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Edited Transcript of CSWC earnings conference call or presentation 5-Feb-19 4:00pm GMT

Q3 2019 Capital Southwest Corp Earnings Call

Dallas Feb 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Capital Southwest Corp earnings conference call or presentation Tuesday, February 5, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bowen S. Diehl

Capital Southwest Corporation - President, CEO & Director

* Chris Rehberger

Capital Southwest Corporation - VP of Finance & Treasurer

* Michael Scott Sarner

Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO

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Conference Call Participants

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* Christopher John York

JMP Securities LLC, Research Division - MD & Senior Research Analyst

* Christopher Robert Testa

National Securities Corporation, Research Division - Equity Research Analyst

* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst

* Timothy Paul Hayes

B. Riley FBR, Inc., Research Division - Analyst

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Presentation

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Operator [1]

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Thank you for joining today's Capital Southwest Third Fiscal Quarter 2019 Earnings Call. Participating on the call today are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance.

I will now turn the call over to Chris Rehberger.

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Chris Rehberger, Capital Southwest Corporation - VP of Finance & Treasurer [2]

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Thank you. I would 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're 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 risk 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.

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

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [3]

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Thanks, Chris. And thanks to everyone for joining us for our third quarter fiscal year 2019 earnings call. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com

We are pleased to be with you this morning to announce our results for the quarter. In summary, we had a strong quarter for net investment income growth and a solid quarter of originations, as our deal teams continue to do an excellent job generating significant deal flow, allowing us to exercise our conservative investment discipline and which deals we want to pursue to closing.

As we have consistently stated, our focus remains on building a predominantly Lower Middle Market portfolio, consisting largely of 1st Lien Senior Secured Debt with equity coinvestments across the loan portfolio, where we believe significant equity upside opportunity exists. Further, we continue to execute under our shareholder-friendly internally managed structure, which at its foundation closely aligns our interest with the interest of our fellow shareholders in generating sustainable long-term value through stable increasing dividends, operating cost efficiency, capital preservation and NAV per share growth.

In general, we had an eventful quarter. We exited one of our 2 remaining legacy equity assets at a modest gain. We completed the company's first ever follow-on equity offering, raising $13.2 million from 2 prominent BDC investors. We completed the upsize and refinance of our ING Capital-led balance sheet credit facility, and we opportunistically repurchased shares of Capital Southwest stock through our 10b5-1 program during the time of excessive market volatility that we saw in December.

Laid out on Slide 6 are some important summary points on our performance for the quarter. During the quarter, we earned $0.40 per share of pretax net investment income and paid a regular dividend of $0.36 per share. In addition, our Supplemental Dividend Program paid out $0.10 per share funded from our sizable, undistributed taxable income balance, or UTI, generated by excess income and capital gains accumulated from our investment strategy to date. For the quarter, the $0.46 per share paid out in total dividends generated a total annualized dividend yield of 9.6%.

During the quarter, we grew our portfolio on a net basis from $492 million at September 30, 2018, to $497 million at December 31, 2018, originating $26 million in total commitments to 2 new portfolio companies and 1 add-on investment in an existing portfolio company, offset by $18 million in proceeds from exits during the quarter.

Again, this quarter, all of the capital deployed by Capital Southwest was in deals directly originated and led by our investment teams, as they continue to demonstrate our traction in the market. Our senior loan fund, I-45, also continued its solid performance, providing a 15.5% annualized yield on our capital in the fund for the quarter.

During the quarter we continued to grow the right side of our balance sheet by increasing the size of our balance sheet credit facility. As part of our comprehensive credit facility amendment, we were able to obtain a significant increase in commitments from our bank lenders while reducing pricing and the overall cost of the facility.

Importantly, we were also able to incorporate the ability to access the increased leverage allowable under the Small Business Credit Availability Act passed in 2018.

As a reminder, while both the legislation and our amended credit facility allows us to increase the leverage at the BDC up to 2:1 debt to equity, our board also approved a policy of limiting the regulatory leverage at Capital Southwest no more than 1.5:1. Michael will discuss the specifics of the amendment in a moment.

By prudently increasing leverage at the BDC, we will enhance our ability to increase the quality of our loan portfolio while also driving higher returns to our shareholders, all through an Internet -- an internally managed structure in which virtually 100% of the economics from the increased leverage in asset base will flow to our shareholders.

Turning to Slide 7, we illustrate our continued track record of growing shareholder dividends as we continue to migrate the BDC to target leverage levels through thoughtfully building a portfolio of well-performing, income-generating assets. On this slide we also illustrate both NAV per share over time as well as adjusted NAV per share, which adjusts for supplemental dividends paid out to shareholders.

For the quarter, NAV per share decreased from $18.43 as of December 31, 2018, from $18.84 dollars as of September 30, 2018. The 41% -- the $0.41 or approximately 2% decrease in NAV this quarter was driven by 3 things. First, we experienced $2.4 million or $0.14 a share in net depreciation on -- of our net investment portfolio, which I will comment on in a moment. Second, we paid out a quarterly supplemental dividend of $0.10 per share from our UTI balance. And third, the board made an annual grant of restricted stock to the Capital Southwest employees. While restricted stock grants invest over 4 years, all granted shares are added to our total shares outstanding immediately upon grant.

