Saratoga Investment Corp. (SAR) Q2 2016 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, thank you for standing by. Welcome to Saratoga Investment Corp.’s Fiscal Second Quarter 2016 Financial Results Conference Call. Please note that today's call is being recorded. During today's presentation all parties will be in a listen-only mode. Following management's prepared remarks, we will open the line for questions. At this time, I would like to turn the call over to Saratoga Investment Corp.'s Chief Financial Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Thank you. I would like to welcome everyone to Saratoga Investment Corp's fiscal second quarter 2016 earnings conference call. Today's conference call includes forward-looking statements and projections. We ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required to do so by law. Today, we will be referencing a presentation during our call. You can find our fiscal second quarter 2016 Shareholder Presentation in the Events & Presentation Section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night. A replay of this conference call will also be available from 1 p.m. today through October 21st. Please refer to our earnings press release for further detail. I would now like to turn the call over to our Chief Executive Officer, Christian Oberbeck, who will be making a few introductory remarks.

Thank you, Henri, and welcome everyone. This past quarter we celebrated five years since we became the manager of Saratoga Investment Corp. I would like to start our earnings call by reviewing our primary focus and long-term objective during these five years, which was increasing the quality and size of our asset base with the ultimate purpose of building Saratoga Investment Corp. into the best-in-class BDC generating meaningful return for our shareholders. As highlighted on slide two, during the second fiscal quarter of 2016, we continued the momentum gained during the first fiscal quarter and last year towards realizing our long-term strategic objectives. To briefly recap, first, we endeavor to maintain a robust high quality asset base, with the strong yield and return on equity. While our asset under management contracted slightly in this quarter due to an unusual concentration of redemptions, something that we saw industry-wide, our metrics remained strong on a quarter-over-quarter basis. We will discuss this in further detail shortly. Second, the overall strengthening of our financial foundation has enabled the continuing increase in our regular quarterly cash dividends. We will pay a quarterly dividend of $0.36 per share for the second fiscal quarter of 2016, payable on November 30, 2015 for all stockholders of record on November 2, 2015. This further increase represents a doubling of our regular quarterly cash dividend in the past 12 months and shareholders continue to be able to participate in our dividend reinvestment plan if they prefer. Third, our base of liquidity remained strong and promises to improve. As mentioned before, on April 2, 2015, we received a green light and go forth letter from the SBA for a second SBI fee license, which if approved will allow us to grow our assets by an additional $112.5 million. We continue the completion of the formal application. And effective May 29, 2015, we entered into a Debt Distribution Agreement with Ladenburg Thalmann through which we may offer first sale from time to time up to $20 million in aggregate principal amount of our existing Baby Bonds issuance through an at the market offering. As of August 31, 2015, we sold bonds with a principal of $8.9 million at an average premium of 1.4%. And finally, our Board of Directors recently extended our share repurchase program that allows us to repurchase up to 400,000 shares of our common stock for another year to October 2016. In addition to the extension, they also increased it to 400,000 shares. During this quarter and as part of this formal plan and its existing terms, we repurchased 2,500 shares. We are also encouraged to continue to see the expansion and diversification of our shareholder base. In addition to these corporate achievements, during this quarter we continued on our path to further strengthening our financial foundation and building scale by consistent originations of $18.9 million, sustaining assets under management among significant redemptions this quarter, improving our net -- our investment quality and credit with over 97% of our loan investments now having our highest rating, expanding our net asset value to $125.3 million, a 1.5% increase from $123.5 million at the end of last quarter, and increasing performance with our key performance indicators for fiscal second quarter 2016 as compared to last year's second quarter. Our adjusted net investment income is up 25% to $2.9 million. Adjusted NII on net asset value increased to 9.3%, up 150 basis points from 7.8%. Adjusted NII per share of $0.52 is up 21% from $0.43 and our return on equity for this quarter ended August 31, 2015 was 4% versus 10.8% last year, reflecting primarily the analyzed impact of the unrealized appreciation in this quarter that we will be discussing later. We are happy about these continued accomplishments and we’ll go into greater detail on each one during today's call. As I mentioned, we remain committed to further advancing the overall quality and size of our asset base. As you can see on slide three, our upward trend of quality and quantity of assets is largely continued. As I mentioned earlier, we saw an unusually concentrated number of redemptions this quarter with $18.9 million of originations offset by $27.4 million of redemptions, resulting in a 4% reduction in assets under management to $252.2 million as of August 31, 2015. Nevertheless, we have seen 165% increase in assets under management since fiscal year ‘12 with over 97% of our current loan investments holding the highest internal rating that we award, up from 96% last quarter. Thus, our overall loan quality continues to increase while we remain committed to growing assets in a measured way. With that, I would like to now turn the call back over to Henri to review in greater detail our full financial results as well as the composition and performance of our portfolio.

