Executive Summary / Key Takeaways

• Saratoga Investment Corp. ($SAZ) operates as a Business Development Company (BDC) specializing in providing debt and equity financing to U.S. middle-market companies, leveraging a diversified capital structure including CLOs and SBIC licenses.
• Recent financial performance in Q1 FY2026 showed a decrease in total investment income, primarily driven by lower SOFR base rates impacting floating-rate investments, partially offset by increased interest from higher cash balances.
• Despite lower investment income, operating expenses also decreased due to lower debt levels and associated fees, contributing to a net increase in net assets from operations for the quarter, a significant improvement year-over-year.
• The company maintains a strong liquidity position with substantial cash reserves and available capacity on its credit facilities, providing flexibility to fund future investments and manage unfunded commitments.
• Key risks include interest rate sensitivity, credit quality fluctuations in the portfolio, and the inherent risks associated with its CLO investment, though mitigation strategies like interest rate floors are in place.

A Structured Approach to Middle-Market Lending

Saratoga Investment Corp. ($SAZ) operates as a Business Development Company (BDC), focusing on generating current income and capital appreciation through investments in private U.S. middle-market companies. The company primarily targets senior and unitranche leveraged loans and mezzanine debt for businesses typically having EBITDA between $2 million and $50 million. This strategy is executed through direct lending and participation in loan syndicates, complemented by opportunistic investments that can constitute up to 30% of the portfolio.

The company's history, marked by a significant recapitalization in 2010 that brought in Saratoga Investment Advisors as manager, has shaped its current strategic framework. This transition reset the incentive fee structure and laid the groundwork for a more focused approach to middle-market finance. A core element of Saratoga's operational structure is its involvement with collateralized loan obligations (CLOs), specifically the Saratoga CLO, which the company manages. This structure provides a unique avenue for yield enhancement and portfolio management, although it introduces specific risks related to the subordinated nature of the company's investment in the CLO. Furthermore, the company has strategically utilized the Small Business Administration (SBA) program, obtaining SBIC licenses for subsidiaries to access attractive long-term, government-guaranteed debenture financing, significantly enhancing its capital-raising capabilities and leverage profile within regulatory limits.

In the competitive landscape of middle-market lending, Saratoga positions itself against larger, more diversified BDCs like Ares Capital Corporation (ARCC) and more niche, sector-focused players like Hercules Capital Inc. (HTGC), as well as broader financial institutions like Goldman Sachs BDC Inc. (GSBD). While larger peers benefit from scale, enabling potentially lower operating costs per deal and access to larger transactions, Saratoga differentiates itself through its specialized focus on smaller deals and transitional financing needs within the lower middle-market. Its diversified portfolio across various industries, including healthcare services, consumer services, and software, provides a buffer against sector-specific downturns, a contrast to the more concentrated approach of some competitors. However, this diversification can sometimes come with higher operational costs per unit compared to highly specialized or larger-scale lenders.

Saratoga's operational "technology" in this context lies not in proprietary software for its portfolio companies, but in its sophisticated financial structures and risk management processes. The Saratoga CLO and the SBIC subsidiaries are key structural differentiators, providing access to capital and investment opportunities that might not be available through traditional BDC financing alone. The company also emphasizes internal systems and procedures for identifying, analyzing, and monitoring risks across its portfolio. While specific quantitative metrics on the efficiency or cost savings derived directly from these internal systems are not detailed, their strategic intent is to enhance portfolio quality and yield. The company's ability to manage its complex capital structure, including multiple layers of secured and unsecured debt, is a critical operational capability that underpins its investment strategy.

Performance Reflecting Market Dynamics

Saratoga's recent financial performance reflects the prevailing market conditions, particularly the interest rate environment. For the three months ended May 31, 2025 (Q1 FY2026), total investment income decreased by 16.4% to $32.32 million compared to $38.68 million in the prior year period. This decline was primarily driven by an 18.4% decrease in interest income from investments, falling to $28.00 million. This reduction stemmed from a smaller investment portfolio size, which decreased by 11.6% to $968.3 million, coupled with a lower weighted average current yield on investments, down to 10.6% from 11.5%, largely influenced by a reduction in SOFR base rates during the period.

However, the impact of lower investment income was partially mitigated by a significant increase in interest income from cash and cash equivalents, which rose to $2.03 million from $0.62 million in the prior year. This increase reflects higher cash balances held by the company, resulting from substantial portfolio repayments during the quarter. Total operating expenses also saw a favorable trend, decreasing by 8.9% to $22.18 million. This was primarily due to lower interest and debt financing expenses, which fell by 3.9% to $12.45 million, reflecting a decrease in the average outstanding debt. Base management fees also decreased by 13.0% to $4.33 million, corresponding to the lower average value of total assets (excluding cash). Incentive management fees saw a notable 29.2% decrease to $2.54 million, reflecting the lower net investment income and the impact of unrealized depreciation on the capital gains accrual.

