Saratoga Investment Corp (SAR) 2022 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Saratoga Investment Corporation's Fiscal Second Quarter 2022 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 Second Quarter 2022 Earnings Conference Call. Today's conference call includes forward-looking statements and projections. We ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required to do so by law.

Today, we will be referencing a presentation during our call. You can find our fiscal second quarter 2022 shareholder presentation in the Events and Presentations section of our Investor Relations website. A link to our IR page is in the earnings press release distributed last night. A replay of this conference call will also be available from 1:00 p.m. today through October 13. Please refer to our earnings press release for details.

I would now like to turn the call over to our Chairman and Chief Executive Officer, Christian Oberbeck, who will be making a few introductory remarks.

Thank you, Henri, and welcome, everyone. As we reflect on the second quarter, we continue to be pleased with the strength and resilience of our financial position and portfolio companies. Despite the unprecedented global impact and continuance of COVID-19, we feel very fortunate to have overcome its challenges thus far to be in a position where we can leverage the upside of the ongoing recovery and substantial ramp-up in market activity.

Our existing portfolio companies continued to perform well, and our current business development activities allow us to find and evaluate a healthy level of new investments. Our AUM contracted slightly this quarter to $666 million. We originated $116 million in new platforms or follow-on investments, almost matched our record Q1 quarter. This was offset by a record number of repayments with $135 million redeemed, including the recognition of the $6.4 million realized gain on our Passageways equity investment. We have often discussed how our long-term growth in assets could be accompanied temporarily by lumpy substantial repayments, of which this quarter was an example.

We continue to bring new platform investments into the portfolio with 4 added this fiscal quarter, and all our originations were made while maintaining the extremely high credit quality bar we have set for our investments. The performance of our existing portfolio also grew our NAV per share by 1% this quarter to $28.97, again, a historical record for us, with this quarter increase being the 14th increase in the past 17 quarters. Our latest 12 months return on equity as of this quarter was 14.4%.

To briefly recap the past quarter on Slide 2, first, we continue to strengthen our financial foundation in Q2 by maintaining a high level of investment credit quality with over 93% of our loan investments retaining our highest credit rating at quarter end, generating a return on equity of 14.4% on a trailing 12-month basis and registering a gross unlevered IRR of 12.7% of our total unrealized portfolio, with our current fair value, 4% above the total cost of our portfolio; and a gross unlevered IRR of 16.1% on total realizations of $698 million.

Our assets under management decreased slightly to $666 million this quarter, a 2% decrease from $678 million as of last quarter due to the record repayments, but a 31% increase from $508 million as of the same time last year and a 20% increase from $554 million as of year-end. Despite this net reduction, our new originations included 4 new portfolio company investments as well as 6 follow-on investments, and our current pipeline remains robust.

Third, despite improving economic conditions, balance sheet strength, liquidity and NAV preservation remain paramount for us. Our current capital structure at quarter end was strong, $324 million of mark-to-market equity supports $238 million of long-term covenant-free non-SBIC debt and $172 million of long-term covenant-free SBIC debentures. Our quarter end regulatory leverage of 236% substantially exceeds our 150% requirement. We have $229 million of liquidity at quarter end, available to support our portfolio companies, with $111 million of the total dedicated to new opportunities in our SBIC II fund.

The all-in cost of this new SBIC II debt is currently less than 2% and the total committed undrawn lending commitments outstanding to existing portfolio companies are $16 million. In July, we issued an additional $125 million 5-year unsecured bonds with an effective yield of 4.125% that strengthens both our capital and liquidity position. In August, we paid our existing $60 million, 6.25% SAF baby bonds, which importantly reduces our current cost of non-SBIC capital by more than 200 basis points. And just this week, we closed a new $50 million facility with Encina Lender Finance, reducing our existing facilities cost of capital by 100 basis points.

Finally, reflecting on our recent note issuance and improved liquidity and the overall portfolio and financial performance, the Board of Directors increased our quarterly dividend by $0.08 to $0.52 per share for the quarter ended August 31, 2021, paid on September 28, 2021. We'll continue to reassess the amount of our dividends on a quarterly basis as we gain better visibility on the economy and fundamental business performance.

This quarter saw a strong performance with our key performance indicators as compared to the quarters ended August 31, 2020, and May 31, 2021. Our adjusted NII is $7 million this quarter, up 27.5% versus $5.5 million last year and up 11.6% versus $6.3 million last quarter. Our adjusted NII per share is $0.63 this quarter, up from $0.49 last year and up from $0.56 last quarter.

Latest 12 months return on equity was 14.4%, up from 14.3% last year but down from 19.4% last quarter. And our NAV per share is $28.97, up 9% from $26.68 last year and up 1% from $28.70 last quarter. This is the highest NAV per share for Saratoga Investment since inception of our management in 2010, and we will provide more detail later.

As you can see on Slide 3, our assets under management have steadily and consistently risen since we took over the BDC more than 11 years ago, and the quality of our credits remain high with no nonaccruals currently. We are currently working diligently to continue this positive trend as we deploy our available capital into our growing pipeline while at the same time being appropriately cautious in this evolving credit environment. With that, I would like to now turn the call back over to Henri to review our financial results as well as the composition and performance of our portfolio.

Thank you, Chris. Slide 4 highlights our key performance metrics for the quarter ended August 31, 2021. When adjusting for the incentive fee accrual related to net capital gains in the second incentive fee calculation and the interest on the redeemed SAF baby bonds during the call period, adjusted NII of $7.0 million was up 11.6% from $6.3 million last quarter and up 27.5% from $5.5 million as compared to last year's Q2. Adjusted NII per share was $0.63, up $0.14 from $0.49 per share last year and up $0.07 from $0.56 per share last quarter.

Across the 3 quarters, weighted average common shares outstanding remained largely unchanged at 11.2 million shares for each quarter. The increase in adjusted NII from last year primarily reflects the higher level of investments and results in higher interest and other income, with AUM up 31% from last year. The increase from Q1 was primarily due to the full period impact of originations made during Q1 as well as the recognition of a $0.6 million interest reserve release to interest income related to our Taco Mac investment that has been removed from nonaccrual this quarter.