Thank you, Chris. Looking at our quarterly key performance metrics on slide four, we see that for the quarter ended August 31, 2015, our net investment income was $3.7 million or $0.66 on a weighted average per share basis. Adjusted for the incentive fee accrual related to net unrealized capital gains in the second incentive fee calculation discussed at length last quarter, our net investment income was $2.9 million or $0.52 per share. This represented an increase of $0.6 million as compared to the same period last year and an increase of $0.2 million compared to the quarter ended May 31, 2015. In the second quarter of fiscal 2016, we experienced a net loss on investments of $2.4 million or $0.43 on a weighted average per share basis, resulting in a total increase in net assets from operations of $1.2 million or $0.22 per share. The $2.4 million net loss on investments was comprised largely of $6.1 million in net unrealized losses on investments offset by $3.7 million in net realized gains. Most of this quarter’s unrealized losses and realized gains are driven by Legacy Investments with the unrealized loss primarily from our Elyria Foundry Investment and the realized gain primarily from the network communications redemption that was discussed last quarter. Net investment income yield as a percentage of average net asset value was 11.8% for the quarter ended August 31, 2015. Adjusted for the incentive fee accrual related to net unrealized capital gains, the net investment income yield was 9.3%, up from 7.2% last year and unchanged from 9.3% last quarter. Return on equity was 4% for this quarter. These will remain performance metrics that we feel are important indicators about success in pursuing our strategy of growing the asset price, building scale and generating competitive yield while continuing to prioritize the quality of our portfolio. As these metrics continue to improve quarter-over-quarter, it highlights the following two important points about the value of our asset growth. Firstly, as our SBIC assets continue to grow as compared to our overall assets under management, the greater net investment income on these investments financed through lower cost SBA debentures contributes more to our bottomline. This is demonstrated again this quarter with SBIC assets increasing to 59% of our total investments. And secondly, we see the benefit of scale becoming more visible as our operating expense is stabilized and reduced as a percentage of our total assets. Our total investment income was $7.8 million for the fiscal second quarter. Total investment income increased $1.3 million, or 19.8% compared to the second fiscal quarter last year. Our total investment income for this quarter was comprised primarily of $6.8 million of interest income, $0.4 million of management fee income associated with our investment in the CLO and $0.6 million of other income. Other income includes dividends received from portfolio companies, as well as origination, structuring and advisory fees. Our total operating expenses were $4.1 million for the fiscal second quarter and consisted of $2.1 million in interest and debt financing expenses, $1.1 million in base and incentive management fees, $0.6 million in professional fees and administrator expenses, and $0.2 million in insurance expenses, directors fees and general, administrative and other expenses, including a $0.1 million excise tax credit. For this fiscal second quarter, total operating expenses decreased by $0.3 million as compared to the same period last year. This decrease was primarily attributable to the incentive fee credit related to the net loss on investments recognized during the quarter. Total expenses excluding interest and debt financing expenses, base management fees and incentive management fees increased slightly from $766,000 for the quarter ended August 31, 2014 to $843,000 for the quarter ended August 31, 2015, which remained unchanged at 1.3% of assets under management for both quarters. As you might have noted, our prior period numbers for August 31, 2014 have been revised to reflect adjustments outlined in our notes to the financial statements included in our Form 10-K, including the early adoption of a new accounting standard. Despite heavy redemptions and a slight reduction in our assets, the unrealized loss on investments this quarter and our growing dividend, net asset value continues to grow, furthering the consistent growth delivered over the past five years. As you can see on slide 5, our NAV has grown from $86 million as of February 28, 2011 to $125 million as of August 31, 2015, an increase of 45% over this period. This $125.3 million current NAV also represents a $1.8 million increase from $123.5 million as of May 31, 2015 and a $2.7 million increase from $122.6 million as of year-end. For the six months ended this quarter, $8.7 million of dividends declared was more than offset by $5.4 million of net investment income, $3.8 million of net realized gains and $3.0 million of stock dividend distributions. NAV per share was $22.42 as of August 