Capital Southwest (CSWC): BDC Buzz Initiates Active Coverage

The following is a quick CSWC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

I have added Capital Southwest (CSWC) to active coverage and included in the BDC Google Sheets along with its Baby Bond that trades publicly on the NASDAQ under the symbol “CSWCL”. CSWC is an internally managed BDC with a $524 million portfolio with mostly first-lien debt positions and equity investments providing realized gains especially in its lower middle market investments similar to Main Street Capital (MAIN).

CSWC has increased its regular quarterly dividend each quarter since 2015 and equity participation is partially responsible for supporting continued quarterly supplemental dividends of $0.10 per share. The current dividend yield is around 9.5% (MAIN is currently 7.1%) which takes into account the recently announced $0.39 quarterly regular dividend and quarterly supplemental dividends of $0.10.

I will have a public article next week on Seeking Alpha discussing the initiation of active coverage. It is important to note that public articles will NEVER discuss specific dividend coverage levels, risk rankings, Target Prices, buying points, EPS/NII projections, etc. as that information is exclusively for subscribers of Premium Reports.

Summary

  • CSWC has ‘Level 1’ dividend coverage mostly due to its ability to leverage its internally managed cost structure.
  • CSWC has been included in the suggested ‘Total Return’ portfolio due to its debt portfolio that is mostly first-lien positions and the potential for realized gains from its equity investments, especially in its lower middle market investments.
  • CSWC continues to increase leverage growing its per-share economics. I am expecting continued supplemental dividends and portfolio growth driving increased regular dividends over the coming quarters.
  • Management is expecting higher expenses in calendar Q2 2019 due to “seasonal operating expenses” and has been taken into account with the previously discussed financial projections.
  • Subsequent to quarter-end, CSWC exited its investment in Prism Spectrum Holdings that resulted in a realized gain of $226,000.
  • CSWC has a history of stable portfolio credit quality that delivers a consistent and growing stream of recurring interest income with the potential for increased earnings through higher leverage and its I-45 Senior Loan Fund.
  • CSWC had undistributed taxable income generated by excess income and capital gains accumulated through March 31, 2019, of approximately $20 million or $1.14 per share.
  • My primary credit concerns include its positions in AG Kings Holdings Inc., American Addiction Centers (AAC), and American Teleconferencing Services.
  • As of March 31, 2019, only AG Kings was on non-accrual status with a fair value of $8.3 million, representing 1.6% of the total portfolio or 2.6% of NAV per share.
  • American Teleconferencing Services (“ATS”) is an investment also held by MAIN that operates as a subsidiary of Premiere Global Services (“PGi”). ATS was marked down during calendar Q1 2019 but still accounts for 1.1% of the portfolio and 1.7% of NAV per share and needs to be watched. On January 28, 2019, Moody’s downgraded PGi’s debt to Caa2.
  • On July 1, 2019, AAC submitted a plan to the NYSE regarding the company’s efforts to improve its total market capitalization, following notice on May 17, 2019 from the NYSE that its stock was at risk of being delisted.
  • There is a good chance that AAC will be selling its real estate assets to avoid bankruptcy and is likely why CSWC has only slightly marked down its first-lien loan. AAC still accounts for around 1.6% of CSWC’s portfolio and 2.6% of NAV per share
  • Equity participation is partially responsible for growing its NAV per share as well as ‘recurring non-recurring’ income, which contributes to the growing amount of undistributed spillover income and gains used to support supplemental dividends.

 

On September 30, 2015, the company completed the spin-off of CSW Industrials, Inc. (CSWI) that is now an independent publicly-traded company. As shown below, there were many reasons for the spin-off including investment concentration issues in assets that did not provide support to pay a “meaningful dividend”:

 

However, the company was able to create significant value for shareholders through the transaction and continues to rotate the portfolio into income-producing assets.

