Capital Southwest Corp Q3 FY2023 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'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 2023 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. You will also find our quarterly earnings press release issued last evening on our website. We'll begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we generated a pretax net investment income of $0.60 per share, which represented an 11% growth over the $0.54 per share generated in the prior quarter, and 18% growth over the $0.51 per share generated a year ago in the December quarter. The $0.60 per share earned a regular dividend paid during the quarter of $0.52 per share, while also covering the supplemental dividend paid during the December quarter of $0.05 per share. We are also pleased to announce today that our Board has declared another $0.01 per share increase in our regular dividend to $0.53 per share for the quarter ending March 31, 2023. This increase represents 1.9% growth over the $0.52 per share paid in the December quarter and 10% growth over the $0.48 per share paid a year ago in the March quarter. These increases in our regular dividend are a result of the increased fundamental earnings power of our portfolio, given its growth and performance as well as improvements in our operating leverage. In addition, due to the continued excess earnings being generated by our floating rate debt investment portfolio, our Board of Directors has again declared a supplemental dividend of $0.05 per share for the March quarter, bringing total dividends declared for the March 2023 quarter to $0.58 per share. While future dividend declarations are at the discretion of our Board of Directors, it is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future, while base rates remain materially above long-term historical averages. Finally, I should note that as we have done in the past, we intend to also distribute additional supplemental dividends as we harvest realized gains from our equity co-investment portfolio. During the quarter, we saw strong deal activity in the lower middle market, primarily focused on acquisitions rather than refinancings. The environment during the quarter was favorable for a first lien lender like Capital Southwest. We saw average spreads that were 50 to 100 basis points wider than a year ago with leverage levels on our new platform deals that were lower by a full turn of EBITDA. Interestingly, loan-to-value levels on new deals, calculated as our first lien loan divided by the enterprise value being paid for an acquisition, were also down meaningfully. This suggests that multiples being paid for strong companies remained robust. Portfolio growth during the quarter was driven by $164 million in new commitments, consisting of commitments to 5 new portfolio companies totaling $122.4 million and add-on commitments to 12 existing portfolio companies totaling $41.6 million. This was offset by $12.4 million in proceeds from one debt prepayment and warrant equity sales during the quarter. On the capitalization front, we raised a total of $104.3 million in gross equity proceeds during the quarter at a weighted average price of $17.99 per share or 109% of the prevailing NAV per share. Our liquidity remains robust with approximately $196 million in cash and undrawn capital commitments as of the end of the quarter. We have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issuances as we think it is critical that we maintain a conservative mindset to BDC leverage given the uncertainty of the economy. As we've said many times, we manage our BDC with a full economic cycle mentality. This starts with the underwriting of our new opportunities, but it also applies to how we manage the BDC's capitalization. Managing leverage to the lower end of our target range positions us to invest throughout a potential recession when risk-adjusted returns can be particularly attractive. It also allows us to support our portfolio of companies while also opportunistically repurchasing our stock if it were to trade meaningfully below NAV. Within this context, we are very pleased with the strength of our balance sheet as we reduced regulatory leverage to 0.91:1 from 1.11:1 in the prior quarter. We maintained our significant liquidity position, and we continue to operate with almost half of our balance sheet liabilities in fixed rate unsecured covenant-free bonds, the earliest of which mature in 2026. On Slides 7 and 8, we illustrate our continued track record of producing strong dividend growth, consistent dividend coverage and solid value creation since the launch of our credit strategy back in January of 2015. Since that time, we have increased our regular dividend paid to shareholders 25 times and have never cut the regular dividend, including during the tumultuous environment we all experienced during the COVID pandemic. Additionally, over the same time period, we have paid or declared 19 special or supplemental dividends totaling $3.60 per share, generated from excess earnings and realized gains from our investment portfolio. We believe our track record of consistently growing our dividend, the solid performance of our portfolio as well as our company's sustained access to the capital markets has demonstrated the strength of our investment and capitalization management strategies as well as the absolute alignment of our decisions with the interest of our shareholders. Continuing to generate this strong track record, we believe, is critically important to building long-term shareholder value. Turning to Slide 9. Our investment strategy is laid out for our shareholders and its launch back in January 2015 