Saratoga Investment Corp (SAR) Q3 2023 Earnings Call Transcript

Saratoga Investment Corp (NYSE:SAR) Q3 2023 Earnings Call dated Jan. 11, 2023.

Corporate Participants:

Henri Steenkamp — Chief Financial Officer, Chief Compliance Officer, Treasurer & Secretary

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Michael Grisius — Chief Investment Officer

Analysts:

Bryce Rowe — B. Riley — Analyst

Casey Alexander — Compass Point Research & Trading — Analyst

Robert Dodd — Raymond James — Analyst

Erik Zwick — Hovde Group — Analyst

Presentation:

Operator

Good morning, ladies and gentlemen, thank you for standing by. Welcome to Saratoga Investment Corp.’s Fiscal Third Quarter 2023 Financial Results Conference Call. Please note that today’s call is being recorded. During today’s presentation, all parties will be in a listen-only mode. Following management’s prepared remarks, we will open the line for questions. At this time, I would like to turn the call over to Saratoga Investment Corp.’s Chief Financial and Compliance Officer, Mr. Henri Steenkamp. Sir, please go ahead.

Henri Steenkamp — Chief Financial Officer, Chief Compliance Officer, Treasurer & Secretary

Thank you. I would like to welcome everyone to Saratoga Investment Corp.’s fiscal third quarter 2023 earnings conference call.

Today’s conference call includes forward-looking statements and projections. We ask you to refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required to do so by law. Today, we will be referencing a presentation during our call. You can find our fiscal third quarter 2023 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. 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.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Thank you, Henri, and welcome everyone. Saratoga’s 33% sequential quarterly increase in adjusted net investment income per share substantially outpaced its recent record 26% dividend increase, as rising interest rates positively impact the company’s largely floating rate assets and drive increasing spread margin due to Saratoga’s largely fixed rate liabilities. Saratoga’s credit structure with interest-only covenant-free long-duration debt incorporating maturities two to 10 years out, positions us well for rising and “higher for longer” interest-rate environment. Importantly, overall portfolio quality continues to remain high as demonstrated by NAV per share remaining essentially flat over the prior quarter.

In this challenging capital markets environment, access to capital for growth is critical and we successfully recently raised more than $100 million in two baby bond offerings, maintaining our triple B-plus investment-grade rating and received an important third SBIC license. In addition to providing liquidity for continued growth, these debt offerings further improve Saratoga’s credit structure by extending its maturities five to 10 years out.

Our existing portfolio companies are generally performing well with our overall fair value close to cost and our current business development pipeline strong. Our AUM continue to grow this quarter to $982 million as we originated $88 million of new follow-on investments offset by $57 million of repayments. We continue to be highly discerning in terms of new commitments in the current environment. Our pipeline remains robust with many actionable opportunities and we executed 18 follow-on investments exclusively in existing portfolio companies with strong business models and balance sheets which are well known to us.

Our NAV per share this quarter was essentially flat with a 0.1% decrease from Q2 to $28.25, with headwinds from our CLO exposure in the broadly syndicated loan market almost completely offset by the positive financial performance of our core BDC portfolio and the over-earning of our Q2 dividend. This quarter’s approval for our third SBIC license allows us to continue to expand upon our existing investments in support of the SBA’s mission to provide growth capital to small businesses, which are so important to our economy. Our SBA guaranteed debentures are great benefit to our capital structure, further enabling us to provide innovative and cost-effective solutions to the many smaller and middle-market companies we finance.

From an earnings perspective, we are reaping benefits from interest rate increases with 98% of our interest-earning portfolio at floating rates, and 96% of our borrowings at fixed rates. Our adjusted net investment income yield of 10.8% reflects a robust 32% increase over the prior quarter’s 8.2%, consistent with LIBOR and social trends. The average LIBOR base rate utilized for our portfolio for interest rate receipts and accruals during the quarter was 3.59%. Quarter-end LIBOR was 33% higher and 4.78%, implying that the entire impact of the current rising rate environment is not yet fully reflected in our reported earnings.

To briefly recap the past quarter on Slide two. First, we continue to strengthen our financial foundation in Q3, by maintaining a high-level of investment credit quality with 96% of our loan investments retaining our highest credit rating at quarter-end and still only one investment on non-accrual, generating a return on equity of 4% on a trailing 12 month basis versus the industry average of 3.1%, recognizing $3.2 million net unrealized appreciation primarily reflecting broadly syndicated loan market volatility in the CLO and JV, offset by the core BDC portfolio appreciating by $2.6 million, and registering a gross unlevered IRR of 11.2% on our total unrealized portfolio and a gross unlevered IRR of 16.4% on total realizations of $879 million.

Second, our assets under management increased to $982 million this quarter, a 3% increase from $955 million as of last quarter, a 20% increase from $818 million since year-end and a 48% increase from $662 million as at the same time last year. Our new originations were exclusively in 18 follow-on investments in our existing portfolio companies and our current pipeline remains robust.

Third, in volatile economic conditions such as we are currently experiencing, balance sheet strength, liquidity and NAV preservation remain paramount for us. Our capital structure at quarter-end was strong, $336 million of mark-to-market equity supporting $459 million of long-term covenant-free non-SBIC debt, $243 million of long-term covenant-free SBIC debentures and $25 million of long-term revolving borrowings. Our total committed undrawn lending commitments outstanding to existing portfolio companies are $19 million.

Our debt maturity schedule ranges from two to 10 years out, providing a solid credit structure at fixed cost, positioning us well in a rising rate environment. Further expanding our liquidity base, we issued $46 million of new baby bonds in October, followed by another $60 million of new baby bonds in December subsequent to quarter-end, both including the fully executed green shoes signaling maximum issuance demand, five year maturities callable after two years and trading under the tickers SAJ and SAY respectively.

Our quarter-end regulatory leverage of 173% has significant cushion over our 150% requirement. And prior to the $60 million new baby bond issued after quarter-end, we had a $179 million of investment capacity available to support our portfolio companies with $107 million available through our newly approved SBIC III Fund and $47 million in cash.

Finally, based on our overall performance and liquidity, the Board of Directors declared a quarterly dividend of $0.68 per share for the quarter ended November 30, 2022, an increase of a record $0.14 or 26% from last quarter and our largest quarterly dividend ever, which was paid on January 4, 2023.

