CSWC - NASDAQ

Thank you for joining today's Capital Southwest Third Quarter Fiscal Year 2023 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances or any other reason after the date of this press release, except as required by law. I will now hand the call off to our President and Chief Executive Officer, Bowen Diehl.

Thanks, Chris, and thank you, everyone, for joining us for our third quarter fiscal year 2023 earnings call. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio as we continue to diligently execute our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. You will also find our quarterly earnings press release issued last evening on our website. We'll begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we generated a pretax net investment income of $0.60 per share, which represented an 11% growth over the $0.54 per share generated in the prior quarter, and 18% growth over the $0.51 per share generated a year ago in the December quarter. The $0.60 per share, Morgan earned a regular dividend paid during the quarter of $0.52 per share, while also covering the supplemental dividend paid during the December quarter of $0.05 per share. We are also pleased to announce today that our Board has declared another $0.01 per share increase in our regular dividend to $0.53 per share for the quarter ending March 31, 2023. This increase represents 1.9% growth over the $0.52 per share paid in the December quarter and 10% growth over the $0.48 per share paid a year ago in the March quarter. These increases in our regular dividend are a result of the increased fundamental earnings power of our portfolio, given its growth and performance as well as improvements in our operating leverage. In addition, due to the continued excess earnings being generated by our floating rate debt investment portfolio. Our Board of Directors has again declared a supplemental dividend of $0.05 per share for the March quarter, bringing total dividends declared for the March '23 quarter to $0.58 per share. While future dividend declarations are at the discretion of our Board of Directors, it is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future, while base rates remain materially above long-term historical averages. Finally, I should note that as we have done in the past, we intend to also distribute additional supplemental dividends as we harvest realized gains from our equity co-investment portfolio. During the quarter, we saw strong deal activity in the lower middle market, primarily focused on acquisitions rather than the refinancings. The environment during the quarter was a favorable 1 for a first lien lender like Capital Southwest. We saw average spreads that were 50 to 100 basis points wider than a year ago with leverage levels on our new platform deals that were lower by a full turn of EBITDA. Interestingly, loan-to-value levels on new deals, calculated as our first lien loan divided body enterprise value being paid for an acquisition, we're also down meaningfully. This suggests that multiples being paid for strong companies remained robust. Portfolio growth during the quarter was driven by $164 million in new commitments, consisting of commitments to 5 new portfolio companies totaling $122.4 million and add-on commitments to 12 existing portfolio companies totaling $41.6 million. This was offset by $12.4 million in proceeds from one debt prepayment and warrant equity sales during the quarter. On the capitalization front, we raised a total of $104.3 million in gross equity proceeds during the quarter at a weighted average price of $17.99 per share or 109% of the prevailing NAV per share. This included $58.3 million raised through our equity ATM program and $46 million raised through an underwritten public equity offering. Our liquidity remains robust with approximately $196 million in cash and undrawn capital commitments as of the end of the quarter. We have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issuances as we think it is critical that we maintain a conservative mindset to BDC leverage given the uncertainty of the economy. As we've said many times, we manage our BDC with a full economic cycle mentality. This starts with the underwriting of our new opportunities, but it also applies to how we manage the BDC's capitalization. Managing leverage to the lower end of our target range positions us to invest throughout a potential recession when risk-adjusted returns can be particularly attractive. It also allows us to support our portfolio of companies, while also opportunistically repurchasing our stock if it were to trade meaningfully below NAV. Within this context, we are very pleased with the strength of our balance sheet as we reduced regulatory leverage to 0.91:1 from 1.11:1 in the prior quarter. We maintained our significant liquidity position, and we continue to operate with almost half of our balance sheet liabilities in fixed rate unsecured covenant-free bonds, the earliest of which mature in 2026. On Slide 7 and 8, we illustrate our continued track record of producing strong dividend growth, consistent dividend coverage and solid value creation since the launch of our credit strategy back in January of 2015. Since that time, we have increased our regular dividend paid to shareholders 25x and have never cut the regular dividend, including during the tumultuous environment we all experienced during the COVID pandemic. Additionally, over the same time period, we have paid or declared 19 special or supplemental dividends totaling $3.60 per share, generated from excess earnings and realized gains from our investment portfolio. We believe our track record of consistently growing our dividend, the solid performance of our portfolio as well as our company's sustained access to the capital markets has demonstrated the strength of our investment and capitalization management strategies as well as the absolute alignment of our decisions with the interest of our shareholders. Continuing to generate this strong track record, we