Golub Capital BDC - Earnings Call - Q3 2021

Transcript

Speaker 0

Welcome to GBDC's 08/10/2021 Quarterly Earnings Conference Call. Before we begin, I would like to take a moment to remind our listeners that remarks made during this call may contain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements other than statements of historical facts made during this call may constitute forward looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward looking statements as a result of a number of factors, including those described from time to time in GBDC's filings with the SEC. For materials the company intends to refer to on today's earnings conference call, please visit the Investor Resources tab on the homepage of the company's website, www.g0lubcapitalbdc.c0m, and click on the events presentations link.

GBDC's earnings release is also available on the company's website in the Investor Resources section. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to David Gallup, Chief Executive Officer of Gollop Capital BDC.

Speaker 1

Thanks, operator. Hello, everybody, and thanks for joining us today. I'm joined by Ross Tunney, our Chief Financial Officer Gregory Robbins, Senior Managing Director and John Simmons, Managing Director. Yesterday afternoon, we issued our earnings press release for the quarter ended June 30, and we posted an earnings presentation on our website. We'll be referring to that presentation throughout the call today.

For those of you who are new to GBDC, I want to briefly describe our investment strategy. Our investment strategy is, and since inception, it's been to focus on providing first lien senior secured loans to healthy, resilient middle market companies that are backed by strong partnership oriented private equity sponsors. The headline for the quarter ended June 30 is that GBDC's results were very strong. GBDC had solid net investment income, continued strong credit performance and robust new deal activity. We'll be discussing each of these topics in greater detail as we go through today's presentation.

Gregory is going to start by providing a brief overview of GBDC's performance for the June 30 quarter, and then we'll hand it off to John and Ross for a more detailed review of those results. I'll then provide some closing commentary, and then we'll open the line for questions. With that, let's take a closer look at GBDC's results for the quarter and the key drivers of those results. Gregory?

Speaker 2

Thank you, David. Turning to Slide four for the quarter ended June 30, GBDC's adjusted NII per share was $0.29 adjusted EPS was $0.49 and ending NAV per share was $15.06 The key drivers of those strong results are summarized on Slide six. Two key themes I want to highlight. First, our portfolio continued to perform well. Golub Capital Middle Market Report, or GCMMR, for June 30, which we published about a month ago, reflected this strength.

The GCMMR normally looks at year over year revenue and profit growth of Golub Capital middle market borrowers, but our approach for June 30 was a bit different. We didn't think year over year comparisons were particularly informative as they would be comparing the lockdown economy of April and May 2020 to the booming economy of April and May 2021. We thought it would be more informative to compare 2021 to the pre COVID economy of April and May 2019. And the results are striking. The median EBITDA growth from 2019 to 2021 exceeded 30%.

Strong earnings growth across GBDC's portfolio was reflected in the four positive credit quality trends listed on the right hand side of the slide. We'll go into them in more detail shortly. Second, middle market new deal activity was strong. The quarter ended June 30 was a new record for Golub Capital origination volume. You may recall that the quarter ended 12/31/2020 was a record breaker at the time, but we beat that record by 30% in the June.

While the impact on GBDC's portfolio growth was muted by elevated repayments in the June, we think the key takeaway is that GBDC is delivering strong originations amidst a robust M and A environment by leveraging the competitive advantages of the Golub Capital platform. Let's now drill down on the four positive credit quality trends listed on the right hand side of the slide, starting with our internal performance ratings. Slide seven summarizes the positive trends in the internal performance ratings of GBDC's portfolio in the post COVID period. Two key trends continued through the quarter ended June 30. First, portfolio companies performing materially below expectations in categories one and two remain very few in number.

Those two categories constituted only 1.1% of the portfolio at fair value at quarter end. We've also seen continued upward migration in credit quality, a steady increase in categories four and five. Those are loans performing at or better than our expectations at underwriting, and a corresponding decrease in category three. Those are loans that are performing or expected to perform below expectations. Specifically, in the quarter ended June 30, categories four and five increased from 86.9% of the portfolio as of 03/31 to 89.4% of the portfolio as of June 30, an improvement of 13.4 percentage points year over year.