As a frame of reference, if we isolate the effect on NAV per share from solely portfolio asset valuation by adding back both the effect from the supplemental dividend paid and the effect from the annual restricted stock grant to employees, our NAV per share would have decreased by approximately $0.14 per share, representing a decrease of 0.75 of 1% or 75 basis points.

As you might expect, the extreme market volatility we saw in December had a negative effect on the valuations of all BDC portfolios, including ours, as quarterly valuations are generally measured as of the last day of the quarter, which in this case was when the markets were at near lows for the year. Specifically, the levels of the various relevant market indices, which are key inputs in our quarterly valuation process, were down meaningfully at the end of the quarter from levels at the end of the September quarter.

On the equity side, we saw public market multiples come down, while on the debt side we saw corporate credit spreads the rise and syndicated loan quotes from syndication desks fall. Though the syndicated markets were down significantly at year-end, in virtually all instances the discounted market quote was not accompanied by paper for sale at the lower price levels. As a result, in our estimation, a significant majority of this quarter's depreciation in the Capital Southwest portfolio was related to this market volatility rather than the fundamental performance of our overall portfolio. In fact, on a weighted average basis across the Capital Southwest portfolio, revenue and EBITDA grew quarter-over-quarter, and the weighted average leverage in our Lower Middle Market portfolio, due to Capital Southwest security, decreased compared to the prior quarter-end.

Within our internal -- within our internal investment rating process, 3 portfolio companies received an investment rating upgrade, while 2 portfolio companies received an investment rating downgrade. As a reminder, all investments 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.

Overall, we were pleased with the performance of the investment portfolio as 96% of the portfolio is rated as investment grade 1 or 2. 4% of the portfolio is rated at investment grade 3 and no portfolio companies are rated as an investment grade 4.

This quarter, we did place our 1st Lien Senior Secured loan to AG Kings on nonaccrual, which was one of the 2 downgrades. We have $9.2 million at cost invested in this particular loan as a club participant alongside a few other prominent middle market lenders.

While I want to be careful not to provide too many specifics on this public call regarding a private company, I will say that the company has defaulted on certain of its financial covenants. In addition, the sponsor decided to withhold payment of the December monthly interest payment to be rolled into a broader amendment discussion. Therefore, today the company remains in payment default with a lender group that is aggressively pursuing revenues.

Based on the company's current leverage level of approximately 4x debt to EBITDA, our estimation of enterprise value and the experience and aggressive posture of the lender group, we are optimistic this default will be resolved in a manner that is favorable for Capital Southwest and its lender partners.

Turning to Slide 8, our investment strategy has remained consistent since its launch in January 2015. As a reminder, we continue to focus on a blend of both Lower Middle Market and Upper Middle Market assets, providing us strategic flexibility as we have built the robust capability to seek attractive risk-adjusted returns in both markets.

In our core market, the Lower Middle Market, we directly originate opportunities consisting of debt investments as well as equity co-investments are made alongside our debt. Building out a highly performing and granular portfolio of equity co-investments is important to driving growth in NAV per share while mitigating future credit losses. At the same time our capability and presence in the Upper Middle Market provides us the ability to opportunistically invest in a more liquid market when attractive risk-adjusted returns exist.

In the Upper Middle Market, over the past year or so, we have been in an environment where it's been very difficult to find value in syndicated loans. For the deals and structures we have found acceptable from a risk-return perspective, we have often chosen to take small positions of approximately $5 million, which fit well into I-45. To the extent that market generations continue, and we see opportunities to invest in the Upper Middle Market syndicated loans at especially attractive spreads, we have the ability and liquidity to capitalize on such opportunities, either through additional exposure on our balance sheet or through possibly increasing the size of I-45.

In contrast, in the Lower Middle Market, our robust origination platform continues to generate strong deal flow, allowing us to close on some highly attractive opportunities from a risk-return perspective. We believe that maximizing the top end of our origination funnel is critical to generating strong credit investment performance over time as it ensures that we consider a wide array of deals so that we are able to employ our conservative underwriting standards in a competitive market and thoughtfully build a portfolio that will perform through the economic cycle.

Our on-balance sheet credit portfolio at Capital Southwest is seen on Slide 9, excluding I-45, grew from $337 million at September 30, 2018, to $351 million at December 31, 2018, driven by continued Lower Middle Market origination activity. As the portfolio has grown, the percentage of the credit portfolio represented by the Lower Middle Market has increased by design to now 77%. While we have increased the percentage of the portfolio represented by the Lower Middle Market, we have also continued to heavily emphasize 1st Lien Senior Secured Debt in our investment strategy.

As of the end of the quarter, we had 86% of our on-balance sheet credit portfolio in 1st Lien Senior Secured Debt.