31st, compared to $22.70 as of February 28, 2015. During these six months, NAV per share decreased by $0.28, primarily reflecting the $2.7 million, or $0.50 per share increase in net assets, which is net of the $1.60 dividend paid during this fiscal year. This was offset by the dilutive impact of the 186,000 shares issued pursuant to the dividend reinvestment plan during this period. Moving on, slide 6 outlines the dry powder available to us as of August 31, 2015. As of the end of the fiscal second quarter, we had $2 million outstanding in borrowings under our revolving credit facility with Madison Capital Funding and $79 million in outstanding SBA debentures. Our Baby Bonds had a carrying amount and fair value of $57.2 million and $57.5 million, respectively. With the $43 million available on the credit facility, $71 million additional borrowing capacity at our SBIC subsidiary and $12.6 million in cash and cash equivalents, we had a total of $126.6 million of available liquidity at our disposal at quarter end. This available liquidity equates to approximately 50% of the value of our investments, meaning we can grow our assets under management by a further 50% without any additional external financing. We remain pleased with our liquidity position, especially taking into account the conservative composition of our balance sheet and the ability we have to substantially grow our assets without the need for external financing. We also continue to assess all our various capital and liquidity sources and will manage our sources and uses on a real-time basis to ensure optimization. As we have previously discussed last quarter we launched an at-the-market offering of our existing Baby Bonds issuance through which we may offer for-sale from time-to-time up to $20 million in aggregate principal amount. This is a benefit of having our NT shelf registration statement allowing us to capitalize on market opportunities. As of August 31, 2015 we had sold 357,807 bonds with the principal of $8.9 million at an average premium of 1.4%, enabling us to further enhance our liquidity and plan ahead for future capital needs, such as the remainder of our first SBIC-licensed and the funding of our secondary SBIC-licensed. These new issuances are under the exact same terms as the original Baby Bond offering in 2013. Now I would like to move onto slide seven through nine and review the composition and performance of our investment portfolio. Slide seven highlights the portfolio of composition and yield at the end of the quarter. As of August 31, the fair value of the company’s investment portfolio was $252 million, principally invested in 32 portfolio companies and one CLO fund. Saratoga’s portfolio was composed of 62.1% of first lien term loans, 16.7% of second lien term loans, 6.6% of syndicated loans, 0.1% of unsecured notes, 6.6% of subordinated notes of the Saratoga’s CLO and 7.9% of common equity. The weighted average current yield on the portfolio as of August 31 was 12.6%, which was comprised of a weighted average current yield of 11.1% on first lien term loans, 10.4% on second lien term loans, 7% on syndicated loans, 10.0% on unsecured notes and 37.8% on our CLO subordinated notes. Despite downward pressure on the yields due to continued competition, our yields have remained strong as compared to the previous fiscal quarters. To future illustrate this point slide eight demonstrates how the yield on our core BDC assets, excluding our CLO and syndicated loans, has remained consistently around 11% over the past four years. The CLO’s yield has remained strong and in fact continued to increase significantly this quarter. Syndicated yields have also been moving steadily upwards. Moving on to slide nine. During the fiscal second quarter we invested $18.9 million in new and existing portfolio companies and had $27.4 million in exits and repayments, resulting in net redemptions of $8.5 million for the quarter. As you can see on this slide, our investments continued to be highly diversified by type as well as in terms of geography and industry with the large focus on business, consumer, and healthcare services, as well as software-as-a-service while spread over 13 distinct industries. It is worth noting that we have most significant direct exposure to the oil and gas industry. Of our total investment portfolio 7.9% consists of equity interest. Equity interests are and will continue to be an important part of our overall investment strategy. Slide 10 demonstrates how realized gains from the sale of equity investment combined with other investments, has helped enhance shareholder’s capital. For the past three years we have had a combined $8.9 million of net realized gains from the sale of equity interest or sale of early redemption of other investments. This consistent performance continues to be a good indicator of our portfolio credit quality. That concludes my financial and portfolio review. I will now turn the call over to Michael Grisius, our President and Chief Investment Officer for an overview of the investment market.

