Capital Southwest Corp (CSWC) 2023 Q1 法說會逐字稿

Thank you for joining today's Capital Southwest First Quarter Fiscal Year 2023 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance.

I will now turn the call over to Chris Rehberger.

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.

Thanks, Chris, and thank you to everyone for joining us for our First Quarter Fiscal Year 2023 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 on our website at www.capitalsouthwest.com. You will also find our quarterly earnings 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 pretax net investment income of $0.50 per share, which represented 11% growth over the $0.45 per share generated in the year-ago June quarter. The $0.50 per share more than earned our regular dividend paid during the quarter of $0.48 per share.

Total dividends for the quarter were $0.63 per share, which included a special dividend of $0.15 per share, also paid out during the quarter. We are pleased to announce today 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 30, 2022. This increase represented 4.2% growth over the $0.48 per share paid out in the June quarter and 16% growth over the $0.43 per share paid out in the year-ago September quarter.

This increase in our recurring regular dividend reflects the increased earnings power of our portfolio, resulting from the increase in market interest rates over the past few months, the growth and performance of our credit portfolio and the improvements in our operating leverage.

During the quarter, acquisition and financing activity in the lower middle market continued to be strong. This quarter, we surpassed the $1 billion threshold in total investment assets, and represented -- and representing 7.5% growth over the -- for the quarter and 26% portfolio growth over the past year.

Portfolio growth during the quarter was driven by $148 million in new commitments, consisting of commitments to 6 new portfolio companies totaling $139 million, and add-on commitments to 8 existing portfolio companies totaling $9 million. This was offset by $50 million in proceeds from 3 debt prepayments and 1 equity exit during the quarter.

On the capitalization front, we raised $46.8 million of equity through our ATM program at an average price of $20.60 per share, representing an average of 123% of the prevailing net asset value per share. Our liquidity remains robust with approximately $180 million in cash and undrawn capital commitments as of the end of the quarter. We feel very good about the condition of our portfolio overall and of our company.

That said, we have remained diligent in funding a meaningful portion of our investment asset growth with accretive equity issuances on our equity ATM program as we think it is critical that we maintain a conservative mindset to BDC leverage given the uncertainty of the economy and capital markets.

On Slide 7 and 8, we illustrate our continued track record of producing steady dividend growth, consistent dividend coverage and value creation since the launch of our credit strategy. We believe the solid performance of our portfolio, as well as our company's sustained access to the capital markets, has demonstrated the strength of our investment and capitalization management strategies. Maintenance and growth of both shareholder dividends and NAV per share remain as core tenets of our long-term investment objective of creating long-term value for our shareholders.

Turning to Slide 9. As a refresher, our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market lending strategy, where we directly originate and lead opportunities, consisting primarily of first lien senior secured loans with smaller equity co-investments made 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, which included $26.6 million in embedded unrealized appreciation for approximately $0.97 per share.

Our equity portfolio, which represented approximately 9% of our total portfolio fair value as of end of the quarter, continues to provide our shareholders the 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 special dividends over time.

As illustrated on Slide 10, our on-balance sheet credit portfolio as of the end of the quarter, excluding our I-45 senior loan fund, grew 9% to $865 million as compared to $794 million as of the end of the prior quarter. Over the past year, our credit portfolio has grown $194 million or 29% from $671 million as of June 2021. For the quarter, 100% of the new portfolio company debt originations were first lien senior secured debt. And as of the end of the quarter, 94% of our total credit portfolio was first lien senior secured.

On Slide 11 and 12, we detail the $148 million of capital invested in and committed to portfolio companies during the quarter. Capital committed this quarter included $136 million in first lien senior secured debt committed to 6 new portfolio companies, including 4 in which we also co-invested a total of $3.1 million in equity. Finally, during the quarter, we also committed $9 million in first lien senior secured debt to 8 existing portfolio companies.

