Capital Southwest Corporation

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 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 in such statements. For information concerning these risks and uncertainties, 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, Rowan Deaton.

Thanks, Chris, and thank you to everyone for joining us for our first quarter fiscal year 2023 earnings call. 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 as we continue to diligently execute our investment strategy for stewards of your capital. 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. You will also find our quarterly earnings release issued last evening on our website. 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 generated pre-tax net investment income of 50 cents per share, which represented 11% growth over the 45 cents per share generated in the year-ago June quarter. The 50 cents per share more than earned our regular dividend paid during the quarter of 48 cents per share. Total dividends for the quarter were 63 cents per share, which included a special dividend of 15 cents per share, also paid out during the quarter. We are pleased to announce today that our Board has declared a $0.02 per share increase in our regular dividend of $0.50 per share for the quarter ending September 30, 2022. This increase represented 4.2% growth over the $0.48 per share paid out in the June quarter and 16% growth over the $0.43 per share paid out in the year-ago September quarter. This increase in our recurring regular dividend reflects the increased earnings power of our portfolio resulting from the increase in market interest rates over the past few months, the growth and performance of our credit portfolio, and the improvements in our operating leverage. During the quarter, acquisition and financing activity in the lower middle market continued to be strong. This quarter, we surpassed the $1 billion threshold in total investment assets, representing 7.5% growth for the quarter and 26% portfolio growth over the past year. Portfolio growth during the quarter was driven by $148 million in new commitments consisting of commitments to six new portfolio companies totaling $139 million and add-on commitments to eight existing portfolio companies totaling $9 million. This was offset by $50 million in proceeds from three debt repayments and one equity exit during the quarter. On the capitalization front, we raised $46.8 million of equity through our ATM program at an average price of $20.60 per share representing an average of 123% of the prevailing net asset value per share. Our liquidity remains robust at approximately 180 million in cash, undrawn capital commitments as of the end of the quarter. We feel very good about the condition of our portfolio overall and of our company. That said, we have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issuances on our equity ATM program, as we think it is critical that we maintain a conservative mindset to BDC leverage given the uncertainty of the economy and capital markets. On 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, as well as our company's sustained access to the capital market, has demonstrated the strength of our investment and capitalization management strategy. Maintenance and growth of both shareholder dividends and NAV per share remain as core tenets of our long-term investment objective of creating long-term value for our shareholders. Turning to slide 9 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, where we directly originate and lead opportunities. consisting primarily of first-line senior secured loans with smaller equity co-investments made alongside many of our loans. As of the end of the quarter, our equity co-investment portfolio consisted of 44 investments with a total fair value of $89.5 million, which included $26.6 million in embedded unrealized appreciation for approximately $0.97 per share. Our equity portfolio, which represented approximately 9% of our total portfolio fair value over the end of the quarter, continues to provide our shareholders the participation and the attractive upside potential of these growing lower middle market businesses, which will come in the form of NAB per share growth and special dividends over time. As illustrated on slide 10, our on-balance sheet credit portfolios at the end of the quarter, excluding our I-45 Senior Loan Fund, grew 9% to $865 million as compared to $794 million as of the end of the prior quarter. Over the past year, our credit portfolio has grown $194 million or 29% from $671 million as of June 2021. For the quarter, 100% of the new portfolio company debt originations were first lien senior secured debt. And as of the end of the quarter, 94% of our total