Capital Southwest Corporation — Form 10-Q Summary
Business and reporting period: Capital Southwest is an internally managed business development company (BDC) that provides debt and equity financing to lower-middle-market companies and selectively lends to upper-middle-market companies. This fiscal second-quarter filing covers the three and six months ended September 30, 2022; balance-sheet comparisons are to March 31, 2022. Amounts below are in U.S. dollars.
Financial performance and position
- Investment income: Second-quarter investment income was $26.8 million, up 32.0% from $20.3 million a year earlier. For the six months, it was $49.3 million, up 26.9% from $38.9 million, primarily reflecting a larger debt-investment portfolio and higher interest income.
- Net investment income: Second-quarter net investment income was $14.4 million ($0.52 per share), up 48.5% from $9.7 million ($0.43 per share). Six-month net investment income was $26.9 million ($1.01 per share), up 43.2% from $18.8 million ($0.86 per share).
- Operating expenses and interest: Second-quarter operating expenses were $11.8 million, including $6.6 million of interest expense; six-month expenses were $21.7 million, including $12.1 million of interest expense. The six-month interest expense increase was 16.9%, as average borrowings rose, partly offset by a lower average borrowing rate than in the prior-year period.
- Investment gains, losses and overall results: The quarter had $5.0 million of net realized and unrealized investment losses, but net assets from operations increased $9.5 million, compared with a $4.6 million decrease a year earlier. For the six months, net investment losses were $14.9 million and net assets from operations increased $12.0 million, versus $10.6 million a year earlier. The prior-year comparison included a $17.1 million loss on extinguishment of debt.
- Portfolio and valuation: Investments at fair value totaled $1.057 billion, up from $936.6 million at March 31, 2022; portfolio cost was $1.065 billion. The portfolio comprised 79 companies and was predominantly debt, with 97.6% of debt investments at fair value floating-rate. All portfolio investments were Level 3 or valued using NAV, making valuations dependent on estimates and unobservable inputs.
- Credit quality: Non-accrual investments were 0.9% of portfolio fair value and 2.3% of cost, down from 1.5% and 2.6%, respectively, at fiscal year-end. Debt investments rated 3 or 4 represented 3.1% of the debt portfolio at fair value, versus 4.7% at March 31.
- Net assets and NAV: Net assets were $475.7 million, up from $420.9 million, while NAV per share declined to $16.53 from $16.86. The filing reports a second-quarter dividend of $0.50 per share and six-month dividends of $1.13 per share.
- Cash flow and liquidity: Cash and cash equivalents were $30.2 million, up from $11.4 million at March 31. Six-month operating activities used $95.6 million, mainly reflecting $216.8 million of investment purchases and originations, partly offset by repayments and sale proceeds. Financing activities provided $114.5 million, including $72.6 million of net ATM equity proceeds, $39.0 million of SBA debenture proceeds and $35.0 million of net credit-facility borrowings, less dividends paid. Management said available cash, investment cash flows and borrowing commitments should meet needs for the next twelve months.
- Debt and leverage: Principal borrowings totaled $610 million at September 30: $240 million on the credit facility, $140 million of January 2026 notes, $150 million of October 2026 notes and $80 million of SBA debentures. Reported asset coverage was 205%; the company was in compliance with credit-facility covenants. The facility commitment was increased to $380 million, with $139.4 million available to borrow. The company also reported $134.3 million of unfunded portfolio-company commitments.
- Share issuance: The company sold 3.64 million shares through its ATM program during the six months for $72.6 million net proceeds. Shares outstanding rose to 28.8 million from 25.0 million at March 31. The ATM program was expanded to $650 million, with $392.9 million remaining available at period-end.
Changes versus comparable periods
- Second-quarter net investment income increased 48.5% year over year; six-month net investment income rose 43.2%, driven chiefly by portfolio growth and higher interest income.
- Investment marks weakened on a six-month basis: the company recorded $14.9 million of net realized and unrealized investment losses, compared with $8.9 million of gains in the prior-year period. Equity-investment gains partially offset losses on debt investments and the I-45 SLF joint venture.
- Portfolio fair value grew by $120.3 million from March 31, reflecting investment activity and valuation changes. Floating-rate debt investments and their current coupons increased as benchmark rates rose.
- Borrowings increased by $75 million from March 31, while NAV per share fell by $0.33. The company issued equity at a weighted-average price of $20.21 per share during the six months.
Outlook, risks and notable items
- Outlook: No specific earnings or investment-return guidance is provided. Management cited adequate near-term liquidity and expects to fund investments through cash, operating receipts, available credit and potential future debt and equity issuance.
- Dividends: The board declared a regular $0.52-per-share dividend and a supplemental $0.05-per-share dividend for the quarter ending December 31, 2022, for a total of $0.57 per share, payable December 30, 2022.
- Interest-rate exposure: Management estimated that a hypothetical 100-basis-point rate increase could raise annual net investment income by up to $7.1 million, or $0.25 per share, with a comparable decrease for a 100-basis-point decline. This sensitivity is not a forecast and excludes potential changes in portfolio size, credit quality and repayments. The company had no interest-rate hedges.
- Key risks: The filing identifies interest-rate volatility and rising funding costs, inflation, supply-chain and labor disruptions, economic and market uncertainty, COVID-19 effects, LIBOR transition and portfolio-company credit deterioration. The company cautions that fair values and realized outcomes may differ materially because investments are privately held and generally valued with Level 3 inputs.
- Non-cash income and commitments: PIK interest was 5.2% of second-quarter investment income and 4.2% for the six months. Such income is recorded before cash collection and may still affect required shareholder distributions. Unfunded commitments totaled $134.3 million, including $0.9 million of outstanding letters of credit.
- Other items: The filing reports no pending material legal proceedings and no material changes to previously disclosed risk factors. Management concluded disclosure controls were effective at September 30, 2022.
Important facts for investors to verify
- Whether portfolio-company earnings and payment capacity support the portfolio’s fair values, particularly for investments with unrealized losses, non-accrual status or PIK interest.
- How rising rates affect both floating-rate investment income and the cost of the company’s floating-rate credit-facility borrowings.
- Whether investment repayments and cash generation, together with facility availability, are sufficient to fund $134.3 million of commitments, dividends and new investments.
- The effects of ATM share issuance on per-share earnings and NAV, including the prices at which additional shares may be sold.
- Whether the reported non-accrual and portfolio-rating trends persist, and whether management’s estimated interest-rate sensitivity remains relevant as portfolio and financing balances change.