Capital Southwest Q4 2024 Earnings Call Transcript

Quartr
Provided by Quartr
May 15, 2024

There are 9 speakers on the call.

Operator

Thank you for joining today's Capital Southwest 4th Quarter and Fiscal Year 2024 Earnings Call. Participating on today's call are Bowen Diehl, CEO Michael Serna, CFO Josh Weinstein, CIO and Chris Rehberger, EVP, Finance. I will now turn the call over to Chris Rehberger.

Speaker 1

Thank you. I would like

Speaker 2

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. 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.

Speaker 2

I will now hand the call off to our President and Chief Executive Officer, Owen Deal.

Speaker 3

Thanks, Chris, and take care, everyone, for joining us for our Q4 fiscal year end 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 over the last quarter, as well as highlights of our performance over the last year. 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. Before we begin, would like to take the opportunity to mention 2 recent promotions which will broaden our executive team here at Capital Southwest.

Speaker 3

Josh Weinstein, who joined Capital Southwest in 2015 and manages all our deal sourcing and underwriting activity has been promoted to Chief Investment Officer. And Chris Reberger, who also joined Capital Southwest in 2015 and manages all our treasury and valuation activities has been promoted to Executive Vice President, Finance and Treasury. Both of these gentlemen have been integral contributors to Capital Southwest in generating our strong track record over the last 9 plus years. Core to our culture is continually cultivating talent up and down our organization and these additions to our executive team illustrate the deep bench strength that our company has developed over the years. We'll now begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the March 31, 2024 fiscal year.

Speaker 3

During the fiscal year, we grew our total investment portfolio at fair value by 22% to $1,500,000,000 up from $1,200,000,000 at the end of the prior fiscal year, while increasing our pre tax net investment income by 18% to $2.72 per share, up from $2.30 per share in the prior fiscal year. We increased our regular dividends paid to shareholders to $2.24 per share for the fiscal year, representing an increase of 10% compared to $2.03 per share regular dividends paid in the prior fiscal year. We continued our strong track record of covering our regular dividends with pre tax net investment income, achieving coverage for the year of 121%. In addition to our regular dividend, we paid a total of $0.23 per share in supplemental dividend during the fiscal year, compared to $0.10 per share in supplemental dividends paid in the prior fiscal year. For our March 2024 fiscal year, assuming reinvestment of our quarterly dividends, we generated a total return for our shareholders of 56 percent, which was among the top performing public BDCs during this time period.

Speaker 3

During the year, we strengthened our balance sheet through a variety of capital markets activities, which raised over $500,000,000 in additional capital, while reducing our regulatory leverage to 0.82 debt to equity as of the end of the fiscal year. Capital raised during the year included $184,000,000 in gross equity proceeds through our equity ATM program. A new senior secured SPV credit facility led by Deutsche Bank and an increase in commitments on our existing corporate credit facility led by ING. During the fiscal year, we also completed an underwritten baby bond offering. We obtained approval for the final amount of leverage on our first SBIC license and we began the licensing process for our 2nd SBIC license.

Speaker 3

Michael will discuss further details around these capital raising activities later in our prepared remarks. Turning to Slide 7 of the earnings presentation, we have summarized key performance highlights specific to the March quarter. During the quarter, we generated pre tax net investment income of $0.68 per share, which more than covered both our regular dividend of $0.50 per share and our supplemental dividend of $0.06 per share paid during the quarter. Portfolio earnings continue to be strong and as of the end of the quarter, we estimate that our undistributed taxable income was $0.64 per share. Net asset value per share ended the fiscal year at $16.77 which was flat compared to the prior quarter and up $0.40 per share compared to the year ago quarter.

Speaker 3

As we look forward to the June quarter, we are pleased to announce today that our Board of Directors has declared a regular dividend of $0.57 per share and a supplemental dividend of $0.06 per share, bringing total dividends declared for the June quarter of 2024 to $0.63 per share. Deal quality and activity in the lower middle market during the March quarter continued at a healthy pace as private equity firms and business owners continue to transact and we continue to source attractive investment opportunities. While we have continued to source and close deals at comfortable loan to value levels, averaging approximately 40% and leverage levels of approximately 3.5x debt to EBITDA. Competition in the lower middle market has increased, resulting in spreads tightening to levels last seen over 18 months ago. The increased competition for quality deals has come from both non bank lenders and to some degree traditional banks.

