10-Q 1 form10q.htm CAPITAL SOUTHWEST CORPORATION 10-Q 12-31-2012 form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2012
 
OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from   to  
 
Commission File Number: 814-61

CAPITAL SOUTHWEST CORPORATION
(Exact name of registrant as specified in its charter)

Texas
 
75-1072796
(State or other jurisdiction of  incorporation or organization)
 
(I.R.S. Employer Identification No.)

12900 Preston Road, Suite 700, Dallas, Texas
 
75230
(Address of principal executive offices)
 
(Zip Code)

Registrant's telephone number, including area code: (972) 233-8242

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such filings).  Yes x No o
 
 Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
 
3,800,393 shares of Common Stock, $1 par value, as of February 7, 2013.
 


 
 

 
 

PART I
FINANCIAL INFORMATION
Page
     
Item 1.
 
 
3
 
4
 
5
 
6
 
7
 
19
Item 2.
32
Item 3.
36
Item 4.
36
     
PART II
OTHER INFORMATION
 
     
Item 1.
37
Item 1A.
37
Item 6.
37
     
 
38

 
PART I – FINANCIAL INFORMATION

Item 1.
Consolidated Financial Statements

CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
(In thousands except per share data)
 
   
December 31
2012
   
March 31
2012
 
Assets
 
(Unaudited)
       
Investments at market or fair value
           
Companies more than 25% owned (Cost: December 31, 2012 - $12,814, March 31, 2012 - $14,870)
  $ 346,595     $ 283,575  
Companies 5% to 25% owned (Cost: December  31, 2012 - $15,594, March 31, 2012 - $14,003)
    135,011       209,222  
Companies less than 5% owned (Cost: December 31, 2012 -$59,220, March 31, 2012 - $60,120)
    69,672       65,749  
Total investments (Cost: December 31, 2012 - $87,628, March 31, 2012 - $88,993)
    551,278       558,546  
Cash and cash equivalents
    67,623       64,895  
Receivables
               
Dividends and interest
    8,203       1,741  
Affiliates
    438       220  
Pension assets
    7,490       7,349  
Other assets
    180       238  
Total assets
  $ 635,212     $ 632,989  
Liabilities
               
Other liabilities
  $ 2,278     $ 688  
Income tax payable
    1,125        
Accrued pension cost
    1,684       1,568  
Deferred income taxes
    2,036       2,027  
Total liabilities
    7,123       4,283  
Net Assets
               
Common stock, $1 par value: authorized, 5,000,000 shares; issued, 4,383,271 shares at December 31, 2012 and 4,339,416 at March 31, 2012
    4,383       4,339  
Additional capital
    182,566       177,841  
Accumulated net investment income
    1,427       412  
Accumulated net realized gain
          498  
Unrealized appreciation of investments
    463,650       469,553  
Treasury stock - at cost on 584,878 shares
    (23,937 )     (23,937 )
Total net assets
    628,089       628,706  
Total liabilities and net assets
  $ 635,212     $ 632,989  
Net asset value per share (on the 3,798,393 shares outstanding at December 31, 2012 and 3,754,538 at March 31, 2012)
  $ 165.36     $ 167.45  

The accompanying Notes are an integral part of these Consolidated Financial Statements
 

CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands)
 
   
Three Months Ended
December 31
   
Nine Months Ended
December 31
 
   
2012
   
2011
   
2012
   
2011
 
Investment income:
                       
Interest
  $ 518     $ 506     $ 1,696     $ 1,444  
Dividends
    6,308       4,955       7,548       6,148  
Management and other income
    146       163       523       486  
      6,972       5,624       9,767       8,078  
Operating expenses:
                               
Salaries
    2,357       588       3,720       1,571  
Stock option expense
    62       253       334       757  
Net pension benefit
    (9 )     (75 )     (26 )     (225 )
Professional fees
    191       202       767       741  
Other operating expenses
    272       244       935       739  
      2,873       1,212       5,730       3,583  
Income before income taxes
    4,099       4,412       4,037       4,495  
Income tax expense/(benefit)
    (43 )     27       (3 )     74  
                                 
Net investment income
  $ 4,142     $ 4,385     $ 4,040     $ 4,421  
                                 
Proceeds from disposition of investments
  $ 11,023     $ 13,417     $ 78,528     $ 31,956  
Cost of investments sold
    9,258       14,528       9,882       20,628  
Realized gain (loss) on investments before income tax
    1,765       (1,111 )     68,646       11,328  
Income tax expense
    1,125       1,249       1,125       1,249  
Net realized gain (loss) on investments
    640       (2,360 )     67,521       10,079  
Net increase (decrease) in unrealized appreciation of investments
    22,296       48,798       (5,904 )     165  
                                 
Net realized and unrealized gain on investments
  $ 22,936     $ 46,438     $ 61,617     $ 10,244  
                                 
Increase in net assets from operations
  $ 27,078     $ 50,823     $ 65,657     $ 14,665  

The accompanying Notes are an integral part of these Consolidated Financial Statements
 

CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
(In thousands)

   
Nine Months
Ended
December 31, 2012
   
Nine Months
Ended
December 31, 2011
 
Operations:
           
Net investment income
  $ 4,040     $ 4,421  
Net realized gain on investments
    67,521       10,079  
Net increase (decrease) in unrealized appreciation of investments
    (5,904 )     165  
Increase in net assets from operations
    65,657       14,665  
Distributions from:
               
Undistributed net investment income
    (3,025 )     (3,003 )
Net realized gain distribution
    (66,826 )     -  
Net realized gains deemed distributed to shareholders
    (1,194 )     (3,216 )
Capital share transactions:
               
Allocated increase in share value for deemed distribution
    1,194       3,216  
Exercise of employee stock options
    3,243       98  
Stock option expense
    334       757  
Increase/(decrease) in net assets
    (617 )     12,517  
Net assets, beginning of period
    628,706       539,233  
Net assets, end of period
  $ 628,089     $ 551,750  

The accompanying Notes are an integral part of these Consolidated Financial Statements


CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

   
Three Months Ended
December 31
   
Nine Months Ended
December 31
 
   
2012
   
2011
   
2012
   
2011
 
Cash flows from operating activities
                       
Increase in net assets from operations
  $ 27,078     $ 50,823     $ 65,657     $ 14,665  
Adjustments to reconcile increase in net assets from operations to net cash provided by operating activities:
                               
Net proceeds from disposition of investments
    11,023       13,417       78,521       31,956  
Return of Capital on Investment
    511             768        
Proceeds from repayment of loan securities or investments
                      2,111  
Purchases of securities
    (2,482 )     (1,577 )     (9,278 )     (13,077 )
Depreciation and amortization
    7       6       25       16  
Net pension benefit
    (9 )     (75 )     (26 )     (225 )
Realized (gain) loss on investments before income tax
    (1,765 )     1,111       (68,646 )     (11,328 )
Taxes payable on behalf of shareholders on deemed distribution
    1,125       1,249       1,125       1,249  
Net (increase) decrease in unrealized appreciation of investments
    (22,296 )     (48,798 )     5,904       (164 )
Stock option expense
    62       253       334       757  
Increase in dividend and interest receivable
    (5,586 )     (5,031 )     (6,462 )     (5,468 )
Decrease (increase) in receivables from affiliates
    (104 )     (5 )     (218 )     50  
Decrease in other assets
    22             32       4  
Increase (decrease) in other liabilities
    1,687       (5 )     1,591       (5 )
Increase in deferred income taxes
    (43 )     27       9       81  
Net cash provided by operating activities
    9,230       11,395       69,336       20,622  
Cash flows from financing activities
                               
Distributions from undistributed net investment income
    (1,520 )     (1,502 )     (3,025 )     (3,003 )
Dividend paid from capital gain
                  (66,826 )      
Proceeds from exercise of employee stock options
    226             3,243       98  
Net cash used in financing activities
    (1,294 )     (1,502 )     (66,608 )     (2,905 )
Net increase in cash and cash equivalents
    7,936       9,893       2,728       17,717  
Cash and cash equivalents at beginning of period
    59,687       53,323       64,895       45,499  
Cash and cash equivalents at end of period
  $ 67,623     $ 63,216     $ 67,623     $ 63,216  
 
