Capital Southwest (CSWC) has a long and storied history, dating back to the early 1960’s. However, the company switched to BDC status only in 1988 and even then with a focus on equity investments in private companies. Finally, on September 15, 2015 a spin-off occurred of the company’s investment portfolio, leaving CSWC to carry on as a leveraged lender and investor. From the outset till today, the BDC has been internally managed, one of the few left. Bowen Diehl has been the CEO since the BDC’s rebranding as a leveraged lender, coming from the senior ranks of the now departed but once dominant American Capital. The rest of the senior management team arrived at about the same time, providing a stable group to build up the public BDC. From the outset – and in apparent blatant imitation of Main Street Capital – the business strategy has been to operate in both the lower middle market and in the upper middle market. In the former, CSWC seeks to lead loans and take equity positions in relatively small businesses, charging relatively high yields and hoping to benefit from eventual exits. In the latter segment, CSWC participates in much larger loans to much larger companies led by other institutions. Yields are lower but there is a bigger universe of potential borrowers and the investments are relatively liquid, if need be. In addition, the BDC has joined with Main Street – who else ? – in an off balance sheet joint venture focused on booking larger loans where CSWC is the enthusiastic junior partner. Like most every other BDC, CSWC has adopted the higher leverage rules allowed by the Small Business Credit Availability Act but has promised not to exceed debt to equity of 1.50x. So far, CSWC but has not yet got even close to reaching that self imposed ceiling. In a way, CSWC is a very young BDC and for its first few years in business had no credit losses, or even many unrealized write-downs. Furthermore, one major equity investment left over from its prior identity accounted for a disproportionate amount of its half a billion dollar portfolio. In a case of great timing, CSWC sold the business for a very great profit just before Covid-19 struck. However, as the years have gone by reality has set in and the BDC has faced – as all lenders do to varying extents – underperforming investments. As has happened with Main Street Capital, these are – ironically – principally concentrated in the supposedly “safer” larger loan group and in the JV. The Covid-19 crisis will be the first major challenge to the BDC’s credit underwriting in both segments. If CSWC is able to muddle through without too much damage, the outlook for the BDC is promising and should allow Bowen Diehl and Co to become a billion dollar BDC. Already, CSWC has received the promise of SBIC debenture funding (2% money !) and is a popular Baby Bond issuer, even attracting institutional investors – unusual for a BDC of this size. Current funding is neatly divided between secured and unsecured; providing healthy liquidity and the portfolio grows ever more diversified with every quarter. CSWC is doing most everything right except – perhaps – for its upper middle market lending which may prove an Achilles Heel. Credit skills will be the deciding factor going forward as most everything a BDC needs to be successful is already in place: a tight management team; a clear cut strategy ; ready access to both the secured and unsecured markets and sufficient liquidity to be a player whenever opportunity knocks.
CSWC has announced an unchanged payout through September 2020, a feat only about half the BDC universe has managed to pull off. We are projecting that the current $2.04 annual dividend – which consists both of a regular distribution of $0.41 per quarter and a special dividend of $0.10 representing capital gains already booked – will need to be reduced by (20%) two years out as credit losses from the Covid-19 crisis begin to erode earnings. That will drop the dividend to $1.6320 for the remaining period. As a terminal price, we’re assuming that CSWC will be valued at 12.5x its reduced dividend level – which should be close to earnings per share. Of course, results could be much worse or much better. On the positive side, if the BDC is able to duck a dividend reduction and is able to grab an SBIC license and occasionally book an equity gain when lower middle market companies are sold, earnings could even go higher than the current level. When we ran a Best Case scenario, the total return over 5 years was almost twice as high as what we’ve projected in the Expected Return Table. For the moment, though, we’re sticking with a modest pullback followed by earnings and dividend stability.
Click here for the Expected Return Table.