0001140361-14-004978.txt : 20140206 0001140361-14-004978.hdr.sgml : 20140206 20140206113016 ACCESSION NUMBER: 0001140361-14-004978 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20131231 FILED AS OF DATE: 20140206 DATE AS OF CHANGE: 20140206 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CAPITAL SOUTHWEST CORP CENTRAL INDEX KEY: 0000017313 IRS NUMBER: 751072796 STATE OF INCORPORATION: TX FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 814-00061 FILM NUMBER: 14578670 BUSINESS ADDRESS: STREET 1: 12900 PRESTON RD STE 700 CITY: DALLAS STATE: TX ZIP: 75230 BUSINESS PHONE: 9722338242 MAIL ADDRESS: STREET 1: 12900 PRESTON RD STREET 2: SUITE 700 CITY: DALLAS STATE: TX ZIP: 75230 10-Q 1 form10q.htm CAPITAL SOUTHWEST CORP 10-Q 12-31-2013


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, 2013

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. Identification No.) Employer

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 definitions of “large accelerated filer,” “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.

15,285,544 shares of Common Stock, $0.25 par value, as of February 4, 2014
 



TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION
Page
 
 
 
Item 1.
Consolidated Financial Statements                                                                                                          
3
 
3
 
4
 
5
 
6
 
7
 
Notes to Consolidated Financial Statements                                                                                                            
19
Item 2.
33
Item 3.
37
Item 4.
Controls and Procedures                                                                                                   
38
 
 
 
PART II
OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings                                                                                           
38
Item 1A.
Risk Factors                                                                                           
38
Item 6.
Exhibits                                                                                                       
38
 
 
 
                                                                                                             
39

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,
2013
   
March 31,
 2013
 
Assets
 
(Unaudited)
   
 
Investments at market or fair value
 
   
 
Companies more than 25% owned (Cost: December 31, 2013 - $13,711; March 31, 2013 - $13,711)
 
$
370,879
   
$
344,790
 
Companies 5% to 25% owned (Cost: December 31, 2013 - $15,594; March 31, 2013 - $15,594)
   
245,896
     
157,394
 
Companies less than 5% owned (Cost: December 31, 2013 - $69,461; March 31, 2013 - $58,961)
   
77,227
     
72,003
 
Total investments (Cost: December 31, 2013 - $98,766, March 31, 2013 - $88,266)
   
694,002
     
574,187
 
Cash and cash equivalents
   
65,717
     
81,767
 
Receivables
               
Dividends and interest
   
10,366
     
2,465
 
Affiliates
   
656
     
291
 
Pension assets
   
8,981
     
8,762
 
Other assets
   
154
     
200
 
Total assets
 
$
779,876
   
$
667,672
 
Liabilities
               
Accounts payable and accrued expenses
 
$
3,826
   
$
3,102
 
Income taxes payable
   
4,110
     
-
 
Accrued pension cost
   
3,001
     
2,650
 
Deferred income taxes
   
1,088
     
2,143
 
Total liabilities
   
12,025
     
7,895
 
Net Assets
               
Common stock, $.25 par value: authorized, 25,000,000 shares; issued, 17,620,256 shares at December 31, 2013 and 17,576,776 at March 31, 2013
   
4,405
     
4,394
 
Additional capital
   
192,035
     
183,668
 
Accumulated net investment income(loss)
   
112
     
(706
)
Accumulated net realized gain
   
-
     
10,437
 
Unrealized appreciation of investments
   
595,236
     
485,921
 
Treasury stock - 2,339,512 shares, at cost
   
(23,937
)
   
(23,937
)
Total net assets
   
767,851
     
659,777
 
Total liabilities and net assets
 
$
779,876
   
$
667,672
 
Net asset value per share (on 15,280,744 shares outstanding at December 31, 2013 and 15,237,264 at March 31, 2013)
 
$
50.25
   
$
43.30
 

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
 
 
 
2013
   
2012
   
2013
   
2012
 
Investment income:
 
   
   
   
 
Interest
 
$
147
   
$
518
   
$
766
   
$
1,696
 
Dividends
   
8,072
     
6,308
     
9,162
     
7,548
 
Management and other income
   
144
     
146
     
467
     
523
 
 
   
8,363
     
6,972
     
10,395
     
9,767
 
Operating expenses:
                               
Salaries
   
2,236
     
2,357
     
5,103
     
3,720
 
Stock option expense
   
(2
)
   
62
     
347
     
334
 
Net pension expense(benefit)
   
45
     
(9
)
   
132
     
(26
)
Professional fees
   
251
     
191
     
664
     
767
 
Other operating expenses
   
273
     
272
     
1,064
     
935
 
 
   
2,803
     
2,873
     
7,310
     
5,730
 
Income before income taxes
   
5,560
     
4,099
     
3,085
     
4,037
 
Income tax benefit
   
(700
)
   
(43
)
   
(782
)
   
(3
)
 
                               
Net investment income
 
$
6,260
   
$
4,142
   
$
3,867
   
$
4,040
 
 
                               
Proceeds from disposition of investments
 
$
-
   
$
11,023
   
$
55
   
$
78,528
 
Cost of investments sold
   
-
     
9,258
     
-
     
9,882
 
Realized gain on investments before income tax
   
-
     
1,765
     
55
     
68,646
 
Net increase (decrease) in unrealized appreciation of investments
   
53,308
     
22,296
     
109,315
     
(5,904
)
 
                               
Net realized and unrealized gain on investments
 
$
53,308
   
$
24,061
   
$
109,370
   
$
62,742
 
 
                               
Increase in net assets from operations
 
$
59,568
   
$
28,203
   
$
113,237
   
$
66,782
 

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
   
Nine Months
Ended
 
 
 
December 31, 2013
   
December 31, 2012
 
Operations:
 
   
 
Net investment income
 
$
3,867
   
$
4,040
 
Net realized gain on investments
   
55
     
68,646
 
Net increase (decrease) in unrealized appreciation of investments
   
109,315
     
(5,904
)
Increase in net assets from operations
   
113,237
     
66,782
 
Distributions from:
               
Undistributed net investment income
   
(3,050
)
   
(3,025
)
Net realized gain distribution
   
-
     
(66,826
)
Taxes incurred in deemed capital gain distributions
   
(3,787
)
   
(1,125
)
Capital share transactions:
               
Exercise of employee stock options
   
1,327
     
3,243
 
Stock option expense
   
347
     
334
 
Increase(decrease) in net assets
   
108,074
     
(617
)
Net assets, beginning of period
   
659,777
     
628,706
 
Net assets, end of period
 
$
767,851
   
$
628,089
 
 
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
 
 
 
2013
   
2012
   
2013
   
2012
 
Cash flows from operating activities
 
   
   
   
 
Increase in net assets from operations
 
$
59,568
   
$
28,203
   
$
113,237
   
$
66,782
 
Adjustments to reconcile increase in net assets from operations to net cash (used in) provided by operating activities:
                               
Net proceeds from disposition of investments
   
     
11,023
     
55
     
78,521
 
Return of Capital on Investment
   
     
511
     
     
768
 
Purchases of securities
   
(679
)
   
(2,482
)
   
(10,501
)
   
(9,278
)
Depreciation and amortization
   
5
     
7
     
16
     
25
 
Net pension expense (benefit)
   
44
     
(9
)
   
132
     
(26
)
Realized gain on investments before income tax
   
     
(1,765
)
   
(55
)
   
(68,646
)
Taxes incurred on deemed capital gain distribution
   
(3,787
)
   
(1,125
)
   
(3,787
)
   
(1,125
)
Net (increase) decrease in unrealized appreciation of investments
   
(53,308
)
   
(22,296
)
   
(109,315
)
   