credit portfolio was first lien senior security. On slide 11 and 12, we detail the $148 million of capital invested in and committed to portfolio companies during the quarter. Capital committed this quarter included $136 million in first lien senior security debt committed to six new portfolio companies, including four in which we also co-invested a total of $3.1 million in equity. Finally, during the quarter, we also committed $9 million in first lien senior secured debt to eight existing portfolio companies. Turning to slide 13, we continued our track record of successful exits with three debt prepayments and one equity exit during the quarter. In total, these exits generated $49 million in total proceeds, realizing gains of $2.3 million and generating a weighted average IRR of 19.6%. Since the launch of our credit strategy over seven and a half years ago, we have had 63 portfolio exits representing $745 million in proceeds that have generated a cumulative weighted average IRR of 14.8%. The market for acquisition capital continues to be active, albeit at a slower pace than we saw at the turn of calendar year 21. Not surprisingly, we have also seen a slowdown in refinancing activities. As a result, we would expect continued solid net portfolio growth in the near term. The activity in our investment pipeline is strong in terms of volume and quality of deal opportunities, as well as the breadth of financial sponsors and other deal sources represented. We are pleased with the strong market position that our team has established in the lower middle market as a premier debt and equity capital partner. as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities. On slide 14, we detail some key stats for our on-balance sheet portfolios at the end of the quarter, again, excluding our 45 senior loan funds. As of the end of the quarter, the total portfolio fair value was weighted 85.4% to first lien senior secured debt, 5.1% to second lien senior secured debt, and 0.1% to subordinated debt and 9.4% to equity co-investment. The credit portfolio had a weighted average yield of 9.3% and weighted average leverage through our security of four times, both flat from the prior quarter. Turning to slide 15, we have laid out the rating migration within our portfolio. During the quarter, we had one loan with a fair value of $10 million upgraded from a 2 to a 1. We had three small loan positions across two portfolio companies with an aggregate fair market value of $10 million downgraded from a 2 to a 3. And we had one loan position with a fair value of $693,000 downgraded from a 3 to a 4. As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4-point scale, with 1 being the highest rating and 4 being the lowest rating. At the end of the quarter, we have 74 loans representing 95% of our investment portfolio fair value rated in one of the top two categories, a one or a two. The number of one-rated loans decreased from seven to five this quarter, and all three of the loan prepayments this quarter had a rating of one, offset by the aforementioned portfolio company that was upgraded and added to the list of one-rated loans this quarter. In aggregate, we had a total of 10 loans representing approximately 5% of the portfolio fair value rated at three or at four as of the end of the quarter. As illustrated on slide 16, 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 remains heavily weighted towards personally and senior secured debt with only 5% of the total portfolio and secondly in senior secured debt. I'll also note that 90% of our credit portfolio is backed by a financial sponsor, providing for potentially meaningful financial support for these portfolio companies if needed. I will now hand the call over to Michael to review more specifics of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the June quarter, as summarized on slide 18, we earned pre-tax net investment income of $12.6 million or $0.50 per share. We paid out $0.48 per share in regular dividends and $0.15 per share in special dividends for the quarter. As mentioned earlier, our Board has approved an increase to the regular dividends for the September quarter to $0.50 per share from the $0.48 per share that was paid for the June quarter. Maintaining a consistent track record of meaningfully covering our dividends with pre-tax NII is important to our investment strategy. We continue to maintain our strong track record of regular dividend coverage with 105% for the last 12 months ended June 30, 2022 and 106% cumulative since the launch of our credit strategy in January 2015. Given the floating rate nature of our credit portfolio, rising interest rates will be a significant tailwind to our net investment income. In fact, the index used to calculate