Description
Filed with the SEC from May 31 to June 6:
Capital Southwest (CSWC)
Investment advisor Zuckerman Investment Group sent a letter, at Capital Southwest's request, outlining its suggestions for capital allocation and corporate governance, with the goal of maximizing value per share. The May 25 letter suggested separating the roles of chairman and CEO, exploring how to maximize the value of a number of Capital Southwest's investments, repurchasing shares, and hiring a tax and financial advisor with significant experience with spinoffs and corporate restructurings. Zuckerman owns 252,509 shares (6.9% of total voting shares).
BUSINESS OVERVIEW
Overview
Capital Southwest Corporation ("CSC") was organized as a Texas corporation on April 19, 1961. Until September 1969, we operated as a licensee under the Small Business Investment Act of 1958. At that time, CSC transferred to our wholly-owned subsidiary, Capital Southwest Venture Corporation ("CSVC"), certain assets and our license as a small business investment company ("SBIC"). CSVC is a closed-end, non-diversified investment company registered under the Investment Company Act of 1940 (the "1940 Act"). Prior to March 30, 1988, CSC was registered as a closed-end, non-diversified investment company under the 1940 Act. On that date, we elected to become a business development company ("BDC") subject to the provisions of the 1940 Act, as amended by the Small Business Incentive Act of 1980. Because CSC wholly owns CSVC, the portfolios of CSC and CVSC are referred to collectively as "our," "we" and "us." Capital Southwest Management Company ("CSMC"), a wholly-owned subsidiary of CSC, is the management company for CSC and CSVC. CSMC generally incurs all normal operating and administrative expenses, including, but not limited to, salaries and related benefits, rent, equipment and other administrative costs required for its day-to-day operations.
Our portfolio is a composite of companies, consisting of companies in which we have controlling interests, developing companies and marketable securities of established publicly traded companies. We make available significant managerial assistance to the companies in which we invest and believe that providing material assistance to such investee companies is critical to their business development activities.
Investment Process
Our investment strategy involves a "team" approach, whereby potential transactions are screened by our investment team before they are presented to the Board of Directors for approval. Our investment team generally categorizes the investment process into seven distinctive stages:
•Deal Generation/Origination: Deal generation and origination is maximized through long-standing and extensive relationships with industry contacts, brokers, commercial and investment bankers, entrepreneurs, service providers, such as lawyers and accountants, as well as current and former portfolio companies and investors.
•Screening: Once it is determined that a potential investment has met our investment criteria, we will perform preliminary due diligence or screening. It is during this stage that we will take into consideration potential investment structures and price terms, as well as regulatory compliance. Upon successful screening of the proposed investment, the investment team makes a recommendation to move forward. We then issue a non-binding term sheet.
•Term Sheet: The non-binding term sheet will include the key economic terms based upon our analysis performed during the screening process as well as a proposed timeline and our qualitative expectation for the transaction. Upon execution of the term sheet, we begin our formal due diligence process.
•Due Diligence: Due diligence is performed by the leader of the designated investment team and certain external resources who together perform due diligence to understand the relationships among the prospective portfolio company’s business plan, operations and financial performance. Additionally, we may include site visits with management and key personnel; detailed review of historical and projected financial statements; interviews with key customers and suppliers; detailed evaluation of company management, including background checks; review of material contracts; in-depth industry, market and strategy analysis; and review by legal, environmental or other consultants, if needed. In certain cases, we may decide not to make an investment based on the results of due diligence.
•Document and Close: Upon completion of a satisfactory due diligence review, our investment team presents its findings, in writing, to our Board of Directors for approval. If any adjustments to the investment terms or structures are proposed by our Board of Directors, such changes are made and applicable analysis is updated. Upon Board approval for the investment, we will re-confirm our regulatory company compliance, process and finalize all required legal documents and fund the investment.