The combination of decreased investment income and reduced operating expenses resulted in net investment income of $10.14 million for the quarter, down from $14.34 million in the prior year. However, the net change in unrealized appreciation on investments was a positive $0.94 million, a significant improvement compared to a net change in unrealized depreciation of $13.93 million in the same period last year. This quarter's unrealized appreciation was attributed to improved performance in certain portfolio companies and decreased leverage. Net realized gains were $2.90 million, primarily from escrow payments and equity sales, compared to $21.19 million in the prior year period which included larger realized losses from restructurings. Overall, the net increase in net assets resulting from operations was $13.93 million, a substantial increase from $6.61 million in the prior year period, demonstrating resilience despite yield compression.

Liquidity, Capital Structure, and Outlook

Saratoga maintains a robust liquidity position, crucial for funding new investments, supporting existing portfolio companies, and managing its debt obligations. As of May 31, 2025, the company held $131.6 million in cash and cash equivalents, with an additional $92.7 million in reserve accounts. This strong cash balance is supplemented by available capacity under its credit facilities.

The Encina Credit Facility had $32.5 million outstanding against a total capacity of $65 million and a borrowing base of $79.5 million. The Live Oak Credit Facility had $37.5 million outstanding against a total capacity of $75 million and a borrowing base of $86.8 million. These facilities, along with $170 million in outstanding SBA-guaranteed debentures, provide significant financial flexibility.

The company's contractual obligations include repayments on its various debt tranches. As of May 31, 2025, $224.5 million in debt is due within one year, primarily consisting of the $175 million 4.38% Notes due 2026 and the $32.5 million Encina Credit Facility. A larger portion, $396.9 million, is due in 1-3 years, including the $75 million 4.35% Notes due 2027, $105.5 million 6.00% Notes due 2027, $46 million 8.00% Notes due 2027, $60.4 million 8.12% Notes due 2027, $15 million 6.25% Notes due 2027, and the $37.5 million Live Oak Credit Facility. The remaining $170 million in SBA debentures are due in 3-5 years ($20 million) and beyond 5 years ($150 million). The company's asset coverage ratio stood at a healthy 163.8% as of May 31, 2025, well above the 150% regulatory minimum, indicating sufficient asset coverage for its outstanding debt.

Saratoga also manages $136.4 million in unfunded commitments to portfolio companies. While a portion of these commitments is at the company's discretion, $58.6 million is at the portfolio companies' discretion, subject to the satisfaction of certain covenants. The company believes its current cash position and available borrowings are adequate to meet these commitments.

Looking ahead, the company intends to continue its strategy of investing in middle-market companies, funding growth through operations, credit facilities, SBA debentures, and future capital raises, including its ATM equity program. The ATM program allows the company to issue shares at prices not less than NAV, providing a potential source of equity capital, although the ability to raise equity is constrained if the stock trades below NAV. The company also continues its practice of declaring monthly dividends, with recent declarations totaling $0.25 per share for June, July, and August 2025, payable in cash or stock via the DRIP.

Risks and Considerations

Investing in a BDC like Saratoga involves inherent risks. Interest rate risk remains a principal concern. While the company's floating-rate investments benefit from higher base rates, a decline in SOFR, as seen impacting recent interest income, can compress yields. Conversely, rising rates increase the cost of borrowings under its floating-rate credit facilities. The company's sensitivity analysis indicates that a hypothetical 1% increase in base rates could increase annualized net investment income by approximately $6.3 million ($0.41 per share), while a 1% decrease could decrease it by the same amount, after accounting for the incentive fee. The presence of interest rate floors on 100% of its floating-rate debt investments helps mitigate the downside risk from falling rates.

Credit risk is also fundamental, as the value of investments and the ability of portfolio companies to repay debt are subject to economic conditions and individual company performance. The company's portfolio includes investments on non-accrual status, representing a small portion (0.3% of the portfolio at fair value as of May 31, 2025), which can impact income and asset values. The investment in the Saratoga CLO subordinated notes is particularly sensitive to credit performance in the underlying loan pool, as it represents a first-loss position.

The ability to access capital markets on favorable terms is crucial for future growth and managing liquidity. While the company currently has diverse funding sources, market volatility or a decline in the company's stock price below NAV could limit its ability to raise equity through the ATM program or public offerings. Regulatory changes impacting BDCs or SBICs could also affect operations and strategy.

Conclusion

Saratoga Investment Corp. operates with a well-defined strategy targeting the U.S. middle-market, supported by a sophisticated capital structure that includes its managed CLO and SBIC licenses. While recent performance has shown some impact from lower base rates on investment income, the company's ability to manage expenses and benefit from improved unrealized gains demonstrates operational resilience. Its strong liquidity position and diversified funding sources provide a solid foundation to navigate potential market volatility and pursue investment opportunities. The core investment thesis hinges on Saratoga's expertise in sourcing and managing middle-market debt, its ability to effectively utilize its unique capital structures, and its capacity to manage associated risks, positioning it as a compelling option for investors seeking exposure to this segment.