Thank you, Henri. I would like to take a couple of minutes to update everyone on the current market as we see it, then I will discuss our strategy and performance as we operate in this environment. Over the past couple of quarters we have found ourselves we’re doing a large number of deals. However, it seems to be harder to find high quality transactions in the pipeline of opportunities that exist. Slide 11 shows the results of a quarterly survey of junior debt participants for calendar Q2. Consistent with our own experience, it demonstrates our junior debt providers were due to higher number of opportunities this past quarter, with 93% of respondents reviewing more than 25, which is up from the prior two quarters. In addition, 100% of respondents submitted at least one Letter of Intent during the first quarter. However, despite this increase and opportunities reviewed and LOI submitted, close transaction activity was down significantly this quarter, as the majority of respondents closed either zero or just one transaction during the quarter. In addition, several data sources and our own experience indicate that gross investment yields have remained tight and our company by wider leverage levels and narrower equity cushions. Despite the NII pressure facing many BDCs, we have not seen a widening of yields in the non-syndicated markets. Our experience is that high-quality deals remain in high demand with most quality investment opportunities being pursued by multiple parties in competitive processes. Slide 12 further demonstrates how fewer deals are being done. The numbers of transactions for deal sizes in U.S. below $25 million year-to-date in 2015 were down 44% from year-to-date 2014. Calendar year 2015 is off to a very slow start with only 642 private equity deals closing in smaller deal market to-date, compared to 1,144 for the same period last year. In the face of these market trends, we remained optimistic of our own pipeline and originations. The growing strength of our origination platform and our expanding presence in the lower end of the middle market has allowed us to increase our origination volume overtime and gives us confidence that we can continue to deploy capital at a healthy pace. With the objective of increasing our capital deployment in high-quality investments, we allocated a second full-time person to our origination team. As we have dedicated more resources to our business development effort and our presence in the marketplace has grown, we have generated an increasing number of investment opportunities. Our reputation for being fair-minded and support of investors has increased our pace of referral from small business owners and management teams. In addition, we have recently more than doubled our private equity sponsor relationships. We believe this in turn will allow us to further accelerate our pace of investment, while we remain diligent and careful in our investment approach. The BDC market can be generally bifurcated into two groups and the outlook for investment activity is dependent on which group a BDC is in. For the vast majority of BDCs that participate in the larger deal market, their origination activity is very much a function of private equity activity and the state of the capital markets. This group of larger BDCs tends to compete for many of the same larger market transactions. As a consequence, their performance and origination activity is highly correlated with one another, and is largely dependent upon deal activity among a more concentrated group of large private equity sponsors. However, where we reside at the smaller end of the market, our origination activity is more function of our presence in the small business marketplace. Given the share quantity of smaller businesses that occupy the lower end of the middle market, we are confident that we can increase our pace of investment by continue to grow our qualified deal pipeline. Moreover, we have significant room to expand our deal sourcing relationships, as we are still not known by many participants in the market, although we have made significant strides in expanding our relationships and are confident these relationships will create higher origination activity in the future. We also continue to believe that the lower middle market is the most attractive market segment to deploy capital and the fundamentals here are remain strong leading to the best risk adjusted returns in our view. And in the chart on slide 13, you can see that multiples in the industry have continued to shoot upwards, 92% of the markets debt to EBITDA multiples were 4.1 times or higher this past calendar quarter, a significant increase from 56% in Q1. Historically, the majority of our closed deals are beneath that level, with the average SAR leverage for all of our deals at 3.99 times, even though SAR leverage for the three deals we did in Q2 2015 was 5.6 times. We are very careful to exercise extraordinary investment discipline and invest only in credits with attractive risk return profiles. Of important to us when doing deals with higher leverage is to ensure that our dollars are invested in companies with exceptionally strong business models where we are confident that the enterprise value of the businesses will sustainably exceed the last dollar of our investment. As we've also noted before, deals are not necessarily low risk when they have low leverage and high risk when they have high leverage. We decline plenty of low level leverage loans to weak credits and frequently pursue high leverage loans to strong companies. The most important thing for us is that we remain thorough and disciplined in assessing the risk profile of each underlying business and that we craft the capital structure to match the relative strength of the each portfolio company. Slide 13 also demonstrates the growth we have had in a number of executed investments. With a strong execution track record the past couple of quarters as well as year-over-year growth, our executed investments doubled from 7 in 2013 to 14 in calendar year 2014. So far in calendar year 2015, we have seen 10 deals closed, a number that is still on pace with last year's performance, despite the current pressures in the marketplace and being able to close deals that we discussed earlier. Our growth the past couple of years has been in an extremely competitive market, which speaks to our strengthening origination efforts and as overall portfolio quality has improved to the risk profile of our investment portfolio and the investment philosophy of the firm. The tougher environment that currently exists in closing deals highlights the importance of having a robust pipeline. And as you can see on slide 14, we have made great strides in expanding our relationships and are confident these relationships have created higher origination activity. In the past three months, the firm established 76 new relationships and engaged in 388 business development activities. The pace of opportunity seen in terms sheets issued, have both increased by 24% so far this year. Even though a number of deals closed dropped slightly on an LTM basis, this was not due to fewer opportunities but rather continued prudence and investment discipline in a tougher credit environment. With additional origination and due diligence resources that we've added to the team recently, we are able to evaluate more deals and are on track to close the same amount of deals in 2015 as in 2014 despite the fact that market conditions have become increasingly adverse and all this, while improving our investment quality. We view this as an achievement. However, we expect to improve upon this performance. With respect to our SBIC, our objective is to maximize our risk adjusted returns in a manner that utilizes the low cost of capital and the 2:1 leverage advantage we possessed through our SBIC license. By focusing on smaller less competitive to enter the market, we are able to reduce the risk profile of our portfolio while delivering highly accretive returns to our investors. As you can see on slide 15 as of August 31, 2015, approximately 81% of our SBIC investments are in senior debt securities, which is up from 75% last quarter. The leverage profile of these investments is very low, especially when compared to market leverage. Because of the leverage -- the leverage and the lower cost of capital advantages inherent in the SBIC program, we can achieve strong returns for our shareholders without moving far out on the spectrum. Therefore and as demonstrated this past quarter, we intend to grow our net investment income by continuing to dedicate the majority of our effort and resources to growing that portion of our portfolio. With that in mind, moving on to slide 16, you can see our SBIC assets continue to grow $150 million as of August 31, 2015 from $136 million at year end. As a percentage of our total portfolio, SBIC’s assets have grown from 0% of our total portfolio at fiscal year end 2012 to 59% this quarter. This growth in SBIC assets is an important part of our continued increase in the net investment income as the lower financing cost help grows our NII yield at a healthy pace. Also it is important to note that as of the fiscal quarter ended August 31, 2015, we have $86.9 million total available SBIC investment capacity, of which, $71 million is leverage capacity within our current SBIC license. If we were to obtain a second license, our leverage capacity would increase by another $75 million with the ability to increase assets by an additional $112.5 million. Fundamentally, our strategy in this market is to focus on our core strengths, our origination platform, our experienced and disciplined underwriting and our SBIC funding capacity. In our view, our origination platform is among the very best that are into the market and we are dedicating more resources toward it. Through our origination platform and our growing list of business relationships, we are seeing a steady flow of SBIC eligible investments and are optimistic about our ability to grow that portfolio at a healthy rate, while remaining extremely diligent in our underwriting and due diligence procedures. This concludes my review of the market and I’d like to turn the call over to our CEO. Chris?

