Capital Southwest Corp Q2 FY2026 Earnings Call

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, everyone, for joining us for our second quarter fiscal year 2026 earnings call. We're pleased to be with you today to discuss our second fiscal quarter as well as share our observations on the current market environment. During the second fiscal quarter, we generated pretax net investment income of $0.61 per share. Additionally, we were able to increase our undistributed taxable income balance to $1.13 per share from $1 per share as of the end of the prior quarter. Over the last 12 months, we've harvested $44.8 million in realized gains from equity exits, which is the main driver of our growth in UTI per share from $0.64 in September 2024 to $1.13 today. Furthermore, our Board of Directors has declared a total of $0.58 in regular dividends for the quarter, payable monthly in each of October, November and December 2025, and has also declared a quarterly supplemental dividend of $0.06 per share, bringing total dividends declared for the December quarter to $0.64 per share. On the capitalization front, we successfully raised $350 million in aggregate principal of 5.95% notes due 2030. Subsequent to quarter end, the proceeds from these notes were partially used to redeem in full our outstanding $150 million notes due October 2026 and our $71.9 million notes due August 2028. Importantly, the redemption of these notes did not require a make-whole premium to be paid in either case. We believe this new capital enhances the strength of our balance sheet and alleviates any concerns surrounding near-term bond maturities with our earliest unsecured maturity now in fiscal year 2030. Finally, we raised approximately $40 million in gross equity proceeds during the quarter through our equity ATM program at a weighted average share price of $22.81 per share or 137% of the prevailing NAV per share. Deal flow in the lower middle market continued to be robust this quarter with $245 million in total new commitments to 7 new portfolio companies and 10 existing portfolio companies. Add-on financings continue to be an important source of originations for us as approximately 32% of the total capital commitments during the quarter were follow-on financings in performing portfolio companies. Over the last 12 months, add-ons as a percentage of total new commitments have been 39%. So this is clearly a strong source of origination volume in deals we know well and have experience with the management team and sponsor. Additionally, the weighted average spread on our new commitments this quarter was approximately 6.5%, which we view as strong in a tight spread environment. I will now hand the call over to Josh to review more specifics of our investment activity and the market environment.