hasn't changed. The vast majority of our activity has been in our core lower middle market where we are the first lien senior secured lender, most often backing a private equity firm's acquisition of a growing lower middle market company. We also often participate on a minority basis in the equity of the company through an equity co-investment made alongside the private equity firm. In fact, 90% of our portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio of companies as well as the potential for new junior capital support if needed. Our lower middle market strategy is complemented by core participations in larger companies led by like-minded lenders with whom we have relationships and have gained confidence in their post-closing loan management from working well together across multiple deals. Virtually all of these club deals are also backed by private equity firms. As of the end of the quarter, our equity co-investment portfolio consisted of 48 investments with a total fair value of $112.1 million, which was 60% over our cost, representing $41.8 million in embedded unrealized appreciation or $1.21 per share. Our equity portfolio, which represented approximately 10% of our total portfolio at fair value as of the end of the quarter, continues to provide our shareholders participation in attractive upside potential of these growing lower middle market businesses, which will come in the form of NAV per share and supplemental dividends over time. As illustrated on Slide 10, our on-balance sheet credit portfolio for the quarter, excluding our I-45 senior loan fund, grew 10% to $990 million as compared to $903 million as of the end of the prior quarter. Over the past year, our credit portfolio has grown by $245 million or 33% from $745 million as of the end of December 2021 quarter. For the current quarter, 99.7% of our new portfolio company debt originations were first lien senior secured debt. And as of the end of the quarter, 96% of our total credit portfolio was first lien senior secured. On Slides 11 and 12, we detail the $164 million of capital invested at and committed to portfolio companies during the quarter. Capital committed this quarter included $120.4 million in first lien senior secured debt and $1.6 million in equity co-investments to 5 new portfolio companies. Additionally, we committed $39.7 million in first lien senior secured debt and $1.9 million in equity co-investments to existing portfolio companies during the quarter. Turning to Slide 13. During the quarter, we had 1 debt prepayment and 1 equity sale. In total, these exits generated approximately $12.4 million in total proceeds, generating a weighted average IRR of 10.1%. Since the launch of our credit strategy 8 years ago, we have realized 67 portfolio exits, representing $775 million in proceeds that have generated a cumulative weighted average IRR of 14.6%. The market for acquisition capital continues to be active. Not surprisingly, given the widening spreads on new loans in the market, the slowdown in refinancing activity continues. So on a net basis, we expect solid net portfolio growth in the near term. 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 provider, as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities. In terms of deal origination, we find that underwriting certain industries is more challenging given today's economic uncertainty. However, an important component of our underwriting has always been to run a stress case downside model for every new deal, simulating an extreme recession occurring soon after closing. In many respects, our underwriting in the current environment hasn't changed, although our models today include much higher base rates than we have experienced historically. Our fundamental analysis ties to a leverage level we are willing to put on a company to the potential performance volatility in a particular business and industry throughout the economic cycle. Performance across different industries can be very different through the economic cycle. So getting this right is an important component of the underwriting process. Specifically, in a stress case financial model, we required a fundamental underwriting standard that we see our loans remain well within the portfolio of the company's enterprise value and the portfolio of the company's cash flow able to cover our loan interest throughout the cycle. On Slide 14, we detail 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 at fair value was weighted approximately 87% to first lien senior secured debt, 3.2% to second lien senior secured debt, 0.1% to subordinated debt and 10.2% to equity co-investments. The credit portfolio had a weighted average yield of 12% and weighted average leverage through our security of 3.6x. The weighted average leverage this quarter was down from 4.1x in the prior quarter due in part to $67.3 million of funded debt originations to 5 new portfolio companies and a weighted average leverage through our security of 1.9x EBITDA. Turning to Slide 15, we have laid out the rating migration within our portfolio. 