Earnings Call Transcript - SAR Q3 2025

Operator, Operator

Good morning, everyone. Thank you for being here. Welcome to Saratoga Investment Corp.'s conference call for the financial results of the third quarter of fiscal year 2025. This call is being recorded. Now, I would like to hand it over to our Chief Financial and Chief Compliance Officer, Mr. Henri Steenkamp. Please proceed, sir.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Thank you. I would like to welcome everyone to Saratoga Investment Corp.'s 2025 Fiscal Third Quarter 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 third quarter 2025 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. 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 Oberbeck, Chairman and Chief Executive Officer

Thank you, Henri, and welcome, everyone. Saratoga Investment Corp. highlights this quarter include a sequential quarterly increase of adjusted NII, excluding the effect of one-time Knowland interest reserve reversal, improved latest 12 months return on equity of 9.2%, reflecting the solid high-quality nature of our existing portfolio. Another increase in total NAV and steady NAV per share, healthy originations in both new and existing portfolio companies, while also experiencing outsized redemptions of successful investments and continued over-earning of our dividends. The substantial over-earning of the dividend this quarter continues to support the current level of dividends, increases NAV, supports increased portfolio growth and provides a cushion against adverse events. This quarter's earnings reflect the impact of the past 6-month trend of decreasing levels of interest rates and spreads on Saratoga Investment's largely floating rate assets, while not yet recognizing the full impact of the recent outsized repayments seen this quarter. The cost of most long-term balance sheet liabilities is largely fixed though callable either now or in the near future. In the context of the significant level of available cash currently creating a negative arbitrage, management is evaluating the use of such calls prospectively to reduce current debt. From an overall investment value and current yield perspective, our annualized third quarter dividend of $0.74 per share implies a 12.2% dividend yield based on the stock price of $24.21 per share on January 7, 2025, or 90% of our third quarter's NAV. During the quarter, we began to see the early stages of a potential increase in M&A in the lower middle market, reflected in multiple repayments during the quarter in addition to significant new originations. As was the case in previous quarters, our strong reputation and differentiated market positioning, combined with our ongoing development of sponsor relationships, continue to create attractive investment opportunities from high-quality sponsors despite lower overall mergers and acquisitions volumes and elevated interest rate levels. 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, resilience and balance of our $960 million portfolio in the current environment. Where we have encountered significant challenges in four of our portfolio companies over the past year, we've completed decisive action and resolved all four of these companies' challenges through two sales and two restructurings. Our current core non-CLO portfolio was marked down slightly by $1.4 million this quarter, and the CLO and JV were marked down by $4 million. This was offset by net realized gains of $1.2 million this quarter on various repayments, most notably the Invita investment and $0.7 million of escrow realized gains, mainly from the former Netreo investment resulting in a total net reduction in portfolio value during the quarter. Our total portfolio fair value is now 0.7% below cost while our core non-CLO portfolio is 3% above cost. Our originations this quarter were elevated as we began to see the effect of declining interest rates and increased M&A activity in the market. Deployments during the quarter included $85 million in 2 new portfolio company investments and 8 follow-on investments in existing portfolio companies that we know well, all with sound business models and strong balance sheets. Our quarter end cash position grew to $250 million, largely due to an outsized $160 million of repayments of successful investments in 5 portfolio companies and amortizations, exceeding the substantial $85 million of originations. The repayments include the recognition of a $4.8 million realized gain along with $67 million of debt repayments from our successful 5-year Invita investment. This increase in our cash position improved our effective leverage from 160.1% regulatory leverage to 183.2% net leverage, netting available cash against outstanding debt. Our overall credit quality for this quarter remained steady with 99.7% of credits rated in our highest category, with the two investments currently still on nonaccrual status being Zollege and Pepper Palace, both of which have been successfully restructured, each representing only 0.3% of both fair value and cost. With 86.8% of our investments at quarter end in first lien debt, our overall portfolio is generally supported by strong enterprise values and balance sheets in industries that have historically performed well in stress situations. We believe our portfolio and leverage are well structured for challenging economic conditions and further changes in interest rates in either direction. 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 $474 million of investment capacity to support our portfolio companies with $136 million available through our existing SBIC II license, $87.5 million from our two revolving credit facilities and $250 million in cash. Saratoga Investment's third quarter of fiscal 2025 demonstrated a solid level of performance with our key performance indicators as compared to the quarters ended November 30, 2023, and August 31, 2024. Our adjusted NII is $12.4 million this quarter, down 5.3% from last year and 31.7% from last quarter. Our adjusted NII per share is $0.90 this quarter, down 10.9% from $1.01 last year and down 32.3% from $1.33 last quarter. When excluding the $7.6 million, which is equivalent to $0.44 per share, net impact of the nonrecurring Knowland investment interest reserve released in the previous and current quarter from its successful sale, adjusted NII increased $0.01 per share from $0.89 to $0.90 as compared to the previous quarter. Adjusted NII yield is 13.3% this quarter, down from 14.6% last year and from 19.7% last quarter. Latest 12 months return on equity is 9.2%, up from 6.6% last year and up from 5.8% last quarter, and beating the industry average of 8.5%. Our NAV per share is 26.95, down 1.7% from 27.42 last year and down 0.4% from 27.07 last quarter. And our quarter end NAV was $374.9 million, up from $359.6 million last year and up from $372.1 million last quarter. The $2.8 million increase in NAV sequentially resulted primarily from at-the-market sales of 108,000 shares at NAV. In addition, a further 356,000 shares were sold to the market at NAV for $9.6 million subsequent to quarter end, resulting in total sales of $12.6 million. While the past 12 months have seen markdowns to a small number of credits in our core BDC portfolio, Slide 3 illustrates how our recent strong results have delivered a return on equity of 9.2% for the last 12 months above the industry average of 8.5%. Additionally, our long-term average return on equity over the last 10 years of 10.4% remains well above the BDC industry average of 6.9%, and has remained consistently strong over the past decade, beating the industry 8 of the past 10 years. 