Capital Southwest Corporation

Thank you for joining today's Capital Southwest 3rd Fiscal Quarter 2019 Earnings Call. Participating on the call today are Bo and Deal, CEO, Michael Sarner, CFO, and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

Thank you. I would 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 Deal.

Thanks, Chris, and thanks to everyone for joining us for our third quarter fiscal year 2019 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 results for the quarter. In summary, we had a strong quarter for net investment income growth and a solid quarter for originations as our deal teams continued to do an excellent job generating significant deal flow, allowing us to exercise our conservative investment discipline in determining which deals we want to pursue to closing. As we have consistently stated, our focus remains on building a predominantly lower middle market portfolio consisting largely of first-linked senior secured debt with equity co-investments across the loan portfolio. where we believe significant equity upside opportunity exists. Further, we continue to execute under our shareholder-friendly internally managed structure which at its foundation closely aligns our interest with the interests of our fellow shareholders in generating sustainable long-term value through stable increasing dividends, operating cost efficiency, capital preservation, and NAV for share growth. In general, we had an eventful quarter. We exited one of our two remaining legacy equity assets at a modest gain. We completed the company's first-ever follow-on equity offering, raising $13.2 million from two prominent BDC investors. We completed the upsize and refinance of our ING Capital-led balance sheet credit facility. And we opportunistically repurchased shares of Capital Southwest stock through our 10B51 program during the time of excessive market volatility that we saw in December. Laid out on slide six are some important summary points on our performance for the quarter. During the quarter, we earned 40 cents per share of pre-tax net investment income and paid a regular dividend of 36 cents per share. In addition, our supplemental dividend program paid out 10 cents per share, funded from our sizable, undistributed taxable income balance, or UTI, generated by excess income and capital gains accumulated from our investment strategy to date. For the quarter, the $0.46 per share paid out in total dividends generated a total annualized dividend yield of 9.6%. During the quarter, we grew our portfolio on a net basis from $492 million at September 30, 2018 to $497 million at December 31, 2018, originating for $26 million in total commitments to two new portfolio companies and one add-on investment in an existing portfolio company offset Thank you for joining us. During the quarter, we continued to grow the right side of our balance sheet by increasing the size of our balance sheet credit facility. As part of our comprehensive credit facility amendment, we were able to obtain a significant increase in commitments for our bank lenders by reducing pricing and the overall cost of the facility. Importantly, we were also able to incorporate the ability to access the increased leverage allowable under the Small Business Credit Availability Act passed in 2018. As a reminder, while both the legislation and our amended credit facility allows us to increase leverage at the BDC up to 2 to 1 debt to equity, our board also approved a policy of limiting the regulatory leverage at Capital Southwest to no more than 1.5 to 1. Michael will discuss the specifics of the amendment in a moment. By prudently increasing leverage at the BDC, we will enhance our ability to increase the quality of our loan portfolio while also driving higher returns to our shareholders. all through an internally managed structure in which virtually 100% of the economics from the increased leverage and asset base will flow to our shareholders. Turning to slide seven, we illustrate our continued track record of growing shareholder dividends as we continue to migrate the BDC to target leverage levels through thoughtfully building a portfolio of well-performing income-generating assets. On this slide, we also illustrate both NAV per share over time as well as adjusted NAV per share, which adjusts for supplemental dividends paid out to shareholders. For the quarter, NAV per share decreased from $18.43 as of December 31, 2018, from $18.84 as of September 30, 2018. The 41 cents, or approximately 2% decrease in NAV this quarter, was driven by three things. First, we experienced $2.4 million or $0.14 a share in net depreciation of our investment portfolio, which I will comment on in a moment. Second, we paid out a quarterly supplemental dividend of $0.10 per share from our UTI balance. And third, the board made an annual grant of restricted stock to the Capital Southwest employees. While restricted stock grants vest over four years, all granted shares are added to our total shares outstanding immediately upon grant. As a frame of reference, if we isolate the effect on NAV per share from solely portfolio asset valuations by adding back both the effect from supplemental dividend paid and the effect from the annual restricted stock grant to employees, our NAV per share would have decreased by approximately 14 cents per share, representing a decrease of three-quarters of 1% or 75 basis points. As you might expect, the extreme market volatility we saw in December had a negative effect on the valuations of all BDC portfolios, including ours, as quarterly valuations are generally measured as of the last day of the quarter, which in this case was when the markets were at near lows for the year. Specifically, the levels of the various relevant market indices, which are key inputs in our quarterly valuation process, were down meaningfully at the end of the quarter from levels at the end of the September quarter. On the equity side, we saw public market multiples come down, while on the debt side, we saw corporate credit spreads rise and syndicated loan quotes from syndication deaths fall. Though the syndicated markets were down significantly at year end, in virtually all instances, the discounted market quote was not accompanied by paper for sale at the lower price levels. As a result, in our estimation, a significant majority of this quarter's depreciation in the Capital Southwest portfolio Thank you very much. Thank you for joining us today. 