•Post-Investment: We continuously monitor the status and progress of our portfolio companies. We offer managerial assistance to our portfolio companies, giving them access to our investment experience, direct industry expertise and contacts. The same investment team lead that was involved in the investment process will continue involvement in the portfolio company post-investment. This provides for continuity of knowledge and allows the investment team to maintain a strong business relationship with key management of our portfolio companies for post-investment assistance and monitoring purposes. As part of the monitoring process, our investment team leader will analyze monthly/quarterly/annual financial statements versus the previous periods, review financial projections, meet with management, attend board meetings and review all compliance certificates and covenants. While we maintain limited involvement in the ordinary course of operations of our portfolio companies, we maintain a higher level of involvement in non-ordinary course financings, potential acquisitions and other strategic activities.
•Exit Strategies: While our approach is primarily focused on providing long-term patient capital for sustained growth, we assist our portfolio companies in developing and planning exit opportunities, including any sale or merger of our portfolio companies, at the appropriate time. We assist in the structure, timing, execution and transition of the exit strategy.
Determination of Net Asset Value and Portfolio Valuation Process
We determine our net asset value per share on a quarterly basis. The net asset value per share is equal to our total assets minus liabilities divided by the total number of shares of common stock outstanding.
We determine in good faith the fair value of our portfolio investments pursuant to a valuation policy in accordance with Accounting Standards Codification ("ASC") Topic 820, Fair Value Measurements and Disclosures (“ASC 820”) and a valuation process approved by our Board of Directors and in accordance with the 1940 Act. Our valuation policy is intended to provide a consistent basis for determining the fair value of the portfolio.
As described below, we undertake a multi-step valuation process each quarter in connection with determining the fair value of our investments, with our Board of Directors ultimately and solely responsible for overseeing, reviewing and approving, in good faith, our estimate of the fair value of each individual investment.
•Our quarterly valuation process begins with each portfolio company or investment being initially valued by the investment team leader responsible for the portfolio investment; and
•Preliminary valuation conclusions will then be reviewed and discussed with our investment team; and
•Our Board of Directors will assess the valuations and will ultimately approve the fair value of each investment in our portfolio, in good faith.
Our Board of Directors is ultimately and solely responsible for determining the fair value of portfolio investments on an annual basis. Annually, Duff & Phelps, LLC ("Duff & Phelps") provides third party valuation consulting services to our Board of Directors, which consists of certain limited procedures that our Board of Directors identifies and requests them to perform. For the year ended March 31, 2012, the Board of Directors asked Duff & Phelps to perform the limited procedures on six investments comprising approximately 85.8% of the total investments at fair value as of March 31, 2012. Upon completion of the limited procedures, Duff & Phelps concluded that the fair value of those investments, subject to the limited procedures, did not appear unreasonable.
Competition
We compete for attractive investment opportunities with private equity funds, venture capital partnerships and corporations, venture capital affiliates of industrial and financial companies, SBICs and wealthy individuals. We believe we are able to be competitive with these entities primarily on the basis of the experience and contacts of our management team and our responsive and efficient investment analysis and decision-making processes; however, this competitive environment could have a material adverse effect on our ability to acquire attractive investments.
Regulation
Regulation as a Business Development Company
We have elected to be regulated as a BDC under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to transactions between BDCs and their affiliates, principal underwriters and affiliates of those affiliates or underwriters. The 1940 Act requires that a majority of the members of the board of directors of a BDC be persons other than “interested persons,” as defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a BDC unless approved by a majority of our outstanding voting securities.
The 1940 Act defines “a majority of the outstanding voting securities” as the lesser of (i) 67% or more of the voting securities present at a meeting if the holders of more than 50% of our outstanding voting securities are present or represented by proxy or (ii) more than 50% of our voting securities.
The following is a brief description of the 1940 Act provisions applicable to BDCs, which is qualified in its entirety by reference to the full text of the 1940 Act and rules issued thereunder by the SEC.