Saratoga Investment’s third quarter demonstrated solid performance within our key performance indicators as compared to the quarters ended November 30, 2021, and August 31, 2022.

Our NII is $9.1 million this quarter, up 50% from last year and up 31% from last quarter. Our adjusted NII per share is $0.77 this quarter, up 45% from $0.53 last year and up 33% from $0.58 last quarter. Latest 12 months return on equity is 4%, down from 14.6% last year and 4.8% last quarter, and our NAV per share is $28.25, down 3.2% from $29.17 last year and down 0.1% from $28.27 last quarter. Henri will provide more detail later.

As you can see on Slide three, our assets under management have steadily and consistently risen since we took over the BDC 12 years ago and the quality of our credits remains high with only one credit currently on non-accrual, the same as last quarter. Our management team is 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 volatile and 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.

Henri Steenkamp — Chief Financial Officer, Chief Compliance Officer, Treasurer & Secretary

Thank you, Chris. Slide four highlights our key performance metrics for the fiscal third quarter ended November 30, 2022. When adjusting for the incentive fee accrual related to net capital gains, adjusted NII of $9.1 million was up 31.1% from last quarter and up 49.8% from last year’s Q3. Adjusted NII per share was $0.77, up $0.19 from $0.58 per share last quarter and up $0.24 from $0.53 per share last year. Across the three quarters, weighted average common shares outstanding were 11.9 million for this year’s Q3, 12.0 million for last quarter and 11.5 million for last year’s Q3. There was zero accretion or dilution due to share repurchases and DRIP plans this quarter.

Adjusted NII increased significantly as compared with last year with a 59.1% increase in investment income resulting primarily from a 48.4% increase in AUM and the increase in the current coupon on non-CLO BDC investments from 9.9% to 11.7%, partially offset by increased base management fees and interest expense resulting from the various new Notes Payable and SBA debentures issued during the past year and quarter. The full benefit of higher rates on AUM is not yet fully reflected in interest income. Sequential quarter changes reflect the same factors as year-over-year. However, the increase in current coupon is greater being from 8.8% to 11.7%.

Adjusted NII yield was 10.8%, this yield is up from 8.2% last quarter and 7.3% last year. For the third quarter, we experienced a net loss on investments of $3.9 million or $0.32 per weighted average share, resulting in a total increase in net assets from operations of $6.0 million or $0.51 per share. The $3.9 million net loss on investments was comprised of $0.7 million in net realized loss on investments, $3.2 million in net unrealized depreciation on investments, and $0.4 million of deferred tax expense on unrealized depreciation on equity investments held in our tax blockers. This was offset by $0.5 million income tax benefit from realized gains on investments. The $0.7 million net realized loss on investments represents a $1.1 million realized loss on the sale of the company’s Targus Holdings investment which is a legacy investment that was originated prior to Saratoga taking on the management of this company, offset by $0.4 million realized gain on the sale of the company’s Ohio Medical equity investment.

The $3.2 million net unrealized depreciation primarily reflects, one, the $5.8 million unrealized depreciation on the company’s CLO and JV equity investments, reflecting the volatility in the broadly syndicated loan market as of quarter-end, and two, the $2.6 million unrealized depreciation on the company’s Pepper Palace investments primarily reflecting company performance. These decreases were then offset by, one, a $1.5 million unrealized appreciation on the company’s Vector Controls investment, two, approximately $1.0 million unrealized appreciation on both the company’s Modern Campus and Hematerra investments, and three, approximately $1.8 million net unrealized appreciation across the remainder of the portfolio. All of the above appreciations primarily reflecting company performance.

Return on equity remains an important performance indicator for us, which includes both realized and unrealized gains. Our return on equity was 4.0% for the last 12 months, beating the industry average of 3.1% despite the depreciations from our CLO and JV broadly syndicated loan investments discussed previously. Total expenses for Q3 excluding interest and debt financing expenses, base management fees and incentive fees and income and excise taxes was $2.1 million as compared to $1.2 million for last year and $1.6 million for last quarter. This represented 0.8% of average total assets on an annualized basis, up from 0.6% last year and unchanged from last quarter.

Also, we have again added the KPI slides 27 through 30 in the appendix at the end of the presentation that shows our income statement and balance sheet metrics for the past nine quarters and the upward trends we have maintained. Of particular note remains slide 30, highlighting how our net interest margin run rate has continued to increase and is more than quadrupled since Saratoga took over management of the BDC and also increased by 20% the last 12 months, while still not yet receiving the full period benefit of putting to work the significant amount of Q3 cash nor the full impact of the currently rising rate environment.

Moving on to Slide five, NAV was $335.8 million as of this quarter-end, a $1.4 million decrease from last quarter and a $6.8 million decrease from the same quarter last year. In Q3, main drivers were $3.9 million of net realized losses and unrealized depreciation and $6.4 million of dividends declared that were partially offset by $9.9 million of net investment income. In addition, during Q3, $1.2 million of stock dividend distributions were made through the company’s DRIP plan offset by $2.2 million of shares repurchased at an average price of $23.17. NAV per share was $28.25 as of quarter-end, down from $29.17, 12 months ago and $28.27 last quarter. This chart also includes our historical NAV per share, which highlights our NAV per share has increased 15 of the past 19 quarters. Over the long-term, our net asset value has steadily increased since 2011 and this growth has been accretive as demonstrated by the consistent increase in NAV per share. We continue to benefit from our history of consistent realized and unrealized gains.

On Slide six, 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 to $0.77 per share, a $0.24 increase in non-CLO net interest income from the partial impact of higher AUM and higher rates and $0.01 increase in other income was offset by a $0.01 decrease in CLO net interest income, a $0.01 increase in base management fees and a $0.04 increase in operating expenses.

Moving on to the lower half of the slide, this reconciles the $0.02 NAV per share decrease for the quarter. $0.83 of GAAP NII and $0.02 net accretion from share repurchases and DRIP was offset by $0.33 of net realized losses and unrealized depreciation and the $0.54 dividend paid in Q3.

