Capital Southwest Corp (CSWC) 2020 Q3 法說會逐字稿

Thank you for joining today's Capital Southwest Third Fiscal Quarter 2020 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, Vice President, Finance.

I will now turn the call over to Chris Rehberger.

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

For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances or any other reason after the date of this press release, except as required by law.

I will now hand the call off to our President and Chief Executive Officer, Bowen Diehl.

Thanks, Chris, and thank you to everyone for joining us for our third quarter fiscal year 2020 earnings call.

Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We're pleased to be with you this morning to announce our quarterly results for the third fiscal quarter ended December 31, 2019.

During the quarter, we continued to advance our credit strategy, achieving the final step in transitioning the BDC to solely a middle market lender with the successful sale of Media Recovery, which, as a reminder, does business under the banner SpotSee. The sale was a great outcome for Capital Southwest as we realized a significant capital gain, while strengthening the company's position as a more traditional yield-oriented BDC by removing the potential NAV per share volatility from holding such a large equity investment in the portfolio.

As you likely recall, we've been discussing the potential sale for several quarters, and we'll provide further details later in our prepared remarks.

We're excited to have achieved this final step and look forward to continuing the pursuit of our core investment strategy of building a predominantly lower middle market portfolio consisting largely of first lien senior secured debt with equity co-investments across the loan portfolio where we believe significant equity upside opportunity exists. Executing this strategy under our shareholder-friendly, internally managed structure closely aligns the interest of our Board and management team with that of our fellow shareholders in generating sustainable long-term value through recurring dividends, capital preservation and operating cost efficiency.

During the December quarter, as laid out on Slide 6, we generated $0.44 per share of pretax net investment income and paid down our regular dividend of $0.40 per share during the quarter. We also paid out $0.10 per share in a quarterly supplemental dividend, funded by our sizable, undistributed taxable income balance or UTI, which was generated by excess income and capital gains accumulated from our investment strategy to date.

The realized gain on sale of Media Recovery allowed us to add approximately $0.50 per share to our UTI balance, bringing the total balance to approximately $27.6 million or $1.48 per share as of December 31, 2019. We believe this provides visibility to the continuation of the quarterly supplemental dividend program well into the future.

During the quarter, we also paid out a special dividend of $0.75 per share, which was the distribution of a portion of the Media Recovery realized gain. Total shareholder dividends for the quarter were $1.25 per share.

We're also pleased to announce that our Board has declared an increase to our quarterly regular dividend to $0.41 per share. Our Board also declared another quarterly supplemental dividend of $0.10 per share, bringing our total dividends paid to shareholders to $0.51 per share for the March quarter.

During the December quarter, we grew our portfolio on a net basis to $559 million from $539 million as of the end of the September quarter, originating approximately $92 million in investments for the quarter, the vast majority of which were deployed in the lower middle market.

From a capitalization perspective, we continue to de-risk the balance sheet by diversifying capital sources and maintaining liquidity. During the quarter, we raised an additional $10 million on our existing 5-year 5.375% institutionally placed bonds due 2024. The aggregate principal amount for this debenture is now $75 million.

In addition, we raised $13.8 million in gross proceeds through our equity ATM program during the quarter, selling over 623,000 shares at a weighted average price of $22.07 per share, representing a 21% premium to the September 2019 net asset value per share.

We're pleased to report that since the initiation of our equity ATM program, Capital Southwest has sold over 1.3 million shares at attractive premiums to book value, raising approximately $29 million in gross proceeds. Our equity ATM program continues to provide a steady flow of equity, equity capital raised on a just-in-time basis in lockstep with our ability to thoughtfully put the capital to work.

Including cash and undrawn commitments on our balance sheet credit facility, we had dry powder of $190 million at quarter-end available to deploy in future investments. This dry powder, when invested, represents a 34% increase in our portfolio investment assets.

Turning to Slide 7 and 8. We illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage and value creation since the launch of our credit strategy.

Turning to Slide 9. As a reminder, our investment strategy has remained consistent since our -- its launch in January 2015. We continue to focus on our core lower middle market, while also maintaining the ability to invest in the upper middle market when attractive risk-adjusted returns exist.

In the lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a well-performing and granular portfolio of equity co-investments is important to driving NAV per share growth in aiding in the mitigation of any future credit losses.

Overall, we believe that maximizing the top end of our deal origination funnel in both markets is critical to generating strong credit performance over time as it ensures that we consider a wide array of deals, allowing us to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic cycle.

We continue to find superior risk-adjusted return opportunities in the lower middle market, where we can lend at lower leverage and loan-to-value levels while maintaining tighter covenants and other terms in the loan documents. Over the past several quarters, this has been especially true as the upper middle market has been the primary source of NAV volatility in our portfolio.

