Capital Southwest Corporation

Thank you for joining today's Capital Southwest second quarter fiscal year 2021 earnings call. Participating on the call today are Bowen Diehl, CEO, Michael Sarner, CFO, and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

Thank you. I'd 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 second quarter fiscal year 2021 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 our second physical quarter ended September 30, 2020. I want to first say that I hope everyone, their families and their employees continue to be safe and well. Here at Capital Southwest we have continued to prioritize the health and safety of our employees and of the employees of our portfolio companies. We remain in regular dialogue with our portfolio company financial sponsors and management teams and have been pleased with the overall performance of the portfolio. We have been most impressed with the management teams and financial sponsors' ability to manage all aspects of company performance, including protecting their employees while increasing operating efficiencies during these unprecedented times. While the pandemic is not yet behind us, as we look back to where we were in March 2020 with so much uncertainty and market volatility, we are very grateful for all the work done by the team here at Capital Southwest and the teams at both our portfolio companies and financial sponsor clients. We were also extremely pleased with the performance of our portfolio and we remain highly confident in the quality of the assets and its earnings power. During the quarter, our portfolio performance continued to improve as evidenced by 8.4 million of net appreciation across the portfolio. For the quarter, we had two loans which had investment rating upgrades. We had no investment rating downgrades. and we had no new loans placed on non-accrual. As a well-capitalized first lien lender with ample liquidity, Capital Southwest continues to be in a favorable position to seek attractive financing opportunities and to provide financial support to help our companies grow. 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 many more. We also continue our supplemental dividend program, paying out an additional 10 cents per share, Funded by our sizable, undistributed taxable income balance. Total dividends for the quarter of 51 cents per share represented an annualized dividend yield on the quarter end on the quarter end stock price per share of 14.5% and an annualized yield on net asset value per share of 13.3%. I'm also pleased to announce that our board has declared total dividends of 51 cents per share again for the quarter ended December 31, 2020 consisting of a regular dividend of 41 cents per share and a supplemental dividend of 10 cents per share. During the quarter, we grew our investment portfolio by over 7% to 631 million as of September 30, 2020. Portfolio growth during the quarter was driven primarily by 66.3 million in total new commitments to four new portfolio companies and six existing portfolio companies. Offset by $21 million in prepayments from two loans, which I will review in a bit more detail in a moment. Additionally, on the capitalization front, we successfully raised $50 million in proceeds at par on our existing 5-3-8 institutional unsecured bonds, bringing the total principal outstanding of this bond issuance to $125 million. Finally, as we mentioned last quarter, we continue to work with the U.S. Small Business Administration towards becoming officially licensed as an SBIC. We are pleased to report that we completed our final license submittal during the quarter and look forward to reporting developments on the status of our pending license application to our shareholders as warranted. As a reminder, final approval and issuance to Capital Southwest of an SBIC license would provide a 10-year commitment to provide Capital Southwest with up to $175 million in debt financing to be drawn to fund investments in our lower middle market strategies. Thank you for joining us. From a cost perspective, if treasury rates remain close to today's level, the all-in cost of the SBIC debentures would be less than 3%. This program is clearly a perfect fit for our lower middle market focus, and we look forward to continuing to work with the SBA in completing the application process and in successfully executing the SBA's mission of supporting growth and employment in U.S. small businesses. Turning to slides seven and eight, We illustrate our track record of producing a strong dividend yield, consistent dividend coverage, and value creation since the launch of our credit strategy. We strongly believe that the maintenance and growth of both NAV per share and dividends paid per share are paramount to creating long-term value for our shareholders. Turning to slide nine, as a reminder, our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market while also maintaining the ability to invest in the upper middle market when attractive 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 driving NAV per share growth as well as aiding in the mitigation of any 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 in thoughtfully building a portfolio that will perform through any economic cycle. Though we continue to take a cautious and extremely selective approach towards deploying new capital, taken into account the new normal of potential pandemics among other risks, we are pleased to have the capital to invest to support acquisitions and growth across our markets. That said, we continue to find superior risk adjusted return opportunities in the lower middle market where we can lend at lower leverage and loan to value levels while maintaining tighter covenants and other terms in the loan documents. As illustrated on slide 10, our on balance sheet credit portfolio excluding I-45 grew 7% during the quarter to $521 million as compared to $487 million as of the end of the prior quarter. Our credit portfolio is currently weighted 82% to lower middle market loans, down slightly from 85% last quarter as a result of two loan prepayments in the lower middle market and two originations in the upper middle market during the quarter. We continue to heavily emphasize first lien senior secured debt lending with 100% of the debt originations this quarter being first lien senior secured. As a result, as of the end of the quarter, 91% of the credit portfolio was in first lien senior secured debt. On slide 11, we lay out the $66.3 million of capital invested in and committed to portfolio companies during the quarter. This included $42.2 million in first lien senior secured debt committed to four new portfolio companies and $20.9 million in additional first lien senior secured debt committed to six existing portfolio companies. Turning to slide 12, as I previously alluded to, we had two lower middle market exits this quarter, Danforth Advisors and Trinity 3. Our debt at Danforth was refinanced by a traditional bank, repaying our loan in full, generating proceeds of $6.7 million and an IRR of 12.4%. We continue to hold equity in Danforth alongside the sponsor, and we are excited to watch this management team and sponsor continue its stellar performance. In the case of Trinity III, which also appears on the new deal fundings for the quarter, we were able to participate in a much larger club deal which refinanced our original loan and financed a large strategic acquisition for Trinity III. We also hold an equity interest in this company and are very excited about its continued growth prospects going forward. Thank you very much. The total portfolio, including equity co-investments, was weighted approximately 84% to the lower middle market and 16% to the upper middle market on a fair value basis. We had 39 lower middle market portfolio companies with a weighted average leverage ratio measured as debt to EBITDA through our security of 3.9 times, down from 4.1 times weighted average leverage in the prior quarter. This reduction in leverage was primarily driven by EBITDA performance across the lower middle market portfolio during the quarter. 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, excluding I45, consisted of 12 companies with an average leverage ratio through our security of 3.7 times down meaningfully from the 4.4 times weighted average leverage for the prior quarter. This decrease was also driven primarily by EBITDA improvement quarter over quarter across the portfolio. Turning to slide 14, we have laid out the rating migration within our portfolio for the quarter. During the quarter, we had two loans upgraded while having no loans downgraded. As a reminder, all loans upon origination are initially assigned an investment rating of 2, Thank you for joining us. We had seven loans representing 10% of the portfolio at fair value rated a 3 and only two loans representing 2% of the portfolio at fair value rated a 4. As illustrated on slide 15, we have established a portfolio well diversified across industries with an asset mix which provides strong security for our shareholders' capital. The portfolio remains heavily weighted towards first-ling senior secured debt with only 6% of the portfolio in second lien senior secured debt and only 2% of the portfolio in one remaining subordinated debt investment. Turning to slide 16, the I-45 portfolio showed meaningful improvement during the quarter. Is our investment in I-45 appreciated by 4.7 million or 8%? Leverage at the I-45 fund level is now 1.39 times debt to equity at fair value. Thanks, Bowen.