Capital Southwest Corp Q3 FY2021 Earnings Call

Thank you for joining today's third 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 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 the actual results to differ materially from such statements. For more information concerning these risks and uncertainties, see our publicly available filings with the SEC.

Thanks, Chris, and thank you to everyone for joining us for our third 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. We are pleased to be with you this morning to announce our results for our third fiscal quarter ended December 31, 2020. I want to first say that I hope everyone, their families, and their employees continue to be safe and well. In summary, this quarter was exceptional in virtually all areas: strong originations, strong capital raises, and strong portfolio performance. As we reflect back on 2020, we were very impressed by how the vast majority of our portfolio management teams and financial sponsors managed our portfolio companies, prioritizing the health and safety of their employees, realizing cost efficiencies where needed, and now recovering nicely from the worst effects of the pandemic. While the pandemic is not yet completely behind us, as we look back to where we were in March of 2020 with so much economic 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. The pandemic has impacted so many people and companies in a variety of ways, and we are humbled by how well the portfolio has held up through this difficult time. The way our deal team has been able to continue to source, diligence, and originate high-quality assets while actively monitoring our existing portfolio over the past year has corroborated my confidence in them and also in the strength and quality of the assets. During the quarter, our portfolio continued to improve as evidenced by $7.1 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. Overall, as of the end of the quarter, we had only one loan on non-accrual, the junior-most tranche of our loan to AG Kings, which had a fair value of $739,000. Subsequently, the sale of AG Kings to Albertsons has closed. Now we're resolving this last non-accrual asset for Capital Southwest.

Thanks, Bowen. Specific to our performance for the December quarter, we earned pretax net investment income of $10 million or $0.52 per share. This was a 23% increase from the $8.1 million or $0.44 per share earned during the prior quarter. We paid out $0.41 per share in regular dividends for the quarter, flat from the $0.41 regular dividend per share paid out in the September quarter. Our Board has declared an increase to our regular dividend from $0.41 to $0.42 per share to be paid out during the March 31st quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pretax net investment income is important to our investment strategy. This track record is demonstrated by our 107% regular dividend coverage over the past 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy. During the quarter, we maintained our supplemental dividend at $0.10 per share, and again, our Board has declared a further $0.10 per share supplemental dividend to be paid out during the March quarter. The supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our undistributed taxable income balance. As of December 31, 2020, our estimated undistributed taxable income balance was $1.09 per share. Our investment portfolio produced $19 million of investment income this quarter with a weighted average yield on all investments of 11.2%. This represents an increase of approximately $2.4 million from the previous quarter. The increase in investment income was driven partly by an increase in debt investments outstanding as well as a distribution of $1.2 million from one of our lower middle market portfolio companies as part of a dividend recapitalization. This is a prime example of the benefits of investing equity with portfolio companies where the growth story is compelling. As Bowen mentioned, we had no new non-accruals as of the end of the quarter, and our weighted average yield on our credit portfolio was 10.6% for the quarter. Our operating leverage was flat for the quarter at 2.6%. Operating expenses were slightly elevated this quarter due to the accrual for our annual bonus program. We expect that our run rate operating leverage going forward will be below our target of 2.5%.

Thanks, Michael, and thank you, everyone for joining us here today. Capital Southwest continues to perform very well and consistent with the vision and strategy we communicated to our shareholders six years ago. Our team has done an excellent job building both a robust asset base, reputation, and deal origination capability as well as a flexible capital structure that prepares us for difficult environments, like the one we experienced in 2020. In fact, performance through difficult environments like 2020 demonstrates the investment acumen of our team at Capital Southwest and the merits of our first lien senior secured debt strategy. We feel very good about the health of our company and portfolio, and we are excited to continue to execute our investment strategy going forward. Everyone here at Capital Southwest is dedicated to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable value for all our stakeholders. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

Our first question comes from Devin Ryan of JMP Securities. Your line is open.

This is Kevin Fultz for Devin this morning. First question, the stock is trading at a healthy premium to NAV. And as we saw last quarter, you were fairly active in selling shares under the ATM program. Can you provide some high-level thoughts around how you balance raising equity in the current environment? And how active we can expect equity issues to be over the next few quarters?

Yes. Look, that's a good question. I would say the ATM program, one of the things we like about the ATM program on top of it being a very inexpensive way to raise equity, is that we can manage the BDC's leverage over time depending on the pipeline—what activity we have coming down and liquidity in our portfolio, the quantum of unfunded commitments, a whole host of variables go into the ultimate equation, which is how much equity we think we need to raise. So it’s really a lever that we pull to manage leverage, and we're looking at activity in the portfolio, liquidity of the company, and unfunded commitments that we need to be ready to support.

Yes. I'd also say, Kevin, just from a modeling perspective, I think we expect, on average, when our stock has been trading well, to raise around $15 million on a quarterly basis. This past quarter, as Bowen said, we had higher deal origination volumes, so we raised a bit more at $21 million. Sometimes it will be slightly less, but I think $15 million is about the right size moving forward.

Great. That's helpful. And then another big picture question. You have a pretty robust deal-making environment currently, fairly significant unused debt capacity. Can you talk about the potential for growth of the investment portfolio in 2021?

Yes. Right now, deal flow is certainly strong. Our team is really hitting its stride on just deal origination activity. We're still closing about 2% of the deals that we review. Over the last 20 years of my career, that's about the number. Sometimes well higher, sometimes a little lower. I think that having gone through the pandemic and deal sources, sponsors see how we behave. We're very commercial and reasonable. We don't roll over. We expect fair outcomes. If we contribute capital to the company, we expect the sponsor to do the same. So it's a very commercial and balanced approach. I think we've developed a lot of street credibility and comfort and track record when people consider us as the financing partner. So I expect deal flow to continue to be solid throughout this year.

