Chris Rehberger – Vice President-Finance Bowen Diehl – Chief Executive Officer Michael Sarner – Chief Financial Officer.

Mickey Schleien – Ladenburg Christopher Testa – National Securities Greg Mason – Ares Management.

Thank you for joining today’s Capital Southwest Third 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 third fiscal 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 be here with you this morning to announce our quarterly results as well as share our progress on the capitalization front. As shown on slide 5 during the quarter we continued our growth, increasing pre-tax net investment income to $0.27 per share while seeing further portfolio appreciation.

NAV increased $0.18 per share to $18.44 per share. During the quarter, we achieved net portfolio of growth of 14% increasing the investment portfolio to $367 million from $322 million at the end of the prior quarter.

In addition, our equity five senior loan fund continued its strong performance providing a 13.5% effective yield on our capital in the fund for the quarter. We were also pleased to report that we are now three years into our credit strategy and we continue to have a portfolio with no loans on non-accrual.

As mentioned last quarter, our one watch list credit, a first lien loan, does remain on our internal watch list however the company’s performance has improved, the interest rate on our loan has increased and since quarter end the company had paid down the loan by 10%, reducing our loan from $11 million to less than $10 million.

While we are most optimistic about the company’s performance, this loan does remain as our only investment with an investment rating of three on our investment rating system. As we have previously stated, we are continually focused on effectively building out the right side of our balance sheet to ensure that we have a funded path to target leverage.

During the quarter, as seen on Slide 6, we made significant progress on this front. We have been very pleased with the tremendous demand from both the bank and bond markets for our investment strategy and track record.

In November, we amended and extended the maturity on our ING-led balance sheet credit facility, while also attaining increased commitments of $65 million from both existing and new bank partners, increasing the facility to $180 million and meaningfully decreasing the cost of the facility. Michael will discuss the facility in more detail in a moment.

We also raised $57.5 million in the capital markets through our Baby Bonds note offering in December. The notes pay acute bond of 5.95%, have a maturity of December 2022 and trade on NASDAQ under the ticker CSWCL.

We were pleased with the market demand as the bond deal was significantly oversubscribed, having strong demand from both retail and institutional investors. In fact, at the time of issuance, our bond had the lowest spread to the applicable five year treasury among BDC Baby Bond issuances, closed over the past few years.

This quarter marked the eighth consecutive quarter of increased dividends to our shareholders. As seen on Slide 7, as we paid out $0.26 per share and achieved and annualized yield of 6.3% as of December 31.

Over the past four quarters, Capital Southwest paid a $1.16 per share in dividends generated from income in gains from strong portfolio performance, while increasing NAV per share from $17.88 to $18.44 driven primarily by appreciation of our equity investments.

Now as we move forward, I'm pleased to report, as seen on Slide 8, that we now have a tangible funded path to target leverage.

We ended the quarter with regulatory leverage of only 0.3 to 1, $145 million available on our ING-led credit facility and $21 million in balance sheet cash, providing us the opportunity to continue our track record of earnings growth, significantly increasing portfolio of net investment income and shareholder dividends.

Our investment strategy as described on Slide 9, 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-investments is important to driving growth and NAV per share, while mitigating future credit losses.

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 10, we committed $71 million to four new portfolio investments, one refinancing of an existing portfolio investments, one refinancing of an existing portfolio, and two add-on investments to existing portfolio companies. All but one investment were in the Lower Middle Market and two included equity co-investments.

On a weighted average basis, the debt investments made during the quarter had a yield to maturity of 11.4%. During the quarter, as seen on Slide 11, we received $21 million in proceeds from the exit of three Upper Middle Market investments, of which one was first lien and two were second lien. The exits realized a weighted average IRR of 13.2%.

This continues our track record of generating strong risk-adjusted returns on our shareholders' capital, as we have now had 17 exits since the launch of our credit strategy three years ago, representing almost $100 million in proceeds and weighted average IRR on the exits of over 19%.

On Slide 12, we break out our on-balance sheet credit portfolio, excluding I-45, between the Lower Middle Market and the Upper Middle Market.

We achieved strong Lower Middle Market portfolio growth during the quarter, and as of the end of the quarter, the portfolio was approximately 70% to 30 weighted on a cost basis, between the Lower Middle Market and Upper Middle Market respectively.

We had 17 Lower Middle Market investments comprised of first lien, sub-debt and equity securities, with an average hold size of $10.9 million, a weighted average EBITDA of $8.9 million, a weighted average yield of 11.5% and leverage measured as debt to EBITDA through our security of 3.4 times.

Within our Lower Middle Market portfolio as of end of the quarter, Capital Southwest held equity ownership in approximately 70% of our portfolio companies.

Our Upper Middle Market portfolio consisted of 11 loans, including first lien and second lien debt, with an average hold side of $6.3 million, a weighted average EBITDA of $88.1 million and weighted average yield of 10.2% and leverage through our security of 4.3 times.

