Saratoga Investment Corp. (SAR) Q2 2020 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Saratoga Investment Corp. Fiscal Second Quarter 2020 Financial Results Conference Call. Please note that today's call is being recorded. During the 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 and Compliance Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Thank you. I would like to welcome everyone to Saratoga Investment Corp's fiscal second quarter 2020 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 2020 shareholder presentation in the Events & Presentations section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night. A replay of this conference call will also be available from 1:00 PM today through October 17th. Please refer to our earnings press release for details.I would now like to turn the call over to our Chairman and Chief Executive Officer, Christian Oberbeck, who will be making a few introductory remarks.

Thank you, Henri, and welcome, everyone. This second fiscal quarter has been a particularly strong and important one for us, with many significant accomplishments. All of this quarter's achievements will support our efforts to build upon our industry leadership within the BDC sector and grow our high-quality portfolio, utilizing our strengthened capital and liquidity base.While a challenging and competitive environment persists, our origination efforts combined with our flexible capital solutions and diversified sources of cost-effective liquidity, continue to support our robust pipeline of available deal sources, driving greater scale.To briefly recap this past quarter's highlights on Slide 2. First, we received approval for a second SBIC license providing us access up to $175 million in additional long-term cost effective capital in the form of SBA debentures to further enable us to support our core small business constituency.Second, we continued to strengthen our financial foundation this quarter by maintaining a high level of investment credit quality, with 99% of our loan investments having our highest rating, generating a return on equity of 14.3% on a trailing 12-month basis, 14.7% annualized in Q2, both significantly beating the BDC industry mean of 8.7%, increasing NAV by a net $2.6 million realized and unrealized gain in this quarter, and registering a gross unlevered IRR of 13.5% on our total unrealized portfolio and a gross unlevered IRR of 14% on total realizations to-date of $393 million.Third, our assets under management grew to $487 million this quarter, a 19% increase from $410 million as of last quarter and a 24% increase from $393 million as of the same time last year. This quarter continues to demonstrate the success of our growing origination platform with a healthy $93 million of originations. This -- importantly, our new originations included four new portfolio company investments with two more closed since quarter end and eight in total since year end.Fourth, the continued strengthening of our financial foundation has enabled us to increase our quarterly dividend for the 20th consecutive quarter, representing five consecutive years of dividend increases. We're one of only two BDCs that have achieved that record. We paid a quarterly dividend of $0.56 per share for the second fiscal quarter on September 26, 2019. This was an increase of $0.01 per share over the past quarter’s dividend of $0.55 per share. All of our dividend payments have been exceeded by adjusted net investment income for the same periods. We are one of only eight BDCs having increased dividends over the past year.And finally, as we look to the future, our capital structure and base of liquidity increased and strengthened meaningfully in this quarter. In addition to the receipt of the SBIC license in August with its long-term benefits and potential accretive returns, we also sold 1.4 million common shares with gross proceeds of $34.1 million through our ATM offering during the quarter. These shares were sold at a gross premium of 3.3% resulting in a $0.06 accretion to NAV per share. Subsequent to quarter end, we sold another 543,000 shares with gross proceeds of $13.6 million also at a similar premium to NAV for a total issuance of $47.7 million.These share issuances provide initial equity capitalization for our new SBIC subsidiary while also funding further BDC asset growth. The total equity capitalization required for the second license is $87.5 million in order to access the $175 million of debentures pursuant to a 2-to-1 debt-to-equity ratio.The most recent debenture pooling priced on September 17th at a 2.283% with added fees and expenses combining for an all-in rate of approximately 3% on recent SBIC debentures. We now have significantly increased dry powder to address future investment opportunities in a changing credit and pricing environment. Our existing available quarter end liquidity of $244 million allows us to grow our current assets under management by 50% without any new external financing. Saratoga delivered strong return on equity performance this quarter and year-to-date as noted above, and continued solid performance within our key performance indicators as compared to the quarters ended August 31, 2018 and May 31, 2019.Our adjusted NII is $5.6 million this quarter, up 18% versus $4.8 million last year, and up 22% versus $4.6 million last quarter. Our adjusted NII per share is $0.68 this quarter, down from $0.69 last year, and up 13% from $0.60 last quarter. Our NAV per share is $24.47, up 6% from $23.16 last year, and up 2% from $24.06 last quarter. Henri will provide more detail later.As you can see on Slide 3, our assets under management has steadily risen since we took over management of the BDC more than nine years ago. And the quality of our credits remains high. We are working diligently to continue this positive trend.With that, I would like to now turn the call back over to Henri to review our financial results as well as the composition and performance of our portfolio.

