GOLUB CAPITAL BDC, Inc. (GBDC) Q2 2020 Earnings Call Transcript

Welcome to the Golub Capital BDC, Inc. March 31, 2020 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 for 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 Golub Capital BDC, Inc.'s filings with the Securities and Exchange Commission. 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.golubcapitalbdc.com and click on the Events/Presentations link. Golub Capital BDC'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 Golub, Chief Executive Officer of Golub Capital BDC.

Thank you, Selena. Hello everyone and thank you for being with us today. With me virtually are Ross Teune, our Chief Financial Officer, and Gregory Robbins and Jon Simmons, both Managing Directors at Golub Capital. We, along with the entire Golub Capital team, hope that you and your families are safe during these challenging times. We are thankful that our team is healthy, safe, and working effectively from home. Today, we will discuss the economic impacts of COVID-19, but first, I want to acknowledge the human toll. About half of Golub Capital's team, myself included, lives in or near New York City, which has been heavily affected by COVID-19, with over 170,000 reported cases and more than 14,000 confirmed deaths. The impact of the virus on our community is deeply felt; we all know people who have been sick or worse. However, there is also a strong spirit of resilience and solidarity. In my neighborhood and across the city, we open our windows at 7 PM each night to applaud and cheer for the healthcare workers on the front lines. This has been an emotional moment for many of us. Recently, The New York Times featured an op-ed by my friend Nick Kristof, which highlighted several outstanding organizations involved in COVID-19 relief. We are proud to support their efforts, and I encourage you to consider joining us. This morning, we issued our earnings press release for the quarter ending March 31, 2020, and we have posted an earnings presentation on our website, which we will refer to throughout the call. Let's start with a key point from Slide 4. GBDC's results for fiscal Q2 aligned with the preliminary estimates we submitted on April 13. Adjusted net investment income per share was $0.33. Adjusted EPS recorded a loss of $1.71, while NAV per share stood at $14.62, which is at the higher end of the NAV range we had previously published. Before diving into these results in detail, I believe it is essential to frame them correctly. COVID-19 is already affecting, and will continue to impact, nearly every U.S. company, including GBDC. Following the completion of the rights offering, we anticipate that GBDC will be better equipped to navigate this COVID-19 environment. Our aim today is to provide you with a clear and analytical overview of the impact of COVID-19 on GBDC so far, and to discuss the risks and opportunities we foresee for GBDC moving forward. We will detail GBDC's quarterly results afterward. So, let's move to Slide 6. On Slide 6, it's evident that the COVID-19 impact on the U.S. economy in March cannot be overstated. After experiencing steady GDP growth of 2% to 3%, the economy contracted by nearly 5% in calendar Q1. Notably, almost all of that decline happened in March; the primary cause was an unprecedented surge in job losses. In late March and into April, job losses surged to over 5 million per week, leading to a spike in the unemployment rate, which recently reached 14.7%, a level not seen since the Great Depression. As vast sections of the economy effectively shut down, financial markets dropped, as seen on Slide 7. In light of this backdrop, how did GBDC perform? I'll start with two positive updates. Turning to Slide 9, the first positive is that GBDC's portfolio was designed to be resilient. It is primarily exposed to sectors that have been relatively insulated from COVID-19, such as enterprise software, technology business services, and financial services. Loans to companies in these areas make up over 75% of GBDC's portfolio. Additionally, the size, diversification, and granularity of GBDC's portfolio help reduce the potential impact of specific COVID-19-related issues affecting particular borrowers. As of March 31, the average size of each investment in GBDC's portfolio was less than 40 bps. The second piece of good news on Slide 10 is that GBDC has minimal exposure to many of the sectors that have been most severely affected by COVID-19, including airlines, aircraft financing, energy, hotels, entertainment, and gaming. Investments in these troubled sectors constituted less than 1% of GBDC's portfolio at fair value as of March 31. Similarly, GBDC's strategy of lending at the top of the capital structure to sponsor-backed companies results in minimal exposure to second lien debt, mezzanine debt, and other asset classes that we view as particularly vulnerable in today’s environment. Aggregate exposure to these asset classes also accounted for less than 1% of the portfolio at fair value as of March 31. However, I do not mean to suggest that GBDC is immune to COVID-19. As shown on Slide 11, GBDC has exposure to several industry sub-sectors that have been and are likely to continue to be significantly affected by COVID-19. Notable areas of concern include restaurants, dental care, eyecare, fitness franchises, and retail, which account for just under 20% of GBDC's portfolio at fair value as of March 31. We believe that many borrowers in these sectors are well-positioned to weather the storm and emerge successfully. To elaborate, in restaurants, we have prioritized proven concepts, primarily in quick service and fast casual sectors, both of which have traditionally thrived during recessions. Many of these establishments offer drive-through or carry-out options and have successfully shifted to that model. In fact, one of our restaurant borrowers recently reported its highest sales day ever without any traditional sit-down service. In dental and eyecare, our focus is on leading regional franchises, which we believe will bounce back once they can reopen, possibly even benefiting from pent-up demand. For fitness franchises, we are targeting low-cost, high-value concepts suited for a market where consumers are more budget-conscious. In retail, we are concentrating on consumer staples and franchises that we believe are relatively shielded from economic cycles. Most of our retail portfolio has been designated as essential and has remained operational during COVID-19. Others that have experienced some store closures have seen a substantial rise in e-commerce revenue. While these are mitigating factors, it's important to note that challenges do exist in this area of the portfolio, and we are actively managing GBDC's investments to address these issues. Before my colleagues and I discuss those initiatives, let's first review how these challenges impacted GBDC's results for the second fiscal quarter ended March 31. In summary, we observed two primary effects. First, on Slide 12, we noted a downward shift in our internal performance ratings, moving from categories 4 and 5, which indicate loans performing at or above our underwriting expectations, to category 3, representing loans that are performing or expected to perform below expectations. Category 3’s share rose from 7.2% of the portfolio at fair value as of December 31, 2019, to 26.5% as of March 31, 2020, largely driven by investments in the sub-sectors previously identified as most vulnerable to COVID-19. The percentage of the portfolio performing considerably below expectations in categories 1 and 2 remained relatively stable quarter-over-quarter. Moving to Slide 13, COVID-19 also triggered a widening of credit spreads. The combination of COVID-related credit issues and expanding spreads led to unrealized losses of $2.06 per share on GBDC’s NAV. Analyzing the drivers of that unrealized loss based on internal performance ratings, for investments in categories 4 and 5, we attribute the unrealized losses primarily to spread widening, as we believe these borrowers are performing at or above expectations. On average, loans in categories 4 and 5 saw a reduction from 99.9% of par at December 31 to 96.2% of par by March 31, 2020. This decrease accounted for $1.02 of GBDC's adjusted unrealized net depreciation per share for the quarter, roughly half of the total. For investments in category 3, our assessment is that the unrealized losses reflect both spread widening and credit stress. The bulk of the increase in category 3 originated from GBDC's investments in sub-sectors we consider significantly impacted by COVID-19. On average, loans in category 3 were marked down from 96% of par at December 31 to 90% of par at March 31, representing a larger average markdown compared to categories 4 and 5. Markdowns in category 3 accounted for $0.86 of GBDC's adjusted unrealized net depreciation per share for the quarter, or about 42% of the total. In categories 1 and 2, the average markdown was a few points higher than in category 3, which is not surprising. We believe the markdowns in this category are indicative of the stress from COVID-19 layered on pre-existing credit challenges. Categories 1 and 2 constitute a relatively small portion of GBDC's portfolio, around 2% of total investments at fair value, with markdowns in these categories contributing $0.18 to GBDC's adjusted unrealized net depreciation per share for the quarter, representing 9% of the total. Slide 14 illustrates the transition from a NAV per share of $16.66 as of December 31, 2019, to a NAV per share of $14.62 as of March 31, 2020. From an adjusted NII standpoint, GBDC generated $0.33 per share, which is understandable given our 8% annualized income incentive fee hurdle rate. In the next column, you can see realized credit losses, with net realized losses amounting to $0.03 per share, a relatively minor sum. The primary reason for the decline in NAV per share for the quarter was the unrealized depreciation of $2.06 per share we reviewed in detail.

