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CAPITAL SOUTHWEST CORP - Quarter Report: 2008 December (Form 10-Q)

 

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, 2008

     

OR

[  ] 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

 (I.R.S. Employer

or organization) 

Identification No.)

12900 Preston Road, Suite 700, Dallas, Texas

   75230

(Address of principal executive offices)

(Zip Code)


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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):  

     Large accelerated filer ____     Accelerated filer    X              Non-accelerated filer ____

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

3,741,638 shares of Common Stock, $1 par value, as of January 31, 2009

 


 

TABLE OF CONTENTS

Page No.

PART I.  FINANCIAL INFORMATION  
 
   ITEM 1.    Consolidated Financial Statements  
 
    Consolidated Statements of Financial Condition  
                  December 31, 2008 (Unaudited) and March 31, 2008

3

 
    Consolidated Statements of Operations (Unaudited)  
                  For the three and nine months ended December 31, 2008 and  
                  December 31, 2007

4

 
    Consolidated Statements of Changes in Net Assets  
                  For the nine months ended December 31, 2008 (Unaudited) and year ended  
                  March 31, 2008

5

 
    Consolidated Statements of Cash Flows (Unaudited)  
                  For the three and nine months ended December 31, 2008 and  
                  December 31, 2007

6

 
    Consolidated Statement of Investments  
                  December 31, 2008

7

 
    Notes to Consolidated Financial Statements

12

 
   ITEM 2.    Management’s Discussion and Analysis of Financial  
                       Condition and Results of Operations

17

 
   ITEM 3.    Quantitative and Qualitative Disclosure About  
                       Market Risk

20

 
   ITEM 4.    Controls and Procedures

21

 
PART II.  OTHER INFORMATION  
 
   ITEM 1      Legal Proceedings

21

 
   ITEM 1A. Risk Factors

21

 
   ITEM 2     Unregistered Sales of Equity Securities and Use of Proceeds

22

 
   ITEM 6.    Exhibits

22

 
 Signatures          

23







PART I. FINANCIAL INFORMATION

Item 1.     Consolidated Financial Statements

CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES

Consolidated Statements of Financial Condition



Assets      

December 31, 2008 

 

March 31, 2008 

                                                                               

(Unaudited)

Investments at market or fair value    
      Companies more than 25% owned    
        (Cost: December 31, 2008 - $29,058,246    
         March 31, 2008 - $28,758,246)     $348,933,470   $410,026,178  
      Companies 5% to 25% owned    
        (Cost: December 31, 2008 - $20,412,243,    
        March 31, 2008 - $20,412,243)       63,301,258     54,895,381  
      Companies less than 5% owned    
        (Cost: December 31, 2008 - $38,588,702,    
        March 31, 2008 - $31,856,977)       44,004,359     82,648,943  
      Total investments    
        (Cost: December 31, 2008- $88,059,191,    
        March 31, 2008 - $81,027,466)       456,239,087     547,570,502  
Cash and cash equivalents       21,574,396     31,327,758  
Receivables       339,670     156,322  
Other assets       7,886,002     7,630,486  
      Totals     $486,039,155   $586,685,068  
 
Liabilities and Shareholders' Equity    
 
Other liabilities     $    6,437,275   $    1,187,796  
Deferred income taxes       1,863,558     1,797,058  
      Total liabilities       8,300,833     2,984,854  
 
Shareholders' equity    
      Common stock, $1 par value: authorized,    
        5,000,000 shares; issued, 4,326,516 shares    
        at December 31, 2008 and March 31, 2008       4,326,516     4,326,516  
      Additional capital       125,902,832     115,687,153  
      Undistributed net investment income       3,265,726     7,036,929  
      Undistributed net realized loss on investments           (2,860,118 )
      Unrealized appreciation of investments       368,179,896     466,543,036  
      Treasury stock - at cost 584,878 shares at December    
        31, 2008 and 437,365 shares at March 31, 2008       (23,936,648 )   (7,033,302 )
      Net assets at market or fair value, equivalent    
        to $127.68 per share at December 31, 2008 on the    
        3,741,638 shares outstanding and $150.09    
        per share at March 31, 2008 on the 3,889,151    
        shares outstanding       477,738,322     583,700,214  
Totals     $486,039,155   $586,685,068  


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

 

 

3

 

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)


                                                                    

Three Months Ended 

 

Nine Months Ended 

 
                                                                        

December 31 

December 31

       

2008

   

2007

   

2008

   

2007

 
Investment income:    
     Interest     $     375,602   $    552,950   $   1,052,625   $   1,797,079  
     Dividends       9,614,029     1,838,757     10,949,508     3,003,651  
     Management and directors' fees       268,680     222,449     810,788     673,849  
        10,258,311     2,614,156     12,812,921     5,474,579  
Operating expenses:    
     Salaries       509,114     380,247     1,287,033     945,468  
     Net pension benefit       (63,306 )   (81,837 )   (189,923 )   (245,508 )
     Other operating expenses       315,432     481,128     1,119,870     1,034,286  
        761,240     779,538     2,216,980     1,734,246  
Income before income taxes       9,497,071     1,834,618     10,595,941     3,740,333  
Income tax expense       25,771     28,500     110,401     82,660  
 
Net investment income     $   9,471,300   $  1,806,118   $ 10,485,540   $   3,657,673  
 
Proceeds from disposition of investments     $ 20,655,024   $670,340   $ 20,655,025   $   1,398,892  
Cost of investments sold       4,670,340     1,158,868     4,718,381     1,158,868  
Realized gain (loss) on investments    
  before income taxes       15,984,684     (488,528 )   15,936,644     240,024  
Income tax expense       5,222,964         5,222,964      
Net realized gain (loss) on investments       10,761,720     (488,528 )   10,713,680     240,024  
 
Net decrease in unrealized    
   appreciation of investments       (67,135,903 )   (64,798,599 )   (98,363,139 )   (185,779,143 )
 
Net realized and unrealized loss    
   on investments     $(56,374,183 ) $(65,287,127 ) $(87,649,459 ) $(185,539,119 )
 
Decrease in net assets from operations     $(46,902,883 ) $(63,481,009 ) $(77,163,919 ) $(181,881,446 )




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

 

4

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statements of Changes in Net Assets


                                                                              