Thank you, Chris. Slide 4 highlights our key performance metrics for the quarter ended August 31, 2019. When adjusting for the incentive fee accruals related to net unrealized capital gains in the second incentive fee calculation, adjusted NII of $5.6 million was up 22% from $4.6 million last quarter and up 18% from $4.8 million as compared to last year's Q2.Adjusted NII per share was $0.68, down $0.01 from $0.69 per share last year, but up $0.08 from $0.60 per share last quarter. The increase in adjusted NII from last year and last quarter primarily reflects the higher level of investments and results in higher interest income with AUM up 19% from last quarter and up 24% from last year. The decrease in adjusted NII per share from last year was primarily due to a steady increase in the number of shares outstanding.Weighted average common shares outstanding increased from 6.9 million shares for the three months ended August 31, 2018 to 7.7 million shares and 8.3 million shares for the three months ended May 31, 2019 and August 31, 2019 respectively.Adjusted NII yield was 11.0% when adjusted for the incentive fee accrual. This yield is up 90 basis points from 10.1% last quarter and down 90 basis points from 11.9% last year, primarily reflecting the impact of our growing NAV and the effect of our currently undeployed capital coupled with Q2, only reflecting the partial benefit of our new investments this quarter.For the second quarter we experienced a net gain on investments of $2.6 million or $0.31 per weighted average share, resulting in a total increase in net assets resulting from operations of $7.6 million or $0.91 per share. The $2.6 million net gain on investments was comprised of $1.9 million net realized gain and $1.5 million net unrealized appreciation on our portfolio investments, offset by $700,000 of net deferred tax expense on unrealized gains in Saratoga Investment's blocker subsidiaries. The $1.9 million net realized gain reflects a $1.3 million gain from the realization of the company's Fancy Chap investment during the quarter as well as a $0.6 million gain on the company's Censis Technologies investment, resulting from the receipt of a dividend in excess of the investment’s cost basis.The $1.5 million unrealized appreciation reflects multiple notable changes: First, a $1.3 million unrealized appreciation on the company's Censis Technologies investment. Second, a $1.9 million unrealized appreciation on our Easy Ice investment. Third, a $1.3 million unrealized appreciation on our Netreo Holdings investment. Fourth, a $0.6 million unrealized appreciation our Grey Heller investment. And also numerous smaller unrealized appreciations across the portfolio on various other investments.These appreciations were offset primarily by a $1.2 million reversal of previously recognized appreciation following the realization of the company's Fancy Chap investment and a $2.7 million unrealized depreciation on the company's CLO equity investment, reflecting both the equity distribution received during the quarter as well as the impact of a 2% increase in the discount rate used to fair value this equity.Return on equity remains an important performance indicator for us, which includes both realized and unrealized gains. Our return on equity was 14.3% for the last 12 months and 14.7% annualized for the quarter, well above the BDC industry average of 8.7%.Quickly touching on expenses. Total expenses, excluding interest and debt financing expenses and base and incentive management fees, increased to $1.0 million this quarter, from $0.9 million in the same period last year.Excluding the deferred income tax benefits in both quarters, operating expenses increased 13.9% from $1.3 million to $1.4 million. Expenses increased as a percentage of average total assets from 0.9% to 1.0%. We have also again added the historical KPIs in slides 25 through 28 in the appendix, and at the end of the presentation, that shows our income statement and balance sheet metrics for the past nine quarters and the upward trends we have maintained. Of particular note is Slide 28, highlighting how our net interest margin run rate has more than tripled since Saratoga took over the management of the BDC, with our current year run rate ahead of last year as well.Moving on to Slide 5, NAV was $224.3 million as of this quarter end, a $43.4 million increase from $180.9 million at year end and a $51.6 million increase from $172.7 million as of the same quarter last year.NAV per share was $24.47 at quarter end, up from $24.06 as of last quarter, up from $23.62 as of year-end and up from $23.16 as of the same period last year. NAV has not only increased in total dollars, we have now had three sequential quarters of NAV per share increases, and growth in seven of the last eight quarters. You can see this on the previously referenced Slide 25.For this past quarter, $5 million of net investment income and $3.3 million of net realized and unrealized appreciation were earned partially offset by $4.3 million of dividends declared and $0.7 million deferred tax expense on net unrealized gains in total blocker subsidiaries.In addition, $0.7 million of stock dividend distributions were made through the company's DRIP plan and 1,371,666 shares were sold for a net $33.6 million raise through the company's ATM equity offering during the quarter. Our stock issuances during this quarter added $0.06 to our NAV per share. Our net asset value has steadily increased since 2011, reflecting our accretive stock issuances, and the benefit of our history of consistent realized and unrealized gains.On Slide 6, you will see a simple reconciliation of the major changes in NII and NAV per share on a sequential quarterly basis. Starting at the top, NII per share increased from $0.60 per share last quarter to $0.68 per share in Q2. The significant increases were a $0.01 increase in CLO interest income, a $0.10 increase in other income and a $0.04 increase in deferred tax benefit that is non-recurring. These increases were offset by a $0.02 increase in base management fees, a $0.01 increase in operating expenses and $0.04 dilution from increased shares from the ATM and DRIP programs.Moving on to the lower half of the slide, this reconciles the $0.41 NAV per share increase for the quarter. The $0.59 generated by our NII in Q2, $0.51 net realized and unrealized gains on investments and $0.06 accretive net impact of our ATM and DRIP programs in Q2 were partially offset by the $0.55 dividend declared for Q1 with the Q2 record date.Slide 7 outlines the dry powder available to us as of August 31, 2019 which totals $244.1 million. This consists of our available cash, our undrawn SBA debentures and our undrawn Madison facility. As Chris mentioned earlier, our recently approved second SBIC license has added $175 million to our dry powder in the form of undrawn SBA debentures. This significantly increases our available capacity, allowing us to grow our assets by an additional 50% without the need for external financing. The composition of this capacity is also more accretive to NII when deployed, with $24 million of it being cash with no additional interest expense attached and $175 million of undrawn SBA debentures with a low 3% total cost of capital based on the current pricing.We remain extremely pleased with our liquidity position especially taking into account the overall conservative nature of our balance sheet and the fact that all our debt is long-term in nature, actually all four years plus.Now I would like to move on to slides 8 through 10 and review the composition and yield of our investment portfolio. Starting with Slide 8, our $486 million of assets are invested in 36 portfolio companies at one CLO fund, and 63% of our investments are in first lien, of which 16% is in first lien last out positions.On Slide 9 you can see how the yield on our core BDC assets, excluding our CLO and syndicated loans, as well as our total assets yield is now below 11%. As LIBOR continues to decline and the buyer trend in market continues to place downward pressure on yields, our overall yield decreased to 10.1% from 10.6% last quarter due to core assets yields decreasing from 10.8% to 10.4% and our CLO yield decreasing from 16.0% to 14.7%. These changes in the core asset yield primarily reflects the 36 basis points reduction in LIBOR during Q2, while the reduction of the weighted average effective interest rate generated by the CLO valuation is driven by the 2% discount rate increase, also this quarter.Turning to Slide 10. During the second fiscal quarter, we made investments of $93.2 million in four new portfolio companies and six follow-ons and had $19.0 million in one exit and one refinancing plus amortization, resulting in a net increase in investments of $74.2 million for the quarter.Our investments remain highly diversified by type as well as in terms of geography and industry, spread over eight distinct industries with a large focus on business, healthcare and education services. We’re often asked about the business services classification, as this category really represents investments in companies that provide specific services to other businesses across a wide variety of industries.As of quarter end the business services classification currently includes investments in 20 different companies. These services range broadly from education to financial advisory to IT management to restaurant supply to human resources and to many other services, 15 in total. This breakdown is provided in our featured presentation on our website.Of our total investment portfolio 9.2% consists of equity interests, which remains an important part of our overall investment strategy. We had net realized gains during Q2 of $1.9 million as previously described. For the past seven fiscal years as you can see on Slide 11, including the first half of fiscal 2020, we had a combined $18.6 million of net realized gains from the sale of equity interests, or sale of early redemption of other investments.As a reminder, for tax purposes we continue to have unused capital loss carry forwards that were carried over from when Saratoga took over management of the BDC, resulting in these gains being fully accretive to NAV. This consistent performance highlights our portfolio credit quality that’s helped to grow our NAV, and is reflected in our healthy long-term ROE.