Capital Southwest Corp (CSWC) 2018 Q2 法說會逐字稿

Thank you for joining today's Capital Southwest Second Fiscal Quarter 2018 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP of Finance. I will now turn the call over to Chris Rehberger.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause 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 thanks to everyone for joining us for our second quarter 2018 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. We are pleased to announce our results this quarter, as we continue down the path of building out our robust middle market lending platform and thoughtfully leveraging the right side of our balance sheet. As you likely recall, we relaunched Capital Southwest in January 2015 as a middle market lending firm. Beginning a transformation of our company from an all equity-focused BDC, paying a negligible dividend and trading at a significant discount to NAV, to a credit-focused BDC paying a market dividend on a path towards trading at a meaningful premium to NAV. As an internally managed BDC, where the interest of management and the shareholders are closely aligned, and where shareholders receive all the benefit from scale and enhanced operating leverage, we are confident our firm is well positioned to successfully complete this transformation. Each quarter, as seen on Slide 6, we continue to make progress in this evolution, increasing both our investment portfolio and investment income, resulting in increasing dividends to shareholders, all while growing NAV per share.

As of the end of the quarter, Capital Southwest's dividend had grown to an annualized yield of 5.6%.

Over the past 4 quarters, Capital Southwest has paid $1.07 per share in dividends, while increasing NAV per share from $17.74 to $18.26. As of the end of the quarter, we have regulatory leverage of 0.2:1. As we continue our evolution over the course of the next 12 months or so, we will target leverage between 0.7:1 and 0.8:1, more typical of a fully ramped BDC. This leaves us today with substantial room to continue to fund investments and build our balance sheet to a more efficiently leveraged state, driving increased dividend to our shareholders. As of the end of the quarter, we had $59 million available on our ING-led credit facility and $33 million in balance sheet cash. We are continually focused on effectively building out the right side of our balance sheet to ensure we are sufficiently capitalized for growth opportunities. With the present strength in the financing market, we are looking to leverage our track record, portfolio quality and performance to date, and as Michael will address in more detail in a moment, we are making substantial progress towards significantly upsizing our credit facility, while achieving improved pricing in turn. We have been pleased with a substantial interest in Capital Southwest from the bank market and look forward to announcing our progress on that front soon.

Finally, as of last week, Capital Southwest shelf registration went effective with the SEC. To our knowledge, this is the first time since its original $15 million IPO in 1961, the Capital Southwest has had a shelf in place. This now gives us the ability to consider capital market options, including public bond and when we earn a premium evaluation to NAV, the public equity markets. This quarter, we also augmented our investment team, adding Curtis Harrison from Goldman Sachs Specialty Lending as a principal. We are very excited about Curtis joining the team and now see the process of building out a robust middle market investment team as being largely complete for the foreseeable future.

Our investment strategy is described on Slide 7, which focuses on a blend of both Lower Middle Market and Upper Middle Market assets, provides us strategic flexibility as we have built the robust capability to seek attractive risk-adjusted returns in both markets.

In our core market, the Lower Middle Market, we directly originate opportunities, consisting of debt investments as well as equity co-investments made alongside our debt. Building out a high-performing and granular portfolio of equity co-investment is important to driving growth in NAV per share, while mitigating future credit offers. On the other hand, our capability and presence in the Upper Middle Market provides us the ability to opportunistically invest in a more liquid market when attractive risk-adjusted returns exist.

This quarter, as seen on Slide 8, we invested $23 million in 2 new portfolio companies, both of which were Lower Middle Market investments and both included equity co-investments. On a weighted average basis, the debt investments made during the quarter had a yield to maturity of 11.5%.

During the quarter, as seen on Slide 9, we received $16 million in proceeds from the exit of 2 Upper Middle Market second lien investments and 1 Lower Middle Market subordinated debt investment, realizing a weighted average IRR of 11.9% on the exits.

Our on-balance sheet credit portfolio Capital Southwest, excluding I-45, grew to $187 million, as seen on Slide 10. And the percentage of our portfolio represented by first lien securities continued to increase, standing at 73% as of the end of the quarter. While our net portfolio growth this quarter was modest, due in part to heavy prepayments, we had several transactions which were signed up that carried over into the current quarter. These opportunities have now either closed or in late-stage diligence and/or documentation. All of these are Lower Middle Market first lien deals, and most of the deals include equity co-investments.