believe, is critically important to building long-term shareholder value. Turning to Slide 9. Our investment strategy is laid out for our shareholders and its launch back in January 2015 hasn't changed. The vast majority of our activity has been in our core lower middle market where we are the first lien senior secured lender, most often backing a private equity firm's acquisition of a growing lower middle market company. We also often participate on a minority basis in the equity of the company -- in the equity of the company through an equity co-investment made alongside the private equity firm. In fact, 90% our portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio of companies as well as the potential for new junior capital support if needed. Our lower middle market strategy is complemented by core participations in larger companies led by like-minded lenders with whom we have relationships and have gained confidence in their post-closing loan management from working well together across multiple deals. Virtually all of these club deals are also backed by private equity firms. As of the end of the quarter, our equity co-investment portfolio consisted of 48 investments with a total fair value of $112.1 million, which was 60% over our cost, representing $41.8 million in embedded unrealized appreciation or $1.21 per share. Our equity portfolio, which represented approximately 10% of our total portfolio at fair value as of the end of the quarter, continues to provide our shareholders participation in attractive upside potential of these growing lower middle market businesses, which will come in the form of NAV per share and supplemental dividends over time. As illustrated on Slide 10, our on-balance sheet credit portfolio is a -- the quarter, excluding our I-45 senior loan fund, grew 10% to $990 million as compared to $903 million as of the end of the prior quarter. Over the past year, our credit portfolio has grown by $245 million or 33% from $745 million as of the end of December '21 quarter. For the current quarter, 99.7% of our new portfolio company debt originations were first lien senior secured debt. And as of the end of the quarter, 96% of our total credit portfolio was first lien senior secured. On Slide 11 and 12, we detail the $164 million of capital invested at and committed to portfolio companies during the quarter. Capital committed this quarter included $120.4 million in first lien senior secured debt and $1.6 million in equity co-investments to 5 new portfolio companies. Additionally, we committed $39.7 million in first lien senior secured debt and $1.9 million in equity co-investments to existing portfolio companies during the quarter. Turning to Slide 13. During the quarter, we had 1 debt prepayment and on equity sale. In total, these exits generated approximately $12.4 million in total proceeds, generating a weighted average IRR of 10.1%. Since the launch of our credit strategy 8 years ago, we have realized 67 portfolio exits, representing $775 million in proceeds that have generated a cumulative weighted average IRR of 14.6%. The market for acquisition capital continues to be active. Not surprisingly, given the widening spreads on new loans in the market, the slowdown in refinancing activity continues. So on a net basis, we expect solid net portfolio growth in the near term. We are pleased with the strong market position that our team has established in the lower middle market as a premier debt and equity capital provider, as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities. In terms of deal origination, we find that underwriting certain industries is more challenging given today's economic uncertainty. However, an important component of our underwriting has always been to run a stress case downside model for every new deal, simulating an extreme recession occurring soon after closing. In many respects, our underwriting in the card environment hasn't changed, although our models today include much higher base rates than we have experienced historically. Our fundamental analysis of test to tie to a leverage level we are willing to put on a company to the potential performance volatility in a particular business and industry throughout the economic cycle. Performance across different industries can be very different through the economic cycle. So getting this right is an important component of the underwriting process. Specifically, in a stress case financial model, we required a fundamental underwriting standard that we see our loans remain well within the portfolio of company's enterprise value and the portfolio of company's cash flow able to cover our loan interest throughout the cycle. On Slide 14, we detail some key stats for our on-balance sheet portfolio as of the end of the quarter, again, excluding our I-45 senior loan fund. As of the end of the quarter, the total portfolio at fair value was weighted approximately 87% to first lien senior secured debt, 3.2% to second lien senior secured debt, 0.1% to subordinated debt and 10.2% to equity co-investments. Credit portfolio had a weighted average yield of 12% and weighted average leverage through our security of 3.6x. The weighted average leverage this quarter was down from 4.1x in the prior quarter due in part to $67.3 million of funded debt originations to 5 new portfolio companies and a weighted average leverage through our security of 1.9x EBITDA. Turning to Slide 15, we have laid out the rating migration within our portfolio. As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4-point scale, with 1 being the highest rating and 4 being the lowest rate. We feel very good about the performance of our portfolio, with 95% of the portfolio at fair value rated in 1 of the top 2 categories, a 1 or 2. As illustrated on Slide 16, our total investment portfolio, including our I-45 senior loan fund continues to be well diversified across industries with an asset mix, which provides strong security for our shareholders' capital. The portfolio remains