Saratoga Investment Corp (SAR) 2018 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Saratoga Investment Corp.'s Fiscal Third Quarter 2018 Financial Results Conference Call. Please note that today's call is being recorded. (Operator Instructions)

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 Third Quarter of 2018 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 third quarter 2018 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 be available from 1 p.m. today through January 18. 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'll be making a few introductory remarks.

Thank you, Henri, and welcome, everyone. As we look back at this most recent fiscal quarter, we're pleased to note the continued progress of our long-term and core objectives of credit quality, growth and earnings. Our flexible capital structure and diversified sources of cost-effective liquidity continues to support a robust pipeline of available deal sources, growing assets and greater scale. While a challenging and competitive environment persists, our originations and credit quality remain strong. Within this environment, Saratoga Investment has risen to and remains at the top of the industry in terms of key performance indicators, and in many categories, far outpaces our competition, generating meaningful and consistent returns for our shareholders.

To briefly recap the past quarter on Slide 2. First, we continue to strengthen our financial foundation this quarter by maintaining a high-level investment credit quality, with 97.2% of our loan investments having our highest rating, consistent with last quarter; generating a return on equity of 10.2% on a trailing 12-month basis, up from 8.3% last quarter and beating the BDC industry mean of 8.4%; and maintaining a gross unlevered IRR of 12.4% on our total unrealized portfolio, with gross unlevered IRR of 16.3% on total realizations of $234.6 million.

Second, we expanded our assets under management to $339 million, a 16% increase from $293 million and -- as of year-end and a 22% increase from $278 million as of the same time last year. Taking a longer-term perspective, our current AUM reflects a 324% increase from $80 million at the end of fiscal year 2011. This quarter reinforced the challenging environment we are operating in and the importance of maintaining a strong origination discipline. While we saw many deals through our sourcing pipeline, limited our originations to $5 million, offset by repayments and amortizations of $2 million based on our view of credit quality and risk reward. Our pipeline continues to increase, giving us confidence in our continued growth.

Third, the continued strengthening of our financial foundation has enabled us to increase our quarterly dividend for the 13th consecutive quarter. We paid a quarterly dividend of $0.49 per share for the third fiscal quarter 2018 on December 27, 2017. This was an increase of $0.01 per share over the past quarter's dividend of $0.48 per share. All of our dividend payments have been exceeded by our adjusted net investment income for the same periods. As a result, we are still comfortably over-earning our dividend currently by 10%, which distinguishes us from most other BDCs. We're only one of 5 BDCs having increased dividends over the past year.

Fourth, our base of liquidity remains strong and has the potential to improve. We continue to preserve significant dry powder to meet future potential opportunities in a changing credit and pricing environment. Our existing available year-end liquidity allows us to grow our current assets under management by 20% without any new external financing.

And finally, on March 16, 2017, we entered into an equity distribution agreement with Ladenburg Thalmann & Co. through which Saratoga may offer for sale from time to time up to $30 million of its common stock through an at-the-market, or ATM, offering. As of November 30, 2017, the company sold 266,113 shares above NAV for gross proceeds of $6 million at an average price of $22.49. This quarter saw a continued strong performance within our key performance indicators as compared to the quarters ended August 31, 2017, and November 30, 2016.

Our adjusted NII is $3.3 million this quarter, up 7% versus $3.1 million last year but down 11% versus $3.7 million last quarter. Our adjusted NII per share is $0.54 this quarter, up from $0.53 last year but down from $0.62 last quarter. And our NAV per share is $0.2258, up from $0.2197 at year-end and $0.2237 last quarter.

Henri will provide more detail on -- later on any significant variances, particularly the temporarily outsized investments benefiting last quarter and that we highlighted in our call -- on our call in October. Overall, we remain pleased with these accomplishments and our progress.

As we've mentioned often in the past, we remain committed to further advancing the overall long-term size of our asset base while maintaining its high quality. As you can see on Slide 3, on a year-by-year comparative basis, our assets under management have steadily risen with healthy growth since year-end and the quality of our credits remain high. We look forward to continuing this positive trend.

With that, I would like to 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 November 30, 2017, in our usual format. Across all these metrics, you can see the positive impact of increased assets to our results. When adjusting for the incentive fee accrual related to net unrealized capital gains in the second incentive fee calculation, adjusted NII of $3.3 million was down 11.3% from $3.7 million last quarter and up 7.0% from $3.1 million as compared to last year's Q3. Adjusted NII per share was $0.54, up $0.01 from $0.53 per share last year and down $0.08 from $0.62 per share last quarter. The increase from last year primarily reflects our higher level of investments and results in higher interest income, with AUM up 22% from last year. The quarter-on-quarter decrease was due primarily to lower interest income earned this quarter following the anticipated and planned downsizing of both our Easy Ice and the (inaudible) investments that occurred in the second half of Q2, with Q2 benefiting from the higher levels for most of the quarter. In addition, other revenue was also lower due to fewer originations during this quarter.

