Capital Southwest Corporation

Thank you for joining today's Capital Southwest third quarter fiscal year 2023 earnings call. Participating on the call today are Bowen Diehl, CEO, Michael Skarner, 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 third 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 as 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 press 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 60 cents per share, which represented 11% growth over the $0.54 per share generated in the prior quarter and 18% growth over the $0.51 per share generated a year ago in the December quarter. The $0.60 per share more than earned a regular dividend paid during the quarter of $0.52 per share while also covering the supplemental dividend paid during the December quarter of $0.05 per share. We are also pleased to announce today that our board has declared another $0.01 per share increase in our regular dividend to $0.53 per share for the quarter ending March 31, 2023. This increase represents 1.9% growth over the $0.52 per share paid in the December quarter and 10% growth over the $0.48 per share paid a year ago in the March quarter. These increases in our regular dividend are a result of the increased fundamental earnings power of our portfolio, given its growth and performance, as well as improvements in our operating leverage. In addition, due to the continued excess earnings being generated by our floating rate debt investment portfolio, our board of directors has again declared a supplemental dividend of $0.05 per share for the March quarter, bringing total dividends declared for the March 23 quarter to $0.58 per share. While future dividend declarations are at the discretion of our board of directors, it is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future while base rates remain materially above long-term historical averages. Finally, I should note that as we have done in the past, we intend to also distribute additional supplemental dividends as we harvest realized gains from our equity co-investment portfolio. During the quarter, we saw strong deal activity in the lower rental market, primarily focused on acquisitions rather than refinancings. The environment during the quarter was a favorable one for a first-ling lender like Capital Southwest. We saw average spreads that were 50 to 100 basis points wider than a year ago, with leverage levels on our new platform deals that were lower by a full turn of EBITDA. Interestingly, loan-to-value levels on new deals calculated as our first lien loan divided by the enterprise value being paid for an acquisition, were also down meaningfully. This suggests that multiples being paid for strong companies remained robust. Portfolio growth during the quarter was driven by $164 million in new commitments, consisting of commitments to five new portfolio companies totaling $122.4 million and add-on commitments to 12 existing portfolio companies totaling $41.6 million. This was offset by $12.4 million in proceeds from one debt prepayment and one equity sale during the quarter. On the capitalization front, we raised a total of $104.3 million in gross equity proceeds during the quarter at a weighted average price of $17.99 per share, or 109% of the prevailing NAV per share. This included $58.3 million raised through our equity ATM program and $46 million raised through an underwritten public equity offering. Our liquidity remains robust with approximately $196 million in cash and undrawn capital commitments as of the end of the quarter. We have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issuances, as we think it is critical that we maintain a conservative mindset to BDC leverage given the uncertainty of the economy. As we have said many times, we manage our BDC with a full economic cycle mentality. This starts with the underwriting of our new opportunities, but it also applies to how we manage the BDC's capitalization. Managing leverage to the lower end of our target range positions us to invest throughout a potential recession, when risk-adjusted returns can be particularly attractive. It also allows us to support our portfolio companies while also opportunistically repurchasing our stock if it were to trade meaningfully below NAV. Within this context, we are very pleased with the strength of our balance sheet as we reduced regulatory leverage to 0.91 to 1 from 1.11 to 1 in the prior quarter. We maintained our significant liquidity position And we continue to operate with almost half of our balance sheet liabilities in fixed-rate, unsecured, covenant-free bonds, the earliest of which mature in 2026. On slides 7 and 8, we illustrate our continued track record of producing strong dividend growth, consistent dividend coverage, and solid value creation since the launch of our credit strategy back in January of 2015. Since that time, we have increased our regular dividend paid to shareholders 25 times and have never cut the regular dividend, including during the tumultuous environment we all experienced during the COVID pandemic. Additionally, over the same time period, we have paid or declared 19 special or supplemental dividends totaling $3.60 per share, generated from excess earnings and realized gains from our investment portfolio. We believe our track record of consistently growing our dividends, the solid performance of our portfolio, as well as our company's sustained access to the capital markets, has demonstrated the strength of our investment and capitalization management strategies, as well as the absolute alignment of our decisions with the interests of our shareholders. Continuing to generate this strong track record, we believe, is critically important to building long-term shareholder value. Slide 9, our investment strategy