Good morning, everyone. My name is Jack Greenberg, with the Midwest IDEAS Conference, hosted by Three Part Advisors. Next up is Capital Southwest Corp, traded under the symbol CSWC. Here on the company's behalf is Michael Sarner, their CFO, and Bowen Diehl, their CEO. And, with that, I'll hand it over to Bowen to begin. Thank you
Thank you very much. Appreciate everybody being here today. I'm gonna give you a little introduction to Capital Southwest, and then we'll open the floor up for questions. I'm Bowen Diehl, CEO of Capital Southwest, and Michael Sarner, CFO, as he said. Josh Weinstein, our CIO, had to hit the road for a new deal we're looking at, so he couldn't join us, but I put him up here for your notes. All right, so Capital Southwest, you know, we're a business development company. We were founded back in 1961. Pretty old BDC. We took it over in 2015 and relaunched it as a credit lender. I'm happy to dig into that history if anyone has an interest later, but that's the summary. We trade on the Nasdaq under CSWC.
We also have a retail bond issue that trades as well, CSWCZ. We're an internally managed BDC, so for those who understand BDCs, that's, you know, our shareholders own the manager and the managed assets, and so we have the same shares that our shareholders own. We don't have a management contract or any management fees. We have the same exact shares. 32 employees, we're all based in Dallas, Texas, and we have about $1.5 billion of assets as of the end of June. And we also have an SBIC subsidiary, which we can get into detail if people are interested in, on how that works, but that's a very valuable source of capital for us. We've almost fully funded the first license, and we applied for our second SBIC license, and that's going very well.
And then lastly, we're investment grade rated by both Moody's and Fitch. So Capital Southwest is a lower middle-market, senior first lien lender, and 95% of what we do is we are lending to private equity funds into their transactions, where a private equity fund is buying a partial or majority, but less than majority or less than 100% interest in a family-owned or founder-owned business. So the world we play in is one where, you know, with the aging population, you've got business owners, 55-75 years old, looking to partially sell their business, but stay involved and roll equity over and continue to stay involved in the business, and then use capital, institutional capital to institutional expertise to institutionalize their business, and institutional capital to then buy three or four of their competitors, let's say.
And so we're basically the debt, the senior debt behind that transaction, and then we, most of the time, will write an equity check on a minority basis alongside that private equity firm. That's our world that we live in. Typically, when we enter a deal where that company's at three to maybe as much as $25 million in EBITDA, most of the deals are, say, three to 10, 12, when we get in, of EBITDA, when we get in the transaction, and then ultimately, as they add on acquisitions and they grow organically, that EBITDA obviously grows from there. Typically, we're lending, you know, say, 2.5 to 4.5 times cash flow, and 25% to maybe as much as 50% of the value of the acquisition.
So we think of that as loan-to-value, but that's generally where we play, and again, on a first lien, top-of-the-capital-stack basis. You know, we can commit up to $50 million, and you know, generally have hold sizes from as small as $5 million and as much as mid-30s, as far as hold size on a debt basis. Most of them are sponsored deals. We also do non-sponsored deals, but the vast majority, 95% of our deals are backed by private equity firms, and I think in this market, that's actually super important, and certainly from a sleep-at-night perspective. You know, floating rate, first lien debt, that's the kind of the market. And as I said, we invest co-investments alongside the PE firms. So this slide basically lays out kind of the three reasons we do what we do.
I mean, we, we think the lower middle market is an attractive market. These are founder-owned businesses. They're typically growing at a nice clip. There's a lot of low-hanging fruit, typically, on what you can do with a relatively, somewhat casually managed business and move it into a professional business with strong KPIs, institutional systems, processes, smartly expanded salesforce, et cetera. A lot of upside opportunity in those relatively unseasoned businesses, although a lot of them have been around a long time, they've just been run, perhaps managed for the founder's checkbook or family's checkbook, as opposed to real cash flow growth. You know, we like the fact that, you know, in our market, all our deals have covenants. I get asked that question a lot. All our deals have covenants. Covenants are super important to our business.
