Capital Southwest Corporation
Q2 2018 Earnings Call Transcript

Published: 12 Nov 2017

[Operator:]

Thank you for joining today’s Capital Southwest Second 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.

[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.

[Bowen Diehl:]

Thanks, Chris. And thanks to everyone for joining us for our second 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 announce our results this quarter, as we continue down the path of building out our robust middle-market lending platform and thoughtfully leveraging the right size of our balance sheet. As you likely recall, we re-launched Capital Southwest in January 2015 as a middle-market lending firm, beginning a transformation of our company from an all equity focused BDC, paying a negligible dividend and trading at a significant discount to NAV, to a credit focused BDC paying a market dividend on a path towards trading at a meaningful premium to NAV. As an internally managed BDC, where the interest of management and the shareholders are closely aligned, and where shareholders receive all the benefit from scale and enhanced operating leverage, we are confident our firm is well-positioned to successfully complete this transformation. Each quarter as seen on slide six, we continue to make progress in this evolution, increasing both our investment portfolio and investment income, resulting in increasing dividends to shareholders, all while growing NAV per share. As of the end of the quarter, Capital Southwest dividend had grown to an annualized yield of 5.6%. Over the past four quarters, Capital Southwest has paid $1.07 per share in dividends, while increasing NAV per share from $17.74 to $18.26. As of the end of the quarter, we have regulatory leverage of 0.2

[Michael Sarner:]

Thanks, Bowen. As seen on slide 15, our investment portfolio produced $8.5 million in investment income this quarter, with a weighted average yield on all investments of 10.7%. Investment income increased $800,000 or 10.2% versus $7.7 million from the previous quarter, mostly attributable to net portfolio growth. We incurred $3.5 million in operating expenses excluding tax and interest expense this quarter, an increase of $120,000 or 3.5% versus $3.4 million in the previous quarter. The increase in operating expenses was due to an increase in G&A, in particular recruiting expenses, which are one-time in nature incurred for our recent principal hire. For the quarter, we earned pretax net investment income of $4.1 million or $0.25 per share, compared to $0.22 per share during the prior quarter and we paid a $0.24 per share quarterly dividend, compared to $0.21 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 111%. As seen on slide 16, during the quarter our NAV increased by $5.1 million to $292.5 million or $18.26 per share. The increase in NAV from the prior quarter is primarily due to an increase in net realized and unrealized gains in the current quarter. In the fiscal year-to-date, we increased NAV over $7.4 million while producing a 9.8% total return on equity. Last year we produced a total return on equity of 8.5%. As illustrated on slide 17, our on balance sheet investment portfolio mix, excluding capital investment in I-45 was 74% debt and 26% equity at quarter end and 90% -- 94% of our total portfolio produces income in the form of either interest or dividends. The weighted average yield on our debt portfolio was 10.7% for the quarter, up from 10.5% the previous quarter and as of the end of the quarter, there were no assets or non-accrual. We did, however, place one first lien asset for $10 million on our internal watch list this quarter. This company is a regional provider of industrial cleaning services to industrial and petrochemical companies in South Texas and Southern Louisiana. The performance has deteriorated in recent months in part due to disruptions resulting from Hurricane Harvey. At this time, we believe the underperformance to be temporary, but they did breach financial covenants for the September period, so as a first lien lender, we will have the ability to address the situation directly with the company. As Bowen mentioned, at quarter end we had $33 million in balance sheet cash, approximately $20 million of which was received in prepayments from portfolio companies in the last week of the quarter. Additionally, we have $59 million of available capacity on our balance sheet credit facility and $26 million in additional capacity on the I-45 credit facility. During the quarter, we amended the Deutsche Bank credit facility to lower the spread to LIBOR plus 2.4%, extended the tenor while enhancing advanced rates modestly. This will increase the run rate return on equity to Capital Southwest from I-45 to approximately 13%. To-date, however, accelerated OID and prepayment fees on exits have boosted annualized ROEs to Capital Southwest to levels ranging from 14% to 18%. At quarter end, we had a leverage ratio of 0.2

[Bowen Diehl:]

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 on our investment strategy with the creation of long-term sustainable shareholder value as our most important goal. This concludes our prepared remarks. I would now like to turn the call over to the, Operator, to open up the lines for Q&A.

[Operator:]

[Operator Instructions] Our first question comes from the line of Christopher Testa with National Securities. Your line is now open.

