Capital Southwest Q3 2025 Earnings Call Transcript

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Operator

Thank you for joining today's Capital Southwest Third Quarter Fiscal Year 2025 Earnings Call. Participating on the call today are Bowen Diehl, Chief Executive Officer Michael Sarner, Chief Financial Officer Josh Weinstein, Chief Investment Officer and Chris Rehberger, Executive Vice President, Finance. I will now turn the call over to Chris Rehberger.

Chris Rehberger
Chris Rehberger
Executive VP & Treasurer at Capital Southwest

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.

Chris Rehberger
Chris Rehberger
Executive VP & Treasurer at Capital Southwest

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 off to our Chief Executive Officer, Bowen G.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Thanks, Chris, and thank you everyone for joining us for our Q3 fiscal year 2025 earnings call. We are pleased to be with you this morning and look forward to giving you an update on the performance of our company and our portfolio as we continue to diligently execute our investment strategy as stewards of your capital. Throughout our prepared remarks, we will refer to various slides in our earnings presentation, which can be found in the Investor Relations section of our website at www.capitalsouthwest.com. You will also find our quarterly earnings press release issued last evening on our website. We'll now begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

During the quarter, we generated pre tax net investment income of $0.64 per share, which fully covered both our regular dividend of $0.58 per share and our supplemental dividend of $0.05 per share paid during the quarter. Portfolio earnings continued to be strong and as of the end of the quarter, we estimate that our undistributed taxable income was $0.68 per share, which is up from our prior quarter estimate of $0.64 per share. As we look forward to the March quarter, we are pleased to announce that our Board of Directors has declared a regular dividend of $0.58 per share for the quarter ending March 31, 2025. Additionally, our Board has declared an increase to the supplemental dividend to $0.06 per share from the $0.05 per share in the December quarter, bringing total dividends declared for the March quarter to $0.64 per share. Deal flow in the lower middle market was very strong this quarter and the competitive environment around quality deals continued at the feverish pace we have seen for the past few quarters.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Portfolio activity during the quarter consisted of $317,500,000 in new commitments to 9 new portfolio companies and 20 existing portfolio companies. Add on financings continued to be an important component of many private equity firms' investment thesis and a highly attractive source of originations for us. In fact, over 41% of total capital commitments during the quarter were follow on financings in performing companies. The deals we are currently underwriting continue to have loan to value levels ranging from 35 percent to 50%, resulting in significant equity capital cushion below our debt and reasonable leverage levels of around 3.5 times debt to EBITDA. Josh Weinstein will provide additional color on the market, our investment activity and the performance of our portfolio later in our prepared remarks.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

On the capitalization front, during the quarter, we issued $230,000,000 in aggregate principal of convertible notes with a coupon of 5.125 percent and an initial conversion price of $25 per share. Net proceeds from these convertible notes were used to redeem in full the $140,000,000 January 2026 notes, as well as pay down our senior secured revolving credit facility. Importantly, there was no make whole payment associated with the repayment of the January 2026 notes. Michael will walk through some additional important mechanics of the convertible bond offering in a moment. Additionally, we received a green light letter from the FDA allowing us to submit our final application for our second SBIC license and we have been informed by the FDA that we will receive final approval any day.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

We are excited about our continued participation in the SBA program as this program has been and will continue to be a very important component of our capitalization strategy. Finally, we raised approximately $54,000,000 in gross equity proceeds during the quarter through our Equity ATM program at a weighted average share price of $22.68 per share or 137 percent of the prevailing NAV per share. We have remained diligent in ensuring that we have strong balance sheet liquidity while also funding a meaningful portion of our investment activity with both unsecured debt and accretive equity issuances. We continue to maintain a conservative mindset to both BDC leverage and balance sheet liquidity. Balance sheet liquidity at Capital Southwest remains robust, which Michael will provide additional commentary on in a moment.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Ensuring strong balance sheet liquidity affords us the ability to continue to invest in new platform companies as well as provide financing for both growth capital and add on acquisitions for our existing portfolio companies. We believe this strategy allows us to continue to grow our balance sheet through any capital markets environment, while also maintaining the flexibility to opportunistically repurchase our stock if it were to trade meaningfully below N and On Slide 7 and 8, we illustrate our continued track record of producing steady dividend growth, consistent dividend coverage and solid value creation. Since the launch of our credit strategy, we have increased our quarterly regular dividend 29 times and have never cut the regular dividend, all while maintaining strong coverage of our regular dividend with pre tax net investment income. In addition, over the same period, we have paid or declared 27 special or supplemental dividends totaling $4.12 per share, all generated from excess earnings and realized gains from our investment portfolio. Dividend sustainability, strong credit performance and continued access to capital from multiple capital sources are all core to our overall strategy.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Our track record in all these areas demonstrates the strength of our investment and capitalization management strategies as well as the absolute alignment of all our decisions with the interest of our fellow shareholders. As a reminder, Slide 9 lays out the core tenets of our investment strategy in lending and investing in the lower middle market. The vast majority of our portfolio and deal activity is in 1st lien senior secured loans to companies backed by private equity firms. Currently, approximately 94% 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, how we pursue with the private equity firm when we believe the equity thesis is compelling.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