Thank you, Mike. This past year we achieved important goal for us since our inception of paying regular quarterly cash dividends. From the start, we said our expectation was that this dividend would continue to increase, which it has -- which in consistent way it’s done since we commenced this program and after today’s further increase, we have now doubled our quarterly dividend since we institute the policy 12 months ago. As outlined on slide 19, over the past five quarters, Saratoga has paid quarterly dividends of $0.18 per share for the quarter ended August 31, 2014, $0.22 per share for the quarter ended November 30, 2014, $0.27 per share for the quarter ended February 28, 2015 and $0.33 per share for the quarter ended May 31, 2015. Saratoga has also paid a special dividend of $1 per share on June 5, 2015. On October 7, 2015, Saratoga Investment Corp.'s Board of Directors declared a dividend to shareholders of $0.36 per share for the quarter ended August 31, 2015, payable on November 30, 2015 to all stockholders of record at the close of business on November 2, 2015. Based on our current share price, this represents a dividend yield of almost 9%. Consistent with our new policy, shareholders will have the option to receive payment of the dividend in cash or receive shares of common stock pursuant to the company's dividend reinvestment plan or DRIP plan, which Saratoga adopted in conjunction with the new dividend policy and provides for the reinvestment of dividends on behalf of its stockholders. Our goal with this policy remains to allow stockholders who want cash to receive their dividends in cash. However, it also provides the opportunity for many stockholders we have spoken to, who are also interested in reinvesting their dividends to receive additional shares of common stock. Experience has shown that those stockholders who hold their shares with a broker must affirmatively instruct their brokers prior to the record date if they prefer to receive this dividend and future dividends in common stock. The number of shares of common stock to be delivered shall be determined by dividing the total dollar amount by 95% of the average of the market prices per share at the close of trading on the 10 trading days immediately preceding and including the payment date. For more information see the Stock Information section of the company's Investor Relations website. In addition and as mentioned earlier, our existing share repurchase plan that allows us to repurchase 200,000 shares of common stock at prices below NAV has been extended for another year and also increased to 400,000 shares. During this quarter and as part of this formal plan, and its existing terms, the company repurchased 2,500 shares. On slide 18, in addition to being very proud about the growth of our NAV, we are not only maintaining but increasing the quality of our assets we are also delighted to see our total return being industry-leading. As you can see on slide 18, our total return, which includes both capital appreciation and dividends, has outperformed the BDC Index quite considerably over the last 12 months. Our total return has been almost 18%, while that of the industry at large was negative. This continues our track record as one of the top five or better performing BDCs on a total return basis over the past one, three and five-year periods. Moving on to slide 19, all of our initiatives are designed to make Saratoga Investment a highly competitive BDC that is attractive to the capital markets community. We hope to drive the size and quality of our investor base, while continue to add institutions to the roster. We have spoken today about many of the components of our competitiveness that is highlighted on slide 19. Earnings yield of more than 9%, dividend yield of almost 9% and growing, ample low cost liquidity, strong earnings per share and expansion of assets under management. In addition, we had only limited exposure to the oil and gas industry, and had no realized right-downs as many other BDCs have experienced. We believe that Saratoga Investment on the path of being a premier BDC in the marketplace and we feel we have already demonstrated superior shareholder returns, we have achieved annualized rates of returns in excess of 18% for the past one, three and five-year periods, positioning the company as one of the top five or better performing BDCs for each period. Moving on to slide 21, our objectives are simple and consistent. Continue to execute our long-term strategy to expand our asset base without sacrificing credit quality while benefiting from scale. We also continue to increase our capacity to source, analyze, close and manage our investments by adding to our management team and capabilities. Our primary focus remains on maximizing the potential high teen returns on the equity invested in our SBIC and utilizing the 2:1 leverage that it provides. This is the optimal means to increase our assets under management and net investment income yield, enabling us to increase returns to shareholders and achieve growth in our net asset and stock values. In closing, I would again like to thank all of our shareholders for their ongoing support. We're excited for the growth and profitability that lies ahead for Saratoga Investment Corp. I would now like to open the call for questions.

