Is credit investing safer than equity investing

Merit from the Southwest Conference Call (CSWC), Q2 2019

Capital southwest


Results conference for the 2nd quarter of 2019
Nov. 7, 2018 11:00 p.m. ET


  • Prepared remarks
  • questions and answers
  • Call participant

Prepared Notes:


Thank you for participating in Capital Southwest's second conference call today. Taking part in the call today: Bowen Diehl, CEO; Michael Sarner, CFO; Chris Rehberger, VP Finance. I will now transfer the call to Chris Rehberger.

Chris Rehberger - Vice President, Finance

Many Thanks. I would like to remind everyone that we will make certain forward-looking statements during the course of this call. These statements are based on current conditions, currently available information and expectations, assumptions and assumptions of management. They are no guarantee of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements.

Information about these risks and uncertainties can be found in Capital Southwest's publicly available filings with the SEC. The company undertakes no obligation, except as required by law, to update or revise any forward-looking statements as a result of new information, future events, changed circumstances or any other reason after the date of this press release. I will now transfer the call to our President and Chief Executive Officer Bowen Diehl.

Bowen Diehl - Chairman of the Board of Directors

Thanks Chris. Thanks to everyone who joined our earnings call for the second quarter of fiscal 2019. In our prepared notes, we will refer to various slides in our Results Presentation, which can be found on our website at We look forward to being with you this morning and announcing our quarterly results. To sum up, we had a strong quarter of origins as deal flow activity has been particularly robust over the past few quarters and our deal teams have done an excellent job capitalizing on our relationships in the industry and some interesting opportunities close.

As we have repeatedly stated, our focus remains on building a portfolio in the lower mid-market segment consisting primarily of senior secured first-lien debt and equity investments across the loan portfolio that we believe have significant upside . We continue to work under our shareholder-friendly, internally managed structure, which, when it was founded, closely connects our interests with the interests of our fellow shareholders in order to achieve sustainable, long-term growth through stable, increasing dividends, capital preservation and NAV per share. Slide 6 provides some key summaries of our performance for the quarter ended September 30, 2018. For the quarter, we made $ 0.36 per share of pre-tax net income and paid a regular dividend of $ 0.34 per share.

On top of that, we paid an additional dividend of $ 0.10 per share, funded from our sizeable UTI balance generated from excessive income and capital gains accumulated from our investment strategy to date. As previously mentioned, we expect that our current UTI balance, expected future capital gains from our portfolio holdings, and gains in excess of the distribution will enable us to add an additional dividend of $ 0 to our shareholders every quarter for the foreseeable future To pay $ 10 per share. The dividends paid out for the quarter of $ 0.44 per share produced an annualized dividend yield of 9.3%. During the quarter, we grew our portfolio 20% from $ 411 million on June 30, 2018 to $ 492 million on September 30, 2018, bringing total commitments to six new portfolio companies and $ 97 million made three additional investments in existing portfolio companies.

Five of the six deals were launched directly by our investment teams as they continue to demonstrate our market position. Our senior loan fund I-45 also continued to perform well, delivering an annualized cash-on-cash return on our capital in the fund for our quarter. We are pleased that for almost four years since we announced and initiated our credit strategy, we have had a no-loan portfolio with no provision and only one investment on our internal watchlist. During the quarter, we continued to grow on the right side of our balance sheet and continued our at-the-market, or ATM, program on our unsecured baby bonds, which trade on the NASDAQ under the ticker CSWCL.

To date, we've had gross proceeds of approximately $ 20 million on this program with an effective return of 5.86%. As a result, the total outstanding CSWCL bonds are compared to the original transaction volume of 57.5 million. USD has risen to currently around USD 77 million. At the end of the quarter, we had $ 127 million outstanding in our credit facility, leaving us with $ 83 million to grow our portfolio and earnings. Additionally, after the quarter ended, we issued 700,000 shares of common stock at a price of $ 18.90 per share. The offering was valued above net asset value and less than a 2% discount from the market, for proceeds of $ 13.2 million.

