SARATOGA INVESTMENT CORP. quarterly report, Q2 FY2024

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Saratoga Investment Corp. — Form 10-Q Summary

Reporting period: Fiscal second quarter and six months ended August 31, 2023. Financial statements are unaudited. Saratoga is an externally managed business development company (BDC) focused primarily on debt and equity investments in U.S. middle-market companies, with a stated objective of generating current income and, to a lesser extent, capital appreciation.

Key financial results and position

  • Quarterly investment income: $35.5 million, up 62.5% from $21.9 million in the comparable 2022 quarter. Net investment income was $14.0 million, up from $7.7 million. Net increase in net assets from operations was $7.9 million, or $0.65 per weighted-average share, versus $0.9 million, or $0.08 per share.
  • Six-month results: Investment income was $70.1 million, up 73.1% year over year; net investment income was $29.9 million, up from $15.7 million. The net increase in net assets from operations was $7.7 million, or $0.64 per share, versus a $0.5 million decrease, or a $0.04 loss per share, in the prior-year period.
  • Investment valuation changes: Six-month net realized and unrealized investment losses were $22.1 million, primarily unrealized depreciation; prior-year comparable unrealized depreciation was $22.6 million. Quarterly unrealized depreciation was $5.7 million. Prior-year quarterly results included a $7.9 million realized gain, while the current quarter had no realized investment gain or loss.
  • Cash flow and liquidity: Operating activities used $118.0 million in cash in the six months, compared with $140.5 million used a year earlier, as investment purchases exceeded sales and repayments. Financing activities provided $70.4 million. Cash and reserve-account balances ended at $48.4 million, down from $96.1 million at February 28, 2023. Management states it believes liquidity is adequate for near-term needs.
  • Portfolio: Investments at fair value were $1.099 billion, up from $972.6 million at February 28. The portfolio was 84.6% first-lien loans; 99.4% of the interest-earning portfolio was floating-rate debt. Weighted-average current yield was 11.3%, compared with 10.7% at February 28. The portfolio covered 55 companies across 43 industries.
  • Credit quality and concentration: Two portfolio-company investments totaling $17.7 million, or 1.6% of portfolio fair value, were on non-accrual, versus one investment of $9.8 million at February 28. Pepper Palace was marked at $7.9 million against $34.3 million cost; management attributed further depreciation to declining company performance. Healthcare software was the largest industry grouping at 10.8% of portfolio fair value.
  • Debt and asset coverage: Principal debt obligations totaled $795.4 million, up from approximately $728.4 million at February 28. This includes $189.0 million of SBA debentures, $35.0 million outstanding on the Encina revolving facility and $571.4 million of notes. The 1940 Act asset coverage ratio was 159.7%, down from 165.9%; the applicable minimum is 150%.
  • NAV and distributions: NAV per share was $28.44, down from $29.18 at fiscal year-end. The company declared dividends of $0.70 and $0.71 per share during the six-month period; the latter was payable September 28, 2023.

Material changes versus the prior comparable period

  • Higher investment income reflected both a larger portfolio and a higher weighted-average current yield. Total portfolio fair value increased 13.1% compared with August 31, 2022, and the reported portfolio yield rose from 9.0% to 11.3%.
  • Higher financing costs partly offset income growth: six-month interest and debt financing expense increased 63.0% to $24.1 million. Saratoga reported higher average debt and a higher weighted-average borrowing rate, 5.66% versus 4.45% for the six-month periods.
  • Operating expenses increased 61.8% to $40.2 million for six months, including higher interest expense, base management fees and income incentive fees. Income incentive fees were $6.5 million for the six months, versus $1.7 million a year earlier.
  • Investment activity shifted to net deployment: Saratoga invested $167.3 million and received $17.1 million from sales and repayments in the six months, compared with net repayments in the prior-year period.
  • The company issued $20.0 million of 8.75% notes due 2024 and $57.5 million of 8.50% notes due 2028 during the period. SBA debentures fell by $13.0 million from February 28, while the Encina facility balance rose by $2.5 million.
  • Unfunded portfolio commitments increased to $140.6 million from $108.8 million. The company reported $30.0 million of available Encina facility borrowings at August 31.

Outlook, risks and unusual items

  • The filing provides no numerical earnings or investment guidance. Management identifies reliance on operating cash flows, borrowings and access to debt and equity markets to fund portfolio growth, commitments, dividends and debt repayment. Equity issuance may be constrained when the stock trades below NAV; ATM sales are subject to a price floor at NAV, and the Manager may contribute funds to support that floor.
  • Interest-rate movements are a major risk. Saratoga estimates that a 100-basis-point increase in rates would raise annual interest income by about $10.0 million and net investment income by about $7.7 million, or $0.64 per share, assuming the portfolio and borrowings remain unchanged. The company also warns that higher rates may pressure portfolio companies and increase credit losses.
  • Private-investment values rely substantially on Level 3 inputs and management estimates; realized values may differ materially from reported fair values. The company reported that most assets in its own portfolio were rated green under its credit-monitoring system, but a $7.9 million position was rated red. Its separate Saratoga CLO had four defaulted investments with $1.1 million fair value.
  • Other principal risks include portfolio-company defaults, inflation, recession, supply-chain and labor pressures, market volatility, regulatory and RIC qualification requirements, and the transition from LIBOR to replacement rates. The filing specifically cautions that replacement benchmarks may not produce economics comparable to LIBOR.
  • The company reported no material legal proceedings and no subsequent events requiring financial-statement adjustment. It stated that disclosure controls were effective and there were no material changes in internal control over financial reporting during the quarter.

Most important facts for investors to verify

  • Whether non-accrual exposure and the severe Pepper Palace valuation reduction lead to further losses, restructurings or cash-interest interruptions.
  • Whether NAV, asset coverage and liquidity can withstand additional portfolio depreciation, commitment funding and debt costs; verify the 159.7% coverage against the 150% minimum.
  • How the $140.6 million of unfunded commitments will be funded and how much of the stated $30.0 million facility availability remains accessible under borrowing-base and covenant tests.
  • Whether the higher-cost debt issuances and the $20.0 million notes due in March 2024 can be refinanced or repaid without materially reducing liquidity or distributions.
  • Reconcile the market-risk discussion: it says interest-rate changes would not affect current financing expense because the facility is “currently undrawn,” while the balance sheet and debt disclosures report $35.0 million outstanding under the Encina facility.
  • Monitor dividend coverage from recurring cash investment income, rather than relying on unrealized valuation changes, PIK income or equity issuance.