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 September 30, 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 October 31, 2008
TABLE OF CONTENTS Page No. -------- PART I. FINANCIAL INFORMATION ITEM 1. Consolidated Financial Statements Consolidated Statements of Financial Condition September 30, 2008 (Unaudited) and March 31, 2008..............3 Consolidated Statements of Operations (Unaudited) For the three and six months ended September 30, 2008 and September 30, 2007.............................................4 Consolidated Statements of Changes in Net Assets For the six months ended September 30, 2008 (Unaudited) and year ended March 31, 2008......................................5 Consolidated Statements of Cash Flows (Unaudited) For the three and six months ended September 30, 2008 and September 30, 2007.............................................6 Portfolio of Investments September 30, 2008.............................................7 Notes to Consolidated Financial Statements.............................14 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.....................19 ITEM 3. Quantitative and Qualitative Disclosure About Market Risk.............................................21 ITEM 4. Controls and Procedures.....................................21 PART II. OTHER INFORMATION ITEM 1 Legal Proceedings............................................22 ITEM 1A. Risk Factors...................................................22 ITEM 4. Submission of Matters to Vote of Security Holders...........22 ITEM 6. Exhibits ...................................................23 Signatures ...................................................................24
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION - ------------------------------- Item 1. Consolidated Financial Statements CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition ---------------------------------------------- September 30, March 31, 2008 2008 ------------- ------------- (Unaudited) <S> <C> <C> Assets Investments at market or fair value Companies more than 25% owned (Cost: September 30, 2008 - $28,908,246 March 31, 2008 - $28,758,246) $387,275,539 $410,026,178 Companies 5% to 25% owned (Cost: September 30, 2008 - $20,412,243, March 31, 2008 - $20,412,243) 57,671,133 54,895,381 Companies less than 5% owned (Cost: September 30, 2008 - $35,762,756, March 31, 2008 - $31,856,977) 75,452,373 82,648,943 ------------- ------------- Total investments (Cost: September 30, 2008- $85,083,245, March 31, 2008 - $81,027,466) 520,399,045 547,570,502 Cash and cash equivalents 9,400,652 31,327,758 Receivables 623,338 156,322 Other assets 7,820,058 7,630,486 ------------- ------------- Totals $538,243,093 $586,685,068 ============= ============= Liabilities and Shareholders' Equity Other liabilities $ 2,323,461 $ 1,187,796 Deferred income taxes 1,841,358 1,797,058 ------------- ------------- Total liabilities 4,164,819 2,984,854 ------------- ------------- Shareholders' equity Common stock, $1 par value: authorized, 5,000,000 shares; issued, 4,326,516 shares at September 30, 2008 and March 31, 2008 4,326,516 4,326,516 Additional capital 115,907,746 115,687,153 Undistributed net investment income 5,373,019 7,036,929 Undistributed net realized loss on investments (2,908,159) (2,860,118) Unrealized appreciation of investments 435,315,800 466,543,036 Treasury stock - at cost 584,878 shares at September 30, 2008 and 437,365 shares at March 31, 2008 (23,936,648) (7,033,302) ------------- ------------- Net assets at market or fair value, equivalent to $142.74 per share at September 30, 2008 on the 3,741,638 shares outstanding and $150.09 per share at March 31, 2008 on the 3,889,151 shares outstanding 534,078,274 583,700,214 ------------- ------------- Totals $538,243,093 $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 Six Months Ended September 30 September 30 ----------------------------- ------------------------------ 2008 2007 2008 2007 ---- ---- ---- ---- Investment income: Interest $ 327,171 $ 679,442 $ 677,023 $ 1,244,129 Dividends 677,999 801,467 1,335,479 1,164,894 Management and directors' fees 