Capital Southwest Corporation (CSWC) Q4 2021 Earnings Report, Transcript and Summary

Thank you for joining today’s Capital Southwest Fourth Quarter and 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 actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest’s publicly available filings with the SEC.

Thanks, Chris, and thank you, everyone, for joining us for our fourth quarter and 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 the fourth quarter and fiscal year ended March 31, 2021. I want to first say, I hope everyone, their families and their employees continue to be safe and well. We are hopeful that the economy will continue to take steps forward as businesses and communities continue to return to pre-pandemic levels. While the aftermath of the pandemic continues to impact certain parts of the U.S. and world economies, we are grateful for all the work done by our employees as well as the sponsors, owners and employees of our portfolio companies. I am pleased to report that this year was another stellar year for Capital Southwest as we continued to steadily grow all aspects of our Company, including investment assets, capital availability and flexibility, and investment income. As we reflect on the year and the unprecedented storm that hit the economy, vis-à-vis the COVID pandemic, we noted some fundamental decisions made in prior years, reflective of our full economic cycle management philosophy that allowed us to perform well during the unprecedented black swan event that we all experienced in 2020. First, we have been intent to always have ample liquidity, which in our case means ample revolver availability and a prudent amount of outstanding unfunded portfolio company commitments. Second, we maintained a flexible leverage structure on our balance sheet with over 50% of our liability structure in the unsecured covenant-light bonds going into the pandemic. And third, and perhaps most importantly, we have maintained our discipline in building a high-quality, almost exclusively first lien credit portfolio with diversity in industries and the granularity of hold sizes. As a result of these decisions, we were able to do three important this fiscal year. First, we had more than ample liquidity to support portfolio companies that needed it, while also continuing to fund new deals that were able to be underwritten in the pandemic environment. Second, we were able to more than cover dividends to our shareholders. And third, when the inevitable stock market volatility presented itself, we were able to repurchase a material amount of our stock.

Thanks, Bowen. Specific to our performance in the March quarter, as summarized on slide 18, we earned pretax net investment income of $8.9 million or $0.44 per share. We paid out $0.42 per share in regular dividends for the quarter, an increase from $0.41 regular dividend per share paid out in the December quarter. As mentioned earlier, our Board has again this quarter increased the quarterly regular dividend, declaring a dividend of $0.43 per share, up from $0.42 per share last quarter to be paid out during the June 30 quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax net income is important to our investment strategy. Over the past 12 months, we maintained our strong track record of regular dividend coverage with 108% for the year and a 107% cumulative since the launch of our credit strategy in January 2015. 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 June quarter. As a reminder the supplemental dividend program allows for shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of March 31, 2021, our estimated UTI balance was $0.92 cents per share. Our investment portfolio produced $17.2 million of investment income this quarter with the weighted average yield on all investments of 10.2%. Investment income was $1.9 million lower this quarter due primarily to last quarter’s investment income, including significant nonrecurring dividend and fee income.

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 over six years ago. Our team has done an excellent job building a robust asset base, deal origination capability as well as a flexible capital structure that prepares us for all environments throughout the economic cycle. We believe that our performance through difficult times like we all experienced during 2020 truly demonstrates 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 the 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 for Q&A.

Thank you. Our first question comes from Devin Ryan with JMP Securities.

I guess, first question here. Clearly, as the credit backdrop stabilized, I’d love to maybe get some more color on appetite for growing assets in the I-45 senior loan fund. And also, if you can just remind us how you guys are thinking about kind of target leverage and target leverage profile in that portfolio.

Yes. I think, I’ll make -- this is Bowen. Thanks for the question. I’ll make a comment on the market, and I’ll let Michael comment on the leverage target. But, I-45 fund is going well. It’s performed much better now from a market quote perspective. It’s primary asset class is a syndicated market. So, we work very hand-in-hand with Main Street. We’re great partners. They’re great partners to us and we to them. And so, we’re kind of looking at the market as we go forward. So, our growth in that fund or the pace of growth in that fund is really candidly just a function of the assets that we see and in syndicated world and to a lesser extent the kind of large club world. And so, I’ll let Michael comment on the leverage targets, et cetera, but we’re managing leverage in the fund, and we certainly have capital to put in the fund to grow and Main Street clearly has capital to put in the fund and grow it. So, it’s really just a function of the windshield -- and looking forward in the windshield and the market and the deals that we see to put in there.

