Stellus Capital Investment Corporation (SCM) Earnings Call Transcript & Summary

Good morning. I'm Adam Prior with The Equity Group, here serving at Stellus as their investor relations representative. And we're very glad you can join us today. Just a couple of things to begin, before I turn it over to the management team. We have lot of time for Q&A following each session. And here's how we'll handle Q&A during the presentation. You're welcome to send a question to myself, Rob, who you see or any of our panelists. And we will try to take that at a designated time for Q&A. I'll gather the questions, and I'll read them off with the team during those sessions. I'll call on each person individually, so that we can keep the session organized and make sure that we get it to everyone. And then I'll remind everyone again, beginning of the session that the method in which they ask. We are sharing a presentation today that was filed as a Form 8-K with the SEC this morning and is also available on our website. On Slide 2 of this presentation is the customary forward-looking disclaimers that I welcome all of you to review. Now with that, I'd like to turn the call over to Mr. Rob Ladd, Chairman and CEO of Stellus Capital, who will introduce his team and kick off the presentation.

Great, Adam. Thank you, and welcome, everyone, and thank you for joining us this morning for our Investor Day of 2021. Just a little bit of historical background here. Our business was started in November of 2012, and so we just completed our ninth year of operation in Stellus Capital Investment Corporation. As you know, we're managed by Stellus Capital Management, the investment adviser. And our team there has one of the longest, most experienced track records in private credit across the country with a combined 300 years of principal investing experience. You'll see some of the statistics about our share price and market capitalization and assets, which we'll cover more in the financial results. As you know, we're based in Houston, Texas and maintain offices in Charlotte, North Carolina and Washington, D.C. Next slide. Just a quick bio. So our 5 partners are on the call this morning. Our 5 partners as the advisers serve as the investment committee of Stellus Capital. And joining me, of course, Todd Huskinson, you know, our Chief Financial Officer; Dean D'Angelo, who's based in Washington, D.C. is Co-Head of Private Credit and Director; Josh Davis, based here in Houston and Co-Head of Private Credit; and then Todd Overbergen, who is an investment committee member and partner in our firm. Next slide. Okay. So we start just with the outset, and we'll come back to this at the end of the presentation, why should you invest in our public company, Stellus Capital Investment Corporation? Well, first of all, we have a robust dividend, currently at about 8.4% on a current basis. This would exclude any additional dividends as an example, the $0.06 that we have declared for the first quarter already of next year. We have a very kind of a top quartile return on equity in the sector at 9.9% over the last 3 years and about 9% life to date. At the company, again, we've just completed 9 years in which we've earned the dividend throughout that period. And overall, as a management team, 17 years working together in private credit. And in net track record, over $7 billion of investments across 300 companies throughout the United States and Canada. And as a platform overall, as you know, we also manage private funds. We have $2.1 billion of assets under management for regulatory purposes across the Stellus platform, which allows us to invest in and win opportunities that would exceed the capital that you'll see in the public company. Now I'm going to turn over the presentation to my colleague, Josh Davis, who will walk you through more about the team and our approach to the lower middle market.

Thanks, Rob. So I'll cover why Stellus. And first and foremost, an experienced a cohesive team, the partners and I have worked together for over 17 years. We've really built a culture of promoting from within. Many of our MDs actually started with us as analysts and associates that have worked their way up, not only learning how to underwrite credit, how to manage the portfolio, but then also, eventually, being out and originating transactions. So an important aspect of our culture. We've not only combined great direct lending experience, but we also, in terms of all the partners cut our teeth in the restructuring world. So turnarounds, workouts, crisis management. We really think that makes a difference. When inevitably, you do have a credit that has a problem. We know what to do, how to do it and have the patience to get to the other side and produce good, strong recoveries from troubled credits. We've been doing this a really long time. Our track record is great. We put out over $7 billion in the lower middle market. We've got great credit discipline with strong underwriting, and we think that's what's really driven low loss ratios and strong recovery rates across our portfolio. We'd leave the vast majority of our transactions. We're focused in the lower middle market in the U.S. and Canada really between $5 million to $50 million of EBITDA, and we're directly originating these transactions. We're not going out and buying paper. And as a result, these are highly structured and highly negotiated transactions with robust covenants and reporting packages. We're a preferred partner, meaning, we've been doing this a very long time. We've got deep and long-lasting sponsor relationships, and that leads to great deal flow. And we think, frankly, better pricing at the end of the day as well. Adam, you can flip to the next slide. So why the lower middle market and what do we think the advantages are? These are great businesses. They generate a significant amount of free cash flow. We'd like that it's a large and growing market. At the end of the day, our transactions are really private equity oriented. And as a result, we know how much deal flow is out there. There's over $300 billion of dry powder in the private equity community focused in this lower middle market, and that's going to drive our deal flow with these great businesses going forward. It's very diverse. We'll see in a slide later that Dean will cover what our industry concentration looks like, but across the U.S. and Canada, very, very diverse in virtually every industry sector. Our sourcing channels, as I mentioned, is really strong, well-established private equity firms, where at the end of the day, relationships really matter in the lower middle market. Again, this is not a business where we're sitting in New York buying paper and really putting together broadly syndicated loan packages. Next slide. Thanks, Adam. So graphically on the right, you can see where we focus. Our primary sector and area of the capital structure is senior secured and unitranche financings. We do have the flexibility to do some junior capital. Really for us, that's focused solely on second liens, but that's a much smaller component of our business. And oftentimes, we will take a small piece of equity alongside our deals. That could be a preferred or common equity. We love the risk return profile here. Our average yields of about 8.3%. And we think, frankly, much higher and stronger than you find in the broader part of the market. And at the end of the day, a great risk return, focusing on first lien unitranche transactions. Next slide. So a lot to unpack on this slide. Maybe just talk a little bit about our target borrowers in the lower middle market. I mentioned it earlier, but this is $5 million to $50 million of EBITDA. It is primarily sponsored private equity transactions across a lot of different industries. These are leverage buyouts, acquisitions, recaps, growth that might be a company expanding, putting together a new factory or a warehouse. What do we avoid most importantly? We don't like unsecured mezz loans. We do not like fundless sponsor or some people call it independent sponsor deals. We don't like large positions. We want to be as granular as possible across the portfolio. So we want to size positions correctly. And at the end of the day, we don't like rescue financings. We really want to be investing in healthy, growing companies. These are, again, typically $10 million to $50 million transaction sizes. Cash pay, upfront fees, prepayment penalties, typically with an interest rate floor. And oftentimes, we'll take a small equity co-invest alongside of the loan. Typical term of 5 years with an average duration across the portfolio of about 2.5 years. I mentioned, we like sponsored transactions. Why do we like it? Really, we love the oversight and the additional layer of governance that a private equity firm provides. We think there's great alignment of interest with us in the private equity firm. We're really partners with them. They have the ability to not only change management when there's a problem, but just as importantly, with a real fund put in new equity. And that could be to provide liquidity, it could be to pay down debt, but really to get us to the other side of problems. We get great unfiltered access to management. We have a great relationship with these firms that give us access to their network of industry experts and expertise. And lastly, with strong relationships, we really get a first and last look at a lot of transactions. If you look on the right side of this box at the bottom right, comparing kind of to the upper middle market and broadly syndicated loans, where you might have 10 to 50 people in a transaction. More typically, we're either the only lender or maybe we have 1 or 2 partners in the loan with us. Instead of having limited diligence, we get a full access and full amount of diligence. We have full covenant packages. They're heavily negotiated as opposed to covenant light ones. We're in a broadly syndicated loan, a large one, you may not have any access to management. We're having regular interaction. Typically, that could be several times a month, we're speaking with management at the end of the day. And then really bespoke reporting. So instead of having very limited reporting, we're designing our reporting packages, we're getting monthly financials and importantly, talking to management about what's going on in the business. Next slide. So quickly on sourcing, which is an incredibly important component of the business. This is a deep relationship business. I mentioned private equity firms drive the transactions for us, and that's where we're getting the vast majority of our deal flow. You can see some of the logos on the right. We also see deals from our friendly competitors. We will see them from commercial banks. And we'll see them from investment banks as well. But at the end of the day, most of our deal flow is coming directly from a private equity firm, who is buying a business for entering into a transaction with one of their portfolio companies. You could see on the pyramid the bottom -- the inverted pyramid on the bottom left. This is a great example of one of our last private funds. We did over 2,500 in actual initial screens. We might have done diligence on 304 of those, brought 107 to our investment committee to evaluate and then ultimately approved 52 and/or closed on 52 deals, typical conversion rate of about 2%, and that's been very consistent for us over the years and continues to be about the same rate, somewhere between kind of a 1.5% to 2.5% conversion rate. Next slide. I'll introduce my partner, Dean D'Angelo, who co-heads the private credit business with me. Dean?