Supplemental disclosure of cash flow information:
                               
Income taxes
  $     $     $     $  
Non-cash transaction:
                               
a.
In December 2012, the $3,200,000 investment in Trax Holdings, Inc. debt security and $800,000 accrued interest were converted into Series B Convertible Preferred Stock. In July 2011, the $1,000,000 investment in iMemories, Inc. debt security was converted into Series C Convertible Preferred Stock.  These transactions had the following non-cash effect on the Company’s Consolidated Statements of Assets and Liabilities:

Total Investments
  $ 4,000     $     $ 4,000     $ 1,000  
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
*†ALAMO GROUP INC.
Seguin, Texas
Tractor-mounted mowing and mobile excavation equipment for governmental, industrial and agricultural markets; street-sweeping equipment for municipalities.
    22.0 %  
‡2,832,300 shares common stock (acquired 4-1-73 thru 5-09-11)
    $ 2,190,937     $ 92,397,312  
ATLANTIC CAPITAL BANCSHARES, INC
Atlanta, Georgia
Holding company of Atlantic Capital Bank, a full service commercial bank.
    1.9 %  
300,000 shares common stock (acquired 4-10-07)
      3,000,000       2,534,000  
¥BALCO, INC.
Wichita, Kansas
Specialty architectural products used in the construction and remodeling of commercial and institutional buildings.
    95.7 %  
445,000 shares common stock and 60,920 shares Class B non-voting common stock (acquired 10-25-83 and 5-30-02)
      624,920       4,600,000  
*BOXX TECHNOLOGIES, INC.
Austin, Texas
Workstations for computer graphic imaging and design.
    14.9 %  
3,125,354 shares Series B Convertible Preferred Stock, convertible into 3,125,354 shares of common stock at $0.50 per share (acquired 8-20-99 thru 8-8-01)
      1,500,000       1,220,000  
CINATRA CLEAN TECHNOLOGIES, INC.
Houston, Texas
Cleans above ground oil storage tanks with a patented, automated system.
    73.4 %  
12% subordinated secured promissory note, due 5-9-16 (acquired 5-19-10 thru 10-20-10)
      779,278       183,000  
           
12% subordinated secured promissory note, due 5-9-17 (acquired 5-9-11 thru 10-26-11)
      2,285,700       537,000  
           
12% subordinated secured promissory note, due 3-31-17 (acquired 9-9-11 and 10-26-11)
      1,523,800       358,000  
           
10% subordinated secured promissory note, due 5-9-17 (acquired 7-14-08 thru 4-28-10)
      6,200,700       1,458,000  
           
12% subordinated secured promissory note, due 10-31-17 (acquired 10-19-12)
      499,997       118,000  
           
3,033,410 shares Series A Convertible Preferred Stock, convertible into 3,033,410 shares common stock at $1.00 per share (acquired 7-14-08 thru 11-18-10)
      3,033,410       1  
           
Warrants to purchase 1,436,499 shares of common stock at $1.00 per share, expiring 10-31-2027 (acquired 5-9-11 thru 10-19-12)
             
                    14,322,885       2,654,001  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
*†ENCORE WIRE
   CORPORATION
McKinney, Texas
Electric wire and cable for residential, commercial and industrial construction use.
    6.2 %  
‡1,312,500 shares common stock (acquired 9-10-92 thru 10-15-98)
              5,200,000               39,768,750  
¥†HEELYS, INC.
Carrollton, Texas
Heelys stealth skate shoes, equipment and apparel sold through sporting goods chains, department stores and footwear retailers.
    31.1 %  
‡9,317,310  shares common stock (acquired 5-26-00)
      102,490       20,684,428  
HOLOGIC, INC.
Bedford, Massachusetts
Medical instruments including bone densitometers, mammography devices and digital radiography systems.
   
< 1%
   
‡582,820 shares common stock (acquired 8-27-99)
      202,529       11,662,286  
iMEMORIES, INC.
Scottsdale, Arizona
Enables online video and photo sharing and DVD creation for home movies recorded in analog and new digital format.
    23 %  
17,391,304 shares Series B Convertible Preferred Stock, convertible into 19,891,304 shares of common stock at $0.23 per share (acquired 7-10-09)
      4,000,000       4,000,000  
           
4,684,967 shares Series C Convertible Preferred Stock, convertible into 4,684,967 shares of common stock at $0.23 per share (acquired 7-20-11)
      1,078,479       1,078,479  
           
Warrants to purchase 2,500,000  shares of common stock at $0.12 per share, expiring 1-21-21(acquired 9-13-10 thru 1-21-11)
             
           
10% convertible notes, $308,000 principal due 7-31-2014 (acquired  9-7-12)
      308,000       308,000  
                    5,386,479       5,386,479  
INSTAWARES HOLDING COMPANY, LLC
Atlanta, Georgia
Provides services to the    restaurant industry via its five subsidiary companies.
    4.5 %  
3,846,154 Class D shares (acquired 5-20-11)
      5,000,000       5,829,000  
KBI BIOPHARMA, INC.
Durham, North Carolina
Provides fully-integrated, outsourced drug development and bio-manufacturing services.
    17.1 %  
7,142,857 shares Series B-2 Convertible Preferred Stock, convertible into 7,142,857 shares of common stock at $0.49 per share (acquired 9-08-09)
      5,000,000       5,400,000  
           
Warrants to purchase 63,007 shares of preferred stock at $ 0.70 per share, acquired 1-26-2012
 
        -         -  
                    5,000,000       5,400,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
¥MEDIA RECOVERY, INC.
Dallas, Texas
Computer datacenter and office automation supplies and accessories; impact, tilt monitoring and temperature sensing devices to detect mishandling shipments; dunnage for protecting shipments.
    97.9 %  
800,000 shares Series A Convertible Preferred Stock, convertible into 800,000 shares of common stock at $1.00 per share (acquired 11-4-97)
      800,000       2,200,000  
                               
           
4,000,002 shares common stock (acquired 11-4-97)
      4,615,000       11,100,000  
                    5,415,000       13,300,000  
*PALLETONE, INC.
Bartow, Florida
Manufacturer of wooden pallets and pressure-treated lumber.
    7.7 %  
12.3% senior subordinated notes, $2,000,000 principal due 12-18-2015 (acquired  9-25-06)
      1,553,150       1,600,000  
           
150,000 shares common stock (acquired 10-18-01)
      150,000       2  
                    1,703,150       1,600,002  
¥THE RECTORSEAL CORPORATION
Houston, Texas
Specialty chemicals for plumbing, HVAC, electrical, construction, industrial, oil field and automotive applications; smoke containment systems for building fires; also owns 20% of The Whitmore Manufacturing Company.
    100.0 %  
27,907 shares common stock (acquired 1-5-73 and 3-31-73)
      52,600       229,600,000  
TCI HOLDINGS, INC.
Denver, Colorado
Cable television systems and microwave relay systems.
       
21 shares 12% Series C Cumulative Compounding Preferred Stock (acquired 1-30-90)
            779,000  
TITANLINER, INC.
Midland, Texas
Manufactures, installs and rents spill containment system for oilfield applications.
    29.9 %  
217,038 shares Series A Convertible Preferred Stock convertible into 217,038 shares of Series A preferred stock at $12.65 per share (acquired 6-29-12)
 
      3,203,000       3,203,000  
           
7%  senior subordinated secured promissory note, due 6-30-17 (acquired 6-29-12)
 
      2,747,000       2,747,000  
           
Warrants to purchase 122,239 shares of Series A preferred stock at $ 0.01 per share, expiring 1-26-12
 
      -       -  
                    5,950,000       5,950,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
TRAX HOLDINGS, INC.
Scottsdale, Arizona
Provides a comprehensive set of solutions to improve the transportation validation, accounting, payment and information management process.
    25.4 %  
475,430 shares Series B convertible Preferred Stock convertible into 475,430 common stock at $8.41 per share(acquired 12-5-12)
      4,000,000       7,000,000  
           