Category three decreased from 12% of the portfolio as of threethirty one to 9.5% of the portfolio as of sixthirty. A portion of the portfolio rated three as of sixthirty was right in line with our pre COVID normal of around ten percent, as you can see from the fiscal year end 2018 and 2019 data at the far left of the slide. The second key indicator of continued credit improvement is the fact that nonaccruals remained very low, just one percent of investments at fair value at quarter end. The nonaccrual rate was unchanged quarter over quarter, but about 50% lower year over year. We'll come back to this point in our usual discussion of GBDC's financial results.

Slide eight shows two other indicators of improving credit quality, net realized gains and net unrealized gains. This slide provides a bridge from GBDC's $14.86 NAV per share as of 03/31 to its increased $15.06 NAV per share as of 06:30. Let's walk through the bridge. Adjusted NII per share was 29¢, in line with our quarterly dividend. No net realized losses were recorded during the quarter.

In fact, there were 3¢ per share of net realized gains, and net unrealized gains were $0.21 per share, excluding the purchase premium adjustment, reflecting the continued reversal of unrealized losses incurred in the March 2020 quarter. In fact, on a price basis, 90% of the unrealized losses recorded in the quarter ended 03/31/2020, have been recovered as of 06/30/2021. Finally, Slide nine shows that the continued strength and quality of GBDC's portfolio enabled us to further optimize the company's debt capital structure post quarter end. On 08/03/2021, GBDC completed its third unsecured bond offering. The $350,000,000 issuance of new unsecured notes mature in February 2027 and have a fixed interest rate of 2.05%, the lowest coupon ever achieved by BDC at the time.

Pro form a for the August offering, unsecured debt represents approximately 50% of GBDC's debt capital stack. You can see from the chart on the right hand side of the slide that GBDC is expected to have no contractual debt maturities until 02/2024, and the vast majority of GBDC's funding matures in 2025 or later. In short, we believe GBDC's balance sheet is stronger and more flexible than ever. Let's now take a closer look at our results for the quarter ended June 30. And for that, let me hand the call over to John Simmons to walk you through the results in more detail.

John?

Speaker 1

Thanks, Gregory. Slide 11 summarizes our results for the quarter ended June 30. You can see in the column on the right that adjusted NII per share was in line with our quarterly dividend and that our credit results remain strong as GBDC generated $0.20 a share of adjusted net realized and unrealized gains. As a result, our net asset value per share at 06/30/2021, increased to $15.06 On August 6, our Board declared a quarterly distribution of $0.29 a share payable on 09/29/2021, to stockholders of record as of 09/08/2021. Turning to Slide 12.

New investment commitments totaled $614,700,000 for the quarter ended June 30. After factoring in total exits and sales of investments of $583,500,000 as well as unrealized appreciation and other portfolio activity, total investments at fair value increased by 1% or $44,300,000 during the quarter. As Gregory noted, originations this quarter were strong while repayments were also elevated. As of 06/30/2021, we had $45,400,000 of undrawn revolver commitments and $171,900,000 of undrawn delayed draw term loan commitments. These unfunded commitments are relatively small in the context of GBDC's large balance sheet and strong liquidity position.

As shown on the bottom of the table, the weighted average rate on new investments and spread over LIBOR on new floating rate investments each increased slightly quarter over quarter. Slide 13 shows that GBDC's portfolio mix by investment type remained consistent quarter over quarter with one stop loans continuing to represent 80% of the portfolio. Slide 14 shows that GBDC's portfolio remained highly diversified by obligor with an average investment size of less than 40 basis points. As of June 30, ninety 6% of our investment portfolio remained in first lien senior secured floating rate loans and defensively positioned in what we believe to be resilient industries. Turning to Slide 15.

This graph summarizes portfolio yields and net investment spreads for the quarter. Focusing first on the light blue line, this line represents the income yield or the actual amount earned on our investments, including interest and fee income, but excluding the amortization of upfront origination fees and the GCIC purchase price premium. The income yield decreased by 10 basis points to 7.4% for the quarter ended 06/30/2021. The investment income yield, or the dark blue line, which includes the amortization of fees and discounts, also decreased by 10 basis points to 7.9 during the quarter. Our weighted average cost of debt, or the aqua blue line, decreased by 20 basis points to 2.8%, primarily due to the early redemption of $165,000,000 in higher priced SBIC debentures in the prior quarter.

