Capital Southwest Corporation Q1 FY2026 earnings call

• Strengthened balance sheet by reducing investment portfolio weighted average debt to EBITDA from 3.5x to 3.4x, PIK rate from 7.6% to 5.8%, and nonaccrual rate from 1.7% to 0.8%.
• Transitioned regular dividend payment frequency from quarterly to monthly, with $0.58 regular dividend per share for the quarter and $0.06 supplemental dividend, totaling $0.64 per share.
• Received final approval from the SBA for a second SBIC license, increased existing corporate credit facility by $25 million to $510 million, and raised $42 million in gross equity proceeds through equity ATM program.
• Took conservative underwriting approach due to tariffs and government policies, with solid deal flow in lower middle market, $115 million in total new commitments to 3 new and 12 existing portfolio companies.
• Progress on AFFE rule with house passage of the Access to Small Business Investor Capital Act, which could impact BDC trading volumes.

The company's credit portfolio is composed of 89.6% first lien senior secured debt, 1% second lien senior secured debt, and 9.3% equity co-investments. Pretax net investment income for the quarter was $0.61 per share. The investment revenue PIK rate decreased from 7.6% to 5.8%, and the nonaccrual rate dropped from 1.7% to 0.8% of the investment portfolio at fair value. The credit portfolio had a weighted average yield of 11.8% and a weighted average leverage of 3.4x EBITDA. The equity co-investment portfolio consisted of 80 investments with a total fair value of $166 million, representing 9% of the total portfolio at fair value, marked at 125% of cost with $33.2 million in embedded unrealized appreciation or $0.60 per share.

• Anticipate operating leverage to be in the 1.4% to 1.5% range by the end of the current fiscal year.
• Plan to continue being opportunistic with balance sheet given robust liquidity and conservative structure.
• Confident in maintaining dividend coverage with $1 per share undistributed taxable income balance and expectation of harvesting equity gains.
• Transitioned regular dividend to monthly, with Board declaring $0.58 regular dividend and $0.06 supplemental dividend for the quarter.

• Competitive lower middle market leading to tight loan pricing for high-quality opportunities not exposed to macroeconomic uncertainty.
• Potential spread compression due to aggressive lending by banks and nonbank lenders.
• Macroeconomic uncertainty impacting health care and government services sectors, affecting deal underwriting.
• Risk of bank derisking in the future, which could impact spreads.

Q: Can you just talk a little bit more about the competitive landscape right now? And kind of how do you see that sort of playing out over the coming quarters?

A: Yes. There's a supply-demand dynamic with private equity sponsors shifting focus and banks/nonbank lenders being aggressive, causing spread compression. But the team's relationships help source attractive risk-return deals. Our weighted average spread has decreased from 8.50% 2 years ago to around 7.50% currently.

Q: Mickey Schleien asked about the M&A market and optimism for the second half. What's underpinning that optimism?

A: Some deals from the June quarter bled over into the September quarter. Already closed $110 million in originations with another $40 million pending, and pipeline has quality deals. Efforts in cultivating private equity relationships are paying dividends.

Q: Robert Dodd asked about competitive pressure from banks. Are banks being pushy and driving down spreads?

A: Banks are being competitive now, driving down spreads. They are 'risk on' but will derisk eventually, which could impact spreads.

Q: Erik Zwick asked about originations breakout between new and add-on. Michael Sarner said this quarter is fairly robust on new, with 75% new vs 25% add-ons recently compared to 65-35 last quarter.

Q: Sean-Paul Adams asked about nonaccruals and risk rating change. Michael Sarner said a large position came back on accrual and a small second lien piece went on nonaccrual, with net effect, and migration to risk rating 2 was due to normal portfolio performance changes.