Thank you David. Turning to Slide 16, we have been focusing on two key strategies. First, proactively managing our portfolio and second fortifying GBDC's balance sheet. Let's discuss each in turn. The first focus area on Slide 17 has been proactive portfolio management. There have been three phases to this. In the first phase, which began earlier this year, we opened up lines for communication with our portfolio companies, private equity sponsors and industry consultants to gather data and assess COVID-19 risk by borrower. In support of these efforts, the Golub Capital direct lending team consisting of more than 130 professionals pivoted from loan origination to portfolio management. We undertook detailed analysis using 13-week cash flow forecasts, real time sales figures and other proprietary data to segment the portfolio and identify the most affected borrowers. In the second phase, we developed and executed on short term game plans for the borrowers most affected by COVID-19. We also helped many of our borrowers apply for loans under government programs where this was appropriate. In the third phase, which is where we are now, we are designing and executing on longer-term game plans for all of our borrowers. We are doing this collaboratively with the management teams and sponsors of each company. In the many cases where the borrowers are doing fine despite COVID-19, the game plan is business as usual. In more challenging cases, we are focused on credit-enhancing amendments or on incremental investments where we, as first lien lenders may contribute to a solution alongside capital support from the private equity sponsors. Every deal is different but we think our deep partnerships with sponsors and our lead position on the preponderance of our loans has given us the power and the nimbleness to structure win-win solutions. Where sponsors are unable or unwilling to support a company, we are also prepared to take the keys and in the small number of cases, we expect we will do so. We have deliberately built out our workouts team over the last 12 months to prepare for an economic downturn. The second focus area as outlined on Slide 18 has been fortifying GBDC's balance sheet to support existing investments and create future opportunities.

