Executive Summary / Key Takeaways

• Capital Southwest Corporation ($CSWC) stands as a resilient internally managed Business Development Company (BDC), strategically focused on providing flexible, predominantly first-lien senior secured debt and opportunistic equity co-investments to the lower middle market. Its robust internal management structure drives superior operating efficiency, significantly outperforming the BDC industry average.
• The company demonstrates strong financial health and consistent dividend coverage, supported by a growing Undistributed Taxable Income (UTI) balance, which reached $1.13 per share as of September 30, 2025, primarily fueled by $44.8 million in realized equity gains over the last 12 months. This substantial UTI, alongside a conservative leverage profile and robust liquidity, underpins management's commitment to sustained regular and supplemental dividends.
• CSWC's proactive capital management, including a recent $350 million unsecured note issuance and the approval of a second SBIC license, has significantly extended its debt maturity profile to fiscal year 2030 and enhanced its funding flexibility. This strategic positioning allows for opportunistic growth and resilience against market volatility.
• Despite a competitive and uncertain macroeconomic environment marked by tight spreads and evolving trade policies, CSWC maintains disciplined underwriting standards, focusing on high-quality opportunities with conservative leverage (3.5x debt to EBITDA) and strong loan-to-value ratios (43% of enterprise value). Its granular and diversified portfolio exhibits strong credit quality, with 91% rated in the top two categories.
• The company's outlook projects continued robust origination volume, targeting $150 million to $200 million per quarter, driven by expanding private equity relationships and a focus on resilient service industries. CSWC's ability to consistently trade above book value provides a crucial advantage for accretive equity raises, further strengthening its balance sheet and investment capacity.

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

Capital Southwest Corporation ($CSWC) operates as a specialized, internally managed investment company, a distinctive characteristic in the Business Development Company (BDC) landscape. Founded in 1961, CSWC has honed its focus on providing customized financing solutions to lower middle market (LMM) companies across the United States. Its core investment objective is dual-pronged: generating attractive current income from debt investments and fostering capital appreciation through equity and equity-related stakes. This strategy is executed by partnering with business owners, management teams, and financial sponsors, offering flexible capital solutions to support growth, facilitate changes of control, and navigate other corporate events.

The company primarily targets LMM businesses with annual EBITDA typically ranging between $3 million and $25 million, with individual investment sizes generally falling between $5 million and $50 million. This niche focus allows CSWC to address an underserved segment of the market, historically characterized by more limited access to traditional financing. This dynamic creates opportunities for CSWC to negotiate favorable transaction terms and secure equity participations, enhancing overall returns.

CSWC's operational model itself serves as a significant differentiator. As an internally managed BDC, it directly incurs the operating costs associated with employing its investment and portfolio management professionals. This structure is believed to provide a beneficial operating expense framework compared to externally managed peers, fostering absolute alignment with shareholder interests. The company's LTM operating leverage stood at 1.6% for the quarter ended September 30, 2025, notably better than the BDC industry average of approximately 2.7%. Management anticipates further improvement, targeting a run rate of 1.4% to 1.5% by the end of the current fiscal year. This efficiency is a direct result of its "real fixed cost leverage," enabling significant resources to be invested in personnel and infrastructure as the portfolio expands.

A cornerstone of CSWC's operational "technology" is its disciplined underwriting and portfolio management approach. The company employs a rigorous investment rating system, recently transitioning from a 4-point to a 5-point scale for enhanced transparency. All new loans are initially rated 2 (on a scale where 1 is highest), and the portfolio's overall health remains robust, with approximately 91% of investments at fair value rated in the top two categories as of September 30, 2025. This discipline extends to new originations, which consistently feature conservative metrics: weighted average senior leverage of 3.5x debt to EBITDA and 38% loan-to-value over the past 12 months. This conservative posture provides substantial equity capital cushion below CSWC's debt positions, mitigating risk.

