Capital Southwest Corp (CSWC) 2026 Q3 法說會逐字稿

Thank you for joining today's Capital Southwest third quarter fiscal year 2026 earnings call. Participating on the call today are Michael Sarner, Chief Executive Officer; Chris Rehberger, Chief Financial Officer; Josh Weinstein, Chief Investment Officer; and Amy Baker, Executive Vice President, Accounting.

I will now turn the call over to Amy Baker.

Thank you. I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements. These statements are based on current conditions, currently available information and management's expectations, assumptions and beliefs. They are not guarantees of future results and are subject to numerous risks, uncertainties and assumptions that could cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see Capital Southwest's publicly available filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, changing circumstances or any other reason after the date of this press release, except as required by law.

I will now hand the call over to our President and Chief Executive Officer, Michael Sarner.

Thanks, Amy, and thank you all for joining us for our third quarter fiscal year 2026 earnings call. We are pleased to be with you today and look forward to walking you through our results for the quarter. During the third fiscal quarter, we generated pretax net investment income of $0.60 per share, supported by strong recurring earnings across the portfolio.

Our undistributed taxable income balance remains robust at $1.02 per share, reflecting consistent realization activity. In fact, over the last 12 months, we have harvested $44.5 million in realized gains from equity exits, driving UTI growth from $0.68 per share in December 2024 to today's level. Subsequent to quarter end, we realized an additional realized gain of $6.8 million from another equity exit, which should further support our UTI balance going forward.

Our Board of Directors has declared a total of $0.58 in regular dividends for the March quarter, payable monthly in each of January, February and March 2026 and has also declared a quarterly dividend -- supplemental dividend of $0.06 per share payable in March, bringing total dividends declared for the March quarter to $0.64 per share.

Turning to originations. Deal flow in the lower middle market remained healthy this quarter. We closed $244 million in total new commitments across eight new portfolio companies and 16 existing portfolio companies. Add-on financings continue to be an important source of originations for us as over the last 12 months, add-ons as a percentage of total new commitments have been 29%. These opportunities allow us to deploy capital into businesses we know well with proven management teams and sponsors. The weighted average spread on our new commitments this quarter was approximately 6.4%, which we view as very attractive given today's competitive spread environment.

On the capitalization front, last quarter, we strengthened our balance sheet by issuing $350 million in aggregate principal of 5.95% notes due 2030. This quarter, we used a portion of the proceeds to fully redeem our $150 million notes due 2026 and $71.9 million notes due 2028, extending our maturity profile at an attractive cost of capital. We also raised approximately $53 million in gross equity proceeds through our equity ATM program at a weighted average share price of $21.11 per share or 127% of the prevailing NAV per share, reinforcing our ability to raise capital efficiently and accretively.

Subsequent to quarter end, we announced a first-out senior loan joint venture with a private credit asset manager, which I would like to spend some time discussing. We believe this new JV will enhance our competitiveness in our core lower middle market by enabling us to participate in larger, higher-quality deals with tighter spreads while maintaining disciplined hold sizes. The structure also allows us to earn outsized economics due to our role as originator and administrator of the JV and higher relative yields on last-out loans, which is extremely important in an environment where SOFR is declining and loan spreads on new deals remain very tight.

The first-out loans within the JV are expected to be conservatively levered at approximately 1.5 times debt to EBITDA or less. And once fully ramped, we expect the JV to generate a low to mid-teens equity return for Capital Southwest. Finally, our partner in the JV is a highly regarded, well-capitalized asset manager with whom we are extremely excited to build a long-term relationship.

We believe this relationship may open up other unique opportunities for co-investment in the future as we continue to expand our platform. Overall, we are pleased with our performance this quarter and enthusiastic about the prospects for this new venture. We look forward to giving further updates on the funds in the coming quarters.

I will now hand the call over to Josh to review more specifics on our investment activity and the market environment.

Thanks, Michael. This quarter, we deployed a total of $199 million of new committed capital, consisting of $197 million in first lien senior secured debt and $2 million of equity across eight new portfolio companies. We also completed add-on financings for 16 existing portfolio companies, totaling $44 million in first lien senior secured debt and $405,000 in equity. Our on-balance sheet credit portfolio ended the quarter at $1.8 billion, representing 19% year-over-year growth from $1.5 billion as of December 2024.