Slide seven outlines the dry powder available to us as of quarter-end, which totaled $179.3 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 18% without the need for external financing with $47 million of pro-forma quarter-end cash available and that’s fully accretive to NII when deployed, and $107 million of available SBA debentures with its low-cost pricing also very accretive. The $107 million is available as a result of the receipt of our third SBIC license approved this quarter.

In December, we also issued a new 8.125% 2027 baby bonds, generating net proceeds of $58.1 million, which is in addition to the above available liquidity. This new baby bond is trading under the ticker SAY. We remain pleased with our available liquidity and leverage position, including our access to diverse sources of both public and private liquidity and especially taking into account the overall conservative nature of our balance sheet, the fact that almost all our debt is long-term in nature with no non-SBIC debt maturing within the next 2.5 years and importantly that almost all our debt is fixed-rate in this rising rate environment. We will talk more about this later.

Also, our debt is structured in such a way that we have no BDC covenants that can be stressed and with available call options in the next two years on the debt with higher coupons, which is very important during such volatile times.

Now. I would like to move on to Slides eight through 12 and review the composition and yield of our investment portfolio. Slide eight highlights we now have $982 million of AUM at fair value or $986 millio at cost invested in 50 portfolio companies, one CLO fund and one joint venture. Our first-lien percentage is 82% of our total investments, of which 25% is in first-lien last-out positions.

On Slide nine, you can see how the yield on our core BDC assets, excluding our CLO has changed over-time, especially the past quarter. After an extended period of low rates and tightening spreads, we are seeing both these trends reverse. We have already seen some benefit in Q3 with our core BDC portfolio yield increasing from 9.9% last quarter and 8.8% last year to 11.7% this quarter and total yield increasing from 9.0% last quarter to 10.4% in Q3, but the full impact of the rising rate environment through today is still not yet reflected in our earnings. In addition, we have started seeing spreads widening as well, with 98% of our interest-earning portfolio being variable-rate, all of our investments being above their floors and rates continuing to rise significantly, we expect to benefit going-forward from the earnings impact of rising rates to our NII, as you can see on the next slide.

The CLO yield decreased from 8.9% to 7.4% quarter-on-quarter reflecting current market performance. The CLO is performing and current.

Slide 10 shows how at the end of Q3 the average three-month LIBOR used in our portfolio was 359 basis-points versus at quarter-end when three-month LIBOR closed at 478 basis-points and versus today at approximately 475. With 98% of our interest-earning assets using variable rates, earnings will benefit from this additional increase in Q4 and Q1 next year, while all but $25 million of our debt is fixed-rate and will not be impacted by these increases in base rates. The increases in SOFR base rates are similar and all indications are that rates could be rising further than this. As a result, we stand to continue to gain significantly as rates rise. That said, there will be a lag in the effect this dynamic has on our earnings due to timing of rate resets and invoicing terms.

Slide 11 shows how our investments are diversified throughout the U.S. And on slide 12, you can see the industry breadth and diversity that our portfolio represents. Our investments are spread over 39 distinct industries with a large focus on healthcare and education software, HVAC services and sales and IT, real estate, education, consumer and healthcare services in addition to our investments in the CLO and JV which I included as structured finance securities. Of our total investment portfolio, 9.6% consists of equity interest which remain an important part of our overall investment strategy. For the past 11 fiscal years, we had a combined $81.5 million of net realized gains from the sale of equity interests. And two=thirds of these historical total gains were fully accretive to NAV due to the unused capital loss carry-forwards that were carried over from when Saratoga took over management of the BDC. This consistent realized gain 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.

Michael Grisius — Chief Investment Officer

Thank you, Henri. I’ll take a few 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 in October, we have observed the persistence of aggressive market conditions for premium credits with lenders remaining open for business and competing heavily for these high-quality opportunities. Liquidity remains abundant after the large-scale fund raisings of last year, but lenders are being more risk-sensitive backing off historically volatile sectors and taking a harder stance on the use of capital.

Leverage levels remain elevated, but where we are seeing movement is on the rate side, as Henri mentioned a couple of slides ago. Absolute yields are growing significantly as LIBOR and SOFR increased almost 170 basis points this past fiscal quarter, although they have moderated slightly in December. In addition, spreads are continuing to widen the lower-middle market, where up until recently it has mainly been happening in the broader syndicated loan and capital markets. In the first half of calendar year 2022, we saw high transaction volumes and M&A activity, albeit slightly lower than in 2021. In the second half of the calendar year 2022, deal volumes remain reasonably healthy in our market despite lower macro volumes. As a result, we continue to enjoy an actionable deal pipeline.

In a competitive market, investors continue to differentiate themselves in other ways such as accelerated timing to close and looser covenant restriction. That said, lenders in our market remain 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, particularly given the concerns around the potential economic recession forecasted for sometime in 2023. The Saratoga management team has successfully managed through a number of credit cycles and that experience has made us particularly aware of the importance of first being disciplined when making investment decisions and second being proactive in managing our portfolio. We’re keeping a very watchful eye on how continued inflationary pressures and labor cost supply chain issues, rising rates and slowing growth could affect both perspective and existing portfolio companies. A natural focus currently is on supporting our existing portfolio companies through follow-ons, as we’ve seen this quarter.

We have confidence in our strong position entering a different credit and rate environments. Our underwriting bar remains high as usual, yet we continue to find opportunities to deploy capital as we will discuss shortly. Calendar year 2022 was a very strong deployment environment for us with a strong pace of originations. Follow-on investments in existing borrowers with strong business models and balance sheets continue to be an important avenue of capital deployment, as demonstrated with 47 follow-ons in the last 12 months ending December 31st and 12 in the last calendar quarter alone, including delayed draws. In addition, we have invested in nine new platform investments this past calendar year with 15 total investments in these new companies during the year.

Portfolio management continues to be a critically important aspect for us and we remain actively engaged with our portfolio companies and in close contact with our management teams, especially in this volatile market environment. All of our loans in our portfolio are paying according to their payment terms except for our Nolan investment that we put on non-accrual this quarter as we work with the company on an agreement that will likely have us pick our interest for a period of time. Nolan is our only non-accrual investment across our portfolio. Through recognizing the unrealized appreciation from spread widening and performance on our overall portfolio this quarter, Saratoga’s overall assets are now just 0.5% below cost basis. We believe the strong performance reflects certain attributes of our portfolio that bolster its overall durability. 82% 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 14, 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 number two on a list of only 11 BDCs that have had a positive number over the past three years. This strong underwriting culture remains paramount at Saratoga. 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, invest capital with the objective of producing the best risk-adjusted and accretive returns for our shareholders over the long term.