Turning to Slide 10. Our on-balance sheet credit portfolio, excluding I-45, grew 18% during the quarter to $456 million as compared to $387 million as of the end of the prior quarter. We continue to heavily emphasize first lien senior secured debt lending. And again, this quarter, the vast majority of our originations were in the lower middle market. As of the end of the quarter, we had 81% of our on-balance sheet credit portfolio invested in the lower middle market companies, while having 90% of the credit portfolio in first lien senior secured debt.

On Slide 11, we lay out the capital invested in and committed to new lower middle market portfolio companies during the quarter. This included $86 million in first lien senior secured debt invested in 5 companies and almost $4 million in equity co-investments invested in 3 of them.

We also committed $3.3 million of additional capital to 4 existing portfolio companies during the quarter, bringing our total capital deployed for the quarter to over $92 million. All of the new portfolio company loans were first lien senior secured, with one being a loan in which a bank lender participated as a first out -- in a first out position.

The weighted average yield to maturity on new debt originations funded this quarter was 9.9%. We are pleased with the pipeline as it stands today and expect that several additional deals currently in diligence should close during the March quarter.

Again, the vast majority of this prospective investment activity is in the lower middle market.

On Slide 12, we show a summary of the exits during the quarter. The sale of Media Recovery generated $51 million in net proceeds, realizing a gain of $44.3 million and an IRR of 11.8% measured back to the original acquisition in 1997.

During the quarter, we also realized a full prepayment of our subordinated debt investment in Chandler Signs. Chandler is performing well, and we remain invested in an equity co-investment position that is appreciated in value since closing.

The subordinated debt exit generated an IRR of 14%. This continues our strong track record of successful exits as we have now had 29 portfolio exits since launching our credit strategy back in January 2015, generating $267 million in proceeds and a cumulative IRR of 15.4%.

On Slide 13, we break out our on-balance sheet portfolio, excluding I-45, between the lower middle market and the upper middle market. As of the end of the quarter, the total portfolio, including equity co-investments, was weighted approximately 83% to the lower middle market and 17% to the upper middle market on a fair value basis. We had 32 lower middle market portfolio companies with an average hold size of $12.6 million, a weighted average EBITDA of $7.9 million, weighted average yield of 11.6% and a leverage ratio measured as debt-to-EBITDA through our security of 3.6x. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately 69% of our portfolio companies.

Our on-balance sheet upper middle market portfolio consisted of 11 companies, with an average hold size of $9.2 million, a weighted average EBITDA of $65.2 million, a weighted average yield of 7.4% and a leverage ratio through our security of 4.6x.

As in the past couple of quarters, we should note that our on-balance sheet upper middle market metrics are shown excluding our investment in American Addiction, as the EBITDA, while improving on a run rate basis, remains at a level that would skew the aggregate portfolio leverage ratios to a degree that would obscure the ratios of the remainder of the upper middle market portfolio. American Addiction remains a 3 on our internal rating system and remains on nonaccrual, having been placed on nonaccrual during the September 2019 quarter.

As a reminder, all investments upon origination are initially assigned an investment rating of 2 on a 4-point scale, with 1 being the highest rating and 4 being the lowest rating. As of the end of the quarter, of the 44 loans in the portfolio, we had 3 with the highest rating of 1, representing 11% of the credit portfolio at fair value. We had 36 loans rated at 2 representing 84% of the credit portfolio at fair value. We had 4 loans rated at 3 representing 4% of the credit portfolio at fair value. And we had 1 loan right rated at 4, which represented 1% of the portfolio at fair value.

The loans rated at 3 in the portfolio, all in the upper middle market include American Addiction; American Teleconferencing, which does business as Premier Global; and Delphi Intermediate, which does business as Delphi Behavioral Health. Delphi was downgraded from a 2 to a 3 during the September quarter and joined American Addiction on nonaccrual status during the December quarter. Both American Addiction and Delphi are in the business of providing addiction treatment services to patients across the country.

While it would be inappropriate to discuss in detail the status of each company on a public call, I will say that the 2 businesses face similar challenges, due in part to the addiction industry increasingly migrating to an in-network insurance reimbursement model. While this results in reduced reimbursement rates, it also results in a greater opportunity for each company to provide high-quality care to a larger number of patients. Due largely to these challenges, cash flow at both companies has decreased materially in the short term. That said, we believe that both situations are rapidly moving to balance sheet restructurings. And in both cases, we believe that the restructurings will benefit each company in their respective missions to provide the highest quality care to their patients. We also believe that these restructurings will provide the respective lender groups the opportunity to realize appreciation in and recovery of their investments as the businesses complete the transitions and grow their respective patient bases.

We continue to believe that the challenges facing both companies are addressable and our unrealized depreciation in each is recoverable. As a result of these restructurings, if and when they occur, we would expect that a portion of Capital Southwest first lien loans currently held in each company would be reinstated as first lien debt on each business, with the resulting interest in that portion of coming back on accrual. The remainder of Capital Southwest position in each company would then be equity, which we anticipate will be the source of recovery of the unrealized depreciation that exists today.