Our on-balance sheet credit portfolio of Capital Southwest, again excluding I-45, grew 21% to $226 million, as shown on Slide 13, driven by strong Lower Middle Market first lien activity. As the portfolio has grown, the percentage of the portfolio represented portfolio represented by the Lower Middle Market has increased by design to now almost 70%.

As we have stated on prior calls, we believe the Lower Middle Market to be the market that has demonstrated the most attractive risk-adjusted returns through the economic cycle, as debt pricing, terms and leverage are more attractive, and we often have the opportunity to invest equity in companies with very interesting growth prospects.

While we have increased the percentage of the portfolio represented by the Lower Middle Market, we have also continue to heavily emphasize first lien loans in our investment strategy. As of the end of the quarter, 79% of our balance sheet credit portfolio was in first lien securities.

As demonstrated on Slide 18, including capital invested in I-45, our overall investment portfolio grew 14% quarter-over-quarter, increasing to $367 million from $322 million at the beginning of the quarter. We continue to believe we have positioned our invested assets well for any economic environment we may face in the future.

We have a well-diversified portfolio, heavily biased towards first lien and secured debt investments, preparing us for a recession. While at the same time, we have a portfolio that is 95% invested in floating rate securities as can be seen on Slide 15. So there – our shareholders also continue to benefit, should interest rates continue to rise.

Specific to our I-45 senior loan fund, as seen on Slide 16, we saw slight net portfolio contraction as originations and prepayments essentially offset each other, and ordinary course amortization of the first lien loans resulted in net portfolio assets decreasing $6 million to $218 million from $224 million at the beginning of the quarter.

During the quarter, I-45 committed $32 million to new credit investments, consisting of $20 million in new portfolio investments and $12 million invested in the refinancing of existing portfolio companies. The $20 million in new dollars invested was offset by approximately $19 million in exits and sales in the portfolio.

As of the end of the quarter, the I-45 portfolio was 96% first lien, with diversity among industries and an average hold size of 2.3% of the portfolio. The portfolio had weighted average EBITDA of $73 million and weighted average leverage through the I-45 security of 3.3x. In our markets, the environment remains robust and highly competitive.

While the business and economic environment is highly favorable for our portfolio companies, with quantum of liquidity in both the private equity and leverage finance markets has given rise to valuation and leverage levels that make it more difficult to find and consistently generate attractive risk-adjusted returns.

As most of you know, the Upper Middle Market or Syndicated market, has seen tightening of spreads as the market has given back much of the increase in LIBOR and reduced LIBOR spreads, all while leverage levels are up, and in many cases, the portion of underwritten EBITDA represented by pro forma adjustments are at elevated levels.

This clearly creates an environment that makes it more difficult to generate attractive risk-adjusted returns in this market.

We believe being highly selective in the credits we invest in, taking small position so that our portfolio is highly granular, diverse and relatively easy to sell out of, all while investing through an efficiently leveraged vehicle like a senior loan fund is the best strategy for creating returns in this market right now.

As a result, we will see quarters where I-45 asset base may contract, which we are okay with if it is a result of our keeping to our discipline. In the Lower Middle Market, it is also very competitive and has been that way for a while. So I don't believe the environment has changed all that much over the past couple of quarters.

Over the past year, LIBOR spreads on senior loans have generally tightened by 50 to 100 basis points, but increases in leverage levels have been much less pronounced than we have seen in the Upper Middle Market. And important loan terms such as covenants have remained intact.

We continue to focus on maximizing our investment pipeline while maintaining investment discipline we have consistently described to you since the launch of our credit strategy three years ago.

We continue to model each and every investments we underwrite for stress test purposes, assuming the Great Recession repeats itself during our hold period, and insisting that a financial market – financial model demonstrate that our loan remains well within enterprise value, with our interest being paid through such a cycle.

This methodology will, by definition, buy us the portfolio towards first lien, while appropriately matching the capital structures in the portfolio to the potential volatility of the businesses and industries. We continue to be pleased with the flow of quality Lower Middle Market deals coming into our investment team.

After the traditional holiday season slowdown, deal flow has picked back up, and we are seeing a solid flow of interesting investment opportunities. Our close rate has remained less than 3% over the last 12 months, so a 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 to review the specifics of our financial performance for the quarter..

Thanks, Bowen. As seen on Slide 17, our investment portfolio produced $9 million in investment income this quarter, with a weighted average yield on all investments of 10.6%. This represents an increase of $510,000 or 6% versus $8.5 million from the previous quarter, mostly attributable to net portfolio growth.

We incurred $3.4 million in operating expenses this quarter, excluding tax and interest expense, a decrease of $84,000 or 2.4% versus $3.5 million in the previous quarter. The decrease in operating expenses is attributed to non-recurring expenses in the prior quarter for recruiting and corporate matters.

