Capital Southwest: Comparing 40 Big Dividend BDCs (NASDAQ: CSWC)
For many, Capital Southwest (CSWC) remains a bit of a hidden gem in the big-dividend BDC space. However, this small cap has many of the important qualities you’d like to see in a BDC (such as internal management, a strong NII, and a healthy dividend), and the growing macroeconomic risks from interest rates are already priced into a large extent. . In this report, we dive into the important details (ahead of its next earnings release on January 31), including a comparison of Capital Southwest with 40 other big-dividend BDCs. We conclude with some key points for investors.
Snapshot: Capital South West (CSWC)
CSWC is a middle market lending company focused on supporting the acquisition and growth of middle market businesses across the capital structure. The company is based in Dallas, Texas, was established in 1961 and elected to be regulated as a BDC in 1988. It is publicly traded (on Nasdaq). Best of all, Capital Southwest is internally managed (this eliminates many conflicts of interest that plague other BDCs). In addition, CSWC enjoys RIC tax treatment for U.S. federal income tax purposes, meaning it can essentially avoid corporate income tax if it pays 90% of its income in the form of dividends.
It should also be noted that in September 2015, the CSWC carried out a tax refund operation spin off of CSW Industrials (CSWI), which helped clean up the business (so it could focus on lending to middle-market businesses, instead of equity investments).
It is also worth mentioning that in April 2021, CSWC received an SBIC license from the US Small Business Administration (this provides some lending support, thereby opening up new lending opportunities that are attractive in terms of risk and reward).
Also, CSWC has only 24 employees (the company’s market cap is only around $550 million – that’s a smaller small cap), and total balance sheet assets were $867 million. as of September 30, 2021. Additionally, and importantly, CSWC also manages the I-45 Senior Loan Fund (“I-45 SLF”) in partnership with Main Street Capital (MAIN).
Equally important (given CSWC’s small size compared to some other BDCs), the company continues to achieve operational efficiencies (through its internal management structure) that continue to impact its bottom line ( as you can see in the graph below).
Capital Southwest compared to 40 other big-dividend BDCs
Before we get into more detail on Capital Southwest, it’s worth looking at some data on 40 high-dividend BDCs, including CSWC. The following tables show BDC’s material metrics, including dividend yields, recent price performance and current price-to-book ratio versus historical and return on equity (“ROE”), for n to name a few.
While the above data is valuable, keep in mind that BDCs can have very different investment strategies, which warrants significantly different valuation metrics. For example, the lowest price-to-book ratio is not necessarily the best; rather, it may be an indication of higher risk (we’ll get into CSWC’s investment strategy momentarily).
Capital Southwest Investment Strategy
The company’s primary lending business focuses on the lower middle market (“LMM”) in what it calls “CSWC led or Club Deals”. These are typically companies with EBITDA between $3 million and $20 million, and typical leverage of 2.0x – 4.0x Debt to EBITDA (via the position of indebtedness of CSWC). They take commitments of up to $30 million (with booking sizes typically $10-25 million), including sponsored and non-sponsored offers. Titles include first lien, unitranche, and second lien. And companies frequently make equity co-investments alongside CSWC’s debt.
The company’s opportunistic business focuses on the upper middle market (“UMM”) in unionized or club privileges, first and second tier. Companies typically have over $20 million in EBITDA; and typical leverage of 3.0x – 5.5x Debt to EBITDA (via CSWC debt position). Holdback sizes are typically $5 million to $15 million, including floating rate senior and junior debt securities. These types of investments are generally more liquid assets than LMM investments. And it provides flexibility to invest/divest opportunistically depending on market conditions and liquidity position.
It is important to note that Capital Southwest’s credit portfolio has a strong focus on first-tier investments, which are less risky than second-tier investments.
And the company has a strong track record of value creation, which isn’t a guarantee of future performance, but it’s still nice to see and adds confidence given the longevity of the existing management team at CSWC.
Also encouraging, CSWC continues to be active in both investment originations and exits, a sign of healthy market conditions and opportunities for the company. For example, in the last quarter, CSWC had $112.9 million in new investments committed to six new portfolio companies and four existing portfolio companies, and $60.9 million in total proceeds from the exit of six companies. of portfolio.
The record of consistent dividends continues
Another encouraging feature of Capital Southwest is its history of consistent and healthy dividends. For example, in the last 12 months (ending 9/30/21), CSWC generated $1.85 per share in pre-tax NII and paid $1.70 per share in regular dividends. Additionally, the NII’s cumulative pre-tax regular dividend coverage has been 107% (over 100% is a good thing) since the 2015 spin-off. $ per share since the 2015 spin-off. Additionally, there was undistributed taxable income (“UTI”) of $0.69 per share as of September 30, 2021.
Interest rate risk
The big macro risk that worries investors in almost every market right now is interest rate risk. Specifically, the US Fed is on track to begin raising interest rates in March (with 3-4 hikes expected this year) while simultaneously slowing quantitative easing bond purchases in the open market. This increasingly hawkish stance by the Fed has had the effect of spooking equity investors as markets have fallen significantly so far this year. This is also of concern for Capital Southwest’s business, as debt (borrowing) is affected by interest rates and is at the heart of everything Capital Southwest does.
Here is a snapshot of the company’s estimate of its sensitivity to changes in interest rates.
As you can see above, CSWC is negatively impacted by rising interest rates as it is slightly more exposed to floating rates on the expense side than on the revenue side. However, given the recent drop in CSWC’s share price, expectations of higher interest rates are already largely anchored in equities. If the Fed becomes slightly more dovish on rates, it could have a negative impact on CSWC stocks, but if the Fed becomes slightly more dovish, it would be a plus for stocks. This is typical of financial companies, such as CSWC. It should also be noted that CSWC is even more sensitive to credit spreads than to interest rates, as the portfolio is made up of higher yielding (higher risk loans). So in a volatile market, where credit spreads are widening, CSWC would like to sell (probably temporarily), but the dividend would likely remain constant, as it has throughout its history.
When it comes to valuation, BDCs often trade in conjunction with their book value. In the case of CSWC, the valuation rose after the 2015 split, and it has recently retreated as interest rate expectations have risen while credit spreads have remained low/healthy.
If you’re looking for a hidden gem of a BDC, Capital Southwest is worth considering. It’s smaller than many BDCs, which arguably rules out the “economies of scale” benefits that larger companies enjoy. However, this is significantly offset by the lower costs of its attractive in-house management team, as well as its small business license (something that may move the needle for a smaller BDC, but not a larger one). The strength of the portfolio and a healthy dividend are also very encouraging, and the recent drop in the share price provides an even more attractive entry point. Depending on how the January 31 (post-trade) earnings announcement plays out, this is worth considering for a place in your carefully diversified long-term investment portfolio.