Capital Southwest Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
January 30, 2024

There are 10 speakers on the call.

Operator

Thank you for joining today's Capital Southwest Third Quarter Fiscal Year 20 24 Earnings Call. Participating on the call today are Bowen Diehl, CEO Michael Sarner, CFO and Chris Reberger, VP, Finance. I will now turn the call over to Chris Reberger.

Speaker 1

Thank you. I'd like to remind everyone that in the course of this call, we will be making certain forward looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC.

Speaker 1

The company does not undertake any obligation to update or revise any forward looking statements whether as a result of new information, future events, changing circumstances or any other reason after the date of this press release, except as required by law. I will now hand the call off to our President and Chief Executive Officer, Bowen Neal.

Speaker 2

Thanks, Chris, and thank you to everyone for joining us for our Q3 fiscal year 2024 earnings call. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio as we continue to diligently execute our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found in the Investor Relations section of our website at www.capitalsouthwest.com. You will also find our quarterly earnings press release issued last evening on our website. We'll begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter.

Speaker 2

During the quarter, we generated pre tax net investment income of $0.72 per share, which represented 20% growth over the $0.60 per share generated a year ago in the December quarter. The $0.72 per share more than covered both our regular dividend of $0.57 per share and our supplemental dividend of $0.06 per share Hey, during the quarter. Portfolio earnings continue to be strong as of the end of the quarter. As of the end of the quarter, we estimate that our undistributable taxable income was $0.52 per share. Additionally, net asset value per share increased 1.9% for the quarter to $16.77 per share from the $16.46 per share as of the end of the prior quarter.

Speaker 2

This increase represented the 4th consecutive quarterly NAV per share increase for Capital Southwest. We are also pleased to announce today that our Board of Directors has declared a regular dividend of $0.57 per share for the March 24 quarter. This represents 7.5% growth over the $0.53 per share paid a year ago in the March quarter. In addition, due to the excess earnings being generated by our floating debt investment portfolio in this high interest rate environment, Our Board has again declared a supplemental dividend of $0.06 per share for the March 24 quarter, bringing total dividends declared for the March 24 quarter to $0.63 per share, which in total represents 9% growth over total dividends paid out in the year ago quarter. While future dividend declarations are at the discretion of our Board of Directors, It is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future, While base rates are above historical averages and we have meaningful UTI, which is generated by earnings in excess of our dividends and realized gains from our equity co investment portfolio.

Speaker 2

During the quarter, deal quality and activity in the lower middle market continued at a healthy pace And we continue to be able to source attractive investment opportunities. Private equity firms and business owners continued to transact while non bank lenders like Capital Southwest continue to provide more certainty to closing than traditional bank financing structures. That said, competition from other non bank lenders for quality lower middle market opportunities has largely returned to the more normal levels seen 12 to 18 months ago, resulting in tighter pricing spreads as well as slightly higher leverage and loan to value in the closing capital structures. In the larger end of the lower middle market, which is typically where we exit our investments, M and A activity picked up during the quarter as well, resulting in increased prepayments across our portfolio. Portfolio growth during the quarter was driven by $116,300,000 in new commitments, consisting of $70,700,000 in commitments to 4 new portfolio companies and $45,600,000 in commitments to 12 existing portfolio companies.

Speaker 2

This was offset by $79,000,000 in proceeds from 5 debt prepayments and one equity exit during the quarter, generating a weighted average IRR of 12.2%. On the capitalization front, we are pleased to announce During the quarter, we successfully upsized our corporate revolving credit facility to $460,000,000 from $435,000,000 with the addition of 1 new lender to the bank syndicate. We also raised $66,500,000 in gross equity proceeds During the quarter, through our equity ATM program at a weighted average price of $21.92 per share or 133% of the prevailing NAV per share. In addition, subsequent to quarter end, The I-forty five credit facility was repaid in full and we are currently in the process of winding down the I-forty five senior loan fund. As most of you know, I-forty five was initially created to invest in small pieces of large syndicated loans.

Speaker 2

The I-forty five has been a success through the years. The market for syndicated loans has evolved and we no longer view this market as a favorable place to generate attractive risk adjusted returns for our shareholders. Michael will discuss the timing and mechanics of the dissolution of I-forty five in further detail in a moment. We have remained diligent in ensuring we have strong balance sheet liquidity, while also funding a meaningful portion of our investment activity with accretive equity issuances. We continue to maintain a conservative mindset to both balance sheet liquidity and BDC leverage, Managing the company with a full economic cycle mentality.

