Thank you for joining today's Capital Southwest First Quarter Fiscal Year 2023 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.

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

Thanks Chris and thank you to everyone for joining us for our first quarter fiscal year 2023 earnings call. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio as we continue to diligently execute our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found on our website at www.capitalsouthwest.com. You will also find our quarterly earnings release issued last evening on our website. We'll begin on slide six of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we generated pretax net investment income of $0.50 per share, which represented 11% growth over the $0.45 per share generated in the year ago June quarter. The $0.50 per share more than earned our regular dividend paid during the quarter of $0.48 per share. Total dividends for the quarter were $0.63 per share, which included a special dividend of $0.15 per share, also paid out during the quarter. We are pleased to announce today that our Board has declared a $0.02 per share increase in our regular dividend of $0.50 per share for the quarter ending September 30th, 2022. This increase represented 4.2% growth over the $0.48 per share paid out in the June quarter and 16% growth over the $0.43 per share paid out in the year ago September quarter. This increase in our recurring regular dividend reflects the increased earnings power of our portfolio, resulting from the increase in market interest rates over the past few months, the growth and performance of our credit portfolio, and the improvements in our operating leverage. During the quarter, acquisition and…

Thanks, Bowen. Specific to our performance for the June quarter, let's summarize on slide 18. We earned pre-tax net investment income of $12.6 million or $0.50 per share. We paid out $0.48 per share in regular dividends and $0.15 per share in special dividends for the quarter. As mentioned earlier, our Board has approved an increase to the regular dividend for the September quarter to $0.50 per share from the $0.48 per share that was paid for the June quarter. Maintaining a consistent track record of meaningfully covering our dividend with pre-tax NII is important to our investment strategy. We continue to maintain our strong track record of regular dividend coverage with 105% for the last 12 months ended June 30, 2022, and 106% cumulative since the launch of our credit strategy in January 2015. Given the floating rate nature of our credit portfolio, rising interest rates will be a significant tailwind to our net investment income. In fact, the index used to calculate interest on a majority of our loans reset in early July to 2.29%, up from its early April reset at 96 basis points. This significant increase quarter-over-quarter will provide an immediate step-up in portfolio income in the September quarter. With that as context, we will continue to execute our policy of having regular dividends follow the trajectory of recurring pre-tax NII per share, while maintaining our track record of strong dividend coverage. For the quarter, our investment portfolio generated total investment income of $22.5 million, producing a weighted average yield on all investments of 9.1%. Total investment income was $1.5 million higher this quarter due to a higher average balance of credit investments outstanding as well as an increase in prepayment and amendment fees compared to the prior quarter. As of the end of the quarter,…

Thanks, Michael, and thank you, everyone, for joining us today. We appreciate the opportunity to provide you an update on our business and progress executing our strategy as stewards of our stakeholders' capital. Our company and portfolio continues to perform well, and I continue to be impressed by the job our team has done in building a robust asset-based, deal origination capability as well as a flexible capital structure. As to the uncertainty in the economy, we have been underwriting with a full economic cycle mentality since day one, which we believe has positioned us well for the potential economic volatility in the coming months and years. We continue to believe that our performance demonstrates the investment acumen and capital structure management capability of our team at Capital Southwest, as well as the merit of our first lien senior secured strategy. We feel very good about the health and positioning of our company and portfolio, and we are excited to continue to execute our investment strategy as stewards of our stakeholders' capital. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

[Operator Instructions] Our first question comes from the line of Kevin Fultz from JMP Securities.

Given the evolution of market conditions over the past two quarters, I'm curious if you've seen that translate to improved pricing on new deals that you're reviewing. And then more broadly, if you can discuss the attractiveness of deals you're seeing in the lower and upper middle market currently?

Yes. Thanks for the question. Yes, I think for a comment on the strength in the market, I think, we're seeing kind of -- for quality deals that you can underwrite, especially, given the economic cycle and with reasonable leverage levels, there's still a lot of competition for those deals. And so, we haven't really seen spread widen tremendously, maybe a little bit on margin, 25 to -- 25 basis points plus or minus. And so still seeing strong activity, still seeing kind of spreads kind of where they are, where they've been.

Okay. That makes sense, Bowen. And then just a follow-up for Michael. Looking at the NAV bridge on slide 20, there's an $0.11 per share loss related to other corporate, just curious if you can identify the items that are included in that bucket.

Yes. I think that had to do with our RSUs. We do our June -- our distribution to employees for RSUs in the June quarter. And so there's -- you'll see that annually in this quarter.

Okay, got it. That's it for me. Congrats on a nice quarter.

Thanks.

Thank you. Our next question comes from the line of Mickey Schleien from Ladenburg.

Bowen, I want to dig a little into credit. Any high-level comments you can give us on how your borrowers revenues are trending and how their margins are trending? I understand it's case-by-case and sector-by-sector. But we're getting such mixed signals as to the trajectory of the economy. Any comments you can make would be helpful.