[Christopher Testa:]

Hey. Good morning, Bowen and Michael. Thanks for taking my questions. Just with the -- touching on the frothiness in the general market, the Lower Middle Market on balance sheet originations were also kind of low this quarter, is -- have you seen an active shift towards more Lower Middle Market borrowers pursuing some more aggressive structures, much as -- much of what has been seen in the Upper Middle Market and broadly syndicated market as well?

[Bowen Diehl:]

Yeah. Thanks for the question. Our activity for the quarter, as I mentioned in my comments, we had several deals that were signed up that carried over into this quarter. So the two originations that we did, not quite illustrative of the activity, but that -- so that’s -- that point. But your question about the Upper Middle Market, Lower Middle Market, I mean, the frothiness in the Upper Middle Market in our observation is much, much more than what we’re seeing in the Lower Middle Market. I mean, Lower Middle Market is competitive, clearly. But covenants are tight, market covenants. I mean its structures are certainly in the first lien where you can negotiate tight structured documents, none of which is really the case in the Upper Middle Market. So we see it as dramatically different between the two.

[Christopher Testa:]

Right. Absolutely and that certainly makes sense. And kind of sticking with the theme, first, I’d like to know what the balance -- what the leverage is on the joint venture at the current time?

[Bowen Diehl:]

Michael?

[Michael Sarner:]

Yeah. Leverage just shy of 2 times.

[Bowen Diehl:]

That is one point 10 times.

[Christopher Testa:]

Okay. Got it. And it’s gotten so frothy that even if you were to plow the prepayments basically back into similar yields on the loans, you’re not getting the ROEs that you’re targeting on the JV, is that safe to say?

[Bowen Diehl:]

Well, I mean, ROEs on the JV, if you just take just the recurring interest off of the portfolio is currently around 13%, which is above where we originally modeled it in our original business plan. We do see churn in the portfolio, as I mentioned, we’re just -- the way you handle that as you take your shot still quality companies, credits are a little bit more aggressive and the spreads are lower, so we just take smaller bets and keep a very granular portfolio. But the ROE is still around recurring basis, around 13%, so, which correctly sized in our portfolio where the JV is today, it’s a nice asset to have on the books.

[Christopher Testa:]

Got it. And so far as you do receive prepayment fees in the JV, is that split pro rata between you and Main Street or is it based upon the economic interest that each of you have in the fund?

[Bowen Diehl:]

So the prepayment fees and OIDs are distributed the same -- at the same relative basis as the rest of the income, the interest income.

[Christopher Testa:]

Okay. Got it.

[Bowen Diehl:]

All distributed the same.

[Christopher Testa:]

And…

[Bowen Diehl:]

It’s distributed real time quarter-by-quarter, that’s why the ROE is historically been kind of in the future could also be much higher 14% to 18% as used by the prepayment and OID acceleration.

[Christopher Testa:]

Got it. And I know you guys had mentioned probably this quarter getting to amend the on balance sheet credit facility. Congratulations on that. Couple questions on that, will it be amended in terms of being upsized and having the spread over LIBOR reduced, and also, will there be a one-time associated expense with amending that credit facility that we should be modeling?

[Michael Sarner:]

Chris, we are reducing the spread, we’re going to extend the tenor. There’s going to be a fee but there will no be -- will not be a one-time fee, there will just be commitment fees that will be amortized over the life of the loan. So you won’t see a one-time impact.

[Christopher Testa:]

Got it. And last one for me and I’ll hop back in the queue. You guys have mentioned 0.7 times to 0.8 times target leverage. Now I know the SBA is moving with the speed of a snail. But should we look at the 0.7 times to 0.8 times target leverage as being all in or on a regulatory basis?

[Michael Sarner:]

I would say for the next 12 months to 18 months you’d say that’s going to be one and the same without the SBA.

[Christopher Testa:]

Right.

[Michael Sarner:]

0.7 times, 0.8 times, would be where we would be. The credit facility is going to be a big part of that process of getting us towards that -- inside that range. And then in the future, you mentioned the SBA, the SBA is probably going to be maybe a longer term venture for us, we’re going to explore, as we talked about in the previous calls, potential to look at the unsecured bond market and continually ramp the credit facility as well.

[Christopher Testa:]

Great. That’s all the questions for me. Thanks for taking my questions.

[Bowen Diehl:]

Thanks, Chris.

[Operator:]

Thank you. [Operator Instructions] And our next question comes from the line of Dan Nicholas with Robert W. Baird. Your line is now open.

[Dan Nicholas:]

Great. Thanks. Good morning, guys.

[Bowen Diehl:]

Hi, Dan.

