Capital Southwest: If You Missed Main Street Capital, Then Look At This 7% Yielder

Summary

Capital Southwest is an internally-managed BDC with similar attributes to Main Street Capital.

It has a strong track record of shareholder returns and is seeing improving operating leverage as it scales up.

CSWC has robust dividend growth, and the recently declared special dividend contributes to the total return story.

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MarsBars/E+ via Getty Images Hindsight is 20/20 as the saying goes, and this applies to investing, too. In the BDC space, those who got in on Main Street Capital ( MAIN ) early and often can give themselves a pat on the back. As I noted in my recent article , MAIN is a money minting machine, and I don’t foresee that changing anytime soon.

Valuation matters, however, even for high quality BDCs. In this article, I’m focused on the relatively newer BDC upstart, Capital Southwest ( CSWC ), which is smaller but has similar attributes to MAIN. I highlight what makes CSWC a good Buy for those investors looking for a well-managed alternative, so let’s get started. Take A Look At This 7% Yielder

Capital Southwest is a BDC that like Main Street Capital, is also internally-managed and based in Texas (city of Dallas). However, it’s comparatively smaller than MAIN, as it currently just has $818M worth of investments at fair value, with focus on lending to middle market businesses with $5-25M investments across their capital stack.

Notably, CSWC partners with MAIN to manage the I-45 Senior Loan Fund. For reference, I-45 is the interstate highway that runs from Dallas to Houston, where MAIN is headquartered. CSWC maintains a prudently managed portfolio comprised primarily of first lien secured debt, representing 84% of its portfolio (including I-45 SLF), with the remaining 16% comprised of second lien secured (6%), subordinated debt (2%) and equity (8%), which gives it a growth kicker.

CSWC also maintains a well-balanced portfolio that resembles the easy-to-understand and economically essential industries that MAIN invests in. As seen below, healthcare, business services, media, and consumer products make up CSWC’s top 4 industries, representing 38% of CSWC’s portfolio fair value. (Source: Investor Presentation )

CSWC also has a strong track record of shareholder returns. Based on the current NAV/share of $16.36 and cumulative dividends paid of $9.96, CSWC has provided investors with a 49% return on investment since inception, as seen below. (Source: Investor Presentation)

While NAV/share did decrease in the latest quarter, it has more to do with realized losses on extinguishment of debt rather than weakness in the underlying business. I don’t see this retirement of debt as being a negative for CSWC, as it enables the company to refinance at a lower rate, thereby saving on interest expense. This, in turn, enabled CSWC to increase the regular dividend by 6.8%, as elaborated by management during the recent conference call : The company’s NAV per share as of September 30, 2021, was $16.36 as compared to $16.58 at June 30, 2021, representing a quarter-over-quarter decrease of 1.3%. The main driver of the NAV per share decrease was $17.1 million in realized losses on the extinguishment of debt on the full prepayment of our 5.375% note due October 2024. The realized loss consists of a make-whole premium payment of $15.2 million as well as the write-off of related unamortized debt issuance costs of $1.9 million. The refinancing of these notes with a new 5-year 3.375% issuance significantly reduces our cost of capital and increases our annual net investment income run rate by approximately $0.10 per share on a risk-free basis. This was the primary catalyst for our decision to increase the regular dividend by $0.03 this quarter from $0.44 per share to $0.47 per share. We believe this considerable increase in earnings power enhances our market capitalization on a dividend yield basis and allows us to pass the cost of capital savings directly to our shareholders in the form of increased dividends. Meanwhile, CSWC maintains a healthy 9.7% weighted average yield on its credit portfolio. It’s also well-prepared for a rising rate environment, as 96% of the credit portfolio is on floating rate. I’m also encouraged by CSWC’s improving operating leverage as it continues to scale up.

As seen below, CSWC’s total assets has grown by 205% since FY 2016, and at the same time, its operating expenses as a percentage of total assets has declined from 4.9% to 2.3%. While this is still above MAIN’s industry-leading 1.5% operating leverage, management has stated […]

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