Our internal credit quality rating reflects the impact of current market volatility and shows 96% of our portfolio at our highest credit rating as of quarter end. Part of our 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. This equity co-investment strategy has not only served as yield protection for our portfolio, but also meaningfully augmented our overall portfolio returns as demonstrated on this slide and the previous one, and we intend to continue that strategy.

Looking at leverage on Slide 15, you can see that industry debt multiples remained relatively unchanged for calendar Q2 to Q3 at historically high levels. Total leverage for our overall portfolio was 4.19 times excluding Nolan and Pepper Palace, while the industry is now well above 5 times leverage. Through past volatility, we have been able to maintain a relatively modest risk profile throughout. Although 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 our investment. In addition, this slide illustrates the strength of our deal flow and our consistent ability to generate new investments over the long term, despite ever-changing and increasingly competitive market dynamics. During the fourth quarter — fourth calendar quarter, we added no new portfolio companies but made 15 follow-on investments, increasing our 12-month production to 62 total new investments versus 47 for the same time period last year.

Despite the success we’re having investing in highly attractive businesses and growing our portfolio, it is important to emphasize that, as always, we’re not aiming to grow simply for growth sake. In the face of this uncertain macro environment, we’re keenly focused on investing in durable businesses with limited exposure to inflationary and cyclical pressures. Our capital deployment bar is always high and is conditioned upon healthy confidence that each incremental investment will be accretive to our shareholders.

Moving on to Slide 16, our team’s skill set, experience and relationships continue to mature, and our significant focus on business development has led to multiple new strategic relationships that have become sources for new deals. Our top line number of deal source remains robust, but has dropped in the past two years, initially due to COVID, but more recently reflecting our efforts to focus on attracting a higher percentage of quality opportunities. Most notably, the number of deals executed during the last 12 months is markedly up from last year’s pace, demonstrating that this more focused sourcing strategy is yielding results.

What is especially pleasing to us is that four of the nine new portfolio companies over the past 12 months are from newly formed relationships, reflecting notable progress as we expand our business development efforts. As you can see on Slide 17, our overall portfolio credit quality remains solid. The gross unleveraged IRR unrealized investments made by the Saratoga Investment management team is 16.4% on $879 million of realizations. On the chart on the right, you can see the total gross unlevered IRR on our $936 million of combined weighted SBIC and BDC unrealized investments is 11.2% since Saratoga took over management.

As of this quarter, we continue to have two yellow rated investments still only being our Nolan Group and Pepper Palace investments. Nolan has been yellow for a while now since COVID being more dependent on in-person business interaction and was also added to nonaccrual status earlier this year. The current unrealized depreciation reflects the current performance of the company, but does not change our view of the fundamental long-term prospects for the business.

The other yellow investment is Pepper Palace. In this quarter, we recognized another $2.6 million of unrealized depreciation on this investment, increasing the total depreciation to $10 million since investment on our first-lien term loan and preferred equity investments. Now this markdown reflects the current performance of the company, but they continue to pay interest. We are working closely with the company and the sponsor as they work to improve performance. Our overall investment approach has yielded exceptional realized returns and recovery of our invested capital.

Moving on to Slide 18. You can see our first and second SBIC licenses are fully funded and deployed with $10 million of cash available for distribution to the BDC in SBIC II. We are also pleased to have received approval for our third SBIC license this quarter, which means we practically have access to another $107 million of low-cost SBIC debentures currently allowing us to continue to support U.S. small businesses.

To summarize this quarter, the way the portfolio has proven itself to be both durable and resilient against the impact of COVID-19 and the subsequent calendar 2022 market adjustments and volatility really underscores the strength of our team, platform and portfolio and our overall underwriting and due diligence procedures.

Credit quality remains our primary focus and new investments have a higher bar, especially at times with such increased activity levels for premium credits 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. I’d like to turn the call back over to our CEO. Chris?

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Thank you, Mike.

Turning to Slide 19. As outlined, our latest dividend of $0.68 per share for the quarter ended November 30, 2022, was paid on January 4, 2023. A 26% increase, this is the largest quarterly dividend increase in our history. The Board of Directors will continue to evaluate the dividend level on at least a quarterly basis, considering both company and general economic factors, including the near-term impact of rising base rates and increased spreads on our earnings.

Moving to Slide 20. Our total return for the last 12 months, which includes both capital appreciation and dividends, has generated total returns of negative 2%, outperforming the BDC index of negative 6% for the same period. This performance reflects the current market volatility impacting both us and the industry. Our longer-term performance is outlined on our next slide.

Our three and five year returns place us in the top quartile of all BDCs for both time horizons. Over the past three years, our 27% return exceeded the index average of return of 12%. Over the past five years, our 71% turn more than double the index average of 35%. When Saratoga took over the management of the BDC in 2010, our total return has been 626% versus the industry’s of 171%.

On Slide 22, you can further see our performance placed in the context of the broader industry and specific to certain key performance metrics. We continue to focus on our long-term metrics such as return on equity, net asset value per share, NII yield and dividend growth, which reflects the growing value our shareholders are receiving. Notwithstanding the slight decline of 0.1% in NAV this quarter, we continue to be one of the few BDCs to have grown NAV over the long term, and we have done it accretively by also growing NAV per share, 15 of the last 19 quarters.

Moving on to Slide 23. All of our initiatives discussed on this call are designed to make Saratoga Investment a leading BDC, and is attractive to the capital markets community. We believe that our differentiated performance characteristics outlined on 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 14%. Access to cost-effective and long-term liquidity with which to support our portfolio and make accretive investments recently demonstrated with our SBIC III license approval this quarter and new baby bond raised in December, a triple-B-plus investment grade rating in active public and private bond issuances, solid historic earnings per share and NII yield benefiting from the rising rate environment, with 98% of our credit AUM floating rate, while 96% of our debt is fixed rate.