Interestingly, this offer represented the first equity raised by Capital Southwest since going public in 1961. The offer was opportunistic in a sense that we responded to direct inquiries from two highly respected institutional investors with deep knowledge of the BDC space that we are, I am pleased to have responded as shareholders. We have been able to make the offering so large that these institutions can build significant positions in Capital Southwest without being too large to dilute our shareholder base too much. The size of the supply is also of an order of magnitude that can be used quickly to generate assets and does not significantly extend our path to achieving the desired leverage effect.

As we've demonstrated in our recent quarterly updates, Slide 7 shows our ongoing track record of increasing shareholder dividend payments by carefully building a portfolio of high performing, income generating assets. On our way to achieving a more complete leverage balance, our internally managed structure will benefit our shareholders as virtually 100% of the additional profits we generate for the benefit of our shareholders are younger than a lucrative external management contract. This slide also illustrates our consistent track record of increasing NAV through our equity portfolio investments. Adjusted NAV per share, defined as NAV plus cumulative additional dividends paid over time, rose for the quarter from $ 19.73 per share to $ 19.80 per share, largely due to the unrealized appreciation of our investments for the Quarter.

Our investment strategy outlined on slide 8, which focuses on a mix of lower-mid-market and upper-mid-market assets, gives us strategic flexibility as we have built the robust ability to look for attractive risk-adjusted returns in both markets. In our core market, the lower middle market, we are directly tapping into opportunities that consist of debt and equity investments that are made alongside our debt. Building a high performing and granular portfolio of equity co-investments is important to increase NAV per share and reduce future credit losses. On the other hand, our capabilities and presence in the upper mid-market allow us to invest opportunistically in a more liquid market when there are attractive risk-adjusted returns.

As we can see, we have found ourselves investing in an environment where it is very difficult to find value in the upper mid-market. With the deals and structures that we deem acceptable, we often opt for small positions of around $ 5 million that fit nicely into I-45 from a risk / return perspective. At the same time, our robust lower mid-market origination platform has generated strong deal flow allowing us to close some very attractive opportunities from a risk / return perspective. We believe that maximizing the top end of our origination funnel is critical to achieving strong credit investment performance over time by ensuring that we consider a wide variety of transactions in order to maintain our conservative underwriting standards Be able to deploy and wisely expand in a competitive marketplace with a portfolio that spans the economic cycle.

As you can see on slide 9, we committed $ 97 million for six new portfolio investments and three add-on investments for existing portfolio companies during the quarter. All but one of the investments were in the lower middle market, with all of the lower middle market transactions being initiated and directed directly by Capital Southwest. The weighted average debt investments made during the quarter had a residual maturity of 11.9%. Our beginnings in the quarter included $ 75.2 million senior secured debt consisting of $ 63.6 million first lien secured debt and $ 8.5 million secured debt investments , as well as $ 3.1 million secured secondary bonds placed alongside a new secured first lien loan debt investment.

During the quarter, we put $ 14.7 million in equity - in co-investments that were funded alongside four of the six new portfolio transactions and all three add-on transactions. In addition, we committed to four of the new portfolio transactions for an amount of $ 6.7 million and one of the add-on transactions either in the form of revolving credit facilities or delayed maturity loans that commit to certain amounts Fund on certain terms including EBITDA growth targets. On slide 10, we divide our balance sheet loan portfolio (excluding I-45) between the lower middle market and the upper middle market. At the end of the quarter, the total portfolio for the lower middle market was weighted at approx. 74% and for the upper middle market at 23% on a cost basis.

We had 24 mid-market investments with an average hold size of $ 12.2 million, weighted average EBITDA of $ 9 million, and weighted average return of 11.9%, as well as - measured as debt versus EBITDA - and the leverage, measured as leverage versus EBITDA by our security of 3, 4 times. At the end of the quarter, we held around 75% of our portfolio companies in our lower middle market portfolio. Our upper mid-market portfolio consisted of eleven loans with an average hold size of $ 7.9 million, weighted average EBITDA of $ 66.7 million, weighted average return of 10.8%, and leverage on our security of 3, 8-fold. Our on-balance sheet loan portfolio at Capital Southwest, shown on slide 11, which again fails without I-45, increased by 24% from $ 302 million on June 30, 2018 to $ 337 million on September 30, 2018, driven by the strong lower middle market creation activity.

