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Capital Southwest: Adopts New Leverage Policy

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NEWS

On April 30, 2018, Capital Southwest (CSWC) issued a press release announcing its new leverage policy, adopted by the Board.

The Board approved the decrease in required asset coverage – as provided for under the Small Business Credit Availability Act – from 200% to 150%.

Technically, this allows a BDC to double balance sheet leverage.

The new asset coverage will become effective April 25, 2019.

However, the Board also decided to cap asset coverage at 166%.

That’s the equivalent of  maximum debt to equity of 1.5x to 1.0.

Here is the full statement made by Bowen Diehl, the BDC’s CEO:

“President and Chief Executive Officer Bowen S. Diehl stated, “Whilst we believe that the passage of the SBCAA is positive for the Company in that it provides Capital Southwest with flexibility to manage balance sheet leverage above our previously stated target of 0.8-to-1, our view on balance sheet leverage for a BDC has not changed. We believe leverage should be prudently applied to an underlying portfolio of assets based on the security and quality of the underlying portfolio. Specifically, we consider factors such as the portion of the portfolio in first lien assets, the weighted average leverage at the portfolio companies and the underlying portfolio loan performance. The previous balance sheet leverage target of 0.8-to-1, was as much set based on a cushion to the regulatory leverage limitations as it was set based upon a view of the optimal balance sheet leverage point for a well performing portfolio of largely first lien assets. While we do not view balance sheet leverage near 2-to-1 as being appropriate, we do believe that targeting balance sheet leverage greater than 0.8-to-1 may be appropriate. The announcement of our Board’s determination to limit our leverage to a level below the 2-to-1 permitted regulatory limitation is meant to communicate this prudence. We believe that the additional leverage will better enable us to increase the security and quality of our loan portfolio. Over the next year, we will work to maintain our strong track record, seek feedback from our shareholders and discuss appropriate covenant amendments with our bank lender group. All of our discussions and decisions will be made in the context of creating attractive, long term sustainable value for our shareholders. Finally, it is important to note that our internally-managed structure allows for virtually 100% of the economics of any incremental leverage to inure to the benefit of our shareholders.”


ANALYSIS

This is the second BDC to adopt the new leverage rules AND outline its future strategy, following New Mountain Finance (NMFC).

Unlike NMFC, which is not charging management fees for syndicated loans acquired with the new leverage, CSWC – which is internally managed – has decided to self limit its asset coverage.

CSWC is the first BDC to take this approach.

The BDC managers and Board will not be putting the new policy to a shareholder vote.

As a result, the new leverage rules will not go into effect until April 2019.


VIEWS

BDC Snowflakes

The BDC Reporter has been saying since Day One that every BDC will react differently to the perceived opportunities and risks inherent in the  new Act.

In this case, CSWC’s Board has taken a halfway approach, but has less much up in the air.

We Have Questions

We are wondering how the BDC will treat off balance sheet leverage in its Senior Loan Joint Venture with Main Street Capital going forward ?

Also – if CSWC eventually receives SBIC financing, how will that debt be treated under this policy ?

Counted or not counted ?

Also, with the ability to substantially grow the portfolio, will incremental investments be made in syndicated, large cap loans (as per NMFC’s stated intent) or in more illiquid lower middle market loans ?

To date as a public BDC, CSWC has invested in both types but has evidenced a preference for the latter given the more promising economics over time, and the possibility of equity gains.

These are important questions as they will determine what increased risk and return will be involved from April 2019 on.

Doing The Numbers

A down and dirty analysis suggests that if CSWC just continues with its existing investment policy, the new debt will be accretive on a risk adjusted basis.

According to the latest quarterly filing the BDC generates a yield of 11.0% on debt investments and 10.6% on all investments, taking into account non-income producing equity stakes.

The BDC’s Credit Facility – recently re-negotiated – costs LIBOR + 3.0%.

With 1 month LIBOR at 1.9%, that’s an effective rate of 4.9%, but headed higher.

Then there is an unused line fee which costs between 0%  to 1%.

We’re assuming that will add 0.5% to the cost of the debt and of the assets being purchased.

Also being assumed is that additional assets will result in a 1% increase in G&A and compensation costs for every dollar invested.

(This is based on our analysis of the cost structure of the BDC, but could be higher).

More Baby Bonds ?

Assuming that not all the increase in assets will be financed with the Credit Facility, CSWC is likely to issue additional Unsecured Notes.

When the BDC came to market just a few weeks ago with its own Baby Bond the debt was placed at a yield just under 6.0%.

Add the cost of raising the debt and the all-in cost of issuing Unsecured Notes is closer to 6.5%.

Additional Note issuances may be priced at higher rates if the market believes the higher leverage is riskier than before, which seems commonsensical.

That may raise the cost of Baby Bond financing to 7.0%, but that’s speculation.

In The Mix

For the moment we’ll just assume the new assets are financed 50% with the Credit facility and 50% with Unsecured Notes as previously priced.

That brings the average cost of new debt to 5.95%.

Add the 1.0% in higher costs and the all in cost is 6.95%.

Some Basic Math

Net of the incremental 10.6% pro-forma income we’ve assumed that would add 3.65% to Net Investment Income for all incremental investments made.

Given the risk profile of CSWC (a treatise unto itself but something the BDC Reporter has spent much time on) we also presume credit losses will average 2% of new assets annually.

Thus, on a risk-adjusted basis, CSWC’s new assets should – over time – generate 1.65% in net returns for its shareholders. 

For a sense of perspective – as of the IVQ 2017 and annualizing – CSWC’s Net Investment Income Return On Equity is 6.2%.

Hedging Ourselves

Of course there are many variables in our assumptions and many uncertainties.

Higher LIBOR or higher cost of Unsecured Notes could erode the accretive benefit.

So could a strategy of investing in “safer” loans, which would reduce income but might not make much of a dent in borrowing costs or operating expenses.

Too Early To Tell

Credit losses could be much higher.

CSWC has a very good credit record so far but that’s often the case with newer BDCs.

Most of the loans on the books are less than a year old.

We’ll have to wait several more years to get a fair picture of management’s credit selection skills, the most important factor in BDC investing.

It’s a little like launching a new plane but never having tested the motors.

Other Thoughts

The Board’s new policy will give SOME relief to existing Baby Bond holders that management is not going to allow itself to push the leverage envelope.

(Of course, our questions about the JV and the SBIC and other off balance sheet activities remain important and could change that picture).

If CSWC chooses to funnel incremental assets into lower yielding, but more liquid and more diversified syndicated loans, Baby Bond investors would be better off.

(Shareholders may not agree but that’s part of the tension in these situations).

Also likely – as we’ve suggested above – is that CSWC will be back in the Baby Bond market next year to raise funds for its balance sheet expansion.

By then we’ll have a clearer idea of what risks the BDC will be choosing to take with the new capital.

Final Note

We are disappointed to see that the Board and managers of CSWC have not chosen to call a Special Shareholders Meeting and bring this subject to a vote.

That would engender a valuable debate and provide shareholders the most direct way to contribute to this unilateral decision by the Board.

Moreover, if the new leverage is worth adding, as the press release vigorously suggests, why wait a year till implementation ?

BDCs which – rightly or wrongly – get shareholder approval for the new asset coverage/leverage will have a nearly year long jump on those BDCs that have only received Board approval.


INVESTMENT DISCLOSURE

We are Long both CSWC’s common stock and Baby Bond.

Both investments remain on hold.

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