I think from a leverage perspective, I think on a steady state basis, we’re probably going to be running leverage between 1.3 and 1.5. I think what you saw during the pandemic, leverage rode up over 2 times, and we put in equity capital to delever down to closer to 1 times. So, we thought that was a prudent thing to do at the time. So, right now, we have about $165 million in assets. I think we’re going to look to grow that to about $200 million in assets, which would get us closer to really 1.5 times. We probably have a pathway to do that in the next two quarters.

Just a follow-up on the liability side, continue to make progress. And you kind of alluded to this a bit in the prepared remarks. But, can you just remind us kind of the pathway from here to kind of that investment-grade rating? And in your view, maybe what else needs to happen to achieve that?

It’s a good question, and we’ve been talking about it for a while. I would tell you right now, I think there’s a size bias. And so, we’re approaching $800 million in assets. I think as we approach $1 billion in assets, I think that’s when we would start approaching the rating agencies because what we’ve tried to do over the last six years is really diversify our sources and products on of the liability side. So, it started with growing that credit facility over time from 3 lenders to 11, doing the baby bond and then having two institutional deals done, and now adding to it the SBA really sort of kind of solidifies, we believe that plus trading above book and having the ability to raise equity on the ATM program. And then, I guess lastly, I think the other thing the rating agencies look at is repayments and liquidity and coming off of the portfolio, which now we see that in a steady state, now that we’re a stronger -- a larger company and more mature. So, I think all that being said, I think it’s really just a little bit more of time and to continue to perform and make certain that we’re also -- our leverage level is prudent.

One of the things on that, Michael had me in front of each of the rating agencies six years ago, five, six years ago when we started, and my goal was not to be an investment-grade company five, six years ago. But my goal was to solidify in our mind very thoroughly what our resume needed to look like when we did get to the size and we were a candidate. And so we’ve been thinking about that for years. And Michael just articulated kind of the resume, but we think we’ve built that resume. Of course, it’s all based on track record as well, as Michael alluded to. But we think we have the resume to be an investment-grade rated candidate and a strong one, but there is a size kind of fair way that you need to be on, so.

Yes. Okay, terrific. I appreciated the process, but you could -- see you guys making progress. So, I’ll leave it there. But, thanks for taking my questions.

Our next question comes from Kyle Joseph with Jefferies.

Just given where we are in the second quarter or your fiscal first quarter, just kind of want to get a sense for investment activity quarter-to-date as well as repayment activity.

Yes. So, I would say, the pipeline is very strong right now. Our activity has been strong. We would expect to have a pretty robust quarter from an origination perspective this quarter. Now, it may be late in the quarter on an average kind of timing of closing. And so, it’s -- I think it’s going to be positive for this quarter, but it also is probably very positive for the September quarter, so just because that timing matters. So I think we’re pretty pleased with the activity. And so, we’d expect it to be pretty solid. Anything you want to add?

Yes. I think just on -- from a net growth perspective, we’re also probably going to see probably $30 million to $35 million in prepayments coming back over the next 60 days. And these are deals that we actually were aware of for the last probably 120 days. So, they’re probably just winding down their processes, but we’re not seeing much behind them. So, we think on a net basis, you can kind of get the picture.

Yes, very helpful. Thanks for that. And then, with the SBIC, obviously, that’s excluded from regulatory leverage calculations. Any change to your sort of target leverages in terms of how we should think about total versus BDC leverage?

So, from an economic perspective, you can expect us to really be in really the 1.2% to 1.35% economic leverage. And I think as we ramp the SBIC, I think regulatory leverage will inevitably be around 1 times, and I would say 0.9% to 1.0% as it’s fully deployed. So, nothing really changed there. I think you’ll see continually a conservative stand?

Got it. And then last one for me. Obviously, no NPAs, it sounds like the portfolio performance has been really strong. But, can you give us a sense for maybe rev and EBITDA growth trends, and how those have trended kind of into the quarter, particularly as we start to comp against COVID impacted…?

Yes. So, it brings up an interesting point. So, if you look at kind of run rate EBITDA and revenue growth across the portfolio as we see it today, I’d say it’s positive because the portfolio is -- and economy, candidly, is from a run rate perspective, opening up, businesses are growing, returning to pre-pandemic levels. Now, from an LTM perspective, especially like this quarter when we tested LTM at February of ‘21. So, that LTM period is March of ‘20 to February of ‘21. So obviously, that’s a period that has 100% of the COVID effect and much less of the recovery effect. And so, I’m making the distinction between run rate and LTM. And so, I think the LTM quarter-over-quarter is still, I guess, I’d say, down across the portfolio, although we have a couple of handful of companies that are candidly just blew right through the COVID pandemic, which -- due to their business models. But the run rate, as we kind of sit here today is clearly -- is across the portfolio, except for half a handful of companies that are still just kind of struggling. But, it’s definitely on the uptrend.