These impacts resulted in adjusted NII yield of $0.096 -- 9.6% when adjusted for the incentive fee accrual. This yield is up 10 basis points from 9.5% last year but down 170 basis points from 11.3% last quarter for the reasons previously mentioned. For this third quarter, we experienced a net gain on investments of $1.2 million or $0.21 per weighted average share, resulting in a total increase in net assets resulting from operations of $4.3 million or $0.71 per share. The $1.2 million net gain on investments was comprised of $21,000 in net realized gains and $1.2 million in net unrealized appreciation. The net unrealized appreciation was due primarily to $0.8 million unrealized appreciation on Saratoga Investment's Elyria equity investment, reflecting improved performance; and $0.5 million unrealized appreciation on our Courion Corporation second lien term loan.

Return on equity remains an important performance indicator for us, which includes both realized and unrealized gains. Our return on equity was 10.3% for the last 12 months and is well above the BDC industry mean of 8.4%. We expect our ROE figure to continue to improve as our increased asset base earned interest for the full 12-month period and we further deploy cash and grow assets, with the benefits of scale becoming more visible. We also expect our operating expenses to stabilize and diminish as a percentage of assets.

A quick note on expenses. Total expenses, excluding interest and debt financing expenses, base management fees and incentive management fees, increased to $1.2 million in Q3 this quarter from $1.05 million in the same period last year, reflecting primarily higher professional fees due to increased Sarbanes-Oxley activities now that the company is an accelerated filer. Despite this, expenses remain unchanged as a percentage of average total assets at 1.4%.

We have also again added the KPI slides starting from Slide 28, it's at the end of the presentation, that shows our income statement and balance sheet metrics for the past 9 quarters and the upward trends we have maintained. Of particular note is a new slide, 31, highlighting our net interest margin has more than doubled since Saratoga took over management of the BDC.

Moving on to Slide 5. NAV this quarter was $138.8 million as of November 30, 2017, a $5.3 million increase from NAV of $133.5 million last quarter and an $11.5 million increase from NAV of $127.3 million as of year-end. NAV per share was $22.58 as of quarter end, up from $22.37 as of last quarter and $21.97 as of year-end.

For the 9 months ended this quarter, $2.7 million of net realized and unrealized gains and $9.4 million of net investment income were earned, offset by $8.3 million of dividends declared. In addition, $1.8 million of stock dividend distributions were made through the company's dividend reinvestment plan and $6.0 million of shares were sold through the company's ATM program. Our net asset value has steadily increased since 2011, and we continue to benefit from our history of consistent realized gains.

On Slide 6, you will see a simpler reconciliation of the major changes in NII and NAV per share on a sequential quarterly basis. Starting at the top, NII per share decreased from $0.62 per share in Q2 to $0.54 per share in Q3. The significant changes were a $0.04 decrease in total interest income, reflecting the anticipated downsizing of our Easy Ice and (inaudible) investments; a $0.06 decrease in other income from lower originations; and a $0.01 decrease due to dilution from increased shares from our DRIP and ATM program. These decreases were offset by a $0.03 reduction in interest and debt financing expenses, reflecting our lower level of Madison borrowings. This all adds up to an $0.08 total decrease, and all changes are shown net of incentive fees.

Moving on to the lower half of the slide. This reconciles the NAV per share increase from $22.37 at Q2 to $22.58 for this quarter. The $0.50 generated by our NII for the quarter and $0.21 net appreciation on investments were offset by the $0.48 dividend declared for Q2 with a Q3 record date. The dilutive impact of the ATM and DRIP issuances for Q3 was $0.02.

Slide 7 outlines the dry powder available to us as of quarter end, which totals $68.0 million. This is spread between our available cash, undrawn SBA debentures and undrawn Madison facility.

We remain 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 6 years plus. For the most part, we have also primarily fixed our interest costs in this rising rate environment with all our borrowings, except our Madison facility, being fixed rate. In addition, we have the ability to continue to grow our assets by 20% without the need for external financing.

Now moving across to the asset side of our balance sheet on Slide 8. Over 84% of our investments have floating rates. And although they have LIBOR floors, we are through all of them, which means we remain a big -- of rising short-term rates. As we have done in past quarters, we have analyzed the potential impact of changes in interest rates on interest income from investments. Assuming that our investments as of November 30, 2017, which remain constant for a full fiscal quarter and no actions were taken to alter the existing interest rate terms, a hypothetical increase of 100 basis points in interest rates would increase our interest income by approximately $600,000 per quarter. This is all incremental to our existing earnings without any other changes.

Now I would like to move on to Slide 9 through 11 and review the composition and yield of our investment portfolio. Slide 9 shows that our composition and weighted average current yield remain consistent with the past, with $339 million invested in 32 portfolio companies and 1 CLO fund and almost 55% of our investments in first lien.

