Capital Southwest Corporation

Thank you for joining today's Capital Southwest fourth quarter and fiscal year 2023 earnings call. Participating on the call today are Bowen Deal, CEO, Michael Sarner, CFO, and Chris Reberger, Vice President of Finance. I will now turn the call over to Chris Reberger.

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 guaranteed the 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 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 in the investor relations page on our website at www.capitalsuswest.com. You will also find our quarterly earnings press release issued last evening on our website. Now turning to slide six of the earnings presentation, we will begin with a summary of the key performance highlights for the 2023 fiscal year. During the fiscal year, we grew our total portfolio at fair value by 29% year-over-year to over $1.2 billion, from $937 million in the prior year, while increasing our pre-tax investment income by 21% to $2.30 per share from $1.90 per share in the prior year. We increased our regular dividends paid to $2.03 per share for the fiscal year, representing an increase of 12% compared to the $1.82 per share of regular dividends paid in the prior year. We continue our track record of covering our regular dividend with pre-tax NII with over 113% coverage for the year. In addition to our regular dividend growth, we began a supplemental dividend program in the December 2022 quarter, paying $0.05 per share in each of the December and March quarters. Our board has again declared a $0.05 per share supplemental dividend for the June 2023 quarter. In addition, during the year, we strengthened our balance sheet through a variety of capital markets activities. First, we raised a total of $207 million in gross equity proceeds through our equity ATM program, as well as an underwritten public offering of our common stock, reducing our regulatory leverage to 0.88 to 1 debt to equity as of the end of the fiscal year, compared to 1.16 to 1 debt to equity as of the end of the prior fiscal year. We received $65 million in additional commitments on our revolving credit facility, bringing total credit facility commitments to $400 million. Third, we received approval for $50 million in additional SBA ventures during the year, which we are currently drawing upon. Finally, in March of 2023, based on our performance, balance sheet leverage, and flexibility, we received a BAA3 investment grade rating with a stable outlook. from Moody's Investor Service. Michael will provide further detail on this later in our prepared remarks. Turning to slide seven of the earnings presentation, we have summarized key performance highlights specific to the March quarter. During the quarter, we generated pre-tax net investment income of $0.65 per share, which represented 8% growth over the $0.60 per share generated in the prior quarter, and 30% growth over the $0.50 per share generated a year ago in the March quarter. The $0.65 per share significantly out-earned our 53% per share regular dividend, as well as our total dividends paid during the quarter of $0.58 per share, which includes the $0.05 per share supplemental dividend. As of the end of the quarter, our estimated undistributed taxable income balance was $0.45 per share. As previously announced, our board has declared another $0.01 per share increase to our regular dividends 54 cents per share for the June 2023 quarter. These increases in our regular dividends are a result of the increased fundamental earnings power of our portfolio, given its growth and performance, as well as further improvements in our operating leverage. We have continued to be prudent in increasing our regular dividends, always endeavoring to set the regular dividend at a level that can be maintained even if market base rates return to more historical norms. In addition, due to continued excess earnings being generated by our floating rate debt portfolio in an elevated base rate environment, our Board of Directors has again declared a supplemental dividend of 5 cents per share for the June quarter, bringing total dividends declared for the June quarter to 59 cents 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 are above historical averages and we have meaningful UTI generated by earnings in excess of our dividends and realized gains from our equity co-investment portfolio. During the quarter, deal activity in the low-end market continued to be solid, primarily focused on acquisitions rather than refinancing. The environment during the quarter continued to be a favorable one for a first-ling lender like Capital Southwest. We continued to see average loans pricing spreads on new portfolio company loans that were 50 to 100 basis points higher than a year ago, and leverage levels on new portfolio company loans that were generally lower by around a full turn of EBITDA. At the same time, loan-to-value levels on these new loans, calculated as our first lien loan divided by the enterprise value being paid for an acquisition, were also down meaningfully from a year ago, as private equity firms remained willing to pay full multiples for quality companies. Portfolio growth during the quarter was driven by $67.3 million in new commitments consisting of commitments to five new portfolio companies totaling $49.5 million and add-on commitments to nine existing portfolio companies totaling $17.8 million. This was offset by $16.8 million in proceeds from one debt prepayment during the quarter. On the capitalization front during the quarter, we raised a total of $29.2 million in gross equity proceeds at an weighted average price of $19.15 per share, or 118% of the prevailing NAD per share. Our liquidity remains robust, with approximately $196 million in cash and undrawn capital commitments at the end of the quarter. We have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issues as we think it is critical that we maintain a conservative mindset to BDC leverage given the current uncertainty in the economy. As we have said many times, we manage our BDC with a full economic cycle mentality. This starts with our underwriting of 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 NAD. With this in context, we are very pleased with the strength of our balance sheet as we further reduce regulatory leverage to 0.8821 debt to equity down from 0.9121 debt to equity in the prior quarter. We also maintain our significant liquidity position, and we continue to operate with almost half of our balance sheet