CAPITAL SOUTHWEST CORP - Quarter Report: 2014 September (Form 10-Q)

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Retirement Plans. We record annual amounts relating to the pension plans based on calculations and various actuarial assumptions. Material changes in pension costs could occur due to changes in the discount rate, the expected long-term rate of return, mortality tables, and in the level of contributions to the plans and other factors.  The funded status of the qualified plan is the difference between the fair value of plan assets and the benefit obligation.  We recognize changes in the funded status of the qualified plan in the Statement of Assets and Liabilities in the year in which the changes occur and measure its assets and obligations as of the date of the employer’s fiscal year-end. In addition, CSWC also sponsors an unfunded Retirement Restoration Plan, which is a nonqualified plan that provides for the payment, upon retirement, of the difference between the maximum annual payment permissible under the qualified retirement plan pursuant to Federal limitations and the amount which would otherwise have been payable under the qualified plan. We presently use March 31 as the measurement date for retirement plans.

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

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 management believes our valuation methodologies are appropriate and consistent with market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  The three levels of the fair value hierarchy and investments that fall into each of the levels are described below:

·

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

·

Level 2: Investments whose values are based on observable inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  These inputs may include quoted prices for the identical instrument in non-active markets, quoted prices for similar instruments in active markets and similar data.  We did not value any of our investments using Level 2 inputs as of September 30, 2014.

·

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 81.1% of our investments as of September 30, 2014.  See “Notes to Consolidated Schedule of Investments” (c) on page 16 for the investment policy used to determine the fair value of these investments.

 

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As required by ASC 820, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within the fair value measurement is categorized based on the lowest level input that is significant to the fair value measurement which may include inputs that are observable (Levels 1 and 2) and unobservable (Level 3).  Therefore, gains and losses for such investments categorized within the Level 3 table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable (Level 3).  We conduct reviews of fair value hierarchy classifications on a quarterly basis.  Changes in the observability of valuation inputs may result in a reclassification of certain investments.

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

·

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

·

Current and projected financial condition of the portfolio company;

·

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

·

Projected operating results of the portfolio company;

·

Current information regarding any offers to purchase the investment or recent private sales transactions;

·

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

·

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

·

Qualitative assessment of key management;

·

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

·

Other factors deemed relevant.

 

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

 

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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. A significant increase or decrease in any of these valuation inputs in isolation would result in a significantly lower or higher fair value measurement. However, due to the nature of certain investments, fair value measurements may be based on other criteria, such as third party inputs.

 

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

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 September 30, 2014 and March 31, 2014. 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 9/30/2014 (in millions)

Unobservable Input

Range

Weighted Average

Preferred & Common Equity

Market Approach

$

453

EBITDA Multiple

2.00x – 7.75

x

7.14

x

Market Approach

20.9

Revenue Multiple

0.42x – 2.46

x

2.46

x

Market Approach

9.3

Cash and Asset Value

NA

NA

Market Approach

3.5

Multiple of Tangible Book Value

1.37

x

1.37

x

Market Approach

0.2

Market Value of Held Securities

NA

NA

486.9

Warrants

Black Scholes Pricing Model

1.2

Stock Price

$

0.00-$9.87

$

9.87

Debt

Liquidation Value

0.5

Cash and Asset Value

NA

NA

Market Approach

2.8

Face Value

NA

NA

3.3

Partnership Interests

Net Asset Value

8.2

Fund Value

NA

NA

Total

$

499.6

 

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Type

Valuation Technique

Fair Value at 3/31/2014 (in millions)

Unobservable Input

Range

Weighted Average

Preferred & Common Equity

Market Approach

$

404.1

EBITDA Multiple

3.50x – 7.78

x

7.00

x

Market Approach

22.0

Revenue Multiple

1.53x – 2.50

x

2.46

x

Market Approach

8.0

Recent Transaction Price

NA

NA

Market Approach

7.6

Cash and Asset Value

NA

NA

Market Approach

3.8

Multiple of Tangible Book Value

1.54

x

1.54

x

Market Approach

0.2

Market Value of Held Securities

NA

NA

445.7

Debt

Discounted Cash Flow

1.5

Discount Rate

11.69

%

11.69

%

Recent Transaction Price

1.2

Recent Transaction Price

NA

NA

Partnership Interests

2.7

Net Asset Value

9.5

Fund Value

NA

NA

Total

$

457.9

*All funds are valued in accordance with ASC 820.