Josh, thanks. So Josh just talked a little bit about the origination and how important is our business. I'm going to speak a little bit overview on some of our credit underwriting and how we think about lessons learned and then also a little bit about portfolio management. So in this slide, as you can imagine, over time, we have a lot of lessons learned after investing in over 300 different portfolio companies through multiple cycles. Josh and I, as we thought through this slide, there are lots of lessons as you can imagine. We just wanted to focus on some of the more important as we think about what's allowed us to really build a group business and a resilient portfolio over time. So first is size and selection. We want a manageable size. We want to create a very granular portfolio over time, so you're never in a position where, one portfolio company underperformance could have a material effect on the company. So when we think about it, we like to keep -- our goal is to keep positions at a maximum of 2.5% right around there. That would be about $20 million for the SCM. Right now, our average position size is about 12.5%. So we're really focused on that and successfully making sure the portfolio is really granular. The next thing is avoid commodity exposure -- next point. And this isn't shying away from industries that are cyclical like oil and gas, which we do shy away from. But this is also looking within our portfolio of companies for what is often hidden commodity exposure. So do they have commodity inputs that they have the ability, either contractually or through the market to pass on? You want to make sure that you don't have uncorrelated inputs and outputs, and not pricing power if that comes up with portfolio companies. It's is very important. The last -- the next point is we focus on free cash flow and operating leverage. We want businesses that really deleverage over time and have a flexible capital structure. So think about it. We like a business every day, where our risk return is getting better, because they're deleveraging quickly. So that means, when you think about the business, that means strong margins, that means high variable costs. So business is soft, they could retain margins, means low CapEx. We don't like businesses that have a need to invest a lot of their free cash flow back in the business to basically to grow. We like to see them being able to distribute cash flow. We also like businesses that improve margins as they scale, so real operating leverage. All -- once again, these are all aspects that create lower leverage over time out of that game. The next point, we sort of -- we labeled or start out strong. And what we're meaning is that we want everything going with us at close on a deal. We want a business that's growing in an industry that's growing. We want a business that has a very defendable market position and niche. We want limited customer concentration. We really want not to be betting on something new or changing. We're not a good lender to say that we'll get an extra 50 or 100 basis points, that business is flat or dipping and trying to hope that it improves over time. We really like things that are doing great at the game. Know your partners. Now as Josh has walked through and Rob, our business is focused on marketing to top private equity firms. We have been fortunate enough to be in this business for almost 20 years continually, staying in our sector. So we know lots of different private equity firms. And quite frankly, it's as important for us to underwrite a private equity firm as well as the company. So some of the things that we really think about is, first of all, we -- you want to find a private equity firm and you're looking at a deal where they know that industry and most likely, they know that management team. It has become so competitive in that world. If you're looking at a deal with a private equity firm that's -- learning about that business or that industry, because of the interaction with the investment banker, that, that's not something that gives us a lot of comfort. Additionally, you need to know where you are in that fund life cycle of a particular sponsor. Do they have the capital to support the business over time? So if a fund -- if it's one of the first few deals in a private equity firm's fund, our history shows us that they will defend that position with additional capital, because that's the position that they're going to be -- those deals are the ones they're going to be marketing on for their next fund. If you're underwriting a deal that's later in the fund, that might be a position where they don't have to defend it to deliver good returns on that particular fund, and they might have already raised their next fund. So not that we won't do the later ons, but those are factors that are really important. It's also important, underwriting the team at a private equity firm also. And that means knowing the different MDs and their skill sets and principles. And finally, as you could appreciate, the private equity firm is fine and having strong hands in ownership, but it all have boils down to management. So really no management teams being able to meet them before we do deals. And importantly, having a private equity firm that is consistently and critically evaluating management. Josh mentioned this earlier. One of the things are is you don't want private equity firms to be too optimistic, better manageable, learn over time or change, we found that often doesn't happen. And being able to quickly go in and understand what the management team needs augmented or change it is a really important part of a successful private equity firm and a partnership. And finally, so a very basic point, a lien matters. When you look at our business lower middle-market investing, when Josh, Rob and I started investing in early 2000s lower middle market, there was no private investors that were doing senior secured. Our business was junior capital, you were lucky if you got one. And that was the market which junior capital back in early 2000s, our market has evolved. Senior debt has become more important. It's a change, as a management team, we welcome. Our business is now over 82% senior secured less than 2.5% of unsecured debt and liens really matter. And we look at how the business has evolved over time and the risk return profile and believe we're in a really fortunate space. We do a small amount of second lien, as Josh has said, and management liens. As I think many people recognize on the call, lien isn't a lien, isn't a lien. It's all in the details. You want to be able to have a lien where when there is a restructuring, you're able to step in and have a voice. Adam, next slide, please. I'm going to talk a little bit. So Josh, we're sort of going on, Josh talked about origination. You've just talked a little bit about underwriting and lessons learned. Let me talk a little bit about portfolio management. Portfolio management as a skill set and a vital activity is often overlooked, when people talk about origination and credit underwriting. But our history has shown that active portfolio management and setting your portfolio of success through, we talk about granularity is key to recovery rates and reducing loss rates. We look at our team, and I think Josh has mentioned this also is that, active portfolio management needs to be coupled with the right skill sets. And we look at our firm. I think Josh mentioned, both he and I spent a lot of our early career and what was the big 4 was, Coopers & Lybrand, Josh with Arthur Andersen Restructuring Group, Rob Ladd, Arthur Andersen's Global Restructuring practice. This core skill set permeates everything when we think about the best way to manage troubled positions. But this portfolio function just has to be underscored. So the first thing that we mentioned is, you start with success. That means you build a portfolio that with size industry and sponsored geography is positioned for success and then you actively manage it. So we are -- for instance, we are continually talking to our borrowers. Those are private equity firms. You have relationships, the management teams we know, we often have board observation rights. We get monthly financial statements, quarterly covenants. So we are able to being in front of positions and issues before they happen. We have quarterly formal performance reviews. It's an area we've invested heavily in, in technology in terms of portfolio management and information systems. We're able to see in real time our portfolio trends and metrics. And each quarter, Todd Huskinson, Rob, myself and Josh sits with every investment team and goes over a very detailed quarterly report that our systems produce. And some of them take a second. Some of them little longer. Obviously, troubled positions or positions of the story we're talking about every day. But this very objective scheduled portfolio management in quarterly meetings has been a key part of our business since inception. And as you can imagine, we have a valuation of over portfolio companies at least semiannually. And any portfolio a company that we rate as a 3, and that means that it's underperforming, but we don't think there's a risk of loss, principal or interest. Anything that's not really on plan, we have valued quarterly. Adam, next slide, please. And this is one of the slide that Josh referred to earlier that underscores just the level of diversification. We look, as I mentioned, I gave you the one stat about size, keeping them below that 2.5 or average well below that. And we also look at industry concentration and geographic concentration. So these are just breaking out some of the industries and the states and the areas that we invest in. Todd, next slide, please. This is -- we wanted to bring out a point and as we look at, one of the most important things obviously is stability and resilience of a portfolio. The best sign of a direct lender is having a portfolio that's very boring over time for our investors and continuing to perform well. And as I think if everyone knows, we've lived through what you would not call a reborn time over the last 18 months. And this is just to bring me out a little bit the resilience of the portfolio over time. So we're looking at 12/31/19 to 9/30 this year. And this is our internal risk rating. So lower the better. So our highest restraining is 1, lowest is 5. And so you look at our risk ratings have actually improved our portfolio is more resilient with 1.92 versus 2.03. And in fact, also, if you look at NAV, we've had an improvement in NAV since 12/19. So we've really been able to ge through as a difficult period and preserve the resiliency of the portfolio. With that, I'm going to turn it over to Rob again to go over a little bit of our equity investment.

