Chris Rehberger - VP, Finance and Treasurer Bowen Diehl - President and CEO Michael Sarner - CFO.

Bryce Rowe - Robert W. Baird & Co..

Thank you for joining today's Capital Southwest Fourth Fiscal Quarter Earnings Call. Participating on the call today is Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, Vice President of Finance. I'll 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 fourth quarter 2017 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 report that fiscal year 2017 marked the first full fiscal year, post the spinoff of CSW Industrials, and a year in which we achieved our goal of establishing a premier middle market lending firm.

Our focus remains on building a portfolio that consists of a diverse set of debt and equity investments from both the lower middle market and the upper middle market. To this point, we believe we are well on our way to building a high-performing portfolio that generates market dividends to our shareholders while growing NAV per share.

We continued to execute under our shareholder-friendly, internally managed structure which at its foundation closely aligns our interests with the interests of our fellow shareholders in generating sustainable, long-term value through stable increasing dividends and NAV per share growth.

During our fiscal year ended March 31st, we delivered a 28% all-in return to shareholders, paying $0.79 per share in cumulative dividends during the year while experiencing stock price appreciation of 22%.

We believe this is evidence of the market both understanding and appreciating the evolution underway at Capital Southwest, from an all-equity focused BDC paying a negligible dividend to a credit-focused BDC paying a market dividend. Slide seven illustrates our progress in this evolution during fiscal year 2017.

As of the end of the March quarter, we generated a 4.5% annualized dividend yield to our shareholders, exclusive of the $0.26 per share special dividend, after increasing NAV per share during the year from $17.34 per share to $17.80 per share.

Though we are proud of our performance to-date, we look forward to continuing to execute on our strategy, with a goal of producing a market dividend for our shareholders while increasing NAV per share.

Our investment strategy is described on slide eight, which focuses on a blend of both lower middle market and upper middle market assets, has served as well throughout this fiscal year.

The upper middle market capability provides us the opportunity to invest capital relatively quickly in times of excess liquidity and to rotate capital out of the upper middle market as we continue to grow our lower middle-market portfolio.

The upper middle market capability also allows us to capitalize on market disruptions, as we saw during the fall of 2015 and spring of 2016. Our ability to underwrite strong credits in the upper middle market during this time resulted in heavy prepayment and attractive returns as the market strengthened over the subsequent 12 months.

As a result, we were able to rotate those dollars out of the upper middle market into the lower middle market, where we were able to originate highly attractive opportunities, many of which provide a potential for equity upside.

We believe investing a portion of our balance sheet in minority equity positions in our lower middle market companies is an important aspect of our strategy.

Our goal is to build out a granular portfolio of equity positions, which as they appreciate and are harvested, a portion will be available to pay out to shareholders as special dividends, as was the case in the fourth quarter.

As seen on slide nine, the evolution of our balance sheet continues, as 88% of our investable assets are now in securities generating recurring cash income compared to 1% in mid-2014 when we began the transformation of Capital Southwest from equity investing to middle market credit.

This fiscal year, as seen on slide 10, we grew our balance sheet credit portfolio by $75 million on a net basis, with $120 million in new investments and $45 million in total repayments during the year. Of our new investments, 87% are floating rate first lien and 100% are floating rate secure.

Specific to the fourth quarter, as we have laid out on slide 11, we originated $41 million in new investments, all in the lower middle market and all floating rate first lien loans, with the new portfolio companies having equity exposure. The investments during the quarter had a weighted average yield to maturity on the debt of 11.2%.

As seen on slide 12, we received $23 million in proceeds from four additional portfolio exits during the quarter, generating a weighted average IRR of 38%. This brings the total exits for the year to $41 million of proceeds from seven portfolio exits with a weighted average IRR of 29%.

Again, we believe these portfolio exits demonstrate early evidence of the attractive risk adjusted returns potential for our investment strategy. As seen on slide 13, excluding capital invested in I-45, our on balance sheet investment portfolio mix was 75% debt and 25% equity at quarter end.

The weighted average yield on our debt portfolio was 10.3% for the quarter, flat to the previous quarter. On slide 14, we break out our investment portfolio between the upper middle market, excluding I-45, and the lower middle market. The portfolio is approximately 50/50 weighted on a cost basis between the two markets.

We had 17 upper middle market investments comprised of first and second lien debt, with an average hold size of $5.6 million, a weighted average EBITDA of $101.3 million, a weighted average yield of 9.6%, and leverage, measured as debt to EBITDA through our security, of four times.

Our lower middle market portfolio consisted of 10 investments comprised of first lien, sub-debt, and equity investments with an average hold size of $9.4 million, a weighted average EBITDA of $7.4 million, a weighted average yield of 11.4%, and leverage through our security of 3.1 times.

As illustrated on slide 15, including our capital invested in I-45, our overall investment portfolio grew to $287 million as of the end of the year, with enhanced diversity and 95% of the invested assets generating yield for our shareholders.