Nine Months Ended

 

Year Ended

 
                                                                              

December 31, 2008

 

March 31, 2008

 
                                                                               

(Unaudited)

Operations    
      Net investment income     $   10,485,540   $    3,715,200  
      Net realized gain on investments       10,713,680     240,024  
      Net decrease in unrealized appreciation    
        of investments       (98,363,139 )   (142,969,698 )
      Decrease in net assets from operations       (77,163,919 )   (139,014,474 )
 
Distributions from:    
      Undistributed net investment income       (12,256,745 )   (2,333,291 )
      Net realized gains deemed distributed    
        to shareholders       (8,646,560 )    
 
Capital share transactions:    
      Allocated increase in share value for    
        deemed distribution       8,646,560      
      Exercise of employee stock options           231,390  
      Change in pension plan funded status           (1,178,764 )
      Stock option expense       362,118     263,664  
      Treasury stock       (16,903,346 )    
      Decrease in net assets       (105,961,892 )   (142,031,475 )
 
Net assets, beginning of period       583,700,214     725,731,689  
 
Net assets, end of period     $ 477,738,322   $ 583,700,214  


 

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

     

5

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)


     

Three Months Ended 

 

Nine Months Ended 

     

December 31

 

December 31 

     

2008

 

2007

 

2008

 

2007

Cash flows from operating activities    
Decrease in net assets from    
  operations     $(46,902,883 ) $(63,481,009 ) $(77,163,919 ) $(181,881,446 )
Adjustments to reconcile increase in net    
  assets from operations to net cash    
  provided by operating activities:    
  Proceeds from disposition of investments       20,655,024     670,339     20,655,025     1,398,891  
  Purchases of securities       (7,646,287 )   (817,186 )   (11,750,107 )   (10,032,280 )
  Maturities of securities             154,500
  Depreciation and amortization       10,547     8,089     30,454     18,770  
  Net pension benefit       (63,306 )   (81,837 )   (189,923 )   (245,508 )
  Realized (gain) loss on investments before    
    income taxes       (15,984,685 )   488,528     (15,936,644 )   (240,024 )
  Taxes payable on behalf of shareholders    
    on deemed distribution       5,222,964       5,222,964  
  Net decrease in unrealized appreciation    
    of investments       67,135,903     64,798,599     98,363,139     185,779,143  
  Stock option expense       141,525     87,989     362,118     175,676  
  (Increase) decrease in receivables       283,669     (155,215 )   (183,347 )   79,720  
  (Increase) decrease in other assets       16,374     (11,451 )   (7,373 )   (41,859 )
  Increase (decrease) in other liabilities       (16,216 )   132,468     6,776     57,084  
  Decrease in accrued pension cost         (34,467 )   (68,934 )   (101,301 )
  Increase in deferred income taxes       22,200     28,500     66,500     85,500  
Net cash provided by (used in) operating    
  activities       22,874,829     1,633,347     19,406,729     (4,793,134 )
 
Cash flows from financing activities    
Distributions from undistributed net    
  investment income       (10,701,085 )   (1,555,661 )   (12,256,745 )   (2,333,291 )
Proceeds from exercise of employee    
  stock options             231,390
Purchase of treasury stock           (16,903,346 )  
Net cash used in financing activities       (10,701,085 )   (1,555,661 )   (29,160,091 )   (2,101,901 )
 
Net increase (decrease) in cash and cash    
  equivalents       12,173,744     77,686     (9,753,362 )   (6,895,035 )
Cash and cash equivalents at beginning    
  of period       9,400,652     31,871,482     31,327,758     38,844,203  
Cash and cash equivalents at end of period     $ 21,574,396   $ 31,949,168   $ $ 21,574,396   $   31,949,168  
 
Supplemental disclosure of cash flow information:    
Cash paid during the period for:    
  Interest     $                 –   $                 –   $                 –  

 

$                  –  
  Income taxes     $          3,571     $                 – $          3,571   $                  –
 
Noncash financing activities not included herein consist of reinvestment of dividends and distributions of $8,646,560.  


 


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

 

6

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statement of Investments

     December 31, 2008

Company 

Investment (a) 

Cost     Value (b)
†ALAMO GROUP INC. 2,830,300 shares common stock (acquired 4-1-73 thru 5-25-07) $        2,190,937 $     30,425,725
     Seguin, Texas
     Tractor-mounted mowing and mobile
     excavation equipment for governmental,
     industrial and agricultural markets; street-
     sweeping equipment for municipalities
 
ALL COMPONENTS, INC. 8.25% subordinated note due 2012 (acquired 6-27-07) 6,000,000 3,000,000
     Austin, Texas 150,000 shares Series A Convertible Preferred Stock, convertible into
     Electronics contract manufacturing;    600,000 shares of common stock at $0.25 per share (acquired 9-16-94) 150,000 1
     distribution and production of memory Warrants to purchase 350,000 shares of common stock at $11.00 per
     and other components for computer    share, expiring 2017 (acquired 6-27-07) --  -- 
     manufacturers, retailers and value-added   6,150,000 3,000,001
     resellers.
 
ATLANTIC CAPITAL      
BANCSHARES, INC. 300,000 shares common stock (acquired 4-10-07) 3,000,000 3,000,000
     Atlanta, Georgia
     Holding company of Atlantic Capital Bank
     a full service commercial bank.
 
BALCO, INC. 445,000 shares common stock and 60,920 shares Class B non-voting    
     Wichita, Kansas    common stock (acquired 10-25-83 and 5-30-02) 624,920 6,000,000
     Specialty architectural products used in
     the construction and remodeling of
     commercial and institutional buildings.
 
BOXX TECHNOLOGIES, INC. 3,125,354 shares Series B Convertible Preferred Stock, convertible    
     Austin, Texas    into 3,125,354 shares of common stock at $0.50 per share
     Workstations for computer graphic    (acquired 8-20-99 thru 8-8-01) 1,500,000
     imaging and design.
 