Speaker 2

While this starts with our underwriting of new investment opportunities, It also applies to how we manage the BDC's capitalization and liquidity. Managing leverage to the lower end of our target range, while ensuring strong balance sheet liquidity affords us the ability to invest in new platform companies even in periods of volatile capital markets when risk adjusted returns can be particularly attractive. Additionally, it allows us to support our portfolio companies, while also opportunistically repurchasing our stock if it were to trade meaningfully below NAV. On Slide 7 and 8, we illustrate our continued track record of producing strong dividend growth, consistent dividend coverage and solid value creation the launch of our credit strategy back in January 2015. Since that time, we have increased our quarterly regular dividend 28 times and have never cut the regular dividend, all while maintaining strong coverage of our regular dividend with pre tax net investment income.

Speaker 2

Additionally, over the same period, we have paid or declared 23 special or supplemental dividends totaling $3.89 per share, including the $0.06 per share the Board has declared for the March 24 quarter, all generated from excess earnings and realized gains from our investment portfolio. We believe our track record of thoughtfully growing our dividend, A consistently solid performance in our portfolio as well as our company's sustained access to multiple capital sources has demonstrated the strength of our investment and capitalization management strategies as well as the absolute alignment of all our decisions with the interest of our shareholders. Turning to Slide 9, we lay out the core tenets of our investment strategy. Our core strategy is lending and investing in the lower middle market, The vast majority of which is in 1st lien senior secured loans to companies backed by private equity firms. In fact, approximately 92% of our credit portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio as well as the potential for new junior capital support if needed.

Speaker 2

In the lower middle market, we often have the opportunity to invest On a minority basis, in the equity, carry pursue with the private equity firm when we believe the equity thesis is compelling. As of the end of the quarter, our equity co investment portfolio consisted of 62 investments with a total fair value of 129,100,000 which was marked at 143 percent of cost, representing $38,500,000 in embedded unrealized appreciation or $0.90 per share. Our equity portfolio, which represented approximately 9% of our total portfolio at fair value as of the end of the quarter, continues to provide our shareholders participation in the attractive upside potential of these growing lower middle market businesses, which will come in the form of NAV per share growth and supplemental dividends over time. As illustrated on Slide 10, Our on balance sheet credit portfolio ended the quarter at $1,200,000,000 representing year over year growth of 19% from $990,000,000 as of December 2022 quarter. For the current quarter, 100% of our new portfolio company debt originations were 1st lien senior secured and as of the end of the quarter, 97% of our credit portfolio was 1st Senior Security.

Speaker 2

The weighted average credit exposure per company remains granular at 1.2%. We believe our portfolio granularity speaks to our continued investment discipline of maintaining a conservative posture to overall risk management as we grow our balance sheet. We fully expect that this metric will continue to improve as our asset base growth. On Slide 11, we detail the $116,300,000 of capital invested in and committed to portfolio companies during the quarter. Capital committed this quarter included $66,700,000 in 1st lien senior secured debt committed to 4 new portfolio companies in which we also invested a total of $4,000,000 in equity.

Speaker 2

We also committed a total of $43,500,000 in 1st lien senior secured debt and $2,100,000 in equity to 12 existing portfolio companies. We are pleased with the strong market position that our has established in the lower middle market as a premier debt and equity capital provider as evidenced by the broad array of relationships across the country, which our team is sourcing quality opportunities as well as this consistency of our origination activity. In fact, deal activity post quarter end has continued at a healthy pace and we expect solid net portfolio growth in the coming quarter. Turning to Slide 12, as I mentioned earlier, increased M and A and refinancing activity during the quarter resulted in greater than average prepayment activity. We continued our track record of strong returns on our exits with 5 debt prepayments and 1 equity exit during the quarter.

Speaker 2

In total, these exits generated approximately $79,000,000 in total proceeds, generating a weighted average IRR of 12.2%. Since the launch of our credit strategy 9 years ago, we have realized 73 portfolio company HEXAs, representing $885,000,000 in proceeds that have generated a cumulative weighted average IRR of 13.9%. On Slide 13, we detail some key steps for our on balance sheet portfolio as of the end of the quarter, excluding our I-forty five joint venture. As of the end of the quarter, the total portfolio at fair value was weighted 87.5 percent to 1st lien senior secured debt, 2.6% to 2nd lien senior secured debt, 0.1% to subordinated debt and 9.8% to equity co investments. The credit portfolio had a weighted average yield of 13.5% and weighted average leverage through our security of 3.6 times.

