Earnings Call Transcript - CSWC Q1 2024

Chris Rehberger, VP Finance

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, see the company'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.

Bowen Diehl, CEO

Thanks, Chris, and thank you everyone for joining us for our first quarter fiscal year 2024 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 section of our website. You will also find a quarterly earnings press release issued last evening on our website. 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 $0.67 per share, which represented 3% growth over the $0.65 per share in the prior quarter and 34% growth over the $0.50 per share generated a year ago in the June quarter. $0.67 per share more than covered both our regular dividend and our supplemental dividend paid during the quarter of $0.54 and $0.05 per share respectively. As of the end of the quarter, we estimate that our undistributed taxable income was $0.34 per share. We're also pleased to announce today that our Board has declared a $0.02 per share increase in our regular dividend to $0.56 per share for the quarter ending September 30, 2023. This represents an increase of 4% compared to the $0.54 per share regular dividend paid during the June quarter and 12% growth over the $0.50 per share paid a year ago in the September 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 further improvements in our operating leverage. In addition, due to the excess earnings being generated by our floating rate debt investment portfolio in this high interest rate environment, our Board has declared a $0.01 per share increase to our supplemental dividend to $0.06 per share for the September 2023 quarter, bringing total dividends declared for the September quarter to $0.62 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 undistributed taxable income generated by earnings in excess of our dividends and realized gains from our equity co-investment portfolio. During the quarter, deal quality and activity in the lower middle market continued to be strong. Activity was mainly focused on acquisitions rather than refinancing, and the environment remains favorable for non-bank first lien lenders like Capital Southwest. Private equity firms and business owners continue to transact, while non-bank lenders provide more certainty to closing traditional bank financing structures. We continue to see loan pricing spreads on new portfolio company loans that were 50 to 100 basis points higher than a year ago and leverage levels of new portfolio company loans that were generally lower by half to a full turn of EBITDA. We also continue to see loan-to-value levels on new loans down meaningfully from a year ago, as private equity firms remain willing to pay relatively full multiples for quality companies. Portfolio growth during the quarter was driven by $111.9 million in new commitments consisting of commitments to six new portfolio companies totaling $98.6 million and to seven existing portfolio companies totaling $13.3 million. This was offset by $3.4 million in proceeds from one equity exit during the quarter. On the capitalization front, we are pleased to announce that subsequent to quarter-end, we successfully amended and extended our corporate revolving credit facility. Total commitments under the facility increased from $400 million to $435 million and the final maturity of the facility was extended from August 2026 to August 2028. Additionally, during the quarter, we issued $71.9 million in aggregate principal of 7.75% notes due August 2028. These unsecured notes commonly referred to as baby bonds are publicly traded on the NASDAQ under the ticker CSWCZ. These notes have a 5-year maturity and are fully callable after year two, giving us significant flexibility to manage our balance sheet in all rate environments. Furthermore, in lockstep with our strong deal pipeline, we raised a total of $45.6 million in gross equity proceeds at a weighted average price of $18.03 per share, or 110% of the prevailing net asset value per share. We have remained diligent in funding a meaningful portion of our investment activity with accretive equity issuances, as we believe it is important to maintain a conservative mindset regarding BDC leverage. We continue to 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 NAV. With this as context, we are very pleased with the strength of our balance sheet. Regulatory leverage remains slightly below our stated target range at 0.8701. And as of the end of the quarter, we had approximately $225 million in cash and undrawn capital commitments on our revolving credit facility. Furthermore, after our recent bond deal, approximately 53% of our balance sheet liabilities are unsecured covenant-free bonds, the earliest of which mature in 2026. Finally, in June 2023, we received a BBB- investment grade rating with a stable outlook from Fitch Ratings. Michael will provide further detail on this later in our prepared remarks.