With the growth of the portfolio, the percentage of the loan portfolio that is represented in the lower middle market has risen to 74% due to the design. While we have increased the percentage of the portfolio in the lower mid-market, we have also continued to emphasize senior-secured first-lien bonds in our investment strategy. At the end of the quarter, we had 85% of our balance sheet loan portfolio in senior-secured first-tier notes. Since launching our credit strategy nearly four years ago, we've ended up investing $ 521 million (excluding I-45 activities) and harvesting 20 exits that generate $ 128 million in revenue with a weighted average IRR of 17 percent.

As shown on slide 12, we've built a well-diversified portfolio that is heavily biased towards first-lien debt and is preparing for the recession. At the same time, 96% of our credit exposure is invested in floating rate securities (see Figure 13), so our shareholders will continue to benefit if interest rates continue to rise. As shown on slide 14, the I-45 portfolio was 94% (First Lien) at the end of the quarter, with industry diversity and average hold size being 2.2% of the portfolio. The portfolio had a weighted average EBITDA of $ 72 million and a weighted average leverage of 3.8.

We have been pleased with the solid performance of the I-45 over the past three years. We and our partner at I-45, Main Street Capital, have invested $ 468 million through the fund, reaping 47 exits, and reaping 47 exits that generate $ 180 million in revenue with a weighted average IRR of 11, Generate 7%. I'm going to transfer the call to Michael now to review the specifics of our financial performance for the quarter.

Michael Sarner - Chief Financial Officer

Thanks, Bowen. As can be seen on slide 15, our investment portfolio generated investment income of $ 12.6 million for the quarter, with the weighted average return on all investments at 11%. This was an increase of $ 1.5 million from $ 11.1 million in the previous quarter, mainly driven by net portfolio growth. The weighted average return on our loan portfolio was 11.6% in the quarter, slightly below the prior-year quarter's figure of 11.7%.

There were no assets at the end of the quarter. Excluding interest, operating expenses were $ 3.7 million for the quarter, which was the same as the prior quarter. For the quarter, we had net investment income before tax of $ 5.8 million, or $ 0.36 per share, compared to $ 0.31 per share for the previous quarter. As a result, we paid $ 0.34 per share for regular dividends for the quarter, an increase of $ 0.05 per share from $ 0.29 per share paid the previous quarter.

We continue to focus on sustained growth in our regular dividends. This shows our cumulative regular dividend coverage of 102% since the spin-off. As Bowen mentioned earlier, we paid an additional dividend of $ 0.1 per share this quarter as part of our recently announced supplementary dividend program. This program enables our shareholders to participate meaningfully in the successful exits of our investment portfolio. The program will continue to be funded from our current estimated non-distributable taxable income generated from realized gains on debt and equity as well as undistributed investment income over the past few quarters.

As we ponder the expected duration of the program, we need to consider the minimum requirements for regulated investment companies, the currently unrealized appreciation of our portfolio, and the importance of equity co-investments in our lower mid-market portfolio to our investment strategy The foundations have been created so that the additional dividend program will be in effect for the foreseeable future. On slide 16 we illustrate our operational leverage, which at the time of the spin-off from CSW Industrials improved significantly from 4.9% to 3% as of September 30, 2012. Although we are certainly satisfied with the progress made so far, we are continuing to work on achieving our longer-term operational leverage of 2.5% in the next few quarters. With all senior executives and corporate infrastructure largely in place, portfolio growth from here will further enhance our operational leverage due to our internally managed structure.

As you can see on slide 17, our NAV per share decreased by $ 0.03 to $ 18.84 per share for the quarter.The $ 0.03 per share decline was caused by the additional dividend of $ 0.10 per share paid during the quarter, which was offset by an increase in unrealized appreciation. The net valuation of the portfolio resulted in an annualized return on equity of 8.6% for the quarter. Our regulatory leverage ended the quarter at 0.65 to 1.

