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Capital Southwest: IVQ 2019 Credit Preview

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On February 3, 2020 Capital Southwest (CSWC) will be one of the first public BDCs to announce IVQ 2019 results, with a conference call to follow the next day. In preparation, the BDC Reporter – drawing on the research we’ve been undertaking on the BDC Credit Reporter – is providing a preview of which are key under-performing investments in CSWC’s portfolio, and what impact each might have on the BDC’s short and medium term performance.


Data Room

At September 30, 2019 had investments with a cost of $498mn and a FMV of $539mn.

Since quarter end, the BDC announced the sale of its largest portfolio company Media Recovery Inc. for a price “generally in line with the most recent valuation”.

See the BDC Reporter’s earlier article about the Media Recovery investment.

Netted

Net of the cost and FMV of Media Recovery, the CSWC portfolio had a cost of $493mn and an FMV of $485mn.

Debt Only

The BDC’s internal investment rating on a 1-4 scale values only debt investments, which totaled $387mn at September 30, 2019.

CSWC shows $27.6mn in the two lowest categories, which indicate under-performance.

That represented 7.1% of portfolio credit assets at FMV.

Fiscal YTD

At the beginning of the fiscal year in March 2019, the FMV of the under-performing loan assets was $21.8mn, all in category 3, representing 5.9% of the total loan portfolio at FMV. 

There have been no material realized losses in the first 6 months of the fiscal year.

However, over the past 6 months, the BDC has reported ($6.3mn) in unrealized depreciation on its overall portfolio (debt and equity). See page 74 of the 10-Q.

Non Accruals

Amongst the under-performing credits “there were 2 assets on nonaccrual with a fair value of $13.8 million, representing 2.6% of our total investment portfolio”.

One was supermarket chain AG Kings and AAC Holdings (aka American Addiction Centers), which was added in the IIIQ 2019.

Management had the following to say about its credit performance and outlook in its last Conference Call on November 15, 2019 in prepared remarks:

Overall, we are pleased with the performance of the investment portfolio as a whole. As of the end of the quarter, of the 40 loans in the portfolio at fair value, we had 3 with the highest rating of 1, representing 13% of the credit portfolio.

We had 32 loans rated at 2, representing 80% of the credit portfolio. We had 4 loans rated at 3, representing 5% of the credit portfolio. And we had 1 loan rated a 4, representing 2% of the credit portfolio.

Unlike some peers, CSWC does identify the number of loans in each investment rating category, but – as is also the BDC rule – does not expressly identify the name of the companies involved.

By this count, CSWC identified 4 loans in the under-performing categories.

Idiosyncratic ?

In answer to an analyst question asking if there was reason to be concerned about further credit issues, management said this:

Yes. No, it’s a good question. Obviously, some of the leverage metrics moving around has something to do with the new deals that were put on the portfolio, right? So that’s part of it. We have had some of our portfolio, it’s a small handful, but it’s a couple of, like you referenced American Addiction and AG Kings. So we have had some softening in certain names, no question about it. Most of it’s really more idiosyncratic on a small handful of names. Across the portfolio, I would say, EBITDA performance has softened slightly from what it was the last couple of quarters, maybe blame that a little bit on the economy. But generally, from a first lien senior secured lender perspective not — yes, disappointing in some of the company’s performance. But from an investor perspective, sitting in the first lien loan, less worrisome. But I mean, everything worries us. We’re managing the portfolio, obviously, it’s our job to worry. But generally speaking, I think the structures are working as designed.


BDC Credit Reporter’s Analysis

For our part, we have identified 6 under-performing companies at CSWC, which we’ll discuss starting with the most concerning and working backwards:

1.AAC Holdings

CSWC has invested $10.1mn at cost in this publicly traded operator of addiction treatment centers, and the debt was valued at $8.0mn at 9/30/2019.

There are two debt facilities involved: a publicly traded 2023 Term Loan, which was placed on non-accrual in the IIIQ 2019 as we’ve seen, and a smaller 2020 Term Loan, which was made more recently and was carried as current.

In the last 6 months CSWC has written its position down on an unrealized basis by ($1.6mn).

Also worth noting is that AAC is also a large position in CSWC’s I-45 JV portfolio.

High Valuation

Given AAC’s well known troubles (its stock has dropped by 99% since its heyday), CSWC’s valuation of the 2023 Term Loan has been relatively high at 80% of cost.

The BDC – and other lenders – are hopeful that the real estate assets owned by the company will provide a high pay-off should AAC’s operational turnaround fail.

Breaking News

However, there have been a number of negative developments since September 30, 2019.

First, the company’s stock has continued to drop by one-third, and is currently trading at $0.43 per share.

Second, the lenders under the 2023 Term Loan entered into a Forbearance Agreement with the company in October 2019 after a default occurred.

The extension given to AAC was till March of 2020.

