NEWS

Apr. 21, 2025 4:01 PM ETCapital Southwest (CSWC)

DALLAS, April 21, 2025 (GLOBE NEWSWIRE) — Capital Southwest Corporation (CSWC), an internally managed business development company focused on providing flexible financing solutions to support the acquisition and growth of middle market businesses, today announced its wholly owned subsidiary, Capital Southwest SBIC II, LP (“SBIC II”), has received a license from the U.S. Small Business Administration (“SBA”) to operate as a Small Business Investment Company (“SBIC”).

As an SBIC, SBIC II will be subject to a variety of regulations and oversight by the SBA concerning, among other things, the size and nature of the companies in which it may invest as well as the structure of those investments. The SBIC license will allow SBIC II to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a leverage commitment by the SBA. SBA debentures are loans issued to an SBIC which have interest payable semi-annually and a ten-year maturity. The interest rate is fixed shortly after issuance at a market-driven spread over U.S. Treasury Notes with ten-year maturities. Current SBA regulations permit SBIC II to borrow up to $175 million in SBA-guaranteed debentures, bringing Capital Southwest’s aggregate borrowing capacity through the SBIC program to a total of up to $350 million of capital.

The SBA program has played a pivotal role within Capital Southwest’s lower middle market investment strategy since receiving its first SBIC license in April 2021. Capital Southwest received exemptive relief from the Securities and Exchange Commission that allows for the exclusion of SBA-guaranteed debentures from the definition of senior securities in the asset coverage requirement applicable to the Company.

Source: CSWC Press Release

Long Time Coming

CSWC began life as a Texas corporation in 1961, and was then licensed as a Small Business Investment Company (SBIC).

In 1969, the company transferred its SBIC license and certain assets to its wholly owned subsidiary, Capital Southwest Venture Corporation (CSVC) and functioned for two decades as a closed-end, non-diversified investment company under the Investment Company Act of 1940, focusing on long-term investments in privately held businesses across various industries.

However, at the time, the strategic focus was on making equity investments – not loans.

On March 30, 1988, CSWC elected to be regulated as an internally-managed Business Development Company (BDC) but continued to invest principally in common stock positions in private companies.

Only in 2015, did CSWC transform into the BDC we know today following a drastic re-organization:

DALLAS, Dec. 2, 2014 (GLOBE NEWSWIRE) — Capital Southwest Corporation (Nasdaq:CSWC) (“CSWC”) today announced that its Board of Directors has unanimously approved a plan to spin-off certain of its control assets into a standalone, publicly traded company. The separation is designed to unlock shareholder value immediately and to enhance long-term shareholder value by establishing two strong, independent companies with distinct growth strategies: one business will be a diversified industrial growth company (“Industrial Co.”) and the other will focus primarily on lending to strong middle-market companies in the Southwest and across the country. 

Source: CSWC Press Release.

Start Again

Ironically, CSWC’s decision to become exclusively a BDC by spinning off its control assets into another entity resulted in management – in agreement with the Small Business Administration (SBA) – to give up its SBIC license.

That license did not have the right to issue SBIC debentures.

Instead, CSWC – somewhere around 2016-2017 – proceeded to apply for a new SBIC license.

This “first” license was granted in April 2021 and required a total equity capital commitment of $87.5mn and gave the licensee the right to issue up to $175mn in 10 year debentures at favorable rates and terms.

The proceeds were used over the next several years to invest in multiple SBIC-eligible investments as both lender and minority equity investor.

By the end of 2024, CSWC was fully drawn on its $175mn in SBIC debentures – issued at different times and at different interest rates:

Comparing And Contrasting

The weighted average cost of the debentures at year end 2024 was 4.42%.

That’s substantially less expensive than CSWC’s secured “SPV Credit Facility”, priced at Term SOFR + 2.50%, or roughly 6.83%. and than its Corporate Credit Facility, whose all in cost is 6.48%.

However, CSWC was able to access $150mn of very inexpensive unsecured notes in 2021 at a yield of only 3.375%.

The notes, though, will mature in October 2026, leaving the debentures – both individually and on average – as the most inexpensive and longest dated debt on the BDC’s balance sheet and accounting for about a fifth of all CSWC’s debt outstanding.

Next Up

By early 2024, the first license was getting fully utilized and CSWC applied for a second license, with similar features as the first.

That’s the license that was just formally approved, as per the press release above.

Management expects to draw down the debentures and invest the proceeds over a 2.5 to 3 year period, and at a slightly faster pace than for the first license given its bigger base of sponsors than before.

About four-fifths of prospective borrowers are of a size that fits the SBIC’s parameters, which are designed to support smaller private U.S. companies.

The most recent SBIC rate fixing was at a yield higher than the average achieved for the first license:

The March 2025 pooling of Small Business Investment Company (SBIC) standard debentures was priced at 4.963%. This most recent semiannual pricing of SBIC standard debentures reflected an increase to the rate set in September 2024 of 4.38%. Despite this increase, this pricing remains below the rate set in March 2024 of 5.035%.  

However, with the path of long term rates uncertain, the specific actual interest rate CSWC will pay between now and 2028 is unknowable.

We can only speak in approximations.

At the moment, though, the second license SBIC license seem likely to become the second least expensive source of capital for the BDC.

Given that the current yield on CSWC’s income producing investments is 12.1%, the “spread” between what the BDC receives and is likely to pay out is – very roughly – about 700 basis points.

That is approximately 200 basis points better than the net spread received on loans funded by one of the BDC’s two Revolvers and far better than most “spreads” in the leveraged loan markets generally.

Impact

The access to new long-term unsecured SBIC debt on favorable terms comes at propitious time for CSWC.

The debentures will more than replace the unsecured notes being retired in 2026, and allow CSWC to remain active in the lower middle market (LMM), which has been its principal bailiwick.

The SBIC debentures – once drawn – will also maintain a balance in the BDC’s funding between secured and unsecured borrowings and “ladder” maturities well into the next decade.

Moreover, management maintains a great deal of choice as to when to draw down on the debentures to minimize its interest expense, as opposed with a “normal” unsecured note, typically drawn down all at once and at a set yield.

VIEWS

Hard To Fault

At a difficult time in the markets – and with no BDC having issued a Baby Bond or privately placed unsecured note in some time – CSWC’s access to long term, relatively inexpensive unsecured debt with few covenants is something of a godsend.

The interest rates being charged borrowers like CSWC are not as attractive as in the days of very low rates but remain highly accretive and provides the BDC with an important source of liquidity for years to come.