Capital Southwest Corp (NASDAQ:CSWC) Q3 2017 Earnings Conference Call February 7, 2017 11:00 AM ET
Chris Rehberger - VP, Finance & Treasurer
Bowen Diehl - President & CEO
Michael Sarner - CFO
Thank you for joining today's Capital Southwest Third Fiscal Quarter Earnings Conference Call. Participating on the call today is Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP of Finance.
I will now turn the call over to Chris Rehberger. You have the floor.
Thank you. I'd 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 quarter fiscal year 2017 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're pleased to report that the December quarter represented another quarter of progress towards our goal of building a premier middle-market lending firm with a diverse credit portfolio consisting of credits from both the lower middle-market and upper middle-market. A summary of our strategy can be seen on slides 5 and 6.
We have seen solid portfolio growth at both Capital Southwest and at I-45, our senior loan fund joint venture with Main Street Capital. We have also had several realizations in the portfolio which we believe begin to provide our shareholders with tangible evidence of our track record and ability to generate attractive risk-adjusted returns in both of our target markets. Finally, we continue to execute under our shareholder-friendly, internally managed structure which we believe closely aligns our interest with the interest of our fellow shareholders to generate sustainable long term value through stable increasing dividends and NAV per share growth.
As seen on slide 7, the evolution of our investment portfolio continues as 84% of our investable assets are now in securities-generating recurring cash income compared to 1% in mid-2014 when we began the transformation of Capital Southwest from equity to middle-market credit. As seen on slide 8, we have grown our own balance sheet credit portfolio during this time to over $150 million while experiencing over $33 million in prepayments along the way as detailed on slide 9. These realizations have generated a weighted average IRR of 32% with the highest IRR being generated from Hygea, our lower middle-market senior debt investment which included equity warrants. Again, we believe these portfolio exits demonstrate some early evidence of the attractive risk-adjusted return potential of our investment strategy.
During the December quarter, as detailed on slide 10, we originated $25 million in five new credits on our balance sheet in both the lower middle-market and upper middle-market, having a weighted average yield to maturity of 10.3%. We continue to close on approximately 2% of the opportunities we review as we remain vigilant in our underwriting discipline. Today our portfolio is performing well with no watch list credits.
Our legacy subordinated debt investment in Titan Liner funded back in 2012 has now been restructured, resulting in Capital Southwest taking a controlling interest in the Company. Titan's performance continues to improve with a more favorable oil field industry environment.
Also during the December quarter as seen on slide 11 our I-45 senior loan fund experienced solid net portfolio growth, increasing portfolio assets to $187 million from $173 million at the beginning of the quarter. I-45 originated $39 million in nine new credit investments while receiving $18 million in proceeds from the prepayment of four credits during the quarter. I-45's fund assets are now approximately 75% of the way toward our target fund size of $250 million.
As it has grown the I-45 loan portfolio has maintained a weighted average asset yield in excess of our original business plan and an increasing ROE to Capital Southwest currently at a run rate of 11.5%. The portfolio is virtually all first lien with diversity among industries and an average hold size of 2.4% of the portfolio. The portfolio has a weighted average EBITDA of $89 million and weighted average leverage through the I-45 security of 3.5 times.
As illustrated on slide 12, including capital invested in I-45, our overall investment portfolio had grown to $267 million as of the end of the quarter with 94% of the invested assets generating yield for our shareholders. Excluding capital invested in I-45 which as a fund holds 96% floating rate first lien investments, our investment portfolio is approximately 43% floating rate first lien and 67% floating rate senior secured as well as being diverse across the industry. Finally, we experienced $5 million in unrealized appreciation in the portfolio during the quarter, driven by solid financial performance in our equity investments as well as appreciation in our upper middle market loan portfolio at I-45 and at Capital Southwest.
Portfolio appreciation has continued to drive increases in NAV per share as seen on slide 13. And our growing credit portfolio is continuing to drive quarterly increases in our dividend per share.
Since the spinoff we have been able to build a well performing credit portfolio with the net investment income necessary to support the cumulative distributions to our shareholders of $0.38 a share over the past four quarters, all while increasing NAV from $17.34 to $17.88 per share. As of the end of the December quarter we generated a 4.2% annualized dividend yield to our shareholders. Though we're proud of our performance to date we look forward to continuing to execute on our strategy with the goal of producing a market dividend yield for our shareholders.