During the quarter, as seen on Slide 10, we committed $26 million to 2 new portfolio investments and 1 add-on investment to an existing portfolio company. All of the investments were in the Lower Middle Market and all were directly originated and led by Capital Southwest. On a weighted average basis, the debt investments made during the quarter had a yield to maturity of 11.1%.

Our originations this quarter included $24.7 million in senior secured debt made up of $12.5 million of first lien secured debt, a $10 million split lien secured debt investment and $2.2 million first lien secured -- a $2.2 million first lien secured delayed draw term loan for an existing portfolio company. We also invested $1 million in an equity co-investment funded alongside one of our new portfolio transactions.

During the quarter, as seen on Slide 11, we received $18 million in proceeds from the exit of 3 investments, 1 Upper Middle Market investment and 2 Lower Middle Market investments. One of our exits resulted from the sale of Deepwater Corrosion Services to a strategic buyer, resulting in a realized gain of $1.7 million or $0.10 per share. Deepwater, a preferred stock investment originated back in 2013, was one of our last 2 remaining legacy equity positions. After going through a tough time in the energy services industry during 2015 and '16, Deepwater was able to recover and position itself for a strategic sale, producing a nice outcome for its shareholders.

This quarter's exits continue our track record of generating strong risk-adjusted returns on our shareholders' capital as we now have 25 exits since the launch of our credit strategy 4 years ago, representing approximately $180 million in proceeds generating a weighted average IRR on the exit of 16.3%. This now leads Media Recovery as the last remaining legacy equity investment in our portfolio. Media Recovery does business under the banner SpotSee. SpotSee's management team continues to do an excellent job growing and increasing the profitability of the business. As we have mentioned on prior earnings calls, there continues to be significant interest in the acquisition of this company.

We have now hired an investment banker and have been working with them in earnest to launch a sale process. Consistent with our past commentary, we expect to exit this investment during the calendar year 2019.

On Slide 12, we break out our on-balance sheet credit portfolio, again excluding I-45, between the Lower Middle Market and the Upper Middle Market. As of the end of the quarter, the total portfolio was weighted approximately 79% to the Lower Middle Market and 21% to the Upper Middle Market on a cost basis. We had 25 Lower Middle Market investments with an average hold size of $12.3 million and weighted average EBITDA of $9.3 million and weighted average yield of 11.9% and leverage measured as debt to EBITDA through our security of 3.2x.

I should also note that 3.2x weighted average portfolio leverage in our Lower Middle Market portfolio is down from 3.4x as of the end of the prior quarter.

Within our Lower Middle Market portfolio, as of the end of the quarter, we held equity ownership in approximately 72% of our portfolio companies. Our Upper Middle Market portfolio consisted of 10 loans with an average hold size of $8.3 million, a weighted average EBITDA of $71.1 million, a weighted average yield of 10.4% and leverage, through our security, of 3.8x, which was flat from the prior quarter.

As illustrated on Slide 13, we have established a well-diversified portfolio heavily biased towards 1st Lien Secured Debt investments, providing strong capital preservation security for our shareholders' capital. In addition, 97% of our credit exposure is invested in floating rate securities, as can be seen on Slide 14, such that our shareholders should continue to benefit should interest rates continue to rise.

As shown on Slide 15, as of the end of the quarter, the I-45 portfolio was 95% first lien with diversity among industries and an average hold size of 2.1% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately $70 million and weighted average leverage through the I-45 security, of 3.7x, down from the 3.8x at the end of the prior quarter.

We have been pleased with the solid performance of I-45 over the past 3.5 years. We and our partner in I-45, Main Street Capital, have invested approximately $500 million through the fund and harvested 50 exits, generating $196 million in proceed at a weighted average IRR on the exits of 11.4%.

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

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [4]

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Thanks, Bowen. As seen on Slide 16, our investment portfolio produced $13.9 million of investment income this quarter with a weighted average yield on all investments of 11.1%. This represents an increase of $1.3 million from the previous quarter, mostly attributable to net portfolio growth.

The weighted average yield on our credit portfolio was 11.6% for the quarter, flat from the previous quarter. As of the end of the quarter, there was 1 assets on nonaccrual with a fair value of $8.6 million, representing 1.7% of our total investment portfolio. Excluding interest expense, we incurred $3.7 million in operating expenses this quarter, which was flat with the previous quarter. We earned pretax net investment income of $6.8 million or $0.40 per share during the quarter compared to $0.36 per share during the prior quarter.

We paid out $0.36 per share in regular dividends for the quarter, an increase of $0.02 per share over the $0.34 per share paid out in the prior quarter. We continue to focus on growing our regular dividends in a sustainable manner, demonstrated by our cumulative regular dividend coverage of 103% since the launch of our credit strategy 4 years ago.

As Bowen mentioned earlier, we also paid out a $0.10 per share supplemental dividend this quarter as part of our Supplemental Dividend Program. This program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio. The program will continue to be funded from our undistributed taxable income earned from both realized gains on debt and equity as well as undistributed net investment income earned each quarter in excess of our regular dividends.

