Thank you for joining today's Capital Southwest Third Quarter Fiscal Year 2024 Earnings Call. Participating on today's call are Bowen Diehl, CEO; Michael Sarner, CFO; and Chris Rehberger, VP Finance. I will now turn the call over to Chris Rehberger.

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 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 off to our President and Chief Executive Officer, Bowen Diehl.

Thanks Chris and thank you to everyone for joining us for our third quarter fiscal year 2024 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 begin on Slide 6 of the earnings presentation, where we have summarized some of the key performance highlights for the quarter. During the quarter, we generated pre-tax net investment income of $0.72 per share, which represented 20% growth over the $0.60 per share generated a year ago in the December quarter. The $0.72 per share more than covered both our regular dividend of $0.57 per share and our supplemental dividend of $0.06 per share paid during the quarter. Portfolio earnings continue to be strong as of the end of the quarter. As of end of quarter, we estimate that our undistributable taxable income was $0.52 per share. Additionally, net asset value per share increased 1.9% for the quarter to $16.77 per share from the $16.46 per share as of the end of the prior quarter. This increase represented the fourth consecutive quarterly NAV per share increase for Capital sublet. We are also pleased to announce today that our Board of Directors has declared a regular dividend of $0.57 per share for the March 2024 quarter. This represents 7.5% growth over the $0.53 per share, paid a year ago in the March quarter. In addition, due to the…

Thanks, Bowen. Specific to our performance for the quarter, as summarized on Slide 17, we increased pre-tax net investment income by 13% quarter-over-quarter to $29.8 million or $0.72 per share, compared to $26.4 million or $0.67 per share in the prior quarter. During the quarter, we paid out a $0.57 per share regular dividend and a $0.06 per share supplemental dividend. As mentioned earlier, our Board has declared a regular dividend of $0.57 per share and declared a $0.06 per share supplemental dividend for the March quarter. Maintaining a consistent track record of meaningfully covering our dividend with pre-tax net investment income is important to our investment strategy. We continue our strong track record of regular dividend coverage with 123% coverage for the last 12 months ended December 31, 2023, and 110% cumulative coverage since the launch of our credit strategy in January 2015. As a reminder, our intent is to continue to distribute a portion of the excess of our quarterly pre-tax NII over our regular dividend to our shareholders in a quarterly supplemental dividend. We are confident in our ability to continue to distribute quarterly supplemental dividends for the foreseeable future based upon our current UTI balance of $0.52 per share, our ability to grow UTI each quarter organically by over earning our total dividend and the expectation that we will harvest gains over time from our existing $0.90 per share in unrealized appreciation on the equity portfolio. For the quarter, we increased total investment income to $48.6 million, representing 14% growth quarter-over-quarter and 48% growth from a year ago. Weighted average yields in the portfolio on all investments was 13.7%. Total investment income was $5.8 million higher this quarter primarily driven by an increase in the weighted average cost basis of our debt investments, as well as…

Thanks Michael. And again, thank you, everyone, for joining us today. We appreciate the opportunity to provide you an update on our business, our portfolio and the market environment. Our company and portfolio continue to demonstrate strong performance, and we continue to be impressed by the job our team has done in building a robust asset base deal origination and portfolio management capability, as well as a flexible capital structure. We believe we have prepared our company well for future growth and performance, and we feel very good about how our shareholders' capital is positioned in the market. In summary, we have a credit portfolio predominantly made up of first lien senior secured debt, allocated across a broad array of companies and industries. Over 90% of which is backed by private equity firms. While also enjoying participation in the equity upside of many of these growing lower middle market businesses. Further, we have a well-capitalized balance sheet with multiple capital sources, very strong liquidity, and a flexible capital structure. 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 the line of Mike Schleien with Ladenburg Thalmann. Your line is open.

Yes, good morning everyone. Bowen, there was this theory that M&A volumes really wouldn't pick up until there was certainty that the Fed would cut rates and I'm in the camp that we don't know and inflation is still not at their target. And obviously, rates have not come down yet. So, from your perspective, what's driving this increase, which you mentioned has spilled over into the first quarter?

