter. As seen on slide 19, we further improved LTM operating leverage to two point two percent as of the end of the quarter, we are targeting operating leverage to approach two percent or better in the coming quarters. Turning to slide 20, the company's NAV per share as of March 31, 2022, increased four point one percent for the quarter to sixteen dollars and eighty-six cents per share compared to sixteen dollars and nineteen cents per share as of the end of the December quarter. The driver of the NAV per share increase was due to the strong performance of the investment portfolio coupled with the accretion from our equity ATM program. Turning to slide 21, we are pleased to report that our balance sheet liquidity continues to be strong with approximately one hundred seventy-eight million dollars in cash and undrawn leverage commitments as of the end of the quarter. As Bowen mentioned earlier in early May, we received broad support from our lender group, which increased commitments on our ING-led senior security facility by forty-five million dollars, bringing total commitments to three hundred eighty million dollars. Our bank syndicate continues to support our growth, and we are pleased with the flexibility the increased revolving credit facility provides to our capital structure. In addition, we continue to draw debentures in our SBIC subsidiary as we originate SBIC-eligible assets. As of the end of the quarter, we had drawn forty million dollars in debentures, with an average capital cost of two point six percent. Our current commitment from the SBA is eighty million dollars, which we fully expect will increase over time to the maximum underwrite license of one hundred seventy-five million dollars as we continue our participation in the SBIC program. As of March 31, 2022, approximately fifty-four percent of our capital structure liabilities were unsecured, and our earliest debt maturity is in January of 2026. Our regulatory leverage, as seen on Slide 22, ended the quarter at a debt-to-equity ratio of one point six to one. Turning to slide 26, our balance sheet is well positioned to benefit from rising interest rates. Short-term interest rates have increased significantly with LIBOR increasing from twenty-one basis points at the end of December to ninety-six basis points at the end of March. And as of yesterday, LIBOR is approximately one hundred fifty basis points. The weighted average floor on our investments is approximately one percent, with the short-term rates exceeding the floor on our investments; this will have a positive impact on net investment income. Based on quarter end rates, we estimate a fifty basis point and a one hundred fifty basis point increase in reference rates would result in an annual increase of approximately ten cents and thirty-three cents per share. 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 continues to perform well and consistent with the original vision and strategy we communicated to our shareholders when we began this journey. We have been underwriting with a full economic cycle mentality since day one, which we believe has prepared us well for any environment presented to us in the coming months and years. I continue to be impressed by the job our team has done in building a robust asset base, deal origination capability, as well as a flexible capital structure. We believe that our performance continues to demonstrate the investment acumen of our team at Capital Southwest and our commitment to a first-lien senior secured debt strategy. We feel very good about the health and positioning of our company and portfolio, and we are excited to continue to execute our investment strategy going forward. Everyone here at Capital Southwest is fully 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 concludes our prepared remarks. Operator, we are ready to open the lines for Q&A.

Our first question comes from Mickey Schleien with Ladenburg.

Yes. Good morning, Bowen. We're experiencing macro headwinds that we have been seeing for a long time. And obviously, you have a lot of factors to consider; are you seeing defaults and non-accruals ahead over the next couple of years?

Yes, it's difficult to predict, Mickey. We've been in this position for a while. When we took over the BDC seven years ago, we were concerned about a recession, and we've prepared for the possibility of increased defaults in our portfolio. We've structured a debt portfolio that is designed to perform well even in severe economic downturns. While it's challenging to predict specific numbers, our portfolio has performed strongly over the full economic cycle. We typically underwrite deals with a loan-to-value ratio of thirty to fifty percent, and the majority of our portfolio consists of sponsor-backed deals. The sponsor community currently has ample liquidity. Therefore, when I consider a portfolio that is set to generate dividends for the shareholders, including us, I feel optimistic about that.

Thanks for that, Bowen.

It’s not a specific answer to your question on a prediction. But we've again been worried about recession or making sure we have a portfolio that could withstand a recession since the beginning.

I understand.

On the dividend side, the other way that we plan for this is obviously to maintain that dividend coverage that's conservative as we've done. I think we keep noting each period that we're at one hundred seven percent dividend coverage since we began this and one hundred five percent, I believe in the last year. So, I think it will be important for us to continue to have enough cushion as we move through this and see how severe a recession could be to ensure that our dividend is conservative, respective of what the environment might look like.

I understand, Michael. I appreciate that. Thank you. When we look at the forward LIBOR and SOFR curves, they're obviously very steep, and that implies nominal rates on the debt investments you've made could go up fairly sharply over the next year or so. So how do you see that trend affecting your borrowers in terms of their appetite for capital and their ability to service their existing debt?