As of the end of the quarter, our equity co investment portfolio consisted of 77 investments with a total fair value of $159,000,000 representing 9% of our total portfolio at fair value. Our equity portfolio was marked at 143 percent of our cost, representing $47,900,000 in embedded unrealized depreciation or $0.96 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 of 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. To that end, I would note that we have 2 equity investments currently in the final stages of sale processes, which should provide meaningful realized gains for Capital Southwest in the March 2025 quarter.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Additionally, we are seeing some increased visibility in our portfolio on companies beginning sales processes in 2025, several of which could result in material realized gains later this year for Capital Southwest. We look forward to providing you updates as appropriate as they develop. As illustrated on Slide 10, our on balance sheet credit portfolio ended the quarter at $1,500,000,000 representing year over year growth of 31% from $1,200,000,000 as of December 2023. For the current quarter, 100 percent of our new portfolio debt originations were 1st lien senior secured and as of the end of the quarter 98% of the credit portfolio was 1st lien senior secured with 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.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I will now hand the call over to Josh to review more specifics of our investment activity, the market environment and the performance of our portfolio for the quarter.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

Thanks Bowen. On Slide 11 and 12, we detailed a $317,500,000 of capital invested in and committed to portfolio companies during the quarter. Capital committed during the quarter included $172,300,000 dollars in 1st lien senior secured debt across 9 new portfolio companies in which we also invested a total of $3,000,000 in equity. In addition, we closed add on financings for 20 existing portfolio companies consisting of $141,100,000 in 1st lien senior secured debt and $1,100,000 in equity. We are pleased with the strong market position that our team has established as a premier lender to the lower middle market.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

This is evidenced by the broad array of relationships across the country from which our team is sourcing quality opportunities. As a point of reference, currently there are 80 unique private equity firms represented across our investment portfolio. Additionally, in the last year, 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 110 different private equity firms across the country, including over 20% with which we have completed multiple transactions. As Bowen mentioned, the lower middle market continues to be quite competitive as this segment of the market is highly attractive to both bank and non bank lenders.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

While this has resulted in tight loan pricing for high quality opportunities, 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. On Slide 14, we detail key statistics for our portfolio as of the end of the quarter. The total portfolio consisted of 125 different companies with fair value as of the end of the quarter weighted 89.1 percent to 1st lien senior secured debt, 1.5% to 2nd lien senior secured debt, 0.1% to subordinated debt and 9.3% to equity co investments. The credit portfolio had a weighted average yield of 12.1 percent and a weighted average leverage through our security of 3.6 times EBITDA. Overall, we are pleased with the operating performance across our loan portfolio.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

In fact, as shown on

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

Slide 15, the number portfolio. In fact, as shown on Slide 15, the number of portfolio upgrades were meaningfully more than the number of downgrades this quarter. As a reminder, all loans upon origination are initially assigned an investment rating of 2 on a 4 point scale with 1 being the highest rating and 4 being the lowest rating. We had 9 loans in 5 portfolio companies representing $99,000,000 in fair value upgraded during the quarter, while having 3 loans in 3 portfolio companies representing approximately $17,400,000 in fair value downgraded during the quarter. Overall, the portfolio remains healthy with approximately 95% of the portfolio at fair value rated in 1 of the top 2 categories, a 1 or a 2, and approximately 5% of the portfolio in the 3 or 4 category.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