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. Outsized repayments offset strong originations this quarter, resulting in our AUM declining, but this does not impact our expectation of long-term AUM growth. The quality of our credits remains solid with only the two recently restructured Pepper Palace and Zollege credits on nonaccrual, consistent with last quarter. Our management team is working diligently to continue this positive 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 environment. With that, I would like to now turn the call back over to Henri to review our financial results as well as the composition and performance of our portfolio.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Thank you, Chris. Slide 5 highlights our key performance metrics for the fiscal third quarter ended November 30, 2024, most of which Chris already highlighted. Of note, the weighted average common shares outstanding in Q3 of this year was 13.8 million shares, increasing from 13.7 million and 13.1 million as compared to last quarter and last year's third quarter, respectively. Adjusted NII decreased this quarter, down 5.3% from last year and 51.7% from last quarter. This quarter's investment income decreases as compared to last quarter were primarily due to the impact of the nonrecurring Knowland interest reserve reversal of $7.9 million last quarter, following the investment's full repayment, including accrued interest, offset by higher prepayment and structuring and advisory fees this quarter, reflective of the high level of both originations and repayments in Q3. Excluding the Knowland interest reserve reversal, adjusted NII per share increased $0.01 per share to $0.90 per share as compared to the previous quarter. Investment income reflects a weighted average interest rate of 11.8% as compared to 12.5% as of the previous year and 12.6% last quarter. Approximately 2/3 of the interest rate reduction is due to SOFR base rate decreases and 1/3 due to the higher yields of the recent repayments. The impact of this quarter's outsized repayments is not yet fully reflected in this quarter's results as most repayments occurred in the last month of the quarter. Total expenses for this year's third quarter, excluding interest and debt financing expenses, base management fees and incentive fees and income and excise taxes increased to $2.8 million as compared to $2.3 million last year and $2.2 million last quarter. This represented 0.9% of average total assets on an annualized basis, up from 0.8% last year and 0.7% last quarter. Also, we have again added the KPI slides 26 through 29 in the appendix at the end of the presentation that shows our income statement and balance sheet metrics for the past 9 quarters and the upward trends we have largely maintained. Moving on to Slide 6. NAV was $374.9 million as of this quarter end, a $2.8 million increase from last quarter and a $15.3 million increase from the same quarter last year. This chart also includes our historical NAV per share, which highlights how this important metric has increased 22 of the past 29 quarters and has stabilized over the past couple of quarters since the resolution of the recent discrete nonaccruals. Over the long term, our net asset value has steadily increased since 2011 and grown by 33% over the past 5 years, and this growth has been accretive, as demonstrated by the long-term increase in NAV per share. Over the past 4.5 years, NAV per share is up $1.84 per share or over 7%. We continue to benefit from our history of consistent realized and unrealized gains. On 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 down $0.43, primarily due to, first, the impact of the nonrecurring Knowland interest reserve reversal last quarter as previously noted. And second, the decrease in non-CLO net interest income reflecting a lower SOFR rate in Q3 and the partial impact of the quarter's repayments. These decreases were partially offset by higher prepayment and structuring and advisory fees this quarter reflective of the high level of originations and repayments. On the lower half of the slide, NAV per share decreased by $0.12, primarily due to the $0.16 over-earning of the dividend being more than offset by the $0.25 quarterly net realized gains and unrealized depreciation on investments. Slide 8 outlines the dry powder available to us as of quarter end, which totaled $473.7 million. This was spread between our available cash, undrawn SBA debentures and undrawn secured credit facilities. This quarter-end level of available liquidity allows us to grow our assets by an additional 49% without the need for external financing, with $250 million of quarter-end cash available and thus fully accretive to NII when deployed, and $136 million of available SBA debentures with its low-cost pricing, also very accretive. We also include a column showing any call options of our debt. This shows that $321 million of baby bond, effectively all of our 6% plus debt is callable, either now or within the next 4 months, 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, the fact that almost all our debt is long term in nature and with almost no non-SBIC debt maturing within the next 2 years. Also, our debt is structured in such a way that we have no BDC covenant that can be stressed during such volatile times. 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 $960.1 million of AUM at fair value and this is invested in 48 portfolio companies, 1 CLO fund and 1 joint venture. Our first lien percentage is 86.8% of our total investments, of which 25.7% is in first lien last out positions. On Slide 10, you can see how the yield on our core BDC assets, excluding our CLO, has changed over time, especially this past quarter, reflecting the recent decreases to interest rates. This quarter, our core BDC yield decreased to 11.8% from 12.6%, with about 2/3 of the decrease due to core SOFR base rates decreasing during the fiscal quarter. The CLO yield increased to 24.6% from 13.0% last quarter, purely reflecting lower fair value. The CLO is performing and current. Slide 11 shows how our investments are diversified throughout 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 and joint venture, which are included as structured finance securities. Moving on to Slide 13. 9.0% of our investment portfolio consists of equity interest, which remain a very important part of our overall investment strategy. This slide shows that for the past 12 fiscal years, we had a combined $32.4 million of net realized gains from the sale of equity interest or sale of early redemption of other investments. This is net of the Zollege, Netreo and Pepper Palace realized losses this year. 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 Grisius, Chief Investment Officer