Our loan rate at a 4, also in the upper middle market portfolio, is AG Kings. The loan has remained on nonaccrual for the past several quarters. Not much has changed with respect to this position, but the lender group continues to work with the company on strategic alternatives for the business. We will attempt to update you on future calls to the extent we can comment on the company's status.

As illustrated on Slide 14, we have established a portfolio well diversified across industries. Despite the few idiosyncratic issues we are dealing with in the upper middle market portfolio today, we believe the portfolio is well positioned for late in the economic cycle.

Further, our portfolio asset mix should provide strong security for our shareholders' capital. The portfolio remains heavily weighted towards first lien senior secured debt, with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio in subordinated debt investments.

Shown on Slide 15, as of the end of the quarter, the portfolio was 93% first lien, with diversity among industries and an average hold size of 2.2% of the portfolio. The I-45 portfolio had weighted average EBITDA of approximately $65 million, a weighted average coupon of LIBOR plus 6.3% and weighted average leverage through the I-45 security of 4.5x. We also excluded American Addiction from these ratios for the aforementioned reasons.

I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.

Thanks, Bowen. As seen on Slide 16, our investment portfolio produced $16 million of investment income this quarter with a weighted average yield on all investments of 10.7%. This represents an increase of approximately $800,000 from the previous quarter.

The increase in investment income was primarily attributable to an increase in average debt investments outstanding and a transaction fee received in connection with the sale of Media Recovery, offset by decreases in dividend income from both I-45 and Media Recovery and Delphi being placed on nonaccrual during the quarter.

As of the end of the quarter, there were 3 assets on nonaccrual with a fair value of $18.2 million, representing 3.3% of our total investment portfolio at fair value. The weighted average yield on our credit portfolio was 11.3% for the quarter.

Excluding interest expense, we incurred $4 million in operating expenses for the quarter, which was $150,000 less than the previous quarter. For the quarter, we earned pretax net investment income of $7.9 million or $0.44 per share. This compared to $0.42 per share during the prior quarter. We paid out $0.40 per share in regular dividends for the quarter, flat from the $0.40 regular dividend per share paid out in the prior quarter.

We have continued our consistent track record of meaningfully covering our regular dividend with pretax NII, as demonstrated by our 109% regular dividend coverage over the last 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy.

As Bowen mentioned earlier, we also paid out a supplemental dividend of $0.10 per share during the quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance over time. Due to the successful sale of MRI, we were able to replenish our UTI balance to a level of $1.48 per share as of December 31, 2019, which we believe provides visibility to the continuation of our supplemental dividend program well into the future. The program will continue to be funded from UTI earned from realized gains on both debt and equity as well as undistributed net investment income earned each quarter in excess of our regular dividends.

In addition, we declared and paid a special dividend of $0.75 per share as we distributed a portion of the realized gain from the Media Recovery sale.

On Slide '17, we illustrate our operating leverage, which as of the end of the quarter was 2.7%, which puts us near our initial target operating leverage of sub-2.5%.

We are fully committed to actively managing our operating costs in lockstep with portfolio growth and have our longer-term sights set on achieving target operating leverage of 2% or better. With senior professionals and corporate infrastructure largely in place, operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure.

Flipping over to Slide '19. The company's NAV per share as of December 31, 2019, was $16.74 as compared to $18.30 at September 30, 2019. Given the number of moving parts this quarter and the fact that much of the NAV per share change was a reset of NAV per share as a result of the final step in the transition of the BDC to a middle market lender achieved through the sale of Media Recovery, we thought we would take a minute and walk through the components of the quarter-over-quarter change.

Moving from left to right. We continued our strong track record of fully covering our regular dividend with NII earned during the quarter, while systematically distributing our undistributed taxable income over time. With respect to the investment portfolio, we saw unrealized depreciation in the upper middle market, partially offset by unrealized appreciation in the lower middle market portfolio. Finally, with respect to the sale of Media Recovery, we paid a special dividend to shareholders of $0.75 per share, distributing a portion of the capital gains from the sale to our shareholders.

For the portion of the capital gains we retain, we paid a $0.19 per share tax on the retained capital. Shareholders will receive a Form 2439 and a letter from us with further explanation of the resulting tax credit and step up on their cost basis, which we expect to be $0.71 per share for shareholders of record as of December 31, 2019.

Finally, we recognized book depreciation from the sale of Media Recovery of $0.23 per share. There were 3 components to the $0.23 per share. First, $0.09 per share was driven by frictional transaction costs from the sale process, including investor banker fees, legal and accounting expenses and a closing working capital adjustment pursuant to the purchase and sale agreement with the buyer.

