Saratoga Investment Corp. Q2 FY2020 Earnings Call

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Saratoga Investment Corp. Fiscal Second Quarter 2020 Financial Results Conference Call. Please note that today's call is being recorded. During the presentation, all parties will be in a listen-only mode. Following management's prepared remarks, we will open the line for questions. At this time, I would like to turn the call over to Saratoga Investment Corp's Chief Financial and Compliance Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Thank you. I would like to welcome everyone to Saratoga Investment Corp's fiscal second quarter 2020 earnings conference call. Today's conference call includes forward-looking statements and projections. We ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required to do so by law. Today, we will be referencing a presentation during our call. You can find our fiscal second quarter 2020 shareholder presentation in the Events & Presentations section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night. A replay of this conference call will also be available from 1:00 PM today through October 17th. Please refer to our earnings press release for details. I would now like to turn the call over to our Chairman and Chief Executive Officer, Christian Oberbeck, who will be making a few introductory remarks.

Thank you, Henri, and welcome, everyone. This second fiscal quarter has been particularly strong and significant for us, with numerous notable accomplishments. The achievements from this quarter will support our goal of enhancing our industry leadership in the BDC sector and expanding our high-quality portfolio, using our strengthened capital and liquidity base. Despite a challenging and competitive environment, our origination efforts, along with our flexible capital solutions and diverse sources of cost-effective liquidity, continue to support a robust pipeline of available deals, driving greater scale. To briefly recap the highlights from this past quarter, we received approval for a second SBIC license, granting us access to up to $175 million in additional long-term cost-effective capital through SBA debentures to better assist our core small business clientele. We further solidified our financial foundation by maintaining a high level of investment credit quality, with 99% of our loan investments at our highest rating, achieving a return on equity of 14.3% on a trailing 12-month basis and 14.7% annualized in Q2, both well above the BDC industry average of 8.7%. We increased our NAV by a net $2.6 million from realized and unrealized gains in this quarter, and registered a gross unlevered IRR of 13.5% on our total unrealized portfolio and 14% on total realizations amounting to $393 million. Our assets under management rose to $487 million this quarter, a 19% increase from $410 million last quarter and a 24% increase from $393 million at the same time last year. This quarter demonstrates the effectiveness of our growing origination platform with a solid $93 million in originations, including four new portfolio company investments, two of which closed since the quarter ended, and a total of eight since year-end. Additionally, our strengthened financial foundation allowed us to increase our quarterly dividend for the 20th consecutive time, marking five years of dividend increases. We are one of only two BDCs to achieve this milestone, paying a dividend of $0.56 per share for the second fiscal quarter, up from $0.55 per share last quarter. Our dividend payments have consistently exceeded adjusted net investment income during these periods, and we are among only eight BDCs to have raised dividends over the past year. Looking ahead, we have made significant strides in our capital structure and liquidity base this quarter. Besides receiving the SBIC license in August, we sold 1.4 million common shares with gross proceeds of $34.1 million through our ATM offering. These shares were sold at a gross premium of 3.3%, leading to a $0.06 accretion to NAV per share. After the quarter ended, we sold an additional 543,000 shares for gross proceeds of $13.6 million, also at a similar premium to NAV, bringing the total issuance to $47.7 million. These share issuances provide initial equity capitalization for our new SBIC subsidiary while also funding additional BDC asset growth. We require a total equity capitalization of $87.5 million for the second license to access the $175 million of debentures, following a 2-to-1 debt-to-equity ratio. The most recent debenture pooling priced on September 17th at a 2.283% interest rate, with added fees leading to an all-in rate of approximately 3% for recent SBIC debentures. We now have significantly increased liquidity to seize future investment opportunities amid a changing credit and pricing landscape. Our available liquidity at the end of the quarter stands at $244 million, allowing us to grow our current assets under management by 50% without needing external financing. Saratoga delivered strong return on equity performance this quarter and year-to-date, maintaining solid performance in comparison to the quarters ending August 31, 2018, and May 31, 2019. Our adjusted NII reached $5.6 million this quarter, an 18% increase from $4.8 million last year, and a 22% rise from $4.6 million last quarter. The adjusted NII per share was $0.68 this quarter, slightly down from $0.69 last year, but up 13% from $0.60 last quarter. Our NAV per share is $24.47, reflecting a 6% increase from $23.16 last year and a 2% increase from $24.06 last quarter. Henri will provide more details later. As shown in the presentation, our assets under management have steadily increased since we took over management of the BDC more than nine years ago, and the quality of our credits remains high. We are working diligently to sustain this positive trend. Now, I would like to turn the call back to Henri to discuss our financial results and the composition and performance of our portfolio.