Michael Sarner, CFO

Thanks, Bowen. Specific to our performance for the quarter, let's summarize on slide 17, we increased pre-tax net investment income by 10% quarter-over-quarter to $25 million or $0.67 per share, compared to $22.8 million or $0.65 per share in the prior quarter. During the quarter, we paid out $0.54 per share regular dividend and a $0.05 per share supplemental dividend. As mentioned earlier, our Board has approved both a $0.02 per share increase to the regular dividend for the September quarter to $0.56 per share and a $0.01 per share increase to the supplemental dividend for the September quarter to $0.06 per share. Maintaining a consistent track record of meaningfully covering our dividend with pre-tax net investment income is important to our investment strategy. We continue our strong track record of regular dividend coverage with 118% coverage for the last 12 months ended June 30, 2023 and 109% cumulative coverage since the launch of our credit strategy in January 2015. Given the floating rate nature of our credit portfolio, elevated interest rates have continued to be a tailwind to our net investment income. The base rate index used to calculate interest on a majority of our loans reset in early July to approximately 5.24%, representing an increase of 35 basis points from its early April base rate reset of approximately 4.89%. Our intent is to distribute approximately half of the excess of our quarterly pre-tax net investment income over our regular dividend to our shareholders in a quarterly supplemental dividend. We are confident in our ability to continue to distribute quarterly supplemental dividends for the foreseeable future based on our current undistributed taxable income balance of $0.34 per share, our ability to grow undistributed taxable income each quarter organically by over-earning our total dividend, and the expectation that we will harvest gains over time from our existing $1.11 per share in unrealized appreciation on the equity portfolio. For the quarter, we increased total investment income from our portfolio by 9% quarter-over-quarter to $40.4 million, producing a weighted average yield on all investments of 12.6%. Total investment income was $3.2 million higher this quarter due to growth in our credit portfolio as well as increased average base rates. As of the end of the quarter, we had three loans on non-accrual representing 1.7% of our investment portfolio at fair value. As seen on slide 18, we maintained last twelve months operating leverage at 1.9% for the current quarter. Achieving 2% or lower operating leverage was one of our initial long-term goals when we relaunched Capital Southwest as a middle market lender back in 2015. With this metric in perspective, our 1.9% operating leverage is the second-best in the entire BDC industry. We believe this metric speaks to our fiscal responsibility as well as our absolute alignment with shareholders. Though we are pleased to have reached this milestone, looking ahead we expect our internally managed structure to produce incremental improvements in operating leverage over time. Turning to slide 19, the company's net asset value per share at the end of the quarter increased by $0.01 per share to $16.38. The primary drivers of the net asset value per share increase for the quarter were earnings in excess of our dividends and accretion from the issuance of common stock at a premium to net asset value per share, partially offset by the annual issuance of restricted stock awards to employees. Turning to slide 20, as Bowen mentioned earlier, we are pleased to report that our balance sheet liquidity remains strong with approximately $225 million in cash and undrawn leverage commitments on our revolving credit facility as of the end of the quarter. We are thrilled to have recently completed an amendment, upsize, and extension on our revolving credit facility as our bank syndicate continues to support our growth. In fact, eight of our existing lenders in the facility upsized their commitments, which we believe demonstrates their confidence in our stewardship, especially in the current capital markets environment. The amendment increased total revolving facility commitments to $435 million and extended the maturity of the facility to August 2028. Based on our current borrowing base, we have full access to the incremental revolver capacity. In addition, we have $5 million in committed but unfunded SBA debentures to be used to fund future SBIC-eligible investments as well as $45 million in uncommitted capacity to draw from in the future. As of the end of the June quarter, more than half of our capital structural liabilities were in unsecured covenant-free bonds and our earliest debt maturity is in January 2026. As Bowen mentioned earlier, we received a BBB- investment grade rating from Fitch Ratings during the quarter in addition to receiving a Baa3 investment-grade rating from Moody's earlier in March of this year. The second investment-grade rating is further validation of our first lien focused investment strategy, our strong credit underwriting track record, and our prudent balance sheet management through a variety of capital markets environments. It's worth noting that Capital Southwest is one of the smallest BDCs in terms of market capitalization currently rated by either Moody's or Fitch. We believe both ratings will help immensely as we look to grow and diversify our investor base in future capital raisings. Our regulatory leverage, as seen on slide 21, ended the quarter at a debt-to-equity ratio of 0.87 to 1, down significantly from 1.10 to 1 as of the June 2022 quarter.

