Thank you for joining today's Capital Southwest third fiscal quarter 2020 earnings call. Participating on the call today are Bowen Diehl, CEO, Michael Sarner, CFO, and Chris Rehberger, Vice President of Finance. I will now turn the call over to Chris Rehberger.
Thank you. I'd like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information, and management's expectations, assumptions, and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties, and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances, or any other reason after the date of this press release, except as required by law. I will now hand the call off to our President and Chief Executive Officer, Bowen Diehl.
Thanks, Chris. Thank you to everyone for joining us for our third quarter fiscal year 2020 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We are pleased to be with you this morning to announce our quarterly results for the third fiscal quarter ended December 31st, 2019. During the quarter, we continued to advance our credit strategy, achieving the final step in transitioning the BDC to solely a middle market lender with the successful sale of Media Recovery, which, as a reminder, does business under the banner SpotSee.
The sale was a great outcome for Capital Southwest as we realized a significant capital gain while strengthening the company's position as a more traditional yield-oriented BDC by removing the potential NAV per share volatility from holding such a large equity investment in the portfolio. As you likely recall, we have been discussing the potential sale for several quarters and will provide further details later in our prepared remarks. We are excited to have achieved this final step and look forward to continuing the pursuit of our core investment strategy of building a predominantly lower middle market portfolio consisting largely of first-lien senior secured debt with equity co-investments across the loan portfolio where we believe significant equity upside opportunity exists.
Executing this strategy under our shareholder-friendly, internally managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable long-term value through recurring dividends, capital preservation, and operating cost efficiency. During the December quarter, as laid out on slide six, we generated $0.44 per share of pre-tax net investment income and paid out a regular dividend of $0.40 per share during the quarter. We also paid out $0.10 per share in a quarterly supplemental dividend funded by our sizable undistributed taxable income balance or UTI, which was generated by excess income and capital gains accumulated from our investment strategy to date.
The realized gain on sale of Media Recovery allowed us to add approximately $0.50 per share to our UTI balance, bringing the total balance to approximately $27.6 million or $1.48 per share as of December 31st, 2019. We believe this provides visibility to the continuation of the quarterly supplemental dividend program well into the future. During the quarter, we also paid out a special dividend of $0.75 per share, which was the distribution of a portion of the Media Recovery realized gain. Total shareholder dividends for the quarter were $1.25 per share. We are also pleased to announce that our board has declared an increase to our quarterly regular dividend to $0.41 per share. Our board also declared another quarterly supplemental dividend of $0.10 per share, bringing our total dividends paid to shareholders to $0.51 per share for the March quarter.
During the December quarter, we grew our portfolio on a net basis to $559 million from $539 million as of the end of the September quarter, originating approximately $92 million in investments for the quarter, the vast majority of which were deployed in the lower middle market. From a capitalization perspective, we continue to de-risk the balance sheet by diversifying capital sources and maintaining liquidity. During the quarter, we raised an additional $10 million on our existing five-year, 5.375% institutionally placed bond due 2024. The aggregate principal amount for this debenture is now $75 million. We raised $13.8 million in gross proceeds through our equity ATM program during the quarter, selling over 623,000 shares at a weighted average price of $22.07 per share, representing a 21% premium to the September 2019 net asset value per share.
We are pleased to report that since the initiation of our equity ATM program, Capital Southwest has sold over 1.3 million shares at attractive premiums to book value, raising approximately $29 million in gross proceeds. Our equity ATM program continues to provide a steady flow of equity capital raised on a just-in-time basis in lockstep with our ability to thoughtfully put the capital to work. Including cash and undrawn commitments on our balance sheet credit facility, we had dry powder of $190 million at quarter end available to deploy in future investments. This dry powder, when invested, represents a 34% increase in our portfolio investment assets. Turning to slides seven and eight, we illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage, and value creation since the launch of our credit strategy.
Turning to slide nine, as a reminder, our investment strategy has remained consistent since its launch in January 2015. We continue to focus on our core lower middle market, while also maintaining the ability to invest in the upper middle market when attractive risk-adjusted returns exist. In the lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a well-performing and granular portfolio of equity co-investments is important to driving NAV per share growth and aiding in the mitigation of any future credit losses. Overall, we believe that maximizing the top end of our deal origination funnel in both markets is critical to generating strong credit performance over time, as it ensures that we consider a wide array of deals, allowing us to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic cycle.
We continue to find superior risk-adjusted return opportunities in the lower middle market, where we can lend at lower leverage and loan-to-value levels while maintaining tighter covenants and other terms in the loan documents. Over the past several quarters, this has been especially true as the upper middle market has been a primary source of NAV volatility in our portfolio. Turning to Slide 10, our on-balance-sheet credit portfolio, excluding I-45, grew 18% during the quarter to $456 million as compared to $387 million as of the end of the prior quarter. We continue to heavily emphasize first-lien senior secured debt lending, and again this quarter, the vast majority of our originations were in the lower middle market.