As a first lien lender, you know, we can better control the outcomes with a debt. Vast majority of the deals go fine, but, you know, there's always a handful, a small handful of deals that struggle, and we're the top of the capital stack, so everyone below us in the capital stack needs to keep us happy. And so we have a lot more optionality to maybe convert a piece of the debt to equity to own part of the business, you know, that kind of thing. And so as far as a, you know, plan A is always to get the money back from the company, but you have to have a plan B, and so your plan B is much more solid when you're a first lien lender, and so that's a critical strategic point of why we do what we do.
And then from a balance sheet financing perspective, it wouldn't surprise you that a portfolio of first lien, top-of-the-stack assets is more attractive to debt capital providers and, candidly, to some extent, equity capital providers. And so it's a much more efficient asset base to then finance on our balance sheet. So since this is an investor conference, you know, the summary I'd like you all to take away from today is, you know, why would you buy? Why would you consider our stock? And, you know, whether you buy tomorrow or a year from now, why is this even relevant to our conversation?
Again, asset portfolio, top of the stack, 90% of our assets are in private equity-backed businesses, so they are funded institutions that could provide support capital, certainly strategic and operational guidance, but then also capital if needed, which ultimately supports our credit book. We've been paranoid about a recession for the last 10 years. Whether one came about or not, that wasn't as important as we need every loan in our portfolio to be underwritten, to be able to handle a recession. That's been fundamental to the DNA of everything we do in our firm that we set in place 10 years ago. We're an internally managed BDC, so as I said, we own the exact same shares our shareholders own. We double assets, and we destroy the stock price, that didn't double our management fees.
That just destroyed my personal balance sheet, so it's personal, and so that, that's a big deal to how we run the firm. And then we have a flexible capital structure. You know, Michael's designed it from day one, very methodical with multiple capital sources. 50% of our capital base, our debt capital is covenant-lite, unsecured bonds. There's a number of reasons why that's important from a flexibility perspective. So as we've grown our book on this slide, you can see, I mean, it's, you know, 98% of our assets are first lien. Our average hold size over time has, you know, candidly, as our assets have grown, our average hold size hasn't really grown all that much.
It's grown some, but so the result of that is our granularity, as we call it, but the number of loans, average hold size of our loan is about 1% of our assets. That's a good metric from a risk management perspective and an important one for us. On the operating, on operating expenses, we keep. You know, we basically, as an internally managed vehicle, we get fixed cost benefit as assets grow, and essentially what that means is we can grow our overhead. We grow our overhead slower than we grow our assets. We're clearly, I think we've more than doubled our overhead over the last eight to 10 years, but we've grown our assets more, so you get real fixed cost benefit from that as shareholders.
And so, you know, our operating leverage, which is basically operating cost divided by assets, was started out close to 5% when we took over, and it's, you know, 'cause we had less assets and less overhead. Today, it's 1.8%, so from a kind of [inaudible] I look at it somewhat it rhymes with a load on a mutual fund, so there's less load going out to manage the assets, and so we can maybe take less risk at the asset base but also generate higher ROE at the end of the day for our shareholders.
Why that's also important is if you look at our NII ROE, so our earnings are in the top three in the BDC space in terms of return and has a lot to do with the fact that we're basically spending less on operating expenses versus the 2.9%, the 1.8% compared to 2.9% for the market. So it's, you know, Bowen's point is a good one. We are able to take less risk and actually produce more, and our leverage today is 0.75 to 1 on a regulatory basis, which is also in the bottom three of the portfolio, you know, BDC portfolio.
Yeah, so nutshell, we're creating higher earnings with less financial leverage. That's a business model that's working, so we're pretty proud of that. All right, so the result of that over time is, you know, we've generated steady and growing dividends. Our shareholders, no surprise, are living on those dividends. That's where a yield play for people. We pay three different kinds of dividends. One's a regular dividend, which is basically matched with our recurring NII or net investment income. We have a supplemental dividend program, where it's excess earnings or distributions over time of our UTI balance.