Yes, it's interesting. I mean if you look at our five exits, three of them were sales and two of them are refinancings. On the sales, I mean these are private equity-backed firms. There's strategic interest in the assets. I think they were all strategic sales looking at them. So, they were just -- it was just candidly, it's private equity firms trying to print gains in companies that are performing. So -- and there is strategic interest in the assets. And so I don't know, we have the same press clippings you do. Those trends are probably true as you laid out, but it's a little random. I mean our portfolio just had a number of sales in it. I attribute part of that to a general increase in M&A activity that we've seen out there. We also see our deal flow as well being really strong.

We've also seen in the top half of our portfolio, the loan grade ones. These companies, we have a significant number of companies that have delevered underneath two times even to the extent that our half turn to 1.5 turn. And so those guys will find potentially a lower-yielding option, than where maybe they were when we originated them.

Yes. That's more of a company performance aspect. That's true, for sure. But the M&A activity, just looking at these names, I mean, there just has been interest in those assets. and those private equity firms, obviously, they don't get paid until they sell and monetize, pay their carry. So they hit the bid.

I understand. That's helpful. I noticed there were a couple of two -- there were two credit downgrades during the quarter. Can you describe general trends in credit quality in the portfolio? And in particular, what these two were about?

Yes. I mean if you can just take a step back and look at trends in our portfolio, if you look at revenue and EBITDA growth, if you look at the number of upgrades versus downgrades, I'd say credit performance in our portfolio as a whole is excellent. The two downgrades, one was already not proven -- already a challenge. We basically had a term loan B and a downgrade and we down lift grade the term loan A. And the other one was a company that's kind of bumping along and we decided to go ahead and upgrade it. So it's a new downgrade, not an existing. But again, if you look at 60 something million of upgrades and 30 million downgrades, I'd say it's a general trend perspective, it looks okay.

Fair enough. And my last question, more housekeeping. Can you help me understand the net realized loss because on Page 12 of the Investor Presentation, there's a realized gain, but there's a much more meaningful net realized loss on the income statement. Can you just reconcile that?

Yes. One of our portfolio companies had a restructuring, which a portion of their debt was converted to equity. And so from an accounting perspective, that's going to -- you'll see that show up as a realized loss for the quarter. And you'll see when the 10-Q comes out, you'll see a full reconciliation of -- for the quarter of kind of what happened to each of the companies.

And that was one of our non-accruals, it's been non-accrual, and we -- I think we voiced on a prior earnings call that we expected to have that restructuring in the calendar year and in fact, it happened [indiscernible]

I got it. And Michael, the Q is coming out tonight?

Yes.

Okay. Those are all my questions. I appreciate your time as always. Thank you.

Thanks, Mike.

Yes, thanks, Mike.

Our next question comes from the line of Robert Dodd with Raymond James. Your line is open.

You might be on mute Robert.

Yes.

Yes. I apologize. I was on mute. Yes, that's my bad. Sorry, on the leverage, right? You see you're below the bottom end of your target range. Obviously, some of that is planning for I-45. I mean, could you give us any -- do you still feel more comfortable at the bottom or below the bottom of the target range for leverage, or can you give us an update on where you think if the economies may be doing better than you thought? Your credit quality is certainly hanging in very well. So I mean, can you give us some thoughts on where you see that in the medium-term conceptually I-45 adjusted?

Sure, of course. So I-45 was adjusted. I think we were more at 0.83 times. I think for a go-forward basis, our -- I would give you the range of 0.8 to really 0.95 that's essentially where we'd like to stay in. And at the moment, like you said, we'd see kind of clear skies ahead at the moment, portfolio is performing well, you could see us tick up closer to the higher end in the next several quarters. But we're -- honestly, if you look at our earnings related to our NAV, we are one of the more productive companies in the BDC space, we're able to produce $0.72 on $0.77 leverage. So we don't really need to press the gas pedal. So you probably see us somewhere along the middle of that range.

Got it. Got it. Thank you. Then on I-45, I mean, it's got $27 million, I think, in unrealized depreciation in it currently. When it's -- when the assets are onboarded, are they going to be onboarded at the existing cost and fair value basis, i.e., the unrealized depreciation of stay, or is any of that going to be crystallized during the onboarding process?

Sure. So a portion of the assets that are being assigned to each of our balance sheets will come over at cost and fair value, the amount of losses or gains that have been incurred in the portfolio of companies that have already exited that will just get reclassified from unrealized equity to retained earnings.