As of the end of the quarter, we had 81% of our on-balance-sheet credit portfolio invested in the lower middle market companies, while having 90% of the credit portfolio in first-lien senior secured debt. On Slide 11, we lay out the capital invested in and committed to new lower middle market portfolio companies during the quarter. This included $86 million in first-lien senior secured debt invested in five companies and almost $4 million in equity co-investments invested in three of them. We also committed $3.3 million of additional capital to four existing portfolio companies during the quarter, bringing our total capital deployed for the quarter to over $92 million. All of the new portfolio company loans were first-lien senior secured, with one being a loan in which a bank lender participated in a first out position.
The weighted average yield to maturity on new debt and originations funded this quarter was 9.9%. We are pleased with the pipeline as it stands today and expect that several additional deals currently in diligence should close during the March quarter. Again, the vast majority of this prospective investment activity is in the lower middle market. On Slide 12, we show a summary of the exits during the quarter. The sale of Media Recovery generated $51 million in net proceeds, realizing a gain of $44.3 million and an IRR of 11.8%, measured back to the original acquisition in 1997. During the quarter, we also realized a full prepayment of our subordinated debt investment in Chandler Signs. Chandler is performing well, and we remain invested in an equity co-investment position that has appreciated in value since closing. The subordinated debt exit generated an IRR of 14%.
This continues our strong track record of successful exits as we have now had 29 portfolio exits since launching our credit strategy back in January 2015, generating $267 million in proceeds and a cumulative IRR of 15.4%. On Slide 13, we break out our on-balance-sheet portfolio, excluding I-45, between the lower middle market and the upper middle market. As of the end of the quarter, the total portfolio, including equity co-investments, was weighted approximately 83% to the lower middle market and 17% to the upper middle market on a fair value basis. We had 32 lower middle market portfolio companies with an average hold size of $12.6 million, a weighted average EBITDA of $7.9 million, weighted average yield of 11.6%, and a leverage ratio measured as debt to EBITDA through our security of 3.6x.
Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately 69% of our portfolio companies. Our on-balance-sheet upper middle market portfolio consisted of 11 companies with an average hold size of $9.2 million, a weighted average EBITDA of $65.2 million, a weighted average yield of 7.4%, and a leverage ratio through our security of 4.6x . As in the past couple of quarters, we should note that our on-balance-sheet upper middle market metrics are shown excluding our investment in American Addiction, as the EBITDA, while improving on a run rate basis, remains at a level that would skew the aggregate portfolio leverage ratios to a degree that would obscure the ratios of the remainder of the upper middle market portfolio.
American Addiction remains a 3 on our internal rating system and remains on non-accrual, having been placed on non-accrual during the September 2019 quarter. As a reminder, all investments upon origination are initially assigned an investment rating of 2 on a 4-point scale, with 1 being the highest rating and 4 being the lowest rating. As of the end of the quarter, of the 44 loans in the portfolio, we had three with the highest rating of 1, representing 11% of the credit portfolio at fair value. We had 36 loans rated at 2, representing 84% of the credit portfolio at fair value. We had four loans rated at 3, representing 4% of the credit portfolio at fair value, and we had one loan rated at 4, which represented 1% of the portfolio at fair value.
The loans rated at 3 in the portfolio, all in the upper middle market, include American Addiction, American Teleconferencing, which does business as Premiere Global, and Delphi Intermediate, which does business as Delphi Behavioral Health. Delphi was downgraded from a 2 to a 3 during the September quarter and joined American Addiction on non-accrual status during the December quarter. Both American Addiction and Delphi are in the business of providing addiction treatment services to patients across the country. While it would be inappropriate to discuss in detail the status of each company on a public call, I will say that the two businesses face similar challenges, due in part to the addiction industry increasingly migrating to an in-network insurance reimbursement model. While this results in reduced reimbursement rates, it also results in a greater opportunity for each company to provide high-quality care to a larger number of patients.
Due largely to these challenges, cash flow at both companies has decreased materially in the short term. That said, we believe that both situations are rapidly moving to balance sheet restructurings, and in both cases, we believe that the restructurings will benefit each company in their respective missions to provide the highest quality care to their patients. We also believe that these restructurings will provide the respective lender groups the opportunity to realize appreciation in and recovery of their investments as the businesses complete the transitions and grow their respective patient bases. We continue to believe that the challenges facing both companies are addressable and our unrealized appreciation in each is recoverable.