5,904
 
Stock option expense
   
(2
)
   
62
     
347
     
334
 
Increase in dividend and interest receivable
   
(7,881
)
   
(5,586
)
   
(7,901
)
   
(6,462
)
Increase in receivables from affiliates
   
(136
)
   
(104
)
   
(365
)
   
(218
)
Decrease (Increase) in other assets
   
(13
)
   
22
     
31
     
32
 
Increase in taxes payable
   
4,110
     
1,125
     
4,110
     
1,125
 
Increase in other liabilities
   
1,295
     
1,687
     
724
     
1,591
 
(Decrease) Increase in deferred income taxes
   
(1,024
)
   
(43
)
   
(1,055
)
   
9
 
Net cash (used in) provided by operating activities
   
(1,808
)
   
9,230
     
(14,327
)
   
69,336
 
Cash flows from financing activities
                               
Distributions from undistributed net investment income
   
(1,525
)
   
(1,520
)
   
(3,050
)
   
(3,025
)
Dividends paid from net realized capital gain
   
     
     
     
(66,826
)
Proceeds from exercise of employee stock options
   
868
     
226
     
1,327
     
3,243
 
Net cash used in financing activities
   
(657
)
   
(1,294
)
   
(1,723
)
   
(66,608
)
Net (decrease) increase in cash and cash equivalents
   
(2,465
)
   
7,936
     
(16,050
)
   
2,728
 
Cash and cash equivalents at beginning of period
   
68,182
     
59,687
     
81,767
     
64,895
 
Cash and cash equivalents at end of period
 
$
65,717
   
$
67,623
   
$
65,717
   
$
67,623
 

The accompanying Notes are an integral part of these Consolidated Financial Statements.
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
December 31, 2013

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 and snow removal equipment for municipalities.
   
22.0
%
‡2,832,300 shares of common stock (acquired 4-1-73 thru 5-09-13)
 
$
2,190,937
   
$
171,831,597
 
ATLANTIC CAPITAL BANCSHARES, INC
Atlanta, Georgia
Holding company of Atlantic Capital Bank, a full service commercial bank.
   
1.9
%
300,000 shares of common stock (acquired 4-10-07)
   
3,000,000
     
3,656,000
 
¥BALCO, INC.
Wichita, Kansas
Specialty architectural products used in the construction and remodeling of commercial and institutional buildings.
   
95.7
%
445,000 shares of 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 of 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
     
1,020,000
 
¥ CAPSTAR HOLDINGS CORPORATION
Dallas, Texas
Acquires holds and manages real estate for potential development and sale.
   
100
%
500 shares of common stock (acquired 6-10-10) and 1,000,000 shares of preferred stock (acquired 12-17-12)
   
4,703,619
     
7,572,000
 
CINATRA CLEAN TECHNOLOGIES, INC.
Houston, Texas
Cleans above ground oil storage tanks with a patented, automated system.
 
 
 
 
   
76.2
%
12% subordinated secured promissory note, due 5-9-16 (acquired 5-19-10 thru 10-20-10)
   
779,278
     
1
 
       
12% subordinated secured promissory note, due 5-9-17 (acquired 5-9-11 thru 10-26-11)
   
2,285,700
     
1
 
       
12% subordinated secured promissory note, due 3-31-17 (acquired 9-9-11 and 10-26-11)
   
1,523,800
     
1
 
       
10% subordinated secured promissory note, due 5-9-17 (acquired 7-14-08 thru 4-28-10)
   
6,200,700
     
1
 
       
12% subordinated secured promissory note, due 10-31-17 (acquired 10-19-12)
   
499,997
     
1
 
       
12% subordinated secured promissory note, due 9-30-14 (acquired 7-25-13)
   
1,157,850
     
1
 
       
3,033,410 shares of Series A Convertible Preferred Stock, convertible into 3,033,410 shares of 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)
   
     
 
 
       
 
   
15,480,735
     
7
 
 
†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, 2013
 
Company
   
Equity (a)
   
Investment (b)
   
Cost
     
Value (c)
DEEPWATER CORROSION SERVICES, INC.
Houston, Texas
Full-service corrosion control   company providing the oil and gas industry with expertise in cathodic protection and asset integrity management.
   
31.3
%
127,004 shares of Series A convertible preferred stock, convertible into 127,004 shares of common stock at $1.00 per shares (acquired 4-9-13)
   
8,000,000
     
8,000,000
 
¥DISCOVERY ALLIANCE, LLC
Dallas, Texas
Provides services related to intellectual property protection and development.
   
90
%
90.0% limited liability company interest (acquired  9-12-08 thru 10-15-12)
 
   
1,315,000
     
404,000
 
*†ENCORE WIRE
CORPORATION
McKinney, Texas
Electric wire and cable for residential, commercial and industrial construction use.
   
6.2
%
‡1,312,500 shares of common stock (acquired 9-10-92 thru 10-15-98)
   
5,200,000
     
71,019,375
 
HOLOGIC, INC.
Bedford, Massachusetts
Medical diagnostic products, imaging systems and surgical products serving the healthcare needs of women.
 
< 1
‡582,820 shares of common stock (acquired 8-27-99)
   
202,529
     
13,020,199
 
iMEMORIES, INC.
Scottsdale, Arizona
Enables online video and photo sharing and DVD creation for home movies and photos recorded in analog and digital formats.
 
 
   
23.3
%
17,391,304 shares of 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 of 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 7-31-14 (acquired  9-7-12)
   
308,000
     
308,000
 
 
       
10% convertible notes, $880,000 principal due 7-31-14 (acquired  from 3-15-13 to 9-26-13)
   
880,000
     
880,000
 
 
       
 
   
6,266,479
     
6,266,479
 
INSTAWARES HOLDING COMPANY, LLC
Atlanta, Georgia
Provides services and distributes equipment and supplies to the restaurant industry via its five subsidiary companies.
   
4.3
%
3,846,154 Class D Convertible Preferred Stock (acquired 5-20-11)
   
5,000,000
     
3,652,000
 
 
†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, 2013
 
Company
   
Equity (a)
   
Investment (b)
   
Cost
     
Value (c)
 
KBI BIOPHARMA, INC.
Durham, North Carolina
Provides fully-integrated, outsourced drug development and bio-manufacturing services.
 
 
   
17.1
%
10,204,082 shares of Series B-2 Convertible Preferred Stock, convertible into 10,204,802 shares of common stock at $0.49 per share (acquired 9-08-09)
   
5,000,000
     
6,900,000
 
       
Warrants to purchase 94,510 shares of Series B preferred stock at $ 0.70 per share, acquired 1-26-12
   
-
     
-
 
       
 
   
5,000,000
     
6,900,000
 
¥MEDIA RECOVERY, INC.
Dallas, Texas
Distributor of computer datacenter and office automation supplies and accessories; manufactures and distributes devices used to monitor and manage intransit inventory and dunnage products for protecting shipments.
   
97.9
%
800,000 shares of Series A Convertible Preferred Stock, convertible into 800,000 shares of common stock at $1.00 per share (acquired 11-4-97)
   
800,000
     
2,900,000
 
       
4,000,002 shares of common stock (acquired 11-4-97)
   
4,615,000
     
14,300,000
 
       
 
   
5,415,000
     
17,200,000
 
*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 of common stock (acquired 10-18-01)
   
150,000
     
2
 
       
 
   
1,703,150
     
2,000,002
 
¥THE RECTORSEAL CORPORATION
Houston, Texas
Specialty chemicals, tools and products for plumbing, HVAC, electrical, construction, industrial, and oil field; smoke containment systems for building fires; also owns 20% of The Whitmore Manufacturing Company.
   
