Capital Southwest Corporation

Southwest First Quarter Fiscal Year 2022 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 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, everyone, for joining us for our earnings call for the quarter ended June 30, 2021, which is the first quarter of our 2022 fiscal year. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio, and our progress on executing our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in the earnings presentation, which can be found on our website at www.capitalsouthwest.com. We'll begin on slide six of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we've generated pre-tax net investment income of 45 cents per share which more than earned our regular dividend paid for the quarter of 43 cents per share. Total dividends for the quarter were 53 cents per share, which included a 10 cent per share supplemental dividend. Total dividends paid during the quarter represented an annualized dividend yield on our stock prices of the last day of the quarter of 9.1 percent and an annualized yield on net asset value per share of 12.8 percent. I am pleased to announce that our Board of Directors has increased our total dividends per share to 54 cents for the coming quarter ending September 30, 2021, consisting of a regular dividend increase from 43 cents per share to 44 cents per share and a quarterly supplemental dividend of 10 cents per share. Our decision to increase the dividend emanates from our continued confidence in the current earnings power of our portfolio as a result of portfolio growth, continued reductions in our cost of capital, and our ability to improve our operating leverage efficiency by actively managing operating costs while growing the asset base. During the quarter, we grew our investment portfolio on a net basis by 16% to $799 million. Portfolio growth during the quarter was driven primarily by a total of $138.9 million in new commitments to eight new portfolio companies, of which $102.6 million was funded at close. offset by $1.6 million in proceeds from the exit of one equity co-investment. The portfolio generated net realized and unrealized gains of $6.1 million during the quarter, driven primarily by unrealized appreciation in our equity co-investment portfolio. On the capitalization front, we successfully raised $28.1 million of equity through our ATM program at an average price of $26.10 per share, representing an average of 163 percent of the prevailing net asset value per share. In addition, during the quarter, our SBIC fund received its initial leverage commitment from the SBA in the amount of $40 million. Turning to slide seven and eight, we illustrate our continued track record of producing steady dividend growth, consistent dividend coverage, and value creation since the launch of our credit strategy. We believe the solid performance of our portfolio and our company's sustained access to the capital markets has demonstrated the strength of our investment and capitalization management strategies. Maintenance and growth of both NAV per share and shareholder dividends remain as core tenets of our long-term investment objective of creating long-term value for our shareholders. Turning to slide nine, as a refresher, our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market lending strategy while also maintaining the ability to opportunistically invest in the upper middle market when attractive risk-adjusted returns exist. In the lower middle market, We directly originate and lead opportunities consisting primarily of first lien senior secured loans with smaller equity co-investments made alongside our loans. We believe that this combination is powerful for a BDC as it provides strong security for the vast majority of our invested capital while also providing NAV upside from equity investments in many of these growing businesses. Building out a well-performing and granular portfolio of equity co-investments is important to driving growth in NAV per share, while aiding in the mitigation of any credit losses over time. As of the end of the quarter, our equity co-investment portfolio consisted of 31 equity investments totaling $66.1 million, representing 8% of our portfolio fair value. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately 57 percent of our portfolio companies. Though the equity portfolio has performed extremely well with 14.3 million in cumulative embedded net unrealized appreciation, some lingering effects of the pandemic aftermath still do persist, leaving us very excited about the potential upside of this equity portfolio moving forward. As illustrated on slide 10, our on-balance sheet credit portfolio as of the end of the quarter, excluding our I-45 Senior Loan Fund, grew 17% to $671 million as compared to $573 million as of the end of the prior quarter. Our credit portfolio is currently weighted 87% to lower middle market loans consistent with prior quarters. For the quarter, seven out of the eight new debt originations were first lien seniors secured. And as of the quarter end, 90% of the credit portfolio was first lien senior secured. On slide 11, we lay out the $138.9 million of capital invested in and committed to portfolio companies during the quarter. This included $119.4 million in first lien senior secured debt committed to seven new portfolio companies, $15.8 million in split lien senior secured debt in one new portfolio company, along with $3.8 million