Thanks, Michael. This quarter, we deployed a total of $166 million of new committed capital, including $162 million in first lien senior secured debt and $3 million of equity across 7 new portfolio companies. In addition, we closed add-on financings for 10 existing portfolio companies, consisting of $79 million in first lien senior secured debt and $1 million in equity. Our on-balance sheet credit portfolio ended the quarter at $1.7 billion, representing year-over-year growth of 24% from $1.4 billion as of September 2024. For the current quarter, 100% of the new portfolio company debt originations were first lien senior secured. And as of the end of the quarter, 99% of the credit portfolio was first lien senior secured with a weighted average exposure per company of only 0.9%. We believe our portfolio granularity speaks to our continued investment discipline of maintaining a conservative posture to overall risk management as we grow our balance sheet. The vast majority of our portfolio and deal activity is in first lien senior secured loans to companies backed by private equity firms. Currently, approximately 93% of our credit portfolio is backed by private equity firms, which provide important guidance and leadership to the portfolio companies as well as the potential for junior capital support if needed. In the lower middle market, we often have the opportunity to invest on a minority basis in the equity of our portfolio companies, pari passu with the private equity firm when we believe the equity thesis is compelling. As of the end of the quarter, our equity co-investment portfolio consisted of 83 investments with a total fair value of $172 million, representing 9% of our total portfolio at fair value. Our equity portfolio was marked at 126% of our cost, representing $35.8 million in embedded unrealized appreciation, or $0.63 per share. Our equity portfolio continues to provide our shareholders participation in the attractive upside potential of these growing lower middle market businesses, often resulting from the institutionalization of the businesses by experienced private equity firms as well as the significant value accretion potential from strategic add-on acquisitions. Equity co-investments across our portfolio provide our shareholders with the potential for asset value appreciation as well as equity distributions to Capital Southwest over time. Consistent with previous quarters, the lower middle market continues to be quite competitive as this segment of the market is highly attractive to both bank and nonbank lenders. While this has resulted in tight loan pricing for high-quality opportunities that are not exposed to the macroeconomic uncertainty, the depth and strength of the relationships our team has cultivated over the years has continued to result in our sourcing and winning opportunities with attractive risk return profiles. As a point of reference, currently, there are 85 unique private equity firms represented across our investment portfolio. Additionally, in the last 12 months, we closed 17 new platforms with financial sponsors with which we had not previously closed the deal, demonstrating our continued penetration in the market. Since the launch of our credit strategy, we have completed transactions with over 120 different private equity firms across the country, including over 20% with which we have completed multiple transactions. Our portfolio currently consists of 126 portfolio companies weighted 89.9% to first lien senior secured debt, 0.9% to second lien senior secured debt and 9.1% to equity co-investments. The credit portfolio had a weighted average yield of 11.5% and weighted average leverage through our security of 3.5x EBITDA. We continue to be pleased with the operating performance across our loan portfolio. All our loans upon origination are initially assigned an investment rating of 2 on a 5-point scale, with 1 being the highest rating and 5 being the lowest rating. Overall, the portfolio remains healthy with approximately 91% of the portfolio at fair value rated in one of the top 2 categories, a 1 or 2. Cash flow coverage of debt service obligations has reached 3.6x, the strongest level in the past 3 years, reflecting an improvement from the 2.9x low observed during the peak of base rates. This enhanced coverage underscores the strength of our portfolio with our loans averaging approximately 43% of portfolio company enterprise value. Our portfolio continues to be broadly diversified across industries, and our average exposure per company is less than 1% of investment assets, which gives us great comfort in the overall risk profile of our portfolio. For the new platform deals we closed in the September quarter, the weighted average senior leverage level was 3.6x debt to EBITDA and the weighted average loan-to-value level was 36%, resulting in significant equity capital cushion below our debt. Over the past 12 months, new platform originations have averaged senior leverage of 3.5x debt to EBITDA and 38% loan-to-value, which highlights our consistent track record of conservative underwriting on new originations. As Michael mentioned earlier, we believe our balance sheet is well positioned with low leverage and significant liquidity, which allows us to continue to be active and opportunistic in all economic environments. I will now hand the call over to Chris to review the specifics of our financial performance for the quarter.