Strong and industry-leading long-term return on equity accompanied by growing NAV and NAV per share, putting us to the top of the industry over the long term, high-quality expansion of AUM and an attractive risk reward profile. In addition, our historically high credit quality portfolio contains a minimum exposure to conventionally cyclical industries, including the oil and gas industry.

In closing, I would like to refer to Slide 10 that Henri walked you through earlier in the presentation. In this rising rate environment, Saratoga is a beneficiary of increased short-term LIBOR and SOFR interest rates. In Q3, Saratoga’s average three-month LIBOR used for interest rate income purposes was 3.59%. At November quarter end, the closing LIBOR rate was 119 basis points or 33% higher at 4.78%, with the spot rate today at a similar level, implying that the entire impact of today’s rate levels is not fully reflected in this quarter’s reported earnings.

We remain confident that our reputation, experienced management team, historically strong underwriting standards and time and market tested investment strategy will serve us well in navigating through the challenges and uncovering opportunities in the current and future environment. And 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.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question will come from Bryce Rowe of B. Riley. Your line is open.

Bryce Rowe — B. Riley — Analyst

Thank you very much. Good morning. I appreciate you taking the question here. I wanted to kind of ask about the dividend. Obviously, great to see the increased dividend and certainly good to see that it followed a nice increase in earnings. Maybe Chris and Henri, Mike, can you speak to how you’re thinking about the dividend constructs we’ve seen other BDCs take an approach, a variable approach where you’re paying a base and then a supplemental on top of the base based on kind of excess earnings. So — and that with the context of the rate environment and the potential for rates to eventually go back down at some point. So just trying to understand how you all are thinking about that dividend and the dividend construct and giving any consideration to a base plus supplemental construct? Thanks.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Sure. Well, I mean, that’s a very good question and something that we have thought a lot about. I think if you look at our earnings level in this recent quarter, while substantially up, the base rate of LIBOR that they’re based on is actually substantially lower than the market rate is at this time. And then if you look at the forward curves and who knows, how right the market is, but the rates go up next year and then they’re projected to come back down in 2024. But they’re projected to come back down in 2024 kind of not that far off of where our average rate is in this most recent quarter. So we feel at this point in time that we are well positioned with our core dividend rate that we can sustain this over certainly the long run.

With that said, rates — I don’t know exactly how much higher they may go from where they are now, we are currently over-earning our dividend by a substantial amount. We may continue to do that. We’re in a very good position relative to our spillover. So we have room, too over-earned should that be something that made sense for the shareholders.

And so we’ve got to kind of see how this plays out. If it looks like the interest rates are going to stay up for quite a while, then we can move, obviously, our core dividend. If we think it’s going to be relatively more temporary, we could consider that sort of bifurcated mode that some of our others have done. So — but all of this is sort of to be seen and to be determined because this rate environment, there’s just a tremendous amount of uncertainty as to exactly how it plays out.

But I think the most important consideration is that we feel that the current level we’re at is sustainable for the long run. And we will look to build upon that as our earnings increase and as the rate environment becomes more clear.

Bryce Rowe — B. Riley — Analyst

Great. That’s good color, Chris. Maybe a follow-up question around rates and the impact on your borrowers. Can you speak to how borrowers are reacting to the higher rates. Obviously, it’s the same for all borrowers expecting with the floating rate debt, but just kind of curious how borrowers are reacting to the higher debt service. And it looks like from a fair value mark perspective, most are performing really well. But any color around borrowers and reaction to debt service would be great. Thanks.

Michael Grisius — Chief Investment Officer

Bryce, this is Mike. That’s a really good question. We feel good about our portfolio construction in terms of interest rate coverage. While most of these deals are reasonably leveraged, we spent a lot of time looking at and trying to seek out businesses that have not only really solid dependable cash flow but really strong cash flow margins. So they’re generally businesses that can withstand some increase in rates and still produce plenty of excess cash flow with which to comfortably service our debt.

So when we look at the interest coverage that we have across our portfolio, there’s healthy room there to support the interest coverage in terms of how people react to it. Yes, they don’t like to see rates up, but it’s kind of the market environment. So anybody else that they’re talking to about borrowing money, it’s kind of they’re facing the same thing. So it’s a little bit of it is what it is, but the important thing, I think, is that our portfolio companies are demonstrating that they continue to perform well and are producing sufficient excess cash flow to handle the increase in rates that we’ve experienced.

Bryce Rowe — B. Riley — Analyst

Great. I appreciate that.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

If I could just add in terms of the new deals, which are kind of — everybody who’s got what they have, they have what they have. But we’re looking at a lot of new opportunities, and we’re pricing in the new level of debt and companies and sponsors are happy to have it, happy to — I think we’re seeing quite a robust pipeline that it seems like the — if there’s a balance of power, if you will, between borrowers and lenders, I think for the last few years, the borrowers seem to have relatively more leverage in negotiations. And I think that balance is moving the other way, how far it is, it depends on the market, depends on the deal, depends on the sponsor. But we are seeing improvement in overall competitive dynamic and negotiating leverage. And as part of that, the rate structure that we’re seeing is being accepted for new deals.

Michael Grisius — Chief Investment Officer

No, it’s a good point, Chris. I mean I should have emphasized that. So one development that certainly we’re seeing, especially in this last quarter and in the environment that we’re in now is Bryce, is that spreads are widening as well. So just in terms of receptivity to a higher rate environment, not only are new borrowers seeing higher indexes but we’re able to get wider pricing now than we were even a few months ago. So we’re finally starting to see that in our market as well. So if there’s an indication of sort of the reaction to rates.

Now I do think the higher rate environment is affecting M&A activity in general. So there may be in the broader market fewer deals just in general because of kind of the macro environment. But for the deals that we are seeing, which are high-quality deals and kind of the micro market that we occupy at the lower end of the middle market, we’re seeing plenty of activity. And for those deals that we’re seeing, they’re expecting higher rates, and we’re getting them.

Bryce Rowe — B. Riley — Analyst

That’s great. Appreciate the commentary guys.

Operator

Thank you. [Operator Instructions] Our next question will come from Casey Alexander of Compass Point Research & Trading. Your line is open.

