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Capital Southwest: Impact of Media Recovery Inc. Sale

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NEWS

On November 25, 2019 Capital Southwest (CSWC) announced the sale of  Media Recovery Inc. (aka SpotSee) to an undisclosed buyer.

The exact price was not disclosed, but the BDC’s press release said “total value to Capital Southwest, in the form of cash and a potential earnout, [was] generally in line with the most recent quarterly valuation”.

The CEO of CSWC Bowen Diehl added the following:

“We are pleased to announce the sale of SpotSee.  SpotSee was one of the legacy portfolio companies we held after the spin-off of CSW Industrials and launch of our credit investment strategy.  Over the past four years, the management team has done a stellar job growing the business and positioning the company for future growth.  We have thoroughly enjoyed our close working relationship with the team and wish them all the best as they continue their strong performance with their new partner.”

The press release is attached.


ANALYSIS

Total Impact

We are seeking to ascertain the likely long term impact of the sale of Media Recovery on CSWC’s balance sheet and income statement in the short and medium term.

At September 2019, the investment – which had a cost of $5.4mn – was valued at $54.0mn.

That value was equal to one-tenth of all CSWC’s portfolio assets at September 30, 2019 and was the largest single investment.

The investment consisted of 4mn shares of common stock and 800 shares of Series A Convertible stock, with a value of $8mn.

Cashing In

Unclear is exactly how much cash CSWC will receive both initially and eventually, given that management has been vague on the subject and the “earn-out” is a previously unknown element whose proceeds could vary.

When the subject was discussed during CSWC’s most recent Conference Call on November 15, 2019 when – we presume – most of the details of the purchase must have been known, the following was said by CSWC:

We’re going to use approximately $50 million of those proceeds [from the sale of Media Recovery] that are going to come back. The majority of those proceeds are going to be used to pay down debt initially, then be redeployed into debt assets. There’s just to be some level of leakage for — depending on deemed distribution or a special dividend. But — so there’ll be — initially, when we pay down, there’ll be — our cost of debt is about 5%, and the dividend yield is about 8%. So there will be a slight reduction at the front end. And then as we redeploy, NII will be flat when we fully transition, and then it will grow when we lever back up.

Debt Repaid

At September 30, 2019 CSWC had $108mn of outstandings under its Revolver.

The facility is priced at LIBOR + 2.50%, which equates to a current interest rate of about 4.2%.

A $50mn reduction will reduce interest expense by $2.1mn annually, but the unused line fee (which ranges from 0.5% to 1.0%)  will increase.

At a pro-forma 0.5% unused line fee that will offset interest expense saved by $0.250mn, to a net of $1.850mn per annum.

Income Generating

We also know from CSWC that Media Recovery was generating $1mn a quarter in dividend income before its sale.

At first – as CSWC admitted above – that loss of income will more than offset the interest expense savings.

Before Long

Down the road – and we’re assuming no longer than two quarters – CSWC should be able to re-draw on its Revolver to invest in new yield assets.

Assuming the BDC is able to maintain its current average portfolio yield of 11.0%, the resulting investment income would be $5.5mn.

Very roughly on paper that should allow CSWC to increase investment income by $1.5mn on an annual basis.

Given that the current running rate of CSWC’s investment income is about $60mn, the incremental income will be 2.5% only.

Caveating

Moreover, it’s unlikely that CSWC will have the full $50mn to deploy.

Besides the uncertain proceeds from the earn-out; some of the monies may be diverted to distributions or spent on non-income producing equity investments.

Just the Special Distribution of $0.75 which CSWC just announced out of the blue will cost about $15.2mn.

Our analysis suggests that the ultimate additional income generated from selling Media Recovery will only modestly improve income and earnings, if at all.


VIEWS

Notwithstanding  the above conclusion, the BDC Reporter considers the sale of Media Recovery a positive step forward for CSWC which increases the value of the overall enterprise.

At a stroke, the diversification of the portfolio is poised to be greatly improved.

The monies released will allow the addition of 3-5 new  companies to a half billion BDC with just 38 companies at the moment.

This will also remove the risk of a sudden drop in the value of Media Recovery which could have seriously impacted the perceived value of the business.

Generally speaking, the BDC Reporter – and most investors  we speak to – are more comfortable with diversified portfolios than big bets on a few names, even those with outsized FMV compared to cost.

With the sale of Media Recovery – which was a legacy investment held over from when CSWC’s predecessor business model was investing principally in common stock – the BDC enters a new phase in its relatively short history as a lender.

Now, if we could just find out how the earn-out works…

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