Figured I'd share my longer write-up on CSWCL (Capital Southwest) below. Worth noting that they plan on redeeming $35m of this issue on April 3 at par...
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Capital Southwest is a business development company (“BDC”) that focuses on lower middle market businesses with <$15m of EBITDA. I will not go into detail on BDCs or how they work, as this is information that is readily available online. The business is publicly traded (“CSWC”) and has publicly traded baby bonds (“CSWCL”). The baby bonds, which are used in conjunction with a revolver to fund investments, have a 5.95% coupon and mature in December 2022.
The broad market sell-off in recent weeks has provided numerous opportunities across sectors, and one interesting space has been yield-driven investments such as BDCs. Not only have the equity markets in this space fallen off in a flight to safety, but so too have the publicly traded bonds. The high level thinking makes sense: 1. investors in fixed income funds and ETFs are selling, creating outflows and mandatory redemptions; 2. yield-based investors feel the go-forward dividends in BDCs are unsustainable; 3. BDCs are often exposed to riskier, smaller businesses that are less likely to survive the coming months.
Numerous BDCs have seen their baby bonds drop into the $15-20 range ($25 par), inferring an impaired expected recovery value between 60 and 80 cents on the dollar. For more levered BDCs, the valuation is reasonable after factoring in a 20-30% haircut to the portfolio fair value and performing a waterfall analysis. But for conservative balance sheets, such as Capital Southwest’s, the sell-off is overstated.
As of 12/31/19, Capital Southwest has $500m of investments (excluding its JV with Main Street) and $273m of total long-term debt, for an asset coverage of over 180%. Further, it’s a high quality portfolio: 74% of its assets are first lien paper and the industry exposure to coronavirus high impact areas is limited. Consumer industries, restaurants and energy represent 14% of the book. Most of its portfolio is comprised of business services, healthcare services, media, software and financial services, which are more insulated from consumer-related cyclicality. The capital structure is comprised of a $124m senior revolver and two subordinated baby bond issuances ($76m 2022 and $73m 2024).
So the crux of the analysis is this: in a performing market, these bonds will be valued at par. This clearly is not a performing market, but let’s look under the hood. As a debt investor by nature, conservatism is the name of the game. So let’s look at a few scenarios:
A 70% recovery on its first lien loans, 50% recovery on its second lien/subordinated, and 0% on equity gives us an asset fair value of $310m, plus $23m of cash, well in excess of the last debt dollar of $273m, implying a full recovery for the baby bonds.
A 50% recovery on the entirety of the portfolio yields a $273m valuation ($250m+$23m cash), or ~100cents on the dollar. This is still a premium over the current trading price of $20 per share. Moreover, this is quite a pessimistic case considering most investments are first lien and being lent at 3-4x. There aren’t too many businesses out there that, if sold, would fetch <3-4x, leading me to believe that these first lien investments would still recovery most of their principal should the underlying businesses be sold.
Precedent transaction. In 2009, Patriot Capital Funding was under significant distress and faced a capital call from its lender. It elected to sell to Prospect Capital for $197 million, or 75% of the investment portfolio fair value. This not only resulted in 100% recovery rate for the debt holders ($110.5m outstanding), but also generated returns for the equity holders!
So in short, we are looking at a 6% coupon with 25% additional capital upside over 2.5 years. That’s a 16% IRR with what I believe is minimal downside based on the cases outlined above. It would take significant fair value erosion (>50%) to the underlying investment portfolio for a loss of capital to baby bond holders.
Risk Areas:
The baby bonds are unsecured and junior to the revolver, meaning that they have fewer protections and are repaid after the revolver in any forced liquidation. There are asset coverage tests in place that could be tripped in the event of a significant portfolio mark-down. The current test is 150%, or 66.7% debt to fair value. A forced liquidation, while unlikely, could result in firesale prices below a reasonable recovery amount.
Refinance risk. BDCs rely on debt to fund investments, so there’s a risk they cannot refinance this debt when it comes due in Dec 22 if performance continues to suffer.
Manager underperformance – capital erosion from poor investment decision making over time.
Coronavirus causing a >50% haircut to portfolio.
Catalysts:
Tender offer. BDCs may issue tender offers to repurchase these notes at a discount to book an immediate realized gain if they have excess cash on hand. Prospect Capital announced one last week. While this may not provide full upside as a redemption at face, it is a potential catalyst for upside.
Upcoming 10-Q reporting in coming weeks. The FV marks for many BDCs will serve as re-pricing opportunities for their stocks and bonds.
General portfolio performance over 2020/2021. These bonds are due at the end of 2022, <3 years from now, which is a natural catalyst in itself. If they are not refinanced before then, I would expect that the price would trade back to par at some point within the next two years as the coronavirus situation plays out and its impact to fair value is known.