Thank you, Chris. Slide 4 highlights our key performance metrics for the quarter ended August 31, 2019. When adjusting for the incentive fee accruals related to net unrealized capital gains in the second incentive fee calculation, adjusted NII of $5.6 million was up 22% from $4.6 million last quarter and up 18% from $4.8 million as compared to last year's Q2. Adjusted NII per share was $0.68, down $0.01 from $0.69 per share last year, but up $0.08 from $0.60 per share last quarter. The increase in adjusted NII from last year and last quarter primarily reflects the higher level of investments and results in higher interest income with AUM up 19% from last quarter and up 24% from last year. The decrease in adjusted NII per share from last year was primarily due to a steady increase in the number of shares outstanding. Weighted average common shares outstanding increased from 6.9 million shares for the three months ended August 31, 2018 to 7.7 million shares and 8.3 million shares for the three months ended May 31, 2019 and August 31, 2019 respectively. Adjusted NII yield was 11.0% when adjusted for the incentive fee accrual. This yield is up 90 basis points from 10.1% last quarter and down 90 basis points from 11.9% last year, primarily reflecting the impact of our growing NAV and the effect of our currently undeployed capital coupled with Q2 only reflecting the partial benefit of our new investments this quarter. For the second quarter we experienced a net gain on investments of $2.6 million or $0.31 per weighted average share, resulting in a total increase in net assets resulting from operations of $7.6 million or $0.91 per share. The $2.6 million net gain on investments was comprised of $1.9 million net realized gain and $1.5 million net unrealized appreciation on our portfolio investments, offset by $700,000 of net deferred tax expense on unrealized gains in Saratoga Investment's blocker subsidiaries. The $1.9 million net realized gain reflects a $1.3 million gain from the realization of the company's Fancy Chap investment during the quarter as well as a $0.6 million gain on the company's Censis Technologies investment, resulting from the receipt of a dividend in excess of the investment’s cost basis. The $1.5 million unrealized appreciation reflects multiple notable changes: First, a $1.3 million unrealized appreciation on the company's Censis Technologies investment. Second, a $1.9 million unrealized appreciation on our Easy Ice investment. Third, a $1.3 million unrealized appreciation on our Netreo Holdings investment. Fourth, a $0.6 million unrealized appreciation on our Grey Heller investment. And also numerous smaller unrealized appreciations across the portfolio on various other investments. These appreciations were offset primarily by a $1.2 million reversal of previously recognized appreciation following the realization of the company's Fancy Chap investment and a $2.7 million unrealized depreciation on the company's CLO equity investment, reflecting both the equity distribution received during the quarter as well as the impact of a 2% increase in the discount rate used to fair value this equity. Return on equity remains an important performance indicator for us, which includes both realized and unrealized gains. Our return on equity was 14.3% for the last 12 months and 14.7% annualized for the quarter, well above the BDC industry average of 8.7%. Quickly touching on expenses. Total expenses, excluding interest and debt financing expenses and base and incentive management fees, increased to $1.0 million this quarter, from $0.9 million in the same period last year. Excluding the deferred income tax benefits in both quarters, operating expenses increased 13.9% from $1.3 million to $1.4 million. Expenses increased as a percentage of average total assets from 0.9% to 1.0%. We have also again added the historical KPIs in slides 25 through 28 in the appendix, and at the end of the presentation, that shows our income statement and balance sheet metrics for the past nine quarters and the upward trends we have maintained. Of particular note is Slide 28, highlighting how our net interest margin run rate has more than tripled since Saratoga took over the management of the BDC, with our current year run rate ahead of last year as well. Moving on to Slide 5, NAV was $224.3 million as of this quarter end, a $43.4 million increase from $180.9 million at year end and a $51.6 million increase from $172.7 million as of the same quarter last year. NAV per share was $24.47 at quarter end, up from $24.06 as of last quarter, up from $23.62 as of year-end and up from $23.16 as of the same period last year. NAV has not only increased in total dollars, we have now had three sequential quarters of NAV per share increases, and growth in seven of the last eight quarters. You can see this on the previously referenced Slide 25. For this past quarter, $5 million of net investment income and $3.3 million of net realized and unrealized appreciation were earned partially offset by $4.3 million of dividends declared and $0.7 million deferred tax expense on net unrealized gains in total blocker subsidiaries. In addition, $0.7 million of stock dividend distributions were made through the company's DRIP plan and 1,371,666 shares were sold for a net $33.6 million raise through the company's ATM equity offering during the quarter. Our stock issuances during this quarter added $0.06 to our NAV per share. Our net asset value has steadily increased since 2011, reflecting our accretive stock issuances, and the benefit of our history of consistent realized and unrealized gains. On Slide 6, you will see a simple reconciliation of the major changes in NII and NAV per share on a sequential quarterly basis. Starting at the top, NII per share increased from $0.60 per share last quarter to $0.68 per share in Q2. The significant increases were a $0.01 increase in CLO interest income, a $0.10 increase in other income and a $0.04 increase in deferred tax benefit that is non-recurring. These increases were offset by a $0.02 increase in base management fees, a $0.01 increase in operating expenses and $0.04 dilution from increased shares from the ATM and DRIP programs. Moving on to the lower half of the slide, this reconciles the $0.41 NAV per share increase for the quarter. The $0.59 generated by our NII in Q2, $0.51 net realized and unrealized gains on investments and $0.06 accretive net impact of our ATM and DRIP programs in Q2 were partially offset by the $0.55 dividend declared for Q1 with the Q2 record date. Slide 7 outlines the dry powder available to us as of August 31, 2019 which totals $244.1 million. This consists of our available cash, our undrawn SBA debentures and our undrawn Madison facility. As Chris mentioned earlier, our recently approved second SBIC license has added $175 million to our dry powder in the form of undrawn SBA debentures. This significantly increases our available capacity, allowing us to grow our assets by an additional 50% without the need for external financing. The composition of this capacity is also more accretive to NII when deployed, with $24 million of it being cash with no additional interest expense attached and $175 million of undrawn SBA debentures with a low 3% total cost of capital based on the current pricing. We remain extremely pleased with our liquidity position especially taking into account the overall conservative nature of our balance sheet and the fact that all our debt is long-term in nature, actually all four years plus.