Turning to Slide 13. We continued our track record of successful exits with 3 debt prepayments and 1 equity exit during the quarter. In total, these exits generated $49 million in total proceeds, realizing gains of $2.3 million and generating a weighted average IRR of 19.6%. Since the launch of our credit strategy over 7.5 years ago, we have had 63 portfolio exits, representing $745 million in proceeds, that have generated a cumulative weighted average IRR of 14.8%.

The market for acquisition capital continues to be active, albeit at a slower pace than we saw at the turn of calendar year '21. Not surprisingly, we have also seen a slowdown in refinancing activity. As a result, we would expect continued solid net portfolio growth in the near term.

The activity in our investment pipeline is strong in terms of volume and quality of deal opportunities as well as the breadth of financial sponsors and other deal sources represented. 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 partner, as evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities.

On Slide 14, we detail some key stats for our on-balance sheet portfolio as of the end of the quarter, again, excluding our I-45 senior loan fund. As of the end of the quarter, the total portfolio fair value was weighted 85.4% to first lien senior secured debt, 5.1% to second lien senior secured debt and 0.1% to subordinated debt and 9.4% to equity co-investment. The credit portfolio had a weighted average yield of 9.3% and weighted average leverage through our security of 4x, both flat from the prior quarter.

Now turning to Slide 15. We have laid out the rating migration within our portfolio. During the quarter, we had 1 loan with a fair value of $10 million upgraded from a 2 to a 1. We had 3 small loan positions across 2 portfolio companies with an aggregate fair market value of $10 million, downgraded from a 2 to a 3. And we had 1 loan position with a fair value of $693,000 downgraded from a 3 to a 4.

As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4-point scale, with 1 being the highest rating and 4 being the lowest rating. As of the end of the quarter, we had 74 loans representing 95% of our investment portfolio at fair value rated in 1 of the top 2 categories, or 1 or 2.

The number of 1-rated loans decreased from 7 to 5 this quarter, and all 3 of the loan prepayments this quarter had a rating of 1, offset by the aforementioned portfolio company that was upgraded and added to the list of 1-rated loans this quarter. In aggregate, we had a total of 10 loans, representing approximately 5% of the portfolio at fair value, rated a 3 or a 4 as of the end of the quarter.

As illustrated on Slide 15, our total investment portfolio continues to be well diversified across industries with an asset mix which provides strong security for our shareholders' capital. The portfolio remains heavily weighted towards first lien senior secured debt, with only 5% of the total portfolio in second lien senior secured debt. I'll also note that 90% of our credit portfolio is backed by a financial sponsor, providing for potentially meaningful financial support for these portfolio companies if needed.

I will now hand the call over to Michael to review more specifics 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 pretax 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 pretax 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 pretax 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 4 loans on nonaccrual, with an average fare 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 nonaccruing 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 Southwest 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 $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 secured 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 continued 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 SBA leverage commitment shortly as we continue to see strong origination volume in SBIC-eligible investment. As of June 30, 2022, approximately 49% of our capital structure liabilities were unsecured, and our earliest debt maturity is in January 2026. 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 the 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 cushions throughout the economic cycle.

I will now hand the call back to Bowen for some final comments.

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 continue 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 1, 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 merits 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.

(Operator Instructions) Our first question comes from the line of Kevin Fultz from JMP Securities.

Given the evolution of market conditions over the past 2 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.

Yes. Thanks for the question. Yes, I think for a comment on the spread in the market, I think we're seeing kind of, for quality deals that you can underwrite, especially given the economic cycle and with reasonable leverage levels, there's still a lot of competition for those deals.

And so we haven't really seen spread widen tremendously. Maybe a little bit on margin, 25 basis points, plus or minus. And so still seeing strong activity, still seeing kind of spreads kind of where they are, where they've been.

Okay. That makes sense, Bowen. And then just a follow-up for Michael. Looking at the NAV bridge on Slide 20, there's an $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 think that had to do with our RSUs. We do our June -- our distribution to employees for RSUs in the June quarter. And so there's -- you'll see that annually in this quarter.