heavily weighted towards first lien senior secured debt, with only 3% of the total portfolio and second lien senior secured debt. I will now hand the call over to Michael to review some specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the December quarter, let's summarize on Slide 18, we increased pretax net investment income 25% quarter-over-quarter to $18.7 million compared to $15 million last quarter. Pretax NII was $0.60 per share for the quarter. During the quarter, we paid out a $0.52 per share regular dividend and a $0.05 per share supplemental dividend. As mentioned earlier, our board has approved an increase to the regular dividend for the March quarter to $0.53 per share and declared another $0.05 per share supplemental dividend for the quarter, maintaining consistent track record, meaningfully covering our dividend with pretax NII, is important to our investment strategy. We continue our strong track record of regular dividend coverage with 108% for the last 12 months ended December 31, 2022, and 107% cumulative since the launch of our credit strategy in January 2015. Given the floating rate nature of our credit portfolio, elevated interest rates continue to be a significant tailwind to our net investment income. The base rate index used to calculate interest on a majority of our loans reset in early January to 4.75%, up from its early October reset at 3.75%. This significant increase quarter-over-quarter will provide another immediate step-up in portfolio income in the March quarter. With that as context, we will continue to execute our policy of having regular dividends followed the trajectory of recurring pretax NII per share. As such, we expect to thoughtfully increase our regular dividend to a level which can be sustained should base rates return to a neutral level. In addition, while base rates remain elevated, our intent is to distribute a portion of excess pretax NII to our shareholders each quarter through supplemental dividends. Based upon our current UTI balance of $0.34 per share the ability to grow UTI each quarter organically by over earning our dividend and harvesting gains from our existing $1.21 per share in unrealized depreciation on the equity portfolio we are confident in our ability to continue to distribute quarterly supplemental dividend for the foreseeable future. For the quarter, we increased total investment income from our portfolio of 22% quarter-over-quarter to $32.8 million, producing a weighted average yield on all investments of 11.7%. Total investment income was $6 million higher this quarter due to a higher average balance of credit investments outstanding, in addition to the tailwind provided from increases in LIBOR and silver base rates. As of the end of the quarter, we had approximately $4 million of our investments on nonaccrual and representing 0.3% of our investment portfolio at fair value. Finally, the weighted average yield on our loan portfolio was 12% for the quarter. As seen on Slide 19, we further improved LTM operating leverage to 1.9% as of the end of the quarter. Achieving 2% or lower operating leverage was one of our initial long-term goals when we relaunched Capital Southwest as a middle market lender back in 2015. Though we are pleased to have reached this milestone. Looking ahead, we expect our internally managed structure to produce additional improvements in operating leverage. Turning to Slide 20. The company's NAV per share at the end of the December quarter decreased by $0.28 per share to $16.25, representing a decrease of 1.4% before giving effect to the supplemental dividend paid for the quarter. The primary drivers of the NAV per share decrease for the quarter included $8.5 million of net unrealized depreciation on the on-balance sheet debt portfolio $1.2 million, unrealized depreciation on the equity portfolio and $3.3 million of unrealized depreciation on the I-45 portfolio, the vast majority of which was mark-to-market quote activity in the syndicated market. We also generated a total of $0.17 per share of accretion from the issuance of common stock at a premium to NAV per share. Turning to Slide 21. As Bowen mentioned earlier, we are pleased to report that our balance sheet liquidity remains strong with approximately $196 million in cash and undrawn leverage commitments on our revolving credit facility as of the end of the quarter. Based on our credit facility borrowing base as of the end of the quarter, we have full access to the incremental revolver capacity and look to opportunistically increase commitments to the facility in the future. Our bank syndicate continues to support our growth, and we're pleased with the flexibility in the revolving credit facility provides to our capital structure. In addition, we have $26 million in committed, but unfunded SBA debentures to be used to fund future SBIC-eligible investments. As of December 31, 2022, approximately 47% of our capital structure liabilities were unsecured and our earliest debt maturity is in January 2026. Our regulatory leverage, as seen on Slide 21, ended the quarter at a debt-to-equity ratio of 0.91:1 down significantly from 1.23:1 as of December 2021 quarter. Over the past couple of years, we've made a concerted effort to strengthen our balance sheet to ensure we are prepared for any macroeconomic headwind and that we may encounter. These efforts have included our opportunistic unsecured bond issuances at record low rates in the late calendar 2021, our continued support from banking relationships, which have followed -- which have allowed for steady growth in our revolving facility commitments and our continued diligence in moderating leverage through accretive equity issuance utilizing both our ATM program as well as the secondary equity market. We'll continue to work towards strengthening the balance sheet, ensuring adequate liquidity and maintaining conservative leverage in covenant cushions throughout the economic cycle. I will now hand the call back to Bowen for some final comments.

