CSWC - NASDAQ

Thank you for joining today's Capital Southwest First Quarter Fiscal Year 2024 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, 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, 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 at www.capitalsouthwest.com. 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 UTI 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 continues to be strong. Activity continued to be focused mainly on acquisitions rather than refinancing and the environment continues to be a favorable one for non-bank first lien lenders like Capital Southwest. Private equity firms and business owners continue to transact, while non-bank lenders continue to provide more certainty to closing the traditional bank financing structures. We continue to see loan pricing spread on new portfolio company loans that were 50 to 100 basis points higher than a year ago and leverage level 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 calculated as our first lien loan divided by the enterprise value being paid for an acquisition that were 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 CSWC

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 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 UTI balance of $0.34 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 $1.11 per share in unrealized appreciation on the equity portfolio. For the quarter, we increased total investment income from our portfolio 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 LTM 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 CSWC 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 NAV per share at the end of the quarter, increased by $0.01 per share to $16.38. The primary drivers of the NAV per share increase for the quarter were earnings in excess of our dividends for the quarter and accretion from the issuance of common stock at a premium to NAV 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 upsize 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 Investor Services 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 environment. It's worth noting that CSWC 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. We believe we have further strengthened our balance sheet this quarter with the baby bond transaction as well as the upsize and extension of the credit facility. These efforts, along with our previous unsecured bond issuances, our SBA license which gives us access to long-term fixed debt at attractive rates and our continued diligence in moderating leverage through accretive equity issuances utilizing both our ATM program as well as the secondary equity market ensure we will continue to maintain significant liquidity, conservative leverage, and adequate covenant cushions throughout the economic cycle. I will now hand the call back to Bowen for some final comments.

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 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% which is -- 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 life. 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.

Thank you. [Operator Instructions] The first question that we have is coming from Kyle Joseph of Jefferies. Your line is open.

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?

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 what's reliable in this market to getting to close and so that's helping like I said in my remarks, I mean that's helping first lien unit tranche-type lenders like Capital Southwest and others. And so my guess is – my expectation is that that will continue. In our first lien loans a lot of the holder revolvers are ourselves. And so having a bank above us that holds a revolver that may not fund in the revolver, et cetera, if things were to get worse for example, doesn't really affect our portfolio in a meaningful way as long as the companies – underlying companies are doing well across the portfolio.

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. And 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, and they were going to pare back commitments to those paying less confidence in. So I think that's probably the sort of the mantra right now in the market.

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 rev and any EBITDA growth trends you're seeing in your portfolio and how that's changed over the last few quarters?

Yes. So it's kind of been the same over the last few quarters. So our revenue growth kind of year-over-year is kind of tracking in high single digits kind of 8% or 9% on the top line. And the EBITDA growth on a weighted average basis is 2.5%, 3% growth over the last year. It's kind of tracking. It's a good question to ask us and all the BDCs every quarter. But for us it's kind of been tracking there for the last several quarters.

Got it. That’s it for me. Thanks for answering my question.

Thanks, Kyle.

The next question will be coming from Sean Paul Adams [ph] of Raymond James. Your line is open.

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?

Sure. That's a good question. As I alluded to my comments across the portfolio we've been absolutely very happy with the support the private equity firms are willing to provide. And it's not only just in struggling situations. It's in – the interest burden is going up. So they're looking for ways to cut operating costs to get the business efficient in providing that leadership to the company is obviously [indiscernible] healthy for companies but also just definitely like to see them doing that. Also if they want to continue to spend an extra growth capital to maintain CapEx budgets et cetera. They put putting capital in to support those growth initiatives has been definitely there. And in the struggling situations -- there's only a few of them fortunately not going within our portfolio, but in those situations the sponsors have been stepping up and supporting the businesses. The two non-accruals this quarter both were free rated last quarter. The company's, I would just -- they're both sponsor backed. I would tell you our expectation is probably the most relevant thing. Our expectation is that both of those will be restructured by the end of this year which would -- we would expect to be partially debt back on accrual. And then part of our debt is converted to equity and we would own a portion of the business. And so in both of those situations that is absolutely our expectation based on what's going on with the companies. And those two companies it's pretty idiosyncratic. I mean it's things like customer shifts -- business lines they're shutting down because they were candidly because they were underperforming and so making a smart decision to stop them and there's costs associated with that. Basically top-line moving, but not really -- it's more specific to those companies and those management teams as opposed anything I can point to the economy on.