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'll take a couple of minutes to describe the current market as we see it, and then comment on our current portfolio performance and investment strategy.The highly competitive landscape that I've described in past calls has continued to intensify. Deal activity is healthy as evidenced this quarter and our pipeline remains robust. But the underlying borrower friendly conditions dominating the market still persist. Generally commercial banks and non-bank direct lenders are becoming more aggressive, exacerbating a supply and demand dynamic that tightens price and expands leverage tolerances.We continue to see no spread expansion, and in fact absolute yields continue to decline due to the impact of decreasing LIBOR with another 36 basis point reduction experienced this quarter. We have been reasonably successful in obtaining floors that reflect current market conditions on most of our new deals, which helps reduce the long-term impact of a decreasing rate environment.Overall, we have not sacrificed quality, but these dynamics have served to put downward pressure on yields generally.In the face of this kind of market, we believe sticking to our strategy has and will continue to serve us best. Our approach has always been to underwrite each investment working directly with management in ownership to make a thorough assessment of the long-term strength of the company and its business model.With the possibility of a market downturn always in our minds, we seek to invest in durable businesses. We invest capital with the objective of producing the best risk-adjusted accretive returns for our shareholders over the long-term.Having a record originations quarter does not mean that approach has changed in the least, nor has there been a change to our credit profile. In fact, our first lien proportion of investments this quarter actually increased to 63% from 54% in Q1, through a healthy combination of new platform companies and follow-ons, and our internal credit quality rating hit 99% for the first time.We believe this approach has contributed to our successful returns and has also positioned us well for any future market downturns.With net portfolio appreciation of $3.3 million in Q2 and $7.3 million year-to-date, we are also pleased with how our overall portfolio is performing. We believe this reflects the strength of our underwriting approach theme and portfolio and the quality of opportunities that exist in our market.Now looking at leverage on Slide 12, total leverage for the overall portfolio was 4.89 times, up slightly from the previous quarter but below average, year-to-date market leverage multiples which are all well above 5 times across our industry. The increase was primarily due to slightly higher leverage of portfolio companies in which we completed follow-ons this quarter.We've been able to maintain a relatively modest risk profile and the new portfolio of company investments this quarter have generally been in line with or below our historical average leverage. As we frequently highlight, rather than just considering leverage, our focus remains on investing new credits with attractive risk return profiles and exceptionally strong business models where we are confident that the enterprise value of the businesses will sustainably exceed the last dollar of our investment.While absolute leverage metrics are an important consideration, we always evaluate leverage relative to the strength of the underlying business.For example, we have developed an expertise in lending to businesses that deliver their services to a software platform. Our investments in this space span a widely diverse set of industries including education, healthcare, insurance services, board governance hospitality, payroll services and many others. Good businesses utilizing a software-as-a-service platform can have terrific credit characteristics with exceptional recurring revenue, customer retention and gross margins.As a result, the valuations for these businesses are high and the corresponding debt multiples are also higher than average. These businesses are typically valued and our underwriting is performed in part on a recurring revenue basis. Because credit profiles of some of these businesses are so strong, we believe we can achieve attractive, risk-adjusted returns lending to good businesses of this type.In fact, the average loan-to-enterprise value of these portfolio investments is considerably lower than the rest of our portfolio.In addition, this slide illustrates our consistent ability to generate new investments over the long-term, despite difficult market dynamics. With 19 originations through the third quarter, including five new portfolio companies and five follow-ons in this quarter alone, we have established an origination level that is on par with last year's record pace, while applying consistent investment criteria.We always emphasize that quarterly portfolio growth can be lumpy from one quarter to the next and is dependent on various factors, including a robust pipeline, credit quality within that pipeline and the pace of repayments. This past quarter was a perfect example as we benefited from all three of the above factors and saw a big jump in AUM.We continue to focus on the longer term and remain confident that we can continue to grow our AUM steadily over the long-term supported by a healthy pipeline as demonstrated on Slide 13.Our team’s skill set, experience and relationships continue to mature and our significant focus on business development has led to new strategic relationships that have become sources for new deals. Our number of deal source continuously increase despite a market that is competitive and frothy. Notably, 25% of term sheets issued and two of our new portfolio companies over the past 12 months are from newly formed relationships reflecting solid progress as we expand our business development efforts.The breath of our deal funnel also evidences how we continue to maintain our investment discipline. We say no to a lot of deals, but maintaining discipline is ingrained in our culture and we will continue to say no if opportunities do not fit our credit profile. We know this is how we will preserve and grow the enterprise value of Saratoga for our shareholders.Our overall portfolio credit quality remains strong with Q2 again demonstrating this. As you can see on Slide 14, the growth on leveraged IRR on realized investments made by the Saratoga Investment management team is 14% on approximately $393 million of realizations.On the repayments in Q2 the weighted average unlevered IRR is just over 77% with our Fancy Chap investment being outstanding for a very short period of time before realizing the $1.3 million gain.On the chart to the right, you can also see the growth unlevered IRR on our $476 million of combined weighted SBIC and BDC unrealized investments is 13.5% since Saratoga took over management. We also previously highlighted that our Roscoe Medical second lien investment was on non-accrual.Our total investment comprises the $4.2 million second lien that is to mark down a further $0.5 million to a fair value of $1.9 million this quarter, as well as an equity investment of $0.5 million that has previously been written down to zero. There is no real update since we last reported. These marks reflect both fundamental weakened performance as well as operational issues.We continue to work with the senior lenders and sponsors to pursue strategic alternatives in the near to medium-term. We also note that we have increased our Censis investment this quarter by $20 million. And having been a lender and investor in this company since 2014, we are extremely confident in the strength of the business and our upsized position in this credit. Censis is the leader in its growing end market and is led by exceptional management and equity sponsorship.So this quarter was another good example of how a solid high quality portfolio interacts as a whole. Our total realized and unrealized appreciation for the quarter was a net positive $3.3 million which included significant value increases in our Censis Technologies, Easy Ice, Netreo Holdings and Grey Heller investments among others and more than offset notable unrealized depreciation in our CLO.Now moving on to Slide 15, you can see our first SBIC license is fully funded with $235 million invested as of the quarter end. This quarter, we received approval from the SBA for a second SBIC license. And as of quarter end had already funded that with $35 million of equity including assets, which allows us to access $70 million of SBA debentures.Overall, we feel the operating results of the quarter demonstrate the strength of our team, platform and portfolio, while we remain extremely diligent in our overall underwriting and due diligence procedures. This culminates in high quality asset selection within a tough market. Credit quality remains our top focus, and we remain committed to this approach.This concludes my review of the market and I'd like to turn the call back over to Chris.

