Capital Southwest Corporation — Form 10-Q Summary
Reporting period: Three months ended June 30, 2023 (the first quarter of fiscal 2024; the filing’s period is not calendar Q1). Capital Southwest is an internally managed business development company (BDC) providing debt and equity financing to lower- and upper-middle-market businesses.
Financial and portfolio performance
| Metric | Quarter ended June 30, 2023 | Comparable 2022 period or prior quarter |
|---|---|---|
| Investment income | $40.4 million | $22.5 million; up 79% year over year |
| Net investment income (NII) | $24.6 million; $0.65 per share | $12.4 million; $0.49 per share |
| Net realized investment gain/(loss), net of tax | $(12.8) million | $2.3 million gain |
| Net unrealized investment appreciation/(depreciation), net of tax | $12.0 million | $(12.2) million |
| Increase in net assets from operations | $23.8 million; $0.63 per share | $2.5 million; $0.10 per share |
| Interest expense | $9.7 million | $5.5 million; up 76.5% |
Investment-income growth reflected a larger debt portfolio and higher yields, including from floating-rate assets. NII increased 97.4% year over year, while higher borrowing costs and employee compensation partly offset income growth. The reported annualized ratio of NII to average net assets was 15.80%, compared with 11.48% a year earlier.
At June 30, investments had a fair value of $1.285 billion, up from $1.206 billion at March 31. The portfolio comprised 90 companies, compared with 86 at March 31. Debt represented 90.1% of direct portfolio fair value; 87.2% of investments were secured by a first lien. The weighted-average effective yield on debt investments was 12.9%, versus 12.8% at March 31.
Non-accrual investments increased to 1.7% of portfolio fair value and 2.5% of cost, from 0.3% and 1.3%, respectively, at March 31. Debt investments rated below underwriting expectations (rating 3) represented 3.9% of the debt portfolio; none were rating 4 at June 30.
Balance sheet, funding and distributions
- Total assets were $1.337 billion; net assets were $636.2 million. Net asset value was $16.38 per share, essentially unchanged from $16.37 at March 31.
- Debt had a recorded value of $672.3 million ($681.9 million principal), including $195.0 million drawn on the credit facility, $125.0 million of SBA debentures, and $361.9 million principal of unsecured notes. Credit-facility borrowings were $40 million lower than at March 31, while the company issued $71.9 million of 7.75% notes due 2028 in June.
- Asset coverage was 237%; the company reported compliance with credit-facility financial covenants. Cash and cash equivalents were $21.3 million, with $204.4 million of credit-facility availability at June 30.
- Operating activities used $55.6 million of cash, primarily reflecting $104.1 million of investment purchases and originations. Financing activities provided $55.3 million, and cash declined $0.3 million. Management said available cash, investment proceeds, operating cash flows and borrowing capacity were adequate for expected needs over the next 12 months.
- The company declared $0.59 per share for the June quarter: $0.54 regular and $0.05 supplemental. On August 3, it declared $0.62 per share for the quarter ending September 30: $0.56 regular and $0.06 supplemental.
Changes, outlook and risks
- Investment income rose sharply year over year, but investment performance included $12.8 million of net realized losses, mainly related to debt losses and restructuring activity. Unrealized appreciation of $12.0 million largely offset those losses; the combined net realized and unrealized investment loss was $0.7 million.
- The company sold 2.53 million common shares through its at-the-market program for $44.9 million of net proceeds, at a weighted-average price of $18.03. Share issuance supported funding but increased the share count. It also cancelled 2.34 million treasury shares.
- After quarter-end, the credit facility was amended to increase commitments from $400 million to $435 million, add an uncommitted accordion feature up to $750 million, and extend the revolving period to August 2027 and maturity to August 2028.
- No quantified earnings or investment guidance is provided. Management cited inflation, supply-chain and labor constraints, rising rates, financial-market volatility, possible recession and geopolitical uncertainty, and said it was increasing oversight of credits in vulnerable industries.
- Rate exposure is material: 97.2% of debt investments by fair value carried floating rates, while the credit facility also has a floating rate. The company was not party to hedging arrangements. Its modeled annualized NII sensitivity was approximately $4.8 million per 50-basis-point rate change, assuming portfolio and borrowings remain unchanged; the filing estimates a $19.1 million decrease for a 200-basis-point decline.
- Investment values rely predominantly on Level 3 inputs and internal valuation judgments; the filing notes actual realized values may differ materially. Unfunded debt and equity commitments totaled approximately $130.5 million, in addition to $0.9 million of outstanding letters of credit. The company reported no pending material legal proceedings.
- The board delegated investment fair-value determinations to an officer valuation committee beginning this quarter, subject to board oversight. The filing reports that substantially all LIBOR-referenced loans had transitioned to CME Term SOFR and warns the replacement rates may not produce equivalent economics.
Most important facts for investors to verify
- Whether the increase in non-accrual investments and rating-3 exposures continues, and how portfolio-company credit quality affects collections and valuations.
- Whether investment income and NII remain sufficient to cover the regular and supplemental dividends, particularly if rates or borrowing costs decline or portfolio performance weakens.
- How much of the $130.5 million in unfunded commitments is drawn, and whether credit-facility availability and asset coverage remain adequate after funding needs and distributions.
- Whether realized losses, the new 7.75% notes, and continued ATM share issuance affect NAV per share, leverage, and per-share earnings.
- The assumptions and valuation sensitivities behind the predominantly Level 3 portfolio, including the rise in non-accrual fair value share from 0.3% to 1.7% of investments.