Capital Southwest Corporation (CSWC) Q3 2021 Earnings Report, Transcript and Summary

Thank you for joining today's Capital Southwest Third Quarter fiscal Year 2021 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions, and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties, and assumptions that could cause the actual results to differ materially from such statements. For more information concerning these risks and uncertainties, see Capital Southwest publicly available filings with the SEC.

Thanks, Chris and thank you to everyone for joining us for our third quarter fiscal Year 2021 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We are pleased to be with you this morning to announce our results for our third fiscal quarter ended December 31, 2020. I want to first say that I hope everyone, their families and their employees continue to be safe and well. In summary, this quarter was exceptional in virtually all areas, strong originations, strong capital raises and strong portfolio performance. As we reflect back on 2020, we were very impressed by how the vast majority of our portfolio management teams and financial sponsors managed our portfolio companies, prioritizing the health and safety of their employees, realizing cost efficiencies where needed, and now recovering nicely from the worst effects of the pandemic. While the pandemic is not yet completely behind us, as we look back to where we were in March of 2020 with so much economic uncertainty and market volatility, we are very grateful for all the work done by the team here at Capital Southwest and the teams at both our portfolio companies and financial sponsor clients. The pandemic has impacted so many people and companies in a variety of ways, and we are humbled by how well the portfolio has held up through this difficult time. The way our deal team has been able to continue to source diligence and originate high-quality assets, while continuing to actively monitor our existing portfolio over the past year has corroborated my confidence in them and also in the strength and quality of the assets. During the quarter, our portfolio continued to improve as evidenced by $7.1 million of net appreciation across the portfolio. For the quarter, we had two loans which had investment rating upgrades. We had no investment rating downgrades and we had no new loans placed on non-accrual. Overall, as of the end of the quarter, we had only one loan on non-accrual, the junior most tranche of our loan to AG Kings, which had a fair value of $739, 000. And substant to quarter end, the sale of AG Kings to Albertsons -- markets has closed. Now we're resolving this last non-accrual asset for Capital Southwest.

Thanks, Bowen. Specific to our performance for the December quarter, as summarized on Slide 18, and we earned pretax net investment income of $10 million or $0.52 per share. This was a 23% increase from the $8.1 million or $0.44 per share earned during the prior quarter. We paid out $0.41 per share in regular dividends for the quarter, flat from the $0.41 regular dividend per share paid out in the September quarter. As mentioned earlier, our Board has declared an increase to our regular dividend from $0.41 to $0.42 per share to be paid out during the March 31st quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax net investment income is important to our investment strategy. This track record is demonstrated by our 107% regular dividend coverage over the past 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy. During the quarter, we maintained our supplemental dividend at $0.10 per share, and again, our Board has declared a further $0.10 per share supplemental dividend to be paid out during the March quarter. As a reminder, the supplemental metal dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of December 31, 2020, our estimated UTI balance was $1.09 per share. Our investment portfolio produced $19 million of investment income this quarter with a weighted average yield on all investments of 11.2%. This represents an increase of approximately $2.4 million from the previous quarter. The increase in investment income was driven partly by an increase in debt investments outstanding as well as a distribution of $1.2 million from one of our lower middle market portfolio companies as part of a dividend recapitalization. This is a prime example of the benefits of investing equity with the portfolio companies where the growth story is compelling. As Bowen mentioned, we had no new non-accruals as of the end of the quarter, and our weighted average yield on our credit portfolio was 10.6% for the quarter. As seen on Slide 19, our operating leverage was flat for the quarter at 2.6%. Operating expenses were slightly elevated this quarter due to the accrual for our annual bonus program. The final payout for our annual bonus will be determined and approved by the Board based upon their review of company performance for the full fiscal year 2021. Based on both our strong NII performance and continued improvement in our overall portfolio, we have accrued the annual bonus above our annual target giving our -- the board the flexibility if they so choose to pay out bonuses in excess of our stated targets. All that said, we do expect that our run rate operating leverage going forward will be below our target of 2.5%. Turning to Slide 20. The company's NAV per share as of December 31, 2020, was $15.74 as compared to $15.36 at September 30, 2020. The main driver of the NAV per share increase was $7.1 million of appreciation in the investment portfolio, much of which was in our equity portfolio. On Slide 21, we lay out our multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to de-risk our liability structure while ensuring that we have adequate investable capital throughout the economic cycle. During the quarter, we raised an aggregate principal of $75 million and 4.5% unsecured notes due 2026 and paid down $20 million on our 5.95% baby bond due 2022. We believe the execution on our new $75 million issuance is corroboration of the market's acceptance of our investment strategy and their confidence in our portfolio and track record. This capital raise provided us the flexibility to fully repay the outstanding balance of $37.1 million on our 5.95% baby bonds subsequent to quarter end, while also providing the company cost competitive and flexible capital to fund future investments. Our debt capitalization today includes a $340 million on balance sheet revolving line of credit with 11 syndicate banks maturing in December 2023, a $125 million institutional bond with over 25 institutional investors maturing in 2024, the aforementioned $75 million institutional bond with 6 institutional investors maturing in 2026 as well as a $150 million revolving credit facility at I-45 with 4 syndicate banks maturing in 2024. Finally, as we mentioned last quarter, we continue to work with the U.S. small business administration toward becoming officially licensed as an SBIC. We received our green light letter in July 2020 and have submitted our final application for licensure. Due to the disruptions around the election and transition between administrations, the pace of processing application approvals by the SBA slowed considerably over the past few months. We continue to expect to complete this process soon, and we'll keep you apprised of progress where appropriate. Overall, we are pleased to report that our liquidity is strong with approximately $187million in cash and undrawn commitments as of the end of the quarter with ample borrowing base capacity and covenant cushions on our senior secured revolving credit facility. As of December 31, 2020, approximately 59% of our capital structure liabilities were unsecured. And subsequent to the pay down of our December 2020 notes, our earliest debt maturity is now in December 2023. Our balance sheet leverage, as seen on Slide 22 ended the quarter at debt-to-equity ratio of 1.22:1. I will now hand the call back to Bowen for some final comments.