•Generally, to be eligible to elect BDC status, a company must primarily engage in the business of furnishing capital and making significant managerial assistance available to companies that do not have ready access to compare through conventional financial channels. Such companies that satisfy certain additional criteria are defined as "eligible portfolio companies." In general, in order to qualify as a BDC, a company must: (i) be a domestic company; (ii) have registered a class of its securities pursuant to Section 12 of the Securities Exchange Act of 1934; (iii) operate for the purpose of investing in the securities of certain types of portfolio companies, including early stage or emerging companies and businesses suffering or just recovering from financial distress (see following paragraph); (iv) make available significant managerial assistance to such portfolio companies; and (v) file a proper notice of election with the SEC.
•An eligible portfolio company generally is a domestic company that is not an investment company or a company excluded from investment company status pursuant to exclusions for certain types of financial companies (such as brokerage firms, banks, insurance companies and investment banking firms) and that: (i) does not have a class of securities listed on a national securities exchange; (ii) does have a class of equity securities listed on a national securities exchange with a market capitalization of less than $250 million; or (iii) is controlled by the BDC itself or together with others (control under the 1940 Act is presumed to exist where a person owns at least 25% of the outstanding voting securities of the portfolio company) and has a representative on the Board of Directors of such company.
•We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect the BDC. Furthermore, as a BDC, we are prohibited from protecting any director or officer against any liability to us or our shareholders arising from willful malfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.
•We are required to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, review these policies and procedures annually for their adequacy and the effectiveness of their implementation and designate a chief compliance officer to be responsible for administering these policies and procedures.
Qualifying Assets
The 1940 Act provides that we may not make an investment in non-qualifying assets unless at the time at least 70% of the value of our total assets (measured as of the date of our most recently filed financial statements) consists of qualifying assets. Qualifying assets include: (i) securities of eligible portfolio companies; (ii) securities of certain companies that were eligible companies at the time we initially acquired their securities and in which we retain a substantial interest; (iii) securities of certain controlled companies; (iv) securities of certain bankrupt, insolvent or distressed companies; (v) securities received in exchange for or distributed in or with respect to any of the foregoing; and (vi) cash items, U.S. government securities and high-quality short-term debt. The SEC has adopted a rule permitting a BDC to invest its funds in certain money market funds. The 1940 Act also places restrictions on the nature of the transactions in which, and the persons for whom, securities can be purchased in some instances in order for the securities to be considered qualifying assets.
Managerial Assistance to Portfolio Companies
In order to count portfolio securities as qualifying assets for the purpose of the 70% test, we must either control the issuer of the securities or must offer to make available to the issuer of the securities (other than small and solvent companies described above) significant managerial assistance; except that, where we purchase such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means, among other things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company.
Marketable Securities and Idle Funds Investments
Pending investments in “qualifying assets,” as described above, our investments may consist of cash, cash equivalents, U.S. government securities, short-term investments in secured debt investments, independently rated debt investments and diversified bond funds, which we refer to, collectively, as marketable securities and idle funds investments, so that 70% of our assets are qualifying assets.
Senior Securities
We are permitted by the 1940 Act, under specific conditions, to issue multiple classes of debt and a single class of preferred stock if our asset coverage, as defined by the 1940 Act, is at least 200% after the issuance of the debt or the preferred stock (i.e. such senior securities may not be in excess of our net assets). Under specific conditions, we are also permitted by the 1940 Act to issue warrants.
Common Stock
Except under certain conditions, we may sell our securities at a price that is below the prevailing net asset value per share only during the 12-month period after (i) a majority of our directors and our disinterested investors have determined that such sale would be in the best interests of us and our stockholders and (ii) the holders of a majority of our outstanding voting securities and the holders of a majority of our voting securities held by persons who are not affiliated person of ours approve such issuances. A majority of the disinterested directors must determine in good faith that the price of the securities being sold is not less than a price which closely approximates market value of the securities, less any distribution discount or commission.