We evaluate this at least every quarter. It begins with the underwriting leverage applied to companies, which needs to be suitable for the potential volatility in specific industries. Our portfolio's weighted average fixed charge coverage is just over three times. If SOFR were to increase by two hundred basis points, that coverage would decrease to about two point four times, and if it increased by three hundred basis points, it would go down to about two point two times. These figures are quite solid, which assures me that even with a significant rise in interest rates, our portfolio would maintain about two point two times coverage of fixed charges.

That's interesting, Bowen. And that's obviously assuming everything else remains equal, right?

That's correct. If the economy begins to slow, we may see more defaults. A covenant default to a first lien lender doesn't necessarily indicate a crisis. It means we will impose additional costs on those loans, whether through fees or other means. However, in a slowing economy, we can expect to see more activity in the portfolio.

Of course. Bowen, when we think about those rising interest rates, that could provide a big tailwind to you and to other PTCs since most portfolios are floating rates. How much of that increase in short-term rates do you think the lenders will keep versus perhaps passing some of that through to the borrowers as spread compression to help support them?

Yes, that's a good question. I've been doing this for a while, and I would say that when rates start to increase, lenders generally tend to give back some of that increase in the index through the spread. However, I believe that most of the increase in the index will remain with the lenders. Our job is to minimize how much we lose in that process, but it is a dynamic that occurs. If we consider our capital structure, more than fifty percent of our liabilities are in fixed-rate notes, while our assets are all floating rate. Therefore, we are fairly well positioned for rising interest rates. You are correct that the lending industry tends to adjust the spread as the index rises, but at the end of the day, our focus is on net interest margin. We need to minimize the impact of that dynamic, but it has historically been the case at the margins.

Yes, I agree with that. My last question, sort of housekeeping maybe for Michael. Could you just give us what the main drivers were of the realized and unrealized gains this quarter?

The depreciation of six point three million dollars was related to the equity portfolio. We had at least three portfolio companies on the equity side that had significant increases and were loan grade one. Additionally, debt increased by about one point four million dollars for the quarter, which was quite detailed. From a broader perspective, our companies experienced revenue growth, and we also saw growth in EBITDA despite higher labor and transportation costs. Overall, while EBITDA margins might have slightly decreased, the portfolio performed strongly on an individual basis.

One of the things, Mickey, I thought was encouraging this quarter was that across our equity portfolio, the equity co-investment portfolio, market multiples were down slightly, but our portfolio appreciated. And so that was a really fundamental performance across that equity book as opposed to just market multiples expanding. So that was a healthy group of companies.

Yes. That's helpful. I appreciate your time this morning. Thank you for taking my questions.

Thanks, Mickey.

Our next question comes from Kevin Fultz with JMP Securities.

Hi. Good morning and thank you for taking my questions. I'd like to start with a question on leverage. Regulatory leverage was one point sixteen times at quarter end. Can you just remind us what your target leverage range is? And then also, could you talk about your target leverage range has shifted at all recently, given the current market backdrop?

Sure. In the past, we've stated that our economic leverage target is between 1.2 and 1.4, while our regulatory target is between 1.0 and 1.2. We are currently positioned in the middle of those ranges. However, we are aware of the current economic climate. With this in mind, we aim to stay towards the middle to the lower end of those ranges as we possibly enter a recession. To achieve this, we plan to fully utilize our ATM like we have before, as we want to avoid being in a situation where we have to raise equity to reduce leverage. Therefore, we will likely take a more conservative approach and aim for a range of 1.2 to 1.25 for economic leverage, and about 1.1 to 1.15 for regulatory leverage.

Okay. That makes sense, Michael. And then just in regards to portfolio positioning, just curious if there are any pockets or industries that you find attractive in the current climate?

Certainly. I've been emphasizing the importance of a recession-aware, full-cycle underwriting mentality for years. If we look at the deals we've completed in the last quarter, we have American Not, a food-related business, and American Thrift Store, a thrift retailer managing supply chain parts like small screws and bolts for manufacturing. We also have air conditioning specialists, an HVAC service company that services residential AC units. These industries are characterized by their low cyclicality. Our focus is on stable industries with high cash flow margins that are not heavily influenced by discretionary spending and are less susceptible to economic fluctuations. For example, National Credit Care operates in a counter-cyclical industry. This consistent theme is evident in our deals, reflecting our approach to the current market conditions.

Okay. Thanks Bowen. That's helpful. And then just one more follow-up on Mickey's question. You had some pretty nice unrealized gains on equity and debt investments in the quarter. That's kind of the opposite of what we saw in the public markets and other BDC portfolios in the March quarter. Just curious, in the equity portfolio, were the unrealized gains primarily in a handful of equity securities or was that kind of spread across the portfolio?