[Dan Nicholas:]

Just want to -- hey, just wanted to follow-up on Chris’ kind of market dynamic question, as we think about sub-debt that you’re seeing out there now in the Lower Middle Market, I mean, some BDCs are certainly seeing headwinds and pressure on the portfolio from subordinated or more mezzanine structure. So just curious how you’re thinking about lower investment -- lower down the capital stack as we sit here in the credit cycle. I know you all underwrite to a recessionary environment or credit cycle. So just curious how you’re thinking about more junior structures at this point in the Lower Middle Market?

[Bowen Diehl:]

Yeah. Yeah. That’s a good question. So, couple of points, and all against the backdrop of kind of how I’ve said, described on prior earnings calls of how we look at a recession environment and stress test where we look at each of our loans and stress test the capital structure against the repeat of the great recession in kind of late ‘18 and ‘19, which of course, we hope doesn’t happen, but we stress test that. So how do we think about a sub-debt investment in that environment? First of all, there are going to be companies that and have proven over time to be less volatile with the economic cycle. And so as demonstrated by historical performance of both the company and the particular industry, they’re going to tend to be -- even within that, they’re going to tend to the lower leveraged situations, all in leverage and also lower loan-to-value being the last dollar of our sub-debt versus the purchase price of the company being paid and so those are the general characteristics, I would say, that we don’t do a lot of sub debt investing, but we did do one this last quarter and those are certainly elements of that deal. Also companies that, if you’re doing -- if you’re making a sub-debt investment in my assessment you’re taking much more enterprise value risk, perhaps, than even a senior debt investment and so you have to, I look at it and say, okay, if you -- if I really like the equity story and it’s a really interesting equity story then that’s the enterprise value risk you might be at the margin we’re willing to take and if that is the case then you ought to be participating in the equity. And so you will see most all the time of us writing a meaningful equity check alongside our mezzanine debt. So those are the elements that we look at and again we don’t do a whole lot of sub-debt investing, but we certainly do look at that piece of the capital structure in certain situations, and again, all against the backdrop of the same stress testing that we do for other investments.

[Dan Nicholas:]

Yeah. Yeah. Okay. That makes a lot of sense, Bowen. Thanks. And just kind of shifting gears to the expense side of the house. You talked about the team build out pretty much being complete here this quarter. Would -- do you think it’s reasonable to say that kind of starting next quarter we probably see a bit of an inflection point in terms of operating leverage or operating expenses relative to earnings and assets?

[Michael Sarner:]

Yeah. I’m going to tell you from in terms of the operating expenses going forward, if you look back over the past three quarters, you’d see absence of few onetime expenses, this quarter being the recruiting expense, few quarters ago we had some legal cost for corporate matters. We’ve come in about $3.4 million. We mentioned, I think, Bowen mentioned that we hired a new principal, so that number’s going to come up a bit for that -- for cash comp, but also after 12/31, the spin-off comp is going to fall off, so we do expect to see expenses should be pretty stable around 3.4%, 3.5% of SG&A and obviously, as the assets grow, the operating leverage will come down. We see by the end of this fiscal year, we should think we will be around 3% and then fast forwarding six months and 12 months after that we find ourselves -- we expect to find ourselves underneath the 2.5% target, if that’s helpful.

[Dan Nicholas:]

Yeah. That is helpful, Michael. And that 2.5% target or below, you -- can that be achieved with kind of a leveraged out balance sheet relative to kind of what the current capital base can support?

[Michael Sarner:]

Yeah. Absolutely and that’s what I was kind of making the point earlier. With the credit facility amendment, we think this is going to get us really right into the range of leverage what we’re looking to be.

[Dan Nicholas:]

Yeah.

[Michael Sarner:]

And certainly we’ll opportunistically look from the capitalization strategy to add on other forms of debt as if we can do it in effective manner. But certainly what’s happening right now is very positive in a way that -- it allows us to fully lever out the balance sheet.

[Dan Nicholas:]

Got it. Okay. Great. That’s helpful. Thanks, guys.

[Michael Sarner:]

Thanks, Dan.

[Bowen Diehl:]

Thanks, Dan.

[Operator:]

Thank you. And I’m showing no further questions at this time. So I’d like to return the call to Mr. Bowen Diehl for any closing remarks.

[Bowen Diehl:]

Thank you, Operator, and thank you all for participating on our call today. We look forward to keeping you appraise of our progress on future calls. And again, as always I say, shareholder value creation is our absolute first priority and we tend to work very hard to make that happen. So thank you all very much and have a great week.

[Operator:]

Ladies and gentlemen, thank you for participating in today’s call. This will conclude the program and you may all disconnect. Everyone have a great day.