Bowen Diehl, CEO

Thanks, Michael. And again thank you everyone for joining us today. We appreciate the opportunity to provide you an update on our business, our portfolio, and the market environment. Our company and portfolio continue to demonstrate strong performance and I continue to be impressed by the job our team has done in building a robust asset base, deal origination capability, as well as a flexible capital structure. As to the uncertainty of the economy, again, we have been underwriting with a full cycle economic mentality since day one, which we believe has positioned us well for the potential economic volatility in the coming months and years. In summary, we have a credit portfolio heavily weighted to first lien senior secured debt, allocated across a broad array of companies and industries, 91% of which is backed by private equity funds. We have a well-capitalized balance sheet with diverse capital sources, strong liquidity, and flexible capital, much of which is fixed rate and covenant lite. We believe our first lien senior secured investment focus and our capitalization strategy provide us complete confidence in the health and positioning of our company and our portfolio as we look ahead. This concludes our prepared remarks. Operator, we are ready to open the lines for Q&A.

Kyle Joseph, Analyst

Hey good morning guys and thanks for taking my questions. Congrats on a good quarter. Just wanted to get your thoughts. There's been a lot on banks kind of in the post SVB world and higher capital requirements. But just to get a sense if you think there's going to be any sort of reverberations down to the lower middle market where you guys focus?

Bowen Diehl, CEO

Yes. I'll make a comment on just the deal environment. We definitely are seeing less direct competition from banks in our world mainly because they're just not reliable in this market to get to close, and so that's helping, like I said in my remarks, helping first lien unit tranche-type lenders like Capital Southwest and others. My expectation is that will continue. In our first lien loans, a lot of the holders of revolvers are ourselves. So having a bank above us that holds a revolver that may not fund doesn't really affect our portfolio in a meaningful way as long as the underlying companies are doing well across the portfolio.

Michael Sarner, CFO

Yes. And probably on the liability side just having gone through the amendment. We have – of our 11 lenders, eight of them participated in the upsize. Essentially, what they communicated was there is a flight to quality that they took a look at their portfolio and they were going to get behind the horses that they thought were successful and that they trusted, while they pared back commitments to those they’re paying less confidence in. So I think that's probably the sort of the mantra right now in the market.

Kyle Joseph, Analyst

Got it. That's helpful. And then I mean it seems like the outlook for the economy changes every week with each macro data point we get. But if you could just give us a sense for kind of the revenue and any EBITDA growth trends you're seeing in your portfolio and how that's changed over the last few quarters?

Bowen Diehl, CEO

Yes. So it's kind of been the same over the last few quarters. Our revenue growth kind of year-over-year is tracking in high single digits kind of 8% or 9% on the top line. The EBITDA growth on a weighted average basis is 2.5%, 3% growth over the last year. It's a question that I think is worth asking all BDCs every quarter. But for us, it's kind of been tracking there for the last several quarters. Thanks, Kyle.

Unidentified Analyst, Analyst

Good morning, guys. Can you provide some commentary on the portfolio companies responsible for the jump in non-accruals as well as the general amendment outlook for the rest of 2023? And just provide some light on whether sponsors have been eager to provide equity infusions or cash infusions to some of the struggling businesses within the portfolio?

Bowen Diehl, CEO

Sure. That's a good question. As I alluded to my comments, we've been very happy with the support the private equity firms are willing to provide. It's not only for struggling situations. In the current environment, sponsors are looking for ways to cut operating costs to get businesses efficient and provide leadership, which is obviously healthy for these companies. Moreover, if they wish to continue to spend extra growth capital to maintain CapEx budgets, they are putting in capital to support those growth initiatives. Fortunately, we have only a few struggling situations within our portfolio, but in those cases, the sponsors have been stepping up and supporting the businesses. The two non-accruals this quarter were all previously rated. Our expectation is that these will be restructured by the end of this year, which we would expect to be partially debt-backed on accrual, with part of our debt converted to equity and we would own a portion of the business. In both situations, we have this expectation based on the progress of these companies, which is quite specific and not broadly reflective of the economy.