On Slide 10, you can see how the yield on our core BDC assets, excluding our CLO and syndicated loans, as well as our total asset yields, has remained relatively consistent in the 11% range for the past several years despite higher levels of repayments and the continued replacement of these assets. This quarter, our overall yield increased slightly to 11.3%. This reflects a slight increase in all our asset yields, with core asset yields increasing from 11.0% to 11.1%, our CLO yield increasing to 19.4% and our syndicated asset yield increasing to 5.6%.

Turning to Slide 11. During the third fiscal quarter, we made investments of $5.2 million in one new portfolio company and one follow-on and had $1.8 million in one exit plus amortization, resulting in a net increase in investments of $3.4 million for the quarter at our BDC. Year-to-date originations of $87 million considerably exceed repayments of $46 million. Our investments remain highly diversified by type as well as in terms of geography and industry, spread over 9 distinct industries with a large focus on business, health care and education services. We continue to have no direct exposure to the oil and gas industry, a fact that has served us well. Of our total investment portfolio, 8.4% consists of [equity] at the moment, which remain an important part of our overall investment strategy. In Q3, we experienced a net realized gain of $20,000.

As you can see on Slide 12, net realized losses this year is $5.7 million, and this was due primarily to the recognition of the $7.7 million realized loss on My Alarm Center investment, which was reclassified from unrealized loss to realize this past quarter. This realized loss was offset by $2.0 million of other realized gains during the rest of the year, primarily in Q2. Despite this onetime loss, for the past 5.5 fiscal years, we have accumulated approximately $12 million of net realized gains from the sale of equity interest or sale or early redemption of other investments. This consistent performance continues to be a good indicator of our portfolio credit quality, has helped 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 will take a couple of minutes to describe the current market as we see it, then I'll comment on our portfolio performance and investment strategy.

The market's extremely competitive conditions have continued to worsen since we last spoke in October. Slide 13 indicates a continued downward trend in the number of transactions for deal sizes in the U.S. below $25 million. The number of transactions in the last -- ended November 30, 2017, is already down significantly as compared to the same period last year, and it's not just volume. Total transaction value for the same period is significantly lower than it was last year as well and significantly trailing the annualized run rate.

Published data is at last showing that spreads in the broader middle market are tightening, which is consistent with what we have seen for some time now. And this narrowing of spreads is also starting to impact the lower middle market, driven by a supply/demand imbalance as competition intensifies and available capital far outstrips quality deals. Now thankfully, LIBOR has continued to increase again this quarter and has provided some counterbalance to spread compression.

An extended benign credit cycle, an overall expectation for continued economic growth and investor appetite for yield have continued to attract new stretch senior and junior capital entrants into the market. This has led to changing pricing dynamics with excess liquidity, giving new receptivity to story paper, higher leverage profiles and sectors exposed to secular changes -- challenges, excuse me. As we frequently highlight, the lower middle market appeals to us because the sheer number of companies that descend at the marketplace allows us to sift through and find transactions that we believe are most likely to deliver the best risk-adjusted returns to our shareholders.

On Slide 14, you can see that industry debt multiples remained extremely high over the course of calendar year 2017 as lenders continued to be aggressive in their pursuit of putting money to work. As of September 30, 2017, 83% of leverage multiples are above 5x. With this as a backdrop, we have been able to achieve our results while maintaining a relatively modest risk profile. Total leverage for the overall portfolio is 4.2x, low compared to the rest of the market. Irrespective of leverage levels, we continue to focus our investing on credits with attractive risk return profiles and exceptionally strong business models where we are confident that the enterprise value for the businesses will sustainably exceed the last dollar of our investment.

In addition, this slide illustrates our consistent ability to generate new investments over the long term despite difficult market dynamics. With 18 originations in calendar year 2017, including 7 new portfolio companies and 11 follow-ons, we have established an origination level that is ahead of last year's record pace while applying a consistent investment criteria. In a tough market, this quarter is another good example of our approach. We believe successful investing rests on sound judgment and steady, continuous discipline, taking one decision at a time and on a basis focused purely on credit quality. Therefore, we are not fazed by low short term or quarterly originations as we saw this quarter. We always emphasize quarterly originations can be lumpy and repayments unpredictable irrespective of healthy sourcing numbers, as demonstrated on the next slide.

Our disciplined underwriting approach will naturally produce lumpy origination volume. Quarterly results or performance cannot drive credit decisions, but we remain confident that we can continue to grow our AUM steadily over the long term as demonstrated again this year with our 16% growth since year-end. We apply the same cautious approach when determining where to invest in the capital structure of our portfolio companies. From our perspective, the credit borrow should always be higher when considering nonfirst lien investments. For us, the majority of our portfolio is in first lien investments. Nevertheless, we believe [nonleave], nonfirst lien investments can also be quite attractive under certain circumstances, and we do continue to seek investments across the entire capital structure. For each business that we consider investing in, the overarching goal of our underwriting and due diligence is to make an assessment of, one, the long-term sustainability of its enterprise value; and two, the potential volatility of its cash flow. The determination made with respect to these factors as well as others dictates whether we're interested in making an investment, and if so, where in the capital structure we would like to invest. First and foremost, whether first lien, second lien, traditional mezzanine or equity, we approach all of our investment decisions with prudence and discipline.