As a result of these restructurings, if and when they occur, we would expect that a portion of Capital Southwest's first- lien loans currently held in each company would be reinstated as first- lien debt on each business, with the resulting interest in that portion coming back on accrual. The remainder of Capital Southwest's position in each company would then be equity, which we anticipate will be the source of recovery of the unrealized depreciation that exists today. Our loan rated a 4, also in the upper middle market portfolio, is A.G. Edwards. The loan has remained on non-accrual for the past several quarters. Not much has changed with respect to this position, the lender group continues to work with the company on strategic alternatives for the business. We will attempt to update you on future calls to the extent we can comment on the company's status.
As illustrated on slide 14, we have established a portfolio well-diversified across industries. Despite the few idiosyncratic issues we are dealing with in the upper middle market portfolio today, we believe the portfolio is well-positioned for late in the economic cycle. Further, our portfolio asset mix should provide strong security for our shareholders' capital. The portfolio remains heavily weighted towards first- lien senior secured debt, with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio in subordinated debt investments. Shown on slide 15, as of the end of the quarter, the portfolio was 93% first lien, with diversity among industries and an average hold size of 2.2% of the portfolio. The I-45 portfolio had weighted average EBITDA of approximately $65 million, a weighted average coupon of LIBOR + 6.3%, and weighted average leverage through the I-45 security of 4.5x .
We also excluded American Addiction from these ratios for the aforementioned reasons. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.
Thanks, Bowen. As seen on slide 16, our investment portfolio produced $16 million of investment income this quarter, with a weighted average yield on all investments of 10.7%. This represents an increase of approximately $800,000 from the previous quarter. The increase in investment income was primarily attributable to an increase in average debt investments outstanding and a transaction fee received in connection with the sale of Media Recovery, offset by decreases in dividend income from both I-45 and Media Recovery, and Delphi being placed on non-accrual during the quarter. As of the end of the quarter, there were three assets on non-accrual with a fair value of $18.2 million, representing 3.3% of our total investment portfolio at fair value. The weighted average yield on our credit portfolio was 11.3% for the quarter.
Excluding interest expense, we incurred $4 million in operating expenses for the quarter, which was $150,000 less than the previous quarter. For the quarter, we earned pre-tax net investment income of $7.9 million, or $0.44 per share. This compared to $0.42 per share during the prior quarter. We paid out $0.40 per share in regular dividends for the quarter, flat from the $0.40 regular dividend per share paid out in the prior quarter. We have continued our consistent track record of meaningfully covering our regular dividend with pre-tax NII, as demonstrated by our 109% regular dividend coverage over the last 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy. As Bowen Diehl mentioned earlier, we also paid out a supplemental dividend of $0.10 per share during the quarter.
As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance over time. Due to the successful sale of MRI, we were able to replenish our UTI balance to a level of $1.48 per share as of December 31, 2019, which we believe provides visibility to the continuation of our supplemental dividend program well into the future. The program will continue to be funded from UTI earned from realized gains on both debt and equity, as well as undistributed net investment income earned each quarter in excess of our regular dividends.
In addition, we declared and paid a special dividend of $0.75 per share as we distributed a portion of the realized gain from the Media Recovery sale. On Slide 17, we illustrate our operating leverage, which as of the end of the quarter, was 2.7%, which puts us near our initial target operating leverage of sub 2.5%. We are fully committed to actively managing our operating costs in lockstep with portfolio growth and have our longer-term sights set on achieving target operating leverage of 2% or better. With senior professionals and corporate infrastructure largely in place, operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure. Flipping over to Slide 19, the company's NAV per share as of December 31, 2019 was $16.74 as compared to $18.30 at September 30, 2019.
Given the number of moving parts this quarter and the fact that much of the NAV per share change was a reset of NAV per share as a result of the final step in the transition of the BDC to a middle market lender achieved through the sale of Media Recovery, we thought we would take a minute and walk through the components of the quarter-over-quarter change. Moving from left to right, we continued our strong track record of fully covering our regular dividend with NII earned during the quarter while systematically distributing our undistributed taxable income over time. With respect to the investment portfolio, we saw unrealized depreciation in the upper middle market, partially offset by unrealized appreciation in the lower middle market portfolio.
Finally, with respect to the sale of Media Recovery, we paid a special dividend to shareholders of $0.75 per share, distributing a portion of the capital gains from the sale to our shareholders. For the portion of the capital gains we retain, we paid a $0.19 per share tax on the retained capital. Shareholders will receive a Form 2439 and a letter from us with further explanation of the resulting tax credit and step-up on their cost basis, which we expect to be $0.71 per share for shareholders of record as of December 31, 2019. Finally, we recognized book depreciation from the sale of Media Recovery of $0.23 per share. There were three components to the $0.23 per share.