This quarter, the realized gain from Deepwater, coupled with our significant regular dividend coverage provided additional UTI to further bed the program. At year-end December 31, 2018, our UTI balance was $1.20 per share, thus providing visibility to funding the supplemental program at its current level into calendar year 2021.

As we look ahead, future realized gains and net investment income earned in excess of our regular dividend will replenish the UTI balance, extending the supplemental program beyond 2021. For example, if we were to assume a sale of SpotSee during the calendar year 2019 at our current valuation with no other realized gains or additional UTI from net investment income, we would expect the Supplemental Dividend Program to extend into calendar year 2023. Beyond 2023, we would hope that our numerous equity co-investments made as part of our Lower Middle Market strategy would serve to continue to replenish the UTI for further extension of the Supplemental Dividend Program.

On Slide 17, we illustrate our operating leverage, which has improved significantly from 4.9% in 2016 to 2.9% as of the quarter ended December 31, 2018. We continue to actively manage operating costs in lockstep with portfolio growth toward the goal of achieving our longer-term operating leverage of sub-2.5%, which we expect to achieve over the next several quarters.

With all senior professionals and corporate infrastructure largely in place, portfolio growth from here should continue to improve our operating leverage due to our internally managed structure. As Bowen mentioned earlier, during the quarter, our NAV per share decreased by $0.41 or 2% to $18.43 per share, as seen on Slide 18.

As seen on Slide 19, on the right side of the balance sheet, we have established multiple pockets of capital with extended maturities to provide us maximum flexibility to thoughtfully grow our investment portfolio. In fact, due to the recent ING credit facility amendment, we currently have approximately $155 million in cash and undrawn commitments available on balance sheet with no obligations till the end of calendar year 2022, with an additional $11 million in undrawn capacity within our I-45 credit facility. Our balance sheet leverage ended the quarter at 0.62:1 debt to equity.

As Bowen indicated earlier, we upsized, extended and amended our credit facility with ING Capital in December. Total commitments under the credit facility increased by $60 million from $210 million to an aggregate total of $270 million at close, provided by a diversified group of 9 lenders. The amendment includes an expansion of the accordion feature to $350 million to accommodate future growth of the company. The credit facility's revolving period was extended from November 2020 to December 2022, and the final maturity was extended from November 2021 to December 2023. The pricing on the credit facility was reduced from LIBOR plus 3% to LIBOR plus 2.5%. The credit facility amended -- the credit facility amendment reduces the minimum asset coverage covenant from 200% to 150%, effective at the 1-year anniversary of our board approval, which is April 25, 2019. We believe this amendment significantly enhances our funding flexibility and improves our competitive position in the market going forward.

In addition, in October 2018, we issued 700,000 shares of common stock at a net price of $18.90 per share to 2 BDC institutional investors. The offering was priced above net asset value and less than a 2% discount to the market price at the time, generating proceeds of $13.2 million.

During the quarter, we also executed on our share repurchase program, which was originally approved by our board in 2016. The market volatility in December temporarily drove Capital Southwest's stock price below NAV, triggering our repurchase program and resulting in the repurchase of approximately 10,500 shares at an average price of $17.72, a 6% discount to NAV at the time of the repurchases.

We continue to be willing buyers of Capital Southwest's stock should time -- if the market volatility put the shares on sale at a meaningful discount to NAV. I will now hand the call back to Bowen for some final comments.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [5]

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Thanks, Michael. And thank you, everyone, for joining us today. Capital Southwest is growing and the business and portfolio have developed consistently with the vision and strategy we communicated to our shareholders over 4 years ago. Our team has done an excellent job generating strong returns for our shareholders. Everyone here at Capital Southwest is totally dedicated to being good stewards of our shareholders' capital, by continuing to deliver strong performance and creating long-term sustainable value for our shareholders.

This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Mickey Schleien with Ladenburg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [2]

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I wanted to just clarify some language, if I may. I think you indicated your Lower Middle Market deals this quarter were directly originated. But if I'm not mistaken, those are also sponsored deals. So does that imply that you found the transactions and then went out and found sponsors? Or what does it mean exactly when you say directly originated?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [3]

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Yes. Mickey, it's Bowen. Thanks for the question. So we think about that as a lot of what we do is go out and we network and we find deals and a lot of who we network to and market to are private equity sponsors. So as opposed to having another lending firm find the sponsor or have the relationship with a sponsor in which we club with them, which we do a little bit of that, but most of what we do is -- it's our sponsor relationships that we initiate -- the sponsors actually find the actual company opportunity in those situations and then they call us, and then we work with them due to our relationships with them to partner with them on those deals. And so when I say directly originated, I mean that's a sponsor relationship that we have, that we've harvested and found an opportunity and partnered with to buy a company.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [4]

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And Bowen, in that process, are these sponsors pricing this thing out? Or is it an exclusive, sort of, negotiation with you?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [5]

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So usually the sponsors, the vast majority of time, the sponsors have relationships with multiple lenders So I would say that we're virtually always competing with other lenders for a situation and one of those that -- one of the metrics in a decision a sponsor makes is pricing, but also the other metrics are reputation of the firm, track record of the individuals and that type of things. So and our knowledge of a certain space or what have you...