 

“Executing our investment strategy under our shareholder-friendly, internally-managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable, long-term value through recurring dividends, capital preservation, NAV per share growth, and operating cost efficiency. While generally fixed nature of our internally managed BDC cost structure improved operating leverage to 2.8% by the end of the year. These factors both contributed to the substantial year-over-year growth in dividends paid to our shareholders.”

CSWC Dividend Coverage Discussion:

CSWC has the ability to leverage its internally managed cost structure. CSWC has a history of stable portfolio credit quality that delivers a consistent and growing stream of recurring cash interest income with the potential for increased earnings through higher leverage and its I-45 Senior Loan Fund. CSWC had undistributed taxable income generated by excess income and capital gains accumulated through March 31, 2019, of approximately $20 million or $1.14 per share.

“Our operating leverage, continues to improve and look toward our target of sub 2.5%. As of the end of the quarter, operating leverage was 2.8% down from 2.9% at the end of the prior quarter, and 4.9% as of the end of fiscal year 2016. We continue to actively manage operating costs in lockstep with portfolio growth and expect to achieve our target operating leverage over the next several quarters. With all senior professionals and corporate infrastructure largely in place, portfolio growth from here should continue to improve our operating leverage, due to our internally managed structure.”

Management is expecting higher expenses in calendar Q2 2019 due to “seasonal operating expenses” and has been taken into account with the previously discussed financial projections:

“Looking ahead to the June 30, 2019 quarter, we do expect to incur certain seasonal operating expenses such as payroll taxes associated with our annual bonus payment and annual shareholder meeting expenses that are incurred.”

CSWC continues to increase leverage growing its per-share economics quarter-over-quarter which is the primary driver for continued higher returns to shareholders. I am expecting continued supplemental dividends and portfolio growth driving increased regular dividends over the coming quarters.

“We continue to grow dividends as we continue to migrate the balance sheet towards target leverage levels through thoughtfully building a portfolio of well performing income generating assets. The regular dividend of $0.39 per share for the current quarter ending June 13 announced in last night’s press release marks our fourteenth consecutive quarterly regular dividend increase. We continue to focus on growing our regular dividends in a sustainable manner demonstrated by our cumulative regular dividend coverage of 105% over the last 12 months, 104% since the launch of our credit strategy four years ago. We are pleased to report that our assets, income and shareholder dividends grew substantially throughout the year, producing a 37% total return to shareholders, driven by a 24% increase in stock price and $2.27 per share in dividends paid out to shareholders during the fiscal year.”

Its I-45 Senior Loan Fund accounts for 13% of the portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 94% invested in first-lien assets with CSWC receiving over 75% of the profits providing 15% annualized yield:

“Overall, we have been pleased with the solid performance of I-45 over the past 3.5 years. We and our partner in I-45, Main Street Capital, have invested approximately $500 million through the fund and have harvested 50 exits generating $196 million in proceeds at a weighted average IRR our on the exit for the 11.4%. Our senior loan fund, I-45 also continued its solid performance producing a 15% annualized yield on our capital in the fund for the quarter.”

 

The updated projections assume a mostly stable portfolio yield of around 11% which is lower than the yields on new investments during the previous quarter:

“Our originations this quarter consisted of $28 million in Senior Secured 1st Lien Debt with a weighted average yield of – weighted average yield to maturity of 12.5% and 1 million in equity.”

Since March 31, 2019, as shown below, CSWC has completed three new transactions totaling $23 million in senior secured first-lien debt at lower yields and exited one portfolio company for the total proceeds of $20 million.

“Our pipeline remains strong and we can currently have several lower middle market deals signed up with expected closings in late June and July.”

Its regular quarterly dividends are covered mostly through recurring cash sources:

Similar to MAIN, the supplemental dividends are typically covered by realized capital gains and over-earning the regular dividend:

“We generated $0.42 per share of pre-tax net investment income and paid a regular dividend of $0.38 per share. Additionally, we distributed $0.10 per share through our supplemental dividend program funded by our sizable undistributed taxable income balance or UTI, which was generated by excess income and capital gains accumulated from our investment strategy today. As of March 31, 2019, we had approximately $20 million or $1.14 per share in UTI, providing visibility to continuing the quarterly supplemental dividend program well into the future. This program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio. The program will continue to be funded from our UTI earned from both realized gains on debt and equity, as well as undistributed net investment income earned each quarter in excess of our regular dividends.”

