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

Q2 2020 Capital Southwest Corp Earnings Call

Dallas Nov 15, 2019 (Thomson StreetEvents) -- Edited Transcript of Capital Southwest Corp earnings conference call or presentation Tuesday, November 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 - CFO, Chief Compliance Officer, Secretary & Treasurer

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Conference Call Participants

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* Christopher John York

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

* Christopher V. McCampbell

* Kyle M. Joseph

Jefferies LLC, Research Division - Equity 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 Second Fiscal Quarter 2020 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 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.

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 thank you everyone for joining us for our Second Quarter Fiscal Year 2020 Earnings Call. Throughout our 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 and to announce our quarterly results for the second fiscal quarter ended September 30, 2019.

During the quarter, we continued to advance our credit strategy of prudently building a well-performing credit portfolio, utilizing conservative late-cycle underwriting principles.

We continue to be committed and excited about our core investment strategy of building a predominantly Lower Middle Market portfolio consisting largely of 1st Lien Senior Secured Debt with equity co-investments across the loan portfolio, where we believe significant equity upside exists.

Executing our investment strategy under our shareholder-friendly internally managed structure closely aligns the interest of our Board and management team with that of our fellow shareholders in generating sustainable long-term value through recurring dividends, capital preservation, NAV per share growth and operating cost efficiently.

During the September 30, 2019 quarter, as summarized on Slide 6, we generated $0.42 per share of pretax net investment income, representing 17% growth over the $0.36 per share generated in the same quarter a year ago.

During the quarter, we incurred $472,000 or 300 -- or $0.03 per share of a onetime expense for the write-off of the deferred operating costs related to our previous Form N-2 registration statement.

We paid out a regular dividend during the quarter of $0.40 per share, achieving 105% dividend coverage on pretax net investment income per share.

Additionally, we distributed $0.10 per share through our supplemental dividend program funded by our sizable, undistributed taxable income balance or UTI, which was generated by excess income and capital gains accumulated from our investment strategy to date.

As of September 30, 2019, we had approximately $18.3 million or $1.02 per share in UTI, providing visibility to continuing the quarterly supplemental dividend program well into the future.

For the September quarter, the $0.50 per share paid out in total dividends generated a total annualized dividend yield of 9.2% based on our September 30, 2019, share price.

We are also pleased to announce our quarterly regular dividend for the December quarter as our Board has again declared dividends of $0.50 per share, made up of a $0.40 per share regular dividend and a $0.10 per share supplemental dividend.

During the September quarter, we grew our portfolio on a net basis to $539 million from $533 million as of June 30, 2019, originating approximately $30 million in new commitments and receiving 1 prepayment totaling $14 million in proceeds.

Our I-45 Senior Loan Fund provided dividends to Capital Southwest, representing a 16% annualized yield at fair value on our capital in the fund for the quarter.

During the quarter, we successfully completed a $65 million 5-year institutionally placed bond offering priced at 5.375%. Subsequent to quarter end, we raised an additional $10 million under the same debenture, bringing the aggregate principal outstanding to $75 million.

In addition, we raised $5 million in gross proceeds through our equity ATM program during the quarter, selling over 231,000 shares at a weighted average price of $21.62 per share, representing a 16% premium to book value.

I'm pleased to report that since the initiation of our equity ATM program, Capital Southwest has sold almost 700,000 shares at similar premiums to book value, raising approximately $15 million in gross proceeds.

Our equity ATM program continues to provide a steady flow of equity capital raised on a just-in-time basis and lockstep with our ability to thoughtfully put the capital to work.

Turning to Slides 7 and 8, we illustrate our continued track record of producing a strong dividend yield, consistent dividend coverage and value creation since the launch of our credit strategy.

Turning to Slide 9. As a reminder, our investment strategy has remained consistent since our -- since its launch in January 2015.

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 and equity co- investments. Building out a highly performing and granular portfolio of equity co-investments is important to driving growth in NAV per share, while aiding in the mitigation of 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.

Overall, we believe that maximizing the top end of our deal origination funnel in both markets is critical to generating strong credit investment performance over time as it ensures that we consider a wide array of deals, allowing us 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, excluding I-45, as shown on Slide 10, grew to $387 million as of September 30, 2019, from $382 million as of June 30, 2019. We continue to heavily emphasize 1st Lien Senior Secured Debt lending in the Lower Middle Market in our investment strategy.