Got it. Thanks very much for answering my questions. And congrats on a solid year.

Our next question comes from Bryce Rowe with Hovde.

Thanks. Good morning. A couple of questions here, Bowen and Michael. I wanted to kind of touch on just pricing in the market. Obviously, we’ve heard from many of the BDCs that pricing is back to pre-COVID levels or in some cases maybe even tighter. Can you -- and it looks like this quarter, you had a weighted average yield of about 8.8% on the newer investments with a spread of 7% to 10% from a yield perspective. Just curious kind of, do you expect pricing to stay in this ballpark in this ZIP code, or are there -- is there -- are you seeing some potential for continued kind of movement to and through pre-COVID?

Yes. Thanks for the question, Bryce. I would say, first of all, there’s lots of liquidity in the market. We all know that. The market is -- has, from an activity perspective, returned -- might certainly from a price perspective, kind of back to kind of pre-pandemics levels. Leverage, pre-pandemic, post-pandemic, I still think it’s slightly lower post-pandemic but pricing is definitely back. When you look at our 8.8%, I’d caution you from getting -- I think yields in our portfolio will come down slightly, maybe 50 basis points in the next 6 to 12 months, based on kind of what we’re seeing, based on LIBOR being down. But you have to keep in mind, our cost of capital has come down quite a bit. As we start layering the SBIC, I think the net interest margin will be very robust, even with a slight kind of 50 basis points kind of retracement over the next kind of 6 to 12 months. Now, don’t look -- if you look at the 8.8% and put that in perspective, if you take out the a 7.1%, that’s actually a first out loan that we did kind of 1.3 times leverage kind of number. And if you take that out, it’s closer to 9.5%. And I would tell you that our pricing on our deals. I mean, it kind of -- it’s deal specific; it’s mix specific quarter-over-quarter. And it kind of is low -- kind of lows of 9.5%. If you look out over the last several quarters, low of 9.5% and high of 10.5%, it kind of fluctuates up and down. And so, the landing zone of our yields is not -- we don’t believe is 8.8%. So, it’s a little bit quarter specific. I think it does flow kind of quarter-to-quarter in those ranges. And so -- and then, as a first lien lender, we always have a portion of our portfolio that underperforms. That’s just the nature of any lender and certainly a nonbank lender. And so, the beauty of a first lien lender is that when his companies underperform, a lot of our loans have grids, so interest rate floats up, we got additional interest in default interest. There are various things. There’s always some level of economic enhancement when you think about the entire first lien portfolio. And that will always be a case. And so, that tends to make up the difference and get you kind of into the mid-10s kind of yield, if that makes sense. So, trying to relate the 8.8% the fair way we live on. I don’t think the fairway has gone from 10.5% to 8.5%, I mean, not even close. And so, I think it’s -- and our cost of capital we think is dropping faster than the yields are dropping. So, that’s been good for us.

Right. And so, if you think about it from margin, right, it will be fixed rate draws on the SBA, but you also look at what we’ve done to date, we have two-thirds of our liability structure that’s fixed rate. So, as rates rise over the next maybe that takes 12 to 18 months before you start seeing that, you’ll see our net interest margin actually start improving as well as the impact on the assets as well.

The other thing, Bryce, I’ll just put out one more comment. It’s important to appreciate -- it’s important to know that about our business. We primarily in the lower middle market. The lower middle market, I think of it as kind of a -- it’s got deep end; it’s got a shallow end. The deep end is a little more story credits and the shallow end is lower loan-to-value, safer credits. Well, the lower end has lower yields and the higher end, the deep end has higher yields and a portfolio is a mix of all that. So, as your cost of capital comes down, you can get nice net interest margins on the shallow end of the pool. So, you can have some of your overall portfolio yield migrate down as you drop your cost of capital down. And then, our job as credit managers is to make sure we’re not putting shallow end pricing on deep end deals, if you know what I mean. And that’s our job and that’s art of what we do, but it is a very real dynamic and one of the key reasons why my getting that track record build, the diversity of sources of capital and ultimately your cost of capital down, so that you can get equal or better net interest margins on a safe for asset portfolio. That’s strategically very important to us.

And not to beat a dead horse, but the other part is our cost structure. So, you’ve seen our operating leverage come down from 4.9% years ago to -- our run rate LTM right now is 2.4%. But this particular quarter, our operating expense was 2%. So, you’re seeing our expenses are growing at a lower clip than our assets are growing. So there’s also that in terms of our net interest margin.

