Capital Southwest Corp Q1 FY2023 Earnings Call

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'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, please 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.

Thank you, Chris, and thank you to everyone for joining us for our first quarter fiscal year 2023 earnings call. We are glad to be here this morning and eager to update you on our company's performance and our portfolio as we continue to execute our investment strategy responsibly. Throughout our remarks, we will reference various slides in our earnings presentation, available on our website. You can also find our quarterly earnings release posted there as well. We'll start with slide six of the earnings presentation, where we summarize some key performance highlights for the quarter. We generated pretax net investment income of $0.50 per share this quarter, reflecting an 11% increase from the $0.45 per share reported in the same quarter last year. This $0.50 per share surpassed our regular dividend of $0.48 per share for the quarter. Total dividends for the quarter amounted to $0.63 per share, including a special dividend of $0.15 per share. We are pleased to announce that our Board has declared a $0.02 per share increase in our regular dividend to $0.50 per share for the quarter ending September 30th, 2022. This increase signifies a 4.2% rise from the $0.48 per share paid in the June quarter and a 16% increase over the $0.43 per share from the prior year’s September quarter. This increase in our recurring regular dividend reflects the enhanced earnings potential of our portfolio, driven by rising market interest rates over recent months, the growth and performance of our credit portfolio, and improvements in our operating leverage. During the quarter, acquisition and financing activity in the lower middle market remained strong. We surpassed the $1 billion mark in total investment assets, indicating 7.5% growth over the last quarter and 26% increase over the past year. Portfolio growth this quarter was fueled by $148 million in new commitments which included six new portfolio companies receiving a total of $139 million and eight existing portfolio companies receiving add-on commitments totaling $9 million. This was partially offset by $50 million from three debt prepayments and one equity exit. In terms of capitalization, we raised $46.8 million through our ATM program at an average price of $20.60 per share, which is about 123% of the prevailing net asset value per share. Our liquidity remains strong, with roughly $180 million in cash and undrawn capital commitments at the end of the quarter. We are optimistic about the overall health of our portfolio and our company. We have been careful to fund a significant portion of our asset growth through accretive equity issuances on our equity ATM program, as we believe it is vital to maintain a prudent approach towards BDC leverage amidst economic and capital market uncertainties. On slides seven and eight, we showcase our continuous record of steady dividend growth, consistent coverage, and value creation since launching our credit strategy. The solid performance of our portfolio, along with our company’s sustained access to capital markets, highlights the strength of our investment and capitalization management strategy. The maintenance and growth of both shareholder dividends and net asset value per share remain fundamental to our long-term investment goal of creating lasting value for our shareholders. Moving to slide nine, our investment strategy has remained unchanged since its inception in January 2015. We continue to concentrate on our core lower middle market lending strategy, where we directly originate and lead opportunities, primarily involving first-lien senior secured loans with smaller equity co-investments 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, including $26.6 million in unrealized appreciation, or about $0.97 per share. This equity portfolio, making up approximately 9% of our total portfolio fair value at the end of the quarter, continues to offer our shareholders exposure to the strong potential growth of these expanding lower middle market businesses, reflected in net asset value growth and special dividends over time. As shown on slide 10, our on-balance sheet credit portfolio, excluding our I-45 Senior Loan fund, increased by 9% to $865 million, compared to $794 million at the end of the previous quarter. Over the past year, our credit portfolio has expanded by $194 million or 29% from $671 million as of June 2021. For this quarter, all new portfolio company debt origins were first lien senior secured debt, with 94% of our total credit portfolio classified as first lien senior security at the close of the quarter. Slides 11 and 12 detail the $148 million in capital invested in and committed to portfolio companies during the quarter, which consisted of $136 million in first lien senior secured loans to six new portfolio companies, four of which also received a co-investment of $3.1 million in equity from us. Additionally, we committed $9 million in first lien senior secured debt to eight existing portfolio companies during the quarter. Moving to slide 13, we maintained our strong track record of successful exits with three debt prepayments and one equity exit this quarter, generating a total of $49 million in proceeds, realizing gains of $2.3 million and a weighted average IRR of 19.6%. Since the beginning of our credit strategy over seven-and-a-half years ago, we have completed 63 portfolio exits, yielding $745 million in proceeds and a cumulative weighted average IRR of 14.8%. The acquisition capital market remains active, though at a slower pace than we experienced at the start of 2021. Consequently, we anticipate ongoing solid net portfolio growth in the near term. Our investment pipeline is robust in volume, quality of deal opportunities, and spans a wide variety of financial sponsors and other deal sources. We are proud of the strong market position our team has established in the lower middle market as a leading debt and equity capital partner, supported by a wide range of relationships across the country that enable us to source quality opportunities. On slide 14, we present some key statistics for our on-balance sheet portfolio at the end of the quarter, again excluding our I-45 Senior Loan fund. The total portfolio fair value was weighted 85.4% to first lien senior secured debt, 5.1% to second lien senior secured debt, 0.1% to subordinated debt, and 9.4% to equity co-investment. Our credit portfolio had a weighted average yield of 9.3% and a weighted average leverage at four times, both consistent with the previous quarter. Lastly, moving to slide 15, we provide an overview of rating migrations within our portfolio. During the quarter, we upgraded one loan valued at $10 million from a two to a one. Three small loan positions across two portfolio companies, with a total fair market value of $10 million, were downgraded from two to three, and one loan worth $693,000 was downgraded from three to four. Please remember that all loans are initially assigned an investment rating of two on a four-point scale when originated, with one being the best and four the worst. By the end of the quarter, 74 loans, which constitute 95% of our investment portfolio at fair value, were rated in the top two categories (one or two). The number of one-rated loans decreased from seven to five this quarter, and all three loan prepayments had a rating of one, balanced against the aforementioned portfolio companies that received upgrades this quarter. In total, we had ten loans, about 5% of the portfolio at fair value, rated three or four at the quarter's end. Our total investment portfolio remains well-diversified across various industries, providing strong security for our shareholders' capital. The portfolio is primarily composed of first lien senior secured debt, with only 5% invested in second lien secured debt. It is also noteworthy that 90% of our credit portfolio is backed by financial sponsors, offering potentially significant financial support for these portfolio companies when needed. I will now pass the call to Michael to review more details of our financial performance for the quarter.