Second, $0.08 per share were the GAAP required book discounts applied to potential earn-out and escrows associated with the company's sale to account for the fact that each is a future event. If we receive both in full, it will result in Capital Southwest receiving an additional $1.5 million in recognized proceeds from the transaction.

Third and finally, pursuant to a management services agreement in place between Capital Southwest and Media Recovery, Capital Southwest received a success fee upon closing the sale, which approximated $0.06 per share. The success fee was recorded as fee revenue rather than sales proceeds for purposes of NII and NAV per share. Our total pretax NII return on equity for the quarter was 9.5%.

On Slide 20, we lay out our multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to de-risk the liability structure of the company, while ensuring that we have adequate investable capital throughout the economic cycle. To that end, we raised an additional $10 million on our October 2024 institutionally placed bond, which has a coupon on 5.375%.

As Bowen mentioned earlier, during the quarter ended December 31, 2019, we sold 623,111 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $22.07 per share, raising $13.8 million of gross proceeds. Cumulative to date, we have sold 1,313,588 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $22.07, raising $28.7 million of gross proceeds. Our balance sheet leverage ended the quarter at a debt-to-equity ratio of 0.88:1. We are pleased to report that our liquidity is strong with significant dry powder and the earliest debt maturity at December 2022.

I will now hand the call back to Bowen for some final comments.

Thanks, Michael, and thank you, everyone, for joining us today. Capital Southwest has grown and the business and portfolio have developed consistent with the vision and strategy we communicated to our shareholders 5 years ago.

Our team has done an excellent job building a robust credit portfolio, generating attractive returns for our shareholders while also demonstrating our extensive credit experience in managing our loan portfolio as it matures in seasons. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable shareholder value.

This concludes our prepared remarks. Operator, we are ready to open the lines for Q&A.

(Operator Instructions) And our first question comes from the line of Tim Hayes from B. Riley FBR.

Congrats on officially completing the portfolio transition. My first question, Bowen, would you just mind expanding on your decision to raise the regular quarterly dividend? On an after-tax basis, NII was a little bit lower than the $0.40 regular dividend in this quarter, and I know you had the excise tax accrual. But you also had the onetime success fee that drove investment income higher. Growth is really strong, but is this a case where it was back-end-weighted and you expect growth will have a much more profound impact on next quarter's results? Just any color around this would be helpful.

Yes, sure. Thanks for the question. It's all of those things. And so let me -- I'm going to let Michael comment on the components.

Sure, sure. So I think looking at the 12/31 run rate if you exclude the nonrecurring MRI fees were about $1.7 million. And then you add back the impact of the $85 million in originations during the quarter for a full quarter's accrual, our run rate for the 12/31 quarter would be $0.40 per share. So that doesn't include, looking forward, originations that have closed this quarter-to-date or that will close between now and the end of the quarter.

Okay. Got it. That's helpful. And then as it relates to Delphi, what exactly triggered the company being added to nonaccrual this quarter. Was there new information you gathered, which increased the likelihood of impairment? Or did they actually stop paying interest and/or principal on the loan?

So they stopped paying interest on the loan, so it's picking, but not going through our income statement. So it's on nonaccrual, but it's just basically a deterioration in EBITDA. And so based on that and the fact that we weren't receiving cash interest, we made a judgment call to put it on nonaccrual.

As Bowen said, Tim, it was picked into the principal balance, and I think Bowen discusses the potential restructuring. So that value will be part of that restructuring process.

Right. And I was -- I guess my follow-up question on that was, can you maybe -- I know this might be difficult to answer, but is there just any rough timeline around the restructuring process that you can give us?

I would say that -- like I said in my prepared remarks, I mean, both of them are rapidly moving in that direction. So I'd say you probably should expect that Delphi probably gets done faster than AAC. It's a little simpler, given its private and AAC is public. But they're both moving on a pretty quick time line, and that's going to be good -- like I said in my prepared remarks, that's going to be good for both companies, because ultimately, the companies exist to provide high-quality health care to their patients and that's what's going to ultimately support the capital structure. So -- but the pace is fairly quick in both cases.

Okay. And then on the $9 million of net depreciation on upper middle market investments, how much of this was the JV? And was it largely -- were the marks largely fundamental and related to company performance? Or were there any technical factors that drove these fair value marks?

So it's about half and half between the JV and balance sheet. And at the JV -- or I should say, on the balance sheet is -- $5.4 million on the balance sheet of depreciation. And that's -- if you looked at the 4 companies that I mentioned, we talked about the depreciation between those 4 is $5.4 million. So all the other companies were kind of pluses and minuses. And then on I-45, it was $4.5 million of total depreciation and $3.2 million of that is essentially 4 credits, including AAC. There are 4 credits in I-45 that I would say are having credit or operational challenges. And then that's 4 out of 46 loans. The other 42 loans are either doing fine, doing great or just kind of bumping along. So the equity guys are working very hard to get their returns, but the loans themselves are probably fine. But there's 4 out of 46 that are having some level of conversations and operational challenges. I hope that kind of gives you some general color.