Speaker 3

Over the past decade, our team has done an excellent job generating attractive returns for our shareholders in all competitive environments, and I'm highly confident we will continue to our track record in the current environment. Portfolio growth during the quarter was driven by $157,500,000 in new commitments to 6 new portfolio companies and 5 existing portfolio companies, offset by $13,700,000 in proceeds from 2 debt prepayments, which generated a later average realized IRR of 16.5%. On the capitalization front during the quarter, in addition to closing the FPD credit facility, we raised nearly $50,000,000 in gross equity proceeds during the quarter through our Equity ATM program at a weighted average price of $23.80 per share or 142% of the prevailing NAV per share. Finally, consistent with our communication on last quarter's conference call, the I-forty five senior loan fund was dissolved and the assets were distributed to the joint venture partners in accordance with their respective ownership percentages. 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.

Speaker 3

We continue to maintain a conservative mindset to both BDC leverage and balance sheet liquidity. Managing leverage to the lower end of our target range while ensuring strong balance sheet liquidity affords us the ability to continue to invest in new platform companies and to grow our balance sheet even in periods of falls in capital markets when risk adjusted returns can be particularly attractive. Additionally, it allows us the ability to support our portfolio companies by either providing growth capital or by financing add on acquisitions, all while maintaining the ability to opportunistically repurchase our stock if it were to trade meaningfully below NAV. On Slide 89, we illustrate our continued track record of producing steady dividend growth, consistent dividend coverage and solid value creation since the launch of our credit strategy back in January of 2015. Since that time, we have increased our quarterly regular dividend 28 times and have never cut the regular dividend.

Speaker 3

All while maintaining strong coverage of our regular dividend with pre tax net investment income. Additionally, over the same time period, we have paid or declared 24 special or supplemental dividends totaling $3.95 per share, all generated through excess earnings and realized gains from our investment portfolio. Dividend sustainability, strong credit performance and continued access to capital from multiple capital sources are all core to our overall business strategy. Our track record in all these areas demonstrates 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 10, as a reminder, we lay out our core tenets of our investment strategy.

Speaker 3

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 companies as well as a potential source of new junior capital support if needed. In the lower middle market, we often have the opportunity to invest on a minority basis in the portfolio company equity carried 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 65 investments with a total fair value of $132,000,000 which was marked at 141 percent of our cost, representing $38,500,000 in embedded unrealized appreciation for $0.85 per share. Our equity portfolio, which represented 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 of these growing lower middle market businesses, which will come in the form of NAV per share growth and supplemental dividends over time.

Speaker 3

As illustrated on Slide 11, our on balance sheet credit portfolio ended the quarter at $1,300,000,000 representing year over year growth of 30% from $1,000,000,000 as of the end of March 23 quarter. For the current quarter, 100% of the new portfolio company debt originations were 1st lien senior secured and as of the end of the quarter, 97% of the credit portfolio was 1st lien senior secured. During the year, we improved the granularity in our portfolio as the average investment exposure per portfolio company ended the fiscal year at 0.9% compared to 1.3% as of the end of the prior fiscal year. 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 expect that this metric will continue to improve in our asset base growth.

Speaker 3

On Slide 12, we detail the 157 point $5,000,000 in capital invested in and committed to portfolio companies during the quarter. Capital committed this quarter included 123 $500,000 in 1st lien senior secured committed to 6 new portfolio companies in which we also invested $2,800,000 in equity. In addition, we committed a total of $31,100,000 in 1st lien senior secured debt and $143,000 in equity to 5 existing portfolio companies. We are pleased with the strong market position that our team has established in the lower middle market as a premier debt and equity capital provider, as evidenced by the consistency of our origination activity and the broad array of relationships across the country from which our team is sourcing quality opportunities. As a point of reference, currently there are 70 different private equity firms represented across our investment portfolio.

Speaker 3

Since the launch of our credit strategy back in January 2015, we have completed transactions with over 100 private equity firms across the country, including over 25% of which we have completed multiple transactions. Turning to Slide 13, we continued our track record of strong returns on our exits with 2 debt prepayments during the quarter. In total, these exits generated $13,700,000 in total proceeds, generating weighted IRR of 16.5%. Since the launch of our credit strategy, we have realized 74 company exits, representing $919,000,000 in proceeds that have generated a cumulative weighted average IRR of 14%. On Slide 14, we detailed key statistics for our portfolios at the end of the quarter.

Speaker 3

The total portfolio fair value ended the quarter weighted 88.7% to 1st lien senior secured debt, 2.3% to 2nd lien senior secured debt, 0.1% to sub debt and 8.9% to equity co investments. The credit portfolio had a weighted average yield of 13.3% and weighted average leverage through our security of 3.6x EBITDA. Overall, we are quite pleased with the portfolio company performance across the portfolio. Cash flow coverage of debt obligations across the portfolio remains at a healthy 3.2 times despite the higher base rate environment. And quarter over quarter revenue and EBITDA growth on a weighted average basis was 3% 5% respectively.