Thanks, Michael. And again, thank you, everyone, for joining us today. We appreciate the opportunity to provide you an update on our business, our portfolio and the market environment. Our company and portfolio continue to perform well, and I continue to be impressed by the job our team has done in building a robust asset base, deal origination capability as well as a flexible capital structure. As to the uncertainty in the economy, again, we have been underwriting with a full economic cycle mentality since day 1, which we believe has positioned us well for the potential economic volatility in the coming months and years. In summary, we have a floating rate credit portfolio heavily weighted to first lien senior secured debt allocated across a broader array of companies and industries, 90% of which is backed by private equity firms. We have a well-capitalized balance sheet with diverse capital sources, strong liquidity and flexible capital, much of which is fixed rate and covenant light. We believe our first lien senior secured investment focus and our capitalization strategy provide us complete confidence in help and positioning of our company and our portfolio as we look ahead. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

[Operator Instructions] And our first question comes from the line of Mickey Schleien with Ladenburg.

Yes. Good morning, everyone. Bowen, in the fourth quarter, we continue to see spreads in the middle market widen a little bit more, which is obviously helpful for your company's financial performance. So I'd like to ask you, what's your outlook on how private lenders will behave going forward this year in terms of spread when we think about the fact that LIBOR and so forth have already climbed a lot and that stresses borrowers. And what types of floors are you getting nowadays?

Yes. Thanks, Mickey. I'll answer them in reverse order. So we're pretty regularly getting 2% floors on the loans. And as far as what the market will do, spreads clearly have widened, we addressed that in our prepared remarks and leverage levels have come down that we're seeing, which is attractive. That's a nice time to be a first lien lender. As far as what the market does in spread going forward, it's an interesting question. I mean in past cycles, candidly, the lending market can tend to basically enjoy the increased index and bring in spreads by a small amount, 25 basis points or so, 50 basis points. I don't know what they'll do that this time. or not, it seems to be that there's a lot of liquidity in the private equity market and the pipeline seems to be solid. So I want to see -- I don't know, I mean, in past cycles, there has been trade-offs between spread and index, but it's hard to tell. We don't see that right now, for sure.

Appreciate that. And Bowen, the portfolio's average debt-to-EBITDA declined quite a bit this quarter. I think you mentioned that some of that was due to new investments at lower multiples. But -- we've also seen data that somewhat surprisingly middle market company EBITDA growth on average rebounded pretty nicely in the fourth quarter. So could you give us a sense of how your portfolio's companies are performing in terms of their revenues and margins?

Yes. We had kind of 2 factors that brought that ratio down. One is what I referenced. The other 1 is we had a couple of names that had very low EBITDA so very high leverage ratios, and that EBITDA went from slightly positive to slightly negative. So that really a significant move from a credit picture perspective, but a very high multiple of a positive EBITDA. EBITDA goes to slightly negative, and there's not really a way to calculate that on the average. So we -- basically, we had a couple of very high-level or high leverage names move out of the average that brought the average down. But organically, if you look at the -- without that, leverage went from 4.1x down to 3.9x to give you an idea. So across the portfolio. I would say our weighted average EBITDA across the portfolio revenue was up and EBITDA was basically flat. So weighted average basis, we had some nice winters and some flat. But basically, it was EBITDA was basically flat for the quarter.