Cash flow coverage of debt service obligations across the portfolio remains at a healthy 3.5 times with our loans across our portfolio averaging approximately 41% of the portfolio company enterprise value. Quarter over quarter revenue and EBITDA growth on a weighted average basis were each approximately 3%. As seen on Slide 16, our portfolio continues to be broadly diversified across industries with an asset mix, which provides strong security for our shareholders' capital. In addition to industry diversification, our average exposure per company is less than 1% of assets, which gives us great comfort in the overall risk profile of our portfolio. Our investment committee members utilize our cumulative experiences navigating through various economic cycles to continually assess risk, both on a company by company basis as well as on the overall portfolio.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

In the current environment, that includes being in close contact with our sponsors and portfolio companies to proactively assess any anticipated effects of recent and future policies on tariffs and immigration. I will now hand the call over to Michael to review the specifics of our financial performance for the quarter.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Thanks, Josh. Specific to our performance for the quarter, as summarized on Slide 17, pre tax net investment income was $30,700,000 or $0.64 per share as compared to $30,000,000 or $0.64 per share in the prior quarter. For the quarter, total investment income increased to $52,000,000 from $48,700,000 in the prior quarter. The increase was driven primarily by a $3,200,000 increase in fees and other income compared to the prior quarter. As of the end of the quarter, our loans on non accrual represented 2.7% of our investment portfolio at fair value.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

And the weighted average yield in the portfolio on all investments was 12.1%. During the quarter, we paid out a $0.58 per share regular dividend and a $0.05 per share supplemental dividend. As mentioned earlier, our Board has declared a regular dividend of $0.58 per share, while also increasing the supplemental dividend to $0.06 per share for the March quarter. Management and the Board have spent significant time contemplating the impact of a lower interest rate environment on future earnings. We have consistently maintained that setting a regular dividend at a level that we believe will never be cut in any foreseeable interest rate environment is key to generating stable, attractive shareholder returns over the long term.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

We continued our strong track record of regular dividend coverage with 115% coverage for the 12 months ended December 31, 2024 and 111% cumulative coverage since the launch of our credit strategy. We are confident in our ability to continue to distribute quarterly supplemental dividends for the foreseeable future based upon our current UTI balance of $0.68 per share and the expectation that we will harvest gains over time from our existing $0.96 per share and unrealized appreciation on the equity portfolio. As Bowen mentioned earlier, we have 2 equity investments in sale processes, both expected to close within the next 2 weeks. These realized gains, all else equal, should increase our UTI balance by a further $0.10 to $0.15 per share as of the end

Michael Sarner
Michael Sarner
CFO at Capital Southwest

of the March quarter. As seen

Michael Sarner
Michael Sarner
CFO at Capital Southwest

on Slide 18, LTM operating leverage ended the quarter at 1.6%. Our operating leverage of 1.6% continues to compare favorably to the BDC industry average of approximately 2.8%. 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. Turning to Slide 19, the company's NAV per share at the end of the quarter was flat at $16.59 per share.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

The primary drivers of the NAV per share bridge for the quarter were accretion from the issuance of common stock at a premium to NAV per share offset by the net realized and unrealized depreciation on our investment portfolio. Turning to Slide 20, we are pleased to report that our balance sheet liquidity is robust with approximately $412,000,000 in cash and undrawn leverage commitments on our 2 credit facilities, which altogether represented 2.1 times the $193,000,000 of unfunded commitments we had across our portfolio as of the end of the quarter. As Bowen mentioned earlier, in the December quarter, we issued $230,000,000 in aggregate principal of 5.125 percent convertible notes to 20.29 with an initial conversion price of $25 per share. These net proceeds were used to redeem in full the $140,000,000 January 2026 bonds as well as pay down our revolving credit facility. As of the end of the December quarter, 48% of our capital structure liabilities were in unsecured covenant free bonds with our earliest debt maturity in October 2026.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Delving a bit deeper into the convertible bond issuance, we believe there's been some confusion in the market regarding the issuance, which I would like to address. First, we did not incur any make whole premium in the takeout of the January 2026 bonds. 2nd, we have always stressed the importance of balance sheet flexibility and staying well ahead of our debt maturity. Using this convertible issuance to redeem our January 2026 bonds as well as to pay down our credit facility gives further dry powder to continue to originate attractive investment opportunities in all market environments. Moreover, based on today's 5 year treasury rate, the rate on the convertible note was approximately 200 basis points cheaper than the current market for a traditional unsecured bond, resulting in significant interest expense savings, which flow directly to pre tax NII.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Additionally, the convertible notes have a flex settlement mechanism. This means that to the extent our stock trades significantly above the conversion price and certain holders of the notes select to convert, Capital Southwest would have the option to redeem the notes in cash, shares or any combination thereof. This gives us the ability to actively manage balance sheet leverage, the impact of any dilution and the opportunity in this instance to issue equity at share prices which would be significantly above net asset value and thus be highly accretive to our shareholders. Turning to our SBIC program. In early 2024, we submitted a MAC application to the SBA, which began the process towards a second SBIC license.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