That also gives you the ability to get net interest margin at the shallow end of the pool, if you will. So that’s how we think about the world, so.

Yes. That’s a perfect perspective and maybe leads into the next question. So, you’ve seen a nice bump in your stock price and then your price to NAV valuation, obviously, took advantage of it, the last couple of quarters with some more active use of the ATM. So, I guess my question is, do we think about this pace of ATM usage being kind of more normal now that you’ve got the multiple that you have or have you tried to be more opportunistic the past couple of quarters in anticipation of the SBIC license coming on line and having to get ready to capitalize that?

Yes. I’m going to make a general comment. I’ll let Michael comment as well. We view -- the ATM is a great tool for an internally managed BDC like us. You keep your track record strong, the internal -- we all know the benefits of the internal managed model. We talked about the operating leverage of various things. If you -- and if we can raise equity capital as a function of the originations that we’re doing -- so, the equity to us is moderating and governing the leverage on the vehicle. And the leverage on the vehicle is a function of asset quality, first lien versus second lien, et cetera. And so, first lien portfolio can -- we believe, can hang out a little bit higher leverage than our second lien portfolio, et cetera. But, you’re using that ATM to govern that leverage now. So, we’re not opportunistically doing it necessarily. We’re thinking about leverage in the pipeline and ATM can be great because we can raise equity at 1.5% kind of spread to trade, and we can do it more in lockstep with putting the dollars to work. And so, -- and if we deserve the multiple, right, and we -- and that’s a function of track record and consistency, and we hold that very dear, it’s very important to us, we have a premium multiple then that -- that ATM program is accretive to NAV per share, but it’s also being put to work very quickly if it’s being done in conjunction with the pipeline minimizes and theoretically eliminates the NII dilution from it if you’re putting it to work. So, anything else, Michael, you’d add?

Yes. I mean, I would say, look, for the next 12 months, I think on an average, you probably would expect to see us raise on average $15 million a quarter. But having said that, the way Bowen described this right, we kind of think about it as sort of like the clutch and the brake that we’re trying to make certain that we stay in that leverage range. And since -- with our earnings timing relative to quarter-end, you have a sense what your pipeline looks like. And so, when you -- when the ATM opens up, like it will two days from today, we’ll sort of know where we want to land, based on the originations and therefore how much equity we want to raise. So, for this quarter, obviously, with it being robust, you can maybe anticipate a more. But in other quarters, we’re indicating originations might be lighter or prepayments are higher than you might see it closer to the lower end of the range.

Our next question comes from Sarkis Sherbetchyan with B. Riley Securities.

I just wanted to quickly touch on the SBIC license. I think you mentioned an initial $80 million capital to commit next six to nine months and plan to draw $175 million on the debenture. So, just want to get a sense for -- from the net originations, like how quickly do you plan to tap into the SBIC side versus the rest of the BDC?

We’re anticipating starting to contribute assets to the FDIC in the next few weeks. The first asset will probably go in, in the next two or three weeks. So we’ll initially put equity to work. We’re still waiting for approval on the leverage application, which is just a paperwork to get completed. But once that occurs, we’ll be basically funding our first $40 million, and then we’ll be drawing $20 million of capital, so a half tier. You have to ask for an examination by the FDIC just to review your books and records at that point, and then they release the additional $20 million. So, I’d say, we see that $80 million. And if you think about the way we’ll allocate assets, we’ll be putting essentially approximately 50% of an asset -- originated asset into our credit facility and 50% in the SBIC. So, in terms of putting the capital to work over the entirety of the program, say six to nine months for the first $80 million, we probably anticipate it will be in the three to four years before we fully utilize the $175 million. And then, obviously, we’ll be replenishing that as repayments come in over the 10-year life.

Great. Thanks for that. And in the last quarter’s call, you mentioned kind of a net origination growth per quarter and kind of the $20 million to $30 million ZIP code. And it sounds like -- it seems like you guys did a really nice shot here in this past quarter, and it sounds like that maybe continues here in this quarter. Is that kind of the right ZIP code to think about from a growth perspective, or would you think originations and kind of prepays go to more, let’s say, normalized levels? Any comments around that?

Yes. It seems -- I think we would amend that based upon the staff we have. We’ve had seasoned professionals. We’ve added staff. And I think we’ve certainly had foothold in markets around the country. I would tell you that at the low end of the quarters or about maybe we should expect $40 million or $50 million of originations and the high is $75 million plus. We kind of anticipate somewhere in the $10 million to $20 million in repayments a quarter. So, the net is somewhere in the middle there. Bowen, do you want to add anything?