Yes. And just probably putting some numbers to it. We project internally to do around $40 million to $50 million in originations each quarter and expect to see between $15 million to $20 million come back. So somewhere in that $20 million to $30 million net portfolio growth a quarter.

Okay. That's very helpful. And then lastly, touching on prepayments. What visibility do you have around prepayments?

I believe we gain some insight at the start of each quarter. This quarter, we know there is limited activity occurring. I would anticipate something towards the lower end of the repayment range. Interest rates vary, so our visibility may change, but I do not expect a significant increase in the next three to six months.

Okay. That's it for me. Congratulations on a great quarter.

Our next question comes from Mickey Schleien from Ladenburg Thalmann. Your line is open.

I want to ask a high-level question about this year. So when we think about the pace of vaccinations and the recent mutations of the COVID virus, it looks like the pandemic could go on longer than we had hoped and that it could continue to stress companies in some industries. Apart from your software-related investments, how do you feel about your borrowers' ability to carry them through the pandemic, particularly regarding liquidity?

Yes, it's interesting. The pandemic is not behind us. The vaccines are out there. We'll see how well they work, how many people take the vaccine, and the unknowns regarding new strains. But I feel like our portfolio has generally found its stride. The companies have managed to adapt, and we do have a strong mix of small businesses that have built-in support from the SBICs in their capital structures. I don't see any companies where survival hinges solely on a PPP loan, but it does help to bridge the noise from the pandemic.

That's really helpful. I want to ask you about American Addiction Centers. It has obviously exited bankruptcy, and if I'm not mistaken, you're the new Chairman of the company. How do you feel about that specific company's prospects? Is it benefiting from the pandemic? What's the long-term exit strategy for AAC?

Yes. I’m quite positive on that platform. It has an incredible asset base and network of facilities, delivering vital work in addiction recovery. They've come out of a tough restructuring and bankruptcy, and I feel confident about the business's recovery and its potential for growth moving forward. The need for addiction treatment is significant, exacerbated by societal stress during the pandemic, which positions AAC well for future success.

Do you expect roll-ups to occur in that industry, and would AAC be an acquirer or ultimately be acquired?

The majority of the upside for AAC is organic growth, signing new contracts, and filling existing beds, which is an attractive economic model. AAC could be both an acquirer in the industry and potentially be acquired by larger platforms as they continue to grow.

My last question touches on CPK. It also emerged from bankruptcy, and I assume the balance sheet is a lot healthier now. However, I've seen local closures, which raises concerns about their strategy moving forward. What’s the outlook for CPK?

CPK's management team is excellent. They faced challenges pre-COVID but had managed to turn the business around before the pandemic hit. Although some locations have closed, the company is cash flow positive, and things are looking good overall. The key to their future growth lies in navigating the timing of the pandemic andRecovery trajectory.

Our next question comes from Kyle Joseph of Jefferies. Your line is open.

Congratulations on a nice quarter! I wanted to talk about net interest margins and the outlook going forward. Could you discuss where spreads are compared to a year ago? Also, regarding liability management, how has your recent activity impacted your cost of funds?

Regarding the asset side, spreads are kind of back to pre-COVID levels. We're not seeing a significant COVID premium out there. There may be a slight premium in terms of leverage, but generally speaking, the spreads on our loans are recovering. Our portfolio is improving in terms of quality and performance.

We raised $75 million on a 4.5% institutional bond, which replaced a 5.95% bond. This represents about a 150 basis point improvement, translating to annual savings of approximately $800,000 a year. If the SBA loan comes to pass, we expect to benefit further from competitive rates.

Got it. Very helpful. And your credit is trending in the right direction. What can you tell us about revenue and EBITDA trends in the fourth quarter compared to the third quarter?

Generally, EBITDA and revenue for the majority of our companies saw positive trends—low single-digit increases. The overall portfolio is in good shape, although a few companies are bumping along. But from our perspective as first lien lenders, there's ample cash flow to service our debts.

Great. And can you discuss your appetite for maintaining the special dividend given the strong UTI balance?

We're continuing the supplemental dividend program for now. We've got the liquidity to support it and are committed to maintaining this program to benefit our shareholders.

The Board will review the UTI balance quarterly. As we have a solid period to make decisions going forward, we anticipate the dividend will grow in alignment with our portfolio's performance.

Our next question comes from Robert Dodd of Raymond James. Your line is open.

Congratulations on the quarter! Can you give us insight into the spread situation? With no COVID premium remaining, where do you stand on risk-adjusted total return expectations compared to pre-COVID?

From a debt perspective, anticipated returns remain consistent with pre-COVID levels, but equity returns may be higher. We also expect potential reduced credit losses moving forward as we focus on safer lending practices.

By putting together a portfolio of high-quality credits, we can enhance our investment-grade portfolio and further improve our cost of capital over time.

Got it. That makes sense. Lastly, can you provide details on the unrealized depreciation in the quarter?

Unrealized appreciation was broad-based, primarily reflected in our equity portfolio. We had significant contributions from multiple equity investments, including Tenuity, which showed great recovery this quarter.

Thank you. And at this time, I'm showing no further questions. I'd like to hand the conference back to Mr. Bowen Diehl for any further comments.

Great. Thanks, operator. Thanks, everybody, for joining us. We appreciate it. Hopefully, you got a good impression that things are going pretty well here. We appreciate your support and look forward to keeping you posted on the business as we go forward.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect. Have a wonderful day.