Speaker 2

Cash flow coverage of debt obligations across our portfolio continued to be strong despite the high base rate environment. With weighted average interest coverage of 3 times and weighted average fixed charge coverage of 2.5 times. As seen on Slide 14, our total investment portfolio continues to be well diversified across industry with an asset mix, which provides strong security for our shareholders' capital. Turning to Slide 15, we have laid out the rating migration within our portfolio during the quarter. As a reminder, all loans upon origination are initially signed an investment rating of 2 on a 4 point scale with 1 being the highest rating and 4 being the lowest rating.

Speaker 2

We feel very good about the performance of our portfolio with 95 of the portfolio at fair value rated as one of the top 2 categories a 1 or a 2. In fact, the portfolio generated weighted average revenue growth of 3% and weighted average EBITDA growth of 7% during the quarter. I will now hand the call over to Michael to review more specifics of our financial performance for

Speaker 1

the quarter. Thanks, Bowen. Specific to our performance for the quarter, as summarized on Slide 17, We increased pretax net investment income by 13% quarter over quarter to $29,800,000 or $0.72 per share compared to $26,400,000 or $0.67 per share in the prior quarter. During the quarter, We paid out a $0.57 per share regular dividend and a $0.06 per share supplemental dividend. As mentioned earlier, Our Board has declared a regular dividend of $0.57 per share and declared a $0.06 per share supplemental dividend for the March quarter.

Speaker 1

Maintaining a consistent track record of meaningfully covering our dividend with pre tax net investment income is important to our investment strategy. We continue our strong track record of regular dividend coverage with 123% coverage for the last 12 months ended December 31, 2023, and 110 percent cumulative coverage since the launch of our credit strategy in January 2015. As a reminder, our intent is to continue to distribute a portion of the excess of our quarterly pre tax NII over our regular dividend to our shareholders in a quarterly supplemental dividend. We are confident in our ability to continue to distribute quarterly supplemental dividends For the foreseeable future, based upon our current UTI balance of $0.52 per share, our ability to grow UTI each quarter organically by over earning our total dividend and the expectation that we will harvest gains over time from our existing $0.90 per share in unrealized appreciation on the equity portfolio. For the quarter, we increased total investment income to $48,600,000 representing 14% growth quarter over quarter and 48% growth from a year ago.

Speaker 1

Weighted average yields in the portfolio on all investments was 13.7%. Total investment income was $5,800,000 higher this quarter, primarily driven by an increase in the weighted average cost basis of our debt investments as well as an increase in dividend and fee income. As of the end of the quarter, we had 3 portfolio companies with loans on non accrual representing 2.2% of our investment portfolio at fair value. As seen on Slide 18, we maintained LTM operating leverage at 1.8% for the current quarter. To put this metric in perspective, our 1.8% operating leverage is the 2nd best in the entire BDC industry.

Speaker 1

We believe this metric speaks to the benefits of the internally managed BDC model and our absolute alignment with shareholders. The internally managed model has and will continue to produce real fixed cost leverage, while also allowing for significant resources to invest in people and infrastructure to continue to build a best in class BDC. As we look forward, we expect further improvements in operating leverage as we continue to grow the balance sheet over time. Turning to Slide 19, the company's NAV per share at the end of the quarter increased by $0.31 per share to $16.77 representing an increase of 1.9% compared to the prior quarter. The primary drivers of the NAV per share increase for the quarter were earnings in excess of our total dividends paid for the quarter and accretion from the issuance of common stock at a premium to NAV per share, partially offset by net unrealized depreciation on our investment portfolio.

Speaker 1

Turning to Slide 20, we are pleased to report that we have significant balance sheet liquidity with approximately $333,000,000 in cash and undrawn leverage commitments on both our revolving credit facility and SBA debentures as of the end of the quarter. We recently completed an increase to our revolving credit facility, adding 1 new lender and bringing total revolver credit facility commitments to $460,000,000 from $435,000,000 in the prior quarter. Based on our current borrowing base, we have access to the full $460,000,000 revolver The facility has an accordion feature allowing for the further increase of total commitments up to an aggregate of 750,000,000 allowing us to continue to grow our revolver capacity in lockstep with the growth of our overall balance sheet. In addition, during the quarter, we received an additional leverage commitment in the amount of $45,000,000 from the SBA from which we can draw upon in the future. As of the end of the December quarter, 53% of our capital structure liabilities were in unsecured covenant free bonds with our earliest debt maturity in January 2026.