Yes. I think that’s right. I think it’s -- net might be a little bit higher than we said last quarter, but it’s not too far off, so.

Our next question comes from Robert Dodd with Raymond James.

Hi, guys. A couple of questions, first of all on I-45. You mentioned, I think, Michael, that you amended the agreement. Does that bring basically your economic share into line with your ownership share, or is there some other delta in terms of amending that agreement with Main now?

Yes. No, essentially, that’s moved that direction, as you said, Robert. I mean it’s -- we just changed the relative economics to reflect the maturation of our firm. And so, it’s not any more complicated than that. I mean, it goes really well, it’s kind of basically what we did. And it was kind of time for that.

Yes, understood. Then just one more on that. I mean, you amended the revolver. It’s now down to 250 basis points. That looks pretty -- were there any onetime expenses or anything like that in this quarter? It looks like the lowest dividend -- I mean, lowest dividend from the JV since probably 2016, I think, was there anything unusual, or -- and obviously, your comments where you expect the returns to be higher in the future, so this quarter…

Yes. So, I would say -- sure, for I-45 this quarter, I think I would tell you that the repayments that came in, which were plentiful, came in early during the quarter. And then, the originations, honestly, that we’ve actually closed but haven’t even settled. So, the settlement process for some of these credits takes a bit of time. So, we’re looking probably at, I think, $15 million to $20 million of originations that will probably settle in this June quarter. So, I think, just a bit of a mismatch, right, for -- in terms of the activity to the dividend. So, to your second question, we do expect there to be a bounce back in this following quarter.

That’s a good question, Robert.

Thank you. And then, just a more broad one. I mean, in the conference, you said equity ownership in 60% of the portfolio companies. I mean, is the target to take that -- I mean, obviously, it will vary quarter-to-quarter. I mean, the 60 one this quarter, there were only two that got equity. So, obviously, lower than a 60% run rate. But would you expect that 60% to go up over time, or are you happy kind of at 60% across long term, or any color you can give us on that?

Yes. It’s an interesting question. I would tell you that we don’t look at -- I mean, maybe it’s obvious, but we don’t look at, okay, we want a certain percentage of our portfolio companies to -- we want equity in. I mean, we’re looking at more from two things. Top level looking at it saying, okay, the equity, we’d like it to be 8% to 10% of the portfolio as overall kind of works for the business model. And then, this question of deal by deal, do we like the equity story or not. I mean, we don’t -- the equity story and the valuation thereof of the equity story and whether we think there’s equity we get the equity store, we think there’s adequate returns on the equity. We take a view of the sponsor, whoever is taking another view. That doesn’t necessarily always blend. And those on the call are around that have done credit before, you do see oftentimes deals where you like the credit story more than the equity story. I mean, the two dynamics between the two are very different. Some would be a really interesting cash flowing business. But it’s like, gee, with it, how do you grow it? How do you scale it? That kind of thing, which is not the lenders problem, that’s the equity-holder’s problem. And so, we don’t always like the equity story. It doesn’t mean we hate the equity story. But the -- but we don’t always love the equity story. And the other thing I would say is that if a private equity firm is a larger firm, writing a smaller check in a deal, sometimes it’s hard for them to share the equity, or they want an outsized carry if we invest in equity, and that starts to deteriorate the equity story to us if we have a huge carry going out. So, it -- there’s just a number of factors. And so, where it all lands, 60% -- I mean, my guess is -- and I’m guessing here, but I’m guessing it’s probably 60% to probably around two-thirds, plus or minus, over time of the deals, of our portfolio loans will have an equity piece next to it. I’d probably say it’s probably very rough rule of thumb. So, 60%, when I looked at that number and thought about the averages, I thought that sounded a little bit low. And if it was above 75%, I feel like that was a little high. So it’s probably two-thirds over time on average.

Got it. Because I mean, obviously, your realized IRR today of north of 15%. I presume that would be a challenge to sustain from that only, right? So equity is kind of required to...

Yes. I think that’s probably true from theoretical perspective. I also think, remember, we’re lending to the lower middle market, these are smaller businesses. And the good news about the smaller businesses, a lot of them are growing pretty interestingly. I mean -- and so, it’s not like these large companies that are trying to grab 2 points of market share et cetera. I mean, these are businesses that have newer ideas, newer business models, grabbing market share at a pretty high rate. The private equity firm is putting basic institutionalish things in place, like ERP systems that generate KPIs that they can help the founder manage the business better and grow it better, adding marketing people because the small company has two marketing people and you look at that and go, they ought to have 10. It’s just obvious without certain industry, they ought to have 10. Well, those are big growth drivers and you don’t see that as much in larger companies, and you see it in this lower middle market quite often. And so, the equity is important if we like it. It’s an important piece of the business model, but it does -- it does enhance returns over time, for sure.