invested in equity co-investments alongside three of the new portfolio loans. A brief description of the split lien structure is explained in the footnote to the table. Turning to slide 12, we continued our track record of successful exits with one this quarter. We exited our equity investment in tax advisors group, generating a realized gain of $1.1 million and an IRR of 34%. To date, we have generated a cumulative weighted average IRR of 15.2% on 39 portfolio exits, representing approximately $385.1 million in proceeds. From a macro perspective, the market for acquisition and refinancing capital was robust this quarter and has continued its momentum into the September quarter. Our investment pipeline, as we have mentioned on previous calls, has also been robust and continues to be in both volume and quality of deals. The deal team continues to do an excellent job broadening the top end of our deal funnel, which maximizes the number of deals in the market for which we have the opportunity to review and consider. As we have always said, this is a critical component of building and maintaining a quality investment portfolio in a competitive market. This activity has presented Capital Southwest with what we believe to be some very interesting investment opportunities. Based on dialogue with our portfolio companies, we also believe that the active market will result in elevated prepayments for Capital Southwest over the remainder of this year. On slide 13, we break out our on-balance sheet portfolio as of the end of the quarter between the lower middle market and the upper middle market, again, excluding our I-45 Senior Loan Fund. As of the end of the quarter, the total portfolio, including equity co-investments, was weighted approximately 87% to the lower middle market, and 13% to the upper middle market on a fair value basis. Our portfolio of 49 lower middle market companies had a weighted average EBITDA of $10.6 million and a weighted average leverage ratio measured as debt to EBITDA through our security of 4.2 times. Our average hold size in our lower middle market portfolio was approximately $13 million. Our on-balance sheet upper middle market portfolio, excluding our I-45 senior loan fund, consisted of 12 companies with a weighted average EBITDA of $61.8 million and an average leverage ratio through our security of four times. Our average whole size in our on-balance sheet upper middle market portfolio was approximately $8 million. Turning to slide 14, we have laid out the rating migration within our portfolios. During the quarter, we had three loans upgraded from a two to a one and one loan upgraded from a three to a two. As a reminder, all loans 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. As of the end of the quarter, we had 64 loans representing 92.2% of our investment portfolio at fair value rated in one of the top two categories, a one or a two. We had six loans representing 7.8% of the portfolio at fair value rated a three and no loans rated a four. During the quarter, we placed two first lien senior secured loans on non-accrual with a cumulative fair value of $14.5 million or 1.8% of the total investment portfolio. Both businesses remain rated a 3 with one loan being in the upper middle market and one loan being in the lower middle market. With respect to the upper middle market loan, this company has experienced softness in their post-COVID performance and is currently engaged in active restructuring conversations. We have decided to place this loan on non-accrual pending more clarity on the loan terms and company performance post-restructuring. The lower middle market loan placed on non-accrual this quarter is a company which has previously experienced operational challenges resulting in poor performance. Recently, the company's senior management team has made significant operational and personnel changes to upgrade the organization. While we believe the company's outlook is improving, illustrated by a significant growth in the company's project pipeline, we have decided to put this loan on non-accrual as we monitor their ability to convert this growing pipeline into revenue. Capital Southwest has representation on this company's board of directors and is attending monthly operating meetings with the company's management team, giving us enhanced access to real-time company performance dynamics. As illustrated on slide 15, our total investment portfolio continues to be well diversified across industries with an asset mix which provides strong security for our shareholders' capital. The portfolio includes remains heavily weighted towards first lien senior secured debt with only 7% of the portfolio in second lien senior secured debt and only 1% of the portfolio in one subordinated debt investment. Turning to slide 16, the I-45 senior loan fund showed solid performance for the quarter with asset growth and unrealized appreciation. Leverage at the I-45 fund level is now 1.4 times debt-to-equity. As of the end of the quarter, 96% of the I-45 portfolio was invested in first lien senior secured debt. Weighted average EBITDA and leverage across the companies in the I-45 portfolio was 77.9 million and 4.8 times, respectively. The portfolio continues to have diversity among industries and an average hold size of 2.6% of the portfolio. I will now hand the call over to Michael to review more specifics. of our financial performance for the quarter. Thanks, Bowen.