Greetings, and welcome to the Gladstone Capital Corporation Third Quarter Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Gladstone, Chief Executive Officer. Thank you, sir. You may begin.

Thank you, Latanya. That was a nice introduction, and good morning, everybody. This is David Gladstone, Chairman. And this is the earnings conference call for Gladstone Capital for the quarter ending June 30, 2023. Thank you all for calling in. We’re always happy to talk to you about all the things going on here. We’d like to update our shareholders and analysts, and welcome the opportunity to provide the update for our company. And now, we’ll hear from our General Counsel, Michael LiCalsi, who makes some statements regarding certain forward-looking statements. Michael?

Thanks, David. Good morning, everybody. Today’s report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. And many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all the risk factors in our Forms 10-Q, 10-K and other documents that we file with the SEC. You can find them on the Investors page of our website at gladstonecapital.com. You can also sign up for e-mail notification on the website or you can find the documents on the SEC’s website as well, which is www.sec.gov. Now, we undertake no obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Now, today’s call is an overview of our results, so we ask that you review our press release and Form 10-Q, both issued yesterday for more detailed information, again, you can find them on the Investors page of our website. Now, with that, I’ll turn the presentation over to Gladstone Capital’s President, Bob Marcotte. Bob?

Good morning and thank you all for dialing in this morning. I’ll cover some of the highlights for last quarter and some comments on the outlook for the balance of 2023 before turning the call over to Nicole Schaltenbrand, our CFO, to review the details of our financial results for the period. So, beginning with our last quarter results, originations were $71 million for the period, with 3 new platform investments representing the majority of these new investments. Portfolio, amortization and repayments were $35 million, so our ending investment balance rose by $36 million. Higher short-term interest rates lifted the weighted average yield on our portfolio by 50 basis points to 13.6%. However, the 6.6% increase in average earning assets was the primary driver behind the 11.4% increase in total interest income, which rose to $21.8 million. Borrowing cost increased by $700,000 with higher SOFR rates and bank borrowings. However, our net interest margin rose by $1.6 million to $15.9 million for the quarter. Net management fees for the period declined to $4.1 million, or 2.3% of assets, as deal closing and advisory fee credits more than offset the higher incentive fees associated with the increase in investment yields. Our net investment income increased to $11.7 million for the quarter, or $0.31 per share, which is up 21% from last quarter and 68% from the same period last year. The net realized and unrealized gain on the portfolio for the period came in at $200,000 positive. However, undistributed earnings for the quarter lifted NAV per share by $0.08 to $9.27. Combination of increased net interest income and lower net expenses lifted our ROE for the quarter to 13.3%. Based on the portfolio performance and increase in net interest income, we recently announced the monthly dividend increase to $0.0825 per month.…

Thanks, Bob. Good morning, everyone. During the June quarter, total interest income rose $2.2 million, or 11.4% to $21.8 million based on the increase in short-term rates and an increase in earning assets. The weighted average yield on our interest bearing portfolio rose 50 basis points to 13.6% with the increase in floating rates on the 92% of the investment portfolio that carries floating rates. The investment portfolio weighted average balance increased to $644 million, which was up $40 million, or 6.6% compared to the prior quarter. Other income was largely unchanged at $1 million and total investment income rose $2.3 million or 11% to 22.8 million for the quarter. Total expenses rose by $200,000 quarter-over-quarter with higher interest expenses. As net management fees declined $500,000 with deal closing advisory fee credits more than offsetting the higher incentive fees paid. Net investment income for the quarter ended June 30 was $11.7 million, which was an increase of $2 million compared to the prior quarter, or $0.31 per share, which exceeded the $0.24 per share dividend paid and supported the increase to $0.2475 per quarter announced in July. The net increase in net assets resulting from operations was $11.9 million, or $0.32 per share, as impacted by the realized and unrealized valuation depreciation covered by Bob earlier. Moving over to the balance sheet. As of June 30, total assets rose to $730 million, consisting of $715 million in investments at fair value and $15 million in cash and other assets. Liabilities rose to $372 million as of June 30 and consisted primarily of $150 million of 5.125% senior notes due 2026, $50 million of 3.75% senior notes due May of 2027. And as of the end of the quarter, advances under our line of credit rose to $164 million. During the…