Thank you, Henri. I'll take a couple of minutes to describe the current market as we see it, and then comment on our current portfolio performance and investment strategy. The highly competitive landscape that I've described in past calls has continued to intensify. Deal activity is healthy as evidenced this quarter, and our pipeline remains robust. But the underlying borrower-friendly conditions dominating the market still persist. Generally, commercial banks and non-bank direct lenders are becoming more aggressive, exacerbating a supply and demand dynamic that tightens price and expands leverage tolerances. We continue to see no spread expansion, and in fact absolute yields continue to decline due to the impact of decreasing LIBOR with another 36 basis point reduction experienced this quarter. We have been reasonably successful in obtaining floors that reflect current market conditions on most of our new deals, which helps reduce the long-term impact of a decreasing rate environment. Overall, we have not sacrificed quality, but these dynamics have served to put downward pressure on yields generally. In the face of this kind of market, we believe sticking to our strategy has and will continue to serve us best. Our approach has always been to underwrite each investment working directly with management in ownership to make a thorough assessment of the long-term strength of the company and its business model. With the possibility of a market downturn always in our minds, we seek to invest in durable businesses. We invest capital with the objective of producing the best risk-adjusted accretive returns for our shareholders over the long-term. Having a record originations quarter does not mean that approach has changed at all.

Mickey, thank you for your question. One of the key points we discuss every quarter is the variability in our business from one quarter to the next. There have been many positive developments recently, and we remain focused on them. Moving forward, our leverage levels may vary. As you mentioned, through our SBIC license, we have funded $35 million, which allows us to access $70 million. With additional funding, we could reach $100 million, as you noted. The way we fund this—whether through more equity, debt, cash reserves, or potential redemptions—is a dynamic process, and our capital allocation can change. At any moment, our leverage may be higher or lower. Therefore, as we proceed, we will evaluate our leverage on a case-by-case basis, and we don't have a specific target for where we believe our leverage should stand. However, we do believe that our leverage structure is sound.

