Earnings Call Transcript - SAR Q1 2026

Operator, Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Saratoga Investment Corp. Fiscal First Quarter 2026 Financial Results Conference Call. Please note that today's call is being recorded. At this time, I would like to turn the call over to Saratoga Investment Corp's Chief Financial and Chief Compliance Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Henri J. Steenkamp, CFO

Thank you. I would like to welcome everyone to Saratoga Investment Corp's fiscal first quarter 2026 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 first quarter 2026 shareholder presentation in the Events and Presentations section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night. For everyone new to our story, please note that our fiscal year-end is February 28, so any reference to Q1 results reflects our May 31 quarter-end period. A replay of this conference call will also be available. 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.

Christian Long Oberbeck, CEO

Thank you, Henri, and welcome, everyone. Saratoga Investment Corp. highlights this quarter include a 17.9% increase in adjusted NII per share from the previous quarter, continued growth of NAV, a strong return on equity beating the industry average, 2 new portfolio company investments and, most importantly, a continued solid performance from the core BDC portfolio in a volatile macro environment. Building on our historical strong dividend distribution history, we announced a base dividend of $0.25 per share per month or $0.75 per share in aggregate for the second quarter of fiscal 2026. Our annualized second quarter dividend of $0.75 per share represents an 11.8% yield based on the stock price of $25.44 as of July 7, 2025, offering strong current income from an investment value standpoint. Our Q1 adjusted NII of $0.66 per share continues to reflect the impact of the past 12-month trend of decreasing levels of short-term interest rates and spreads on Saratoga Investment's largely floating rate assets and the continued effect of the recent repayments. This has resulted in $224 million of cash as of quarter end, available to be deployed accretively in investments or to repay existing debt. During the quarter, we continued to see a slower level of deal volume and M&A activity in the lower middle market following the recent tariff developments and a slowdown in new debt issuances. Despite these macro factors, our portfolio had multiple debt repayments and an equity realization in Q1, in addition to healthy new originations generating $2.9 million of realized gains and $50.1 million invested in 2 new portfolio companies, 6 follow-ons and new investments in multiple BB CLO debt securities. Our strong reputation and differentiated market positioning, combined with our ongoing development of sponsor relationships, continues to create attractive investment opportunities from high-quality sponsors, while we remain prudent and discerning in terms of new commitments in the current volatile environment. We believe Saratoga continues to be favorably situated for potential future economic opportunities as well as challenges. At the foundation of our strong operating performance is the high-quality nature and resilience of our $968.3 million portfolio in the current environment with all 4 challenged portfolio company situations resolved. Our current core non-CLO portfolio was marked up by $2.6 million this quarter, and the CLO and JV were marked down by $0.2 million. We also had $0.6 million net realized appreciation on an equity realization and numerous debt repayments that generated $2.2 million of life-to-date realized gains, further net realized gains of $0.7 million from escrow payments on the Netreo and HemaTerra investments and $0.2 million of net appreciation in our new BB investments, resulting in the fair value of the portfolio increasing by $3.8 million during the quarter. As of quarter end, our total portfolio fair value was 2.1% below cost, while our core non-CLO portfolio was 1.7% above cost. The overall financial performance and solid earnings power of our current portfolio reflects strong underwriting in our growing portfolio companies and sponsors in well-selected industry segments. During the first quarter, our net interest margin expanded meaningfully from $13.7 million last quarter to $15.6 million, driven by a $1.4 million increase in non-CLO interest income as the full benefit of Q4 originations was realized and repayments largely occurred late in Q1. Average yields were relatively unchanged. This was further supported by a $0.5 million decrease in interest expense, reflecting the full quarter benefit of repaying $44 million in SBIC II debentures at year-end and the partial period impact of retiring the $20 million 8.75% baby bond this quarter. In addition, the full period impact of the 1.2 million shares issued through the ATM program in Q4 and a partial impact of the additional 0.2 million shares issued in Q1 resulted in a $0.04 per share dilution to NII per share. Our overall credit quality for this quarter remained steady at 99.7% of credits rated in our highest category, with the 2 investments remaining on nonaccrual status being Zollege and Pepper Palace, both of which have been successfully restructured, representing only 0.3% and 0.6% of fair value and cost, respectively. With 90% of our investments at quarter end in first lien debt and