Capital Southwest Corp Q1 FY2022 Earnings Call

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 Diehl.

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, 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 6 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 $0.45 per share, which more than earned our regular dividend paid for the quarter of $0.43 per share. Total dividends for the quarter were $0.53 per share, which included a $0.10 per share supplemental dividend. Total dividends paid during the quarter represented an annualized dividend yield on our stock price as of the last day of the quarter of 9.1% and an annualized yield on net asset value per share of 12.8%. I am pleased to announce that our Board of Directors has increased our total dividends per share to $0.54 for the coming quarter ending September 30, 2021, consisting of a regular dividend increase from $0.43 per share to $0.44 per share and a quarterly supplemental dividend of $0.10 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% 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 7 and 8, 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 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 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 at fair value. Within our lower middle market portfolio as of the end of the quarter, we held equity ownership in approximately 57% 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 senior 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.

Thanks, Bowen. Specific to our performance for the June quarter, as summarized on Slide 17, we earned pre-tax net investment income of $9.4 million or $0.45 per share. We paid out $0.43 per share in regular dividends for the quarter, an increase from the $0.42 regular dividend per share paid out in the March quarter. As mentioned earlier, our Board has again this quarter increased the regular dividend declaring a quarterly dividend of $0.44 per share to be paid out during the September quarter, up from $0.43 per share paid out in the June quarter. Maintaining a consistent track record of meaningfully covering our regular dividend with pre-tax NII is important to our investment strategy. We continue to maintain our strong track record of regular dividend coverage with 110% for the last 12 months ended June 30, 2021, and 107% cumulative since the launch of our credit strategy in January 2015. 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 September quarter. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of June 30, 2021, our estimated UTI balance was $0.83 per share. Our investment portfolio produced $18.6 million of investment income this quarter, with a weighted average yield on all investments of 10.1%. Investment income was $1.4 million higher this quarter, due primarily to an increase in average credit investments outstanding, as well as an increase in cash dividends paid from our equity portfolio. There were two non-accruals, with an aggregate fair value of $14.5 million or 1.8% of the investment portfolio as of the end of the quarter. Our weighted average yield on our credit portfolio was 10.7% for the quarter. As seen on slide 18, our LTM operating leverage continued to improve, decreasing to 2.3% as of the end of the quarter. For fiscal year 2022, we expect operating leverage to be between 2% and 2.2%. Turning to slide 19, the company's NAV per share as of June 30, 2021, was $16.58, as compared to $16.01 at March 31, 2021, representing a quarter-over-quarter increase of 3.6%. The main drivers of the NAV per share increase were $6.1 million of net appreciation in the investment portfolio and the accretion generated by the issuance of equity at a premium to NAV per share during the quarter. On slide 20, we lay out multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to derisk our liability structure, while ensuring that we have adequate investable capital throughout the economic cycle. Our debt capitalization today includes a $340 million on-balance sheet revolving line of credit with 11 syndicate banks maturing in December 2023, a $125 million institutional bond with 25 institutional investors maturing in 2024, a $140 million institutional bond maturing in 2026, a $150 million revolving line of credit at I-45, also maturing in 2026, and an initial $40 million leverage commitment from the SBA which is yet to be drawn upon. With regard to our revolving line of credit, we are currently in discussions with our bank syndicate on an amendment and extension. While we do not have anything formal to announce today, we can say that we are very pleased with the terms of the amendment and the tremendous support we continue to receive from our bank syndicate. The closing of the amendment is imminent and we plan to announce the details in the coming days. Finally, as we've discussed on prior calls, we have now begun operations with our SBIC subsidiary, which we'll see going forward denoted as CSWC SBIC I. As a reminder, our initial equity commitment to the fund is $40 million and we have received an initial commitment from the SBA for $40 million of fund leverage, which is also referred to as one tier of leverage. We expect to invest this initial $80 million of capital over the next six to nine months, at which point we will apply for a second tier of leverage. Over the life of the fund, we plan to draw the full $175 million in SBIC debentures, alongside $87.5 million in capital from Capital Southwest. We are excited to be part of this program and believe it will be a natural fit with our investment strategy. Overall, we are pleased to report that our liquidity continues to be strong with approximately $203 million in cash and undrawn leverage commitments as of the end of the quarter. As of June 30, 2021, approximately 58% of our capital structure liabilities were unsecured. Our earliest debt maturity is in December 2023, which we would expect to extend upon the closing of the credit facility amendment. Our regulatory leverage, as seen on slide 21, ended the quarter at a debt-to-equity ratio of 1.23:1. Finally, our Board announced a further share repurchase program, authorizing the company to repurchase up to $20 million of stock below NAV. As you recall, we maxed out our prior $10 million program during the extreme market volatility seen in 2020. While we don't wish for future black swan events, we do endeavor to manage our balance sheet in a manner to provide our shareholders the benefit of repurchasing shares, if such extreme volatility is experienced in the future.