Thank you, Henri. Today, I will focus on our perspective on the changes in the market since we last spoke with everyone and then comment on our current portfolio performance and investment strategy. While broader middle market deal volumes are showing signs of improvement, deal activity in the lower middle market where we operate has yet to pick up. Year-to-date deal volumes through calendar Q4 for transactions below $150 million are down significantly over prior year by more than 34% and down further still as compared to 2021 and 2022. We believe a number of factors are influencing the decline in the lower middle market deal activity, including a disconnect between where buyers and sellers are willing to transact, elevated interest rates making debt financing more expensive and a trend toward private equity firms holding on to assets longer to meet their return expectations. The combination of historically low M&A volume 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. This was evidenced this past quarter, with outsized repayments being experienced in some cases, due to lenders offering extremely aggressive pricing on some of our low-leverage assets. The historically low deal volume we're experiencing currently has made it more difficult to find quality new platform investments than in prior periods. Now that said, the relationships and overall presence we've built in the marketplace, combined with our ongoing 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. This quarter, we closed two new platform investments and our investment pipeline is solid. I'll also point out that we continue to believe that the lower 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. The Saratoga management team has successfully managed through a number of credit cycles, and that experience has made us particularly aware of the importance of first, being disciplined when making investment decisions; and second, being proactive in managing our portfolio. Our underwriting bar remains high as usual, 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 40 follow-ons this calendar year versus 2 investments in new platform portfolio companies. During the fiscal quarter, we invested $85 million through a combination of 2 new platform investments and 8 follow-on investments. Overall, our origination platform remains strong and 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. There remain 2 portfolio companies that we are actively managing as discussed in previous quarters, and I will touch on them shortly. But in general, our portfolio companies are healthy and the fair value of our core BDC portfolio is 3% above its cost. 86.8% 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. 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, but their combined remaining value, including equity, is just $5.8 million or 0.6% of total portfolio fair value, with Zollege's fair value being written up this quarter, reflecting positive company performance. Looking at leverage on the same slide, you can see that industry debt multiples remain above 5x. Total leverage of our overall portfolio increased to 5.56x, excluding Pepper Palace and Zollege, reflecting both the repayment of a handful of low leverage investments as well as follow-on debt this quarter by some of our existing investments. Slide 15 provides more data on our deal flow. As you can see, the top of our deal pipeline is down from last year, in part because we made a conscious effort to improve the quality of our deal pipeline and in part because market activity is down considerably as previously discussed. Despite these macro trends, our investment volume was the highest we've had in the past 6 quarters. 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 in 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 investment. 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 a dozen plus years ago, we've invested $2.24 billion in 119 portfolio companies and have had just 3 realized economic losses on these investments. Over that same timeframe, we've successfully exited 78 of those investments, achieving gross unlevered realized returns up 15% on $1.2 billion of realizations. Even taking into account the recent write-downs of a few discrete credits, our combined realized and unrealized returns on all capital invested equal 13.6%. We think this performance profile is particularly attractive for a portfolio predominantly constructed with first lien senior debt. As was the case in the previous quarter, with Knowland repaid, we have only 2 investments on nonaccrual. Although both Pepper Palace and Zollege have been successfully restructured, we are still classifying Pepper Palace as red, while Zollege has been elevated back to yellow, with a combined fair value of only $5.8 million, including equity. During the previous quarter, the Pepper Palace restructuring was successfully completed with us taking over a majority control of the business. The turnaround specialists we have been working with have substantial successful experience in similar situations, have invested significant equity in the business and became the CEO and a board member. The total fair value of the remaining investment is $1.6 million. And following the Zollege restructuring of the balance sheet during the first quarter that resulted in us taking over the company and starting to actively manage the investment. The founder and previous owner has invested meaningful dollars in the business and is leading the enterprise and has reassembled some of the former senior leadership. He and the management team are working in partnership with us with the immediate goal of returning the business to its former profitability levels and the ultimate objective of exceeding those levels. We still have equity in a first lien term loan in the company with a current fair value of $4.2 million, with the equity marked up this quarter to reflect the recent positive financial performance of the company. In addition, we recognized a $4.8 million realized gain on our Invita equity resulting from the sale of the company and recognized $0.7 million of realized gain on a Netreo escrow payment, further improving the overall positive outcome of that investment sold earlier this year. The CLO and JV had $4 million of unrealized depreciation this quarter, reflecting primarily markdowns due to individual credits, most notably in the first CLO. Our overall investment approach has yielded exceptional realized returns and recovery of our invested capital and our long-term performance remains strong as seen by our track record on this slide. 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 over to our CEO. Chris?