generally supported by strong enterprise values and balance sheets in industries that have historically performed well in stress situations, we believe our portfolio and company leverage is well structured for future economic conditions and uncertainty. As we continue to navigate the challenges posed by the current geopolitical landscape and the volatility seen in the broader underwriting and macro environment, we remain confident in our experienced management team, robust pipeline, strong leverage structure and high underwriting standards to continue to steadily increase the size, quality and investment performance of our portfolio over the long term and deliver exceptional risk adjusted returns to our shareholders. As always, and particularly in the current uncertain environment, balance sheet strength, liquidity and NAV preservation remain paramount for us. At quarter end, we maintained a substantial $430 million of investment capacity to support our portfolio companies with $136 million available through our existing SBIC III license, $70 million from our 2 revolving credit facilities and $224 million in cash. This level of cash improves our current regulatory leverage of 163.8% to 188.1% net leverage, netting available cash against outstanding debt. Moving on to Saratoga Investments fiscal year 2026 first quarter key performance indicators compared to the quarters ending May 31, 2024, and February 28, 2025. Our quarter-end net asset value was $396.4 million, an increase of 7.8% from $367.9 million last year and up 0.9% from $392.7 million last quarter. Our adjusted net investment income was $10.1 million this quarter, down 29.3% from last year but up 26.2% from last quarter. Adjusted net investment income per share was $0.66 this quarter, down 37.1% from $1.05 last year and up 17.9% from $0.56 last quarter. The adjusted net investment income yield was 10.3% this quarter, down from 15.5% last year but up from 8.4% last quarter. The latest twelve months return on equity was 9.3%, an increase from 4.4% last year and up from 7.5% last quarter, also above the industry average of 7%. Our net asset value per share was $25.52, down from $26.85 last year and down from $25.86 last quarter. Notably, the recent change to monthly dividend distributions resulted in the March and April dividend record dates falling into this first quarter for a one-time additional dividend, which reduced net asset value per share by $0.50. Without this one-time occurrence, net asset value per share would have risen to $26.02, representing a $0.16 or 0.6% increase. Although last year saw markdowns to a small number of credits in our core business development company, our recent strong results show a return on equity of 9.3% for the last twelve months, exceeding the industry average of 7%. Additionally, our long-term average return on equity over the past 11 years is 10.2%, well above the BDC industry average of 6.9%. Our long-term return on equity has remained robust over the past decade plus, surpassing the industry average in 8 of the last 11 years and consistently positive each year. Importantly, the weighted average common shares outstanding in Q1 was 15.3 million, up from 14.5 million and 13.7 million shares for the last quarter and last year's first quarter, respectively. This quarter's adjusted net investment income of $10.1 million decreased 29.3% from last year while increasing 26.2% from the prior quarter. The increase in adjusted net investment income compared to the previous quarter can primarily be attributed to the absence of the $2.4 million annual excise tax recognized in the prior quarter. The decline from the previous year's first quarter was mainly due to lower assets under management from significant recent repayments and reduced base interest rates. The weighted average interest rate on the core BDC portfolio of 11.5% this quarter compared to 12.6% as of the previous year's first quarter and 11.5% as of last quarter. The yield reduction from last year primarily reflects the SOFR base rate decreases over the past year. Total expenses for this first quarter 2026, excluding interest and debt financing expenses, base management fees and incentive fees and income and excise taxes, decreased $0.1 million to $2.8 million as compared to $2.9 million last year and increased $1.4 million from $1.4 million last quarter. This represents 0.8% of average total assets on an annualized basis, unchanged from last quarter and down from 1% last year. As you can see on Slide 4, our assets under management have steadily and consistently risen since we took over the BDC 14 years ago, despite a slight pullback recently reflecting significant repayments. This quarter saw significant repayments again, offsetting solid originations. This recent AUM decline does not detract from our expectation of long-term AUM growth. The quality of our credits remain strong, with only the 2 recently restructured Pepper Palace and Zollege credits on nonaccrual, consistent with last quarter. Our management team is working diligently to continue this positive long-term trend as we deploy our significant levels of available capital into our pipeline, while at the same time being appropriately cautious in this evolving credit and volatile economic environment. With that, I would like to now turn the call over to Henri to review our financial results as well as the composition and performance of our portfolio.