Yes, it's a good question. We obviously work with our accountants on sort of assessing what should be excluded from adjusted NII. As you know, non-GAAP measures have quite a high hurdle around what you can be – what you can exclude. And because the deferred tax benefits relate to our blockers and you will have an element of that every single quarter, the view has been to leave it and to not exclude it from adjusted NII. However, to your point, we have really tried to highlight it in the NII per share role, and also always in our prepared remarks so that people can understand that that’s sort of a unique element to our blocker structure and strategy and can be volatile on a quarter-over-quarter basis.

I think the way we look at this, Casey, is that when we evaluate a credit, especially a new credit, we take into account the size for our investment, as well as the strength of the underlying business. One of the things that we’ve had the benefit of as we've grown our business is that we've been able to invest in businesses that have been pretty long-dated investments where we've come to know the business extremely well. And as our relationship with the business has grown, and our experience with the business has grown so has our confidence in the strength of that business. And so in both of those cases, these are businesses that we've been investors in for quite some time. Censis it was 2014 and I think Easy Ice may go back to 2012 or '13. So fundamentally, they are businesses that we know extremely well, they're both leaders in their industry verticals that they operate in, and we feel like they're fundamentally terrific investments. And that's what's giving us confidence to upsize our exposure to those two credits.

Obviously, you guys have done a great job of managing this portfolio. I have a couple of questions. Henri, you alluded to the increase in other income as a contributing factor to the strong results this quarter. And that is a number that $1.3 million that the company has never achieved before and is well over historicals. What drove that, and to what extent is that other income recurring or not?

Yes. Casey, absolutely, I highlighted that obviously on purpose. I think two things to consider. One is, there are no unusual items in the other income this quarter. So, there's no dividend or any other unusual items. It really includes sort of just the two things that you'd always expect in other income. Firstly, it's the 1% advisory fee that relates to new originations that we have in a quarter. And then secondly, there was a prepayment fee of a couple of hundred thousand that related to the realization of our Fancy Chap investment. So, no unique items in other income this quarter. However, why we highlighted it was obviously that our originations were at a very, very high level this quarter. And so, therefore that advisory fee that relates to it was at a high level as well. We always view it as partially recurring because of the fact that we are originating every single quarter, but because of the high level of originations, it was at a much higher level than it normally is.

I also want to congratulate you on a strong quarter. I want to start off by discussing leverage. If you were to use half of the availability on the credit facility and half of the cash you have at the end of the quarter for additional capital in the new SBIC subsidiary, including the equity you've already invested, then you would have access to about $100 million of new SBA debentures. This would result in a total debt-to-equity ratio of 1.7, all else being equal. I understand that you have issued some equity since this quarter was reported, so that ratio is now above the 1.5 you have been maintaining over the last several quarters. Are you willing to increase to 1.7, or is 1.5 more comfortable for you? Any guidance you can provide would be appreciated.

Thank you for that question. I think that among the concepts we constantly talk about every quarter is the relative lumpiness of our business on a quarter-by-quarter basis. There's a lot of very good things have happened and we're very concentrated in this most recent quarter. And as we go forward, our leverage levels may fluctuate. As you point out, in our SBIC license, we funded $35 million, which gives us access to $70 million. If we put in some more, we can have access to $100 million, as you discussed. How we fund that, whether it’s more equity or more debt or cash on hand, or maybe we have redemptions that come in and fund it, that's a constantly fluid situation as to how we allocate our capital.

Yes.

We have a revolving line of credit that we utilize based on changes in investment rates and redemptions. This line of credit has no strict covenants or defaults, which allows us to maintain a solid structure regarding our leverage in relation to our assets. We have been originating assets, which are primarily floating rate. Consequently, we feel very confident about our leverage profile and structure.

Absolutely.

We continue to see no spread expansion, and in fact absolute yields continue to decline due to the impact of decreasing LIBOR with another 36 basis point reduction experienced this quarter. We have been reasonably successful in obtaining floors that reflect current market conditions on most of our new deals, which helps reduce the long-term impact of a decreasing rate environment.

