Executive Summary / Key Takeaways

• Saratoga Investment Corp. ($SAR) maintains a highly disciplined investment strategy focused on the lower middle-market, emphasizing senior secured debt and strategic equity co-investments, which has historically yielded strong unlevered realized returns of 14.9% on exits.
• Despite a challenging macroeconomic environment characterized by low M&A volumes and competitive market dynamics, SAR's portfolio demonstrates exceptional credit quality, with only one investment (Pepper Palace) remaining on non-accrual status, representing a mere 0.2% of portfolio fair value as of August 31, 2025.
• The company possesses substantial liquidity and investment capacity of $407 million, including $201 million in cash, positioning it to capitalize on future accretive deployment opportunities and support its dividend, even as net investment income has recently been impacted by decreasing SOFR rates and significant repayments.
• SAR is strategically expanding its investment scope into BB and BBB CLO debt securities, leveraging its deep analytical expertise in this asset class to capture enhanced yields and liquidity, complementing its core private credit business.
• Management is committed to long-term value creation through expanding business development efforts and a flexible, low-covenant debt structure, which provides a significant competitive advantage and financial resilience in volatile markets.

Saratoga's Enduring Strategy in a Volatile Market

Saratoga Investment Corp. ($SAR) operates as a business development company (BDC), primarily focused on generating current income and capital appreciation through investments in senior and unitranche leveraged loans and mezzanine debt within the private U.S. lower middle-market. These target companies typically exhibit EBITDA between $2 million and $50 million. SAR's strategic journey, from its inception as GSC Investment Corp. in 2007 to its transformation under Saratoga Investment Advisors in 2010, has consistently aimed at building a robust and flexible financial platform. This evolution included multiple refinancings of its Saratoga CLO, securing Small Business Investment Company (SBIC) licenses, and establishing diverse credit facilities, all designed to fortify its capital structure and enhance its investment capabilities.

The current market landscape is characterized by significant headwinds. Deal volumes in the lower middle-market have been notably subdued year-to-date, down significantly compared to prior years, with M&A activity remaining muted. This environment, coupled with an abundant supply of capital, has led to tightening spreads and sustained high leverage as lenders intensely compete for quality deals. Adding to the complexity, larger market participants are increasingly venturing into SAR's lower middle-market segment, often offering less restrictive covenants and more aggressive terms.

Saratoga Investment Corp. differentiates itself in this competitive arena through a highly disciplined approach. It prioritizes robust due diligence, conservative capital structures, and strong legal protections, which are hallmarks of its lower middle-market focus. This strategy contrasts sharply with the broader market's commoditized lending, where SAR often passes on deals with relaxed covenants. While larger competitors like Ares Capital Corporation (ARCC) and Goldman Sachs BDC, Inc. (GSBD) benefit from scale and extensive networks, SAR's niche specialization allows for more tailored, hands-on support for smaller transactions. Similarly, against technology-focused BDCs like Hercules Capital, Inc. (HTGC), SAR's diversified sector coverage and preference for majority stakes offer a balanced risk profile. Main Street Capital Corporation (MAIN), a direct peer in the lower middle-market, shares SAR's emphasis on operational involvement. SAR's competitive advantage lies in its ability to forge deeper relationships and provide personalized financing solutions, which often leads to repeat business and a dependable deal flow.

Operational Excellence and Analytical Edge

Saratoga's competitive moat is not built on proprietary product technology but on its sophisticated operational processes and analytical capabilities, particularly in underwriting and portfolio management. The company employs rigorous underwriting standards, integrating deep industry expertise, especially within its substantial portfolio of SaaS businesses. Artificial intelligence (AI) underwriting is a significant component of its evaluation process, allowing for a nuanced understanding of potential investments. This analytical edge focuses on identifying companies with high retention rates, critical workflow integration, and enterprise software products embedded as "systems of record" within their industries.

For its CLO investments, Saratoga utilizes advanced valuation techniques, including Intex cash flow models, which incorporate historical experience, projected performance, economic factors, and underlying cash flow characteristics. This detailed analytical framework contributes directly to SAR's competitive moat, enabling superior asset selection and robust risk management. The tangible benefits for investors include a portfolio with consistently low non-accrual rates and a history of strong realized returns. This operational and analytical differentiation positions SAR as a trusted partner in complex deals, particularly in underserved segments of the lower middle-market.