As of the end of the quarter, we have 76% of our on-balance sheet credit portfolio invested in the Lower Middle Market company, while having 87% of the credit portfolio in 1st Lien Senior Secured Debt.

Turning to Slide 11. During the quarter, we originated $29 million in 1st Lien Senior Secured Debt and a $1 million in equity co-investment. The capital committed went to 1 Lower Middle Market portfolio company and 2 add-ons to existing portfolio companies.

The new portfolio company was the first lien last out senior secured loan with an equity co-investment. One of the add-ons was in the Upper Middle Market, while the other was in the low -- in a Lower Middle Market company in which Capital Southwest is the sole lender and also an equity investor.

The weighted average yield to maturity on all originations this quarter was 11.7%.

Subsequent to quarter end, we have originated $33 million in new commitments to 2 new portfolio companies. This included $30 million in 1st Lien Senior Secured Debt, $2.5 million in an unfunded revolving credit facility and $1 million in an equity co-investment.

We are pleased with the pipeline as it stands today and expect that 2 or 3 additional deals currently in diligence should close by calendar year-end.

As shown on Slide 12, we also had a full prepayment of 1 credit investment during the quarter for $14 million in total proceeds, generating a realized gain of $244,000 and an IRR of 13.7% on total invested capital.

The portfolio company has grown significantly, giving it the opportunity to refinance its debt with cheaper debt capital.

Capital Southwest continues to have an equity co-investment in the company with significant unrealized depreciation. This continues our strong track record of successful exits as we have now had 27 portfolio exits since launch of our credit strategy, generating $214 million in total proceeds and a cumulative IRR of 15.5%.

On Slide 13, we break out our on-balance sheet portfolio, again excluding I-45, between the Lower Middle Market and Upper Middle Market. As of the end of the quarter, the total portfolio weighted -- was weighted approximately 76% to the Lower Middle Market and 24% to the Upper Middle Market on a cost basis.

We had 27 Lower Middle Market portfolio companies with an average hold size of $12.2 million, a weighted average EBITDA of $8.2 million. A weighted average yield of 12% and a leverage ratio measured as debt-to-EBITDA through our security of 3.5x.

Within our Lower Middle Market portfolio, as of the end of the quarter, we held equity ownership in 70% of our portfolio companies.

Our on-balance sheet Upper Middle Market portfolio consisted of 11 companies with an average hold size of $9.2 million, a weighted average EBITDA of $68.8 million, a weighted average yield of 8.4% and a leverage ratio through our security of 3.7x.

We should note that our on-balance sheet, Upper Middle Market metrics are shown excluding our investment in American Addiction as the EBITDA is not meaningful, and therefore, including it would obscure the ratios of the remainder of the Upper Middle Market portfolio.

With respect to American Addiction, the company continues to have challenges. As in prior quarters, due to being a public company, we want to be careful not to effectively announce developments prior to the American Addiction management team appropriately communicating to our shareholders.

What we will say is that the lender group continues to work with the company on solutions to the capital structure. The company's lending -- leading market position in the substance abuse industry, the company's cost saving and business development initiatives and its large owned real estate portfolio, all provide reasons to remain optimistic on the prospects of a favorable resolution.

American Addiction was placed on nonaccrual this quarter and remains a -- rated a 3 on our internal rating system.

As a reminder, all investments 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 rate.

Overall, we are pleased with the performance of the investment portfolio as a whole. As of the end of the quarter, of the 40 loans in the portfolio at fair value, we had 3 with the highest rating of 1, representing 13% of the credit portfolio.

We had 32 loans rated at 2, representing 80% of the credit portfolio. We had 4 loans rated at 3, representing 5% of the credit portfolio. And we had 1 loan rated a 4, representing 2% of the credit portfolio.

As illustrated on Slide 14, we have established a portfolio well diversified across industries, which we believe is well positioned for late in the economic cycle.

Further, our portfolio asset mix should provide strong security for our shareholders' capital. The portfolio remains heavily weighted towards 1st Lien Senior Secured Debt, with only 6% in Second Lien Senior Secured Debt and only 3% in subordinated debt.