Yes. Thank you, Dean, very much. Adam, do you want any questions at this point that we want to pose? Or do we come to the end? How are you doing on the questions?

We do have several questions. Would you like to jump into a few of them now. Why don't we start with a more broader question, which goes through the 9.9% ROE number that you referenced earlier. Is that inclusive of all unrealized and net unrealized gains?

Yes. So this would be a GAAP figure. So it incorporates all the accounting for positions, both realized and unrealized.

Okay. And then another question is, as you look at your deal flow, and this may be for Dean or Josh or, either of you, who are the comps that you go against the competitors? And who do you see most often? And that question comes from Chris Nolan, who is in the room with us.

Okay. Great. Yes. Josh, would you like to answer that? And maybe the question is, who do we see in the marketplace from a competitive standpoint around the country?

It obviously varies by geography and sponsor to sponsor, but names that might come to mind would be an LBC out of Philadelphia, PennantPark out of New York. Occasionally, Monroe and Maranon, those would kind of be a handful of folks we see most often in the lower middle market sponsored back transaction world.

Yes. Thank you, Josh. We'll take one more question, and then we'll keep going with the slides.

Okay. Well, why don't want to take one from the audience. We're going to try to let them talk. And go from there. So Dave, if you want a -- Dave from Confluence, I'm going to ask you to unmute and then maybe you can ask your question out loud into the audience.

Can you hear me okay?

Yes.

Okay. Great. So I think that when you talk about the underwriting, and you made the comment that like to lead -- you lead the majority of your transactions and that your focus is on the lower middle market. I'm just kind of wondering when I look at some of the holdings that you have, there are some participants in your loans that are really kind of more mid- to upper middle market kind of lenders that the Ares, the Owl Rocks, [ Goblins ] of the world. And I'm just kind of wondering how that dynamic works when you are leading the majority of your transactions. So how do you share the proportion of your portfolio that's in these lower middle market transactions that you're leading alongside with some of these larger deals that you're doing? And how do you really prioritize the proportions?