I mean revenue we saw, Mickey, we're still increasing, but at a slower clip than in previous quarters. And we think maybe potentially we're peaking on inflationary impacts in terms of cost -- that remains to be seen, but that kind of resulted in still being high and us having flat EBITDA-ish, but even though revenue was up.

Okay. I understand. And that's a nice segue into my next question. you have several investments in the consumer sector, at least if we look at the SOI, the word consumer shows up. And we're seeing data that the consumer is really starting to retrench now. So could you give us some insight into how your -- specifically your consumer-related investments are performing and what you think their outlook is this year?

Yes. I mean across our consumer, I'm just thinking about the names. We have had a couple of cases where revenue has kind of slowed -- in 1 case, you saw retailers resetting inventory levels to an anticipated throughput and so basically, kind of in the short term, if you're selling into the retailers, your revenue go down, but if you kind of look at the sell-through, you get comfortable the revenue is not going to stay down and not really be down all that much yet. The first lien lender, I'm not sure it gives you credit worries, but as far as economic signposts for the U.S. economy or the U.S. consumer? Yes, I mean I would put that in the category of what you're saying about the U.S. consumer, but not really in those cases, most of them we don't have equity investments in. But those -- in those cases, not a lot of not credit concern, but definitely mixed signals.

Okay. I appreciate and understand. One last question, if I can. With this quarter's deleveraging of the balance sheet, I'd like to ask whether you've adjusted your leverage targets? And if not, where do they stand both on a total and regulatory basis?

So historically, I think we've said we expected once the FDA got ramped that our regulatory leverage would be somewhere in the 0.9 to 1.1 range. And that's -- obviously, we sit right now at the very bottom of that range. I think our perspective is going into a potential cycle, we would like to delever and you'd expect the expectations that if there are concerns and you'll see us lever back up to some degree based upon depreciation. So we got ahead of the curve from that perspective. But from a go-forward basis, you'd expect to see us continue to stay within that 0.9 to 1.1 range. On an economic basis, we're at 1.1, which is also within the 1.1% to 1.3% range we've discussed. And we think we'll follow suit will vacillate inside that range.

Yes. I mean, obviously, as I tried to address in the prepared remarks, I mean, it's through a cycle, you kind of want to be at the lower end of your range going into a recession. And if we don't have a recession for some natural reason, then that's great. We're fine. But -- if we do, you want to maintain the ability to invest throughout the recession because risk-adjusted returns, especially in the second half of the recession, can become really interesting based on past cycles, and then, obviously, we mentioned stock buybacks as well. So we want to be able to manage as we've always had a full cycle mentality. We want to be able to position the ship, if you will, to really perform and do well for the shareholders throughout the cycle.

And our next question comes from the line of Kevin Fultz with JMP Securities. .

My first question is on credit. I'm just curious if you've seen an increase in amendment request and if you can discuss your expectations for that to potentially pick up in the near term?

Yes. We had 2 for the quarter. I would say it's increased slightly, but not really a lot. I mean it's not 0, but it's kind of they've been request candidly, when a first lien lender gets to request for an amendment we get a fee. So it's a nice dynamic of a first lien lender book. So it's part of our business to have those amendments, but I wouldn't say there has definitely not been a flood of increase of amendment, but there's been some increase.

Okay. That's helpful. And then just in regards to portfolio positioning, are there any pockets of industries that you find particularly attractive in the current environment? And if you can, maybe parsing out lower middle market and upper middle market opportunities?

Yes. I mean the vast majority that we've been doing is in the lower middle market, I would say business is, first and foremost, that we can underwrite a full cycle. We've been looking at certain situations at high asset coverage. Basically, the industries that have like higher free cash flow margins, recurring revenue subscription-type businesses that have shown to be low churn in past cycles. I mean those are the kind of sectors that certainly we lot can help to in this market.

And our next question comes from the line of Bryce Rowe with B. Riley.