MRI, which does business under the banner, Spotsee, represented 10% of the investment portfolio at fair value as of the end of the quarter, while all other equity co-investments represented 7% of the investment portfolio.

The sales process for SpotSee continues to progress, albeit slower than we expected earlier in the year. As we all know, the current global trade environment is complicated with many elements of uncertainty. SpotSee continues to perform very well despite having over half of its revenue generated by customers outside the United States.

These uncertainties have caused the sales process to take longer than we expected at the beginning of the year.

All that being said, we continue to expect that the transaction should close in the next few months. SpotSee is a well-performing company with exciting products that provide its customers with valuable real-time information regarding the condition of their assets, both remote and in transit.

To us, timing is much less important than ensuring that we complete a transaction that benefits our shareholders, short term and long term.

Shown on Slide 15, as of the end of the quarter, the I-45 portfolio is 95% first lien with diversity among industries and an average hold size of 2.2% of the portfolio.

The I-45 portfolio, weighted average EBITDA of approximately $69 million and weighted average leverage through the I-45 security of 4.3x. We also excluded American Addiction from these ratios for the aforementioned reasons.

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 - CFO, Chief Compliance Officer, Secretary & Treasurer [4]

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Thanks, Bowen. As seen on Slide 16, our investment portfolio produced $15.2 million of investment income this quarter with weighted average yield on all investments of 11.1%. This represents a decrease of approximately $600,000 from the previous quarter. This reduction is attributable to a decrease in dividend income from the I-45 Senior Loan Fund due to a large realized gain received by I-45 during the prior quarter, a decline in LIBOR during the quarter and American addiction being placed on nonaccrual during the quarter.

As of the end of the quarter, there were 2 assets on nonaccrual with a fair value of $13.8 million, representing 2.6% of our total investment portfolio. The weighted average yield on our credit portfolio was 11% for the quarter.

Excluding interest expense, we incurred $4.1 million in operating expenses for the quarter, which was a decrease of approximately $200,000 from the prior quarter.

During the quarter, we incurred a onetime write-off of $472,000 or $0.03 per share of deferred offering costs related to our previous Form 2 registration statement.

Excluding this onetime charge, operating expenses would have been approximately $3.6 million.

For the quarter, we earned pretax net investment income of $7.4 million or $0.42 per share, again, after the onetime deferred offering cost write-off. This compared to $0.44 per share during the prior quarter.

We paid out $0.40 per share in regular dividends for the quarter, an increase of $0.01 per share over the $0.39 regular dividend per share paid out in the prior quarter. We have continued our consistent track record of meaningfully covering a regular dividend with pretax net investment income as demonstrated by our 110% regular dividend coverage over the last 12 months and 108% cumulative regular dividend coverage since the launch of our credit strategy.

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

On Slide 17, we illustrate our operating leverage, which at the end of the quarter was 2.9%. Excluding the aforementioned onetime deferred offering cost write-off, our run rate operating leverage for the quarter would have been approximately 2.6%, which puts us near our initial target operating leverage of 2.5%.

We are fully committed to actively managing our operating costs in lockstep with portfolio growth and will now set our sights on our longer-term goal of achieving target operating leverage of 2% or better.

With senior professionals and corporate infrastructure largely in place, operating leverage should continue to improve as the investment portfolio grows due to our internally managed structure.

Our NAV per share as of the end of the quarter was $18.30 per share as seen on Slide 18. The decrease from the prior quarter was largely driven by net depreciation in our Upper Middle Market investment portfolio as well as by the $0.10 per share quarterly dividend paid to shareholders.

The net depreciation in our Upper Middle Market portfolio was offset by appreciation in our Lower Middle Market debt and equity portfolio.

Our total pretax net investment return on equity for the quarter was 8.9%.

On Slide 19, we laid out our multiple pockets of capital. As we have mentioned on prior calls, a strategic priority for our company is to continually evaluate approaches to derisk the liability structure of the company, while ensuring that we have adequate investable capital throughout the economic cycle.

To that end, we completed a 5-year $75 million institutionally placed bond offering, attractively priced at 5.375%. We believe we are the first BDC with less than $1 billion in market cap to have raised an all institutional bond offering in recent history.