Strategic Evolution and Capital Fortification

CSWC's history is marked by strategic initiatives aimed at fortifying its capital structure and expanding its investment capacity. The launch of its credit strategy has been a primary growth engine, with the on-balance sheet credit portfolio expanding by 24% year-over-year to $1.7 billion as of September 30, 2025. This growth has been supported by a diversified funding base.

The company has strategically utilized various capital sources, including its Corporate Credit Facility, which saw commitments increase to $510 million. The Equity ATM Program, established in 2019 and expanded multiple times to $1 billion, provides continuous access to public equity markets. This program proved valuable in the second fiscal quarter of 2026, raising approximately $40 million in gross equity proceeds at a weighted average share price of $22.81, representing 137% of the prevailing Net Asset Value (NAV) per share, thus being accretive to shareholders.

A pivotal development in CSWC's funding strategy is its Small Business Investment Company (SBIC) program. Capital Southwest SBIC I, LP received its license in April 2021, followed by SBIC II in April 2025. These licenses enable access to cost-effective, long-term leverage for its LMM investment strategy. Management anticipates utilizing SBIC II over the next three months, with initial debenture draws expected around three months from the Q4 2025 call date. Borrowing under SBIC II is projected to be between 4% and 5%, significantly cheaper than traditional unsecured bonds and highly accretive to shareholders.

Proactive debt management is another hallmark of CSWC's strategy. During the second fiscal quarter, the company successfully raised $350 million in 5.95% notes due 2030. Subsequent to quarter-end, these proceeds were strategically used to redeem in full the $150 million notes due October 2026 and the $71.9 million notes due August 2028, with no make-whole premiums incurred. This move effectively pushed CSWC's earliest unsecured debt maturity to fiscal year 2030, significantly enhancing its balance sheet flexibility and alleviating near-term maturity concerns. The 2029 Convertible Notes, issued in November 2024 with a 5.125% coupon, also exemplify CSWC's innovative capital management. These notes were approximately 200 basis points cheaper than a traditional unsecured bond at the time of issuance, generating substantial interest expense savings. Their "flex settlement mechanism" provides CSWC the option to redeem in cash, shares, or a combination if the stock trades significantly above the $25 conversion price, allowing for active management of balance sheet leverage and dilution.

Robust Performance Amidst Competitive Currents

CSWC's financial performance reflects its disciplined strategy and operational efficiency. For the second fiscal quarter ended September 30, 2025, the company reported pretax net investment income of $0.61 per share. Total investment income increased to $56.9 million from $55.9 million in the prior quarter, driven by a $1.3 million increase in fees and other income. Notably, Payment-in-Kind (PIK) interest income as a percentage of total investment income decreased to 4.9% from 5.8% in the prior quarter, signaling a higher proportion of cash-generating assets. Loans on non-accrual status remained low at 1% of the total investment portfolio at fair value.

The company's Undistributed Taxable Income (UTI) balance is a key indicator of its dividend sustainability, increasing to $1.13 per share as of September 30, 2025. This growth was primarily fueled by $44.8 million in realized gains from equity exits over the last 12 months. The equity co-investment portfolio, valued at $172 million (9% of the total portfolio), was marked at 126% of cost, representing $35.8 million in embedded unrealized appreciation, or $0.63 per share. This equity component provides shareholders with participation in the attractive upside potential of growing LMM businesses, often driven by strategic add-on acquisitions.

CSWC's credit portfolio, predominantly first-lien senior secured debt (99% of the credit portfolio), maintains a weighted average yield of 11.5%. The weighted average leverage through CSWC's security is a conservative 3.5x EBITDA. Cash flow coverage of debt service obligations reached 3.6x, representing the strongest level in the past three years, a significant improvement from the 2.9x low observed during peak base rates. This enhanced coverage underscores the strength of the portfolio, with CSWC's loans averaging approximately 43% of portfolio company enterprise value.