311,108 226,200 542,108 451,400 ------------- ------------- ------------- ------------- 1,316,278 1,707,109 2,554,610 2,860,423 ------------- ------------- ------------- ------------- Operating expenses: Salaries 439,480 291,085 777,919 565,221 Net pension benefit (44,779) (127,434) (126,617) (163,671) Other operating expenses 435,192 288,194 804,437 553,158 ------------- ------------- ------------- ------------- 829,893 451,845 1,455,739 954,708 ------------- ------------- ------------- ------------- Income before income taxes 486,385 1,255,264 1,098,871 1,905,715 Income tax expense 57,343 44,400 84,630 54,160 ------------- ------------- ------------- ------------- Net investment income $ 429,042 $ 1,210,864 $ 1,014,241 $ 1,851,555 ============= ============= ============= ============= Proceeds from disposition of investments $ -- $ 402,777 $ -- $ 728,552 Cost of investments sold 48,041 -- 48,041 -- ------------- ------------- ------------- ------------- Net realized gain (loss) on investments (48,041) 402,777 (48,041) 728,552 ------------- ------------- ------------- ------------- Net decrease in unrealized appreciation of investments (30,970,122) (138,128,989) (31,227,236) (120,980,544) ------------- ------------- ------------- ------------- Net realized and unrealized loss on investments $(31,018,163) $(137,726,212) $(31,275,277) $(120,251,992) ============= ============= ============= ============= Decrease in net assets from operations $(30,589,121) $(136,515,348) $(30,261,036) $(118,400,437) ============= ============= ============= ============= 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 ------------------------------------------------ Six Months Ended Year Ended September 30, 2008 March 31, 2008 ------------------ -------------- (Unaudited) Operations Net investment income $ 1,014,241 $ 3,715,200 Net realized gain (loss) on investments (48,041) 240,024 Net decrease in unrealized appreciation of investments (31,227,236) (142,969,698) ------------- ------------- Decrease in net assets from operations (30,261,036) (139,014,474) Distributions from: Undistributed net investment income (2,678,152) (2,333,291) Capital share transactions: Exercise of employee stock options -- 231,390 Change in pension plan funded status -- (1,178,764) Stock option expense 220,594 263,664 Treasury stock (16,903,346) -- ------------- ------------- Decrease in net assets (49,621,940) (142,031,475) Net assets, beginning of period 583,700,214 725,731,689 ------------- ------------- Net assets, end of period $534,078,274 $ 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 Six Months Ended September 30 September 30 ------------------------------ ------------------------------ 2008 2007 2008 2007 ---- ---- ---- ---- Cash flows from operating activities Decrease in net assets from operations $(30,589,121) $(136,515,348) $(30,261,036) $(118,400,437) Adjustments to reconcile increase in net assets from operations to net cash provided by operating activities: Proceeds from disposition of investments -- 402,777 -- 728,552 Purchases of securities (3,994,279) (1,163,347) (4,103,820) (9,215,094) Maturities of securities -- 150,000 -- 154,500 Depreciation and amortization 10,638 6,272 19,907 10,681 Net pension benefit (44,780) (127,434) (126,617) (163,671) Realized (gain) loss on investments before income taxes 48,041 (402,777) 48,041 (728,552) Net decrease in unrealized appreciation of investments 30,970,122 138,128,989 31,227,236 120,980,544 Stock option expense 132,605 44,100 220,594 87,686 (Increase) decrease in receivables (442,880) 50,016 (467,016) 234,936 Increase in other assets (26,325) (23,679) (23,747) (30,408) Increase (decrease) in other liabilities (497,383) 43,779 22,992 (75,384) Decrease in accrued pension cost (34,467) (30,266) (68,934) (66,834) Increase in deferred income taxes 15,800 44,400 44,300 57,000 ------------- ------------- ------------- ------------- Net cash provided by (used in) operating activities (4,452,029) 607,482 (3,468,100) (6,426,481) ------------- ------------- ------------- ------------- Cash flows from financing activities Distributions from