As of September 30, 2014 and March 31, 2014, 81.1% and 67.5%, 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 September 30, 2014 and March 31, 2014 (in millions):

						Fair Value Measurements at September 30, 2014 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		$	3.3			$	−			$	−			$	3.3
Partnership Interests			8.2				−				−				8.2
Preferred Equity			50				−				−				50
Common Equity			553.7				116.8				−				436.9
Warrants			1.2				−				−				1.2
Total Investments		$	616.4			$	116.8			$	−			$	499.6

						Fair Value Measurements at March 31, 2014 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		$	2.7			$	−			$	−			$	2.7
Partnership Interests			9.5				−				−				9.5
Preferred Equity			47.0				−				−				47.0
Common Equity			618.7				220.0				−				398.7
Total Investments		$	677.9			$	220.0			$	−			$	457.9

 

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The following table provides a summary of changes in the fair value of investments measured using Level 3 inputs during the six months ended September 30, 2014 (in millions):

		Fair Value 3/31/14				Net Unrealized Appreciation (Depreciation)				New Investments				Divestitures				Conversion of Security from Debt to Equity				Fair Value at 9/30/2014
Debt		$	2.7			$	0.6			$	−			$	−			$	−			$	3.3
Partnership Interests			9.5				0.1				−				(1.4	)			−				8.2
Warrants			−				1.2				−				−				−				1.2
Preferred Equity			47.0				3.0				−				−				−				50.0
Common Equity			398.7				38.2				−				−				−				436.9
Total Investments		$	457.9			$	43.1			$	−			$	(1.4	)		$	−			$	499.6

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 income, as defined by the IRC, to our shareholders in a timely manner.  Investment company income generally includes net short-term capital gains but excludes net long-term capital gains.  A RIC is not subject to federal income tax on the portion of its ordinary income and long-term capital gains that are distributed to its shareholders, including “deemed distributions” discussed below.  As permitted by the Code, a RIC can designate dividends paid in the subsequent tax year as dividends of current year ordinary income and net long-term gains if those dividends are both declared by the extended due date of the RIC’s federal income tax return and paid to shareholders by the last day of the subsequent tax year.

We have distributed or intend to distribute sufficient dividends to eliminate taxable income for our completed tax years.  If we fail to satisfy the 90% distribution requirement or otherwise fail to qualify as a RIC in any tax year, we would be subject to tax in such year on all of our taxable income, regardless of whether we made any distributions to our shareholders.  For the tax years ended December 31, 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 “deemed distribution” to its shareholders and paying a federal tax rate of 35% on the long-term capital gains for the benefit of its shareholders.  Shareholders then report their share of the retained capital gains on their income tax returns as if it had been received and report a tax credit for tax paid on their behalf by the RIC.  Shareholders then add the amount of the “deemed distribution” net of such tax, to the basis of their shares.

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.

 

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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 September 30, 2014 and 2013, CSWC and CSVC qualified to be taxed as RICs.  We intend to meet the applicable qualifications to be taxed as a RIC in future years.  Management feels it is probable that we will maintain our RIC status for a period longer than one year.  However, either company’s ability to meet certain portfolio diversification requirements of RICs in future years may not be controllable by such company.

CSMC, a wholly-owned subsidiary of CSWC, 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 September 30, 2014, CSMC has a deferred tax liability of $2,189,383.

5.	ACCUMULATED NET REALIZED GAINS (LOSSES) ON INVESTMENTS

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

We incur federal taxes on behalf of our shareholders as a result of our election to retain long-term capital gains. We had $44,708,977 of accumulated long term capital gains at September 30, 2014 and $14,029,087 of accumulated long term capital gains at March 31, 2014.

