Capital Southwest Corporation

Thank you for joining today's Capital Southwest fourth quarter and fiscal year 2020 earnings call. Participating on the call today are Bowen Gill, 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 thank you to everyone for joining us for our fourth quarter and 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 results for the fourth quarter and fiscal year ended March 31, 2020. I want to first say that I hope everyone, their families, and their employees are safe and well. Today our prepared remarks will be a bit longer than is typical given the unprecedented times our country has been going through as we are going to try to provide you with a thorough understanding of the status of our company and portfolio and an appreciation for the level of confidence we have in the future. I will discuss the company, the portfolio, and the market environment. Michael will then walk through some details around our quarterly performance and the BDC's capitalization, followed by our opening up the lines for Q&A. We are meeting with you today in a far different environment than any of us have ever lived through before. The COVID-19 pandemic and associated shelter-in-place directives across the country have impacted the U.S. and global economies negatively at an order of magnitude not seen in our lifetimes. and certainly in excess of the impact seen in the Great Recession of 08 and 09. While we are certainly pleased with the early indications that the economy is beginning to open back up, by no means has COVID-19 gone away. In response to the pandemic, we have first and foremost prioritized the health and safety of the employees of Capital Southwest and of our portfolio companies. I am pleased to say that we have remained safe and productive as the team has done a fantastic job rallying to the occasion. At Capital Southwest, we have been working remotely since early March. We immediately instituted daily calls with the entire team to monitor portfolio activity. We instituted a COVID tracker sheet which compiles salient performance data for all of the portfolio companies, including actual and anticipated real-time revenue and EBITDA effects of the economic shutdown, PPP funding eligibility and application status, liquidity status, and any anticipated liquidity needs and covenant breaches. This central repository allows real-time access to the latest status of each portfolio company in a format that can be easily accessed by Michael and I and the team. While the pandemic has clearly had a negative impact on the market and on our portfolio, as evidenced by the quarter-over-quarter 9.6% decline in net asset value per share and the addition of one portfolio company to our non-accrual list, we feel good about the quality of the assets and earnings power of the portfolio as a whole. Indeed, we ended the year producing a solid 40 cents per share in NII in the March quarter. Further, as a well-capitalized first lien lender with ample liquidity, Capital Southwest is in a favorable position to provide financial support to our portfolio companies and, where warranted, receive enhanced economics in doing so. While it is impossible to calculate the full and precise impact on our portfolio from the COVID-19 pandemic, It is important to note some key aspects of Capital Southwest and critical decisions that were made over the past two years that have positioned us well to weather this unprecedented time in our nation's history. We have laid out these points on slide six. First, Capital Southwest's balance sheet credit portfolio consists of 49 loans across 41 portfolio companies, with 90% of Capital Southwest's capital invested in first lien senior secured debt. Moreover, the percentage of our at-risk capital in first lien senior secured debt is even higher, including I-45, given that 97% of I-45's assets are in first lien senior secured debt. Second, despite the sale process for media recovery being long and difficult in a choppy global economy, we opted to close on the sale in November 2019, reducing the equity exposure on our balance sheet from 19% down to 8%. as of the end of the fiscal year. We were then able to distribute 75 cents per share in cash to our shareholders during the December quarter. Next, over two years ago, we started negotiating for higher LIBOR floors on our loans, many as high as 2%. As of March 31, 2020, the weighted average LIBOR floor across our credit portfolio was approximately 1.4%, protecting our portfolio asset yield from decreases in LIBOR below 1.4%. and as a reminder, our balance sheet credit facility does not have a LIBOR floor, allowing our cost of debt to float with LIBOR all the way down to a LIBOR rate of zero. Next, given that 84% of our balance sheet credit portfolio is invested in the lower middle market, many of our portfolio companies were eligible for the payment protection plan or PPP funding provided within the CARES Act. across our $550 million balance sheet portfolio, almost 90 million of PPP funding has been applied for and received by 24 of our portfolio companies. On the capitalization front, during the fiscal year, we grew our revolver commitments on our ING-led balance sheet credit facility from 270 million to 325 million. The most recent increase of 30 million included adding two new lenders which closed during the March quarter subsequent to the COVID-19 outbreak. Our bank lender group has shown us incredible support and now stands at 11 banks. As of 3-31-2020, we had approximately $170 million in availability on the credit facility, while on the asset side, we had only $15.2 million in unfunded commitments across our loan portfolio. Approximately seven and a half million of which was in delayed draw term loans or other revolving loans in which drawing conditions had not been met. Including cash and undrawn commitments on our balance sheet credit facility, we had dry powder of approximately 180 million allowing us ample liquidity to both support our portfolio companies and seek new financing opportunities. Unfunded commitments remain approximately the same today is we have had approximately equal draws and repayments since quarter end. Finally, during the fiscal year, we completed a $75 million institutionally placed unsecured bond issuance, allowing us to end the fiscal year 2020 with approximately 50% of our balance sheet debt capital provided by the unsecured bond market. We also made the difficult but appropriate decision to forego a previously announced voluntary pay down of our December 22 baby bonds. We originally announced the pay down in February 2020 with the intent of proactively reducing our overall cost of debt, but determined in March that based on the uncertainty in the market at the time, the best course of action for our shareholders was to retain capital flexibility. Future voluntary paydowns on the notes is certainly something we will revisit in the future. Overall, during the fiscal year, we continue 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. 