Thanks a bunch. I wanted to maybe start on the dividend, great to see another quarter of increase here -- and based on your comments, it sounds like you're approaching these regular dividend increases pretty methodically. You noted in the prepared remarks some inclination to be careful about where the -- where the dividend or where earnings could be when rates get back to kind of a neutral level. So any thoughts on what that neutral level might look like and how it kind of translates into kind of a neutral NII type of generation level?

Yes, Bryce, so looking specifically at this quarter, for example, we posted at $0.60. If rates were neutral, I'd say neutral was 3% the run rate on the portfolio would look more like $0.56 per share. So when you look at that relative to the dividend that we paid this quarter of $0.52, still $0.04 of cushion. As we move forward and we grow the portfolio, and you see -- we mentioned earlier, operating leverage, we expect operating leverage to continue to decline. That $0.56 bogey will grow. And that's why well, as you stated, we're going to methodically grow that dividend, but we do feel between now and high 50s, there's safety on the regular dividend.

Got it. That's helpful, Michael. You mentioned the -- kind of the majority of your loans kind of resetting in January maybe a 100 basis points higher based on what we've seen in base rates. Is your expectation that we'll see, give or take, 100 basis points of weighted average yield expansion in the portfolio as we kind of get into April or into May when you report earnings next?

Yes. We would expect that on the revenue side. I would just say that the 1 overhang you'll also see is obviously, we raised a lot of capital in the prior quarter and much of that was late stage. So there will be some level of dilution that will offset that increase on the top line revenue. So we will expect to see grow meaningfully next quarter, but there will be a little bit of an overhang.

Okay. That's helpful. Maybe question around quarterly marks. You obviously highlighted the more kind of broader credit market-driven marks on the I-45 portfolio -- in terms of the $1.2 million of unrealized depreciation on the equity book, can you kind of talk or walk through kind of some of the puts and takes within that? And I would assume you're seeing some with appreciation versus some with some depreciation?

Yes. I mean if I look down to equity marks, we had 1 -- 2 companies that were downgraded that were the majority of the decrease. And so really taking those out, I mean, looking down, there's several very large winners, and then a bunch of like kind of slight positives and a bunch of flats and a few kind of downs. And so I think the equity portfolio, we had those 2 kind of underperformed other than that the portfolio was kind of net up. So -- did that answer your question?

That's helpful. Appreciate that. And then maybe last 1 for me. From a pacing perspective, just kind of curious kind of how the pipeline is shaping up, it looks like, it sounds like repayment activity is going to continue to be muted. So just thoughts on how to think about pacing within our models would be great.

Go ahead, so originate, we did a pretty robust pipeline this quarter, probably not to the same extent as last quarter for sure. But numerically, we would expect to be somewhere in the $90 million to $110 million of new originations this quarter. And we are only seeing -- we're saying like the pace of repayments have certainly slowed, I think our expectation is about $15 million this quarter and maybe going forward. So it's essentially maybe one credit a quarter that it might come back. So net portfolio growth is going to be somewhere in the, I think, $75 million to $100 million for the next few quarters.

I think that's right. And we have definitely that kind of repayment activity. We do have some visibility on some sales processes that are going on that based on the company's health, you would expect the companies to in fact sell. So we'll see some repayment activity, but it won't be a refinancing, everybody will be someone acquiring that company and resulting in us getting refinanced out. So our recent won't be 0, but they definitely like Michael, so it to be lower. And I agree with that general comment on the pipeline.

our next question comes from the line of Erik

First question, within the prepared comments, you mentioned that underwriting certain industries is more challenging today. And I'm curious how you approach that. Does that mean there are certain industries that you are not willing to underwrite in today? Or does it just mean you need to adapt and maybe change your underwriting standards and structures for those particular industries? And maybe if you could what those industries are as well?