The offering was led by Raymond James and JMP Securities as book runners and included investments by 21 institutional investors who are new to the Capital Southwest story. We believe the execution of this transaction stands as a testament to our strong company performance and confirmation that our story resonates with BDC investors.

As Bowen mentioned earlier, during the quarter ended September 30, 2019, we sold 231,272 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $21.62 per share, raising $5 million of gross proceeds.

Cumulative to date, we have sold 690,477 shares of Capital Southwest common stock under the equity ATM program at a weighted average price of $21.57, raising $14.9 million of gross proceeds.

Our balance sheet leverage ended the quarter at a debt-to-equity ratio of 0.75:1.

We are pleased to report that our liquidity is strong with approximately $238 million in cash and undrawn commitments available between our balance sheet and I-45 with the earliest debt maturity at December 2022.

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 has grown and the business and portfolio have developed consistent with the vision and strategy we communicated to our shareholders almost 5 years ago.

Our team has done an excellent job building a robust credit portfolio and generating significant returns for our shareholders. Everyone here at Capital Southwest is totally dedicated to beginning -- to being good stewards of our shareholders' capital by continuing to deliver strong performance and creating long-term sustainable value. This concludes our prepared remarks. Operator, we are ready to open the lines 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 or comment comes from the line of Tim Hayes from B. Riley FBR.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [2]

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My first question, just on American Addiction. I know you've been cautious on this credit for a while. But can you just remind us what the investment was rated at the end of the fiscal first quarter? And what actually triggered placing the investment on nonaccrual this quarter and whether that was something you may have seen coming?

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

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Yes. Tim, so it was rated a 3 at the end, so its rating is the same as it was last quarter. Nonaccrual is kind of -- it's obviously a judgment call, and the company is not paying cash interest. So honestly, it's -- we wanted to -- it was kind of judgment on our part that it ought to be -- we shouldn't be accruing it through income at the moment.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [4]

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Okay. And then just on the other investment on nonaccrual, AG Kings, we don't have the Q in front of us. Was that credit marked up or down at all this quarter and is -- or materially? And is there any update to pass along?

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

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Yes. Company is kind of still in the same -- It's just -- it's kind of bumping along. It hasn't gotten worse. It really hasn't gotten a whole lot better. We did mark it down by 10 points this quarter, so down from mid-80s to the mid-70s.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [6]

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Okay. And so just portfolio metrics are still healthy, but this quarter, we saw, I guess, that AG Kings get marked down, American Addiction added to nonaccrual, your weighted average risk rating has gone up a little bit and portfolio company leverage has also increased in both Lower Middle Market and Upper Middle Market portfolios. So can you just touch on this trend? And why it is or is not concerning to you or an indicator of broader deteriorating credit quality in the portfolio?

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

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Yes. No, it's a good question. Obviously, some of the leverage metrics moving around has something to do with the new deals that were put on the portfolio, right? So that's part of it. We have had some of our portfolio, it's a small handful, but it's a couple of, like you referenced American Addiction and AG Kings. So we have had some softening in certain names, no question about it. Most of it's really more idiosyncratic on a small handful of names. Across the portfolio, I would say, EBITDA performance has softened slightly from what it was the last couple of quarters, maybe blame that a little bit on the economy. But generally, from a first lien senior secured lender perspective not -- yes, disappointing in some of the company's performance. But from an investor perspective, sitting in the first lien loan, less worrisome. But I mean, everything worries us. We're managing the portfolio, obviously, it's our job to worry. But generally speaking, I think the structures are working as designed.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [8]

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Okay. And then one more from me. Just switching to the dividend. Can you remind me how you think about dividend coverage as it relates to the recurring quarterly dividend? You covered it on a pretax basis, but did not net of tax. The weighted average debt yield has come down, I assume largely related to the nonaccrual and maybe some of that due to lower LIBOR. But if these headwinds persist, what is your confidence level in your ability to sustain and/or continue to grow the quarterly dividend?