Thanks, Josh. Specific to our performance for the quarter, pretax net investment income was $34 million or $0.61 per share. For the quarter, total investment income increased to $56.9 million from $55.9 million in the prior quarter. The increase was driven primarily by a $1.3 million increase in fees and other income, which was offset by a decrease of approximately $500,000 in PIK income compared to the prior quarter. Importantly, PIK as a percentage of our total investment income decreased to 4.9% as compared to 5.8% in the prior quarter. Additionally, as of the end of the quarter, our loans on nonaccrual represented 1% of our investment portfolio at fair value. During the quarter, we paid out a $0.58 per share regular dividend and a $0.06 per share supplemental dividend. For the December 2025 quarter, our Board has declared a total of $0.58 per share in regular dividends payable monthly in each of October, November and December 2025, while also maintaining the supplemental dividend at $0.06 per share, bringing total dividends to $0.64 per share for the December 2025 quarter. We continued our consistent track record of regular dividend coverage with 104% coverage for the 12 months ended September 30, 2025, and 110% cumulative coverage since the launch of our credit strategy. We are confident in our ability to continue to distribute quarterly supplemental dividends based upon our current UTI balance of $1.13 per share and the expectation that we will continue to harvest gains over time from our sizable unrealized appreciation balance on the equity portfolio. LTM operating leverage ended the quarter at 1.6%, a slight decrease from the prior quarter. Our operating leverage is significantly better than the BDC industry average of approximately 2.7%, and we believe this metric speaks to the benefits of the internally managed BDC model and our absolute alignment with shareholders. The internally managed model has and will continue to produce real fixed cost leverage while also allowing for significant resources to be invested in people and infrastructure as we continue to grow and manage a best-in-class BDC. The company's NAV per share at the end of the quarter was $16.62 per share, an increase from $16.59 per share in the prior quarter. The primary driver of the NAV per share increase was the accretion from the ATM equity program during the quarter. As Michael mentioned, during the quarter, we successfully raised $350 million in new 5.95% unsecured notes due September 23. Subsequent to quarter end, the proceeds from these notes were partially used to redeem in full our $71.9 million August 2028 notes and $150 million October 2026 notes with no make-whole payment required on either redemption. The cost of the $350 million notes at 5.95% fixed was approximately breakeven with the cost of the debt we subsequently paid off, inclusive of the secured credit facilities. We view this capital raise as a highly favorable outcome for both the company and its shareholders as it strengthens our balance sheet and positions us to thrive across a wide range of capital markets environments. We are pleased to report that our balance sheet liquidity is robust with approximately $719 million in cash and undrawn leverage commitments on our 2 credit facilities, which represents over 2x the $334 million of unfunded commitments we had across our portfolio as of the end of the quarter. Our regulatory leverage ended the quarter at a debt-to-equity ratio of 0.91:1, up from 0.82:1 as of the prior quarter. However, given that the $350 million bond issuance occurred during the September quarter and the bond redemptions occurred subsequent to quarter end, we ended the quarter with significant cash on the balance sheet. Net leverage, which assumes paying down outstanding debt liabilities with cash on hand as of 9/30 would result in pro forma regulatory leverage of 0.82x. While our optimal target leverage continues to be in the 0.8 to 0.95 range, we continue to weigh the impacts of the current macroeconomic landscape and intend to maintain a regulatory leverage cushion, which will mitigate capital markets volatility. We will continue to methodically and opportunistically raise secured and unsecured debt capital as well as equity capital through our ATM program to ensure we maintain significant liquidity and conservative balance sheet construction with adequate covenant cushions. I will now hand the call back to Michael for some final comments.

Thank you, Chris, Josh and Amy and all the employees who help us tell the story each and every quarter. And thank you, everyone, for joining us today. This concludes our prepared remarks. Operator, we are ready to open the lines up for Q&A.

Our first question comes from Brian McKenna of Citizens.

So it's clearly a strong quarter of origination activity. It does feel like industry-wide M&A has picked up pretty meaningfully even since the last earnings call. So what does the pipeline look like heading into year-end? And then is there a way to think about the size of the pipeline today relative to the last quarter or two or even a year ago?

Yes. We have definitely observed a noticeable increase in the size of our pipeline. This past quarter, we generated $248 million with 7 platform companies and 10 add-ons. The add-ons have been consistently coming in, and I expect we'll continue to see 8 to 12 transactions each quarter. For the upcoming quarter ending December 31, I anticipate that our volume will be similar to what we experienced in the September 30 quarter based on current trends. Moving forward, it seems like our principals and managing directors have made substantial progress with sponsor activity, and we continue to see a significant number of high-quality deals. Therefore, I don’t foresee any slowdown in growth. Previously, we originated $100 million to $125 million per quarter, and now we're looking at something closer to $150 million to $200 million in a typical quarter.

Okay. That's helpful. And then just for my follow-up, Michael, you've been CEO for a few quarters now. Can you just remind us of your top priorities for the firm heading into calendar 2026? You've also made some early changes like moving to a monthly regular dividend. But is there anything else you can do that ultimately benefits shareholders?

We have previously mentioned that we aim to monetize our investment platform to strengthen our market position and potentially generate fees and additional economics. We have spent significant time engaging with potential opportunities that we believe could materialize soon. Over the last eight months, we have developed an internal portfolio operations group, which we consider essential for scalability. We are also focused on adding more originators to the platform. Our goal is to build for growth, and while our deal volume has seen remarkable growth, it doesn't always translate into closed deals. However, increasing the funnel leads to higher-quality opportunities. Internally, we are concentrated on this focus. Although our operating leverage in the market is low, we are committed to expanding our staff to be prepared for the anticipated growth.

Our next question comes from the line of Doug Harter of UBS.

I'm hoping you could just talk a little bit more about credit quality and kind of what you're seeing in the underlying portfolio companies. Any change in kind of their growth or profitability and just kind of how you're thinking about the credit outlook over the coming quarters?