Speaker 3

As seen on Slide 15, our total investment portfolio continues to be broadly diversified across industries with an asset mix which provides strong security for our shareholders' capital. On Slide 16, we have laid out the ratings migration across our portfolio during the quarter. As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4 point scale, with 1 being the highest rating and 4 being the lowest rating. We had 4 loans representing almost $30,000,000 in fair value upgraded this quarter, while having 4 loans representing about $14,000,000 in fair value downgraded this quarter. The portfolio remains healthy with 94.7 percent of portfolio at fair value rated in 1 of the top 2 categories of 1 or a 2.

Speaker 3

I will now hand the call over to Michael to review some specifics of our financial performance for the quarter.

Speaker 4

Thanks, Bowen. Specific to our performance for the quarter, as summarized on Slide 17, pre tax net investment income was $29,800,000 or $0.68 per share as compared to $29,800,000 or $0.72 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 a supplemental dividend of $0.06 per share for the June quarter. Maintaining a consistent track record of meaningfully covering our dividend with pre tax net investment income is important to our investment strategy.

Speaker 4

We continued our strong track record of regular dividend coverage with 121% coverage for the 12 months ended March 31, 2024 and 111% 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 0.6 $4 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 $0.85 per share in unrealized depreciation on the equity portfolio. For the quarter, total investment income decreased to $46,400,000 from $48,600,000 in the prior quarter. The prior quarter's investment income included a significant one time dividend from 1 of our portfolio companies.

Speaker 4

The quarter over quarter decrease in dividend income was offset by an increase in interest income from the growth in our credit portfolio. As of the end of the quarter, our loans on non accrual represented 2 point 3% of our investment portfolio at fair value and the weighted average yield in the portfolio on all investments was 12.7%. As seen on Slide 18, LTM operating leverage ended the quarter at 1.7%, which compares favorably to the BDC industry of approximately 3%. 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 as we continue to build a best in class BDC.

Speaker 4

As we look forward, we expect further improvements in operating leverage as we continue to grow our balance sheet over time. Turning to Slide 19, the company's NAV per share at the end of the quarter was $16.77 which was flat from the prior quarter and up $0.40 per share from the year ago March 2023 quarter. Turning to Slide 20, we're pleased to report that we have significant balance sheet liquidity with approximately $398,000,000 in cash and undrawn leverage commitments on our 2 credit facilities and our SBA debenture commitments, which altogether represented 2.8 times the $140,000,000 unfunded commitments we had across our portfolio as of the end of the quarter. As Bowen mentioned, during the quarter we raised a new senior secured SDB credit facility led by Deutsche Bank. The facility has $150,000,000 in initial commitments, which will contractually increase to $200,000,000 of total commitments by June 2024.

Speaker 4

In addition, based on the current borrowing base, we have access to the full $460,000,000 in total commitments for the ING led corporate credit facility, which has an accordion feature allowing for the further increase in total commitments in this facility 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. We are actively working to further increase commitments in the corporate credit facility and provide updates on that process in the coming months. In March 2024, we submitted a MAC application to the SBA, which has begun the process towards the second SBIC license. We look forward to providing updates on this process as they become available. Finally, as of the end of the March quarter, 46% of our capital structure liabilities were in unsecured covenant free bonds with our earliest debt maturity in January 2026.

Speaker 4

As Bowen alluded to earlier, during the quarter, the I-forty five Board of Managers approved the dissolution of the fund, which included a full repayment of the I-forty five credit facility and the distribution of the I-forty five assets to the joint venture partners in accordance with their ownership percentages. The assets distributed to Capital Southwest from the I-forty five fund are now included on the scheduled investments in our financial statements. Our regulatory leverage as seen on Slide 21 ended the quarter at a debt to equity ratio of 0.821, down from 0.88:one as of the year ago March quarter. 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 and conservative leverage with adequate covenant cushions. Despite not having any maturities within our debt structure until 2026, we were always proactively planning our path forward to mitigate the risk of capital markets volatility.

Speaker 4

Finally, we are very pleased that both Moody's and Fitch have recently affirmed our investment grade ratings. I will now hand the call back to Bowen for some final comments.

Speaker 3

Thanks, Michael. And again, thank you everyone for joining us today. As always, we appreciate the opportunity to provide you with an update on our business, our portfolio and the market environment. Our company and portfolio continue to demonstrate strong 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.