As Bowen noted, after the quarter ended, we completed a stock offering of 700,000 common shares at $ 18.90 per share with two institutional investors. Total net revenue before expenses was approximately $ 13.2 million. We were able to carry out this capital increase above our NAV and only a 1.9% discount on our closing price on the day before the issue. We believe this settlement is cheap compared to a normal market discount of 8% to 10% on a fully marketed deal.

Given our current regulatory leverage of 0.65 and realizing that the new regulatory BDC level for BDC won't take effect until April 25, 2019, we consider it prudent - it was prudent to raise a modest amount of equity at that point . In addition, we continue to have constructive discussions with ING about an amendment to our revolving revolving credit facility of $ 210 million. While we don't currently have to provide a formal announcement, we are working with our lenders to provide more flexibility and terms within the facility. Once the change is complete, we will be reporting on our progress in the coming weeks. At the end of the quarter, we had $ 83 million of spare capacity on the ING facility, $ 18 million of additional capacity on the Deutsche Bank-managed I-45 credit facility, and $ 10.2 million of total cash .

As noted last quarter, we put in place an ATM program to raise additional capital for our 5.95% listings in December 2022. To date, we've sold 785,447 shares of our bonds under the program for gross proceeds of approximately $ 20 million with an effective return of 5.86%. We believe the ATM program is an effective means of attracting attractive capital in a timely manner as we continue to carefully expand our investment portfolio. As can be seen on slide 19, we have significant unused debt capacity and no payment obligations until the end of the calendar year 2021, which means that we can significantly expand our portfolio.

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

Bowen Diehl - Chairman of the Board of Directors

Thank you, Michael, and thank you for being with us today. Capital Southwest has grown, and the business and portfolio have performed in line with the vision and strategy we communicated to our shareholders nearly four years ago. Our team did an excellent job and delivered a strong performance for our shareholders. Everyone here at Capital Southwest is committed to protecting our shareholders' capital by continuing to perform well and creating sustainable value for our shareholders over the long term.

This concludes our prepared remarks. Operator, we are ready to open the lines for questions and answers.

Questions and answers:


Many Thanks. [Operating instructions] Our first question comes from Mickey Schleien from Ladenburg. Your line is now open.

Mickey Tench - Ladenburg Thalmann - Analyst

Yes. Good morning, Bowen and Michael. Thank you for my questions. In June you decided to pay the special dividend of $ 0.60 and the sum of $ 10 million.

A few months later in October, you sold the common stock for about $ 13 million in proceeds. So I'm assuming you had a good look at the backlog over the entire period. And I'd like to understand - or could you guide us through these choices? Was that cheaper than if you had instead declared a distribution permissible?

Michael Sarner - Chief Financial Officer

Yes. We talked about it before. Yes, we have sales requirements. They really depend on how much your UTI balance is at the end of the year. So we have designed our balance to be in line with the expected dividend in the future.

So the $ 0.60 payout that we made was pretty much necessary from our point of view to get us to a level where we were comfortable so that we wouldn't increase our regular dividend in subsequent quarters had to. I think the supply of stocks that we bring up, we talk about it, has different variables that we looked at.

Bowen Diehl - Chairman of the Board of Directors

Well, I mean, stock offering, Mickey, like I said, it was really a reverse investigation, and so it was a decision that was made after the decision. Michael touched the $ 0.60 type that needed to be cashed out, but the stock offering is a separate decision. We thought - based on the places of origin, leverage level, and basis - of the two shareholders we wanted in the shareholder base that it made sense to raise some modest capital in a bit of a Goldilocks situation, it wasn't too small so they didn't get a meaningful position, but it wasn't too much as we were on our way to goal setting and didn't want to lengthen that path too much so it seemed like the right size and the right Opportunity to do whatever is considered.

Michael Sarner - Chief Financial Officer

And also from a UTI perspective, Mickey, you need to look at our unrealized depreciation. We've talked about Deepwater and MRI in the past. So these are other assets that represent probable UTI balances in the future. So making a $ 0.60 distribution was prudent.