First, $0.09 per share was driven by frictional transaction costs from the sale process, including investor banker fees, legal and accounting expenses, and a closing working capital adjustment pursuant to the purchase and sale agreement with the buyer. Second, $0.08 per share were the GAAP-required book discounts applied to the potential earn-out and escrows associated with a company sale to account for the fact that each is a future event. If we receive both in full, it will result in Capital Southwest receiving an additional $1.5 million in recognized proceeds from the transaction. Third and finally, pursuant to a management services agreement in place between Capital Southwest and Media Recovery, Capital Southwest received a success fee upon closing the sale, which approximated $0.06 per share. The success fee was recorded as fee revenue rather than sales proceeds for purposes of NII and NAV per share.
Our total pre-tax NII return on equity for the quarter was 9.5%. On Slide 20, we lay out our multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to de-risk the liability structure of the company while ensuring that we have adequate investable capital throughout the economic cycle. To that end, we raised an additional $10 million on our October 2024 institutionally placed bond, which has a coupon of 5.375%. As Bowen mentioned earlier, during the quarter ended December 31, 2019, we sold 623,111 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $22.07 per share, raising $13.8 million of gross proceeds.
Cumulatively to date, we have sold 1,313,588 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $22.07, raising $28.7 million of gross proceeds. Our balance sheet leverage ended the quarter at a debt-to-equity ratio of 0.88: 1. We are pleased to report that our liquidity is strong, with significant dry powder and the earliest debt maturity at December 2022. I will now hand the call back to Bowen for some final comments.
Thanks, Michael, and thank you, everyone, for joining us today. Capital Southwest has grown, and the business and portfolio have developed consistent with the vision and strategy we communicated to our shareholders five years ago. Our team has done an excellent job building a robust credit portfolio, generating attractive returns for our shareholders, while also demonstrating our extensive credit experience in managing our loan portfolio as it matures and seasons. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable shareholder value. This concludes our prepared remarks. Operator, we are ready to open the lines for Q&A.
Thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Tim Hayes from B. Riley FBR. Your line is now open.
Good morning, guys, congrats on officially completing the portfolio transition. My first question, Bowen, would you just mind expanding on your decision to raise the regular quarterly dividend? On an after-tax basis, NII is a little bit lower than the $0.40 regular dividend this quarter. I know you had the excise tax accrual. You also had the one-time success fee that drove investment income higher. Growth is really strong. Was this a case where it was back-end weighted and you expect growth will have a much more profound impact on next quarter's results? Just any color around this would be helpful.
Yeah, sure. Thanks for the question. It's all of those things, and so I'm going to let Michael comment on the components.
Oh, sure. I think in looking at the 12/31 run rate, if you exclude the non-recurring MRI fees were about $1.7 million, you add back the impact of the $85 million in originations during the quarter for a full quarter's accrual, our run rate for the 12/31 quarter would be $0.40 per share. That doesn't include, looking forward, originations that have closed this quarter to date or that'll close between now and the end of the quarter.
Okay. Got it. That's helpful. As it relates to Delphi, what exactly triggered the company being added to non-accrual this quarter? Was there new information you gathered which increased the likelihood of impairment, or did they actually stop paying interest and/or principal on the loan?
They stopped paying interest on the loan, so it's picking, but not going through our income statement. It's on non-accrual. It's just basically deterioration in EBITDA. Based on that and the fact that we weren't receiving cash interest, we made a judgment call to put it on non-accrual.
Okay.
As Bowen said, Tim, it was picked into the principal balance, and I think Bowen discusses the potential restructuring, so that value will be part of that restructuring process.
Right. I guess my follow-up question on that was, I know this might be difficult to answer, but is there just any rough timeline around the restructuring process that you can give us?
I would say that, like I said in my prepared remarks, both of them are rapidly moving that direction. I'd say you probably should expect that Delphi probably gets done faster than AAC. It's a little simpler given it's private and AAC's public. They're both moving on a pretty quick timeline, and that's going to be good. Like I said in my prepared remarks, that's going to be good for both companies, because ultimately, the companies exist to provide high quality healthcare to their patients, and that's what's going to ultimately support the capital structure. The pace is fairly quick in both cases.
Okay. Then on the $9 million of net depreciation on upper middle market investments, how much of this was the JV, and were the marks largely fundamental and related to company performance, or were there any technical factors that drove these fair value marks?
It's about half and half between the JV and balance sheet. At the JV, or I should say, on the balance sheet, is $5.4 on the balance sheet of depreciation. If you looked at the four companies that I mentioned, we talked about the depreciation between those four is $5.4 million.
Okay.