Speaker 3

The overall health and security of our portfolio is strong. Our credit portfolio is predominantly made up of 1st lien senior secured loans allocated across a broad array of companies and industries, the vast majority of which are backed by private equity firms. Further, interest coverage on the debt obligations across our portfolio is a strong 3.2x with our loans across our portfolio averaging approximately 40% of in the equity upside of many of these growing lower middle market businesses, providing further enhancement to our long term shareholder returns. Last but not least, we have a very well capitalized balance sheet with multiple capital sources, strong liquidity, a flexible capital structure and an exciting runway to continue to grow our company generating strong shareholder returns for years to come. This concludes our prepared remarks.

Speaker 3

Operator, we are ready to open the lines for Q and A.

Operator

Thank And our first question is going to come from the line of Mickey Schleien with Ladenburg. Your line is open. Please go ahead.

Speaker 5

Yes. Good morning, everyone. Bowen, you mentioned spreads tightening, which is certainly consistent with everything we're hearing across the space. When you look at the vintages of your portfolio, how much refinancing risk do you see going forward?

Speaker 3

Yes. Thanks, Mickey. I mean, look, if we think about the strengthening of the market, the liquidity in the market, and if you look at our rated number 1 companies rated number 1, companies have significantly outperformed. They're clearly in most all cases refinancing candidates. All that said, I mean, there's some things you should most the don't should understand.

Speaker 3

I mean, there are ways that we can defend against in some respects refinancing risk on outperforming companies. And obviously, we can go proactively if the risk is materially changed, we can go proactively and reduce interest rate on our loans to make it less incentive to have us refinanced out, we can do dividend recaps. We can add additional debt on the business that's still well underneath what you'd be comfortable with leveraging a very well performing business that we understand. And in some cases, we got one case where the leverage is so low and the company's cash flowing so well, we actually have a situation where we let the sponsor take cash dividends out each quarter. We take a little money to pay back the debt.

Speaker 3

They take a little money to put in our pocket. And it kind of removes the incentive for them to refinance us out in a very, very safe credit. So there's things you can do us and anyone else in our position to defend against those refinancing risk. But clearly when the market strengthens and you have companies that are outperforming, you definitely have refinancing risk. And so that's kind of just give you a flavor of some of the ways we manage it.

Speaker 4

Yes. And also, I mean, just to quantify, so it's about $200,000,000 we would say of the portfolio as loan grade 1 that would fall in that category, many of which has been originated in the past 18 months. So to them, they still have call protection on many of those loans. And then the other piece to note is our all in yield is 8% spread over so far on our portfolio, which is obviously robust. So if we have a portion of that $200,000,000 that we're not able to retain and it comes back, we don't feel like it's a material down drop to the earnings going forward.

Speaker 5

Thanks for that. That's very helpful. Could you give us some highlights on what caused the net realized loss this quarter?

Speaker 4

So predominantly it was the I-forty five loss. So if you think about it, we had depreciation embedded in I-forty five that was unrealized as an equity position. And when I-forty five dissolved, that became a realized event into

Speaker 5

Was that caused by a new non accrual or was that valuation adjustments of the previous non accruals?

Speaker 3

Yes. We had 2 new names. 1 is a very highly talked about syndicated name and another one is a small company in the education space where we had fraud involved. And so yes, we have 2 new non accrual names. Yes.

Speaker 3

And I think this is as

Speaker 4

well noted, Mickey, those are both from the watch list. So I mean, is it really a degradation of portfolio, just sort of two names that had some issues. What we'd also say is when you look at our non accrual, we have our granularity in the total portfolio is about 0.9%, down from 1.3%. So when you look at our portfolio, very granular portfolio, so non accruals are painful and we don't like seeing them pop up. We do say that the impact to earnings is quite small.

Speaker 4

Those 2 non accruals accounted for about a penny of earnings for the quarter.

Speaker 5

Yes, I appreciate that. And that's certainly something I watch carefully. Lastly, Michael, the new SPV credit facility has a higher spread than the existing corporate credit facility. So notwithstanding that, what are the advantages of putting that into place?

Speaker 3

Sure.

Speaker 4

Well, first I would say this.

Speaker 3

So the spread only in

Speaker 4

and of itself is higher, but the fees and the unused are lower. So they're actually at parity, the 2 facilities. So the other benefit is, let me tell you, but we wanted to expand our diversity of our sources. Some banks we've been told over the last few years, we're looking for something of an SPV variety because better from a capital charge perspective rather than the on balance sheet credit facility. So that's one of the reasons why we were pursuing an FPV structure.

Speaker 4

The other thing we would tell you is that the lenders that were involved in I-forty five, who once it was dissolved, were still very interested in doing business with Capital Southwest. So they were looking for a way to get back in. So this was one way to which it took down the $150,000,000 plus the additional $50,000,000 that's coming on board in June. But the other lenders in there have some interest as well. So when we're looking forward, we're looking at our maturities out in 2026 and we're thinking about today.