is laid out for our shareholders at its launch back in January 2015 hasn't changed. The vast majority of our activity has been in our core lower middle market, where we are the first lien senior secured lender, most often backing a private equity firm's acquisition of a growing lower middle market company. We also often participate on a minority basis in the equity of and the equity of the company through an equity co-investment made alongside the private equity firm. In fact, 90% of our credit portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio companies, as well as the potential for new junior capital support if needed. Our low-end-to-market strategy is complemented by club participations in larger companies led by like-minded lenders with whom we have relationships and have gained confidence in their post-closing loan management from working well together across multiple deals. Virtually all of these club deals are also backed by private equity firms. As of the end of the quarter, our equity co-investment portfolio consisted of 48 investments with a total fair value of $112.1 million, which was 60% over our cost, representing $41.8 million in embedded unrealized appreciation are $1.21 per share. Our equity portfolio, which represented approximately 10% of our total portfolio value at the end of the quarter, continues to provide our shareholders participation in attractive upside potential of these growing lower middle market businesses, which will come in the form of NAB per share and supplemental 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 funds, grew 10% to $990 million as compared to $903 million as of the end of the prior quarter. Over the past year, our credit portfolio has grown by $245 million, or 33%, from $745 million as of the end of December 21 quarter. For the current quarter, 99.7% of our new portfolio company debt originations were first lien senior secured debt. And as of the end of the quarter, 96% of our total credit portfolio was first lien senior secured. On slide 11 and 12, we detail the $164 million of capital invested and committed to portfolio companies during the quarter. Capital committed this quarter included $120.4 million in first lien senior secured debt and $1.6 million in equity co-investments to five new portfolio companies. Additionally, we committed $39.7 million in first lien senior secured debt and $1.9 million in equity co-investments to existing portfolio companies during the quarter. Turning to slide 13, during the quarter, we had one debt prepayment and one equity sale. In total, these exits generated approximately $12.4 million in total proceeds generating a weighted average IRR of 10.1%. Since the launch of our credit strategy eight years ago, we have realized 67 portfolio exits, representing $775 million in proceeds, that have generated a cumulative weighted average IRR of 14.6%. The market for acquisition capital continues to be active, not surprisingly given the widening spreads on new loans in the market. The slowdown in refinancing activity continues. So on a net basis, we expect solid net portfolio growth in the near term. 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 provider, as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities. In terms of deal origination, we find that underwriting certain industries is more challenging given today's economic uncertainty. An important component of our underwriting has always been to run a stress case downside model for every new deal, simulating an extreme recession occurring soon after closing. In many respects, our underwriting in the current environment hasn't changed, although our models today include much higher base rates than we have experienced historically. Our fundamental analysis attempts to tie the leverage level we are willing to put on a company to the potential performance volatility of a particular business and industry throughout the economic cycle. Performance across different industries can be very different through the economic cycle, so getting this right is an important component of the underwriting process. Specifically, in a stress case financial model, we require a fundamental underwriting standard that we see our loan remain well within the portfolio company's enterprise value and the portfolio company's cash flow able to cover our loan interest throughout the cycle. On slide 14, we detailed some key steps for our on-balance sheet portfolio as of the end of the quarter, again, excluding our I-45 senior loan funds. As of the end of the quarter, the total portfolio at fair value was weighted approximately 87% to first lien senior secured debt, 3.2% to second lien senior secured debt, 0.1% to subordinated debt, and 10.2% to equity co-investment. Credit portfolio had a weighted average yield of 12% and weighted average leverage through our security of 3.6 times. The weighted average leverage this quarter was down from 4.1 times in the prior quarter due in part to $67.3 million of funded debt originations to five new portfolio companies and a weighted average leverage through our security of 1.9 times even down. Turning to slide 15, we have laid out the rating migration within our portfolio. 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. We feel very good about the performance of our portfolio, with 95% of the portfolio at fair value, rated in one of the top two categories, a one or a two. As illustrated on slide 16, Our total investment portfolio, including our I-45 Senior Loan Fund, 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 first-lane senior secured debt, with only 3% of the total portfolio in second-lane senior secured debt. I will now hand the call over to Michael to review some specifics of our financial performance for the quarter.