Importantly, 100% of new portfolio company debt originations were first lien senior secured. And as of quarter end, 99% of the credit portfolio remained first lien senior secured with a weighted average exposure per company of only 0.9%. This level of portfolio granularity reflects our disciplined approach to risk management as we continue to scale the balance sheet.

The vast majority of our deal activity continues to be in first lien senior secured loans to private equity-backed companies. Approximately 93% of our credit portfolio is sponsor-backed, who provides strong governance, operational support and when needed, the potential for junior capital. In the lower middle market, we frequently have the opportunity to invest on a monthly -- on a minority basis in the equity of our portfolio companies, pari passu with the private equity firm where we believe the equity thesis is compelling.

As of quarter end, our equity co-investment portfolio consisted of 86 investments with a total fair value of $183 million, representing 9% of our total portfolio at fair value. This portfolio was marked at 133% of our cost, representing $45.2 million of embedded unrealized appreciation or $0.76 per share. These equity positions continue to give our shareholders meaningful upside participation in growing lower middle market businesses, driven by both operational improvements and strategic add-on acquisitions. This is evident from the recent realized gains, which Michael mentioned earlier.

The lower middle market remains highly competitive as this segment of the market continues to attract both bank and nonbank lenders. While this has resulted in tight loan pricing for high-quality opportunities, the depth and strength of our sponsor relationships the team has cultivated over the years has continued to result in our sourcing and winning opportunities with attractive risk return profiles.

Today, our portfolio includes investments from 90 unique private equity firms. And over the past 12 months, we closed 14 new platform investments with sponsors we had not previously partnered with. Since launching our credit strategy, we have completed transactions with over 129 private equity firms nationwide, including more than 20% with whom we have completed multiple deals. Our portfolio now consists of 132 portfolio companies, allocated 90% to first lien senior secured debt, 0.8% to second lien senior secured debt and 9.1% to equity co-investments. The credit portfolio generated a weighted average yield of 11.3% with weighted average leverage through our security of 3.6 times EBITDA.

We remain pleased with the overall performance of the portfolio. At originations, all loans are initially assigned an investment rating of two on a five point scale, with one being the highest rating and five being the lowest rating. As of quarter end, 90% of the portfolio at fair value was rated in the top two categories. Cash flow coverage remained strong at 3.4 times, reflecting an improvement from the 2.9 times low observed during the peak of base rate. This strength is further supported by the fact that our loans represent, on average, only 44% of portfolio company enterprise value.

Our portfolio remains broadly diversified across industries and our average exposure per company of less than 1% continues to provide meaningful protection against idiosyncratic risk. For new platform deals closed during the December quarter, weighted average senior leverage was 3 times debt to EBITDA and weighted average loan-to-value was 36%, providing a substantial equity cushion beneath our debt. Over the past 12 months, new platform originations have averaged 3.3 times senior leverage and 37% loan-to-value, underscoring our consistent commitment to conservative underwriting.

I will now hand the call over to Chris to review the specifics of our financial performance for the quarter.

Thanks, Josh. Turning to our financial performance for the quarter. Pretax net income investment was $34.6 million or $0.60 per share. Total investment income increased to $61.4 million, up from $56.9 million in the prior quarter. The increase was driven primarily by a $1.8 million increase in PIK income, a $1.1 million increase in fees and other income and a $1 million increase in dividend income.

The increase in PIK was driven by an amendment to one of our portfolio companies, in which the sponsor provided significant new cash equity support and a debt paydown in exchange for a PIK option. As of quarter end, nonaccruals represented just 1.5% of our investment portfolio at fair value.

During the quarter, we paid a $0.58 per share regular dividend and a $0.06 per share supplemental dividend. For the March 2026 quarter, our Board has again declared a total of $0.58 per share in regular dividends payable monthly in each of January, February and March 2026 and maintained the $0.06 supplemental dividend also payable in March, bringing total dividends declared to $0.64 per share.