Yes. No, it does. And just broadly, would you say -- how would you describe kind of sponsor behavior? Are they being supportive in working with companies -- distressed companies to try to restructure investments or just inject liquidity to help for a better outcome? Are you seeing sponsors kind of ditch some of the, I don't want to call them, losers, but ones that are struggling a little bit more and focusing on winners? Or maybe you could just -- some color on that would be helpful.

Yes. So I think sponsors are making, for the most part, smart informed decisions and not just throwing good money after bad. So across our portfolio over the last year, 1.5 years' time frame when we have -- the vast majority of the time, sponsors have supported the companies, and that's a rational thing for them to do in every one of those instances. There are a couple of them. One that -- one in particular, where the sponsors made the decision to hand the keys over to the first lien lender, i.e., restructured balance sheet, as I referenced earlier. And so in that case, I think that was probably a rational decision and the right thing to do for the business, and frankly, the right thing to do for the senior lenders. And so -- but I'd say, generally, I think we've seen sponsors make smart decisions. But in virtually every case, that right decision was to support the business, and frankly, keep the first lien lenders happy, which is what we want them doing.

Our next question comes from the line of Mickey Schleien from Ladenburg.

I wanted to ask about deal flow. I've been hearing that the volatility in the more liquid markets in the fourth calendar quarter led larger borrowers to gravitate toward direct lenders instead of the syndicated market and that caused larger lenders, including larger BDCs, to focus more on bigger deals and that may have resulted in more opportunities for smaller BDCs. Was that a trend that you saw, and did that impact your deal flow during the quarter?

Well, we certainly saw a slowdown of general activity in the syndicated market. So that would be consistent with that comment. And we've looked at some larger club deals, which I think is also consistent with that. But is -- in a -- as a general matter, the number of upper middle market deals that we've been excited about has been low. And so -- and hence, you see I-45 not growing because it's been -- capital has been refinanced and a low number of new deals really that we've been looking at in that fund. So it's -- activity in I-45 is slow -- so you -- slower, so you can see that there. But I would say, virtually everything you just said was certainly consistent with what we're seeing.

And I think you mentioned in your prepared remarks that, at least so far, the first calendar quarter looks pretty busy, and that's usually a slow quarter. So is there something specific going on this quarter that's leading to that volume? Or is it just spillover from deals that just didn't get done in the fourth quarter?

Yes. I mean the lower middle market, honestly, is -- I've always said, it's lumpy and it's frankly kind of random. And so I would say that if you look across our pipeline, and I look down the list and I see deals that we've signed up and that we're -- that they're essentially, I would say, are ours if we want them kind of category. It's above average. And so -- and the December quarter was obviously a very strong quarter of originations, but they're a quarter or 2 below -- before that were below average. And so -- I mean if I look -- if I'm just thinking our line of the deals that we're working on, I wouldn't say that it's albeit strains that I've been working on in the March quarter. So it's a little bit random. I would just say that the pipeline this quarter is above average. It may not be last quarter's volume, but it's going to be -- we would expect it to be above average and probably closing towards the latter half of the quarter.

Okay. I appreciate that. And just a follow-up on AAC. And I know you're limited as to what you can say. But there has been news about the extension of the forbearance agreement and some additional capital provided by the lenders. Did you participate in that additional injection of capital into AAC?

We did. I mean our piece is small because there's a $400 million loan that we all split the incremental capital. So our dollars are small, but we participated in it. Net incremental capital has very outsized economics. And so it's directly first priority secured by the real estate. So it's -- and frankly, other people are going to put it in if we don't. So it's the rational thing to do. But fortunately, the numbers for us are relatively small.

Okay. And then I just wanted to confirm, there's real estate in the collateral, correct?

That's correct.

Our next question comes from the line of Kyle Joseph from Jefferies.

Most have been answered, but I just wanted to get a sense -- it sounds like the lower middle market continues to be very attractive and you're maybe a little disappointed with some of the investments in the upper middle market. I want to get a sense for what's driving that [AR]? Is it -- have you seen things in the upper middle market get more competitive? Yes. What -- can you explain the discrepancy there?

Yes. I mean if you look at our -- if you just kind of break in its components, I mean, there's $5.4 million of depreciation in the upper middle market. That's -- if you take the depreciation on Delphi, AAC and AG Kings and add those together, it's $5.4 million. So that's the story in the upper middle market. And frankly, as a credit guy, I look at myself and go, we just made bad choices on those loans. I mean those loans -- I mean I wish we hadn't done them. They were structured well. The structure and the restructuring is going to work out fine in the long run. But certainly, we wish we had never made those loans, right? I mean -- but that's -- it's not a 0 defect business. And so those are the -- that's the upper middle market story so far. We do think that loan -- as we've really referenced really pretty consistently over the last several years, the upper middle market is a market where it is more competitive. There's more people willing to lend to larger companies. And so you have higher leverage ratios on average, higher loan-to-value on average, the lower yields on average across. And so when there's a problem, you have less degrees of freedom. So that's the nature of the upper middle market. So as far as is it getting more competitive versus less competitive, it's kind of been that way for certainly a few years now.