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [9]

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I think we've said in the past, we look at recurring income and a run rate of net investment income going forward. So this quarter, I think we posted our number. We look at the $0.03 of expense that was incurred, that's onetime, and we have added that back to our run rate. So really our NII for this period was $0.45. And if you look at it, net of taxes, that's $0.41. I'd also note, on our $0.41, most of our taxes are actually part of our -- the accrual on the blocker, [CSCI], which is not a cash expense and sort of varies based upon the estimate of future taxable income for those investments held in the blocker. So I'd tell you, going forward, we think our run rate of NII is certainly in -- above the level of our dividend. We probably are going to be slowing the dividend pace as we just announced, $0.40 for this current quarter. And that also has to do with our expectations potentially for MRI in the future as well.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [10]

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Clearly, and it drives it, obviously, in originations, and so we tried to be transparent on the originations that we've closed since the September quarter end. And we've got 2 or 3 deals in diligence right now that we would expect to close by the end of the year. So we feel pretty good about the origination pace as well.

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [11]

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And to your point, also, the drop in the yield from 11.7% to 11.1%, half of that was from LIBOR and the other half was from the nonaccrual this quarter.

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Operator [12]

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Our next question or comment comes from the line of Mickey Schleien from Ladenberg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [13]

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Guys, when we look at the performance of larger companies, we're generally seeing consistent deterioration in some of their fundamentals. And that's showing up in metrics like the proportion of leveraged loans being downgraded and declines in the revenue growth and margins. On the other hand, in general, the middle market companies seem to be continuing to perform pretty well. I'm curious what do you think is causing that divergence in the performance of those 2 segments?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [14]

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That's a good question. I mean a lot of the deterioration -- deteriorating performance in the loans in the Upper Middle Market has to do with leverage levels in the market, in the Upper Middle Market. So obviously, a loan performance is a function of both the fundamental performance of the company as well as the structure of the deal. In the Upper Middle Market, oftentimes, you have an agent sitting on a desk that just decides to mark the -- change the quote in the market and not really with respect to necessarily paper that's trading. So you have a dynamic in the Upper Middle Market, you don't have in the Lower Middle Market. I think that's probably the main thing. I mean our Lower Middle Market portfolio, just to give you a reference -- we referenced in our remarks that the portfolio, Lower Middle Market portfolio saw appreciation this quarter, I think you saw in our press release that, that was $2.1 million, that's made up of $100,000 on the debt portfolio and $2 million on Lower Middle Market equity portfolio, and that includes MRI being held flat for the quarter. So if you look at our equity co-investment bunch of companies, frankly, did pretty well this quarter. And -- so that's a little bit more of a real-time indicator of the performance of -- fundamental performance of the loan book because every one of those equity investments is accompanying a loan. So -- and then if you look at our Upper Middle Market portfolio, I mean, it's kind of certain names we talk about each quarter, right? I mean, Kings is in the Upper Middle Market, American Addiction is in the Upper Middle Market. We've got another company Delphi that we made a 3 this quarter. It's also in the behavioral health space in the Upper Middle Market. And so it's -- but if you look at the -- there's -- I think I attribute it mainly, Mickey, to your question, really more of the structures and the quote "dynamic" in the Upper Middle Market would be how I would see -- how I'd react to that divergence you referenced.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [15]

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Just one follow on, Bowen. So just thinking about larger companies in general, not specifically your portfolio. The weakness in their trends has caused weakness in the more liquid leverage loan market in general. And we are also seeing bifurcation of performance. I do see that you added a little bit to your Upper Middle Market bucket. But I'm curious if the recent trends in the Upper Middle Market are providing you with more pockets of opportunity. And if that's the case, what looks interesting to you on a risk-adjusted basis.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [16]

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Yes. You mean as far as just -- does the upper rental market look interesting, risk adjusted in general? Is that...

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [17]

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Yes. And given that there's been a lot of volatility, there's been weakness, there's bifurcation. There -- it seems that there may be some fear in the market and that generally results in some opportunities.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [18]

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Yes. Generally speaking, we've seen deal flow in the Upper Middle Market slow. And frankly, a lot of the index deterioration you referenced is not always necessarily accompanied by paper that trades. So as I said earlier, I mean, it's agents at their desk changing quotes, which is what they're supposed to do, by the their judgment, but it doesn't necessarily mean that you can trade paper there. So just because of those opportunities, what you said is not wrong, but really on the ground floor in the market, we haven't really seen a whole lot of opportunities that we think are interesting. And frankly, we've had a fair amount of demand for our assets, for our capital in the Lower Middle Market, an asset class that we like.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [19]

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So all else equal, right now, you prefer the risk-adjusted returns in the Lower Middle Market versus Upper, is that right?