interest on a majority of our loans reset in early July 2.29%, up from its early April reset at 96 basis points. This significant increase, quarter over quarter, will provide an immediate step-up in portfolio income in the September quarter. With that as context, we will continue to execute our policy of having regular dividends follow the trajectory of recurring pre-tax NII per share while maintaining our track record of strong dividend coverage. the quarter, our investment portfolio generated total investment income of $22.5 million, producing a weighted average yield on all investments of 9.1%. Total investment income was $1.5 million higher this quarter due to a higher average balance of credit investments outstanding, as well as an increase in prepayment and amendment fees compared to the prior quarter. As at the end of the quarter, There were four loans on non-accrual with an average fair value, with aggregate fair value of approximately $16 million, representing 1.6% of the investment portfolio at fair value. On July 1, 2022, one of the non-accruing loans with a fair market value of approximately $13 million was restructured in the transaction that resulted in Capital Southwest equitizing a portion of its debt, providing Capital Southwest significant participation in the company turnaround. and reinstating the remainder of our quarter-end debt, called as debt on the new company. The transaction also resulted in a significant amount of new equity capital being invested into the company by the sponsor. We expect that our reinstated debt will be back on accrual in the coming quarters. Finally, as at the end of the quarter, the weighted average yield on our credit portfolio was 9.3% for the quarter. As seen on slide 19, we further improved LTM operating leverage to 2.1% as of the end of the quarter. We expect operating leverage to approach 2% or better in the coming quarters. During slide 20, the company's NAV per share at the end of the June quarter decreased by 32 cents per share to $16.54, which included a 15 cents per share special dividend paid to shareholders during the quarter. This represented a 1.9% decrease quarter over quarter compared to $16.86 per share as of the end of the March quarter. Outside of the special dividends, the primary driver of the NAV per share decrease for the quarter was investment portfolio depreciation, which consisted of $5.9 million of depreciation at I-45, most of which was mark-to-market quote activity in the syndicated market. We also saw $5.5 million of depreciation on the on-balance sheet debt portfolio, partially offset by by $1.5 million of net appreciation on the equity portfolio and accretion from the issuance of common stock at a premiumed NAB per share under the equity ATM program. Turning to slide 21, as Bowen mentioned earlier, we are pleased to report that our balance sheet liquidity continues to be strong, with approximately $180 million in cash and undrawn leverage commitments at the end of the quarter. During the quarter, we successfully completed an amendment with the lender group on our ING-led senior security credit facility, which increased commitments on the credit facility by $45 million, bringing total commitments to $380 million. Based on our borrowing basis at the end of the quarter, we have full access to the incremental revolver capacity. Our bank syndicate continues to support our growth, and we are pleased with the flexibility the increased revolving credit facility commitment provides to our capital structure. In addition, we continue to draw debentures in our SBIC subsidiary as we originate SBIC eligible assets. As at the end of the quarter, we had drawn $80 million in debentures with an average cost of 2.4%. We intend to apply for another SBA leverage commitment shortly as we continue to see strong origination volume in SBIC eligible investments. As of June 30, 2022, approximately 49% of our capital structure liabilities were unsecured and our earliest debt maturity is in January 2026. Our regulatory leverage, as seen on slide 22, ended the quarter at a debt-to-equity ratio of 1.1 to 1. Over the past year, we've made a concerted effort to strengthen our balance sheet to ensure we are prepared for any macroeconomic headwinds that we may encounter. These efforts have included our opportunistic unsecured bond issuances at record low rates in the late calendar 2021, and our continued diligence in moderating leverage through accretive share issuances on our equity ATM program. We will continue to work toward strengthening the balance sheet, ensuring adequate liquidity, and maintaining conservative leverage in covenant cushions throughout the economic cycle. I will now hand the call back to Bowen for some final comments.