Sure, Dave. So thanks for joining this morning. So that would be very infrequent. And it'd be unusual for us to be working with [Gallberry's] or Owl Rock. So again, we can take that off-line with you. But again, we're operating at a level where much below what their hold size would be.

Right. Okay. So I guess I might just be looking at some of the wrong information, it's only a cross-holding fund.

I would say it'd be very limited.

Yes. I mean off the top of my head, I know of one position, frankly with Ares. But I don't know of any positions where we're with those guys. We'd be happy to look into it. I just don't...

Okay. My apologies, and I must be looking at incorrect data. If I could then just kind of to drill in a little bit more on a specific credit, and I know it's one that you guys have spent time on. And I don't want to get too much into the details of a particular name, because I know you're limited in what you can say. But in your experience in lending to the hospital industry and how you have a credit there that didn't really -- hasn't really worked out very well. How do you underwrite into the hospital industry or more broadly into the health care industry when we have so many -- the dynamic there is changing so much, either from a reimbursement side or from how the environment has changed because of COVID. What are some of the things you've learned and what is your strategy going forward?

Sure, Dave. And of course, you've asked that question in the past. We do have one hospital system position that's probably 7 years old. We've not had one since then. And our approach to health care and pharmaceutical work here too kind of growth-oriented businesses and not delivering medical services. So we've had a significant shift, but that took place a number of years ago. It would not consider a hospital system currently. Okay. Why don't we -- if it's okay, we'll keep on with the presentation, and then we'll come back to questions later.

Well, before we do, we have an audience in the room, I'd love to -- is there anybody -- Bill, would you like to ask the question? The question for the viewing audiences is coming from Bill.

The third-party valuations surprised that when you do have a credit you think paid more attention, and what does that mean a third-party evaluation based on internal evaluation. How deep do they go, and how much time they spend? What are you getting out of it, which gives you additional insight to get deeper?

That's great, Bill. Good question. So Todd. H, I'm going to ask you to answer this. So for the benefit of everyone if you've -- Bill heard, he's here with this in-person is, Todd, what goes into the valuation process from the third-party valuation work as perhaps to the work that we're doing. And Bill again, I think is focusing on those that are more troubled.

Yes. No, it sounds good. So we do a full valuation process on all of our investments. And for the loans that involves discounted cash flow, analysis, taking into account market factors and company-specific factors. On the equity positions, it's more of a market multiple times EBITDA with some other adjustments that you would typically do in evaluation. Duff & Phelps is our third-party valuation consultant, and they do effectively the same work that we do. So they reperform their own work independently and then look at the valuations that we came up with and then they'll issue their opinion as to the reasonableness of the valuations. With respect to any deal that is troubled or and some form of difficulty, again, they will do the same independent valuation that we do with all the same information. And typically, what will happen is if it's a loan, it won't be on our normal discounted cash flow model. We'll have some kind of a scenario analysis that would look at valuations under certain outcomes. And probability weight those, as the same process that they do. So think of it like, we do our work. They do their independent work and it's robust and their reports are very robust with lots of analysis. And at the end of the day, we'll discuss valuations that we may differ on and ultimately wind up agreeing on what's an appropriate valuation. So it's a robust process. And of course, we also have auditors, who look at those valuations each -- to some extent, each quarter and certainly each year.

Great. Thank you. There is some further comments, would you anticipate there being an increase in the discount rate used to start to tighten. I mean you're going to be reactive or proactive, to interest rate changes in the marketing.

Sure. Sure. Todd, you may want to cover that, too as variables that go into the valuation.

Sure. So the primary -- think about the loan model is basically a forecasting of the cash flows from that loan at the coupon. And then those cash flows are discounted back to present at a discount rate, and that discount rate is a combination of market spreads. So that's where you'll really pick up a change in the market spreads based on a similarly rated loan, which we do an internal rating and then look at an LCD index, which is a loan -- bank loan index. So not exactly what we do, but as close as we can get. So to the extent that spreads in the market are widening, that discount rate is going to increase and the valuation will drop. And conversely, if there's a tightening, it will increase. Not above par, however. So there are times -- and over the last several years, rates have really tightened. And the valuation might technically look like it's above par, but we would cap it at par. So you're right there. And we also take into account risk-free rates and in certain circumstances, there may be other adjustments based on company-specific factors that would alter the discount rate.

I might add to that, Bill, that to the extent interest rates rise, that would cause the discount rate to be higher and the valuation to be less. But what typically happens when the interest rates rise, the yield goes up. So it tends to counterbalance and does not have a material effect and the price mix. And we'll come to it later that we clearly will be a beneficiary of higher rates. We'll have to get to a certain level, which we'll talk about. But higher rate interest rate environment is good for the portfolio and our company is positioned today.

Okay. With that, why don't we turn it back to you.

We'll go back to the presentation. Thank you all for those questions. So you've heard about this before, but as part of our investment strategy, we've always tried to make equity co-investments alongside loans that we're making. These are typically unpromoted, and it's been key to our results, which I'll walk you through. And this is the first time we've gone through this level of detail. So through 9/30, we had $39 million of net equity realized gains in the portfolio. That's across 22 companies. So some good diversification within the gains of the portfolio. And our current portfolio at 9/30, 61 companies with a cost basis of $48 million and currently market fair value at $70 million. And then historically, from the start of the business again in November 2012, if you take that $39 million of realized gains from the equity co-invest portfolio, excuse me, we have, on average, about a 2.8x return. And so if you could extrapolate the $48 million times 2.8, you'll see a valuation potential that would be far in excess of the current mark of $70 million. Of course, this is company specific and occurs over time, but our history is that, you would expect our equity portfolio to have more appreciation in it by the time it's ultimately realized. And then let me add, Adam, that we do have some updated information to share with you that as of really yesterday, providing some current information for the quarter. We had mentioned on the earnings call in November -- late October, that we thought we would have $7.5 million of additional realized gains in the fourth quarter. And we're glad to report that so far, that number is $9.2 million through again yesterday. And there is still some potential for that to increase by the end of December, but this is the updated information from today. So again, pretty -- co-invest portfolio, very helpful to the business, part of our strategy. We size them modestly. But ultimately, we've had a really good return that has helped our ROE. Next slide. And now I'm going to turn it back to Todd Overbergen, who will walk us through the financials. And at the end, I will cover more information about where we're headed in terms of outlook.