Mickey Tench - Ladenburg Thalmann - Analyst

OK. I think I understand. And Bowen, I'm also curious what trends you see in your portfolio's fixed coverage ratios, given the significant rate hikes we've seen over the past few quarters.

Bowen Diehl - Chairman of the Board of Directors

Yes. I mean, of course, as interest rates go up, there is a greater burden on portfolio companies that is all the same. It's one of the things we look at when we hedge these deals. We look at this - we've talked about it a lot in the past, we look at recession performance, especially during the Great Recession, and we just look at the company's inherent volatility.

As you can see in our portfolio, our leverage level tends to be lower across the portfolio than many other players in the industry. In part, I think this can also, as you can imagine, have a big cushioning effect on cash flow and cover the rising interest rates. While the rate hike has a negative impact on fixed cost coverage, it really depends on how much buffer you have and you need to get companies to levels that are prudent when considering both internal and inherent volatility take into account business or potential volatility and cash flow margins. So I would simply say that the lower portfolio leverage in relation to the fixed fee means significantly more cushions.

Michael Sarner - Chief Financial Officer

But what is clear is that the rise in interest rates is putting pressure on fixed coverages above zero.

Mickey Tench - Ladenburg Thalmann - Analyst

But - Bowen, are you saying that interest expenses, at least for your borrowers, are growing faster than their EBITDA?

Bowen Diehl - Chairman of the Board of Directors

No, I wouldn't say that in the last few quarters. It's about - I obviously don't have it in front of me, but it's probably about offset.

Mickey Tench - Ladenburg Thalmann - Analyst

So that would be ...

Bowen Diehl - Chairman of the Board of Directors

Maybe it's a little, I mean I would say, a fixed fee cover in the portfolio. I don't have it in front of me, but I'd say it's probably increasing. Presumably, EBITDA is growing a little faster across the portfolio than interest rates are rising for these companies because the companies are - I mean, our typical value for the lending business - the leverage you can see on average, the loan to the value is typically 50 % or - certainly 30% - 50%. So you have a lot of equity among these companies, which obviously does not incur any interest costs.

Mickey Tench - Ladenburg Thalmann - Analyst

I understand. These are all my questions today. I appreciate your time. Many Thanks.

Bowen Diehl - Chairman of the Board of Directors

For sure.


Many Thanks. Our next question comes from Christopher Testa of National Securities Corporation. Your line is now open.

Christopher Testa - National Securities - Analyst

Hey, good morning, Bowen and Michael. Thank you for asking my questions today. Given that the SLF appears to be on the flat on the Quarters, and Bowen had obviously quoted you the lack of foam in the upper-middle market, should we assume that the joint venture will remain static unless there are quite significant dislocations in credit markets?

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Bowen Diehl - Chairman of the Board of Directors

I think that's a fair assumption, Chris. We actually have a couple of loans in the fund that say we can trade on equal terms and take advantage of some trends in business that we are not untouched, and we took the opportunity to trade the loans. So there will still be some refinancing going on. We have - we are not afraid to sell a loan if we can get out of whack, if we are not completely familiar with it.

And we are - it's a great fund, it works for us, it works for Main Street. The market is what it is now. Like I said, you cook all of this together and it's likely a shallow fund for at least a while.

Christopher Testa - National Securities - Analyst

I have it. OK. And have you seen encouraging trends starting at least in the upper middle market? I mean, obviously we haven't seen the dreaded dividend recap volume exceeding 50% of the market. We saw more kind of LBOs and M&A and some organic growth, excuse me.

Is that kind of encouragement at all? Or is it still as frothy and bad as always when the calendar year ends here?

Bowen Diehl - Chairman of the Board of Directors

Well you just answered my question for me. I mean that's right. Hence, this trend in the market is definitely encouraging. In terms of leverage and spreads, I'd say the market was, in some instances, more sensitive to the strong, strong EBITDA gains we've seen.

I hesitate to necessarily call this a trend, but we saw that. Certainly the lack of dividend withdrawals in such situations is encouraging.

Christopher Testa - National Securities - Analyst

Yes. I would definitely agree. Just wanted to talk about media recovery. That was of course very successful for you.