Christian Oberbeck, Chairman and Chief Executive Officer

Thank you, Mike. As outlined on Slide 18, our latest dividend of $0.74 per share for the quarter ended November 30, 2024, was paid on December 19, 2024. Though unchanged from last quarter, this reflects a 3% and a 9% increase over the past 1 and 2 years, respectively. Additionally, we paid a special dividend of $0.35 per share concurrently with $1.09 per share of total distribution fulfilling our fiscal 2024 requirements. 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 environment's impact on our earnings. Moving to Slide 19. Our total return for the last 12 months, which includes both capital appreciation and dividends, has generated total returns of 4%, which is uncharacteristically low and underperforms the BDC index of 13% for the same period. Our longer-term performance is outlined on our next Slide 20. Our 5-year return places us in line with the BDC index, while our 3-year performance is slightly below the index, reflecting the impact of the recent latest 12 months' performance and discrete credit issues. Since Saratoga took over management of the BDC in 2010, our total return has been 740% versus the industry's 284%. On Slide 21, you can further see our differentiated 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 five of which are above industry averages, reflecting the growing value our shareholders are receiving. The negative NAV per share metric this past year is primarily due to the two discrete nonaccruals, Zollege and Pepper Palace previously discussed. Yet we continue to be 3x better than the industry average at negative 0.4% versus negative 1.2% for the industry. Our dividend coverage and dividend growth has been one of the strongest in the industry. We also continue to be one of the few BDCs to have grown NAV over the long term, and we have done it accretively, and our long-term return on equity is 1.5x the long-term 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 on 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 12.1%, ensuring we are 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, 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. We also believe that our strong balance sheet, capital structure and liquidity will benefit Saratoga's shareholders in the near and long term. In closing, I would like to again thank all of our shareholders for their ongoing support. I would like to now open the call for questions.

Operator, Operator

Our first question will come from Eric Zwick of Lucid Capital Markets.

Eric Zwick, Analyst

So I wanted to start first and just looking at Slide 23, since we kind of just wrapped up there. You remain committed to expanding the asset base and growing the investment portfolio. You made comments during the call that the pipeline remains solid and then you had a pretty good quarter. Here the one that just wrapped up. So I guess maybe the harder part for me and maybe for you guys as well to have a longer-term view, and it's just the pace of repayments, which was obviously strong in the most recent quarter. So to the degree that you have some sort of sightline, at least over the next maybe 3 to 6 months, what are your expectations there, just given that some of it seemed to be the repayments in this most recent quarter were driven by the pickup in the M&A market and you expect that to continue as well. So just trying to kind of balance the outlook for new growth versus repayments as well.

Christian Oberbeck, Chairman and Chief Executive Officer

I will start and then Mike can follow up. In the last quarter, we had $85 million in originations, which is quite strong. Our Invita investment, a 5-year commitment, accounted for about half of the $160 million in redemptions. If you exclude that, we were essentially neutral on redemptions. These situations occur; the cycles of investment redemptions and new investments vary. It’s challenging to predict exactly when that investment will pay off over the 5-year span. Mike, if I recall, that investment began at around $6 million, right?