On Slide 11, we break out our on-balance sheet credit portfolio, again excluding I-45, between the Lower Middle Market and the Upper Middle Market. As of the end of the quarter, the portfolio was approximately 60%-40% weighted on a cost basis between the Lower Middle Market and Upper Middle Market, respectively. We had 13 Lower Middle Market investments comprised of first lien, sub debt and equity securities, with an average hold size of $10.1 million and weighted average EBITDA of $9.1 million, a weighted average yield of 11.4% and leverage measured as debt to EBITDA through our security of 3.5x. Within our Lower Middle Market portfolio, as of the end of the quarter, Capital Southwest held equity ownership in approximately 85% of the companies. Our Upper Middle Market portfolio consisted of 13 loans, including first lien and second lien debt with an average hold size of $6.4 million, a weighted average EBITDA of $93.8 million, a weighted average yield of 9.9% and leverage through our security of 3.7x.

As illustrated on Slide 12, including our capital invested in I-45, our overall investment portfolio grew to $322 million as of the end of the quarter. Overall, we believe that we have positioned our invested assets well for the economic uncertainty we face today, being late in the economic cycle. We have a well diversified portfolio, heavily biased towards first lien and secure debt investments. And as can seen -- as can be seen on Slide 13, the vast majority of our credit portfolio is invested in floating rate securities. So our shareholders capital is positioned to benefit if we continue to see rising interest rates.

Specific to our I-45 senior loan fund, as seen on Slide 14, we saw a solid net portfolio growth, increasing portfolio assets to $224 million from $210 million at the beginning of the quarter.

During the quarter, I-45 originated $28 million in 6 new credit investments and 5 add-on investments, while receiving $12 million in proceeds from the exit of 6 credits. As it has grown, the I-45 loan portfolio have maintained a weighted average asset yield in excess of our original business plan and an increasing ROE to Capital Southwest. In contrast to my comments on the strong post quarter-end activity in our direct lending to the Lower Middle Market, I-45 has seen continued heavy prepayment activity and limited new investing since quarter-end, as the syndicated market continues to be white-hot with value for our shareholders capital being increasingly difficult to find. As of the end of the quarter, the I-45 portfolio was 94% first lien with diversity among industries and an average hold size of 2.2% of the portfolio. The portfolio had a weighted average EBITDA of $79 million and a weighted average leverage through the I-45 security of 3.5x. The credit markets continue to be highly competitive, although on a relative basis, less so in the Lower Middle Market than the Upper Middle Market. We continue to see banks be conservative in their lending approach when they lend directly to lower middle market companies. However, as I mentioned before, we are seeing significant demand from banks to lend to us against a performing portfolio of secured lower middle market loans. This results in a nice dynamic at Capital Southwest in generating attractive returns to our shareholders in the Lower Middle Market. We continue to be pleased with the flow of quality Lower Middle Market deals coming to our investment team. Our close rate has remained at 2.5% range over the last 12 months. So our robust pipeline of opportunities is key to maintaining our conservative underwriting approach in a competitive market. I will now hand the call over to Michael Sarner to review the specifics of our financial performance for the quarter.

Thanks, Bowen. As seen on Slide 15, our investment portfolio produced $8.5 million in investment income this quarter, with a weighted average yield on all investments of 10.7%. Investment income increased $800,000 or 10.2% versus $7.7 million from the previous quarter, mostly attributable to net portfolio growth. We incurred $3.5 million in operating expenses, excluding tax and interest expense this quarter, an increase of $120,000 or 3.5% versus $3.4 million in the previous quarter. The increase in operating expenses was due to an increase in G&A, in particular, recruiting expenses, which are one time in nature, incurred for our recent principal hire. For the quarter, we earned pretax net investment income of $4.1 million or $0.25 per share, compared to $0.22 per share during the prior quarter, and we paid a $0.24 per share quarterly dividend compared to $0.21 per share in the prior quarter. We continue to focus on growing our quarterly dividends in a sustainable manner, demonstrated by our last 12 months dividend coverage of 111%.

As seen on Slide 16, during the quarter, our NAV increased by $5.1 million to $292.5 million, or $18.26 per share. The increase in NAV from the prior quarter is primarily due to an increase in net realized and unrealized gains in the current quarter.

In the fiscal year-to-date, we increased NAV over $7.4 million, while producing a 9.8% total return on equity.

Last year, we produced a total return on equity of 8.5%.

As illustrated on Slide 17, our on-balance sheet investment portfolio mix, excluding capital investment in I-45, was 74% debt and 26% equity at quarter-end, and 94% of our total portfolio produces income in the form of either interest or dividends.

The weighted average yield on our debt portfolio was 10.7% for the quarter, up from 10.5% the previous quarter. And as of the end of the quarter, there were no assets on nonaccrual. We did, however, place 1 first lien asset for $10 million on our internal watch list this quarter. This company is a regional provider of industrial cleaning services to industrial and petrochemical companies in South Texas and Southern Louisiana. The performance has deteriorated in recent months, in part, due to disruptions resulting from Hurricane Harvey. At this time, we believe the under performance to be temporary but they did breach financial covenants for the September period. So as a first lien lender, we will have the ability to address the situation directly with the company.