And then if we have a large gain in any one juncture, which we've got a handful of those seasoning in the portfolio, if one or more of those would sell, then that would be a potential opportunity to pay a special dividend. Ultimately, our board is very biased towards distributing capital to our shareholders, 'cause we think that's what our shareholders want.
Right, and, and we have, to date, we have $0.50 of UTI, or undistributed taxable income, that backs that supplemental program. We have also these exits that goes into that bucket, and that allows us either to do a special dividend or to dribble out a supplemental dividend that can be paid out in perpetuity.
And then the ultimate scorecard is value creation over time. So, you know, you look at our total value creation over time, we've created significant value for our shareholders. Portfolio is, you know, highly first lien. You can see the wheel chart on the right. You know, that's. It's very diversified by design across industry groups. That's. You know, most BDCs would show graphs like that, but that's kind of. We exist to create yield at limited risk. Ultimately, it needs to be a diversified portfolio. So our portfolio, we've got on the right here, 117 portfolio companies, about $1.5 billion in assets, with an average hold size of $12.7 million. Again, that's 89% first lien. Our average yield across our debt investments is 13.3%.
And our average EBITDA is, you know, a little less than $20 million, $19.7 million. And an average leverage across the portfolio of about three point eight times cash flow, and that equates to about, on average, across the book, about 41% loan-to-value. So, to give you an idea where our credit book sits with respect to the underlying value of those portfolio companies.
Yeah, and just from some of the questions we've heard today, so our average hold size, you can see collectively with the debt and equity is still, you know, sub-$15 million. We see deals that are really in the $20-$50 million size that we're splitting with other partners. So when we look at our growth going forward, without having to change what we do in the sandbox we play in, we can continue to increase the size of our hold, and, you know, we're below 1% on, we mentioned earlier, on granularity. So we're very conservative, but we do have that ability to continue to grow that hold size, which helps grow the balance sheet without taking on additional risk.
You wanna talk about our capitalization strategy?
Yeah. So it's obviously important to a BDC. You know, when we started the venture in 2015, the company had, you know, $285 million in cash and no debt, no analysts, and, you know, no banks to speak of. So, you know, we started off with a credit facility with ING and grew that one credit facility from $75 million up to $460 million today, and it's spread across 10 different banks. Subsequent to that, we were able to tap the baby bond market, which was, you know, our retail product, which was about $75 million. And from there, we were able to branch out into doing institutional bonds. We're actually the first lower middle market, you know, small cap BDC to be able to raise an institutional bond.
So we were sort of, you know, our track record were able to net us some success in the debt markets. Since then, we've done several institutional bond deals, two of which that are outstanding today. You know, our balance sheet cash is $33 million. Our total dry powder available to invest today is $485 million, so pretty significant, and we, you know, you compare that to our unfunded commitments, which is about $150 million. We've got a lot of available capital to deploy in pretty much any market. And what makes that even more powerful is the fact that we're only levered, like I said, 0.75 to one.
The regulatory limit is two to one, but we would tell you that, you know, we're more conservative, that, you know, one to one is probably the, you know, as high as we like to go, but we still have cushion to lever up a bit, depending on the market. We have the cash flow, obviously, and dry powder to continue to do so. So I think the next point on this slide is just that, you know, we do have. We have two maturities coming up in 2026. That's the nearest ones. We're already sort of working on the takeout for those bonds.
And then, you know, from there, we don't have maturities for quite a while, so we're actively managing any cliff maturities, and making certain where we have. We do that well in advance of whenever those maturities come.
