CSWC

Business Context and Reporting Period

Company: Capital Southwest Corporation (CSWC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: December 31, 2017
Business Overview: CSWC is an internally managed Business Development Company (BDC) and Registered Investment Company (RIC) specializing in customized debt and equity financing for lower middle market (LMM) and upper middle market (UMM) companies in the United States. The company invests primarily in senior secured debt, subordinated debt, and equity interests.

Key Financial Metrics

Note: Debt consists of $35.0 million under the Credit Facility and $55.2 million in Notes (net of issuance costs).

Material Changes vs. Prior Period

• Revenue Growth: Total investment income increased 31.4% quarter-over-quarter and 60.4% year-over-year (nine-month comparison), driven by a 49.9% increase in the cost basis of debt investments and higher weighted average yields.
• Profitability: Net investment income rose 62.3% for the quarter and 161.1% for the nine-month period compared to the prior year, aided by a significant reduction in income tax expense due to the Tax Reform Act of 2017.
• Debt Issuance: In December 2017, the company issued $57.5 million in 5.95% Notes due 2022. This was a new debt instrument not present in the prior period.
• Portfolio Expansion: Total investment portfolio fair value grew from $286.9 million (March 31, 2017) to $367.1 million (December 31, 2017). New debt investments totaled $127.4 million during the nine-month period.
• Expense Increase: Operating expenses increased 36.5% for the quarter and 37.9% for the nine-month period, primarily due to higher interest expense from increased borrowings and the new Notes issuance.

Guidance, Outlook, and Risks

• Capital Resources: Management believes cash, cash equivalents, and available borrowings under the Credit Facility are adequate for the next 12 months. The Credit Facility was amended in November 2017 to increase capacity to $180.0 million and extend maturity to November 2021.
• Tax Reform Impact: The Tax Reform Act of 2017 reduced the corporate tax rate for the company's taxable subsidiaries and the rate for "deemed distributions" of retained capital gains from 35% to 21% effective January 1, 2018. This resulted in a release of valuation allowances on deferred tax assets.
• LIBOR Risk: Approximately 91.7% of the debt portfolio is indexed to LIBOR. The potential phase-out of LIBOR by 2021 poses a risk to interest income and expense calculations.
• Portfolio Quality: As of December 31, 2017, 91.8% of the debt portfolio was rated "2" (performing as expected) and 3.6% was rated "1" (performing above expectations). No investments were on non-accrual status.
• Dividends: The company paid a quarterly dividend of $0.26 per share on January 2, 2018. For the full year 2017, total dividends were $1.16 per share.

Investor Verification Checklist

• Debt Covenants: Verify continued compliance with the 200% asset coverage ratio required by the 1940 Act and the specific covenants of the new December 2022 Notes.
• Unfunded Commitments: Confirm the status of $7.2 million in unfunded commitments (including $3.2 million to the I-45 SLF joint venture) and the company's liquidity to meet them.
• Valuation Methodology: Review the Level 3 fair value inputs used for the $299.9 million of investments valued using unobservable inputs, particularly the significant unrealized gains in TitanLiner, Inc. ($12.9 million) and Media Recovery, Inc. ($2.3 million).
• Tax Status: Monitor the company's ability to maintain RIC status and the impact of the new 21% tax rate on future distributions and retained earnings.
• LIBOR Transition: Assess the company's contingency plans for the transition away from LIBOR, given the high exposure of its floating-rate debt portfolio.