liabilities as fixed-rate, unsecured, covenant-free bonds, the earliest of which mature in 2026. On slides eight and nine, 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 quarterly regular dividend pay to shareholders 26 times and have never cut the regular dividend, even in the tumultuous environment we all experienced during the COVID pandemic. Additionally, over the same period, we have paid 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 all 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. Turning to slide 10, we lay out the core tenets of our strategy, which hasn't changed since its launch back in January of 2015. Our core strategy is lending and investing in the low-income market, the vast majority of which is in first lien senior secured loans to private equity-backed companies. In fact, approximately 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. In the low-income market, we often have the opportunity to invest on a minority basis in the equity carried with the private equity firm. As of the end of the quarter, our equity co-investment portfolio consisted of 53 investments with a total fair value of $117.5 million, which was 155% of our cost, representing $41.6 million in embedded, unrealized appreciation, or $1.15 per share. Our equity portfolio, which represented approximately 10% of our total portfolio fair value as of the end of the quarter, continues to provide our shareholders participation in the attractive upside potential of these growing lower middle market businesses, which will come in the form of NAD per share growth and supplemental dividends over time. Our lower middle market strategy is complemented by core 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 illustrated on slide 11, our on-balance sheet credit portfolio is at the end of the quarter, excluding our I-45 Senior Loan Fund, grew 31% year-over-year to over $1 billion, compared to $794 million as of the end of the prior year. For the current quarter, 100% of our new portfolio company debt originations were first lien senior security. And as of the end of the quarter, 96% of the total unbalanced sheet credit portfolio was firstly in senior security. Over the past eight years, as we have grown the credit portfolio, we have significantly improved the granularity of loan hold sizes in the portfolio, with the average hold size as a percent of the total loan portfolio falling from 5% to less than 1.5%. On slide 12, we detail the $67.3 million of capital invested in and committed to portfolio companies during the quarter. The capital committed this quarter included $45.7 million in first lien senior secured debt committed to five new portfolio companies, including four in which we invested a total of $3.9 million in equity. We also committed $16 million in first lien senior secured debt and $1.7 million in equity to nine existing portfolio companies. Deal activity continues in the current quarter at a healthy pace, as we have originated over $80 million in new commitments since the March quarter end. Turning to slide 13, during the quarter, we had one loan originated in July 2016 prepaid based on the sale of the portfolio company by the private equity sponsor. This exit generated approximately $16.8 million in proceeds, generating a weighted average IRR of 13%. Since the launch of our credit strategy, we have realized 68 portfolio exits, representing approximately 800 million in proceeds that have generated a cumulative weighted average IRR of 14.5%. Not surprisingly, refinancing activity continues to be slow given the widening spread on new loans in the market. Based on these dynamics, we expect solid net portfolio growth in the coming quarters. We are pleased with the strong market position that our team has established in the lower middle market. is a premier debt and equity capital provider as evidenced by our consistent deal origination activity and the broad array of relationships across the country from which our team is sourcing quality opportunities. In terms of underwriting this market, while our company and portfolio are performing well, we do find underwriting certain industries is more challenging given today's economic uncertainty. An important component of our loan underwriting has always been to run a stress case downside financial model for every new loan, simulating an extreme recession occurring soon after the closing of our loan. So in that respect, our underwriting in the current environment hasn't changed from what we have done in the past, although models today include much higher base rates than we have experienced historically. This modeling 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. Peak to trough recessionary performance volatility across industries, as demonstrated by performance in past recessions, can be very different. So it is critical to assign leverage levels that are appropriate for a given level of potential performance volatility. Specifically, in our stress case financial model, we require the fundamental underwriting standards that the model demonstrates that our loan remains well within the portfolio company's enterprise value and that the portfolio company's cash flow is able to cover our loan interest throughout the simulated recession. On slide 14, we detail some key stats for our on-balance sheet portfolio as of the end of the quarter, again excluding our I-45 senior loan fund. As of the end of the quarter, this total portfolio at fair value was weighted 86.6% to first-line senior security, 3.1% to second-line senior security, 0.1% to subordinated debt, and 10.2% to equity co-investments. The average hold size for portfolio loans and equity co-investments was $13.3 million and $2.2 million, respectively. The credit portfolio had a weighted average yield of 12.8% and weighted average leverage through our debt security of four times. 515 illustrates the rating migration within our portfolio for the quarter. 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. Is there being the quarter? 95.7% of the portfolio fair value was rated in one of the top two categories, a one or a two. As illustrated on slide 16, our total investment portfolio on this slide now, 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. Again, the portfolio remains heavily weighted towards first-ling senior secured debt with only 3% of the portfolio and secondly in senior secured debt. I will now hand the call over to Michael to review more specifics of our financial performance for the quarter. Thanks, Don.