Yes. I would say there are definitely a few companies that stood out positively. We observed a fairly broad range of performance throughout the portfolio, but there were certainly a few standout performers. This is generally what we see in an equity portfolio. However, I am encouraged by the overall growth in our equity portfolio, where EBITDA increased, despite market multiples declining, as we've all seen reflected in the public markets.

Okay. I appreciate the color there and I’ll leave it there. Congratulations on the nice quarter.

Thank you.

Our next question comes from Kyle Joseph with Jefferies.

Hey, good morning guys. Thanks for taking my questions. Most have been answered. But we talked about kind of the rising rate environment impact on demand for middle market credit. Can you go to the kind of maybe the other side of the spectrum and talk about how you see rising rates impacting competition in the overall supply of credit to the middle market?

That's a good question. I don't expect the supply from our competitors or the availability of capital to change significantly. The market is competitive now, it was competitive yesterday, and it will continue to be competitive. The private equity community is quite dynamic, and there is a lot of conversation about potential recessions. The sensitivity to these recessions is definitely heightened, and the market has been aware of this for some time. As lenders consider the possibility of recessions and try to underwrite during such times, it usually leads to increased conservatism throughout the industry. However, I don’t see the overall amount of capital changing. What I do notice is that the mentality of both lenders and sponsors is becoming more sensitive to recession concerns as they plan their investments.

From a competitor's perspective, it's going to depend on their overall health of their portfolio and the leverage they have going into a cycle whether they're going to be able to be aggressive in finding unique opportunities, which is what you tend to see in a down market.

Got it. Very helpful. Thanks for answering my questions.

You bet.

Our next question comes from Bryce Rowe with Hovde.

Thanks. Good morning. I wanted to maybe start on your commentary around the pipeline; it feels like you’ve got another healthy quarter coming. For the June quarter, we're two-thirds of the way through, maybe you could speak to what you're seeing kind of from the terms or pricing perspective with some of the shifting market dynamics that we've seen over the last few months?

Yes. From a volume standpoint, everything is down compared to the December quarter of last year, which was quite busy. However, the June quarter is comparable to the March quarter in terms of general activity. Pricing and terms have remained relatively consistent; there hasn't been a significant difference between the quarters. While there are variations between deals, overall, we haven't observed a notable change in pricing or terms. In the oral middle market, we continue to acquire strong covenants, first lien, and lower LTV cash flow businesses, and this has been consistent in the June quarter compared to the March quarter.

That's helpful, Bowen. And you've obviously had some monetizations, exits; are you still seeing some opportunity for that here, or do you expect that activity to slow down?

Well, I mean, again, kind of follows the market activity. So the market activity in the December quarter was obviously really high. Prepayments were high, but into this year, they kind of have slowed down a little bit. I can’t give comment on specific deal. I mean, I don’t think.

It definitely slowed down. But what I would say, just looking down for the next six to twelve months, some of the loan grade ones that are performing extremely well, those are always possibilities for repayment sort of exits. And I think if you look to our history, since 2016, we've had a large exit that we were able to provide a supplemental dividend or special dividend in every year since. So looking at that list, we would think that there’s a high likelihood that there could be an exit before the end of the year.

And I think that's a fair comment. I mean, if you look at those names, if I was an owner of some of those businesses, I'd certainly be considering a sale. I mean, given the extreme outperformance of some of these names. So no line of sight on any particular one at the moment, but certainly not unreasonable; I think we would see something by the end of the year.

Okay. Maybe a couple of housekeeping questions for me. From access to future SBA draws, is that something Michael that you guys can access here now, or I seem to remember there being a review by the SBA now that you hit that first year?

Yes, that's correct. We received our review at the midpoint of the year, which was for forty million dollars, and we have since surpassed that. Currently, we have access to eighty million dollars. By the end of this quarter, we had utilized forty million dollars. The activity this quarter appears strong, and several of the deals we are considering qualify for SBIC. We expect to be close to eighty million by the end of the June quarter or into July. Therefore, we plan to approach the SBA again in the summer for additional leverage commitment.

Okay. Okay. That's helpful. And then maybe one more around I-45. It looks like the dividend that came into the BDC from I-45 was up. Is this a good run rate? Anything kind of driving that that might cause that to fall back down?

Honestly, it was a strong quarter. We did see, I would tell you, towards the end of the quarter some exits in I-45. And then we're ramping that back up right now more late-stage, so I would say that number is coming down a bit, but it's not going to be too far off.

Okay. Okay, great. Thank you.

Our next question comes from Robert Dodd with Raymond James.

Thank you. Congratulations on the quarter. I want to discuss the special dividends. The spillover is currently forty-seven cents. Over the past year, you have distributed a significant amount of special dividends to shareholders, which has been quite beneficial for them. Is the intention to stabilize the spillover and primarily distribute any over-earnings when there is a realized gain? Or will you continue to focus on over-earning the dividend based on net investment income? If interest rates increase, it seems there is additional earning potential as well. Is there a possibility of implementing a plan to regularly distribute any over-earnings each quarter to manage the spillover and avoid the excise tax? Can you provide any insights on this matter?