Yes, I'll share my thoughts and I believe Josh should too. Over the past 12 months, our existing portfolio companies have seen about 10% annual growth in EBITDA and revenue, which remains strong. Looking back 18 to 24 months, that figure was closer to 15%, so there has been a slight slowdown. However, when we examine our individual portfolio companies, they are performing exceptionally well, and we aren't identifying any specific industry facing problems. One challenge we notice in the boardroom is the shifting environment influenced by White House policies and their potential impacts on various industries in the future. Nothing has remained constant, and I feel we are keeping a closer eye on the news than ever to grasp its effects on our portfolio and to identify future investment opportunities. Josh, do you have anything to add?

Yes. I mean, look, we have over 100 portfolio companies in the lower middle market. So obviously, not all of them are going to perform really well or as expected. But we have created a very diversified by industry and granular by company portfolio. So feel pretty comfortable with where we sit today.

When we evaluate the deals we're engaging in, despite the competitive environment leading to spread compression, the loan-to-value ratios and leverage of these deals have remained very conservative and stable. Over the past nine months, we have observed a loan-to-value of approximately 36% and leverage at 3.4 times. Companies are not overextending themselves; rather, borrowers are securing lower spreads for essentially the same amount of debt. This discipline, maintained in a market that experienced considerable activity over the last year, positions us strongly moving forward.

Our next question comes from the line of Mickey Schleien of Clear Street.

In your internal ratings, about 9% of the debt portfolio is performing below expectations. It appears that these include companies like Bradner, Apple Roofing, LL Flex, U.S. Telepacific, and Everest. How would you describe the overall trends impacting those companies and their outlook?

When we look at our watch list and compare ourselves to the upper middle market, it's important to note that our leverage levels are much lower than others, typically around 2.5 to 3 times, with covenant cushions of 30%. When defaults occur in our portfolio, they generally happen at leverage levels of 4 to 6 times. This context suggests that the companies on our watch list are not in critical situations. While they do face challenges, they have private equity sponsors who are backing the deals.

I want to emphasize that we have a diversified portfolio and we monitor the industry breakdown of underperforming assets. However, we do not observe any real consistency or correlation among these assets. There are many unique issues that have arisen in some of these lower middle market companies, which we did not expect in terms of predicting which companies would be affected. Nonetheless, with a large and varied portfolio, we are aware that such issues will occur. We keep an eye on them by industry, yet we do not find correlations among our underperforming assets.

Yes, that's what I was getting at actually. And on the flip side, you have about 20% of the portfolio performing above expectations, which is great, but that could imply meaningful prepayment risk. What is your gauge of that risk? And how much could that impact the portfolio's yield, obviously, excluding the fees that you could collect on those prepayments?

I believe this highlights our focus on granularity. When we managed a $500 million fund, we were originating about $12 million to $13 million per asset. Now that our fund has grown to $2 billion, we're still originating approximately $15 million to $16 million per hold. This granularity mitigates both prepayment risk and nonaccrual risk, ensuring that no single credit significantly affects our portfolio. In fact, during the 6/3 quarter, we received a repayment of around $50 million from one company, yet we still reported earnings of $0.61 this quarter. We are not concerned about this situation. Our top five investments do not constitute a disproportionately large part of the portfolio, which is intentional.

Yes, Mickey, if you look back in history, the other thing I would add is we've sort of had over the past 2 to 3 years, consistently 15% to 20% of the portfolio in that investment rating 1 bucket for outperformance. And that is not correlated directly to sort of 20% of prepayment per year. Our prepayment is more like 10% to 12% per year as a percentage of the portfolio. So it's an indication of performance, but it doesn't necessarily indicate that all of those are going to prepay in the near term.

No, I understand. It's just that you also mentioned the tight spread environment, which I clearly agree with, and we're seeing that across not only your lower middle market, but as well in the middle market and the upper middle market. So I was trying to gauge if that was a consideration.

