Capital Southwest Corp (NASDAQ:CSWC)
Q3 2016 Earnings Conference Call
February 09, 2016, 11:00 ET
Chris Rehberger - Treasurer & VP, Finance
Bowen Diehl - President & CEO
Michael Sarner - CFO
John Deysher - Pinnacle Value Fund
Ron Davis - Private Investor
Thank you for joining today's Capital Southwest third fiscal quarter earnings call. Participating on the call today is Bowen Diehl, CEO; Michael Sarner, CFO; Douglas Kelley, Managing Director; 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 the result of new information, future events, changing circumstances or any other reason after the date of the 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 quarter fiscal year 2016 earnings call. 2015 was a watershed year for Capital Southwest, as we completed an exciting transformation that began 18 months ago during the summer of 2014. We set out to unlock what at the time was a substantial 35%-plus discount to NAV per share.
Capital Southwest, from its original IPO in 1961, had a long history of successful equity investing, but in more recent history had become an anomaly in the market. We were a BDC with a portfolio consisting of 100% equity with extreme asset concentration in a few high-quality companies. In fact, over half our portfolio at the time was in two 100%-owned high-performing businesses that had grown significantly over the years, resulting in large embedded capital gains and associated deferred tax liability.
Additionally, our ability to invest in either of these 100%-owned businesses or in new investments was greatly hindered by RIC and BDC's regulatory restrictions associated with the high level of portfolio concentration. Further, unlike most other BDCs, we paid no meaningful dividend to our shareholders. As a result of all these factors, the market applied a significant discount to our share price versus net asset value.
On September 30, 2015, Capital Southwest successfully spun out these large, 100%-owned businesses tax-free to our shareholders, unlocking almost $300 million in shareholder value and establishing CSW Industrials as a new publicly-traded industrial growth company. CSW Industrials trades on the NASDAQ under the ticker CSWI and is led by Joe Armes, former CEO of Capital Southwest and the original leader and visionary of the Capital Southwest transformation. Joe Armes remains the chairman of our Board today.
During the summer of 2014, we began the process of rotating the legacy investment portfolio from equity investments to cash and in January 2015 formally launched our effort to establish ourselves as a lender to the middle market. During 2015 we brought on investment professionals at multiple levels with a depth of middle-market lending experience. Additionally, we brought on an experienced BDC professional as our CFO, who has built out a strong finance and accounting team to enhance our ability to make informed investment and portfolio decisions that maximize shareholder value as we move forward.
To-date, we have made significant progress towards executing our investment strategy. Our strategy was designed with the endgame in mind of creating a portfolio that has granularity and diversity across asset classes, that generates sustainable dividends to our shareholders funded from net investment income and that generates steady growth in NAV per share.
Essential to this strategy is the ability to establish investment capabilities in both the upper middle-market, where the syndicated market allows us the flexibility to opportunistically put capital to work without taking outsized risk; and the lower middle market, where investments have a much longer gestation period, where returns are attractive on a risk-adjusted basis and where financing sources exist, like the SBIC program, that have the potential to generate an attractive ROE for our shareholders.
In 2015, we successfully launched the I-45 Senior Loan Fund in partnership with Main Street Capital. We committed the fund's $68 million of equity capital alongside a $17 million capital commitment from Main Street. Additionally, we originated a credit facility with Deutsche Bank within the fund which provides us leverage of up to 2 times debt to equity.
Thus, I-45 will have approximately $250 million of investable capital with which to build a granular, upper middle-market portfolio, predominately comprised of first lien credits. Once fully ramped, this fund will deliver a 12% to 13% ROE to our shareholders. As you can see on slide 8 of the earnings presentation, since the strategy was set in motion in the summer of 2014, we have made significant strides towards repurposing our investment capital. First, by divesting most of our minority equity positions and then by beginning to build our credit investment portfolio.
At June 30, 2014, 77% of our investment capital consisted of controlled and non-controlled -- non-yielding equity positions and 1% in yielding debt. As of December 31, 2015, we had 52% of our balance sheet in investable cash, 43% in yielding debt and yielding equity assets including I-45 and no balance sheet leverage. During this time we exited 21 portfolio companies, receiving $222 million in proceeds and realizing $169 million in gains.