In December 2024, we received a green light letter from the SBA, allowing us to submit our final application, which we completed in January 2025. We expect to receive final approval for SBIC II imminently. Our regulatory leverage as seen on Slide 21 ended the quarter at a debt to equity ratio of 0.9:one, up from 0.8:one as of the prior quarter. While our optimal target leverage continues to be in the 0.8 to 0.95 range, we are weighing the impacts of future base rate reductions and maintaining adequate cushion levels to allow us the flexibility to potentially increase leverage to support future earnings and dividend growth. 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 leverage with adequate covenant cushions.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

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

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Thank you, Michael, and thank you, Josh. And again, thank you everyone for joining us today. As always, we appreciate the opportunity to provide you with an update on our business, our portfolio and the market environment. Our company and portfolio continue to perform well and we are pleased with the company's robust asset base, deal origination and portfolio management capability as well as flexible capital structure. The overall health and security of our portfolio is strong.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Our credit portfolio is predominantly made up of 1st lien senior secured loans allocated across a broader array of companies and industries with weighted average exposure per company under 1%. The vast majority of our portfolio is backed by private equity firms. Interest coverage of the debt obligations across our portfolio was a solid 3.5 times with strong equity value cushion and support below our debt investments. Additionally, our equity co investment portfolio gives our shareholders participation in the equity upside of many of these growing lower middle market businesses, providing further enhancement to our long term shareholder returns. Last but not least, we have a very well capitalized balance sheet with multiple capital sources and significant balance sheet liquidity, all of which provides our company an exciting runway to continue to grow and generate strong shareholder returns.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

This concludes our prepared remarks. Operator, we are ready to open the lines up for Q and A.

Operator

Thank you, sir. And I show our first question comes from the line of Mickey Schleien from Ladenburg. Please go ahead.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Yes. Good morning, everyone. Bowen, you mentioned that follow on investments were important part of your investment activity this quarter. But could you also give us some insight into the trends you're seeing in terms of new investment M and A activity in your market, considering that the election is behind us now and maybe there's a little bit more certainty in the direction of interest rates?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes. I mean, so obviously the M and A market was in our market was active in the Q4. We've seen that activity go continue into the Q1. Generally speaking, as we referenced, we're seeing some visibility on some exits in our portfolio for the calendar 2025 and some immediate ones and then we think some future ones. So M and A market, as we've all heard in the industry, people talk about it hoping that it increases in 2025.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I think we're seeing some early signs that that actually might be the case as we look forward. I don't know, Josh, you have anything to add to that?

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

Yes. I mean, I think you covered most of it, but I think we've obviously worked really hard over the last 10 years or so to create and cultivate relationships in that lower middle market. And we feel like we're while it remains competitive, we're continuing to just to be well positioned to participate in that M and A activity in 2025.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Yes. And the anecdote we did $320,000,000 of funded or I should say committed investments in the twelvethirty one quarter And that had I think we had 11 new platform companies and 20 something add ons. For this current quarter, we are also seeing continuation of that, seeing a lot of granularity in the deals we're seeing and the expectation that we're able to put on additional platform companies. So it's definitely something where we do expect our baseline originations in the near term to be higher than the previous.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Even though this tends to be a seasonally slower quarter, Mike?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Yes. Now this quarter for certain, I think we would tell you our normal quarter probably would be somewhere between maybe 125 and 150. But I would also say to Josh's point, we've added on a lot of sponsors. I mean, we've seen a lot of traction in the market. So I would expect our number to be something closer to $150,000,000 to $200,000,000 in originations for this coming quarter.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

We had a number of deals that we're targeting closing by the end of the Q4 that leaked into the Q1 that people help mitigate some of that seasonality this year.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

I understand. You also had really low repayment activity. To what extent did call protection keep repayments low? And how much refinancing risk do you see in the portfolio given all the pressure there is on spreads?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