Yes. Sure, Mickey. Thanks for the question. So, we look at that, if you look at our portfolio, and let's take the 95% of the portfolio that are either performing kind of as expected are ahead of expected because of the 5% that are underperforming, let's set those aside for a second because I would say we look at those underperformers, they're all idiosyncratic situations in the company. So, let's take the 95% and let's look at that. And when we look at that, revenues year-over-year and EBITDA year-over-year is up about 23%. If you look at the last quarter, revenue is up about a little over 5%, and EBITDA is basically flat. And so I look down through the portfolio and asking why is that? And it's hard to look at it and say it's necessarily the economy per se but there are certain things like labor increases and cost of inputs, hard inputs. And so -- and I look at that, I'd say revenue is up and EBITDA is flat. So, we certainly have seen the companies is very general comments with the pricing power to increase prices to maintain margins. And so I'd say the quarter-over-quarter for general economic activity is kind of flat with these kind of sub issues that we're all hearing about in the economy. We look across our portfolio and they seem to be doing a good job passing those costs on to their customers to maintain the margins -- margin dollars.

Absolutely.

Mickey, the only thing from a timing perspective, I'd also say we're using April and May financials for all our valuation not that we're seeing any softening since then, but we're -- a lot of the financials are yet to come to see whether anything that's occurring--

And I would say from just commentary, we talked about these companies a lot, I would say, commentary-wise, I think that those steps kind of would continue through now. But Michael is right. I mean the financials all the BDCs used for valuations, as you know, Mickey, are April, May or June quarter so.

Yes, I understand. And Bowen, this may be idiosyncratic, but there was one loan downgraded to a three. Is there any -- what was the nature of the problem there? Is it something specific to that company or something broader?

Well, you're asking about the one small loan that was downgraded to a four?

I thought there was a migration to a $3 million of $10 million at fair value?

Yes. No, that's -- so there was 1 upgrade to 1, it was $10 million and there were three loans across two portfolio companies that were downgraded to three. And they were all very small loan positions, they were definitely idiosyncratic. One has to do with -- it's very idiosyncratic based on certain pipeline stats and things that they have to achieve to basically offtake their products. So – but it's very idiosyncratic to that company. And it's also -- I should also say it's fat by a very strong funded sponsor as well. So we've got -- fair amount of equity to support potential equities more certainly in that company.

And Bowen, is there any update you can provide us on the loans that are on nonaccrual in terms of progress you might be making with those credits?

Yes. So as Michael said in his remarks, all I'll reiterate because it might have been lost. So, there was $16 million in fair value on nonaccrual at the end of the quarter. One of those loans was restructured on the first day of the new quarter, so July 1, '22. And that loan had a fair value of $13 million out of the $16 million. And that restructuring resulted in equitizing a portion of our debt and the sponsor putting in a very meaningful amount of equity into that business. And so, we've got significant equity participation in turnaround, serve on the Board of that company. And if you feel okay about where we are, I'm certainly very happy about the significant amount of liquidity that the company – the thoughts are put in the business and is sitting on the balance sheet currently.

I understand, that's helpful. And in terms of the unrealized appreciation of the on-balance sheet debt portfolio, was that – I mean you have the downgrade that you mentioned was there also something attributed to wider credit spreads in general?

Yes. So, on the depreciation, there's two pieces, right? We mentioned the $5.5 million on balance sheet and that's probably, a little -- more than half credit and less than half spread market investors. And the I-45 piece is two-third market indexes and quote movement, as you can imagine, and kind of one-third credit issue stuff.

Okay. And just to wrap up, in the SBIC are you going to ask for the full $87.5 million of regulatory capital and the full two turns of leverage or how do we -- how should we expect that to work out over the next several quarters?

We'll absolutely overtime, be drawing the entire amount. But what you're faced to do during this process with the SBIC is, you need to actually bed a portion of eligible assets and to go in as equity prior to asking for a commitment to draw a fund. So, we have to go to the SBIC with a further leverage commitment, which we plan on doing. So, it would probably be something in the neighborhood of $50 million for the next commitment. So, we're right now in the process of bedding that $50 million before we're able to ask for the formal commitment.

Okay. $50 million of new debentures, right?

So the $50 million would be the net definitely, yes. So we'll put $25 million of eligible assets as our equity and then we'll draw the next $50 million. And as you get full -- when that $50 million is completed, then you go back to the SBIC for another commitment – prior to asking for a commitment.

Mickey, I mean that's very typical for these SBICs. We've always presented it to the shareholders is kind of showing the different steps as opposed to presenting the entire debt, but it's very typical to be stair steps like that, and there's not really any notable or even risk at all of really getting those commitments, but it's a step documentation process until we presented it that way, not to get confused by it being like you know...

No, no, it's very helpful. The transparency is really helpful, Bowen. Bowen, have you adjusted your target leverage goals given the current market environment, or does that remain unchanged? And if you could just remind us what those are?

Yes. Michael – I'll comment – just walk here in a minute. But...