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

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Yes. We do. I mean honestly, the view of many in the market, the market that larger companies are inherently safer than smaller companies, that's not -- I mean, obviously, size of the company is an element in your analysis. But, yes. Frankly, there are a lot of really interesting companies that are capitalized appropriately in the Lower Middle Market. And then frankly, when we like the equity upside, we oftentimes have the opportunity to invest in the equity which we like. So overall, yes, we like that asset class from a risk-adjusted basis better than the Upper Middle Market, certainly right now.

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Operator [21]

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Our next question or comment comes from the line of Kyle Joseph from Jefferies.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [22]

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Most of my questions have been asked. Just 2 more from me. And this is a follow-up. But just trying to think about the yield on your portfolio? Obviously, there's a lot of moving parts. There's a shift between Lower Middle Market, Upper Middle Market. There's the forward rate curve. And then you guys also have some equity in your balance sheet. But can you just -- from either -- for both a shorter-term and then longer-term perspective, give us a sense for where you see that heading?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [23]

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I mean if I think about yields in the market. I mean they certainly have gone down over the last couple of years, less so in the last 6 months. I mean we kind of saw the down -- the trend down. We certainly -- I mean, I don't know, Michael, what would you say, yield going forward? I mean our yields on our deals, I mean, they can range, right, from anywhere from 600 over LIBOR to 900 over LIBOR, most of them are kind of 650 to 750. And 2 years ago or 1.5 years ago, it's probable 750 to 850. So over the last couple of years, we are probably seeing 100 -- slightly over 100 basis points of deterioration, but less really market-wide in the last, call it, 6 months.

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [24]

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Yes. And I think that's right, I think the 11.75% down to 11% -- I think we probably -- 11% will probably be right going forward. But I will tell you that our cost of debt has come down. So that we may be putting on assets that are slightly less yielding. I think, our overall cost and our operating leverage are going to be coming down. So it should -- we actually should see a net pickup on net investment income.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [25]

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And obviously, if I can trade some level of yield for even better structured, safer credits, over time, that's probably not a bad trade off. And so that's -- there are deals in the market that are going to be priced tighter because they're lower loan-to-value, higher cash flowing companies at the margin. And one of the reasons we want to decrease our cost of capital, one of the reasons we want to improve our operating leverage, are all expenses to our business model that if we can add efficiency in those areas, we can compete for safer credits. And that's a really important dynamic in the market that we definitely spend time on.

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [26]

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And the other thing I probably noted that we have been pushing for 2% LIBOR floors. So we've had probably a majority of our floors at 1% and then another proportion at 1.5%. And then lately, we'd say, [think] about 15% of the portfolio is at 2%. So it does -- there's some protection should LIBOR drop any lower.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [27]

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Sure. That's great color. And then, Michael, one thing you brought up, it was a good segue to my second question. On the liability side, obviously, you guys did a very attractive bond deal this quarter. But going forward, given the rate environment, would we expect further increases to be more from your credit facility and of the floating rate type? Or how are you thinking about the liability side going forward?

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [28]

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Yes. I think we think that the -- we're around $300 million in total commitments on the revolver. And I think that was probably going to be where we're going to be for the next, let's call it, 12 to 24 months. I think that we'll look to see if there's opportunistic capital raises on the debt side to take out the -- our older version of the bonds that are at 5.95%. I don't think there's anything in the foreseeable future. But if the call period does end in December of this year, so if there's an opportunity to reduce cost and extend the maturity, we certainly would like that on the fixed-rate side.

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Operator [29]

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Our next question or comment comes from the line of Chris York from JMP Securities.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [30]

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So Bowen and Michael, investors are understandably worried about the churn of the cycle in a downturn. So as an internally managed BDC, can you remind us of your approach and the resources in terms of staff that you can apply towards restructuring or working out a defaulted credit when you are agent to a Lower Middle Market credit to achieve a positive resolution for investors?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [31]