4% of the portfolio is rated an investment grade 3 and no portfolio companies are rated as an investment grade 4. This quarter we did place our first lien senior secured loan to AG Kings on non-accrual, which was one of the two downgrades. We have $9.2 million at cost invested in this particular loan as a club participant alongside a few other prominent middle market lenders. While I want to be careful not to provide too many specifics on this public call regarding a private company, Thank you for joining us. Our estimation of enterprise value and the experience and aggressive posture of the lender group, we are optimistic this default will be resolved in a manner that is favorable for Capital Southwest and its lender partners. Turning to slide eight, our investment strategy has remained consistent since the launch in January 2015. As a reminder, we continue to focus on a blend of both lower middle market and upper middle market assets, providing us strategic flexibility as we have built the robust capability to seek attractive risk-adjusted returns in both markets. In our core market, the lower middle market, we directly originate opportunities consisting of debt investments as well as equity co-investments alongside our debt. Building out a highly performing and granular portfolio of equity co-investments is important to driving growth in NAD per share while mitigating future credit losses. At the same time, our capability and presence in the upper middle market provides us the ability to opportunistically invest in a more liquid market when attractive risk-adjusted returns exist. In the upper middle market, over the past year or so, we have been in an environment where it has been difficult to find value in syndicated loans. For deals and structures we have found acceptable from a risk-return perspective, we have often chosen to take small positions of approximately $5 million, which fit well into I-45. To the extent that market gyrations continue and we see opportunities to invest in the upper middle market syndicated loans at especially attractive spreads, we have the ability and liquidity to capitalize on such opportunities, either through additional exposure on our balance sheet or through possibly increasing the size of I-45. In contrast, in the lower middle market, our robust origination platform continues to generate strong deal flow, allowing us to close on some highly attractive opportunities from a risk-return perspective. We believe that maximizing the top end of our origination funnel is critical to generating strong credit investment performance over time. It ensures that we consider a wide array of deals so that we are able to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic cycle. Our on-balance sheet credit portfolio at Capital Southwest is seen on slide 9, excluding I-45s, grew from $337 million at September 30, 2018 to $351 million at December 31, 2018, driven by continued lower middle market origination activity. As the portfolio has grown, the percentage of the credit portfolio represented by the lower middle market has increased by design to now 77%. While we have increased the percentage of the portfolio represented by the lower middle market, we have also continued to heavily emphasize first lien senior secured debt in our investment strategy. At the end of the quarter, we had 86% of our on-balance sheet credit portfolio in first lien senior secured debt. During the quarter, as seen on slide 10, we committed $26 million to two new portfolio investments and one add-on investment to an existing portfolio company. All of the investments were in the lower middle market and all were directly originated and led by Capital Southwest. On a weighted average basis, The debt investments made during the quarter had a yield to maturity of 11.1%. Our originations this quarter included $24.7 million in senior secured debt made up of $12.5 million of first lien secured debt, a $10 million split lien secured debt investment, and $2.2 million first lien secured delayed draw term loan for an existing portfolio company. We also invested $1 million in an equity co-investment funded alongside one of our new portfolio transactions. During the quarter, as seen on slide 11, we received $18 million in proceeds from the exit of three investments, one upper middle market investment, and two lower middle market investments. One of our exits resulted from the sale of deep water corrosion services to a strategic buyer, resulting in a realized gain of $1.7 million, or $0.10 per share. Deepwater, a preferred stock investment originated back in 2013, was one of our last two remaining legacy equity positions. After going through a tough time in the energy services industry during 2015 and 16, Deepwater was able to recover and position itself for a strategic sale, producing a nice outcome for its shareholders. This quarter's exits continue our track record of generating strong risk-adjusted returns on our shareholders' capital, We now have 25 exits since the launch of our credit strategy four years ago, representing approximately $180 million in proceeds, generating a weighted average IRR on the exits of 16.3%. This now leaves Media Recovery as the last remaining legacy equity investment in our portfolio. Media Recovery does business under the banner Spotsy. Spotsy's management team continues to do an excellent job growing and increasing the profitability of the business. As we have mentioned on prior earnings calls, there continues to be significant interest in the acquisition of this company. We have now hired an investment banker and have been working with them in earnest to launch a sale process. Consisting with our past commentary, we expect to exit this investment during the calendar year 2019. On slide 12, we break out our unbalanced sheet credit portfolio, again excluding I-45, between the lower middle market and the upper middle market. is at the end of the quarter. The total portfolio was weighted approximately 79% to the lower middle market and 21% to the upper middle market on a cost basis. We had 25 lower middle market investments with an average hold size of 12.3 million, a weighted average EBITDA of 9.3 million, a weighted average yield of 11.9% and leveraged Thank you very much for joining us. A weighted average EBITDA of $71.1 million, a weighted average yield of 10.4%, and leverage through our security of 3.8 times, which was flat from the prior quarter. As illustrated on slide 13, we have established a well-diversified portfolio, heavily biased towards first-ling secured debt investments, providing strong capital preservation security for our shareholders' capital. In addition, 97% of our credit exposure is invested in floating rate securities as can be seen on slide 14, such that our shareholders should continue to benefit should interest rates continue to rise. As shown on slide 15, as of the end of the quarter, the I-45 portfolio was 95% first lien with diversity among industries and an average hold size of 2.1% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately $70 million and weighted average leverage through the I-45 security of 3.7 times, down from the 3.8 times at the end of the prior quarter. We have been pleased with the solid performance of I-45 over the past three and a half years. We and our partner in I-45, Main Street Capital, have invested approximately $500 million through the fund. and harvested 50 exits generating $196 million in proceeds at a weighted average IRR on the exits of 11.4%. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.