Thank you, Mike. As outlined on Slide 16, this past quarter, we again increased our dividend by $0.01 to $0.56, a 2% increase, the 20th sequential quarter of dividend increases representing five years of sequential increases. We are only one of two BDCs to accomplish this.Slide 17 shows that the 7.7% year-over-year dividend growth easily places us near the very top of our peers, and one of only eight BDCs have grown dividends in the past year. With most BDCs having either no increases or decreasing the size of their dividend payments, our continually increasing dividends, which we have over earned in each quarter has differentiated us within the marketplace.Moving to Slide 18, our total return over the last 12 months, which includes both capital appreciation and dividends, has generated total returns of 12%, double the BDC index of 6%. Our longer term performance is outlined on our next slide, 19.Our three and five year returns place us in the top two and four respectively of all BDCs for both time horizons. Over the past three years our 81% return exceeded the 22% return of the index and over the past five years our 161% return exceeded the index of 27% return.On Slide 20 you can further see our outperformance placed in the context of the broader industry and specific to certain key performance metrics. We continue to achieve high marks and outperform the industry across diverse categories, including interest yield on the portfolio, latest 12 months NII yield, latest 12 months return on equity, dividend coverage, year-over-year dividend growth and NAV per share growth.Of note is that as our assets have grown and we're increasingly achieving scale, our expense ratio is moving closer towards the industry averages. Notably, our latest 12 months return on equity and NAV per share outperformance reflects the growing value our shareholders are receiving.Moving on to Slide 21, all of our initiatives and achievements discussed today on this call are designed to make Saratoga Investment a highly competitive BDC that is attractive to the capital markets community. We believe that our differentiated characteristics, as outlined on this slide, will help drive the size and quality of our investor base, including adding more institutions.Differentiating characteristics include: maintaining one of the highest levels of management ownership in the industry at 16%, which has been updated for recent equity issuances, with no shares sold by management; a strong and growing dividend covered by NII; access to low cost and long-term liquidity with which to grow our current asset base by another 50%; further strength in this quarter with a receipt of our second SBIC license; a BBB investment grade rating, solid earnings per share and NII yield with substantial growth potential; high quality expansion of AUM and an attractive risk profile. In addition, our high credit quality portfolio contains minimal exposure to cyclical industries, including the oil and gas industry.Finally, looking at Slide 22, we continue to progress on our long-term goal 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, enabling us to execute on our simple and consistent objectives.In closing, I'd again like to thank all of our shareholders for their ongoing support. We are excited for the growth and profitability that lies ahead for Saratoga Investment Corp.I would like to now open the call for questions.

