CAPITAL SOUTHWEST CORP annual report, FY2023

Full document

Capital Southwest Corporation — FY2023 Form 10-K

Reporting period: Fiscal year ended March 31, 2023; comparisons are primarily with the year ended March 31, 2022. This is an annual filing, not a calendar-year 2022 fourth-quarter report.

Business context

Capital Southwest is an internally managed business development company (BDC) and regulated investment company (RIC). It provides customized debt and equity financing mainly to U.S. lower-middle-market companies, with selective upper-middle-market lending. Its objective is current income from debt and capital appreciation from equity investments.

Financial performance and position

  • Investment income: $119.3 million, up 45.1% from $82.2 million. Management attributed the increase mainly to higher debt-investment balances and yields.
  • Net investment income (NII): $68.7 million, up 61.0% from $42.7 million; NII per share was $2.29 versus $1.87. Total operating expenses, including interest, were $50.3 million versus $38.9 million. Interest expense rose 44.9% to $28.9 million.
  • Net increase in net assets from operations: $33.1 million, down 22.7% from $42.8 million. FY2023 included $17.0 million of net realized investment losses and $18.6 million of net unrealized depreciation; FY2022 had gains in both categories and a $17.1 million debt-extinguishment loss.
  • Portfolio: Fair value grew to $1.206 billion from $936.6 million, across 86 portfolio companies versus 73. Debt investments were 89.8% of direct portfolio fair value; 86.7% of investments were first-lien secured. Weighted-average effective yield on debt investments increased to 12.8% from 9.3%.
  • Credit quality: 95.7% of debt-portfolio fair value was rated 1 or 2, compared with 95.3% a year earlier. Rating 3 exposure was 4.3%; rating 4 was less than 0.1%. Non-accrual investments were 0.3% of portfolio fair value, down from 1.5%.
  • Assets and NAV: Total assets were $1.258 billion; net assets were $590.4 million. NAV per share fell to $16.37 from $16.86. The filing identifies investment valuation as a significant estimate: $1.155 billion of investments were Level 3 fair-value measurements.
  • Cash flow and liquidity: Cash and equivalents were $21.6 million at year-end, up from $11.4 million. Operating activities used $227.1 million, largely reflecting $433.2 million of investment purchases; financing activities provided $237.5 million. The company reported $164.4 million of available Credit Facility capacity and said liquidity was adequate for the next 12 months.
  • Debt and leverage: Principal debt outstanding totaled $645 million: $235 million under the secured revolving facility, $140 million of 4.50% notes due January 2026, $150 million of 3.375% notes due October 2026, and $120 million of SBA debentures. Asset coverage was 235%, versus 193% a year earlier; the Board’s stated internal minimum is 166% (statutory minimum 150%). The Credit Facility had $400 million of commitments and a final maturity of August 2026.
  • Capital and distributions: ATM sales generated $158.8 million net proceeds and an underwritten offering generated $44.1 million net proceeds. Cash dividends paid were $71.1 million. The Board declared a $0.58-per-share dividend for the quarter ended March 31, 2023; after year-end it declared $0.59 per share for the quarter ending June 30, 2023.

Material changes versus FY2022

  • Investment income and NII increased substantially, while interest costs also rose amid greater average borrowings and higher rates.
  • Investment fair value expanded by about $269.8 million, and the portfolio grew by 13 companies. New debt investment activity was $374.6 million, below FY2022’s $458.4 million; repayments and prepayments were also lower.
  • Investment results shifted from net realized and unrealized gains in FY2022 to combined net realized and unrealized losses of $35.6 million in FY2023.
  • Year-end debt principal increased from $535 million to $645 million, including SBA debentures increasing from $40 million to $120 million. Common shares outstanding rose from 25.0 million to 36.1 million, principally through equity issuance.
  • Credit Facility borrowings moved from LIBOR to Adjusted Term SOFR during FY2023; the weighted-average facility rate rose to 5.22% from 2.50%.

Outlook, risks, and unusual items

  • No earnings or investment-return guidance was provided. Management said available cash, expected operating cash flows, and borrowing capacity should support needs for the next 12 months, while noting it would continue monitoring liquidity and market conditions.
  • Management cited inflation, supply-chain and labor pressures, rising interest rates, banking-system volatility, geopolitical uncertainty, and possible recession as risks to portfolio-company performance and valuations. Floating-rate assets may raise income, but higher rates can also increase borrower stress and the cost of the floating-rate Credit Facility.
  • About 96.7% of debt-investment fair value bore floating rates, with contractual floors. The company was not party to interest-rate hedges. Its sensitivity analysis estimated that a 100-basis-point rate decrease would reduce annual NII by approximately $8.5 million, assuming the portfolio and borrowings remained unchanged.
  • Unfunded investment commitments were approximately $125.2 million, including $0.9 million of outstanding letters of credit. The filing states assets and available facility capacity were adequate to cover commitments.
  • Portfolio values are largely based on unobservable inputs. The independent auditor issued an unmodified opinion and identified Level 3 investment valuation as a critical audit matter. Management reported effective disclosure controls and internal control over financial reporting.
  • Moody’s assigned the company a Baa3 long-term issuer rating with a stable outlook on March 31, 2023. No material pending legal proceedings were reported.

Important facts for investors to verify

  1. Whether portfolio-company operating results, non-accrual levels, and the 4.3% rating-3 exposure remain stable after year-end, especially amid higher rates and economic uncertainty.
  2. How subsequent realizations and valuation changes compare with the $1.155 billion Level 3 portfolio valuation, including performance of I-45 SLF LLC, whose FY2023 operations included $15.2 million of unrealized depreciation.
  3. Whether NII and dividend coverage remain resilient as borrowing costs rise; compare reported NII per share of $2.29 with distributions and the company’s cash versus non-cash income.
  4. How the $125.2 million of unfunded commitments, $235 million of secured-facility borrowings, and debt maturities are managed while maintaining asset coverage and credit covenants.
  5. The effects of equity issuance on per-share results and NAV: shares outstanding increased materially while NAV per share declined to $16.37.