Henri J. Steenkamp, CFO

Thank you, Chris. Moving on to Slide 6. NAV was $396.4 million as of fiscal quarter end, a $3.7 million increase from last quarter and a $28.5 million increase from the same quarter last year. During this quarter, $6.4 million of new equity was raised at or above net asset value through our ATM program. This chart also includes our historical NAV per share, which highlights how this important metric has increased 22 of the past 31 quarters, seeing a decrease this quarter solely due to the transition to monthly dividends in March, resulting in the March and April dividend record date both falling into the first fiscal quarter, reducing NAV per share by an additional $0.50. Excluding this one-time reduction, NAV per share would have risen to $26.02, reflecting a 0.6% increase. Over the long term, our net asset value has steadily increased since 2011 and grown by $3.55 per share or 16% over the past 8 years. Also we have again added the KPI slides 26 through 30 in the appendix at the end of the presentation that shows our income statement and balance sheet metrics for the past 2 years. Slide 30 is a new slide comparing our nonaccruals to the BDC industry. You will see that our nonaccrual rate of 0.6% of cost is significantly lower than the industry average of 3.7%, and that the broader industry has experienced an increase in nonaccruals of 0.3% since the previous quarter, while ours have remained steady and low. This highlights the strength in credit quality of our core BDC portfolio. Moving on to Slide 7. You will see a simple reconciliation of the major changes in adjusted NII and NAV per share on a sequential quarterly basis. Starting at the top, adjusted NII per share was up $0.10 in Q1 primarily due to: first, the nonrecurrence of the annual excise tax, which was $0.13 in the previous quarter related to unpaid spillover; and second, an increase of $0.09 in non-CLO net interest income, reflecting the full period impact of Q4 originations. This was offset by an increase in operating expenses, excluding excise taxes and dilution from the increased net ATM and DRIP share count, reducing NII by $0.06 and $0.04, respectively. On the lower half of the slide, NAV per share decreased by $0.34, primarily due to the $0.50 reduction from the change to a monthly dividend payment structure discussed earlier. Net realized gains and unrealized depreciation added $0.25 to NAV per share. There was no dilution from the ATM and DRIP program. Slide 8 outlines the dry powder available to us as of quarter end, which totaled $430.3 million. This was spread between our available cash, undrawn SBA debentures and undrawn secured credit facility. This quarter end level of available liquidity allows us to grow our assets by an additional 44% without the need for external financing, with $224 million of quarter end cash available, and that's fully accretive to NII when deployed, and $136 million of available SBA debentures with its low-cost pricing also very accretive. In addition, all $301 million of our baby bonds, effectively all our 6% plus debt is callable now, creating a natural protection against potential continuing future decreasing interest rates, which should allow us to protect our net interest margin, if needed. These calls are also available to be used prospectively to reduce current debt. We remain pleased with our available liquidity and leverage position, including our access to diverse sources of both public and private liquidity and especially taking into account the overall conservative nature of our balance sheet. Also our debt is structured in such a way that we have no BDC covenants that can be stressed during volatile times, especially important in the current economic environment. Now I would like to move on to Slides 9 through 12 and review the composition and yield of our investment portfolio. Slide 9 highlights that we have $968 million of AUM at fair value, and this is invested in 46 portfolio companies, 1 CLO fund, 1 joint venture and various new BB investments. Our first lien percentage is 86.9% of our total investments, of which 22% is in first lien last out positions. On Slide 10, you can see how the yield on our core BDC assets, excluding our CLO investments, has changed over time especially this past year, reflecting the recent decreases to interest rates. This quarter, our core BDC yield remained unchanged from last quarter at 11.5%, despite the 10 basis points reduction in average SOFR. The CLO yield decreased to 13.7% from 16.4% last quarter, reflecting the inclusion of the new BB CLO debt investments to this category that have a yield of approximately 10%. Slide 11 shows how our investments are diversified through primarily the U.S., and on Slide 12, you can see the industry breadth and diversity that our portfolio represents, spread over 40 distinct industries in addition to our investments in the CLO JV and BB CLO debt securities, which are all included as structured finance securities. Moving on to Slide 13. 7.9% of our investment portfolio consists of equity interest, which remain an important part of our overall investment strategy. This slide shows that for the past 13 fiscal years, we had a combined $42.5 million of net realized gains from the sale of equity interest or sale or early redemption of other investments. This includes $2.2 million of realized gains on the sale of our identity equity investment this quarter. This long-term realized gain performance highlights our portfolio credit quality, has helped grow our NAV and is reflected in our healthy long-term ROE. That concludes my financial and portfolio review. Our Chief Investment Officer, Michael Grisius, will now provide an overview of the investment market.