Speaker 1

Finally, as Bowen mentioned earlier, subsequent to quarter end, The I-forty five credit facility was repaid in full at the option of the joint venture partners. We are currently in the process of winding down the I-forty five fund by allocating the residual assets in the fund to the joint venture partners. Assets from the fund will be allocated from the financing subsidiary to the balance sheet of each joint venture partner consistent with their invested capital. The impact to Capital Southwest will be a small increase in assets, Slightly higher leverage due to the pay down of the I-forty five credit facility and a modest increase in earnings as we eliminate frictional costs related to the FUD. Our regulatory leverage, as seen on Slide 21, ended the quarter at a debt to equity ratio of 0.77:one, down meaningfully from 0.91 to 1 as of the year ago December quarter.

Speaker 1

We opportunistically brought leverage slightly below our target range as of the end of December quarter, in part to accommodate the I-forty five credit facility payoff and I-forty five fund wind down. We will continue to methodically and opportunistically raise secured and unsecured debt capital as well as equity capital through our ATM program to ensure we continue to maintain significant liquidity, conservative leverage and adequate covenant cushions throughout all economic cycles. Will now hand the call back to Bowen for some final comments.

Speaker 2

Thanks, Michael. And again, thank you everyone for joining us today. We appreciate the opportunity to provide you an update on our business, our portfolio and the market environment. Our company and portfolio continue to demonstrate performance and we continue to be impressed by the job our team has done in building a robust asset base, deal origination and portfolio management capability, as well as a flexible capital structure. We believe we have prepared our company well for future growth and performance and we feel very good about how our shareholders' capital is positioned in the market.

Speaker 2

In summary, we have a credit portfolio predominantly made up 1st lien senior secured debt allocated across a broad array of companies and industries, over 90% of which is backed by private equity firms, while also enjoying participation in the equity upside of many of these growing lower middle market businesses. Further, We have a well capitalized balance sheet with multiple capital sources, very strong liquidity and a flexible capital structure. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q and A.

Speaker 3

Thank you. Our first question comes from the line of Mickey Schleien with Ladenburg Thalmann. Your line is open.

Speaker 4

Yes, good morning, everyone. Bowen, there was this theory that M and A volumes really wouldn't pick up until So with certainty that the Fed would cut rates and I'm in the camp that we don't know and inflation is still not at their target And obviously, rates have not come down yet. So from your perspective, what's driving this increase, which you mentioned has spilled over into the Q1?

Speaker 2

Yes, it's interesting. I mean, if you look at our 5x, 3 of them were sales And 2 of them are refinancing. On the sales, I mean, these are privately backed firms. There's strategic interest In the assets, I think they were all strategic sales looking at them. So they were just it was just Kindly, it's private equity firms trying to print gains in companies that are performing.

Speaker 2

So there is strategic interest in the assets. And so I don't know, we had the same press clippings you do. Those trends are probably true as you laid out, but it's a little random. I mean, Our portfolio just had a number of sales in it. I attribute part of that to general Increase in M and A activity we've seen out there.

Speaker 2

We also see our deal flow as well-being really strong. We've also seen

Speaker 1

the top half of our portfolio, the long grade ones. These companies, we have a significant number of companies that have delevered Underneath 2 times even to the extent that are half term to a turn and a half. And so those guys will find potentially a lower yielding option than where maybe they were when we originated them.

Speaker 2

Yes, that's more of a company performance aspect. That's true for sure. But the M and A activity, just looking at these names, I mean, there just has been interest in those assets. In those private equity firms, obviously, they don't get paid until they sell and monetize, pay their carry. So they hit the bid.

Speaker 4

I understand. That's helpful. I noticed there were a couple of 2 credit downgrades during the quarter. Can you Describe general trends in credit quality in the portfolio and in particular what these two were about?