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [6]

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And liquidity as well.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [7]

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Yes, liquidity as well. I mean, how much staying power does our entity have long term and that type of things. So -- but in all the cases this quarter, we had other lenders looking at the deals as well.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [8]

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Okay. I understand. If I could just ask about valuation, particularly with the volatility at the end of the last year, we saw the S&P Leveraged loan index widened by about 150 basis points, which I assume probably impacted the valuation of your Upper Middle Market and senior loan fund investments. So does that widening go directly into your -- the discount rate calculation that you use, at least with respect to the income approach investments? Or is there some other methodology that you use?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [9]

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Well, first of all, I'll say -- Michael you can comment on it as well, but the metric goes, it's one component that goes into the process, so the metric itself, the actual index that we're utilizing for a loan, absolutely on a 1:1 basis goes into the loan. And then just like if you're valuing a private company on an equity basis, you might use public company comps but then you have discount the concluding multiple on a large public company, you had to discount that multiple down to get what an equivalent private multiple would be. The same concept applies to debt as well, as thinking about widening of spread versus what a large loan would be. So there's adjustments made to both equity indexes as well as debt indexes but the core index, if you will, goes into the calculation and is the basis that you start with.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [10]

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On the syndicated side, the broker quotes really where we ended the quarter at 12/31 with the market being quite down, those are what are going to dictate a lot where I-45 would have ended.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [11]

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Yes, we take the market quote irrespective of whether there was actually paper for sale of the market quote. If the market quote moves and is often the case, no papers for sale at the discounted price, our valuation comes down.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [12]

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I understand. Just one last question then I'll get back in the queue. Was there any impact on your borrowers from the government's shutdown?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [13]

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I mean, I'd almost say really none. I mean, we might find out at the end of March quarter, looking back on the quarterly performance and reflecting at our various board meetings that maybe we would theorize that something affected the business here or there. But nothing that would be -- like a phone call to us on a situation that was material.

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Operator [14]

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And our next question comes from the line of Chris York with JMP Securities.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [15]

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Maybe Michael or Bowen, dividend income from the quarterly record on the dollar basis and also a yield basis and the Q net out have me kind of dig a little bit further, so I have a couple of questions. One, was there any nonrecurring income in the quarter embedded in the distribution? And then, two, is the level of dividend income and then, therefore, yield sustainable?

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [16]

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Yes. So this quarter we had about $0.01 from prepayment penalties from exits in our portfolio companies. In I-45, we had an increase in leverage at the fund. We increased it from 1.75 to about 1.87, which increased about $100,000 of additional income from I-45. The rest of the income pickup for the quarter was really related to seasoning from originations in the 9/30 quarter and originations from the 12/31 quarter. So we'd say that if you're looking at the $0.40 run rate of the net investment income, that is sustainable.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [17]

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Got it. So I'm looking specifically at the dividend income, the $2.5 million provided to Capital Southwest as opposed to the $0.40 there.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [18]

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Yes. So that would be sustainable. That is what we were saying earlier, the I-45 pickup in leverage increased that -- plus repayments at the I-45 fund as well. So I would tell you that the $2.5 million should be sustainable into the following quarters.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [19]

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Got it. Okay, great. And then Bowen, maybe a little bit on investment strategy. So with the approval of additional leverage provided by shareholders and then an increase in committed capital under revolver, how are you thinking about the trade-offs today of investing or holding larger deal sizes without a partner versus the risk that could manifest in the concentration risk in the portfolio?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [20]

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Yes. So I think as we've talked about before, I mean, concentration risk is something that we're very cognizant of. So one of the things that excites us over time is that as we grow the asset base, we can hold larger and larger pieces of the loans. And so, if you look across our portfolio, I think 40% of our Lower Middle Market portfolio or deals that we've led and originated but that we have brought in a co-lender alongside us. And so over time, as we can hold larger loans, given a certain level of granularity and frankly, I'd like to improve the granularity from where we are today. So -- and so, I look at it as that's a nice upside for us as we grow, we can improve granularity and hold more of the loans and have to rely less on partners that we bring in. And so the act of increasing the credit facility is part of that funding the asset growth and so are opportunistically when we raise bonds or even equity, I mean, it's all part of growing scale, and it's not growing scale just to say, hey, we're larger, hey we can do larger deals, it's actually this scale growth is going to allow us to do all of more of our existing deals. And so there's no scope creep into larger deals sandbox where competition is greater and leverage is higher, et cetera. It's all about growing scale to be able to hold more -- 100% of more of our loans in our existing sandbox. And so the credit facility is a step in that process, if that makes sense.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [21]

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It does, that's helpful.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [22]

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And Chris, the granularity was helpful in our ING negotiation. The fact that we've moved down on granularity over time, allowed us to drop 50 basis points, we see the same sort of dynamic hopefully at I-45 with us dropping down to 2.1% in granularity in the I-45 fund and that should hopefully translate to a lower cost of capital there as well.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [23]