Subsequent to quarter-end, CSWC exited its investment in Prism Spectrum Holdings that resulted in a realized gain of $226,000:

 

On April 25, 2018, the Board of Directors unanimously approved the application of the modified asset coverage requirements and the minimum asset coverage ratio applicable to the company was decreased from 200% to 150%, which became effective April 25, 2019.

“The Board of Directors also approved a resolution which limits the Company’s issuance of senior securities such that the asset coverage ratio, taking into account any such issuance, would not be less than 166%.”

Management is targeting a debt-to-equity ratio between 1.00 and 1.20 which is taken into account with the previously discussed financial projections:

“Let’s say, you utilize 90% of the credit facility, you are basically within our target leverage of 1.0 to 1.2. So, having that capital deals, okay, we’ve raised the capital irrespective of what happens in the market, the capital markets to approach target leverage is important to us strategically.”

“During the year, we also made significant progress towards diversifying our capital sources, while reducing the cost of our debt capital. We increased commitments on our revolving line of credit to $270 million as of the end of the year from $180 million at the beginning of the year, while also meaningfully decreasing the cost of the credit facility and amending the terms to allow for the additional leverage now allowable under the Small Business Credit Availability Act.”

In December 2017, CSWC issued $57.5 million in aggregate principal amount of 5.95% Baby Bond Notes due 2022 that trade publicly on the NASDAQ under the symbol “CSWCL” and have been included in the BDC Google Sheets. In June 2018, the company established its “At-The-Market” (“ATM”) debt distribution agreement to issue up to $50 million in additional notes including $19.5 million during the last year:

“During the year, we also issued $19.5 million in additional baby bonds through our debt ATM program. We raised $13.2 million through our first equity offering since our IPO in 1961 and we raised an additional $5.5 million in equity through the launch of our equity ATM program. Subsequent to year-end, we further upsized our revolving line of credit by adding an additional commitment for $25 million from a new lender resulting in the current total of $295 million in commitments from 10 lenders in our facility.”

On May 23, 2019, the company announced the expansion of total commitments under its revolving credit facility from $270 million to $295 million. The recent increase was executed under the accordion feature which allows for an increase up to $350 million in total commitments.

“On Slide 21, we lay out our multiple pockets of capital. As of the end of the quarter, we had approximately $141 million in cash and undrawn commitments available between our balance sheet and I-45 with the earliest debt maturity at December 2022. I should also note that subsequent to quarter-end, we added an additional $25 million commitment from a new lender to our credit facility, increasing total commitments to $295 million and our total cash and undrawn commitments between our balance sheet and I-45 to over $160 million. We feel good about our liquidity and capital structure flexibility and believe that it will allow us to thoughtfully grow our investment portfolio.”

On March 4, 2019, CSWC established its equity ATM program of slowly issuing small amounts of shares at a premium to book value/NAV and accretive to shareholders. During calendar Q1 2019, the company sold 263,656 shares of its common stock under the ATM program at a weighted-average price of $21.47 per share (~16% premium to previous NAV), raising $5.5 million of net proceeds after commissions to the sales agents on shares sold. Management will likely continue to use the ATM program for raising equity capital, rather than larger equity offerings. This approach is beneficial for many reasons including being more efficient, delivering higher net proceeds to the company and less disruptive to market pricing.

“CSWC launched its initial equity ATM program and raised $5.5 million. We believe our equity ATM program is a prudent and cost-effective way to issue equity over time at tight spreads to the latest trade, while selling equity on a just-in-time basis so it can be thoughtfully invested in income generating assets. We certainly intend to do that by growing the portfolio, but we want to be, and we use the word prudent, we want to be prudent and diligent of raising kind of on a just-in-time basis and certain amount of equity, again, allowing us to get to target leverage in a reasonable timeframe, but being diligent about being in on a just-in-time basis some level of equity into the capital structure. ”

October 4, 2018, CSWC announced that it completed an offering of 700,000 shares at a net price of $18.90 per share for total net proceeds of approximately $13.2 million.