CMI HOLDING COMPANY, INC. 10% convertible subordinated note, due 2009 , (acquired 7-2-07 2,363,347  1,000,000 
     Richardson, Texas    thru 10-9-07)
     Owns Chase Medical, which develops 2,327,658 shares Series A Convertible Preferred Stock, convertible
     and sells devices used in cardiac surgery    into 2,327,658 shares of common stock at $1.72 per share (acquired
     to relieve congestive heart failure; develops    8-21-02 and 6-4-03) 4,000,000
     and supports cardiac imaging systems. Warrants to purchase 109,012 shares of common stock at $1.72 per
                                                          share, expiring 2012 (acquired 4-7-04)

                                                       Warrant to purchase 431,982 shares of  Series A-1 Convertible 
                                                          Preferred Stock at $1.72 per share, expiring 2017 (acquired 7-2-07)

    6,363,347 1,000,002


 

 

 

7

 

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statement of Investments

December 31, 2008

(continued)

Company      

Investment (a) 

   

Cost 

   

Value (b)

CINATRA CLEAN TECHNOLOGIES, INC.      

10% subordinated secured promissory note (acquired 7-14-08

   
   Houston, Texas      

   thru 12-08-08)

  $    4,263,000   $    4,263,000
   Cleans above ground oil storage tanks      

1,128,649 shares Series A Convertible Preferred Stock, convertible

   
   with a patented, automated system.      

   into 1,128,649 shares common stock at $1.00 per share

   
                                                            

   (acquired 7-14-08 and 11-19-08)

    1,128,649  

1,128,649

          5,391,649

5,391,649


DENNIS TOOL COMPANY 20,725 shares 5% Convertible Preferred Stock, convertible into    
     Houston, Texas    20,725 shares of common stock at $48.25 per share (acquired 8-10-98) 999,981 999,981
     Polycrystalline diamond compacts (PDCs) 140,137 shares common stock (acquired 3-7-94 and 8-10-98) 2,329,963 3,200,000
     used in oil field drill bits and in mining   3,329,944 4,199,981
     and industrial applications.
 
†ENCORE WIRE CORPORATION 4,086,750 shares common stock (acquired 7-16-92 thru 10-7-98) 5,800,000 61,301,250
     McKinney, Texas
     Electric wire and cable for residential, commercial
     and industrial use.
 
EXTREME INTERNATIONAL, INC. 13,035 shares Series A common stock (acquired 9-26-08 and    
     Sugar Land, Texas      12-12-08) 

325,875

463,850

     Owns Bill Young Productions, Texas 39,359 shares Series C Convertible Preferred Stock, convertible  
     Video and Post, and Extreme Communi-     into 157,436 shares of common stock at $25.00 per share
     cations, which produce radio and television     (acquired 9-30-03) 2,625,000 5,602,376
     commercials and corporate communica- 3,750 shares 8% Series A Convertible Preferred Stock, convertible into
     tions videos.    15,000 shares of common stock at $25.00 per share (acquired 9-30-03)

375,000

533,774
    3,325,875 6,600,000

        

†HEELYS, INC. 9,317,310 shares common stock (acquired 5-26-00)

             102,490

     18,634,620

     Carrollton, Texas
     Heelys stealth skate shoes, equipment
     and apparel sold through sporting goods
     chains, department stores and footwear
     retailers.
   
†HOLOGIC, INC. ‡632,820 shares common stock (acquired 8-27-99) 220,000 8,264,629
     Bedford, Massachusetts
     Medical instruments including bone
     densitometers, mammography devices
     and digital radiography systems.
  
LIFEMARK GROUP 1,449,026 shares common stock (acquired 7-16-69) 4,510,400 71,000,000
     Hayward, California
     Cemeteries, mausoleums and mortuaries
     located in northern California.
8

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statement of Investments

December 31, 2008
(continued)

 

Company 

Investment (a)

Cost 

 

Value (b)

MEDIA RECOVERY, INC. 800,000 shares Series A Convertible Preferred Stock, convertible into    
     Dallas, Texas    800,000 shares of common stock at $1.00 per share (acquired
     Computer datacenter and office automation    11-4-97) $        800,000 $    4,733,000
     supplies and accessories; impact, tilt 4,000,002 shares common stock (acquired 11-4-97) 4,615,000 23,667,000
     monitoring and temperature sensing   5,415,000 28,400,000
     devices to detect mishandling shipments;
     dunnage for protecting shipments.
 
PALLETONE, INC. 12.3% senior subordinated notes due 2012 (acquired 9-25-06) 1,553,150 1,000,000
     Bartow, Florida 150,000 shares common stock (acquired 10-18-01) 150,000 2
     Manufacturer of wooden pallets and Warrant to purchase 15,294 shares of common stock at $1.00
     pressure-treated lumber.    per share, expiring 2011 (acquired 2-17-06) 45,746 – 
    1,748,896 1,000,002

    

†PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85 thru 7-31-95)

        10,931,955

      25,529,144

     Dallas, Texas
     Integrated manufacturing, retailing,
     financing and insuring of manufactured
     housing and modular homes.
 
THE RECTORSEAL CORPORATION 27,907 shares common stock (acquired 1-5-73 and 3-31-73) 52,600 127,300,000
     Houston, Texas
     Specialty chemicals for plumbing, HVAC,
     electrical, construction, industrial, oil field
     and automotive applications; smoke contain-
     ment systems for building fires; also owns 20%
     of The Whitmore Manuacturing Company.
 
TCI HOLDINGS, INC. 21 shares 12% Series C Cumulative Compounding Preferred    
     Denver, Colarodo    stock (acquired 1-30-90)

677,250 
     Cable television systems and microwave
     relay systems.
 
†TEXAS CAPITAL BANCSHARES, INC. ‡489,656 shares common stock (acquired 5-1-00) 3,550,006 6,536,908
     Dallas, Texas
     Regional bank holding company with
     banking operations in six Texas cities.

TRAX HOLDINGS, INC. 849,023 shares Series A Convertible Preferred Stock, convertible
     Scottsdale, Arizona    into 849,023 common stock at $4.71 per share (acquired 12-08-08)

4,000,000

4,000,000

     Provides a comprehensive set of solutions
     to improve the transportation validation,
     accounting, payment and information
     management process.