Thank you. Bob, Nicole, Michael, you all did great job, informing shareholders and the analysts that follow our company. In summary, another good quarter, congratulations to Bob and Nicole for really putting on a show of earnings increase. The company delivered net investment income originations of $36 million for the quarter, which lifted the asset growth of the company to over $125 million, or 22% in the last 12 months. Portfolio is in good shape with modest leverage and very low non-performing assets. The net interest income rose 11% to $15.9 million on a higher rate of earnings and investments in support the monthly common distribution increase to $0.0825. I just think this has been a stellar quarter. In summary, the company continues to stick with the strategy of investing in growth oriented, lower middle market businesses with good management. Many of these investments are supported by mid-sized private equity funds that are looking for experienced partners to support the acquisition and growth of the business, which is what we know how to do. This gives the company the opportunity to make attractive interest paying loans to support the ongoing commitment to pay cash distributions to our shareholders. And now, the operator, Latanya, if you’ll come on, ask the questions about the company from our people listening.

Thank you. We will now conduct a question-and-answer session. [Operator Instructions] Our first question comes from Mickey Schleien with Ladenburg. Please proceed.

Yes. Good morning, everyone. Bob, I’m curious about this portfolio company fee credit. Your investment activity was sort of in line with the last several quarters, but the level of fee credit was the highest it’s been in a couple of years. Could you tell us about the nature of that portfolio company fee and to the extent possible, any outlook on what these fees could look like in the next few quarters?

Good morning, Mickey. Good observation. I would say that there are probably two unusual events; one, the exit that I referred to earlier of PIC 360. We’ve been in that business, gosh, it predates me. So it’s going over a decade. There was an asset sale of the residuals there, which was a decent size fee on the exit of that small position. So that was kind of an unusual item. I would also say that there was – I think, we flagged in our investment activity. There was a prepayment and a reinvestment in Inspire, and so it was an unusual event. Market conditions were positive. We actually got a prepayment fee and a new fee on the new facility. So it was kind of a double hit on that particular point, which probably lifted the numbers closer to $1 million for the period. That said, I would also suggest the fee levels that you’re referencing from prior quarters. There was probably a lot more competition driving fee pressures down last year than there is today. I think in this current market environment, we’re getting full fees. We are talking about origination fees that could be 2% or north of 2%. So, general fee levels have increased, because the access to capital in the market has gotten tighter. So, on average, I would say we’ll probably be above where we have been historically. But last quarter was obviously a bit of an anomaly, if that helps.

Yeah. That’s helpful. I appreciate that. Bob, one of your new positions is a company called Trowbridge, and I couldn’t find anything about them online. Can you just describe what this company does? What sort of business they’re in?

It actually is a business that is buying and accumulating condo association management companies and HOA management companies. It’s a very interesting market. When you look at the real estate market today, most community developments or large multi-family dwellings have some sort of HOA management role, and that includes financial accounting, banking, contracting and other services. It’s a growing business. There are several large players in the business, but it’s a very broad market and this company is aggregating those businesses and systematizing and institutionalizing those processes. It’s a modestly leveraged investment that actually is backed by several very large real estate investors. So we view that as a nice services business that is increasing in its demands and service capabilities in the marketplace today.

That sounds interesting. Bob, you mentioned that in terms of fees, there’s less pressure in the current market, but at the same time, I have seen some spreads on deals which are actively sought after, perhaps tightening a little bit. Are you seeing that in the market where you participate or not?

We really haven’t seen that. Your observation, I think, is very correct. I mean, typically in the marketplace where rates are higher, there’s almost a reverse effect where market multiples go up. And that’s not, because people like paying more for their financing. It has to do with the fact that it’s only the strongest of companies that can come to market in an adverse situation, and they’re growth oriented. So what you’re seeing in spreads and in fees has to do with high grading the investment activity. So only the best companies come through, and there is always going to be a certain amount of capital available to those good companies. So there is a little bit more of a competitive dynamic, given what’s happening in the regional bank marketplace and the general withdraw its tighter terms and capital position. We’re not seeing that in our segment, because the amount of capital that’s currently trying to find a home in the segment where we play doesn’t have quite the same overhang that you would have in a larger facilities and a broader private capital investor base.

I understand. That’s helpful. My last question, perhaps, for Nicole. I think Nicole said that you’re looking to maybe upsize the credit facility as the portfolio grows, but if I’m not mistaken, you just downsized it. So could you just reconcile why you would downsize it and then re-upsize it?

Yeah, one of our banks fell out of the facility, so we weren’t necessarily intending to downsize it. Just one of the banks was changing their focus. So in light of that and as well as our growth plans, we will continuously look to potentially upsize.