CSWC Risk Profile Discussion:

My primary credit concerns for CSWC’s portfolio include its positions in AG Kings Holdings Inc., American Addiction Centers (AAC), and American Teleconferencing Services. As of March 31, 2019, only AG Kings was on non-accrual status with a fair value of $8.3 million, representing 1.6% of the total portfolio or 2.6% of NAV per share. This investment is still marked at 91% of cost and was discussed on the recent call:

“The company [AG Kings] is kind of performing generally the same. The management team is doing a great job, managing a tough business, and the lender group is supportive of the business and kind of working through the situation. So, that’s really all I can say about the company itself, but we brought the valuation down slightly this quarter, which you will see in the K.”

American Teleconferencing Services, Ltd. (“ATS”) is an investment also held by MAIN that operates as a subsidiary of Premiere Global Services (“PGi”), offering conference call and group communication services. As shown in the previous table, ATS was marked down during calendar Q1 2019 but still accounts for 1.1% of the portfolio and 1.7% of NAV per share and needs to be watched. On January 28, 2019, Moody’s downgraded PGi’s debt to Caa2:

Moody’s: “The downgrade of the CFR reflects Moody’s view that PGi’s EBITDA will deteriorate significantly over the next 12 months. Given PGi’s challenges, Moody’s believes that the company’s ability to meet covenants beyond 2Q 2019 is highly uncertain and the capital structure is unsustainable. The risk of default and debt impairment is high given the continuing erosion in revenues and EBITDA. PGi has proposed amendments to its existing credit agreements to waive the total leverage covenant for 2Q 2019 and a potential going concern qualification requirement in its 2018 financial statements. The company also expects to complete the sale of certain non-core assets in the near term, which management believes, along with the equity support, will provide the company adequate liquidity through 2019 to execute on its plans to commercially offer a new UCaaS offering. The continuing support from financial sponsors’ is credit positive. However, Moody’s believes that the proposed amendment and equity infusion will only improve PGi’s liquidity on a short-term basis.”

As of March 31, 2019, the portfolio (excluding the I-45 SLF) was weighted approximately 79% in the lower middle market (“LMM”), and 21% of the upper-middle market (“UMM”) on a cost basis. The leverage ratio of its UMM portfolio increased to 4.8 times, which was up from 3.8 times in the prior quarter, driven primarily by the underperformance in American Addiction, which increased its debt-to-EBITDA leverage ratio significantly quarter-over-quarter.

“Excluding this company’s underperformance, the leverage ratio through our security for the upper middle market portfolio would have been flat to last quarter at 3.8 times.”

American Addiction Centers is a provider of inpatient and outpatient substance abuse treatment services operating facilities located throughout the United States and is a subsidiary of AAC Holdings, Inc. (AAC) to which CSWC has invested $8.9 million slightly marked down to $8.4 million. On June 14, 2019, Michael Nanko, President and Chief Operating Officer of AAC resigned from his positions according to an AAC filing with the SEC. Mr. Nanko leaves AAC one month after CEO Michael Cartwright and CFO Andrew McWilliams conducted a call with investors to map out a 10-year strategy for the company to reverse a slide that began in 2015.

On July 1, 2019, AAC submitted a plan to the NYSE regarding the company’s efforts to improve its total market capitalization, following notice on May 17, 2019 from the NYSE that its stock was at risk of being delisted as its average market capitalization was less than the required $50 million over a 30-day trading period.