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 rate. We feel very good about the performance of our portfolio, with 95% of the portfolio at fair value rated in one of the top two categories, a 1 or 2. As illustrated on Slide 16, our total investment portfolio, including our I-45 senior loan fund 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 3% of the total portfolio in second lien senior secured debt. I will now hand the call over to Michael to review some specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the December quarter, let's summarize on Slide 18, we increased pretax net investment income 25% quarter-over-quarter to $18.7 million compared to $15 million last quarter. Pretax NII was $0.60 per share for the quarter. During the quarter, we paid out a $0.52 per share regular dividend and a $0.05 per share supplemental dividend. As mentioned earlier, our board has approved an increase to the regular dividend for the March quarter to $0.53 per share and declared another $0.05 per share supplemental dividend for the quarter, maintaining a consistent track record, meaningfully covering our dividend with pretax NII, is important to our investment strategy. We continue our strong track record of regular dividend coverage with 108% for the last 12 months ended December 31, 2022, and 107% cumulative since the launch of our credit strategy in January 2015. Given the floating rate nature of our credit portfolio, elevated interest rates continue to be a significant tailwind to our net investment income. The base rate index used to calculate interest on a majority of our loans reset in early January to 4.75%, up from its early October reset at 3.75%. This significant increase quarter-over-quarter will provide another immediate step-up in portfolio income in the March quarter. With that as context, we will continue to execute our policy of having regular dividends follow the trajectory of recurring pretax NII per share. As such, we expect to thoughtfully increase our regular dividend to a level which can be sustained should base rates return to a neutral level. In addition, while base rates remain elevated, our intent is to distribute a portion of excess pretax NII to our shareholders each quarter through supplemental dividends. Based upon our current UTI balance of $0.34 per share, the ability to grow UTI each quarter organically by over earning our dividend and harvesting gains from our existing $1.21 per share in unrealized depreciation on the equity portfolio, we are confident in our ability to continue to distribute quarterly supplemental dividends for the foreseeable future. For the quarter, we increased total investment income from our portfolio by 22% quarter-over-quarter to $32.8 million, producing a weighted average yield on all investments of 11.7%. Total investment income was $6 million higher this quarter due to a higher average balance of credit investments outstanding, in addition to the tailwind provided from increases in LIBOR and silver base rates. As of the end of the quarter, we had approximately $4 million of our investments on nonaccrual and representing 0.3% of our investment portfolio at fair value. Finally, the weighted average yield on our loan portfolio was 12% for the quarter. As seen on Slide 19, we further improved LTM operating leverage to 1.9% as of the end of the quarter. Achieving 2% or lower operating leverage was one of our initial long-term goals when we relaunched Capital Southwest as a middle market lender back in 2015. Though we are pleased to have reached this milestone. Looking ahead, we expect our internally managed structure to produce additional improvements in operating leverage. Turning to Slide 20. The company's NAV per share at the end of the December quarter decreased by $0.28 per share to $16.25, representing a decrease of 1.4% before giving effect to the supplemental dividend paid for the quarter. The primary drivers of the NAV per share decrease for the quarter included $8.5 million of net unrealized depreciation on the on-balance sheet debt portfolio, $1.2 million of unrealized depreciation on the equity portfolio, and $3.3 million of unrealized depreciation on the I-45 portfolio, the vast majority of which was mark-to-market quote activity in the syndicated market. We also generated a total of $0.17 per share of accretion from the issuance of common stock at a premium to NAV per share. Turning to Slide 21. As Bowen mentioned earlier, we are pleased to report that our balance sheet liquidity remains strong with approximately $196 million in cash and undrawn leverage commitments on our revolving credit facility as of the end of the quarter. Based on our credit facility borrowing base as of the end of the quarter, we have full access to the incremental revolver capacity and look to opportunistically increase commitments to the facility in the future. Our bank syndicate continues to support our growth, and we're pleased with the flexibility in the revolving credit facility provides to our capital structure. In addition, we have $26 million in committed, but unfunded SBA debentures to be used to fund future SBIC-eligible investments. As of December 31, 2022, approximately 47% of our capital structure liabilities were unsecured and our earliest debt maturity is in January 2026. Our regulatory leverage, as seen on Slide 21, ended the quarter at a debt-to-equity ratio of 0.91:1 down significantly from 1.23:1 as of December 2021 quarter. Over the past couple of years, we've made a concerted effort to strengthen our balance sheet to ensure we are prepared for any macroeconomic headwind we may encounter. These efforts have included our opportunistic unsecured bond issuances at record low rates in late calendar 2021, our continued support from banking relationships, which have allowed for steady growth in our revolving facility commitments, and our continued diligence in moderating leverage through accretive equity issuance utilizing both our ATM program as well as the secondary equity market. We'll continue to work towards strengthening the balance sheet, ensuring adequate liquidity, and maintaining conservative leverage in covenant cushions throughout the economic cycle. I will now hand the call back to Bowen for some final comments.