1,061,279 shares Series A Convertible Preferred Stock, convertible into 1,061,279 common stock at $4.64 per share (acquired 12-8-08 and 2-17-09)
      5,000,000       12,400,000  
                    9,000,000       19,400,000  
*WELLOGIX, INC.
Houston, Texas
Developer and supporter of software used by the oil and gas industry.
    19.1 %  
4,788,371 shares Series A-1 Convertible Participating Preferred Stock, convertible into 4,788,371 shares of common stock at $1.0441 per share (acquired 8-19-05 thru 6-15-08)
 
      5,000,000       25,000  
¥THE WHITMORE MANUFACTURING COMPANY
Rockwall, Texas
Specialized surface mining, railroad and industrial lubricants; coatings for automobiles and primary metals; fluid contamination control devices.
    80.0 %  
80 shares common stock (acquired 8-31-79)
      1,600,000       71,400,000  
MISCELLANEOUS
       
Ballast Point Ventures II, L.P.
2.2% limited partnership interest (acquired 8-4-08 thru 6-18-10)
 
      1,359,790       1,359,000  
         
BankCap Partners Fund I, L.P.
5.5% limited partnership interest (acquired 7-14-06 thru 11-30-11)
 
      5,897,276       5,016,000  
         
CapitalSouth Partners Fund III, L.P.
1.9% limited partnership interest (acquired 1-22-08 and 11-16-11)
      1,331,256       1,816,000  
      100.0 %  
¥CapStar Holdings   Corporation
500 shares common stock (acquired 6-10-10); 1,000,000 shares preferred stock (acquired 12-17-12)
 
      4,703,619       6,674,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
Miscellaneous (continued)
 
                 
Diamond State Ventures, L.P.
1.4% limited partnership interest (acquired 10-12-99 thru 8-26-05)
                -                 96,000  
         
¥Discovery Alliance, LLC
90.0% limited liability company (acquired  9-12-08 thru 10-20-11)
      1,315,000       1,167,000  
         
First Capital Group of Texas III, L.P.
3.0% limited partnership interest (acquired 12-26-00 thru 8-12-05)
      778,895       164,000  
      100 %  
¥Humac Company
1,041,000 shares common stock (acquired 1-31-75 and 12-31-75)
            169,000  
         
†North American Energy Partners, Inc.
77,194 shares common stock (acquired 8-20-12)
      236,986       262,460  
         
STARTech Seed Fund II
3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05)
      754,327       364,000  
TOTAL INVESTMENTS
                $ 87,628,139     $ 551,277,718  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS

March 31, 2012
 
Company
 
Equity (a)
   
Investment (b)
   
Cost
   
Value (c)
 
*†ALAMO GROUP INC.
Seguin, Texas
Tractor-mounted mowing and mobile excavation equipment for governmental, industrial and agricultural markets; street-sweeping equipment for municipalities.
    22.0 %  
‡2,832,300 shares common stock (acquired 4-1-73 thru 5-09-11)
    $ 2,190,937     $ 85,138,938  
ATLANTIC CAPITAL BANCSHARES, INC
Atlanta, Georgia
Holding company of Atlantic Capital Bank, a full service commercial bank.
    1.9 %  
300,000 shares common stock (acquired 4-10-07)
      3,000,000       2,299,000  
¥BALCO, INC.
Wichita, Kansas
Specialty architectural products used in the construction and remodeling of commercial and institutional buildings.
    95.7 %  
445,000 shares common stock and 60,920 shares Class B non-voting common stock (acquired 10-25-83 and 5-30-02)
      624,920       4,100,000  
*BOXX TECHNOLOGIES, INC.
Austin, Texas
Workstations for computer graphic imaging and design.
    14.9 %  
3,125,354 shares Series B Convertible Preferred Stock, convertible into 3,125,354 shares of common stock at $0.50 per share (acquired 8-20-99 thru 8-8-01)
      1,500,000       600,000  
CINATRA CLEAN TECHNOLOGIES, INC.
Houston, Texas
Cleans above ground oil storage tanks with a patented, automated system.
    73.4 %  
12% subordinated secured promissory note, due 5-9-16 (acquired 5-19-10 thru 10-20-10)
      779,278       444,189  
         
12% subordinated secured promissory note, due 5-9-17 (acquired 5-9-11 thru 10-26-11)
      2,285,700       1,302,849  
         
12% subordinated secured promissory note, due 8-31-16 (acquired 9-9-11 and 10-26-11)
      1,264,754       720,910  
         
10% subordinated secured promissory note, due 5-9-17 (acquired 7-14-08 thru 4-28-10)
      6,200,700       3,534,399  
           
3,033,410 shares Series A Convertible Preferred Stock, convertible into 3,033,410 shares common stock at $1.00 per share (acquired 7-14-08 thru 11-18-10)
      3,033,410       1  
           
Warrants to purchase 1,269,833 shares of common stock at $1.00 per share, expiring 8-31-2021 (acquired 5-9-11 thru 8-31-11)
             
                    13,563,842       6,002,348  
*†ENCORE WIRE
   CORPORATION
McKinney, Texas
Electric wire and cable for residential, commercial and industrial construction use.
    16.9 %  
‡4,086,750 shares common stock (acquired 7-16-92 thru 10-7-98)
      5,800,000       121,458,210  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED SCHEDULE OF INVESTMENTS
 
March 31, 2012
 
Company
   
Equity (a)
   
Investment (b)
     
Cost
     
Value (c)
 
EXTREME INTERNATIONAL, INC.
   Sugar Land, Texas
Owns Bill Young Productions, Texas Video and Post, and Extreme and television commercials and corporate communications videos.
    53.6 %  
13,035 shares Series A Common Stock (acquired 9-26-08 and 12-18-08)
 
      325,875       714,000  
           
39,359.18 shares Series C Convertible Preferred Stock, convertible into 157,437.72 shares of common stock at $25.00 per share (acquired 9-30-03)
      2,625,000       8,626,000  
           
3,750 shares 8% Series A Convertible Preferred Stock, convertible into 15,000 shares of common stock at $25.00 per share (acquired 9-30-03)
      375,000       822,000  
                    3,325,875       10,162,000  
¥†HEELYS, INC.
Carrollton, Texas
Heelys stealth skate shoes, equipment and apparel sold through sporting goods chains, department stores and footwear retailers.
    31.1 %  
‡9,317,310  shares common stock (acquired 5-26-00)
      102,490       20,498,082  
HOLOGIC, INC.
Bedford, Massachusetts
Medical instruments including bone densitometers, mammography devices and digital radiography systems.
   
< 1
%  
‡632,820 shares common stock (acquired 8-27-99)
      220,000       13,637,271  
iMEMORIES, INC.
Scottsdale, Arizona
Enables online video and photo sharing and DVD creation for home movies recorded in analog and new digital format.
    25.3 %  
17,391,304 shares Series B Convertible Preferred Stock, convertible into 19,891,304 shares of common stock at $0.23 per share (acquired 7-10-09)
      4,000,000       4,000,000  
           
4,684,967 shares Series C Convertible Preferred Stock, convertible into 4,684,967 shares of common stock at $0.23 per share (acquired 7-20-11)
      1,078,479       1,078,479  
           
Warrants to purchase 2,500,000  shares of common stock at $0.12 per share, expiring 1-21-21(acquired 9-13-10 thru 1-21-11)
             
                    5,078,479       5,078,479  
INSTAWARES HOLDING COMPANY, LLC
Atlanta, Georgia
Provides services to the    restaurant industry via its five subsidiary companies.
    4.5 %  
3,846,154 Class D shares (acquired 5-20-11)
      5,000,000       5,000,000  
KBI BIOPHARMA, INC.
Durham, North Carolina
Provides fully-integrated, outsourced drug development and bio-manufacturing services.
    17.1 %  
7,142,857 shares Series B-2 Convertible Preferred Stock, convertible into 10,204,082 shares of common stock at $0.49 per share (acquired 9-08-09)
      5,000,000       3,200,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED SCHEDULE OF INVESTMENTS
 
March 31, 2012
 
Company
   
Equity (a)
   
Investment (b)
     
Cost
     
Value (c)
 
¥MEDIA RECOVERY, INC.
Dallas, Texas
Computer datacenter and office automation supplies and accessories; impact, tilt monitoring and temperature sensing devices to detect mishandling shipments; dunnage for protecting shipments.
    97.9 %  
800,000 shares Series A Convertible Preferred Stock, convertible into 800,000 shares of common stock at $1.00 per share (acquired 11-4-97)
 
      800,000       3,100,000  
           
4,000,002 shares common stock (acquired 11-4-97)
      4,615,000       15,600,000  
                    5,415,000       18,700,000  
*PALLETONE, INC.
Bartow, Florida
Manufacturer of wooden pallets and pressure-treated lumber.
    7.7 %  
12.3% senior subordinated notes, $2,000,000 principal due 12-18-15 (acquired  9-25-06)
      1,553,150       2,000,000  
           
150,000 shares common stock (acquired 10-18-01)
      150,000       2  
                    1,703,150       2,000,002  
¥THE RECTORSEAL CORPORATION
Houston, Texas
Specialty chemicals for plumbing, HVAC, electrical, construction, industrial, oil field and automotive applications; smoke containment systems for building fires; also owns 20% of The Whitmore Manufacturing Company.
    100.0 %  
27,907 shares common stock (acquired 1-5-73 and 3-31-73)
      52,600       166,300,000  
TCI HOLDINGS, INC.
Denver, Colorado
Cable television systems and microwave relay systems.
       