Speaker 2

Yes, I mean if you kind of take a step back and look at trends in our portfolio, if you look at revenue and EBITDA growth, you look at the number of upgrades versus downgrades, I'd say credit performance in our portfolio as a whole is excellent. The 2 down rates, 1 was Already a non accrual or a challenge. We basically had a Term Loan B and downgraded. We downloaded the Term Loan A. And the other one was a company that's kind of bumping along and we decided to go ahead and downgrade it.

Speaker 2

So it's a new downgrade, not an existing. But again, if you look at 60 something 1000000 of upgrades and 30,000,000 of downgrades, I'd say it's a general trends perspective, it looks okay.

Speaker 4

Fair enough. And my last question, More housekeeping. Can you help me understand the net realized loss because on Page 12 of the investor presentation, there is a realized gain, but there is a much more meaningful net realized loss on the income statement. Can you just reconcile that?

Speaker 1

Yes. 1 of our portfolio companies had a restructuring, which a portion of their debt was converted to equity.

Speaker 5

So from a

Speaker 1

accounting perspective, that's

Speaker 3

going

Speaker 1

to you'll see that show up as a realized loss for the quarter. And you'll see when the 10 Q comes out, You'll see a full reconciliation for the quarter of kind of what happened to each of the companies.

Speaker 6

And that was one

Speaker 2

of our non accruals. It's been a non accrual and we think we voiced on a prior earnings call that we expected to have that restructuring calendar year.

Speaker 1

In fact, it happened besides

Speaker 4

I got it. And Michael, the queue is coming out tonight?

Speaker 1

Yes. Okay.

Speaker 4

Those are all my questions. I appreciate your Time as always. Thank you.

Speaker 1

Thanks, Becky. Yes, thanks, Becky.

Speaker 3

Thank you. Please standby for our next question. Our next question comes from the line of Robert Dodd with Raymond James. Your line is open.

Speaker 1

You must be on mute, Robert.

Speaker 3

Yes. I

Speaker 7

apologize. I was on mute. Yes, that's my back. On the leverage, right, you say you're below the bottom end of your target range, obviously some of that's planning for I-forty 5. I mean, Could you give us any color do you still feel more comfortable at the bottom or below the bottom of the target range for leverage?

Speaker 7

Or can you give us an update on where you think if the economies may be doing better than you thought, your credit quality Hanging in very well. So I mean, can you give us some thoughts on where you see that in the medium term Conceptually I-forty five adjusted.

Speaker 5

Sure, of course.

Speaker 1

So I-forty five is adjusted. I think we were more at 0.83 times. I think for a go forward basis, I would give you the range of 0.8 to really 0.95. That's essentially where we'd like to stay in. And at the moment, like you said, we'd see kind of clear skies ahead at the moment.

Speaker 1

Portfolio is performing well. You can see us tick up closer to the higher end in the next several quarters. But we're honestly, if you look at our earnings Related to our NAV, we are one of the more productive companies in the BDC space. We'll be able to produce $0.72 on 0.77 leverage. So we don't really need to press the gas pedals.

Speaker 1

So you probably see us somewhere along the middle of that range.

Speaker 7

Got it. Got it. Thank you. Then on I-twenty five real quick, I mean, it's got $27,000,000 I think in unrealized Appreciation and apparently when it's when the assets are onboarded, are they going to be onboarded at the existing cost and fair value basis, I. E.

Speaker 7

The unrealized Depreciation will stay or is any of that going to be crystallized during the onboarding process?

Speaker 1

Sure. So a portion so the assets that are being assigned to each of our balance sheets will come over at cost and fair value. The amount of losses or gains that have been incurred in portfolio companies that have already exited, that will just get reclassified from unrealized equity to retained earnings.

Speaker 7

Got it. Thank you. And then sorry, go ahead.

Speaker 1

No, go ahead. I apologize.

Speaker 7

Yes. Last one kind of has to be on the dividend income was quite large. It looks like there was maybe a $2,000,000 non recurring Maybe to do with one of the portfolio company sales, if you don't have any capital or anything like that. Can you give us any I mean, was it a one time kind of $2,000,000 or has something changed in one of the performing the early performing portfolio companies where it's going to start paying your consistent dividend or was that one off?

Speaker 1

No. So yes, so this quarter we had one portfolio company, It's probably one of our most successful portfolio companies that had essentially less than one time had a dividend recap. We have an equity position with significant appreciation on the company. And so we participated in that dividend to the tune of $2,300,000 and that's So one time occurrence.