On the lower middle market side, our story is different. I mean we have $370 million loan portfolio depreciated by $140,000 this quarter. So that's basically flat. And then our lower middle market equity portfolio appreciated by $2.9 million. And so it's -- that portfolio is working as designed. It's first lien with equity co-investments, and that was equity co-investments. The winners are far outpacing any depreciation in the equity portfolio. And so it's working like as designed. Hopefully, that's helpful.

Got it. And that's a good segue to my next question. So as you think about the pipeline between upper and lower middle market -- or I guess, this is kind of a 3-part question. But talk about yield trends you're seeing in the upper and lower middle market and what that means for your portfolio more broadly.

Yes, I would say that the sandbox, if you will, of loans in the lower middle market yields are basically generally the same. And I think generally saying, I mean, there's a range of deals within a market, right? So you'll have loans that are very high margin, recurring revenue type businesses where we're making a relatively low loan-to-value kind of loan. And those are going to have a tighter spread, and maybe sponsored, right? So then that's going to be -- have a tighter spread than a deal that has maybe a slightly higher loan-to-value, maybe less recurring base business, maybe a sponsor that's not as large of a fund or maybe don't have specific sector expertise as the other, not that those are negatives, but that would be a higher yield deal. So there's going to be ranges of yields. And so if you look quarter-to-quarter, we're going to do sum of all of that. As we move to target leverage, our cost of capital is coming down. And frankly, as we lever up the BDC, one should expect that we do safer deals. And so you may move from one edge of that same sandbox to the other edge of that sandbox. But I would say that over the last several quarters, I don't -- I really haven't seen the sandbox itself move all that much. I mean it's been competitive for a long time.

And the upper middle market has been more competitive than the lower middle market for a long time. A long time meaning a couple of years. I mean it's been the same theme. But we don't feel like this quarter we didn't see the sandbox, as I defined it, change all that much.

Our next question comes from the line of Bryce Rowe from National Security (sic) [National Securities].

Michael, I wanted to ask you about the source of dividend income here this quarter. Obviously, you had the I-45 dividend, but curious what the other portion of that dividend income was.

Sure. The other portion was a stub dividend from MRI for about $500,000 that was paid out of the proceeds before close.

Okay. That's helpful. Okay. And then, Bowen, you talk about the pipeline being maybe above average and can be quite random in terms of the lower middle market. I'm curious what you're seeing from maybe a repayment visibility perspective? Obviously, this past quarter was dominated by the proceeds from MRI. But just wondering if you have any visibility into repayments over the next quarter or 2.

Yes, I'm just thinking -- I'm looking, Michael, thinking about that. I think prepayments are kind of -- obviously, they're kind of a constant aspect of our business model. But we don't really have large, like, right now visibility on large prepayments coming in the next quarter or 2. I mean that we maybe one phone call away from seeing that in some of our companies, but we don't have any -- prepayments, I would expect the prepayments over the next quarter to be, in the lower middle market certainly, relatively light.

And we did have two, what we call A+ performers that the potential for refinancing existed. And I think we've worked through that where we're going to stay in as a lender. So that's part of the reason we say we don't see any visibility right now for additional repayments.

Okay. Okay. And then if you guys can -- I don't know if you can speak to this or not. The earn-out that you mentioned with MRI, what kind of time frame are we talking about there?

So the earn-out will be tested on a 9/30/2020 fiscal year. That's MRI's fiscal year basis. So it'll be earnings performance for that year.

Our next question comes from the line of Christopher York from JMP Securities.

So Michael or Bowen, I noticed a decent pickup in the weighted average leverage to your security in upper middle market investments of about a churn from 3.7 to 4.6. So could you maybe just comment on what drove that big increase?

Yes, thanks. It's all Delphi basically. So if you take Delphi out, the 4.6 is 3.6.

Very good. Okay. And then in I-45, would you also have decent increase there? And I would have to look at the Q and the SOI Delphi in I-45 as well?

No, it's not. So the leverage on I-45 went from 4.3 last quarter to 4.5. During the quarter, we had $9.3 million pay down or prepaid on companies where the leverage was mid-2.5, kind of 2.5x EBITDA basis because of the performance. And we put 2 credits on that were new deals, new issues, and they were kind of in the low 4x, like 4.2 to 4.3 type leverage. And so that's basically the change.