Thanks, Michael, and thank you everyone for joining us today. Capital Southwest continues to perform well and consistent with the vision and strategy we communicated to our shareholders six-and-a-half years ago. Our team has done an outstanding job, building a robust asset base, deal origination capability as well as a flexible capital structure that prepares us for all environments throughout the economic cycle. We believe that our performance continues to demonstrate 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 totally dedicated to being good stewards of our shareholders' capital by continuing to deliver 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.

Hi. Good morning. This is Kevin Fultz on for Devin. First question, dividend income was elevated in the quarter, due to dividends received from portfolio companies of roughly $1.1 million. Can you provide some color on the source of that dividend? And then also confirm whether that should be considered recurring or nonrecurring?

A portion of that is recurring or received from our shareholders from our portfolio companies held in our blocker. On a quarterly basis, I think the level is around $300,000 to $350,000 that we're receiving. Some of those tend to be one-time in nature from dividend income coming from portfolio company distributions.

Okay. That's helpful. And then, looking at the expense side, G&A tracked a bit higher this quarter than last quarter. Is that increase driven by one-time expenses, or is that reflective of higher G&A due to increased scale of the business?

Sure. Some of this is related to seasonality, as our annual meeting takes place in July. We incurred some audit costs and expenses related to the 10-K, amounting to approximately $200,000, which is a recurring charge each year in the 6/30 quarter. Additionally, we had one-time costs of $100,000 for a headhunter for a new principal we hired. We also added a new board member, which increased our professional expenses by $100,000, and that increase will be ongoing in the future.

Good morning, everyone. I appreciate you taking my question. Regarding other income, it was low this quarter, which I suspect is due to the reduced prepayment activity. From your remarks, it seems you anticipate an increase in prepayment activity as the year progresses. Should we then expect a rise in other income?

So I mean, we're looking probably at maybe somewhere in the $30 million to $60 million in potential prepayments between now and the end of the year. Now some of those have make-wholes so the newer companies that maybe have been with us a year or two, they'll have either 102 or 101. But there's, others that potentially come back and don't have a make-whole. So I'm not sure that it's going to be elevated beyond somewhere in the $500,000 range.

Yeah. Okay, got it. And then, I just want to get your high-level thoughts on credit. Obviously the ratings were positive. There were some unrealized depreciation, but we did see two investments go on non-accrual. Just broadly, talk about the, whether it’s revenue or EBITDA growth trends you're seeing across your portfolio?

Yeah, I'd say across the portfolio EBITDA is from an LTM perspective is growing slightly. As we move forward, each quarter we're progressively further across the calendar. So we start losing some of those COVID months of last year. So yeah I think generally EBITDA is kind of flat to slightly up across the portfolio.

Okay, got it. And then last one for me, obviously a good quarter on the origination side. Can you give us a sense for the cadence of originations throughout the quarter whether that was front-weighted or back-weighted? Just help us figure out modeling yields going forward.

Yeah. I'd probably say it's in the middle. I think we had some very early and then probably like 40% very early, and 60% very late. So it sounds like, it's a fairly evenly weighted.

Yeah. I think that's right.

Thank you. Good morning. Good morning Michael.

Good morning.

Wanted to ask you to make note of I guess the additional employees at Capital Southwest. So, maybe you could speak to the principal that was hired and how that might impact kind of deal flow going forward and the investment funnel?