Michael Grisius, Chief Investment Officer

Yes. It's actually a significant investment for us in many ways regarding our operations and market presence. Initially, it was a $6 million debt deal, along with $2 million of equity. We held it for about 5 years and supported the company's growth, which led the debt position to rise into the high 60s as the company expanded successfully. Ultimately, we achieved a $4.8 million gain on our equity investment, resulting in a substantial gross return for our shareholders over that 5-year period. One of the challenges we face with this model is that when we add new portfolio companies, they tend to be smaller and more granular. The successful ones in our portfolio, particularly the larger positions, allow us to support their growth over time. However, when they pay off, those returns can be uneven, and it requires more platform companies to offset those irregular payoffs. In this quarter, as Chris mentioned, we experienced a couple of significant irregular payoffs that were somewhat unusual overall.

Christian Oberbeck, Chairman and Chief Executive Officer

Yes. It's difficult to predict exactly what our origination will be. We have a substantial and robust portfolio, and we receive calls from our portfolio companies that want to pursue large acquisitions, which often require significant follow-on investments. Therefore, it's not something we can forecast accurately. Looking ahead, we do have considerable cash on hand, as well as a historical perspective on our pipeline. However, the future redemptions and origination remain unpredictable, and it may not be wise for us to attempt to forecast those.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

And Eric, we often talk about how quarters can be lumpy, right, either that you have a lot of originations and repayments in one quarter or even none. And Slide 4 is the best slide to sort of illustrate how we think of things, which is long term and being able to grow on a long-term basis rather than quarterly that could be a lot more volatile.

Michael Grisius, Chief Investment Officer

I want to emphasize that as a management team, we are very focused on this issue. The overall market is currently seeing a lot of add-on activity, particularly in the lower end of the middle market where new M&A activity has significantly declined and continues to do so. We are optimistic that the factors contributing to the drop in M&A volume will eventually reverse with potential decreases in interest rates and other favorable developments. We believe there will be a new equilibrium reached, leading to an increase in M&A activity that we can take advantage of. Recently, our portfolio growth has not matched the healthy origination pace we experienced a couple of years ago. However, because M&A activity has decreased, our repayments have also been lower. Over the past several quarters, we managed to grow despite having reduced origination activity and limited repayments. In the latest quarter, even with solid production, we experienced some uneven repayments. Looking ahead, we are confident that our origination efforts and the strengthening of our market relationships will enable our deployment pace to exceed any repayments over time.

Eric Zwick, Analyst

That's helpful. I appreciate all the detail you've provided. You're right; referring to some of the slides, you've demonstrated your capability in the areas you mentioned. Moving to my second question, regarding Slide 8, Henri, I believe you pointed out the potential opportunities with the publicly traded notes. I see that SAT is around 6%, while JY notes are all above 8%, indicating there is a chance to achieve savings if you pay those down or refinance. Concerning the SBIC ventures, I've noticed the call period has calmed down. However, I'm intrigued about how the mechanics of potentially calling those or re-pricing them would work since they are linked to specific assets. Perhaps I should start by asking what the current average cost of those debentures is now; maybe that's not even a discussion point for us.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Yes, the most important thing when you’re in a license is whether you’re still in the reinvestment period, Eric. For example, SBIC III is a newer license. If we receive a repayment, we get cash, which we would use to redeploy into new assets rather than repaying debentures. Once you exit the reinvestment period, as we are in SBIC II, you can only use cash from repayments for follow-on investments to support existing ones. So, you face a decision when you have cash in a license outside of its reinvestment period—whether to hold the cash because you anticipate follow-on needs for the companies, or whether to repay existing SBIC debentures. The process is fairly straightforward. You have two opportunities each year, at the end of August and February, to decide if you want to repay the debentures. If you choose not to at the end of August, you will hold those debentures until the next six-month period arrives. That’s why I say they’re callable. For instance, in February, we will need to decide whether to use some cash in SBIC II to repay some of the existing debentures. A lot of those debentures in SBIC II were issued when rates were low, so we need to consider whether to continue earning cash for potential follow-on opportunities or to repay, and we will reassess that by mid-February.

Eric Zwick, Analyst

Got it. And then last one for me. You noted your success in the past with realizing some equity gains with your investments there. Remind me just how you think about the potential to realize future gains? Is it really just tied to if the company sells in those transactions? Or do you typically sometimes proactively go out and seek to commoditize where a fair value might be well above kind of your holding?

Michael Grisius, Chief Investment Officer

On the equity side, we usually invest as a minority partner. We believe this is a crucial aspect of our investment strategy, allowing us to enhance our returns on debt through co-investments in equity. The relationships we maintain, whether with private equity sponsors or management teams, often appreciate the alignment of interests that co-investing provides. However, as a minority investor, we typically do not control the exit; instead, we have the right to exit when the company is sold or some realization occurs, which is generally when we see returns on equity. From a strategic perspective, we conduct thorough analyses of these businesses, equipping us to assess whether co-investment opportunities in equity are worthwhile. Our experience indicates that there is significant overlap between the criteria for a strong credit and a solid equity investment. We tend to see businesses that excel in markets with robust dynamics, strong management teams, and high free cash flow. These factors often align with what we seek in good business investments, which is why we have achieved 15% unlevered returns on our portfolio over time. While most of this return stems from debt, reaching 15% has also resulted from successful equity co-investments, which we consider a cornerstone of our strategy.