Casey Alexander — Compass Point Research & Trading — Analyst

Hi, good morning. I think this quarter really highlights the underappreciated power – earnings power that you guys have many BDCs are exhibiting right now, and I don’t think the market is really appreciating it. And if it weren’t for spread widening, your NAV actually would have been up $0.40 a share. So I think it’s a very good, and I appreciate the commentary around the dividend because I think holding on to those excess earnings right now to allow NAV to build or to hold against potential credit issues is a great idea. With all those positives, I’m going to do my job and trying to find a couple of places to pick out here. One is looking at the new baby bond deal that you did in December, the absolute and regulatory leverage ratio is really quite high. Can you speak to those leverage ratios and to the extent to which you’re comfortable — I mean, I calculate a regulatory leverage ratio close to 1.5 times when you factor in the new baby bond deal. Can you speak to those leverage ratios and why you can comfortably carry a leverage ratio that high?

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Sure. Maybe I’ll start and then and Henri, you can fill in. Well, first of all, Casey, there’s several components to anyone’s leverage, right? And the character of the leverage is very, very important. And I think one of the things that we’ve always carried and the market sort of come around to make our structure work very well right now. And what we have in our leverage is we’ve got a long-term fixed rate, interest-only covenant-free debt, and our maturity schedule is two to 10 years out.

So it’s a long time from now before we have to repay any of our leverage. And the spreads off of the marketplace to our leverage are widening, both absolutely with the base rates and with spreads and in terms of our new deals coming on. So our profit margins are expanding, and our leverage structure is very solid.

And then on the other side of it, of course, is portfolio. And so when we look at our portfolio and the character and the stability of our portfolio, we look at all that together, and we think we’re very well positioned for really substantial earnings. And I think we’ve just demonstrated this past quarter. I think the earlier quarters in the year, there was a lot of things working through the system and LIBOR lags and adjustments and where our liabilities might have gone up a little higher — the CLO might have gone up earlier than our asset base rates and all those types of things, but we’re kind of through that period now.

And so the incremental improvements are kind of flowing directly through to our bottom line. So we have a tremendous amount of earnings that we’re generating against this leverage and the structure is extremely favorable. A further point picking up on what Bryce said earlier, there’s a question as to whether we’re going to see the same rates in two years or three years. And there’s a possibility that as rates come up, then they come back down.

But I think what’s really important also about our leverage structure is — and Henri correct me on the number, but I think almost two-thirds of our debt is callable in two years or less. And so we do have the ability to reconfigure this fixed rate structure of ours should rates decline.

And so I think those are elements that give us comfort operating within the structure. Another part of the dynamic that we’ve been experiencing is, as Mike said earlier, there’s been a slowdown in M&A as gaps between buyers and sellers, ability to finance, leverage all those things have come about. And one of the benefits that we have received as a result of that is a little slower repayments than we might have had before. And so we have this phenomenon of a lot of our high-quality loans are not getting refinanced, right? The only time we get paid off is generally with an M&A transaction and M&A transactions have slowed down.

So our core portfolio is sticking with us longer than it had before. And then as our scale is improving and our relationships are broadening and that type of thing, we’re getting a lot more new investments coming in. So there’s kind of — those two forces at work are allowing us to add very high-quality assets through our very high-quality asset portfolio right now with improving new relationships. And each of those as you can see, I mean, last quarter, we did 18 follow-on investments.

So we have a very solid portfolio with good demand in credits that we know extraordinarily well. The other thing I would say, too, about the leverage is we have very long duration leverage, and we have essentially on a historic basis shorter duration assets. And so we think we’re very well positioned, the way we’re set up. And I think that the earnings flow that we’re seeing is reflective of that.

Casey Alexander — Compass Point Research & Trading — Analyst

All right. Thank you. My next question is for Mike. Mike, looking at the fact that all of your new issuance in this quarter was follow-ons. I’m curious, do you have what you would call a higher bar for new investments than you have for follow-ons? And is it more important in this environment with what you see coming at you economically to make sure that you’re more supportive of existing portfolio companies as opposed to new companies, which you don’t have that history with?

Michael Grisius — Chief Investment Officer

Really good question. And the answer, very succinctly is yes. We certainly, first and foremost, want to make sure that we’ve got capital available to support our existing portfolio companies. There’s not a better call you can get in our industry than a call from a borrower who is performing really well. You know them really well. You like the ownership group, and they’ve got an opportunity to continue to grow their platform and they’re looking for additional capital to put to work.

So we did that very successfully this past quarter. It’s a big part of what we do just institutionally, if you sort of look at the playbook that we operate under very often, we’re making a bit smaller investment as we’re getting to know a portfolio company. And then most of our deals and certainly almost all of our best deals have been ones that have started off small and have become much more sizable.

Now having said that, we still are seeing good actionable opportunities. And it so happens that just this past quarter, we didn’t get any that really — or didn’t find any that really met our underwriting bar. Some of that was due to the fact that we just have a really high standard to begin with. Are we thinking even harder now about businesses that — what the outlook for a business could be if we were to go through an even a difficult economic time, yes, we are. And certainly, that’s probably affecting our bar at the margin.

But generally, we have a high bar to begin with. And I think most of the fact that we have fewer portfolio companies this past quarter is sort of reflective of just M&A activity being down. Now having said that, our business doesn’t operate sort of like a switch. It just — it’s really hard to predict how these things work. Right now, our pipeline of new portfolio opportunities is quite full. We’re seeing a lot of things that we think are really interesting.

In fact, I’d add to it, Casey, while I’m on that topic, we’ve been doing this for a long time. Now is a great time to be investing in new portfolio companies. If you see a deal that’s in market right now, first of all, it means it’s performing well, and it’s performing well in a market where the company is producing really solid cash flow growing, and it’s doing that despite facing growing pressure from a cost standpoint and you get a chance to underwrite that with some of that kind of right in front of you.

You also get a chance to underwrite it and lend capital with better pricing and less competition than what we’ve seen just six months ago. So it is a really nice time to be investing capital. For those deals that meet those standards that are probably slightly higher than what they usually are, and they’re already — the standards are already really high to begin with.