Thanks for taking my questions. Most of them have been asked and answered at this point, but your deployment activity really picked up this quarter and it sounds like you guys have been spending a lot of time on business development and growing your book of relationships. So in light of that, I mean, is it fair to think that origination levels can generally be higher as we're looking ahead at least relative to kind of where your historical metrics have been? Of course, that's still understanding there is a lot of quarterly volatility and the timing of originations and repayments as largely out of your control and subject available capital.

I believe we are significantly better at origination than we have ever been. We are much more organized and addressing many more areas. However, we have discovered that forecasting quarterly originations and redemptions is quite challenging. Occasionally, we gain some insight into our portfolio going into our processes and think we can project over the next six months, but when we actually reach that point, we may find that the results are disappointing or that investors prefer to wait. Therefore, it remains very unpredictable from quarter to quarter.

My first one, just as you noted, growth, obviously very strong this quarter, and the portfolio is performing very well. You guys seem pretty optimistic overall. But you look at the NFIB survey data and you see that small businesses continue to report they're facing headwinds with trade, rising labor costs, margin compression, all that good stuff. How do you balance growth in light of these headwinds? And as a follow up and you kind of touched on this a bit, Michael on Mickey's question, but we've seen you guys move more first lien and invest in some more healthcare services companies over the past couple of quarters, would you say this is an intentionally defensive move on your part to position the portfolio for the later stages of the cycle, or is it just a function of what's in the pipeline?

Let me answer the questions in order. The first question was whether we are experiencing any challenges with the small to medium-sized businesses we support. We haven't seen any. If you consider our portfolio, particularly in trade, most of the businesses we invest in and lend to are heavily involved in international trade and are not significantly impacted by it. As for higher labor costs, most of the businesses in our portfolio have strong margins and operate efficiently, allowing them to handle slight increases in labor expenses while continuing to perform well. Therefore, we have not experienced those challenges within our portfolio.

We continuously monitor the situation. Our investment strategy does not solely rely on macro trends. We always consider potential downturns and assess businesses with the expectation that a decline may occur during our investment period, determining their resilience during such times. This assessment influences our decision on whether to proceed with a deal. Regarding the second question about adjusting our portfolio concentration, the answer is no, we are not making significant shifts. Our approach remains consistent. As I mentioned earlier, we maintain a higher threshold for second lien investments due to the increased risk associated with that position on the balance sheet.

Understood. Henri, could you explain how you set floors on your floating rate loans? Are they typically based on spot LIBOR, or are they around 20 to 25 basis points below spot? Also, have you noticed any recent changes in that approach?

That's a good question. I'll address it because it's a negotiated item on a deal-by-deal basis, and you made an insightful observation. A few years ago, when LIBOR was lower, the floors were also lower. Typically, in negotiations, we aim to set the floor as close to the current LIBOR as possible, and that involves some back and forth. If you look at our portfolio from a few years ago, many of the floors were around 1% or slightly higher, and we benefited as LIBOR increased. However, the older loans did not produce as LIBOR declined. Recently, in new originations, we've been quite successful in establishing LIBOR floors that are very close to the current LIBOR. Therefore, these new originations should generally have solid protection against any further declines in LIBOR.

Our next question comes from Tim Hayes with B. Riley FBR.

I have to ask, and I've discussed this before in Easy Ice, and now I’m going to lump in Censis, is the concentration issue. You have two portfolio companies that encompass almost $90 million of the portfolio, 18% of the total portfolio, 38% of net assets. I know Censis and Easy Ice have been very successful investments. But how would you suggest the investors get comfortable with that degree of concentration in just two names?

I think that the way we look at this, Casey, is that when we evaluate a credit, especially a new credit, we take into account the size for our investment, as well as the strength of the underlying business. One of the things that we’ve had the benefit of as we've grown our business is that we've been able to invest in businesses that have been pretty long dated investments where we've come to know the business extremely well. And as our relationship with the business has grown, and our experience with the business has grown so has our confidence in the strength of that business. And so in both of those cases, these are businesses that we've been investors in for quite some time. Censis it was 2014 and I think Easy Ice may go back to 2012 or '13. So fundamentally, they are businesses that we know extremely well, they're both leaders in their industry verticals that they operate in and we feel like they're fundamentally terrific investments. And that's what's giving us confidence to upsize our exposure to those two credits.

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