Now moving on to Slide 15. 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. As you can see on this slide, our number of deals sourced and evaluated has increased materially over the past couple of years despite competitive market conditions. 50% of these deals come from companies without institutional ownership, the rest come from private equity sponsors.

The chart also underscores our originations discipline. While the size -- the top of the tunnel has grown, increasing from 480 deals sourced in 2014 to 722 deals sourced in 2017, term sheets issued have not increased by the same percentage. In fact, due to inconsistent quality, we're looking at many more deals now in order to find a similar number of high-quality deals as we have in past years. It means that we have to work harder to get the same outcome. Nevertheless, no matter how many deals we see at the top, the overarching goal is to maintain the same high level of credit quality. What is especially noteworthy is that the strength of our pipeline has enabled us to close deals with 7 new portfolio companies in the past 12 months, giving further validation of our strengthening business development platform. And at the same time, we also completed numerous follow-on investments supporting existing portfolio companies such as Easy Ice, Identity Automation, Vector, CLEO Communications and others, demonstrating our ability to deliver outsized return to our shareholders by recognizing fundamental value in businesses and supporting their growth over time.

Our overall portfolio of credit quality is strong and even stronger when taking into account only the assets originated by us since taking over the BDC management in 2010. As you can see on Slide 16, the gross unlevered IRR on realized investments made by Saratoga Investment management team is 17.7% on approximately $162.7 million invested in our SBIC and 13.3% on approximately $71.9 million invested in the rest of our BDC. On a combined basis, the gross unlevered IRR is 16.3% on $234.6 million of realizations. On the chart at the right, you can also see that gross unlevered IRR on our $343.5 million of combined weighted SBIC and BDC unrealized investments is 12.4% since Saratoga took over management.

The track record numbers discussed above includes a $9.8 million first lien investment called Taco Mac that currently carries a $1.5 million of unrealized depreciation, reflecting declining business fundamentals. We put this investment on nonaccrual in Q4 last year, and while there have been developments the past several months, we continue to work closely with the company and other first lien lenders to pursue various options. We will keep this investment on nonaccrual until this is resolved.

As a reminder, this year is a good example of how solid, high-quality portfolio interacts as a whole. Despite the recognition of $7.7 million loss on My Alarm Center, year-to-date, our net realized and unrealized gains and losses equal a gain of $2.7 million, with the loss of My Alarm Center being offset by other realizations such as our $1.8 million gain on sale of Mercury Network last quarter as well as the appreciation in the fair values of other investments.

As you can see on Slide 17, the mix of securities in our SBIC portfolio is conservative, with 55.4% of our investments comprised of senior debt first lien investments. And the leverage profile of these 22 investments remains relatively low at 4.3x, especially when compared to the overall market leverage. Our favorable cost of capital from this program allows us to deliver highly accretive returns to our shareholders without stretching out on the risk spectrum.

Moving on to Slide 18. You can see our SBIC assets increased at $212.7 million as of November 30, 2017, up from $207.8 million as of August 31, 2017. It is important to note as well that as of quarter ended November 30, 2017, we had $22.4 million total available SBIC investment capacity, including cash, of which $15 million is leverage capacity within our SBIC license. This represents approximately 33% of our total available firm capacity as of quarter end.

Overall, this quarter's operating results demonstrate the growing strength of our sourcing and origination capabilities, leading to a growing base of high-quality assets over the long term. Producing these results has required us to remain extremely diligent in our overall underwriting and due diligence procedures, culminating 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. I'd like to turn the call over to our CEO, Chris.

Thank you, Mike. As outlined on Slide 19, our quarterly cash dividend payment program has grown by 172% since the program launched. During fiscal year 2017, we declared and paid dividends of $1.93 per share, gradually raising the dividend through the year. In addition, we've continued to pay increasing quarterly dividends regularly throughout fiscal year 2018, including 46% -- $0.46 per share for Q4 last year, $0.47 per share for Q1, $0.48 per share for Q2 and most recently, in December, $0.49 per share for Q3. Total dividends declared and paid during fiscal year 2018 thus far is $1.90 per share. We're also still over-earning our dividend by 10.2%, giving us one of the higher dividend coverages in the BDC industry.

As you can see on Slide 20, we have had 8.8% year-over-year dividend growth, which easily places us near the top -- very top of our peers, and 1 of only 5 BDCs have grown dividends in the past year. We have now had 13 sequential quarters of dividend increases, while most BDCs have either had no increases or decreased the size of their dividend payments. We believe our continually increasing dividend has truly differentiated us within the marketplace.

We're also pleased to see SAR continuing to outperform the industry. Moving to Slide 21, our total return for the last 12 months, which includes both capital appreciation and dividends, has generated total returns of 31%, significantly beating the BDC index of 14%. And when viewed over a longer time horizon, as you can see on Slide 22, which is when we took over management of the BDC, our 3- and 7-year return places us in the top 1 and 2 of all BDCs, respectively.