VIA HOLDINGS, INC. 9,118 shares Series B Preferred Stock (acquired 9-19-05) 4,559,000 2
     Sparks, Nevada 1,118 shares Series C Preferred Stock (acquired 11-01-07) 281,523 2
     Designer, manufacturer and distributor   4,840,523 4
     of high-quality office seating.
9

CAPITAL SOUTHWEST CORPORATION

AND SUBSIDIARIES

Consolidated Statement of Investments

December 31, 2008
(continued)

 

Company

Investment (a)

Cost  

Value (b)

WELLOGIX, INC. 4,788,371 shares Series A-1 Convertible Participating Preferred    
     Houston, Texas    Stock, convertible into 4,788,371 shares of common stock at
     Developer and supporter of software    $1.0441 per share (acquired 8-19-05 thru 6-15-08) $    5,000,000  $                 2 
     used by the oil and gas industry.
     
     
 
THE WHITMORE MANUFACTURING      
COMPANY 80 shares common stock (acquired 8-31-79) 1,600,000  37,000,000 
     Rockwall, Texas
     Specialized mining, railroad and industrial
     lubricants; coatings for automobiles and
     primary metals; fluid contamination control
     devices.
  
MISCELLANEOUS   – Ballast Point Ventures, II, L.P. - 2.6% limited partnership interest
     (acquired 8-4-08 thru 10-24-08) 375,000 375,000
           

– BankCap Partners Fund I, L.P. – 6.0% limited partnership interest

 
                                                 

     (acquired 7-14-06 thru 10-10-08)

3,766,681 3,766,681
                                                 – CapitalSouth Partners Fund III, L.P. – 2.8% limited partnership interest
                                                 

     (acquired 1-22-08)

701,256  701,256 
                                                 – Diamond State Ventures, L.P. – 1.9% limited partnership interest
                                                

     (acquired 10-12-99 thru 8-26-05)

111,000  111,000 
– Discovery Alliance, LLC - 90.0% limited liability company
      (acquired 9-12-08 thru 12-1-08)

300,000

300,000

                                                 – First Capital Group of Texas III, L.P. – 3.3% limited partnership
                                                  

     interest (acquired 12-26-00 thru 8-12-05)

964,604  771,814
                                                – Humac Company – 1,041,000 shares common stock (acquired 1-31-75
                                                  

     and 12-31-75)

–  144,000 
                                                – STARTech Seed Fund I – 12.1% limited partnership interest (acquired
                                                 

     4-17-98 thru 1-5-00)

178,066 
                                                 – STARTech Seed Fund II – 3.2% limited partnership interest (acquired
                                                  

    4-28-00 thru 2-23-05)

950,000 
                                                 – Sterling Group Partners I, L.P. – 1.7% limited partnership interest
                                                   

    (acquired 4-20-01 thru 1-24-05)

1,064,042    808,165

TOTAL INVESTMENTS   

$88,059,191 

 

$456,239,087

Publicly-owned company  Unrestricted securities as defined in Note (a)

   

 

Notes to Consolidated Statement of Investments

(a)     Definitions

         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 restriction on resale and are not freely marketable. At December 31, 2008, restricted securities represented approximately 96.7% of the value of the consolidated investment portfolio.  


(b)     Investment Valuation Policy

          Our investments are carried at fair value in accordance with the Investment Company Act of 1940 (the “1940 Act”) and SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). 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; and restricted publicly traded securities and other privately held securities are valued as determined in good faith by our Board of Directors.



        

10


 

Notes to Consolidated Statement of Investments
(continued)

   We adopted SFAS No. 157 on April 1, 2008 (see footnote 1 in “Notes to Consolidated Financial Statements,” page 12). SFAS No. 157 provides a framework for measuring the fair value of assets and liabilities. SFAS No. 157 also provides guidance regarding a fair value hierarchy, which prioritizes information used to measure fair value and the effect of fair value measurements on earnings and provides for enhanced disclosures determined by the level within the hierarchy of information used for valuation. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.

    SFAS No. 157 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 SFAS No. 157, 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 SFAS No. 157, it is assumed that the reporting entity has access to the market as of the measurement date.

(c) Valuation Methodologies

                    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.



                    Partnership Interests and Common Equity including unrestricted marketable securities, which 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; and restricted marketable securities for which there is a public market, 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 adjusted in good faith by our Board of Directors if they deem a discount or premium would be likely or obtainable upon a sale or transfer of our interest, for those without a principal market, the 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; the proportion of the issuer’s securities owned by the Company; protective put analysis based on the Black-Scholes option pricing model, the nature and duration of resale restrictions and the nature of any rights enabling the Company to require the issuer to register restricted securities under applicable securities laws. In determining the fair value of restricted securities, the Board of Directors considers the inherent value of such securities without regard to the restrictive feature and adjusts for any diminution in value resulting from restrictions on resale.
 
                  Preferred Equity is valued on the basis of the price (bond value) the security would carry in the absence of the conversion feature plus the value allocable to the conversion feature (conversion value).
 
                 Equity Warrants are valued on the basis of accepted formulas derived from empirical studies which define the market value of a warrant in relation to the market price of its common stock. These formulas measure the “option value” of a warrant as well as its “exercise value” (the amount, if any, by which the value of the stock exceeds the exercise price of the warrant). In applying such formulas, the market price of the stock is usually discounted to reflect the fact that the stock is restricted and the calculated value of the warrant itself may be discounted (if deemed appropriate) to reflect its restrictive nature. Generally, the option value is excluded if the formula indicates (i) the warrant expires within six months, (ii) the market price of the stock (discounted) is less than one-half of the exercise price of the warrant, or (iii) the market price of the stock (discounted) is more than two times the amount of the exercise price of the warrant.

11

Notes to Consolidated Financial Statements

(Unaudited)



1.     Basis of Presentation

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

     The financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 6 of Regulation S-X. The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Form 10-K for the year ended March 31, 2008. Certain information and footnotes normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted, although we believe that the disclosures are adequate for a fair presentation. The information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results of operations for the interim periods. 

Fair Value Measurements. The Company adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”), on April 1, 2008. SFAS 157 (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. The Statement 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. The Statement does not change existing accounting rules governing what can or what must be recognized and reported at fair value in the Company’s financial statements, or disclosed at fair value in the Company’s notes to the financial statements. Additionally, SFAS 157 does not eliminate practicability exceptions that exist in accounting pronouncements amended by this Statement when measuring fair value. As a result, the Company will not be required to recognize any new assets or liabilities at fair value.

