Capital Southwest Corporation (NASDAQ:CSWC) Q3 2024 Earnings Call Transcript

Capital Southwest Corporation (NASDAQ:CSWC) Q3 2024 Earnings Call Transcript January 30, 2024

Capital Southwest Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you for joining today’s Capital Southwest Third Quarter Fiscal Year 2024 Earnings Call. Participating on today’s call are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

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 actual results to differ materially from such statements. For information concerning these risks and uncertainties see Capital Southwest 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: Thanks Chris and thank you to everyone for joining us for our third 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 at www.capitalsouthwest.com. You will also find our 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 $0.72 per share, which represented 20% growth over the $0.60 per share generated a year ago in the December quarter. The $0.72 per share more than covered both our regular dividend of $0.57 per share and our supplemental dividend of $0.06 per share paid during the quarter. Portfolio earnings continue to be strong as of the end of the quarter. As of end of quarter, we estimate that our undistributable taxable income was $0.52 per share. Additionally, net asset value per share increased 1.9% for the quarter to $16.77 per share from the $16.46 per share as of the end of the prior quarter. This increase represented the fourth consecutive quarterly NAV per share increase for Capital sublet.

We are also pleased to announce today that our Board of Directors has declared a regular dividend of $0.57 per share for the March 2024 quarter. This represents 7.5% growth over the $0.53 per share, paid a year ago in the March quarter. In addition, due to the excess earnings being generated by our floating debt investment portfolio in this high interest rate environment, our Board has again declared a supplemental dividend of $0.06 per share for the March 2024 quarter, bringing total dividends declared for the March 2024 quarter, to $0.63 per share, which in total represents 9% growth over total dividends paid out in the year ago quarter. 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 dividend for the foreseeable future.

While base rates are above historical averages and we have meaningful UTI, which is 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 than market continued at a healthy pace, and we continue to be able to source attractive investment opportunities. Private equity firms and business owners continue to transact, while non-bank lenders like Capital Southwest continue to provide more certainty to clothing than traditional bank financing structures. That said, competition from other non-bank lenders for quality lower middle market opportunities has largely returned to the more normal levels seen 12 to 18 months ago, resulting in tighter pricing spreads as well as slightly higher leverage and loan-to-value in the closing capital structures.

In the larger end of the lower middle market, which is typically where we exit our investments, M&A activity picked up during the quarter as well, resulting in increased prepayments across our portfolio. Portfolio growth during the quarter was driven by $116.3 million in new commitments, consisting of $70.7 million in commitments to four new portfolio companies and $45.6 million in commitments to 12 existing portfolio companies. This was offset by $79 million in proceeds from five debt prepayments and one equity exit during the quarter, generating a weighted average IRR of 12.2%. On the capitalization front, we are pleased to announce that during the quarter, we successfully upsized our corporate revolving credit facility to $460 million from $435 million, with the addition of one new lender to the bank syndicate.

We also raised $66.5 million in gross equity proceeds during the quarter, through our equity ATM program, at a weighted average price of $21.92 per share or 133% of the prevailing NAV per share. In addition, subsequent to quarter end, the I-45 credit facility was repaid in full and we are currently in the process of winding down the I-45 Senior Loan Fund. As most of you know, I-45 was initially created to invest in small pieces of large syndicated loans. That I-45 has been a success through the years. The market for syndicated loans have evolved, and we no longer view this market as a favorable place to generate attractive risk-adjusted returns for our shareholders. Michael will discuss the timing and mechanics of the dissolution of I-45 in further detail in a moment.

We have remained diligent in ensuring we have strong balance sheet liquidity, while also funding a meaningful portion of our investment activity with accretive equity issuances. We continue to maintain a conservative mindset to both balance sheet liquidity and BDC leverage, managing the company with a full economic cycle mentality. While this starts with our underwriting of new investment opportunities, it also applies to how we manage the BDC’s capitalization and liquidity, managing leverage to the lower end of our target range, while ensuring strong balance sheet liquidity, affords us the ability to invest in new platform companies even in periods of volatile capital markets, when risk-adjusted returns can be particularly attractive. Additionally, it allows us to support our portfolio companies while also opportunistically repurchasing our stock if it were to trade meaningfully below NAV.

On slide 7 and 8, we illustrate our continued track record of producing strong dividend growth, consistent dividend coverage and solid value creation, since the launch of our credit strategy back in January 2015. Since that time, we have increased our quarterly regular dividend 28 times, and have never cut the regular dividend, all while maintaining strong coverage of our regular dividend with pre-tax net investment income. Additionally, over the same period, we have paid or declared 23 special or supplemental dividends, totaling $3.89 per share, including the $0.06 per share the Board has declared for the March 2024 quarter. All generated from excess earnings and realized gains from our investment portfolio. We believe our track record of thoughtfully growing our dividend, a consistently solid performance in our portfolio, as well as our company’s sustained access to multiple capital sources has demonstrated the strength of our investment and capitalization management strategies, as well as the absolute alignment of all our decisions with the interest of our shareholders.