Adjusted NII yield was 8.7%. This yield is up 70 basis points from 8.0% last year and up 110 basis points from 7.6% last quarter. For the second quarter, we experienced a net gain on investments of $3.1 million or $0.28 per weighted average share and a $1.6 million realized loss on the extinguishment of our SAF baby bonds and SBIC I debentures or $0.14 per weighted average share, resulting in a total increase in net assets from operations of $7.9 million or $0.71 per share.

The $3.1 million net gain on investments was comprised of $1.5 million in net realized gains and $3.4 million in net unrealized appreciation on investments, offset by $0.4 million of income tax expense on realized gains and $1.3 million net deferred tax expense on unrealized appreciation in our blocker subsidiaries. The $1.5 million net realized gain primarily comprises a $6.4 million realized gain on the sale of the company's Passageways investment, offset by the recognition of a $4.9 million realized loss on the final write-down of the company's My Alarm Center investment.

The $3.4 million unrealized appreciation reflects: one, the $6.5 million reversal of previously recognized appreciation and the $4.9 million reversal of previously recognized depreciation on the Passageways realization and the My Alarm Center write-off, respectively; and two, a 1.1% increase in the total value of the remaining portfolio, primarily related to improvements in market spreads, EBITDA multiples and/or revised portfolio company performance. All of the net reduction in the value of the non-CLO portfolio in the first quarter of last year has been more than reversed and the overall portfolio fair value is now 3.8% above cost. Return on equity remains an important performance indicator for us, which includes both realized and unrealized gains. Our return on equity was 14.4% for the last 12 months.

Total expenses, excluding interest and debt financing expenses, base management fees and incentive management fees and income taxes, increased from $1.4 million as of the quarter ended August 31, 2020, to $1.8 million this quarter. This represents 1.1% of average total assets unchanged over these same periods. We have also again added the KPI slides, starting from Slides 26 through 29 in the appendix 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 Slide 29, highlighting how our net interest margin run rate has almost quadrupled since Saratoga took over management of the BDC, has increased by 8% the past 12 months and has continued to increase in Q2.

Moving on to Slide 5. NAV was $324.1 million as of this quarter end, a $3.8 million increase from last quarter and a $25.9 million increase from the same quarter last year, primarily driven by realized and unrealized gains. During Q2, 9,623 shares were repurchased at a cost of $0.2 million at an average price of $25.85 per share, while 5,441 shares were sold for net proceeds of $0.2 million at an average price of $28.86.

NAV per share was $28.97 as of quarter end, up from $28.70 as of last quarter and from $26.68 as of 12 months ago. NAV per share has increased 14 of the past 17 quarters. Our net asset value has steadily increased since 2011, and this growth has been accretive, as demonstrated by the increase in NAV per share. We continue to benefit from our history of consistent realized and unrealized gains.

On Slide 6, you will see a simple reconciliation of the major changes in NII and NAV per share on a sequential quarterly basis. Starting at the top, adjusted NII per share increased from $0.56 per share last quarter to $0.63 per share this quarter, a $0.06 increase in non-CLO net interest income, a $0.01 increase in both CLO interest income and other income and a $0.01 benefit from lower operating expenses were partially offset by a $0.02 decrease due to higher base management fees.

Moving on to the lower half of the slide. This reconciles the $0.27 NAV per share increase for the quarter. The $0.57 of GAAP NII and $0.44 of net realized gains and unrealized appreciation on investments were partially offset by a $0.16 net expense related to income and deferred taxes on gains, the $0.44 dividend paid in Q2 and a $0.14 realized loss on extinguishment of debt.

Slide 7 outlines the dry powder available to us as of quarter end, which totaled $229.3 million. This was spread between our available cash, undrawn SBA debentures and undrawn secured credit facility. This quarter end level of available liquidity allows us to grow our assets by an additional 34% without the need for external financing, with $73 million of it being cash, and that's fully accretive to NII when deployed, and $111 million of SBA debentures with an all-in cost of less than 2%, also very accretive.

On July 15, 2021, we reopened our existing 4.375% notes due 2026 and issued an additional $125 million of notes at a premium of 1%, resulting in an effective yield of 4.125% further strengthening our capital structure and reducing our cost of capital significantly. At quarter end, we used some of those proceeds to redeem our $60 million 6.25% SAF baby bonds effectively cutting our interest expense by more than 200 basis points on that amount. SAF has been delisted on NYSE. With our stock again trading at or above NAV per share, we also have an active ATM equity program in place.

And finally, just this week, we closed a new 3-year $50 million revolving credit facility with Encina Lender Finance. This facility replaces our existing Madison facility, and with a floating rate of LIBOR plus 4% with a 75 basis points floor has reduced our credit facility cost of capital by 100 basis points while retaining strong structure and flexibility.

We remain pleased with our liquidity and leverage 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 with no non-SBIC debt maturing within the next 4 years and mostly fixed rate.

Now I would like to move on to Slides 8 through 11 and quickly review the composition and yield of our investment portfolio. Slide 8 highlights that we now have $666 million of AUM at fair value or $642 million at cost, invested in 43 portfolio companies and 1 CLO fund. Our first lien percentage is 74% of our total investments, of which 3.5% of that is in first lien last out positions.

On Slide 9, you can see how the yield on our core BDC assets, excluding our CLO, as well as our total assets yield has dropped this year. This is partly due to continued tightening of spreads in our market, but also due to a mix shift as some of our high-yielding assets were repaid this quarter. In addition, our equity position this fiscal year has almost doubled from 6.7% to 12.1% in Q2. Some of this equity increase is in the form of preferred equity that earns recurring dividend income that is now reflected in its own dividend income line in the P&L rather than in interest income.

And as a reminder, 100 basis points is our lowest floor. So we do not expect to see further decreases in LIBOR impact interest income. The CLO yield remained steady, almost unchanged at 13.2% quarter-on-quarter. The CLO is currently performing and current.

Turning to Slide 10. During the second fiscal quarter, we made investments of $116 million in 4 new portfolio companies and 6 follow-on investments and had a record $135 million in 6 repayments plus amortizations, resulting in a net decrease in investments of $19 million for the quarter.

On Slide 11, you can see the industry breadth and diversity that our portfolio represents. Our investments are spread over 34 distinct industries with a large focus on health care, software, IT services and education and health care services, in addition to our investment in the CLO, which has included a structured finance securities. Of our total investment portfolio, 12.1% consists of equity interest, which remain a very important part of our overall investment strategy.