Thanks, Michael and thank you, everyone for joining us here today. Capital Southwest continues to perform very well and consistent with the vision and strategy we communicated to our shareholders 6 years ago. Our team has done an excellent job building both a robust asset base, reputation, and deal origination capability as well as a flexible capital structure that prepares us for difficult environments, like the one we experienced in 2020. In fact, performance through difficult environments like 2020 demonstrate the investment acumen of our team at Capital Southwest and the merits of our first lien senior secured debt strategy. We feel very good about the health of our company and portfolio, and we are excited to continue to execute our investment strategy going forward. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable value for all our stakeholders. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

Our first question comes from Devin Ryan of JMP Securities. Your line is open.

This is Kevin Fultz for Devon this morning. First question, the stock is trading at a healthy premium to NAV. And as we saw last quarter, you were fairly active in selling shares under the ATM program. Can you provide some high-level thoughts around how you balance raising equity in the current environment? And how active we can expect equity issues to be over the next few quarters?

Yes. Look, that's a good question. I would say the ATM program, one of the things we like about the ATM program on top of it being a very inexpensive way to raise equity, 2% spread to trade, but you can also -- you can manage the BDC's leverage over time vis-à-vis the pipeline, what activity -- how much activity we have coming down, liquidity we have in our portfolio, the quantum of unfunded commitments, a whole host of kind of variables go into the ultimate equation, which is how much equity we think we need to raise. And we always want to stay out in front of and prepare ourselves for hiccups in the night from the economy or what have you. So not an exact answer to your question as to how much we plan to raise. But one of the reasons we raised so much equity this last quarter was that we had a lot of investment activity. And candidly weren't able to raise a lot of equity in the prior 2 quarters before that during the pandemic. So it's really a lever that we pull to manage leverage, and we're looking at again. We're looking at activity in the portfolio, liquidity of the company and unfunded commitments on our balance sheet that we need to be ready to support.

Yes. I'd also say, Kevin, just from a modeling perspective, I think we expect, on an average, probably -- when our stock has been trading well, to raise around $15 million, I would say, on a quarterly basis. Now some in this past quarter, as Bowen said, we had higher deal origination volumes, so we raised a bit more at $21 million. Sometimes it will be slightly less, but I think $15 million is about the right size on a go-forward okay.

Great. That's helpful. And then kind of another big picture question. You have a pretty robust deal-making environment currently, fairly significant unused debt capacity. And as mentioned, the ability to issue equity under the ATM. Can you talk about the potential for growth of the investment portfolio in 2021?

