Capital Southwest Corporation (CSWC) Earnings Call Transcript & Summary

Thank you for joining today's Capital Southwest first quarter fiscal year 2027 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, 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 everyone for joining us for our first quarter fiscal year 2027 earnings call. We're pleased to be with you today and look forward to discussing our results for the quarter. Before turning to the quarter, I want to highlight that we are still seeking additional shareholder votes for our proposal to increase Capital Southwest's authorized shares. The company has received substantial shareholder support for the proposal to date. As of today, approximately 89% of votes cast have been cast in favor of the proposal. However, because approval under Texas law requires the affirmative vote of holders of at least two-thirds of all outstanding shares, shareholder participation remains critical to the proposal's approval. A failure to vote has the same practical effect as a vote against the proposal. The proposal would provide Capital Southwest with the flexibility to continue executing the strategy that has supported the company's growth and long-term performance. Approval would not by itself authorize the issuance of any new shares. Rather, it would ensure that the company has sufficient authorized shares available to issue accretive equity when attractive investment opportunities arise. Additionally, I would like to highlight that ISS and Glass Lewis have both issued reports recommending that shareholders vote for the proposal. We would encourage all shareholders who have not voted or have voted against the proposals to support the company by casting their affirmative vote prior to the September 1 meeting date. Turning to the financial results, during the first fiscal quarter, we generated pre-tax net investment income of 57 cents per share, supported by strong recurring earnings across the portfolio. Our undistributed taxable income balance remains robust at 87 cents per share, reflecting consistent realization activity. Although our UTI balance declined this quarter as a result of normal annual corporate activity, we remain confident in our ability to continue growing this balance over time. Chris will provide additional detail later in the call. Our Board of Directors has declared a 58-cent regular dividend for the September quarter payable monthly in each of July, August, and September 2026. And has also declared a quarterly supplemental dividend of 6 cents per share payable in September, bringing total dividends declared for the September quarter to 64 cents per share. Turning to originations, deal flow in the lower middle market was strong this quarter. We closed $222 million in total new commitments across 11 new portfolio companies and 16 existing portfolio companies. Add-on financings continue to be an important source of originations for us as over the percentage of total new commitments have been 25%. These opportunities allow us to deploy capital into businesses we know well with proven management teams and sponsors. Our investment pipeline of new opportunities continues to meaningfully expand. Over the last 12 months, we have screened approximately 1,300 deals, of which we've closed 19 new platform companies. That is an increase from the 1,200 deals we screened in fiscal year 2025 and 1,000 deals we screened in fiscal year 2025. We have continued to source more deals with each passing year, while our close rate has decreased from 1.7% in fiscal year 2024 to 1.5% today. This highlights both our disciplined underwriting process and our continued penetration into opportunities in the lower middle market. Demonstrating our continued investment discipline, for new platform deals closed during the June quarter, weighted average senior leverage was 2.8x debt to EBITDA, and weighted average loan-to-value was 29%, providing a substantial equity cushion beneath our debt. Over the past 12 months, new platform originations have averaged 3.1x senior leverage and 34% loan-to-value, further underscoring our consistent commitment to conservative underwriting. Additionally, our portfolio continues to benefit from the broad industry diversification with an average position size of 0.8% per company, which helps mitigate company-specific risk. Furthermore, the weighted average yield on our debt portfolio increased to 10.9% during the quarter, up from 10.8% in the previous quarter. The main driver of this increase was an increase in the weighted average spread of our portfolio, which reflects our continued ability to originate high-quality opportunities while maintaining attractive spread economics, even amidst a more competitive and tighter spread credit environment. On the capitalization front, we raised $64 million in gross equity proceeds through our ATM program this quarter. Our ability to assess the ATM program continues to be a meaningful competitive advantage for Capital Southwest. In a market where fewer publicly traded BDCs are trading above book value, our improved price-to-book valuation gives us a differentiated ability to raise growth capital in a way that is accretive to NAV and supportive of long-term shareholder value. We believe our relative position has strengthened significantly over the past few years, and it provides us with the flexibility that many of our peers simply do not have today. In fact, only 6 BDCs were trading above book on June 30, 2026, down from 17 BDCs on June 30, 2024. Additionally, while the median BDC price-to-book multiple declined from 0.96x to 0.73x over that same two-year period, SWC has continued to trade well above book value in a range of 1.2x to 1.5x. I'll now hand the call over to Josh to review more specifics of our investment activity.