So we want to give an overview of the company. We're happy to go through maybe the latest quarter. You know, we produced $0.69 a share last quarter, and if you recall from this graph back here, you know, we paid out, you know, $0.64 total, supplemental and regular. Obviously, with yields being, and SOFR being high, earnings are high. We've shared some of that in excess earnings with our shareholders. So we produced $0.69 per share, and that includes, you know, a $0.58 per share regular dividend, which we view that as sacrosanct. That doesn't ever go down, so we set that at a rate that we think under any kind of future scenario, rates coming down included, recession included, that dividend should be covered. So that's a regular dividend.
On our supplemental dividend, that's a $0.06 extra, and that's a function of the UTI balance on our balance sheet, as well as just excess earnings, wherever SOFR first stands at the moment. And then, our investment portfolio, $1.5 billion. You know, we originated, you know, $108 million in commitments last quarter. Our net asset value of $16.60 a share. We raised almost $40 million of ATM equity last quarter, so that's a very active program we have, where we just sell equity into the general trading volume. We're trading at, you know, almost 1.5 times book, so that's very accretive to our shareholders to do that.
And so we do that on a just-in-time basis to basically look at our originations during the quarter, our prepayments during the quarter, and where we want leverage to be at the end of the quarter, and then we tell the traders how much equity to kind of bleed into the market.
Yeah, and if you compare us to other BDCs, so of the, you know, 60 BDCs, there's probably only about 5-10 that can continually trade above book, and so therefore they have access to an ATM program. The rest of them, you know, they when they trade above book, they'll issue a large equity raise 'cause they don't know when they're gonna be above their next. So that's dilutive, obviously. So for us, to Bowen's point, from an efficiency standpoint, we're raising capital very, like, on a day-in, day-out basis and utilizing that to invest. So we don't have a use for capital, we're not raising money, and the discount is quite small relative to a fully, you know, marketed, you know, 8-10% deal.
So I'll pause there. Any questions? You'd like me to, we wanna make sure we cover ground you guys wanna cover. Yes.
Would you explain your SBIC and SBA debentures? We're confused between the two, and you're doing a new SBIC cause you're almost maxed out.
Yeah. So let me give you a macro, and I want Michael to talk about how he kind of manages that. The SBIC program is through the SBA, and it's a government private-public partnership. Basically, if you get a license, which is a proctology exam, but if you get a license, then you basically can access that program. We draw down on the SBA debenture, and then they issue SBIC debentures, which are guaranteed by the government. They're lower cost to people that will invest in SBIC-eligible assets, and so they have to be small businesses, which is a defined term, which is a large part of what we do. It fits right into what we do.
Then as we draw down on that and we make a draw, those are 10-year notes, which, as you can imagine, is not what we can raise cost-efficient elsewhere in the capital markets as a VC.
Great.
So do you wanna talk about the rest of it?
Because of its, you know, it's floating in the way that every time you make a draw, it's floating, and then it gets pooled to a fixed rate. So for our $175 million on the first lien, it's about 4.25%, our blended cost. You know, like, as Bowen said, we've got an application in, and we expect to, you know, have approval for the second lien. You'd expect with rates coming down that, you know, that next $175 million might be something, you know, south of that rate 'cause this is. In the last 10 years, the pooling amounts have been the highest they've been in, you know, for a very long time.
You've got 153 outstanding there?
Correct.
What's the SBA $22 million?
So the full approval by the SBA for our SBIC license is $175 million. So we've drawn $153 million, and we still have $22 million that have been approved by the SBA, but we haven't actually drawn it, 'cause you have to have the assets in, you know, identified before you're able to receive the draw.
What's your expected timing on the second license?
So I think we're, you know, the government's kind of difficult to kinda predict, but I would say it's probably by the end of this year for sure.
Yeah, we've turned our application in, and we've had our org meeting, which tells me they pulled us out of the stack. So that's good news to me, but they ultimately define the timing.
They did say two to four months, so-
And our SBIC, our assets and our SBIC have done very well. So you're looking at a track record that's stellar. So that's, that's great. So we'll see. Yes?