Great. Thank you, Rob. So Adam, the first slide with the financials, please. So since year-end, our portfolio has grown $129 million on a cost basis, and that growth has been funded by our 3 primary capital sources, which I'll discuss in a little more detail in a minute, but the SBA debentures were the largest contributor and then the notes payable and then our bank facility. So a good diversified source of capital for us beyond our equity. Our NAV has been stable and increasing for a good while now. It ended the quarter at $14.15, and so a good stable NAV as we stand today. From an earnings perspective, we've covered our dividend since inception and the third quarter was no exception. I'd also note that you can see a realized gain, the net realized gain of $7.9 million is an example of what Rob just mentioned about our realized gains where we generated those in the third quarter and have the additional gains expected for the fourth quarter. That contributed $0.37 a share to our overall realized earnings. And coupled with GAAP net investment income of $0.21 was $0.58 total earnings for the quarter. And one thing I would note is that we typically track core net investment income at $0.31 a share. That excludes capital gains, incentive fees and taxes, which relate to income below the line. So a better measure for our earnings above the line, our net investment income is our definition of core net investment income. Next slide, please. So we've got long-term low-cost, efficient capital, diversified sources. The primary source is our bank facility, which is led by Amegy Bank here in town. Has 10 banks in it, we've got great relationships with all of those banks. And that group has got dry powder for us to be able to increase that facility when needed. We have 2 SBIC licenses, which give us access to low-cost, long-term SBA debentures. So those debentures are 10-year maturities and their rates are fixed based on the 10-year treasury. So our first license, we've deployed all of the debentures and they are recycling that capital as we go forward. The first of those debentures mature in 2025. So we still have a way to go before we need to begin repaying them. Our second license has a total debenture capacity of $175 million, and we've drawn $100 million thus far. And you can see the benefit of the 10-year treasury, the rates are much lower on the second license than they were in the first, both low and fixed rates. And then finally, we've got $100 million of institutional bonds that we issued in January of 2021. And $50 million of it was to refinance existing bonds, and then we upsized it by an additional $50 million. So a good stable long-term source of funding and as we noted, for the most part, fixed rate. Next slide, Adam. So back on the interest rate sensitivity we were discussing. So as you heard earlier, our loan portfolio is largely floating. So 95% of our loans are floating with LIBOR, and only 35% of our liabilities are floating. So that makes us a beneficiary of a higher rate environment. However, effectively, all of our loans have LIBOR floors that average 1.2% across the portfolio. So LIBOR will have to increase above 1.2% before we really see an increase, but once it goes over 1.2%, we will be the beneficiary of that going forward. And just in general, back on leverage, as we think about it, our total leverage -- regulatory leverage is 1.05% or 1.05x compared to a regulatory limit of 2x. Next slide, Adam. So just a sense of what the cumulative dividends have been since our IPO. So if you were an IPO investor and paid $15 a share and held the stock through the third quarter, you would have received $12 of dividends during that time. Next slide, Adam. So our current dividends are $0.28 a share. Our board increased it in the fourth quarter to $0.28 per share on a regular basis and then also declared a $0.06 additional dividend payable in the first quarter of 2022. And that additional dividend is related to the gains that we've been discussing. So while the Board hasn't declared those dividends going forward, our expectation is we'll continue to pay that $0.06 per quarter per share dividend for the foreseeable future. And another way to look at this in terms of what our dividends means. So -- and again, I'll just caveat this by saying the Board has only declared the fourth quarter regular dividend, not the first quarter. But if we assume that, that declaration is the same in the first quarter, a holder of our shares today would receive $0.43 of dividends between now and March 31. So that's about a 3.3% return just for that short period. And maybe looking at it another way, is our ongoing dividends at $0.28 a share regular and $0.06 per quarter, $0.34 total. At yesterday's stock close, stock price close is a 10.6% dividend yield. So with that, I'll turn it back over to Rob.

Okay. Thank you, Todd, very much. So at this point, maybe talk about the factors ahead for 2022. I know our analysts are probably very interested in this. So it's hard to predict the future, but we'll give you our view as we see it. So first, how do we think about the year ahead. First, what's the macroeconomic outlook. And we study this constantly and studied it more over the weekend. It would appear from the best sources that you can gather that we ought to have a good economy in 2022. This is, of course, subject to exogenous events that are unpredictable. But perhaps the equity markets and private credit or public credit markets would be stable. Equity markets are expected to be up somewhat next year. Interest rates are expected to be higher. But again, we're a net beneficiary over time with higher interest rates. And of course, this is -- we're all worried about inflation. But as a general matter, we think the year is set up well. And this most affects the valuation of the portfolio. So the 2 factors are effectively the public comparables that we use to mark the debt and equity portfolio and then also company-specific performance. As we look at the portfolio itself, from a micro standpoint, as you can see from the remarks that Dean has made earlier, and Todd has made that we have a relatively stable portfolio. So we're positioned, we think, well for 2022 as a general matter. Next question you might ask is, how do we look in terms of new investing? And so if you think about our business on new investing is principally driven by lower middle market and middle market private equity firms acquiring new businesses. And as Josh pointed out, close to $300 million of dry powder across the sector and beyond, we're expecting our private equity firms we work with around the country to be active in the year ahead. And if it's helpful, we look back as a platform at the firm. So this would be across all of our vehicles. Over the last 5 years, we've averaged about $430 million of investing each year, of which the public company is $221 million on average. And interestingly, this year, perhaps our most robust year, we're on a pace now through effectively yesterday of $307 million of new investments in 2021. And we use this as the best example of the year ahead is what we've done in the past. Again, we can't predict the future perfectly, but we're expecting a very busy year on the M&A front in supporting the private equity firms that we work with throughout the country. And I'd say just in terms of maybe what our analysts would be most interested in, as a result, we're optimistic that we'll be able to certainly cover the current dividend that we've declared, which is a $0.28 per quarter run rate. And then also, we would expect we'll likely see some additional realized gains on our equity portfolio in 2022. Next slide, Adam. So maybe I'll just recap where we started and a reminder of the positive factors as you think about investing or investing more in our company. Our current yield of over 8%, a strong ROE that's been proven over time, not just the last 3 years, 9 years of covering our dividend through earnings, a 17-year track record of investing in private credit. And again, that track record is over $7 billion of investments across 300 companies. And just a reminder, as the entire platform of Stellus, we were operating in the $2 billion range. So our capacity to do larger transactions and create good diversification for the public company is certainly there. So with that, I think just one last slide, Adam. This is just a recap for everyone. Again, I'll give you a sense from a corporate standpoint. Again, Todd and myself as the officers of your company, our investment committee comprised of our 5 partners -- on the lower left are independent Board members, this you'll note. And then our analysts, who were very grateful to, as you can see, and all of whom are participating this morning to follow our company. So with that, I'm going to stop. We certainly have more questions. But thanks again, everyone, for being here and listening. And Adam, we'll turn it back to see what questions you might have.