All the other companies were kind of pluses and minuses. On I-45, it was $4.5 million of total depreciation, and $3.2 million of that is essentially four credits, including AAC. There are four credits in I-45 that I would say are having credit or operational challenges. That's four out of 46 loans. The other 42 loans are either doing fine, doing great, or just kind of bumping along. The equity guys are working very hard to get their returns, but the loans themselves are probably fine. There's four out of 46 that are having some level of conversations and operational challenges. Hope that kind of gives you some general color.
Yeah. No, it does. Thanks. Just broadly, how would you describe kind of sponsor behavior? Are they being supportive in working with companies, distressed companies to try to restructure investments or just inject liquidity to help for a better outcome? Are you seeing sponsors maybe kind of ditch some of the, I don't want to call them losers, but ones that are struggling a little bit more and focusing on winners? If you could just, some color on that would be helpful.
Yeah. I think sponsors are making, for the most part, smart, informed decisions, and not just throwing good money after bad. Across our portfolio over the last year and a half timeframe when we have the vast majority of the time, sponsors have supported the companies, and that's a rational thing for them to do in every one of those instances. There are a couple of them, one in particular, where the sponsors made the decision to hand the keys over to the first lien lender, i.e., restructured the balance sheet, as I referenced earlier. In that case, I think that was probably a rational decision, and the right thing to do for the business, and frankly, the right thing to do for the senior lenders. I'd say generally, I think we've seen sponsors make smart decisions.
In virtually every case, that right decision was to support the business, and frankly, keep the first lien lenders happy, which is what we want them doing.
Okay, got it. Thanks for the color there. I'll hop back in the queue.
Thank you.
Thank you. Our next question comes from the line of Mickey Schleien from Ladenburg. Your line is now open.
Good morning, Bowen and Michael. Wanted to ask about deal flow. I've been hearing that the volatility in the more liquid markets in the fourth calendar quarter led larger borrowers to gravitate toward direct lenders, instead of the syndicated market. That caused larger lenders, including larger BDCs, to focus more on bigger deals, and that may have resulted in more opportunities for smaller BDCs. Was that a trend that you saw, and did that impact your deal flow, during the quarter?
Well, we certainly saw a slowdown of general activity in the syndicated market, that would be consistent with that comment. We've looked at some larger club deals, which I think is also consistent with that. As a general matter, the number of upper middle market deals that we've been excited about has been low. Hence you see I-45 not growing because capital's been refinanced and a low number of new deals really that we've been looking at in that fund. It's activity in I-45 is slow, so slower, you can see that there. I would say virtually everything you just said was certainly consistent with what we're seeing.
I think you mentioned in your prepared remarks that at least so far, the first calendar quarter looks pretty busy, and that's usually a slow quarter. Is there something specific going on this quarter that's leading to that volume, or is it just spillover from deals that just didn't get done in the fourth quarter?
Yeah. The lower middle market honestly I've always said it's lumpy, and it's frankly kind of random. I would say that if you look across our pipeline and I look down the list and I see deals that we've signed up and that they're essentially, I would say, are ours if we want them kind of category. It's above average. The December quarter was obviously a very strong quarter of originations, but the quarter or two before that were below average. If I'm just thinking along the deals that we're working on, I wouldn't say that it's albeit strange that we're working on them in the March quarter. It's a little bit random. I would just say that the pipeline this quarter is above average.
May not be last quarter's volume, but we would expect it to be above average, probably closing towards the latter half of the quarter.
Okay, I appreciate that. Just a follow-up on AAC, I know you're limited as to what you can say. There has been news about the extension of the forbearance agreement and some additional capital provided by the lenders. Did you participate in that additional injection of capital into AAC?
We did. Our piece is small because there's a $400 million loan that we all split the incremental capital, so our dollars are small, but we participated in it. That incremental capital has very outsized economics, and so it's directly first priority secured by the real estate. Frankly, other people are going to put it in if we don't. It's the rational thing to do. Fortunately, the numbers for us are relatively small.
Okay. I just wanted to confirm, there is real estate in the collateral, correct?
That's correct.
Okay. That's it for me this morning. I thank you for your time.
Thank you. Our next question comes from the line of Kyle Joseph from Jefferies. Your line is now open.
Hey, good morning, guys. Thanks for taking my questions. Most have been answered. I just wanted to get a sense. It sounds like the lower middle market continues to be very attractive, and you're maybe a little disappointed with some of the investments in the upper middle market. I want to get a sense for what's driving that. Have you seen things in the upper middle market get more competitive? Can you explain the discrepancy there?