[Operator Instructions]. Our first question comes from Casey Alexander with Compass Point.

Obviously, you guys have done a great job of managing this portfolio. I have a couple of questions. Henri, you alluded to the increase in other income as a contributing factor to the strong results this quarter. And that is a number that $1.3 million that the company has never achieved before and is well over historicals. What drove that, and to what extent is that other income recurring or not?

Yes. Casey, absolutely, I highlighted that obviously on purpose. I think two things to consider. One is, there is no unusual items in the other income this quarter. So, there's no dividend or any other unusual items. It really includes sort of just the two things that you know you'd always expect in other income. Firstly, it's the 1% advisory fee that relates to new originations that we have in a quarter. And then secondly, there was a prepayment fee of a couple of hundred thousand that related to the realization of our Fancy Chap investment.So, no unique items in other income this quarter. However, why we highlighted it was obviously that our originations was at a very, very high level this quarter. And so, therefore that advisory fee that relates to it was at a high level as well. We always view it as partially recurring because of the fact that we are originating every single quarter, but because of the high level of originations, it was at a much higher level than it normally is as you know.

So, that advisory fee by itself was a little less, just a little less than $1 million then based upon your originations.

Yes. It's -- I think was a little less than that, but, yes, close, probably somewhere around $800,000.

And secondly, when you calculate adjusted NII -- and I know it's a non-GAAP number, I'm curious why you don't also pull out the income tax benefit from that number, because that’s clearly an unusual item, not a recurring item and has dropped in maybe once a year. I'm curious why you didn't take that out of adjusted NII also?

Yes. It's a good question. We obviously work with our accountants on sort of assessing what should be excluded from adjusted NII. As you know, non-GAAP measures have quite a high hurdle around what you can be – what you can exclude. And because the deferred tax benefits relates to our blockers and you will have an element of that every single quarter, the view has been to leave it and to not exclude it from adjusted NII. However, to your point, we have really tried to highlight it in the NII per share, a role, and also and always in our prepared remarks so that people can understand that that’s sort of a unique element to our blocker structure and strategy and can be volatile on a quarter-over-quarter basis.

And for Michael. I have to ask, and I've discussed this before in Easy Ice, and now I’m going to lump in Censis, is the concentration issue. You have two portfolio companies that encompass almost $90 million of the portfolio, 18% of the total portfolio, 38% of net assets. I know Censis and Easy Ice have been very successful investments. But how would you suggest the investors get comfortable with that degree of concentration in just two names?

I think the way we look at this, Casey, is that when we evaluate a credit, especially a new credit, we take into account the size for our investment, as well as the strength of the underlying business. One of the things that we’ve had the benefit of as we've grown our business is that we've been able to invest in businesses that have been pretty long dated investments where we've come to know the business extremely well. And as our relationship with the business has grown, and our experience with the business has grown so as our confidence in the strength of that business. And so in both of those cases, these are businesses that we've been investors in for quite some time. Censis it was 2014 and I think Easy Ice may go back to 2012 or ‘13. So fundamentally, they are businesses that we know extremely well, they're both leaders in their industry verticals that they operate in and we feel like they're fundamentally terrific investments. And that's what's giving us confidence to upsize our exposure to those two credits.

Our next question comes from Mickey Schleien with Ladenburg.

I also want to congratulate you on a strong quarter. I want to start off by talking about -- a little bit about leverage. So back of the envelope, if you drew say half of the availability on the credit facility and half of the cash you have as of the end of the quarter for additional capital in the new SBIC subsidiary including the equity you've already injected there, then you’d have access to about $100 million of new SBA debentures. And that would take you to total debt-to-equity of 1.7 all else equal. And I do realize you've issued some equity since this quarter was reported. So that level is above the 1.5 you've been operating at the last several quarters. Are you willing to go up to the 1.7 or is the 1.5 more your comfort level or any guidance you can give us?

Mickey, thank you for that question. I think that among the concepts we constantly talk about every quarter is the relative lumpiness of our business on a quarter-by-quarter basis. There's a lot of very good things have happened and we're very concentrated in this most recent quarter. And as we go forward, our leverage levels may fluctuate. As you point out, in our SBIC license, we funded $35 million, which gives us access to $70 million. If we put in some more, we can have access to $100 million, as you discussed. How we fund that, whether it’s more equity or more debt or cash on hand, or maybe we have redemptions that come in and fund it, that's a constantly fluid situation as to how we allocate our capital. At any given point in time, we might be relatively higher leveraged or relatively lower leveraged. I think that as -- so as we go forward, and we will be looking at -- on a case-by-case basis, and so we don't have a fixed number in terms of exactly where we think our leverage should be. We do note, however, that the structure of our leverage is, we think very sound. If you look at the SBIC debentures, our 10 year interest only bullet maturity debentures with no covenants. So there's only a requirement to pay. There is no pay the interest. No amortization at all. Our baby bonds are similar. On our structure of our baby bonds we have no maturities for four years now.