Haven't got the benefit of having the Q in front of me just yet, but just wondering what your thoughts are on monetizing this topic if the way you look at this has changed and maybe the way it looks is a pretty big position within the portfolio and to reduce an equity of it.

Bowen Diehl - Chairman of the Board of Directors

Yes. That was a good question. I would say there are two things. First and foremost, we are sticking to our strategy of building a loan portfolio that generates attractive returns with lower risk for our shareholders in order to optimize this risk-return equation.

That doesn't include $ 45 million, 100% stock investments, right? So media recovery is not necessarily a core from this perspective. And as I said in previous calls, and it is still true, that is a benefit that we see for a high level of strategic interest. We think this is an interesting asset for a private equity firm that can afford to invest $ 20 million, $ 30 million, and $ 40 million in the company to make acquisitions in the area. As a platform, we think that's pretty attractive.

We couldn't do that, right. So we are the wrong partner for this business. And so you look at all of this and it's like OK, it's a sales candidate, the question is when. And when we think about the different things the management team is doing with the business and the nature of our strategy, it feels like it's an intermediate.

And I would say over the course of the next - I think about it like a sales prospect for the next nine months plus or minus.

Christopher Testa - National Securities - Analyst

OK. I have it. This is helpful. Thank you, Bowen.

And just remember, is your credit facility - is that OK with the lower asset coverage you have over 167%?

Michael Sarner - Chief Financial Officer

No. That is something - that is part of the negotiations that are currently under way with ING. That - we want to do different things with it. We hope to extend runtime, lower costs, increase capacity and reduce facility coverage.

It's all part of the negotiation.

Christopher Testa - National Securities - Analyst

I have it. OK. And Michael, when would you expect it? Is that some kind of a one-quarter or two-quarter event?

Michael Sarner - Chief Financial Officer

I would say it's short term.

Christopher Testa - National Securities - Analyst

OK. I have it. And if you just look at the quarter's new origins, you have a coal company there with earnings maturity of 14% plus. Just wondering if you could add some color to this potential - excuse me, having the ability to discuss the leverage of the attachment points, and if there was a revolver in front of you and just things like that.

Bowen Diehl - Chairman of the Board of Directors

Yes. So you want to know why we would invest in a coal company around the world?

Christopher Testa - National Securities - Analyst

Yes. Quite a lot.

Bowen Diehl - Chairman of the Board of Directors

Yes. Law. So it's interesting. Blaschak is a regional niche migrant and distributor of coal - anthracite coal for heating houses in rural areas in the northeast, where no gas infrastructure can be built. It's not real - it doesn't pay to build this gas infrastructure.

It's a very low leverage point. So less than twice - well, it's less than twice and the asset coverage is substantial. As you mentioned, as I said, it is a split-lien loan. So, first of all, we have a mortgage on multiple assets, including the coal reserves themselves.

And so - and it has significant equity from a private equity sponsor. So if you were ever to get a loan - a coal company, this would be a pretty interesting one. And because a lot of people react the way you react, given the risk, your rate is pretty interesting. And so I think about it like an asset - well, well, asset deal deal at a pretty interesting rate with a very low cash flow multiple and a niche business that has a very important reason to exist and a pretty moat around it and go on and on pretty interesting credit.

Christopher Testa - National Securities - Analyst

Yes. No, that definitely sounds really unique. Those are all my questions this morning. I appreciate your time today.

Bowen Diehl - Chairman of the Board of Directors

Thank you, Christopher.

Michael Sarner - Chief Financial Officer

Thanks Chris.


Many Thanks. [Operator Instructions] And that concludes our question-and-answer session. I would now like to send the call back to Bowen Diehl to give a final answer.

Bowen Diehl - Chairman of the Board of Directors

Thank you, operator. Thank you again for being with us today. We look forward to keeping you informed of future progress. Have a great week


[Operator deregistration]

Duration: 32 minutes

Call participant:

Chris Rehberger - Vice President, Finance

Bowen Diehl - CEO

Michael Sarner - CFO

Mickey Schleien - Ladenburg Thalmann - Analyst

Christopher Testa - National Securities Analyst

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