Thank you. [Operator Instructions] And our first question comes from Casey Alexander from Ladenburg Thalmann (sic) [Gilford Securities]. Your line is now open.

Good morning, Casey. Are you on?

Pardon me, [David] [ph], please check your mute button. Casey Alexander?

Hi. Can you hear me?

Yes, we can hear you. Hi Casey.

Okay. Great. I’m not sure what the problem was. Good morning. Can -- Henri, do you have the breakdown of the fixed rate to floating rate percentages of the qualifying portion of the portfolio?

Yeah. It’s relatively consistent with last quarter. Let me just double check it here. I think it's around 57% floating rate again. Hang on one sec, 56% floating rate, 44% fixed.

Okay. Thank you. Secondly, the reserved cash, is that cash that came into the SBA subsidiary as a result of redemption?

That's correct. Effectively what ends up in our reserved line on our balance sheet is the cash that we hold in our actual SBIC subsidiary. So any cash that might come from redemption or obviously when we draw any SBA debentures would go into that cash line on the balance sheet.

Okay. So that’s clearly money that’s going to be redeployed?

Correct. Lastly, just in relation to -- I get the Elyria Foundry, it was a big move in equity position on a commodity related company and the debt position stayed fairly stable. I would love a little bit of commentary on Smile Brands that’s marked at around 66% of par and had a pretty decent mark in the portfolio. Can you give me some color on Smile Brands please?

Yes. That’s a -- it's a product we sponsored transaction. That’s faced some challenges. They have some softness in their revenue line and have incurred a lot of additional expenses trying to grow those revenues but haven’t had as much success doing so as they would like. And as a consequence, their cash flow has come down and the valuation adjustment reflects that and they declined in EBITDA. That credit was just restructured last week in a way that increased the interest rate that the equity sponsor put infusion in cash into the balance sheet as well. The important thing to note, Casey, is that we’re at the top of the capital stack in that investment. We have our first lien security and I think we’re -- we feel like we’re well secured by the enterprise value but that’s the state of play. I think the sponsor is working hard to try to improve things of the company.

Okay. Well, that’s good news to hear that the sponsor stepped up. Thank you for taking my questions.

Thanks, Casey.

Our next question comes from David Chiaverini from Cantor Fitzgerald. Your line is now open.

Thanks. Good morning. Couple of questions for you. You mentioned about how deal activity has been low for the overall middle market, but you are seeing decent deal flow at the lower end of the middle market. Is it safe to assume that you expect net portfolio growth to resume on an upward trend in coming quarters?

That’s our expectation. Right now, we have competing influences. The market -- on the one hand, the market is tougher, the credit environment is tougher. So you see that in sort of the leverage profile that we outlined on one of the slides. We are also seeing just more competition in general, even at our end of the market. Even though we feel like our end of the market is less competitive than the larger market, we are seeing an increase in competition and sort of tougher credit profiles. Now offsetting that and what gives us confidence that we can resume growing our portfolio on a net basis, is that we are continuing to grow our presence in the marketplace and we talked about that a little bit further too. And the one thing I would remind you is that when we received our SBIC license in 2012, we really started in this business sort of standing start. So as we’ve continued to grow our portfolio and do transactions, gives us more credibility has enabled us to grow our relationships with not only private equity sponsors but business owners in general. And so you see that in our growing pipeline of activity and we think that with that growing pipeline of activity, we will still find more deals that we want to do and execute on then we will have redemptions.

I think the other side of that question is redemptions. And we basically had -- unfortunately, we made some very good loans that got repaid so and then there was a concentration of them in this quarter. We don't expect that concentration to occur in subsequent quarters. We think our origination was solid this quarter. It’s just the redemptions were a little more concentrated than they might have been in other quarter. So, we view that redemption side as more of anomalist and not necessarily reflective of a trend.

Okay. Got it. And then next question is on, as you get the deal flow and you take on more borrowings, can you talk about balancing the pros and cons of going with, increasing the amount outstanding of the SBA debentures? I noticed that you have been at $79 million for the past few quarters versus you've been issuing Baby Bonds at higher interest rate than the SBA debentures. Can you talk about the merits between the two?

Well, I think as we’ve outlined in our discussion today and in general, our primary objective is to originate and to deploy the SBA capital. Again, I think the originations were concentrated in our portfolio of SBIC loans and so our objective is to do that. The SBIC, we have certain criteria in terms of what types of investments can go into that portfolio and so that is -- so it’s a combination of redemptions and criteria that sort of drive the net asset growth inside the SBIC versus at the BDC level. We feel fortunate that we can originate on both platforms and it gives us a lot of flexibility in addressing the market because we are not limited to SIBC style and criteria alone, so we can be very flexible with our presence in the marketplace. But yes, our objective is the SBIC portfolio. However, that's where some of the redemptions have been. So it's really not an either/or. It's what we are working on both and they just have different dynamics.

Okay. That’s helpful. Next question. Following up on your comments on Smile Brands and how the equity sponsor had a cash infusion, was the cash infusion enough that you may perhaps be able to write-up the first lien loan from $2.9 million up to, closer to the $4.4 million cost?

No, I don’t think we look at it that way. I think the sponsor has some work ahead. Obviously, we’ve got to be careful because it’s a private company. But I think the sponsor has work ahead of it and the bank group was well into work with the sponsor and they are cooperating as well and they are working hard to try to improve the fundamentals of the business. And I think that you won’t see that valuation move upward until we see some fundamental improvement in the business.

Okay. And the other portfolio company, it was mentioned in the prepared remarks, Elyria Foundry, I mean, how there is the rate down there? Can you talk about the performance of that company? I know it’s in the challenged metals industry, but how comfortable do you feel with the revolver as that’s been carried at cost? Is the trend such that there could be any risk with the valuation on the revolver?