Well, we have several. I will take them in the order that they come. And when possible, I'll try to integrate where parties that have asked questions of a similar vein. And say that loud. The first question comes from Eddie Allen of Eagle Global. What do you think is the sustainable ROE going forward? And how much equity would you need to be able to reach that goal?

So I would say as a general matter, we certainly expect to continue to perform at a similar ROE as we have for the entirety of our business, which is approximately 9%. And certainly could approximate the current 3-year levels. So we think 9-plus percent ROE for sure, is achievable. And in terms of additional equity, additional equity is not required to achieve that. We would like to have additional equity over time to continue to grow the business and of course, which we would also leverage roughly 1x to have a larger portfolio, but achieving that ROE is doable with the existing capital base.

I'll ask the question from Kevin Fultz of JMP Securities. And it's along that same vein in terms of need for capital. Given your desire to raise additional capital -- permanent capital over time, what is your expectation on the pace of utilizing the recently announced ATM program?

Yes. And welcome, Kevin. I'd say that the ATM program is an ideal way to raise equity capital. In that it happens daily, subject to having an acceptable stock price and is least disruptive in terms of dilution. So we like the ATM program very much. And so our intention would be to use it continuously. And it does take time, though. There's a limit about how much you could issue on a certain day. And in our case, we want to be issuing it at NAV. So when the price is right, we'll be active in the marketplace in the time periods that are allowed.

Next question comes from Bryce Rowe of Hovde. And I'll open up his line to talk, so that he can ask the question out loud.

Maybe along the lines of equity raising and capital raises. Obviously, in the middle of November, you signaled to the market a public offering that would not take the form of an ATM, and you pulled that offering. So I just -- I wanted to get a feel for maybe, why it was pulled? And then if you could speak to maybe the valuation dynamic that we've seen since that offering, you were trading at or just above NAV when that offering was announced. And now we're looking at a price to NAV that's closer to 90%. So any commentary around that would be really interesting.

Sure, Bryce. Thank you for the question. So relative to the -- we tested the market through our underwriters in November, and we felt like that, this is the -- an offering at that time, a regular way offering was not in the best interests of our shareholders. In that, we didn't know how well the stock would trade after a transaction. So we decided not to go to market and then immediately a few days later, we put out the ATM to raise money that way. And then relative to the question of the current price, as you know, over time, it's hard to predict in the market cap businesses like ours, the actual trading stock price, but we certainly think that it's trading way below where it should. And as evidenced by, one, the quarter we just finished to the realized gains that I've mentioned, that were flagged earlier, but now we're able to report on. And then if it's helpful, we would expect NAV at the end of the year, all things being equal, to rise since the third quarter. So I think there's a disconnect, Bryce, so thanks for pointing it out. And that we think there's a disconnect, and we hopefully that -- that delta will narrow here shortly.

That's helpful, Rob. And maybe just a follow-up to that comment. Did you all view the opportunity that the -- I guess that equity raise is more opportunistic or was it -- and I think you -- I think I know what the answer is, because you answered this previously, but assuming that you didn't necessarily need the equity, so to speak, it was more opportunistic with the stock having captured that premium to NAV?

Yes, certainly, opportunistic. Again, we think over time, it's healthy to raise more equity to help the business be larger, but it was not necessary. Interestingly, as I've kind of inferred from the life to date investing at across our platform, in particular, at SCM. We've had an addition of new investments. We've had a number of repayments that have occurred in the fourth quarter. So that recycling of capital has been very helpful in terms of new investing. So again, opportunistic, but again, over time, we'd like to raise more equity when it's beneficial to the shareholders and how our stock will trade.

Okay. I'll ask a question from a party in the room. This is Chris Nolan of Ladenburg. Any plans to implement senior going fund?

Yes, within the public company. Not at this time. Not at this time. The strategy that we have is the one that we have and -- but not within the public company at this time.

Bear with me a moment. Next question I'm going to is Robert Dodd covering analyst at Raymond James. Robert, I have made your line available, thus far. Feel free to chime in, if you'd like to ask your question.

And hopefully, you can hear me well. I appreciate you hosting this event. I've got a couple of questions on the credit underwriting process. I mean one of them going back to essentially the inverted pyramid on Slide 11, right? You start off with 2,500 opportunities and end up closing 50. I mean, what would you say are the primary reasons things drop out. And I'm primarily interested particularly between the 300 where you start due diligence and the 100 that actually make it to investment committee. What is it that causes 2/3 of those when you've already whittled them down to drop out at that stage?

Yes, sure. That's a great question. I think that's the right level to focus in. So I'm going to ask Josh Davis to cover that question.

Robert, I don't know if there is a primary reason. There's just lots of examples, right? As we're digging in to these companies, the industries, the sectors, their financial statements and balance sheets, things will stand out. So maybe we've been led to believe that there's $6 million of growth CapEx in the business. But in fact, there's $4 million to $5 million of it is actually maintenance CapEx. We run a preliminary background check on a management team and something pops up that scares us. You'd be surprised how often that happens. We dig into the contracts, and we find they're actually really short term and cancelable by the potential clients could be an issue. We're getting in customer returns too high. So it's -- there are just so many things as we really start digging in. We just had one the other day where we spent a lot of time on it. We thought it was interesting, but at the end of the day, when we dug in and looked at how cyclical the business really was during the last true big downturn in '08, '09, it just scared us off and it was just too cyclical of a business. So it's things like that as we really peel back the onion and get into these deals, we find things that doesn't make them a bad business, just makes them less of a fit for what we really want, which is less cyclical, more stable, growth-oriented, really high free cash flow businesses.