I mean, looking ahead, I would tell you that we have had we've had calls. I mean, I think we do expect to see some level of prepayments into the future. To your point on call protection, we had one repayment of size in the previous quarter that had call protection where we generated, I think, approximately $600,000 in fees. But some of the deals we're looking at are probably 2022 and 2023 where you have some of that call protection either winding down or maybe it's only 1% and they're willing to pay that and get out of the credit. So I think rule of thumb for us, I mean, we're expecting probably maybe to see 10% to 15% of the portfolio rotate in the 2025 calendar year.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

But based on the risk

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

we've created over the years, we usually get the call before there's a repricing where we have the opportunity to lower our pricing and stay in the deal. And we obviously assess that on a situation by situation basis to see if we want to stay in the deal at the lower pricing. So we would expect some pressure just given potential competitive factors. But we feel like we're pretty well positioned to continue to stay in the deals and not get repriced out.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I would add Mickey that as we referenced the UTI increase and the potential exits this year, those are obviously well performing companies, but oftentimes they also have debt in them if we haven't already been recapped out. So I think it's probably fair to expect that a meaningful portion of our prepayments will be driven by M and A activity, which is not really a function of prepayment penalties. I don't I mean, private equity firms selling the business because it's time to sell the business, not because of the prepayment.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Yes. I understand. That's helpful. Last question, then I'll get back in the queue. You have investments in sectors like food and consumer machinery.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

How do you see tariffs, which I know are a moving target, but we seem to be moving in the direction of tariffs. How do you see those tariffs impacting these companies or the portfolio in general?

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

Yes, I mean, you mentioned that we have 120, 125 portfolio companies. So clearly, we're going to have some exposure. Based on our preliminary analysis, it looks like around 10% of our portfolio could see some impact. That being said, we are 1st lien senior secured lenders. So we think that positioning in the capital structure will mute the impact to our portfolio.

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

And obviously, we're information is real time and we're continuing to monitor it and analyze it as it comes through. But the diverse portfolio with the 1st lien position feels like we're in a good position to mitigate that risk.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

The other point I'd make too is during the 2016 Trump administration, they did increase tariffs as well then, particularly with China. And so we saw that impact with some of our portfolio companies. And honestly, they were still able to thrive under the environment. Obviously, it's a moving target as you said, Mickey. So we'll have to see where those go on a go forward basis.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

But I think Josh points a good one. We're also in the boardroom during investment committee meetings. We're certainly discussing the impacts to make certain any deals we're looking at on a prospective basis, we're taking into that into account on a downside scenario.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I mean, it's all happening kind

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

of real time, obviously, as we all know, and goalposts are moving around, but there's a lot of communication gathering, as we referenced, Josh referenced, from our sponsors and our portfolio companies. But like Josh referenced that was kind of our initial take over the weekend.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Understand. I have some more questions, but I'll get back in the queue and let some of the folks take the microphone. Thanks.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Thanks, Becky.

Operator

Thank you. And I show our next question comes from the line of Doug Harter from UBS. Please go ahead.

Douglas Harter
Douglas Harter
Equity Research Analyst at UBS Group

Thanks. I was hoping to get a little bit more on the SBA license. I guess how do you think about how long it might take to fill that up and what type of funding costs do you anticipate that being?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Yes. I think, well, first of all, I mean, I'll start by saying, look, we were expecting that license to come in any day now. However, what's going on with the government right now, we understand that there's sort of a freeze for the next week or 2 or actually they don't really have a good timing on it before they come back to us. Let's just assume that we do see that license in the next few weeks. We'd expect to be able to ramp that fairly quickly.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

I mean, majority of our deals when we break it down, 80 plus percent of our deals are lower middle market that fit the SBIC perfectly. So I think our previous license we got in April of 2021 and it took us, what, 2.5, 3 years to fill it up. I assume the same cadence, maybe slightly quicker just because the amount of sponsors we've won and the deals we're doing. In terms of an expectation on pricing, I would expect somewhere this is a big range, but I would imagine that we'd be borrowing somewhere between 4% 5%, which if you compare that obviously to what our credit facility or what the bond market is, that's exceptional. I mean, it's certainly not the 2% or 1% that you saw 5 years ago, but it's still net accretive to our shareholders.