We continue to demonstrate strong dividend coverage with 110% cumulative coverage since launching our credit strategy. With UTI of $1.02 per share and a sizable unrealized depreciation balance in our equity portfolio, we remain confident in our ability to continue distributing quarterly supplemental dividends over time.

LTM operating leverage ended the quarter at 1.7%, significantly better than the BDC industry average of approximately 2.6%. As our asset base continues to grow, our near-term target for operating leverage is 1.5% or below, reflecting the inherent efficiency of the internally managed BDC model. The internally managed model has and will continue to provide meaningful fixed cost leverage to shareholders while still allowing us to invest in talent and infrastructure as we continue to scale a best-in-class BDC platform.

NAV per share increased to $16.75 per share, up from $16.62 per share in the prior quarter, driven primarily by our equity ATM program. As Michael noted, last quarter, we issued $350 million of 5.95% unsecured notes due 2030. During the December quarter, we used a portion of the proceeds to fully redeem our $71.9 million August 2028 notes and $150 million October 2026 notes with no make-whole payments required. We view this refinancing as a highly favorable outcome for shareholders, strengthening our balance sheet and positioning us well across a range of market environments.

Our liquidity position remains robust, with approximately $438 million in cash and undrawn leverage commitments across our two credit facilities plus $20 million available on SBA debentures. In total, this represents more than 1.5 times coverage of the $285 million in unfunded commitments across the portfolio.

Regulatory leverage ended the quarter at 0.89:1 debt to equity, down slightly from 0.91:1 in the prior quarter. While our target leverage remains 0.8 to 0.95, we continue to factor in the macroeconomic backdrop and intend to maintain a prudent leverage cushion to help mitigate capital markets volatility. We will continue to raise secured and unsecured debt capital as well as equity through our ATM program in a methodical and opportunistic manner to ensure we maintain significant liquidity and a conservatively constructed balance sheet with adequate covenant cushion.

I will now hand the call back to Michael for some final comments.

Thank you, Chris, Josh and Amy, and thank you to all of our employees who work tirelessly behind the scenes to help us deliver for our shareholders and communicate our progress each quarter. Your dedication is a critical part of what makes this platform so strong, and it remains a deep source of pride for me. And to everyone joining us today, we appreciate your continued interest, engagement and support. We remain focused on executing our strategy, maintaining disciplined growth and creating long-term value for our shareholders.

That concludes our prepared remarks. Operator, we're ready to open the line for Q&A.

(Operator Instructions)

Doug Harter, UBS.

I was hoping you could just expand a little more, talk about the lower middle market. Just how do you view that from a competitive dynamic today? What are you seeing in terms of players? Or is anyone kind of moving back into that market, moving out of the market? Just how are you seeing that? And what's the outlook for spreads as a result?

Yes. I don't think it's really changed much over the last probably six months. I think over the last 12 and 18 months, we have seen regional banks, I think I've noted this before, that have dropped down. Historically, they only lended to maybe 1.5 turns of leverage maybe in a senior mezz structure. And more recently, we're seeing regional banks actually underwrite a whole unitranche loan.

Now they come and go. Certainly, anytime you see headlines of private credit issues, they sort of back off. But by and large, I think that it's kind of the same players. I mean what we probably have seen in the last, I would say, one to two months is that there's particularly on the BDC space, there's 27 of 42 BDCs have cut their dividends.

And I think we're only seeing five BDCs trade above book right now. So there's a little less competition from our peers as they sort of lick their wounds right now. But other than that, I think that we're in a very strong competitive position. Obviously, we've announced this joint venture, which we think is going to strengthen our ability to continue to win deals that are in our core competency, the lower middle market.

Great. And I guess just then on the spread outlook, how that -- kind of those comments would lead to kind of how you think spreads progress over the coming quarters?

Yes. So when we look at it, the spread on debt is actually from March 31, 2025, it was 7.35%. And today, it's 7.24%. So we've held in pretty well from a spread perspective. I think we'd say that we've seen spread -- the spread compression has seemed to stop the last 12 months and even the last three months, we've seen our spreads on our newly originated deals in the mid-6s, and those are with 3 times leverage and 36% loan-to-value. So very conservatively structured deals with decent spreads. So I think for us, we'll continue to be somewhere between 7% and 7.25%, we would expect for the next 12 months.