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

Yes. I mean, looking at our portfolio I kind of look at what are the signals we're seeing in the portfolio. And I would say across the portfolio no sectors that I would say are like bright line -- and bright light struggling. It's interesting on the -- we're still -- we saw a couple of quarters ago trends with a couple of our portfolio companies that sell into retailers' inventories and those retailer inventories were pulling back readjusting if you will. And those companies sales decline in the short-term once that inventory has normalized and the sales kind of -- sales from our portfolio company that's supplying those inventories stabilizes and starts to increase and that's happening in those two cases because the retailers' inventories have been reset. On the consumer side, it's kind of mixed. I mean half our companies are -- half are looking down the list and half of them are doing great and the other half are starting to talk about softness, but in one case we're starting to see some softness. So I would say pretty mix from a consumer perspective across our portfolio. The transport sector we've got a company in the transport sector. It's clearly reporting softness. Not enough to really worry you as a first lien lender, but it's definitely seeing softness. The industrial companies are doing great. We've got two or three industrial companies and they're just -- they're not going to knock on wood, crank it along. So data points I guess are going in different directions. And again no one sector that's causing us angst. But some of those are some of the interesting kind of signals we've seen across the portfolio.

Okay. Perfect. Thank you for the commentary.

Thank you. One moment. Our next question will be coming from Bryce Rowe of B. Riley. Your line is open.

Thanks. Good morning. Bowen, I wanted to maybe start on the prepared remarks about maybe M&A. M&A is starting to pick up a bit here and just kind of wanted to get your view of 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?

Yeah. We have -- in our portfolio out of 90 something companies, we have a handful of companies that we have visibility on sale processes that are starting. And so, obviously that would be an uptick from what we've seen in the past few quarters. But clearly, in most of the cases those could end up being significant equity wins for us. And so that happens to be fantastic. I'm not sure, if our comment that we expect kind of net growth across the portfolio I think is definitely still the case. But refinancing like I said no surprise refinancing activity tends to be relatively light because spreads are wider. But the M&A activity there's a handful of situations where sponsors are seeking a chance to ring the bell.

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

Okay. And maybe a follow-up. The -- you've seen good appreciation within the equity book. Is that more a function of what you're seeing with potential M&A like you just talked about, or is it more kind of widespread across the portfolio?

Well, I mean our equity portfolio is exactly that it's the portfolio. So we have companies that are doing really well and others that are doing fine and then others that are either multiples in the sectors are coming down slightly or the companies are softening a bit from an equity perspective. But overall, the portfolio has done really well and we would -- some of these companies have a lot of growth left.

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 -- is that signaling pipeline or some level of conservatism on your part or maybe a combination of both?

I would definitely say it's a combination of both. We would probably tell you that, this is where we are right now at the low-end and probably where we'd want to maintain. But having said your earlier question regarding repayments, if we do see a flurry of repayments towards the end of the year, originations are robust as well, but you might end up even de-levering slightly more. But we will continue to use our ATM and certainly with the bond issuance and the revolver we put in ample liquidity to be able to maintain net originations as well as control leverage.

Yeah. And Bryce, I mean, to your more macro part of your question, I mean, we've been attempting to speak to what we're doing at the BDC from a leverage perspective in the last several quarters. And as we've always said, I mean we're managing everything here from a full cycle perspective. And so certainly, I think, everyone would agree that the potential for a recession is high. That's why all the comment or questions about what's going on in the portfolio across all BDCs. And so we're at the top of the cycle, right? And so, we want to be low levered at the top of the cycle. So when we go through the cycle, we can do all the things we want to be able to do. We want to be able to support our companies, the economics on support capital ends up being very, very lender friendly, very attractive. There'll be deals that we can underwrite and do throughout the recession. I think most asset managers would agree that, your vintage of deals invested kind of in the second half of recession end up being the best vintages most of the time. So we want to be in a position to participate in that. And if our stock doesn't trade well trades meaning below NAV, we want to buy it back. And so all those things and if, we're not great and if our stock is not trading well then all those things will be levering up a bit. And so we want to be at low leverage at the top of the cycle and then potentially lever up if the environment just described paves a path. And so that's what we've done with position the BDC. And if you look at our earnings divided by NAV, it's one of the highest in the industry with one of the lowest utilization of leverage in the industry. So we don't really need to lever the BDC up, as we sit here today. We can prepare for an economic cycle. And if for some reason it doesn't come great then we'd all be thrilled. But that's kind of what we've been trying to do. And feel really good about, what we've accomplished and where we positioned ourselves.

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

Thanks.

Thank you. This concludes the Q&A session. I would like to turn the call over to Bowen Diehl, for closing remarks. Please go ahead.

Thank you everyone. And we appreciate everybody being on the call today and look forward to giving you, updates in the future. And have a great rest of the week.