Our net investment spread, the green line, which is the difference between the investment income yield and the weighted average cost of debt, increased by 10 basis points to 5.1%. With that, I'll hand the call over to Ross to continue the discussion of our quarterly results. Ross?

Speaker 3

Thanks, John. Looking to the next two slides, nonaccrual investments as a percentage of total debt investments at cost and fair value remained low and consistent quarter over quarter at 1.41% respectively as of June 30. During the quarter, the number of non accrual investments remained unchanged at six portfolio company investments. As Gregory discussed in his opening commentary, as a result of continued strong portfolio company performance, the percentage of investments rated three on our internal performance rating scale decreased to 9.5% of the portfolio at fair value as of June 30. As a reminder, independent valuation firms value at least 25% of our investments each quarter.

Slides eighteen and nineteen provide further details on our balance sheet and income statement as of and for the three months ended June 30. Turn to Slide 20. The graph on the top summarizes our quarterly returns and equity over the past five years, and the graph on the bottom summarizes our regular quarterly distributions as well as our special distributions over the same time period. Turning to Slide 21. This graph illustrates our long history of strong shareholder returns since our IPO.

As illustrated, investors in GBDC's 2010 IPO have achieved a 10% IRR on NAV since inception. Slide 22 summarizes liquidity and investment capacity as of June 30, which remains strong with over $800,000,000 of capital available through cash, restricted cash and availability in our various credit facilities. We also highlight our continued progress in optimizing the right hand side of the balance sheet. Three key highlights here. First, on 04/13/2021, we amended our revolving credit facility with Morgan Stanley to, among other things, extend the reinvestment period to 04/12/2024 from 05/03/2021, extend the maturity date to 04/12/2026 from 05/01/2024 and reduce the interest rate on borrowings to one month LIBOR plus two point o 5% from one month LIBOR plus 2.45%.

Second, on July 16, we issued a notice of redemption to redeem all of the 189,000,000 of notes issued under the 2020 debt securitization, which are priced at three month LIBOR plus 2.44%. This redemption is expected to occur on 08/26/2021. And third, as Gregory mentioned earlier, on August 3, we issued 350,000,000 of unsecured notes, which bear a fixed interest rate of two point o 5% and mature on 02/15/2027, bringing unsecured debt up to approximately 50% of GBDC's total funding mix. Slide 23 summarizes the terms for our debt capital as of June 30. And lastly, slide 24 summarizes our recent distributions to stockholders.

And most recently, our board declared a quarterly distribution of 29¢ per share payable on 09/29/2021 to stockholders of record as of 09/08/2021. With that, I'll turn it over to David for his closing remarks. David?

Speaker 1

Thanks, Ross. To sum up, GBDC had a very strong quarter. Adjusted NII matched our dividend, realized and unrealized gains were substantial, and robust new origination enabled the portfolio to grow despite unusually high payoffs. Let me talk about our outlook, and then I'll take your questions. The headline is the same as last quarter.

We're cautiously optimistic. I'll start with why we're cautious. We've been concerned about COVID variants for some time. You've heard us talk about this in our last two earnings calls. As much as we'd all like to put this tragic pandemic behind us, it seems we're far from done with hundreds of millions of COVID cases around the globe, eighty five percent of people worldwide not yet fully vaccinated, and the possibility of more mutations.

That said, there are also reasons for optimism. We believe GBDC is prepared for this environment that we're in right now and has a set of powerful tailwinds. I'll focus on three. We've spoken about them before, but they bear repeating. The first tailwind is GBDC's strong portfolio performance.

We've highlighted throughout today's presentation the positive credit trends since 03/31/2020. Our pre COVID underwriting has proved to be strong. Realized and unrealized gains and losses for the eighteen months from 01/01/2020 through 06/30/2021 have netted to a loss of only $7,000,000 or 0.16% of the portfolio at cost. That's an annualized loss rate of less than 11 basis points. And as Gregory described, the portfolio today has very low nonaccruals and minimal Category one and two loans.