Through December 2015 we had originated $61 million in 12 credits on our balance sheet and funded $29 million of our $68 million commitment to I-45 to fund the purchase of $84 million and 19 credits in the fund. Specific to the December quarter, we originated $19 million in upper middle-market first- and second-lien credits on our balance sheet as presented on slide 9.
Subsequent to quarter end, we invested an additional $16 million in one lower middle-market investment and two upper middle-market first-lien credits, bringing our balance sheet credit portfolio to a total of $77 million invested in 15 credits.
As one would expect, our portfolio today is more heavily weighted towards syndicated and club deals in the upper middle-market as we have been able to find some attractive credit investments in the syndicated market, benefiting from the choppy market conditions during the second half of 2015. Additionally, we have now closed three lower middle-market credit investments that we're excited about and, thus, our lower middle-market business is off to a nice start.
Though we have a lot of work left to do to grow our investment portfolio, we believe it is a great time to be in the market with a substantial amount of liquidity.
I will now hand the call over to our Chief Financial Officer, Michael Sarner, to review our financial performance for the quarter.
Thanks, Bowen. During the quarter we grew our investment portfolio from $93 million to $135 million at fair value. Our debt portfolio grew from $45 million to $61 million at fair value. All of our debt investments are currently performing on plan and we have no non-accruals.
At quarter end we had $144 million in cash available for investment activity and zero dollars in debt outstanding. For the quarter, our NAV declined from $276 million to $271 million which was primarily due to a $2.9 million tax payment for deemed distributions for the 2015 tax year and $1.1 million of net portfolio depreciation. The $1.1 million reduction is due to depreciation of approximately $400,000 from the I-45 Senior Loan Fund portfolio and $700,000 on the legacy equity portfolio.
As part of our quarterly internal valuation process, we engaged an independent consulting firm specializing in financial due diligence and valuations to provide third-party valuation review of certain investments. As Bowen indicated earlier, the past year we have made significant progress towards divesting targeted legacy assets. As part of that process, this quarter we exited three legacy equity portfolio companies which resulted in proceeds of $3.2 million and a realized loss of $8.2 million.
As a reminder, Capital Southwest has a GAAP fiscal year-end of March 31 and a December 31 year-end for tax purposes. Thus, part of the rationale for liquidating these investments during the quarter was due to year-end 2015 tax planning.
As of December 31, 2015, excluding our equity investment in the I-45 Senior Loan Fund, our investment portfolio mix was 57% debt and 43% equity. The weighted average yield on our debt investments was 10.3% versus 10.1% the previous quarter. Overall, 89% of our portfolio currently generates a recurring cash yield and 99% of our investment income was paid in cash.
Our investment portfolio produced $3.3 million in investment income with a weighted average yield on all investments of 11.3%. This represented an increase of $2.2 million from the previous quarter's investment income of $1.1 million. Included in our investment income this quarter was a dividend payment of $1.3 million from our largest equity investment, of which we own 98% and which has no debt outstanding.
Looking ahead, we anticipate the ability to earn dividends on a recurring basis, assuming the portfolio company continues to perform on plan. With the spinoff complete, we were able to reduce our operating expenses to $3.9 million, down from $10.3 million during the previous quarter.
For the quarter we incurred a net investment loss of $20,000 or $0.00 per share, compared to a $9.3 million net investment loss or $0.60 per share, in the previous period. Excluding spinoff expenses, our net investment income was $700,000 or $0.04 per share, this quarter. Based on our current investment portfolio, we expect to have positive net investment income in the following quarter.
From a financing perspective, we have made considerable progress toward our overall capitalization strategy. During the quarter, we negotiated and closed a $75 million credit facility with Deutsche Bank within the I-45 Senior Loan Fund. The facility includes an accordion feature allowing for up to 2 times debt to equity at a cost of funding of LIBOR plus 250. We're currently in the process of working with Deutsche Bank to syndicate the additional commitment.
