Capital Southwest: 10.7% Yield on Strong Floating Rate Loan (NASDAQ:CSWC)

James Bray

Articles: Well-Managed Sources of High Income

Capital Southwest (NASDAQ:CSWC) A Business Development Company (“BDC”) based in Dallas, Texas, provides senior loans to a variety of mid-market businesses across the United States.

Broader despite recent sales CSWC reported a strong performance in the second quarter of 2022, demonstrating the resilience of its holdings and the benefits of its overwhelming variable rate loan portfolio.

Given that only 0.9% of the entire portfolio has occurred and other indicators show no signs of deterioration in the underlying company’s financials, CSWC believes that investors should be able to secure a dividend yield of 10% or more. looks like an excellent method. Interest rates will continue for some time.

Review of Capital Southwest

CSWC offers senior-level loans primarily targeted at lower middle-market companies with an EBITDA of $3 million to $20 million and a leverage ratio of 2x to 4x (including CSWC’s loans). Including some mid-market loans, for which CSWC permits higher leverage ratios, BDC’s weighted average portfolio company debt to EBITDA is 4.1x.

CSWC loans typically range in size from $5 million to $35 million (with an average holding size of $12.9 million) and have terms of two to four years. In addition, CSWCs often also own portfolio holdings, enhancing alignment of interests. Approximately 10% of total investment is in equities.

Portfolio of CSWC

CSWC November presentation

As the loan portfolio grows, so does the percentage of first mortgages. This is the highest priority debt in the capital stack and therefore one of the safest forms in terms of downside recovery. Currently, 94% of CSWC’s loan portfolio is first lien loans.

CSWC First Lien Investment

CSWC November presentation

Importantly, the majority (virtually all) of CSWC’s loans are variable rate. So with each successive Federal Reserve interest rate hike, more and more interest income.

CSWC interest rate sensitivity

CSWC November presentation

The Fed rate hikes by the end of September are already showing up in CSWC performance. The weighted average yield on fixed income investments rose from 9.3% in the quarter ending June to 10.6% in the quarter ending September.

Here, CSWC and Houston-based Main Street Capital (major). MAIN has a lower payout ratio in order to retain more cash and increase its net asset value per share, while CSWC is able to attract shareholders with higher income by paying almost all of its cash flow. choose to reward

MAIN’s NAV per share history looks like this:

Key NAV per share

Main November presentation

CSWC’s NAV per share is much flatter:

CSWC loan

CSWC November presentation

So MAIN is more of a total return investment, whereas CSWC is primarily an income investment. As long as CSWC continues to trade at a premium to NAV, shares can be issued for incremental growth. But don’t expect the stock to rise much above 150% to 160% of NAV.

CSWC is currently trading at around $19.40, at a premium of around 17% to NAV. This is significantly lower than the 60%+ premium traded a year ago, but higher than the 10%+ premium. discount To the NAV traded by CSWC in the early stages of the COVID-19 pandemic.

As such, we recommend purchasing CSWC as close to NAV (or at a discount to NAV) as possible. It’s mostly about income.

However, even with almost all NII paid out as a regular dividend, CSWC has managed to slowly raise its quarterly dividend over time, from $0.28 in early 2018 to $0.52 today.

Dividends of CSWC

CSWC November presentation

There are basically three classes of payouts in CSWC: regular, extra and special. Regular is about 95% of the average NII. Complementary is the combination of retained cash and “spillovers” from successful portfolio exits and cash on hand. Finally, the occasional special payout comes from ripple effects that accumulate over time.

However, this is not possible without strong underwriting and investment success. Fortunately, CSWC has a strong track record in this sector.

Since 2015, CSWC has achieved a cumulative IRR of 14.7% across 66 portfolio company exits.

That doesn’t mean it doesn’t have the occasional stench. For example, in the latest quarter, CSWC closed his 1 second lien loan at his IRR -5.8%. However, CSWC also closed two first lien loans during the quarter with his IRR of 11.4% and 19.4%, resulting in a weighted average IRR of 10.1% for the quarter.

Second quarter financial results (closing September 30)

In its most recent reported quarter (the second quarter of the fiscal year ending September), CSWC reported a pre-tax net investment income of $0.54. In fact, management has shown confidence in the sustainability of higher NII by raising its regular dividend to $0.52 per quarter.

Additionally, at the end of the quarter, CSWC had undistributed earnings of $0.33 per share. This retained pool of cash will fund BDC’s additional dividend payments. For this December, management declared him an additional dividend of $0.05.

One of the reasons for our optimism that we will continue to be able to cover the increased dividend is likely due to the performance of our loan portfolio. CSWC quality rating scale from 1 to 4, where 1 is ‘Performing above expectations’, 2 is ‘Performing as expected’, 3 is Watchlist, 4 is ‘Performing below expectations’ or not met and feeling safe give Note that 97% of the portfolio performed as expected or better.

CSWC Credit Portfolio Quality

CSWC November presentation

This was an improvement in valuations from the end of the previous quarter.

CSWC ended the quarter with $139.4 million in credit facilities and an additional $30.2 million in cash (approximately 2.7% of the value of CSWC’s investment portfolio).

Additionally, BDC has no debt maturities until 2026 and its regulatory obligations on capital have decreased from 1.23x at the end of 2021 to 1.11x.

Overall, CSWC exudes quality and conservatism, both from an investment portfolio and balance sheet perspective.

Conclusion

Based on a regular dividend of just $2.08 per year, CSWC currently offers a dividend yield of 10.7%. Its dividend payout rate is around 96%, buffered by a quality investment portfolio, relatively low leverage, and strong liquidity.

At a premium to NAV of around 17%, CSWC still looks affordable today. Personally, at a premium of over 20% ($19.84) he probably wouldn’t buy CSWC. So that’s my own “buy under” price.

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