100.0
%
27,907 shares of common stock (acquired 1-5-73 and 3-31-73)
   
52,600
     
257,900,000
 
TITANLINER, INC.
Midland, Texas
Manufactures, installs and rents spill containment system for oilfield applications.
   
31.2
%
217,038 shares of Series A Convertible Preferred Stock convertible into 217,038 shares of Series A Preferred Stock at $14.76 per share (acquired 6-29-12)
   
3,203,000
     
-
 
       
7%  senior subordinated secured promissory note, due 6-30-17 (acquired 6-29-12)
   
2,747,000
     
2,536,000
 
       
Warrants to purchase 122,239 shares of Series A Preferred Stock at $ 0.01 per share, expiring 12-31-22
   
-
     
-
 
       
 
   
5,950,000
     
2,536,000
 
 
†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, 2013
 
Company
   
Equity (a)
   
Investment (b)
   
Cost
     
Value (c)
 
TRAX HOLDINGS, INC.
Scottsdale, Arizona
Provides a comprehensive set of solutions to improve the  validation, accounting and payment of transportation-related invoices.
   
28.4
%
475,430 shares of Series B convertible Preferred Stock convertible into 475,430 shares of  common stock at $8.41 per share(acquired 12-5-12)
   
4,000,000
     
7,800,000
 
       
1,061,279 shares of Series A Convertible Preferred Stock, convertible into 1,061,279 shares of common stock at $4.71 per share (acquired 12-8-08 and 2-17-09)
   
5,000,000
     
13,500,000
 
       
 
   
9,000,000
     
21,300,000
 
*WELLOGIX, INC.
Houston, Texas
Formerly a developer and supporter of business process software used by the oil and gas industry.
   
19.0
%
4,788,371 shares of Series A-1 Convertible Participating Preferred Stock, convertible into 4,788,371 shares of common stock at $1.04 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 of common stock (acquired 8-31-79)
   
1,600,000
     
83,000,000
 
MISCELLANEOUS
   
 
Ballast Point Ventures II, L.P.
2.2% limited partnership interest (acquired 8-4-08 thru 2-15-13)
   
1,959,790
     
2,757,000
 
 
   
 
BankCap Partners Fund I, L.P.
5.5% limited partnership interest (acquired 7-14-06 thru 11-16-12)
   
6,000,000
     
5,249,000
 
 
   
 
†Capitala Finance Corporation
108,105 shares of common stock (acquired 9-25-13)
   
1,363,799
     
2,151,290
 
 
   
 
CapitalSouth Partners Fund III, L.P.
1.9% limited partnership interest (acquired 1-22-08 and 11-16-11)
   
467,457
     
237,000
 
 
   
 
Diamond State Ventures, L.P.
1.4% limited partnership interest (acquired 10-12-99 thru 8-26-05)
   
-
     
16,000
 
 
   
 
First Capital Group of Texas III, L.P.
3.0% limited partnership interest (acquired 12-26-00 thru 8-12-05)
   
778,895
     
169,000
 
 
   
100
%
¥Humac Company
1,041,000 shares of common stock (acquired 1-31-75 and 12-31-75)
   
     
203,000
 
 
†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, 2013
 
Company    
Equity (a)
   
Investment (b)
   
Cost
     
Value (c)
Miscellaneous (continued)
 
   
 
†North American Energy Partners, Inc.
77,194 shares of common stock (acquired 8-20-12)
   
236,986
     
448,498
 
 
   
 
STARTech Seed Fund II
3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05)
   
754,327
     
161,000
 
 
   
 
TCI Holdings, Inc.
21 shares of 12% Series C Cumulative Compounding Preferred Stock (acquired 1-30-90)
   
     
708,000
 
TOTAL INVESTMENTS
          
  
 
$
98,766,223
   
$
694,002,447
 
 
†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, 2013

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 of common stock (acquired 4-1-73 thru 5-09-11)
 
$
2,190,937
   
$
108,278,100
 
ATLANTIC CAPITAL BANCSHARES, INC
Atlanta, Georgia
Holding company of Atlantic Capital Bank, a full service commercial bank.
   
1.9
%
300,000 shares of common stock (acquired 4-10-07)
   
3,000,000
     
2,950,000
 
¥BALCO, INC.
Wichita, Kansas
Specialty architectural products used in the construction and remodeling of commercial and institutional buildings.
   
95.7
%
445,000 shares of common stock and 60,920 shares Class B non-voting common stock (acquired 10-25-83 and 5-30-02)
   
624,920
     
4,500,000
 
*BOXX TECHNOLOGIES, INC.
Austin, Texas
Workstations for computer graphic imaging and design.
   
14.9
%
3,125,354 shares of 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
     
1,240,000
 
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
     
81,000
 
       
12% subordinated secured promissory note, due 5-9-17 (acquired 5-9-11 thru 10-26-11)
   
2,285,700
     
237,000
 
       
12% subordinated secured promissory note, due 3-31-17 (acquired 9-9-11 and 10-26-11)
   
1,523,800
     
158,000
 
       
10% subordinated secured promissory note, due 5-9-17 (acquired 7-14-08 thru 4-28-10)
   
6,200,700
     
643,000
 
 
       
12% subordinated secured promissory note, due 10-31-17 (acquired 10-19-12)
   
499,997
     
52,000
 
 
       
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
     
1,171,001
 
 
†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

March 31, 2013
 
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 of common stock (acquired 9-10-92 thru 10-15-98)
   
5,200,000
     
45,950,625
 
HOLOGIC, INC.
Bedford, Massachusetts
Medical instruments including bone densitometers, mammography devices and digital radiography systems.
 
 
< 1
%
‡582,820 shares of common stock (acquired 8-27-99)
   
202,529
     
13,165,904
 
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 of 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 of 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 7-31-14 (acquired  9-7-12)
   
308,000
     
308,000
 
       
10% convertible notes, $400,000 principal due 7-31-14 (acquired  3-15-13
   
440,000
     
440,000
 
 
       
 
   
5,826,479
     
5,826,479
 
INSTAWARES HOLDING COMPANY, LLC
Atlanta, Georgia
Provides services to the    restaurant industry via its five subsidiary companies.
   
4.5
%
3,846,154 shares of Class D Convertible Preferred Stock (acquired 5-20-11)
   
5,000,000
     
5,975,000
 
KBI BIOPHARMA, INC.
Durham, North Carolina
Provides fully-integrated, outsourced drug development and bio-manufacturing services.
 
   
17.1
%
10,204,082 shares of Series B-2 Convertible Preferred Stock, convertible into 10,204,802 shares of common stock at $0.49 per share (acquired 9-08-09)
 
   
5,000,000
     
5,200,000
 
       
Warrants to purchase 94,510 shares of Series B Preferred stock at $ 0.70 per share, acquired 1-26-12
   
-
     
-
 
 
       
 
   
5,000,000
     
5,200,000
 
 
†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, 2013
 
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 of Series A Convertible Preferred Stock, convertible into 800,000 shares of common stock at $1.00 per share (acquired 11-4-97)
 
   
800,000
     
2,000,000
 
       
4,000,002 shares of common stock (acquired 11-4-97)
   
4,615,000
     
9,900,000
 
 
       
 
   
5,415,000
     
11,900,000
 
*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
     
1,900,000
 
       
150,000 shares of common stock (acquired 10-18-01)
   
150,000
     
2
 
 
       
 
   
1,703,150
     
1,900,002
 
¥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 of common stock (acquired 1-5-73 and 3-31-73)
   
52,600
     
238,900,000
 
TCI HOLDINGS, INC.
Denver, Colorado
Cable television systems and microwave relay systems.
   