Prior to SFAS 157, certain measurements of fair value were based on the price that would be paid to acquire an asset, or received to assume a liability (an entry price). SFAS 157 clarifies the definition of fair value as the price that would be received from the sale of an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (that is, an exit price). The exit price is based on the amount that the holder of the asset or liability would receive or need to pay in an actual transaction (or in a hypothetical transaction if an actual transaction does not exist) at the measurement date. In some circumstances, the entry and exit price may be the same; however, they are conceptually different.

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, the Company uses valuation techniques that place greater reliance on observable inputs and less reliance on unobservable inputs. In measuring fair value, the Company may make adjustments for risks and uncertainties, if a market participant would include such an adjustment in its pricing.

 

12

 

Notes to Consolidated Financial Statements
(continued)

2.      Investments

     We fair value our investments in accordance with GAAP as determined in good faith by our Board of Directors. 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 SFAS No. 157, Fair Value Measurements (“SFAS 157”). Where inputs for an asset or liability fall in more than one level in the fair value hierarchy, the investment is classified in its entirety based on the lowest level input that is significant to that investment’s fair value measurement. We use judgment and consider factors specific to the investment in determining the significance of an input to a fair value measurement. The three levels of the fair value hierarchy and investments that fall into each of the levels are described below:

·     

Level 1: Level 1 inputs are unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. We use Level 1 inputs for publicly traded unrestricted securities for which we do not have a controlling interest. 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 over-the-counter (NASDAQ) securities on the valuation date.


·     

Level 2: Level 2 inputs are inputs other than the quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. We did not value any of our investments using level 2 inputs as of December 31, 2008.


·     

Level 3: Level 3 inputs are unobservable and cannot be corroborated by observable market data. We use Level 3 inputs for measuring the fair value of substantially all of our investments. See “Notes to Portfolio of Investments” (c) on page 12 for the investment policy used to determine the fair value of these investments.


The following fair value hierarchy table sets forth our investment portfolio by level as of December 31, 2008 (in millions):

 

Level 1

 

Level 2

 

Level 3

 

Total

Debt

$     -

 

$-

 

$    9.2

 

$    9.2

Partnership Interests

-

 

-

 

10.5

 

10.5

Preferred Equity

-

 

-

 

17.0

 

17.0

Common Equity

14.8

 

-

 

404.7

 

419.5

Equity Warrants

-

 

-

 

-

 

-

Total Investments

$14.8

 

$-

 

$441.4

 

$456.2



The following table sets forth a summary of changes in the fair value of investment assets and liabilities measured using Level 3 inputs during the quarter ended December 31, 2008 (in millions):

 

Beginning Balance

 

Unrealized gain (loss)

 

Purchases, Sales, Issuance & Settlement

 

Ending Balances

Debt

$  10.6

 

$  (2.9)

 

$1.5

 

$    9.2

Partnership Interests

9.9

 

(0.9)

 

1.5

 

10.5

Preferred Equity

14.6

 

(2.2)

 

4.6

 

17.0

Common Equity

436.5

 

(3.18)

 

-

 

404.7

Total Investments

$471.6

 

$(37.8)

 

$7.6

 

$441.4

13

Notes to Consolidated Financial Statements
(continued)

The following table sets forth a summary of changes in the fair value of investment assets and liabilities measured using Level 3 inputs during the nine months ended December 31, 2008 (in millions):

 

Beginning Balance

 

Unrealized gain (loss)

 

Purchases, Sales, Issuance & Settlement

 

Ending Balances

Debt

$    9.0

 

$ (4.0)

 

$ 4.2

 

$    9.2

Partnership Interests

9.0

 

(0.5)

 

2.0

 

10.5

Preferred Equity

21.8

 

(10.0)

 

5.2

 

17.0

Common Equity

454.6

 

(50.5)

 

0.6

 

404.7

Equity Warrants

0.4

(0.1)

(0.3)

-

Total Investments

$494.8

 

$(65.1)

 

$11.7

 

$441.4



3.      Income Taxes

     Capital Southwest Corporation (“CSC”) and Capital Southwest Venture Corporation (“CSVC”) operate to qualify as a RIC under Subchapter M of the Code. In order to qualify as a RIC, we must annually distribute at least 90% of our taxable ordinary income, based on our tax year, to our shareholders in a timely manner. Ordinary income includes net short-term capital gains but excludes net long-term capital gains. A RIC is not subject to federal income tax on the portion of its ordinary income and long-term capital gains that are distributed to its shareholders, including “deemed distributions” discussed below. As permitted by the Code, a RIC can designate dividends paid in the subsequent tax year as dividends of current year ordinary income and net long-term gains if those dividends are both declared by the extended due date of the RIC’s federal income tax return and paid to shareholders by the last day of the subsequent tax year. We have distributed or intend to distribute sufficient dividends to eliminate taxable income for our completed tax fiscal 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, 2008 and 2007, Capital Southwest Corporation (“CSC”) and Capital Southwest Venture Corporation (“CSVC”) qualified to be taxed as RICs. We intend to meet the applicable qualifications to be taxed as a RIC in future years; management feels it is probable that we will maintain our RIC status for a period longer than one year. However, either company’s ability to meet certain portfolio diversification requirements of RICs in future years may not be controllable by such company.

  In addition, 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 of 35% on the long-term capital gains for the benefit of its shareholders. Shareholders would then report their share of the retained capital gains on their income tax returns as if it had been received and report a tax credit for the 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.

     As permitted by the Internal Revenue Code, a RIC can designate dividends paid in the subsequent tax year as dividends of the current year ordinary taxable income and long-term capital 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. For the tax years ended December 31, 2008 and 2007 we declared and paid dividends in the amounts of $12,256,745 and $2,333,291, respectively.

     Additionally, we are also 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 year ended December 31, 2008 we distributed 100% of our investment company ordinary taxable income. As a result we have made no provision for income taxes on ordinary taxable income for the tax year ended December 31, 2008. For the tax year ended December 31, 2007, we distributed 100% of our investment company ordinary taxable income, however only 70% was distributed by the end of the tax year. As a result, we incurred and an excise tax of 4% of the undistributed income or $41,543, which was paid in 2008 and is included in income tax expense on the accompanying consolidated statements of operation.