If you just kind of break it into its components, there's $5.4 million of depreciation in the upper middle market. If you take the depreciation on Delphi, AAC, and AG Kings and add those together, it's $5.4 million. That's the story in the upper middle market. Frankly, as a credit guy, I look at myself and go, we just made bad choices on those loans. Those loans, we wish we hadn't done them. They were structured well. The structure and the restructuring is going to work out fine in the long run. Certainly we wish we'd never made those loans, right? It's not a zero defect business. That's the upper middle market story so far.
We do think that loan, as we've really referenced really pretty consistently over the last several years, the upper middle market is a market where it is more competitive. There's more people willing to lend to larger companies. You have higher leverage ratios on average, higher loan-to-value on average, lower yields on average across. When there's a problem, you have less degrees of freedom. That's the nature of the upper middle market. As far as is it getting more competitive or less competitive, it's kind of been that way for certainly a few years now. On the lower middle market side, our story is different. We have a $370 million loan portfolio depreciated by $140,000 this quarter. That's basically flat. Our lower middle market equity portfolio appreciated by $2.9 million. That portfolio is working as designed.
It's first lien with equity co-investments, those equity co-investments, the winners are far outpacing any depreciation in the equity portfolio. It's working like as designed. Hopefully that's helpful.
Got it. That's a good segue to my next question. As you think about the pipeline between upper and lower middle market, or I guess this is kind of a three-part question, but talk about yield trends you're seeing in the upper and lower middle market, and what that means for your portfolio more broadly.
Yeah, I would say that the sandbox, if you will, of loans in the lower middle market yields are basically generally the same. I say generally the same, there's a range of deals within a market, right? You'll have loans that are very high margin, recurring revenue type businesses, where we're making a relatively low loan-to-value kind of loan, and those are going to have a tighter spread and may be sponsored, right? That's going to have a tighter spread than a deal that has maybe a slightly higher loan-to-value, maybe less recurring-based business. Maybe a sponsor that's not as large of a fund or maybe doesn't have specific sector expertise as the other. Not that those are negatives, but that would be a higher yield deal. There's going to be ranges of yields.
If you look quarter to quarter, we're going to do some of all of that as we move to target leverage. Our cost to capital is coming down, and frankly, as we lever up the BDC, one should expect that we do safer deals. You may move from one edge of that same sandbox to the other edge of that sandbox. I would say that over the last several quarters, I really haven't seen the sandbox itself move all that much. It's been competitive for a long time. The upper middle market has been more competitive than the lower middle market for a long time. By a long time, meaning a couple of years. It's been the same thing. We don't see, like this quarter, we didn't see the sandbox, as I defined it, change all that much.
Appreciate it. That's good color, and that's it for me. Thanks a lot for answering my questions.
Thank you. Our next question comes from the line of Bryce Rowe from National Securities. Your line is now open.
Thanks. Good morning, guys.
Morning.
Morning, Bryce.
Hey, Michael, I wanted to ask you about the source of dividend income here this quarter. Obviously, you had the I-45 dividend. Curious what the other portion of that dividend income was.
Sure. The other portion was a stub dividend from MRI for about $500,000 that was paid out of the proceeds before close.
Okay. That's helpful. Okay. Then, Bowen, you talk about the pipeline being maybe above average and can be quite random in terms of the lower middle market. I'm curious what you're seeing from maybe a repayment visibility perspective. Obviously, this past quarter was dominated by the proceeds from MRI, but just wondering if you have any visibility into repayments over the next quarter or two.
Yeah, I'm just thinking. I'm looking at Michael thinking about that. I think prepayments are obviously, they're kind of a constant aspect of our business model. We don't really have large, right now, visibility on large prepayments coming in the next quarter for two. We may be one phone call away from seeing that, some of our companies, but we don't have any.
Right.
Prepayments, I would expect the prepayments over the next quarter to be, in the lower middle market, certainly relatively light.
Right.
Yeah, we did have two, what we'd call A-plus performers that the potential for refinancing existed, and I think we've worked through that where we're going to stay in as a lender. That's part of the reason we'd say we don't see any visibility right now for additional repayments.
Okay. If you guys can, I don't know if you can speak to this or not, the earn-out that you mentioned with MRI, what kind of timeframe are we talking about there?
The earn-out will be tested on a 9/30/2020 fiscal year. That's MRI's fiscal year basis. It'll be earnings performance for that year.
Excellent. Okay. Thanks. Appreciate the answers.
Thanks, Bryce.
Thanks, Bryce.
Yep.
Thank you. Our next question comes from the line of Christopher York from JMP Securities. Your line is now open.
Good afternoon, guys. Thanks for taking my questions. Michael or Bowen, I noticed a decent pickup in the weighted average leverage to your security in upper middle market investments of about a jump from 3.7 to 4.6. Could you maybe just comment on what drove that big increase?