[inaudible] traditional bank lenders, and what's your advantage?
You need to read repeat the question like...
Yeah, so I'm gonna repeat the question. So he wants... Very good question. Why would a private equity firm use our capital as opposed to a bank's capital? Our capital is more expensive, so why would they use our capital versus a bank capital? So there's a number of reasons. Other than just reliability to get to closing for banks versus non-banks, that can be a factor sometimes and sometimes not so much, right? So there was a period of time when the regional bank noise was going on, that was a big deal. Like, banks were very, I mean, let's face it, a lot of banks don't wanna lend to smaller companies without founder guarantees and various things, right? But there are a handful that will.
And so when the regional bank noise was happening, they were completely out of the market, and now they're kind of back, okay? So they compete with us. And so, but the competing structure is, look, I'm gonna give you an example to kind of illustrate it. So let's say a business is being bought by a private equity firm for eight times cash flow, right? You know, and they wanna lever it three times cash flow. A bank option, the bank might lever it, they might be willing to go one and a half to, let's just say, two times cash flow, and they get a mezzanine partner to put in junior capital for another turn to get to the 3%, okay? Or they come to someone like us, and we lend them three times cash flow in one strip.
So why would they do that? Well, it's one investment committee, not two, and it's not only the initial closing, but they wanna do four or five acquisitions, and they don't wanna deal with sub-debt and senior banks, and the preference would be to not have to have the food fight between senior and sub-debt lenders. Now, sub-debt's a very robust market. It's not one we're in, so a lot of private equity firms will use sub-debt, but that's the alternative. So there's a lot of firms that want the one investment committee. They also like the fact that we're the same lender who has all the debt is also writing an equity check alongside them on a minority basis. So you look at our portfolio, we're 90% credit and 10% or 9%.
No, 91% credit, 9% equity, and that equity is small equity investments across 69 portfolio companies, right? So that's part of our business and one of the reasons we like the lower middle market, 'cause we can do that. So they like that alignment of interest, and then there's other things like banks, you know, have scheduled amortization. They're very rigid. They wanna be paid scheduled amortization down, you know, different banks, 80% in, or their loan paid off, scheduled in four years or whatever it is, right, to get to a certain duration. So we don't have scheduled amortization most of the time. We have cash flow sweeps. So at the end of the year, they sweep our debt down by their excess cash flow. So excess cash flows go down, their debt obligation goes down, right? So they like that flexibility.
And then, you know, a lot of these private equity firms, it's a big relationship business as well. So these private equity firms, there are some that sit at their desk, and they financially engineer leveraged buyouts. And then there's others that buy founder-owned businesses, and they want to do ten things to the business that are operationally intensive, and they look at a five-year IRR model, and it's, the generation of IRR is way more influenced by the operational changes and not by the fifty or a hundred basis points or even a hundred and fifty basis points different than the capital cost. And so,
And they want a lender to come in that has flexibility and will invest alongside them on an equity minority basis, align the interest, and if they pay 150 basis points more in pricing, it doesn't matter to them. So we're franchise building and building that source, and the fact that we've done deals with 105, 104 private equity firms in 10 years, and we have 75 of them in the book today, I mean, that franchise, that to me, that's our franchise. We're working the aging population system and the buyout and sale world and financing that, and so those relationships are what generate our deal flow, and the relationship is a track record of working with PE firms in a way that's constructive for what they're trying to accomplish. So
I mean, along those lines, when things do go sideways, I think the rigidity that we kind of—Bowen just touched on, I mean, it comes to play with the banks relative to where we will work with them. You know, a good example even is if a company's doing well, and there's a cash flow sweep, they may come to us and say, "Look, you know, they've already de-levered based on their performance. You guys, you want to just pass on that sweep, and we'll use the cash to continue to grow." We can make that decision. I think the banks are far less flexible to do something like that.