Michael Joseph Grisius, CIO

Thank you, Henri. Today, I will give an update on the market since we recently spoke with everyone in May and then comment on our current portfolio performance and investment strategy. Year-to-date deal volumes in our market have been down significantly every month as compared to 2024 and are down further still as compared to 2021 through 2023. We believe that M&A activity will invariably revert to historical levels, but that pickup in deal volume appears to be postponed for the time being. The combination of historically low M&A volume in the lower middle market and an abundant supply of capital is causing spreads to tighten and leverage to remain full, as lenders compete to win deals especially premium ones. We've also experienced repayment activity from some of our lower leverage loans being refinanced on more favorable terms. The historically low deal volumes we're experiencing has made it more difficult to find quality new platform investments than in prior periods. As we noted on last quarter's call, this may naturally prompt the question of what is our approach to operating in this difficult asset deployment climate. First, the Saratoga management team has successfully managed through a number of credit cycles over many years, and that experience has made us particularly aware of being disciplined when making investment decisions and being proactive in managing our portfolio. Taking this approach has allowed us to produce unlevered realized returns in our core non-CLO portfolio of 15%. The weighted average return on our exits this quarter were consistent with our track record at 14.9%. We'll continue to invest in high-quality assets and will not lower our investment standards and take on more risk than we feel is prudent, just because the market is presently difficult. We believe our shareholders will appreciate this approach in the long run. Second, we're greatly expanding our business development efforts and are investing in resources to provide greater bandwidth for our professionals to dedicate themselves to this effort. We have a new Managing Director joining us this summer, who has a strong origination and investment track record in our markets. We've also recently hired a VP of Portfolio Management and a business development analyst, and we have 2 new investment associates joining us this summer. All of these investments will allow our professionals to better leverage themselves and shift more emphasis on investment origination. While we have developed a strong presence in the lower end of the middle market, the number of companies in our marketplace is vast compared to the traditional middle market and is occupied with hundreds of thousands of businesses. We believe the number of deal sources in our market that we have yet to build relationships with far exceeds the number that we have. Further, our market benefits from a natural underpinning of deal flow, driven by business owners seeking to transition ownership as they age. We're in the early stages of our expanded business development initiatives, but have already seen some positive results in our current pipeline and in the most recent portfolio company we closed in April. Third, our existing portfolio serves as a healthy source of deal flow. Our payoffs, as again seen this quarter, tend to be lumpy as our portfolio investments reach scale and maturity, while our new portfolio companies tend to be small initially and provide an embedded resource for asset deployment as we support their growth. Because of the nature of the way we invest our capital in this manner, follow-on activity has exceeded our new portfolio company deployment in each of our past 5 fiscal years. In summary, the way we're approaching the currently challenging environment is to first stay disciplined on asset selection; second, invest in and greatly expand our business development efforts in a market that is still largely underpenetrated by us; and third, continue to support our existing healthy portfolio companies as they pursue growth. The relationships and overall presence we've built in the marketplace, combined with our ramped up business development initiatives, give us confidence in our ability to achieve healthy portfolio growth in a manner that we expect to be accretive to our shareholders in the long run. In the midst of these market conditions, we had $50 million of gross originations in the lower end of the middle market this quarter. Now before leaving this topic, I'll also point out that we continue to believe that the lower end of the middle market is the best place to be in terms of capital deployment. As compared to the larger end of the middle market, the due diligence we're able to perform when evaluating an investment is much more robust. The capital structures are generally more conservative with less leverage and more equity. The legal protections and covenant features in our documents are considerably stronger, and our ability to actively manage our portfolio through ongoing interaction with management and ownership is greater. As a result, we continue to believe that the lower middle market offers the best risk adjusted returns, and our track record of realized returns reflects this. A new initiative I'd like to highlight is that we have recently seen a new opportunity to invest BB and BBB CLO debt securities. These investments have performed well through numerous economic cycles in the past, experiencing very low long-term default rates, while also providing enhanced yields relative to comparably rated corporate debt securities. Further, our underwriting process driven by quantitative metrics that measure individual manager and deal level performance allows us to identify those managers and deals we believe will outperform over the long term and provide attractive risk adjusted returns for our shareholders. During this past quarter, we invested in 9 different CLO BB securities