Operator, Operator

And our next question will be coming from the line of Casey Alexander of Compass Point Research & Trading.

Casey Alexander, Analyst

I do find it interesting when we all sound sort of disappointed when you get large repayments because that's kind of the goal, right? And I get you're a platform that originates small and repays big. I get that. But one question I would ask is that you discussed kind of the reduction in weighted average yields as being 2/3 rate and 1/3 higher-yielding loans paying off. Looking at the quarter-over-quarter, it looks like your portfolio yields declined by about 80 basis points. So would it be fair to say that you're only about halfway through the resetting function of the 100 rates that base rates have gone down, you still have about half way to go. I mean, that seems like the reasonable math to me.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Okay. So it's a little more than half. I’d say we’re more about two-thirds of it being reflected in the way our loans reset, and when they reset, about two-thirds of the decrease has been reflected. We definitely haven’t seen the full effect yet, since we experienced a reset in September. So I’d say it’s about two-thirds. Additionally, since the end of the quarter, there has been a slight decline in SOFR.

Casey Alexander, Analyst

So right. Well, that's what I mean. I mean, when I look at it across the entire 100 basis points of what the Fed has done, it would seem to me that you've reflected about 50 basis points in your results as of the end of November and maybe there's another 50 bps to go counting what the Fed has done subsequent to the end of your quarter.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Yes. I haven't done like the exact count, but I would guess it's again, slightly more than that, probably in the low 60s.

Casey Alexander, Analyst

Okay. When I think in terms of decline in rates, higher yielding loans paying off, clearly a reduced portfolio balance that's going to take some time to build up. Do you still feel comfortable? Or is there maybe a quarter or two here where maybe it might seem reasonable to actually under-earn the dividend a little bit until you can build the portfolio back up?

Christian Oberbeck, Chairman and Chief Executive Officer

Well, Casey, I don't think we've ever under-earned our dividend, and that's certainly not something we would welcome. There are factors beyond our control, such as the rate of repayments and deployments. However, we have a strong pipeline, and as Mike mentioned earlier, M&A activity has really slowed down. Many private equity firms are holding onto assets that aren't meeting their goals, but there's significant pressure in the market. With the new administration and potential changes in antitrust policies, we might see a resurgence in deal activity. People have been waiting for this. Some large deals have been rejected by the Justice Department, which raises questions about those decisions. I believe there are many people ready to engage in business in the near future. While we cannot predict the timing and pace of these developments, we do anticipate a good amount of activity ahead. We are not expecting to under-earn our dividend, but that is not something we can fully control.

Casey Alexander, Analyst

Okay. Looking at Slide 17, with $77 million of cash in SBIC II and as Henri said, you're no longer in the reinvestment period there. Is it reasonable to think that there could be that much follow-on activity? Or does it make sense to at least start paying down some of those? And when do you start dusting off the paperwork on SBIC IV?

Christian Oberbeck, Chairman and Chief Executive Officer

First of all, I think it’s fair to say that the current cash rate is higher than the cost of the debentures in SBIC II. This creates a positive arbitrage in not paying off the debt in that scenario. If the situation were reversed, we would likely reduce it. So, we're monitoring that closely. If it turns into a negative arbitrage, it would make sense to pay it off. We also need to consider the type of acquisition activity we expect from those companies. Regarding SBIC IV, there’s a significant amount of paperwork involved, but we still have a lot of progress to make on SBIC III. Our program there has been very successful, and we don’t foresee any issues in obtaining the next license; it’s primarily a timing concern. There are also some metrics related to investment levels that need to be considered before proceeding.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

There is a new process in licensing for repeat issuers that has streamlined things, which is great. Casey, you're familiar with it as well, and that's been beneficial. However, we still have $136 million in debentures, and we haven't seen much realization in SBIC III yet. Actual realizations in the fund are something I monitor closely as part of my assessment.

Casey Alexander, Analyst

My last question is regarding your knowledge at the end of the quarter about the high repayments you would face. I find it puzzling that you opted to sell equity in the market while having $250 million in cash. This decision came right at the end of the quarter and at the start of the next quarter. Can you clarify the reasoning behind this? It appears illogical when considering your cash balance and the implications of negative arbitrage while paying down some of your debt.