Yes.

And that we do have our revolving line of credit, which we go in and out of as you see depending on fluctuations in investment rates and redemptions, et cetera. And that too has no hard covenants, hard defaults in it. So we are very soundly structured, in terms of the -- in terms of how our leverage interacts with our assets. And we've been originating assets and our book of asset is mostly floating rate as you know. And as a result of that, we have -- we feel very comfortable with our leverage profile and our leverage structure.

Thank you for that, Chris. That’s helpful. I could move on. It looks like you helped finance the dividend recap for Censis. And we're all aware that dividend recaps are usually looked at pretty skeptically by the market. So I'd like to understand what was the thesis behind that particular transaction?

Yes. What -- I'm trying to figure out exactly what I can relate to you. I think what I said in my prepared remarks is the company is performing exceedingly well. We have a very high degree of confidence in the management team that we know well, as well as the equity sponsorship. The company had an opportunity to recapitalize itself. We actually believe that we recapitalized it, Mickey, on terms that were better than market. We know that the market -- the company had offers to finance the business and refinance the capital structure on terms that were much more aggressive than what we proposed. But given the fact that we are in the deal already and knew the management team very well, and most importantly, the ownership group, we were in the pole position to lead that financing. But just in terms of the way we look at it primarily is, are we comfortable with the enterprise value of the business and do we feel like we're well covered, well supported by that enterprise value? And I would say, on that credit, we feel exceedingly comfortable with the business.

Mike, in the dividend recap, I'm assuming the sponsor obviously got a big chunk of that. But was there also an incentive or reward paid to the management for their efforts?

Well, that's -- the -- I can't get into the details of the recapitalization just given that it’s a private company. But I can say that the sponsorship that we work with typically understands how important it is to align management’s interest with their own and in this case they did a great job of doing that as well.

Okay. Mike, your investments this quarter were overwhelmingly focused on first liens. And I appreciate the thoughts behind that. But the portfolio’s average leverage continues to climb. So, I'd like to understand what's driving that increase? Is it lending to larger companies, which may deserve a higher multiple or is it just how difficult the market environment is or was it something else?

I think, from our perspective, we always just evaluate each credit on its own merits. And we've always said that, just because the credit is a low leverage credit, it doesn't necessarily make it a good deal. And we pass on those transactions all the time and did so this quarter. So, it's really just reflective of the opportunities that we saw before us. The thing I would point out in our originations this quarter, it might give you some more color, and it’s reflective of a playbook that we've capitalized on for years, $56 million of that production this quarter was in follow-on investments to very well performing companies, and then $36 million of it was to businesses that are new portfolio companies.We've been very successful doing the work to get close to businesses, one that are at a smaller stage of their development and doing the work to write a smaller check at the front end and that's put us in the pole position to support the company as they grow over time, and that's what we did a lot of this quarter and have done a lot of successfully over time. And if you look at some of the most successful investments that we've made and exited over time, certainly we upsized Censis this quarter, but if you look historically, deals like Community Investors and Expedited and HMN and [MTP] and Mercury, I'm just taking off the top of my head, were many of our most successful investments. They started off smaller and we grew with them. As the companies grew, the leverage profile grew as well, getting back to your question. And so, some of those follow-ons also were situations where the company's credit profile grew quite a bit and we expanded the leverage profile consistent with that.

So, there’s not a meaningful deterioration of EBITDA on the portfolio that's causing the multiple [decline]?

No. We feel very good about the performance of the underlying portfolio. We're not seeing any trends that would reflect softness in our portfolio at all.

Okay. And sticking to risk-management, again I understand that you have been focused on first liens but second liens are still meaningful proportion of the portfolio. Could you give us a sense of the relative risk in your first versus second lien investments in terms of the size of the borrowers, maybe their average leverage or overall how you manage that risk?

Well, the way we manage that risk -- and it's the approach that we've taken all along. We recognize that there's the talk in the marketplace about whether a strategy for BDCs has to be in second lien or in first lien and we've never really taken that broad brush approach. We've always said, let's evaluate the business gain comfort with the underlying credit metrics of that business. And once we assess a business and feel like we understand it, then we figure out where we feel is appropriate to position ourselves in the balance sheet. So in some cases a business that is strong enough will get comfortable making a second lien investment. Certainly the bar is higher for a second lien investment than a first lien investment. There certainly are deals that we will look at and we will have a second lien opportunity to invest. And we don't feel comfortable being in that position in the balance sheet. There are other deals where we look at and say being dollar one in the capital structure is a safer place to be, we feel like that's a position where our chance to recoup our capital if things don't go right is much better. So that's a place where we will deploy capital.So, we think about it that way but we don't think about it in broad strokes where we say let's allocate X percent of our portfolio to second lien and Y percent to first lien. It really is a function of looking at each deal, evaluating the strength of the credit and determining where we want to play in the balance sheet.

I understand. Just a couple of more questions focused on the CLO. I see that the estimated yields came down and that's consistent with what I am seeing elsewhere. Could you give us a sense of what changes in your assumptions were made that caused that reduction?

Yes. Sure, Mickey. If you look at sort of that $2.7 million, really the reason why there was that unrealized depreciation is two different buckets, and they're sort of almost 50-50. The first one is just the fact that we are getting a larger obviously equity distribution now and that therefore as a starting point that will reduce the fair value. And so, probably about a half of the change relates to that. The other half of the change relates to any changes in your inputs that you include in your model and the largest by far and the main driver of that other 50% of the change was the discount rate as I noted in my comments. We actually increased it by 200 basis points which we believe was appropriate and that drove obviously a significant decrease or significant unrealized depreciation.