Speaker 4

So we'd like to build up a secured dry powder and secured facilities that allow us if need be to take down portions of those the debt and those maturities if the capital markets were closed. We do anticipate probably paying it down prior to getting within 6 or 12 months, but having diversity of secured sources that we can draw, especially to refinance is really helpful in terms of flexibility.

Speaker 5

Yes, I understand and that makes sense. Those are all my questions this morning. I appreciate your time as always. Thank you.

Speaker 4

Thanks, Mickey.

Operator

Thank you. And one moment as we move on to our next question. And our next question comes from the line of Bylus Abraham with UBS. Your line is open. Please go ahead.

Speaker 6

Hi, everyone. Thanks for taking the question.

Speaker 3

I wanted

Speaker 6

to ask about the mix of originations in the March quarter. It looks like the top 3 about $70,000,000 or so in fundings were consumer products and consumer services. Can you update us on just how you're feeling about more cyclical industries? And in general, what kind of internal framework you might have on managing industry concentrations across the portfolio?

Speaker 3

Yes. Well, first of all, I'll say we look at economic sensitivity the same across all our companies. We look at past recessions and what that customer base or that type companies in that industry did from an economic filing from an earnings volatility. So that's the same way we look at consumers. And so I think and we lever accordingly.

Speaker 3

So these consumer companies, I mean, they're kind of interesting names, it's lower leverage, high free cash flow, high variable cost component of their cost structure. In one case, it's an enthusiast type product. In the other case, it's an incubator for new fragrance lines and things in the industry. So interesting consumer plays and then the consumer services company is a 2 man in a truck franchise that basically both of their businesses moving renters from apartment to apartment in local markets. And so obviously a segment that may perhaps less cyclical, but ultimately we look at the businesses as we match leverage to potential economic volatility.

Speaker 3

So with respect to your question on sectors, we look at that. I mean, clearly, I'd say, we're consumer is an area that is probably close to the top what we'd be doing from a weighted perspective. But we're constantly Josh and I and Michael are constantly looking at that from a risk management perspective. We don't want something in the market ex essential in the market to basically move the credit picture of our portfolio meaningfully.

Speaker 6

Got it. And you don't necessarily have any hard ceilings in terms of concentration for particular industries, right?

Speaker 3

No, I don't think so. I mean, look, I think our sectors, we've got some of the larger concentration sectors around a relative basis. You probably would look at us increasing those meaningfully. But I don't feel I mean, we don't feel like there's like I mean, of course, it's not just the sectors, it's the actual companies that are in there and what they do within that sector. But we don't think we're over weighted in any sector.

Speaker 4

And to these sectors that certainly consumer is something that has a higher bar. I think Bowen mentioned earlier in the statement just now that our leverage levels on those really in the 2 to 3 times and with loan to values in sub 40%. So these are companies that we feel like the financial profile and their cash flow history would withstand the cycle well.

Speaker 3

Yes, given I mean, obviously, we all have sensitivity to consumer sectors and it starts with us having sensitivity to that as well. I think it is interesting to point out I think all three of these consumer names are with private equity firms that virtually all they do is consumer. So they're very deep. And what's interesting about a sponsor who has deep expertise in a sector, especially like consumers, is if you look across their portfolio, they have relationships across customers or suppliers or sales channels like retail or whatever across the other companies that they use to leverage to support and enhance the consumer company that they're buying. And so it's interesting.

Speaker 3

I mean, you really can't say that about a generalist private equity firm necessarily, but one that's deeply rooted in the consumer sector or healthcare sector, but consumer especially, they can really leverage their relationships across their portfolio to enhance and that's kind of part of their playbook currently to leverage those relationships to enhance each new platform they buy.

Speaker 6

Got it. Okay, that's helpful. And my next question is, yes, so I appreciate your remarks on competition and spread tightening. Has there been any impact to structure that you're seeing at this point? And is it any harder now to get equity co invest than in the past?

Speaker 3

So on the structure, I would tell you, any kind of the market increases in competition, you have some erosion of structure. But the good news is that we always talk about and I know you know this, but like in the lower than the market, I mean our documents are tight, our covenants are tight, reasonable, EBITDA add backs were very sensitive to that. So sometimes credit performance, obviously credit, I mean it's wrong to say it doesn't change at all when the market gets more competitive. But in our market, I mean, it's already well within what one would be comfortable with. And so it doesn't really deteriorate that much, but it's not 0.

Speaker 3

And then what was your what was the other question?