CEO BACKGROUND
Mr. Martin has been associated with the Company since 1972, including serving as a director since 1988, while serving as Chief Executive Officer of The Whitmore Manufacturing Company, a specialty lubricant manufacturer and wholly-owned portfolio company of Capital Southwest Corporation. Mr. Martin has experience serving as Chairman and/or Director on several public company boards (listed in bold above) and brings to us a breadth of business experience across a broad range of industries. Mr. Martin holds a Bachelor of Business Administration from the University of Oklahoma and was a certified public accountant in the State of Texas (now retired, inactive status).
Mr. Burton has served as Managing General Partner of South Atlantic Venture Funds since 1983, General Partner of the Burton Partnerships since 1979 and President and Chairman of South Atlantic Capital Corporation since 1997. The Company benefits from Mr. Burton’s vast experience in equity investing. Mr. Burton holds a Bachelor of Arts degree from Yale University and an MBA from Harvard Business School.
Mr. Henderson has been associated with the Company since 1961, giving him tremendous insight into our Company and its operations. Mr. Henderson has served as President of numerous companies including Source Capital, Inc., Capstan, Inc. and National TV Log. In addition, Mr. Henderson has served on over fifty public and private corporate boards and trusts. Mr. Henderson holds a Bachelor of Arts degree from Princeton University and an MBA from Harvard Business School.
Mr. Ligon has over 30 years experience as a CEO of a private company, demonstrating his leadership ability and business acumen, and has extensive experience supervising principal financial officers, working with auditors for private and public companies, evaluating financial statements and control systems, as well as analyzing acquisitions. Mr. Ligon has experience serving as Chairman on several public company audit committees. The Company benefits greatly from Mr. Ligon’s extensive business, finance and audit committee oversight experience, as well as his executive leadership and management experience as a chief executive office. Mr. Ligon holds a Bachelor of Science degree from Auburn University and an MBA from Harvard Business School.
Mr. Wilson has been President of U.S. Equity Corporation since 1983 and has over 45 years experience as an executive or investor in numerous companies in the banking, insurance, manufacturing, communications, health and transportation industries. The Company benefits greatly from Mr. Wilson’s diverse industry experience, as well as his experience as both an executive and an investor in numerous companies. Mr. Wilson has a Bachelor of Business Administration degree from Baylor University.
MANAGEMENT DISCUSSION FROM LATEST 10K
Results of Operations
The composite measure of our financial performance in the Consolidated Statements of Operations is captioned “Increase in net assets from operations” and consists of three elements. The first is “Net investment income,” which is the difference between income from interest, dividends and fees and our combined operating and interest expenses, net of applicable income taxes. The second element is “Net realized gain (loss) on investments,” which is the difference between the proceeds received from the disposition of portfolio securities and their stated cost, net of applicable income tax expense based on our tax year. The third element is the “Net increase (decrease) in unrealized appreciation of investments,” which is the net change in the market or fair value of our investment portfolio, compared with stated cost. It should be noted that the “Net realized gain (loss) on investments” and “Net increase (decrease) in unrealized appreciation of investments” are directly related in that when an appreciated portfolio security is sold to realize a gain, a corresponding decrease in net unrealized appreciation occurs by transferring the gain associated with the transaction from being “unrealized” to being “realized.” Conversely, when a loss is realized on a depreciated portfolio security, an increase in net unrealized appreciation occurs.