Speaker 7

Got it. Thank you.

Speaker 3

Our next question comes from the line of Kyle Joseph with Jefferies. Your line is open.

Speaker 8

Hey, good morning guys. Thanks for taking my questions. Most have been answered, but just, I know the queue is coming out, but just, do you mind running through any inflows or outflows to non accrual? I know you mentioned there was a structuring there and on a fair value basis, I think it ticked up 20 basis points or whatever, but just help us out in terms of the inflows and outflows?

Speaker 1

Yes. So for the non accruals, we had one portfolio company that came off. And I think we noted earlier, the portfolio company that was restructured that had the realized loss that portion came off and then we had a term loan A of another portfolio company that where the B is already on non accrual. Owen mentioned it earlier, it went on non accrual. So I think it was $15,000,000 at a cost basis coming off and $12,000,000 coming on.

Speaker 1

So a slight reduction on the cost basis and then the fair value was slightly higher.

Speaker 8

Got it. And then as you're thinking about the dividend going forward, obviously, the forward curve has adjusted pretty dramatically since the last time we spoke, but and I know you guys have strong coverage, especially over The run rate dividend, but how you're thinking about the dividend from here? Yes.

Speaker 1

So obviously, we bifurcated between the regular dividend and the supplemental dividend. On the regular dividend, obviously, we had $0.72 this quarter, which we would tell you the run rate absent that dividend, Cash dividend was really like $0.69 So we compare that $0.69 to the $0.57 we paid, so it's still significant coverage there. You noted we're still kind of in a wait and see approach to see what the Fed does to see the pace of rate reductions. We feel comfortable that when the rates come down to a neutral spot in the next 18 months to 24 months, we would expect that our NII would trough in the low 60s. So there's still plenty of room for growth on the regular dividend.

Speaker 1

But having said that, we will wait to just see how things play out. On the supplemental dividend, we continue to bank UTI by over earning our dividend, we have $0.90 of unrealized depreciation on the balance sheet that we would hope to exit a portion either something $0.04 or beyond. And so that coupled with the $0.52 of UTI we have currently, we feel very comfortable that this program will continue into the future. It's $0.06 today that may vacillate up or down, but we feel comfortable about that program going forward.

Speaker 8

Got it. Helpful. And then last one for me. We talked about credit. We talked about the ratings.

Speaker 8

But just in terms of classify with revenue or EBITDA growth and any sort of changes since we last spoke?

Speaker 2

Yes. I mean, as I noted in our remarks, we had across the portfolio, we had revenue growth quarter over quarter of 3% and EBITDA growth quarter over quarter of 7%. So portfolios feel pretty good about portfolio is general performance for sure.

Speaker 8

Got it. That's it for me. Thanks for answering my questions.

Speaker 3

Thank you. Please stand by for our next question. Our next question comes from the line of Bryce Roe with B. Riley. Your line is open.

Speaker 9

Thanks. Good morning. Maybe Bowen wanted to start on some of the exit activity. You've got, I guess, a couple of equity investment stubs that remain After those exits, what's the plan there? Is the plan to stay in those equity investments?

Speaker 9

Or Are those potential exit opportunities here over the near term?

Speaker 2

Yes. Thanks for the question. I mean, as a general matter, obviously, there are companies, the majority of them are owned by private equity firms. And so they obviously sell the company then we don't have an equity So the equity stubs are ones that we've been refinanced out of. And so just It's pretty much the rule that we will ride the liquidity curve, if you will, with the private equity firm.

Speaker 2

Private equity firms as we all know don't really get paid their carry until they exit. And so they're looking to maximize value and then looking to exit when it's prudent to exit. And we kind of ride that train with them. So long winded answer to yes, I mean those are equity stubs Our potential future exits and usually the company has been refinanced. It's probably growing and doing really well.

Speaker 2

And so just because it's market X today, I would say product equity for our money for another year or 2 probably is the exits could be lower than X, but it's pretty highly likely to be higher than X. But we ride that curve or ride that train with the private equity firm and exit when they exit.

Speaker 9

Got it. Okay. That's helpful. And then maybe a couple more for me. In terms of The assets that come on your balance sheet from I-forty five, obviously have a different profile than What you might like to put in your portfolio today, do you look for an opportunity to exit those to create some liquidity or will you in fact ride those out as well?