For the quarter, we earned pretax net investment income of $4.3 million or $0.27 per share, compared to $0.25 per share during the prior quarter, and we paid a $0.26 per share quarterly dividend compared to $0.24 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 107%. As seen on Slide 18, during the quarter, our NAV increased by $6 million to $298.5 million or $18.44 per share.

The increase in NAV is primarily due to an increase in net realized and unrealized gains during the quarter, generated primarily from appreciation in our equity portfolio. We produced a total annualized return on equity of 13.9% during the quarter.

In the fiscal year-to-date, we have increased NAV approximately $13.5 million, producing an 11.3% total return on equity. Last year, we produced a total return on equity of 8.5%.

As illustrated on Slide 19, our on-balance sheet investment portfolio mix, excluding capital invested in I-45, was 75% debt and 25% equity at quarter end, and 94% of our total portfolio produced income in the form of either interest or dividends.

The weighted average yield on our debt portfolio was 11% for the quarter, up from 10.7% the previous quarter, and as of the end of the quarter, there were no assets on non-accrual.

As Bowen mentioned earlier, during the quarter, we raised $57.5 million in unsecured notes, which included the initial offering of $50 million as well as an overallotment or greenshoe of $7.5 million. The notes were priced at 5.95% fixed, with a maturity of December 2022 and call protection of two years.

We are extremely pleased with the heavy demand from both institutional and retail investors as the deal was heavily oversubscribed. This capital is important to our long-term strategy as it turns out a significant portion of our debt for five years and at an attractive fixed rate in a rising rate environment.

Additionally, in November, we amended and upsized the ING-led balance sheet credit facility by $65 million to total commitments of $180 million from a lender group consisting of eight banks. The facility includes an accordion feature to increase the facility up to $250 million to accommodate future portfolio growth.

The amendment also includes, among other things, a 25 basis point reduction in pricing to LIBOR plus 3%, with a step down to LIBOR plus 2.75% when certain conditions are met and extension of the revolving period in final maturity and an increase in advance rates on first lien loans.

At quarter end, we had $145 million of available capacity on our balance sheet credit facility, $31 million in additional capacity on the I-45 credit facility and $21 million in balance sheet cash.

As seen on Slide 20, we have significant unused debt capacity and no payment obligations until late 2021, which will enable us to significantly grow our portfolio.

We believe our abilities to access various pockets of capital such as the bond market, our syndicated credit facilities at ING and Deutsche Bank, liquidity from both our Upper and Lower Middle Market portfolios, and in the future the equity markets and potentially SBIC debt, greatly enhances our ability to achieve an investment grade credit rating, a longer-term goal of ours.

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

Thanks, Michael. And thank you to everyone for joining us today. I’m extremely proud of what our team has accomplished so far, as we are all working tirelessly to execute our investment strategy and to be good stewards of our shareholders’ capital.

Everyone here at Capital Southwest is totally dedicated to our number one goal of the creation of long-term sustainable shareholder value. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A..

[Operator Instructions] Our first question comes from Mickey Schleien of Ladenburg..

Good morning everyone.

One of the reasons I think the equity markets have been spooked the last couple of days is the potential impact of higher interest rates on companies with meaningful leverage, and we look at the last couple of years in the middle market and terms have been pretty borrower friendly and that’s the time when you launch the credit strategy.

So I’m interested in understanding what assumptions you’ve made in terms of underwriting to manage this risk of climbing interest rates in terms of the impact on your borrowers?.

Yes, Mick, thanks for the question. Yes, we do model going forward increase in LIBOR rates, obviously, absent a recession. And so, we are – we have been looking at that from the beginning.

And then we also just – we tend to be, as you can see in the leverage statistics, we tend to be a bit more conservative than some out there on leverage in our portfolio. And so that also translates into companies that have cash flow that can handle increased interest rates..

Thank you for that.

And just one housekeeping question, can you tell me when you plan to file your 10-Q?.

Later this afternoon..

Okay. That’s it for me. Thanks for your time..

Thanks Mickey..

Thanks Mickey..

Our next question comes from Christopher Testa with National Securities..

Hey, good morning guys. Thank you taking my questions. Just looking at the one Upper Middle Market investment you guys had researched now, it’s second lien, has a 9.5% spread, which is still definitely good in the Upper Middle Market in this environment.

I’m wondering if you could provide some color on the leverage on this investment?.

Yes, so the leverage was typical second lien leverage and kind of the 5.5% EBITDA basis. This is a credit that we have been in from the – I think, it was maybe our first loan we made back in early 2015. So we followed it for quite a while. And it has performed well from a credit perspective. Probably so, so from an equity perspective.