That's great color. Okay. And then I see the I-45 dividend decreased $400,000 sequentially. Given the decline in the portfolio there, is this a level of recurring dividend that we should be expecting to continue?

Yes, based upon the number of credits that are in the portfolio right now and the cash yield, I think the $2.1 million is a good run rate number going forward.

Okay. And then maybe taking a step back given the competition that you described, Bowen, in the upper middle market, losses you've experienced here in the upper middle market, has this caused you to reconsider the dual-pronged strategy or allocating capital between the strategies?

No. I mean our strategy from the beginning has been core market, lower middle market, opportunistic market, upper middle market. And so right now, it's very competitive. I think I've said it really over the last couple of years, I mean, finding value in the upper middle market has been certainly much more challenging in our view than finding value, value from a credit perspective in the lower middle market. So -- or said differently, risk-adjusted returns. And so I don't -- that strategy hasn't changed. And so given what I just said, in our core business, the lower middle market, we've had a lot of -- our deal teams have done a great job originating deals. And we're kind of tracking -- closing about 2% of the deals we look at.

So they've done a great job originating opportunities for us to look at. And so there's -- so I look at that and I'm like, okay, there's demand for our lower middle market, our balance sheet in the lower middle market and value is more challenging to find in the upper middle market. Doesn't mean it doesn't exist. I mean I mentioned earlier, we did 2 deals this quarter. So it's not like it doesn't exist, there are 2 deals on I-45, but it's just more challenging. So that hasn't changed. I mean now we've got 3 -- a couple of situations that in the upper middle market that are obviously credit challenged and being restructured. That's just noise thrown on top of the strategy statement that I laid out. But the strategy, I wouldn't say, has changed. But where we're putting our money and where we're allocating capital is going to ebb and flow based on the risk-adjusted returns we see in those markets.

And so I still think it's important for us to maintain, certainly, the lower middle market. I mean -- and you -- we've talked quite a bit about why we like the lower middle market. But we want to maintain the ability to look at and consider and evaluate the upper middle market because we do think there's opportunities. And as we've always said, when things move in the market, the upper middle market moves, from a quote perspective, it doesn't necessarily immediately result in assets you can buy. But it certainly moves around with Wall Street Journal, if you will. And so it's going to be opportunistic for us in the future. So we're going to still continue to look at it, maintain that capability, maintain those contacts in the market. But it's just -- right now, it's just -- it's harder to find value, if you will, in that market.

Sure. It's a great context. And then last one from me, it's maybe a 2-part question. Bowen, you said that you may have not made some of these upper middle market investments if you were approached to potentially invest today. Maybe could you describe some of the characteristics that led you to say that? And then secondly, what gives you such confidence that there is recoverable value and some of the unrecognized appreciation, given that your ability to control the outcome as part of a syndicate is less than maybe an (inaudible) or a led deal?

Yes. So first of all, any time you make an investment or an investor buys a stock and it doesn't go up in value, you might question -- you wished you had never done it, right? So that's a general comment. I would say, with respect to those industries, I mean, the addiction treatment industry, which is most of the story here, right? So we'll talk about -- I'll come back to Kings in a minute. But the addiction industry -- unfortunately, the opioid and drug epidemic in this country is growing. And that -- I think we all would agree on that. And it's certainly is not a positive. But people need help and lives are being saved in that industry. So it is an industry that unfortunately or fortunately, depending on your perspective, is growing. But with that comes increased cost.

And so payers are -- had to bear that burden. And so the industry is moving -- making a transition from out of network, in network. Both of these businesses have had a portion of their business out of network. And then there's a number of different challenges, management or otherwise. But that's a large piece of it. And so do I wish we never invested in the lower -- in the addiction treatment industry? No, I can't say that. I mean one of my former -- one of my better investments I made at my former firm was in the addiction treatment business. And so we like that industry. We think -- and it gets to your recoverability question. I mean these are viable platforms, we still believe. And certainly, I guess -- I suppose, theoretically, that could change. But we think these are viable platforms in a growing industry that is going through a transition. So I still view that certainly, the vast majority of that, if not all of that unrealized depreciation should be recoverable. And so that's kind of why I said that. And so no, I don't think that addiction industry is a horrible place to invest and all that. It's just -- it's those factors I just laid out.

And then on the grocery side, the grocery business is a very competitive business. I mean we know that. I mean people don't stop eating. And so that's good. There's always a chance -- there's always a -- it's a consumer staple type product, but it's one that's increasingly larger and larger competitors that are opening up stores in more and more geographies. And so it's just -- and that pace is moving faster than, frankly, we anticipated several years ago when we made that loan. And so that unrealized depreciation is going to be harder to recover, and that's why it's a 4, not a 3. And so it's a different situation. Not super-excited about making any other grocery loans, quite frankly. So hopefully, you're hearing a different answer to that question than with respect to addiction treatment space. All 3 are challenged situations, no question about it, but the 2 industries are very different.

