Capital Southwest Corporation — Form 10-Q
Business context and period: Capital Southwest is an internally managed business development company (BDC) providing debt and equity financing primarily to lower-middle-market companies, with some upper-middle-market exposure. This filing covers the fiscal first quarter ended June 30, 2022; income and cash-flow comparisons are against the three months ended June 30, 2021. Balance-sheet comparisons are against March 31, 2022. Figures are in U.S. dollars.
Financial performance and position
- Investment income: $22.5 million, up 21.3% year over year. Growth reflected higher debt investment balances and fee income, partly offset by lower dividend income from I-45 SLF LLC.
- Net investment income (NII): $12.4 million, up 37.5%; NII per share was $0.49 versus $0.43. Total operating expenses were $9.9 million, including $5.5 million of interest expense.
- Operating results: Net increase in net assets from operations was $2.5 million, or $0.10 per share, versus $15.1 million, or $0.71 per share, a year earlier. Net realized gains after tax of $2.3 million were more than offset by net unrealized investment depreciation after tax of $12.2 million.
- Portfolio: Fair value was $1.007 billion, up from $936.6 million at March 31; the company held investments in 76 portfolio companies. Weighted-average annual effective yield on direct portfolio debt was 9.3%. About 97.7% of debt investments at fair value bore floating rates.
- Credit quality: Four investments were on non-accrual, representing 1.6% of portfolio fair value and 2.7% of cost, versus three investments at March 31. Debt investments rated 3 or 4 represented 5.2% of the debt portfolio, compared with 4.7% at March 31.
- Net assets and liquidity: Net assets were $453.0 million; NAV was $16.54 per share, down from $16.86 at March 31. Cash and cash equivalents were $18.8 million. Management said cash, investment cash flows and available credit were adequate for the next 12 months; available credit-facility borrowings were $161.3 million.
- Debt and leverage: Debt principal totaled $585 million: $215 million under the credit facility, $140 million of January 2026 Notes, $150 million of October 2026 Notes and $80 million of SBA debentures. Regulatory asset coverage was 206%; the company reported compliance with credit-facility covenants.
- Cash flow: Operating activities used $69.8 million, principally reflecting $135.0 million of investment purchases, partly offset by debt investment repayments and sales. Financing activities provided $77.3 million, including $46.1 million net ATM proceeds and $39.0 million from SBA debentures, partly offset by $16.6 million in dividends. Cash increased $7.3 million during the quarter.
- Shareholder distributions and equity: The quarter’s distributions were $0.63 per share, comprising $0.48 regular and $0.15 special dividends. The company issued 2.26 million ATM shares for $46.8 million gross proceeds at a weighted-average price of $20.66 per share.
Material changes versus comparable periods
- Investment income rose 21.3% and NII rose 37.5% year over year, supported by portfolio growth and increased fee income.
- Despite higher NII, total operating results declined substantially from the prior-year quarter because investment valuation changes shifted from appreciation to depreciation. The quarter’s $12.2 million net unrealized depreciation included losses on the I-45 joint venture and other investments.
- Portfolio fair value increased $70.0 million from March 31, reflecting new investment activity, partly offset by repayments and valuation declines. Direct portfolio debt cost basis increased year over year.
- Debt principal increased by $50 million from March 31, including an additional $40 million of SBA debentures and a $10 million increase in credit-facility borrowings. The credit facility’s commitments were increased from $335 million to $380 million, and its benchmark changed from LIBOR to Adjusted Term SOFR.
- NAV per share fell $0.32 during the quarter after the $0.63 distribution, while the company raised substantial equity through ATM issuance.
Outlook, commentary and risks
- Management stated that available liquidity was adequate for anticipated needs over the next 12 months and expects to fund investments through operating cash flows, available credit and potential future debt and equity issuance. No earnings or portfolio guidance was provided.
- Management highlighted continued monitoring of COVID-19 impacts, inflation, supply-chain constraints, labor difficulties, financial-market conditions and portfolio-company performance.
- Interest-rate exposure is significant: floating-rate investments may benefit from rising rates, but borrowing costs can also increase. A hypothetical 100-basis-point increase was estimated to raise annual NII by up to $6.8 million, or $0.25 per share; a decrease was estimated to reduce it by up to $6.4 million, or $0.23 per share. The filing cautions that these estimates exclude potential changes in credit quality, portfolio composition, repayments and future borrowing.
- Most portfolio investments are privately held and valued using Level 3 inputs. Actual realizations may differ materially from reported fair values. Other risks include non-accrual loans, PIK income that is not received in cash, $125.3 million of unfunded portfolio commitments, and reliance on external and equity-market financing. The filing reports no pending material legal proceedings and no material changes to previously disclosed risk factors.
- After quarter-end, the board declared a $0.50-per-share dividend for the quarter ending September 30, 2022, payable September 30 to shareholders of record September 15.
Most important facts for investors to verify
- Whether portfolio-company performance and collateral support the Level 3 fair values, particularly for investments with declines or impaired credit ratings.
- Trends in non-accruals, payment-in-kind income and the collectability of accrued interest and dividends.
- Whether floating-rate income growth outweighs higher funding costs as rates rise, including the effect of the credit facility’s SOFR transition.
- How unfunded commitments, letters of credit and new investment activity affect liquidity, leverage and asset-coverage headroom.
- The effect of ATM share issuance and future distributions on NAV per share and shareholder returns; distinguish reported NII from total investment results and market-price returns.
- The risk that estimated taxable income and required distributions differ from book earnings; the filing’s interim taxable-income estimate is not final.