Yes, we're very excited about it. You'll see Laura Zengilowski on our website. Very excited. She joined us from AllianceBernstein, obviously, another competing credit shop down in Austin. We're very excited for her addition and she comes with a very robust underwriting track record and she gives us more horsepower to originate deals so to put out in the market. So, pretty excited about her joining.

Great. Okay. Bowen, you mentioned the effect of appreciation in the equity portfolio on NAV for the quarter. Can you discuss how widespread that was? Was it driven by multiple investments or just a few?

No, it's a pretty accurate observation. If you look at the list of investments, about 40% of them experienced appreciation. Considering the list, I would estimate that around 20% faced some level of depreciation, with the appreciation surpassing that smaller 20% portion of depreciated companies, and several others remained relatively flat. Therefore, I would say slightly less than half of the companies showed appreciation.

Yes, I would just say on the equity side, we had four companies.

That's pretty material.

Material appreciation is performing exceptionally well. On the debt side, the $0.5 million of appreciation may be small, but it is very detailed.

On the debt side, the $0.5 million of appreciation, though small, was very granular.

On the debt. So, to some degree, it's just like the companies that were struggling during COVID are starting to come out from that and you're starting to see some granular appreciation on those assets that they reappreciate.

Okay. Okay. And then maybe following up on Kyle's question there around yields and pricing. It looked like spreads have kind of been relatively stable quarter-to-quarter. Are you seeing that within the pipeline that you described as robust? And just trying to get a feel for how you think about portfolio yield as we move forward here?

The portfolio and pipeline have been strong, which we're pleased about. The yields have clearly adjusted from the changes during COVID, and the market is quite competitive. We are actively working in the market and expanding the upper end of our deal funnel to increase the percentage of deals we're reviewing. We believe this is essential for maintaining our track record. Over time, our average yield may decrease slightly, but not significantly. Currently, yields in the market appear to be relatively stable compared to the last quarter.

Yes. And so obviously this quarter it dropped from due to our non-accruals, but we also saw probably like 20 basis points of reduction through lower-yielding assets. We think that's probably going to come back up a bit in the coming quarters. And then on the hopeful side, I think we think that the two credits that are on non-accrual have a very high likelihood of coming back on accrual and those are higher yielding assets that would bring the yield back up.

Yes, we had an extensive discussion last quarter regarding my analogy of the deep end and shallow end of the pool. Our cost of capital has decreased, and we've improved our operating efficiency, which means our assets are growing at a faster rate than our operating costs. Consequently, our business costs are declining, although this is somewhat countered by non-accruals. I would like to say this is a flawless business, but unfortunately, it's not. As our costs for delivering the investment strategy to shareholders decrease, we are now able to compete in the safer segment of the lower middle market, which tends to have lower spread pricing. A few years ago, those deals were challenging for us to compete in due to an unattractive net interest margin. Now, we are seeing deals with LIBOR rates of 6.50% and 6.25%, which offer a much more appealing net interest margin for us as our business has evolved. The recent yield migration is not simply the same deals that were previously higher yielding; rather, it's different, safer deals with lower loan-to-value ratios. This trend has been a topic we've discussed for the past few quarters, and I believe it's a compelling aspect of our narrative moving forward.

Bowen makes a good point regarding the net interest margin. Yields may decrease from 10.7% to about 10.25% over the next six to twelve months. However, our SG&A or operating leverage is expected to stabilize around 2%. Although you didn't ask, we are currently working on amending our credit facility, which we believe will significantly reduce costs. When we start to draw on it—having already accessed $7.5 million from our SBIC, which should rise to $25 million by the end of the quarter—we anticipate borrowing at a rate below 3%. With our SG&A at 2%, we expect to see an increase in our net interest income despite the yield reduction.

Great. That’s a good detail, and really nice to see the dividend increase, and you all continuing to execute. Appreciate.

Hey. Good morning and thank you for taking my question here. I just wanted to see if I can get some more color on the pipeline share quarter-to-date as well as the activity that you're seeing. And then, just if you can kind of pair that up with your expectation for the repayments to come in as the balance of the year progresses?