On Slide 23, you can further see our outperformance placed in the context of the broader industry. We continue to achieve high marks 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, NAV per share and investment capacity. Of note, as our assets have grown and we're starting to reach scale, our expense ratio is moving closer towards the industry averages while we are easily beating the industry in most of the other metrics. We continue to emphasize our latest 12 months return on equity and NAV per share outperformance, which reflects the growing value our shareholders are receiving.

Moving on to Slide 24. All of our initiatives we have discussed on this call are designed to make Saratoga Investment a highly competitive BDC, is attractive to the capital markets community. We maintain that our differentiated characteristics outlined on this slide will help drive the size and quality of our investor base, including the addition of more institutions. These characteristics include maintaining highest levels of management ownership in the industry of 25%; a strong and growing dividend; strong return on equity; ample low-cost available and long-term liquidity with which to grow our current asset base; solid earnings per share and NII yield with substantial growth potential; steady, high-quality expansion of assets under management; and attractive risk profile with protection against potential interest rate risk. Our high credit quality portfolio contains minimal exposure to cyclical industries, including the oil and gas industry. With this overall performance, Saratoga Investment remains solidly on the path to being a premier BDC in the marketplace.

Finally, looking at Slide 25, we've accomplished a lot in this quarter and are proud of our financial results. We remain on course with 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. Executing on our simple and consistent objectives should result in our continued industry leadership and shareholder total return performance.

In closing, I would 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., and I would now like to open the call for questions.

(Operator Instructions) And our first question comes from the line of Casey Alexander.

First of all, I know this is not a control investment, but you are finally regaining some value in Elyria Foundry. Can you give us some color as to your potential ability to eventually dispose of this investment? I know it's a legacy investment that comes before your time, but -- I mean, it's been around for years and it's finally starting to pick up some value. Where do you see it -- what can you -- how can you control its fate? And what are your chances of eventually turning it into an interest-earning asset?

Casey, well, thank you for that question. Everything you said is correct. It is a legacy investment. It -- unlike a lot of what we have in our portfolio, it has some highly cyclical elements in it and it basically cycled very hard in the past, which caused its value to be -- get very low. Its EBITDA reached some low levels. However, we do have a partner in that, and we had made some significant management changes and the company itself has done some acquisitions. And the cycle is turning. They have exposure to oil and gas, for example. They have gas compressors and things like that, that as the pipeline business picks up, are coming back and there are some other new developments. So there have been some very positive aspects inside of that company that have driven the increase in value and substantial increase in earnings. We are a small minority investment -- investor in that entity, and it's an equity investment, but there's not that much debt on the company. So ultimately, we can't drive the exit timing. However, I would say that throughout the process, we've been highly aligned with our -- at the recent process, aligned with our other investor. And so we think that at the right moment, there will be an exit and we don't see our partner holding on too long, if you will. But there is a fair amount of runway ahead given some of the positive dynamics in that investment.

Okay. Great. That's very helpful. Secondly, Mike, I know I've asked this before, but new investors that are looking at your income statement might scratch their heads a little bit. So if you could walk us through the composition of the PIK income and why investors should feel comfortable with the level of PIK income, I think that would be very helpful color.

Well, Casey, why don't I take just the first tab at sort of just the breakdown because I think it's important to note when you sort of look at our PIK income that we have a couple of investments that are driving -- or that comprise PIK income. But more than half of our PIK income year-to-date consists of our Easy Ice investment and relates to the -- obviously, the transaction we did and everything that we've spoken about in the past. If you look at the remaining PIK investment, there's probably about 4 to 6 investments that make up the year-to-date components of PIK in there. But a couple of them such as Identity and Vector actually both represent realizations of those instruments that we've had during the year. So I guess the way to look at it is although PIK has increased, it's primarily due to the Easy Ice component that's increased. The remaining number of PIK investments have actually decreased.

And the thing I'll add to that, Casey, is the amount that's coming from Easy Ice, if you look at those instruments, what gives us ultimate comfort with recognizing that PIK income is that we think that those instruments are well within the enterprise value of the investment.

Right. Okay. I just think for people who haven't looked at it before, it's important to reiterate some of those facts. Mike, again, you've detailed very often in the past the lumpy nature of originations, and this was kind of a quiet quarter. Can you give us a feel for how you see the cadence going forward from the end of this quarter?

Obviously, you have to be careful in that respect. I think -- as I said in the prepared remarks, with the success that we've had building up our business development function, we feel confident that we can continue to grow the balance sheet and that our origination pace should exceed our repayments. It's just -- it's very hard to do that quarter-to-quarter. We have confidence that we can grow, and that's probably the best answer I can give you as it relates to forward-looking.

Look, Mike, looking at a couple of your slides, your funnel versus what you showed as the deal activity year-to-date on deals below $25 million, if I read that right, it looks like you guys are in on approximately 40-some percent of the deals that exist out there. Is that accurate?