undistributed net investment income -- -- (1,555,660) (777,630) Proceeds from exercise of employee stock options -- -- -- 231,390 Purchase of treasury stock (16,178,867) -- (16,903,346) -- ------------- ------------- ------------- ------------- Net cash used in financing activities (16,178,867) -- (18,459,006) (546,240) ------------- ------------- ------------- ------------- Net increase (decrease) in cash and cash equivalents (20,630,896) 607,482 (21,927,106) (6,972,721) Cash and cash equivalents at beginning of period 30,031,548 31,264,000 31,327,758 38,844,203 ------------- ------------- ------------- ------------- Cash and cash equivalents at end of period $ 9,400,652 $ 31,871,482 $ 9,400,652 $ 31,871,482 ============= ============= ============= ============= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ -- $ -- $ -- $ -- Income taxes $ -- $ -- $ -- $ -- </TABLE> The accompanying Notes are an integral part of these Consolidated Financial Statements 6
<TABLE> <CAPTION> CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- September 30, 2008 Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> +AT&T INC. ++20,770 shares common stock (acquired 3-9-99) $ 12 $ 579,898 San Antonio, Texas Global leader in local, long distance, Internet and transaction-based voice and data services. +ALAMO GROUP INC. 2,830,300 shares common stock Seguin, Texas (acquired 4-1-73 thru 5-25-07) 2,190,937 33,963,600 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 5,400,000 Austin, Texas 150,000 shares Series A Convertible Preferred Stock, Electronics contract manufacturing; convertible into 600,000 shares of common stock distribution and production of memory at $0.25 per share (acquired 9-16-94) 150,000 -- and other components for computer Warrants to purchase 350,000 shares of common stock manufacturers, retailers and value-added at $11.00 per share, expiring 2017 (acquired 6-27-07) -- -- resellers. ---------- ---------- 6,150,000 5,400,000 +ASCENT MEDIA CORPORATION ++3,525 shares Series A common stock (acquired 9-26-08) -- 86,045 Santa Monica, California Provider of content production, management and distribution services for television and film industries. 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 Wichita, Kansas Class B non-voting common stock Specialty architectural products used in (acquired 10-25-83 and 5-30-02) 624,920 6,000,000 the construction and remodeling of commercial and institutional buildings. BOXX TECHNOLOGIES, INC. 3,125,354 shares Series B Convertible Preferred Stock, Austin, Texas convertible into 3,125,354 shares of common stock Workstations for computer graphic at $0.50 per share (acquired 8-20-99 thru 8-8-01) 1,500,000 2 imaging and design. 7
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- September 30, 2008 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ CMI HOLDING COMPANY, INC. 10% convertible subordinated note, due 2009, Richardson, Texas (acquired 7-2-07 thru 10-9-07) $ 2,363,347 $ 1,000,000 Owns Chase Medical, which develops 2,327,658 shares Series A Convertible Preferred Stock, and sells devices used in cardiac surgery convertible into 2,327,658 shares of common stock to relieve congestive heart failure; develops at $1.72 per share (acquired 8-21-02 and 6-4-03) 4,000,000 2 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 CINATRA CLEAN TECHNOLOGIES, INC, 10% subordinated secured promissory note 2,743,000 2,743,000 Houston, Texas (acquired 7-14-08) Cleans above ground oil storage tanks 533,300 shares Series A Convertible Preferred with a patented, automated system. Stock, convertible into 533,300 shares common 533,300 533,300 stock at $1.00 per share(acquired 7-14-08) ---------- ---------- 3,276,300 3,276,300 +COMCAST CORPORATION ++64,656 shares common stock (acquired 11-18-02) 21 1,269,197 Philadelphia, Pennsylvania Leading provider of cable, entertainment and communications products and services. DENNIS TOOL COMPANY 20,725 shares 5% Convertible Preferred Stock, Houston, Texas convertible into 20,725 shares of common stock Polycrystalline diamond compacts (PDCs) at $48.25 per share (acquired 8-10-98) 999,981 999,981 used in oil