Thanks, Bowen. Specific to our performance for the June quarter, let's summarize 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 dividend 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 dividend 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 to 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. For 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 of 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 South led significant participation in the company turnaround and reinstating the remainder of our quarter-end debt hold 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 of 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. Turning to Slide 20. The company's NAV per share at the end of the June quarter decreased by $0.32 per share to $16.54, which included a $0.15 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 dividend, 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 it was mark-to-market quote activity in the syndicated market. We also saw a $5.5 million of depreciation on the on-balance sheet debt portfolio, partially offset by $1.5 million of net appreciation on the equity portfolio and accretion from the issuance of common stock at a premium to NAV 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 as of 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 base as of the end of the quarter, we have full access to the incremental revolver capacity. Our banks syndicate continues to support our growth, and we are pleased with the flexibility of the increased revolving credit facility commitment provides to our capital structure. In addition, we continue to draw debentures in our SBIC subsidiaries as we originate SBIC-eligible assets. As of 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 FDA 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 2020. Our regulatory leverage, as seen on slide 22, ended the quarter at a debt-to-equity ratio of 1.1:1. 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 late calendar 2021 and our continued diligence in moderating leverage through accretive share issuances on our equity ATM program. We will continue to work towards strengthening the balance sheet, ensuring adequate liquidity and maintaining conservative leverage and covenant cushion throughout the economic cycle.

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 continues to perform well, and I continue to be impressed by the job our team has done in building a robust asset-based, 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 merit of our first lien 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.

Our first question comes from the line of Kevin Fultz from JMP Securities.

Given the evolution of market conditions over the past two quarters, I'm curious if you've seen that translate to improved 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?

Thanks for the question. Regarding the strength in the market, we're seeing that for quality deals that can be underwritten, especially considering the economic cycle and reasonable leverage levels, there remains significant competition for those opportunities. We haven't observed a substantial widening of spreads, perhaps a slight change of about 25 basis points. Overall, we continue to experience strong activity, and spreads remain consistent with where they have been.

Okay. That makes sense, Bowen. And then just a follow-up for Michael. Looking at the NAV bridge on slide 20, there's a $0.11 per share loss related to other corporate, just curious if you can identify the items that are included in that bucket.

Yes. I believe that was related to our RSUs. We distribute RSUs to employees in the June quarter, so you'll notice that reflected annually during this time.

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

Thanks.

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

Bowen, I want to dig a little into credit. Any high-level comments you can give us on how your borrowers' 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 the trajectory of the economy. Any comments you can make would be helpful.

Yes, thanks for the question, Mickey. When we examine our portfolio, 95% of it is performing as expected or better, while we can set aside the 5% that are underperforming, which are all unique situations within the company. Therefore, focusing on the 95%, we see that revenues and EBITDA are up approximately 23% year-over-year. In the last quarter, revenue increased by just over 5%, while EBITDA remained flat. It’s challenging to attribute these trends solely to the economy; however, factors like rising labor costs and input expenses are contributing. While revenue is rising, EBITDA has not changed significantly. Generally, we've observed that companies are effectively leveraging their pricing power to maintain margins. Overall, economic activity appears flat, with some specific challenges that we're all aware of. Companies in our portfolio are doing a solid job of passing on these costs to their customers to sustain margin dollars.

Absolutely.

Mickey, from a timing perspective, I want to mention that we're using April and May financials for all our valuations. While we haven't noticed any softening since then, many financials are still pending, so we need to see if anything changes. Based on our discussions, I believe these trends will continue for now. Michael is correct that the financials used for valuations by all the BDCs are from the April, May, or June quarter.

Yes, I understand. Bowen, there was one loan that was 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?

I thought there was a migration to a $3 million of $10 million at fair value?