Thanks, Michael, and thank you, everyone, for joining us today. We appreciate the opportunity to provide you an update on our business and progress executing our strategy as stewards of our stakeholders' capital. Our company and portfolio continue to perform well, and I continue to be impressed by the job our team has done in building a robust asset base, deal origination capability, as well as a flexible capital structure. As to the uncertainty in the economy, we have been underwriting with a full economic cycle mentality since day one. which we believe has positioned us well for the potential economic volatility in the coming months and years. We continue to believe that our performance demonstrates the investment acumen and capital structure management capability of our team at Capital Southwest, as well as the merits of our first lean senior secured strategy. We feel very good about the health and positioning of our company and portfolio, and we are excited to continue to execute our investment strategy as stewards of our stakeholders' capital. This concludes our prepared remarks operator. We are ready to open the lines up for Q&A.

As a reminder, to ask a question, you will need to press star 1-1 on your telephone. Please stand by while we compile the Q&A roster. Our first question comes from the line of Kevin Fultz from JMP Securities.

You know, given the evolution of market conditions over the past two quarters, I'm curious if you've seen that translate to improve pricing on new deals that you're reviewing. And then more broadly, if you can discuss the attractiveness of deals you're seeing in the lower and upper middle market currently. Yeah, thanks for the question.

Yeah, I think for a comment on the strength in the market, I think, you know, we're seeing kind of for quality deals that you can underwrite, especially given the economic cycle. And with reasonable leverage levels, there's still a lot of competition for those deals. And so we haven't really seen spread widen tremendously, maybe a little bit on the margin, 25 to 25 basis points, plus or minus. And so, you know, still seeing strong activity, still seeing, you know, kind of spreads kind of where they are, where they've been.

Okay, that makes sense, Bowen. And then just to follow up for Michael, looking at the NAV bridge on slide 20, there's an 11 cent per share loss related to other corporates. Just curious if you can identify the items that are included in that bucket.

Yeah, I think that has to do with our RSUs. We do our June distribution to employees for RSUs in the June quarter. And so you'll see that annually in this quarter.

Okay, got it. That's it for me. Congrats on a nice quarter. Thanks.

Thank you. Our next question comes in the line of Mickey Schlein from Ladenburg.

Bowen, I want to dig a little into credit. Any high-level comments you can give us on how your borrower's revenues are trending and how their margins are trending? I understand it's case by case and sector by sector, but We're getting such mixed signals as to, you know, the trajectory of the economy. Any comments you can make would be helpful.

Yeah, sure, Mickey. Thanks for the question. So let's look at that. If you look at our portfolio and let's take the 95% of the portfolio that are either performing kind of as expected or ahead of expected, you kind of get the 5% that are underperforming. Let's set those aside for a second because I would say if we look at those underperformers, they're all idiosyncratic. in the companies. So let's take the 95%, and let's look at that. And when we look at that, you know, revenues year over year and EBITDA year over year is up about 23%. If you look at the last quarter, revenue is up about a little over 5%, and EBITDA is basically flat, which I thought that was kind of interesting. I mean, obviously, different industries are different, so you take the weighted average across the portfolio. It's kind of the index that the easiest thing to look at. And so it's not perfect, but let's just say that. So revenue is over 5% and EBITDA is basically flat. And so I looked down through the portfolio and I said, why is that? And it's hard to look at it and say it's necessarily the economy per se, but there are certain things like labor increases and cost of inputs, hard inputs, And so, and I look at that and I say, revenue's up and EBITDA's flat. So we certainly have seen the companies with very general comments with the pricing power to increase prices to maintain margins. And so, you know, I'd say the quarter over quarter for general economic activity is kind of flat with these kind of sub-issues that we're all hearing about in the economy. We look across our portfolio and they seem to be doing a good job passing those costs on to their customers to maintain the margin dollars.

Mickey, from a timing perspective, we're using April and May for all our valuations. Not that we're seeing any softening since then, but a lot of the financials are yet to come to see whether anything that's occurring.

I would say from just commentary, we talk about these companies a lot. I would say commentary-wise, I think that those steps kind of would continue through now, but Michael's right. I mean, the financials, all the BDCs use for valuations, as you know, Mickey, are April, May, for a June quarter.

Yeah, I understand. And Bowen, this may be idiosyncratic, but there was one loan downgraded to a three. What was the nature of the problem there? Is it something specific to that company or something broader?

Well, you're asking about the one small loan that was downgraded to a four.

There were, there were, I thought there was a migration to a three of 10 million of fair value.

Yeah, no, that's, um, so there was one upgrade to a one, it was 10 and there were three loans across two portfolio companies that were downgraded to three. And, um, You know, they were all very small loan positions. They were definitely idiosyncratic. One has to do with, you know, it's very idiosyncratic based on certain pipeline stats and things that they have to achieve to basically offtake their product. But it's very idiosyncratic to that company. And it's also, I should also say, it's backed by a very strong funded sponsor as well. So, you know, we've got to... fair amount of equity support, potential equity support certainly in that company.