across 7 different CLO managers for a total notional amount of $13 million. We anticipate third-party managed CLO BBs and, to a lesser extent, CLO BBBs will play a role in our investment portfolio going forward and will also allow us to take advantage of dislocations in the liquid loan and high-yield credit markets. Our underwriting bar remains high as usual. In a very tough market, yet we continue to find opportunities to deploy capital. As seen on Slide 14, our more recent performance has been characterized by continued asset deployment to existing portfolio companies, as demonstrated with 8 follow-ons in calendar year 2025 thus far, and we have invested in 3 new platform investments this calendar year as well. More recently, during calendar Q2, we closed 1 new portfolio company. Overall, our deal flow is increasing as our business development efforts continue to ramp up. Our consistent ability to generate new investments over the long term, despite ever-changing and increasingly competitive market dynamics, is a strength of ours. Portfolio management continues to be critically important, and we remain actively engaged with our portfolio companies and in close contact with our management teams. They remain the same 2 portfolio companies that we are actively managing as discussed in previous quarters. But in general, our portfolio companies are healthy, and the fair value of our core BDC portfolio is 1.7% above its cost. 86.9% of our portfolio is in first lien debt and generally supported by strong enterprise values in industries that have historically performed well in stressed situations. We have no direct energy or commodities exposure. In addition, the majority of our portfolio is comprised of businesses that produce a high degree of recurring revenue and have historically demonstrated strong revenue retention. At quarter end, we have the same 2 investments on nonaccrual, namely Pepper Palace and Zollege, consistent with last quarter. We continue to hold them on nonaccrual following their restructurings, with Zollege particularly demonstrating notable improvement in company performance. Looking at leverage on the same slide, you can see that industry debt multiples increased north of 5x with unitranche loans in the mid-5s. Total leverage for our overall portfolio decreased slightly to 5.22x, excluding Pepper Palace and Zollege, reflecting lower leverage across several portfolio companies. Slide 15 provides more data on our deal flow. As you can see, the top of our deal pipeline is significantly up from the end of calendar year 2024, despite the current M&A activity in the lower middle market remaining low. This recent increase of deal sourced is a result of our recent business development initiatives, with 18 of the term sheets issued over the last 12 months being from deals that came from new relationships. Overall, the significant progress we've made in building broader and deeper relationships in the marketplace is noteworthy because it strengthens the dependability of our deal flow and reinforces our ability to remain highly selective as we rigorously screen opportunities to execute on the best investments. As you can see on Slide 16, our overall portfolio credit quality and returns remain solid. As demonstrated by the actions taken and outcomes achieved on the nonaccrual and watch list credits we had over the past year, our team remains focused on deploying capital and strong business models where we are confident that under all reasonable scenarios, the enterprise value of the businesses will sustainably exceed the last dollar of our investments. Our approach and underwriting strategy has always been focused on being thorough and cautious at the same time. Since our management team began working together almost 15 years ago, we've invested $2.36 billion in 122 portfolio companies and have had just 3 realized economic losses on these investments. Over that same time frame, we've successfully exited 82 of those investments, achieving gross unlevered realized returns of 15% on $1.26 billion of realizations. Even taking into account the recent credit write-downs of a few discrete credits, our combined realized and unrealized returns on all capital invested equal 13.4%. Total realized gains for the quarter were $2.9 million, of which, this quarter's identity realization produced a gross IRR of 22.6% with a $2.2 million realized gain, continuing our track record of successful capital deployment. We think this performance profile is particularly attractive for a portfolio predominantly constructed with first lien debt. Consistent with previous couple of quarters, we have only 2 investments on nonaccrual. Although both Pepper Palace and Zollege have been restructured, we are still classifying Pepper Palace as red and Zollege as yellow, with a combined fair value of $6.9 million, including equity. Pepper Palace continues to be managed actively with several initiatives underway. Zollege has demonstrated notable improvements in company performance that resulted in a $1.1 million appreciation in its value this quarter. In addition, during the quarter, our overall core non-CLO portfolio was marked up by $2.6 million of net appreciation, including Pepper Palace and Zollege, reflecting the strength of our overall portfolio. Our overall investment approach has yielded exceptional realized returns and recovery of our invested capital, and our long-term performance remained strong as seen by our track record on this slide. Now moving on to Slide 17. You can see our second SBIC license is fully funded and deployed, although there is cash available there to invest in follow-ons, and we are currently ramping up our new SBIC III license with $136 million of lower cost undrawn debentures available, allowing us to continue to support U.S. small businesses, both new and existing. This concludes my review of the market, and I'd like to turn the call back to our CEO. Chris?