As Bowen mentioned, at quarter-end, we had $33 million in balance sheet cash, approximately $20 million of which was received in prepayments from portfolio companies in the last week of the quarter.

Additionally, we have $59 million of available capacity on our balance sheet credit facility and $26 million in additional capacity on the I-45 credit facility.

During the quarter, we amended the Deutsche Bank credit facility to lower the spread to LIBOR plus 2.4%, extended the tenor, while enhancing advanced rates modestly. This will increase the run rate return on equity to Capital Southwest from I-45 to approximately 13%. To-date, however, accelerated OID and prepayment fees on exits have boosted annualized ROEs to Capital Southwest to levels ranging from 14% to 18%. At quarter-end, we had a leverage ratio of 0.2:1, leaving a substantial room to increase our balance sheet leverage and drive dividend growth for our shareholders. As Bowen mentioned, we are currently also working on an amendment to our ING-led credit facility with existing lenders as well as several new banks to further expand our borrowing capacity, lower the overall cost of our credit facility and extend the tenure of the facility. The net impact of this amendment will be to provide the available capital necessary, enhance leverage on the balance sheet of both lowering cost and increasing advanced rates. This will allow us, at the margin, to take less portfolio investment risk, while maintaining attractive returns for our shareholders. We anticipate completing this amendment process during the current quarter.

Finally, we recently completed the shelf registration process with the SEC and went effective on our N2 shelf registration for up to an aggregate $500 million, which will allow us to opportunistically raise public debt and equity capital in the future. This is clearly a huge step for the company and one which we are very excited to announce. I will now hand the call back to Bowen for some final comments.

Thanks, Michael, and thank you to our shareholders for giving us the opportunity to be stewards of your capital, a responsibility that we take very seriously. We continue to thoughtfully and carefully execute on our investment strategy with the creation of long-term, sustainable shareholder value as our most important goal. This concludes our prepared remarks. I would now like to turn the call over to the operator to open up the lines for Q&A.

(Operator Instructions) Our first question comes from the line of Christopher Testa with National Securities.

Just with the -- touching on the frothiness from the general market, the Lower Middle Market on-balance sheet originations were also kind of low this quarter. Is -- have you seen an active shift towards more Lower Middle Market borrowers pursuing some more aggressive structures, much as -- much of what has been seen in the Upper Middle Market and broadly syndicated market as well?

Yes. Thanks for the question. Our activity for the quarter, as I mentioned in my comments, we had several deals that were signed up and carried over into this quarter. So the 2 originations that we did, not quite illustrative of the activity, but that -- so that's -- that point. But your question about the Upper Middle Market, Lower Middle Market, I mean, the frothiness in the Upper Middle Market, in our observation, is much, much more than what we're seeing in the Lower Middle Market. I mean, the Lower Middle Market is competitive, clearly. But covenants are tight, market covenants. I mean its structures are certainly in the first lien world you can negotiate tight structured documents. None of which is really the case in the Upper Middle Market. So we see it as dramatically different between the 2.

Right. Absolutely. And that certainly makes sense. And kind of sticking with the theme, first, I'd like to know what the leverage is on the joint venture at the current time?

Michael?

Yes. Leverage, just shy of 2x.

Okay. Got it. And it's gotten so frothy that even if you were to plow the prepayments basically back into similar yields on the loans, you're not getting the ROEs that you're targeting on the JV, is that safe to say?

Well, I mean, ROEs on the JV, if you just take just the recurring interest off of the portfolio is currently around 13%, which is above where we originally modeled it in our original business plan. We do see churn in the portfolio. As I mentioned, we're just -- the way you handle that as you take -- there are still quality companies, credits are a little bit more aggressive and the spreads are lower, so we just take smaller bets and keep a very granular portfolio. But the ROE is still around on a recurring basis, around 13%, So -- which correctly sized in our portfolio where the JV is today. It's a nice asset to have on the books.

Got it. And so far as you do receive prepayment fees in the JV, is that split pro rata between you and Main Street? Or is it based upon the economic interest that each of you have in the fund?

So the prepayment fees and OIDs are distributed at the same relative basis as the rest of the income, the interest income. It's all distributed the same. And it's distributed real time quarter-by-quarter, that's why the ROE is historically been kind of, in the future, could also be much higher, 14% to 18% as juiced by the prepayment and OID acceleration.

Got it. And I know you guys had mentioned probably this quarter, getting to amend the on-balance sheet credit facility, congratulations on that. Couple questions on that. Will it be amended in terms of being upsized and having the spread over LIBOR reduced? And also, will there be a onetime associated expense with amending that credit facility that we should be modeling?

Chris, so we are reducing the spread. We're going to extend the tenor. There's going to be a fee, but there will not be a onetime fee, that will just be commitment fees that will be amortized over the life of the loan. So you won't see a onetime impact.