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Yes. Thanks for the question. So a couple of things. I mean, we spent -- our staffing increases in the last 12 months have been primarily in the kind of the mid- to junior levels in the organization. And that's important because that helps leverage the guys that have a lot of experience, over multiple decades through cycles of restructuring and kind of, can help myself and the investment committee make decisions. And so we definitely have increased the capacity of what our guys can do. But I also would say, when you have a troubled credit, I mean, it's not a 100% us doing -- burning every calorie on restructuring that. I mean you do outsource consultants. You bring consultants in to be on the ground of the company. We have to make decisions with respect to the capital and the strategy of turning around those companies. But that's intellectual decisions based on analysis that's being done. And so you can -- we saw this in the Great Recession, and our portfolio is in the Great Recession, right? I mean you bring in consultants that can help you understand factually what's going on at the -- at the operating level. You can produce spreadsheets and analysis based on that, and you can make good investment decisions. So I think our staff, we're going to -- we will continue to add people. I think it's mainly on the junior -- mid-level, junior side. But in last step, as we've always said, with our portfolio growth because we are very intent on hitting our operating leverage targets. But I think our -- I think we're set up well to manage that dynamic that you described. So hopefully, that's helpful as to how we think about it.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [32]

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It is helpful. And one interesting comment I gathered there. So you would consider hiring consultants to help you there? Is that fair?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [33]

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Yes. Well, it's a yes. So if a loan goes bad, right? I mean there's a couple of things going on, right? One, first and foremost, is the operating of the business, right? And so the first thing you have to do is get under the covers and figure out exactly what the heck is going on, right? We monitor companies. We sit down every month and we go through financial statements, and we -- as a team, and we're pretty well versed on what we're being told is going on with the companies, and we understand the businesses and the industries enough to, kind of, hopefully decipher what's right and what's kind of fishy, and what we need to dig in on more. But when you trip a covenant, and now you're getting in the operations of the company, there's a myriad of consultants out there that are x operating guys and girls that have done this all their life and now have chosen the profession of going in and really recreating cash flow forecasts and strategic decisions that are being made and then can advise us on the fundamental operating side of the business. And that's -- obviously, and then the potential of the business and how long the turnaround will take and what cash flow forecasts are like. And all those things that we have to have, when we're making decisions on what to do with our capital to protect our shareholders' capital and to, frankly, create upside from where we are at that point in the cycle.

And so you can do a lot of that. I mean it's not like -- I mean, I don't think any of the BDCs would tell you that, hey, we're a deal guys that we're going to go pretend to the operating guys and turn these companies around. I mean that's -- I'd be skeptical of anyone who said that. And so a lot of what you do in the restructuring turnaround situations is outside expense or cost or labor that's obviously attributable to that particular portfolio company.

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Christopher John York, JMP Securities LLC, Research Division - MD & Senior Research Analyst [34]

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Got it. Very helpful. Okay. Switching gears. So Bowen, appreciate the color on MRI in the prepared remarks. Question is for Michael and, Bowen, you can take it too. Can you remind investors of your expectations for the impacts of the exit of MRI on quarterly financials? Because it's a sizable earning asset, and then we do have the expectation that you're likely to use some of those proceeds to pay down debt?

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [35]

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Yes. So the current dividend is about $1 million a quarter coming from MRI. Obviously, that's going to go away. But we're going to use approximately $50 million of those proceeds that are going to come back. The majority of those proceeds are going to be used to pay down debt initially, then be redeployed into debt assets. There's just to be some level of leakage for -- depending on deemed distribution or a special dividend. But -- so there'll be -- initially, when we pay down, there'll be -- our cost of debt is about 5%, and the dividend yield is about 8%. So there will be a slight reduction at the front end. And then as we redeploy, NII will be flat when we fully transition, and then it will grow when we lever back up.

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Operator [36]

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Our next question or comment comes from the line of Chris McCampbell from Hilltop Securities.

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Christopher V. McCampbell, [37]

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You've talked about the factors that contributed to keeping the dividend at the same level quarter-over-quarter. But can you give some color on, I guess, your dividend growth goals going forward, whether maybe we should expect year-over-year kind of growth? Or are we at the point of the cycle where it's really kind of hard to say?