Mickey Schleien, Clear Street.

Michael, could you give us a sense of the breakdown of the portfolio between sponsored and nonsponsored at this time?

I think it's 93% sponsored and 7% nonsponsored. And that's probably the high side. It's typically been somewhere between 85% and 95% sponsored deals.

And how are those sponsors behaving in terms of their appetite for deals in the current market environment? I mean we go quarter-to-quarter and sometimes it's risk on, sometimes it's risk off, there's so much going on. Can you give us a sense of just the backdrop?

Josh, do you want to take this one?

I think there's still a lot of capital in the private equity, lower middle market private equity funds. So they're still looking for deals. I think that if you ask most private equity sponsors in the lower middle market, they would say last year was a pretty weak year from a deployment perspective, and they're hoping 2026, there'll be more opportunities for them. But yes, I think that they're looking for deals. They have capital to spend, but they're not -- but last year, they didn't find as many deals available to them.

The other thing I would add is that the lower middle market where we play the $3 million to $15 million in EBITDA. We're not -- the volume you see isn't as typical as what you hear in the headlines of M&A going up and down. There are founders. There's an aging population where companies are turning over. There's been a steady drumbeat.

I wouldn't say that there's been -- there's clearly not the same peaks and troughs that you see in the upper and middle middle market. So I think the sponsors that Josh was referring to, they're still seeing plenty of deal flow.

And Michael, with that in mind, I mean, we're certainly reading a lot about pressure from LPs on these sponsors to provide them some liquidity. But I'm getting the sense that the sponsors you work with, which are focused on the lower middle market, is that less of an issue for them?

I think it's -- I mean I think it can be an issue depends on where they are in the life cycle of fund. I mean I think that they're looking for opportunities to exit as well to provide that liquidity to LPs, but probably a little bit less pressure than you'd see in the middle market or upper middle market. But we obviously talk to a lot of sponsors in the country and have deep relationships with them. But speaking specifically about their liquidity situations and all that stuff is a little bit tough for us.

And other thing I would note for you, this is -- when we go through our investment committee process on new deals, we definitely focus on where this investment stands in a fund life. So if a fund or a sponsor, this is one of the last deals and we know there's only $5 million to $10 million of dry powder that's allocated with the rest of the portfolio, that's certainly going to be a negative and something that we're going to discuss to see whether we still feel good about the credit. So we typically want these deals to be in the beginning or the middle stages of a fund life.

Understood. Michael, given what we've just talked about in terms of sponsors, any sense of how active you expect to be this calendar year and maybe even next year in terms of deal flow and repayment risk in the portfolio? And essentially, what's your sort of business plan for net portfolio growth?

No, I feel very bullish for several reasons. One, we've grown our sponsor relationships. I think we cited the numbers earlier over time. We've recently added another MD -- originating MD, Ryan Mullins, who brings his own unique set of sponsors, who's going to be covering the country. We recently promoted Grant Eason, one of our principles to MD, and he's firing on all cylinders, and so he's another source of origination.

And then the joint venture, I'll go back to it. So the joint venture allows us to compete on the same deals we're looking at today, but we've historically held the line at around 5.75% because that's a moving target. But most recently, 5.75% spread kind of meets our ROE target. And anything below that we didn't view as accretive to the portfolio and helpful to our dividend. By doing this joint venture, we're able to compete and win on deals at 5% or above, while still actually incorporating additional arranger fees, profit allocation and enhanced spread that increases the yield on the deal by 100 basis points.

So we're going to be able to see the same amount of deals from one perspective, but be winning more of them. And these are typically -- the reason this venture was really important to us is we were focused over the last 12 months saying, look, we've seen a lot of really high-quality deals that we would love to put in our portfolio that we thought were sleep at night credit but we weren't getting our deal team the ability to go below 5.75%. This is giving them another arrow in quiver to actually go out and compete.

And again, these are deals that we can consider cleaner and more high quality. And it also allows us to maintain granularity. We think that's been a huge part of our success is maintaining granularity through the last 10 years and not really getting greedy, staying below that 1% on average.

