Executive Summary / Key Takeaways

• Disciplined Growth & Credit Quality: Capital Southwest (CSWC) continues to demonstrate robust portfolio growth, expanding its investment portfolio by 21% year-over-year to $1.6 billion, while simultaneously enhancing credit quality. This is evidenced by a reduced weighted average debt to EBITDA of 3.4x, a lower PIK rate of 5.8%, and a significantly improved non-accrual rate of 0.8% of the portfolio at fair value.
• Strategic Capital Management: The company has proactively strengthened its balance sheet through diverse capital sources, including the recent final approval for its second SBIC license (unlocking $175 million in cost-effective debentures) and a $25 million increase to its corporate credit facility, bringing total commitments to $510 million. Its regulatory leverage stands at a conservative 0.82:1 debt-to-equity.
• Shareholder-Friendly Dividend Policy: CSWC transitioned its regular dividend to a monthly payment frequency, a move aimed at enhancing shareholder value. With a robust undistributed taxable income (UTI) balance of $1.00 per share, bolstered by $27.2 million in realized equity gains in Q1 FY26, the company is well-positioned to sustain its $0.58 regular dividend and potentially increase its $0.06 supplemental dividend.
• Operational Efficiency & Internal Management: As an internally managed BDC, CSWC benefits from a highly efficient operating model, with LTM operating leverage at 1.7% and an anticipated run rate of 1.4% to 1.5% by fiscal year-end 2026. This significantly outperforms the BDC industry average, providing a distinct competitive advantage and direct alignment with shareholder interests.
• Resilience Amidst Market Uncertainty: Despite facing macroeconomic headwinds, including spread compression, interest rate volatility, and trade policy uncertainties impacting certain industries, CSWC's conservative underwriting, strong private equity relationships, and diversified, first-lien-heavy portfolio position it for continued opportunistic growth and stable returns.

A Foundation of Discipline: CSWC's Enduring Strategy in the Lower Middle Market

Capital Southwest Corporation (CSWC), founded in 1961, has evolved into a formidable internally managed Business Development Company (BDC) specializing in providing bespoke debt and equity financing to the Lower Middle Market (LMM) in the United States. Its core investment objective is to generate attractive risk-adjusted returns through current income from debt investments and capital appreciation from equity co-investments. This foundational strategy, solidified with the launch of its dedicated credit platform in 2015, targets companies with annual EBITDA typically ranging from $3 million to $25 million, with individual investments between $5 million and $50 million.

CSWC's market positioning is defined by its niche focus on profitable, growth-oriented companies, often partnering with private equity firms. This approach contrasts with larger, more diversified BDCs like Ares Capital Corporation (ARCC), which operate across a broader spectrum of the middle market. While ARCC leverages its scale for extensive market reach, CSWC differentiates itself through deep relationships and sector-specific expertise, particularly in industrial manufacturing, energy services, and healthcare. This allows CSWC to maintain a stable, relationship-driven lending model, even as the LMM remains highly competitive, attracting both bank and non-bank lenders.

The competitive landscape for CSWC is dynamic. The LMM is characterized by a "supply-demand dynamic" where private equity sponsors are increasingly selective, leading to a scarcity of quality assets. Simultaneously, aggressive bank and non-bank lenders are incentivized to deploy capital, resulting in "tight loan pricing" and "spread compression." CSWC has observed spreads tightening from 8.5% two years ago to approximately 7-7.5% currently, with some credits as low as 5.25%. However, CSWC's disciplined underwriting ensures that loan-to-value levels remain conservative (35-50%) and leverage is reasonable (2.5-4x debt to EBITDA), providing significant equity cushion below its debt.

Operational Technology and Strategic Innovation: CSWC's Competitive Edge

CSWC's competitive advantages are not rooted in a traditional product technology but rather in its sophisticated operational and financial "technology" that underpins its internally managed BDC model. This structure is a significant differentiator, leading to a "beneficial operating expense structure" and "real fixed cost leverage." For the last twelve months (LTM) ended June 30, 2025, CSWC's operating leverage stood at 1.7%, with an anticipated run rate of 1.4% to 1.5% by the end of fiscal year 2026. This is notably superior to the BDC industry average of approximately 2.7-2.8%, directly enhancing net investment income (NII) and shareholder returns.

A core component of CSWC's operational technology is its "internally developed investment rating system." This 5-point scale (recently updated from a 4-point scale for enhanced transparency) is crucial for continuously monitoring the performance and expected returns of each debt investment. It integrates both quantitative and qualitative factors, including portfolio company financial health, market trends, and collectability. This analytical rigor contributes to CSWC's strong credit quality, as evidenced by approximately 92% of its debt portfolio (at fair value) being rated in the top two categories (1 or 2) as of June 30, 2025.