Christian Long Oberbeck, CEO

Thank you, Mike. As outlined on Slide 18, our latest dividend of $0.75 per share in aggregate for the quarter ended May 31, 2025, was paid in 3 monthly increments of $0.25. Recently, we declared that same level of $0.75 for the quarter ended August 31, 2025, marking the second quarter of our new dividend payment structure. The Board of Directors will continue to evaluate the dividend level on at least a quarterly basis, considering both company and general economic factors, including the current interest rate and macro environment's impact on our earnings. Moving to Slide 19. Our total return over the last 12 months, which includes both capital appreciation and dividends, has generated total returns of 22%, beating the BDC index's 3% for the same period by over 7 times. Our longer-term performance is outlined on the next Slide 20. Also, our 5-year and 3-year returns both place us above the BDC index. And since Saratoga took over management of the BDC in 2010, our total return has been 826% versus the industry's 294%. On Slide 21, you can further see our last 12 months' performance placed in the context of the broader industry and specific to certain key performance metrics. We continue to focus on our long-term metrics such as return on equity, NAV per share, NII yield and dividend growth and coverage, all of which reflect the value our shareholders are receiving. While NAV per share growth and dividend coverage are lagging this past year, this is largely due to last year's 2 discrete nonaccrual investments previously discussed as well as the aforementioned impact of the shift to a new dividend structure impacting this quarter's NAV per share growth. In addition, we had significant recent repayments that have reduced Q1's NII as AUM has recently shrunk, resulting in us having healthy levels of cash to deploy. In this volatile macro environment, we will be prudent in deploying our significant available capital into strong credit opportunities that meet our high underwriting standards. We also continue to be one of the few BDCs who have grown NAV accretively over the long term with our long-term return on equity at 1.5 times the industry average. Moving on to Slide 22. All of our initiatives discussed on this call are designed to make Saratoga Investment a leading BDC that is attractive to the capital markets community. We believe that our differentiated performance characteristics outlined in this slide will help drive the size and quality of our investor base, including adding more institutions. These differentiating characteristics, many previously discussed, include maintaining one of the highest levels of management ownership in the industry at 11.1%, ensuring that we are strongly aligned with our shareholders. Looking ahead on Slide 23, as we navigate through a reshaped yield curve environment with decreasing short term and increasing long-term rates and an uncertain economic outlook in the face of an ever-evolving geopolitical landscape, we remain confident that our reputation, experienced management team, robust pipeline and historically strong underwriting standards and time and market-tested investment strategy will serve us well to continue to steadily increase our portfolio size, quality and investment performance over the long term. This will allow us to deliver exceptional risk adjusted returns to shareholders and to navigate through the current challenges in the market and uncover opportunities in the current and future environment. Recognizing the challenges posed by the current tariff discussions and the volatility seen in the broader macro environment, we also believe that our strong balance sheet, capital structure and liquidity places us in a strong position to successfully address these types of uncertainties. In closing, I would again like to thank all of our shareholders for their ongoing support. I would like to now open the call for questions.

Operator, Operator

And our first question will be coming from Erik Zwick of Lucid Capital Markets.

Erik Edward Zwick, Analyst

I wanted to kind of just start on your commitment to kind of getting back to AUM expansion, and I realize there's some variables outside of your control that have kind of driven the declines over the past couple of quarters. But as you kind of frame up the opportunities now, it sounds like the efforts you've made on kind of the nonsponsored origination side are showing some positive trends. I think the things that are harder to predict now are just the level of prepayments going forward. And I guess, to some extent, you may have some visibility into potential relatively large maturities that could be coming due over the next quarter or 2. But as you kind of frame those all together, what is your expectation for your ability to return growing the portfolio over the next quarter or 2?

Christian Long Oberbeck, CEO

I'll begin and then pass it over to Mike. You articulated it well. Predicting redemptions is just as challenging as forecasting originations. One key focus for us has been on maintaining portfolio quality. Henri shared some metrics where you can observe that, despite a decline in our assets under management due to net originations being lower than redemptions, the credit quality of our portfolio remains exceptionally strong. We believe our credit performance significantly surpasses industry standards. Currently, we're in a period where there's a substantial inflow of capital into the private credit sector while the total M&A market has slowed down, mainly due to tariffs and other factors. M&A activity has historically driven both operations and financings, leading to considerable refinancing activity, but without as much M&A activity. This creates a bit of a supply and demand imbalance, which we are managing very carefully. Enhancing credit quality is essential; investing in assets that aren't solid is not beneficial for us or our shareholders. Hence, we are being cautious. Although there have been numerous opportunities, we haven't pursued many because of quality concerns, primarily credit quality and occasionally pricing. That said, we're focused on revamping our new business initiatives. As Mike mentioned, we're hiring new talent and developing a strong pipeline, which we believe will yield positive results over time. However, we've learned the importance of being selective and strategic rather than pushing for asset growth at the expense of our core focus on quality credits, which is crucial for long-term success. Mike, feel free to chime in if you have anything to add.