Thanks, Michael. As previously mentioned, this quarter we deployed a total of $222 million of new committed capital consisting of $167 million in first-lien senior secured debt and $6 million of equity across 11 new portfolio companies. We also completed add-on financing for 16 existing portfolio companies, totaling $49 million in first-lien senior secured debt and $285,000 in equity. Our on-balance sheet credit portfolio ended the quarter at $2 billion, representing 24% year-over-year growth from $1.6 billion as of June 2025. 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 0.8%. This level of portfolio granularity reflects our disciplined approach to risk management as we continue to scale the balance. The vast majority of our deal activity continues to be in first-lien senior secured loans to private equity-backed companies. Approximately 92% of our credit portfolio is sponsor-backed, which 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 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 quarter end, our equity co-investment portfolio consisted of 95 investments with a total fair value of $202 million, representing 9% of our total portfolio at fair value. This portfolio was marked at 121% of our cost, representing $34.4 million of embedded, unrealized appreciation, or $0.54 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. The lower middle market remains competitive as this segment of the market continues to attract both bank and non-bank lenders. Although this environment has produced tighter loan pricing for higher-quality opportunities, the depth and durability of the sponsor relationships our team has built, combined with the enhanced deal flow generated by our expanded and more seasoned investment staff continue to position us to source and win transactions with compelling risk-return profiles. Today, our portfolio includes investments from 95 unique private equity firms, and over the past 12 months, we have closed new platform investments with 20 sponsors with which we had not previously partnered. Since launching our credit strategy, we have completed transactions with over 135 private equity firms nationwide, including more than 20% with whom we have completed multiple deals. Our portfolio now consists of 141 portfolio companies, allocated 89.6% to first-lien senior secured debt, 1.1% to second-lien senior secured debt, and 9.2% to equity co-investments. The credit portfolio generated a weighted average yield of 10.9% with weighted average leverage through our security of 3.7x EBITDA. We remain pleased with the overall performance of the portfolio. At origination, all loans are initially assigned an investment rating of 2 on our 5-point scale, with 1 being the highest rating and 5 being the lowest rating. As of quarter end, 89% of the portfolio at fair value was rated in the top 2 categories. Cash flow coverage remains strong at 3.6x, reflecting an improvement from the 2.9x low observed during the peak of base rates. 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, pre-tax net investment income was $35 million, or 57 cents per share. For the quarter, total investment income increased to $61 million from $57.8 million in the prior quarter. The increase was primarily driven by a $2.6 million increase in cash interest income, coupled with an increase of $1.1 million in PIK interest income. The increase in PIK income was driven by an amendment to one of our portfolio companies, which capitalized two quarters of PIK into the current quarter, half of which will be non-recurring going forward. As of the end of the quarter, our loans on non-accrual represented 1.1% of our investment portfolio at fair value, flat from the end of the prior quarter. During the quarter, we paid a 58-cent per share regular quarterly dividend, paid monthly, and a 6-cent per share supplemental quarterly dividend. In the September 2026 quarter, our board has again declared 58 cents per share regular quarterly dividends payable monthly in each of July, August, and September 2026 and maintained the 6 cents supplemental quarterly dividend also payable in September, bringing total dividends declared to 64 cents per share. We continue to demonstrate strong dividend coverage with 109% cumulative coverage since launching our credit strategy. Our UTI balance declined to 87 cents per share this quarter, primarily due to book-to-tax differences related to annual cash bonus payments and equity award vesting. However, we have visibility on an equity realization expected to close in the near term, which should generate a realized gain and increase our UTI balance as of September 30. In addition, we continue to hold significant unrealized appreciation across our equity portfolio. As a result, we remain confident in our ability to grow our UTI balance and continue paying quarterly supplemental dividends over time. LTM operating leverage ended the quarter at 1.4%, a meaningful improvement from the 1.7% observed a year ago in June 2025. Notably, this reduction occurred despite the addition of 12 new employees. Going forward, we expect to continue to add resources to our team while maintaining operating leverage in the 1.4% to 1.5% range. Operating leverage remains significantly better than the BDC industry median of approximately 2.6%, underscoring the inherent deficiency of the internally managed BDC model. This structure has consistently delivered meaningful fixed-cost leverage to shareholders, while still enabling us to invest in talent and infrastructure as we continue to scale a best-in-class BDC platform. NAV per share decreased to $16.61 per share, down from $16.69 per share in the prior quarter. The primary drivers of the NAV per share decline for the quarter were net realized and unrealized depreciation on our investment portfolio and our annual equity grant to employees, offset by accruing from our equity ATM program. We raised approximately $64 million in gross equity proceeds during the quarter through our equity ATM program at a weighted average share price of $23.47 per share, or 141% of the prevailing NAV per share, reinforcing our ability to raise capital efficiently and accretively. Our liquidity position remains robust with approximately $375 million in cash and undrawn leverage commitments across our two credit facilities. In total, this represents more than 1.2x coverage of the $312 million in unfunded commitments across the portfolio. Currently, we are working on an amendment and maturity extension of our corporate credit facility, which should provide beneficial economic changes to our cost of capital. We'll share further details regarding the outcome of this process over the next few weeks. Regulatory leverage ends the quarter at 0.91 to 1 debt to equity. 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 cushions. We've made meaningful progress with [ capturing partners ], our joint venture with Trinity Capital. During the quarter, we closed a $150 million revolving credit facility, which will provide the liquidity to meaningfully increase the scale of our joint venture over time with advance rates that should produce a 13% to 15% return once fully ramped. The JV currently holds approximately $98 million in first-lien securities in 14 portfolio companies with a weighted average leverage of 1.2x debt to EBITDA. We expect to continue originating low leverage, high-quality investments within this structure. 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 this story on a quarterly basis. 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.