No, I appreciate that Henri and I did see the change in the discount rate and that's also consistent with what I'm seeing elsewhere. I was referring to the estimated yield of the equity of the CLO. It was down from 19.5 to 16, which implies you've become more pessimistic about something or the cash flow is perhaps not performing well? That's what I was asking about.

No. So on the estimated yield, it’s obviously an output from the actual valuation. So once you’ve put in all your cash flows and then once you discount it based on your input such as the discount rate, that would drive the effective interest yield down. So again the primary driver of that was also the discount rate change which resulted in a lower valuation and a larger adjustment to the cash flows, which brought the weighted average effective interest rate down.

But Mickey, just one comment though. None of this a reflection of the credit in the portfolio. This is more about -- it's about market change ….

The cash flow was still performing well.

… arbitrage differentials. Yes.

Correct. Yes. The -- obviously, most of the inputs that go into the valuation, like the discount rates are driven by market comparables primarily.

Right, yes. And that market has been very weak, I understand. Those are all my questions this morning. I appreciate your time. Thank you.

Our next question comes from Tim Hayes with B. Riley FBR.

My first one, just as you noted, growth, obviously very strong this quarter, and the portfolio is performing very well. You guys seem pretty optimistic overall. But you look at the NFIB survey data and you see that small businesses continue to report they're facing headwinds with trade, rising labor costs, margin compression, all that good stuff. How do you balance growth in light of these headwinds? And as a follow up and you kind of touched on this a bit, Michael on Mickey's question, but we've seen you guys move more first lien and invest in some more healthcare services companies over the past couple of quarters, would you say this is an intentionally defensive move on your part to position the portfolio for the later stages of the cycle or it’s just a function of what's in the pipeline?

Let me answer them in order. So the first question was, are we seeing any headwinds in the smaller -- small to medium sized businesses that we support? And we haven't seen that. If you think about our portfolio, for instance trade, most of the businesses that we invest in, lend to, really are doing a whole lot of international trade or affected by that too much. And when you look at -- another example you highlighted was higher labor costs. Most of the businesses that we have in our portfolio have really strong margin profiles. And they're very efficient. So they can withstand a little bit of increase in labor costs, and still ride through that very successfully. So we really haven't seen those headwinds in our portfolio. We're always on the watch for that. We don't invest entirely thinking about macro trends. We're always investing thinking what if there's a downturn and evaluating a business with the assumption that during our investment period, there will be a downturn and try to determine how well that business could hold up. And that'll affect our interest in moving forward on a deal or not based on that determination.As it relates to the second question, which is, are we making any moves in the portfolio to shift our concentration one way or another? And the answer there is no, not really, that's not how we think about it either. We -- the bar is higher, as I said before, on making a second lien investment, just because you're in a riskier position in the balance sheet. So there are plenty of deals that we will decide not to do if we only have an opportunity to invest in a second lien, and therefore, that'll affect, the number of transactions that we're doing in that space. But it really depends on our pipeline in a given quarter. What are the opportunities we're seeing? Even in a downturn, if we saw a business that was strong enough, and had characteristics that were just fantastic, we would evaluate doing a second lien investment. And at the same time, there are plenty of businesses that we see -- where we have an opportunity to a low leverage first lien deal and we don't think the business has sufficient strength to warrant an investment of that nature.

Tim, building on Mike's comments, I think this sort of points up on the opportunities we have at Saratoga given our size, which is relatively small and our focus, which is very much on secular growing companies. We are not necessarily buying the market or the industry or the broad economic circumstances. And I think as Mike articulated, we are very much a bottoms up driven organization in that. We're doing the transactions as they arise and we just happen to have more first liens that came about more recently. But if we had good second liens, we would have probably gotten ahead and done those too. So, we're very much driven by the bottom up but also don't have to -- we don't have to participate across the board. And so, we're very selective and we have a good fortune with our new business generation activities to be finding really attractive businesses that are kind of all weather businesses that are going to grow despite these type of headwinds.

The thing I'd add to that just to emphasize the point further, we have always said that with our business model and especially with the SBIC capital that we have, we've never sought lean out on the risk spectrum. We don't need to do that. Even in this yield environment, we just need to make safe investments to get returns that are consistent with what we can get in this environment, especially at the lower end of the middle-market where those opportunities are even more abundant. And if we do that, that's highly accretive to our shareholders and that's the playbook that we've operated under, since we’ve took over management of the BDC and that's what we will continue to do.

Thanks for the comments guys. That was really helpful and pretty consistent with what I feel like you guys have been saying over the past several quarters if not years. So, makes a lot of sense. And then, just on the portfolio yield, you attributed most of the decline near to LIBOR, but you also noted just how competitive it is out there and that you guys are staying pretty disciplined. But even so, would you say, spread compression played a role at all in the decline? And if so, do you anticipate any further yield compression just based off of either competitive pressures or it doesn't sound like anything with the mix of the portfolio is changing? So, I assume there is no change in yield from that standpoint.

To-date, we haven't been any significant change in spread. The decline in overall yield has primarily been just a result of LIBOR.