So it's apparent we're not going to be distracted by needing to play defense on a troubled portfolio. A second tailwind is the attractive opportunity set before us. Two of the last three quarters set new records for Golub Capital origination. All signs are pointing to robust middle market M and A activity in the second half of the year. While it's too early to tell if we'll set another record before year end, we think Dollar Capital is capturing more than our fair share of attractive deals.

The competitive advantages of leading lenders have grown stronger through this COVID period, advantages like scale and sponsor relationships, incumbencies, breadth of solutions, industry expertise, and reputation for reliability. We believe GBDC has a compelling opportunity to grow its portfolio in this environment without compromising on credit quality. And finally, a third tailwind. The third tailwind is that GBDC has ample liquidity and flexibility to capture opportunities. We've achieved our goal of substantially increasing the proportion of unsecured debt in GBDC's funding mix while keeping our cost of debt very low.

Unsecured debt is now about 50% of our debt stack, and we believe GBDC has among the lowest unsecured funding costs of any BDC. GBDC's debt stack is well diversified, long term, low cost and highly flexible. We're currently operating at the low end of our target leverage range of 0.85 to 1.15x debt to equity, and we think we have room to operate closer to the high end of that range in the coming quarters, which would help drive even stronger earnings power for the company. Thank you, operator. Please open the line for questions.

Speaker 0

Your first question comes from the line of Finian O'Shea with Wells Fargo Securities.

Speaker 4

Hi, good afternoon. First question, David, on the comments you were just touching on, on the market opportunity and your market share, which remains very strong. Can you go specifically into the the comeback of these larger private, you know, $12,000,000,000 transactions? You know, last last time around before COVID, you were, you know, the obvious ringleader in in in these, especially on a senior basis. And, you know, this time around, there's a couple more couple more big players in in those as I'm sure you're familiar with.

So how do you feel that, you know, your market share and and competitiveness in terms of underwriting is is holding up? And then as as a second part there, how much of challenge is that? Do you think that paper is much better than the core middle market paper? Or is it less of a challenge to the Golub platform?

Speaker 1

Sure. Thanks, Fin. Thanks for your question. So by way of context for we at Golub Capital, we underwrite loans that range in size from 10,000,000 or $20,000,000 at the low end up to multiple billions. As you pointed out, Fin, we've been a market share leader in what we call mega one stops, which are $500,000,000 and up one stops since those really began to be on the scene in 2019.

Mega one stops remain a relatively small portion of the overall mix of what we do. The predominance of what we do is financing companies that generate between $20,000,000 and and and $50,000,000 of EBITDA, those are not companies where a a mega one stop would be appropriate. In the last quarter, we closed 95 separate loans, representing a bit more than the $9,000,000,000 in total commitments. So if you just do the math on that, you can quickly calculate that our average loan size is in the approximately $90,000,000 range. Over the course of the last couple of years, we've seen, and as you pointed out, Fin, we've been a pioneer in expanding the role of private debt in larger sized transactions.

And I've said previously that there are a couple of key drivers of that phenomenon. One is that sponsors increasingly are looking at buy and build transactions, transactions where they're building a company over time through acquisitions as a means of of creating a company of great scale and of great promise. They're not just doing financial engineering anymore. They're looking at creating great companies in large measure through acquisition strategies. The broadly syndicated bank loan market is not an extremely efficient way of financing a company that's doing serial acquisitions.

What many sponsors have found is that using a one stop and a series of of either delayed draw term loans or serial expansions of that one stop can be a more effective way of of financing their their portfolio company that's that's doing serial acquisitions. Until relatively recently, that large scalable one stop was not on the menu. It wasn't one of the choices that a sponsor could choose from, if they were looking at financing a company that had loan needs in excess of $500,000,000. That's now changed. And, as you point out, in the last six months or so, we've seen transactions as high as $3,000,000,000 being pursued by private market, by direct lenders.