Yes. I mean, right now, I mean, deal flow right now is certainly strong. Our team is really hitting its stride on just deal origination activity. We're still closing about 2% of the deals that we review. It's about -- over the last 20 years of my career, that's kind of about the number. Sometimes well higher, sometimes a little lower. I think that having gone through the pandemic and deal sources, sponsors see how we behave. And we we're very commercial and reasonable. We don't roll over. We expect fair outcomes. If we contribute capital to the company, we expect the sponsor to do the same. So it's a very commercial and balanced approach. But candidly, one of the ways that we manage an anticipated downturn is structuring deals upfront better and more responsible. In other words, you don't go to a very strong sponsor relationship who maybe wants more debt on a deal than we think is prudent for the potential volatility of the business. We don't win those deals, candidly because we think about it upfront. Look, if we're going to overlever something, we don't want to have a tough conversation with a really good sponsor of ours. So part of kind of being able to manage commercially and responsibly and through a pandemic environment is the structuring and stuff you've done upfront. So now we come out of this -- come out of pandemic. Candidly, I think we've -- our team has developed a lot of street credibility and comfort and track record when people are considering us as the financing partner. So it's not always being the lowest priced deal. You've got to be in the ZIP code of market pricing, but you don't have to like low price every deal that you look at if you develop that reputation and how you conduct yourself when things bump in the night. So I think that's what's attributing to some extent, our deal flow and the quantum of deals we see and the quantum of deals we win. So look, I expect deal flow to continue to be solid throughout this year, but we'll see. We'll see. But yes.

Yes. And just probably putting some numbers to it. I think that we project internally to do around $40 million to $50 million in originations each quarter and expect to see between $15 million to $20 million come back. Sometimes we do a little bit more on the origination side. And obviously, sometimes you'll see a run-on prepayments as well, but essentially somewhere in that $20 million to $30 million net portfolio growth a quarter.

Okay. That's very helpful. And then lastly, touching on prepayments. What visibility do you have around prepayments?

Yes. I think we -- obviously, we get within a quarter, in the beginning of the quarter, we probably have some level of visibility. We'd say, for this quarter, we know that there's limited amount of activity going on. And so we're not expecting -- probably something on the low end of that range of repayments. The interest rate environment goes up and down, obviously, you see that change. But I think right now, you've seen a lot of repayments come back when people kind of settled into where the market is at the moment. So I wouldn't expect a whole rash in the next 3 to 6 months.

Okay. That's it for me. Congratulations on a great quarter.

Our next question comes from Mickey Schleien from Ladenburg Thalmann. Your line is open.

I want to ask a high-level question about this year. So when we think about the pace of vaccinations and the recent mutations of the COVID virus, it looks like the pandemic will -- or could go on longer than we had hoped and that it could continue to stress companies in some industries. So apart from your software-related investments, how do you feel about your borrowers' availability of your borrowers' ability to carry them through the pandemic, particularly with respect to liquidity.

Yes, it's interesting. I mean, just personal view of this, I mean, the things you said are correct. The pandemic is not behind us. The vaccines out there. It's we'll see how well the vaccine works, how many people take the vaccine, all those kinds of things, and you've got new strains and lots of unknowns. But I think at some level, and speaking to our portfolio, people -- the companies are kind of -- they found, for the most part, they kind of found their stride. So aside from a complete panic lot, everybody goes back to everybody, goes back to the living rooms, et cetera. Aside from that, I mean, I feel like our portfolio is kind of found its stride. Now if the pandemic sticks with us within 12 or 18 months, if I had a concern about that, it's more of -- it's just going to be muddy quick sand for companies that are trying to grow. And so progress and growth could definitely be affected. And that's really our equity portfolio, right? Upside of the equity portfolio, that could stretch out. So that's a concern from a credit perspective and security of our capital perspective. I feel pretty good about that. Now the other thing I would point out is the vast majority of our companies are small businesses, and many of them have SBICs in the capital structures in some way. And candidly, we would expect to be an SBIC or having SBIC relatively soon. And so there is a PDP money that's out there. And I don't -- looking across the portfolio, I don't really see any companies that are like, geez, the difference between survival and not survival as a PPP loan. But I do think that helps kind of bridge noise across the portfolio that might come from the pandemic. So.

That's really helpful. I want to ask you about American addiction. It has obviously exited bankruptcy. And if I'm not mistaken, you're the new Chairman of the company, how do you feel about that specific company's prospects? And is it benefiting from the pandemic? And what's the long-term sort of exit strategy for AAC?