Okay. And then one last question from me. I'm going to pry a little bit here. You just mentioned that, you had two new investments in two new portfolio companies this quarter. Could you give us a size of those investments for us and give us an idea of any other investment activity so far this quarter?

No. We have made a practice of not disclosing that, but we do feel very comfortable with our -- and excited about the progress that we're making with our business development efforts and the new relationships that we're building over time.

Our next question comes from Ben Zucker with Aegis Capital.

Thanks for taking my questions. Most of them have been asked and answered at this point, but your deployment activity really picked up this quarter and it sounds like you guys have been spending a lot of time on business development and growing your book of relationships. So in light of that, I mean, is it fair to think that origination levels can generally be higher as we're looking ahead at least relative to kind of where your historical metrics have been? Of course, that's still understanding there is a lot of quarterly volatility and the timing of originations and repayments as largely out of your control and subject available capital.

Ben, I think that certainly, I think we're a lot better at origination than we've ever been. I think we're much more organized and we're covering many more bases out there. However, the one thing we've kind of discovered is forecasting certainly on a quarterly basis what originations and redemptions will be is really not something -- we get -- I mean, sometimes we get some visibility on our portfolio that we're going into our process and we think it's going to be over the next six months, but we've had them do that and they say, oh, we don't like the results or we want to stick around for a long curtains. So it's very unpredictable on a quarter-to-quarter basis and then we get calls and say, okay, that's it we're getting our money back or we've got an acquisition that needs to close in three weeks. And so, we -- it is not very predictable. Again, like for a sports analogy, we could focus on our inputs, but we can't focus on the results. So we think we're much better, we're doing much better. We certainly are planning and organize ourselves to have higher rates of origination as our overall asset base has grown because we need to replace all those assets. So we're doing all those things, but we are not necessarily comfortable forecasting any kind of increased level of originations.

No, I definitely appreciate that. It's kind of -- the business itself is a little bit like a hamster wheel I suppose. Following up on that and your comments about the market being as competitive as ever, are borrowers -- for the most part in broad stroking, are they just a lot of them looking to get as much capital as possible at the lowest rate possible or are they actually trying to align themselves with lenders that understand their business and can serve as a kind of an advisory or a business partner as well? I'm just trying to think about ways that you guys might be differentiating your capital in this environment.

Well, I think what you just described there is what we spent a lot of time talking about, which is aligning ourselves with the type of sponsors and not just sponsors, but people doing transactions where they do a value-added partner and a constructive -- creative solution-oriented provider of capital, that's where our new business efforts are focused. Those are the types of parties that give us the first look and the last look when they're coming up with originations or growth inside of their portfolio. So that is where we are trying to align ourselves. I mean, there are situations and we're at this kind of more of an auction like environment and we try to identify those and we try to avoid those. Because again, that's not the highest best use we find. We're trying to do relationship-driven, solution-oriented investment services for our relationships and we're trying to find those that appreciate that. And yes, we have to be competitive, and yes, we have to sometimes come to where the market is, but we want to be in a position where we have a sort of a preferred opportunity, rather than just bidding in general.

And then I would add to that in every market, including this one, there are a subset of players who are seeking the absolute highest dollars they can get at the lowest rate. And if we start working with somebody where that behavior is clearly, if that's how they -- it becomes clear that that's how they operate, at some point, it's time to for us to move on to another relationship because we're seeking relationships with people that understand that we bring a lot to the table and understanding these businesses and supporting them over time and seek relationships where they're not focused on getting that last dollar or that you're not going to lose the deal for just basis points. We've been successful building those relationships and are seeking to continue to grow those.

Understood. And maybe if you let me pick on Henri for a second. On your floating rate loans, where -- I mean, historically, how have you gone about putting in floors? Are they based off of spot LIBOR, are they like 20 to 25 bps below spot? And then has that dynamic started to shift recently? And I'm just, obviously I'm getting at over the last few years when you were originating floating rate loans, there was an obvious assumption that rates were being moving higher. And over the last six months or so that's probably completely flipped. So I'm just kind of wondering if there's been any change in that practice and how you think about LIBOR floor is now that there is probably a downward bias to short-term rates?

That's a good question. I'll answer that just because it's a negotiated item deal by deal and it's a good observation on your part as well. Back a few years ago when LIBOR was lower, the floors were lower as well. So we -- typically the way a negotiation works is that typically we're trying to set the floor as close to the current LIBOR as we can and there's some back and forth on that. And so if you looked at our portfolio a few years ago, many of the floors were in the 1% range or a bit higher and then we had the benefit of lift as LIBOR came up, but you didn't have the production on some of those older dated loans as LIBOR has come down. More recently, in the more recent originations, we've been pretty successful establishing LIBOR floors very close to where LIBOR is today. So those newer origination should have by and large good protection against further declines in LIBOR.

Our next question comes from Mitchel Penn with Janney Montgomery.

Real quick. Censis and Easy Ice, what portion of, if any, is in the SBIC subsidiary?

Yes. I think just off the top of my head, Mitchel, I believe, Censis, about half of it now is in the SBIC subsidiary. So I think the existing loan we had was in the SBIC subsidiary; the new piece isn't. And then on Easy Ice, I believe -- and I could be stand corrected, but I believe of our debt, about half of it is also in the SBIC, may be a little more actually; the equity -- the preferred equity is not in SBIC.

And I am not showing any further questions at this time. I'd like to turn the call back over to Christian.

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

Ladies and gentlemen, this concludes today's presentation. You may now disconnect and have a wonderful day.