Net Investment Income
For the year ended March 31, 2012, total investment income was $9,334,236, a $1,766,089, or 23.3%, increase over the $7,568,147 of total investment income for the year ended March 31, 2011. This comparable period increase was primarily attributable to a $1,288,170 or 23.7% increase in dividend income and a $616,042 or 45.1% increase in interest income, partially offset by a $138,122 or 17.9% decrease in management and director fee income. For the year ended March 31, 2011, total investment income was $7,568,147, a $1,458,841, or 23.9%, increase over the $6,109,306 of total investment income for the year ended March 31, 2010. This comparable period increase was primarily attributable to a $1,643,591 or 43.4% increase in dividend income and a $319,271 or 30.6% increase in interest income, partially offset by a $504,921 or 39.5% decrease in management and director fee income
Our principal objective is to achieve capital appreciation. Therefore, a significant portion of the investment portfolio is structured to maximize the potential return from equity participation and provides minimal current yield in the form of interest or dividends. We also earn interest income from the short-term investment of cash funds, and the annual amount of such income varies based upon the average level of funds invested during the year and fluctuations in short-term interest rates. During the three years ended March 31, we also had interest income from temporary cash investments of $52,477 in 2012, $59,642 in 2011 and $19,618 in 2010.
We also receive management fees primarily from our controlled affiliated investments which aggregated $564,050 in 2012, $695,567 in 2011 and $984,800 in 2010. As compared to the period ended March 31, 2011, management fees for the year ended March 31, 2012 decreased by $131,517 or 18.9%, primarily due to the sale of Lifemark Group, which was offset by increase in management fees from Trax Holdings and Instawares Holding Company, LLC. As compared to March 31, 2010, management fees for the year ended March 31, 2011 decreased by $289,233 or 29.4%, primarily due to the sale of Lifemark Group in June 2010.
Due to the nature of our business, the majority of our Company’s operating expenses are related to employee and director compensation, office expenses, legal, professional and accounting fees and the net pension benefit. Total operating expenses, increased by $1,033,836 or 18.3% during the year ended March 31, 2012, while total operating expenses increased by $1,735,100 or 44.4% during the year ended March 31, 2011. The increase in 2012 is due primarily to salary increases, bonuses paid, stock options granted, rent increase and an increase in legal and other professional fees. The increase in 2011 is due primarily to the creation of two new officer positions, as well as bonuses paid, stock option granted, and an increase in remediation costs related to the Bowie Plant, a prior portfolio holding.
Net Realized Gain (Loss) on Investments
Net realized gain on investments was $10,577,944 (after income tax expense of $1,248,932) during the year ended March 31, 2012, compared with a gain of $38,885,026 (after income tax expense of $24,577,557) during fiscal 2011 and a gain of $1,639,994 (after income tax expense of $814,503) during fiscal 2010.
During the twelve months ended March 31, 2012, we sold Phi Health, Inc. on June 29, 2011 for $38,959 resulting in a realized loss of $5,910,655. On September 9, 2011, All Components was sold for $18,000,000, resulting in a realized gain of $17,850,000. We also sold all of our shares of common stock of Texas Capital Bancshares, Inc. in November, resulting in a realized gain of $9,866,335. On December 5, 2011, Palm Harbor Homes Inc. filed Chapter 11 bankruptcy in state of Delaware; therefore, we subsequently wrote off this investment of $10,931,955.
Net realized gain on investments was $38,885,026 (after income tax expense of $24,577,557) during the year ended March 31, 2011, compared with a gain of $1,639,994 (after income tax expense of $814,503) during fiscal 2010 During the twelve months ended March 31, 2011, we sold all of our shares of common stock of Lifemark Group to NorthStar Memorial Group LLC resulting in net cash proceeds of $70,547,210 and $3,703,619 of real estate and assets, which were directly transferred to CapStar Holdings Corporation, our controlled affiliate created to hold assets transferred from Lifemark Group at time of sale. Transfer taxes in the amount of $1,218,855 related to the transfer of real estate were deducted from the realized gain on the Lifemark transaction
Management does not attempt to maintain a consistent level of realized gains from year to year, but instead attempts to maximize total investment portfolio appreciation. This strategy often dictates the long-term holding of portfolio securities in pursuit of increased values and increased unrealized appreciation, but may at opportune times dictate realizing gains or losses through the disposition of certain portfolio investments.