Casey Alexander — Compass Point Research & Trading — Analyst

All right, thank you. Appreciate you taking my questions. Thanks Mike.

Michael Grisius — Chief Investment Officer

Thanks Casey.

Operator

Thank you. [Operator Instructions] Our next question will come from Robert Dodd of Raymond James. Your line is open.

Robert Dodd — Raymond James — Analyst

Hi guys. And congratulations on the quarter. One sort of a follow-up to Casey actually. On follow-on investments being a greater portion of the mix. I mean all the credit and knowing the borrower I understand. So the other question though is when doing a follow-on, do you get the opportunity to put incremental equity into an investment where you’ve already got an equity investment? Or is it the equity goes in day 1, the follow-ons are debt only? I mean, just trying to get a feel of so much of your performance historically has been generating realized gains on equity, et cetera. If you shift on to follow-ons, are you at the margin losing a little bit of opportunity to keep equity at some portion of the portfolio that you want to target?

Michael Grisius — Chief Investment Officer

Yeah, it’s an interesting question. So here’s how we think about it. And the answer is that it depends. So in some cases when an existing borrower is looking for more capital to grow, the capital that they need requires both debt and equity. There’s a portion that makes sense to fund with debt, but also we need to step up with additional equity. In those cases, we have co-investment rights for our equity, and we typically almost always participate and co-invest alongside the control owner. So when that happens, we’re co-investing along the way. Now in other cases, they’re looking for follow-on capital and the business is performing so well that when you look at the capital structure pro forma for whatever the growth initiative is, it may be an acquisition, it may just be growth to fuel growth in EBITDA.

When you look at the capital structure, it may not need equity. But if you’re already an existing equity investor, it’s very accretive to the existing equity that you have. So that’s still good news as well. So to the extent that we have an equity investment in an existing portfolio company, whether we’re co-investing along the way or sitting on our current position or our initial position of equity, it typically benefits our initial equity investment very significantly and that’s proven out well over time.

Robert Dodd — Raymond James — Analyst

Got it. Got it. Yeah. I appreciate that color, and I appreciate the classic opening of it depends, which is always the case. On the dividend, I mean, I understand your comment on the earnings power is going to go up materially from here as we get into the middle of the year based on where the forward curve is, I understand retaining some to grow NAV, et cetera, but the BDC rules are what they are, right? So you can’t just keep by the distribution requirements. And given an increased dividend but potential earnings power that — not putting words in your mouth, but could get to like $1 per share kind of per quarter in future quarters. You’re going to generate a lot of spillover income in a hurry. So what are your thoughts on how you would handle that if rates do stay higher for longer, that at some point, it’s a good problem to have, but it becomes a problem if you build up too large a bucket on spillover, if there’s a big earnings dividend missed. So can you give us your thoughts there?

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Sure. I think as you point out, I mean, I think these are the type of problems we like to work on. Absolutely, you’re right. I mean there are hard rules. You have to — you’ve got kind of a two-year period to pay all the — pay out your high percentage of income from, and we have a certain spillover equation right now, which is fortunately not — we’ve got a lot of room in it.

And — but ultimately, if our earnings do increase, as you outlined, that amount of spillover will increase. And then ultimately, all this has to be paid out to shareholders. So in the meantime, right, it would build NAV and so the shareholders are going to get it one way or the other, right? They’re going to get either through NAV or through dividends along the way. I think the biggest issue, right, is what’s going to happen next in our economy. I mean everybody knows we’re in an inflection point to sort of an unprecedented environment, right? We’re kind of in a higher for longer rising rate environment, inflation, all these type of things.

No one has seen that for 40 years, experienced that systematically, consistently, you’ve got a very hawkish position from the Fed, which is more aggressive than the market. So there’s just a lot of questions to what’s this all going to look like. If we have sort of this rising rate environment, followed by massive cuts back down to a hyper stimulative environment, which is — that’s one scenario.

I don’t know what the odds of that scenario are. We have to be prepared for that. We don’t want to get too far out on that and then you could have a difficult economy. And so all those are still questions. Right now, as you can see, we’re up 26% on dividend and 33% on earnings. So that’s not too big a problem for us right now. In another quarter, we’ll see how that goes. As you know, from the embedded increased interest rates, right, there’s some base increase built in just doing the math where interest rates were at the end of our quarter versus the average during the quarter.

So all this is building. And — but you look at the forward curves, I said there’s a battle between them, is the Fed going to hold it like they say? Or is it going to come off like the market says. And I saw an interview with Larry Summers recently, and he said he thinks it’s going to be relatively more towards the Fed than towards the market. And it’s very hard to tell that. And so we’re just going to have to make these decisions over time.

And fortunately, we’re in a very good position to make these decisions, right? I mean we have these increased earnings. We’ve got lots of spillover room, and we can watch and see. And I think in an earlier question from Bryce, I mean, there’s an ability to do dividend payouts that aren’t permanent and there’s ways to do it that are permanent.

And I think what we’ve been attempting to do is to give our shareholders confidence in a dividend level that they can depend on. And that’s something that we’re working to do to say, look, you can depend on this dividend and the excess is going to be going into NAV for a period of time, but you’re going to benefit it from it one way or the other. Henri, do you want to add to that.

Henri Steenkamp — Chief Financial Officer, Chief Compliance Officer, Treasurer & Secretary

Yes, Robert. And I think just the nice thing about the RIC rules and you know how they constructed is, it allows you to plan really well sort of looking ahead more longer term and to manage the payment and to manage the spillover. So as you mentioned, yes, as rates go up, our earnings, i.e., our taxable income that we need to distribute will increase quickly. But that doesn’t mean that we will have to pay it out quickly based on the payment rules of the rig structure.

So that allows us to sort of — if you manage your spillover well, which we think we have. It allows you to really plan more long term how you want to pay it out, especially in an economic environment. As Chris was talking about, that is more uncertain. So although the accretion maybe happens quickly, the payment doesn’t necessarily happen quickly, which is the nice thing about the sort of the planning mechanism of the RIC rules.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

One for the point — I’m sorry, just one further point on this. And I think that we have been very careful. And I think as you may recall from our very, very long conference call in April of 2020, we’ve been very careful with our spillover. And we’ve used our spillover as sort of like a rainy day fund, if you will, or something like that. And some other BDCs are kind of max on their spillover. They view it as a source of capital, perhaps. And so they don’t really have a lot of room. And if they have an increase, they kind of have to pay it out immediately. But we’ve created this flexibility for ourselves utilizable in this environment to give us the time to consider an optimal approach to sort of permanent dividends versus temporary dividends.

