MARKETS

As Yahoo Finance summarized neatly “Stocks touched records on Monday, with equities looking to build on gains after the S&P 500’s best month since November 2020. The S&P 500, Dow and Nasdaq each set record intraday and closing levels“. As you can also see, the Russell 2000 had quite a day: up 2.65%. November has started strongly for the major indices.

Surprisingly – given the heady atmosphere – the BDC sector did not tag along. BDCZ – the UBS-sponsored Exchange Traded Note which owns most BDC stocks – fell (0.35%) to $20.00. The more traded Van Eck sponsored exchange traded fund with the ticker BIZD – which also owns most BDC stocks – fell (0.17%) to $17.54. Trading volumes were modest.

17 BDCs eked out a price gain, 1 was unchanged and 24 were down in price. The price leader was Hercules Technology (HTGC), which has reported IIIQ 2021 results already, and jumped to $18.06. Intra-day, the venture debt BDC reached $18.20 – a new 52 week high. Apparently investors were not put off by the BDC’s slightly lower net book value per share and more impressed with its higher reported distribution. HTGC trades at a 57% premium to its current book value.

The number two highest price increase was achieved by Stellus Capital (SCM), which also reached a new 52 week high, after setting a new record las week. SCM closed at $14.11, up from $13.98.

Price-wise, though, the big news of the day was the huge one day (8.7%) drop in Capital Southwest’s (CSWC) price. The stock closed Friday at $28.23, opened at $27.40, dropped to a low of $25.60 and rallied only slightly to $25.78 at the end of the day. Volume was 7x the normal average.

This all happened just before the BDC announced its IIIQ 2021 results. This caused plenty of fluster in the BDC-ecosphere as interested parties sought to evaluate the reason for the price drop. We can’t point to anything clear-cut, but we discuss CSWC’s earnings – without the benefit of either the 10-Q or the conference call – below.

That price setback at CSWC probably accounts for the slight drop at BDCZ/BIZD, but still leaves the sector very close to its 52 week highs. Godot-like, we’ve been expecting BDC sector prices to break through their 52 week highs for weeks now. Like Vladimir and Estragon, we’ve been disappointed so far, but hopes springs eternal – or at least for a little time more. Tomorrow is another day and as the major indices stay strong, a chance for an upward price burst by BDCZ and BIZD remains.

NEWS

As mentioned above, CSWC did report results after the close. There was certainly no obvious major setbacks contained in the numbers or what was mentioned in the press release. However, there are a couple of niggling items which deserve mention, and which we’ll return to. In any case, investment income and AUM were both up versus the prior quarter. The portfolio increased from $798mn to $818mn. Revenues jumped to $20.3mn from $18.6mn, despite the absence this quarter of $0.5mn of dividend income received in the IIQ that was not replicated, and ($0.9mn) less in fees.

Expenses were higher on greater compensation and interest expense. Still, NII reached $9.7mn, up from $9.0mn a quarter before. Because CSWC has been issuing new shares under its ATM (“At The Market” program), that higher earnings number ended up leaving “Pre-Tax Investment Income” unchanged at $0.45 for the quarter.

Previously the BDC had announced that its quarterly dividend was going to increase to $0.47 from the IVQ, but the special distributions being paid would come to an end with a big $0.50 payout in the period.

Also good news: CSWC booked $3.7mn in realized gains in the period and boosted NAV Per Share by selling stock at a substantial premium to book through the ATM. However, the overall net book value per share – as reflected in the BDC: NAV Change Table – dropped from the IIQ, from $16.58 to $16.36. That was unexpected – at least where the BDC Reporter was concerned. However, this drop can be attributed to a one-time occurrence – and a “good thing” from the BDC’s point of view: the repayment on September 24 of $125mn of 2024 unsecured notes from a new debt offering. This caused CSWC to have to pay an amount “equal to the write-off of the related unamortized debt issuance costs of $1.8 million and the “make-whole” premium of $15.2 million, which was expensed in this period.

We calculate that without this expense CSWC’s NAV Per Share would have been $17.12 or 3.3% higher than at the end of the IIQ 2021.