Certainly, I understand that.

Our next question comes from the line of Robert Dodd from Raymond James.

Just some quick housekeeping ones, I think, on MRI and then a couple of more detailed ones. Michael, you mentioned earlier in the call $1.7 million success fee from -- related to MRI. It's like nonrecurring. I presume that $1.7 million includes the $0.5 million dividend because otherwise, it would be more than your total fee income.

That's correct. It was -- that's right, $1.16 million for the success fee, and it was approximately $500,000 for the stub dividend.

Got it. Got it. And then on the form, if I've got the number right, the 2429 (sic) [Form 2439], I know I'm going to get questions about this, but when can your shareholders expect that?

I think we should have that in the next week. And it has full description of the definition of the deemed distribution. It'll describe the tax -- the long-term gain and tax treatment. It will help them provide the information to their tax advisers to get it done correctly.

Got it. Got it. And then the last one on that. On the $27.6 million in undistributed income, that's adjusted for the deemed distribution, right, the amount you were taking?

Yes, that's correct.

Yes. Got it. Okay. So just going to I-45 and looking at that level -- I mean, the portfolio, obviously, over the last year, and I'm looking at Page 15, which is very helpful, it's shrunk a little bit. Leverage has gone up. You mentioned, Bowen, that you had some low leverage repayments. Should we have -- so i.e. some good assets -- or you're a successful -- assets had repaid. Should we be worried, given the leverage has gone up a point over the course of the year while it's shrinking, that there's any adverse selection going on in that portfolio about what the remaining borrowers are? I mean, obviously, the more successful a borrower, the more likely they are to repay early and get out of a portfolio. And when the portfolio is shrinking, do you end up with a mix that you might not have wanted upfront?

Well, I think clearly, as any portfolio and certainly a loan portfolio, the ones that outperform, leverage goes down, gets repaid earlier. So then just academically, by definition, the lesser quality credits are the ones left in the portfolio. So having said that as I look across the loan portfolio, it's really kind of 4 or 5 loans that I would -- that are kind of companies are going through operational issues, one of those being AAC, but the other ones aren't on our balance sheet. They're just unique to I-45, which is the bulk of the depreciation. And so -- and that's also affecting the leverage as well. And so I would say, other than just -- yes, from a high level, the portfolio, the better quality loans pay off faster and then get recycled in newer loans and some of the older loans, but it doesn't mean that what's left is a disaster. But I think that -- I'm agreeing with your general comment, but I'm telling you that we don't think that's like a dramatic issue as I-45.

Got it. Got it. I appreciate it. And then on the lower middle market, if I can, I mean, very strong originations in the quarter. And as you said earlier, the -- I mean it can be lumpy. But have you seen anything out in the market -- on the lower middle market in terms of the borrowers or the company owners, is the ask on what they're looking for shifted any that makes the deals maybe slightly more appealing to you?

Well -- I mean there's a lot of variables, right? I mean, they ask -- when I say the ask, I mean, every industry is different, right? Every industry, every company is different. So the different profit levels, the industries have different profit drivers. There's different levels of sensitivity to the economic cycle. And so we look at it and go, is the ask appropriate for our view of that industry and that company. So -- and I don't think -- I mean I don't think that sponsors are, for a given -- I mean they always ask -- there's varying levels of aggressive behavior from sponsors, right? Some sponsors are very aggressive. They want the last nickel of leverage, and other sponsors are much more measured, because ultimately, most of their IRR is going to be driven by the operational improvements they provide that business and less by the financial engineering. We do better with the second -- the latter category, and it's not surprising. But I don't -- again, it's more -- in general, it's the same comments I made with respect to the sandbox and leverage and pricing. I mean the sandbox, I don't think, has changed. But as we can play in different portions of the sandbox, if you will, and certainly, as we move up in leverage, bringing our cost of capital down, it allows us to compete and put assets on the books that generate attractive ROE to our shareholders, which is ultimately what's important in maybe a safer side of the sandbox, if that makes sense.

Yes, yes, yes, it does, absolutely. If I can, on that size question, one more on -- and I ask here. The target of getting operating leverage sub-2.5. And obviously, it's been trending down and the increasing returns to shareholders. I mean what -- not necessarily what time, when do you think you can get that, but so much as what do you think your asset level needs to be for that sustainably for that OpEx ratio to be sub-2.5.

Honestly, Robert, I'd tell you that we think we can achieve it. I'll give you the timing and the amount. I think we can achieve it in the next 2 quarters. And I think the amounts can be in somewhere in the -- close to $650 million of assets on balance sheet.

Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Bowen Diehl for closing remarks.

Thank you, operator, and thanks, everybody, for joining us today, and thanks to all the analysts that asked us the questions. Those were great questions. And we appreciate everybody's support and look forward to giving you updates as we move forward.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.