6.	EXECUTIVE COMPENSATION PLAN

On August 28, 2014, our Board of Directors adopted an executive compensation consisting of grants of nonqualified stock options, restricted stock and cash incentive awards to executive officers of the Company that is intended to align the compensation of the Company’s executive officers with the Company’s key strategic objective of increasing the market value of the Company’s shares through a transformative transaction for the benefit of the Company’s shareholders. Under the plan, Joseph B. Armes, Chief Executive Officer, Kelly Tacke, Chief Financial Officer, and Bowen S. Diehl, Chief Investment Officer, will receive an amount equal to six percent of the aggregate appreciation in the Company’s share price from August 28, 2014 (using a base price of $36.16 per share) to the date of the transformative transaction (such transaction, the “Trigger Event,” the transaction date, the “Trigger Event Date” and such payment amount, the “Total Payout Amount”).  The value accretion will include the value of any distributions to the Company shareholders, including any capital stock spun-off to the Company shareholders.  As to any payout up to $22.5 million, one-third of the payout will be allocated to each such officer, with any payout in excess of $22.5 million to be allocated as follows: Mr. Armes-- 50%, Ms. Tacke--25% and Mr. Diehl--25%.  The initial plan component consists of nonqualified options awarded to purchase 259,000 shares of common stock at an exercise price of $36.60 per share. The second plan component consists of awards of 127,000 shares of restricted stock, which have voting rights but do not have cash dividend rights. The final plan component consists of cash incentive payments awarded to each of Mr. Armes, Ms. Tacke and Mr. Diehl in an amount equal to the excess of each awardee’s allocable portion of the Total Payment Amount over the aggregate value as of the Trigger Event Date of the awardee’s restricted common stock and nonqualified option awards under the plan.  The awards shall vest and be exercisable as follows: (i) 1/3 on the Trigger Event Date; (ii) 1/3 on the first anniversary of the Trigger Event Date; and (iii) 1/3 on the second anniversary of the Trigger Event Date. Entitlement to such awards is conditioned on the awardee remaining in the employment of the Company or its subsidiaries on the vesting date, or in the event the employment of the awardee is transferred to a Company subsidiary spun-off to the Company’s shareholders, continuing employment by such spun-off subsidiary. The Company, however, reserves the right, in its sole discretion, to terminate the cash incentive award or to reduce the amount payable thereunder at any time prior to the Trigger Event Date.

 

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7.	STOCK BASED COMPENSATION PLANS

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 $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 $23.95 per share (market price at time of grant) were granted on March 22, 2010, options to purchase 60,000 shares at $22.05 per share were granted on July 19, 2010 and options to purchase 40,000 shares at $24.23 per share were granted on July 18, 2011. Options to purchase 30,000 shares at $37.02 per share, 25,000 shares at $33.52 and 30,000 shares at $34.91 were granted on July 15, 2013, January 20, 2014 and March 17, 2014, respectively.  On August 28, 2014, options to purchase 259,000 shares at $36.60 per share were granted under the previously mentioned executive compensation plan. These options will not begin to be exercisable or vest until the occurrence of previously mentioned transformative transaction under Note 6. In addition, our Board of Directors amended the 2009 Plan, as permitted pursuant to Section 18 of the 2009 Plan (the “First Amendment to the 2009 Plan”).  The First Amendment to the 2009 Plan provides that an award agreement may allow an award to remain outstanding after a spin-off or change in control of one or more wholly-owned subsidiaries of the Company. At September 30, 2014, there are options to acquire 374,600 shares of common stock outstanding and options to acquire 4,000 shares of common stock available for grant under the 2009 Plan.

We previously granted stock options under our 1999 Stock Option Plan (the “1999 Plan”), as approved by shareholders on July 19, 1999.  The 1999 Plan expired on April 19, 2009.  Options previously granted under our 1999 Stock Option Plan and outstanding on July 20, 2009 continue in effect and are governed by the provisions of the 1999 Plan.  All options granted under the 1999 Plan were granted at or above market price on the date of grant, 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. At September 30, 2014, there are options to acquire 38,000 shares of common stock outstanding under the 1999 Plan.

 

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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. Share-based compensation cost for stock options 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 September 30, 2014 and 2013, we recognized stock option compensation expense of $54,107 and $132,136, respectively. For the six months ended September 30, 2014 and 2013, we recognized stock option compensation expense of $127,210 and $275,297, respectively.  We have not recognized any compensation expense related to the 259,000 options granted on August 28, 2014 as these options are subject to a contingent vesting mechanism.

As of September 30, 2014, the total remaining unrecognized compensation cost related to non-vested stock options was $720,192, which will be amortized over the weighted-average vesting period of approximately 2.6 years.

The following table summarizes the 2009 Plan and the 1999 Plan intrinsic 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		$	11.82				0.54	%			1.40	%			36.1	%			5
January 20, 2014		$	8.37				0.60	%			1.64	%			27.0	%			5
March 17, 2014		$	7.04				0.57	%			1.58	%			21.1	%			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

 

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* Excludes August 28, 2014 grant of options to purchase 259,000 shares of common stock at an exercise price of $36.60 as these options will not begin to be exercisable until the occurrence of a transformative transaction intended to increase the market value of the Company’s equity for the benefit of shareholders and cannot be modeled under the Black-Scholes pricing model at this time.