Thanks, Michael. And again, thank you, everyone, for joining us today. We appreciate the opportunity to provide you an update on our business, our portfolio, and the market environment. Our company and portfolio continue to perform well, and 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. As to the uncertainty in the economy, again, we have been underwriting with a full economic cycle mentality since day one, which we believe has positioned us well for the potential economic volatility in the coming months and years. In summary, we have a floating rate credit portfolio heavily weighted to first lien senior secured debt allocated across a broader array of companies and industries, 90% of which is backed by private equity firms. We have a well-capitalized balance sheet with diverse capital sources, strong liquidity, and flexible capital, much of which is fixed rate and covenant light. We believe our first lien senior secured investment focus and our capitalization strategy provide us complete confidence in the positioning of our company and our portfolio as we look ahead. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

And our first question comes from the line of Mickey Schleien with Ladenburg.

Yes. Good morning, everyone. Bowen, in the fourth quarter, we continue to see spreads in the middle market widen a little bit more, which is obviously helpful for your company's financial performance. So I'd like to ask you, what's your outlook on how private lenders will behave going forward this year in terms of spread when we think about the fact that LIBOR and so forth have already climbed a lot and that stresses borrowers? And what types of floors are you getting nowadays?

Thank you, Mickey. I'll address your questions in reverse order. We are consistently getting 2% floors on the loans. Regarding the market, spreads have indeed widened, as mentioned in our prepared remarks, and we are seeing lower leverage levels, which is favorable. This is a good time to be a first lien lender. As for the future of spreads in the market, that's an interesting question. Historically, the lending market tends to react positively to increased indices by slightly widening spreads, typically by around 25 to 50 basis points. It's uncertain if this will happen this time, but there appears to be substantial liquidity in the private equity market, and the pipeline looks solid. Traditionally, there have been trade-offs between spreads and indices, but currently, we don't observe that.

Appreciate that. And Bowen, the portfolio's average debt-to-EBITDA declined quite a bit this quarter. I think you mentioned that some of that was due to new investments at lower multiples. But we've also seen data that somewhat surprisingly middle market company EBITDA growth on average rebounded pretty nicely in the fourth quarter. So could you give us a sense of how your portfolio's companies are performing in terms of their revenues and margins?

We had two factors that contributed to the lower ratio. One was what I mentioned earlier. The other was that we had a few companies with very low EBITDA, leading to high leverage ratios, and their EBITDA shifted from slightly positive to slightly negative. This change significantly impacted the credit picture, as these companies had a high multiple when EBITDA was positive. Once it turned slightly negative, it was difficult to calculate that on average. As a result, some of these high leverage companies influenced the overall average downward. However, if we exclude those, leverage improved from 4.1x to 3.9x. Across the portfolio, our weighted average EBITDA remained flat, even though revenue increased. Overall, while some companies performed well, the overall EBITDA was essentially flat for the quarter.

Our revenue continues to grow, but at a slower pace than in previous quarters. We believe we may be reaching a peak regarding inflationary effects on costs, though that is yet to be confirmed. This situation has resulted in relatively high figures while our EBITDA has remained flat, despite the increase in revenue.

I understand. That leads into my next question. You have several investments in the consumer sector, as indicated in the SOI. We are observing that consumers are beginning to pull back. Can you provide some insights into the performance of your consumer-related investments and your outlook for them this year?

Yes. In the consumer sector, we've noticed some instances where revenue has slowed down. In some cases, retailers have adjusted their inventory levels based on expected sales. This means that in the short term, if you're selling to these retailers, your revenue may decrease. However, if you examine the sell-through rates, it's reasonable to conclude that revenue won't remain low for long and won't drop significantly. Regarding the first lien lender, there may not be major credit concerns, but in terms of economic indicators for the U.S. economy or consumer, I would categorize that in line with your observations about the U.S. consumer. However, for most of these cases, we don't have equity investments. While there isn't significant credit concern, we are definitely seeing mixed signals.

Okay. I appreciate and understand. One last question, if I can. With this quarter's deleveraging of the balance sheet, I'd like to ask whether you've adjusted your leverage targets? And if not, where do they stand both on a total and regulatory basis?