Yes. Looking at our current pipeline, the deals we've either closed so far this quarter or are in the process of due diligence total between $60 million and $70 million, along with six new companies. The quarter is not finished yet, so we anticipate additional deals closing before September 30. This gives you a perspective on it. A total of $138 million in one quarter is substantial, and while I don't expect that to happen again in the next quarter or two, our originations remain very strong. In terms of repayments, as we review our portfolio and the conversations we're having with our companies, we estimate that around $50 million is likely to prepay before the end of the calendar year. The timing of these repayments is harder for us to control, but it seems plausible that they will be fairly evenly distributed between the two upcoming quarters, September and December. Therefore, if you're making projections, you could consider $50 million total or about $25 million per quarter in prepayments.

Understood. Thanks for that. And I think another one is a little bit more, I suppose of a hypothetical question, but just want to kind of understand with your cost of debt capital and just kind of the overall cost of doing business coming down for you. If there is, let's say, a change in interest rates, it seems like maybe the first 125 basis points might be a little bit of an NII headwind. I guess, how do we think about that? Is there a way to kind of parse through that in the event that happens, or do you think you're kind of insulated from any of the potential changes that may come about there?

We have considered hedging but found it to be quite challenging. It involves significant costs to accurately predict the timing of interest rate increases, particularly for the initial 100 basis points. Therefore, we see it as an unviable option. Instead, we anticipate that as our originations and the costs of our debt and operating leverage decline, if interest rates begin to rise by the first 75 basis points, our growth in net interest income will slow down. However, once we surpass that initial threshold, we expect to see a rebound in growth. So, while we won't experience a decrease in net interest income or dividends, the rate of growth will be slower initially, followed by a surge once we move past that point. To clarify about our cost of debt, currently, the pooled debt is around 2%, approximately 1.65%, and the cost before pooling, which occurs biannually, is closer to 60 basis points. As interest rates increase, we believe that our access to very affordable capital will mitigate those impacts. This is why we are confident in our ability to continue growing dividends even as interest rates rise.

Okay. You also have to keep in mind that that interest analysis on that last slide is a static analysis. So it seems like nothing else happens like new portfolio originations, portfolio growth and that kind of thing. So...

No, I understood, it’s dynamic. Just wanted to get a sense for the changing dynamics there. And obviously you'll be originating and you'd probably get some repayments and what have you back. But I just wanted to get a sense for the NII and dividend, and how insulated the business is. That's all. Very helpful comments. Thank you, guys.

Great. Thanks. Good questions.

Hi, all. Good morning and appreciate you taking my questions. First one for me following up on the equity book. Can you give us a sense of how much of the appreciation was a function of improved performance or kind of expanded market multiples? And if it was some combination of the two kind of what proportion was which?

Yes. The vast majority of it is I'm just looking down the names so a vast majority of it is company performance. I mean a pretty robust performance. So…

Yes, we've mentioned this before. Our economic leverage is expected to be in the range of 1.2 to 1.3, while our regulatory leverage will be between 0.9 and 1.1. We believe that with the pace of originations and the draws from SBIC, we should be close to 1 times within the next six months.

Got it. That's helpful. Last one for me on PIK income. So looks like over the last four quarters, PIK income both nominally and as a percentage of total investment income has fallen pretty materially. Any color you can give on how much of that is purposeful? Is that a kind of a concentrated effort to steer away from PIK income? Is that just how the docs are being signed? Any high-level color there?

I would say that the situation is somewhat concentrated. The company, which is one of the lower middle market firms, transitioned from cash to PIK, and as a result, we placed it in non-accrual this quarter. There was a write-up of PIK for that company over the previous two quarters, and it was reserved against this quarter. Thus, what you are observing now reflects the typical run rate of PIK income.

Thank you.

Thank you.

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Bowen Diehl for closing remarks.

Great. Thanks, operator and thanks everybody for joining today. We appreciate your time and we certainly love talking about our business and giving you all updates on the business. So appreciate it and have a great week. We look forward to talking to you next quarter.

And this concludes today's conference call. Thank you for participating. You may now disconnect.