Over the last six months, our spread has remained quite stable. This quarter, we had seven new portfolio companies with yields ranging from 5.50% to 7.25%. The add-on activity was at 6.7%, leading to a blended rate of 6.5%. I don't believe this is significantly off our typical pace. I should also mention that one of our top-performing portfolio companies, which we hold the largest stake in, has appreciated in equity. If that exits, the debt holding is small, and the equity generally does not yield anything. We will redeploy that capital into debt yields, which could lead to an increase in our UTI bucket.

I understand. And in terms of the change of the portfolio's weighted average yield during the quarter, which fell about 30 basis points in a quarter where SOFR was stable. Was that due to the spread environment that you're talking about? Or was it due to maybe going up market a little bit toward higher quality names with lower spreads? Or could you give us some insight into that?

Sure, I would like to reflect on the previous quarters. In the first quarter on March 31, our total yield was 11.68%. It increased to 11.83% in the second quarter on June 30, mainly due to one significant exit that contributed 16 basis points of accelerated Original Issue Discount. This led to a bit of an increase. In the current quarter, the yield returned to 11.68%, but we experienced an 8 basis points decrease attributed to nonaccruals, along with a 5 basis points decline from compression.

Okay. And lastly for me, could you give us some guidance on stock-based compensation and salary expense for the fourth calendar quarter, the quarter we're in right now, given that there's some seasonality that would be helpful for us.

There won't be any seasonality affecting the RSU expense, so it will remain consistent with the current quarter. The cash compensation will depend on our performance during the quarter. I would estimate it to be approximately flat compared to September 30, with a potential slight increase due to some of the staffing initiatives that Michael mentioned. Ultimately, it hinges on our performance for the quarter and the bonus accrual we decide to take.

Our next question comes from the line of Erik Zwick of Lucid Capital Markets.

I wanted to follow up with a kind of a question on the credit outlook you provided. And just curious, you mentioned that the top of the funnel for originations has continued to expand, and there are maybe a couple of pockets of the economy that are showing some weakness now. So as you evaluate these new opportunities, are there any industries or segments that you're maybe kind of looking at a little bit more with a more kind of discerning eye or staying away from that maybe you weren't 12 months ago?

I would begin by mentioning that health care is a very diverse area. With the recent significant legislation, there is uncertainty regarding Medicare and Medicaid reimbursement. Historically, we've been quite favorable towards this sector, but now it necessitates thorough analysis to understand its future implications. As for other industries, I don’t think there are any we are completely avoiding. Josh?

Government-funded and sponsored companies present challenges for us at the moment. However, as generalists, we prefer to partner with private equity groups that have extensive expertise in dynamic sectors such as health care or government to leverage their insights. When we engage in deals within these evolving industries, we typically collaborate with experienced investors who have been active in these areas, given our generalist approach. Additionally, we structure our transactions to address these risks by being more selective, increasing spreads, and importantly, reducing leverage while tightening deal structures in industries that raise our concerns.

Another thing to notice is that our operating leverage has decreased as we have expanded our portfolio and our funnel has become larger. This allows us to be more discerning. We now have the ability to originate deals in the range of $550 million to $575 million. I would mention that four years ago, our deals needed to be $750 million and above, and it was $650 million previously. Today, we can consider a wider range of investments in our space and choose to opt out of those that pose more risk while focusing on those that we believe offer the strongest competitive advantages.

I appreciate the insights. Mike, could you remind me about your strategy for bringing in new originators? Do you typically seek individuals with several years of experience, or do you prefer to hire recent graduates and train them to align with Capital Southwest's policies? How do you handle this?

We've approached it in various ways. Currently, we aim to do all of the above. On the originator side, we're looking to add another resource to cover one of the coasts where our presence isn't as strong as we would like. We're also onboarding several analysts to support our growth structure and are searching for another Operations VP. I've noticed that this department brings significant value. The operations team collaborates closely with our deal team, allowing us to gather multiple perspectives when we head into the boardroom, which helps us make better decisions before investing. Overall, I believe we have a sufficient staff right now, but as we grow, we will need a more scalable infrastructure.

Our next question comes from the line of John Hecht of Jefferies.