And Bowen, is there any update you can provide us on the loans that are on non-accrual in terms of progress you might be making with those credits?

Yeah, so as Michael said in his remarks, I'll reiterate because it might have gotten lost. So there are $16 million in fair value on non-accrual at the end of the quarter. One of those loans was restructured on the first day of the new quarter, so July 1 of 2022. And that loan had a fair value of $13 million out of the $16. And that restructuring resulted in us equitizing a portion of our debt and the sponsor putting in a very meaningful amount of equity into that business. And so we've got significant equity participation in the turnaround, serve on the board of that company. And, you know, if you feel okay about where we are, I'm certainly very happy about the significant amount of liquidity that the company, the sponsor put in the business and is sitting on the balance sheet currently.

I understand. That's helpful. And in terms of the unrealized appreciation of the on-balance sheet debt portfolio, was that, I mean, you have the downgrade that you mentioned. Was there also something attributed to wider credit spreads in general?

Yeah, so on the depreciation, there's two pieces, right? We mentioned the $5.5 million bond balance sheet, and that's probably a little more than half credit and less than half spread market indexers. And the I-45 piece is two-thirds market indexes and quote movement, as you can imagine, and kind of one-third credit issue stuff.

Okay. And just to wrap up, in the SBIC, are you going to ask for the full $87.5 million of regulatory capital and the full two turns of leverage, or how should we expect that to work out over the next several quarters?

We'll absolutely, over time, be drawing the entire amount. But what you're faced to do during this process with the SBIC is you need to actually bed a portion of eligible assets need to go in as equity prior to asking for a commitment to draw upon. So we have to go to the FDIC with a further leverage commitment, which we plan on doing. So it would probably be something in the neighborhood of $50 million for the next commitment. So we're right now in the process of betting that $50 before we're able to ask for the formal commitment.

Okay, $50 million of new debentures, right?

So the $50 million would be the next debt commitment, yes. So we'll put $25 million of eligible assets as our equity, and then we'll draw the next $50. And as that $50 is completed, then you go back to the SBIC for another commitment. Because you need to bet prior to asking for a commitment.

Yeah, as Mickey, you know, that's very typical for these SBICs. We've always presented it to the shareholders as kind of showing the different steps as opposed to just presenting the entire FDIC, but it's very typical to be stair-stepped like that, and, you know, there's not really any notable or even risk at all of really getting those commitments, but it's a stepped documentation process, and so we presented it that way, not to get confused by it being like, you know... No, no, it's very helpful.

The transparency is really helpful, Bowen. Bowen, have you adjusted your... target leverage goals given the current market environment, or does that remain unchanged? And if you could just remind us what those are.

Yeah, Michael.

I'll comment on the stuff a lot here in a minute, but we certainly... I mean, looking at whatever economic volatility that we might be heading into, we previously stated a target of 1.2 to 1.3 on economic and 1.1 to 1.2 on regulatory, stated a target of 1.2 to 1.3 on economic and 1.1 to 1.2 on regulatory. Right now, we're targeting regulatory at 1.0. And probably economically something more like 1.1 to 1.2. And I think until we see how long and deep the recession, if it was to come to pass, that's kind of where we'll try to target. And by doing so, we're going to need to raise equity. We started that. We noted earlier we raised 46 million in this previous quarter. As long as we're trading meaningfully above book, I think you'll continue to see us raise meaningful equity. We haven't seen a slowdown in the portfolio. I think Bowen noted earlier that even in an environment where M&A activity might slow down, repayments will slow as well. So we will continue to see net portfolio growth. So raising equity alongside these originations and maintaining leverage in this conservative range is certainly one of our targets.

Yeah, I think that's well said. I mean, we think about full cycle economics in our portfolio underwriting, and we think about full cycle economics in our BDC as well. So I think Michael said that perfectly.