Yes, I would say generally, business -- I would say what I'm trying to communicate is that really the way we look at the world hasn't changed. And so there's underwriting certain industries has always been tricky industries where there's higher fixed cost, lower margins. And then when you look at an economic backdrop or economic effect on the customers maybe the customers are making a capital investment decision, which results in your revenue at your portfolio company. Capital has become more expensive CEOs across -- you hear on news or whatever, CEOs are being more judicious or careful about capital investment decisions they're making. And if you have a portfolio company that's got whose customers are making capital investment decisions that would drive revenue, that would be an industry that we would shy away from as an example. And then you throw on top of that industry, if you look at the margins on a portfolio of company, the split between fixed cost and variable cost is a really, really important metric to look at. The industry is going have more manufacturing, for example, that has -- obviously, if you have a manufacturing plant, you naturally have higher fixed cost, right? So -- and so those are tight industries that Candidly, we shy away from, but also were the ones that are kind of tricky to underwrite. So -- but at the same time, what I'm trying to communicate is really the way we look at the world hasn't changed. We've been saying that since day 1 that we look at an extreme recession right after our loans made and trying to spell out for everyone kind of what that means in a financial model. And so we were -- we've been thinking about the possibility of a recession for the last 8 years because there's always -- you could have always along the way, maybe argument that were pretty long in the tube on this expansion. And in each year didn't come, now we're facing it potentially, but certainly a very advertised recession for good reason. And so in 1 sense, our underwriting hasn't changed at all, except for higher base rates going into that model.

Yes. The other thing I'd add as well is I think everybody probably have to deal with this is the COVID hangover. So looking at financials and seeing how far is that -- the bounce back from '21 and '22 related to coming off the bottom of 2020 with COVID as well as now if you look at health care, sometimes you're seeing flair ups and COVID various places in the country. And so sometimes it's difficult to underwrite what the run rate was before and whether the run rate is current as well today.

COVID is an interesting example. So looking at rather than EBITDA as a portfolio company, post-COVID, some industries have kind of pent-up demand, as we all know. So the bounce back can be pretty extreme. And so it makes looking at kind of 2018 and '19 performance and getting a sense as to what the pre-COVID level of performance was for a particular company. So that's a little bit different than we were doing 4 years ago, for example.

That's great color. I really appreciate that. And then my other question was just in your conversations with the PE sponsors that you work with. I'm curious if you've noticed any change and sentiment, certainly the industry data, I look at indicates there's still a lot of dry powder there for them. Are they sensing potential recession and maybe keeping some dry powder on hand in the event that they'd have to commit extra equity to initial investments? Or are they still out there looking for -- I'm sorry, to existing investments? Or are they still out there looking for new opportunities to the same level that they were 12, 18, 24 months ago?

So yes, there's liquidity out there in the private equity market. And yes, they're out looking for acquisitions. And hopefully, in the next 12 months, there's a bunch of sponsors. I think they'll have a nice opportunity to add some very accretive acquisitions. So that's definitely the case. I would also say that private equity firms, they're smart, right? And they're actively managing these companies, their spreads are widening on their rent spreads, the index and so their cost of their debt is going up, and they're thinking about a recession like all of us on the call are, right? All of people listening to this call are thinking about that, right? And so what are the private equity firms are doing? I mean, their cost of debt is going up and they're thinking about recession. So they're leaning in and really actively looking at cost structures -- and candidly, I think that's probably -- that's really imposing really good discipline on these companies. And so I think that's going to benefit the companies in the long run. The increased index or the cost of debt going up and poses discipline on the cost structure of a business. That's 1 thing. And then as I think about recessions and all that, they're imposing discipline also on the cost structures as well. And so we'll see. I mean, we'll see where that results in the layoffs or what have you. But I do think the dynamic -- to answer your question, private equity firms are kind of doing and signaling. Yes, liquidity, yes, acquisitions, but also unenhanced discipline on looking at their cost structures, which I think is helping. And we've also seen the company that have come to us with amendments or waivers or companies that might be having a little bit of trouble. They been willing and able to fund into these companies. Those negotiations have gone well. There's no signs that they're taking -- there's a dooming recession coming and that they're kind of taking the keys to us. They've been pretty productive in conversations across the board.

Yes. That's a good point and very transparent on what they want to do with the business as well.

And our next question comes from the line of Robert Dodd with Raymond James.