Michael, did you say in your prepared remarks that the JV would be primarily a last out fund? Did I hear you correctly?

No. So well, I'd say it's primarily, but there's going to be different types of assets that go into the fund. Probably the best example of what this fund is, is if you look at a $10 million EBITDA company that's levered 3.5 times with, say, 35% loan-to-value at a 5.50 spread. That's a $35 million total debt check. So in our -- in the example I give you, the first out that would go into the joint venture, so probably to correct myself, the only that's pretty much going into the joint ventures would be first out position.

So they would hold $10 million at 3.75 spread, 1 turn of leverage and 10% loan to value. On our balance sheet, we would hold $25 million of that debt of the debt stack, and that would get a 6.25% spread and still levered at the same 3.5 times and 35% loan-to- value. So that kind of gives you an idea of what it will look like on balance sheet and in the JV.

Understood. And what kind of leverage do you expect the JV's balance sheet to have?

So I'll start. The asset level is going to be between 1 and 1.5 turns of leverage for individually on the asset side. The fund itself will be probably something around 2.5 turns, plus or minus.

Okay. And that gets you to your ROE target. I understand. And lastly, and I appreciate your patience. The portfolio has about 21% at fair value in consumer products and services, restaurants and movies. Those are sort of cyclical segments. Can you discuss your underwriting approach to those segments? And how are those portfolio companies doing given everything we're reading about a K-shaped economy?

So I think Josh, if you want to take this one. I would tell you that when I look at our weighted average leverage for consumer services that fall into the buckets you're referring to, their leverage is slightly elevated at 4.2 times. When we look at where other portfolios begin at 5.5 to 6 times in upper middle market, we would say it's still pretty conservatively levered because our entry multiple on many of these companies are going to be somewhere between 1.5 to 3 times leverage.

We're certainly cognizant of consumer discretionary. So I would say there's a decent amount of that consumer, probably the majority of that consumer, we think, are well positioned for consumer pullback or economic pullback. And on top of that, we do structure our deals recognizing where we are with the potential consumer pullback.

Erik Zwick, Lucid Capital Markets.

This is Justin Marca on for Erik today. Just going back to the spread conversation, I was wondering if you guys could talk about the current state of underwriting conditions and if you're seeing any other signs of pressure on structure terms?

From a performance standpoint, I would tell you that we're not seeing pressure on any particular industry. Any issues in the portfolio will continue to be idiosyncratic.

I think you're asking about the structure of new deals we're doing. I think -- is that your question?

Yes.

Yes. So I think we've said this and it's stayed consistent that we've definitely seen -- we had seen spread compression over the last kind of 12, 18 months considerably. But structurally, in the lower middle market, we have not seen sort of weak credit agreements or asks coming through from our private equity sponsors. It's pretty status quo from a structural perspective over the last bunch of years. I think where the lower middle market has moved in the last kind of 18 months or so has been on the pricing and spread, not on the structure. So still seeing good covenants and solid credit documents.

Yes. I mean almost, I'd say, 100% of our portfolio or close to it, have a fixed charge covenant, they have a leverage covenant, they have a CapEx covenant. And then to the extent that there's a DDTL, you'll see an incurrence covenant as well.

Okay. And last one for me. Any other additional details on the new JV, whether you have like a targeted size in mind or when you're expecting to be fully ramped up?

Sure. So we've actually -- we've been negotiating that for a bit of time. We've already started ramping. We closed three deals that will be contributed -- closed two deals in the 12/31 quarter that will be contributed in the coming weeks. And we're close to closing a credit facility. I guess how many -- that $150 million? $150 million credit facility.

I think the answer to the question is each party is contributing -- has committed $50 million of equity to date. We think it's going to take probably at least a year to get probably up to the full leverage. So it's going to probably be -- it will eventually be a mid-teens return. I think it will be double-digits return by the end of the year.

Dylan Heinz, B. Riley Securities.

I was just wondering, I know you talked about the spreads in the quarter for the originations. I was wondering, do you have -- do you know what the weighted average yield was for your originations in the quarter?