Additionally, based on the significant progress we have made in developing a granular pool of credit investments on our balance sheet, we have also begun initial discussions with financial institutions towards originating an on-balance-sheet financing facility. We're optimistic that we can have a facility in place within the calendar year 2016.
As many of you may know, we have held an SBIC license for the past 50-plus years. Our license has been kept current, but has had limited investment activity and currently has no leverage. As we have discussed previously, we have been in discussions with the SBA on the best path forward to obtaining approval for participation in the SBIC debenture program.
Given the significant change in both the management and investment teams, as well as our investment strategy, it has been determined that the best path for us to obtain such approval is to file for a new SBIC license, a process which we have begun. While we're cautiously optimistic about the process, our available liquidity on hand provides us the flexibility so that the likely timeline for approval and participation in the program should not alter our overall capitalization strategy. As the process moves forward, we will update you on our progress as appropriate.
I will now hand the call back to Bowen for some final comments.
Thanks, Michael. We're off to a nice start, but we have a lot of work left to do. We consider every day where we might be in the credit cycle and so we remain diligent and highly selective in our credit decision process. We're heavily biased towards high-quality companies with strong management teams in either not cyclical businesses or businesses in which we can analyze in detail the performance during the Great Recession.
We use the lessons we learned from the previous cycle to ensure that the capital structure is appropriate and can withstand such a reoccurrence. We're excited about the team that we have built and remain highly focused on creating shareholder value.
Consistent with that mindset, on January 25 we announced that our Board approved a $10 million share repurchase program which will allow us to enhance shareholder value in times of extreme market volatility when we believe our stock is significantly undervalued. Our focus as a management team is to deliver value to our shareholders, both through dividends and stock appreciation and thus we will continually be assessing the optimal use of capital to achieve that 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 Instructions]. And our first question comes from John Deysher of Pinnacle. Your line is now open.
I was just curious, in terms of the expectation of positive net investment income in the next quarter which would be your fourth quarter, does that imply that there will be a dividend forthcoming either in fourth quarter or early in Q1?
Our taxable year ends 12/31 and our GAAP year ends 3/31, so our first quarter that will have investment income where we're possibly projecting positive investment income would be this following quarter of 3/31. That's based on where our balance sheet is today, the investment activity at I-45 and our expense load being reduced with the spinoff being complete.
Okay, so that would be for the quarter March 31. Do you anticipate paying a dividend in that quarter?
We won't generally provide projections, but, yes, the answer to that question is that we will pay out our undistributable cash taxable income each quarter. And so if we do have positive net investment income, you should expect to see a dividend being paid.
Okay. How does it work timing wise? Do you pay it at the end of the quarter for that quarter or would it be paid early in the subsequent quarter?
No, it would be paid at the end of the quarter for that current quarter.
And did I hear you correctly in saying that 99% of your income is cash, not paid in kind?
That is correct.
[Operator Instructions]. And our next question comes from Ron Davis of Morgan Stanley. Your line is now open.
The question is mine as an individual investor, not for the firm I work for. The ongoing dividend at your annual meeting last year, Bowen, I think you said you thought you could sustain an 8% yield. Is that still a goal for you today? Also, the secondary part of that question, it sounds like you might have a variable payout going forward depending on how the quarter goes. Can you comment on that as well?
Generally I would say, as Michael said, we're going to distribute our taxable income and we're in a position now where we have generated a bunch of liquidity through exiting equity investments and we've started to build a credit portfolio. So as that income off the portfolio increases, the dividend will increase.
And so your 8% number, I would say that we think of our future dividend as the 8% to 10% kind of number and so I think that's probably fair. But I think you will see this build; as we've got largely cash and we build the credit portfolio thoughtfully and carefully, you will see that dividend build.
Thank you, I'm showing no further questions at this time. I would like to turn the conference back over to Mr. Diehl for closing remarks.
Thank you, operator and thank you all for participating in our call today. This is the first of many quarterly calls. We look forward to keeping you apprised of the progress of our business. Shareholder value is our absolute first priority and we intend to work hard to make that happen. We hope everybody has a great week. Thank you very much.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Have a great day, everyone.
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