Yes. The other thing I would note, too, Robert, is that we have -- we’ve actually in some of the companies that have stumbled during COVID, like AAC or Delphi or CDK, we’ll be able to pick up equity in the restructures. And so, those assets, actually, we have kind of push on them. And those might see some significant recoveries on equity as well. So that’s…

Yes, the reality is that’s recovering former principal. But if you think about it from where NAV is today, that’s all upside. So, look at it both ways, right? And so, we think that’s something that we’re pretty bullish on, honestly.

Understood. If I can, one last housekeeping one. On the tax side, I mean, the tax in the -- I mean, obviously, there was the onetime write-off last quarter. But this quarter, even so, the tax looks elevated relative to what I would expect excise tax to be. So that it seems like there’s something more in the tax in the NII line than just size. Can you give us any color on what that is?

Sure. Sure, Rob. And you’re right, the excise tax actually of the $850,000 is only $50,000. And that’s a run rate number going forward. We did have, as part of the write-off of CSMC, as you noted, there was -- a majority of it was last quarter. There was an additional $425,000 because the previous number was off of a provisional return and the final tax return was done in April. So, there’s another $425,000. And then, the last one we had -- and that was obviously onetime in nature. And then, we had another onetime expense as well for whenever our portfolio companies paid a dividend, cash dividend. And so, from a tax basis, it reduces your cost basis and therefore, increases your unrealized gain, and therefore, we had to increase the income tax accrual. So, that was $375,000. And so, that’s essentially $800,000 of the $850 million were onetime in nature, and both of them are noncash.

Thank you. Our next question comes from David Miyazaki with Confluence Investment Management.

Hi. Good morning, gentlemen. First of all, just a couple of comments. I really appreciate that you guys years ago set out to tell us what you’re going to do. And years later, you’re now -- you’ve done what you said you were going to do. Unfortunately, in this industry, there’s oftentimes a gap between those two things. So, I really appreciate it. Your credit underwriting, the formation of your JV and its growth and its management, your liability management, particularly your use of the ATM and how you characterize its use versus your leverage, all those things help make things a lot easier for us to shareholders to not have to manage through surprises, not have to manage through NII dilution after equity issuance. It’s just very helpful. And congratulations on getting the SBIC over the line.

Thanks, David.

Just a kind of -- yes, so you guys have done a great job. And one of the things that we often here, particularly as BDCs become larger, there’s this recognition that the lower middle market is less efficient, pricing is more stable, the terms are more consistent, whereas the upper middle market gets tugged around by what’s happening in the public markets and the big capital flows. And usually, you hear these things based upon how big a BDC is and managers usually characterize whatever they’re doing is to be the best place to be. But, you guys are kind of in a unique situation because you’re straddling the upper and the lower middle markets. And the difference in EBITDA size that you have from about $10 million on the lower middle market exposure and $70 million in the upper middle market. I’m just curious, is -- what are your thoughts, the basic theme that the larger upper middle market borrowers are the place to be because they’re bigger companies with less credit risk versus the opportunities you might see in the lower middle market, you’re doing both. But, how do you feel about the way that the two sides of the middle market get characterized?

Well, first -- hey David, thanks for the question. I would say, first of all, there clearly is a bias across the whole financial markets, bigger is better, right? I mean, we know that. And so there’s just ...

So, the rating agencies say that too, right?