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 interests 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. Slide seven and eight of the presentation summarize some of the key performance highlights for the fiscal year and for the quarter. We grew our portfolio over 6% year over year to 553 million as of March 31, 2020 and increased our credit portfolio by 107 million or 29% to 474 million. This growth was driven primarily by 195 million in total commitments to 19 portfolio companies. including $6 million invested in equity alongside six of our loans. During the fiscal year, we also exited five companies for $100 million in proceeds, generating a weighted average IRR of 11.6%. Included in the $100 million was $48 million in proceeds from the sale of Media Recovery, which generated an IRR of 11.8% measured back to our original investment in 1997. Since the launch of our credit strategy five years ago, we have had 31 exits representing approximately $287 million in proceeds and generating a weighted average IRR on the exits of 16.4%. Our net credit portfolio growth drove a 20% increase in total investment revenue for the year to $62 million, up from $52 million in a prior fiscal year. While while the generally fixed nature of our internally managed BDC cost structure improved operating leverage to 2.4% by the end of the year, achieving our previously stated goal of sub 2.5%. We will endeavor to achieve continued improvement operating leverage by growing our total operating expenses at a slower pace than the growth of our asset base. The ability to improve operating leverage over time is one of the fundamental advantages of the internally managed structure. These factors both contributed to a 17% year-over-year growth in quarterly regular dividends paid to our shareholders in total for the year. In total for the year, we paid out $2.75 per share in regular, special, and supplemental dividends, representing a 21% increase over the $2.27 per share paid out in fiscal 2019. Additionally, on the equity capitalization front, We raised $26.7 million in gross proceeds during the year through our equity ATM program, selling over 1.2 million shares at a weighted average price of $21.71 per share, representing an average premium of 17% to net asset value as measured at the time of sale. Our diligence in selling limited amounts of equity each quarter when our stock is trading meaningfully above NAV and lockstep with our ability to deploy that capital was one of the key contributors to our financial flexibility in today's market. Further, our financial flexibility during the March quarter allowed us the ability to opportunistically execute on our share buyback program. Amidst the extreme market volatility instigated by the COVID-19 pandemic, we were able to repurchase approximately 800,000 shares at a weighted average price of $11.57. Total accretion from the share buybacks to net asset value was 23 cents per share. Additionally, the management team and board members were also active buyers in the market during the March quarter, collectively purchasing approximately 107,000 shares during the quarter. The total shares owned by employees and board members now represents approximately 10% of the total shares outstanding, illustrating further our commitment and total alignment with shareholders. Turning to slides 9 and 10, we illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage, and the value creation since the launch of our credit strategy. We previously announced that our board declared total dividends of 51 cents per share for the quarter ended June 30, 2020. Today, we are pleased to announce that our board has also declared dividends of 51 cents per share for the quarter ended September 30, 2020. consisting of a regular dividend of 41 cents per share and a supplemental dividend of 10 cents per share. In an effort to create some level of certainty in an otherwise uncertain world, we believe this announcement demonstrates our continued competence in our portfolio and the ability to earn our dividend at the current level over time through net investment income. Turning to slide 11, 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 tractive 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 aiding the mitigation of credit losses over time. 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 and thoughtfully building a portfolio that will perform through any economic cycle. Though we are currently taking a cautious and extremely selective approach towards deploying new capital, taking into account the new normal of of potential pandemics among other risks, we continue to find superior risk-adjusted return opportunities in the lower middle market where we can lend at lower leverage and lower 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 the primary source of NAV volatility in our portfolio. Turning to slide 12, Our unbalanced sheet credit portfolio, excluding I-45, grew 4% during the quarter to $474 million, as compared to $456 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 84% of our unbalanced sheet credit portfolio invested in the lower middle market companies, while not having 90% of the credit portfolio in first lien senior secured debt. On slide 13, we lay out the 38 million of capital invested in and committed to new portfolio companies during the quarter, all closed prior to COVID-19. This included 32 million in first lien senior secured debt provided to three new portfolio companies and 6.1 million of additional capital to three existing portfolio companies. which included $4 million of first lien senior secured debt and $2 million of second lien senior secured debt. Included in the $38 million was $8.5 million in capital to two upper middle market investments, one existing and one new. Our net exposure to the upper middle market actually went down slightly quarter over quarter as we were able to sell one upper middle market syndicated credit realizing $12.6 million in proceeds. The weighted average yield to maturity on debt originations this quarter was 9.6%. On slide 14, we break out our on-balance sheet portfolio, excluding I-45, between the lower middle market and the upper middle market. At the end of the quarter, the total portfolio, including equity co-investments, was weighted approximately 85% to the lower middle market and 15% to the upper middle market on a fair value basis. We had 34 lower middle market portfolio companies with an average hold size of $12.8 million, a weighted average EBITDA of $8.3 million, weighted average yield of 11.2%, and a leverage ratio measured as debt to EBITDA through our security of 3.7 times. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately two-thirds of our portfolio companies. Our on-balance sheet upper middle market portfolio consisted of 11 companies, with an average hold size of 8.7 million, a weighted average EBITDA of 74.1 million, a weighted average yield of 6.6%, and a leverage ratio through our security of 4.2 times. We should also note that our on-balance sheet upper middle market leverage metrics are shown excluding our investments in American Addiction and Delphi Behavioral Health, as the EBITDA, while improving in both cases on a run rate basis, remains at levels that would skew the aggregate and many more. We believe that the risk ratings represented on this slide largely hold as of today based on our communications to date with our portfolio companies. As a reminder, all investments upon origination are initially assigned an investment rating of two on a four-point scale, with a one being the highest rating and a four being the lowest rating. During the quarter, mainly as a result of the COVID-19 pandemic and associated shelter-in-place orders, We had nine of our 49 balance sheet loans downgraded and one upgraded. The downgrades included a one rated loan downgraded to a two, representing 2.4% of our portfolio at fair value. This is a company that has been a consistently strong performer since origination, and we believe the company will continue its very strong performance once COVID-19 is under control and the economy opens back up. We had six loans downgraded from a two to a three, representing 11.4% of our portfolio at fair value. Of these six loans, five are sponsored and two are past due on their principal and interest as of today. In one of these past due situations, the sponsor has proposed a meaningful equity infusion into the company, the terms of which are currently being negotiated. In both cases, the company performance is improving and we believe we will collect our interest and ultimately recover par for the loans. Finally, we had two loans representing 1.9% of the portfolio at fair value downgraded from a three to a four. These two loans are our two investments in the addiction treatment space, American Addiction or AAC Holdings and Delphi Behavioral, both of which were put on non-accrual in past quarters. Both companies saw their patient admissions fall meaningfully due to the pandemic and both received PPP funding. Subsequent to quarter end, Delphi's capital structure issues were successfully resolved as the balance sheet was restructured out of court, resulting in the first lien lenders reinstating a portion of their first lien debt and owning the equity of the company. Capital Southwest now owns 10.8% of the common equity and has a board seat on the company's board. The new ownership group and board are working closely with the management team to streamline the cost structure, protect their employees, and maintain the company's track record of providing the highest level of patient care. We believe that the performance of Delphi can and will improve significantly in the future and our equity position in the company should provide a mechanism for meaningful NAV upside going forward. With respect to AAC, the capital structure solution is taking longer to achieve due to its additional complexity. AAC is a public company and a much larger enterprise than Delphi, and the facility in which Capital Southwest participates is broadly syndicated, thus involving numerous other lenders. AAC's challenges are similar to that of Delphi, and AAC's management team seems to be doing a good job managing its cost structure and protecting its employees while also continuing to maintain the highest level of patient care. Both of these companies perform critical life-saving work each and every day. They clearly have many important reasons to exist, and in both cases, there is significant upside in financial performance from where they are today. The remaining company rated at four is AG Kings, which was put on non-accrual back in December 2018. AG Kings, a grocery business in the Northeast United States, has seen a significant uptick in its performance. Thank you for joining us. Thank you very much. We have established a portfolio well diversified across industries. 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% of the portfolio in second lien senior secured debt and only 2% of the portfolio in one subordinated debt investment. Shown on slide 17 as of the end of the quarter, The I-45 portfolio was 97% first lien with diversity among industries and an average hold size of 2.3% of the portfolio. The I-45 portfolio had weighted average EBITDA of approximately $65 million, a weighted average coupon of LIBOR plus 6.3%, and weighted average leverage through the I-45 security of 4.6 times. We also excluded American Addiction from these ratios for the aforementioned reasons. Of the 43 portfolio companies in I-45, we would estimate that 11 of them, representing 23% of the assets at fair value, have been meaningfully impacted, albeit temporarily, by the COVID-19 disruptions to the U.S. economy. Four of the portfolio companies, representing 7.5% of the assets at fair value, are not current as of today on interest of principle, which includes AAC. Three out of four of these past due situations are companies that are owned by financial sponsors. Overall, we would estimate that approximately two thirds of the depreciation for the quarter was due to mark to market quote volatility and approximately one third was specific to company performance. We would also estimate that the company performance component of the overall estimate for the quarter was virtually all COVID-19 related. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.