21 shares 12% Series C Cumulative Compounding Preferred Stock (acquired 1-30-90)
            802,000  
TRAX HOLDINGS, INC.
Scottsdale, Arizona
Provides a comprehensive set of solutions to improve the transportation validation, accounting, payment and information management process.
    29.4 %  
18% convertible  promissory note, $3,200,000 principal  due 9-17-2012 (acquired 4-6-11 thru 11-10-11)
      3,200,000       3,200,000  
           
1,061,279 shares Series A Convertible Preferred Stock, convertible into 1,061,279 common stock at $4.64 per share (acquired 12-8-08 and 2-17-09)
      5,000,000       6,600,000  
                    8,200,000       9,800,000  
VIA HOLDINGS, INC.
Sparks, Nevada
Designer, manufacturer and distributor of high-quality office seating.
    3.2 %  
12,686 shares common stock (acquired 3-4-11 and 3-25-11)
 
      4,926,290       2  
*WELLOGIX, INC.
Houston, Texas
Developer and supporter of software used by the oil and gas industry.
    19.1 %  
4,788,371 shares Series A-1 Convertible Participating Preferred Stock, convertible into 4,788,371 shares of common stock at $1.0441 per share (acquired 8-19-05 thru 6-15-08)
 
      5,000,000       25,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED SCHEDULE OF INVESTMENTS
 
March 31, 2012
 
Company
   
Equity (a)
   
Investment (b)
     
Cost
     
Value (c)
 
¥THE WHITMORE MANUFACTURING COMPANY
Rockwall, Texas
Specialized surface mining, railroad and industrial lubricants; coatings for automobiles and primary metals; fluid contamination control devices.
    80.0 %  
80 shares common stock (acquired 8-31-79)
      1,600,000       67,200,000  
MISCELLANEOUS
       
Ballast Point Ventures II, L.P.
2.2% limited partnership interest (acquired 8-4-08 thru 6-18-10)
 
      1,725,000       1,551,000  
         
BankCap Partners Fund I, L.P.
5.5% limited partnership interest (acquired 7-14-06 thru 11-30-11)
 
      5,808,470       5,012,000  
         
CapitalSouth Partners Fund III, L.P.
1.9% limited partnership interest (acquired 1-22-08 and 11-16-11)
      1,331,256       1,438,000  
      100.0 %  
¥CapStar Holdings   Corporation
500 shares common stock (acquired 6-10-10)
 
      3,703,619       5,338,000  
         
Diamond State Ventures, L.P.
1.4% limited partnership interest (acquired 10-12-99 thru 8-26-05)
 
      76,000       184,000  
         
¥Discovery Alliance, LLC
90.0% limited liability company (acquired  9-12-08 thru 10-20-11)
 
      1,180,000       1,280,000  
         
First Capital Group of Texas III, L.P.
3.0% limited partnership interest (acquired 12-26-00 thru 8-12-05)
 
      778,895       662,000  
      100 %  
¥Humac Company
1,041,000 shares common stock (acquired 1-31-75 and 12-31-75)
 
            159,000  
         
STARTech Seed Fund I
12.1% limited partnership interest (acquired 4-17-98 thru 1-5-00)
 
      178,066       39,000  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
 
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES
 
CONSOLIDATED SCHEDULE OF INVESTMENTS
 
March 31, 2012
 
Company
   
Equity (a)
   
Investment (b)
     
Cost
     
Value (c)
 
Miscellaneous (continued)        
STARTech Seed Fund II
3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05)
 
      843,891       371,000  
         
Sterling Group Partners I, L.P.
1.7% limited partnership interest (acquired 4-20-01 thru 1-24-05)
      1,064,042       511,000  
TOTAL INVESTMENTS
                $ 88,992,822     $ 558,546,332  
 
Publicly-owned company   ¥ Control investment   * Affiliated investment Unrestricted securities as defined in Note (a)
 
The accompanying Notes are an integral part of these Consolidated Financial Statements
 
Notes to Consolidated Schedule of Investments
 
(a) 
Equity

The percentages in the “Equity” column express equity interests held by Capital Southwest Corporation and Capital Southwest Venture Corporation (together, the “Company”) in each issuer.  Each percentage represents the amount of the issuer’s common stock the Company owns or can acquire as a percentage of the issuer’s total outstanding common stock, plus stock reserved for all warrants, convertible securities and employee stock options.
 
(b) 
Investments
 
Unrestricted securities (indicated by ) are freely marketable securities having readily available market quotations.  All other securities are restricted securities, which are subject to one or more restrictions on resale and are not freely marketable.  At December 31, 2012 and March 31, 2012, restricted securities represented approximately 70.1% and 56.9% of the value of the consolidated investment portfolio, respectively.

Our investments are carried at fair value in accordance with the Investment Company Act of 1940 (the “1940 Act”) and FASB Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures.  In accordance with the 1940 Act, unrestricted minority-owned publicly traded securities, for which the market quotations are readily available, are valued at the closing sale price for the NYSE listed securities and the lower of the closing bid price or the last sale price for NASDAQ securities on the valuation date; other privately held securities are valued as determined in good faith by our Board of Directors.

ASC 820 defines fair value in terms of the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the “exit price”) and excludes transaction costs.  Under ASC 820, the fair value measurement also assumes that the transaction to sell an asset occurs in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset.  The principal market is the market in which the reporting entity would sell or transfer the asset with the greatest volume and level of activity for the asset.  In determining the principal market for an asset or liability under ASC 820, it is assumed that the reporting entity has access to the market as of the measurement date.

(c) 
Value

Debt Securities are generally valued on the basis of the price the security would command in order to provide a yield-to-maturity equivalent to the present yield of comparable debt instruments of similar quality.  Issuers whose debt securities are judged to be of poor quality and doubtful collectability may instead be valued by assigning percentage discounts commensurate with the quality of such debt securities.  Debt securities may also be valued based on the resulting value from the sale of the business at the estimated fair market value.

Partnership Interests, Preferred Equity and Common Equity, including unrestricted marketable securities, are valued at the closing sale price for the NYSE listed securities and the lower of the closing bid price or the last sale price for NASDAQ securities on the valuation date. For those without a principal market, our Board of Directors considers 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; and the proportion of the issuer’s securities owned by the Company.  Investments in certain entities that calculate net asset value per share (or its equivalent) and for which fair market value is not readily determinable are valued using the net asset value per share (or its equivalent, such as member units or ownership interest in partners’ capital to which a proportionate share of net assets is attributed) of the investment.
 

Equity Warrants are valued on the basis of the Black-Scholes model which defines the market value of a warrant in relation to the market price of its common stock, share price volatility, and time to maturity.

(d) 
Agreements between Certain Issuers and the Company

Agreements between certain issuers and the Company provide that the issuer will bear substantially all costs in connection with the Company disposing such common stock, including those costs involved in registration under the Securities Act of 1933, but excluding underwriting discounts and commissions.  These agreements cover common stock owned at December 31, 2012 and common stock which may be acquired thereafter through the exercise of warrants and conversion of debentures and preferred stock.  They apply to restricted securities of all issuers in the investment portfolio of the Company except securities of the following issuers which are not obligated to bear registration costs:  Humac Company and The Whitmore Manufacturing Company.