Speaker 4

So equity co investment.

Speaker 3

Yes. Equity co investment is usually a function of that private equity firms, the size of their check versus the size of their fund, where they are in their fund life and that type of thing. It's not necessarily a function of how competitive the market is. It's more of a function of the individual private equity firm and where they are on their liquidity profile.

Speaker 4

And then you will see though as our checks, we haven't really grown our whole size that much. Obviously, we talked about the granularity. But to the extent we have or maybe our debt goes up from $12,000,000 to $15,000,000 or maybe $18,000,000 You're not seeing the equity check. It's still difficult to get a large equity investment from all these sponsors, Toye Boen has indicated. And in other cases, obviously, we places where we get the debt store if we don't get the equity story.

Speaker 4

So with that all being said, we would expect our equity hold as a portfolio would probably be in the 8% to 10%, probably not going to be able to grow beyond 10%.

Speaker 6

Okay. I'll hop back in the queue. Thank you.

Operator

Thank you. And one moment as we move on to our next question. And our next question is going to come from the line of Bryce Roe with B. Riley. Your line is open.

Operator

Please go ahead.

Speaker 7

Thanks. Good morning. Maybe wanted to start on with a couple more questions about I-forty five. I'm just curious what was the impact on the debt portfolio from that resolution or dissolution and just trying to understand the quarter over quarter increase in the debt portfolio. What percentage of that or what dollar amount was coming from the I-forty five asset?

Speaker 4

Sure. So there were 17 portfolio companies that came over for approximately $80,000,000 and just the yield on those were about S plus $650,000,000 so not materially lower than our portfolio. But obviously the $80,000,000 is a very small percentage. So it had a very little impact. And I've mentioned on other calls that the impact to earnings is a net positive because we're getting rid of a lot of frictional costs associated with trustees and audits, etcetera.

Speaker 4

So this is a you could consider this a net impact to earnings to CSWC.

Speaker 7

Okay. And Michael, I mean, what's the inclination

Speaker 3

to hold those

Speaker 4

or just to be opportunistic if you see an opportunity to get out? I assume you're not in think about it. That would be the right way to think about it.

Speaker 3

That's right. We just write the story out.

Speaker 2

Okay.

Speaker 7

And then Bowen or Michael, you mentioned the dividend income for the quarter and it being more one time in nature. Any color around the source of that dividend and then help us quantify how much it in fact was?

Speaker 3

Yes. So actually what

Speaker 4

I was indicating was last quarter we had a $2,400,000 one time dividend. So that's for the twelvethirty one quarter. And in this quarter, we had some dividends, but we certainly didn't have anything of that materiality. So I think dividend income came down about $2,000,000 quarter over quarter. But at the same time, our interest income, 1, because you had assets coming over from I-forty 5 into the portfolio as we just noted, there was additional interest income there, plus we had net portfolio growth during the quarter.

Speaker 7

Okay. And so the was there any I-forty five dividend income in the quarter? I assume there's not, but maybe there was.

Speaker 4

Yes, there was a benefit. I think it was around $500,000 It wasn't significant for the quarter.

Speaker 2

Okay.

Speaker 7

Last one for me. The comp line down a bit, it sounds like from the press release, there was just a difference in bonus accrual quarter over quarter. Any thoughts on kind of what a good run rate might be from a comp perspective?

Speaker 4

Sure, sure. So cash comp, I would expect for this coming quarter, this fiscal year to be on a quarterly basis around 2,800,000 for cash comp, probably the RSU expense around $1,500,000 and G and A is about $2,500,000 a quarter. So the total you'd expect about $6,800,000 as a run rate quarterly. That will obviously backslide up and down, but that's what you should expect maybe on that times 4 would be your annualized amount.

Speaker 1

Okay.

Speaker 7

And what was the reason for the lower bonus accrual in the quarter?

Speaker 4

Sure. So in that previous quarter, they indicated that we had that $2,400,000 dividend. And so that point, we accrued additional bonus accrual above the target. And then in the Q4, we had accrued probably above where we decided to pay out the company. And so there was a back out of some accrual

Speaker 2

for the balance. Okay.

Speaker 7

All right. That's it for me. Appreciate it.

Speaker 4

Thanks, Bryce. Thanks, Bryce.

Operator

And one moment as we move on to our next question. And our next question is going to come from the line of Eric Zwick with Hovde Group. Your line is open. Please go ahead.

Speaker 1

Thank you. Good morning, everyone. Just one question for me today. One, it was good nice to see that the kind of the dollar value of investment upgrades was a little bit more than twice what was downgraded in the quarter. And I guess my question is more towards those downgrades, those three relationships you have there.