Sure. So honestly, that is what we have been doing. Our balance was quite high; back in the MRI days, we had over a dollar in UTI and they were paying significant excise tax. We reduced that through the supplemental dividend program. This fifteen cents was related to an exit of one of our equity portfolio companies that generated this distribution that we are now paying out. It brings our UTI balance down to approximately thirty to thirty-two cents, and we believe we should be around twenty to thirty cents. We aim to maintain that balance moving forward, and we expect that normal activities will support it. Additionally, we noted we have about twenty-five million dollars of unrealized appreciation, so we anticipate exits that will produce gains, leading to special distributions in the future, while keeping the UTI balance between twenty and thirty cents.

I appreciate that. Thank you. I have one more question regarding the information you provided about revenues and EBITDA both increasing, while margins slightly decreased. I don't see that as a significant concern. Were there any areas within the portfolio, not necessarily linked to specific businesses, where you experienced margin compression that might have surprised you? Clearly, labor costs and raw material prices have risen, but were there any other unexpected factors?

Labor and material costs have risen significantly. Fortunately, in an inflationary environment, companies find it easier to approach customers and raise prices, as this is often expected. However, the supply chain issues also bring challenges, not just in costs but in obtaining inputs. We have observed some companies using working capital to pre-purchase and build up their inventory, which essentially results in a cash flow margin impact. While this was somewhat anticipated, given ongoing supply chain disruptions, it remains an important factor affecting companies across the economy as they stock up to ensure input availability.

Has that contributed to the strength of the pipeline in terms of whether it’s just a marginal impact, with some using working capital, or is it more widespread and common across the portfolio?

No, our pipeline is not primarily focused on working capital deals; we do have revolvers across our portfolio. Some of these revolvers may have been influenced by certain factors. The pipeline mainly consists of founder-owned businesses that are either selling or diversifying their holdings as they progress in their business life cycle. These are private equity transactions that present an interesting opportunity, as they allow founders to reinvest a portion of their proceeds into the company, remaining involved while also diversifying their assets. With the pandemic behind us and the economy presenting some challenges, there are individuals who may not have been quite ready to sell but are now considering the option to reduce their stakes. This has created an opportunity for private equity to invest in these companies. Therefore, the overall dynamic remains intact. This is not solely about seeking working capital; rather, it leans more towards M&A transactions.

Got it. Thanks, that makes sense. You had twelve million dollars in add-ons this quarter. If I can ask, when underwriting, you typically prepare for the possibility of a recession occurring during the loan's duration. What is your assessment of the quality of the additional knowledge you have about borrowers? Considering the COVID situation and the performance of the new portfolio, which successfully navigated COVID along with supply chain disruptions and economic challenges, how does the financial information you possess about borrowers compare to what you had during the financial crisis over a decade ago? Does this give you more confidence in borrowers' ability to endure potential economic challenges in the coming years, or do you believe the uniqueness of COVID makes it difficult to draw conclusions about their survivability or success in the face of a typical recession, should one arise?

There are several aspects to consider. The stress from COVID did cause a slowdown in business. Regardless of whether this slowdown is due to a recession, COVID, or other factors, it reveals how well companies manage their business models during economic stresses. COVID was unique in that it was a sudden decline but thankfully didn't result in prolonged economic issues. The COVID situation has highlighted interesting dynamics; we have seen various business models in new deals and some in our portfolio that actually benefited from COVID in terms of EBITDA. Essentially, they provided products or services that were more in demand during the pandemic than prior. As we evaluate deals now, we're considering not only the potential downsides but also whether any increase in EBITDA stems from a temporary COVID surge, which could affect longevity. Generally, we observe that while some businesses experienced significant EBITDA growth for specific reasons, many others faced declines during COVID. From a broader perspective, assessing the portfolio under stress is helpful. It's reassuring to see our borrowers withstand economic pressures, which is a positive indicator. However, many of these companies were not adequately prepared for repayment during difficult times. Overall, while the Great Recession was a long time ago, having a more recent stressor like COVID and seeing the portfolio perform well is definitely a positive sign for us.

On the liquidity side, Robert, we observed that despite having access to seamless money, about one-third of our portfolio companies utilized the revolver and subsequently repaid it, with nearly all doing so within one month to a month and a half. This gives an insight into how they manage during a recessionary environment.

Got it. Thank you.

And I'm not showing any further questions at this time. I'd like to turn the call back to Bowen for any closing remarks.

All right. Well, thanks, everybody. Thanks for joining us. I appreciate your time, and we look forward to giving you further updates as we go forward.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.