(e) 
Descriptions and Ownership Percentages

The descriptions of the companies and ownership percentages shown in the Consolidated Schedule of Investments were obtained from published reports and other sources believed to be reliable.  Acquisition dates indicated are the dates specific securities were acquired, which may differ from the original investment dates.  Certain securities were received in exchange for or upon conversion or exercise of other securities previously acquired.
 

Notes to Consolidated Financial Statements

1.
ORGANIZATION AND BASIS OF PRESENTATION

Organization

Capital Southwest Corporation (“CSW”) was organized as a Texas corporation on April 19, 1961.  Until September 1969, CSW operated as a licensee under the Small Business Investment Act of 1958.  At that time, we 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, CSW was registered as a closed-end, non-diversified investment company under the 1940 Act.  On that date, CSW 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 CSW wholly owns CSVC, the portfolios of both CSW and CSVC are referred to collectively as “our,” “we” and “us.”  Capital Southwest Management Company (“CSMC”), a wholly-owned subsidiary of CSW, is the management company for CSW 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 managerial assistance to such investee companies is critical to their business development activities.  CSMC receives a monthly fixed fee for management services provided to certain of its control portfolio companies.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  Under rules and regulations applicable to investment companies, we are precluded from consolidating any entity other than another investment company.  An exception to this general principle occurs if the investment company has an investment in an operating company that provides services to the investment company.  Accordingly, our consolidated financial statements include CSMC, our management company.

The financial statements included herein have been prepared in accordance with GAAP for interim financial information and the instructions to Form 10-Q and Article 6 of Regulation S-X. The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended March 31, 2012 (the “Form 10-K”), as filed with the Securities and Exchange Commission (SEC).  Certain information and footnotes normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, although we believe that the disclosures provided in this Form 10-Q are adequate for a fair presentation.  The information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results of operations for the interim period.
 

Portfolio Investment Classification

We classify our investments in accordance with the requirements of the 1940 Act.  Under the 1940 Act, “Control Investments” are defined as investments in which we own more than 25% of the voting securities or have rights to maintain greater than 50% of the board representation; “Affiliated Investments” are defined as investments in which we own between 5% and 25% of the voting securities; and “Non-Control/Non-Affiliated Investments” are defined as investments that are neither “Control Investments” nor “Affiliated Investments.”

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following is a summary of significant accounting policies followed in the preparation of the consolidated financial statements of CSW, CSVC and CSMC.

Fair Value Measurements We adopted FASB ASC 820 on April 1, 2008.  ASC 820 (1) creates a single definition of fair value, (2) establishes a framework for measuring fair value, and (3) expands disclosure requirements about items measured at fair value.  ASC 820 applies to both items recognized and reported at fair value in the financial statements and items disclosed at fair value in the notes to the financial statements.  ASC 820 does not change existing accounting rules governing what can or what must be recognized and reported at fair value in our financial statements, or disclosed at fair value in our notes to financial statements. Additionally, ASC 820 does not eliminate practicability exceptions that exist in accounting pronouncements amended by this Topic when measuring fair value.

Fair value is generally determined based on quoted market prices in the active markets for identical assets or liabilities.  If quoted market prices are not available, we use valuation techniques that place greater reliance on observable inputs and less reliance on unobservable inputs.  Due to the inherent uncertainty in the valuation process, our estimate of fair value may differ materially from the values that would have been used had a ready market for the securities existed.  In addition, changes in the market environment, portfolio company performance and other events may occur over the lives of the investments that may cause the gains or losses ultimately realized on these investments to be materially different than the valuations currently assigned.  We determine the fair value of each individual investment and record changes in fair value as unrealized appreciation or depreciation.

Pursuant to our internal valuation process, each portfolio company is valued once a quarter.  In addition to our internal valuation process, our Board of Directors retains a nationally recognized firm to provide limited scope third party valuation services on certain portfolio investments at the end of our fiscal year.  Our Board of Directors retained Duff & Phelps to provide limited scope third party valuation services on six investments comprising 85.8% of our net asset value at March 31, 2012.  For full disclosure of Duff & Phelps’ services, see page 5 of the Form 10-K under the heading “Determination of Net Asset Value and Portfolio Valuation Process.”

We believe our investments at December 31, 2012 and March 31, 2012 approximate fair value based on the market in which we operate and other conditions in existence as of these dates.

Investments Investments are stated at fair value determined by our Board of Directors as described in Notes to the Consolidated Schedule of Investments and Note 3 below.  The average cost method is used in determining cost of investments sold.  Investments are recorded on a trade date basis.
 

Cash and Cash Equivalents Cash and cash equivalents consist of highly liquid investments with an original maturity of three months or less at the date of purchase.  Cash and cash equivalents are carried at cost, which approximates fair value.

Segment Information We operate and manage our business in a singular segment.  As an investment company, we invest in portfolio companies in various industries and geographic areas as presented in the Consolidated Schedule of Investments.

Use of Estimates  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.

Interest and Dividend Income  Interest and dividend income is recorded on an accrual basis to the extent amounts are expected to be collected.  Dividend income is recorded at the ex-dividend date for marketable securities and restricted securities.  In accordance with our valuation policy, accrued interest and dividend income is evaluated periodically for collectability.  When a debt or loan becomes 90 days or more past due, and if we otherwise do not expect the debtor to be able to service all of its debt or other obligations, we will generally establish a reserve against the interest income, thereby placing the loan or debt security’s status on non-accrual basis, and cease to recognize interest income on that loan or debt security until the borrower has demonstrated the ability and intent to pay contractual amounts due.  If a loan or debt security’s status significantly improves regarding ability to service debt or other obligations, it will be restored to accrual basis.

Federal Income Taxes  CSW and CSVC have elected and intend to comply with the requirements of the Internal Revenue Code (IRC) necessary to qualify as regulated investment companies (RICs).  By meeting these requirements, they will not be subject to corporate federal income taxes on ordinary income distributed to shareholders.  In order to comply as a RIC, each company is required to timely distribute to its shareholders at least 90% of investment company taxable income, as defined by the IRC, each year.  Investment company taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses.  Investment company taxable income generally excludes net unrealized appreciation or depreciation, as investment gains and losses are not included in investment company taxable income until they are realized.

In addition to the requirement that we must annually distribute at least 90% of our investment company taxable income, we may either distribute or retain our realized net capital gains from investments, but any net capital gains not distributed may be subject to corporate level tax. Historically, we have not distributed net capital gains; however, during the nine months ended December 31, 2012, we distributed capital gains dividends in the amount of $17.59 per share to our shareholders. When we retain the capital gains, they are classified as a “deemed distribution” to our shareholders and are subject to our corporate tax rate of 35%.  As an investment company that qualifies as a RIC under the IRC, federal income taxes payable on security gains that we elect to retain are accrued only on the last day of our tax year, December 31.  Any capital gains actually distributed to shareholders are generally taxable to the shareholders as long-term capital gains. See Note 4 for further discussion.

CSMC, a wholly owned subsidiary of CSW, is not a RIC and is required to pay taxes at the current corporate rate.
 

We account for interest and penalties as part of operating expenses.  There were no interest or penalties incurred during the nine months ended December 31, 2012 and 2011.

Deferred Taxes  CSMC sponsors a qualified defined benefit pension plan which covers its employees and employees of certain of its controlled affiliates.  Deferred taxes related to the qualified defined benefit pension plan are recorded as incurred.

Stock-Based Compensation  We account for our stock-based compensation using the fair value method, as prescribed by ASC 718, Compensation – Stock Compensation.  Accordingly, we recognize stock-based compensation cost over the straight-line method for all share-based payments awards granted to employees.  The fair value of stock options are determined on the date of grant using the Black-Scholes pricing model and are expensed over the vesting period of the related stock options. For restricted stock awards, we measured the grant date fair value based upon the market price of our common stock on the date of the grant and will amortize this fair value to shared-based compensation expense over the vesting term.  See Note 6 for further discussion.