You have a diverse set of sourcing with the bond, the ATM, and the SBIC included in your margin strategy. As we approach 2026, is there anything we should consider regarding the mix of your capital structure and potential impacts from changes in interest rates?

I don’t think so. We have recently completed a $350 million unsecured bond offering, and we redeemed the previous two bonds. Our liquidity situation is quite strong. We plan to continue utilizing the SBIC, which will be a primary source of new capital for 2026, while also maintaining flexibility in our secured credit facilities to ensure we have sufficient liquidity. However, I don't anticipate any significant changes in our approach regarding the balance of unsecured debt, secured debt, and SBIC from where we are today.

Okay. And then a follow-up question. You guys mentioned at the beginning of the call that seeing a lot of competition from both banks and nonbanks. I'm wondering, has that changed just in light of some of these idiosyncratic events in the bond market over the last few weeks?

It's difficult to assess in real time because we consistently propose on deals. There has been some stabilization in the market, but I believe it's a bit too early to say that it's widespread.

Our next question comes from the line of Robert Dodd of Raymond James.

In your prepared remarks, it appears that you are looking to monetize the investment platform through asset management. If I understand correctly, it seems you might be suggesting that there could be an opportunity in this area within the next 12 months. I could be overinterpreting your wording, but if you could provide any further insights, that would be great. This would certainly represent a low capital initiative since you would mainly be utilizing your existing staffing. Is there anything else you would like to add?

Look, yes, look, these processes tend to take a lot longer than you hope or you think going in. Yes, it definitely answers like we have a direction. I think backing up, we've been seeking out partners to help grow and I said monetize on our investment platform that we've built over the last 10 years. And I think been on the road 3 years doing it, and I think we finally sort of to hone on the right structure and found potentially a partner that is someone that's like-minded. I don't have anything to announce right now, but we're hopeful as we keep pushing along that, that will be something that we can make an announcement, and it would be net helpful to this organization going forward.

Got it. Has there been any change in your thinking regarding the equity co-invest, where you have a strong track record and unrealized appreciation in the portfolio? As spreads narrow a bit in your end markets, is there an opportunity to increase the allocation to equity? If the spreads tighten and it's a solid equity story, would it make sense to allocate a bit more to that area to enhance overall return or IRR over the life of an asset, even if it means sacrificing some spread for a high-quality business?

Yes, it's a valid question and something we consider internally. As our hold sizes increase while we remain in the same area, our debt investments will likely represent a larger portion of the overall invested capital, with equity typically ranging from $0.5 million to $1.5 million. We're interested in increasing this. I believe we might achieve this by identifying more non-sponsored deals, and we have a pipeline of such opportunities that generally require smaller debt investments and larger equity investments. However, many of these deals come with challenges. Therefore, as the saying goes, we may need to "kiss a lot of frogs" in this process. That's why I mentioned scalability as a focus area where we may allocate additional resources. It aligns well with our business strategy since we operate in the small business sector. Currently, we are at about 9% equity, and I would like to see that increase. However, I don't expect significant changes in the next 6 to 12 months. Over the next 24 to 36 months, we plan to work towards this goal.

Our next question comes from the line of Dylan Hynes of B. Riley Securities.

I was just wondering, so while rate cuts are slowing, if your commitments growth maintains moving forward, do you expect the yield dilution to be roughly the same quarter-over-quarter as it was from last quarter to this quarter?

It's a tough question to answer. Over the last three quarters, we haven't seen that degradation. The deals in our pipeline for this quarter and possibly for the next quarter are likely to have similar yield profiles. Therefore, I don't foresee yields decreasing. Additionally, some of the activities we are pursuing may enable us to maintain or even improve our spreads going forward. So, from a spread perspective, I'm not expecting a decline. On the base rate, we know that SOFR is coming down, which is beyond our control. However, we have built a portfolio that we believe is well-positioned, both with our regular dividend and our UTI bucket.

Thank you I'm showing no further questions at this time. I would now like to turn it back to Michael Sarner for closing remarks.

Well, we appreciate everybody joining us today. We look forward to speaking to you in 3 months. Have a good weekend.

All right. Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.