14

Notes to Consolidated Financial Statements
(continued)

For the tax year ended December 31, 2008, we have estimated net long-term capital gains of $14,922,751 for tax purposes and $15,936,644 for book purposes, which we elected to retain and treat as deemed distributions to our shareholders. For the tax year ended December 31, 2007, we had net long-term capital losses of $944,872 for tax purposes and $860,118 for book purposes, which we carried forward and offset by future net long-term capital gains. In order to make the election to retain capital gains, we incurred a federal tax on behalf of our shareholders of $5,222,964 for the tax year ended December 31, 2008. As of December 31, 2008, we did not have any undistributed long-term capital gains since they are treated as being distributed through the “deemed distribution”.

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

4.     Stock-Based Compensation

Effective April 1, 2006, we adopted SFAS 123R using the modified prospective transition method. We recognize compensation cost over the straight-line method for all share-based payments granted on or after that date and for all awards granted to employees prior to April 1, 2006 that remain unvested on that date. The fair value of stock options are determined on the date of grant using the Black-Scholes pricing model and are expensed over the vesting period of the related stock options. Accordingly, for the quarter and nine months ended December 31, 2008, we recognized compensation expense of $141,525 and $362,118, respectively.

As of December 31, 2008, the total remaining unrecognized compensation cost related to non-vested stock options was $2,504,452, which will be amortized over the weighted-average service period of approximately 4.9 years.

5.       Employee Stock Option Plan

On July 19, 1999, shareholders approved the 1999 Stock Option (“Plan”), which provides for the granting of stock options to employees and officers of the Company and authorizes the issuance of common stock upon exercise of such options for up to 140,000 shares. All options are granted at or above market price, generally expire ten years from the date of grant and are generally exercisable on or after the first anniversary of the date of grant in five to ten annual installments.

At December 31, 2008, there were no shares available for grant under the Plan. The following table summarizes the 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)

May 15, 2006

 

$ 31.28

 

0.64%

 

5.08%

 

21.1%

 

7

July 17, 2006

 

$ 33.05

 

0.61%

 

5.04%

 

21.2%

 

7

July 16, 2007

 

$ 41.78

 

0.39%

 

4.95%

 

19.9%

 

5

July 21, 2008

 

$ 27.35

 

0.67%

 

3.41%

 

20.2%

 

5

July 30, 2008

 

$ 29.93

 

0.62%

 

3.36%

 

20.2%

 

5



 

 

 

 

 

 

15

Notes to Consolidated Financial Statements
(continued)

The following table summarizes activity in the Plan as of September 30, 2008:

   

Number

   

Weighted-Average

   
                                                                                 

of shares

   

Exercise Price

Balance at March 31, 2008    

70,400

   

$109.99

   
   Granted    

37,500

   

$123.72

   
   Exercised    

   

   
   Canceled    

   

   
Balance at December 31, 2008    

107,900

   

$114.78

   
   

     At December 31, 2008, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $65.00 to $152.98 and 4.9 years, respectively. No options were exercised during the nine months ended December 31, 2008.

     At December 31, 2008, the number of options exercisable was 21,445 and the weighted-average exercise price of those options was $97.00.

6.     Summary of Per Share Information

     

Three Months Ended 

 

  Nine Months Ended

 
     

December 31 

 

December 31

 
     

2008

   

2007

   

2008

   

2007

 
Investment income     $   2.74   $    .67   $   3.42   $  1.41  
Operating expenses       (.20 )   (.20 )   (.59 )   (.46 )
Interest expense                    
Income taxes       (.01 )   (.01 )   (.03 )   (.01 )
Net investment income       2.53     .46     2.80     9.4  
Distributions from undistributed    
  net investment income       (2.56 )   (.40 )   (3.28 )   (.60 )
Net realized gain (loss) on investments       2.87     (.12 )   2.86     .06  
Net decrease in unrealized appreciation    
  of investments       (17.94 )   (16.66 )   (26.29 )   (47.77 )
Treasury stock repurchase *               1.40      
Exercise of employee stock options **                   (.09 )
Stock option expense       .04     .02     .10     .05  
Decrease in net asset value       (15.06 )   (16.70 )   (22.41 )   (47.41 )
Net asset value:    
      Beginning of period       142.74     156.04     150.09     186.75  
      End of period     $127.68   $139.34   $127.68   $139.34  
Shares outstanding at end of period    
  (000s omitted)       3,742     3,889     3,742     3,889  


*      Net increase is due to purchases of Common Stock at prices less than beginning period net asset value. 

**      Net decrease is due to the exercise of employee stock options at prices less than beginning of period net asset value.

16

Notes to Consolidated Financial Statements
(continued)

7.     Share Repurchase Plan

On June 12, 2008, the Company announced that its Board of Directors authorized a share repurchase plan, which allowed for the repurchase of up to 10 percent (or 388,915 shares) of its Common Stock at prices not above the lower of the net asset value per share of its Common Stock, or prices prevailing in the over-the-counter market at the time of such purchases. The repurchase program remained in effect through December 10, 2008. The Company did not make purchases under the plan during the quarter ended December 31, 2008. In total the Company purchased 147,513 shares of Common Stock for $16,903,346 at an average price of $114.59 per share, on the open market, while the plan was in effect.

8.     Recent Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (SFAS 157). The standard defines fair value, outlines a framework for measuring fair value, and details the required disclosures about fair value measurements. The standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company has adopted this statement on a prospective basis beginning in the quarter ended June 30, 2008. Adoption of this statement did not have a material effect on the Company’s consolidated financial statements for the period ended June 30, 2008. However, the impact on its consolidated financial statements for the periods subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for those periods, the number and amount of investments the Company originates, acquires or exits, and the effect of any additional guidance or any changes in the interpretation of this statement.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for us beginning April 1, 2008. We did not elect the fair value option provisions upon adoption of SFAS 159 on April 1, 2008.

In February 2008, the FASB issued FASB Staff Position (“FSP”) SFAS 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2), which defers the effective date of SFAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years, for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We are currently evaluating the impact of our adoption of FSP 157-2 effective April 1, 2009 on our consolidated financial statements.