The competitive landscape in the LMM remains robust, with both banks and non-bank lenders actively seeking opportunities. While this has led to tight loan pricing, CSWC's deep relationships with 85 unique private equity firms (and over 120 total since its credit strategy launch) enable it to consistently source and win attractive deals. The weighted average spread on new commitments for the September quarter was approximately 6.5%, which management views as strong in the current tight spread environment. While the overall weighted average spread has compressed from 8.5% two years ago to around 7.5% currently, CSWC has maintained discipline, with new platform originations averaging 3.5x debt to EBITDA and 38% loan-to-value over the last 12 months.

Outlook, Guidance, and Risk Mitigation

Management's outlook for CSWC is one of continued growth and disciplined execution. Michael Sarner projects sustained origination volume, targeting $150 million to $200 million per quarter, driven by an expanding pipeline and strong sponsor activity. Add-on financings are expected to remain a consistent source of activity, contributing 8 to 12 transactions quarterly. The company is particularly focused on resilient service industries such as accounting and finance, HVAC, marketing services, and data centers, which are less exposed to current macroeconomic uncertainties.

Regarding dividends, the Board of Directors has declared a total of $0.58 in regular dividends (payable monthly) and a quarterly supplemental dividend of $0.06 per share for the December 2025 quarter, totaling $0.64 per share. Management is confident in its ability to maintain these distributions, citing the robust UTI balance and the expectation of continued realized gains from its equity portfolio. Michael Sarner emphasized that the regular dividend is set at a level believed to be sustainable in any foreseeable interest rate environment. Should Net Investment Income (NII) temporarily fall below the regular dividend due to macroeconomic factors, the UTI balance would be utilized to support it. The company prefers programmatic increases in supplemental dividends over one-time special dividends, viewing this as a more beneficial and sustainable approach to returning capital to shareholders.

CSWC acknowledges the evolving macroeconomic landscape, including anticipated base rate reductions of approximately 100 basis points over the next 15 months. While this could impact gross investment income, the company's fixed-rate liabilities (such as the SBIC debentures and unsecured notes) provide some insulation. Historically, declining SOFR rates have often led to a widening of spreads, suggesting the current market might be at a trough. The company also monitors the impact of trade policies and government spending, particularly in healthcare and government services. An in-depth review identified 7% of the debt portfolio at fair value with "moderate risk" exposure to tariffs, but only 1% had both moderate risk and a loan-to-value above 50%, indicating limited direct exposure. Mitigation strategies include supply chain adjustments, price increases, and maintaining elevated inventory levels.

Despite these challenges, CSWC has not observed an increase in revolver draws or amendment requests, which would signal portfolio stress. The company's consistent ability to trade above book value, a rarity among BDCs, provides a critical advantage for accretive equity raises, enabling it to deleverage, invest in new platforms, and finance add-on acquisitions even in uncertain times. This flexibility, coupled with its conservative balance sheet and robust liquidity ($719 million in cash and undrawn commitments, more than 2x unfunded commitments), positions CSWC as a resilient investment in the LMM.

Conclusion

Capital Southwest Corporation presents a compelling investment thesis rooted in its internally managed structure, disciplined LMM investment strategy, and robust capital management. The company's ability to generate strong, consistent NII, supported by a growing UTI balance and opportunistic equity exits, underpins its commitment to a sustainable and growing dividend. Its proactive approach to capital structure, exemplified by recent unsecured note issuances and the second SBIC license, significantly de-risks its maturity profile and enhances funding flexibility.

In a competitive and dynamic market, CSWC's granular, first-lien-heavy portfolio, conservative underwriting, and deep relationships with private equity sponsors provide a strong defensive posture. While macroeconomic uncertainties and tight spreads persist, the company's operational efficiencies and strategic positioning allow it to continue sourcing high-quality deals and maintain superior operating leverage. For discerning investors, CSWC offers a unique combination of yield, credit quality, and strategic agility, making it a noteworthy contender in the BDC space.