Performance and Strategic Capital Deployment

Saratoga Investment Corp. reported Net Investment Income (NII) of $9.08 million for the three months ended August 31, 2025, a decrease from $18.20 million in the prior year. Total investment income also saw a decline, falling 28.8% year-over-year to $30.60 million for the same period. These reductions were primarily driven by the non-recurrence of a $7.90 million interest income from the Knowland investment, a 4.4% decrease in total investments to $995.30 million, and a lower weighted average current yield of 10.40% on investments due to declining SOFR base rates. Conversely, interest income from cash and cash equivalents increased to $2.36 million, reflecting higher cash balances.

Despite these headwinds, SAR's portfolio quality remains robust. The Zollege PBC investment was returned to accrual status, leaving only Pepper Palace on non-accrual, representing a mere 0.2% of the portfolio's fair value. The core non-CLO portfolio was marked up by $3.9 million and stands 2.1% above cost. Historically, SAR has invested $2.34 billion in 122 portfolio companies over fifteen years, incurring only three realized economic losses. Exits from 84 investments have yielded gross unlevered realized returns of 14.9% on $1.29 billion of realizations, with total realized gains year-to-date reaching $3 million.

As of August 31, 2025, SAR maintains a strong liquidity position with $105.70 million in cash and cash equivalents, supplemented by $95.14 million in reserve accounts. The company boasts a substantial investment capacity of $407 million, comprising $136 million from its SBIC III license, $70 million from its two revolving credit facilities, and $201 million in cash. This liquidity enhances its net regulatory leverage from 166.6% to 186.5%. Furthermore, all $296 million of SAR's baby bonds (debt with interest rates of 6% or more) are currently callable, offering strategic flexibility to manage interest expense in a declining rate environment. The company also benefits from a positive arbitrage, as the current rate earned on cash in its SBIC II license exceeds the cost of its debentures.

Outlook and Risk Assessment

Saratoga Investment Corp. is poised for strategic growth, leveraging its substantial capital and disciplined approach. Management expresses confidence in deploying its available capital, anticipating that increased deal volumes, as the M&A environment normalizes, will enable it to cover its dividend. The company has declared monthly dividends of $0.25 per share for the quarter ending November 30, 2025, totaling $0.75 per share. A significant spillover income balance of approximately $2.50 per share provides a substantial cushion, mitigating immediate pressure to reduce the dividend. The 4% excise tax on spillover income is viewed as a "low-cost financing" option in the current interest rate environment.

SAR is strategically expanding its investment focus to include BB and BBB CLO debt securities. These investments, which have a notional amount of $26.3 million across eight CLO managers, are expected to play an increased role in the portfolio due to their attractive yields, historical resilience, and liquidity. This diversification allows SAR to capitalize on dislocations in liquid loan and high-yield credit markets. The company's debt structure, characterized by long-term, covenant-free, fixed-rate financing, is a significant competitive advantage, providing exceptional safety and flexibility. This structure allows SAR to operate with higher leverage than some peers without incurring comparable risks, as demonstrated by its resilience during past economic downturns.

Key risks include continued interest rate sensitivity, as a prolonged reduction in SOFR could impact net investment income. The competitive market, with tightening spreads and aggressive terms from larger players, also presents challenges in sourcing quality new platform investments. While tariffs and AI encroachment pose broader industry risks, SAR's portfolio, heavily weighted towards SaaS and domestic services, is relatively insulated from direct tariff impacts. Furthermore, its rigorous AI-informed underwriting process for software companies helps mitigate the disruptive potential of artificial intelligence.

Conclusion

Saratoga Investment Corp. stands as a compelling investment opportunity, distinguished by its unwavering commitment to disciplined underwriting and a strategically robust balance sheet. The company's historical performance, marked by low realized losses and strong unlevered returns, underscores the effectiveness of its lower middle-market focus and hands-on investment approach. While recent quarters have seen a temporary dip in net investment income due to market dynamics and significant repayments, SAR's substantial liquidity and diversified capital structure position it for accretive growth.

The strategic expansion into BB and BBB CLO debt securities, coupled with ongoing business development initiatives, reflects a proactive stance in a challenging environment. SAR's analytical prowess, particularly in evaluating software companies and CLO tranches, provides a critical competitive edge. With a clear path to capital deployment, a flexible debt structure, and a strong long-term track record, Saratoga Investment Corp. is well-equipped to generate attractive risk-adjusted returns for shareholders, reinforcing its competitive standing and driving future value creation.