Net Increase/(Decrease) in Unrealized Appreciation of Investments
For the three years ended March 31, 2012, we recorded an increase in unrealized appreciation of investments of $78,634,914 in 2012, an increase in unrealized appreciation of investments of $12,998,532 in 2011 and an increase in unrealized appreciation of investments of $70,624,231 in 2010, in each case compared to the prior fiscal year. This change in unrealized appreciation of investments for the year ended March 31, 2011 includes a $66,489,600 reduction related to the aforementioned sale of Lifemark Group. Excluding the Lifemark Group, net unrealized appreciation of investments for the year ended March 31, 2011 increased by $79,488,132. As explained in the first paragraph of “Results of Operations” above, the realization of gains or losses results in a corresponding decrease or increase in unrealized appreciation of investments. Set forth in the following table are the significant increases and decreases in unrealized appreciation excluding the effect of gains or losses realized during the year by the portfolio company for securities held at the end of each year.
As shown in the table for the year ended March 31, 2012, we recognized significant increases in several of our largest investments. The largest increases in unrealized appreciation are attributable to Encore Wire Corporation, which increased $39,723,210 and Alamo Group, which increased $22,872,338. In March 2012, Form S-3 registration statements of Alamo Group, Inc. (NYSE: ALG), Encore Wire Corporation (NASDAQ: WIRE), and Heelys Inc. (NASDAQ: HLYS) were filed with the Securities and Exchange Commission, or SEC. As a result of these registrations becoming effective, restrictions of the common stock of these companies imposed by Rule 144 of the Securities Exchange Act of 1933 were lifted, and discounts on these common stocks were subsequently removed. Due to these recent registrations with the SEC, Encore Wire Corporation, Alamo Group Inc. and Heelys Inc. common stock was transferred from Level 3 to Level 1 under the fair value hierarchy of ASC 820. On March 13, 2012, Encore’s registration statement became effective. As a result, Encore’s fair value is equivalent to the company’s closing bid price of $29.72 per share on March 31, 2012. Alamo’s registration statement became effective March 28, 2012. As a result, Alamo’s fair value is equivalent to the company’s closing bid price of $30.06 per share on March 31, 2012.
In addition, unrealized appreciation in RectorSeal Corporation and Whitmore Manufacturing Company increased $21,600,000 and $11,600,000, respectively, due to improved earnings; Heelys, Inc. increased $1,304,723 due to recent Form S-3 registration statement filed with the SEC. On April 17, 2012, Heelys’ registration statement became effective. As a result, Heelys’ fair value is equivalent to the company’s closing bid price of $2.20 per share (See Note 3 Investments).
A description of the investments listed above and other material components of the investment portfolio are included elsewhere in this report under the caption “Consolidated Schedule of Investments – March 31, 2012 and 2011” in Item 8 “Financial Statements and Supplemental Data.”
Portfolio Investments
During the year ended March 31, 2012, we invested a total of $13,377,408. During the year ended March 31, 2011, we invested $17,136,824 ($10,519,954 in cash and $6,616,870 non-cash, consisting of $3,707,619 in transferred real estate and assets from sale of Lifemark Group, Inc. and $2,913,251 in preferred stock in Phi Health, Inc. resulting from the conversion of CMI Holding Company, Inc. notes as part of its friendly foreclosure transaction). In various portfolio securities listed elsewhere under the caption “Portfolio Changes During the Year Ended March 31, 2012,” which also lists dispositions of portfolio securities. During the 2010 fiscal year, the Company invested a total of $17,234,456.
Financial Liquidity and Capital Resources
At March 31, 2012, we had cash and cash equivalents of approximately $64.9 million. Pursuant to the SBA regulations, cash and cash equivalents of $3.2 million held by CSVC may not be transferred or advanced to CSC without the consent of the SBA.
With the exception of a capital gain distribution made in the form of a distribution of the stock of a portfolio company in the fiscal year ended March 31, 1996, we elected to retain all gains realized during its 50 years of operations. Retention of future gains is viewed as an important source of funds to sustain our investment activity. Approximately $240 million of our investment portfolio is represented by unrestricted publicly traded securities and represents a source of liquidity as of March 31, 2012.