Yes. So as I was involved with an addiction treatment business for 10 years, 8 years, a while ago, my former firm. And so I had some experience in the space and the firm, the Meadows is a firm that had some posh out there and it's a very successful company. And so they wanted -- they asked me to be Chairman, so they could put me in the press release and so that the employees would see, okay, someone on the Board actually has industry experience, that type of thing. So what's not happening is I'm not running the company. But what is happening as I am on the Board, which I'm happy to do. I don't want to do a lot of those things across the portfolio, but I'm happy in this instance. I am pretty positive on that platform. It's got an incredible asset base, network of facilities. They do really, really good work saving lives in the addiction area, they do a really good job at it. So it's just been in a tough restructuring and bankruptcy, which we're now clear of. And so now it's kind of sunshine ahead. I mean, pretty positive on the upside on that business from where we are today. Just given the -- just the quality of their network and they add the things, the building blocks that the company has to work with to really recover from where they are on a valuation perspective today. So I would say, clearly, the pandemic and lockdowns has created stress in society. And when stress and society increases, a lot of folks struggle with medicating around stress, and that obviously results in alcoholism and drug addiction which are very, very unfortunate things and really need to be helped, and people lose lives from that. And to be able to help those people is obviously a great mission. And it's one that can be done profitably and one that needs to build a really good business around. So I think -- so from that perspective, you do have a tailwind across the addiction treatment space from that stress. But that said, when these are facilities, people live there, while they're going through addiction and so COVID and COVID protocols and quarantines and lockdowns, et cetera, are all things that you would imagine -- you could imagine go on. So you've got headwind from those types of things, but you have tailwind from just the general stress in the society. And so I feel pretty -- I feel actually great about the upside of that business going forward. So.

Bowen, do you expect roll-ups to occur in that industry? And would AAC be an acquirer? Or do you expect them ultimately to be acquired by someone else looking to grow.

Yes. So I wouldn't say, first of all, the majority of the upside is just EBITDA growth from the business and signing new network contracts, filling the beds that aren't filled. Organically, the economics of adding a few beds to an existing facility, the ROI of that is staggering, actually, if you -- but if you can fill them. So there's just not a lot -- it doesn't cost a lot. It's like adding on a wing on a hotel or something or not even that, like it's -- it's kind of like a hotel, adding on beds and then recurring or the recurring economics if you can fill those beds, is really attractive. So there's a lot of organic growth. There's a lot of recovery type growth recovering from where it is today, and then we may make acquisitions. I think that AAC could absolutely be acquired at some point. There are definitely larger platforms in the space. We have a lot of interest in the bankruptcy auction, just not at valuations that made a lot of sense, candidly. A lot of vultures swarming around in a bankruptcy. There's a lot of noise in that people trying to take advantage. In Canada, we had a lender group now an investor group that see a lot of upside. So we just credit bid and took over the company, and that's now we're the owners. And so those people are still out there. Those big platforms are still out there. They're just -- we're just going to do the things we want to do with the business or the management team with the business, and then we'll -- it could absolutely be acquired in the next couple of years. I mean, that's clearly an exit strategy.

My last question, just to touch on CPK. It also emerged from bankruptcy. And I assume the balance sheet is a lot healthier now. But I was in -- I was walking near my home recently, and I saw that my local CPK was closed. So I have read, I think that the footprint has shrunk. So in terms of strategy for CPK in this pandemic environment, are you looking sort of to manage that business through the pandemic and status quo or do you expect some growth opportunities to occur? What's the outlook in general for CPK in the environment that we're in?