Weighted average yield? I think I said earlier, so the spread on the new deals this quarter was 6.5% and leverage was 3 times and loan-to-value was 36%. Sorry, you're just saying -- I mean with the SOFR, so the weighted average yield was approximately 10.50.

And then I was wondering about the ATM issuances. Do you expect to continue doing that as long as the premium is favorable? Do you have a target rate that you generally want to issue at or?

Yes, sure. So if you look past history, we do somewhere between $30 million and $50 million every quarter. That vacillates depending on deal flow and repayments and liquidity needs. But certainly, with the premium we're trading at, somewhere in that range is -- would be a good expectation for the coming quarter.

Robert Dodd, Raymond James.

Hope you can hear me with background noise. On the JV, is there any intent -- I mean you said you don't need to expand kind of your net currently in terms of being able to stock that up. But is there any intent to expand maybe the size of the businesses or the type of leverage multiple, anything like that, maybe once it gets closer to scale? Or is it just -- it's exactly the same assets, just the lower spread ones going in that JV?

So I see this way. It's pretty much exactly the same asset. I think these deals that are really targeted for this are going to be the deals that are between $5 million and $10 million of EBITDA. So that, like I said many times, are very clean deals and that are priced between 5 and 5.75. I would say to the extent that we're seeing deals that are slightly larger, so let's call them $35 million to $40 million check, which we don't prefer to hold because of our preference for granularity, this does give us the ability on those deals to put $10 million to $15 million in the JV, while still maintaining a $20 million to $30 million hold. So I think on the margin, it allows us to feel more comfortable with deals that are slightly larger. But for the most part, it's just the cleanest deals in our core space.

Got it. One more, if I can. It's been topical over the last couple of days. How are you evaluating AI disruption risk, both within the assets you already have in the portfolio, but then when you look at new originations and opportunities, how much, if any, is AI risk being factored into your underwriting case?

Honestly, that is something that we started taking up about probably a year ago. We formed an AI committee and then actually created a segment in our investment committee process, which rates the various aspects of a company in terms of the AI risk or so -- because look, when we look at companies, sometimes AI is going to be helpful. We've seen sometimes financial services companies, they're going to be using AI to basically become more efficient.

In other deals, we're seeing AI as a potential. We just saw a deal maybe two weeks ago that we couldn't get comfortable with because the advent of AI may not impact the business in the next two years, but it would impact the business in five, and therefore, the concern of how it's going to get sold and at what valuation would that cover the debt. So I think we're looking at it -- we're certainly -- it's definitely a heavy segment of our investment committee discussion. And then internally, we're looking to see how we can utilize AI as well to become more efficient as an organization, and that's something that has begun in earnest.

That concludes today's question-and-answer session. I'd like to turn the call back to Michael Sarner for closing remarks.

Yes. I want to take one minute to just pause and reflect our company, our balance sheet just passed $2 billion in assets. And though growing the balance sheet is not the goal here, it's creating value. It is a testament to everybody who's worked here and all the value that's created to allow us to continue to grow.

My optimism today, and I think our optimism as a group has never been higher. I mean we've mentioned the two new MDs that are helping enhance the business, the joint venture, which we spent a lot of time discussing. We've talked about over the last 12 months, we've exited to date, like $50 million in equity. And I'd remind everybody that's on a $5 million -- 5% equity portfolio at cost.

So we're punching way above our weight, which tells you our underwriting, both on our debt and our ability to create equity gains has been strong. That's created the $1.02 per share of UTI. We had $0.76 of unrealized depreciation, and we would tell you the majority of that are in companies that are in the market, some in the first half of 2026 and other in the back half.

Our operating leverage in the company is 1.4% on a run rate basis, excluding the onetime charge from last year. Conservative leverage at the corporate level of 0.89, conservative leverage at our portfolio level of 3.6 times, significant liquidity. And all of that has brought us to a place where we have a 40%-plus premium to book on our stock, which reflects, I think, all the strong work we've done at the company. So as we leave this call, I just -- I'm thankful to all of the shareholders that supported the company. I'm extremely proud of all of the employees who have done this great work. And as we look forward, we see this optimism and hope you understand it as well. Thanks to everyone, and have a great week.

This concludes today's conference call. Thank you for participating. You may now disconnect.