And we're not alone in this. We're still among the market leaders, but there are a number of very large players who are also capable of playing in this arena. My view is that the MEGA One Stop product is a great option for sponsors. It is not always a great opportunity for direct lenders. We we here, just as we are in smaller loans, we need to be very selective.

We need to make sure that we're backing really good companies, that the terms and and conditions of the loans, that the the pricing of the loans are attractive relative to other options that we have. So we're we're always gonna be evaluating the relative attractiveness of different niches within direct lending that we operate in. And we're purposefully going to be moving around as we see best opportunities arise in in one area, one industry sector, one geography versus versus others. And I think that's what we've been doing over the course of recent months.

Speaker 3

That's helpful. Thank you. And just a follow on on the equity co investment. Looks like it it out of this quarter. I guess, versus historical.

And, you know, given you're able to earn your dividend at such a low rate of leverage, one might one might say that you have to put you have the ability to straighten the bat much more often on on equity co invest. So any thoughts on on on the above there?

Speaker 1

We've been pretty consistent in our percentage of the portfolio that's in equity co investments. If you look at Page 13 of our investor presentation, it's been in the 2% to 3% range for an extended period of time. I think that you can reasonably expect that we're going to continue to grow the portfolio, that we're going to move our debt to equity ratio from where we are now, which is at the low end of our range, more toward the middle or higher end of our range, I don't anticipate a meaningful change at this point in the mix that we're going to see. Of course, that's always subject to change based on market conditions, but that's my expectation now. Your

Speaker 0

next question comes from the line of Paul Johnson with KBW.

Speaker 5

First, I know you guys were just slightly below the low end of your hurdle rate this quarter and therefore did not earn the incentive fee. I'm just curious, are you okay with, I guess, operating around that area kind of right at or even below the low end of your hurdle? Or would you is the goal to essentially generate a an ROE that's maybe above that 8%? I'm just trying to get your thoughts around around the the hurdle rate.

Speaker 1

Yeah. I I think this quarter was a bit of an anomaly because the degree of repayments was as high as it was. My expectation, as I mentioned, is that we're going to see growth in the size of the portfolio. That, in turn, will grow net investment income and will give us more pre incentive fee net investment income. I think when we look back backwards, we'll see this quarter as a bit of an anomaly in in the respect that you're mentioning.

I think it's good for shareholders if we can operate in or above the catch up as opposed to below the catch up, provided we can do so without taking too much credit risk. Right now, I think we can do that.

Speaker 5

Great. Thank you. Thanks, David. That's very helpful. And then just one on your your software lending portfolio.

It's, you know, I think 26% or so, I think, from the slide deck of your portfolio. I'm just maybe trying to get your thoughts on how you guys view that market today, how you guys view that sort of competitive landscape. Obviously, we've seen a lot of growth in popularity of that type of lending. So is there anything that you guys see differently today maybe versus, several quarters ago? Or what are you looking out for, in the new deals that you evaluate there today?

Speaker 1

Sure. Again, let me just provide some context. So we've been leaders in software lending to sponsor backed companies for more than a decade. I think we have a larger portfolio and more transactions under our belt in this sector than any of our competitive brethren. It's an area where we have very strong sponsor relationships, very strong incumbencies because of the portfolio that we've built and very strong expertise.

We have a group within our underwriting team that specializes in software lending. We think we're very good at it. Our results over time in software have been outstanding. And we think that it's a robust area for future opportunity. I think your statement's fair that we're seeing somewhat more competition in the software area than we did years back.

But the flip side is also true that the private equity ecosystem, the component of that ecosystem that's software companies continues to grow. And so we continue to find very attractive opportunities in the software space. We really haven't changed our approach in any meaningful way. We continue to be focused on really high quality companies with mission critical software tools that have been well integrated and are difficult to rip out of their clients with high recurring revenue streams and high renewal rates. The same sorts of underwriting criteria that we started out investing in the industry with more than ten years ago.

Speaker 5

Got you. And then my last question was just, again, your thoughts around the market, for one stop unitranche loans versus maybe the the senior loan, you know, first lien, traditional, first lien, second lien structure. What we've kind of seen, the returns have compressed over time, obviously, in the in the unitranche market. I'm wondering, it doesn't seem to show up in your new investment mix, but do you evaluate those two markets any differently today in terms of just the value proposition of one stop loans versus the first lien traditional structure?