During the March quarter, as seen on slide 16, at our I-45 senior loan fund experienced solid net portfolio growth, increasing portfolio assets to over $200 million from $187 million at the beginning of the quarter, and $99 million at the beginning of the year.

This quarter, I-45 originated $32 million in seven new and four add-on credit investments, while receiving $18 million in proceeds from the prepayment of five credits during the quarter.

As it has grown, the I-45 loan portfolio has maintained a weighted average asset yield in excess of our original business plan and an increasing ROE to Capital Southwest. The run rate recurring ROE to Capital Southwest is currently over 12%.

In recent quarters, however, accelerated OID [ph] and prepayment fees have boosted annualized ROEs to Capital Southwest to levels ranging from 14% to 18%. The I-45 portfolio is virtually all first lien, with diversity among industries and an average hold size of 2.3% of the portfolio.

The portfolio has a weighted average EBITDA of $81 million and a weighted average leverage through the I-45 security of three times. We continue to see robust credit markets in a generally favorable environment for our portfolio companies.

In the upper middle market, it has become more difficult to find value as spreads continue to tighten, leverage levels remain high, and many deals include dividend recaps and/or covenant light structures. In the lower middle market, the flow of quality deals was robust during the quarter.

Our pipeline remained solid through the quarter and has continued into the current quarter. We continue to see the banks be conservative in their lending approach. But we are seeing increased competition from non-bank senior lenders levering companies deep into the junior capital levels of the capital structure at very low senior lending rates.

Essentially stretch senior lenders, as they are often called, levering companies to unitranche levels at stretch senior pricing. Overall, the market remains competitive with significant liquidity needing to be put to work among non-bank lenders as well as private equity firms.

As we have previously stated, to mitigate risk in times like these, which we believe is characteristic of being late in the economic cycle, we must aggressively broaden our deal pipeline, but we must maintain both our conservative underwriting approach and high levels of investment discipline.

For example, during the fiscal year 2017, we closed on approximately 1.5% of the lower middle market opportunities we reviewed, and approximately 12.8% of upper middle market opportunities we reviewed.

In every deal we structure and underwrite, we stress test the capital structure by modeling a recession during our hold period equivalent to the Great Recession.

As a result, we focus on situations where we can understand how the business and industry performed during the Great Recession, applying capital structures to these businesses that are appropriate for their potential volatility, and invest our shareholders' capital in securities that will remain inside enterprise value with interest being paid during a repeat of such tough times.

While this discipline sometimes causes us to pass on opportunities or lose opportunities we like, we are pleased with the credits we have added to our portfolio, and continue to believe this discipline will pay off in the long run. I will now hand the call over to Michael Sarner to review the specifics of our financial performance for the quarter..

Thanks Bowen. On the capital raising front, during fiscal year 2017, we closed on a $150 million ING Capital led credit facility, consisting of $100 million in commitments from five banks, and a $50 million accordion. As of March 31, 2017, we had $25 million drawn on their credit facility.

In addition, we were able to close on the remainder of the I-45 credit facility commitments led by Deutsche Bank, bringing the facility to its target size of $165 million. As of March 31, 2017, I-45 had $122 million drawn on the facility.

As of the end of the quarter, we had $22 million in balance sheet cash, $75 million available on the ING credit facility and $43 million in additional capacity on the I-45 credit facility, leaving us with significant liquidity to fund investments going forward.

Further, we had a leverage ratio of 0.1 to 1, leaving us substantial running room to increase our balance sheet leverage and drive dividend growth for our shareholders.

Turning to the income statement on slide 18, our investment portfolio produced $7.7 million in investment income this quarter, with a weighted average yield on all investments of 10.5%. This represented an increase of $900,000 or 13% from the previous quarter's investment income of $6.9 million.

The increase was due to net investment growth in the credit portfolio during the quarter and an increase in prepayment fees, as well as an increase in the cash dividend from I-45 generated from short-term realized gains.

We incurred $3.6 million in operating expenses, excluding tax and interest expense, this quarter, an increase of $500,000 or 16% versus $3.1 million in the previous quarter. The increase in operating expenses was due primarily to legal fees related to corporate matters and an increase in our year-end bonus accrual.

For the quarter, we earned pretax net investment income of $3.6 million or $0.22 per share compared to $3.4 million or $0.21 per share in the previous period. We paid a $0.19 per share quarterly dividend along with a $0.26 per share special dividend on April 3rd for the quarter ended March 31st.

Our net investment income exceeded our quarterly dividend this quarter [ph] by $0.03 per share. We continue to focus on growing our quarterly dividends in a sustainable manner. Our dividend coverage over the last 12 months was 115%.

As mentioned on previous calls, as we continue to work toward our goal of receiving approval from the SBA for a new SBIC license with participation in the SBIC debenture program, we would provide updates to our shareholders.

We have received recent feedback from the SBA indicating their preference to monitor our post-spinoff progress and reassess our portfolio once it has had the opportunity to further season. We appreciate the feedback from the SBA and will continue our dialogue with their staff as we continue to build our lower middle market portfolio.