Got it. Thank you. And then -- sorry, go ahead.

No, go ahead, I apologize.

Yes. The last one is kind on housekeeping, the dividend income was quite like. It looks like there was maybe a $2 million non-recurring maybe to do with one of the portfolio company sales, or is it going to be anything. Can you give us any color -- I mean, was it a one-time kind of $2 million or has something changed in one of the performance -- you get the highly performing portfolio companies where it's going to start paying your consistent dividend, or was that one-off?

No. So yes. So this quarter, we had one portfolio company. It's probably one of our most successful portfolio companies that had essentially levered less than one time to the dividend recap. We have an equity position with significant appreciation on the company. And so we participated in that dividend to the tune of $2.3 million, and that's a one-time occurrence.

Got it. Thank you.

Thank you. We'll standby for our next question. Our next question comes from the line of Kyle Joseph with Jefferies. Your line is open.

Hey, good morning guys. Thanks for taking my questions. Most have been answered, but just -- I know the Q is coming out, but just do you mind running through any inflows or outflows to non-accrual. I know you mentioned there was a restructuring there and on a fair value basis, I think it ticked up 20 basis points or whatever, but just help us out in terms of the inflows and outflows.

Yeah. So for the non-accruals, we had one portfolio company that came-off, and I think we noted earlier, the portfolio company that was restructured that had the realized loss, that portion came off. And then we had a term loan A, another portfolio company that -- where the B is already on non-accrual. I think Bowen mentioned it earlier. It went on non-accrual. So, I think it was $15 million at a cost basis coming off and $12 million coming on. So, a slight reduction on the cost basis and then the fair value was slightly higher.

Got it. And then as you're thinking about the dividend going forward, obviously, the forward curve has adjusted pretty dramatically since the last time we spoke. But -- and I know you guys are have strong coverage, especially over the run rate dividend, but how you're thinking about the dividend from here?

Yeah. So obviously, we bifurcated between the regular dividend and the supplemental dividend. So on the regular dividend, obviously, we had $0.72 this quarter, which we would tell you the run rate absent that dividend, cash dividend was really like $0.69. So we compare that $0.69 to $0.57 we pay. So it's still significant coverage there. You noted we're still kind of in a wait-and-see approach to see what the Fed does, to see the pace of rate reductions. We feel comfortable that, if the rates come down to a neutral -- a neutral spot in the next 18 months to 24 months, we would expect that our NII would trough in the low 60s, so there's still plenty of room for growth on the regular dividend. And having said that, we will wait to just see how things play out. On the supplemental dividend, we continue to bank UTI by over-earning our dividend. We have $0.90 of unrealized depreciation on the balance sheet that we would hope to exit a portion of either something between $0.24 or beyond. And so that, coupled with the $0.52 of UTI we have, currently, we feel very comfortable that this program will continue into the future at $0.06 today that may vacillate up or down, but we feel comfortable about that program going forward.

Got it. Helpful. And then last one for me. We talked about credit. We talked about the ratings. But just in terms of classified with revenue or EBITDA growth and any sort of changes in, since we last spoke?

Yeah. I mean, as I noted in our remarks, we had across the portfolio, we had revenue growth quarter-over-quarter at 3% and EBITDA growth quarter-over-quarter of 7%. So the portfolios feel pretty good about some of the portfolio's general performance for sure.

Got it. That's for me. Thanks for answering my questions.

Thank you. Please stand by for our next question. Our next question comes from the line of Bryce Rowe with B. Riley. Your line is open.

Hi. Thanks. Good morning. Maybe, Bowen, wanted to start on some of the exit activity. You've got, I guess, a couple of equity investment stubs that remain after those exits. What's the plan there? Is the plan to stay in those equity investments, or are those potential exit opportunities here over the near term?

Yeah. Thanks for the question. I mean, as a general matter, obviously, there are companies, the vast majority of them are owned by private equity firms. And so the obviously sell the company, then we don't have an equity stuff. So the equity stuffs are ones that we've been refinanced out of. And so just -- it's pretty much the rule that we will ride the liquidity curve, if you will, with the private equity firm. So private equity firms, as we all know, don't really get paid their carry until they exit. And so they're looking to maximize value and then looking to exit when it's prudent to exit and we kind of ride that train with them. So long-winded answer to, yes. I mean, those are equity stubs or potential future exits. And usually, the company has been refinanced, it's probably growing and doing really well. And so just because it's marked at X today, I would say private equity firm owning it for another year or two, probably is the exit could be little to X, but it's pretty highly likely to be higher than X. But we ride that curve or ride that train with the private equity firm and exit when they exit.