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. Sure, Mickey. Thanks for the question. So we've looked at that. If you look at our portfolio, and let's take the 95% of the portfolio that are either performing kind of as expected or ahead of expected. Because the 5% that are underperforming, let's set those aside for a second. Because I would say, if we look at those underperformers, they're all idiosyncratic situations in the company. So let's take the 95% and let's look at that.

And when we look at that, revenues year-over-year and EBITDA year-over-year is up about 23%. If you look at the last quarter, revenue is up about a little over 5% and EBITDA is basically flat, which I thought that was kind of interesting. I mean, obviously, different industries are different. So you take the weighted average across the portfolio as kind of the index that's the easiest thing to look at. And so it's not perfect.

But let's just say that revenues were up over 5% and EBITDA is basically flat. And so I look down through the portfolio and asking why is that? And it's hard to look at it and say it's necessarily the economy per se, but there are certain things, like labor increases and cost of inputs, hard inputs. And so -- and I look at that and I say revenue is up and EBITDA is flat. So we certainly have seen the companies, this is a very general comment, with the pricing power to increase prices to maintain margins.

And so I'd say the quarter-over-quarter for general economic activity is kind of flat with these kind of sub issues that we're all hearing about in the economy. We look across our portfolio, and they seem to be doing a good job passing those costs on to their customers to maintain the margins -- margin dollars.

Mickey, the only thing from a timing perspective, I'd also say we're using April and May financials for all our valuation. Not that we're seeing any softening since then, but we're -- a lot of the financials are yet to come to see whether anything is occurring...

And I would say from, just commentary, we talk about these companies a lot. I would say, commentary-wise, I think that those steps kind of would continue through now. But Michael is right. I mean, the financial is all the BDCs used for valuations, as you know, Mickey, are April, May for a June quarter. So...

Yes, I understand. And Bowen, this may be idiosyncratic, but there was 1 loan downgraded to a 3. Is there any -- what was the nature of the problem there? Is it something specific to that company, or something broader?

Well, you're asking about the 1 small loan that was downgraded to a 4? There -- yes.

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

Yes. No, that's -- so there was 1 upgrade to 1, it was $10 million. And there were 3 loans across 2 portfolio companies that were downgraded to a 3. And they were all very small loan positions. They were definitely idiosyncratic.

One has to do with -- it's very idiosyncratic, based on certain pipeline stats and things that they have to achieve to basically offtake their products. So -- but it's very idiosyncratic to that company.

And it's also -- I should also say it's backed by a very strong-funded sponsor as well. So we've got (inaudible) amount of equity to support -- potential equity support, certainly, 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, 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 of '22. And that loan had a fair value of $13 million out of the $16 million.

And that restructuring resulted in us 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 we feel okay about where we are. I'm certainly very happy about the significant amount of liquidity that the company -- the sponsor put in the business and is sitting on the balance sheet currently.

I understand. That's helpful. And in terms of the unrealized depreciation 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. So on the depreciation, there's 2 pieces, right? We mentioned the $5.5 million on-balance sheet. And that's probably a little more than half credit and less than half spread market indexes. And the I-45 piece is 2/3 market indexes and quote movement, as you can imagine. And kind of 1/3, credit issue stuff.

Okay. And just to wrap up, in the SBIC, are you going to ask for the full $87.5 million of regulatory capital and the full 2 turns of leverage? Or how do we -- how should we expect that to work out over the next several quarters?

We'll absolutely, over time, be drawing the entire amount. But what you're faced to do during this process with the SBIC is you need to actually vet a portion of eligible assets and to go in as equity prior to asking for a commitment to draw upon. 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 vetting 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, yes. So we'll put $25 million of eligible assets as our equity, and then we'll draw the next $50 million. And as you get full -- when that $50 million is completed, then you go back to the SBIC for another commitment. Because your -- you need to vet prior to asking for a commitment.