Historically, we anticipated that once the FDA was fully operational, our regulatory leverage would fall between 0.9 and 1.1. Currently, we are at the lower end of that range. As we look towards a potential cycle, we'd like to reduce our leverage, but if there are concerns, we may need to increase it somewhat due to depreciation. We aimed to be proactive in this regard. Moving forward, we expect to remain within the 0.9 to 1.1 range. Economically, we are at 1.1, which aligns with the 1.1% to 1.3% range we previously discussed, and we anticipate fluctuating within that range.

Yes. I mean, obviously, as I tried to address in the prepared remarks, I mean, it's through a cycle, you kind of want to be at the lower end of your range going into a recession. And if we don't have a recession for some natural reason, then that's great. We're fine. But if we do, you want to maintain the ability to invest throughout the recession because risk-adjusted returns, especially in the second half of the recession, can become really interesting based on past cycles, and then, obviously, we mentioned stock buybacks as well. So we want to be able to manage as we've always had a full cycle mentality. We want to be able to position the ship, if you will, to really perform and do well for the shareholders throughout the cycle.

And our next question comes from the line of Kevin Fultz with JMP Securities.

My first question is on credit. I'm just curious if you've seen an increase in amendment requests and if you can discuss your expectations for that to potentially pick up in the near term?

Yes. We had 2 for the quarter. I would say it's increased slightly, but not really a lot. I mean it's not zero, but it's kind of they've been requests candidly. When a first lien lender gets a request for an amendment we get a fee. So it's a nice dynamic of a first lien lender book. So it's part of our business to have those amendments, but I wouldn't say there has definitely not been a flood of increase of amendments, but there's been some increase.

Okay. That's helpful. And then just in regards to portfolio positioning, are there any pockets of industries that you find particularly attractive in the current environment? And if you can, maybe parsing out lower middle market and upper middle market opportunities?

Yes. I mean the vast majority that we've been doing is in the lower middle market, I would say businesses, first and foremost, that we can underwrite a full cycle. We've been looking at certain situations at high asset coverage. Basically, the industries that have like higher free cash flow margins, recurring revenue subscription-type businesses that have shown to be low churn in past cycles. I mean those are the kind of sectors that certainly we look to in this market.

And our next question comes from the line of Bryce Rowe with B. Riley.

Thank you very much. I wanted to start with the dividend. It’s great to see another quarter of increase here, and it sounds like you're approaching these regular dividend increases in a methodical way. You mentioned in your prepared remarks a cautious approach regarding the dividend and earnings when rates reach a neutral level. Could you share your thoughts on what that neutral level might be and how it relates to a neutral net interest income generation level?

Yes, Bryce, looking specifically at this quarter, we reported earnings of $0.60. Assuming rates were neutral, which I would define as 3%, the run rate on the portfolio would be around $0.56 per share. When comparing this to the dividend we paid this quarter of $0.52, there's still a cushion of $0.04. As we progress and grow the portfolio, as mentioned earlier, we expect that operating leverage will continue to decrease, allowing the $0.56 target to increase. Therefore, while we intend to grow the dividend steadily, we believe that between now and the high 50s, the regular dividend remains secure.

Got it. That's helpful, Michael. You mentioned that most of your loans will reset in January at possibly 100 basis points higher based on current base rates. Do you expect to see around 100 basis points of weighted average yield expansion in the portfolio as we approach April or May when you report earnings next?

Yes. We would expect that on the revenue side. I would just say that the one overhang you'll also see is obviously, we raised a lot of capital in the prior quarter and much of that was late stage. So there will be some level of dilution that will offset that increase on the top line revenue. So we will expect to see growth meaningfully next quarter, but there will be a little bit of an overhang.

Okay. That's helpful. Can you discuss the quarterly marks? You mentioned the broader credit market-driven marks on the I-45 portfolio, including the $1.2 million of unrealized depreciation on the equity book. Can you explain some of the factors affecting that? I assume you are experiencing both appreciation and depreciation in that area?

Yes. If I look at the equity markets, we had one or two companies that were downgraded, which accounted for most of the decrease. Excluding those, there are several significant winners, along with a number of slight positives, some flat performances, and a few declines. Overall, despite those two underperformers, the equity portfolio was generally net up. Did that answer your question?