Speaker 9

Well,

Speaker 2

I would say They're over in I-forty five, but there's still assets that generate returns and so that won't change. Certainly, there are bigger companies for the most part, syndicated credits for the most part. On one hand, we don't need the liquidity, but on the other hand, Yes, we will look for opportunities to exit those names at attractive values and Over time, those names will get refinanced out, of course, as those companies grow and sell. But I hope that's helpful.

Speaker 1

And the spread to LIBOR on these assets is 6.5%, which is we've on the slightly lower end of our yield continuum, but it's certainly on the fairway.

Speaker 9

Okay. That's helpful. And maybe one more for you, Michael. You kind of laid out the potential, I guess, regulatory debt to equity range with the I-forty five assets coming on balance sheet. Can you kind of give us a feel for what the economic leverage range might look at?

Speaker 9

And I'm kind of thinking about The ability to now draw $45,000,000 more of SBA debentures and kind of how that works into the equation? Thanks.

Speaker 1

Yes. I mean, kind of what I said earlier and I would say it's not I don't know that I have anything to add to it is that we'll probably be in the midpoint 8. We'll finish up this the $45,000,000 on the SBA probably by this summer. And so I think our leverage economic leverage will be around one times with the regulatory something in the 0.85 range Then next to me, it'll vacillate. Look, there's opportunities to raise capital at premium to book today.

Speaker 1

And so you'd be at certain points in time delever a bit when the There and then pull back the range at other times.

Speaker 2

I was just saying just one of the things you just asked, I mean, we have A lot of liquidity on the balance sheet. So the ability to fund into the SBIC subsidiary and borrow that leverage commitments,

Speaker 1

That's not hard to do. Yes. And one other point I'd probably make just a longer term is like we have an eye to the future. We look at our 26, we get 2 Bonds will be repaid and there's cliff maturities. That's obviously 2 years away, but we're starting that planning today.

Speaker 1

So The collateral that comes back from I-forty five comes on balance sheet and we're going to look for opportunities to increase our secured financing. So to give us the ability that if and when we want to pay down those bonds, if we don't like what's going on in the capital markets in terms of Unsecured market, you could always fund it with our secured facility. So the I-forty five consolidations gives us additional collateral to work with to really continue to diversify our capital sources.

Speaker 9

Got it. Okay. Appreciate you guys taking the time.

Speaker 1

Thanks, Brett.

Speaker 3

Thank you. Our next question comes from the line of Eric Zwick with Hovde Group. Your line is open.

Speaker 6

Good morning. I may have missed this in the earlier comments, but just in terms of the winding down of I-forty five, did you provide a time frame? Will that be done at the end of current quarter, it will take a little bit longer, I may have thought, I'm not sure if I caught that earlier.

Speaker 1

Our expectation is that would be done at the end of the quarter. But Having said that, with some of these credits, when we do the we essentially do the allocation and we put in for assignment, Some of the agents work faster than others. And so to the extent that we are not able to get every asset assigned, it could live on a very small basis for another quarter, but we are working in earnest at the moment to try to get that all accomplished.

Speaker 6

That's helpful. Thanks. And then I just noticed that the PIK income increased to just above $4,000,000 or so in the quarter higher run rate than we've seen Recently, is there something I wonder if you could just talk about kind of what drove that higher and if there was anything kind of one time or should we expect something along that run rate going forward?

Speaker 2

Yes. So I mean it's a little bit higher this quarter, but just to put it in perspective, I mean 2 of the companies in the portfolio optioned up to pick toggles. We don't have a lot of pick toggles in our portfolio, but we've got a small handful.

Speaker 1

And so a couple of them picked. One of them was

Speaker 2

Company affected by the rider strike, that's obviously behind us. And so the company is obviously turning around. It was actually a one before the riders strike. So it's a very healthy company. It did pick Toggle.

Speaker 2

The other one is a company that It's very effective in the next few years and so it's going to have a big you should have a very big year this year. So they picked a quarter. So if you took those 2, those are PIK income aspects. But if you were to look at, okay, what's the trend? If you were to look at the rest of the PIK income, it's about 5 percent of our income and so the cash portion is 95%.

Speaker 2

If you look back over the last several quarters, it's kind of where we've been living 95%, 96% Cash. And so just to help put that in perspective, it's kind of how we're trending.