It may be. I mean, it's obviously a highly fragmented market, and so you've got to take some sources that we get when we're looking at transaction activity that you see on that one slide with a bit of a grain of salt. But we do know that our pipeline is accurate. And the one comment that we often make is that as tough as the market is, one of the things that's wonderful about being in the lower end of middle market is that there are thousands and thousands of companies out there. And if you have a good origination function, you can find those diamonds in the rough, and that's really what we've set ourselves up to do.

And our next question comes from the line of Mickey Schleien.

I want to follow up on Casey's last question because my sense is that the level of competition in the market is not abating. That may or may not change down the road, it's hard to say. But it's certainly been increasing lately. And meanwhile, the portfolio is healthy, but it's highly concentrated. So what I'd like to understand is, you just expressed some confidence in your ability to grow the balance sheet. What underlies that? Is that an expansion of your origination capacity or something else?

Well, we have -- it's a few things. But it's mostly the origination side of things. If you go back to when Saratoga took over management, this is really a much different business model than the predecessor had. So getting out into the marketplace and letting people know who Saratoga was took some time. And there are still plenty of folks out there that are doing deals actively in our space that really don't know us. And so a lot of it is reflective of just the efforts that we put forward in getting our name and reputation out there so that we're seeing the best quality of opportunities. We've also allocated more resources to that, so we've got -- once upon a time, we had one person -- in addition to all the execution people, but one person who was 100% focused on business development scouring the marketplace for deals. Now we have 3 people who are pretty much 100% focused on that effort, and that's one of the reasons you see the pipeline grow. Another thing that's happened and it's been delightful to experience is that we now get referrals just because we are good partners to people. Folks that we've done business with are referring us. Opportunities that I wouldn't call them proprietary all the time, but they definitely give us a much better -- a higher probability of getting some of those deals done if we decide that we like those deals. And I think the thing that I can't overemphasize is how important it is that we remain disciplined. And we're going to remain disciplined. We're certainly not going to stretch for yield in this marketplace. And the management team here, as you know, is very seasoned, so we've seen a lot of these cycles. The last thing you can do when market gets very competitive here, the last thing you should do is chase yield. You've really got to go for credit quality, and that's what we've always done and that's what we're going to continue to do and remind ourselves of that. Having said all that, and as difficult as the market is, we still feel confident that we can grow the balance sheet. And it's going to be hard to peg exactly quarter-to-quarter how that -- the shape that it takes, but we do feel over the long run that we can grow at a healthy pace.

Mike, correct me if I'm wrong, but if I remember correctly, the private Saratoga [are pretty] limited, other BDCs have expanded that portion of their platform in order to leverage expenses and also to improve diversification across their funds. Is that something Saratoga is considering doing?

It's Chris, Mickey. That's definitely something we -- it's out there. There's a lot of private credit funds that are not public like BDCs. And we've looked into that, and it's an interesting space. As of this moment, we are very focused on our own portfolio. We see the growth prospects are very good. And we feel like getting SAR to the right size and scale and performance characteristics is really our #1 objective, and that's where we're really concentrating our management efforts here. And we think we are on a good path. When you look year-over-year, a year over 2 years, I mean, this substantial progress has been made. And as Mike says, I mean, we have a very healthy pipeline. And in a given quarter -- the quarter before this was fairly good, this one was a little light, but that's sort of been our history. But if you look at any kind of longer-range basis, we've had a really steady climb, and we don't see that changing.

I'd add to that, Mickey. It's not to say that we wouldn't -- I think Chris touched on it a bit, but it's not to say that we wouldn't give consideration to private funds or other investment vehicles. But for the time being, we are laser-focused on building SAR and creating as much value to shareholders as we can. The things that we could consider certainly would be ones that we felt complemented our existing line of business didn't conflict with it in any way. And so those aren't off the table by any means, but that's not really where we're focused at this present moment.

Okay. Another question, in terms of the dividend policy. I know it's running now around -- the dividend is now around 90% of NII. I do realize that NII is moving up and down but roughly speaking. So do you envision further upside in the dividend? Or do you think it might be time to maybe keep it at this level and then consider special dividends down the road if they're needed?

Well, Mickey, I mean, that's a very good question. That's something that we consider every time we declare a new dividend. And we've got a lot of factors to evaluate. I think it really is -- it really depends on the growth of our asset base. We have significant dry powder that we can access right now that the incremental earnings from that incremental asset growth would be very -- would be sizable and would be at a higher marginal profitability than what we have now. So just deploying that alone should increase our earnings. So the question is what rate at which we deploy that, and we evaluate each quarter on a basis based on the facts at the time. And I think we've had a consistent rising dividend and we've also had consistent rising asset. So I think they're kind of linked, and I think your point is a good one. I mean, we don't want to get in a situation where we got to cut back on dividend, right? So we want to grow it with enough (inaudible) so that we can absorb any kind of excess redemptions that might occur relative to originations. So to specifically answer your questions, the facts that you recite are right. We are at a 90% payout ratio. And if we were to remain flat, that would be one consideration. But if we were to grow, that would be another. And we'll evaluate that on a quarter-by-quarter basis.