In terms of our capitalization strategy, we have been actively working with banks to further diversify our financing sources. And this delay should not impact our ability to grow our portfolio and achieve a competitive market dividend yield.

We will continue to update our shareholders with our progress toward receiving a new SBIC license with participation in the SBIC debenture program in the future.

Finally, this year we conducted a review of our organizational documents and determined that Capital Southwest and its shareholders would benefit from changing Capital Southwest's state of incorporation from Texas to Maryland.

We found that Capital Southwest was the only business development company incorporated in Texas, with most other BDCs incorporated in either Maryland our Delaware due to those states' well-developed case law and familiarity with registered investment companies.

After a full evaluation, the Board of Directors decided that converting Capital Southwest to a Maryland corporation was the most beneficial course of action for our shareholders.

In reviewing the details included within the Maryland provisions, the Board of Directors has proactively chosen to opt out of the several Maryland provisions that could restrict shareholder rights in an effort to preserve current shareholder rights and distinguish ourselves from other business development companies incorporated in Maryland.

The proxy statement includes a summary of changes that will result from our proposed conversion. We strongly urge each of our shareholders to read the detailed provided for each provision change included within the proxy and contact either Bowen or myself with any questions you may have. 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 our investment strategy with the creation of long-term sustainable shareholder value as our most important goal.

This concludes our prepared remarks. I would like to turn the call over to the operator to open up the line for Q&A..

Thank you. [Operator Instructions] Our first question comes from the line of Bryce Rowe of Baird. Your line is now open..

Thanks good morning..

Hey Bryce..

Bowen, I was -- maybe you've covered this in past calls, but did want to ask you about the undistributed spillover income on the balance sheet. Just curious how you think about that philosophically, how you think about paying that out to shareholders over the course of time..

Yes, you want to cover that?.

Sure. So, first of all, thanks for the question, Bryce. First of all, that's built up, first and foremost, by some undistributed realized gains in the past as well as some of the taxable income that we earned this year that wasn't paid out. We see having a UTI balance is important sort of for the shareholders for a surety on the dividend.

We see ourselves paying out a portion in time, certainly not the entire amount, as we think building up and maintaining NAV growth is important to our shareholders..

Yes, I mean like you said, I think paying that out over time is our intent. It does provide surety of the dividend in times where we might have heavy prepayments at the same time as light originations if the market gets really white hot and we're just not comfortable investing.

There's also a benefit as we move towards a time where we're above book and we have an equity offering on the table that it helps cushion the dividends, the J curve effect, if you will, post-equity offer..

Yes, got it. That's helpful. And then appreciate the comments around the market, bifurcating both lower middle market and upper middle market. It sounds like the upper middle market is increasingly competitive and maybe a little less attractive.

Do we read into that that maybe future activity, at least over the next couple quarters, will likely be driven by lower middle market activity?.

Yes, I mean I would say that's absolutely right. Our lower middle market activity is -- we're finding some pretty attractive opportunities, as you saw in our quarterly release, the deals we closed recently. We've seen similar transactions coming into this quarter. So, the lower middle market, as we've said before, is our premium product.

The upper middle market is important to manage cash inflows and outflows. It's a slightly more liquid market obviously. The spreads for quality deals have been -- have tightened significantly. I-45 remains a very attractive financing vehicle, given the terms, provisions of that credit facility with Deutsche Bank.

So, for the quality companies there's room -- they fit in that vehicle and still create ROEs that make sense for our shareholders. On our balance sheet, those assets right now -- we're pretty heavily focused on the lower middle market, because we think the value is there where it's tougher on the upper middle market side..

Yes, got it. And then maybe one more for you, Michael. On the expense side of the income statement, you obviously called out some bonus accruals, incentive accruals, as well as some legal expenses. Just curious what portion of that may recur here in the future? Thanks..

Sure. So, a portion of this was included in actually in the proxy when we discuss the reincorporation. So, we're seeing about $100,000 to $200,000 of expense that we've spent over the last quarter. I think we're really at the tail end of that, so some of that is going to go away.

And in terms of the bonus accrual the Board had indicated, based on performance for the company, that they increased a few hundred thousand -- $200,000 for the bonus accruals for the entire pool this year. And that's obviously a one-time in nature.

So, we expect really the run rate to come back down to around a $3.4 million to $3.5 million on a quarterly basis..

Great. That's helpful. Thank you, guys. Appreciate it..

Thanks Bryce..

Thank you. [Operator Instructions] And I'm showing no further questions at this time. I'd hand the call back over to Bowen Diehl for any closing remarks..

Thank you, operator and thank you all for participating in our call today. We look forward to keeping you apprised of our progress on future quarterly calls. Again, shareholder value creation is our absolute first priority and we intend to work hard to make that happen. Thank you very much and we hope everyone has a great rest of the week..

Ladies and gentlemen, thank you for participating in today's conference. That does conclude today's program. You can [ph] disconnect. Everyone have a great day..