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Okay, it's helpful. And then in reference to AG Kings, so another club lender had the loan marked at 94% versus your September 30 mark of 98% on the percentage of amortized path. So it appears the market is down to 92% in this quarter, but maybe just -- I don't think that BDC is recorded yet, but in November is the residual (inaudible) mark in there? What explains the previous quarter residual in valuation?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [24]

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I don't really know. I can't speak for -- I mean, it's WhiteHorse is the other one in there that you're probably referring to because they're probably public BDC like us. And I can't explain the difference between the 2. I mean, we've got our valuation process, actually, I'll tell you that our valuations are -- have always been within the range of our third-party valuation consultants' range. And frankly, vast majority of the time, it's been at the lower end of the range from our third-party consultant. So we try to be conservative -- on the conservative end of correct. And frankly, there's a debate, it would probably be interesting to see across the BDC space as why we put this on nonaccrual. We think it was the right thing to do based on the criteria we look at. We think that it would maybe in hindsight be viewed as conservative, who knows, but that's what we decided to do. So last quarter, I don't really know. I would tell you that it's -- that our valuation is within what our third-parties tell us, and so we tend to be conservative in that range. But I can't really speak to WhiteHorse's view on that.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [25]

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Understood. (inaudible) BDC has board observation to some other qualitative input that (inaudible) different evaluation. So I was just wondering if that was the case with you guys.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [26]

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Yes. There's only 3 of us in this deal -- I should say 4, there's 3 BDCs and there's 1 private loan group. It's a relatively speaking a tight club. We all communicate pretty often and frequently.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [27]

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Okay. And then last one and I'll jump back in the queue. How many employees were at the firm at quarter-end?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [28]

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21.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [29]

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Okay. And then is that -- I think we had 19 at year-end, so quarter-over-quarter, was there any increases?

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [30]

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Yes, we added an associate and I think an analyst.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [31]

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Okay. So up 2 from the September quarter? Is that right?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [32]

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No, I don't think it's right. Was it 19, I think there was...

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [33]

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I don't know how many joined.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [34]

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I don't think they were -- we haven't -- what's that?

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Unidentified Company Representative [35]

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19 at the end...

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [36]

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They were 19 at the end of March. And then since then, we have added an analyst and an associate.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [37]

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And we have one more analyst on the way.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [38]

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And we have another analyst that's scheduled to start this summer.

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Operator [39]

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And our next question comes from the line of Christopher Testa with National Securities.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [40]

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Just given the volatility we've seen, obviously, in the broadly syndicated market during the quarter, just curious, why there wasn't more Upper Middle Market originations done during the quarter. Are you guys still concerned with the obvious the lack of documentation and EBITDA add-backs? Is that kind of outweighing the back of the yields that you're seeing? Just curious kind of what the thinking was on that.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [41]

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Yes. So thanks -- Chris, thanks. I would -- couple of things, I would say. First of all, as I said in my remarks that probably didn't come out clear. But the vast majority of it, when these -- at least in our book, as we saw it, the markdown in quotes. And I think this is probably fair across the market is -- certainly, when a quote comes down on a syndicated debt, they mark something down from 98% to 94%, perhaps. That does not -- as you know, that does not necessarily mean there's paper available at 94%. So we didn't see a lot of opportunities to buy paper at significant discounts to what we thought value would be. We just didn't see the paper for sale. That said, I would also tell you -- and frankly, there would need to be probably gyrations in the market that lasted a little bit longer so that you actually had assets' stress at funds. So that fund would start selling paper at a discounted price. That's a different -- you've got to have something more than just the last 2 weeks of December to cause that. And so -- and we may see that in the future. We didn't see that in December. And I'd also tell you that from the caution perspective, we absolutely are cautious on add-backs and all the other things that we were cautious about 6 month ago, we're still cautious about now. And I would tell you that the first time we see gyrations in the market, we're not going to be diving in and buying in and catching a falling knife. We're pretty cognizant of that. And so net-net, it all, kind of, happened really quickly at the end of December. Thankfully, a lot it's bounced back now. So -- and we just didn't see a lot of opportunities out there to really buy paper at the discounted price and against the backdrop of being cautious the first time you see market gyrations just start going and buying things. We're going to be cautious in that respect.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [42]

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Okay. That makes sense. And staying on this topic, given the volatility, if this does, indeed -- now, it's obviously snapped back, but if it does, indeed, be sustained over a longer period of time, is this something that could potentially get you guys thinking about upsizing the I-45 to more so take advantage of some gyrations that last for longer periods of time?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [43]