And then the new deal included dividend to the sponsor, which essentially replaced the senior debt that had been paid down over the period of time. So the deal – that 9.5% spread of LIBOR was probably a function of that dividend, if anything else.

So as a credit, we followed it for a long time and know this really well, and so we decided to participate in the refinancing..

Okay, great. And just sticking with that topic, Bowen, the Upper Middle Market leverage crept up a bit quarter-over-quarter.

Is that primarily because of Redbox repaying?.

Exactly. Very well leverage and then the rest of the portfolio is kind of the same and so the average increased..

Got it. And how much – how are you thinking about potentially monetizing Media Recovery? I mean, I know it’s kind of a million-dollar question here, but it’s obviously a good time to be a seller in today’s market. But I know that this is one of your favorite assets and it keeps performing well.

And to the extent you do seek to monetize it, is that something that you would only monetize in the whole? Or would you be open to potentially selling them parts of it?.

Well, the good news is, it’s performing well. The company has no debt. It’s equity, all equity, we own 98% of the business. So we have options, right? And so, it’s not a business that we’re going to fall in love with and hold 10 years kind of thing.

But at the same time, we have the flexibility to make the right decision for our shareholders and our shareholders’ capital. So we have some flexibility to do a number of different things. So that could involve an outright sale, it could involve a partial sale and rollover in the credit. It could involve different things.

And so we are evaluating those things. There is, as I said on prior calls, a lot of interest in that asset from potential buyers. We’ve also got a number of new products that have been launched. An investor would want and owner like us would want to see those things season somewhat, so we can get value for those products.

And so, you have to really map that, the growth against the fact that you’re absolutely right. The market is white-hot to sell businesses. And so you don’t want to hold it necessarily too long, but you also – I mean, the company’s performing very well.

And so, I would just tell you that it’s an asset that we would look to monetize over the coming several quarters to a year or so and at the right time. And so, that's really how that kind of color I can give you at this point.

But we do have – with our ownership percentage, the unlevered balance sheet, and the company's growth prospects and cash flow, we have some optionality there..

Okay. That's good. And do you think that there is going to be in any increased challenges to grow in the SLF, given roughly 65% of the syndicated market is now par plus and the leverage multiples just continue to remain stubbornly high.

Do you foresee this presents any challenge to potentially growing the I-45 more?.

Well, clearly, the hot market, as I said in my comments, I mean, it's a tricky market in the Upper Middle Market. It's radically different than the Lower Middle Market. And so, you need to take small debts and put them in an efficiently levered vehicle like a senior loan fund so you can get equity return – ROE returns to our shareholders on it.

But I think, as I've I said before, our senior loan fund is kind of the right size. We're not itching to really grow it from an absolute dollars committed to the fund. So it's a nice vehicle that's making nice returns for us, making nice returns for Main Street, that relationship is going very well.

And so there will be quarters where, you know what, originations offset prepayments. And so the growth stagnates, maybe even contracts. But we're not really looking to greatly increase the size of the senior loan fund, certainly not in this Upper Middle Market environment..

Okay, great. And last one for me, and I'll hop back in the queue.

Michael, just on the credit facility, could you provide some detail on what the advance rate increased to? And what would trigger a step down to L plus 2.75% from $300 million?.

Sure. So the first lien advanced rates went up by 5% in the Upper and the Lower Middle markets. And the step down to L plus 2.75% is when we hit $325 million in NAV..

Got it. Okay, that’s all for me guys. Thanks for taking my questions..

Thanks Chris..

Thank you..

Our next question comes from Greg Mason with Ares Management..

Great. Good morning guys. I wanted to talk a little bit about the operating leverage in the business. Obviously, putting to work $145 million to get your target leverage, the math on income is pretty straightforward and the interest expense.

But given that you guys are internally managed, just looking to see as you build out your portfolio and get your target leverage, are there any expectations of increased operating expenses, higher cash compensation, other G&A? Just how do we think about the operating leverage in the business?.

Yes, I think – thanks for the question Greg. Really where we are right now, we have been between $3.4 million to $3.5 million in operating expenses over the last two or five quarters. I tell you, things going to be right around the same levels. This quarter, you saw an uptick in cash comp but our G&A came down.

Going forward, our spinoff comp is going to be coming out of the – our income statement as well. So we're right around 3% of our target operating leverage right now, going down to hopefully, 2.5% and eventually 2%. So I think Bowen has said in previous calls, we just hired two additional professionals on the previous quarter.

You see that in the cash comp. We're pretty much fully staffed at this point. So you shouldn't see a whole lot of additional G&A or cash comp..

All right, great. Thanks guys..

And I'm not showing any further questions at this time. I'll turn the call back over to Bowen..

Thank you, all. Thanks, everybody, for joining the call today. We appreciate your time, and we look forward to giving you further updates as we move forward. Have a great week..

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect. And have a wonderful day..