AAC received waiver defaults to remain operating but needs to improve its positive cash flows/EBITDA to avoid a bankruptcy/restructuring. CSWC management discussed its investment in AAC on the recent call:

“I’m just reiterating what you can go to their website and what you could hear them say is terrible market, but Google changed their algorithm, which affected their senses flow, patient flow or missions I should say in the fourth calendar quarter of last year. So, that brought on EBITDA pretty substantially kind of fourth quarter and into the first calendar quarter of this year. So, they are rebuilding from there. They have cut a bunch of cost, which we think is smart and they are rebuilding the admissions across their national franchise and so LTM EBITDA has come down, so leverage has gone up. They have got a very large real estate portfolio that I believe the market use and the management team says is worth in excess of the 1st Lien Debt, which is why that debt I think remains in the low-to-mid 90s kind of quoted level.”

However, there is a good chance that AAC will be selling its real estate assets to avoid bankruptcy and is likely why CSWC has only slightly marked down its first-lien loan. AAC still accounts for around 1.6% of CSWC’s portfolio and 2.6% of NAV per share.

“Despite its underperformance, we continue to feel reasonably confident about our 1st Lien position in the company, due to the value of its national substance abuse treatment franchise, managements operational efficiency initiatives, the tremendous demand for drug addiction treatment in the U.S., and the company’s large real estate portfolio associated with its street facilities.”

On March 15, 2019, S&P Global Ratings downgraded AAC Holdings Inc.’s issuer credit rating to CCC from B- after the company took out a $30 million term loan.

The outlook is negative for AAC, which provides substance use treatment services for people with drug and alcohol addiction, and co-occurring mental and behavioral issues in the U.S. S&P Global Ratings said the downgrade reflects an increased risk of default and risk that AAC’s liquidity will not be sufficient over the next 12 months as the loan matures in about one year. The rating agency expects AAC to monetize its real estate assets to repay the new term loan March 31, 2020, and fund its operations in 2019. It believes there are risks that proceeds from a potential sale-leaseback may not be sufficient to cover operating needs and repay the term loan. S&P Global Ratings noted that AAC’s solvency heavily depended on executing its cost-saving initiatives. The Brentwood, Tenn.-based healthcare facilities provider implemented a cost-reduction plan in December 2018 to improve liquidity and reduce operating expenses. The company said in its fourth-quarter earnings report that it has continued its expense savings initiatives into 2019, which combined with cost savings plan announced in 2018, will save about $30 million for the company. According to the rating agency, AAC faces significant operational uncertainties as the company works to improve its census. Another main constraint for AAC was weak free cash flow, which could be further impacted by litigation risk.

“Within our internal investment rating process, the changes for the quarter included an upgrade from 2 to 1 for the 1st Lien secured loan to Environmental Pest Service, due to the company’s strong performance and a downgrade from a 2 to 3 from a 1st Lien Senior Secured loan to American Addiction due to its underperformance. As a reminder, all investments upon origination are initially signed in an investment rating of 2 on a 4-point scale with 1 being the highest rating, and 4 being the lowest rating. Overall, we are pleased with the performance of the investment portfolio. As of the end of the quarter, of the 36 loans in the portfolio, we had 4 with the highest rating of 1, representing 17% of invested capital. We had 29 loans rated at 2, representing 77% of the invested capital. And we had 3 loans rated at 3, representing 6% of the invested capital. As of the end of the quarter, we had no loans rated at 4 in the portfolio.”

The portfolio has energy/oil-related exposure of around 1.9% and commodities/mining exposure of 1.6%. The energy investments are considered “midstream” as compared to “upstream” which usually involves more commodity-related risk.

 

As the portfolio has grown, the percentage of its debt investments (excluding I-45 SLF) represented by the lower middle market has increased by design to 78% and first-lien accounts for 86%:

“While we have increased the percentage of the portfolio represented by the lower middle market, we have also continued to heavily emphasize Senior Secured 1st Lien Debt in our investment strategy. As of the end of the quarter, we had 86% of our on-balance sheet credit portfolio in 1st Lien Senior Secured Debt.”

 

 

Its I-45 Senior Loan Fund accounts for 13% of the portfolio and is a joint venture with MAIN created in September 2015, 94% invested first-lien.