That's helpful. Appreciate that. And then maybe last one for me. From a pacing perspective, just kind of curious kind of how the pipeline is shaping up, it looks like, it sounds like, it sounds like repayment activity is going to continue to be muted. So just thoughts on how to think about pacing within our models would be great.

We had a strong pipeline this quarter, though not as robust as last quarter. We anticipate new originations to be between $90 million and $110 million this quarter. The pace of repayments has slowed, with expectations of about $15 million this quarter and possibly into the future. It seems likely that we might see one credit return each quarter. Consequently, we expect net portfolio growth to be around $75 million to $100 million over the next few quarters.

I think that's right. And we have definitely that kind of repayment activity. We do have some visibility on some sales processes that are going on that based on the company's health, you would expect the companies to in fact sell. So we'll see some repayment activity, but it won't be a refinancing, everybody will be someone acquiring that company and resulting in us getting refinanced out. So our recent won't be zero, but they definitely like Michael, so it would be lower. And I agree with that general comment on the pipeline.

Our next question comes from the line of Erik Zwick with Hovde Group.

First question, within the prepared comments, you mentioned that underwriting certain industries is more challenging today. And I'm curious how you approach that. Does that mean there are certain industries that you are not willing to underwrite in today? Or does it just mean you need to adapt and maybe change your underwriting standards and structures for those particular industries? And maybe if you could what those industries are as well?

Yes, I would say that overall, our perspective on the market remains consistent. Underwriting certain industries has always been difficult, particularly those with high fixed costs and low margins. Additionally, economic conditions affect customers’ capital investment decisions, which in turn impact the revenue of our portfolio companies. As capital has become more costly, CEOs are becoming more cautious with their investment choices. If we have a portfolio company whose customers are making such capital investments that drive revenue, we would tend to avoid that industry. Furthermore, analyzing the margins of a portfolio of companies, especially the balance between fixed and variable costs, is crucial. Industries with significant manufacturing operations typically entail higher fixed costs, which complicates underwriting for us. However, I want to emphasize that our viewpoint has not changed. We have consistently acknowledged the risk of a recession since we began lending, and our financial models reflect those concerns. We have been considering the chances of a recession for the past eight years, recognizing that we are long into this economic expansion. Although a recession has not occurred yet, we are now faced with the likelihood of one being on the horizon, and it is being highlighted for understandable reasons.

Yes, I would also mention that everyone is likely dealing with the aftermath of COVID. When examining financials, it's important to consider how the recovery from 2021 and 2022 relates to bouncing back from the lows of 2020 due to COVID. Additionally, in health care, we are still witnessing occasional COVID flare-ups in various areas across the country. This makes it challenging to accurately determine what the previous run rate was and if the current run rate is reflective of that.

COVID is an interesting example. So looking at rather than EBITDA as a portfolio company, post-COVID, some industries have kind of pent-up demand, as we all know. So the bounce back can be pretty extreme. And so it makes looking at kind of 2018 and '19 performance and getting a sense as to what the pre-COVID level of performance was for a particular company. So that's a little bit different than we were doing 4 years ago, for example.

That's great color. I really appreciate that. And then my other question was just in your conversations with the PE sponsors that you work with. I'm curious if you've noticed any change in sentiment, certainly the industry data, I look at indicates there's still a lot of dry powder there for them. Are they sensing potential recession and maybe keeping some dry powder on hand in the event that they'd have to commit extra equity to initial investments? Or are they still out there looking for new opportunities to the same level that they were 12, 18, 24 months ago?

Yes, there is liquidity in the private equity market, and firms are actively seeking acquisitions. Over the next year, several sponsors will likely find valuable opportunities for accretive acquisitions. Private equity firms are smart and are managing their companies diligently, as they see their debt costs rising and are considering the potential for a recession, much like everyone on this call. As their debt costs increase, they are focusing on optimizing cost structures, which I believe is instilling a sense of discipline in these companies. This discipline, influenced by rising costs and market conditions, will ultimately benefit the companies in the long term. As I consider the impact of recessions, I see that companies are tightening their cost structures. We will have to wait and see if this leads to layoffs or other changes. To respond to your question, private equity firms are indeed signaling that while they are focused on liquidity and acquisitions, they are also maintaining a strong discipline regarding their cost structures, which I believe is beneficial. Additionally, we have observed companies coming to us for amendments or waivers, and those that may be facing challenges have been willing and able to seek funding. The negotiations have gone smoothly, and there are no indications that a recession is looming or that they are withdrawing support. Overall, conversations have been quite productive.