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 just presenting the entire [deck]. But it's very typical to be stair-stepped like that. And there's not really any notable or even risk at all of really getting those commitments, but it's a stepped documentation process, and so we present it that way. Not to get confused by it being like...

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 can comment on the stuff here in a minute. But...

We certainly have -- I mean, looking at whatever economic volatility that we might be heading into, we previously stated a target of 1.2 to 1.3 on economic, and 1.1 to 1.2 on regulatory -- stated a target of 1.2 to 1.3 on economic and 1.1 to 1.2 on regulatory.

But right now, we're targeting regulatory at 1.0, and probably economic will be something more like 1.1 to 1.2. And I think until we see how long and deep the recession, if it was to come to pass, that's kind of where we'll try to target. And by doing so, we're going to need to raise equity. We started that. We noted earlier we raised $46 million in this previous quarter. As long as we're trading meaningfully above book, I think you'll continue to see us raise meaningful equity.

We haven't seen a slowdown in the portfolio. And I think Bowen noted earlier that, even in an environment where M&A activity might slow down, repayments will slow as well. So we will continue to see net portfolio growth. So raising equity alongside these originations and maintaining leverage in this conservative range is certainly one of our targets.

Yes, I think that's well said. 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 Michael said that perfectly.

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

Two questions -- or just 1 really, but 2 parts. In terms of the margins, pretty stable quarter-on-quarter. I think you said rates either reset post quarter or late in the quarter. And just -- so how do we think about your assets resetting versus the kind of the cadence of your liabilities resetting? Recognizing that a lot of your liabilities are fixed rate.

And then on rising rates, how are you -- how is that impacting your expectations for credit going forward? Obviously, it's a good thing. We should see your net interest income go up. But at the same time, companies have a higher debt servicing cost.

Yes. So on the -- for our liability side, we -- those reset, probably you could think of them on a monthly basis. And so there's -- that's probably on more of a weighted basis. You saw it go from 96 basis points to 2.29%, so from 1 quarter to the next. So the average is probably something in the mid 1.5% in terms of the increase of the interest expense.

For the assets, pretty much 90%, if not more, of the assets reset on that on the quarterly date. So we're looking at -- when we looked at our 6/30 numbers, if we were using the 2.9% -- 2.29% at the end of June, pro forma, on our balance sheet, we would have had an additional $0.03 of NII. So the $0.50 that we produced probably would have been closer to $0.53. And so that's -- that gives you a little guidepost going forward.

Yes so the second part of your question, we've got an analysis we track. And looking across the portfolio and taking the current index, the 2.29% index, and looking at the portfolio and then increasing that index up to a point where you start seeing meaningful credit issues, you really have to get that index up into the mid-5%. So 5.5%, plus or minus, on the index before you start seeing fixed charge coverage ratios across.

Keenly, a lot of the portfolio is still fantastic, but you kind of take the number of names at a 5.5-plus percent kind of LIBOR, and you start seeing your red light names that start to make you nervous, start to move like in a meaningful way. Or you really got to have the index up to 5.5-plus percent.

So I feel pretty good that we're not going to see -- I don't think we're going to see a 5.5%, 6% on the index. But that's -- feel pretty good about where the portfolio is.

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

My questions have been asked and answered. So just one quick one, if I can. I think, Michael, in your prepared remarks, you said you expect the dividends to follow the trajectory of pretax income. So are you talking about basically, if rates -- I mean, rates are up, right? If earnings go up, along the lines of that $0.03 or whatever over the quarter and the subsequent quarters, through at least the beginning of '23, the base dividend would be increasing at the same time.

And just for color, obviously, the forward curve, et cetera, is lower in the second half of '23 than it is in the first half of '23. So is that taken into account in terms of what path the dividend might follow? Because obviously, you don't necessarily want to be cutting the dividend when rates are falling. If that comes to pass, obviously.

Absolutely. That is certainly the way we're looking at it. I mean, 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 pretax 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. 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. Thank (inaudible) now disconnect.