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

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Well, I would say, look, dividend growth is going to be a function of portfolio growth. It's a function of a bunch of factors. But portfolio growth, portfolio performance. And what's really important with the dividend policy, in my view, is to have a dividend that you -- that the shareholders can rely on. And so we don't want to just increase it just to increase it and then decrease its security, right? So that's why Michael has always talked in terms of kind of recurring run rate earnings, kind of, as we exit a quarter, right? So as we exit a quarter, there's -- there might be deals that we closed very late in the quarter, which, from a run rate perspective, would be a higher income off of those loans than they would if they have been done at the first of the quarter. But in the following quarter, that would be a full quarter of earnings. So you have those loans, you have loans that you've exited, you've got onetime prepayment fees and various things that are in a certain quarter that you can't really assume will recur next quarter. You also have expenses like we had this quarter of $0.03 a share, that also won't be expenses next quarter. So we look at all that. We try to set a dividend at a level that is a level that, frankly, shareholders can rely on going forward. And then hopefully, that high watermark, if you will, or that watermark will increase as our portfolio grows, as it should, based on where we are on a leverage level based on the liquidity we have available to us in our cash and credit facility availability. It's just a matter of we need to go find the deals that are good deals. So we've never really been in a rush to grow portfolio or increase dividends or earnings. We want to hustle to find the deals, find the opportunities and be very diligent and careful and thoughtful in actually which ones we close. If that makes sense. But -- so it's a function of a lot of things that we have to manage and continue going forward. I would say the good news is we have a substantial amount of liquidity. So we have the capital available when we find those deals. So we've made a lot of effort to decrease, as Michael said, the risk in the right side of the balance sheet, right? So risk being cost to capital, covenant levels on capital sources and then just availability of capital, so we can concentrate on having substantial investable capital throughout the cycle. So -- and the result of that is, as we grow the portfolio, then the earnings should increase.

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Michael Scott Sarner, Capital Southwest Corporation - CFO, Chief Compliance Officer, Secretary & Treasurer [39]

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And I'd probably tell you where the dividend level is right now, it may stabilize for the moment as we absorb the capital we just received as well as the potential for an MRI exit, but we would definitely tell you that we expected the dividend to grow as exactly as Bowen's described as we redeploy capital.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [40]

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Yes. So when I -- it's an important point. So when I say growth in the portfolio, obviously, growth in the investment portfolio is net growth. So it's new assets being put on minus assets being prepaid. We're first lien lenders, so every quarter we have amortization payments and prepayments and things that come in because we're -- and a lot of our companies were $1 risk. And so when that company generates cash flow, it goes to the first lien lender first and that's oftentimes us. And then you have large exits potentially like an MRI exit, that would be big capital inflows. And obviously, our capital -- to Chris York's question earlier, that immediately -- our asset base will be lower, and then it would be -- we'd have to redeploy that capital. So hopefully that helps.

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Christopher V. McCampbell, [41]

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Yes. Would it be safe to say that at this point of the cycle, though, it's -- you're maybe being a little more conservative than you were 2, 3, 4 years ago. And so the pace of the growth of the portfolio would likely be slower as well?

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [42]

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Yes. I think that's right. We've always -- since the beginning, had a mentality of, we need to prepare for a large, bad recession starting in the next couple of years. And obviously, back in 2015, we thought that -- we didn't think it, doesn't matter what we think, it matters what we prepare for. We were preparing for a recession, '16 and '17, didn't happen, everyone on this phone is super happy that, that didn't happen, but we prepared for it. And now we're doing the same thing for kind of '20 and '21. Obviously, none of us hope for that and whether we expect it or not, it doesn't matter. We prepare it. We prepare for it. So I mean, look, every year that goes by you're closer to the end of the economic cycle, right? When is it going to happen? None of us know, but we all have to prepare for it. In our loan portfolio and your client stock portfolios, everybody ought to be preparing for that. And hopefully, it doesn't happen for another several years, but you never know. So all that said, I would say that each year, we get closer to the theoretical end of the cycle. And -- so yes, at some level, we're more conservative in how we look at things. But we've kind of taken that mentality from the beginning.

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Operator [43]

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I'm showing no additional questions in the queue at this time. I'd like to turn the conference back over to Mr. Bowen Diehl for any closing remarks.

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Bowen S. Diehl, Capital Southwest Corporation - President, CEO & Director [44]

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Great. Thanks, operator. Hey, thanks to everybody for joining us, and we appreciate you all the time, your support and your focus, and we look forward to talking to you next quarter. Have a great week.

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Operator [45]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a wonderful day.