Yes. That's a good point and very transparent on what they want to do with the business as well.

And our next question comes from the line of Robert Dodd with Raymond James.

Congratulations on the quarter. I would like to follow up on your earlier point about leverage, specifically the fact that it has decreased by a full turn in some cases for new originations, which is reducing portfolio leverage. Can you provide any insights on what is driving this change? Is it that sponsors are asking for less, or are lenders maintaining strict standards? With leverage down a turn, even with interest rates increasing by 20 basis points, you might be underwriting interest coverage similarly to how it was a year ago. This situation is clearly impacted by both leverage and rates working together. So, is it primarily the sponsors being more disciplined in their requests, or is it lenders who are holding firm?

Yes, that's an interesting question. It's a combination of both factors. From a sponsor's perspective, as indexes widen, the cash cost of debt increases dollar for dollar when acquiring a company. To address this, if you want to start generating free cash flow to support and grow the business, you need to reduce leverage. That's why I mentioned the loan-to-value ratio, which is also declining. This trend suggests that in the market we are observing, the multiples for strong companies haven't significantly decreased yet. It's a favorable time to be a first lien lender, as we are effectively capturing a larger portion of the cash flow. We've been able to be more conservative with our proposals and, honestly, have won some deals as a result. I see this as a sign that the lending market is becoming more cautious, influenced by various factors. Many lenders are supported by insurance companies that invest capital and have specific appetites for different types of credit, affecting their availability in the market. As we continue our discussions with sponsors we've been in contact with for the past three to six years, we find we can now be more helpful to them, especially with fewer lenders participating in the market. We believe this will strengthen our originations platform in the long run.

I really appreciate the color. Kind of are you seeing in the pipeline early stage or whatever? Are you seeing any changes in the quality of companies? Obviously, that can be in customer environment, obviously, the average quality tends to go up and vice versa and things like that. So are you seeing a mix shift on who's coming to market versus where it was, say, a year ago?

Yes, I would definitely say there is some aspect of that. It's true because really companies that are in the market right now for sale are ones that are candidly not super cyclical, right, because they would be able to raise the financing to do the deal, et cetera. So in many respects, higher-quality companies, higher margins all the aspects of the company that make it higher quality credit. I think it's definitely the case because anything that's even more lovely offset of the fairway, it would be very hard to sell the convert. So I think we do that. I would definitely agree with that CnF factor.

In your experience, where do you think the quality of the 2023 vintage could compare to previous originations and production, considering all these dynamics?

Yes. I believe that if 2023 experiences any kind of recession, it could turn out to be an exceptional year. This aligns with historical trends, particularly in the latter half of a recession, when the issues have been addressed and sponsors possess the liquidity to negotiate favorable valuations. Sellers tend to be more flexible in their terms, allowing for deal structures with attractive valuation and leverage multiples, as we typically see at the low point in the cycle. Consequently, overall EBITDA tends to increase, which enhances value and reduces debt. In my experience, looking back at past cycles, recession years can actually present appealing opportunities for institutions. The only downside is that these assets may be less stable. We have had to negotiate cost protections, which are crucial for these companies given their high leverage. If this recession is mild or ends soon, 2024 could see a significant number of refinancing opportunities. And that's consistent with past cycles, too. I mean that's a term that is that we're pretty aggressive on holding the line on, but that's a pushback term from sponsors, they want some relief or some lower prepayment penalties and that kind of thing. So it's a term that's heavily negotiated deals right now. And that will be the case through the recession. And then clearly, coming out of a recession to Michael's point, is to best leverage comes down, things normalize and then you want to kind of normalize the capital structure. So that ends up being less sticky debt investments and really interesting on the equity piece.

Thank you. And I would like to turn the conference back to Bowen for any closing remarks.

Well, thank you, everyone, for joining us, and we always appreciate giving you an update on the company. And thanks for all the questions, and we look forward to talking to you next quarter.

This concludes the conference call. Thank you for participating. You may now disconnect.