Speaker 1

If you could just talk maybe about the circumstances or characteristics that led to those downgrades in terms of company performance or whether they're facing some industry challenges or anything you could provide there would be interesting.

Speaker 3

Yes. No, I mean, I'm just looking at the list here. I mean, they're all pretty idiosyncratic. 2 of them were our non accruals. One of them was another company that's relatively idiosyncratic.

Speaker 3

So hard to really put like, oh, there's a point on the economy that we see. One of them was broad and one of them is a large syndicated deal that seems to be over levered. So there are not really any trends in those names that I can point to.

Speaker 1

Okay. No, that's helpful. I appreciate it. And maybe then kind of one quick follow-up on that point, Sal. If we look at the interest rate futures curve, it seems that we're likely to be in this higher for longer interest rate environment for a while.

Speaker 1

And I guess how are your companies coping with this? Were there any that were holding out, hoping we would see a decline in interest rates or most managed well and have continued to be able to grow EBITDA and hopefully delever over time? How are they handling this interest rate environment?

Speaker 3

Yes. A couple of comments I'll make on that. On the last 12 months of 12, 18 months of this kind of interest cycle, we've kind of commented on some of the things we've seen these private equity firms do and cutting operational costs because their interest burden is going up. And they've been doing that. And if you look at our and then we're also leverage levels that we're levering companies up.

Speaker 3

Fixed charge coverage is a very important metric, right, obviously. And so as rates come up, leverage on new loans can come down. And so if you look at ultimately if you zone out and say, okay, what's the health of the engine that's generating earnings and dividends for our shareholders, things like EBITDA to interest coverage metrics on a weighted average basis of 3.2x pretty healthy, especially in the current interest rate environment. And then average loan to values, which is not necessarily a fixed charge issue, but it's just an absolute leverage issue, 40% is pretty healthy. So we feel like as a portfolio, we look at narratively, we look at what the private equity firms are doing in the portfolio to manage the business in a higher interest rate environment.

Speaker 3

And we look at the kind of portfolio level test metrics and you feel pretty good. I mean there's small problems here and there, small handful of companies that we talk about. But overall, portfolio looks pretty good from an engine creating earnings for our shareholders perspective. And then the longer we go into this, the longer the industries, companies, private equity firms have kind of gotten their sea legs, if you will, in the higher interest rate environment and they've managed the business. So the longer we're in this environment, the less you kind of wake up in the middle of the night thinking something's going to blow kind of thinking.

Speaker 3

Does that mean you're going to have the one thing I will say is interest rates are higher. It brings problems to the table faster and our deal teams can get in front of the private equity firms and insist that they put money in the businesses and support anything from liquidity, but also they want to continue to increase their CapEx budgets maybe higher than what we have on our credit agreement. It's sponsors that have put equity in, so they can continue to focus on their growth, those types of things. So when the system gets tighter because the interest burden is going up, it tightens the whole system and brings conversations to the table faster before there's a kind of a material problem or shift in the thesis of the business that makes sense.

Speaker 4

And we always I think the lever that's available probably to all BDCs is the PIC toggle. We haven't even seen that across the portfolio, but certainly there's probably 1 or 2 where that has come into play. But we saw that our PIK number came down significantly from the previous quarter. So we're still at a very low level. But again, that's a lever you can utilize if companies have a short term issue with interest coverage.

Speaker 3

Yes. I can't really I think some of the analysts have asked us questions about that early on like 18 months ago, like what do we expect. And I can't really would have expected more pit toggles in the rising interest rate environment than we've seen. And I think some of that's the profitability of our companies. But or in the sponsors' willingness to support the businesses rather than take on additional kind of interest burden on the business.

Speaker 3

But Michael is right.

Speaker 4

But also, you know what, a lot of the deals,

Speaker 2

I would

Speaker 4

say, majority of the deals that we originate, the interest coverage is well above 3x. It's 3x to 5x at close. So the fact that it's ours is 3.2x right now, it's and that's had degradation because of base rates. But you compare that to the syndicated market where those guys are living at 2 times in a normal environment. And so they're going to get crushed a lot harder and a lot sooner than our lower middle market portfolio has or

Speaker 1

will. That was a great commentary and insight. Thanks for taking my questions today.

Speaker 4

Thanks, Eric. Thanks, Eric.

Operator

Thank you. One moment for our next question. And our next question is going to come from the line of Robert Dodd with Raymond James. Your line is open. Please go ahead.

Speaker 8

Hey, guys. Good morning. This is Sean Paul Adams on the line for Robert Dodd. On the downgrades and the risk ratings in the portfolio, it looks like it was primarily driven by the non accruals. I'm just asking for a little bit more color on the non accruals.