For the past 9 fiscal years, including Q2, we had a combined $63 million of net realized gains from the sale of equity interest or sale or early redemption of other investments. Over 2/3 of these gains were fully accretive to NAV due to the unused capital loss carryforwards that were carried over from when Saratoga took over management of the BDC. Following our Elyria realization last year and My Alarm Center final write-down this quarter, we are again in a cumulative capital loss carryforward tax position, which will offset current and future realized gains. This consistent performance highlights 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 Chief Investment Officer, for an overview of the investment market.

Thank you, Henri. I'll take a couple of minutes to describe our perspective on the current state of the market and then comment on our current portfolio performance and investment strategy. Since our last update, we see market conditions continuing to tighten, returning to where they were pre COVID-19 and very much a borrower's market. Liquidity conditions remain exceptionally robust. We are seeing increasing transaction volumes, tightening credit yields and greater leverage multiples and an aggressive capital deployment posture overall.

Pricing and leverage metrics are among the most competitive levels that we've ever seen. As a result, there is increasing pressure for investors to compete in other ways, such as accelerated timing to close and looser covenant restrictions.

Now that said, lenders in our market are still wary of thinly capitalized deals and for the most part, are staying disciplined in terms of minimum aggregate base levels of equity and requiring reasonable covenants. Deal volume in the first half of the year was quite robust, and there appears to be a positive outlook in this regard for the remainder of calendar year 2021. Calendar Q4 2021 is on a path to be particularly active, driven by unusually robust M&A activity resulting from frenzy post-pandemic trading conditions, a potential for future capital gains tax legislation and unabated Fed support of the economy through low interest rates.

Our underwriting bar remains high as usual, yet we are actively seeking and finding opportunities to deploy capital, as evidenced by 2 record origination quarters back to back and 4 new platform companies added in fiscal Q2. Follow-on investments with existing borrowers with strong business models and balance sheets continue to be an important avenue of capital deployment, as demonstrated with 6 follow-ons this past fiscal quarter and 9 in the previous. Most notably, we have invested in 19 new platform investments since the onset of the pandemic, including 3 in this past calendar quarter.

Portfolio management continues to be critically important, and we remain actively engaged with our portfolio companies. We have found that they have generally positioned themselves to benefit from the uptick in general economic activity as the economy recovers.

All of our loans in our portfolio are paying according to their payment terms. Taco Mac has been placed back on accrual. And so in addition to not having any nonaccruals prior to and through COVID, we now have 0 nonaccruals across the whole portfolio. We also recognized $1.5 million net realized gains and an additional $3.4 million in unrealized appreciation this quarter, which means that our overall portfolio has more than recovered the unrealized appreciation associated with COVID last year, and the fair value of Saratoga's overall assets now exceeds its cost basis by 3.8%. We believe this strong performance reflects certain attributes of our portfolio that bolster its overall durability. 74% of our portfolio is in first lien debt and generally supported by strong enterprise values in industries that have historically performed well in stressed situations. We have no direct energy or commodities exposure. In addition, the majority of our portfolio is comprised of businesses that produce a high degree of recurring revenue and have historically demonstrated strong revenue retention.

Our approach has always been to stay focused on the quality of our underwriting. And as you can see on Slide 13, this approach has resulted in our portfolio performance being at the top of the BDC space with respect to net realized gains as a percentage of portfolio at cost. We are at the top of the list of only 8 BDCs that had a positive number over the past 3 years.

A strong underwriting culture remains paramount at Saratoga, and we approach each investment working directly with management and ownership to thoroughly assess the long-term strength of the company and its business model. We endeavor to peer as deeply as possible into a business in order to understand accurately its underlying strengths and characteristics. We always have sought durable businesses and invested capital with the objective of producing the best risk-adjusted accretive returns for our shareholders over the long term. Our internal credit quality rating reflects the impact of COVID and shows 93% of our portfolio at our highest credit rating as of quarter end.

Part of our investment strategy is to selectively co-invest in the equity of our portfolio companies when we're given that opportunity and when we believe in the equity upside potential. It has been our experience that there is significant overlap between those businesses that meet our strict debt underwriting requirements and those that possess attributes that make them attractive equity investments. This equity co-investment strategy has not only served as yield protection for our portfolio, but also meaningfully augmented our overall portfolio returns. We intend to continue this strategy.

Now looking at leverage on Slide 14, you can see that industry debt multiples increased slightly from calendar Q1 to Q2. Total leverage for overall portfolio -- for our overall portfolio was 3.68x, decreasing slightly from last quarter, reflecting strength in portfolio company capitalization and new originations with lower leverage. Through past volatility, we have been able to maintain a relatively modest leverage profile. That said, we never consider leverage in isolation, rather focusing on investing in credits with attractive risk return profiles and exceptionally strong business models where we are confident the enterprise value of the businesses will sustainably exceed the last dollar of investment.

In addition, this slide illustrates our consistent ability to generate new investments over the long term despite ever-changing market dynamics. During the first 3 calendar quarters, we added 9 new portfolio companies and made 22 follow-on investments.

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. Our number of deal sources dropped, initially due to COVID, but more recently, reflecting our efforts to focus on attracting a higher percentage of quality opportunities. Our deal pipeline is robust. Most notably, the 66 term sheets issued during the last 12 months is markedly up from last year's pace. Similarly, the first 9 months of calendar year 2021 is up compared to the calendar year 2020, showing that we are generating more shots on goal. What is especially pleasing to us is that over 1/3 of our term sheets issued over the past 12 months, and 4 of our 14 new portfolio company investments are from newly formed relationships, reflecting notable progress as we expand our business development efforts. There are a number of factors that give us measured confidence that we can continue to grow our AUM steadily in this environment as well as over the long term.

First, we continue to grow our reach into the marketplace, as is evidenced by several investments we have recently made with newly formed relationships. Second, we have developed numerous deep long-term relationships with active and established firms that look to us as their preferred source of financing. Third, we continue to see plenty of investment opportunities in industry segments that are experiencing long-term secular growth trends and within which we have intentionally developed expertise.