Okay. I understand. And my last question, can you give us an update, if possible, on Taco Mac in terms of restructuring that and where that process stands?

Well, obviously, it's private company, so we have to be real careful what we can convey. I can say this, that the -- where we have it valued now is reflective of a couple of things: the performance of the company, which is -- has been challenged, obviously, it's on nonaccrual; as well as the ongoing discussions that we and our senior lender group are having in the marketplace.

And our next question comes from the line of Christopher Testa from National Securities.

The structured credit yields were up roughly 60 bps quarter-over-quarter. There's some pretty significant spread compression in the CLO market. Just wondering if you could provide some color around how the yields went up pretty significantly this quarter.

You mean our own interest -- our own effective interest rate? Or you mean the actual [indiscernible].

Yes.

Yes. Well, I mean, our -- the effective interest rate is a function of what we're obviously earning and the projected future cash flows that are being derived by the CLO. Chris was -- and if you look at our valuation as well, it was just slightly down because we obviously had our own Q3 distribution, but that was more than offset by an increase in collections because what you effectively saw was that the projected LIBOR over the projection period increased by 21 basis points. So that obviously had an impact on the quarterly cash flows in the valuation, which then drove the effective interest rate up slightly. I mean, it wasn't a big increase. I think it was probably about a 50 or 100 bps increase in the quarter, which was partially reflected in the actual interest income for the period.

Got it. So it's fair to say that, that increase is your expectations for further LIBOR increases in your projections. Is that holding kind of a current reinvestment environment static, though?

Well, I mean, I think we've had a pretty -- we've seen pretty healthy reinvestment opportunities out there, and that's why we've been managed to -- why it's being possible to keep the cash flows positive through the reinvestment of any repayments we've had.

Okay. And just touching on something Casey was asking about with the jump in payment in kind interest. The PIK rates on both the preferred and second lien portion of Easy Ice were constant quarter-over-quarter, but PIK income, in total, jumped pretty substantially during the quarter. What were the other investments that made up the increase in PIK during the quarter?

I think it was primarily Easy Ice because you had both the preferred as well as a portion of the second lien being accrued for the full period where it essentially was [indiscernible] a full period in the last quarter. So I think it was primarily Easy Ice. You're going to see a slight reduction now going forward because of Identity and Vector being repaid and not PIK-ing anymore.

Not Vector but Targus.

I'm sorry. Targus, not Vector. Mike's just correcting me. Thanks, Mike.

So Identity and Targus are the ones that came off, so that should lower the PIK income?

Yes. We had realizations on those 2 and they were partially PIK, so that would slightly [rate them] going forward, then you have Easy Ice continuing for the full period.

And Chris, just one further nuance on Easy Ice and its PIK, and I think we talked about this in prior calls. There's an interplay between the rate we pay on the senior credit at Easy Ice and our PIK. I mean, we could have had less PIK, but then we probably would have higher rate on our senior. So we're kind of supporting a low-cost senior situation by kind of softening how we get paid. But from our standpoint, as Mike said earlier, we feel the earnings on that are rock solid, but it's helping our overall cost of capital be lower by having sort of a variable PIK amount in our instrument.

Right. That makes sense definitely. And were the stability in your first and second lien yields this quarter just indicative of the further increases on LIBOR?

Yes. I think we are continuing to see spread compression and all the competition that we've been talking about. Thankfully, the increase in LIBOR has offset that.

Got it. And with your SBIC, I know you guys break it out roughly 41% you have in [last out], second lien and subdebt. Just curious, how -- what's your -- is this kind of your comfort level for having that composition within a 2:1 vehicle? What I'm getting at is it seems like it would make more sense to put more of the first lien, more senior secured assets into the SBIC given the increased leverage capacity in that vehicle. Could you just provide some detail on that?

It's a good question. I think the way we think about it, though, is that we really look at each business very carefully and we evaluate where we want to be in the capital structure, whether it be first lien or second lien, based on what we think the opportunity presents and if it's offering a good risk-adjusted return to our shareholders. The SBIC -- now even though it's 2:1 leveraged, we don't think it is super aggressive. Most of the SBICs that are out there are doing almost entirely junior. Ours has a healthier mix of senior capital than most of the SBICs that are out there. But the SBIC's economics are so accretive to our shareholders and so attractive that, candidly, if we think that an asset qualifies for the SBIC, we're going to put it in there. We, instead, just look at credit separate from that and say, let's make sure that we think this is a money good investment and is this the right place to reside on the balance sheet.

Got it. Okay. That's helpful. And last one for me would just be on the leverage. Obviously, your leverage and regulatory leverage, of course, have come down as the portfolio has been roughly flat. Just curious how we should think about your target leverage. And given the commentary on the pipeline being strong, should we expect maybe just very, very little ATM issuance and you guys kind of ramping the debt to equity in order to bolster the ROE? Or should we expect a pretty measured kind of ATM usage onward?