     In October 2008, the FASB issued Staff Position 157-3, “Determining the Fair Value of a Financial Asset in a Market That Is Not Active” (“FSP 157-3”), which clarifies the application of SFAS 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is not active. The guidance provided by FSP 157-3 is consistent with Capital Southwest’s approach to valuing financial assets for which there are no active markets.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Net asset value at December 31, 2008 was $477,738,322, equivalent to $127.68 per share. Assuming reinvestment of all dividends and tax credits on retained long-term capital gains, the December 31, 2008 net asset value reflects a decrease of 3.71% during the past twelve months.

17

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
(continued)


     

December 31,

   

December 31,

 
            

2008

   

2007

 
      Net assets     $477,738,322   $541,924,018  
      Shares outstanding       3,741,638     3,889,151  
      Net assets per share     $         127.68   $         139.34  
        

Results of Operations

The composite measure of our financial performance in the Consolidated Statements of Operations is captioned “Increase (decrease) in net assets from operations” and consists of three elements. The first is “Net investment income,” which is the difference between our income from interest, dividends and fees and our combined operating and interest expenses, net of applicable income taxes. The second element is “Net realized gain (loss) on investments”, which is the difference between the proceeds received from disposition of portfolio securities and their stated cost. The third element is the “Net increase (decrease) in unrealized appreciation of investments,” which is the net change in the market or fair value of our investment portfolio, compared with stated cost. It should be noted that the “Net realized gain (loss) on investments” and “Net increase (decrease) in unrealized appreciation of investments” are directly related in that when an appreciated portfolio security is sold to realize a gain, a corresponding decrease in net unrealized appreciation occurs by transferring the gain associated with the transaction from “unrealized” to “realized.” Conversely, when a loss is realized on a depreciated portfolio security, an increase in net unrealized appreciation occurs.

Net Investment Income     

     Interest income of $1,052,625 for the nine months ended December 31, 2008 decreased from $1,797,079 in the year-ago period due to a decrease in excess cash and interest rates. During the nine months ended December 31, 2008 and 2007, we recorded dividend income from the following sources:

         

Nine Months Ended 

 
         

December

           

2008

   

2007

 
    Alamo Group Inc.     $    509,454   $   508,914  
    Balco, Inc.       0     224,400  
    CapitalSouth Partners       20,519     0  
    Dennis Tool Company       37,499     49,999  
    Encore Wire Corporation       245,205     245,205  
    Heelys, Inc.       9,317,310     0  
    Kimberly-Clark Corporation       89,529     122,716  
    Lifemark Group       0     571,333  
    PETsMart, Inc.       18,000     27,000  
    The RectorSeal Corporation       480,000     914,133  
    TCI Holdings, Inc.       60,953     60,953  
    The Whitmore Manufacturing Company       120,000     228,533  
    Other       51,039     50,465  
        $10,949,508   $3,003,651  


Net Realized Gain on Investments 

     During the nine months ended December 31, 2008, the Company sold certain of its unrestricted marketable securities generating proceeds of $20,655,024, resulting in a net realized gain of $10,716,720; as compared with net realized gains of $240,024 during the nine months ended December 31, 2007.

18

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
(continued)


                     During the nine months ended December 31, 2008, the Company realized gains of 15,936,664, consisting primarily of $6,646,883 on Petsmart, Inc., $2,487,019 on Liberty Entertainment Group, and $1,991,256 on Kimberly-Clark, Inc. These unrestricted marketable securities were sold in connection with our major share repurchase plan, which was announced on June 12, 2008. It was announced that we would fund our repurchase plan through the use of cash on hand and or proceeds from the sale of our unrestricted marketable securities. Our repurchase plan expired on December 10, 2008. 

     During the nine months ended December 31, 2007, the Company realized gains of $240,024 consisting of $546,221 of Alltel Corporation, $518,020 of Sterling Group Partners, and $245,950 of Exopack, Inc, which were offset by a realized loss of $1,070,167 from the sale of Hic-Star Corporation.

Net Increase (Decrease) in Unrealized Appreciation of Investments     

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

     

Three Months Ended 

 

   Nine Months Ended

 
     

December 31  

   

December 31  

 
     

2008

   

2007

   

2008

   

2007

 
Alamo Group Inc.     $(3,537,875 ) $(9,905,950 ) $(14,859,075 ) $(9,878,840 )
All Components, Inc.       (2,399,999 )       (9,599,999 )   5,600,000  
Encore Wire Corporation       6,130,125     (30,650,750 )   10,216,875     (24,520,750 )
Heelys, Inc.       (16,305,293 )   (18,634,760 )   (16,305,293 )   (158,394,760 )
Media Recovery, Inc.       (3,600,000 )       (9,100,000 )   (9,000,000 )
Palm Harbor Homes, Inc.       (9,818,901 )   (11,782,713 )   (5,891,341 )   (19,637,713 )
The RectorSeal Corporation       (4,200,000 )   11,150,000     (16,900,000 )   22,000,000  

 

 

 

 


 

    During the nine months ended December 31, 2008, the value of our investments in The RectorSeal Corporation decreased by $16,900,000, All Components, Inc. decreased $9,599,999 and Media Recovery, Inc decreased $9,100,000, due to decreases in their respective sales resulting from slowdowns in segments of their businesses. Additionally, our investments in Alamo Group Inc. decreased $14,859,075; Heelys Inc. decreased $16,305,293; and Palm Harbor Homes, Inc. decreased $5,891,341 due primarily to the decreases in their respective stock prices at December 31, 2008. Offsetting the aforementioned losses during the nine months ended December 31, 2008, was a $10,216,875 increase in the value of Encore Wire Corporation due primarily to an increase in their stock price at December 31, 2008.                         

Portfolio Investments

      During the quarter ended December 31, 2008, we made investments of $4,000,000 in one new portfolio company and investments of $3,646,287 in existing portfolio companies.

     We have agreed, subject to certain conditions, to invest up to $9,963,070 in seven portfolio companies.

Financial Liquidity and Capital Resources

          At December 31, 2008, we had cash and cash equivalents of approximately $21.6 million. Pursuant to Small Business Administration (SBA) regulations, cash and cash equivalents of $5.2 million held by Capital Southwest Venture Corporation (CSVC) may not be transferred or advanced to us without the consent of the SBA. Under current SBA regulations and subject to SBA’s approval of its credit application, CSVC would be entitled to borrow up to $17.0 million. With the exception of a capital gain distribution made in the form of a distribution of the stock of a portfolio company in the

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
(continued)


fiscal year ended March 31, 1996, we have elected to retain all gains realized during the past 40 years. Retention of future gains is viewed as an important source of funds to sustain our investment activity. Approximately $14.8 million of our investment portfolio is represented by unrestricted publicly-traded securities, and represent a source of liquidity.