Yes. So that CPK is different in the sense that we're not on the Board there. So we're a smaller investor, I guess, in that platform. So -- but I'll give you my impressions and kind of what we -- what I can tell you about what we hear and see. Management team is doing -- the management team there is excellent. And they had this business doing much, much better pre-COVID. They started, I think, in mid '19, and the business was kind of had a difficult time, no reason other than just kind of difficult, and the management team came in, just did fantastic and then COVID hit. Obviously, it's a restaurant. And so that struggle, they went out and during the bankruptcy process and negotiated leases and the realtors or the lessors that were landlords. There are certain landlords just they decided it wasn't worth keeping that lease and took the excuse to get out of the lease. And candidly, in my neighborhood, our CPK closed as well. But there's a bunch of CPKs around Dallas, and they're doing fine. The one when it closed, candidly, that was probably a really expensive lease. And so the network of footprint of restaurants, yes, decreased as one would expect in the bankruptcy process. It's a chance to clean out leases that are less profitable. But if you look across the network, I mean, I will tell you just thematically, the ones that are open, it's pretty interesting how well they were doing versus kind of pre COVID revenues. I mean they're -- it's got a couple of things. It's got a licensing business with Nestlé in grocery stores. It's got obviously a pizza business. And so it's got delivery that's obviously natural for people to order pizza delivery. So those are some things that help the business. And the management team has done great. They've been -- as far as creativity on keeping big expanding patios and doing things creatively. We need to get past the pandemic before this thing takes off. But they've done a really good job managing it. It's cash flow positive. So we're not thinking about funding it. We're going to have to wait a bit before -- to get out of the malaise of the pandemic, but it's going to be fine. I mean, I really do. I think it's -- there's a fair amount of upside in that business going forward. It's just a question of pace at which we see the upside, vis-à-vis a pandemic and timing. But it's -- if you look at this the KPIs, the performance indicators that we look at, there's a lot of things about it that are -- you jump off the page, like if the pandemic would only go and pass, this thing is in fantastic shape. That's the reaction you have to it. So we feel pretty good about it. Timing is somewhat dependent on the pandemic.

And our next question comes from Kyle Joseph of Jefferies. Your line is open.

Congratulations on a nice quarter, and I wanted to talk about net interest margins in the outlook going forward. Obviously, it's an active deal environment. Just talk about spreads. And where we are versus, call it, year ago levels? And then on the cost of funds side, talk about what the liability management you guys have done recently, could -- how that could help on the cost of fund side?

Yes. Sure. Well, I'll just comment on the asset side, the spreads, I mean, we're kind of back to pre-COVID spreads. So we're not -- it's not -- there's not a -- we don't see a whole lot of COVID premium out there. Maybe a little bit of premium in the sense that leverage. People look at the pandemic and the rear view mirror and leverage as are slightly lower than they were a year ago. So from my perspective, that is a risk element that's in our favor. Generally, but the spreads are -- on the loans we do are kind of back to pre COVID levels, but our cost of capital, which I'll let Michael comment on, has come down. So we feel pretty good about the asset liability relationship. Do you want to talk about that?

Yes. So obviously, we raised $75 million on that 4.5% institutional bond, which took out -- if you think about it over the last 2 quarters, we've taken out the entire potentially, I think we have $60 million left on that bond. So we've converted it from 4 -- 5.95% down to 4.5%, so that's about 150 basis points. Which if you annualize that, that's really about $800,000 a year, so about $0.01 a quarter. So that's going to be helpful. I think going forward, the SBA is still hanging out there. The notion would be between $340 million on the credit facility, which is about 2.75% all in, and we should expect to see the SBA if and when that comes to pass at a similar cost. So you'll have 3 parts of the portfolio in sub 3, and then you'll have that bond at 4.5% plus the $75 million we have at around 5%. So the kind of your blend right now is around 4.85%, and we think we're going to be coming down to 4.25%, probably in the next year.

Got it. Very helpful. And then obviously, your credit is trending in the right direction and your books in good shape, but just trying to peel back the onion a little bit. Can you give us a sense for revenue and EBITDA trends in the fourth quarter and how those compared to the third quarter and either in terms of growth or contraction and kind of early performance year-to-date?

Yes. I would say, generally, EBITDA and revenue in the portfolio for the -- for a strong majority of the companies was positive, kind of low single digits and looks pretty good. I mean, deleveraging in the portfolio is good. We've got a handful of names that are kind of bumping along, but from where we sit from a first lien perspective, it's -- that just means that they bust a covenant here and there. We get to charge economics and -- but there's plenty of cash flow to service our debt and that type of thing. So that's part of being a first lien lender. That's a benefit. You get as things bump along a little bit. But a very strong majority of the companies were -- last quarter and this quarter were positive.

Got it. And then one last one for me. Just talk about your appetite for continuing the special. Obviously, you guys have a strong UTI balance, but kind of the outlook for that going forward, given where the base went to as well as the overall strong portfolio performance.

Yes. So I mean, it's -- we're continuing to -- until the Board decides otherwise, we're continuing the supplemental dividend program, like we stated, it's a liquidity thing, right? There's -- the UTI is not going anywhere. So we distribute it over time. So it's a liquidity thing for us to have the capital to do it, which we have plenty to do. We manage it that way. And so our goal was to create a program that the market can rely on and then obviously can price the stock accordingly. But as of now, we're continuing to pay it.