Okay, that's great. That's it for me this morning. I appreciate your time. Thank you. Thank you.

Thank you. Our next question comes from the line of Kyle Joseph from Jefferies.

questions, or just one really, but two parts. In terms of the margins, pretty stable quarter on quarter. I think you said rates either reset post quarter or late in the quarter. So how do we think about your assets resetting versus the cadence of your liabilities resetting, recognizing that a lot of your liabilities are fixed rate? And then on rising rates, how are you how is that impacting your expectations for credit going forward? Obviously, it's a good thing. We should see your net interest income go up, but at the same time, companies have a higher debt servicing cost.

For our liability side, those reset, probably you could think of them on a monthly basis. That's probably on more of a weighted basis. You saw it go from 96 basis points to 2.29%. So from one quarter to the next. So the average is probably, you know, something in the mid-1.5 in terms of the increase on the interest expense. For the assets, pretty much 90%, if not more, of the assets reset on the quarterly date. So what we're looking at, you know, we look at our 630 numbers. If we were using the 2.29% at the end of June, pro forma on our balance sheet, we would have had an additional $0.03 of NII. So the $0.50 that we produced probably would have been closer to $0.53. And so that gives you a little guidepost going forward.

Yeah, so the second part of your question, you know, we've got an analysis we track and looking across the portfolio and taking the current index, the 2.29% index, and looking at the portfolio and then increasing that index up to a point where, you know, you start seeing meaningful credit issues, you really have to get that index up into the mid 5%. So, you know, 5.5 plus or minus percent on the index before you start seeing, you know, fixed charge coverage ratios across, you know, candidly a lot of portfolios are still fantastic, but you kind of take the number of names at a 5.5 plus percent kind of LIBOR and you start seeing your, you know, red light names that start to make you nervous, start to move like in a meaningful way or, you know, you really got to have the index up to, you know, five and a half plus percent. So I feel, you know, pretty good that, you know, we're not going to see, you know, I don't think we're going to see five and a half, six percent on the index, but I feel pretty good about what the portfolio is.

Got it. Really helpful. Thanks for answering my question.

Thank you. Our next question comes from the line of Robert Dodd from Raymond James.

This has been asked and answered. So just one quick one, if I can. I think, Michael, in your prepared remarks, you said you expect the the dividends to follow the trajectory of pre-tax income. So you're talking about basically, you know, if rates, I mean, rates are up, right? If earnings go up along the lines of 3 cents or whatever for next quarter and the subsequent quarters through at least the beginning of 23, the base dividend would be increasing at the same time. And just for Carl, obviously the forward curve, et cetera, is lower in the second half of 23 than it is in the first half of 23. So, you know, is that taken into account in terms of what path the dividend goes?

uh might follow because obviously you don't necessarily want to be cutting the dividend when rates are falling if if that comes to pass obviously absolutely that is certainly the way we're looking at things if you look at the fed funds rate right now or it's given the range of 2.25 to 2.5 and it's considered neutral um and so when we're looking at projecting forward we're not really assuming that there's going to be any increases beyond the levels that they are today So we do believe that there's between the 50-cent dividend we announced today and where we see earnings going, just based on the 2.29, there's certainly room for another dividend increase. However, we do want to maintain, and we'd probably say we want to maintain maybe two to three cents of difference between the dividend paid and pre-tax net investment income earned. So that's what we're going to focus on going forward. We're not going to be projecting additional dividends. rates to increase and you know if it was going to come back down um where we feel like the dividend that we will have set will will match the rate where it comes back to that if that's helpful that that is very helpful thank you and uh congrats on the on the on a really solid quarter thanks

Thank you. I would now like to turn the conference back over to Bowen Beal for closing remarks.

Well, thanks, everybody, for joining us. We appreciate the opportunity to give you an update, and we look forward to talking to you in future quarters.

This concludes today's conference call.

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