Unidentified Analyst, Analyst

Perfect. Thank you. And is there any specific struggles with any sectors or any certain part of the market?

Bowen Diehl, CEO

Yes. I mean, looking at our portfolio, I see a mixed picture. In general, no sectors are struggling significantly. We saw a couple of trends with some companies that supply inventory to retailers, and those companies are experiencing short-term sales declines as inventories normalize. On the consumer side, half of our companies are doing well while others are starting to report some softness. In one case, we've noted some softness. In the transport sector, we have a company that is clearly reporting softness as well, although it's not enough to cause concern as a first lien lender. However, our industrial companies are performing well without any significant concerns.

Unidentified Analyst, Analyst

Okay. Perfect. Thank you for the commentary.

Bryce Rowe, Analyst

Thanks. Good morning. Bowen, I wanted to maybe start on the prepared remarks about M&A. M&A is starting to pick up a bit here and just wanted to get your view on potential repayment activity? It's been muted for the last few quarters and certainly don't I know it's hard to predict, but do you think that we could see some pickup in repayment activity relative to what we've seen here over the last few quarters?

Bowen Diehl, CEO

Yeah. In our portfolio, we have visibility on a handful of companies starting sale processes. So, obviously this could result in some uptick compared to what we've seen in the past few quarters. However, I would suggest that those could end up being significant equity wins for us, making this a positive situation either way. We're still expecting net growth across the portfolio, but refinancing activity remains light due to wider spreads. Nonetheless, the M&A activity is beginning to show promise.

Michael Sarner, CFO

Yeah. I think from a numbers perspective, it's potential to see around $35 million to $75 million in repayments between now and the end of the year.

Bryce Rowe, Analyst

Okay. And maybe a follow-up. You've seen good appreciation within the equity book. Is that due to potential M&A, or is it more widespread across the portfolio?

Bowen Diehl, CEO

Well, our equity portfolio reflects that; we have companies performing well, others doing fine, and some perhaps softening. Overall, the portfolio has done well, and many of these companies still retain significant growth potential.

Bryce Rowe, Analyst

Got it. Okay. And then one more for me from a kind of a balance sheet leverage perspective on the lower end of what we might see from other BDCs in terms of net debt to equity. Certainly your access to capital markets probably has something to do with that, but is that more a signaling of pipeline or some level of conservatism on your part or maybe a combination of both?

Michael Sarner, CFO

I would definitely say it's a combination of both. This is where we are right now at the low end and probably where we'd want to maintain. However, if we do see a flow of repayments towards the end of the year, and with robust originations, we might end up deleveraging slightly more. But we will continue to use our ATM and with the bond issuance and the revolver, we put in ample liquidity to maintain net originations as well as control leverage.

Bowen Diehl, CEO

To address your macro question, we've been attempting to clarify our BDC leverage perspective over the last several quarters. As we've always stated, we're managing everything here from a full cycle perspective. Certainly, everyone acknowledges the potential for a recession is high. We want to be low-leveraged at the top of the cycle, so when we enter a recession, we can execute on our desired initiatives. Our goal is to support our companies and take advantage of attractive capital opportunities if our stock trades below NAV. Our current position allows us this flexibility.

Bryce Rowe, Analyst

Great. I appreciate the comment. Yeah. Have a good day. Appreciate it.

Bowen Diehl, CEO

Thanks.

Operator, Operator

Thank you. The next question will be from Kyle Joseph of Jefferies. Your line is open.

Bowen Diehl, CEO

Thank you everyone. We appreciate everybody being on the call today and look forward to providing updates in the future. Have a great rest of the week.

Operator, Operator

This concludes today's conference call. Thank you all for joining. You may now disconnect. And everyone enjoy the rest of your day.