We continue to see a robust credit market and generally a favorable business environment for our portfolio companies. In the upper middle market deal volume of solid in the December quarter but spreads were tight, leverage levels remain high and many deals were covenant-light. However, we were able to source a first lien and several second lien opportunities in exceptionally high-quality businesses.
In the lower middle market deal flow was strong during the quarter. We closed a senior first lien loan in Lighting Retrofit International in partnership with Alcentra Capital. Our investment was in support of the acquisition of the company by DFW Capital Partners, a private equity firm with a stellar track record and one that we have known for over a decade having successfully invested with them in the past.
Our pipeline remains strong through the quarter and into the current quarter and we expect to be announcing a few additional lower middle market investments very soon. We have continued to see the banks be conservative in their lending approach and we continue to see what we hope is some level of pricing discipline across the lower middle market. That said, the market remains competitive with large amounts of liquidity to put to work among non-bank lenders as well as among private firms.
As we have said before, to mitigate risk in times like these we must aggressively broaden our deal pipeline but we must maintain both our conservative underwriting approach and high level of investment discipline. In every deal we structure and underwrite we stress test the capital structure by modeling a recession during our hold period equivalent to the Great Recession.
As a result, we focus on situations where we can understand how the businesses and industries performed during the Great Recession, apply capital structures to these businesses that are appropriate for their potential volatility and invest our shareholders' capital in securities that will remain inside enterprise value with interest being paid during a repeat of such tough times. While this discipline sometimes causes us to pass on opportunities or lose opportunities that we like, we're pleased with the credits we have added to our portfolio and continue to believe this discipline will pay off in the long run.
I will now hand the call over to Michael Sarner to review the specifics of our financial performance for the quarter.
Thanks, Bowen. As seen on slide 15 excluding our equity investment in I-45, our investment portfolio mix was 73% debt and 27% equity at quarter-end. Our debt portfolio consisted of 60% first lien, 32% second lien and 8% secured subordinated debt. The weighted average yield on our debt portfolio was 10.3% for the quarter versus 10% for the previous quarter.
As shown on slide 17, our NAV during the quarter increased by $6.5 million to $285 million or $17.88 per share which was mainly due to net portfolio appreciation. At quarter-end we had $33 million in cash available for investment activity and $15 million in debt outstanding.
Turning to the income statement on slide 18, our investment portfolio produced $6.9 million in investment income with a weighted average yield on all investments of 10.78%. This represented an increase of $2.2 million or 47% from the previous quarter's investment income of $4.7 million. The increase was due to net investment growth in the credit portfolio during the quarter as well as an increase in the cash dividend from I-45 generated from short term realized gains.
We incurred $3.1 million in operating expenses excluding tax and interest expense this quarter, an increase of $200,000 or 7% versus $2.9 million in the previous quarter. The increase in operating expenses was due primarily to legal fees related to corporate matters and an increase in share-based compensation during the quarter. For the quarter, we earned pre-tax net investment income of $3.4 million, or $0.21 per share compared to $1.8 million, or $0.11 per share in the previous period.
We paid a $0.17 per share dividend on January 3 for the quarter ended December 31. Our net investment income exceeded our dividend this quarter by $0.04 per share which was due to a large realized gain at I-45 that occurred at quarter-end.
Additionally, we continue to work toward our goal of receiving approval from the SBA for a new SBIC license with participation in the SBIC debenture program. As we previously mentioned, out of respect for the SBA and their licensing process we will only be providing updates on major milestones going forward. Finally, in regards to the share repurchase program currently in place we did not repurchase any shares during the quarter ended December 31, 2016.
I will now hand the call back to Bowen for some final comments.
Thanks, Michael and thank you to our shareholders for giving us the opportunity to be stewards of your capital, a responsibility we take very seriously. We continue to thoughtfully and carefully execute our investment strategy, the creation of long term sustainable shareholder value, as our most important goal.
This concludes our prepared remarks. I would like to turn the call over to the operator to open up the lines for Q&A.
Okay, thank you, operator and thank you to all participating on our call today. We look forward to keeping you apprised of our progress on future quarter calls.
Again shareholder value creation is our absolute first priority and we intend to work hard to make that happen. Thank you very much and we hope everyone has a great week.
Thank you. Ladies and gentlemen, thank you again for your participation in today's conference call.
This now concludes the program and you may now disconnect your telephone lines at this time. Everyone have a great day.
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