Capital Southwest Corporation
Q4 2018 Earnings Call Transcript

Published: 5 Jun 2018

[Operator:]

Thank you for joining today’s Capital Southwest Fourth Fiscal Quarter 2018 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

[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 fourth quarter fiscal year 2018 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our Web site at www.capitalsouthwest.com. We are pleased to be here with you this morning to announce our quarterly and annual results for the fiscal year 2018. This year, our focus remain on building a lower a middle market portfolio, consisting largely of first lien senior debt with smaller equity co-investments across the loan portfolio where significant equity upside opportunity exist. We continue to execute under our shareholder friendly internal managed structure, which at its foundation, closely aligns our interest with the interest of our fellow shareholders in generating sustainable long-term value through stable increasing dividends and NAV per share growth. Laid out on Slide 5 are some important summary points on our performance for the fiscal year ending March 31, 2018. During the year, we paid $0.99 per share in quarterly dividends, a 25% increase in dividends over the $0.76 we paid out during our fiscal year 2017. We were able to accomplish this while growing NAV per share to $19.08 from $17.80 per share as of the end of the fiscal year ’17. As a result, our total return on equity for the fiscal year '18 was 13.7%. During the year, we significantly grew the right side of our balance sheet, increasing our total debt capitalization through increasing commitments on our revolving line of credit from 100 million to 180 million, and issuing 57.5 million in unsecured baby bonds, which today trade on the NASDAQ under the ticker CSWCL. Subsequent to year-end, we added an additional $30 million in commitments to our credit facility from both new and existing lenders, bringing our total credit facility commitments to its current level of $210 million. Our increased capital base has been utilized to grow our portfolio over 35% from $287 million in March 31, 2017 to $393 million at March 31, 2018. During the year, we originated $169 million in total commitments in 17 portfolio companies, including $10 million invested in equity alongside eight of our loans, while exiting 11 companies for $61 million in proceeds, generating a weighted average IRR of 12.2%. We are pleased to note that three years into our credit strategy, we have a portfolio with no loans on non-accrual, and only one investment on our internal watch list. In fact, Wastewater Specialties, the company we have mentioned on previous calls is being on our internal watch list, has now been sold. The transaction closed last Friday, resulting in our first lien loan being prepaid in full with contractual prepayment fees. The exit generated an IRR of approximately 17%. Our current watch list credit recently added to the list is a distribution and logistics company, in which we have a first lien loan and no equity. The company has underperformed and has breached our financial covenants. That said, the company has signed up a large number of new customers that are expected to ramp up in the coming months. The financial sponsor and other equity investors are very bullish on the Company's prospects, and are preparing to invest significant equity dollars to fund the necessary growth CapEx to prepare the company to take on this new business. We feel pretty good about the long-term prospects of this company and very good about the security of our shareholders’ capital in this deal. We’re also pleased with the support the sponsor is providing the company, and think the management team has done an excellent job signing up some interesting new customers. Specific to the fourth quarter, as seen on Slide 6, we experienced strong portfolio performance, growing NAV per share by $0.64 during the quarter to $19.08 per share, while earning $0.28 per share in pretax net investment income. During the quarter, we achieved net portfolio growth of 7%, increasing the investment portfolio to $393 million from $367 million at the end of the prior quarter. Our I-45 senior loan fund continued its solid performance, providing a 13% annualized cash yield on our capital in the fund for the quarter. Finally this quarter, we repurchased 36,000 shares under our share repurchase program. As we have previously said, we are committed to building long-term shareholder value, while the number of shares we can purchase in any given day or week is significantly limited due to the low trading volume of our stock. If the market price presents itself where it makes sense to repurchase shares then we will repurchase what we can. As we have illustrated in the past quarterly updates, Slide 7 shows our continued progress and track record of increasing shareholder dividends and driving increases in NAV per share through thoughtfully building a portfolio of well performing assets. For the quarter ending March 31, 2018, we paid out $0.28 per share in quarterly dividend, generating a 6.6% annualized dividend yield to our shareholders, while increasing NAV significantly. NAV appreciation this quarter was driven largely by appreciation in our equity investment in TitanLiner and in MRI. As we have mentioned on our last several quarterly calls, TitanLiner's financial performance has been quite robust. As the company has continued to benefit from significant increases in oil and gas drilling activity and from a management team that has done a great job managing the business and generating what we believe a market share gain. TitanLiner has been an active sale process for the past several months, and is under letter of intent today for a sale transaction that we expect to close very soon. Regarding MRI, the company continues to perform very well with growth being driven by increased profit margins on its core products, and increasing market penetration with several new products. We also recently announced a capitalization policy, following the passage of the small business credit availability act. The act allows for business development companies to decrease the required minimum asset coverage ratio applicable to the company from 200% down to 150%. Stated differently, maximum allowable leverage at the BDC can be increased from the prior limit of 1

