2023-09-11 21:18:58 ET
Summary
- Capital Southwest is a Dallas-based business development company (BDC) that focuses on the Lower Middle Market (LMM).
- The company primarily makes debt investments in LMM companies, with a majority of its investments in floating rate debt.
- The stock has rallied 31% in the last year, but the future outlook is uncertain due to potential interest rate cuts and the subsequent downward pressure on net investment income.
Where Banks Fear To Tread
For large companies, securing new capital via debt issuance is generally fairly easy, and simple. Investment banks are enlisted (often they are knocking on the company's door for the opportunity) to issue debt in the form of bonds, the proceeds from which the investment bank makes a healthy fee while the company receives the net proceeds. It's a process that happens virtually every day around the corporate globe.
For many companies, however, access to this streamlined process is all but impossible. Often these are companies that the average person would consider large, but in the world of syndicated debt, they're small fries. This is the middle market--the realm of companies with generally not enough revenue to support a bond offering juicy enough to entice investment bankers. This is where business development companies [BDCs] step in.
The subject of our article today is Capital Southwest ( CSWC ), a Dallas based BDC with a niche of focusing on what is known as the Lower Middle Market [LMM], which is essentially comprised of smaller companies that other middle market-focused BDCs would consider to be too small.
Capital Southwest makes mainly debt investments in LMM companies, but it can take equity stakes as well in its portfolio companies, which is fairly normal for the industry. It also has a majority of its investments in floating rate debt -- debt which, as you might imagine, has become much more lucrative in the past year or so as the Fed has aggressively raised rates.
The market has not missed this fact, and the stock has rallied on a total return basis by 31% in the last twelve months (price appreciation, which excludes dividends, has been 16% in the same time frame). Despite this rise, the stock sports a robust dividend of 11.1% as of this writing.
The question, of course, is can the good times keep going? And is the stock a bargain today? These are the questions we aim to answer.
The Loan Portfolio
There are a few key terms that matter a lot in the BDC world. First lien loans mean that the lender sits atop the credit stack, and is typically the last to lose money in a liquidation event. Second lien means that the lender is second in line, and third... well, you get the picture.
Thus, for peace of mind, one of the first questions investors often ask is whether or not a BDC's loan portfolio is majority first or second-lien. In Capital Southwest's case, it is roughly 97% first lien.
This is especially important, in our view, given the interest rate profile of the debt--virtually all (97%) of the company's credit portfolio is floating rate debt set above SOFR. In this instance, the first lien status of the debt becomes even more important since interest income is now tied to a floating benchmark. Even more important is the fact that Capital Southwest must now monitor portfolio companies to ensure that they are able to make the required payments.
The above chart provided by the company for investors illustrates the sensitivity of the portfolio to changes in interest rates. For example, a 50 basis point hike in interest rates is expected to cause an increase of net investment income by $4.7 million, while a decrease of 50 basis points would cause an equal decrease in net investment income.
Now, this is where things get tricky in our opinion (and not just for Capital Southwest, but for any BDC engaged in a majority floating interest rate investment portfolio). With a current average weighted yield on all portfolio investments of 12.94% , how will the portfolio hold up if and when interest rates begin to decline?
This, we think, is a more forward looking question than the one of whether or not Capital Southwest's portfolio companies can keep up with payments at current levels. For one thing, Capital Southwest does engage in payment-in-kind [PIK] deals, which allow portfolio companies to offer up securities or accrue interest payments until the end of the loan rather than paying cash at the time that it's due. By our count, Capital Southwest has 27 such agreements in its loan book.
This is generally not an attractive feature of debt, but it is one in this case that we think is a bit more acceptable than it would be at a BDC investing in pure middle market companies. To our minds, investing in the LMM market carries an additional risk, and PIK covenants may be a reasonable way for Capital Southwest to offer a pressure release valve to portfolio companies when needed.
Going back to the possibility of rate cuts, it does not appear that declines in interest rates are all that far off .
As early as May of 2024, traders are generally expecting that interest rate cuts could begin to take shape, with a large consensus of traders of the opinion that rates will settle in the 4.25%-4.75% range by the end of 2024.
A simple reference to the chart above shows that the expected hit to Capital Southwest's net investment income could be in the ballpark of $9.5 million. This is not insignificant when you consider that the twelve month run rate of net interest income for the company is roughly $100 million based on the latest quarterly results.
Also consider that Capital Southwest paid out $22.9 million in dividends for the quarter ending June 23, 2023. Annualized, that amount comes to $91.6 million. Given the fact that the company has been rapidly issuing shares (not uncommon for a BDC), it is not difficult to envision a future where dividend payments come under pressure as existing portfolio companies see their payments due fall and new deals yield lower rates.
Add in the fact that the company currently trades above its five-year average book value, and the levels at which the stock trades today certainly feel risky.
The Bottom Line
While it is likely that the next 3-4 quarters for Capital Southwest will provide ample income, the longer term picture is decidedly more murky, in our opinion. We will be watching to see how management addresses the prospect of lower NII in the future, as well as keeping a close eye on PIK balances of portfolio companies for signs of weakness in the near term. For now, however, the shares of this well-run niche BDC are a bit too expensive for our taste.
For further details see:
Capital Southwest: Is This Double-Digit Dividend Yield A Bargain?