Turning to slide 9, we lay out the core tenets of our investment strategy. Our core strategy is lending and investing in the lower middle market, the vast majority of which is in first lien senior secured loans to companies backed by private equity firms. In fact, approximately 92% of our credit portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio companies, as well as the potential for new junior capital support if needed. In the lower middle market, we often have the opportunity to invest on a minority basis, in the equity carry pursued with the private equity firm, when we believe the equity thesis is compelling. As of the end of the quarter, our equity co-investment portfolio consisted of 62 investments, with a total fair value of $129.1 million, which was marked at 143% of cost, representing $38.5 million in embedded unrealized appreciation or $0.90 per share.

Our equity portfolio, which represented approximately 9% of our total portfolio at fair value, as of the end of the quarter, continues to provide our shareholders participation in the attractive upside potential of these growing lower middle market businesses, which will come in the form of NAV per share growth and supplemental dividends over time. As illustrated on slide 10, our on-balance sheet credit portfolio ended the quarter at $1.2 billion, representing year-over-year growth of 19%, from $990 million as of the December 2022 quarter. For the current quarter, 100% of our new portfolio company debt originations were first lien senior secured. And as of the end of the quarter, 97% of our credit portfolio was first lien senior secured. The weighted average credit exposure per company remains granular at 1.2%.

We believe our portfolio granularity speaks to our continued investment discipline of maintaining a conservative posture to overall risk management as we grow our balance sheet. We fully expect that this metric will continue to improve as our asset base growth. On slide 11, we detailed the $116.3 million of capital invested in and committed to portfolio companies during the quarter. Capital committed this quarter included $66.7 million in first lien senior secured debt committed to four new portfolio companies, in which we also invested a total of $4 million in equity. We also committed a total of $43.5 million in first lien senior secured debt and $2.1 million in equity to 12 existing portfolio companies. We are pleased with the strong market position that our team has established in the lower middle market as a premier debt and equity capital provider, as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities, as well as the consistency of our origination activity.

In fact, deal activity post quarter end has continued at a healthy pace, and we expect solid net portfolio growth in the coming quarter. Turning to Slide 12, as I mentioned earlier, increased M&A and refinancing activity during the quarter resulted in greater than average prepayment activity. We continued our track record of strong returns on our exits, with five debt prepayments and one equity exit during the quarter. In total, these exits generated approximately $79 million in total proceeds, generating a weighted average IRR of 12.2%. Since the launch of our credit strategy nine years ago, we have realized 73 portfolio company hectares, representing $885 million in proceeds, that have generated a cumulative weighted average IRR of 13.9%.

On Slide 13, we detail some key steps for our on-balance sheet portfolio as of the end of the quarter, excluding our I-45 joint venture. As of the end of the quarter, the total portfolio at fair value was weighted 87.5% to first lien senior secured debt, 2.6% to second lien senior secured debt, 0.1% to subordinated debt and 9.8% to equity co-investments. The credit portfolio had a weighted average yield of 13.5% and weighted average leverage through our security of 3.6 times. Cash flow coverage of debt obligations across our portfolio continued to be strong despite the high base rate environment. With weighted average interest coverage of three times and weighted average fixed charge coverage of 2.5 times. As seen on Slide 14, our total investment portfolio continues to be well diversified across industry with an asset mix, which provides strong security for our shareholders’ capital.

Turning to Slide 15. We have laid out the rating migration within our portfolio during the quarter. As a reminder, all loans upon origination are initially signed an investment rating of two, on a 4-point scale, with one being the highest rating and four being the lowest rating. We feel very good about the performance of our portfolio with 95% of the portfolio at fair value, rated in one of the top two categories of one or two. In fact, the portfolio generated weighted average revenue growth of 3% and weighted average EBITDA growth of 7%, during the quarter. I will now hand the call over to Michael to review more specifics of our financial performance for the quarter.

Michael Sarner: Thanks, Bowen. Specific to our performance for the quarter, as summarized on Slide 17, we increased pre-tax net investment income by 13% quarter-over-quarter to $29.8 million or $0.72 per share, compared to $26.4 million or $0.67 per share in the prior quarter. During the quarter, we paid out a $0.57 per share regular dividend and a $0.06 per share supplemental dividend. As mentioned earlier, our Board has declared a regular dividend of $0.57 per share and declared a $0.06 per share supplemental dividend for the March quarter. 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 123% coverage for the last 12 months ended December 31, 2023, and 110% cumulative coverage since the launch of our credit strategy in January 2015.