 
21 shares of 12% Series C Cumulative Compounding Preferred Stock (acquired 1-30-90)
   
     
763,000
 
TITANLINER, INC.
Midland, Texas
Manufactures, installs and rents spill containment system for oilfield applications.
 
 
   
29.9
%
217,038 shares of Series A Convertible Preferred Stock convertible into 217,038 shares of Series A Preferred Stock at $14.76 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 12-31-22
   
-
     
-
 
 
       
 
   
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

March 31, 2013
 
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 of Series B convertible Preferred Stock convertible into 475,430 shares of  common stock at $8.41 per share(acquired 12-5-12)
   
4,000,000
     
7,000,000
 
       
1,061,279 shares of Series A Convertible Preferred Stock, convertible into 1,061,279 shares of common stock at $4.71 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 of Series A-1 Convertible Participating Preferred Stock, convertible into 4,788,371 shares of common stock at $1.04 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 of common stock (acquired 8-31-79)
   
1,600,000
     
80,500,000
 
MISCELLANEOUS
   
 
Ballast Point Ventures II, L.P.
2.2% limited partnership interest (acquired 8-4-08 thru 2-15-13)
   
1,659,790
     
1,843,000
 
 
   
 
BankCap Partners Fund I, L.P.
5.5% limited partnership interest (acquired 7-14-06 thru 11-16-12)
   
5,897,276
     
5,013,000
 
 
   
 
CapitalSouth Partners Fund III, L.P.
1.9% limited partnership interest (acquired 1-22-08 and 11-16-11)
   
1,331,256
     
3,934,000
 
 
   
100.0
%
¥CapStar Holdings   Corporation
500 shares common stock (acquired 6-10-10); 1,000,000 shares of preferred stock (acquired 12-17-12)
   
4,703,619
     
7,846,000
 
 
†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, 2013
 
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)
   
-
     
120,000
 
 
   
 
¥Discovery Alliance, LLC
90.0% limited liability company interest (acquired  9-12-08 thru 10-15-12)
   
1,315,000
     
956,000
 
 
   
 
First Capital Group of Texas III, L.P.
3.0% limited partnership interest (acquired 12-26-00 thru 8-12-05)
   
778,895
     
190,000
 
 
   
100
%
¥Humac Company
1,041,000 shares common stock (acquired 1-31-75 and 12-31-75)
   
     
188,000
 
 
   
 
†North American Energy Partners, Inc.
77,194 shares of common stock (acquired 8-20-12)
   
236,986
     
350,461
 
 
   
   
STARTech Seed Fund II
3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05)
   
754,327
     
151,000
 
TOTAL INVESTMENTS
         
  
 
$
88,265,649
   
$
574,186,572
 
 
†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 collectively 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 owned by the Company, or which the Company has the right to 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, 2013, restricted securities represented approximately 63.1% of the value of the consolidated investment portfolio and unrestricted securities represented 36.9% of the value of the consolidated investment portfolio. At March 31, 2013, restricted securities represented approximately 70.8% of the value of the consolidated investment portfolio and unrestricted securities represented 29.2% of the value of the consolidated investment portfolio.

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; 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 securities 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 the underlying 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 of 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, 2013 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 Humac Company and The Whitmore Manufacturing Company which are not obligated to bear registration costs.

(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, as amended (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 controlled affiliates, fund holdings, publicly-traded holdings, and other non-control holdings. 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 the 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, consolidated financial statements include CSMC, our management company.

On July 15, 2013, a four-for-one split of our common stock was approved by our shareholders. The stock split was payable on August 15, 2013 to shareholders of record at the close of business on July 31, 2013. Our common stock began trading at the split-adjusted price on August 16, 2013. All share numbers and per share amounts presented herein reflect the stock split.

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 Topic 820 on April 1, 2008.  ASC Topic 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.  This topic 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.  This topic 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 Topic 820 does not eliminate practicability exceptions that exist in accounting pronouncements amended by this Statement 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.  Our Board of Directors retained Duff & Phelps to provide limited scope third party valuation services on three investments comprising 57.7% of our net asset value at March 31, 2013.

We believe our investments at December 31, 2013 and March 31, 2013 approximate fair value as of those dates based on the markets in which we operate and other conditions in existence at those reporting periods.

Investments. Investments are stated at fair value determined by our Board of Directors as described in the 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 generally will establish a reserve against the interest income. At that point, the loan or debt security’s status is on non-accrual basis, and we cease recognizing 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 its ability to service debt or, pay 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 (“RIC”s).  By meeting these requirements, we 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. 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, 2013 and 2012.
 
Deferred Taxes.  CSMC sponsors a qualified defined benefit pension plan which covers its employees and employees of certain wholly owned portfolio companies.  In addition, CSMC records phantom stock option and bonus accruals on a quarterly basis. Deferred taxes related to the qualified defined pension plan and phantom stock option and bonus accruals 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 expense over the straight-line method for all share-based payment awards granted to employees.  The fair value of stock options is determined on the date of grant using the Black-Scholes pricing model and is expensed over the vesting period of the related stock options. For restricted stock unit 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.  For phantom stock options, the option value of phantom stock awards is calculated based on the last available net asset value of the Company. We value phantom stock awards each quarter and either increase or decrease the liability based on the phantom option value. See Note 6 for further discussion.


Defined Pension Benefits and Other Postretirement Plans.  We record annual amounts relating to our defined benefit pension plan based on calculations, which include various actuarial assumptions such as discount rates and assumed rates of return. Material changes in pension costs could occur due to changes in the discount rate, in the expected long-term rate of return, or in the 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 our 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 our fiscal year-end, which is March 31.

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. We have not experienced any losses in such accounts and do not believe we are subject to any significant credit risk.
 
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 ASC.  We use judgment and consider factors specific to the investment in determining the significance of an input to a fair value measurement.  While we believe 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 unrestricted 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.

· 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 used Level 3 inputs for measuring the fair value of approximately 62.8% of our investments as of December 31, 2013.

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 inputs (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, and tangible book value multiples. Generally, increases or decreases in EBITDA or revenue multiple inputs result in a higher or lower 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 increases or decreases 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 generally evaluate limited partnership or limited liability company interests at cost, which is deemed to represent fair 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 the 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 by each fund 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, 2013 and March 31, 2013. 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 at 12/31/2013
 (in millions)
 
Unobservable
 Input
 
Range
   
Weighted
Average
 
Preferred & Common Equity
Market Approach
 
$
374.2
 
EBITDA Multiple
   
3.50x – 7.78
x
   
6.92
x
 
Market Approach
$
26.3
Revenue Multiple
2.50x – 2.98
x
2.59
x
 
Market Approach
$
7.6
Cash and Asset Value
NA
NA
 
Income Approach
$
0.7
Discount Rate
2.86
%
2.86
%
 
Market Approach
$
3.7
Multiple of Tangible Book Value
1.47
x
1.47
x
 
Market Approach
$
8.0
Recent Transaction Price
NA
NA
 
Market Approach
$
0.2
Market Value of Held Securities
NA
NA
 
  
 
$
420.7
 
 
               
Debt
Income Approach
 
$
4.6
 
Discount Rate
   
11.69% -13.02
%
   
12.28
%
 
Recent Transaction Price
$
1.2
Recent Transaction Price
NA
NA
 
  
 
$
5.8
 
 
               
Partnership Interests
Net Asset Value*
 
$
9.0
 
Fund Value
 
NA
   
NA
 
 
Total
$
435.5
 
Type
Valuation
Technique
 
Fair Value at 3/31/2013
 (in millions)
 
Unobservable
 Input
 
Range
   
Weighted
Average
 
Preferred & Common Equity
Market Approach
 
$
342.2
 
EBITDA Multiple
   
3.25x – 7.00
x
   
6.45
x
 
Market Approach
$
11.1
Revenue Multiple
0.25x – 1.82
x
0.97
x
 
Market Approach
$
7.9
Cash and Asset Value
NA
NA
 
Income Approach
$
0.7
Discount Rate
1.75
%
1.75
%
 
Market Approach
$
3.0
Multiple of Tangible Book Value
1.22
x
1.22
x
 
Market Approach
$
22.6
Recent Transaction Price
NA
NA
 
Market Approach
$
0.2
Market Value of Held Securities
NA
NA
 
  
 
$
387.7
 
 
               
Debt
Income Approach
 
$
3.1
 
Discount Rate
   
10.02% -12.00
%
   
10.77
%
 
Recent Transaction Price
$
3.5
Recent Transaction Price
NA
NA
 
  
 
$
6.6
 
 
               
Partnership Interests
Net Asset Value*
 
$
12.2
 
Fund Value
 
NA
   
NA
 
 
Total
$
406.5
 
*All funds are valued in accordance with ASC 820.