Michael Joseph Grisius, CIO

Yes. Let me add a little bit of additional color. And I'll also just address one of the things that you had brought up to directly, which is that on the redemption side, as Chris mentioned, that's very unpredictable. But I would say that best that we know, we don't see anything that's looming, if you will. So we would expect that the redemption experience that we'd have would be sort of consistent with what we've experienced in the past generally. Also our pipeline is growing and not only with non-sponsored deals, but there are a number of lower middle market sponsors and investor groups that we're forming relationships with that we haven't historically. And it's just due to the fact that the lower end of the middle market that we operate in is so fragmented that it's amazing. I mean, we'll go to a new city and make the rounds with 4 or 5 of the groups that we know, and we'll come back with new groups that we didn't know of almost every time we visit the countryside looking for deal opportunities. I'll take a step back. It's healthy to consider our business in this context. We prefer being at the lower end of the middle market, as it has contributed to our strong returns of 15% over time with minimal volatility and low loss experience, primarily in senior debt. This segment is attractive to us because it enables better underwriting. We can add more value to our borrowers and ownership groups, unlike the upper end of the middle market where transactions are often driven by price competitiveness and borrower-friendly terms. In our case, we can forge genuine relationships with management teams and ownership groups. Typically, we have observation rights on Boards and maintain active interaction with the management teams we're lending to, fostering a robust pipeline of follow-on opportunities. Over the past five years, our follow-on activity has actually surpassed our new origination activities in dollar terms, which reflects the strong relationships we've developed with our borrowers. However, this does involve a considerable amount of hands-on effort, not only in selecting and underwriting assets—where we maintain disciplined practices—but also in monitoring our portfolio. Being close to the businesses we fund promotes growth in follow-on activity, but it does require more time. In a normal market with historical deal activity levels, we would typically see healthy growth, with our origination pace outstripping repayments. At this point, particularly in the lower end of the middle market where deal activity is significantly below historical norms, we've recognized the need to invest in our team. The investments I mentioned are focused on allowing our deal professionals to dedicate more time to outward-facing origination activities, enabling them to be more efficient. We're already observing positive results in our pipeline due to this approach, and we believe it will support our long-term growth while we maintain our discipline in asset selection.

Erik Edward Zwick, Analyst

I appreciate the very detailed commentary there. Kind of taking some of that and realizing that the near-term growth is likely to continue to still be challenged kind of given all of the factors that you've mentioned there, it seems that the run rate of NII could continue to come in below the kind of declared dividend here for the near term. So could you just remind us, I don't think I have it for the most recent quarter, kind of where the spillover level is, either dollar terms or on a per share basis?

Henri J. Steenkamp, CFO

Yes. As of year-end, we had just over $3, and we paid $1.24 this quarter. Currently, we're just under $2 from the February spillover. Since March 1, we've also earned additional earnings, so we are likely closer to the $2.50 level now.

Erik Edward Zwick, Analyst

Henri, okay. And then just kind of continuing on the theme of growth being challenged in the near term, you have quite a bit of liquidity on the balance sheet and capacity to lend further. You do have some notes coming due later this year and some in early calendar '26 as well. So just kind of thoughts on how you would look to kind of replace those today with new notes versus maybe using the revolver. And I guess, there's also the unknown of where rates may be. I think the market over the next year is forecasting about another 100 basis points in Fed funds cut. But whether or not we get those, I think still remains to be seen. But just curious on your thoughts on kind of the liability and funding side of the balance sheet.

Christian Long Oberbeck, CEO

I believe we typically address issues as they arise since there are many variables at play. By the time we need to tackle those challenges, we will be in a strong position thanks to our liquidity. We have significant flexibility in managing upcoming maturities with ample credit facilities and cash available. Our approach will largely depend on the next six months of originations and overall asset deployment. When the time comes, we’ll see how much has changed in the last three months. We anticipate a very different economic landscape in the next three to six months. It could improve, worsen, or remain stable. We don't claim to have economic expertise; we just aim to be flexible and cautious. We don't believe this is the right time to take on excessive risks. As we approach that situation, we’ll have to make decisions, and I regret not providing a definitive answer since we are not managing it that way at the moment. We have considerable flexibility, and as conditions evolve—whether it involves Fed cuts, economic growth post-Build Back Better bill, or the impact of tariffs—there are numerous factors to consider. Nevertheless, we feel very well positioned with substantial liquidity and a strong-performing portfolio. We have many options, and we intend to keep those options open as situations develop.

Erik Edward Zwick, Analyst

Yes. No, that makes sense. Optionality is very positive to have. So that's great. And last topic for me, then I'll step aside, in terms of the new CLO, the BB investments kind of maybe 2 questions. One, were those new primary issues? Or were those purchased in the secondary market? And secondarily, just kind of thinking maybe longer term, it sounds like you're attracted to that asset class. How large could you potentially see that portfolio come relative to the total investment portfolio?

Christian Long Oberbeck, CEO

We've been managing CLOs for many years, which has made us very familiar with that marketplace. Our goal is to achieve strong risk-adjusted returns, primarily through credit securities. Over time, our research shows that the BB asset classes typically provide yields similar to what we seek in our regular private credit investments, along with solid historical credit performance and good liquidity. This allows us to enter and exit positions relatively easily, although market disruptions can change that temporarily. A notable difference in this asset class is its higher liquidity compared to others. We have a well-defined process for selecting which BBs and managers to invest in, using a tiering system to categorize them, and we’ve accumulated extensive research and experience in this market. We're just beginning to increase our presence in it. The industry is significant but not overly large, and while we have the capacity to deploy more capital, whether we will depends on the opportunities available in the BB sector and our traditional private credit areas.