Thank you. [Operator Instructions] Our first question comes from Erik Zwick from Lucid Capital Markets. Please go ahead.

First question may be for either Josh or Michael. Just curious for the 11 new portfolio companies that you added during the quarter, if you could provide any detail into the average or the range of spreads on those new companies as well as maybe a sampling of the industries that they operate in. I'm curious if you're seeing some common themes there, some industries that you're finding more attractive today or it's pretty, you know, a little bit more diverse and widespread at this point.

[ David Chambers ] - yes, I mean, I saw the coupons. I think they ranged between 5.75% and I'd say as high as 7%. And some of the uplift in our spreads this quarter were due to [ capturing ] starting to take shape. But we've had additional first-out, last-out positions. So the yield on our last position is a little bit higher. I'm going to ask Josh. Do you have any thoughts on the industry?

I mean, generally speaking, I think it's pretty consistent with our portfolio broadly. I mean, we've not seen any specific industries that we've focused on the last couple quarters or seen more volume. It's really across the board from an industry perspective and continues to really remain diversified. And I think the other thing to add as well, so again we've noted this in the opening comments, is that the add-on investments that we've seen, some of those are for deals that are older deals that maybe started with $5 million EBITDA and they've grown through add-on originations that we funded. And so some of those have been on the higher end of the yield as well.

It's always nice when you continue to maintain those relationships as they grow. A good testament to the service that you're providing. So, I'm just curious, given the strong origination activity you had in the past quarter, how does the pipeline look today in terms of maybe dollars compared to 3 months ago? And then it's the mix of, between new and add-ons still kind of, you know, I guess in terms of dollar size, you did more. It's easier to do bigger, chunkier ones on the new ones, but you had a nice, you know, a number of new add-ons as well. So just curious what that mix looks like today.

Yes, so I think when we're looking ahead, we're just into August. We've already closed about $125 million in originations this quarter, and in a continued granular sense, we still are originating somewhere between $15 million and $20 million on each origination. We would tell you based on the pipeline of deals that we've actually signed up that we expect to close over the next 60 days, I mean, we could be in the $250 million to $300 million range. And that's going to include probably about 75% of that are new platform companies and the other 25% are add-ons to existing companies. We continue to ramp our origination staff that's helped drive continued pipeline strength. That coupled with [ cap trend ] again where we'll be able to originate deals with slightly lower yields on the phase. I think those two things together, yes, really, I think we noted also just the amount of deals that we look at on an annual basis is just, it's growing and we fully expect that to continue to grow because it feels like momentum is real and sustainable.

That's good to hear. It's certainly a little bit of a difference from some of the other of your competitors that are having a little bit more challenge growing the portfolio today. So last question for me and then I'll step aside. Just I think you mentioned 14 companies in that [ cap trend ] fund today. Are any of those just solely in that fund or is it they all have shared overlap with your legacy portfolio?

Erik, they're all, it's a mix of, so we did a secondary transaction to sort of seed the portfolio and we originated some new first-out into that fund as Michael mentioned. So there's overlap. There's nothing that's solely in [ capturing ]. There's overlap on every asset between Capital Southwest and [ capturing ] in some form or fashion, whether it's...