             As of December 31, 2013 and March 31, 2013, 62.8% and 70.8%, 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, 2013 and March 31, 2013 (in millions):

 
 
   
Fair Value Measurements
at 12/31/13 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
 
$
5.8
   
$
   
$
   
$
5.8
 
Partnership Interests
   
9.0
     
     
     
9.0
 
Preferred Equity
   
51.2
     
     
     
51.2
 
Common Equity
   
628.0
     
256.3
     
2.2
     
369.5
 
Total Investments
 
$
694.0
   
$
256.3
   
$
2.2
   
$
435.5
 
 
 
 
   
Fair Value Measurements
at 3/31/13 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
 
$
6.6
   
$
   
$
   
$
6.6
 
Partnership Interests
   
12.2
     
     
     
12.2
 
Preferred Equity
   
44.6
     
     
     
44.6
 
Common Equity
   
510.8
     
167.7
     
     
343.1
 
Total Investments
 
$
574.2
   
$
167.7
   
$
   
$
406.5
 

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, 2013 (in millions):

 
 
Fair
 Value
 3/31/13
   
Net
 Unrealized
Appreciation
(Depreciation)
   
New
 Investments
   
Distribution
   
Net
Changes
 from
 Unrealized
 to
 Realized
   
Conversion
 of Security
 from Debt
to Equity
   
Fair
Value at
 12/31/13
 
Debt
 
$
6.6
   
$
(2.4
)
 
$
1.6
   
$
   
$
   
$
   
$
5.8
 
Partnership Interests
   
12.2
     
(2.7
)
   
0.9
     
(1.4
)
   
     
     
9.0
 
Preferred Equity
   
44.6
     
(1.4
)
   
8.0
     
     
     
     
51.2
 
Common Equity
   
343.1
     
26.4
     
     
     
     
     
369.5
 
Total Investments
 
$
406.5
   
$
19.9
   
$
10.5
   
$
(1.4
)
 
$
   
$
   
$
435.5
 
 
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.  As permitted by the IRC, 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 any 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, 2013 and 2012, we declared and paid ordinary dividends in the amounts of $3,049,614 and $3,025,032, 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, 2013 and 2012, 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, 2013 and 2012.

A RIC may elect to retain its long-term capital gains by designating them as a “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 they 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.

           During our tax year ended December 31, 2013, we sold 9,317,310 shares of common stock of Heelys, Inc. to Sequential Brands Group, Inc. and generated cash proceeds of $20,963,948 and a capital gain of $20,861,458. Subsequently, we distributed and paid $0.69 per share or $10,474,932 of Heely’s gain to our shareholders on March 28, 2013. For the tax year ended December 31, 2013, we had net long-term capital gains of $10,819,079 for tax purposes and $10,491,526 for book purposes, which we elected to retain and treat as deemed distributions to our shareholders. During the tax year ended December 31, 2012, we distributed capital gains dividends in the amount of $4.40 per share or $66,825,782 to our shareholders; we also 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.

            In order to make the election to retain capital gains, we incurred federal taxes on behalf of our shareholders in the amount of $3,786,678 for the tax year ended December 31, 2013.  For the tax year ended December 31, 2012, we incurred federal taxes on behalf of our shareholders in the amount of $1,125,092.

For the quarter ended December 31, 2013 and 2012, CSW and CSVC qualified to be taxed as RICs.  We intend to continue meet the applicable qualifications to be taxed as a RIC.  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 wholly owned portfolio companies.  In addition, CSMC records phantom stock option and bonus accruals on a quarterly basis. Deferred taxes related to the qualified defined benefit pension plan and phantom stock option and bonus accruals are recorded as incurred. As of December 31, 2013, CSMC has a net deferred tax liability of $1,087,981.

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 of the difference 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. We had $10,491,526 and $10,436,526 of accumulated long term capital gains, as of December 31, 2013 and March 31, 2013, respectively. In accordance with the RIC rules, we elected to retain our long-term capital gains for the tax year ended December 31, 2013, incur the applicable income taxes of $3,786,678, and designate the after-tax gain as “deemed distributions” to shareholders. “Deemed distributions” are reclassified from accumulated net realized gains into additional paid in capital at the end of December.
6.
EMPLOYEE STOCK BASED COMPENSATION PLANS

On July 15, 2013, a four-for-one split of our common stock was approved by our shareholders. The stock split was payable on August 15, 2013 to shareholders of record at the close of business on July 31, 2013. Our common stock began trading at the split-adjusted price on August 16, 2013. All share numbers and per share amounts presented herein reflect the stock split.

Stock Options

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 560,000 shares.  All options are granted at or above market price, generally expire up to 10 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 155,000 shares at a price of $19.19 per share (market price at the time of grant) were granted on October 19, 2009. Additionally, options to purchase 80,000 shares at a price of $23.95 per share (market price at time of grant) were granted on March 22, 2010, options to purchase 60,000 shares at a price of $22.05 per share were granted on July 19, 2010 and options to purchase 40,000 shares at a price of $24.23 per share were granted on July 18, 2011. During the nine months ended December 31, 2013, options to purchase 30,000 shares at a price of $37.02 per share (market price at the time of grant) were granted on July 15, 2013. Additionally, 13,720 options were exercised and 47,000 options were forfeited during the nine months ended December 31, 2013 and thus leaving 140,188 options outstanding and 298,000 options available to grant under the 2009 Plan as of December 31, 2013.

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 10 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 nine months ended December 31, 2013, 38,000 options were exercised, thus leaving 208,000 options outstanding under the 1999 Plan.

We recognize compensation expense 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 is determined on the date of grant using the Black-Scholes pricing model and are expensed over the vesting period of the related stock options. Share-based compensation cost for restricted stock is measured based on the closing fair market value of our Company’s common stock on the date of the grant.  Accordingly, for the quarters ended December 31, 2013 and 2012, we recognized stock option compensation expense of $8,044 and  $33,769, respectively. For the nine months ended December 31, 2013 and 2012, we recognized stock option compensation expense of $283,341 and $ 262,785, respectively. Changes in stock option compensation expense for 2013 versus 2012 is due to forfeitures of unexercised stock options that occurred with the departures of employees during the quarter ended December 31, 2013.