As you can see on Slide 16, our overall portfolio credit quality remains solid. The gross unlevered IRR on realized investments made by the Saratoga Investment management team is 16.1% on $698 million of realizations. The single Passageways repayment in Q2 had an IRR of 34%.

On the chart to the right, you can see the total gross unlevered IRR on our $612 million of combined weighted SBIC and BDC unrealized investments is 12.7% since Saratoga took over management. The 2 largest unrealized appreciations remaining due to COVID are in our Nolan Group and C2 Education investments, both of which are more dependent on in-person human interaction. We do not believe the remaining unrealized appreciation changes our view of their fundamental long-term performance. Even with those current markdowns, our overall portfolio of fair value is now 4% above its total cost.

Our investment approach has yielded exceptional realized returns. Moving on to Slide 17, you can see our first SBIC license is fully funded, with $210 million invested as of quarter end. Our second SBIC license has already been fully funded with $87.5 million of equity of which $172 million of equity in SBA debentures have been deployed. There is still $7.6 million of cash and $111 million of debentures currently available against that equity. When comparing this quarter to much of last year, the way the portfolio has proven itself to be both durable and resilient against the impact of COVID-19 really underscores the strength of our team, platform and portfolio and our overall underwriting and due diligence procedures. Credit quality remains our primary focus, especially at times with such high activity levels as we are seeing now. And while the world is in continuous flux, we remain intensely focused on preserving asset value and remain confident in our team and the future for Saratoga.

This concludes my review of the market, and I'd like to turn the call back over to our CEO. Chris?

Thank you, Mike. As outlined on Slide 18, the Board of Directors declared a $0.52 per share dividend for the quarter ended August 31, 2021. This reflected an $0.08 or 18% increase from last quarter. The Board of Directors will continue to reassess this on at least a quarterly basis, considering both company and general economic factors.

Moving on to Slide 19. Our total return for the last 12 months, which includes both capital appreciation and dividends, has generated total returns of 77%, well above the BDC index of 50%. Our longer-term performance is outlined on our next slide. Our 3- and 5-year returns place us in the top 20 and top 10, respectively, of all BDCs for both time horizons. Over the past 3 years, our 46% return exceeded the 30% return of the index. Over the past 5 years, our 123% return greatly exceeded the index's 59% return.

On Slide 21, you can further see our outperformance placed in the context of the broader industry and specific to certain key performance metrics. We continue to focus on our long-term return on equity and NAV per share performance, which are both consistent and at the top of the industry and reflects the growing value our shareholders are receiving. Not only are we one of the few BDCs who have grown NAV, we have done it accretively by also growing NAV per share.

Moving on to Slide 22. All of our initiatives discussed on this call are designed to make Saratoga Investment a highly competitive BDC that is attractive to the capital markets community. We believe that our differentiated performance characteristics outlined in this slide will help drive the size and quality of our investor base, including adding more institutions.

Our differentiating characteristics include: maintaining one of the highest levels of management ownership in the industry at 15%, access to low cost and long-term liquidity with which to support our portfolio and make accretive investments, receipt of our second SBIC license providing a sub-2% cost liquidity, a BBB+ investment-grade rating and active public and private bond issuances, solid historic earnings per share and NII yield, strong and industry-leading historic and long-term return on equity accompanied by growing NAV and NAV per share, putting us at the top of the industry for both; high-quality expansion of AUM and an attractive risk profile. In addition, our historically high credit quality portfolio contains minimal exposure to conventionally cyclical industries, including the oil and gas industry.

We remain confident that our experienced management team, historically strong underwriting standards and tested investment strategy will serve us well in battling through the challenges in the current and future environment; that our balance sheet, capital structure and liquidity will benefit Saratoga's shareholders in the near and long term.

In closing, I would again like to thank all of our shareholders for their ongoing support. And I would like to now open the call for questions.

(Operator Instructions) First question comes from the line of Bryce Rowe with Hovde.

I wanted to maybe start with either Mike or Chris. You've described the pipeline here as robust and obviously highlighted the repayment activity here in the August quarter and kind of describing it as lumpy. How do you all kind of juxtapose the record and near-record activity that you've had over the last 2 quarters from an origination perspective against the adjective robust that you used to describe the pipeline?

And then any thoughts on repayment activity as we are in the fourth quarter -- fourth calendar quarter here and as we move into '22 with potential tax law changes taking effect.

Sure. Maybe I'll start with that, and then I'll pass it on to Mike. And just sort of as a broad overview, not to be casual about it, but I mean it's sort of like the weddings. There are more weddings taking place this year than last year because they were all postponed and held over. So I think that there's a lot of pent-up demand in transaction activity because of the long pause, if you will, in activity last year from COVID.

And so all the markets have kind of opened up in a major way; valuations have accelerated in many of the businesses that we've invested in. And so there was sort of a pent-up exit demand, I think. There was an increase in valuation. So a lot of sponsors and equity owners of their businesses saw opportunities to sell and are still seeing them.

I think everywhere, record M&A activity this year across the board, the big deals, small deals everywhere. So it's just a lot of activity. So on the repayment side, obviously, that's an impact because it decreases our assets under management. But on the other hand, in our business, in the credit business, when you get paid back, that's a good report card that you made a good investment. I think the other side is our originations are very strong. So just as there's a lot of activity, on the sell side, there's also a tremendous amount of activity on the buy side. And so fortunately, these relatively balanced out in the most recent quarter. We were pretty far ahead on the buy side in the quarter before.

And again, these are things -- we say lumpy because it means we can't predict. We get calls and people say, "Oh, we're going to -- we decided to sell our company, and we've agreed to sell it, and we're going to pay you off in a week or we're going to pay you off in a month." Sometimes they say "We're going to reprocess." So our absolute visibility in sort of -- we can't predict it 3 months out necessarily. We might be able to predict it 1 month out. So we got some visibility there. And some of our companies are working with us.

So sort of a long-winded way to say that on the redemption side, we're really not able to predict that. And we've had companies that have decided to put this up for sale and they decided not to and then decided to acquire companies.

So -- but I think the overall comment is we are in a very active market on both sides. And so we're seeing our share of both new portfolio investments, but very importantly, as was highlighted in our presentation, new relationships and new platforms. And that's really been the secret to -- one of the important elements to our performance is new platforms because often new platforms wind up growing and creating new relationships. Mike?