Douglas Harter
Douglas Harter
Equity Research Analyst at UBS Group

Great. And I appreciate the details you gave around the convert. Just wondering how you think about kind of the option cost of the convert when you're kind of factoring that into it and maybe any sort of short term impact it has on kind of the trading of the stock when into the calculus of the decision to do convert or forms of capital?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

I mean, I think if you look at the convertible over the long term, what we've been seeing is, first of all, it's very unlikely most bond traders are going to actually convert from into equity or in our situation, actually just put it to us and give us the option for cash or shares. So from a what we're looking at is if it's $25 on a conversion price, we're trading at $22.50 or $23 The expectation is, first of all, there's a lot of cushion between now and then. The convertible holders would have to see significant accretion above the $25 before they would actually call and ask for the conversion. And at that point, they're taking the risk that we are going to just redeem their bonds and they lose any option value. So from our perspective, it seems to be a low risk.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

And when we compare that 12 months ago and 6 months ago to what we saw in the market, which is a lot of uncertainty with the change administration, whatever is going on in the macro economy, it's kind of played itself out where if you look at the risk premium and the 5 year treasuries, if we were to go to market today, it would look like something in the 7.5% to 8% range, even through a baby bond and maybe it's slightly better for an institutional bond. When you look that, you compare it to 5 and an 8, knowing all along that SOFR over the last 9 months has come in over 100 basis points. This felt like this was from an accretion perspective, we're giving our shareholders a reduction in interest expense, therefore, an increase in their dividend. And if the risk is in 2 or 3 years, we see some additional dilution, it's at a $26 or $27 share price, which is accretive to shareholders. And therefore, we think that they're winning along the way and they'll win if and when a conversion takes place.

Douglas Harter
Douglas Harter
Equity Research Analyst at UBS Group

Thank you.

Douglas Harter
Douglas Harter
Equity Research Analyst at UBS Group

Great. Appreciate it.

Operator

Thank you. And I show our next question comes from the line of Eric Zwick from Lucid Capital Markets. Please go ahead.

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

Thank you. Good morning, everyone. I wanted to start with you mentioned, and we've been hearing it from others as well, just that the competition in the market is certainly driving some spread compression. Wondering if you could quantify that a little bit. If you take a look at the what's in pipeline today and what the average spread is, how that compares to maybe 6 months ago?

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

I mean, I would say the market moved from our perspective, the market moved about 9 months ago and it probably reflects 50 to 100 basis points.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

But generally pretty flat this quarter than last quarter. I mean like it was 9 months ago, 6, 9 months ago event that's kind of been kind of more of

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

the same.

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

Thanks for the color there. And maybe just is the competition spreading into structure at all as you go out and potentially compete with others in the market? Are you seeing some bending there? And if so, how are you dealing with that?

Josh Weinstein
Josh Weinstein
Senior MD & Chief Investment Officer at Capital Southwest

We have not seen as much pressure on the structure. Loan to value still remain pretty consistent from where they've been in the last year or 2. And it's mostly been focused on the pricing.

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

That's good to hear. And if I just switch gears a little bit, could you provide an update on the relationships that are currently on non accrual? Have there been any changes over the past 3 months in terms of anything maybe getting closer to a resolution or any companies improving performance that could potentially move them off non accrual in the next quarter or 2?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes. We've we had a non accrual, one of our non accruals can restructure in the December quarter. One of the other non accruals is now restructured in this quarter that's in non accrual as of the end of December. So it's now restructured. The non accrual group is the vast majority of the depreciation this quarter.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

That's depreciation is not okay with us. It's very frustrating. At the same time though, the main depreciation is coming from companies that aren't in NII. So it's more of an NAV effect on us as opposed to earnings effect. But that's hopefully helpful general color on what's happening.

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

And for those that did restructure, are they currently will they have they moved back to accrual? And then do you have any equity positions or

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

how does this play out?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes. So we restructured into varying levels of debt and the remainder of the debt is equity. So we have the ability as the company recovers to retain recoup our NAV.

Erik Zwick
Managing Director, Equity Research at Lucid Capital Markets LLC

Great. Thank you for all the answers today. That's all for me.

Operator

Thank you. And I show our next question comes from the line of Robert Dodd from Raymond James. Please go ahead.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Good morning. Congrats on the quarter. A couple of questions. First, I mean, very, very busy, right? I mean, somewhere around, I think, 30 deals between follow ons and new platforms this quarter.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

How do you feel about the staffing levels with expanding the number of sponsors you're working with, the number of add ons? I mean, you're incredibly active. And is the staffing of a sufficient level to keep going on at that kind of pace? It sounds like Q1 is pretty active as well. So I mean, can you give us any color about needs there?