Yeah, thanks. It's all Delphi, basically. If you take Delphi out, the $4.6 is $3.6.
Very good. Okay. In I-45, we also have a decent increase there. I would have to look at the Q and the SOI Delphi in I-45 as well?
No, it's not. The leverage on I-45 went from 4.3 last quarter to 4.5. During the quarter, we had $9.3 million paid down or prepaid on companies where the leverage was mid 2.5x EBITDA basis because of the performance. We put two credits on that were new deals, new issues, and they were in the low 4x , like 4.2x-4.3x type leverage. That's basically the change.
That's a great color. Okay. Let's see, the I-45 dividend decreased $400K sequentially. Given the decline in the portfolio there, is this a level of recurring dividend that we should be expecting to continue?
Yeah. Based upon the number of credits that are in the portfolio right now and the cash yield, I think that the $2.1 is a good run rate number going forward.
Okay. Maybe taking a step back, given the competition that you described, Bowen, in the upper middle market, losses you've experienced here in the upper middle market, has this caused you to reconsider the dual prong strategy or allocating capital between the strategies?
No. Our strategy from the beginning has been core market, lower middle market, opportunistic market, upper middle market. Right now it's very competitive. I think I've said really over the last couple of years, finding value in the upper middle market has been certainly much more challenging in our view than finding value from a credit perspective in the lower middle market. Or said differently, risk-adjusted returns. That strategy hasn't changed. Given what I just said, in our core business in the lower middle market, our deal teams have done a great job originating deals, and we're kind of closing about 2% of the deals we look at. So they've done a great job originating opportunities for us to look at.
I look at that and I'm like, okay, there's demand for our lower middle market, our balance sheet in the lower middle market, and value is more challenging to find in the upper middle market. Doesn't mean it doesn't exist. I mentioned earlier we did two deals this quarter, so it's not like it doesn't exist or two deals in I-45. It's just more challenging. That hasn't changed. Now we've got a couple of situations in the upper middle market that are obviously credit-challenged and being restructured. That's just noise thrown on top of the strategy statement that I laid out. The strategy I wouldn't say has changed. Where we're putting our money and where we're allocating capital is going to ebb and flow based on the risk-adjusted returns we see in those markets.
I still think it's important for us to maintain, certainly in the lower middle market. We've talked quite a bit about why we like the lower middle market. We want to maintain the ability to look at and consider and evaluate the upper middle market, because we do think there's opportunities, and as we've always said, when things move in the market, the upper middle market moves from a quote perspective. It doesn't necessarily immediately result in assets you can buy, but it certainly moves around with The Wall Street Journal, if you will. It's going to be opportunistic for us in the future. We're going to still continue to look at it, maintain that capability, maintain those contacts in the market. Right now it's harder to find value, if you will, in that market.
Sure. It's great context. Last one from me, it's maybe a two-part question. Bowen, you said that you may have not made some of these upper middle market investments if you were approached to potentially invest today. Could you describe some of the characteristics that led you to say that? Secondly, what gives you such confidence that there is recoverable value in some of the unrecognized depreciation, given that your ability to control the outcome as a part of a syndicate is less than maybe an 1PG Syndicate deal or a led deal?
First of all, anytime you make an investment or an investor buys a stock and it doesn't go up in value, you might question, you wish you'd never done it, right? That's a general comment. I would say with respect to those industries. The addiction treatment industry, which is most of the story here. I'll come back to Kings in a minute. The addiction industry, unfortunately, the opioid and drug epidemic in this country is growing, and I think we all would agree on that, and it certainly is not a positive. People need help and lives are being saved in that industry. It is an industry that unfortunately, or fortunately, depending on your perspective, is growing. With that comes increased cost, and so payers have to bear that burden. The industry is making a transition from out-of-network, in-network.
Both of these businesses have had a portion of their business out-of-network. There's a number of different challenges, management or otherwise. That's a large piece of it. Do I wish we never invested in the addiction treatment industry? No, I can't say that. One of my better investments I made at my former firm was in the addiction treatment business. We like that industry. It gets to your recoverability question. These are viable platforms we still believe, certainly I suppose theoretically that could change, we think these are viable platforms in a growing industry that is going through a transition. I still view, certainly the vast majority of that, if not all of that, unrealized depreciation should be recoverable. That's why I said that.
No, I don't think that addiction industry is a horrible place to invest and all that. It's those factors I just laid out. On the grocery side, the grocery business is a very competitive business. We know that. People don't stop eating, and so that's good. It's a consumer staple type product. It's one that's increasingly larger and larger competitors that are opening up stores in more and more geographies. That pace is moving faster than, frankly, we anticipated several years ago when we made that loan. That unrealized appreciation is going to be harder to recover, and that's why it's a 4, not a 3. It's a different situation. Not super excited about making any other grocery loans, quite frankly.