field drill bits and in mining 140,137 shares common stock (acquired 3-7-94 and industrial applications. and 8-10-98) 2,329,963 3,200,000 ---------- ---------- 3,329,944 4,199,981 +DISCOVERY COMMUNICATIONS, INC. ++35,250 shares Series A common stock (acquired 9-26-08) 10,131 502,313 Silver Spring, MD ++35,250 shares Series A common stock (acquired 9-26-08) 10,131 488,918 Provider of creative content, media -------- -------- management and network services 20,262 991,231 worldwide. +EMBARQ CORPORATION ++4,500 shares common stock (acquired 5-17-06) 46,532 182,475 Overland Park, Kansas Local exchange carrier that provides voice and data services, including high-speed Internet. +ENCORE WIRE CORPORATION 4,086,750 shares common stock (acquired 7-16-92 McKinney, Texas thru 10-7-98) 5,800,000 55,171,125 Electric wire and cable for residential and commercial use. 8
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- September 30, 2008 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ EXTREME INTERNATIONAL, INC. 11,797.5 shares Series A common stock Sugar Land, Texas (acquired 9-26-08) $ 294,938 $ 526,000 Owns Bill Young Productions, Texas 39,359.18 shares Series C Convertible Preferred Stock, Video and Post, and Extreme Communi- convertible into 157,436.72 shares of common stock cations, which produce radio and television at $25.00 per share (acquired 9-30-03) 2,625,000 7,026,000 commercials and corporate communica- 3,750 shares 8% Series A Convertible Preferred Stock, tions videos. convertible into 15,000 shares of common stock at $25.00 per share (acquired 9-30-03) 375,000 669,000 Warrants to purchase 1,237.50 shares of common stock at $25.00 per share, expiring 2008 (acquired 1-15-02) -- 28,000 ---------- ---------- 3,294,938 8,249,000 +FMC CORPORATION ++12,860 shares common stock (acquired 6-6-86 Philadelphia, Pennsylvania and 9-13-07) 66,727 660,875 Chemicals for agricultural, industrial and consumer markets. +FMC TECHNOLOGIES, INC. ++22,114 shares common stock (acquired 1-2-02 Houston, Texas and 8-31-07) 57,051 1,029,407 Equipment and systems for the energy, food processing and air transportation industries. +HEELYS, INC. 9,317,310 shares common stock (acquired 5-26-00) 102,490 34,939,913 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 12,143,816 Bedford, Massachusetts Medical instruments including bone densitometers, mammography devices and digital radiography systems. +JOHNBEAN TECHNOLOGIES CORP ++4,776 shares common stock (acquired 7-31-08) -- 60,464 Chicago, Illinois Global technology solutions provider to high-value segments of the food processing and air transportation industry. +KIMBERLY-CLARK CORPORATION ++77,180 shares common stock (acquired 12-18-97) 2,358,518 5,004,351 Dallas, Texas Manufacturer of tissue, personal care and health care products. +LIBERTY GLOBAL, INC. ++42,463 shares Series A common stock (acquired 6-15-05) 106,553 1,285,355 Englewood, Colorado ++42,463 shares Series C common stock (acquired 9-6-05) 100,870 1,192,786 Owns interests in broadband, distribution ---------- ---------- and content companies. 207,423 2,478,141 9
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- September 30, 2008 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ +LIBERTY MEDIA CORPORATION ++35,250 shares of Liberty Capital Series A common Englewood, Colorado stock (acquired 5-9-06) $ 7,833 $ 470,588 Holding company owning interests in ++176,252 shares of Liberty Interactive Series A electronic retailing, media, communica- common stock (acquired 5-9-06) 66,423 2,275,413 tions and entertainment businesses. ++141,000 shares of Liberty Entertainment Series A common stock (acquired 3-3-08) 43,996 3,513,720 ---------- ---------- 118,252 6,259,721 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. MEDIA RECOVERY, INC. 800,000 shares Series A Convertible Preferred Stock, Dallas, Texas convertible into 800,000 shares of common stock at Computer datacenter and office automation $1.00 per share (acquired 11-4-97) 800,000 5,333,000 supplies and accessories; impact, tilt 4,000,002 shares common stock (acquired 11-4-97) 4,615,000 26,667,000 monitoring and temperature sensing ---------- ---------- devices to detect mishandling shipments; 5,415,000 32,000,000 dunnage for protecting shipments. PALLETONE, INC. 12.3% senior subordinated notes due 2012 Bartow, Florida (acquired 9-25-06) 1,553,150 1,500,000 Manufacturer of wooden pallets and 150,000 shares common stock (acquired 10-18-01) 150,000 2 pressure-treated lumber. Warrant to purchase 15,294 shares of common stock at $1.00 per share, expiring 2011 (acquired 2-17-06) 45,746 -- ---------- ---------- 1,748,896 1,500,002 +PALM HARBOR HOMES, INC. 7,855,121 shares common stock (acquired 1-3-85 Dallas, Texas thru 7-31-95) 10,931,955 35,348,045 Integrated manufacturing, retailing, financing and insuring of manufactured housing and modular homes. +PETSMART, INC. ++300,000 shares common stock (acquired 6-1-95) 1,318,771 7,410,000 Phoenix, Arizona Retail chain of more than 928 stores selling pet foods, supplies and services. THE RECTORSEAL CORPORATION 27,907 shares common stock (acquired 1-5-73 Houston, Texas and 3-31-73) 52,600 131,500,000 Specialty chemicals for plumbing, HVAC, electrical, construction, industrial, oil field and automotive applications; smoke containment systems for building fires; also owns 20% of The Whitmore Manuacturing Company. +SPRINT NEXTEL CORPORATION ++90,000 shares common stock (acquired 6-20-84) 457,113 549,000 Reston, Virginia Diversified telecommunications company. 10
CAPITAL SOUTHWEST CORPORATION AND SUBSIDIARIES Consolidated Statement of Investments ------------------------------------- September 30, 2008 (continued) Company Investment (a) Cost Value (b) - ------------------------------------------------------------------------------------------------------------------------------------ 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 9,969,396 Dallas, Texas Regional bank holding company with banking operations in six Texas cities. VIA HOLDINGS, INC. 9,118 shares Series B Preferred Stock Sparks, Nevada (acquired 9-19-05) 4,559,000 2 Designer, manufacturer and distributor 1,118 shares Series C Preferred Stock of high-quality office seating. (acquired 11-01-07) 281,523 2 ---------- ---------- 4,840,523 4 WELLOGIX, INC. 4,788,371 shares Series A-1 Convertible Participating Houston, Texas Preferred Stock, convertible into 4,788,371 shares Developer and supporter of software of common stock at $1.0441 per share used by the oil and gas industry to (acquired 8-19-05 thru 6-15-08) 5,000,000 2 control drilling and maintenance expenses. THE WHITMORE MANUFACTURING COMPANY 80 shares common stock (acquired 8-31-79) 1,600,000 38,000,000 Rockwall, Texas Specialized mining, railroad and industrial lubricants; coatings for automobiles and primary metals; fluid contamination control devices. +WINDSTREAM CORPORATION ++9,181 shares common stock (acquired 7-17-06) 19,656 100,440 Little Rock, Arkansas Provider of voice, broadband and entertainment services. MISCELLANEOUS - Ballast Point Ventures II, L.P. - 2.6% limited partnership interest(acquired 8-4-08) 225,000 225,000 - BankCap Partners Fund I, L.P. - 6.0% limited partnership interest (acquired 7-14-06 thru 6-23-08) 2,566,681 2,566,681 - 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) 150,000 150,000 - First Capital Group of Texas III, L.P. - 3.3% limited partnership interest (acquired 12-26-00 thru 8-12-05) 964,604 964,604 - Humac Company - 1,041,000 shares common stock (acquired 1-31-75 and 12-31-75) -- 174,000 - PharmaFab, Inc. - contingent payment agreement (acquired 2-15-07) 2 2 - STARTech Seed Fund I - 12.1% limited partnership interest (acquired 4-17-98 thru 1-5-00) 178,066 1 - STARTech Seed Fund II - 3.2% limited partnership interest (acquired 4-28-00 thru 2-23-05) 950,000 1 - Sterling Group Partners I, L.P. - 1.7% limited partnership interest (acquired 4-20-01 thru 1-24-05) 1,064,042 1,506,817 - ------------------------------------------------------------------------------------------------------------------------------------ TOTAL INVESTMENTS $85,083,245 $520,399,045 =========== ============ - ------------------------------------------------------------------------------------------------------------------------------------ +Publicly-owned company ++Unrestricted securities as defined in Note (a) </TABLE> 11
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 September 30, 2008, restricted securities represented approximately 90.6% 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. We adopted SFAS No. 157 on April 1, 2008 (see footnote 1 in "Notes to Consolidated Financial Statements," page 13). 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 12
Notes to Consolidated Statement of Investments (continued) 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. 13
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. 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 14
<TABLE> <CAPTION> Notes to Consolidated Financial Statements (continued) 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: o 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. o 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 September 30, 2008. o 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 September 30, 2008 (in millions): Level 1 Level 2 Level 3 Total ------- ------- ------- ------- Debt $ -- $ -- $ 10.6 $ 10.6 Partnership Interests -- -- 9.9 9.9 Preferred Equity -- -- 14.6 14.6 Common Equity 48.8 -- 436.5 485.3 Equity Warrants -- -- -- -- ------- ------- ------- ------- Total Investments $48.8 $ -- $471.6 $520.4 ======= ======= ======= ======= 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 September 30, 2008 (in millions): Purchases, Sales, Beginning Unrealized Issuance & Ending Balance gain (loss) Settlement Balances ------- ----------- ---------- -------- <S> <C> <C> <C> <C> Debt $ 9.0 $( 1.1) $ 2.7 $ 10.6 Partnership Interests 9.2 0.4 0.4 9.9 Preferred Equity 20.5 (6.4) 0.5 14.6 Common Equity 459.8 (23.9) 0.6 436.5 Equity Warrants 0.3 -- (0.3) -- ------ ------ ------ ------ Total Investments $498.7 $(31.0) $ 3.9 $471.6 ====== ====== ====== ====== 15
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 six months ended September 30, 2008 (in millions): Purchases, Sales, Beginning Unrealized Issuance & Ending Balance gain (loss) Settlement Balances ------- ----------- ---------- -------- Debt $ 9.0 $ (1.1) $ 2.7 $ 10.6 Partnership Interests 9.1 0.4 0.4 9.9 Preferred Equity 20.4 (6.3) 0.5 14.6 Common Equity 456.0 (20.2) 0.7 436.5 Equity Warrants 0.4 (0.1) (0.3) -- ------ ------ ------ ------ Total Investments $494.8 $(27.3) $ 4.1 $471.6 ====== ====== ====== ====== 3. 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 six months ended September 30, 2008, we recognized compensation expense of $132,605 and $220,594, respectively. As of September 30, 2008, the total remaining unrecognized compensation cost related to non-vested stock options was $2,645,978, which will be amortized over the weighted-average service period of approximately 5.2 years. 4. 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 September 30, 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 ----------------------------------------------------------- Weighted Expected Risk-Free Expected Average Dividend Interest Expected Life Date of Issuance Fair Value Yield Rate Volatility (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 16
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 September 30, 2008 107,900 $114.78 ======= ======= At September 30, 2008, the range of exercise prices and weighted-average remaining contractual life of outstanding options was $65.00 to $152.98 and 5.2 years, respectively. No options were exercised during the six months ended September 30, 2008. At September 30, 2008, the number of options exercisable was 21,445 and the weighted-average exercise price of those options was $97.00. 5. Summary of Per Share Information Three Months Ended Six Months Ended September 30 September 30 ----------------- ----------------- 2008 2007 2008 2007 ---- ---- ---- ---- Investment income $ .35 $ .44 $ .68 $ .74 Operating expenses (.22) (.12) (.39) (.25) Interest expense -- -- -- -- Income taxes (.02) (.01) (.02) (.01) ------- ------- ------- ------- Net investment income .11 .31 .27 .48 Distributions from undistributed net investment income (.30) -- (.72) (.20) Net realized gain (loss) on investments (.01) .10 (.01) .19 Net decrease in unrealized appreciation of investments (8.28) (35.52) (8.35) (31.11) Treasury stock repurchase * 1.33 -- 1.40 -- Exercise of employee stock options ** -- -- -- (.09) Stock option expense 0.4 .01 .06 .02 ------- ------- ------- ------- Decrease in net asset value (7.11) (35.10) (7.35) (30.71) Net asset value: Beginning of period 149.85 191.13 150.09 186.75 ------- ------- ------- ------- End of period $142.74 $156.04 $142.74 $156.04 ======= ======= ======= ======= Shares outstanding at end of period (000s omitted) 3,742 3,889 3,742 3,889 </TABLE> * 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. 6. Share Repurchase Plan On June 12, 2008, the Company announced that its Board of Directors authorized a share repurchase plan, which allows 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 17
Notes to Consolidated Financial Statements (continued) prices prevailing in the over-the-counter market at the time of such purchases. The Company anticipates that share purchases will be made from time to time, depending upon market conditions. Shares may be purchased on the open market, including block repurchases, or through privately negotiated transactions. The Company does not intend to purchase any shares from its directors, officers or other affiliates. The repurchase program does not obligate the Company to acquire any specific number of shares and may be discontinued at any time. The Company intends to fund the purchases with available cash and/or the sale of marketable securities readily available for sale. The repurchase program is expected to be in effect through December 10, 2008, or until the approved number of shares has been repurchased. During the quarter ended September 30, 2008, the Company purchased a total of 141,028 shares of its Common Stock on the open market for $16,178,867 at an average price of $114.72 per share, which brings the total shares of its Common Stock purchased on the open market since announcing its plan to 147,513 shares for $16,903,346 at an average price of $114.59 per share. 7. 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. 18
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Net asset value at September 30, 2008 was $534,078,274, equivalent to $142.74 per share. Assuming reinvestment of all dividends and tax credits on retained long-term capital gains, the September 30, 2008 net asset value reflects a decrease of 7.91% during the past twelve months. September 30, September 30, 2008 2007 ---- ---- Net assets $534,078,274 $606,872,698 Shares outstanding 3,741,638 3,889,151 Net assets per share $142.74 $156.04 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 $677,023 for the six months ended September 30, 2008 decreased from $1,244,125 in the year-ago period due to a decrease in excess cash and interest rates. During the six months ended September 30, 2008 and 2007, we recorded dividend income from the following sources: Six Months Ended September --------- 2008 2007 ---- ---- Alamo Group Inc. $ 339,636 $ 339,096 Dennis Tool Company 25,000 37,499 Encore Wire Corporation 163,470 163,470 Kimberly-Clark Corporation 89,529 81,811 Lifemark Group 0 150,000 PETsMart, Inc. 18,000 18,000 The RectorSeal Corporation 480,000 240,000 TCI Holdings, Inc. 40,635 40,635 The Whitmore Manufacturing Company 120,000 60,000 Other 59,209 34,383 ---------- ---------- $1,335,479 $1,164,894 ========== ========== 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: 19
<TABLE> <CAPTION> Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Three Months Ended Six Months Ended September 30 September 30 ------------ ------------ 2008 2007 2008 2007 ---- ---- ---- ---- <S> <C> <C> <C> <C> Alamo Group Inc. $(11,321,200) $ -- $(11,321,200) $ 27,110 All Components, Inc. (7,200,000) 5,600,000 (7,200,000) 5,600,000 Encore Wire Corporation (10,216,875) -- 4,086,750 6,130,000 Heelys, Inc. -- (130,442,000) -- (139,760,000) Media Recovery, Inc. (5,500,000) (9,000,000) (5,500,000) (9,000,000) Palm Harbor Homes, Inc. -- (7,855,000) 3,927,561 (7,855,000) The RectorSeal Corporation 2,300,000 -- (12,700,000) 10,850,000 </TABLE> During the six months ended September 30, 2008, the value of our investments in The RectorSeal Corporation decreased by $12,700,000, All Components, Inc. decreased $7,200,000 and Media Recovery, Inc decreased $5,500,000, due to decreases in their respective sales resulting from slowdowns in segments of their businesses. Additionally, our investment in Alamo Group Inc. decreased $11,321,200 due primarily to the decrease in their stock price at September 30, 2008. Offsetting the loss at The RectorSeal Corporation, All Components, Inc., Media Recovery, Inc. and Alamo Group Inc. during the six months ended September 30, 2008, was a $4,086,750 increase in the value of Encore Wire Corporation and a $3,927,561 increase in the value of Palm Harbor Homes, Inc. due to increases in their respective stock prices. Portfolio Investments During the quarter ended September 30, 2008, we made investments of $3,651,300 in three new portfolio companies and an investment of $294,938 in an existing portfolio company. We have agreed, subject to certain conditions, to invest up to $12,578,419 in six portfolio companies. Financial Liquidity and Capital Resources At September 30, 2008, we had cash and cash equivalents of approximately $9.4 million. Pursuant to Small Business Administration (SBA) regulations, cash and cash equivalents of $4.6 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 fiscal year ended March 31, 1996, we have elected to retain all gains realized during the past 39 years. Retention of future gains is viewed as an important source of funds to sustain our investment activity. Approximately $48.8 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 Lifemark Group, 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. 20
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 $10,643,000 at September 30, 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. Item 4. Controls and Procedures As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the President and Chairman of the Board 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 President and Chairman of the Board 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 President and Chairman of the Board and Chief Financial Officer, as appropriate, to allow timely decisions regarding such required disclosure. During the fiscal quarter ended September 30, 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. 21
<TABLE> <CAPTION> 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 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. Item 4. Submission of Matters to a Vote of Security Holders Our Annual Meeting of Stockholders was held on July 21, 2008, with the following results of elections and approval: Votes Cast ------------------------------------------- <S> <C> Against/ Abstentions/ For Withheld Non-Votes a. The following Directors were elected to serve ------- -------- --------- until the next Annual Meeting of Stockholders: Donald W. Burton 2,831,910 592,506 464,735 Graeme W. Henderson 2,720,798 703,618 464,735 Samuel B. Ligon 2,734,283 690,133 464,735 Gary L. Martin 2,811,850 612,566 464,735 William R. Thomas 2,691,304 733,112 464,735 John H. Wilson 2,722,722 701,694 464,735 22
Item 4. Submission of Matters to a Vote of Security Holders (continued) Votes Cast ------------------------------------------- Against/ Abstentions/ For Withheld Non-Votes ------- -------- --------- b. Grant Thornton LLP was approved as our independent registered accounting firm for the 2009 fiscal year. 2,797,197 627,219 464,735 </TABLE> Item 6. Exhibits (a) Exhibits Exhibit 31.1- Certification of President and Chairman of the Board 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 President and Chairman of the Board 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. 23
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: November 7, 2008 By: --------------------- ------------------------------------------- Gary L. Martin, President and Chairman of the Board /s/ Tracy L. Morris Date: November 7, 2008 By: --------------------- ------------------------------------------ Tracy L. Morris, Chief Financial Officer 24