However, the lenders – as is their right – prematurely ended that forbearance on January 9, 2020.

Here is the 8-K reporting the lenders change of heart:

On January 9, 2020, the Forbearing Lenders delivered to the Company notice of the termination of the respective forbearance periods under the Forbearance Agreements due to, among other things, the continuance of certain events of default under the Credit Facilities and the failure of the Company under the Forbearance Agreements to have provided the Forbearing Lenders with a three-year business plan for the Company. Due to the foregoing termination of the forbearance periods, the lenders under the Credit Facilities may now exercise any and all creditors’ remedies available to such lenders in respect of the Credit Facilities, including, without limitation, the lenders’ right to accelerate the respective maturities of, and make immediately due and payable, all amounts currently outstanding under the Credit Facilities due the Company’s continuing default of certain of its obligations thereunder.

The Company is currently negotiating with the Forbearing Lenders both potential amendments to the Forbearance Agreements that would reinstitute such lenders’ agreements to forbear from exercising their respective creditors’ remedies with respect to the Credit Facilities, as well as additional incremental funding; however, there can be no assurance that the Company will successfully consummate such amendments or receive any such funding on terms acceptable to the Company or at all.

Compounding the situation, the company’s CEO – in a related move – conditionally resigned. Here is how the resignation was expressed in another 8-K:

On January 8, 2020, Michael T. Cartwright, Chairman of the Board of Directors (the “Board”) and Chief Executive Officer of AAC Holdings, Inc., a Nevada corporation (the “Company”), delivered to the Board his conditional resignation as Chief Executive Officer. Mr. Cartwright’s resignation as Chief Executive Officer will become effective only upon (i) the Company entering into amendments to its two previously reported forbearance agreements, each dated October 30, 2019, entered into between the Company and the lenders under the Company’s two primary credit facilities and (ii) the Company receiving $10.0 million of incremental funding under the Company’s previously disclosed credit facility entered into by the Company in March 2019. Mr. Cartwright currently intends to remain as Chairman of the Board.

Also on January 8, 2020, the Board appointed Andrew W. McWilliams, the Company’s Chief Financial Officer, to serve as Chief Executive Officer, commencing upon the effectiveness of Mr. Cartwright’s resignation, as described above.

Back And Forth

This all suggests that there is some hard negotiating going on between company and lenders and anything could happen in the weeks ahead, ranging from the input of more capital and a new forbearance agreement to a restructuring or a Chapter 11 filing.

As an excellent article by the Nashville Post on the subject makes clear, the situation is pretty dire all around:

It’s not clear how much AAC — which finished its 2019 third quarter with just $1.5 million in cash and equivalents on hand — would be called upon to pay immediately should the banks call their loans. The company last fall classified more than $300 million outstanding under the 2017 credit facility as current liabilities.

Holding Firm-Ish

For what it’s worth – which may not be much – the 2023 Term Loan is quoted at trading at 75 cents on the dollar, only a couple of percentage points below the 9/30/2019 CSWC valuation.

Our Call

Our conservative view is that CSWC should not expect to collect any interest from its two debt facilities and a further write-down – and possibly a Realized Loss – is likely in 2020.

Ultimately a realized loss of up to $5mn – or 50% – of capital advanced is possible.

We are concerned about the obvious gap between the company and the lenders expectations which has the effect of increasing costs and delaying any possible restructuring or rescue.

Or, we may see another debt for equity swap which would make CSWC one of the owners but would have the effect of likely decreasing further – in the short run – any income from the position.

2. AG Kings Holdings.

This supermarket chain in the North-East has been a non-performing asset for CSWC since the IVQ 2018, and has the dubious honor of being the BDC’s first non-performing debt investment.

Currently, CSWC has $9.2mn invested with a FMV of $7.0mn, a discount of (24%).

The traded loan is currently valued at a (30%) discount.

We’ve not been able to find anything in the public record about recent developments at the company’s component chains (which includes Balducci’s and Kings Food Markets).

However, given what we’ve seen nearby at Fairway Market in New York, which just filed Chapter 11 today, we have to be worried.

Our Guesswork

Again, a range of possibilities exist for outcomes, the least likely of which is a return to performing status.

We’d guess that the BDC might have to write off half its cost, which is an additional ($2.5mn) over the current FMV.

3. American Teleconferencing Services.

This telecom company has been deteriorating in value throughout 2019.

CSWC is invested in two debt facilities: the 2021 and 2022 Term Loans and has written the $7.8mn exposure down substantially to $4.3mn.

There’s a long back story here but suffice to say the sponsor supported the company with more capital but the company remains challenged and the debt rated speculative by Moody’s in October 2019.

We’ve found no new public information in 2020, but the company could yet default or drop in value.

There may be no great valuation or income impact in CSWC’s IVQ 2019 results.  ( In fact, there may be an upgrade in unrealized appreciation).