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Yes. So as we think about it, look, the first question is, is there value in the asset class, do we see value, do we want to buy in, and do we want to increase our exposure to the asset class. So that's the first question. So setting that question aside, the answer to that question at some point in the future very well could be yes, and so then the question is, how do we fund it. And so we would be able to fund it. We've increased the liquidity on our credit facility substantially and we'll continue managing that up. We'll continue to try to stay half a step ahead on capitalization through bond offerings and potentially equity, that type of thing. But we also have the opportunity -- we also possibly -- I don't want to speak for our partner, Main Street, but we do have the option potentially to increase I-45. I would tell you that we're very happy with the relationship with Main Street. We're like-minded firms. The fund management, it's been very smooth. And so -- and it's in a very efficient funding vehicle, thanks to the capitalization, credit facility that Michael and his team have put together around that fund. So from an ROE perspective, it's definitely an option for a place that we could either put the capital on I-45, lever it up through our credit facility there or we could put the investments on our balance sheet and lever it with ING's credit facility. And that's more of an ROE question and a relationship question. So I would definitely tell you that it's a possibility on the table. Nothing imminent, nothing frankly, the initial question of is there value in the asset class, we're still very cautious in that as a general matter in that asset class. So we're not itching to greatly increase the exposure to asset class at the moment. But like I said, we're capitalized on our balance sheet to increase the exposure if we change our mind on that. And I do think that increasing I-45 over time could be an option.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [44]

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And there's significant interest from our bank as well as other banks in the asset class, should we choose to put in more equity and want to lever back up.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [45]

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Yes, there's definitely interest from the lender community on both our balance sheet as well as I-45 to increasing to -- to continue to provide increased leverage dollar from the deal.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [46]

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Okay. That's helpful. And just again, congrats on exiting Deepwater, so that's one down, one to go for the remaining legacy investments. Given that this was a real small realized gain, should we expect this to just solely be used to pad the UTI going forward? Or is there going to be a plan to maybe declare some of this to be a special dividend up front? Or is this just too small to really, kind of, make a difference for that?

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [47]

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No, this one will go into our UTI bucket as well as the additional UTI from our dividend coverage this quarter, which was $0.03 as well. So that's all to continue to bed that program.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [48]

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Okay, got it. And just to the extent you're able to talk about the current nonaccrual, you guys had mentioned that it's 4x levered, is that through the last dollar of leverage?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [49]

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That's correct.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [50]

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And is this -- I know you had said that the sponsor is withholding payment and you guys and the other lenders are obviously, pursuing it. Is the sponsor of this one that you have other investments with or have 1, 2 in the past?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [51]

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No, it's not. It's actually a family office in the Middle East. It's got a U.S. office in New York and a representative in New York. So no, it's not somebody that we've done other business with.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [52]

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Got it. Okay. And just one last one if I may, and then I'll hop back in the queue. Looking at the originations during the quarter, you guys did a split lien on an energy company, a midstream one. Just wondering if you could provide some color on the leverage of that and just any other detail would be helpful.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [53]

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Yes. So leverage low, it's in 1.5 to 2 kind of fairway, multiple EBITDA, very low LTV. It's a -- basically, it's a gathering company and what they do is you've got -- there's just a gazillion stripper wells, which are basically wells that produce less than 10 barrels a day, spattered across the Permian basin. And there's no -- the economics don't make sense to build pipelines up to those wells and they've been producing for decades. And so someone has to go pick up all that oil and take it to market. And so it's a very -- and you can't shut those wells off. I mean, you can't really -- they are longtail wells. And you can't really shut them off and efficiently turn them back on or even be able to turn them back on. So -- and then they also clean out oil tanks that are part of the production process. And so pretty stable, very stable business, it exists whether prices are up or prices are down. It had a little bit of flexibility -- little bit of fluctuation with the commodity prices in that they actually -- some of the oil that they clean out of their tanks, they do sell that oil into market. So there's a little bit of commodity exposure, but that -- I think -- we think that's more than offset by the low leverage as it exists. But like I said, it's been, kind of, in the 1.5 to 1.8 kind of multiple EBITDA zip code.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [54]

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Got it. Okay...

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [55]

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By the way, I should also say it's a sponsor that's very experienced in the energy space.

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Operator [56]

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And it looks like we do have a follow-up from Chris York with JMP Securities.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [57]

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I have two follow-ups. In reference to your hire of an investment banker associated with the sale of Media Recovery. Is the payout of that fee on a contingency basis? Or should we expect some G&A pickup in '19?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [58]

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So it's a typical investment banker relationship. It's going to have a retainer, and it's going to have a success fee. The vast majority of the fees paid out to that banker are going to be on the success fee side upon its sale. And that all flows through -- that's a Media Recovery expense.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [59]

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It's -- actually on the flip side, we're actually going to get a success fee with the sale of MRI that will show up in fees in the quarter of the exit.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [60]

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Got it, okay. So that's helpful to clarify. So your -- the reference of your hire was the Media Recovery made the hire of the banker, so it's expense borne by the MRI as opposed to Capital Southwest.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [61]

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Technically speaking, that's exactly right. Yes.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [62]

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Okay. And then the last one is just on dividend. So the context of the core dividend being increased for 12 consecutive quarters and Michael you said $0.40 per share in pretax NII appeared to be reoccurring. How should investors think about the payout ratio going forward? And then, maybe even longer term, the ROE target under your leverage above 1x?