Yes, right. And so, the bigger -- so therefore, there is more capital available, there’s just more, big insurance companies, et cetera. Everybody is like, okay, well, we’ll invest, but it needs to be at least filling the blank. I mean, we’ll do it, but it’s got to be at least 25% in EBITDA or at 10 That’s just all reflective of that bias. And so, what does that -- that business rolls itself. That manifests itself in two things. First of all, there’s less -- there’s more competition for those larger deals. And therefore, the spreads are lower for those larger deals, now they’re bigger companies. But, I would say, candidly, they’re necessarily more -- they’re not always necessarily better credits, but they are bigger companies. But there’s more capital chasing those deals. So there’s less -- so the second way to manage itself is because there’s less capital chasing the smaller deals, the documentation and leverage and those types of things that matter to a credit group like us are much more robust. I mean, leverage is lower, covenants are real. And documents are tight. You don’t see cov light loans in our world. And so, those are all reflective. So yes, they’re smaller companies. But, we think the risk-adjusted returns, which takes into account the company, the quality of the growth and the credit structure and the integrity of the documents in, they are just more attractive. Now, that’s why you see the majority of our -- vast majority of our portfolio in the lower middle market. I mean, it just fits. We like that asset class. We like the fact we can do an equity co-investment, if we like, the equity. You can have that equity kicker in our portfolio. That’s important. Those opportunities don’t exist in a larger market. All that said, I mean, we do think there are credits from time to time in the upper middle market that makes sense. Now, the other thing is in the lower middle market, we lead the vast majority, 80-plus-percent of the credits in the lower middle market, we originate lead. That’s a big deal. I mean, if we’re one part of a large bank group in the upper middle market and something goes wrong, you can’t really make decisions. You just sit on committee calls at nauseam, right? And the lender steering committee calls and blah, blah, blah, right? So, you don’t -- you can’t -- and lawyers and consultants get to make tons of money advising those steering committees. And so, it’s tough to watch when something bumps like an AAC or someone like that, right -- something like that. So, it’s just the nature of that asset class. And so, some of it is a function of our size. But candidly, the vast majority of the reason we like the lower middle market is because of the growing nature of those businesses, the quality of the documentation and structures. And candidly, we just think that there’s not -- we just don’t have that large company bias. We don’t think it -- we don’t think bigger is better, positive bias or small is harder negative bias overcomes the credit quality and the asset qualities in the space. And so, I’ll also say, as we grow, the last time we looked at this number, I think -- so 80% to 85% of our portfolio were deals that we originated in lead, okay? And of that, the last time we looked at the stat, which was maybe a quarter or two ago, but I don’t think it’s that much different. Over half -- or half of that piece that we lead, we brought in another lender or two into those deals because we’re managing our hold size. And so, as we grow, we can hold more and more of the same sandbox of loans that we hold today to keep with the same level or better granularity. So, we have a lot of growth potential within the lower market before we ever have to think about moving up-market. And we’re -- I’m very reluctant to go and compete with the large, bigger is better BDCs. They do a fine job in that space. And there’s plenty of people and plenty of capital chasing those deals in that market. And so, the lower middle market, we’ve got a lot of growing room in the lower middle market before we’re even talking about doing deals out and a larger percentage of our portfolio being outside the lower middle market. Hopefully, that’s helpful.

And David, one thing I would add, our viewpoint on the lower middle market, as Bowen said, it’s been consistent through the years. I think that our viewpoint on the upper middle market has varied, depending on what the market looks like. So, if you look at 2016 and 2017, we were very active in the upper middle market portfolio. The market was sort of beaten up, and we found some great opportunities, and we made some nice returns. Between 2018 and 2020, you saw barely any transactions in the upper middle market from us. You saw the I-45 funds kind of shrink over time. And that’s just our viewpoint and the upper middle market became -- it was frothy, and it wasn’t a place for us to find value.

So, it’s kind of why we had our original slice, six years ago, said core market, lower middle market, opportunistic market, upper middle market, it’s just the same thing today. I mean it’s -- we got to -- you got to remember, you got to define who you are and what you’re good at. And then -- but you got to maintain a capability to look at deals and participate in large upper middle market deals when there’s -- when the dynamic exists. And it does exist from time to time. It’s just the majority of things we do for sure.

And it’s the same sort of thought process we go through with a share buyback program, right, where we want to maintain liquidity to find opportunities in the market when they’re there. Sometimes it’s in the upper middle market. It seems like it will always be in the lower middle market. And then sometimes, it’s buying back our stock when we feel like we’re undervalued.

Right. So, when you think about the thesis that the bigger companies are safer, obviously, that’s very dependent upon individual situations and credits. When you’ve come across credit problems even before default, but you’re just kind of seeing an erosion in operating fundamentals, is it fair to say that your experience has not really -- based upon your individual lending decisions, has not really been adversely affected by the fact that your companies are smaller versus larger?