Yes. Let me expound on that. So on the origination side, there's probably 2 factors that are driving the robust origination that you've seen in the last couple of quarters. One is the market, as Chris referenced, and there's a lot of pent-up demand. People were on the sidelines for much of the pandemic. And so now that we're getting past that period, there's a lot more transaction volume period. And so we're right in the flow of that transaction volume and benefiting from it.

But the more important thing, the second thing, and this is what we think is we're really pleased by and we think is fundamental to the growth of our business in the long run is that we're starting to see the benefits of the investments that we're making in business development, specifically focusing on expanding our relationship set. We've done a really good job historically of creating relationships. And because of the way we do business, we think we're very thoughtful, and the marketplace recognizes that. We're very partnership-oriented. As a result of those things, we get a lot of repeat business from the relationships that we have. But we've made a concerted effort to try to seek out new relationships that we can support as they invest capital in the marketplace. And we've done that very successfully.

So in this last quarter, for instance, I think 38% of that production was from new relationships. So both factors are at play. And certainly, where market activity is will kind of go up and down, and we don't have as much control over that. But at the lower end of the middle market, where there's just so many companies out there, if we continue to do what we've done historically, which is develop really strong relationships with smart investors then that will be a means for lots of follow-on activity as well as repeat business from those groups. But add to that, to that stable, if you will, we feel confident that we can grow that origination volume and keep it pretty steady.

It's always unpredictable. We're never going to do originations, try to meet some quarterly objective. That's just something we're never going to do. But it's more reflective of us finding more and more really high-quality opportunities to invest.

And then on the payoff side, as Chris referenced, that's just a lot less predictable and much more reflective of kind of capital markets activity. I would highlight, though, for us, and we talked about this in our prepared remarks, we very much seek to co-invest in the equity in most of the deals that we invest in when we're given that opportunity and we think the equity upside is there. And when you see the payoffs, and you saw that in Passageways and some other deals, certainly this year, that bears fruit on our realized gains as well. So there's a blessing and a curse with payoffs, but I'd just add that. But in general, those are a little less predictable. I would expect in a market as robust as this that the payoff volume on average is going to be a bit higher just because there are so many transactions and so many companies trading. But in the long run, we do feel like we can outpace that with our origination activity.

Okay. That's helpful. And it might segue into my follow-up question. I think last quarter, you all highlighted a couple of one-off stand-alone preferred equity investments and then here in your prepared remarks and in the financial statements, you've carved out what the dividend income is. So I was hoping to understand the source of the dividend income here this quarter. It looks like 1 of those 2 preferred equity investments was exited in the August quarter. And then the preferred -- or the equity investments that you made here in the August quarter, is there a chance that we'll see some dividend income coming off of those in addition to the interest incoming -- interest income coming off of the complementary debt investments?

Yes, Brian, let me start off on that question. So we actually had 3 investments last quarter that had -- that was preferred equity in nature and that was receiving dividend income. As you noted, one, Greenfire was repaid during this quarter. And so we left with 2 investments like that. We obviously recognize that although this has recurring return and income, it's not interest income in nature, it's dividend income in nature. And so it's not highlighted on the schedule of investments, it's like an interest rate. And for that reason, we included it on its own line on the P&L in the dividend income, as you mentioned, so that you guys and obviously all investors can see it and start thinking of that as more of a recurring revenue stream or recurring in nature as these dividends are declared on a quarterly basis.

If you think of this quarter, it's primarily related to those 2 investments. That's a little bit related to the third investment that was repaid but that was reasonably early on in the quarter end. But so with a small haircut, you could start thinking of that dividend income line as being recurring in nature on a quarterly basis going forward.

And let me add to that, Bryce. Just thinking back or thinking from a broader perspective, I think what we discussed last quarter is still the case. I mean we're looking at these preferred investments a bit more opportunistically. We're always looking at opportunities to invest in the capital structure of good businesses in various spots. Most of it is in the senior debt position. But occasionally, we find an opportunity to deploy capital in a way where we feel like we can get really attractive risk-adjusted returns in a preferred instrument or other instruments. And these were a bit more opportunistic.

I think the way you should think about it is that we'll continue to look for those opportunities, and you may see more of them in the future, but it's not our expectation that we're going to fill our balance sheet with lots of them. It's going to be kind of a measured way of approaching it, in general.

Next question comes from the line of Casey Alexander from Compass Point.

I have a couple of questions, nothing particularly compelling, frankly. First of all -- this is for Henri. On the new credit facility, Saratoga has historically not had much reliance on the Madison Capital credit facility. And as a matter of fact, it probably had a 0 balance in 7 of the last 8 quarters. So I'm curious why on the new credit facility, you agreed to minimum draws on the credit facility as opposed to some form of nonuse fee?

Sure. So I think, firstly, although we, as you note, have used this minimally over the past couple of years, there have been at times during the quarter periods where we've used it for either timing differences or sort of intra-quarter cash flow needs that we've had. So it has been drawn a little more than it sort of, I guess, it would appear just looking at a point in time on the balance sheet.

But putting that aside, I think as we sort of thought of this new credit facility, obviously, we had a wonderful relationship with Madison over the years, but we had an opportunity here to -- with a minimum draw have the ability to bring the cost of capital down quite substantially for us on this credit facility and potentially have the opportunity to increase the use of the facility, not necessarily like most BDCs use it where it's drawn most of the time all of it, but to actually increase the usage of the facility because it's a lower cost of capital, and it allows us the opportunity to invest at a return that makes sense for us.

We still view the draw as sort of minimal. There is still -- you'll see an 8-K will come out later in the week. As required with the SEC rules, there is still a undrawn fee associated with it. Obviously, that undrawn fee will go away on whatever portion is drawn.

Yes, Casey, if I could just weigh in on this as well. Yes, I think Henri mentioned that there have been a lot of draws that maybe don't show up in our quarterly financial statements. And -- but also very importantly, as you know, in looking at our capital structure, we mostly have fixed rate bond type financings, which we think are the safest, no covenants, long term, those type of things. However, those are fairly chunky and then the market for those changes a bit.