We feel very comfortable about the revolver and its position on the balance sheet. In fact, we think that the risk adjusted returns on the revolver are fabulous. This is a company that could have been sold for significantly higher price just based on the value of the assets sort of the plant and equipment and the asset that Elyria owns. And so we feel like where we are on the top of the capital stack with our revolver is a very solid position. As it relates to the equity and the write-down that you see there, that’s just the company continued to struggle as it’s shifting its customer base, some of its customers which were relatively concentrated or having some challenges in the end markets they sell to. And this is a business that has a fair degree of operating leverage etcetera. So when their revenues come down, it really affects their EBITDA significantly. But we think that the company has pretty valuable asset and is looking to shift its customer base and grow the revenue profile. And if they are successful in doing that that they should have improved performance over time, and that’s what management has confidence in, as does the equity ownership.

And to further comments, Elyria is a legacy investment that existed before we became involved, before we took over the management of Saratoga Investment Corp. and the debt aspect of the business was converted. The reason it’s an equity investment is because all the debt was converted to equity. And so that revolving credit is the only debt on the company, there is no other debt and all the other equity is owned by the former debt holders which included us. And so there is actually cash flow generation at the company, even though they are in John’s times. And so it’s very well-structured to address and deal with some of its problem, some of which are cyclical, some of which are business -- they are fundamental business issues. So again, we don’t feel we are ended all about the revolver and we do continue to watch and work with the company on the equity side very closely.

Okay. That’s very helpful. And then my last question is, when I run the calculation, so book value is down 1.4% and it looks like half of the book value decline came from dilution from the dividend reinvestment program, can you talk about why this program makes sense when reinvestments occur at such significant discounts to book value and lead to dilution because it seems like you increased the authorization from 200,000 to 400,000, which I think is great and it seems that at this valuation roughly 75% of book value needs to be buying shares back as opposed to issuing shares? Can you make some comments on that?

Sure. There are several things in your question. First, let’s just talk about the shareholder repurchase plan. We had a plan of 200,000, we increased to 400,000, but basically a big chunk of that increase was sort of reflective of the increased volume in our shares. And so since we succeeded the plan we’ve had doubling of the volume which we’re very happy about, I mean that we’re very interested in promoting as much creating volume as we can. And so that was really just a tuning of that purchase program relative to the trading volume in the stock. With regards to the dilution from that plan, I think ever since we became involved five years ago before we start paying regularly cash dividends, we basically had an equity reinvestment plan compared to 80% in stock and 20% in cash. And we have a relatively small company, we’ve been working to achieve scale and we’re getting much closer to achieving scale. As Henri mentioned, our expense metrics and the like are very much bright on track with the industry now. They were able to higher relative to industry before. So we are making progress on scale. And then what we’ve effectively done is we’ve grown by retaining our earnings and that retention of earnings, the reinvestment rate on those earnings is very high. In the SBIC it’s high-teens, even 20s depending on the investment. So every dollar that’s retained by the company, it gets reinvested at a very high rate of return because of our dynamics, specifically in the SBIC but also across the company. What we’ve endeavored to do when we went to the regular cash dividend was to continue the opportunity for shareholders to reinvest. I think that on the one hand it’s dilution but on the other hand, it’s what we view is a very fair program and with all shareholders are given the right to reinvest in this dividend. And so, we’re not selling stock to like one party or another party, we’re offering all shareholders the ability voluntarily to either invest in the stock at effectively at a slight discount to what the market is or to take cash. And every quarter they have a chance to do it, they can mix and match, if they want to do one quarter one thing, another quarter another. But I think what’s really important is the utilization of those retained earnings, which is to grow our asset base into scale. And then the further backdrop to that is that we are one of the very best performing BDCs over the last one, three and five year periods of time. So the total return on our stock, everything included, dilution included but we don't view it as dilution because our existing shareholders doing it. But our total return has exceeded 18% overall in that period of time. So, we are a top performing stock on a total return basis and so right now we’re very total return focused. And over time when we improve and when the market basically recognizes more fully our achievements, we don't think we’re getting as much credit for our performances as we should and that’s reflected in the stock price that’s sort of slight discount maybe industry average. We think we should be at a premium given our overall performance. And as we move towards that level, I think the dilution aspect of this will go away. But I think what’s important to note is that that retained earning is being utilized in a very high return basis.

Okay. Thanks very much.

[Operator Instructions] And I’m showing a question from Mickey Schleien from Ladenburg Thalmann. Your line is now open.

Yes. Good morning, everyone. I wanted to ask a broad question, actually two questions. As we’re heading into next year, I was curious what your thoughts or sort of base case scenario is for the U.S. economy in terms of GDP growth? What the fed may or may not be doing? What your expectations are for defaults? And also if you could give us some sense of how your borrowers are doing in terms of their revenue growth and margins?

Let me try to address that, Mickey. The way -- well, let me just say directly. We don’t spend a lot of time trying to predict the macroeconomic state of the economy. We really -- we’re mindful of it. We pay attention to it. And the approach that we take is that when we underwrite a business and look to invest or lend to a business, we want to look for businesses that are going to hold up well in almost all economic environments. Everybody of course, faces some pressure if the economy goes down. But we’ve spent a lot of time underwriting each business and going through scenarios. We are doing what/if scenarios, going back to the last recession and seeing, well, how much the sales decline during that period and we’d hold up with this capital structure, et cetera. So the core of our focuses is really finding good businesses and making sure that they are once that we feel will perform even if the economy goes through a tougher time. So it’s hard for us to really have a crystal ball and predict what the outlook is going to be. And I’m sorry, your second question was….

