Capital Southwest Corporation

Thank you for joining today's Capital Southwest first fiscal quarter 2020 earnings call. Participating on the call today are Bowen Deal, CEO, Michael Sarner, CFO, and Chris Rehberger, Vice President Finance. I'll 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 thank you to everyone for joining us for our first 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 first quarter ended June 30, 2019. During the quarter, we continued to advance the credit strategy we laid out for our shareholders four and a half years ago of prudently building a well-performing credit portfolio utilizing conservative late cycle underwriting principles. We continue to be committed and excited about 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 upsides exist. Executing our investment strategy under our shareholder-friendly internally managed structure closely aligns the interests of our board and management team with that of our fellow shareholders. and generating sustainable long-term value through recurring dividends, capital preservation, NAD per share growth and operating cost efficiency. During the June 30, 2019 quarter as laid out on slide six, we generated 44 cents per share of pre-tax net investment income representing 42% growth over the 31 cents per share generated in the same quarter a year ago. while paying out a regular dividend of $0.39 per share for the June quarter representing 34% growth over the $0.29 per share paid out in the same quarter a year ago. Additionally, we distributed $0.10 per share through our supplemental dividend program 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. As of June 30, 2019, we had approximately $19.5 million or $1.10 per share in UTI, providing visibility into continuing the quarterly supplemental dividend program well into the future. For the June quarter, the $0.49 per share paid out in total dividends generated a total annualized dividend yield of 9.4% based upon our June 30, 2019 share price. We are also pleased to announce further growth in our quarterly regular dividend for the September quarter as our board has declared dividends of 50 cents per share for the September quarter made up of a 40 cent per share regular dividend and a 10 cent per share supplemental dividend. This will mark our 15th consecutive quarter of increasing shareholder dividends. During the June quarter, we grew our portfolio on a net basis to $533 million from $524 million as of March 31, 2019, originating $35 million in new commitments and exiting one portfolio company for $20 million in total proceeds. Our senior loan fund, I-45, also continued its solid performance, providing a 17.7% annualized yield in fair value on our capital in the fund for the quarter. Additionally, during the quarter, we raised $4.2 million in gross proceeds through our equity ATM program and upsized our evolving credit facility by $25 million to a total of $295 million in total commitments from 10 banks. Turning to slide seven, we illustrate our continued track record of growing shareholder dividends as we continue to migrate the balance sheet towards target leverage levels through thoughtfully building a portfolio of well-performing income-generating assets. Turning to slide eight, as a reminder, our investment strategy has remained consistent since its launch in January 2015. We continue to focus on a blend of 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 lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments, Building out a highly performing and granular portfolio of equity co-investments is important to driving NAV per share growth while aiding in the mitigation of any 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. Overall, we believe that maximizing the top end of our deal origination funnel in both markets is critical to generating strong credit investment 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. Our on-balance sheet credit portfolio, excluding I-45 as shown on slide nine, grew to 382 million as of June 30, 2019, from $368 million as of March 31, 2019. We continue to heavily emphasize first lien senior secured debt lending to the lower middle market in our investment strategy. As of the end of the quarter, we had 76% of our on-balance sheet credit portfolio invested in lower middle market companies while having 87% of the credit portfolio in first lien senior secured debt. Turning to slide 10, We originated $35 million in first lien senior secured debt this quarter consisting of two new portfolio companies and two add-ons to existing portfolio companies. One of the new portfolio companies was a club deal in the upper middle market and the other was a first lien senior secured loan to a lower middle market company in which Capital Southwest is the sole lender. Both of the add-ons were in the lower middle market, with one being a Capital Southwest-led deal in which we brought in a co-lender, and one being a deal in which Capital Southwest is the sole lender. The weighted average yield to maturity on all originations this quarter was 11.1%. As shown on slide 11, we also exited one portfolio company during the quarter for $20 million in total proceeds, generating a realized gain of $226,000 and an IRR of 10.9% on total invested capital. This continues our strong track record as we have now had 26 portfolio exits since launching our credit strategy back in January 2015, generating 182 million in proceeds and a cumulative IRR of 15.7%. On slide 12, we break out our unbalanced sheet portfolio, again excluding I-45, between the lower middle market and the upper middle market. As of the end of the quarter, the total portfolio was weighted approximately 77% to the lower middle market and 23% to the upper middle market on a cost basis. We had 26 lower middle market portfolio companies with an average hold size of 12.5 million, a weighted average EBITDA of 8.8 million, a weighted average yield of 12.2% and a leverage ratio measured as debt to EBITDA through our security of 3.4 times. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in 69% of our portfolio companies. Our upper middle market portfolio consisted of 11 companies with an average hold size of 8.8 million, a weighted average EBITDA of 65.6 million, a weighted average yield of 9.9%, and a leverage ratio through our security of 3.4 times. We should note that our balance sheet upper middle market metrics are shown excluding our investment in American Addiction as the EBITDA is not meaningful and thus skews the total upper middle market portfolio ratios so as not to be able to clearly show the ratios of the remainder of the upper middle market portfolio. With respect to American Addiction, the company continues to struggle, albeit with recently improving operating metrics. Since American Addiction is a public company, we want to be careful not to effectively announce developments prior to the American Addiction management team appropriately communicating to their shareholders. What we will say is that the lender group continues to work with the company on solutions to the capital structure. The company's leading market position in the substance abuse industry, the company's cost savings and business development initiatives, and its large owned real estate portfolio all provide reasons to be optimistic on the prospects of a favorable resolution. American Addiction remains rated a three on our internal rating system. As a reminder, all investments upon origination are initially assigned an investment rating of two on a four-point scale, with one being the highest rating and four being the lowest rating. Overall, we are pleased with the performance of the investment portfolio as a whole. It is at the end of the quarter. of the 40 loans in the portfolio, we had four with the highest rating of one representing 17% of the credit portfolio. We had 32 loans rated a two representing 77% of the credit portfolio. And we had three loans rated a three representing 4% of the credit portfolio. We did reduce AG Kings to a four this quarter, making it the only investment rated a four in the credit portfolio. The investment is our first and only non-accrual among the investments made since launching our credit strategy four and a half years ago. As a reminder, AG Kings was placed on non-accrual during our December 2018 quarter. As illustrated on slide 13, we have established a portfolio well diversified across industries, which we believe 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 7% and 3% of the portfolio in second lien senior secured debt and the subordinated debt investments respectively. Our last remaining legacy equity investment, Media Recovery, which does business under the banner Spot Seed, represents 10% of the portfolio and other equity co-investments as of the end of the quarter represented 6%. As we have mentioned on prior calls, Media Recovery is currently undergoing a sale process. The process is going well, and our expectation continues to be that this company will sell during the 2019 calendar year. Shown on slide 14 is at the end of the quarter, the I-45 portfolio was 95% first lien with diversity among industries and an average hold size of 2% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately $71 million and a weighted average leverage through the I-45 security of 3.9 times. We also excluded American Indiction from these ratios for the aforementioned reasons. We should also note that the increase in weighted average leverage to 3.9 times from 3.6 times last quarter was driven primarily by the prepayment of two lower leveraged loans in the I-45 portfolio during the quarter. Overall, we have been pleased with the solid performance of I-45 since its inception back in 2015. We and our partner in I-45, Main Street Capital, have invested approximately $500 million through the fund, primarily in first lien senior secured syndicated loans. Since inception, we have harvested 54 exits, generating $223 million in proceeds at a weighted average IRR on the exits of 11.3%. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.