“the I-45 portfolio was 94% 1st Lien with diversity among industries at an average hold size of 2.1% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately 68 million, and a weighted average leverage through the I-45 security of 3.9 times, which was up from 3.7 times at the end of the prior quarter. Here as well, the increase in the portfolio weighted average leverage was influenced by the underperformance of American Addiction. Without this underperformance, weighted average leverage of the portfolio would have been 3.6 times, which was down from 3.7 times at the end of the prior quarter.”

“In the upper middle market, over the past year or so we have been in an environment where it has been difficult to find value in syndicated loans. For the syndicated deals we have found acceptable from a risk return perspective, we have often chosen to pick small positions of approximately $5 million, which fit well into the I-45 portfolio. To the extent that syndicated spread widened, terms improve and we identify our especially attractive opportunities to invest in the upper middle market syndicated loans. We have the ability through our loan relationships with syndicate banks to capitalize on such opportunities either through additional exposure on our balance sheet or through I-45.”

CSWC has been included in the suggested ‘Total Return’ portfolio due to its debt portfolio that is mostly first-lien positions and the potential for realized gains from its equity investments, especially in its lower middle market investments(similar to MAIN). Equity participation is partially responsible for growing its NAV per share as well as ‘recurring non-recurring’ income, which contributes to the growing amount of undistributed spillover income and gains used to support continued supplemental dividends.

“In our core lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a highly performing and granular portfolio of equity co-investments is important to driving growth in NAV per share and aids in mitigating future credit losses. At the same time, our capability and presence in the upper middle market provides us the ability to opportunistically invest in a more liquid market when attractive risk-adjusted returns exist. Slide 12 illustrates our history of value creation from September 2015 to the date of our spin-off of CSW Industrials making Capital Southwest purely of middle market lender. Total value, which we show here as net asset value plus cumulative dividends paid has increased $5.03 per share to a value of $22.71 per share as of March 31, 2019 from $17.68 per share as of the spin-off. Our increasing regular dividend coupled with the supplemental dividend program and a well-performing investment portfolio should continue to create attractive long-term returns for our shareholders. During the year, we continued to advance the credit strategy we laid out for our shareholders over four years ago of prudently building a well performing credit portfolio through conservative late-cycle underwriting principals. We continue to be committed and excited about our core investment strategy of building a predominantly lower middle market portfolio consisting largely of Senior Secured 1st Lien Debt with equity co-investments across the loan portfolio, where we believe significant equity upside opportunity exists. The portfolio as a whole continued to perform well this quarter generating $3.6 million in net appreciation, which was the primary driver of our NAV per share growth to $18.62 per share”

“In the lower middle market, our robust origination platform continues to generate solid deal flow allowing us to close on some highly attractive opportunities from a risk return perspective. We believe that maximizing the top of our origination funnel is critical to generating strong credit investment performance over time as it ensures that we consider a wider array of deals allowing us to employ our conservative underwriting standards in a competitive market, and thoughtfully build a portfolio that will perform through the economic cycle. Our investment strategy has remained consistent since its launch in January 2015. We continue to focus on a blend of both lower middle market and upper middle market assets, providing us strategic flexibility as we have built the robust capability to seek attractive risk-adjusted returns in both markets.”

Q. “We’ve seen a continued escalation in the trade war, seemingly now and not just with China, but with other trading partners. Just wondering how much you are hearing this from your portfolio company management teams if at all if they see business as a threat or potential threat to any business?”

A. “Yes, it’s definitely something that the management teams in our portfolio that have inputs there and shipping in the country are paying attention to. We’ve looked at our portfolio and the general comment I would make is, you know the companies in the portfolio that it could is or could affect the cost structure. They’ve really all been situations where the price increase that they would need to pass on to the customer is small enough and they are in markets where we think that they could pass it on. So, as you hear that you hear that obviously in the Reuters account in news cycle of consumer prices and producer prices going up as a result of the tariffs. With respect to our portfolio, we feel pretty good that our companies that are effective can pass us on to their customers.

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated CSWC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

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