Henri J. Steenkamp, CFO

In response to your question about the mix, we are experiencing a combination of both secondary and primary issuance. Currently, there is a notable cycle of issuance. This pattern can vary seasonally, with different times of the year seeing more primary issuances due to factors like payment dates. The market has its unique characteristics, and lately, there has been a greater focus on primary assets, whereas in other periods it might tilt towards secondary assets. We continually monitor both segments and aim to identify the best opportunities for generating returns.

Operator, Operator

Our next question will be coming from Robert Dodd of Raymond James.

Robert James Dodd, Analyst

Following up on the balance sheet question, you have significant liquidity and enough time to handle larger maturities. This quarter, you paid off a $20 million bond. However, it seems you chose to adjust the revolvers by increasing the Live Oak facility instead of using cash. Does this imply a preference to retain cash for investments while managing refinancings through other debt liabilities, such as refinancing or the revolver? Essentially, do you plan to use cash to grow your assets under management, or how likely is that cash to be allocated toward debt repayment?

Christian Long Oberbeck, CEO

That's a very good question and something we are always considering. We would take issue with your use of the word bias. We aim to avoid having a bias. Our goal is to optimize... We try not to have a specific inclination or bias and aim to assess situations from a neutral standpoint with much flexibility. It's generally understood that capital should be raised when possible, particularly during favorable times, as increasing credit facilities can be challenging in adverse market conditions. Henri and the team have worked diligently to establish an optimal flexible credit facility for the company during these favorable circumstances. Our relationship with Valley Bank is strong, and while it's hard to predict outcomes, we have long-standing relationships with our creditors that could last for many years. This situation is somewhat independent of market conditions, giving us the flexibility we need for our balance sheet. We have a considerable amount of fixed-rate debt, and this variable-rate revolver provides us with options for drawing and repaying funds. Currently, our cash is earning around 4%, which is a significant improvement compared to a few years ago. We're making risk-free investments to be prepared for various eventualities. We've faced substantial redemptions recently, with many of those redemptions coming from large investments made several years ago that began as small amounts and grew over time. This is a normal aspect of our business and not something that necessitates a change in our approach. Sometimes, matching everything perfectly isn't possible, but we prioritize maximizing our flexibility and establishing a strong credit structure during good times, so we're ready for any downturns or can grow without constraints when times are good.

Henri J. Steenkamp, CFO

Yes. Robert, just to clarify one thing on the credit facility. So we actually didn't choose to draw that. What we chose to do was to upsize it, which for us is much more strategic, long term, and there's a 50% utilization. So that's why there was the draw. The more important thing is it's upsize and creating more liquidity for us that's available.

Robert James Dodd, Analyst

Understood. Moving on to the next point, in regards to repayment, focusing on high-quality assets leads to good outcomes. However, there seems to be less of that available right now. It's a tough question, but what does the market need? Is it just stability? Are we too late in the year for any shifts, even if tariffs stabilize? Is M&A activity something we can expect in 2026, or could you provide insights on when we might see an increase in quality deals? There are always lower quality options, but those are not desirable. So, when do you expect quality deals to become available?

Christian Long Oberbeck, CEO

Sure. I'll hand it over to Mike after I share a few thoughts. We have a number of intriguing deals in our pipeline. It's a competitive environment right now. If we experience a bit of a winning streak, we could see some significant additions in the next three to six months, but there's no guarantee. Some of our sponsors are at the letter of intent stage while others are still in the exploratory phase. We're looking at some excellent quality deals, but we can't predict which ones will make it to our balance sheet. That's not something we'll discuss on this call, and it's largely unpredictable. We will work hard to position ourselves to win these deals, but the market is competitive. We're not concerned about our cash position because we see ample opportunities and are actively pursuing them. However, we can't control the timing on a quarterly basis. Mike?

Michael Joseph Grisius, CIO

Let me add to that. Addressing your question directly about our current position and what we observe in the marketplace, we continue to see a decline in deal activity, with no signs of recovery. From my experience, it's usually difficult to foresee such trends, and we don't try to predict or time the market. However, we have confidence in our current pipeline and the initiatives we're implementing by investing additional resources and intensifying our efforts in origination. We believe this will lead us back to a growth trajectory, even if deal activity remains low. We're optimistic about this outcome. While time will tell, we are confident we can operate successfully and grow our balance sheet, with or without a recovery in the deal market. If a recovery does happen, that would be an added benefit.

Operator, Operator

And I would now like to hand the call back to Christian Oberbeck for closing remarks.

Christian Long Oberbeck, CEO

Okay. Well, again, we'd like to thank everyone for joining us today, and we look forward to speaking with you next quarter.

Operator, Operator

Thank you, everyone, for joining us today. We look forward to speaking to everyone next quarter. This concludes today's conference call.