Funds to be used by us for operating or investment purposes may be transferred in the form of dividends or management fees from The RectorSeal Corporation and The Whitmore Manufacturing Company, controlled affiliates of the Company, to the extent of their available cash reserves and borrowing capacities.
Management believes that our cash and cash equivalents and cash available from other sources described above are adequate to meet our expected requirements. Consistent with our long-term strategy, the disposition of investments from time to time may also be an important source of funds for future investment activities.
Critical Accounting Policies
Valuation of Investments
In accordance with the Investment Company Act of 1940, investments in unrestricted securities (freely marketable securities having readily available market quotations) are valued at market, and investments in restricted securities (securities subject to one or more resale restrictions) are valued at fair value determined in good faith by our Board of Directors. Under our valuation policy, unrestricted securities are valued at the closing sale price for NYSE listed securities and at the lower of the closing bid price or the last sale price for Nasdaq securities on the valuation date.
Among the factors considered by our Board of Directors in determining the fair value of restricted securities are the financial condition and operating results of the issuer, the long-term potential of the business of the issuer, the market for and recent sales prices of the issuer’s securities, the values of similar securities issued by companies in similar businesses, the proportion of the issuer’s securities owned by us. Valuations as of any particular date, however, are not necessarily indicative of amounts which may ultimately be realized as a result of future sales or other dispositions of securities.
Impact of Inflation
We do not believe that our business is materially affected by inflation, other than the impact which inflation may have on the securities markets, the valuations of business enterprises and the relationship of such valuations to underlying earnings, all of which will influence the value of our investments.
BDC Risks
Pursuant to Section 64(b)(1) of the Investment Company Act of 1940, a BDC is required to describe the risk factors involved in an investment in the securities of such company due to the nature of the company’s investment portfolio. Accordingly we state that:
Our objective is to achieve capital appreciation through investments in businesses believed to have favorable growth potential. Such businesses are often undercapitalized small companies which lack management depth and have not yet attained profitability. Our venture investments often include securities which do not yield interest or dividends and are subject to legal or contractual restrictions on resale, which restrictions adversely affect the liquidity and marketability of such securities.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
The composite measure of our financial performance in the Consolidated Statements of Operations is captioned “Increase in net assets from operations” and consists of three elements. The first is “Net investment income,” which is the difference between income from interest, dividends and fees and the Company's combined operating and interest expenses, net of applicable income taxes. The second element is “Net realized gain (loss) on investments,” which is the difference between the proceeds received from disposition of portfolio securities and their stated cost, net of applicable income tax expense based on the Company’s tax year. The third element is the “Net increase in unrealized appreciation of investments,” which is the net change in the market or fair value of the Company’s investment portfolio. It should be noted that the “Net realized gain (loss) on investments” and “Net increase in unrealized appreciation of investments” are directly related in that when an appreciated portfolio security is sold to realize a gain, a corresponding decrease in net unrealized appreciation occurs by transferring the gain associated with the transaction from being “unrealized” to being “realized.” Conversely, when a loss is realized on a depreciated portfolio security, an increase in net unrealized appreciation occurs.
Net Investment Income
For the nine months ended December 31, 2011, total investment income was $8,078,208, a $1,585,950, or 24%, increase from the $6,492,258 total investment income for the nine months ended December 31, 2010. This comparable period increase was primarily attributable to a $1,288,050 or 27% increase in dividend income and partially offset by a $(68,500) or 14% decrease in management fees.
The Company’s principal objective is to achieve capital appreciation. Therefore, a significant portion of the investment portfolio is structured to maximize the potential return from equity participation and provides minimal current yield in the form of interest or dividends. The Company also earns interest income from the short-term investment of cash funds, and the annual amount of such income varies based upon the average level of funds invested during the year and fluctuations in short-term interest rates. During the nine months ended December 31, 2011 and 2010, respectively the Company also had interest income of $35,421 and $45,862 from temporary cash investments.