Speaker 1

And also the cash the Pick A Pay Toggles are generally only for a few quarters. Those are not indefinite for the loan. So those will either roll off because they've reached the end or they will be choosing cash along the cash along the way.

Speaker 6

Got it. And then one just last one for you. You seem fairly optimistic about the opportunity to make new commitments and fund new loans, at least for the next quarter. So wondering if you as you look at the pipeline, if you could just provide a little commentary. Are there any commonalities in terms of kind of the industries where you're seeing strength today or is it more broad based at this point?

Speaker 2

It's pretty broad based. It's interesting question. It's pretty broad based. The activity is pretty robust right now, Which is a good thing. The vast majority as we talked about, the vast majority of our business is family owned, entrepreneur owned businesses that are selling to private equity firms that are buying controlling interest in the business and heavy rollovers from the founders kind of situations.

Speaker 2

But it's Pretty broad. The other thing is we've got a decent amount of add ons going on in the portfolio too, which is Kind of a steady drumbeat over the last several quarters and should be continuing in the future. I mean, just add ons are Probably a third of our originations on kind of a regular basis. And so the activity this quarter Since quarter end is definitely on the new platforms, but it's also on the adults as well.

Speaker 1

And that's been a trend. We've seen that over the last probably 4 quarters. And I think With the portfolio the size it is today, we'd expect that to continue. Yes.

Speaker 7

It's an aspect of the business model.

Speaker 2

I mean, these private equity firms buy controlling interest in the founder or family owned business. And family or founder rolls over a big chunk of their equity to the business as we talked about. And then one of the things that The founders and families like is the ability to then have a private equity firm by 3 or 4 of their competitors. And it's one of the reasons they want to roll over and keep that equity in the business because of the accretion and opportunity that entails. And so Because that's generally a nature of our deal flow, we should expect to continue to always kind of see a meaningful amount of add That's great because it's additional credit commitment in businesses that we know.

Speaker 2

It's not new platforms that we have to learn about. It's been as we know we've seen performance And so it's a very attractive portion of deal flow in general.

Speaker 1

And these are generally not delayed draw term loans, I. E, we are doing diligence on these add ons and making a new investment decision.

Speaker 2

Yes. That's right.

Speaker 6

Yes. Great. It makes a lot of sense. For taking my questions today.

Speaker 1

Thank you.

Speaker 3

Thank you. Please standby for our next question. Our next question comes from the line of Dheus Abraham with UBS. Your line is open.

Speaker 5

Hey everybody. Just one for me. You guys mentioned in your prepared remarks competition coming back to where it was about 12 to 18 months ago. Can you just give a little bit more color on the nature of that competition and how you think that translates into spreads here over the next few quarters?

Speaker 7

Yes. I mean, the competition

Speaker 2

is definitely strengthened in market. It's just reflection of just overall health in the financial markets. It is mainly from non bank lenders,

Speaker 7

but it's kind of like I

Speaker 2

said, it's kind of back to where it was 18 months ago, which is Competition we've been dealing with for 8 years. So it's not really necessarily new players. And so I feel pretty good about the spreads. I mean, kind of where they are this quarter is kind of where they'll stay. And so it's not like they're Tightening to a point where we have an earnings issue and what that just wanted to express that for the last several quarters, I mean the competition has been lighter and It's coming back, which I don't necessarily think is a bad thing.

Speaker 2

We've certainly based on our cost of capital and Our institution, we can compete fine for quality deals and so it generate nice risk adjusted returns. But But I would say spreads are kind of where we should expect them to be kind of the next few quarters.

Speaker 1

Yes. When we actually looked at like the last 12 months, we had 24 deals that closed and the spread was essentially $750 ish, but the last 9 deals September has been just a little over $700,000,000 and the LTVs for the whole year were around well, in the first half of the year were 25 to 30, And the overall is around 30% now. So we saw maybe the LTV is kicking up to 35% 40%. So it's just I think what Bowen said is correct. It's about where it usually is.

Speaker 1

It was significantly lower for a period of time.

Speaker 3

I'm showing no further questions in the queue. I would now like to turn the call back over to Vaughan Diehl for closing remarks.

Speaker 2

Well, thank you, everyone. As always, we enjoy talking about our business, your business, and answer questions. And so we appreciate everybody's time and look forward to continuing to give you all quarterly updates.

Speaker 3

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.

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Earnings Conference Call
Capital Southwest Q3 2024
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