Defined Pension Benefits and Other Postretirement Plans  We record annual amounts relating to the defined benefit pension plan based on calculations, which include various actuarial assumptions such as discount rates and assumed rates of return depending on the pension plan.  Material changes in pension costs may occur in the future due to changes in the discount rate, changes in the expected long-term rate of return, changes in level of contributions to the plans and other factors.  The funded status is the difference between the fair value of plan assets and the benefit obligation.  We recognize changes in the funded status of defined benefit plan in the Statement of Assets and Liabilities in the year in which the changes occur and measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end.  We presently use March 31 as the measurement date for our defined benefit plan.

Concentration of Risk  We place our idle cash in financial institutions, and at times, such balances may be in excess of the federally insured limits.

Recent Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update ("ASU") 2011-04, Fair Value Measurements (ASC 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs ("ASU 2011-04"). ASU 2011-04 results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. ASU 2011-04 is effective for interim and annual reporting periods beginning after December 15, 2011. The adoption of ASU 2011-04 did not have a significant impact on our financial condition and results of operations. See Note 3 Investments, for further information regarding valuation techniques and quantitative information about the significant unobservable inputs utilized by our Company to value Level 3 investments.

3. 
INVESTMENTS

We record our investments at fair value as determined in good faith by our Board of Directors in accordance with GAAP.  When available, we base the fair value of our investments on directly observable market prices or on market data derived for comparable assets.  For all other investments, inputs used to measure fair value reflect management’s best estimate of assumptions that would be used by market participants in pricing the investments in a hypothetical transaction.
 

The levels of fair value inputs used to measure our investments are characterized in accordance with the fair value hierarchy established by the Accounting Standards Codification (“ASC”).  We use judgment and consider factors specific to the investment in determining the significance of an input to a fair value measurement.  While management believes our valuation methodologies are appropriate and consistent with market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  The three levels of the fair value hierarchy and investments that fall into each of the levels are described below:

 
·
Level 1:  Investments whose values are based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access.  We use Level 1 inputs for publicly traded securities.  Such investments are valued at the closing price for listed securities and at the lower of the closing bid price or the closing sale price for NASDAQ securities on the valuation date.

 
·
Level 2: Investments whose values are based on observable inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  These inputs may include quoted prices for the identical instrument in non-active markets, quoted prices for similar instruments in active markets and similar data.  We did not value any of our investments using Level 2 inputs as of December 31, 2012 and 2011.

 
·
Level 3: Investments whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement.  These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the investment.  We use Level 3 inputs for measuring the fair value of approximately 70.1% of our investments.
 
As required by ASC 820, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within the fair value measurement is categorized based on the lowest level input that is significant to the fair value measurement which may include inputs that are observable (Levels 1 and 2) and unobservable (Level 3).  Therefore, gains and losses for such investments categorized within the Level 3 table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable (Level 3).  We conduct reviews of fair value hierarchy classifications on a quarterly basis.  Changes in the observability of valuation inputs may result in a reclassification of certain investments.

Unobservable inputs are those inputs for which little or no market data exists and, therefore, require an entity to develop its own assumptions. The fair value determination of each portfolio company requires one or more of the following unobservable inputs:

 
·
Financial information obtained from each portfolio company, including audited and unaudited statements of operations and balance sheets for the most recent period available as compared to budgeted numbers;

 
·
Current and projected financial condition of the portfolio company;

 
·
Current and projected ability of the portfolio company to service its debt obligations;

 
·
Projected operating results of the portfolio company;
 
 
 
·
Current information regarding any offers to purchase the investment or recent private sales transactions;

 
·
Current ability of the portfolio company to raise any additional financing as needed;

 
·
Change in the economic environment which may have a material impact on the operating results of the portfolio company;

 
·
Qualitative assessment of key management;

 
·
Contractual rights, obligations or restrictions associated with the investment; and

 
·
Other factors deemed relevant.
 
Preferred Stock and Common Stock

The significant unobservable inputs used in the fair value measurement of our equity securities are EBITDA multiples, revenue multiples, net book values, tangible book value multiples, and the weighted average costs of capital (“WACC”). Generally, increases or decreases in EBITDA or revenue multiple inputs result in a higher or lower fair value measurement, respectively. Generally, increases or decreases in WACC result in a lower or higher fair value measurement, respectively. However, due to the nature of certain investments, fair value measurements may be based on other criteria, such as third party-appraisals. For recent investments, we generally rely on our cost basis to determine the fair value unless fair value is deemed to have departed from this level.
 
Debt Securities

The significant unobservable inputs used in the fair value measurement of our debt securities are risk adjusted discount factors used in the yield valuation technique and probability of principal recovery. Significant increase or decrease in any of these valuation inputs in isolation would result in a significantly lower or higher fair value measurement. However, due to the nature of certain investments, fair value measurements may be based on other criteria, such as third party inputs.
 
Limited Partnership or Limited Liability Company Interests

For recent investments, we evaluate limited partnership or limited liability company interests at cost, which is deemed to represent market value, unless or until there is substantive evidence that cost does not correspond to fair value. Thereafter, these securities are generally valued at our percentage interest of the fund or company’s calculated net asset value, unless there is substantive evidence that the net asset value does not correspond to fair value. All investments of each fund are valued in accordance with ASC 820.
 
Warrants

We generally use the Black-Scholes option pricing model to determine the fair value of warrants held in our portfolio. Option pricing models, including the Black-Scholes model, require the use of subjective inputs, including expected volatility, expected life, expected dividend rate, and expected risk-free rate of return. In the Black-Scholes model, variation in the expected volatility or expected term assumptions has a significant impact on fair value.
 

The table below presents the valuation technique and quantitative information about the significant unobservable inputs utilized by the Company to value our Level 3 investments as of December 31, 2012. Unobservable inputs are those inputs for which little or no market data exists and therefore require an entity to develop its own assumptions. The table is not intended to be all inclusive, but instead captures the significant unobservable inputs relevant to our determination of fair value.

Type
Valuation Technique
 
Fair Value
(in millions)
 
Unobservable Input
 
Range
     
Weighted
Average
 
Preferred & Common Equity
Market Approach
  $ 325.5  
EBITDA Multiple
    3.25x - 6.56x       6.42 x
 
Market Approach
  $ 10.9  
Revenue Multiple
    0.30x – 1.70x       0.95 x
 
Market Approach
  $ 6.7  
Cash and Asset Value
    NA      
NA
 
 
Discounted Cash Flow
  $ 0.8  
Discount Rate
    1.81 %     1.81 %
 
Market Approach
  $ 2.5  
Multiple of Tangible Book Value
    1.05 x     1.05 x
 
Market Approach
  $ 22.6  
Recent Transaction Price
   
NA
     
NA
 
 
Market Approach
  $ 0.2  
Market Value of Held Securities
   
NA
     
NA
 
      $ 369.2                    
Warrants
Black Scholes Pricing Model
  $ 0.0  
Stock Price and Expected Volatility
  $ 0.00     $ 0.00  
                             
Debt
Discounted Cash Flow
  $ 4.3  
Discount Rate
    10.00 %     10.00 %
 
Recent Transaction Price
  $ 3.0  
Recent Transaction Price
   
NA
     
NA
 
      $ 7.3                    
Partnership Interests
Net Asset Value*
  $ 10.0  
Fund Value
   
NA
     
NA
 
 
Total
  $ 386.5                    

*
All funds are valued in accordance with ASC 820.

As of December 31, 2012 and March 31, 2012, 70.1% and 56.9%, respectively, of our portfolio investments were categorized as Level 3.