Christian Oberbeck, Chairman and Chief Executive Officer

Sure, Casey, that's a good question. We have discussed this in depth internally. If you consider the history of Business Development Companies, particularly ours, the ability to raise equity is linked to whether we can sell stock at Net Asset Value. In this case, we were close to NAV, and the manager assisted with sales to reach it. Such opportunities for significant sales are rare. There's a common saying on Wall Street that raising money is challenging when you need it, while easier when you don’t. Equity serves as permanent capital, and when the chance to raise it arises, it's crucial to take advantage of it. As we've discussed in other calls, we have different approaches to managing our leverage. One method is to pay down debt, while another is to increase our equity. Naturally, we prefer to grow equity through capital gains, which we've successfully achieved over our history, and we've also issued new equity periodically. We see equity sales as a long-term strategic choice, rather than a decision influenced by our current cash balance. Currently, we have $250 million in cash, but there have been times when we had limited cash and faced challenges in finding liquidity for our investments. Therefore, we consider cash as a short-term matter, while viewing equity as a long-term factor essential for the growth of our BDC. We don't anticipate a long-term slowdown in our investment opportunities, and we project significant growth moving forward, which informed our decision.

Operator, Operator

And our next question will be coming from the line of Mickey Schleien of Ladenburg.

Mickey Schleien, Analyst

First question I'd like to ask is, could you give us a sense of how much more refinancing risk you believe exists in the portfolio given the current terms available in the market?

Michael Grisius, Chief Investment Officer

That's a good question, Mickey, just in terms of what we could see in terms of pace of repayments. Hard to answer it candidly. You could see for several quarters, we were getting almost no repayments, and a lot of that was just due to the fact that there wasn't much M&A activity. We have seen some deals that have exited our portfolio because somebody approached the owner with terms that were just way below kind of the rates that we play in, in the marketplace. But we don't see generally when we look at our portfolio now, a lot of exposure to that dynamic. It doesn't mean it doesn't exist, but I don't think we're highly vulnerable to that. Our expectation is that when M&A activity picks up, our origination pipeline will pick up in earnest, and that will probably be the same time that we'll start to see payoffs kind of resume to their normal pace. And we think that this last quarter was a bit of an anomaly, just having some pretty chunky payoffs all at once.

Mickey Schleien, Analyst

Okay. That's helpful. And a question for Henri. Could you give us a sense of where your spillover taxable income stands net of the special, and are you envisioning more special dividends to get that number down a little bit and reduce some of the drag from the excise tax?

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Sure, Mickey. So the most recent dividend that included the special dividend covered our fiscal 2024. So February '24 tax year, and so it's cleaned out our spillover fully. We're now in our February '25, fiscal '25 tax year. And so we're effectively about 3 quarters in, which means it's just over the $3 in spillover at the moment, reflecting the taxable income of the last 3 quarters.

Mickey Schleien, Analyst

And that's still relatively high, Henri, and there is an excise tax that you pay on that. Is the Board thinking about distributing some more of that to shareholders?

Christian Oberbeck, Chairman and Chief Executive Officer

Well, I believe that regarding the excise tax, with the changes in interest rates and the excise tax being at 4%, it's currently one of the least expensive sources of financing available. Therefore, if we want to decrease our liabilities, it would be more economically sensible to redeem some of our higher-interest bonds, which have rates like 8.7%, more than double the marginal cost of financing through baby bonds today, which ranges from 7% to 8%. Thus, the cost of financing is significantly greater than the excise tax, making the excise tax a very advantageous source of financing.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

And in addition, Mickey, excise tax is a point in time tax, it's not an accrual. So in other words, you get no credit for, for example, distributing something today versus like December 30.

Mickey Schleien, Analyst

Yes, I agree. I understand. I'm just curious how the Board is thinking about it. And Chris, I completely agree with you on the debt. I mean, to me, it seems like at least some of your debt, it's a no-brainer to call that given where you could probably deploy that capital. But those are all my questions this morning. Thank you for your time.

Christian Oberbeck, Chairman and Chief Executive Officer

Well, Mick, I have a slight disagreement with your perspective. If you examine the yield curve, you'll notice that the increase at the 10-year mark is comparable to the decrease at the short end. The expense of selling 5-year debentures might rise in the upcoming years as well. Therefore, there are numerous factors to consider regarding the overall cost of debt and how it compares to our origination pace. Furthermore, it's a new year and a new administration, which brings a fresh outlook on many issues. As such, we plan to be cautious in making significant decisions until we have more information about the upcoming environment we are entering.

Operator, Operator

And our next question will be coming from the line of Bryce Rowe of B. Riley.

Bryce Rowe, Analyst

Most of my questions have been asked and answered. I wanted to get a sense of the marks we observed quarter-over-quarter. The debt portfolio remains marked at very high levels, with only a few below cost. From an equity perspective, we noticed some consumer-facing investments marked lower, but there were offsets with other businesses marked higher. I just wanted to understand the overall health of the more consumer-related businesses in your portfolio.