Furthermore, CSWC employs innovative financial strategies as a form of "technological" differentiation in capital management. The Equity ATM Program, which has cumulatively raised $751.7 million in gross proceeds, provides flexible access to equity capital, often at a premium to Net Asset Value (NAV). For instance, in Q1 FY26, $42 million was raised at 123% of NAV. This allows CSWC to "delever the balance sheet, invest in new platform companies, and provide financing for add-on acquisitions" across various market environments. The recent final approval for its second SBIC license is another strategic innovation, providing access to an additional $175 million in SBA debentures, which are a "cost-effective way to finance" its LMM strategy at anticipated fixed rates of 4-5%. These capital-raising "technologies" enhance CSWC's liquidity and reduce its cost of capital, directly supporting its growth and dividend sustainability.

Financial Performance and Portfolio Resilience

CSWC's financial performance in Q1 FY26 (ended June 30, 2025) reflects the effectiveness of its disciplined strategy and operational advantages. The company reported pretax net investment income of $0.61 per share. Total investment income increased by $4.6 million (8.9%) year-over-year to $55.9 million, primarily driven by a 21.7% increase in the average monthly cost basis of debt investments. This growth was partially offset by a decrease in the weighted average yield on debt investments from 13.3% to 11.8%, reflecting broader market spread compression.

The company's focus on credit quality is evident in several key metrics. The investment portfolio's weighted average debt to EBITDA improved from 3.5x to 3.4x. Critically, the non-accrual rate significantly decreased from 1.7% to 0.8% of the investment portfolio at fair value, a testament to proactive portfolio management and successful restructurings. The investment revenue PIK rate also declined from 7.6% to 5.8%, indicating a higher proportion of cash-paying interest, which strengthens the quality of earnings.

CSWC's equity portfolio continues to be a significant value driver. The company harvested $27.2 million in realized gains from two equity investment exits in Q1 FY26, contributing to a robust undistributed taxable income (UTI) balance of $1.00 per share. This follows a strong fiscal year 2025, where unrealized appreciation grew from $38.5 million to $53.2 million ($1.00 per share). This substantial UTI balance provides a critical buffer for dividend distributions, reinforcing CSWC's commitment to shareholder returns.

Outlook, Guidance, and Risk Management

Looking ahead, CSWC anticipates "significant activity in terms of new platform company originations as well as add-on activity" in Q2 FY26, with expected originations between $150 million and $200 million. This robust pipeline is a direct result of its deep private equity relationships and ability to identify quality deals despite market competition. The company expects to begin funding its second SBIC subsidiary in Q2 FY26, with debenture draws likely in the subsequent quarter, further enhancing its NII.

Management's dividend policy remains a cornerstone of its shareholder value proposition. The recent transition to a monthly regular dividend of $0.1934 per share (totaling $0.58 quarterly) and a maintained quarterly supplemental dividend of $0.06 per share for Q2 FY26 underscores its confidence. This confidence is grounded in the expectation of maintaining a $0.58 NII coverage, even with an anticipated 100 basis point drop in base rates over the next 15 months, supported by 7%+ spreads and operational efficiencies. The growing UTI balance is expected to "grow sizably" in the coming 6-9 months, providing further support for both regular and supplemental dividends.

CSWC operates in an environment fraught with macroeconomic and geopolitical risks. Management acknowledges commodity inflation, elevated interest rates, supply chain disruptions, and uncertainties from U.S. tariff and import/export regulations. "We took a conservative approach to underwriting this quarter due to the noise and uncertainty related to tariffs and government policies impacting health care and government services," stated Michael Sarner in Q1 FY26. An in-depth review revealed that only 7% of the debt portfolio (at fair value) has moderate tariff risk exposure, and a mere 1% has both moderate tariff risk and a loan-to-value above 50%. This limited exposure, coupled with portfolio companies' mitigants (e.g., pivoting supply chains, price adjustments), demonstrates CSWC's proactive risk management.

Interest rate risk is another key consideration. While 96.3% of CSWC's debt investments are floating rate (100% subject to floors), its fixed-rate debt (October 2026 Notes, August 2028 Notes, 2029 Convertible Notes, and SBA Debentures) provides some insulation against falling rates. The company's internal risk management systems continuously assess interest rate exposure, and its conservative leverage (0.82:1 regulatory debt-to-equity ratio, targeting 0.8-0.95) provides a cushion against market volatility.

Conclusion

Capital Southwest stands as a resilient and strategically positioned BDC within the competitive Lower Middle Market. Its long history, coupled with a disciplined, relationship-driven investment strategy, has fostered a robust portfolio characterized by strong credit quality and consistent income generation. The company's operational and financial innovations, particularly its internally managed structure and diverse capital-raising mechanisms, provide a distinct competitive edge, driving superior operating leverage and efficient growth.

With a healthy pipeline, a shareholder-friendly dividend policy backed by a growing UTI balance, and a conservative balance sheet, CSWC is well-equipped to navigate evolving market dynamics. While macroeconomic uncertainties and competitive pressures persist, the company's proactive risk management, focus on first-lien senior secured debt, and ability to generate accretive equity gains underscore a compelling investment thesis. CSWC's commitment to long-term shareholder value, supported by its operational excellence and strategic flexibility, positions it as a fortress in the LMM.