Got it. Okay. That's helpful. And then maybe a couple more for me. In terms of the assets that come on your balance sheet from I-45, obviously, have a different profile than what you might like to put in your portfolio today, do you look for an opportunity to exit those to create some liquidity, or will you, in fact, ride those out as well?

Well, I would say, they're over in I-45, but there's still assets that generate returns in true pressure force [ph], so that won't change. Certainly, there are bigger companies, for the most part, syndicated credits for the most part, the one we don't need the liquidity. But on the other hand, yes, we'll look for opportunities to exit those names at attractive values. And over time, those names will get refinanced out, of course, as those companies grow and sell. But I hope for that.

And the spread to LIBOR on these assets is 6.5%, which is maybe on the slightly lower end of our yield continuum, but it's certainly on the fairway.

Yes, that's good. Okay. That's helpful. And maybe one more for you, Michael. You, kind of, laid out the potential, I guess, regulatory debt-to-equity range with the I-45 assets coming on balance sheet. Can you give us a feel for what the economic leverage range might look at? And I'm thinking about the ability to now draw $45 million more of SBA debentures and how that works in to the equation? Thanks.

Yeah. I mean, kind of what I said earlier, and I would say it's not -- I don't have anything to add to it is that it will probably be in the midpoint 8. We'll finish up this the $45 million on the SBA probably by the summer. And so I think our economic leverage will be around one times with the regulatory something in the [indiscernible]. It will vacillate. Look, there's opportunities to raise capital at premium to book today. And, so you'd be at certain points in time, delever a bit when the opportunities are there and then pull back the range at other times.

I was just saying just -- one of the things you just asked, I mean, we have a lot of liquidity on the balance sheet. So the ability to fund into the SBIC subsidiary and borrow net leverage commitments, that's not hard to do.

So, yeah. One other point I'd probably make just on longer term is like we have an eye to the future. We look at our 2026 [indiscernible] bond to repay then there's clip maturities. That's obviously two years away, but we're starting that planning today. So, the collateral that comes back from I-45 comes on balance sheet, and we're going to look for opportunities to increase our secured financing. So, you give us that, if and when we want to pay down those bonds, if we don't like what's going on in the capital markets in terms of unsecured market, you can always fund it with unsecured facility. The I-45 consolidation gives us additional collateral to work with to really continue to diversify our capital sources.

Okay, appreciate you guys taking the time.

Thanks Rob.

Thank you. Our next question comes from the line of Erik Zwick with Hovde Group. Your line is open.

Good morning. I may have missed this in the earlier comments, but just in terms of the winding down of I-45, did you provide a timeframe? Will that be done at the end of this current quarter, or would it take a little bit longer? I may have I'm not sure if I caught that earlier.

Our expectation is that it would be done at the end of the quarter. But having said that, with some of these credits, when we do the -- we essentially do the allocation and we put in for assignment, some of the agents work faster than others. And so to the extent that we are not able to get every asset assigned, it could live on a very small basis for another quarter, but we are working in earnest at the moment to try to get that all accomplished.

That's helpful. Thanks. And then I just noticed that the PIK income increased to just above about $4 million or so in the quarter, higher run rate than we've seen recently, is there something -- I wonder if you could just talk about kind of what drove that higher? And if there was anything kind of onetime or should we expect something along that run rate going forward?

Yes. So, I mean it's a little bit higher this quarter, but just to put it in perspective, I mean, two of the companies in the portfolio optioned up to PIK -- they have PIK toggles. We don't have a lot of PIK toggles in our portfolio, but we've got a small handful and so a couple of them PIK. One of them was company affected by the rider strike, that's obviously behind us. And so the company is obviously turning around, it was actually one for the rider strike. So, it's a very healthy company. It is PIK toggle. The other one is the company that is very effective in the next few years. And so it's going to have a big -- you should have a very big year this year. So, they picked a quarter. So, if you took those two, those are PIK income aspects. But if you were to look at what's the trend? If you were to look at the rest of the PIK income, it's about 5% of our income. And so the cash portion is 95%. If you look back over the last several quarters, it's kind of where we've been in 95%, 96% cash. And so just to help put that in perspective is kind of how we're trending.