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Do you need more increases in staffing? Could that in the short term impact the expense ratio?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes. I was making a comment generally. I mean, we feel like where we sit we're look, that's a good question. And we're constantly thinking about that. I mean, staffing is super important.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I mean, one of the one of the reasons we didn't mention that our deal flow has been up, it's a factor. I mean it's all the things we've talked about. But it's also we in our net across the country has expanded too as Josh has done a great job training up some of these folks with new people in the market over the last couple of years and then gaining traction has resulted in a wider net in the market. But I would say and Josh and Michael can comment, I don't know that we're like way off base, but it's something that we definitely are constantly looking at. We should we would probably expand as we grow.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Yes, I mean, I would tell you just on a run rate basis, we typically add, let's say, on the deal side, 3 professionals minimum a year that usually on the junior side. And then I would say probably every other year, we'll add a somewhat at the senior associate or VP level. On the deals, now on the accounting back office side, we probably also add around 1 to 2 people based on volume as well. So I don't think that this is a there's a point where we say, oh, volume has caught up to a place where we can't accommodate it. I think that we're continually assessing, as Bowen said, but we continually add to it.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

If you look back, I think when we started to venture, we had 6 or 8 employees and now we have I think 36 employees today. So the answer to your question is, I think the asset base might be growing slightly quicker than the employee base, which is why our operating leverage is going down, but it's not because we are either A, not hiring people or B, not paying our people. Because we also make it a point to promote from within, which has worked wonderfully, honestly, over the last decade, which has allowed us to be able to add the people at the local levels and be trained up by the people that have been through the system and understand our underwriting process.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes, Michael touched on it.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

I mean, it's not all part of it is activity as you referenced Robert, but it's also just us constantly looking at the size of the portfolio and specifically the number of portfolio companies. And as Josh's team and we think about who's monitoring those companies and managing those loans. Do we have enough people and then Michael on the back office side as he referenced, I mean, do we have the infrastructure to manage that portfolio 125 companies, which is growth, some get prepaid, some new ones come on. But that's how we're looking at that.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Got it. Thank you. I appreciate that, Karl. Another one, I think, Paul, I mean, you mentioned obviously tariffs and immigration. I mean, what percentage of your portfolio has exposure as kind of federal contractors?

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Because it looks like there's efforts there to cut some payments. How sticky those cuts are is a wild card. But do you have any significant any portfolio companies with any material exposure to more federal contracting than government contracting in general?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Yes. So I'm sitting here on the fly thinking about that, looking at my colleagues here. I mean, I just imagine the 125 companies that can come up in my head, 3 of them, 2 definitely have do business with federal with contracting with the federal, I guess, government, the other one indirectly. So I mean Most

Michael Sarner
Michael Sarner
CFO at Capital Southwest

of those are subcontractors. So they're actually not federal government workers. So I think Bowen, point is a good point. It's probably it's very small and even within those 3, I'm not sure if it's going to have a direct impact.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

So if I'm at the C level thinking about the portfolio at risk to the company, I think that is not the first thing we're worried about. But it's a good question. It's definitely what you should have.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Yes, got it. Thank you. One last one if I can. I mean, obviously, spillovers, still back up $0.68 sounds like that's going to go up again in Q2 in the March quarter. In the past, you did run that up and then you distributed it, it's going to be like maybe 2021, it's in one of your charts, but to keep the absolute level of spillover down and reduce your excise tax, etcetera.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

So have you changed your mind and now you're going to build it back up? Or is there some level where you'd want to distribute that again to keep the spillover level down. And does the existence to convert now change any dynamics there? That's obviously extra dividends.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Yes. I don't really want to say there was a change. I think if you go back to the first program we put in place, we had an extremely large gain that we couldn't even hold all of it just from rec and BDC restriction. And so we distributed what we had to upfront and then we paid over time. And when we no longer thought we had the pathway to continue the program, we decided to distribute it back to shareholders.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

So that was sort of the natural evolution. I would tell you now, we're at $0.68 we see ourselves climbing into the $0.80 range by next quarter. And we do anticipate distributing probably a little more than our run rate today, walking if we've gone down to 5, we went up to 6, we anticipate walking that up slowly. And then I think the point that we've all made today that there's a pathway to some sizable gains towards the

Michael Sarner
Michael Sarner
CFO at Capital Southwest

end of the year.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

And if that was the case, we'd be back in sort of the same territory where we have a significant UTI bucket, which we would intend to increase the supplemental and continue to pay our shareholders on a quarterly basis. And would be a larger percentage of the total distribution. So that's sort of the plan going forward.