 

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The following table summarizes activity in the 2009 Plan and the 1999 Plan as of September 30, 2014:

 

		Number of Shares				Weighted Average Exercise Price
2009 Plan
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			85,000				35.25
Exercised			(69,108	)			22.27
Canceled/Forfeited			(63,000	)			22.08
Balance at March 31, 2014			123,800				31.40
Granted			259,000¹				36.60
Exercised			(4,200	)			23.95
Canceled/Forfeited			(4,000	)			23.95
Balance at September 30, 2014			374,600			$	35.16
1999 Plan
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			(108,000	)			30.37
Canceled/Forfeited			(100,000	)			38.25
Balance at March 31, 2014			38,000			$	26.68
Granted			–				–
Exercised			–				–
Canceled/Forfeited			–				–
Balance at September 30, 2014			38,000				26.68
Combined Balance at September 30, 2014			412,600			$	34.61
¹See Note 6.

 

September 30, 2014	Weighted Average Aggregate Intrinsic Remaining Contractual Term		Value*
Outstanding	2.6 years		$	1,240,573
Exercisable	0.8 years		$	415,790

 

* Excludes August 28, 2014 grant of options to purchase 259,000 shares of common stock at an exercise price of $36.60 as these options will not begin to be exercisable until the occurrence of a transformative transaction intended to increase the market value of the Company’s equity for the benefit of shareholders and cannot be modeled under the Black-Scholes pricing model at this time.

           At September 30, 2014, the range of exercise prices was $19.19 to $37.02 and the weighted-average remaining contractual life of outstanding options was 2.6 years, excluding the 259,000 shares of non-vested stock options which do not have a set vesting period. The total number of shares of common stock exercisable under both the 2009 Plan and the 1999 Plan at September 30, 2014, was 54,600 shares with a weighted-average exercise price of $27.07. During the quarter ended September 30, 2014, 4,200 options were exercised. During the quarter ended September 30, 2013, no options were exercised.

 

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Stock Awards

Pursuant to the Capital Southwest Corporation 2010 Restricted Stock Award Plan, our Board of Directors reserved for issuance to certain key employees 188,000 shares of restricted stock. A restricted stock award is an award of shares of our common stock, which generally have full voting and dividend rights but are restricted with regard to sale or transfer.  Unless otherwise specified in the award agreement, the restrictions 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. Unless otherwise specified in the award agreement, these shares vest in equal annual installments over a five-year period from the grant date and are expensed over the five-year vesting 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. On January 20, 2014, the Board of Directors granted 4,800 shares of restricted stock to key employees of the Company. On March 17, 2014, the Board of Directors granted 5,000 shares of restricted stock to a key employee of the Company. On August 28, 2014, the Board of Directors granted 127,000 shares of restricted stock under the previously mentioned executive compensation plan.  In addition, our Board of Directors amended the 2010 Plan, as permitted pursuant to Section 14 of the 2010 Plan (the “First Amendment to the 2010 Plan”).  The First Amendment to the 2010 Plan provides that an award agreement may allow an award to remain outstanding after a spin-off or change in control of one or more wholly-owned subsidiaries of the Company.

The following table summarizes the restricted stock available for issuance as of September 30, 2014:

Restricted stock available for issuance as of March 31, 2014			154,240
Restricted stock granted during the six months ended September 30, 2014			127,000¹
Restricted stock forfeited during the six months ended September 30, 2014			4,000
Restricted stock available for issuance as of September 30, 2014			31,240

¹See Note 6.

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. For these purposes, the fair value of the restricted stock award is determined based upon the closing price of our common stock on the date of the grant. For the quarters ended September 30, 2014 and 2013, we recognized total share based compensation expense of $22,421 and $43,574, respectively, related to the restricted stock issued to our employees and officers. For the six months ended September 30, 2014 and 2013, we recognized restricted stock compensation expense of $65,211 and $73,980, respectively. We have not recognized any compensation expense related to the 127,000 restricted stock awards granted on August 28, 2014 as these awards are subject to a contingent vesting mechanism.

As of September 30, 2014, the total remaining unrecognized compensation expense related to non-vested restricted stock awards was $535,185, which will be amortized over the weighted-average vesting period of approximately 3.8 years, excluding the 127,000 shares of non-vested restricted stock which do not have a set vesting period.

 

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The following table summarizes the restricted stock outstanding as of September 30, 2014:

 

Restricted Stock Awards		Number of Shares				Weighted Average Fair Value Per Share				Weighted Average Remaining Vesting Term (in Years)
Unvested at March 31, 2014			24,680			$	30.30				4.1
Granted			127,000¹				36.60			NA		²
Vested			−				−				−
Forfeited			(4,000	)			22.98				−
Unvested at September 30, 2014			147,680			$	30.30				3.8

 

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¹See Note 6.