So if we have like a robust pipeline and we're making forward commitments and we don't have necessarily a lot of cash on hand at that moment, we can still be comfortable making commitments because we know we have the swing line in place. And so it allows us to run without a lot of large cash balances and drawn interest payments that would impact our earnings negatively, but we always have the liquidity. So it's been a very important liquidity enhancer, and it's sort of been sort of a standby facility that's enabled us to be -- to do our business very, very well.

In terms of the drawn and undrawn, I think we've been fortunate with Madison, who was a subsidiary of New York Life, in that as an insurance institution, they are maybe less sensitive to undrawn facilities because they don't have the same type of capital ratio reporting that most banks do, for example. So most bank facilities, they're not very comfortable with large undrawn facilities. They like to have them largely drawn. Encina is not a bank. It's a nonbank facility, but nonetheless, they are interested in some level of draw. And that's just kind of what the market is. I think we were fortunate that we were able to have a facility that was kind of nonmarket from in terms of the minimum draw side of Life.

Again, I think very importantly, this facility carries forward so many of the benefits plus more that we've had with our Madison facility, so we were all very, very comfortable with this new facility and this new relationship.

My next question is for Mike. Mike, can you just put some brackets around the Passageways sale. Was that driven by the private equity sponsor and you guys were going along? Or were you guys a driver of that transaction? If you can just give us some feel for how that came about?

Absolutely. We were a minority investor in support of a private equity sponsor group that we have a very good relationship with, and they got a very compelling offer to sell the business, and we all benefited from it. So we were not driving the exit. It was more consistent with what we most often do, which is find a good business where we're providing debt capital to help them grow their business, but then in conjunction with that, we co-invested in the equity as well.

Okay. Great. And one more question for you, Mike. You're investing to a balance sheet that's twice the size of what it was 3 years ago. Can you give us some feel for the challenges from the increase in scale? And does it have you working with new sponsors as a way of sort of increasing your entry size into these investments to help keep fully funded in the balance sheet of this size?

It's a good question. We really are anxious to stay at what we would call the lower end of the middle market. And sometimes people throw especially in our town, middle market can be companies that are $1 billion in size. But the lower end of the middle market where we play is really our sweet spot. We think you can get much better risk-adjusted returns there. You can actually get real covenants. And so we're sticking to our knitting. We've done really well, especially if you kind of see many of our best investments are ones that started off fairly small, some of them initially less than $10 million check sizes out of the box. And then as our balance sheet has grown, we've had the benefit of having the capacity to expand the investment after the company is performing well, we know it well, and we have even greater confidence to support it with more capital. So we intend to continue to do that.

As it relates to new relationships, these are relationships that take quite a bit of time to court these folks and get to know them, and they feel the same way about us. I mean to tell you just recently, for instance, we have closed just last week, another deal with a new relationship. We've been courting that group for 3 years. I know them really well, reputationally, and have gotten to know them. And in fact, in that deal, we won the deal because they basically felt like we understood the business much better and would be better partners than the other lending group that kind of was pricing it exactly the same way we were with very similar terms. So we're going to continue to play in the marketplace in that manner.

As we've gotten bigger, certainly, we can take on larger check sizes. So that's helpful as we've expanded our equity base as well. In terms of managing a larger balance sheet, we've invested substantial resources in our people and believe that we've got as good underwriting credit quality and culture as anybody, if not the best in the marketplace. And we continue to add bodies and bring people up in the junior ranks where we can share what we know in terms of how we underwrite; we view it very much as an apprenticeship business. And so we think we've got plenty of capacity to not only manage the balance sheet that we have at this size, but grow it significantly beyond here, and we continue to invest in resources to do so.

If I could add just one more point to that is that this larger balance sheet also allows us to be much better in our marketplace. In other words, there's a lot of deals where we can look to underwriting larger pieces and actually being the lead and maybe syndicating out to others. We can be able to solve problems for our sponsors where they need a commitment early and we can commit to much more sizable pieces, including tranches of equity and things like that. So it makes us a -- we're not stretching as much as maybe we used to serve some of our clients and some of our relationships in some of their stretchier situations.

All right. Great. Well, Michael, thank you for breaking news. We now know that you've made at least one new investment to a new portfolio company, with a new sponsor in the quarter. So thanks for breaking news for us there.

Thanks. Casey.

Next question comes from the line of Robert Dodd from Raymond James.

Congrats on the quarter. And I'd like to express my appreciation following on Casey there. On kind of 2 theme questions. First, on the origination on the asset side and the liability side as well. On -- I mean given the color you've given in this last quarter in a seasonally -- relatively seasonally slow quarter, having the second highest origination quarter ever, and the fourth quarter calendar, not necessarily fiscal, though, even September activity -- market activity seems to be extremely robust. I mean what probability would you -- I mean I'm not looking for an exact number, but what would you say the probability is that this year-end calendar Q4, for example, is going to represent the highest level of origination in the Saratoga platform history?

Our own origination in the fourth quarter? That's a tough thing for us to answer. I mean I think what I can say is that we feel very confident in our ability to outpace our payoffs over the long term. The things that I said earlier in terms of sort of benefiting from a robust market, we don't see that changing. And benefiting from new relationships that we've invested in, we don't see that changing either. But where it exactly comes out for the quarter, impossible to say.

I think the one thing I would say is that we're just never going to try to think about things in terms of volumes in a quarter. The outcome is the outcome, but we remain laser-focused on trying to find as many quality opportunities as we can and then going after the ones that we think our shareholders would want us to go after that offer the right risk-adjusted returns. And the marketplace is favorable. So those things are lined up well in that respect, but it's impossible to say, really.

It was worth a shot. Go ahead.

Yes, it is Chris. If I could just add to that. I mean I think that we're a growing organization, and we've had very consistent growth over many, many years. And as a growing organization, we're setting a lot of records as the quarters roll on, just because we're growing larger than we have been in the past. And I think as Mike very well said, I think our trend line is up and to the right. But there can be setbacks in any given quarter and there can be variations in it. So we're confident in our trajectory based on our history.

We don't want to make any forward-looking statements, of course. But our trajectory is growth and setting records in many different areas. But again, I think focusing on what we talked about earlier, our key metrics are credit quality, number one. Return on equity, sort of number -- very close number two. So we're very focused on profitable growth. And even in these robust markets. I mean we are losing deals because we're declining to participate at certain levels, too. So there's a little bit of that going on to us making judgments as to where we want to play and how we want to play.