As of December 31, 2013, the total remaining unrecognized compensation expense related to non-vested stock options was $691,754, which will be amortized over the weighted-average service period of approximately 0.9 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
 
$
8.27
     
0.83
%
   
1.45
%
   
40.0
%
   
5
 
July 19, 2010
 
$
7.15
     
0.91
%
   
1.73
%
   
37.5
%
   
5
 
March 22, 2010
 
$
8.14
     
0.84
%
   
2.43
%
   
37.8
%
   
5
 
October 19, 2009
 
$
6.34
     
1.04
%
   
2.36
%
   
37.6
%
   
5
 
July 15, 2013
 
$
14.80
     
0.54
%
   
1.40
%
   
46.6
%
   
5
 
1999 Plan
                                       
July 30, 2008
 
$
7.48
     
0.62
%
   
3.36
%
   
20.2
%
   
5
 
July 21, 2008
 
$
6.84
     
0.67
%
   
3.41
%
   
20.2
%
   
5
 
July 16, 2007
 
$
10.44
     
0.39
%
   
4.95
%
   
19.9
%
   
5
 
July 17, 2006
 
$
8.26
     
0.61
%
   
5.04
%
   
21.2
%
   
7
 
May 15, 2006
 
$
7.82
     
0.64
%
   
5.08
%
   
21.1
%
   
7
 
 
The following table summarizes activity in the 2009 Plan and the 1999 Plan as of December 31, 2013:
 
 
 
Number of Shares
   
Weighted
Average
 Exercise
 Price
 
2009 Plan
 
   
 
Balance at March 31, 2011
   
295,000
   
$
21.06
 
Granted
   
40,000
     
24.23
 
Exercised
   
     
 
Canceled/Forfeited
   
     
 
Balance at March 31, 2012
   
335,000
     
21.44
 
Granted
   
     
 
Exercised
   
(108,092
)
   
19.96
 
Canceled/Forfeited
   
(56,000
)
   
21.44
 
Balance at March 31, 2013
   
170,908
     
22.37
 
Granted
   
30,000
     
37.02
 
Exercised
   
(13,720
)
   
22.71
 
Canceled/Forfeited
   
(47,000
)
   
22.10
 
Balance at December 31, 2013
   
140,188
   
$
25.55
 
 
1999 Plan
               
Balance at March 31, 2011
   
386,000
   
$
28.70
 
Granted
   
     
 
Exercised
   
(6,000
)
   
16.43
 
Canceled/Forfeited
   
     
 
Balance at March 31, 2012
   
380,000
     
28.41
 
Granted
   
     
 
Exercised
   
(76,420
)
   
23.83
 
Canceled/Forfeited
   
(57,580
)
   
27.79
 
Balance at March 31, 2013
   
246,000
     
33.00
 
Granted
   
     
 
Exercised
   
(38,000
)
   
26.69
 
Canceled/Forfeited
   
     
 
Balance at December 31, 2013
   
208,000
   
$
34.16
 
Combined Balance at December 31, 2013
   
348,188
   
$
30.69
 
 
December 31, 2013
Weighted Average
Aggregate Intrinsic
Remaining Contractual Term
 
Value
 
Outstanding
0.9 years
 
$
3,068,087
 
Exercisable
0.3 years
 
$
2,260,194
 

At December 31, 2013, the range of exercise prices was $19.19 to $38.25 and the weighted-average remaining contractual life of outstanding options was 0.9 years. The total number of options exercisable under both the 2009 Plan and the 1999 Plan at December 31, 2013 and 2012, was 264,188 shares with a weighted-average exercise price of $31.58 and 272,600 shares with a weighted-average exercise price of $31.10, respectively. During the nine months ended December 31, 2013, 47,000 options were forfeited and 51,720 options were exercised. During the nine months ended December 31, 2012, 113,580 options were forfeited, and 148,820 options were exercised.

Stock Awards
 
Pursuant to the Capital Southwest Corporation 2010 Restricted Stock Award Plan, our Board of Directors reserved for issuance 188,000 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 grants and are subject to forfeiture 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 38,600 shares of restricted stock to key employees of the Company. On January 22, 2013, the Board of Directors granted 8,000 shares of restricted stock to officers of the Company. On July 15, 2013, The Board of Directors granted 5,000 shares of restricted stock to a key officer of the Company. During the nine months ended December 31, 2013, 13,240 shares of restricted stock were forfeited. The following table summarizes the restricted stock available for issuance as of December 31 2013:

Restricted stock available for issuance as of March 31, 2013
   
153,400
 
Restricted stock granted during the nine Months ended December 31, 2013
   
(5,000
)
Restricted stock forfeited during the nine Months ended December 31, 2013
   
13,240
 
Restricted stock available for issuance as of December 31, 2013
   
161,640
 
 
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 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 quarters ended December 2013 and 2012, we recognized total share based compensation expense of $(9,930) and $27,797, respectively, related to the restricted stock issued to our employees and officers.  For the nine months ended December 31, 2013 and 2012, we recognized share based compensation expense of $64,050 and $70,851, respectively, related to restricted stock issued to employees and officers. Changes in stock option compensation expense for 2013 versus 2012 are due to forfeitures of unvested restricted stock that occurred with the departures of employees during the quarter ended December 31, 2013.

As of December 31, 2013, the total remaining unrecognized compensation expense related to non-vested restricted stock awards was $443,979, which will be amortized over the weighted-average service period of approximately 3.6 years.

            The following table represents a summary of the activity for our restricted stock awards for the nine months ended December 31, 2013:

Restricted Stock Awards
 
Number of
 Shares
   
Weighted
 Average Fair
 Value Per
 Share
   
Weighted
Average
 Remaining
Vesting Term
 (in Years)
 
Unvested at March 31, 2013
   
29,280
   
$
22.32
     
4.1
 
Granted
   
5,000
     
37.02
     
4.5
 
Vested
   
     
     
 
Forfeited
   
(13,240
)
   
22.08
     
 
Unvested at December 31, 2013
   
21,040
   
$
25.96
     
3.6
 

Phantom Stock Plan

On January 16, 2012, our Board of Directors approved the issuance of 104,000 phantom stock options at an exercise price of $36.74 (Net Asset Value at December 31, 2011) pursuant to the Capital Southwest Corporation Phantom Stock Option Plan to provide deferred compensation to certain key employees. On January 22, 2013, the Board of Directors granted 16,200 shares of phantom stock options at an exercise price of $41.34 per share (Net Asset Value at December 31, 2012) to officers of the Company.  On July 15, 2013, the Board of Directors granted 24,000 shares of phantom stock options at an exercise price of $43.80 per share (Net Asset Value at June 30, 2013) to a key officer of the Company. 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, adjusted for capital gain dividends declared, will be distributed to plan participants. For the nine months ended December 31, 2013, we recognized estimated liability for phantom stock options in the amount of $605,822. The estimated liability for phantom stock awards was $541,865 for the nine months ended December 31, 2012.

The following table represents a summary of the activity for our phantom stock plan for the fiscal year ended December 31, 2013:
 
Phantom Stock Awards
 
Number of
 Shares
   
Weighted
Average
Grant
Price Per
 Share
   
Weighted
Average
 Remaining
Vesting Term
 (in Years)
 
Unvested at March 31, 2013
   
90,200
   
$
37.26
     
4.0
 
Granted
   
24,000
     
43.80
     
4.5
 
Vested
   
     
     
 
Forfeited or expired
   
(19,200
)
   
41.34
     
 
Unvested at December 31, 2013
   
95,000
   
$
39.00
     
3.5
 

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.

CSC has agreed, subject to certain conditions, to invest up to $4,817,576 in five portfolio companies as of December 31, 2013.

8.
SUMMARY OF PER SHARE INFORMATION

The following presents a summary of per share data for the three and nine months ended December 31, 2013 and 2012.

On July 15, 2013, a four-for-one split of our issued common stock was approved by our shareholders. The stock split was payable on August 15, 2013 to shareholders of record at the close of business July 31, 2013. Our common stock began trading at the split-adjusted price on August 16, 2013. All share numbers and per share amounts presented herein reflect the stock split.