Due to the nature of its business, the majority of the Company’s operating expenses are related to employee and director compensation, office expenses, legal, professional and accounting fees and the net pension benefit. Total operating expenses, increased by $435,225 or 14% during the nine months ended December 31, 2011 and 2010. The increase in 2011 is due primarily to higher salaries and bonuses paid, higher non-cash stock option expense, as well as increases in professional fees related to divestitures.
Net Realized Gain (Loss) on Investments
During the nine months ended December 31, 2011, we sold all of our shares of preferred stock (Series A, Series B and Series C) in Phi Health, Inc, generating net cash proceeds of $38,959 and a realized loss of $5,910,655; we sold all of our shares of Series A convertible preferred stock, along with warrants to purchase additional shares of common stock of All Components, Inc. in a management buy-out generating cash proceeds of $18,000,000 and a realized gain of $17,850,000; we received $500,000 in cash proceeds from Essex Capital Corporation as settlement for an unsecured promissory note generating a gain of $500,000, which was the by-product of an option exercise agreement; we sold all of our shares of common stock of Texas Capital BancShares, Inc., generating net cash proceeds of $13,416,341 and a realized gain of $9,866,335; we sold our warrants in PalletOne, Inc. generating cash proceeds of $459 and a realized loss of $45,287; and we recognized a loss of $10,820,624 when Palm Harbor Homes, Inc. was officially declared bankrupt. In total, we recognized net realized gains of $11,328,436 for the nine months ended December 31, 2011.
During the nine months ended December 31, 2010, we sold all of our shares of common stock of Lifemark Group to NorthStar Memorial Group LLC resulting in net cash proceeds of $74,822,145 and $3,703,619 of real estate and assets, which were directly transferred to CapStar Holdings Corporation, our controlled affiliate created to hold assets transferred from Lifemark Group at time of sale. Transfer taxes in the amount of $1,218,855 related to the transfer of real estate were deducted from the realized gain on the Lifemark transaction. As a result of this transaction we recognized net realized gains on investments of $74,015,364 before taxes.
Management does not attempt to maintain a consistent level of realized gains from year to year, but instead attempts to maximize total investment portfolio appreciation. This strategy often dictates the long-term holding of portfolio securities in pursuit of increased values and increased unrealized appreciation, but may at opportune times dictate realizing gains or losses through the disposition of certain portfolio investments.
Net Increase/(Decrease) in Unrealized Appreciation of Investments
For the nine months ended December 31, 2011, we recognized a $163,937 increase in net change in unrealized appreciation of investments. Total unrealized gains included in earnings that related to assets still held at report date was $10,243,394. The largest increases in unrealized appreciation are attributable to Encore Wire Corporation, which increased $13,281,938, which is a reflection of an increase in its stock price; as well as The RectorSeal Corporation, which increased $9,000,000 and The Whitmore Manufacturing Company, which increased $5,400,000 attributable to increases in its respective earnings. Offsetting these increases were Heelys, Inc., which decreased $3,931,905 due to a decrease in its stock price, along with Cinatra Clean Technologies, Inc., which decreased $6,192,538 due to slowdowns in its business segment.
Portfolio Investments
During the quarter ended December 31, 2011, we made investments of $1,577,150 in existing portfolio companies.
We have agreed, subject to certain conditions, to invest up to $9,658,215 in nine portfolio companies.
Financial Liquidity and Capital Resources
At December 31, 2011, the Company had cash and cash equivalents of approximately $63.2 million. Pursuant to the SBA regulations, cash and cash equivalents of $5.6 million held by CSVC may not be transferred or advanced to CSC without the consent of the SBA.
Management believes that the Company’s cash and cash equivalents and cash available from other sources described above are adequate to meet its expected requirements. Consistent with the long-term strategy of the Company, the disposition of investments from time to time may also be an important source of funds for future investment activities.
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Fund Letters