Yeah, I'll say one more thing on that. As a first lien lender, we have a lot of control in the capital structure if things start moving around, and so our optionality and the things we can do to... We're not a sub-debt guy that's getting ready to get swamped by the bank, you know, that's above us, and so when you do that, you have to sprout fangs, and you have to do all kinds of stuff to defend yourself. As a first lien lender, we can do a lot of things that defend our capital for our shareholders, which is goal number one, but also do it in a flexible, constructive, and creative way so that the management team on the ground managing the company can do and meet the challenges that they're facing as a company.
That's a big deal in our world, to be able to have that flexibility to kind of manage a credit book, at the same time, you're managing a set of relationships and generating shareholder returns over time. So that's the theory behind it. So
You did a great job with the earnings and such. There have been net losses over the past five quarters, so gone up from $700,000 up to 14 last quarter. Is it a trend in the industry, or, but, or is it just kind of economies getting a little tougher? Is there a pattern you can identify?
Yeah, you're talking about unrealized appreciation in the portfolio. Like, we mark our book to market every quarter.
Yeah.
And you're talking about the book, the value of those loans
Yeah
coming down. Yeah, so it's. I mean, we have a hundred and seventeen portfolio companies, and we have four that are struggling. I mean, meaningfully struggling, where we're having conversations around converting a piece of our debt to equity, that type of thing, and so we've taken depreciation on that. That's probably the biggest piece, and then we also. You know, we have seen. We have definitely started to see some signs across the portfolio.
I don't know that it's so much of material to the overall book, but it definitely is narrative from management teams in certain industries, you know, it's kind of both business to business, where businesses are taking longer to make the sales decisions or cutting back costs, you know, or the quantum of things they're buying, usually in IT services or things like that. And then, you know, we have consumer businesses that are doing really well, but we definitely have two or three consumer businesses that are starting to talk about their consumer slowing down.
That doesn't really marry up to our problem credits, but I always look at, you know, people ask me, "With 117 portfolio companies across the economy, what are you seeing that can help me think about what I'm hearing on the news," right? And so we definitely are hearing narrative about slowing down consumer purchases in certain companies. And so that rhymes with what you hear on the news, right? And you see in some of the information, although there's some data out there that suggests the consumer's still strong, but we're starting to see that, and we definitely are seeing, hearing, you know, companies, mainly IT services, but things like that, where clients are either cutting back expenses or delaying purchase decisions. We definitely have seen that.
When you say the economy is slowing, maybe still growing but slowing, I'd say that's, you know, I would say that, you know, the signaling we're seeing across all these management teams. We're hearing signals that rhyme with that.
But-
If that makes sense.
But some of the portfolio metrics on that, we did, even last quarter, we had revenue still growing 5% and EBITDA up 1.5%. Over the last five quarters, we would tell you that Bowen kind of hit on it. There's been four, you know, or so portfolio companies that have struggled for the last two years, and we took some sizable hits to. You know, they, some of the stuff got converted from debt to equity, and then inevitably, some of these companies, the equity got written down. Over the last two years, I would probably tell you that, you know, that our watchlist companies, which are probably 10 or 11 companies, hasn't expanded. So it's not like we're seeing, you know, across-the-board depreciation.
It's really been kind of lumpy in credits that we've sort of just, you know, we're trying and trying, but some of them are just not working out.
Yeah, as you imagine, we have a watchlist. We have a, the policy internally on how, when something makes a watchlist, and that's not train wreck, that's just significant challenge, right? So something you may not be worried about your
debt getting paid back, but something's different, something's going on. So we meet every month and plow through every one of those companies, and as I said, there's maybe twelve on there right now. A handful of them are doing much better, but they're ones that have a big spotlight on them, you know? Yeah.
What is the impact on NII after your debt gets refinanced, the 2026 debt?