As a reminder, our intent is to continue to distribute a portion of the excess of our quarterly pre-tax NII 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 upon our current UTI balance of $0.52 per share, our ability to grow UTI each quarter organically by over earning our total dividend and the expectation that we will harvest gains over time from our existing $0.90 per share in unrealized appreciation on the equity portfolio. For the quarter, we increased total investment income to $48.6 million, representing 14% growth quarter-over-quarter and 48% growth from a year ago. Weighted average yields in the portfolio on all investments was 13.7%.

Total investment income was $5.8 million higher this quarter primarily driven by an increase in the weighted average cost basis of our debt investments, as well as an increase in dividend and fee income. As of the end of the quarter, we had three portfolio companies with loans on non-accrual, representing 2.2% of our Investment portfolio at fair value. As seen on Slide 18, we maintained LTM operating leverage at 1.8% for the current quarter. To put this metric in perspective, our 1.8% operating leverage is the second best in the entire BDC industry. We believe this metric speaks to the benefits of the internally managed BDC model and our absolute alignment with shareholders. The internally managed model has and will continue to produce real fixed cost leverage, while also allowing for significant resources to invest in people and infrastructure to continue to build a best-in-class BDC.

As we look forward, we expect further improvements in operating leverage, as we continue to grow the balance sheet over time. Turning to Slide 19. The company’s NAV per share at the end of the quarter increased by $0.31 per share to $16.77, representing an increase of 1.9%, compared to the prior quarter. The primary drivers of the NAV per share increase for the quarter were earnings in excess of our total dividends paid for the quarter and accretion from the issuance of common stock at a premium to NAV per share, partially offset by net unrealized depreciation on our Investment portfolio. Turning to Slide 20. We are pleased to report that we have significant balance sheet liquidity with approximately $333 million in cash and undrawn leverage commitments on both our revolving credit facility and SBA debentures, as of the end of the quarter.

We recently completed an increase to our revolving credit facility, adding one new lender and bringing total revolver credit facility commitments to $460 million from $435 million in the prior quarter. Based on our current borrowing base, we have access to the full $460 million revolver capacity. The facility has an accordion feature allowing for the further increase of total commitments up to an aggregate of $750 million, allowing us to continue to grow our revolver capacity in lockstep with the growth of our overall balance sheet. In addition, during the quarter, we received an additional leverage commitment in the amount of $45 million from the FDA from which we can draw upon in the future. As of the end of the December quarter, 53% of our capital structure liabilities were in unsecured covenant-free bonds with our earliest debt maturity in January 2026.

Finally, as Bowen mentioned earlier, subsequent to quarter end, the I-45 credit facility was repaid in full at the option of the joint venture partners. We are currently in the process of winding down the I-45 fund by allocating the residual assets in the fund to the joint venture partners. Assets from the fund will be allocated from the financing subsidiary to the balance sheet of each joint venture partner, consistent with their invested capital. The impact to Capital Southwest will be a small increase in assets, slightly higher leverage due to the pay down of the I-45 credit facility and a modest increase in earnings, as we eliminate frictional costs related to the fund. Our regulatory leverage, as seen on Slide 21, ended the quarter at a debt-to-equity ratio of 0.77 to 1, down meaningfully from 0.91 to 1, as of the year ago December quarter.

We opportunistically brought leverage slightly below our target range, as of the end of the December quarter, in part to accommodate the I-45 credit facility payoff and I-45’s fund wind down. We will continue to methodically and opportunistically raise secured and unsecured debt capital, as well as equity capital through our ATM program, to ensure we continue to maintain significant liquidity, conservative leverage, and adequate covenant cushions throughout all economic cycles. I will now hand the call back to Bowen for some final comments.

Bowen Diehl: 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 we continue to be impressed by the job our team has done in building a robust asset base deal origination and portfolio management capability, as well as a flexible capital structure. We believe we have prepared our company well for future growth and performance, and we feel very good about how our shareholders’ capital is positioned in the market. In summary, we have a credit portfolio predominantly made up of first lien senior secured debt, allocated across a broad array of companies and industries.

Over 90% of which is backed by private equity firms. While also enjoying participation in the equity upside of many of these growing lower middle market businesses. Further, we have a well-capitalized balance sheet with multiple capital sources, very strong liquidity, and a flexible capital structure. This concludes our prepared remarks, operator. We are ready to open the lines up for Q&A.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from the line of Mike Schleien with Ladenburg Thalmann. Your line is open.

Mike Schleien: Yes, good morning everyone. Bowen, there was this theory that M&A volumes really wouldn’t pick up until there was certainty that the Fed would cut rates and I’m in the camp that we don’t know and inflation is still not at their target. And obviously, rates have not come down yet. So, from your perspective, what’s driving this increase, which you mentioned has spilled over into the first quarter?

