CSWC

Business Context and Reporting Period

Company: Capital Southwest Corporation (CSWC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: December 31, 2018
Business Overview: CSWC is an internally managed Business Development Company (BDC) regulated under the Investment Company Act of 1940. It specializes in providing customized debt and equity financing to lower middle market (LMM) and upper middle market (UMM) companies in the United States. The company has elected to be taxed as a Regulated Investment Company (RIC).

Key Financial Metrics

Material Changes vs. Prior Comparable Period

• Investment Income Growth: Total investment income increased 53.8% for the quarter and 48.8% year-to-date compared to the prior year periods. This was driven by a 42% increase in the cost basis of debt investments and a rise in the weighted average yield on debt investments from 10.95% to 11.56%.
• Increased Interest Expense: Interest expense rose significantly, up 162.5% for the quarter and 201.9% year-to-date. This was primarily due to increased average borrowings on the Credit Facility and the issuance of additional December 2022 Notes.
• Realized Gains: Net realized gains surged to $20.8 million for the nine months ended Dec 31, 2018, compared to $1.5 million in the prior year period, largely due to the sale and repayment of several portfolio investments.
• Unrealized Depreciation: The company recorded net unrealized depreciation of $15.1 million for the nine-month period, a reversal from the $10.8 million appreciation in the prior year. This was primarily due to the reversal of prior unrealized appreciation upon realizing gains and specific valuation adjustments on investments such as I-45 SLF LLC and American Nuts Operations LLC.
• Portfolio Expansion: Total investment portfolio fair value grew from $393.1 million at March 31, 2018, to $496.7 million at December 31, 2018.

Guidance, Outlook, Risks, and Unusual Items

• Capital Resources: Management believes cash, cash equivalents, and available credit facility commitments are adequate for the next 12 months. The company recently amended its Credit Facility to increase total commitments to $270 million and extend the maturity to December 2023.
• Dividend Policy: To maintain RIC status, the company intends to distribute substantially all taxable income. For the nine months ended Dec 31, 2018, dividends totaled $2.07 per share.
• Asset Coverage: As of December 31, 2018, the asset coverage ratio was 260%, well above the 200% requirement (which is set to decrease to 150% effective April 25, 2019).
• Portfolio Quality: As of December 31, 2018, one debt investment (approx. 1.7% of portfolio fair value) was on non-accrual status. The majority of the debt portfolio (84.4%) held an Investment Rating of 2 (performing as expected).
• Unusual Items: The significant unrealized depreciation in the current period was largely mechanical, resulting from the reclassification of unrealized gains to realized gains upon the sale of appreciated assets.

Key Facts for Investor Verification

• Debt Leverage: Verify the impact of the increased leverage (Total Borrowings of $197 million) on future net investment income, particularly given the rise in interest expense.
• Valuation Methodology: Confirm the fair value of Level 3 investments, which comprise the vast majority of the portfolio, as these rely on unobservable inputs and management estimates.
• Non-Accrual Status: Monitor the single investment on non-accrual status and its potential impact on future cash flows and valuation.
• Dividend Sustainability: Assess whether the current dividend payout rate is sustainable given the mix of cash and non-cash (PIK) income and the increased interest costs.
• Asset Coverage Ratio: Track the asset coverage ratio as the regulatory minimum decreases to 150% in April 2019, which may allow for increased leverage.