Yes. There was one upgrade to a loan totaling $10 million, and three loans across two companies were downgraded to three. These were all small loan positions and were very specific to their circumstances. One of the downgrades is related to certain pipeline statistics and conditions that the company needs to meet in order to successfully sell their products. This situation is unique to that company. Additionally, it is important to note that it is supported by a very strong and well-funded sponsor. So, we have a considerable amount of equity to bolster potential equities in that company.

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

Yes. So as Michael said in his remarks, all I'll reiterate because it might have been lost. So, there was $16 million in fair value on nonaccrual at the end of the quarter. One of those loans was restructured on the first day of the new quarter, so July 1, '22. And that loan had a fair value of $13 million out of the $16 million. And that restructuring resulted in 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 turnaround, serve on the Board of that company. And if you feel okay about where we are, I'm certainly very happy about the significant amount of liquidity that the company – the thoughts are 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?

Yes. Regarding depreciation, there are two components to consider. We noted the $5.5 million on the balance sheet, which is likely just over half attributed to credit and just under half to market investor spread. As for the I-45 portion, about two-thirds relates to market indexes and quote movements, while the remaining one-third pertains to credit issues.

Okay. And just to wrap up, in the SBIC, are you planning to request the entire $87.5 million of regulatory capital along with the full two turns of leverage, or how should we expect that to unfold over the next several quarters?

We'll absolutely overtime, 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 and to go in as equity prior to asking for a commitment to draw a fund. So, we have to go to the SBIC 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 bedding that $50 million before we're able to ask for the formal commitment.

Okay. $50 million of new debentures, right?

So the $50 million would be the net, definitely. We'll allocate $25 million of eligible assets as our equity and then we'll draw the next $50 million. Once that $50 million is completed, we will return to the SBIC for another commitment before asking for it.

Mickey, I mean 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 presenting the entire debt, but it's very typical to be stair steps like that, and there's not really any notable or even risk at all of really getting those commitments, but it's a step documentation process until 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?

Yes. Michael – I'll comment – just walk here in a minute. But...

We are certainly aware of the economic volatility we might be facing. Previously, we set targets of 1.2 to 1.3 for economic factors and 1.1 to 1.2 for regulatory aspects. Currently, we are adjusting our regulatory target to 1.0, and we now expect economic factors to be between 1.1 and 1.2. Until we gain clarity on the potential depth and duration of the recession, we will maintain these targets. To support this, we plan to raise equity, having already secured $46 million in the last quarter. As long as our trading levels remain significantly above book value, we will continue to pursue equity raises. Our portfolio has not shown signs of slowing, and even if merger and acquisition activities decrease, we anticipate continued growth in repayments and net portfolio growth. Therefore, our goal remains to raise equity alongside these originations while maintaining leverage within a conservative range.

Yes, I think that’s one. 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 Mike that's...

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

Thanks, Mickey.

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

I have two questions, or really just one with two parts. First, regarding the margins that remain stable quarter after quarter, did you mention that rates either reset after the quarter or late in the quarter? How should we think about your assets resetting compared to when your liabilities reset, considering many of your liabilities have fixed rates? Second, with rising rates, how is that influencing your expectations for credit in the future? It seems like it should positively affect your net interest income, but companies are also facing increased debt servicing costs.

Yes. So regarding our liabilities, these reset monthly, which means you would have observed an increase from 96 basis points to 2.29% from one quarter to the next. The average increase in interest expense is likely around the mid 1.5s. For our assets, around 90% or more reset on a quarterly basis. When we reviewed our June 30 numbers, if we had applied the 2.29% rate from the end of June to our balance sheet, we would have seen an additional $0.03 in net interest income. This suggests that the $0.50 we reported would have been closer to $0.53, providing some context for what to expect moving forward. In response to your second question, we are conducting an analysis. We're examining the portfolio using the current index of 2.29%. If we increase that index, we would need to reach the mid 5% range before we start seeing significant credit issues. Specifically, around 5.5% is where we would begin to notice changes in fixed charge coverage ratios across much of the portfolio, which remains strong. However, if we look at names affected by a LIBOR exceeding 5.5%, we may see some concerning movements. I’m optimistic that we won’t reach 5.5% or 6% on the index, and we feel confident about the current state of the portfolio.

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

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

I have a quick question. Michael, in your prepared remarks, you mentioned that you expect the dividends to follow the trend of pre-tax income. Are you suggesting that if rates increase, and earnings go up by about $0.03 or $0.01 in the next quarter and the following quarters at least through the beginning of 2023, then the base dividend would also increase? Additionally, I’d like to know if the forward curve being lower in the second half of 2023 compared to the first half is considered when determining the path of the dividend. You don't want to cut the dividend if rates are falling, should that scenario arise.

Absolutely. That is certainly the way we're looking at it. If you look at the Fed funds rate right now, where it's given the range of 2.25 to 2.5 and it's considered neutral. And so 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 is between the $0.50 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 probably say we want to maintain maybe $0.02 to $0.03 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 rates to increase. And if it was going to come back down, where we feel like the dividend that we will have set will match the rate where it comes back to, if that's helpful.

That is very helpful. Thank you and congrats on a really solid quarter.

Thanks, Robert.

Thanks.

I would now like to turn the conference back over to Bowen Diehl 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. You may now disconnect.