Speaker 8

It seems like the education space one could be related to the student resource center. Is that just an accreditation issue or is there a path forward for getting that back on accrual?

Speaker 3

So I would summarize the challenges there as the education partner, one of the education partners that they do work with and play students in. And there were some broad involved as well in that deal. So it's a little bit idiosyncratic to that particular company and situation.

Speaker 2

Got you. And

Speaker 4

the other one was Research Now, which was obviously broadly held in BDC portfolios across the board. That's that one we have limited information because 1st lien lenders are negotiating. It doesn't look like it's going to be a great outcome for the 2nd lien lenders. But

Speaker 3

We'll end up with a small equity ownership in the business and the 2nd lien lender probably the way most of these situations work out.

Speaker 4

And we will say also to your question, I also tell you, we just had our watch list meeting literally 2 days ago and we went through all the list of companies. And on that watch list, what we actually saw is that a lot of these companies are either stable to slightly positive. And there is a hope and I wouldn't say it's

Speaker 3

in the next 1 or

Speaker 4

2 quarters, but where some of the non accrual names might actually turn around. So to go back on accrual rather than seeing any of those watch list names in the near future going on non accrual. That's not the prediction or a projection, but that's just an observation based upon the information we reviewed the other day.

Speaker 8

Got it. Got it. That's perfect. And on the outlook for the next fiscal year, have there been any shifts in the long term target range concerning leverage given like changes in the forward curve? It seems like you guys just tapped the lower end of the short term target you guys were talking about last quarter for leverage?

Speaker 4

Yes. I mean, I wouldn't say it's a change. I think what I would tell you is leverage is going to be probably as low as 0.8 on a regulatory basis or as high as 0.95. That's probably where our comfort level is. We're at 0.82 at the moment.

Speaker 4

I would anticipate based on how we feel about our portfolio that we might lever that up closer to the middle of the range. But as we've shown during the course of the last few years, we're mindful of where the economy is and got to make certain that we vacillate it in the same rhythm of the economy itself.

Speaker 8

Got it. Thank you for the color.

Speaker 2

That's perfect. Thank you.

Speaker 3

Sure. Thank you.

Operator

Thank you. And one moment as we move on to our next question. And our next question is a follow-up question with Bila Abraham with UBS. Your line is open. Please go ahead.

Speaker 6

Hey, just one more follow-up here, more of a high level question. And we've talked about this a little bit before in the past, but if you guys think about the internal management structure and the flexibility it provides, can you give us any thoughts on how you might be thinking about any potential partnership sidecar vehicles that kind of thing?

Speaker 4

I mean, that's obviously something that we've been thinking about and honestly probably working on behind the scenes. As our portfolio has grown, our hold size can grow as well. There's a lot of deals that we share with other partners where that we could be putting maybe having a separate account, separately managed account where they would be we manage that capital and be a portion of what of origination we hold That obviously would earn a fee and an incentive carry. So it would be honestly, it would be strategic, but it also be it would work well within what we're already doing today. So it wouldn't require us to go up balance sheet.

Speaker 4

So that is something we were considering. I think that that's kind of a I hear people say you have to test a lot of frogs in that in those ventures in order to actually meet and kind of close on a partnership. So I don't think that's a calendar year 2024 event, but we would definitely expect that that'd be something in the future that we were able to be able to incorporate into the balance sheet.

Speaker 3

Yes. It's an interesting opportunity for us. There's definitely institutions out there interested in investing in our track record of our asset class that don't want to pay above net asset value. So if they can partner with us in a fund concept and invest in some of our deals directly, it's interesting.

Speaker 2

But it's all those types of

Speaker 3

things are always for us. I mean, we're all about the shareholder, long term shareholder returns. And candidly, there's a lot of opportunity just organically doing what we're doing and continuing to basically slightly higher hold sizes by sharing less of deals and as our guys get in our mid level as they're growing up in the industry and increasing their franchise personally of relationships, It's really broadening the top end of our funnel of deals we look at. There's a lot of organic growth really in front of us. And we don't want to distract ourselves from that.

Speaker 3

But it's absolutely an opportunity to be thinking this.

Speaker 6

Great. Thank you.

Operator

Thank you. And I would like to hand the conference back over to Bowen Diehl for closing remarks.

Speaker 3

Thanks, operator, and thanks for all the questions today. And we appreciate the opportunity to update you on the business. So we look forward to continuing to execute and talking to you all next quarter. Thank you.

Operator

This concludes today's conference call. Thank you for participating and you may now disconnect.

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Earnings Conference Call
Capital Southwest Q4 2024
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