However, this is a credit that may deteriorate later in 2020.

4. Delphi Intermediate.

This is a company that is similar to AAC Holdings, “specializing in providing chemical dependent and addiction treatment services to adults.”

CSWC booked a 2022 Term Loan to the company in IVQ 2017, which performed normally till the IIIQ 2019.

At that point, CSWC wrote the debt down (8%) and – more importantly –  downgraded the company to a 3 rating on its internal scale.

That’s the same internal category as AAC.

No other BDC has exposure and the publicly traded debt has not changed markedly in value.

The loan seems to be performing normally, but we hope to get a new read on the company, which is paying CSWC about $1.0mn in annual investment income, when the latest results are published.

5. Gauge American Nuts

This company, in which CSWC holds both debt and equity of $21.8mn, has been on our Under Performers List all year.

That’s principally because the equity has been written down from (9%) to (74%). The 2023 term debt remains valued at only a small discount to par of (3%).

Currently, that same term loan is discounted by the market (5%).

The investment income earned is equal to 8% of CSWC’s most recent Net Investment Income – i.e. material.

There’s no immediate cause for alarm, but this credit bears watching through 2020.

6. I-45 JV

We know that many BDC investors regard off balance sheet joint ventures – like the I-45 SLF JV that CSWC has with Main Street Capital (MAIN) as essentially credit invulnerable.

Typically – and I-45 is no exception – the loan assets involved are to bigger companies and spread over a diversified, lower yielding portfolio.

Nonetheless, we regularly evaluate each BDCs JV for early signs of stress.

After all, thanks to the third party borrowing used to goose returns, these are – like any other investment – subject to credit risk if enough investments go wrong.

In this case, there has been a clear deterioration in the valuation and earnings in the JV.

That’s partly – as CSWC management admitted in its most recent conference call – due to the presence of AAC Holdings amongst the borrowers, which went on non, accrual and the impact of lower LIBOR.

Analysis

However, there’s more to the story.

Besides AAC, we identified 5 additional under-performing companies (including American Teleconferencing) in the 46 borrower portfolio list.

For the quarter ended September 30, 2019 Unrealized Depreciation of the portfolio exceeded Net Investment Income and for the first half of the fiscal year the JV wrote down ($3.8mn),  4x the level in the same period in 2018.

This has shaved down the distributions from the JV when measured on a cost basis.

For the first six months of the year, unrealized losses have offset 72% of income credited to CSWC in the JV. See page 71 of the 10-Q.

We added the JV to our Under Performers List for the first time in the IIIQ 2019 with a Credit Corporate Rating of 3 on our own 5 point scale.

We project that the JV will continue to drop in value in the fourth quarter 2019 and into 2020.

There’s no risk to the current income for the moment but if this JV – or any of the others out there – accumulate enough losses the senior lenders will cease to allow pay-outs and/or require new capital contributions.

Let’s not forget as well that CSWC has invested capital at cost equal to more than 20% its equity in the JV, an even bigger number than the just realized value of Media Recovery.


CONCLUSION

One Of Many

We won’t seek to project whether CSWC’s book value will increase or decrease in the IVQ 2019.

Besides the investments mentioned above, there are many other inputs into net assets that we have not considered.

However, we do not that the valuation trend in all six companies mentioned above was down in the IIIQ 2019 over the prior period.

Our Own Assessment

We are pessimistic about the credit trend in 2020 for  the JV, AAC Holdings, American Teleconferencing and AG Kings.

On Gauge American Nuts and Delphi Intermediate, we are agnostic at this point.

The income most at risk of interruption is the small 2020 Term Loan to AAC Holdings.

At the moment, we have no reason to believe there’s any risk of income interruption from the other 4 performing borrowers.

However, we wouldn’t be surprised if there were credit problems at American Teleconferencing during 2020.

Big Picture

Overall, the number and value of stressed investments at CSWC has clearly risen in recent years.

That’s to be expected for what is essentially a relatively new lender, given that CSWC only became a yield seeking BDC in September 2015, after a spin-off from its parent.

As of March 2017, the BDC had no under-performing assets as per its investment rating system and just $10mn at the end of 2017.

Whether the increased degree of credit uncertainty is above tolerable levels will depend on each investor.

Commonality

However, the common thread amongst under-performers does seem to be – whether through the JV or on its balance sheet – to borrowers in the supposedly “safer” upper middle market.

(Anecdotally, when reviewing MAIN’s portfolio – also bifurcated between larger and lower middle market borrowers – we’ve noticed a similar phenomenal).

That may not be coincidental given  the unusually high level of co-operation between the two BDCs.

In fact, half the CSWC under-performers also have exposure by MAIN or its non-listed sister BDC: HMS Capital.

In any case, we hope this preview will provide readers some useful pointers as to what to look out for when CSWC reports its results.

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