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [63]

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Yes. So I tell you that I think we're -- our dividend coverage will continue to be above 100%. I think we're looking at something more in the neighborhood of 105% going forward. So I think the $0.40 per share-- the NII still has a tail to it, but the dividend growth pace might slow down a bit. What was your second question, Chris?

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [64]

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The longer-term ROE target, maybe 1x leverage or 1.25x?

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [65]

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Sure. I think that we're actually looking at a target somewhere between 9.5% to 10% on an NII ROE and total earnings probably closer to 11% to 11.5% with our equity investments as they appreciate over time.

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Operator [66]

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Our next question comes from the line of Tim Hayes with B. Riley FBR.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [67]

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Just a few questions on MRI to start. We don't have the Q in front of us but you mentioned that revenues and EBITDA continues to grow there. Was there any material change in the fair value mark this quarter over the last quarter? We saw the mark on control investments is pretty stable quarter-over-quarter, but I assume the JV was marked down a little bit. So was that offset by some appreciation in MRI?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [68]

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Yes. So MRI appreciated this quarter about $4.3 million. So -- go ahead.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [69]

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Okay. Yes, no, I was just -- so does any of that appreciation at all fundamental to the company or does any of that reflect any kind of take-out premium or increased visibility into the timing of a sale following the hiring of the banker?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [70]

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So there's no -- it doesn't take into account any official IOIs or visibility into the market valuation from specifics in the sale process. We did do a quality of earnings analysis. We had a third-party account that come in and actually kind of do a QOE, quality of earnings, analysis on the company. And that has validated a higher EBITDA number, incorporating some of the profit growth that the company has been driving over the last 12 months. And so it is based on that level of EBITDA, which was higher than EBITDA last quarter, for example. So that's part of the growth as well.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [71]

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Okay. That's helpful. And then have you put any more thought and I'm sure you have, but into how you intend to distribute the proceeds once the sale closes and you exist the investment? Just assuming no further markup in MRI, do you have an idea of how much of the gain or any other exits you might see over that same time? How much of the gain do you believe you'd be willing to pay out to shareholders versus retain and reinvest?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [72]

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Yes, Tim, thanks for the question. I mean, we have not made that decision yet. I would just tell you there's 3 things we can do with the gain, right? One is that, that we would -- and we will do this, which is basically restaff the UTI bucket and there's a limit, as you know, as to how much UTI we can hold. So whatever that limit is, which is a moving target, so at the end of -- let's just say we sell the company in 2019, the tax year 2019, at the end of the tax year, we'll make an estimation as to how much UTI we can hold. And so whatever that amount is, we will stuff as much of the gain into that bucket as we can. Okay? Then you'll have -- at the current valuation, you most probably would have a significant amount more that you would have to do something within. And the other 2 options are, retain it, do a deemed distribution to the shareholders or distribute it to shareholders or both. Some of both. And that's the decision that we haven't made yet. And that's going to be a function of a lot of different variables including things like where our stock is trading on a multiples NAV, what our pipeline looks like, various things whether we retain or distribute the capital. And so we just haven't made that decision. And that's probably a decision that we're making after we close the sale.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [73]

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Got it. That makes sense. And just one more for me. You had one small equity co-investment this quarter and obviously, the majority of the exit portfolios coming in the form of MRI. Just wondering how big you see the equity portfolio getting relative to the debt portfolio once MRI is sold.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [74]

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Yes. I mean, it's just like longer-term kind of asset allocation comment I would make. I think for a BDC, I mean, income is really important, and that comes from -- primarily from interest on loans and then we've talked about 1st Lien versus sub debt, and our view that we're very -- we're very heavily emphasizing 1st Lien debt. But within that, having some level of equity in the portfolio to drive NAV per share growth over time and to mitigate credit losses as well, we think the equity is also important -- the question is the mix and I think kind of overall comment I would tell you is kind of 10% to 15% of the portfolio in equity and 85% to 90% of it in income-generating debt is probably the right general mix with I'd say over time probably -- it's probably -- that' is probably the range, 10% to 15% over time.

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Michael Scott Sarner, Capital Southwest Corporation - Treasurer, Secretary, Chief Compliance Officer & CFO [75]

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After the MRI exit, I think our expectation is it's going to be around 6% or 7%. So it's going to take a bit of time, to Bowen's point, to actually get up to that 10% to 15% (added by company after the call) level over time.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [76]

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And you may end up hanging around, around 10% for a long period of time. And that's okay. I mean, we don't make -- we're not out making equity investments solely. I mean, it's usually they're equity and vast majority of time, it's equity coinvestments alongside a senior loan we're making as well. So you can't migrate -- we can't migrate it super quickly, but like I said, we'll come out of the gates around 6% or so, after we sell MRI.

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Operator [77]

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I'm not showing any further questions. So I'll now turn the call back over to Bowen Diehl for closing remarks.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [78]

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Thanks, operator. And again, thank you, everyone, for participating on our call today. We look forward to keeping you apprised of our progress on future calls. Have a great week.

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Operator [79]

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Ladies and gentlemen, this does conclude the program. You may now disconnect.