Yes. And I would say that you need to really look at them independent of one another. So the UTI balance is going to dictate, as Bowen said, whether something that will differ is approved by the Board on a quarterly basis. And obviously, we have about 2.5 years of runway there. So plenty of time to make a decision on how we play that out over time. But on the regular dividend, all the things we're talking about, we're having a growing portfolio, our cost of debt is coming down. Operating leverage, even though it was around $2.6 million this quarter, the run rate for operating leverage is really around $2.2 million on a normal course. So all that being said, we think that this is the first of several dividend increases probably over the next several quarters. And so you should expect to see growth on the regular and supplemental should continue along the way.

Our next question comes from Robert Dodd of Raymond James. Your line is open.

Congratulations on the quarter. And if I can go back to the spread issue, right? I mean, obviously, I think you said no COVID premium anymore, which I don't think is that surprising. But if leverage is down, can you give us any color? Today, if you work a risk-adjusted total return expectation when you're looking at doing a deal. Is that wider today still than pre COVID? Or is all of that evacuated as well with the no COVID premiums? Is the lower leverage not enough to kind of make you raise your expectations for what total returns going to be over the life of an incremental loan? Or is it?

Yes, it's a question. I would say this. I mean, I think generally speaking, the models we're looking at now from a debt perspective, have kind of the same debt returns with a difference that I want to make in a second, that's important. But the debt returns are all anticipated returns on your debt, which is spread and LIBOR and OID, upfront and prepayment penalties if they pay early, those types of things, it's all generally the same. One of the things that -- your equity returns might be higher because some of the businesses performed really well during COVID, but they're still kind of down from COVID. And so we can underwrite the founders want to go ahead and de-risk their personal situation and roll over, maybe even more equity because the valuations maybe are down in certain instances. And so as we look forward, the equity upside in a company like I just described, might actually be higher than it was a year ago where everything is up and to the right, and there's no problems in the world. Whenever there's no problems in the world, that means the problems come in, right? So -- and so there are situations that we've definitely seen where the equity returns, if we had done the deal a year ago, would probably be anticipated a base case equity return might be less. And so that's the difference. I would say as our cost of capital, as we have always said, the range of pricing in the lower middle market a range. And some of that's competition, but some of that's just things like leverage, but also loan-to-value. A company that's your lending 30% loan-to-value is going to -- on a cash flow and higher-margin business is going to have a lower pricing than something you're 50% loan-to-value and maybe lower margin, and so it's going to price cheaper. So like there's a safe end of the lower middle market and a little bit less safe into the lower middle market, right? There's a range, right? That shouldn't be all that surprising. And so as we manage our capitalization and get our cost of capital now, we can play more in the safer end of the lower middle market. And so it's a lower loan-to-value, but maybe tighter spreads. But then one of the big, as you know, one of the big drivers of long-term all in returns is principal loss rates, right? So I think that as we invest, maybe slightly lower spreads and a safer end of the market with lower loan-to-value, higher-margin businesses, you asked me about my anticipation. I mean the more we do in that, I anticipate materially less long-term credit losses. And so I -- look, I think our track record of our team is excellent. But credit losses are an expense of our business, right? I mean, your expenses, your business, right, with a spread business, but we have 3 buckets, right? One is the cost of our capital, we're borrowing. Another is our overhead, that's operating leverage you hear about every quarter. And then the third cost is losses over time. So you're always trying to gain efficiency by decreasing all 3 of those buckets. And so one of the buckets is losses over time. So as we do slightly safer loans, i.e., a slightly lower spreads, yes, my anticipated all in return over time increases. And we also --

By putting together, Robert, a portfolio of those credits that bone just described, it's also going to enhance our investment-grade portfolio. Right, in terms of going to the rating agencies, which in time would mean we'll actually be able to reduce our cost of capital even further by putting together that high-quality portfolio.

Hopefully, that's helpful on how spreads relate to all-in return. Hopefully that's helpful.

Yes, absolutely. Very helpful. I really appreciate that. Exactly right. I mean it's a total return vehicle. It's not just a coupon business. On the portfolio, as it stands, I obviously, we don't have the queue yet, right? So when I look at the unrealized depreciation in the quarter, can you give us any color of how broad-based that was? I mean, obviously, you had 2 upgrades. Did those account for most of the unrealized appreciation? Or is it just -- is it much more broad than that across the portfolio?