The following fair value hierarchy tables set forth our investment portfolio by level as of December 31, 2012 and March 31, 2012 (in millions):

   
Fair Value Measurements
at 12/31/12 Using
 
Asset Category
 
Total
   
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
Debt
  $ 7.3     $     $     $ 7.3  
Partnership Interests
    10.0                   10.0  
Preferred Equity
    44.1                   44.1  
Common Equity
    489.9       164.8             325.1  
Total Investments
  $ 551.3     $ 164.8     $     $ 386.5  
 

   
Fair Value Measurements
at 3/31/12 Using
 
Asset Category
 
Total
   
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
Debt
  $ 11.2     $     $     $ 11.2  
Partnership Interests
    11.0                   11.0  
Preferred Equity
    33.9                   33.9  
Common Equity
    502.4       240.7             261.7  
Total Investments
  $ 558.5     $ 240.7     $     $ 317.8  

The following table provides a summary of changes in the fair value of investments measured using Level 3 inputs during the nine months ended December 31, 2012 (in millions):

   
Fair
Value
3/31/12
   
Net
Unrealized Appreciation (Depreciation)
   
Net
Changes
from
Unrealized
to Realized
   
New /
Add-On
Invest-
ments
   
Conversion of Security from Debt to Equity
   
Fair
Value
12/31/12
 
Debt
  $ 11.2     $ (4.2 )   $     $ 3.5     $ (3.2 )   $ 7.3  
Partnership Interest
    11.0       (0.4 )     (0.8 )     0.2             10.0  
Preferred Equity
    33.9       11.8       (4.8 )           3.2       44.1  
Common Equity
    261.7       64.1       (0.7 )                 325.1  
Total Investments
  $ 317.8     $ 71.3     $ (6.3 )   $ 3.7     $     $ 386.5  

The total unrealized gains included in earnings that related to assets still held at report date for the nine months ended December 31, 2012 and 2011 were $78,199,034 and $10,243,394, respectively.

4. 
INCOME TAXES

We operate to qualify as a RIC under Subchapter M of the IRC and have a calendar tax year end of December 31.  In order to qualify as a RIC, we must annually distribute at least 90% of our investment company taxable ordinary income, based on our tax year, to our shareholders in a timely manner.  Investment company ordinary income includes net short-term capital gains but excludes net long-term capital gains.  A RIC is not subject to federal income tax on the portion of its ordinary income and long-term capital gains that are distributed to its shareholders, including “deemed distributions” discussed below.  As permitted by the Code, a RIC can designate dividends paid in the subsequent tax year as dividends of current year ordinary income and net long-term gains if those dividends are both declared by the extended due date of the RIC’s federal income tax return and paid to shareholders by the last day of the subsequent tax year.

We have distributed or intend to distribute sufficient dividends to eliminate taxable income for our completed tax years.  If we fail to satisfy the 90% distribution requirement or otherwise fail to qualify as a RIC in any tax year, we would be subject to tax in such year on all of our taxable income, regardless of whether we made any distributions to our shareholders.  For the tax years ended December 31, 2012 and 2011, we declared and paid ordinary dividends in the amounts of $3,025,032 and $3,003,030, respectively.
 

Additionally, we are subject to a nondeductible federal excise tax of 4% if we do not distribute at least 98% of our investment company ordinary taxable income before the end of our tax year. For the tax years ended December 31, 2012 and 2011, we distributed 100% of our investment company ordinary taxable income.  As a result, we have made no tax provisions for income taxes on ordinary taxable income for the tax years ended December 31, 2012 and 2011.

A RIC may elect to retain its long-term capital gains by designating them as “deemed distribution” to its shareholders and paying a federal tax rate of 35% on the long-term capital gains for the benefit of its shareholders.  Shareholders then report their share of the retained capital gains on their income tax returns as if it had been received and report a tax credit for tax paid on their behalf by the RIC.  Shareholders then add the amount of the “deemed distribution” net of such tax, to the basis of their shares.

 
·
Historically, we have not distributed net capital gains; however, during the nine months ended December 31, 2012, we distributed capital gains dividends in the amount of $17.59 per share to our shareholders. For the tax year ended December 31, 2012, we had net long-term capital gains of $3,214,547 for tax purposes and $2,319,012 for book purposes, which we elected to retain and treat as deemed distributions to our shareholders. For the tax year ended December 31, 2011, we had net long-term capital gains of $3,568,376 for tax purposes and $4,465,088 for book purposes, which we elected to retain and treat as deemed distributions to our shareholders.

 
·
In order to make the election to retain capital gains, we incurred federal taxes on behalf of our shareholders in the amount of $1,125,092 for the tax year ended December 31, 2012.  For the tax year ended December 31, 2011, we incurred federal taxes on behalf of our shareholders in the amount of $1,248,932.
 
For the quarters ended December 31, 2012 and 2011, CSW and CSVC qualified to be taxed as RICs.  We intend to meet the applicable qualifications to be taxed as a RIC in future years.  Management feels it is probable that we will maintain our RIC status for a period longer than one year.  However, either company’s ability to meet certain portfolio diversification requirements of RICs in future years may not be controllable by such company.

CSMC, a wholly owned subsidiary of CSW, is not a RIC and is required to pay taxes at the current corporate rate.  CSMC sponsors a qualified defined benefit pension plan which covers its employees and employees of certain of its wholly owned portfolio companies.  Deferred taxes related to the qualified defined pension plan are recorded as incurred.

5. 
ACCUMULATED NET REALIZED GAINS (LOSSES) ON INVESTMENTS

Distributions made by RICs often differ from aggregate GAAP-basis undistributed net investment income and accumulated net realized gains (total GAAP-basis net realized gains).  The principal cause is that required minimum fund distributions are based on income and gain amounts determined in accordance with federal income tax regulations, rather than GAAP.  The differences created can be temporary, meaning that they will reverse in the future, or they can be permanent.  In subsequent periods, when all or a portion of a temporary difference becomes a permanent difference, the amount of the permanent difference will be reclassified to “additional capital.”

 
We incur federal taxes on behalf of our shareholders as a result of our election to retain long-term capital gains. Historically, we have not distributed net capital gains; however, during the nine months ended December 31, 2012, we distributed capital gains dividends in the amount of $17.59 per share to our shareholders. As of December 31, 2012, we had accumulated long-term capital gains of $1,820,574. As of March 31, 2012 we had accumulated long-term capital gains of $498,438.  In accordance with the RIC rules, we elected to retain our long-term capital gains for the tax year ended December 31, 2012, pay the applicable income taxes of  $1,125,092, and designate the after-tax gain as “deemed distributions” to our shareholders.  “Deemed distributions” are reclassed from accumulated net realized gains into additional paid in capital. As of December 31, 2012, we reclassed $1,193,920 as “deemed distributions.”
 
6. 
EMPLOYEE STOCK OPTION PLANS

On July 20, 2009, shareholders approved our 2009 Stock Incentive Plan (the “2009 Plan”), which provides for the granting of stock options to employees and officers  and authorizes the issuance of common stock upon exercise of such options for up to 140,000 shares.  All options are granted at or above market price, generally expire up to ten years from the date of grant and are generally exercisable on or after the first anniversary of the date of grant in five annual installments.  Options to purchase 38,750 shares at a price of $76.74 (market price at the time of the grant) were granted on October 19, 2009. Additionally, options to purchase 20,000 shares at a price of $95.79 (market price at time of the grant) were granted on March 22, 2010, options to purchase 15,000 shares at a price of $88.20 were granted on July 19, 2010 and options to purchase 10,000 shares at a price of $96.92 were granted on July 18, 2011. During the quarter ended December 31, 2012, 1,300 options were exercised, thus leaving 49,650 options outstanding and 70,250 options available for grant under the 2009 Plan.

We previously granted stock options under our 1999 Stock Option Plan (the “1999 Plan”), as approved by shareholders on July 19, 1999.  The 1999 Plan expired on April 19, 2009.  Options previously made under our 1999 Stock Option Plan and outstanding on July 20, 2009 continue in effect governed by provisions of the 1999 Plan.  All options granted under the 1999 Plan were granted at or above market price, generally expire up to ten years from the date of grant and are generally exercisable on or after the first anniversary of the date of grant in five to ten annual installments. During the quarter ended December 31, 2012, 4,000 options were forfeited and 1,015 options were exercised, thus leaving 63,500 options outstanding under the 1999 Plan.

We recognize compensation cost over the straight-line method for all share-based payments granted on or after that date and for all awards granted to employees prior to April 1, 2006 that remain unvested on that date.  The fair value of stock options are determined on the date of grant using the Black-Scholes pricing model and are expensed over the vesting period of the related stock options.  Accordingly, for the quarters ended December 31, 2012 and 2011, we recognized compensation expense of $33,769 and $253,350, respectively.