Got it. And last one for me and I'll hop back in the queue. You guys have mentioned 0.7x to 0.8x target leverage. Now I know the SBA is moving with the speed of a snail, but should we look at the 0.7x to 0.8x target leverage as being all in or on a regulatory basis?

I would say, for the next 12 to 18 months, you'd say that's going to be one and the same without the SBA, 0.7x to 0.8x would be where we'd be. The credit facility is going to be a big part of that process of getting us towards that -- inside that range. And then in the future, you mentioned the SBA, the SBA is probably going to be maybe a longer-term venture for us. We're going to explore, as we talked about in the previous calls, potential to look at the unsecured bond market and continually ramp the credit facility as well.

(Operator Instructions) And our next question comes from the line of Dan Nicholas with Robert W. Baird.

Just wanted to follow up on Chris' kind of market dynamic question. As we think about sub debt that you're seeing out there now in the Lower Middle Market, I mean some BDCs are certainly seeing some headwinds and pressure on the portfolio from subordinated or more mezzanine structure, so just curious how you're thinking about lower investment -- lower down the capital stack as we sit here in the credit cycle. I know you all underwrite to a recessionary environment or credit cycle, so just curious how you're thinking about more junior structures at this point in the lower Midwest?

Yes, that's a good question. So couple of points. And all against the backdrop of kind of how I've said -- described on prior earnings calls of how we look at a recession environment and stress test where we look at each of our loans and stress test the capital structure against the repeat of the Great Recession in kind of late '18 and '19, which, of course, we hope doesn't happen, but we stress test that. So how do we think about a sub debt investment in that environment? First of all, there are going to be companies that have proven over time to be less volatile with the economic cycle, and so as demonstrated by historical performance of both the company and the particular industry, they're going to tend to be -- even within that, they're going to tend to the lower leveraged situations all in leverage and also, lower loan-to-value being the last dollar of our sub debt versus the purchase price of the company being paid. And so those are the general characteristics, I would say, that -- we don't do a lot of sub debt investing, but we did do one this last quarter. I mean, those are certainly elements of that deal. Also, companies that -- if you're doing -- if you're making a sub debt investment, in my assessment, you're taking much more enterprise value risk, perhaps than even a senior debt investment, and so you have to -- I look at it and say, okay if I really like the equity story and it's a really interesting equity story, then that's the enterprise value risk you might be -- at the margin we're willing to take. And if that is the case, then you ought to be participating in the equity. And so you will see most all the time of us writing a meaningful equity check alongside our mezzanine debt. So those are the elements that we look at and again, we don't do a whole lot of sub debt investing but we certainly do look at that piece of the capital structure in certain situations. And again, all against the backdrop of the same stress testing that we do for other investments.

Yes. Okay. That makes a lot of sense, Bowen. And just kind of shifting gears to the expense side of the house. You talked about the team build-out pretty much being complete hear this quarter. Do you think it's reasonable to say that kind of starting next quarter, we'd probably see a bit of an inflection point in terms of operating leverage or operating expenses relative to earnings and assets?

Yes. I'm going to tell you from in terms of the operating expenses going forward, if you look back over the past 3 quarters, you'd see several one time expenses, this quarter being the recruiting expense. Few quarters ago, we had some legal cost for corporate matters. We've come in about $3.4 million. We mentioned, and Bowen mentioned that we hired a new principal. So that number's going to come up a bit for that -- for cash comp. But also, after 12/31, the spin-off comp is going to fall off, so we do expect to see -- expenses should be pretty stable around 3.4 million to 3.5 million for SG&A. And obviously, as the assets grow, the operating leverage will come down. We see -- by the end of this fiscal year, we should think it will be around 3%. And then fast forwarding 6 and 12 months after that, we find ourselves -- we expect to find ourselves underneath the 2.5% target, if that's helpful.

Yes, that is helpful, Michael. And that 2.5% target or below, can that be achieved with kind of a leveraged out balance sheet relative to kind of what the current capital base can support?

Yes, absolutely. And that's what I was kind of making the point earlier. With the credit facility amendment, we think this is going to get us really right into the range of leverage where we're looking to be. And certainly, we'll opportunistically look from the capitalization strategy to add on other forms of debt if we can do it in an effective manner. But certainly what's happening right now is very positive in a way. It allows us to fully lever out the balance sheet.

And I'm showing no further questions at this time. So I'd like to return the call to Mr. Bowen Diehl for any closing remarks.

Thank you, operator, and thank you all for participating on our call today. We look forward to keeping you appraised of our progress on future calls. And again, as I always say, shareholder value creation is our absolute first priority and we tend to work very hard to make that happen. So thank you all very much, and have a great week.

Ladies and gentlemen, thank you for participating in today's call. This will conclude the program and you may all disconnect. Everyone, have a great day.