Hopefully you're hearing a different answer to that question than with respect to the addiction treatment space. All three are challenged situations, no question about it, but the two industries are very different.
Certainly understand that. Great. That's it for me. Thanks for the candor, and thanks for taking my questions.
Thanks, Chris.
Thank you. Our next question comes from the line of Robert Dodd from Raymond James. Your line is now open.
Hi, guys. Just some quick housekeeping ones, I think, on MRI and then a couple of more detailed ones. Michael, you mentioned earlier in the call, $1.7 million success fee from or related to MRI is like normal. I presume that $1.7 million includes the half a million dividend because otherwise it'd be more than your total fee income.
That's correct. It was $1.16 million for the success fee, and it was approximately $500,000 for the stub dividend.
Got it. On the form, if I got the number right, the Form 2439, I know I'm going to get questions about this, but when can your shareholders expect that?
I think we should have that in the next week. It has full description of the definition of the deemed distribution. It'll describe the long-term gain and tax treatment. It'll help them provide the information to their tax advisors to get it done correctly.
Got it. The last one on that. The $27.6 million in undistributed income, that's adjusted for the deemed distribution, right? The amount you were taking in.
Yes, that's correct.
Yeah. Got it. Okay. Thank you on that. Just going to I-45, and looking at that level. The portfolio, obviously, over the last year, and I'm looking at page 15, which is very helpful. It's shrunk a little bit. Leverage has gone up. You mentioned about that you had some low-levered repayments. i.e., some good assets or successful assets had repaid. Should we be worried given the leverage has gone up a point over the course of the year while it's shrinking, that there's any adverse selection going on in that portfolio about what the remaining borrowers are? Obviously, the more successful a borrower, the more likely they are to repay early and get out of a portfolio. When the portfolio is shrinking, do you end up with a mix that you might not have wanted up front?
I think clearly as any portfolio, and certainly loan portfolio, the ones that outperform leverage goes down, gets repaid earlier. It just academically, by definition, the lesser quality credits are the ones left in the portfolio. Having said that, if I look across the loan portfolio, it's really kind of four or five loans that are kind of companies are going through operational issues, one of those being AAC, but the other ones aren't on our balance sheet. They're just unique to I-45, which is the bulk of the depreciation. That's also affecting the leverage as well. I would say other than just, yes, from a high level, the better quality loans pay off faster and then get recycled in newer loans and some of the older loans. It doesn't mean that what's left is a disaster.
I'm agreeing with your general comment, but I'm telling you that we don't think that's like a dramatic issue with I-45.
Got it. I appreciate it. On the lower middle market, if I can. Very strong originations in the quarter. As you said earlier in the call, it can be lumpy, but have you seen anything out in the market on the lower middle market in terms of the borrowers or the company owners, has the ask on what they're looking for shifted any that makes the deals maybe slightly more appealing to you?
Well, there's a lot of variables, right? When I say the ask, every industry is different, right? Every industry, every company is different. The different profit levels, the industries have different profit drivers. There are different levels of sensitivity to the economic cycle. We look at it and go, is the ask appropriate for our view of that industry and that company?
I don't think that they always ask, they have varying levels of aggressive behavior from sponsors, right? Some sponsors are very aggressive. They want the last nickel of leverage, and other sponsors are much more measured because ultimately, most of their IRR is going to be driven by the operational improvements they provide that business and less by the financial engineering. We do better with the second, the latter category. It's not surprising.
Right.
Again, it's the same comments I made with respect to the sandbox and leverage and pricing. The sandbox, I don't think has changed, but as we can play in different portions of the sandbox, if you will. Certainly as we move up in leverage, bringing our cost of capital down, it allows us to compete and put assets on the books that generate attractive ROE to our shareholders, which is ultimately what's important in maybe a safer side of the sandbox, if that makes sense.
It does, absolutely. If I can, on that size question, one more on asking you. The target of getting operating leverage sub- 2.5%, obviously it's been trending down and increasing returns to shareholders, not necessarily what time, when do you think you can get there, but so much as what do you think your asset level needs to be sustainably for that OPEX ratio to be sub- 2.5%?
Honestly, Robert, I tell you that we think we can achieve it. I'll give you the timing and the amount. I think we can achieve it in the next two quarters, and I think the amount's going to be in somewhere close to $650 million of assets on balance sheet.
Got it. Appreciate it. Thank you.
Sure.
Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Bowen Diehl for closing remarks.
Thank you, operator, and thanks everybody for joining us today. Thanks to all the analysts that asked us the questions. Those are great questions, and we appreciate everybody's support and look forward to giving you updates as we move forward.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.