Well, before I go to the second question, Mike, can I interpret that answer as another way of saying that perhaps you’re being defensive in terms of how you are allocating your capital today?

Yes. Well and generally we are. It’s a reactive piece of capital. And I guess a perfect example is one of the reasons you don’t see us with very much energy exposure at all. We don’t have any direct energy exposure for sure. I think if we had more of the momentum investing philosophy, we would have been there two years ago, we're seeing these deals constantly and what I’ve seen an upward to the right trajectory in EBITDA for a lot of these businesses. And said well, let’s go for it. Let's make a loan and hope that the energy prices don't change. We just don't do that in general. So that’s just not the approach that we take. We tend to be a little more defensive. We are certainly aggressive in trying to lend to and partner with businesses that we think are very solid and sound and we are aggressive in that respect. But it’s only when we feel like there are good business that will hold up pretty well in most economic times.

I’m sorry, further to the macro perspective, I mean, I think all of us and all that public dialogue you see about it. I mean, this recovery has not been highly robust recovery. I mean, it’s sort of recovered, but it's been sort of weak recovery along the way and there's been -- there is always a potential or reversal and some of the news in general has not been that great. So it's not that that would radically change what Mike said. I mean, we are really looking for niche companies and that's the beauty of the aspect of our market, right, is that all the companies we invested in, the GDP is not that relevant too, I mean they have their own niches, they have their own growth opportunities, they are sort of independent of broad economy. And so it doesn't necessarily affect us that much. But again in terms of the overall backdrop, we've been in a pretty big -- it is felt like a pretty precarious environment for whole a lot number of years. And so we have, as Mike said, we’ve had a defensive posture every time we made a loan and I think it's reflected in a steady asset growth where some of our peers in the industry have had very rapid asset growth. But we had a very steady measured level of asset growth. As we find these companies that we think are sort of all weather, all season companies that we can feel comfortable investing in almost regardless of the economic climate.

And then to your second question, Mickey, if you are ready for us, then to ask.

Well, I was just going to ask Chris, is the -- whatever you are assuming in terms of where we are in the credit cycle, are there particular industries that you are attracted to now?

I don’t know if I would characterize it is particular industries so much as niche companies. And again because of the size we’re at, we are looking at lots of service companies, companies that have software components, but they are not software companies, they are focused on specific applications of software in sort of highly niche areas. So it's not so much industries. I think what might be better to characterize it is what we’re not, what we’re avoiding, and what we’re avoiding is cyclical companies, commodity oriented businesses which would -- which energy would be part of. And as we said, we’ve been basically zero direct energy exposure. But there is a lot of other commodity related businesses that are out there and we kind of avoid those. We look for companies to where they have sort of leading market positions, pricing power, strong gross margin, stable market places, and room to grow within their market niches.

High recurring cash flow, high free cash flow and really good management teams.

Right. Okay. And the other part of my question was, we’re getting just such a mixed signals about our economy and obviously outside the U.S. even more mixed signals. So I would like to ask how your customers are doing, your borrowers are doing in terms of revenue and margins? I mean you get to see their numbers at least quarterly and probably monthly in many cases, so what is the thermometer saying right now?

Well, I think as a general statement I would say a lot of our companies are U.S. based companies.

Right.

And the United States’ economy is and U.S. focused. And so the U.S. economy is, I’m not saying it’s the strongest in the world, but it’s pretty -- it’s held us a lot better than a lot of the other places in the world. So our economic environment in United States is good and attractive. And so -- and our companies are niches inside of that. And so we have not with the exception of Smile brands and then Elyria legacy investments had some certain exposures. But in general, our companies are U.S. focused businesses and the U.S. economy in general is doing well, and our companies are doing quite well. And also our credit positions inside these companies with our sort of dollar -- first dollar credit first lien predilections that we’ve been executing on. We feel our credit position on top of that is very strong and Mike do you want to…

By and large, though to answer your question directly -- by and large our portfolio in total, the portfolio companies are performing better than they had in the previous years and just a broad statement throughout the portfolio. But by and large they are also underperforming where they expect. Now that that can be sort of, that’s something you have to take with a grain of salt though because no two company ownerships are alike in terms of how they put their projections together.

Yes.

Some ownership groups will put real aggressive projections to try to drive management goals that they probably can’t really reach and other extent to sandbags, so it’s hard to say, but across the portfolio I would say that by and large they are not performing as well as they would have liked, but better than last year.

And Mike is that to some extent driven by -- in the sponsored companies or the private equity sponsors putting or asking for overly aggressive budgets?

In some cases and some cases not, it’s just really depends. I think though that, if you look at across the portfolio that probably, it probably tells you something about where the economy is.

Yes.

I think it is pretty representative group of businesses in the U.S. and they are doing pretty well and performing better than they did last year by and large, but not as well they like.

Okay. I appreciate all of your time this morning. Thank you.

Thank you.

Thanks, Mickey.

I am not showing any further questions, I would like turn the call back to Christian Oberbeck for any further remarks.

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