Michael Grisius, Chief Investment Officer

That's a good question. The declines in some of our portfolio investments reflect slightly weaker performance overall. Equity tends to show more volatility in response to underperformance compared to debt. While your question is valid, I wouldn't necessarily connect it to a broader view on the consumer. The modest write-downs in a few of our portfolio companies seem more linked to the specific circumstances of those businesses rather than general macro trends, at least from our perspective.

Bryce Rowe, Analyst

Okay. Okay. That's helpful, Mike. And then maybe a different topic. You all are talking about a solid pipeline. From an origination perspective, did that refer to the pipeline of new opportunities for both new and existing?

Michael Grisius, Chief Investment Officer

That's a really good question. We have enjoyed the ability to continue growing at a healthy pace by supporting our existing portfolio companies. We expect to maintain that pace in line with our past performance. Currently, we're not seeing as many new platforms. During times like this, we tend to pause and assess our portfolio and pipeline. Right now, even some of the new opportunities we're pursuing are not entirely new for the sponsors; they are cases where sponsors have upsized, allowing us the chance to step in and replace the existing lender. This indicates that owners are holding onto their businesses longer and focusing on maximizing value within their existing portfolios, with less increase in M&A activity. More than half of what we’re considering currently, where we have term sheets out, involves opportunities that are not new M&A deals but rather upsizings of some kind.

Bryce Rowe, Analyst

Okay. I have one more question regarding leverage, which has been discussed in previous calls. We've observed a significant decrease in our net debt to equity ratio, particularly this quarter due to strong repayment activity. Considering the situation two or three years ago, the ratio is higher than in 2022 but lower than what we recorded in 2023 and 2024. What are your thoughts on how you plan to manage balance sheet leverage moving forward, especially since you have typically maintained more leverage than most BDCs in recent years?

Christian Oberbeck, Chairman and Chief Executive Officer

Certainly. We've put a lot of consideration into this matter. There are specific aspects of Saratoga that set us apart from the broader BDC landscape, particularly our substantial SBIC portfolio and investments. The leverage associated with these is treated differently compared to baby bond leverage in terms of regulatory guidelines. Regulatory leverage presents one picture, while total leverage offers another perspective. The nature of our debt is crucial; as we have mentioned in our quarterly calls, short-term leverage tied to assets can be risky if you reach the limits of asset-based formulas. In adverse situations, such as with the COVID-19 pandemic, that could lead to potential foreclosure by banks. On the other hand, SBIC debt is composed of long-term instruments with interest-only payments and no covenants, reducing the threat to the overall health of the company. Similarly, our baby bonds function as long-term instruments, also featuring bullet maturities, interest-only payments, and no covenants. Most of our debt lacks covenants, and the interest expenses are minimal compared to our liquidity and earnings. Therefore, our overall debt structure is remarkably secure relative to its scale.

Henri Steenkamp, Chief Financial and Chief Compliance Officer

Even our asset-based loan that we have, although they're lowly drawn, so they also have no recourse to the BDC and no BDC covenants in them either which is different than the BDC...

Christian Oberbeck, Chairman and Chief Executive Officer

All of our leverage is organized within special-purpose vehicles, allowing us to maintain a structured and low-impact approach. While our cost of capital may be slightly higher than some other business development companies, it offers significantly greater safety. Our long-term debt structure is solid, with maturities that range from a small amount due in the next year to mostly 2- to 10-year terms. We have invested considerable effort into establishing this debt structure, making changes carefully. On the asset side, we have previously discussed discrete portfolio issues, with two losses but recovering strongly from the others in the last year. Currently, over 85% of our portfolio consists of senior secured debt where we are the primary lender, actively involved in decision-making. The credit quality and performance of our asset base are robust, and we believe this combination is solid. It’s important to not isolate discussions of leverage or compare it with other BDCs without considering both asset and liability characteristics, as it simplifies a complex situation. We don’t consider our leverage to be particularly high or risky; rather, it is a significant asset. The average cost of our leverage is lower than our dividend yield, which is around 12%, while our average cost is about 5% to 6%. This debt cost effectively enhances our equity. For example, during the COVID period, many BDCs faced challenges managing short-term asset-based credit facilities, while we stood firm, allowing us to allocate capital efficiently due to our well-structured leverage. This led to significant high-quality growth and strengthened our relationships by supporting our sponsors in critical moments. We are confident in our debt structure, viewing it as a positive rather than a negative.

Operator, Operator

Thank you. That does conclude today's Q&A session. I would now like to turn the call back over to Christian for closing remarks. Please go ahead.

Christian Oberbeck, Chairman and Chief Executive Officer

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

Operator, Operator

Thank you all for joining today's conference call. You may now disconnect.