Bowen Diehl: Yes, it’s interesting. I mean if you look at our five exits, three of them were sales and two of them are refinancings. On the sales, I mean these are private equity-backed firms. There’s strategic interest in the assets. I think they were all strategic sales looking at them. So, they were just — it was just candidly, it’s private equity firms trying to print gains in companies that are performing. So — and there is strategic interest in the assets. And so I don’t know, we have the same press clippings you do. Those trends are probably true as you laid out, but it’s a little random. I mean our portfolio just had a number of sales in it. I attribute part of that to a general increase in M&A activity that we’ve seen out there. We also see our deal flow as well being really strong.

Michael Sarner: We’ve also seen in the top half of our portfolio, the loan grade ones. These companies, we have a significant number of companies that have delevered underneath two times even to the extent that our half turn to 1.5 turn. And so those guys will find potentially a lower-yielding option, than where maybe they were when we originated them.

Bowen Diehl: Yes. That’s more of a company performance aspect. That’s true, for sure. But the M&A activity, just looking at these names, I mean, there just has been interest in those assets. and those private equity firms, obviously, they don’t get paid until they sell and monetize, pay their carry. So they hit the bid.

Mike Schleien: I understand. That’s helpful. I noticed there were a couple of two — there were two credit downgrades during the quarter. Can you describe general trends in credit quality in the portfolio? And in particular, what these two were about?

Bowen Diehl: Yes. I mean if you can just take a step back and look at trends in our portfolio, if you look at revenue and EBITDA growth, if you look at the number of upgrades versus downgrades, I’d say credit performance in our portfolio as a whole is excellent. The two downgrades, one was already not proven — already a challenge. We basically had a term loan B and a downgrade and we down lift grade the term loan A. And the other one was a company that’s kind of bumping along and we decided to go ahead and upgrade it. So it’s a new downgrade, not an existing. But again, if you look at 60 something million of upgrades and 30 million downgrades, I’d say it’s a general trend perspective, it looks okay.

Mike Schleien: Fair enough. And my last question, more housekeeping. Can you help me understand the net realized loss because on Page 12 of the Investor Presentation, there’s a realized gain, but there’s a much more meaningful net realized loss on the income statement. Can you just reconcile that?

Michael Sarner: Yes. One of our portfolio companies had a restructuring, which a portion of their debt was converted to equity. And so from an accounting perspective, that’s going to — you’ll see that show up as a realized loss for the quarter. And you’ll see when the 10-Q comes out, you’ll see a full reconciliation of — for the quarter of kind of what happened to each of the companies.

Bowen Diehl: And that was one of our non-accruals, it’s been non-accrual, and we — I think we voiced on a prior earnings call that we expected to have that restructuring in the calendar year and in fact, it happened [indiscernible]

Mike Schleien: I got it. And Michael, the Q is coming out tonight?

Michael Sarner: Yes.

Mike Schleien: Okay. Those are all my questions. I appreciate your time as always. Thank you.

Michael Sarner: Thanks, Mike.

Bowen Diehl: Yes, thanks, Mike.

Operator: Our next question comes from the line of Robert Dodd with Raymond James. Your line is open.

Michael Sarner: You might be on mute Robert.

Operator: Yes.

Robert Dodd: Yes. I apologize. I was on mute. Yes, that’s my bad. Sorry, on the leverage, right? You see you’re below the bottom end of your target range. Obviously, some of that is planning for I-45. I mean, could you give us any — do you still feel more comfortable at the bottom or below the bottom of the target range for leverage, or can you give us an update on where you think if the economies may be doing better than you thought? Your credit quality is certainly hanging in very well. So I mean, can you give us some thoughts on where you see that in the medium-term conceptually I-45 adjusted?

Michael Sarner: Sure, of course. So I-45 was adjusted. I think we were more at 0.83 times. I think for a go-forward basis, our — I would give you the range of 0.8 to really 0.95 that’s essentially where we’d like to stay in. And at the moment, like you said, we’d see kind of clear skies ahead at the moment, portfolio is performing well, you could see us tick up closer to the higher end in the next several quarters. But we’re — honestly, if you look at our earnings related to our NAV, we are one of the more productive companies in the BDC space, we’re able to produce $0.72 on $0.77 leverage. So we don’t really need to press the gas pedal. So you probably see us somewhere along the middle of that range.

Robert Dodd: Got it. Got it. Thank you. Then on I-45, I mean, it’s got $27 million, I think, in unrealized depreciation in it currently. When it’s — when the assets are onboarded, are they going to be onboarded at the existing cost and fair value basis, i.e., the unrealized depreciation of stay, or is any of that going to be crystallized during the onboarding process?