 
 
Three Months Ended
December 31
   
Nine Months Ended
December 31
 
Per Share Data
 
2013
   
2012
   
2013
   
2012
 
Investment income
 
$
.55
   
$
.46
   
$
.68
   
$
.64
 
Operating expenses
   
(.18
)
   
(.18
)
   
(.48
)
   
(.37
)
Income taxes
   
.04
     
(.01
)
   
.05
     
(.01
)
Net investment income
   
.41
     
.27
     
.25
     
.26
 
Distributions from undistributed net investment income
   
(.10
)
   
(.10
)
   
(.20
)
   
(.20
)
Net realized gain/(loss) net of tax
   
(.25
)
   
.04
     
(.25
)
   
4.45
 
Net increase (decrease) in unrealized appreciation of investments
   
3.49
     
1.47
     
7.16
     
(.39
)
Dividends from capital gains
   
     
     
     
(4.40
)
Exercise of employee stock options
   
(.04
)
   
(.01
)
   
(.07
)
   
(.19
)
Stock option expense
   
     
.01
     
.02
     
.02
 
Forfeiture (Issuance) of restricted stock
   
.03
     
     
.04
     
(.07
)
Increase (decrease) in net asset value
   
3.54
     
1.68
     
6.95
     
(.52
)
Net asset value
                               
Beginning of period
   
46.71
     
39.66
     
43.30
     
41.86
 
End of period
 
$
50.25
   
$
41.34
   
$
50.25
   
$
41.34
 
 
Item 2. – Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our financial statements and the notes thereto included elsewhere in our Annual Report on Form 10-K for the fiscal year ended March 31, 2013 (the “Form 10-K”).

The information contained herein may contain “forward-looking statements” based on our current expectations, assumptions and estimates about us and our industry.  These forward-looking statements involve risks and uncertainties.  Words such as “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “will,” “may,” “might,” “could,” “continue” and other similar expressions identify forward-looking statements.  In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements.  Our actual results could differ materially from those anticipated in the forward-looking statements as a result of several factors more fully described in “Risk Factors” and elsewhere in this Form 10-Q, and in our Form 10-K for the year ended March 31, 2013.  The forward-looking statements made in this Form 10-Q related only to events as of the date on which the statements are made.  You should read the following discussion in conjunction with the consolidated financial statements and related footnotes and other financial information included in our Form 10-K for the year ended March 31, 2013.  We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

General

On July 15, 2013, a four-for-one split of our issued common stock was approved by our shareholders. The stock split was payable on August 15, 2013 to shareholders of record at the close of business July 31, 2013. Our common stock began trading at the split-adjusted price on August 16, 2013. All share numbers and per share amounts presented herein reflect the stock split.

On November 20, 2013, Kelly Tacke was appointed as the Company’s Senior Vice President, Chief Financial Officer, Chief Compliance Officer, Secretary and Treasurer, effective November 18, 2013.  Ms. Tacke replaced Tracy Morris, who resigned as the Company's Chief Financial Officer, Chief Operating Officer and Secretary, effective November 15, 2013, to pursue other opportunities.

            Ms. Tacke was with Palm Harbor Homes, Inc., a publicly traded manufacturer and marketer of factory-built homes for 18 years, where she served as Executive Vice President, Chief Financial Officer and Corporate Secretary.  The Company was a long-time investor in Palm Harbor Homes. Ms. Tacke began her career with PricewaterhouseCoopers, where she was a Senior Audit Manager.  She holds a Bachelors of Business Administration degree from the University of Texas at Austin and is a Certified Public Accountant.

            On January 20, 2014, the Board of Directors of the Company elected Joseph B. Armes as Chairman of the Board and appointed David R. Brooks and William R. Thomas III to the Board.  The Board increased its size from six to seven members and appointed Messrs. Brooks and Thomas to fill the vacancies created by the resignation of Richard F. Strup in November 2013 and the increase in the size of the Board. 

             Mr. Armes has served as a director and President and Chief Executive Officer of the Company since June 2013.  Mr. Brooks has been the Chairman of the Board and Chief Executive Officer of Independent Bank Group, Inc., a publicly-traded bank holding company with approximately $2.0 billion in assets, since its founding in 2002.  Mr. Thomas is a private investor and has served as the President of the Thomas Heritage Foundation, a non-profit grant-making corporation, since 2008.   Mr. Thomas worked for the Company from July 2006 to September 2012, most recently as a Vice President.  Mr. Thomas currently serves as a director of Encore Wire Corporation. 

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 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, compared with stated cost.  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 three months ended December 31, 2013, total investment income was $8,363,469, a $1,390,797, or 19.9% increase from $6,972,672 for the three months ended December 31, 2012. For the nine months ended December 31, 2013, total investment income was $10,395,126, a $627,654, or a 6.4% increase from $9,767,472, total investment income for the nine months ended December 31, 2012.  This comparable period increase was primarily attributable to a $1,364,628 and a $350,000 increase in third quarter dividend income from The Rectorseal Corporation and Capstar Corporation, respectively, offset by Cinatra Clean Technologies, Inc.’s current year’s fully reserved interest income.

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.  The Company received interest income from temporary cash investments of $16,599 and $14,772 during the quarters ended December 31, 2013 and 2012, respectively. During the nine months ended December 31, 2013 and 2012, the Company had interest income from temporary cash investments of $51,729 and $50,400, respectively.

The Company’s management fees, received primarily from its controlled affiliates, totaled $419,850 and $456,850 for the nine months ended December 31, 2013 and 2012, respectively. During the quarters ended December 31, 2013 and 2012, the Company received management fees of $139,950 and $156,450, respectively.

During the three and nine months ended December 31, 2013 and 2012, the Company recorded dividend income from the following sources:
 
 
 
Three Months Ended
December 31,
   
Nine Months Ended
December 31,
 
 
 
2013
   
2012
   
2013
   
2012
 
Alamo Group, Inc.
 
$
198,311
   
$
169,938
   
$
594,882
   
$
509,814
 
CapitalSouth Partners Fund III
   
     
47,297
     
     
198,647
 
Capitala Finance Corporation
   
50,809
             
50,809
     
 
Capstar Holdings Corporation
   
350,000
             
350,000
     
 
Encore Wire Corporation
   
52,500
     
26,250
     
105,000
     
134,235
 
The RectorSeal Corporation
   
6,200,000
     
4,835,372
     
6,680,000
     
5,315,372
 
TCI Holdings, Inc.
   
20,318
     
20,318
     
60,953
     
60,953
 
The Whitmore Manufacturing Company
   
1,200,000
     
1,208,842
     
1,320,000
     
1,328,842
 
 
 
$
8,071,938
   
$
6,308,017
   
$
9,161,644
   
$
7,547,863
 

Due to the nature of its business, the majority of the Company’s operating expenses are related to officer and employee compensation, office expenses, and legal, professional and accounting fees. Total operating expenses decreased by $70,158 or 2.4% for the three months ended December 31, 2013 as compared to the three months ended December 31, 2012.  This decrease is primarily due to $61,411, or 32.3%, decrease in professional fees during the three months ended December 31, 2013.  Total operating expenses increased by $1,579,052 or 27.6% for the nine months ended December 31, 2013 as compared to the nine months ended December 31, 2012.  This increase is primarily due to $1,382,507, or 37.2%, increase in salaries related to bonus and phantom option accruals recorded as well as the expense associated with certain staffing changes incurred during the nine months ended December 31, 2013.

Net Realized Gain (Loss) on Investments

During the nine months ended December 31, 2013, we received a capital gain dividend in the amount of $55,000 from Diamond State Venture, L.P.