Congratulations on the quarter. Kind of a follow-up, but the leverage question on a very beginning of your opening remark, you talked about leverage being a full turn lower in some cases on new originations, and that's driving that is portfolio leverage down a little, but can you give us any color on what's the driver? Is it the sponsors with lower asks? Or is it lenders kind of holding the line? Because obviously, if leverage is a turn lower, even with rates up 20 basis points, you might be underwriting the interest coverage where it was a year ago, i.e. it's very different with that leverage and the rate dynamic that both work together. So -- but is it really the sponsors that are asking less to your point, being disciplined? Or is it the lenders holding the line?

Yes. So that's a good -- an interesting question. So it's kind of both of those things. So from a sponsor perspective, I mean, as indexes widening, if you're buying a company, the cash cost of that debt has gone up, right, dollar for dollar. And so naturally, the way you solve for that is if you want to start amount of free cash flow to support the business and grow the business, you bring leverage down. That's why my comment on loan to value, not really -- loan to value also coming down, it's interesting because that would suggest certainly in the universe we're looking at the multiple for good, strong companies hasn't really come down much yet. It's kind of a nice wave nice time to be a first lien lender because we're effectively capturing a larger piece of the cash flow. And so -- and then on top of that, I think lender, we've been able to be more conservative on our proposals and candidly win some deals. And so I would interpret that as the lending market being may be more cautious, also some dynamics. I mean many lenders are backed by insurance companies and they're investing capital and it's their access their appetite for illiquid credit versus some of the more liquid credit and as they're investing in their books. And so they kind of come and go. So there's a dynamic of that in the market as well. So it's kind of over all of those things. rather, we've been -- we're working with sponsors now that -- in conversations with for the last 3 to 6 years, we probably haven't found a way to be useful to them. And right now with sort of less lenders playing in the market, we are able to be helpful to them, and we think long term, this is going to enhance our originations platform.

I really appreciate the color. Kind of are you seeing in the pipeline early stage or whatever? Are you seeing any changes in quality of companies. Obviously, that can be in customer environment, obviously, the average quality tends to go up and vice versa and things like that. So are you seeing a mix shift on who's coming to market versus where it was, say, a year ago?

Yes, I would definitely say there is some aspect of that. It's true because really companies that are in the market right now for sale are ones that are candidly not super cyclical, right, because they would be able to raise the financing to do the deal, et cetera. So in many respects, higher-quality companies, higher margins all the aspects of the company that make it higher quality credit. I think it's definitely the case because anything that's even more lovely offset of the fairway, it would be very hard to sell the convert. So I think we do that. I would definitely agree with that CnF factor.

And just if I can, this is maybe an unfair question. In your experience over the -- where is your impression of where do you think that given all these dynamics? Where do you think the 2023 vintage in terms of quality could shake out as a lag against previous originations and produce.

Yes. I mean I think '23, if it plays out of any kind of recession, that I think the '23 vintage could end up being an outstanding vintage. I mean that -- and that would be consistent with past cycles, right? And so especially in kind of the theoretical second half of a recession, right, where kind of the laundry has been -- the dirty laundry has been aired and sponsors have liquidity that can negotiate relatively interesting valuations from a cycle perspective, sellers are a little bit more flexible in structure or what have you, and really end up structuring deals at valuation multiples and leverage multiples because you're at a trough in the -- so from a cycle perspective. So all people EBITDA goes up, which drives value, delevers. And so all those factors go in and make a recession year when you look back at past cycles, in my experience to end up being very attractive institutions. And the only downside of that is these assets may spend to be less sticky, right? We've had to negotiate cost protection and extremely important on these companies where the leverage is so well in the LTV as well. So we'd expect if things -- if this recession is mild and/or if it passes, 2024 could be a high refinancing year. And that's consistent with past cycles, too. I mean that's a term that is that we're pretty aggressive on holding the line on, but that's a pushback term from sponsors, they want some relief or some lower prepayment penalties and that kind of thing. So -- it's a term that's heavily negotiated deals right now. And that will be the case through the recession. And then clearly, coming out of a recession to Michael's point, is to best leverage comes down, things normalize and then you want to kind of normalize the capital structure. So that ends up being less sticky debt investments to really interesting on the equity piece.

Thank you. And I would like to turn the conference back to Bowen for any closing remarks.

Well, thank you, everyone, for joining us, and we always appreciate giving you update on the company. and thanks for all the questions, and we look forward to talking to you next quarter.