I appreciate the additional color. On the second part of that, obviously, to your point, is repayments and net growth. In this kind of environment, would you say -- does the notice period, how much warning you get about a repayment? Does it shrink in this kind of highly active environment? I mean, obviously, the more activity, the quicker things can happen. So is there any color on how that kind of does your visibility on repayments, not that it's ever that great, and that's not a criticism, that's market-wide? Does it get even worse in this kind of environment? Or is there any kind of dynamic there?

I think it's hard to generalize. If everyone is situation-specific. There's a lot of companies that -- they've had a lot of interest over periods of time and sometimes they get a negotiated offer, and they don't really want to talk about it until it's real and live, and then -- and basically done. And then other ones, they go into processes and in a process, you get a lot more visibility. So this kind of a spectrum. Sometimes we find out in a short period of time, we were paying off on Friday and other times, we're thinking we're going to sell in the first half of next year. We've got an investment bank. We're going into a process, and we've got a lot of feedback and updates on that. So it's sort of -- those may be the 2 sides of the extreme, and then there's a lot of pieces -- a lot of different situations in between.

And I'd just add to that -- I'd say that all that Chris said is absolutely true. On the margin, your point is probably accurate. And it's mostly driven by the fact that in robust markets, even if somebody feels like they're going to run a process you'll see people preempt in a process. So it's something that you think might be 6 months out for a payoff. Some people will get really aggressive. And before you know it, they're selling the business a lot sooner than otherwise. But that's at the margin. I think as Chris pointed out, it's very much deal specific. And sometimes it's -- you don't have a lot of forewarning and other times, you kind of know that it's quite a ways out.

I appreciate that because it ties into the next part of the question. In some cases, I'm sure you would like to remain the incumbent lender to one of these business, even if there's an equity transaction. If you've got a good credit that you know, you would, oftentimes, I would imagine, like to remain the lender to that credit.

In an active market where there's a lot of repayment, what's -- as you expand the number of relationships you have, is the probability of remaining an incumbent lender in one of these transactions high or low? Or it just doesn't matter, it's just random?

It's certainly a lot higher now that our balance sheet is bigger. Well, once upon a time, there is a change of control transaction and the company had grown significantly it was just harder for us to stay in the credit because they are looking for more capital than we could see for. So now that we have a larger balance sheet it does afford us that opportunity to raise our hands and say, we really like this business, we'd like to support at the next go round, either 100% ourselves or in partnership with somebody. And as you correctly pointed out, that presents an opportunity for us to get to know additional investors. So it has that benefit as well. And so yes, there is that opportunity is something that in the right circumstances, we very much try to do.

I appreciate that. And then if I can one more kind of on the liability side. Obviously, I mean, the Encina credit facility is an improvement on the last secured facility in terms of terms with Madison. But all in, L plus 4.75% floor, with nonuse fees, et cetera, et cetera. It sounds like probably the all-in borrowing cost is actually effectively north of 5%. You can borrow probably incrementally in the unsecured institutional market sub-4% today, right, given where your bonds are trading. What's -- 2 components to that question. One, what do you think Encina is seeing that the institutional -- the investment grade unsecured are willing to lend you cheaper than the secure guys? What's the information gap or what do you think those 2 relative groups are missing with respect to each other?

And then the other question, I guess, tied to that is, was there a consideration given to just not running revolver at all and just running a little cash heavy?

Well, I think a couple of things. I mean we are cash heavy right now on top of that, too. So there's a lot of variability just because of the way our business works. But importantly, I think we talked about it a little earlier in one of the other questions, what we get from a revolving credit facility is flexibility. So if we have -- if we want to raise some bonds, if we have a given position, right? And then we've got -- let's say, we've got $10 million of cash, and we've got $50 million of commitments we want to make and we don't necessarily want to raise a bond at this moment in time, we have a swing line of credit to help us bridge that. and gives us some time to more optimally approach whatever marketplace we're interested in.

So -- and part of the reason it costs more is it's flexible. The bonds, you go to market point in time, you issue a fixed amount of bonds over a fixed period of time with fixed terms. This is something that it's variable. We can decide to draw it or not draw, and that gives us a lot of flexibility. That's something we've had all along. It goes with our whole mindset of having a very flexible approach to being able to do business.

I think going back to last year, when there was a lot of big problems in the marketplace last -- the spring of 2020, we had an undrawn revolver that we could have done a lot of business with, and it allowed us to enter a number of conversations that did result in deals. We were able to issue a bond in June of 2020. But if we hadn't been able to issue that bond, we have the flexibility to draw on our revolver and fund those deals. So there's a flexibility component that allows us to do our business and we think better than running cash heavy.

Yes. And Robert, I would also just add that, obviously, this is a nonbank lender And this -- whether we're originating assets or whether we're building our capital structure, structure of the facilities have always been extremely important to us at Saratoga. And this is a nonbank lender, the structure and the sort of recourse to the BDC, et cetera, is very different than a bank lenders structures. Obviously, that comes with a higher cost. But for us, we prioritize structure above cost. And this is much more beneficial, flexible, better than what a bank lenders normal borrowing base facility structure is.

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

A lot of good questions have already been asked. I just wanted to follow-up on a high-level question. How do you view the investment opportunity for more unitranche or perhaps second lien loan investments, which could help support portfolio yield, considering how difficult the market is in first liens and how spreads have tightened? And do you see an opportunity to sell first out pieces of unitranche deals?

Well, Mickey, I think the unitranche opportunity is quite robust. In fact, over time, it used to be that many deals were done, and you're probably aware there's many deals were done with a bifurcated capital structure, where there was a first lien lender and then somebody came in either with unsecured mezz or second lien. Unitranche is really the dominant security in the marketplace supporting middle market companies for change of control transactions. And many of the first lien deals that we do, I would categorize more as unitranche, if you will, vis-a-vis kind of a first lien that a bank might do. And so that's most of what you see in our portfolio, and it's what we intend to continue to do, and we think there's some really good opportunities to deploy capital there.