I'd say it's pretty broad in the sense, but it's mainly on the equity portfolio. So that's why we put that bridge slide, Slide 20 in the shareholder deck. And so we did that kind of footfall chart going across the page. And you can see the change in the equity portfolio being $0.33 a share for the quarter. That's not a small number for one quarter. And that's probably -- it's definitely 2 handfuls of equity investments. Now we did have the Tenuity exit this quarter. That was materially higher than it was valued at the end of last quarter. So that contributed to that equity upside as well.

Got it. Got it. And then one last one I've got. On ag Kings, I mean obviously, again, we don't have the mark. The exit at the end of the quarter was that about -- in line with the mark that you had at 12/31. And if you can give us any color on where that market was versus 9/30 since that's the only one that -- that's the scheduled investments that we currently have right now.

Yes. So our exit was higher than where it was valued last quarter. So that's the first thing I would say. And then the $739,000 that's left is basically the last interest. I mean, there's a litigation trust and the final bankruptcy cleanup and there's a final working capital adjustment and some final economics, which, candidly, we believe, is going to be meaningfully higher than the $740,000, we have it valued right now. So we think there's upside in NAV from that perspective. And then our all-in recovery at the end of the day, will be about $0.80 on the dollar.

And our next question comes from Sarkis Sherbetchyan with B. Riley Securities. Your line is open.

I just want to hit on the point regarding the comments on operating leverage run rate at 2.2% on a normal course you just mentioned in your commentary. Can you maybe help us understand the timetable that you're anticipating on getting there as well as maybe the portfolio or total portfolio size that you would expect to achieve that?

Well, I would tell you, right now, as noted earlier in the script that we've had an essentially onetime accrual above the annual target rate, which is about $700,000. So this quarter, the actual run rate for cash compensation would be $1.7 million. Our share-based compensation run rate is usually around $800,000 and so you're looking usually at about $2.5 million on a run rate basis right now. And based on that asset base, it's a 2.2%. So we would expect additional -- I mean we've already said we've closed $33 million in assets in January. So moving forward, on a normal run rate basis, we would expect that percentage to be somewhere between $2.0 million and $2.2 million.

Great. And just want to hop on Page 11 and 12 of the slide deck for the Q3 originations and then the subsequent quarter end originations, right? So if I look at the debt spread, the weighted average was 8.2% almost on the Q3 originations. And then if I look at the 2 in quarter end, it's about 7%. Is that really just deal specific? Or is that an indication of what's going on from a tightening perspective in the environment. Any color there, please?

Yes. You got to really -- it's deal specific. I mean, if you look down through there, I mean, like there's a couple of deals that were -- one in particular is the first last out structure. So we brought in the first out party to take a small piece of the loan. So our spread is higher on that. We've got -- one of the companies had a 9.50% spread. That's a portfolio the company we've been in for a long time, and there's some precedents set as to what the spreads are in that deal, so it's not completely new deal type thing. But it's really kind of -- I'm just looking down the list, it's pretty deal specific. So if you go into I mean 600 larger product club type situations, larger company. So -- and we're -- yes, we're actually first out in the 600 deal. We're actually first out, interestingly enough. So it's a little bit more deal specific. I wouldn't say that's a difference between Slide 11 and 12 is directly parallel to some trend in the market.

Great. That's helpful. And I guess last question on me regarding kind of the leverage front. I believe from an economic leverage perspective, had you targeted kind of the 1.3 to 1.4 range, assuming you get the SBIC licensure. And from a regulatory leverage perspective, you still kind of be in the 1:1 zip code. Can you kind of give me some color on that?

Yes. I would tell you from an economic leverage perspective, we really have targeted between 1.2 and 1.3, even getting the SBA money when that does happen, we don't plan on levering up economic leverage beyond there. So I think to your point, we probably will show up with 1.0 to 1.15 on regulatory leverage and stick to 1.2 to 1.3 on our total economic leverage.

Thank you. And at this time, I'm showing no further questions. I'd like to hand the conference back to Mr. Bowen Diehl for any further comments.

Great. Thanks, operator. Thanks, everybody, for joining us. We appreciate it. Hopefully, you got a good impression if things are going pretty well here, and we appreciate your all support and time and look forward to keeping you posted on the business as we go forward.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.