And as we said before, we’re trying to come up with a sustainable, dependable dividend rate and that our shareholders can expect and then look behind all this question and our thinking, right, is what levels of dividend increase are we going to have next quarter and the quarters and the quarters after that? And obviously, I think the balance of consideration is that’s going to be relatively more available than in sequential quarters, certainly in the very near term than there has been in the past.

Robert Dodd — Raymond James — Analyst

Understood. I really appreciate the color and to your point you’ve managed spillover such that it’s not going to force your hand by being near a cap. So that’s a good spot to be in as well. So, thank you for the color.

Operator

Thank you. [Operator Instructions] Our next question will come from Erik Zwick of Hovde Group. Your line is open.

Erik Zwick — Hovde Group — Analyst

Thanks. Good morning. Most of my questions have been asked and answered at this point. And I guess the one I still have is a bit of a follow-up in some terms. So I guess thinking about the health of the borrowers in your current portfolio? And what could impact them certainly based on the outlook for the Fed funds curve, there’s another 50 basis points, maybe 75 that would happened here at the beginning of the year in LIBOR would likely follow suit higher to a similar magnitude. There’s also a concern about the trajectory of the economy and whether we dip into a mild recession or something more moderate or severe. As you think about the potential for credit and the health of your borrowers.

At this point, what would be a larger risk if the Fed had to continue hiking further beyond current expectations, which would put a higher debt burden on your companies or material slowdown in the economy that would materially impact EBITDA and the cash flow of those companies. Just curious how you think about that and weigh those risk factors today?

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Well, let me try and answer it first from a high level, and then Mike can speak very specifically to our portfolio. So at a high level, we have the good fortune of investing in the smaller middle market. And so each of our companies has its own destiny, its own marketplace, its own universe. And a lot of these macro considerations, they kind of affect the broader economy in sort of broader ways and there’s a lot of cyclicality in the economy. I mean we were just — in our last investment meetings, we have one of our portfolio companies, we’re actually talking about decreasing their rate because they’re earning so much money, they want to pay us back, like no, don’t do that.

I mean they’re having surging increase in revenues. And so — the U.S. market is such a huge, huge place, and there’s so many opportunities and efficiencies and all of the Software as a Service companies that we invest in they’re creating efficiencies to their products. And so there’s a growth dynamic that’s going to persist even in a negative — in a recession. I mean if we have a mild recession, it may not affect a lot of our companies really much at all. And if we have a severe recession, there’s a bunch of our companies that will still continue to do well, can continue to do well.

So I don’t mean to paint an overly rosy picture of everything for everybody. But what I would say is that each of our companies is not necessarily as affected by these macro trends on a current basis and then it partly has to do with the nature of our portfolio and also they’re the smaller companies.

I mean if you’re Walmart, if you’re McDonald’s, if you’re Procter & Gamble, I mean they’re much more exposed to the very broad gauge what’s going on in the big economy. But our companies have very specific niches in very specific markets and market opportunities. When you add them all up, they aren’t necessarily as correlated to the broader economy.

Michael Grisius — Chief Investment Officer

Yeah. Let me add to that a little bit, Chris, because it’s a good question and an interesting observation you make. We spend a lot of time thinking about that at the front end when we’re underwriting deals, and there’s so many things that we think about. But first and foremost, at the end of the day, all of the work that we’re doing is centered around trying to get a comfort level that the business that we’re lending to is at a minimum going to be in a position where under almost all reasonable circumstances we feel comfortable they’re going to sustain their cash flow level. And we do that by looking at the end markets that they’re in.

We look at the value proposition that they offer their customers. We try to think about all the vulnerabilities they may have in the future and reach an assessment as to whether they’re going to be able to continue to offer that value proposition to the customer in a way that’s very profitable for them.

And that underwriting is the most important component to what we do. It makes us — it draws us to certain industries. It draws us to industries that are less cyclical. It draws us to companies that have wide margins that produce lots of cash flow, why do they have wide margins because they can price their products at a level that allows them to have strong margins because people want their products, they see our services. They see the value in them. And the most important thing in the underwriting and the capital structure, therefore, tends to be the persistency of the cash flow.

Now when we underwrite, and I should say before I move into the interest rate part of your question, when we underwrite as I said, we’re thinking about all the downside scenarios, but the cash flow is — and the persistency of that cash flow is the most important thing. As you get into another component that we look at, which is what is the capital structure, how much leverage is reasonable for the business relative to all the things I discussed that we think about in terms of the business fundamentals that factors in as well.

And as we look at our portfolio, generally, and this is just true in credit in general, the businesses are going to be affected more if their cash flow were to go down much more than if their interest rates go up. So we construct our businesses and the capital structures that we lend to in a way where as I said, we, first and foremost, get comfortable that the cash flow is persistent and usually it’s going to grow, that we feel comfortable it’s going to grow quite considerably.

But in the downside scenarios that we run, we’re looking at things like interest rate sensitivity, et cetera. And while there’s some effect that, that can have on free cash flow of the business, that has a much more marginal impact than the fundamentals of the business itself.

We feel comfortable. I want to make this point that when we look at our portfolio construction right now that we are in really good businesses in really good end markets in companies that are well positioned to continue to offer that same value proposition that I mentioned to their customers in a way that will allow them to continue to be solidly profitable.

Erik Zwick — Hovde Group — Analyst

That’s great color. I appreciate the commentary from both of you. Thanks so much. That’s all I had today.

Michael Grisius — Chief Investment Officer

Thank you.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

Thank you, Erik.

Operator

Thank you. I see no further questions in the queue. I would now like to turn the conference back to Mr. Christian Oberbeck for closing remarks.

Chris Oberbeck — Chairman of the Board, Chief Executive Officer & President

I would like to thank all of you for joining us today, and we look forward to speaking with you next quarter.

Operator

[Operator Closing Remarks]