And also the cash -- the PIK-Pay toggles are generally only for a few quarters. Those are not indefinite for the loan. So, those will either roll off because they've reached the end or they will be choosing to take a lot of cash along the way.

Got it. And then one just last one for you. You seem fairly optimistic about the opportunity to make new commitments and fund new loans, at least for the next quarter. So, wondering if you -- as you look at the pipeline, if you could just provide a little commentary, is there any commonalities in terms of kind of the industries where you're seeing strength today, or is it more broad-based at this point?

It's pretty broad-based. It's an interesting question. It's pretty broad-based. The activity is pretty robust right now, which is a good thing. The vast majority as we talked about, the vast majority of our business is family-owned, entrepreneur businesses that are selling to private equity firms, that are buying controlling interest in the business and heavy rollovers from the founders situations. But it's pretty broad. The other thing -- the other thing is we've got a decent amount of add-ons going on in the portfolio, too, which is kind of a steady drumbeat over the last several quarters and should be continuing in the future. I mean just add-ons are probably one-third of our originations on kind of a regular basis. And so the activity this quarter since quarter end is definitely on the new platforms but it’s also up as well.

And that's been a trend. We've seen that over the last probably four quarters. And I think the portfolio of the size it is today, we expect that to continue.

Yes. Aspect of the business model. I mean these prime equity firms buy a controlling interest in the founder or family-owned business and the family -- our founder rolls over a big chunk of their equity to the business, as we talked about. And then one of the things that the founders and families like is the ability to then have a private equity firm by three or 4 of their competitors. And it's one of the reasons they want to roll over and keep that equity in the business because of the accretion and opportunity that entails. And so because that's generally a nature of our deal flow, we should expect to continue to always kind of see a meaningful amount of add-ons. And that's great because it's additional credit commitment in businesses that we know. It's not new platforms that we have to learn about. But it's business we know, we've seen performance. And so it's a very attractive portion of deal flow in journal.

And these are generally not delayed draw term loans, i.e., we are doing diligence on these add-ons to making a new investment decision.

Yes. That's right.

Yes. Sounds great. Makes of lot sense. Thanks for taking my question today.

Thank you.

Thank you. Our next question comes from the line of Vilas Abraham with UBS. Your line is open.

Hey, everybody. Just one for me. You guys mentioned in your prepared remarks, competition coming back, where it was about 12 to 18 months ago. Can you just give a little bit more color on the nature of that competition and how you think that translates into a spread over the next few quarters?

Yes. I mean the competition has definitely strengthened the market. It's just a reflection of just overall health in the financial markets. It is mainly from non-bank lenders. But it's kind of like I said, it's kind of back to where it was 18 months ago, which is competition we've been dealing with for eight years. So it's not really necessarily new players. And so I feel pretty good about the spreads. I mean, kind of where they are this quarter is kind of where they'll stay. And so it's not like they're tightening to a point where we have an earnings issue or anything like that. It just I wanted to express that for the last several quarters, I mean, the competition has been lighter, and it's starting to -- it's coming back, which I don't necessarily think the bad thing. We've certainly -- based on our cost of capital and our institution, we can compete fine for quality deals and so and generate nice risk-adjusted returns. But -- but I would say spreads are kind of where we should expect them to be kind of the next few quarters.

Yes, we actually looked at like the last 12 months, we had 24 deals that closed, and the spread was essentially $750-ish but the last nine deals of September have been just a little over 700 and the LTVs for the whole year were around -- well, in the first half of the year were 25% to 30% and the overall is around 30% now. So we saw maybe the LTV is kicking up to 35% and 40%. So it's just things -- I think Bowen is correct, it's about where it usually is. It was significantly lower for a period of time.

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

Thank you. I'm showing no further questions in the queue. I would now like to turn the call back over to Bowen Diehl for closing remarks.

Well, thank you, everyone. As always, we enjoy talking about our business, your business and your questions. And so we appreciate everybody's time and look forward to continuing to give you all quarterly updates.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.