Speaker 1

So every time we're we're looking at a new transaction, we're thinking about what the right way to play in this in it is and and what the right answer is for the transaction. And we'll proceed with a first lien solution if we think that it's compelling from a risk reward standpoint and right for the transaction. Or alternatively, we'll proceed with a one stop solution if we think the risk reward is is compelling and it's right for the transaction. So so it's it's a multifaceted test that we use to to assess what's the what's the right solution to be to be emphasizing in our discussions with sponsors. At the end of the day, obviously, it's the the sponsors make that choice.

We don't make the choice as to what financial structure to put in place. But we do have choices about where we play and where we don't play. Right now, I would tell you that we continue to find a lot of attractive one stop opportunities. To your point, we're seeing a lot of steadiness in our income yield and in our weighted average net investment spread. I think you are seeing meaningful compression in junior debt spreads, Second lien spreads, in particular, come down.

And so I think perhaps that's putting some pressure on if you think about a one stop as being an instrument that's priced as a hybrid, that could be seen as putting some pressure on one stop spreads as well. But I think the data suggests more steadiness, more continuity than change there.

Speaker 5

Your

Speaker 0

next question comes from the line of Ray Cheeseman with Anfield Capital.

Speaker 6

David, as we approach the end of the year and get closer to LIBOR going poof and going away, do you perceive there to be any challenges in rolling all of the clients over to a I I think they're now talking about a SOFR term as the the preferred way they're to steer everybody. Is everybody ready for that? And do you perceive there'll be any impact on any income lines in your P and L?

Speaker 1

So thanks for the question about LIBOR and SOFR. I think you may know I serve on the Board of the LSTA, the main industry trade association. It's been very involved in this LIBOR transition and in ensuring from an industry standpoint that the industry is ready. We, at Golub Capital, have also dedicated significant resources to make sure we're ready. Look, I think it's going to be a meaningful amount of work.

Whether this transition happens at the end of this year or later, I think that's still an open question. I'm confident that whenever the timing is, we'll be ready, and we'll have the resources in place to do the work with our borrowers to make sure that that whatever changes are required and loan agreements are made. This is this is gonna be a very significant lift, but I'm not I I I say that from a work standpoint, not from a risk standpoint. I I think from a risk standpoint, it's it's quite under control.

Speaker 6

Super. Glad to hear. Based upon the experience that you've had, when loans at the beginning, you were saying that the number of loans outperforming expectations, category four and five, has increased at at a very good speed coming up out of the lousy period a year ago. When when your portfolio performs above expectations, should we expect to see a higher churn or or higher repayments than otherwise? Because, obviously, they've got higher profit levels.

Speaker 1

Sure. Let me clarify one thing. Category four is performing at or above, and category five is performing above. So, the the statement that I hope we made before, I'm I'm not sure exactly how we phrase this, is that the proportion of our portfolio that's performing in categories four and five, meaning they're performing at or above expectations, has grown significantly. If you flip to Page 17 of our presentation deck, you'll see that those two categories are just under 90% of our loans as of 06/30/2021.

And that's right that that that's back in the range of the pre COVID numbers. I think you're on to an important point, which is more relevant for category five loans than for category four loans. I think category five loans do have a tendency to be refinanced or repaid, more quickly than loans in other categories. And I think that has been part of the story of the more rapid than expected repayment rate that we saw in this last quarter. I don't think that's the main factor.

I think the main factor is the very rapid pace of M and A, that we've seen in the middle market generally. But I think you make an interesting point, which is that the category five loans do tend to refinance more quickly than one, two, three, and four loans.

Speaker 6

Totally fit you if you lose the good ones. Right?

Speaker 1

Yep. Nature credit.

Speaker 6

Last is kind of a it's an open ended question, and you've done unbelievably well at at steering the company through a a credit thunderstorm. You've lowered the cost of your funding. What are we looking for in the next couple of quarters to move the whole organization back from I'm just gonna use the base number for shareholders, 29¢ to 32¢. What is

Speaker 0

it