Sure, sure. So I mean, there's a few things on that. So one, you know, we have one of our- we did a bond last year for 7.75%. That's got a non-call too, that, that comes up in August of next year. So it's probably similar timing. We, I mean, we would expect to raise a large offering, maybe either a convertible bond or, you know, traditional way, institutional bond. You know, the market we'd expect is going to be somewhere in the 5.5%-6%, perhaps, is what we're considering, well, based on market intel. So we're going to be paying down $70 million plus at 7.75%, and then we're going to be- one of those bonds is going to be 4.25%, so that's probably going to come up.
But the balance between the two is going to kind of meet in the middle. On the other end, we're going to be raising that second SBIC license, which we expect to be in, you know, a sub 4% on the following. Like, if you look at 2025 and 2026 going forward, you'd expect to see that a blended, let's say, 3.5% or below cost of capital. We still see the ability to reduce our operating leverage, quite frankly. We still have that ability as well. So I think all in all, you're gonna. I'd be, you know, lying if I told you that we're not going to see our cost of debt go up, that's sure. But it's I feel like it's going to come up for a period of time, and then it's going to normalize.
When we go look at the 2026 late October bond, we'd expect that might be, you know, less of a drop, based on what, you know, SOFR's, you know, cut, rate cuts coming to bear.
As you can imagine, there's a lot of strategy on the right side of the balance sheet, and, Michael's very good at that, so...
[inaudible]
Yeah. So, I mean, we've kind of said it on call, so I'm not telling you anything different. But so we've set our dividend, you know, so our regular dividend, we just increased it to $0.58, but we would probably tell you that we see from the $0.69 of NII right now, we expect that to come down into the low 60s. So there is going to be a material impact, and that's going to be in the short run. It's the way we're modeling this out, we do expect to have day one, to the previous question, we're going to be refinancing, you know, 4.25 up to 5.5, 5.75. So there will be a hit, maybe that'll be a penny, a penny and a half.
Then we're going to start seeing, you know, the ability to refinance the later debt at a later time. Our floating rate, if you think about it, half of our debt stack is floating, and we're paying almost 8%, so it's two fifty plus SOFR. That's going to start coming down as the rate cuts. That also is going to mitigate the increase in the fixed cost from the bonds that we're probably going to refinance.
Yeah, there's several. That's exactly right. There's several variables as the rate cycle, the SOFR comes down, right? As SOFR has gone up really high, the lending industry, all these senior loans are floating rate. Spreads have tightened in our market because people are fat and happy on all the index side, right?
And so that's what I've been doing this for 25 years is exactly what's happened in past cycles. And so as the index comes down, the spread will typically widen. So there's a little bit of a. It's not exactly a one-to-one rate goes down 200 basis points, our yields go down 200 basis points. It's really not the way it typically works. Definitely, our yields will go down, but our cost capital go down too. And you know, the relative risk premium across the market or the relative yield alternatives, all yields come down. And so if everything stays equal at Capital Southwest and yields come down, the stock price will go up, right? Or at least not go down. You know what I mean?
So it's all these things work together where you can actually manage that in a way that it's not as one-to-one as, you know what I mean, on ultimately your investment as it comes-
They only get the benefit of the lower rates or the wider spreads on new originations.
That's right.
[inaudible]
You know,
the portfolio is first lien, by the way, it's always churning, so like, you know, when the company has cash flow and pays something down, if you're a sub-debt lender, they're paying the debt and the bank down, and your leverage is going down because you have less bank debt above you, but when you're the first lien lender, all the cash goes to us, so it's constantly churning all the time, right, so just kind of a treadmill in our market, which, but that's just, that's first lien lending, so.
So I think your equity portfolio adds up to many, many different investments. I think they add up to 9% or 10% of your equity.
9% .
I think the equity is revalued each quarter also.
Mm-hmm.
But where do you think you're going with that equity? Is that going to grow faster than your loans? Or is it really worth a little more in your minds than the appraisers have said it's worth?