Robert Dodd
Robert Dodd
Director - Finance at Raymond James Financial

Thank you for that. That's it for me.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Thank you, Doug.

Operator

Thank you. And I show our next question comes from the line of Mickey Schleien from Ladenburg. Please go ahead.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Yes. To follow-up, I wanted to get a sense of what drove the increase in fee income this quarter?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Sure. So there's a number of things on it. First, we had I mentioned earlier, we had a prepayment penalty for approximately $600,000 We also had, if you recall, the bonds that we raised, so we brought that $230,000,000 in. Most of that was used to pay down and redeem the 2026 bonds, but there was a 30 day redemption period. So we essentially held cash on the balance sheet for 30 days, which came out to about $1,200,000 in income.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

So that's $1,800,000 between those. And then on top of that, there was some few amendment fees, waiver fees and some arranger fees as well on some directly led deals.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Okay. And my other another follow-up is, what were the main drivers of the realized loss this quarter?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

The realized loss was a restructured deal.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Okay.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

That was I think it was $12,700,000 So most of that was just to be clear was in depreciation was reversed and a portion of that was new depreciation that was taken during the quarter.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Understand. And so you had this diversion in portfolio company performance, which was a nice increase in companies performing above expectations, but you also had some below expectations. Are there can you help us understand what are the trends that drove that movement?

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

No. As I look down the list here, I mean, it's a bit idiosyncratic honestly, the upgrades and downgrades. There's one that's in the shipping space where spot rates have moved to the company's detriment. So that was a negative to that. Another company is a little bit weather related, probably cover some based on the snow of recent.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

And then the other downgrade was just one of our non accruals that's this continued struggle.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Okay. And lastly, I think Michael gave us guidance on regulatory leverage targets. Could you also give us an idea of where you're expecting your economic leverage or your total leverage to what is your target in the current market environment?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

Sure. So I think we've been between 1.01.1 for economic leverage. And we've been on a regulatory basis, we've been between really 0.8 and 0.9 or even lower. I would tell you we're at 0.9 on regulatory, we'll start there. And we tell you we're going to keep an eye on what's going on obviously in the macro economy, geopolitical scene to determine whether there's more or less risk.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

But we feel comfortable right now that the 0.9 leverage that we have right now in the 1.08, that's about a decent place to be. And we're looking down the road. We would tell you as we look back, we did the convertible bond offering, we're seeing all the things that are happening in the world. That was one reason why we took risk off the table by bringing these bonds into the on our balance sheet earlier. And then we can make decisions in terms of leverage going forward.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

So we feel like we're in a really good place, especially with trade significantly above book. And so we are active in the ATM market, to manage that metric going forward.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Okay. And just to make sure I understand, the income on idle on your cash, some of that's accruing into fee income as opposed to other income?

Michael Sarner
Michael Sarner
CFO at Capital Southwest

No, I think the line item you're looking like it says fee and other income. And so the other income, because it's not portfolio interest income, it's actually money market income, interest income. It falls into other. And I would probably tell you, I wouldn't anticipate seeing that happen ever again, right? This is a one off.

Michael Sarner
Michael Sarner
CFO at Capital Southwest

So it's

Michael Sarner
Michael Sarner
CFO at Capital Southwest

that's why it fits into the

Michael Sarner
Michael Sarner
CFO at Capital Southwest

other rather than interest income.

Mickey Schleien
Mickey Schleien
MD - Equity Research at Ladenburg Thalmann

Okay. Those are all my follow ups. I appreciate your time. Thanks so much.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Thanks, Mickey.

Operator

Thank you. And I show no further questions in the queue. At this time, I'd like to turn the call back to Bowen Diehl for closing remarks.

Bowen Diehl
Bowen Diehl
CEO at Capital Southwest

Thank you, operator. Thanks everybody for joining us. We appreciate it. Appreciate your time and look forward to giving you further updates in the future. Have a great rest of the week.

Operator

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

Executives
    • Chris Rehberger
      Chris Rehberger
      Executive VP & Treasurer
    • Bowen Diehl
      Bowen Diehl
      CEO
    • Josh Weinstein
      Josh Weinstein
      Senior MD & Chief Investment Officer
Analysts
Earnings Conference Call
Capital Southwest Q3 2025
00:00 / 00:00

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