During the nine months ended December 31, 2012, we sold 2,774,250 shares of common stock in Encore Wire Corporation held by our subsidiary, CSVC, to Encore Wire, generating a capital gain of $66,037,485. We also sold 50,000 shares of common stock of Hologic, Inc., generating a capital gain of $850,548. In addition, we sold all investment ownership in Extreme International, Inc., generating net cash proceeds of $11,890,630 and a realized gain of $7,600,125. We also received cash proceeds in the amount of $2,823 from Palm Harbor Home Liquidating Trust. These gains were offset by a $4,926,289 realized loss associated with sales of all investment ownership in VIA Holdings., a $760,742 realized loss related to liquidation of Sterling Group Partners, L.P., a $150,594 realized loss related to liquidation of StarTech Seed Fund I, L.P., and a $7,000 capital loss adjustment related to a final true-up of the Lifemark Group, Inc. divesture from June 2010. The net realized gain for the nine months ended December 31, 2012 was $68,646,356. We declared and paid a cash dividend in the amount of $66,825,782 or $17.59 per share of common stock in June 2012. In total, we recognized net realized gains of $1,820,574 for the nine months ended December 31, 2012.

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, 2013, we recognized a $109,315,301 increase in net change in unrealized appreciation of investments.  The increases in unrealized appreciation are attributable to Alamo Group, Inc. and Encore Wire Corporation, which increased by $63,553,497 and $25,068,750, respectively, due to increases in their stock price at December 31, 2013, while The Rectorseal Corporation increased by $19,000,000; The Whitmore Manufacturing Company increased by $2,500,000; Media Recovery, Inc. increased by $5,300,000; and Trax Holdings, Inc. increased by $1,900,000 due to increases in each entity’s respective earnings. Offsetting these increases were Cinatra Clean Technologies, Inc., TitanLiner Inc., and Instawares Holding Company, LLC., which decreased by $2,328,844, $3,414,000, and $2,323,000, respectively, due to each entity’s under performance in their respective markets. In addition, CapitalSouth Partners Fund III, L.P. decreased by $2,833,201; during the nine months ended December 31, 2013 due to a distribution of 108,105 shares of Capitala Finance Corporation (CPTA) valued at $2,151,290, which represented 71% of our interest in Capital South Partners Fund III, L.P.

Set forth in the following table are the significant increases and decreases in unrealized appreciation by portfolio company:

 
 
Nine Months Ended
December 31,
 
 
 
2013
   
2012
 
Alamo Group, Inc.
 
$
63,553,497
   
$
7,258,374
 
Capital South Partners Fund III, L.P.
   
(2,833,201
)
   
378,000
 
Cinatra Clean Technologies, Inc.
   
(2,328,844
)
   
(4,107,390
)
Encore Wire Corporation
   
25,068,750
     
(81,089,460
)*
Instawares Holding Company LLC.
   
(2,323,000
)
   
829,000
 
Media Recovery, Inc.
   
5,300,000
     
(5,400,000
)
The RectorSeal Corporation
   
19,000,000
     
63,300,000
 
The Whitmore Manufacturing Company
   
2,500,000
     
4,200,000
 
TitanLiner, Inc.
   
(3,414,000
)
   
-
 
Trax Holdings, Inc.
   
1,900,000
     
8,800,000
 

* During the nine months ended December 31, 2012, we sold 2,774,250 shares of common stock in Encore Wire Corporation held by our subsidiary, CSVC, to Encore Wire generating a capital gain of $66,037,485.

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 – December 31, 2013 and March 31, 2013.
 
Portfolio Investments

During the nine months ended December 31, 2013, we invested $8,000,000 in Deepwater Corrosion Services, Inc., a full service corrosion control company providing the oil and gas industry with expertise in cathodic protection and asset integrity management. Deepwater’s products and services provide life extension to and support regulatory compliance of mission-critical, energy production assets. In addition, we funded $2,500,574 in commitments to existing portfolio companies.

We have commitments, subject to certain conditions, to invest up to $4,817,576 in five portfolio companies as of December 31, 2013.

Financial Liquidity and Capital Resources

At December 31, 2013, the Company had cash and cash equivalents of approximately $65.7 million.

            Management believes that the Company’s cash and cash equivalents and cash available 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.
 
Application of Critical Accounting Policies and Accounting Estimates

There have been no changes during the nine months ended December 31, 2013 to the critical accounting policies or the areas that involve the use of significant judgments or estimates we described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2013.
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk

We are subject to financial market risks, including changes in marketable equity security prices.  We do not use derivative financial instruments to mitigate any of these risks.

Our investment performance is a function of our portfolio companies’ profitability, which may be affected by economic cycles, competitive forces, foreign currency fluctuations and production costs including labor rates, raw material prices and certain basic commodity prices. While the portfolio company with the most significant exposure to foreign currency fluctuations generally hedges its exposure, most of the companies in our investment portfolio do not hedge their exposure to raw material and commodity price fluctuations. All of these factors may have an adverse effect on the value of our investments and on our net asset value.

Our investment in portfolio securities includes fixed-rate debt securities which totaled $5,724,007 at December 31 2013, equivalent to 0.82% of the value of our total investments.  Generally, these debt securities are below investment grade and have relatively high fixed rates of interest; therefore, minor changes in market yields of publicly traded debt securities have little or no effect on the values of debt securities in our portfolio and no effect on interest income. Our investments in debt securities are generally held to maturity and their fair values are determined on the basis of the terms of the debt security and the financial condition of the issuer.

A portion of our investment portfolio consists of debt and equity securities of private companies.  We anticipate little or no effect on the values of these investments from modest changes in public market equity valuations.  Should significant changes in market valuations of comparable publicly traded companies occur, there may be a corresponding effect on valuations of private companies, which would affect the value and the amount and timing of proceeds eventually realized from these investments.  A portion of our investment portfolio also consists of unrestricted, freely marketable common stock of publicly traded companies.  These freely marketable investments, which are valued at the public market price, are directly exposed to equity price risks because a change in an issuer’s public market equity price would result in an identical change in the value of our investment in such security.
Item 4.
Controls and Procedures

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 of the Securities Exchange Act of 1934). Based upon this evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that our current disclosure controls and procedures are effective in timely alerting them of material information relating to us that is required to be disclosed in the reports we file or submit under Securities Exchange Act of 1934.

During the fiscal quarter ended December 31, 2013, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.
 
PART II. – OTHER INFORMATION
 
Item 1.
Legal Proceedings

We may, from time to time, be involved in litigation arising out of our operations in the normal course of business or otherwise.  Furthermore, third parties may try to seek to impose liability on us in connection with the activities of our portfolio companies.  We have no current pending legal proceedings to which we are party or to which any of our assets is subject.

Item 1A.
Risk Factors

There have been no material changes to our risk factors disclosed in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended March 31, 2013.

Item 6.
Exhibits

Exhibit No.
Description
Certification of President and Chief Executive Officer required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), filed herewith.
Certification of Chief Financial Officer required by Rule 13a-14(a) of the Exchange Act, filed herewith.
Certification of President and Chief Executive Officer required by Rule 13a-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith.
Certification of Chief Financial Officer required by Rule 13a-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith.

SIGNATURES

Pursuant to the requirements the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
CAPITAL SOUTHWEST CORPORATION
 
 
 
February 6, 2014
By:
/s/ Joseph B. Armes
Date
 
Joseph B. Armes
 
Chairman of the Board
 
President and Chief Executive Officer
 
 
 
February 6, 2014
By:
/s/ Kelly Tacke
Date
 
Kelly Tacke
 
Chief Financial Officer
 
 
39

EX-31.1 2 ex31_1.htm EXHIBIT 31.1

Exhibit 31.1

CERTIFICATIONS
 
I, Joseph B. Armes certify that:
 
1. I have reviewed this interim report on Form 10-Q of Capital Southwest Corporation (the “registrant”);
 
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
 
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
 
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:
 
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial report