Capital Southwest Corporation (CSWC) Earnings

Management highlights

- Overall Annual Performance: Fiscal year 2026 delivered strong results, including 17% portfolio growth, 14% investment income growth, a 40% return on equity, and stable NAV, demonstrating resilience through market volatility. Non-accrual loans fell to 1.1% of fair value from 1.7% year-over-year, with seven watchlist companies improving and two removed from the watchlist during the quarter. - Credit Underwriting and Portfolio Quality: The firm maintains a conservative underwriting approach, with a weighted average leverage of 3.6x EBITDA, weighted average interest coverage of 3.5x, and average loan exposure equal to 43% of portfolio company enterprise value. 88% of the portfolio at fair value is rated in the top two internal risk categories, and granular exposure (less than 1% per company) mitigates idiosyncratic risk. - Capital Raising and Diversification: Capital Southwest raised over $465 million in new debt capital during the year (including a $350 million 5.9% bond issuance, $90 million in SBIC fund leverage commitments, and $25 million in corporate credit facility commitments) and over $160 million in gross equity proceeds via its ATM program at 1.3x prevailing NAV. - Joint Venture Progress: CapTrend Partners, the JV with Trinity Capital, now holds ~$85 million in assets, and a post-quarter-end $150 million revolving credit facility was closed to expand origination capacity. The JV targets 13-14% returns once fully ramped and improves the firm’s competitiveness on mid-spread deals. - Dividend Track Record: Total dividends per share increased from $2.54 in fiscal 2025 to $2.56 in fiscal 2026, despite a 60 basis point decline in SOFR. Undistributed taxable income (UTI) stands at $1.07 per share, providing a buffer for future dividend distributions. - Lower Middle Market Dynamics: Contrary to broader middle market M&A slowdowns, the lower middle market has steady, resilient transaction activity driven by non-cyclical founder catalysts (retirement, succession, de-risking). Deal flow has increased, driven by team expansion and the JV, though the close rate has moderated to 1.5% from the historical 2% as the firm maintains pricing and structure discipline.

Guidance

- Operating leverage is expected to be maintained in a 1.4% to 1.5% range as the team expands, which remains well below the BDC industry median of 2.7%. - A portion of the $37.8 million in unrealized equity appreciation is expected to be harvested as realized gains in fiscal 2027, adding to the UTI balance to support future dividend distributions. Two large equity exits are expected to close in the near term: one via IPO within 3-4 months, and another currently marketed for sale. - The CapTrend Partners JV is expected to take 18 to 24 months to reach full ramp, and will generate double-digit returns within the next 6 months, reaching the 13-14% target once fully scaled. It is expected to add 1-2 cents per share in incremental upside once ramped. - Regulatory leverage target remains 0.85x to 0.95x debt-to-equity, with the firm maintaining a prudent leverage cushion to mitigate capital markets volatility. - Quarterly total compensation expense is expected to average ~$5.5 million going forward, with minor volatility from bonus accrual adjustments.

Segment performance

Capital Southwest’s total portfolio grew 17% year-over-year to $2.1 billion as of fiscal year end 2026. The portfolio allocation is: 90.1% first lien senior secured debt, 1.2% second lien senior secured debt, and 8.6% equity co-investments. The on-balance sheet credit portfolio grew 19% year-over-year to $1.9 billion, with a weighted average yield of 10.8%, 99% first lien exposure, and a weighted average exposure per company of 0.9%. The equity co-investment portfolio has a total fair value of $181 million (9% of total portfolio fair value), marked at 126% of cost with $37.8 million in embedded unrealized appreciation ($0.62 per share). For the fourth quarter, pre-tax net investment income was $35.2 million, or $0.59 per share, and total investment income decreased to $57.8 million from $61.4 million in the prior quarter. Net asset value (NAV) per share closed the fiscal year at $16.69, essentially flat from $16.70 in the prior fiscal year. Full fiscal year 2026 investment income grew 14% year-over-year to $232 million from $204 million.

Risks & headwinds

- Broader macroeconomic volatility, geopolitical conflict (specifically the conflict in Iran), inflation uncertainty, and AI-related market risks have created disruption, though the firm’s lower middle market focus and conservative underwriting have mitigated these impacts. - The lower middle market lending space is competitive, with both bank and non-bank lenders compressing pricing for high-quality opportunities. - Market valuation multiples declined in the fourth quarter, creating downward pressure on net asset value even for fundamentally strong portfolio companies. - Elevated base rates in prior periods created pressure on portfolio company cash flow, though interest coverage has improved as rates have declined.

Analyst Q&A

• Q: What drove unrealized depreciation in the credit portfolio this quarter, is it credit-specific or market-driven? Why has Capital Southwest maintained such low software exposure compared to peer BDCs? /

  A: Most of the quarterly unrealized markdown came from broad market multiple declines, with only one material credit-specific write-down of a single watchlist company; 95% of the portfolio performed well. Low software exposure is intentional: most software companies are larger, venture-focused, and rely on ARR-based valuation, which does not fit Capital Southwest’s conservative cash flow EBITDA-based underwriting framework, and the team has opted to stick to its core area of expertise rather than pursue unfamiliar asset classes.

• Q: What drove the unusually low operating leverage in the fourth quarter, and can you confirm what operating costs to expect going forward? /

  A: The lower operating leverage stemmed from a year-end adjustment to over-accrued annual bonus pools, not underperformance or missed deployment targets; the year was viewed as very successful. Going forward, investors should expect quarterly total compensation expenses to hover around $5.5 million, with only minor volatility from similar year-end accrual adjustments.

• Q: What gives management confidence that unrealized equity appreciation will be monetized in 2027, and what is the timeline for the CapTrend JV to reach its 13-14% target return? /

  A: Two large appreciated equity positions are already in the exit process: one is in an active IPO pipeline expected to close within 3-4 months with a price floor on equity value, and another is currently being marketed for sale. The JV will take 18 to 24 months to reach full ramp, but will generate double-digit returns within 6 months, gradually rising to the 13-14% target as leverage is scaled. The JV also improves competitiveness on mid-spread deals that the firm previously could not win.

• Q: How will expanded headcount impact fiscal 2027 origination activity? /

  A: Headcount has grown from 27 employees 18 months ago to 36 at quarter-end, with 7 more hires planned to reach 43 total, including expanded deal and operations teams. This expansion supports a near 75% increase in annual deal review volume, from 800 deals per year two years ago to a current run rate of 1,400 deals per year, enabling sustained origination growth while maintaining underwriting discipline.