     Funds to be used by us for operating or investment purposes may be transferred in the form of dividends, management fees or loans from The RectorSeal Corporation and The Whitmore Manufacturing Company, wholly-owned portfolio companies, to the extent of their available cash reserves and borrowing capacities.

     Management believes that our cash and cash equivalents and cash available from other sources described above are adequate to meet our expected requirements. Consistent with our long-term strategy, the disposition of investments from time to time may also be an important source of funds for future investment activities.

Item 3. Quantitative and Qualitative Disclosure 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 commodity prices. Most of the companies in our investment portfolio do not hedge their exposure to raw material and commodity price fluctuations. However, the portfolio company with the greatest exposure to foreign currency fluctuations generally hedges its exposure. All of these factors may have an adverse effect on the value of our investments on our net asset value. 

                  Our investment in portfolio securities includes fixed-rate debt securities which totaled $9,263,000 at December 31, 2008, equivalent to 2.0% 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-owned 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 restricted common stock of publicly-owned companies. The fair values of these restricted securities are influenced by the nature of applicable resale restrictions, the underlying earnings and financial condition of the issuers of such restricted securities and the market valuations of comparable publicly-owned companies. A portion of our investment portfolio also consists of unrestricted, freely marketable common stock of publicly-owned companies. These freely marketable investments, which are valued at the public market price, are directly exposed to equity price risks, in that a change in an issuer’s public market equity price would result in an identical change in the fair value of our investment in such security.

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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   Chairman of the Board and President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934). Based on that evaluation, the Chairman of the Board and President and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that the information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and is accumulated and communicated to management, including the  Chairman of the Board and President and Chief Financial Officer  , as appropriate, to allow timely decisions regarding such required disclosure.

During the fiscal quarter ended December 31, 2008, there were no changes to the 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 are currently the subject of certain legal actions. In our judgment, none of the lawsuits currently pending against us, either individually or in the aggregate, is likely to have a material adverse effect on our business, results of operations, or financial position.

     We, Capital Southwest Corporation and Capital Southwest Venture Corporation, have been named in a lawsuit filed on August 27, 2007 in the United States District Court of the Northern District of Texas, Dallas Division, against Heelys, Inc and its Chief Executive Officer, Chief Financial Officer and the directors who signed its registration statement with the Securities and Exchange Commission in connection with its December 7, 2006 initial public offering (“IPO”), and its underwriters for the IPO. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933 and the plaintiffs are seeking compensatory damages in an unspecified amount, as well as reasonable costs and expenses incurred in the action, including counsel fees and expert fees.

     Similar suits were also filed in 2007 and 2008 in the United States District Court of the Northern District of Texas making substantially similar allegations under Sections 11, 12 and 15 of the Securities Act of 1933, and seeking substantially similar damages.

     We believe that the plaintiffs’ claims are without merit, we deny the allegations in the complaints, and we intend to vigorously defend the lawsuits.

Item 1A. Risk Factors

Deterioration in economic conditions could impair our portfolio companies, as a result, could reduce valuations and adversely affect our financial condition.

Changes in national and local economic conditions could have a negative impact on our business. Many of the companies in which we have made or will make investments may be susceptible to economic slowdowns or recessions. An economic slowdown may affect the ability of a company to operate profitably, acquire other companies, or engage in a liquidity event such as a sale.

Our business of making private equity investments also may be affected by current and future market conditions. As a result, the pace of our investment activity may slow. In addition, significant changes in the capital markets could have a negative effect on the valuations of our investments. This could have an adverse affect on our net asset value.

     There have been no material changes to our risk factors as disclosed in Item 1A, “Risk Factors”, in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
             Repurchases of Equity Securities
     

The following table provides information for the nine months ended December 31, 2008, regarding shares of our common stock that were repurchased under our repurchase plan which began on June 12, 2008 when the Company announced that its Board of Directors authorized a share repurchase plan, which allowed for the repurchase of up to 10 percent (or 388,915 shares) of its Common Stock at prices not above the lower of the net asset value per share of its Common Stock, or prices prevailing in the over-the-counter market at the time of such purchases. The repurchase program remained in effect until its expiration date of December 10, 2008. The Company did not make purchases under the plan during the quarter ended December 31, 2008. In total the Company purchased 147,513 shares of Common Stock for $16,903,346 at an average price of $114.59 per share, on the open market, while the plan was in effect.

                 

Maximum

 
           

Total Number of

     

Number of

 
           

Shares Purchased

     

Shares that

 
   

Total Number

       

as Part of

     

May be

 
   

of Shares

   

Average Price

   

Publicly

     

Purchased

 
Period    

Purchased

   

Paid Per Share

   

Announced Plan

     

Under the Plan

 
June 2008    

6,485

   

$ 111.72

   

6,485

      382,430  
July 2008    

132,727

   

$ 114.08

   

139,212

      249,703  
August 2008    

8,201

   

$ 124.96

   

147,413

      241,502  
September 2008    

100

   

$ 125.18

   

147,513

      241,402  
October 2008    

--

   

$          0

   

--

      241,402  
November 2008    

--

   

$          0

   

--

      241,402  
December 2008    

--

   

$          0

   

--

      241,402  
Total for the nine months    
    ended December 31, 2008    

147,513

   

$ 114.59

   

147,513

      241,402  


Item 6.     Exhibits

     (a) Exhibits

Exhibit 31.1- Certification of Chairman of the Board and President required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), filed herewith.

Exhibit 31.2- Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, filed herewith.

Exhibit 32.1- Certification of Chairman of the Board and President required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith.

Exhibit 32.2- Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, furnished herewith.


 

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SIGNATURES

Pursuant to the requirements of 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          
 
                                                                            /s/ Gary L. Martin
Date:   February 6, 2009  By:                
                                                                  Gary L. Martin, Chairman of the Board and President
 
 
                                                                            /s/ Tracy L. Morris
Date:   February 6, 2009  By:            
                                                                   Tracy L. Morris, Chief Financial Officer
 
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