Again…

I think the regional banks are going through a soul search of what their long-term strategy is. And, sure, the bank that actually dropped out exited the lender finance business. And it so happens that they recently announced a very large acquisition of, believe it or not, a venture lending portfolio from another failed institution. So people trying to figure out where they want to play, where they want to allocate their capital and how they want to – how they are going to make their earnings work under a more capital constrained environment. So we failed. It prudent to close the facility, stabilize the framework and move on going into a more positive outlook for the company. Clearly, there are going to be banks that are still out there interested in the kind of financing that we do. We just needed to cast a wider net and are currently working with a number of institutions we would expect to bring in.

And Bob, do you – would you consider more unsecured debt to help expand the balance sheet or are the terms just not economical right now?

Well, that’s a big question. Obviously, doing a term placement in some of the rate environment is a bit of a gamble. I would say, we’ve been watching the momentum and certainly the feeling is that rates probably are near peak. And, I think, what we’re starting to see is, investors are starting to creep into the marketplace to recognize that time to probably extend maturities and duration. And that’s something that we are actively monitoring and would expect to pursue something in modest size. I would also point you to the fact that we filed a number of months ago the intention to begin to distribute our perpetual preferred, which will begin to be in the marketplace in relatively short order. So we have multiple irons in the fire to begin to build out the debt side. But as I said in my comments, we’re going to maintain the leverage in our target zone and it’s obviously going to ultimately come back to continued access to the ATM market on the equity side in order to support that growth. There’s clearly more opportunities today than we necessarily have fully capitalized in our balance sheet today from a capacity perspective.

Bob, the perpetual preferred you’re referring to that, that’s the 6.25% preferred? So or…

Yes.

And that would seem to be quite a bit below the current market. You’re saying you are seeing interest at that price level?

It’s a bit of an anomaly. Mickey, we can talk about it separately, but it is a stable value security. It is not going to be traded. It is sold to certain accounts that value that. As you may know, there’s a few others that we have sold through some of our REIT funds and this is actually priced wide to those securities. I would also point you to the fact that there are other BDCs that have been selling similar securities in very large volumes to some of these same accounts. It tends not to be public. It tends to be high net worth or more RIA distributed networks. And so, we are reasonably optimistic that the selling agreements and the comfort with Gladstone management companies in some of these similar securities will provide some momentum for us in that marketplace given the story. And, frankly, I think what people are beginning to recognize, the banking business is not going to be where these companies are going to be financed on a go-forward basis. We are well positioned to grow with as a player in financing those businesses. So it’s just a – it’s a diversity of funding that I think we need to demonstrate as we look to continue to scale the business.

I understand. That’s interesting. Those are all my questions this morning. Thank you for your time.

Thank you for calling in, Mickey.

Okay. Next up? Here we go.

Our next question comes from Kyle Joseph with Jefferies. Please proceed.

Hey, good morning, all. Thanks for taking my questions. Just want to get kind of your thoughts almost on the economy, given your portfolio. I know non-accruals were stable quarter-on-quarter, but just get a sense for revenue and EBITDA growth trends you’ve been seeing and how those differ between recent quarters?

Thanks for calling in. When we go through the portfolio, I would say for the most part, we’re very focused on revenue growth, obviously. And what we’re beginning to sense or what we’re focusing on right now is. The price increases associated with the broad inflationary pressures of the last year have for the most part been positive on a lot of the companies. People increased price, because people didn’t know where things costs were and they wanted to get availability and they wanted to continue to support their downstream customers. And so, I think, what we’re seeing now is revenue increases in the portfolio are almost 100% price oriented and the volumes are getting softer. So we’re very concerned that in the near-term, you’re going to get some blowback, inflation is going to get squeezed down and customers are going to resist more vehemently the price increases. So we’re very focused on what that revenue growth is going to look like. For the most part, I think our portfolios’ companies are holding together. Obviously, the places where people would be impacted most directly are things like consumer building, maybe some of the services sides of things. I think, right now, we’re feeling like it’s solid, but we’re very cognizant of inflationary pressures pushing down the revenue trends on some of these companies. But we don’t really see any significant fall off. Most of our businesses that are serving downstream customers, we focus on businesses where there’s decent revenue visibility or competitive position or barriers to entry. And so, when I look at anybody that’s got any measurable level of leverage, the biggest challenges that they face are probably their own isolated instances, or maybe some one or two where we have some measure of commercial pressures. The only other comment that I would make is when we think about the businesses and some of the trends, we’ve begun to see some of the withdrawal of the banks from funding companies, and it’s creating an interesting opportunity for us, while we traditionally have done a lot of buyout and leverage financings. We’re now seeing folks that lines aren’t getting renewed and they’re coming in, and those companies tend to have lower leverage and dramatically higher asset coverage. I mean, folks with real asset coverage ratios as opposed to purely cash flow based deals. So I would expect our portfolio will probably migrate to have higher asset coverage, although that’s not our primary focus, because of some of the movement in the underlying market. So I realize that’s a bit of a diversion from your original question, but I hope that gives you some sense of what we’re seeing.