[Michael Sarner:]

Thanks, Bowen. As seen on Slide 16, our investment portfolio produced $9.9 million in investment income this quarter with the weighted average yield on all investments of 10.5%. This represents an increase of $855,000 versus $9 million from the previous quarter, mostly attributable to net portfolio growth. We incurred $3.4 million in operating expenses this quarter, excluding interest expense, which was flat from $3.4 million in the previous quarter. For the quarter, we earned pretax net investment income of $4.5 million or $0.28 per share compared to $0.27 per share during the prior quarter. As a result, we paid out $0.28 per share in regular dividends for the quarter, an increase of $0.02 per share over the $0.26 per share paid out 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 103%. As seen on Slide 17, during the quarter, our NAV increased by $9.8 million to $308.3 million or $19.08 per share. The increase in NAV is primarily due to an increase in net realized and unrealized gains during the current quarter generated primarily from, as Bowen mentioned, appreciation in our equity investments and TitanLiner and MRI. We’ve produced total annualized return on equity of 20.1% during the quarter. During fiscal year 2018, we produced 13.7% total return on equity and increased NAV approximately $23.2 million. This compares to a total return on equity of 8.5% during fiscal year 2017. As illustrated on Slide 18, our on balance sheet investment portfolio mix, excluding capital invested in I-45, was 73% debt and 27% equity at quarter end and 92% of our total portfolio produced income in the form of either interest or dividend. The weighted average yield on our debt portfolio was 11.5% for the quarter, up from 11% the previous quarter. And as of the end of the quarter, there were no assets on non-accrual. During the March quarter, the equity markets experienced significant volatility, which presented an excellent opportunity to repurchase shares at an attractive discount to our net asset value. As Bowen mentioned, despite being limited by trading volume in the quantity of shares we can accumulate on any trading day, we were able to repurchase 36,000 shares at a blended price of $16.37 per share, representing approximately $600,000. We believe these purchases provide both immediate and long-term accretion that will benefit all shareholders. The repurchases also further highlight the advantages of our internally managed structure, which incentivizes us to grow shareholder value while maintaining sufficient capital flexibility, rather than solely focusing on growing our assets under management. After these purchases, we have approximately $9.4 million remaining on our $10 million Board approved share repurchase program. We will continue to assess opportunities in the market to purchase shares when we believe our stock is undervalued. At quarter end, we had significant liquidity consisting of $140 million of available capacity on our ING led balance sheet credit facility, $22 million in additional capacity on the Deutsche Bank led I-45 credit facility, and $8 million in balance sheet cash. In April, we increased the ING credit facility commitments to $200 million with the addition of the lender. In May, we further increased the ING credit facility commitments to $210 million with a commitment increase from a current lender. As seen on Slide 19, we have significant unused debt capacity and no payment obligations until late 2021, which will enable us to significantly grow our portfolio. I will now hand the call back to Bowen for some final comments.

[Bowen Diehl:]

Thanks, Michael, and thank you everyone for joining us today. I'm extremely proud of what our team has accomplished so far. Capital Southwest has grown and the business and portfolio has developed consistent with the vision and strategy we communicated to our shareholders over three years ago. We continue to work 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, the creation of long-term sustainable shareholder value. This concludes our prepared remarks. Operator, we are ready to open the lines up for questions?

[Operator:]

Thank you [Operator Instructions]. And our first question comes from Mickey Schleien from Ladenburg. Your line is open.

[Mickey Schleien:]

Bowen, I wanted to ask you about dynamics in the lower middle market. I think the market appreciates that it's partially insulated from the volatility in the more liquid markets, and that it's harder to do -- harder to originates deals there, so you get better terms. But on the other hand, can you give us some insight into how the LMM companies that you target performed during downturns in the economy, especially EBITDA declines and default rates?

[Bowen Diehl:]

I would say to your question on how they performed, and if you think about across our portfolio, we have companies that EBITDA and the great recession went down maybe 30% and others that EBITDA were flat or even up during the great recession based on the nuances of their business models. And so it's a fairly big range that what we try to do is we try to match the capital structure, which may or may not work for the borrower, which is why we lose a deal. But we try to match the capital structure with that potential volatility. So as you would imagine, the lower middle market companies that have the higher potential volatility are going to have lower leverage in our portfolio.

[Mickey Schleien:]

And on the two LMM deals, Prism and ITA, how did you source those two deals? And are they small companies where you did all the financing or did you lead a club of some sort?

[Bowen Diehl:]

So on Prism, we led a club with another lower middle market lender. We lead it. It's a small deal initially but it's going to grow as they do acquisitions. And so we brought on a co-lender to join us in that deal. And so when we source that just do networking with sponsors. And then on the ITA, we actually sourced that to founder owned business. We sourced it through a small intermediary actually that I had done business with, or a couple of us have done business within our former firm. We’ve had relationship in the market with them and we were the -- we lead that. We’re the only financing party there.

[Mickey Schleien:]

And my last question, do you -- I haven't seen the proxy yet for the shareholder meeting. Do you expect to potentially add a proposal there for higher leverage to accelerate the clock for that process?

[Bowen Diehl:]

We haven’t gone that route. The Board decided -- as I said in my remarks. The Board decided to approve the leveraged change also though message prudent and approving a self-imposed limitation. And then takes next year, because as we said, we don’t need the leverage above our target for the next year. And so we've got a lot of time to talk to our shareholders, talk to our lenders and watch the portfolio, watch the market and make that decision over that time period in the context of the feedback we've gained over that year. And so rather than going in through the additional expense of terms of the proxy, preliminary things like preliminary proxy issuances and comments from the SEC, which generate legal expenses, which is a smaller BDC like us that matters, we decided to take this route.

[Operator:]

Thank you [Operator Instructions]. And our next question comes from Christopher Testa from National Securities Port. Your line is open.

[Christopher Testa:]

I appreciate all the thoughtfulness that you guys put into describing how you’re going to handle the leverage increase. I have just a couple of more questions about that. You guys mentioned that you see the SLF as one of the better risk-adjusted returns in the market given where spreads are, but at the same time, you guys have, predominantly on the balance sheet more lower middle market loans. Going forward, as you guys are able to move towards 1

[Bowen Diehl:]

So let me correct part of what you said, Chris, and thanks for the question by the way. You said that we said that one of the more attractive returns in the market is in the upper middle market. That’s actually not correct. What I meant to convey is that every market is very competitive; like I said spreads tight, leverage level high, lots of add backs. And so the way to play in that market is to take small pieces of a lot of loans within the universe of loans that we find attractive and basically good fundamental businesses. Take small pieces so that you have a very granular portfolio, so if any one of them doesn't do well, it doesn't move the needle. So that's the granularity the key. Then efficiently levering it in a senior loan fund, which as you know, a very low leverage CLO entity, it’s not tend to one leverage its 2

[Michael Sarner:]

And also, Chris, the I-45 credit facility has a lower cost of capital surplus 240 and slightly higher advance rates. So we’re able to get decent returns even with lower yields in the upper middle market…

[Bowen Diehl:]

But again small bites very granular it's how I would see play in this market.

[Christopher Testa:]

And just you had mentioned media recovery continues to perform well and obviously, that's been a really great investment for you guys. I'm just curious, I mean as you look in your crystal ball. What do you think the timeline on monetization of this is? Is the thinking behind that somewhat that you actually want to take on more leverage on the revolver before you actually monetize this, so you don’t have to deploy so much capital and risk creating a drag on earnings? Or is that just totally out of the question and you guys were simply looking to wait until things are going to get the best value for this?

[Bowen Diehl:]

Well, first and foremost, we’re looking at the investment the Company strategy, the Company's growth and working with the management team that we put in place three years ago who’s doing an excellent job managing that business. But trying to think, okay, when is the right time to sell against the backdrop of a couple of things. We’re in a very wide hot M&A market. We need not lose context to that. We are -- ultimately if it continues to grow and it continues to depreciate, it's just going to become a larger and larger asset on our books. And I don’t -- the strategy that we laid out three years ago was not to becoming MRI strategy. So we want -- at some point, it gets large and it probably needs to be sold and we're in a nice market. So you put all those variables together, you can't really turn the dial up and down by days or weeks of course. But if you think about general timing of all of those variables, I think it’s fair to say that this is an asset that will be sold in the next 12 months.

[Michael Sarner:]

And Chris to your question, I think, also I would tell you with the dry powder we have. We anticipate putting that capital to work and levering up, over the next 12 to 15 months. So it actually might be around the same timing of when we lever up and when we see this exit occur.

[Christopher Testa:]

And cov light obviously has been a problem in the upper middle market with over three quarters of the loans being cov light there. Just wondering how much of that gets down into the sub-40 million to 50 million EBITDA market. I mean, I would assume it’s in the 8 million to 10 million EBITDA market where you have a lot of your lower middle market loans at that level. But if you could just give us a sense of how much you've seen covenants and deterioration in terms kind of dip down from the upper middle market that would be appreciated.

[Bowen Diehl:]

Given we’re in the upper middle market, which is large and you just described it and we’ve been talking about the competitiveness and the term deterioration and stuff in the upper middle market. In the lower middle market where we play actively, as you also said, it's certainly -- as we said, we certainly are getting robust terms in those deals. In the middle zone of larger not quite upper middle market, larger not quite lower middle market world. We don’t do a lot of deals in that area but we do a handful year of -- handful or half of handful of club deals where we’re partnering with maybe two other lenders or so that they lead and that were taken $10 million-ish position in. And on those deals, we’ve had covenants, and I think the covenants are a little bit -- certainly higher cushions than the lower middle market and terms are a little bit looser. But it hasn’t been near as much -- it’s not near as looses in the upper middle market. So it’s somewhere in between, Chris, I guess is the best way to say.

[Christopher Testa:]

And last one from me just, what caused the increase in income from your affiliate investments this quarter?

[Michael Sarner:]

There’s actually a few factors there. We re-class two portfolio companies from non-accrual to affiliate -- non-control to affiliate, to the voting securities percentage being greater than 5%, that was that $35 million. We had two originations during the quarter that were in the affiliate category, and that was about $15 million. And then we had one prepayment during the quarter that was a non-control category about $5 million.

[Christopher Testa:]

So the current quarterly run rate we should for modeling purposes use that going forward as a base?

[Michael Sarner:]

That’s correct.

[Bowen Diehl:]

Yes, the affiliate hurdle, as you know, is a 5% ownership, so it’s pretty low. So as you move forward, you'll see a lot of our investments when we make a co-investment, often times we’re in the 5% to 10% ownership, which would be affiliate.

[Operator:]

Thank you. And our next question comes from Troy Ward from Ares. Your line is open.

[Troy Ward:]

Actually a question on the current liability stack, so on Slide 19, you show the facility and the 2022 senior notes, baby bonds. Can you just talk about, if any of these liabilities have covenants tied to the 200% asset coverage? And I know you did some -- you had conversations with your lenders post quarter end, some changes, some increases. Can you just talk about how the lenders are thinking about lower asset coverage or higher debt to equity, going forward?

[Michael Sarner:]

So the revolver, as other BDCs have, has a 1

[Operator:]

Thank you. And our next question comes from Chris McCampbell from Hilltop Securities. Your line is open.

[Chris McCampbell:]

In regards to dividend policy, you rated change and dividend growth is slowing. Should our expectations be that we've gotten to a point where increases are going to be less frequent?

[Bowen Diehl:]

No, I don’t think that’s the case. I think what you saw this quarter was that we did raise a significant amount of capital, the baby bonds that were raised at the very end of December. And therefore -- so there’s a bit of an overhang in this quarter. We also have unused fees on our revolver. So therefore, when you use those proceeds to pay it down, we’re going to incur additional cost there, and also say we had some late stage originations. So I think there’ll be a bit of a J-curve as we move forward, and we still expect to see dividend growth over the next really six to 12 months.

[Operator:]

Thank you. And I am showing no further questions at this time. I would now like to turn the conference back over to Bowen Diehl for any closing remarks.

[Bowen Diehl:]

Thanks operator. And thanks, everybody, for joining us today. We really appreciate it and we look forward to keeping you appraised of our progress on future calls. Have a great week.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.