I appreciate that. And on a -- makes it hard, but lots of different reasons are good reasons. On the private equity side, I mean, obviously, you primarily sponsor that. How -- I'm not talking about when you initiate a relationship with a new private equity firm. You talked about that. But when you're looking at a deal, for example, how does the positioning of a deal in a fund, I mean there's a big difference between being the first new loan in a fund that's early in a disbursement period with plenty of capital versus being the last 1 that, hey, it's 30 days before the investment period ends or whatever. How does that play in? And does anything that you learned through COVID changed how you wait kind of the amount of available capital that needs to be in a fund, before you'll do a loan into an asset in a fund or anything like that?

Yes. So, Robert, I think you said it really well. It actually does make a difference. The first deal in a brand-new fund that's been raised is easier for us to underwrite than that last deal or even a more extreme case, a fund that's been effectively closed out, meaning they've moved on to investing in the next fund, and they -- while they do have some capital reserved, it's not a currently active fund. So that definitely affects our underwriting. And we'll start looking at whether that's a business we really want to move forward with. It doesn't completely exclude it, but it definitely makes the underwriting tougher and the calculus a little bit harder from an approval standpoint. At the end of the day, we didn't -- I can't think of a single example during COVID where one of our businesses needed capital from a sponsor and the sponsor did not have the liquidity to provide it. So I don't know that we really learned any lessons from COVID other than what everybody knows, which is, it is important to have capital available, but we didn't have a single example of one of our private equity sponsors, who did not have capital available to support a business through what was a kind of a 2- to 3-month liquidity crisis for some companies.

Okay. I appreciate that. One last one, if I can kind of a follow-up to Eddie's question. How much of your portfolio needs to be in equity co-invests in order to sustain that 9% plus ROE?

Yes. So, Robert, I'll cover this. So I think the way we would think about this is that the level that we've been achieving in the equity co-invest is right level to achieve in the first -- in the future. So we -- I should have mentioned that we appropriately sized the investments to not be outsized. So imagine that the loan is say, $15 million for the public company, having an equity co-investment of $750,000 to $1 million would be fine, but not $3 million. So I think we approach it that way, properly sized given the overall exposure to the company. And then that natural selection over time has resulted in these nice gains. So I think it would be the same program that we've had in the past. And as the portfolio grows, of course, we'll have more absolute equity co-investments in dollars, but a similar percentage. So I'd say at the same level that we've been doing over time.

I'll ask a question from the audience. There's also another covering analyst, who's Mitchel Penn from Op Co. [indiscernible] Here with us today. What is your outlook for the impact of your borrowers -- on your borrowers from supply chain issues and disruption?

Yes. So it's a very good question. So we have noticed in the portfolio, although it's limited so far, 2 phenomenon. The first would be supply chain issues and the second would be labor and cost of labor. So relative to supply chain, it hasn't affected many yet, but it has affected certain subsectors, if you will, of industries. It's our expectation and the best research that we know is that, this will start to moderate as you get toward the end of next year, but it's certainly an issue. But it hasn't been to the effect to materially impact those individual companies and certainly not to impact the portfolio. Relative to labor and labor costs and this is probably less an issue of cost, but maybe availability of good people to work. And so we have seen in some of the businesses where they could have applied for the PPP loans, the client decided not to. They reduced their labor force during COVID. And we've had a few portfolio companies where they've had challenges of hiring back. And certainly, when they are hiring back, it's at an increased wage. And so overall, increased wages in this country has to be good for our country. So -- but more to come, but it has had a limited impact at this point.

I'll keep you there. Mitch Penn has a follow-up question. What is your inflation assumption as you review new deals?

Yes. So we are expecting as the world is that -- inflation will be increasing. It looks like this latest spike of 6-plus percent, it's not what's expected to be in place by the end of next year. So we do think that inflation will start to moderate as you get towards the end of 2022. And so because if it returns to a more normal level of 2% to 3%, let's say, or 1% to 3%, this is not a meaningful change relative to the cost of items. Now we would look at a company -- specific company and is there something unusual about them. But we're not anticipating that this is a large factor to be considered in underwriting, but rather than it ought to result in, yes, more inflation in the past and two, higher interest rates, which, again, we think is good for our portfolio overall.

The next question comes from Ryan Lynch of KBW. Ryan, can you hear me or -- part of the room...

Can you guys hear me okay?

You sound great.

I just have a few. One of the trends we've seen over the last several years in the BDC space is certain BDCs as a component of their portfolio or their platform moving segment away from sponsor-backed lending, exclusively and moving into some other, more specialty finance areas, whether that be ABL or equipment lending or consumer finance, things like that. Have you given any consideration to move into any of those areas and why?

Yes, Ryan. Thank you for the question. So as you know, we have a history of investing in specialty credit providers that goes back to our time at D.E. Shaw. And up to this point, we've been focusing exclusively on the sponsor-backed activity as you indicate. We have considered other areas. The one that we're just starting to work on and have closed one investment so far is what we call a hybrid strategy. And this will be where we're providing both debt and equity. And it's principally to facilitate the buyout of a nonactive owner of a lower middle market company. So there would not be a sponsor, the management team effectively would be the sponsor. So we're just getting this started. So -- but it's in its nascent stage at this point. There are other areas that we might consider. And by the way, this hybrid strategy is a nice fit for our SBIC activity given that most of these companies if not all will qualify for SBIC financing. But beyond that, nothing that at this point we would announce, but we're certainly looking at other areas to diversify. I would say if it's helpful, there's so much to do in what we do currently. And it seems to be going well, but that will be our principal focus.