As of December 31, 2012, the total remaining unrecognized compensation cost related to non-vested stock options was $1,040,698, which will be amortized over the remaining weighted average service period of approximately 1.5 years.
 

The following table summarizes the 2009 Plan and the 1999 Plan price per option at grant date using the Black-Scholes pricing model:

         
Black-Scholes Pricing Model Assumptions
       
Date of Issuance
 
Weighted Average
Fair
Value
   
Expected Dividend
Yield
   
Risk-
Free
Interest
Rate
   
Expected Volatility
   
Expected
Life 
(in years)
 
2009 Plan
                             
July 18, 2011
  $ 33.07       0.83 %     1.45 %     40.0 %     5  
July 19, 2010
  $ 28.58       0.91 %     1.73 %     37.5 %     5  
March 22, 2010
  $ 32.56       0.84 %     2.43 %     37.8 %     5  
October 19, 2009
  $ 25.36       1.04 %     2.36 %     37.6 %     5  
1999 Plan
                                       
July 30, 2008
  $ 29.93       0.62 %     3.36 %     20.2 %     5  
July 21, 2008
  $ 27.35       0.67 %     3.41 %     20.2 %     5  
July 16, 2007
  $ 41.78       0.39 %     4.95 %     19.9 %     5  
July 17, 2006
  $ 33.05       0.61 %     5.04 %     21.2 %     7  
May 15, 2006
  $ 31.28       0.64 %     5.08 %     21.1 %     7  

The following table summarizes activity in the 2009 Plan and the 1999 Plan as of December 31, 2012:

   
Number of Shares
   
Weighted Average Exercise
Price
 
2009 Plan
           
Balance at March 31, 2011
    73,750     $ 84.24  
Granted
    10,000       96.92  
Exercised
           
Canceled / Forfeited
           
Balance at March 31, 2012
    83,750     $ 85.75  
Granted
           
Exercised
    (20,100 )     79.91  
Canceled / Forfeited
    (14,000 )     98.64  
Balance at December 31, 2012
    49,650     $ 88.11  
                 
1999 Plan
               
Balance at March 31, 2011
    96,500     $ 114.78  
Granted
           
Exercised
    (1,500 )     65.70  
Canceled / Forfeited
           
Balance at March 31, 2012
    95,000     $ 113.63  
Granted
           
Exercised
    (17,105 )     95.55  
Canceled / Forfeited
    (14,395 )     111.14  
Balance at December 31, 2012
    63,500     $ 130.80  
Combined Balance at December 31, 2012
    113,150     $ 112.06  
 
 
December 31, 2012
 
Weighted Average Aggregate
Intrinsic Remaining Contractual Term
 
Value
 
Outstanding
 
1.5 years
  $ 3,534,415  
Exercisable
 
 1.0 years
  $ 2,263,512  

At December 31, 2012, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $76.74 to $152.98 and 1.0 year, respectively.  The total number of options exercisable under both the 2009 Plan and the 1999 Plan at December 31, 2012 and 2011, was 68,150 shares with a weighted-average exercise price of $124.39 and 83,590 with a weighted-average exercise price of $113.04, respectively. During the nine months ended December 31, 2012, 28,395 options were forfeited, 37,205 options were exercised. There were 1,500 options exercised and new shares issued for $98,550 in cash during the nine months ended December 31, 2011.

Stock Awards

Pursuant to the Capital Southwest Corporation 2010 Restricted Stock Award Plan, our Board of Directors has reserved for issuance 47,000 shares of restricted stock to certain key employees. A restricted stock award is an award of shares of our common stock (which have full voting and dividend rights but are restricted with regard to sale or transfer), the restrictions on which lapse ratably over a specified period of time (generally five years). Restricted stock awards are independent of stock option grants and are subject to forfeit if employment terminates prior to these restrictions lapsing. These shares vest over a five-year period from the grant date and are expensed over the five-year service period starting on the grant date. On January 16, 2012, the Board of Directors granted 9,650 shares of restricted stock to key employees of the Company. During the nine months ended December 31, 2012, 3,000 shares of restricted stock were forfeited. The following table summarizes the restricted stock available for issuance as of December 31, 2012:

Restricted stock available for issuance as of March 31, 2012
 
37,350
 
Less restricted stock forfeited during the year
 
(3,000
)
Restricted stock available for issuance as of December 31, 2012
 
40,350
 

We expense the cost of the restricted stock awards, which is determined to equal the fair value of the restricted stock award at the date of the grant on a straight-line basis over the vesting period in which the restrictions on these stock awards lapse. For these purposes, the fair value of the restricted stock award is determined based on the closing price of our common stock on the date of grant. For the quarter ended December 31, 2012, we recognized total share based compensation expense of $27,797 related to the restricted stock issued to our employees and officers.  For the quarter ended December 31, 2011, no restricted stock had been issued.

As of December 31, 2012, the total remaining unrecognized compensation cost related to non-vested restricted stock awards was $444,752, which will be amortized over the weighted-average service period of approximately 4.1 years.
 

The following table represents a summary of the activity for our restricted stock awards for the fiscal year ended December 31, 2012:

Restricted Stock Awards
 
Number of Shares
   
Weighted Average Fair Value Per
Share
   
Weighted
Average
Remaining
Vesting Term
(in Years)
 
Unvested at March 31, 2012
    9,650     $ 83.60       4.8  
Granted
                 
Vested
                 
Forfeited or expired
    (3,000 )   $ 83.60        
Unvested at December 31, 2012
    6,650     $ 83.60       4.1  

Phantom Stock Plan
 
On January 16, 2012, our Board of Directors approved the issuance of 26,000 phantom stock options pursuant to the Capital Southwest Corporation Phantom Stock Option Plan to provide deferred compensation to certain key employees.  Under the plan, awards vest on the fifth anniversary of the award date. Upon exercise of the phantom option, a cash payment in an amount for each phantom share equal to estimated fair market value minus the phantom option exercise price will be distributed to plan participants. The exercise price of each phantom share is $146.95 (Net Asset Value at December 31, 2011), and the estimated liability for phantom stock awards is $541,865 as of December 31, 2012.

The following table represents a summary of the activity for our phantom stock plan for the fiscal year ended December 31, 2012:

Phantom Stock Awards
 
Number of Shares
   
Exercise Price Per Share
   
Weighted
Average
Remaining
Vesting Term
(in Years)
 
Unvested at March 31, 2012
    26,000     $ 146.95       4.8  
Granted
                 
Vested
                 
Forfeited or expired
    (7,500 )   $ 146.95        
Unvested at December 31, 2012
    18,500     $ 146.95       4.1  
 
7. 
COMMITMENTS

From time to time, the Company may be liable for claims against its portfolio companies.  We do not believe the effects of such claims would have a material impact on our results of operations and financial condition.

CSW has agreed, subject to certain conditions, to invest up to $8,456,366 in nine portfolio companies as of December 31, 2012.
 
 
8. 
SUMMARY OF PER SHARE INFORMATION

The following presents a summary of per share data for the three and nine months ended December 31, 2012 and 2011.

   
Three Months Ended
December 31
   
Nine Months Ended
December 31
 
Per Share Data
 
2012
   
2011
   
2012
   
2011
 
Investment income
  $ 1.84     $ 1.50     $ 2.57     $ 2.15  
Operating expenses
    (.74 )     (.32 )     (1.50 )     (.96 )
Income taxes
    (.01 )     (.01 )     (.01 )     (.01 )
Net investment income
    1.09       1.17       1.06       1.18  
Distributions from undistributed net investment income
    (.40 )     (.40 )     (.80 )     (.80 )
Net realized gain/(loss) net of tax
    .17       (.64 )     17.78       2.68  
Net increase (decrease) in unrealized appreciation of investments
    5.87       13.00       (1.56 )     .04  
Dividends from capital gains
                  (17.59 )        
Exercise of employee stock options
    (.04 )           (.76 )     (.03 )
Stock option expense
    .02       .07       .09       .20  
Other*
                (.31 )      
Increase (decrease) in net asset value
    6.71       13.20       (2.09 )     3.27  
Net asset value
                               
Beginning of period
    158.65       133.75