Yeah. So it's 69 portfolio companies out of 117 that we have equity in, right? And the vast majority of those, we have a loan next to it. We always invest equity alongside a loan. We don't ever just do one-off equity investments. But some of our equity investments don't have a loan anymore because the company's grown, and they refinance this out with a larger lender or even a bank, and then we, you know, we get liquid on that equity when the private equity firm sells the business. And they have a natural instinct to sell the business because they don't get paid their carry until they sell it. So that happens organically. And so the theory on equity in a portfolio like this is the winners make money, and that's what we've seen.
The winners make multiples of your capital, right? So obviously, if the equity is doing great, your loan's doing fine, right?
But the small number of loans over here that, you know, debt by definition is only downside, right? You get your interest, and if one thing happens, there's no upside on debt, right? And so the winners more than offset the losers on the debt side, right? 'Cause as a senior lender, you end up losing very little money, but sometimes you can lose some, and so the equity makes- so that's the theory, and what we've seen is the equity upside over time has more than offset the debt losses. But that's the theory of having, If you only add debt, then you pay interest, but, you know, the first loan that struggles is just downside, right? So as a portfolio, yeah, we think, I mean, that portfolio is pretty exciting.
We've got some handful of really interesting upside plays in that, that are outsized, you know, upside, and as long as we're investing with private equity firms that buy good businesses as a whole and generate upside, that's gonna accrue to us. So we're pretty positive on that equity book.
Okay.
So
To your question
And a role for that equity in our strategy
Yeah
and why we do it, you know?
But we wouldn't expect that 9% to change materially. It's like our debt checks, as we noted earlier, are likely to grow as the balance sheet grows. The equity checks in these small, lower middle market companies, you don't typically invest, you know, $3 million-$5 million. It's more gonna be in the $1 million-$3 million range, so the debt's probably gonna be a higher percentage of the capital stack per company.
And what ends up happening is, as the 9% maybe goes to 10%, maybe goes to 8%, that's a function of what exits are happening, too. So, like, you know, it, it's designed to be around 10%. If we went to 20%, in our view, that's too much equity in the portfolio, and you start having earnings, earnings issues, right? And so, and he's right. So as we're doing new equity deals, we're also exiting some of these old equity deals, and so it stays around that kind of 10% world. But you're spinning off gains as, as you, as you go, as it churns, if that makes sense.
Question on page 20, if you flip to that. Do these gains include all the equity that was sold with these in every case? Is that why you're getting realized gains?
These don't include equity.
No, the
Yeah, these are just debt.
Yeah, this, so this is [inaudible] , so this would be the fees and interest income.
Totally.
Well, but a realized gain would be included in OID.
If there was, yeah. Oh, yeah, so realized gain on a debt check is whatever portion of OID has not been fully accreted. So we accrete it over four years, so if you exit it, if it's a 2% fee, after two years, if we haven't, you know, only half of it's been accreted, the rest comes into realized gains.
This doesn't include any equity sales?
Correct.
We would label it equity on one of our earnings decks and so that-
is there any equity sales of any of these companies, along with the payoff of the debt?
Not in that quarter, no.
I see.
We didn't own equity in a lot of these companies either. Did not.
And you'll see a lot of the majority of these companies are pretty large companies, so there are some of the, you know, prior syndicated deals or large businesses. And so you look up, back on another slide, you'll see our average EBITDA in the portfolios came down a little bit, and that was because our exits were large EBITDA businesses, so
But
Yeah
But the one, like Producto Group, the first one, that one we actually have a large unembedded, unrealized appreciation. We got refinanced out of the debt, but we'll continue to hold that stub equity, and that
Yeah
we expect a sizable gain when that thing exits.
Yeah, that's, you know, we've got a gain now, and we expect that to grow. So that's a good, that's a good one. It's a good example of one where we get refinanced out, and we keep the equity, and that PE firm will absolutely sell that business probably in the next 18-24 months, I guess.
Thank you.
All right. Red light's blinking, that's the hook.
Thanks for your time, guys.
Thank you, all.