Now the second lien market is also available to us, and we're wide open to those opportunities in the right circumstance. We certainly have a higher bar for second lien than we do for dollar one risk. And so we would expect that the mix of kind of unitranche or first lien investments versus second lien would be consistent with what it's been in the past. We don't see a big change there. Now as it relates to selling down first lien positions. That is something that we're open to, and it hasn't been core to how we underwrite, but certainly in terms of optimizing our returns. And even in some cases, if we're in a position that -- where we have an opportunity to do a deal, but maybe it's kind of a full position for us. being able to develop partnerships with folks that might have an interest in a piece of our security is something that is part of our intent over time as well.

Mike, just to follow-up on your last comment. Are you already set up to sell out those first out pieces, given that usually folks like to do this at the time deals are funded, otherwise, you end up with the secured borrowing and it's kind of messy? Or is this something still sort of a work in progress?

No, we -- it's a good question. We have been actively doing deals where we're closing simultaneously where we're doing a first out last out, let's call it, structure. So it's a unitranche that has that waterfall, if you will. And we've done a number of those for years.

Okay. Good to hear. Mike, food retailers are typically hard to underwrite. They can be quirky in terms of their performance. But curious what attracted you to Pepper Palace to sort of offset the general risks of that sector?

Yes. And it's a good question. And even before I get into some of the detail, I will, of course, remind you that these are private companies, and we're not the control owner here. So there's limited in terms of what we can share. But I'd say this, we're well aware of what you just commented on that some of these businesses can have a certain amount of volatility. We, as a result, went into our underwriting with our eyes wide open and became convinced that this is a really interesting business model. One of the things that I can say is that in our experience, underwriting many of those businesses, where they can get into trouble is they take on lease structures where they're tied into a good deal of obligations. And if some of their locations underperformed, they get saddled with those, and that can add volatility to the capital structure.

This business has some really advantageous structures in that respect. And so there's a lot less of that. Their return on capital is just fantastic in terms of the amount of money that it takes to open one of these and the flexibility that they have in terms of how they structure their leases. So we feel like as it relates to that structural element that can add volatility to those business models.

This one doesn't have those features. And it's a business that we became quite comfortable investing in for a variety of other reasons as well, just in terms of its market position and its performance and the ownership group, we think is quite knowledgeable. And we think that the business has a bright future.

That's really helpful. Interesting comments on the leases. One more last question, more of a housekeeping question, perhaps for Henri. I noticed you lowered the estimated yield on the CLO, which is a little bit counterintuitive given how strong fundamentals are in terms of defaults and things of that nature. Is there any insight that you can give us into what's going on there?

Yes. Well, Mickey, nothing specific other than I would say, I mean, obviously, the interest rates and output from the valuation. You probably saw the valuation stayed relatively unchanged quarter-over-quarter. And I would say probably the biggest driver in net interest rate change was that our principal cost balance increased during the quarter just from the function of receiving a large equity distribution larger than projected. And as you know, how the accounting works is you get the equity distribution and then a portion of its interest income from the prior quarter's rate, and then the remaining increases your cost basis or principal, if you will. And so because the principal went up, that sort of drove as an output, the rate slightly lower.

So that was really the largest driver of that. It wasn't really performance or anything. It was probably more driven by outperformance, if anything else.

Next question come from the line of Sarkis Sherbetchyan from B. Riley Securities.

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on repayments. I'm just curious on what you view as the appropriate level of cash to keep on the books versus deploying that cash into earning assets?

Sarkis, it's Henri. We just missed a little bit of the first part, but I think what you are asking is just with the level of repayments, how one sort of thinks of cash. We obviously don't have that problem or issue at the moment because we have cash remaining from the bond offering that we did. And so we have quite a bit of cash. I think at quarter end, it was around $72 million to deploy. I think with the terms and the availability of the credit facility that we have, we feel relatively comfortable to utilize all of that cash because, again, if there's a timing need if there is a cash need, we can access the credit facility, only have $12.5 million of the $50 million drawn, which allows a lot of additional cash capacity to be used. And then, of course, obviously, the baby bond or the bond market -- institutional bond market is available for us if we have more cash needs.

So from a liquidity perspective, we feel pretty good about it at the moment. And are not really concerned, especially with the credit facility and about having additional cash on hand.

Henri, I think my line might be chopping up. But I guess my question was more so what do you think is the appropriate level of cash to keep on the books compared to deploying that cash? I super appreciate that you're in a really good liquidity spot. And I'm just wondering, essentially, what's the right cash to keep on the balance sheet here?

Well, if I could maybe jump in there. I think it's a very good question. It's something we are constantly thinking about. I think we kind of have a forward-look like what to we -- how many deals do we think we have in our pipeline that are going to close within a given period of time and what is our capital relative to that. And we've been fortunate to have pretty good access to the capital markets, although there are times when the capital markets close given this second quarter of 2020, for example. And so we want to be able to continue to do our business. So that's why we have the line of credit.

I think if you noticed in some of the terms, it's a $50 million facility, but we have the ability to upsize that to $75 million. So we have the ability to have our revolving line of credit increase. And so that allows us to maybe run with a little less cash on hand at the time. I think depending where your cash comes from, we also have redemptions, right? We have repayments. So we have repayments coming in. So we have some visibility about cash coming back. We have some visibility on cash going out. And so it's a very dynamic decision we're making.

But one of the things that's informing us is obviously being efficient, right? And if you have a given $10 million of cash that's on your books, but that cash is matched up against even a very well-priced bond offering at 4.25%, you're not earning anything on the $10 million and you're paying 4.25% or something, depending where that cash came from exactly. And so there's a negative arbitrage to cash. And so we want to minimize the negative arbitrage, and then our unused line fee, Henri, is 75 basis points.

Yes, it's 75 basis points until we are 50% drawn, and then it drops to 50 basis points.

Yes. So we're paying between 50 and 75 basis points for our undrawn facility, which, in general, is less expensive than running cash that we sold bonds to fund, if you will. So that -- again, those are considerations. But some level of cash is certainly good to have from a safety standpoint, but then managing the negative arbitrage of cash relative to all of the other things we've talked about is an ongoing process.

There are no further questions at this time. I'll hand back the call over to Chris Oberbeck for closing remarks.

Well, thank you all. We appreciate everyone for joining us today, and we appreciate your questions and interest, and we look forward to speaking with you next quarter. Thank you.

This concludes today's conference call. Thank you all for joining. You may now disconnect.