Yeah, that’s really helpful and kind of a good segue into my follow-up. With everything that’s gone on with regional banks, and rumors of increased capital requirements for banks, I know you guys focus on kind of the lower middle market, and banks don’t necessarily operate there anymore, it’s quite attractive. But just want to get your sense for potential implications of what’s gone on with banks in recent months and quarters?

The interesting thing is, when you think about $20 million, $30 million, $40 million financings, that’s the bread and butter of a lot of the regional banks in their C&I loans. And many cases it might be asset backed type financings. And we’ve seen situations where a bank buys a bank, and that bank gets bought, and the other bank gets bought, and there’s an asset backed loan in it and the parent company says, I’m not really in that business anymore. And so, where does $20 million or $30 million asset backed receivable back loan go in this marketplace, when the regional bank that services that area is no longer willing to do that deal and it’s not big enough to go to the mega banks that want to do $100 million to $300 million ABLs. So there is a little bit of a vacuum that’s created in the market such as I’m referring to in the deal that I referenced earlier. And so, I think, it’s beginning to happen. I don’t think, it – I think, it may be somewhat temporary. I think you have banks that are probably managing their capital base and reallocating it based on the strategy where they want to play. But there’s also thousands of banks. So there are others that aren’t overexposed to the C&I market or didn’t stretch their loan to deposit ratios. And so what we’re finding is, we’re attracting banks that have capacity want to grow and not only would they like to finance some of our portfolio companies with us, but they are interested in coming into our bank facilities. So we’re kind of rehoning [ph] to look at the folks that are going to be active in the C&I market going forward, and we’ll likely transition some of our relationships in that way. And it’s for that reason that I tend to think it’s going to be somewhat temporary. We’re going through probably contraction. There’s going to be other banks that will come in and fill it. Whether there’s a – how long that dislocation exists is probably a function of the magnitude of capital shortfall that the banks have. I tend to think it will last a little longer based upon the sheer challenges of losses, of deposits and of regulation. And it will take a while for that to ultimately work through the system and the lending criteria of those banks to come back into a more positive investment mode. So, I think, we’ve probably got if I were crystal balling, I think we’ve easily got a year, but it’s probably not multi-year scenario where the banks are generally not active in certain segments of the market for us.

Got it. Very helpful. Thanks for answering my questions.

Thank you for calling in.

Okay.

[Operator Instructions] Our next question comes from Robert Dodd with Raymond James. Please proceed.

Hi, good morning, and congratulations on the quarter. So a couple of questions. I mean, first, the simple one quick to answer. Do you have a target size for the preferred equity program? I mean, obviously, it’s in principle a maximum 6 million share offering, which would be pretty big. But is there a view of how large or what proportionate capital structure would actually prefer that to be?

It’s a good question, since we really haven’t brought in a whole lot of it, Robert. I think, if we look out 12 to 18 months from now, given the growth rate that we’re experiencing, I would put us at our goal. As I’ve stated in earlier calls, is to get closer to $1 billion, which would support getting a more traditional major rating agency investment-grade rating. And so, given our current trajectory, that’s kind of where I’m shooting to. Given that we’ll be selling that preferred over that period of time, getting it to $100 million to $150 million to be 10% or 15% of our capital base, I don’t think is out of line. And it’s really doing two things. It’s hedging what we’re going to have in the way of maturities as we get out in 2025 and 2026, or 2026 and 2027. And the second is, we need to diversify away from the regional banks that have been traditionally supporting the lower middle market BDCs. So while we might have thought in the past 20% or 25% of our capital base could come from those banks, I think the lessons of the last couple of quarters have suggested that might be high. So, I think, there will be a lesser reliance on the commercial banks for funding capacity on a permanent basis inside the portfolio. So if you were at $1 billion and we had $100 million to $150 million here, having $200 million to $250 million in the banks is a more modest strategy. And beyond that, you have to tell me kind of where the medium-term placement market rates are. I think we will go back to that marketplace, but certainly, given the current spreads, it’s not as attractive as pushing on the perpetual preferred. So 10% to 15% from the perpetual preferred of a pro forma capitalization, I think, is where you should think about our target.