Yes. So, there’s lots of different facets of your question. So, bigger is safer. I would say, bigger companies are more established in their relative industries, but loans to bigger companies are not necessarily safer, because the loans to bigger companies have less looser covenants and higher leverage generally. And so, larger loan portfolios don’t necessarily -- are not necessarily -- the risk-adjusted returns candidly are not, we think, not as attractive as a general matter. And so, candidly, with things bump in the night, we like to be the decision maker. If we re-originate a loan and we are controlling that loan, the sponsor or the owner is talking to us, they’re not talking to a steering committee, they’re talking to us, and we can make decisions. And we have -- I guess, we have leverage in those conversations. We make decisions on being commercial and being reasonable and maintaining our reputation and all that. But, the point is, we get to control those situations. When you’re -- I think is what you’re asking, Dave. And when you’re in a larger lender group, you can influence it, but it’s almost a political influence with the lender group. It’s not an actual decision because you can influence the group think, and the group think maybe gets to the right answer and most often, they get to an okay answer. That’s not the best answer is usually what happens. But, that’s a very different dynamic. In the lower middle market, leverage lower generally documents tighter, we have more decision-making authority and power in those loans. And so, you look across the entire loan book, I would rather be in that -- I would rather have that loan book -- that kind of loan book where I can make real decisions.

That’s helpful. So, I mean, one of the things that -- when you look at the trend of your cost of capital, right, it’s declining, both in equity as well on your debt, right, which is great. And it can help offset to the extent that your asset yields decline, your NIM can remain intact. It’s just kind of helpful for you -- for me, anyway, to have you described your views towards the upper middle market because you could see how, if your liability cost and your cost of capital was going down, that there could be a draw to go into the upper middle market, where the yields are lower, but you can do it because your cost of capital went down. But, it doesn’t sound like that’s really your strategic plan. Do you -- there’s a couple of the larger BDCs that are internally managed. Obviously, your front is at Main Street. The other ones, like our Hercules have been able to maintain their focus while being an internally managed BDC. As you guys grow, and you are continuing to focus on the lower middle market, how do you feel about sort of scaling your employee base and your resources to continue focusing on smaller loans, even though your capital base is larger?

I think you always -- I know you know this, David. But I mean, you have to remember that we’re not -- there’s no incentive here for us to scale, just to scale. That’s not -- we don’t have a management contract that doubles in size if we double the assets. There’s no -- there’s only one incentive here, and that is, yes, we want to grow, but there’s a why, why do we want to grow? Well, we want to get investment-grade credit rating. We want to hold larger -- we want to bring in other parties, maybe less so that we can be a sole lender on more of our own book because that allows us to be more reliable to close. And in theory, we should be getting even better deals if we don’t have to insert the closing risk associated with bringing in somebody else into our loans. So, I want to grow for those reasons, not just to scale. And so, like you mentioned, cost of capital tempting you to get in the upper middle market. I can just tell you that is absolutely not the case here because what are you going to do it, we’re going to go out and do a bunch of upper middle market deals where we don’t control any of the loans and we have a bunch of participants who are participant in a big chunk of our books solely because our cost of capital went down. I mean that would be like -- that would make no sense. And I’m not saying your question made no sense. I think your question makes a lot of sense. I’m just trying to make that distinction. And so, we’re incentivized to grow this vehicle to make it higher quality and more effective in the market. Operating cost scaling, same thing, right? I mean, we want to grow, of course, we’re going to need to grow operating cost dollars over time as our portfolio grows, of course. We look at operating leverage because we want to grow operating costs slower than we grow assets, which brings the percentage operating leverage that we’re always putting in our slide decks. That comes down. As we talked about, there’s three costs to this business. And we’re taking our costs and we’re re-lending the money at a higher rate, right? And so, what are our costs. Our costs are financing costs, obviously. We talked about that. Operating cost, which is our operating leverage as a percent of assets. If that comes down, that increases our margin at the end of the day. And then, the third cost is nonaccruals, right? I mean, we’re going to have nonaccruals, we model in nonaccruals in our future. We’re not going to hang out with zero nonaccruals forever. It’s just part of our business, but we want that number to be either zero or low because that’s a further cost to our business. And we want to make that cost efficiency. And as we increase that cost efficiency, we’re going to enhance our margin in our business. And so, yes, we’ll grow operating costs, but we don’t think of it as scaling. We think of it as growing proportional to or at a slower rate than asset growth, because that’s where the efficiency comes in.

Well, I greatly appreciate that answer. It’s certainly what I wanted to hear. I like the focus that you have. But I also like the fact that you have the ability to take advantage of the opportunities that episodically seem to come about in the upper middle market. So, I appreciate your answers. And congratulations on a good year.

Thanks, David.

Thank you. This concludes the question-and-answer session. I’d now like to turn the call back over to Bowen Diehl for closing remarks.

Thank you, operator. Thanks, everyone, for being with us here today. We love talking about our business, and we look forward to giving you guys updates in the quarters to come. We appreciate your support.

This concludes today’s conference call. Thank you for participating. You may now disconnect.