Well, I think that's a good question. I think implicit in all of the things you just said are what we consider, right? I mean, we consider how -- what is our outlook for portfolio growth? What is our capital structure? And with regards to the ATM, what is the receptivity of the marketplace, because as one can see from our past issuances, we were able to issue a fair amount of equity but in a very market-friendly manner, which is our intention to maintain good trading characteristics. So we factor all that together in looking at how we look at our capital structure. And it's a dynamic situation that we evaluate at each point in time, and probably the biggest factor really is our view on portfolio growth.

And our next question comes from the line of [William James] from [Mayer].

The new tax bill outlines the deduction, elimination for interest expense starting with 30% of EBITDA and [even excels] that. And then it moves up and you're 5% to 30% of EBIT. And so my question is, how does that affect your existing portfolio for total debt? And then does that create any opportunities for you guys in these companies that are going to suffer free cash flow shortfalls?

Well, that's a very interesting question, and it's going to play out on a kind of case-by-case basis. That deductibility -- but on the other side, if the entity is a C Corp, it's got a substantially lower tax rate. So how all those economics fully shake out sort of is a case-by-case analysis. It's clear from the writers of the tax bill that there is a view that absolute leverage -- high absolute leverage should be discouraged, and so they're trying to discourage that -- actually those few extra turns. I think as a practical matter in our business, we have the flexibility of designing our credit instruments in many different ways, and we can -- we might wind up with a little more preferred stock in addition to debt instrument to manage the company's absolute leverage and tax deductibility. I mean, it's something we think will favor us because we can work constructively with our portfolio companies to -- really, to come up with an optimization of their capital structures. I think there's some potentially pernicious dynamics in this where -- I think that was part of your question, I think where -- I think as a company that might be highly levered runs into problems and troubles and their EBITDA declines all of sudden, the deductibility of their interest actually is going to decline, just at the same moment that they're having other cash flow problems. So there may well be an accelerant to a company's distress as a result of this bill. Now we're in a pretty rising generalized -- generally, the economy is looking pretty good. And with some certain sectors, retail, for example, that might be having more challenges than others. But in a downturn, these dynamics might -- the cash flow, tax and deductibility dynamics could have some adverse cash flow consequences at precisely the wrong time for some companies. And that would give rise -- obviously, if they're in your portfolio, that's one set of issues. But if they're not and they're out in the world at large, it also creates an opportunity to come up with some creative capital solutions. I was just going to say that it's going to be highly dynamic and it's going to be case-by-case out there and -- but it's definitely a change, and change has risks and change has opportunities, and so we'll be evaluating all of that.

So as you look through the total debt exposure of your portfolio, what percentage of the portfolio do you see where there's going to be free cash flow issues and maybe you guys moving to preferred stock issuance and adjusting these capital structures in your portfolio?

I think at this moment in time, we don't see any major issues inside of our portfolio at this time. Now we are in budget season, right? I mean, it is January and a lot of companies are calendar year companies. The tax bill just passed. So as a lender, they are required to give budgets and projections for the year. So we haven't seen all that out of our portfolio group because it's coming and everything is brand new. So this is something that's going to be watched by us and by our portfolio companies and, really, by everybody in the marketplace. This quarter, I think we'll have a lot more visibly on precisely what's going to -- what the dynamics are on a company-by-company basis probably towards the end of this quarter because we'll have the benefit of budgets and people have the benefit of putting the tax bill into their cash flow equations. But again, from what we know about the tax bill and our portfolio companies, we don't anticipate credit events being driven by our companies.

Okay. As you look at potential deal flow -- in the deal flow over the last year and your existing portfolio, as you look at the EBITDAs across all of these spectrums of industries, what's [your] sense of the economy? Are these EBITDAs growing? Or is this just all arbitrage leverage buying out family, people buying companies back and forth? Or do you sense that there's true good return on investment and CapEx and, therefore, EBITDAs are growing? And I know it depends upon industry, but just -- if you just give us some color around that.

Yes, it does. And the one thing that our perspective is colored by is that we're so highly selective on the assets that we -- the companies that we invest in, that it's not uncommon for us to see a business that's growing at an exceptional rate because the fundamentals of that business model are so strong, that it's not necessarily a good indicator of sort of broader economic trends. But having said that, overall, we're seeing our portfolio of companies have success. They're not all necessarily growing at the same pace that they're budgeting, but their year-over-year performance, by and large, is positive. And...

It's also -- we think their outlook is positive. We're seeing a lot of our portfolio companies coming to us with acquisitions. There's a sense of let's invest for the future with -- a number of our portfolio companies are coming to us to recalibrate because they want to invest more in their businesses. So we think the mindset is very much one of growth that we see coming out of our portfolio.

And it looks like we have no further questions at this time. I would now like to pass it over to Mr. Henri Steenkamp.

Well, this is Chris here. We just want to thank everyone for joining us today. We appreciate your time and interest and support for Saratoga and to speaking with you next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.