Perfect. Thank you for all that detail. On the portfolio, I mean, average leverage at 3.5, I mean, interest coverage is going to be really healthy across the bulk of the portfolio. So can you give us any kind of you talked about inflation, you talked about worries about revenue volumes and things like that? From your perspective and also from portfolio companies’ perspective, what’s kind of the primary worry right now? Because at low leverage, it might not be rates like it is for somebody who’s got a portfolio with 6.5 times leverage on it. So you just kind of what’s the – is it the revenue or is it the unit volumes for these businesses? Or what is it that’s your worry right now?

When we start – when we underwrite the credits, Robert. We’re trying to find places that there’s going to be a market growth opportunity that will drive volume over time, it will attract additional add on investments and it will support an organic deleveraging. So our primary focus is the growth outlook and underwriting strategy intact. And if it’s not intact, then the capital structure and the risk profile that we started with is probably something that we have to reevaluate. And when we start to see that growth outlook diminish, our cost of capital and our discussions with those sponsors tends to go in the direction of what can you do to refinance and deleverage the balance sheet. And we do have some investments where growth is going to be harder. If you’re an industrial services business, and industrial services aren’t necessarily growing in a particular segment, we need to make sure the leverage is low enough to sustain and continue to amortize the structure. And so, if it’s not coming down, typically, the equity value isn’t growing. And in most cases, those equity sponsors, it’s probably time to think about exiting. So we can exit via a refinance, because many of these companies have grown to deleverage over time. We can exit when the sponsor seeks to exit, because they’ve reached the pinnacle or the peak point for them to exit the business. And so we’re focusing on growth. So I would say right now, certain industrial services, certain consumer services, I think, we’re also cognizant of things in the healthcare space. Healthcare is a sector that has grown fairly well, but it’s beginning to see some price pressures. It will invariably see some reimbursement pressures and it’s certainly seeing costs on the staffing side that are increasing or will continue to increase. And so, we’re probably mindful of places where staffing availability and staffing costs may fundamentally impair the margins of the business. So, I guess, when I kind of circle back to conclude, I would say, is the growth intact? And are there pricing pressures that are going to make it more difficult for them to sustain their margins and cash flows? And those are the sectors where we are probably more acutely focused on either deleveraging or deemphasizing our investments in those sectors.

Again, I really appreciate that color. That’s very helpful. Last one, if I can. I mean, what is based on your remarks when you were talking, I think, to Karl. If we’re going to see the portfolio and the platform has largely been built around to a degree for gladly funding helpers [ph]. Your remarks that you say you might see more asset backed, et cetera, because the bank’s withdrawing, which sounds quite attractive, et cetera. But how does your current sourcing effort, which may – have been more focused on sponsors in many cases to find the LBO activity? How does that sourcing transition or not to sourcing more of the direct basically taking over relationships with banks rather than building relationships with a new company, with a sponsor? I don’t know if that made any sense.

It’s interesting. I would say we’re probably not going to change our sourcing framework. It’s somewhat topical, but we’re not going to be able to cover the breadth of where those transactions might come from. It’s far too broad. I will say that what we have seen so far is, good sized companies, I mean, $150 million revenue companies in some cases who have bank issues. They’re going to call an investment bank or a regional broker or somebody and say we need help. And those intermediaries are going to say, who’s open? And in today’s environment, there are a few open BDCs with equity capital and capacity. There may be a few SBICs, but they’re obviously a little pricier and a little smaller. And so, what we’re going to find, I think, is at least in the near-term, given the dislocations and the need to serve problems, those companies are going to call who’s open to pick-up that business. And in some cases, their first commentary is, the banks are in disarray. I don’t understand what they want to do. They’re not acting rationally. Let me find somebody that might understand my business and be a good financial partner to help me grow my business. And so in the near-term, I would expect the vast major majority of those to come through the intermediary contacts, given our position in the marketplace and, I mean, we’ve been doing this for quite a while. I know, David’s here and he’s not saying a lot, but he’s been doing it longer than anybody. So we’re going to get our share of cost.

Yeah. Understood. Thank you.

Okay. Latanya, is there anybody else that would like to ask a question?

There are no further questions, Mr. Gladstone. So I’ll turn it back to you for closing comments.

Oh, shucks. We wanted more questions. But thanks a lot all of you for calling in and asking us good questions. And we’ll see you next quarter. That’s the end of this call.

Thank you. This does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a great day.