We certainly have -- I mean, looking at whatever economic volatility that we might be heading into, we previously stated a target of 1.2 to 1.3 uneconomic and 1.1 to 1.2 on regulatory, stated a target of 1.2 to 1.3 on economic and 1.1 to 1.2 on regulatory. Right now, we're targeting regulatory at 1.0, and probably economic will be something more like 1.1 to 1.2. And I think until we see how long and deep the recession if it was to come to pass, that's kind of where we'll try to target. And by doing so, we're going to need to raise equity. We started that. We noted earlier, we raised $46 million in this previous quarter. As long as we're trading meaningfully above book, I think you'll continue to see us raise meaningful equity. We haven't seen a slowdown in the portfolio. And I think Bowen noted earlier that even in an environment where M&A activity might slow down, repayments will slow as well. So we will continue to see net portfolio growth. So raising equity alongside these originations and maintaining leverage in this conservative range is certainly one of our targets.

Yes, I think that’s one. I mean, we think about full cycle economics in our portfolio underwriting, and we think about full cycle economics in our BDC as well. So I think Mike that's...

Okay. That’s great. That’s it for me this morning. I appreciate your time. Thank you.

Thanks, Mickey.

Thank you. Our next question comes from the line of Kyle Joseph from Jefferies.

Two questions -- or just one really, but two parts. In terms of the margins that are pretty stable quarter-on-quarter. I think you said rates either reset post-quarter or late in the quarter? And just -- so how do we think about your – your assets resetting versus the kind of the cadence of your liabilities resetting, recognizing that a lot of your liabilities are fixed rate. And then on rising rates, how are you -- how is that impacting your expectations for credit going forward? Obviously, it's a good thing we should see your net interest income go up. But at the same time, companies have a higher debt servicing cost.

Yes. So on the -- for our liability side, we -- those reset probably you could think of them on a monthly basis. And so there's -- that's probably on more of a weighted basis, you saw it go from 96 basis points to 2.29%. So from one quarter to the next. So the average is probably something in the mid 1.5-- in terms of the increase of the interest expense. For the assets, pretty much 90%, if not more of the assets reset on that on the quarterly date. So we're looking at we looked at our 6/30 numbers, if we were using the 2.9 -- 2.29% at the end of June, pro forma on our balance sheet, we would have had an additional $0.03 of NII. So the $0.50 that we produced probably would have been closer to $0.53. And so that's -- that gives you a little guidepost going forward.

Yeah, so the second part of your question, we've got an analysis we're tracking. Looking across the portfolio and taking the current index, the 2.29% index and looking at the portfolio and then increasing that index up to a point where you start seeing meaningful credit issues, you really have to get that index up into the mid 5%. So 5.5% plus or minus percent on the index before you start seeing fixed charge coverage ratios across clearly, a lot of the portfolio is still fantastic, but if you take the number of names at a 5.5 plus percent kind of LIBOR, and you start seeing your red light names if you start to make you nervous start to move like in a meaningful way or you really not have the index up to 5.5 plus percent. So I feel pretty good that we're not going to see, I don't think we're going to see 5.5%, 6% on the index, but that's -- we feel pretty good about where the portfolio is.

Got it. Really helpful. Thanks for answering my question.

Thank you. Our next question comes from the line of Robert Dodd from Raymond James.

…questions have been asked and answered. So just one quick one, if I can. I think, Michael, in your prepared remarks, you said you expect the dividends to follow the trajectory of pre-tax income. So are you talking about basically if rates -- I mean, rates are up, right, if earnings go up, along the lines of $0.03 or $0.01 up in the next quarter, and the subsequent quarters through at least the beginning of 2023, the base dividend would be increasing at the same time. And just for color, obviously, the forward curve, et cetera, is lower in the second half of 2023 than it is in the first half of 2023. So is that taken into account in terms of what path the dividend might follow because, obviously, you don't necessarily want to be cut in the dividend when rates are falling, if that comes to pass, obviously.

Absolutely. That is certainly the way we're looking at it. If you look at the Fed funds rate right now, where it's given the range of 2.25 to 2.5 and it's considered neutral. And so we're looking at projecting forward. We're not really assuming that there's going to be any increases beyond the levels that they are today. So we do believe that there is between the $0.50 dividend we announced today, and where we see earnings going just based on the 2.29, there's certainly room for another dividend increase. However, we do want to maintain, and we probably say we want to maintain maybe $0.02 to $0.03 of difference between the dividend paid and pre-tax net investment income earned. So that's what we're going to focus on going forward. We're not going to be projecting additional rates to increase. And if it was going to come back down, where we feel like the dividend that we will have set will match the rate where it comes back to, if that's helpful.

That is very helpful. Thank you and congrats on a really solid quarter.

Thanks, Robert.

Thanks.

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

Well, thanks, everybody, for joining us. We appreciate the opportunity to give you an update, and we look forward to talking to you in future quarters.

This concludes today's conference call. You may now disconnect.