Going forward CSWC’s borrowing cost should be significantly lower. The most expensive unsecured debt yields 4.5%, while the Revolver – following a recent renegotiation has an all-in cost of 2.3% or so and the SBIC debentures the BDC has recently issued cost just 1.58% for a ten year maturity. The sacrifices CSWC has made today will show up in materially lower interest expense and higher Pre-Tax Net Investment Income. Our very rough estimate is that the benefit might be as much as $0.15 per share per annum. (To put that into perspective, CSWC reported $1.79 in Pre-Tax Net Investment Income Per share in the fiscal year ended in March 2021).

Back to the niggles: The number of non performing “credit investments” – to use CSWC’s lingo – increased from 2 to 3 since June. The dollars involved jumped from $14.5mn to $27.2mn. Without the benefit of the 10-Q we cannot tell you more. However, we can remind you about CSWC’s troubled credits in the IIQ 2021, which we discussed at length in an article on August 30, 2021.

Also noteworthy is that CSWC’s investment in its joint venture with Main Street Capital (MAIN), called the I-45 SLF LLC dropped again in value by ($1.6mn). That’s not a huge amount but, as of the IIQ 2021, the JV’s value to CSWC was already discounted (20%). Both the managers – and the BDC Reporter – had hoped that being 6 quarters away from the worst of the pandemic – when the equity stake in the JV was discounted (42%) – we would see a continuing improvement in the value. Still, the JV paid out the same dividend to CSWC as the quarter before. The 10-Q will tell us more once available.

Looking further down the road, we have projected that CSWC will be able to pay out $1.96 a share in regular distributions five years from now. Now that the “special distribution” from realized gains is going away, the regular distribution announced annualizes at $1.88 a year, and the analyst consensus for Pre-Tax Net Investment Income Per Share is $1.95 in fiscal 2023. After this quarter’s results – and subject to a host of caveats relating to credit results and the level of LIBOR – we could see how the BDC might pay out and earn even more thanks to lower borrowing costs and additional income from incremental SBIC loans. A $2.00 a year distribution by 2026 from recurring income (setting aside whether net realized gains might also get paid out) is not out of the question.

Undoubtedly, as CSWC reached a 52 week high of $28.41, the stock has been pricey relative to prospective future earnings. At its new price of $25.78, CSWC is hardly cheap, but we could see investors pushing the price up again in the quarters or years ahead, if earnings continue to climb as we anticipate. For the moment, we’re retaining our price target of $28.91, and are projecting a decent 51% return over the next 5 years. That’s hardly outlandish as CSWC over the past 5 years – according to Seeking Alpha – has generated a 252% total return. The current yield – once the $0.50 special dividend in the IVQ has been paid – will be 7.3%. (By way of comparison Golub Capital’s (GBDC) yield is 7.4% and MAIN’s 5.8%).

In other news, Stellus Capital (SCM) – shortly after announcing IIIQ 2021 results and an amalgam of distributions to be paid in the IVQ 2021, issued a new press release promising $0.06 per share in additional distributions to occur in the IQ of 2022, and payable in 3 monthly $0.02 increments. The BDC recently increased its “regular” dividend to $0.28. This suggests SCM will pay out $0.34 at the beginning of the year and that annualizes to $1.36, the number we’ve projected for the year. If that’s correct, SCM – currently priced at $14.11 – yields 9.6%. With the analysts only projecting 2022 Net Investment Income Per Share of $1.14, a good portion of those payouts will be funded from recently achieved net realized gains.

This is what SCM’s CEO said about the prospective dividend payout just two days on the conference call:

“Looking forward, we expect to continue this $0.06 dividend each quarter for the foreseeable future. So when you combine the current dividend of $0.28 per share per quarter and the additional $0.06 per share per quarter, our shareholders will be receiving an aggregate of $0.34 per quarter of dividends. At this rate, we’ll be back to the pre-COVID level of $1.36 per year, which as a reminder there’s as 9% return on our IPO price of $15″.