Okay. Understood. If I take a step back and look at your business and how it's kind of evolved, one metric it kind of stands out is, looking at your portfolio yield, it's come down quite a bit over the last several years from, call it, the 11% to 12% type of range to now kind of the [ mid-8s ] today. Is that a function of any sort of shift or change in investment strategy or philosophy? Or is that a change in just kind of market dynamics of pressure on spreads or some combination between those both? And is there any action items you can take to kind of slow or stop any sort of further declines in your portfolio yield today without, and this is important, without taking on a meaningful amount of credit risk, is that managing to a certain portfolio yield with credit risk being the buffers usually not a good usually ends up with a good result?

Sure. Sure. So as a general observation, I'd say that you should expect that our yield will be about where it is. So we don't intend to make any material change in the investing strategy to take greater risk. How we've gotten to this lower yield from certainly where we started out. And even if you go back about 3 years, it's really a function of 2 things, I'd say. The first is a reminder that the 90-day LIBOR, which is the principal benchmark we use to price the loans was roughly 200 basis points at the end of 2019. It's currently 19 basis points. So that's the most impactful thing, is effectively at close to 200 basis point drop in LIBOR. Now we do know, fortunately, these LIBOR floors that we put in place a number of years ago that captured some of that, but not all of that drop in LIBOR. The second thing that's more meaningful is a conscious decision to move the portfolio to a first lien unitranche product. And this is in line, of course, with the sponsors that we work with, looking for one tranche of debt and ideally one partner to provide that financing. So this is working with our sponsors. It's the desired product today. And the last thing I'd add, Ryan, would just be the impact of -- we did historically have some participation in the mezzanine market. As Dean pointed out, that was really the world we operated in 17 years ago, but we've really moved away from it. And as Dean indicated, a lien matters. And so if we had a mezzanine position, it would be highly unlikely today. And so all of these factors have moved the yield lower. Interestingly, though, of course, at the current level of the low 8% all-in yield coupled with benefit of equity co-invest gains over time. We're able to provide, we think, a very attractive yield and return to our shareholders. So don't expect it to change. And those are the factors that got us here and when it comes to shift to the unitranche lending.

Okay. Makes sense. And then just the last question I had, I might missed this. On Slide 16, with the equity co-investment strategy. Was there a total -- did you guys provide a total dollar amount deployed into that strategy since inception that has generated that 2.8x return?

Just in terms of the total dollars that created that return?

Correct?

Yes. So the way you could back into it is the 2.8x times or 2.8x. So as you can see -- this might be helpful, too. When we first started out in November '12, we had no equity co-invest. So original portfolio was just a debt portfolio that we acquired. And then over time, we make new equity coinvestments. Those have finally and they take typically 4 to 5 years to mature and to realize, so we're now getting the benefit now that number of years of investing. So again, that's -- and it effectively was across 22 companies. And then as you can tell, by the way, that's happening in the fourth quarter, we're getting more of that activity to occur.

I'll layer one on top of Ryan's previous question from Casey Alexander of Compass Point. Can you describe your management fee structure since you changed or first lien senior secured strategy? And are you pursuing a lower yielding, less risky strategy and reducing those fees?

Yes. So thank you, Casey, for joining. So the management fee structure is the same as we started out with 9 years ago. So there's been no change there. What has changed over time is we do operate at a higher leverage factor, and we also have the benefit of the SBIC financing. And as Todd pointed out, the second licensee, average interest rate is less than 2%. Now with fees it's higher, but -- so very attractive financing. So we think where the company is positioned and its ability to generate earnings that we're not intending to look at the management fee at this time. And we think it works within the context of the portfolio and the leverage we're able to maintain.

This next question might be more for Todd. Do you think SCM will be able to maintain or possibly lower borrowing costs in 2022? And that's from Chris Nolan.

Todd, would you like to take that?

Sure. Sure. Yes, I think there's a couple of ways that could occur. I mean, I think on the SBIC debentures, if you look at our weighted average borrowing cost, as long as the treasuries, I would like it to stay where they are, but they remain low as we layer on new SBIC debentures, that will drop our weighted average borrowing cost. And then to the extent that we have the capacity to do so in the future, I think the market today for institutional bonds could be lower than where we have it now. So there's a possibility there. And I think with respect to the bank facility, we are regularly discussing with the bank each time we kind of go with them to make sure that we feel like the rate is good and so forth. So it's conceivable that, that could drop as well. But my guess is, and now it's a market rate and well priced. So those things could occur and could reduce our borrowing costs going forward.

And Todd, I'd agree with all those points. The one thing just to caveat in terms of the bank facility, we'd like it to be lower, but not optimistic in the near term, it will be lower. And then just a reminder that, it is the one floating rate instrument that we have. It currently has a LIBOR floor of 25 basis points. So there's some chance we may, again, it's about 19 today. We might get past that. So you could see some slight increase in the cost of the bank facility. But again, I think that will be more than offset by additional debentures we'll take down under the second license. As you know, the debentures are priced off the 10-year treasury plus a market premium less price, it was like less than 1.5%. So I think we would expect our costs overall to probably be less, not more, but just to caveat that the bank facility is floating.

Anyone have a question in the room that you would like to ask. Since you're in the room, joined us in Houston, I wanted to open it up to in-person call.

Any plans to increase or decrease leverage ratio, given that the portfolio is interest-rate sensitive, will you theoretically you'll lower leverage ratio and keep reduction in ROE?

I ask you to repeat the question.

Yes. So the question from Chris Nolan of Ladenburg is, do we expect to change the leverage quotient of the company? And I would say that we don't. And there's an argument it could be slightly more levered from a regulatory standpoint given the unitranche first lien portfolio that we have today. So you could see a slight increase in the regulatory leverage from roughly 1:1 today. But I wouldn't imagine to get more than 1.2 or so 1.25. But the current plan is to keep where it is. Yes. Thank you, Chris.

With that, Rob, I think we are coming to an end. I'd like to turn it back to you.

Yes. Good. Thank you, everyone, very much for joining us today. And hopefully, this has been helpful to you. We tried to provide some new information and one to get to know more of our management team by meeting Josh Davis and Dean D'Angelo. And then some information that had not previously been able to share. But we've been able to share it today on this public event, if you will. So again, thank you very much for your support. We hopefully picked up some new shareholders today. And very much appreciate those who've joined us in-person. Thank you. And great holiday, everyone. We'll be back, of course, in front of you in late February, early March with the results from the fourth quarter and for the year of 2021.

Thank you, everyone.