² The 127,000 shares of restricted stock granted on August 28, 2014 will not begin to vest until the occurrence of a transformative transaction intended to increase the market value of the Company’s equity for the benefit of shareholders.

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. Additionally, the Board of Directors granted 38,000 shares of phantom stock options at an exercise price of $50.25 per share (Net Asset Value at December 31, 2013) to several key employees of the Company in January 2014 and March 2014. 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. The estimated liability for phantom stock awards was $591,225 as of September 30, 2014.

There were no phantom stock options granted during the six months ended September 30, 2014.

Phantom Stock Awards

Number of Shares

Weighted Average Grant Price Per Share

Weighted Average Remaining Vesting Term (in Years)

Unvested at March 31, 2014

95,000

$

43.59

4.1

Granted

−

−

−

Vested

−

−

−

Forfeited or expired

3,000

41.34

−

Unvested at September 30, 2014

92,000

$

43.66

3.6

8.	COMMITMENTS

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

 

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9.	SUMMARY OF PER SHARE INFORMATION

The following presents a summary of per share data for the three and six months ended September 30, 2014 and 2013.

		Three Months Ended September 30,								Six Months Ended September 30,
Per Share Data		2014				2013				2014				2013
Investment income		$	.05			$	.06			$	.10			$	.13
Operating expenses			(.11	)			(.13	)			(.27	)			(.28	)
Income taxes			(.02	)			(.01	)			(.01	)			(.01	)
Net investment loss			(.08	)			(.08	)			(.18	)			(.16	)
Distributions from undistributed net investment income			–				–				(.10	)			(.10	)
Net realized gains			2.99				–				1.97				–
Net increase in unrealized appreciation of investment			(4.87	)			2.99				(2.50	)			3.67
Capital Share transactions:
Exercise of employee stock options			(.01	)			–				(.01	)			(.03	)
Issuance of restricted stock*			(.41	)			(.01	)			(.38	)			.02
Stock option expense			–				.01				.01				.01
Increase in net asset value			(2.38	)			2.91				(1.19	)			3.41
Net asset value
Beginning of period			51.17				43.80				49.98				43.30
End of period		$	48.79			$	46.71			$	48.79			$	46.71

*Reflects impact of the different share amounts as a result of issuance or forfeiture of restricted stock during the period.

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, 2014 (the “Form 10-K”).

 

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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/loss,” which is the difference between income from interest, dividends and fees and our combined operating and interest expense, net of applicable income taxes.  The second element is “Net realized gain/loss on investments,” which is the difference between the proceeds received from the disposition of portfolio securities and their stated cost, net of applicable income tax expense based on our tax year.  The third element is the “Net increase 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 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 six months ended September 30, 2014, total investment income was $1,575,419, a $456,238, or 22.5%, decrease from total investment income of $2,031,657 for the six months ended September 30, 2013.  This decrease was primarily attributable to a decrease in interest income from PalletOne and i-Memories. PalletOne was sold in FY 2014 and we ceased accruing interest from i-Memories in the first quarter of the current year.

Our principal objective is to achieve capital appreciation. Therefore, a significant portion of our investment portfolio is structured to maximize the potential return from equity participation which typically provides minimal current yield in the form of interest or dividends.  We also earn interest income from the short-term investment of cash funds, and the annual amount of such income varies based upon the average level of funds invested during the year and fluctuations in short-term interest rates.  During the six months ended September 30, 2014 and 2013, the Company had interest income from temporary cash investments of $37,119 and $35,130, respectively.

The Company’s management fees, received primarily from its controlled affiliates, totaled $279,900 for both the six months ended September 30, 2014 and 2013.

During the three and six months ended September 30, 2014 and 2013, the Company recorded dividend income from the following sources:

		Three Months Ended September 30,								Six Months Ended September 30,
		2014				2013				2014				2013
Alamo Group, Inc.		$	198,310			$	198,310			$	396,620			$	396,571
Capitala Finance Corporation			50,810				–				50,810				–
Encore Wire Corporation			26,250				26,250				26,250				52,500
North American Energy Partners			–				–				1,190				–
The RectorSeal Corporation			240,000				240,000				480,000				480,000
TCI Holdings, Inc.			–				20,317				–				40,635
The Whitmore Manufacturing Company			60,000				60,000				120,000				120,000
		$	575,370			$	544,877			$	1,074,870			$	1,089,706