Thanks Gregory. I'm on Slide 22. First, just as a reminder, in addition to the GAAP financial measures in our investor presentation we've also provided certain non-GAAP measures to make GBDC's financial results easier to compare to our results prior to our merger with GCIC. These non-GAAP or adjusted measures seek to strip out the impact of the merger-related purchase premium write-off and amortization and are further described in the appendix of our earnings presentation. We'll refer to these adjusted measures where appropriate as we think they are a better indicator of GBDC's financial performance. With that context, let's look at the results for the quarter in the column on the far right of the page. Adjusted net investment income per share or, as we call it, income before credit losses for the March 31, 2020 quarter was $0.33, unchanged from the previous quarter. Adjusted net realized and unrealized loss per share was $2.04. This compares to adjusted net realized and unrealized gain per share of $0.02 for the quarter ended December 31, 2019. As David discussed in his remarks, the adjusted net realized and unrealized loss for this quarter was primarily driven by unrealized losses from the impact of COVID-19. Loss per share and adjusted loss per share for the March 31, 2020 quarter was $1.71, this compares to earnings per share and adjusted earnings per share to the December 31, 2019 quarter of $0.35. As a result of a loss per share, our NAV per share declined approximately 12.2% to $14.62 as of March 31 from $16.66 at December 31. On March 30, 2020 we paid a quarterly distribution of $0.33 per share and then finally on April 9, 2020 our board declared a quarterly distribution of $0.29 per share payable on June 29, 2020 to stockholders of record as of June 9, 2020. This distribution is consistent with historical quarterly cash distributions and an annualized rate of approximately 8% of net asset value.

Great, thanks Jon. I'll start on Slide 23. This slide highlights our total originations of $167 million and total exits and sales of investments of $291 million for the quarter ended March 31, 2020 factoring an unrealized depreciation and other portfolio activity including a record level of revolver fundings, total investments at fair value decreased by 5.4% or approximately $238.1 million. One point I want to highlight, as of March 31, 2020 we had just $17.5 million of remaining undrawn commitments on revolvers and $134.1 million of remaining undrawn commitments on delayed draw term loans. These are small numbers in the context that GBDC's balance sheet and liquidity position. As shown on the bottom table, the weighted average rate of 7.1% on new investments, the weighted average spread over LIBOR on new floating rate investments of 5.2% and the weighted average fee on new investments all declined from the prior quarter primarily due to a higher percentage of traditional senior secured originations this quarter. The weighted average rate on investments that paid off of 7.7% was relatively consistent with the prior quarter. As a reminder, the weighted average interest rate and new investments is based on the contractual interest rate at the time of funding. For variable rate loans, the contractual rate would be calculated using current LIBOR, the spread over LIBOR and the impact of any LIBOR floor. The top of Slide 24 shows that GBDC's portfolio remained highly diversified by obligor with an average investment size of less than 40 basis points. The bottom of the slide shows that our overall portfolio mix by investment type has remained consistent quarter-over-quarter with one-stop loans continuing to represent our largest category at 82%. Turning to Slide 25, 97% of our investment portfolio remains in first lien, senior secured floating rate loans and defensively positioned in what we believe are to be resilient industries. Turning to Slide 26, this graph summarizes portfolio yields and net investment income spreads for the quarter. Focusing first on the light blue line, this line summarizes or represents the income yield or the actual amount earned on the investments including interest and fee income but excluding the amortization of upfront origination fees and purchase price premium. The income yield decreased by 20 basis points to 7.8% for the quarter ended March 31, 2020 primarily due to the continued decline in LIBOR. The investment income yield, the dark blue line, which includes amortization of fees and discounts also decreased by 20 basis points to 8.2% for the quarter ended March 31, 2020. The weighted average cost of debt, or the aqua blue line, also decreased by 20 basis points to 3.7%. As a result, our net investment spread, or the green line, which is the difference between the investment income yield and the weighted average cost of debt remains stable at 4.5%. Flipping to the next two slides, non-accrual investments as a percentage of total debt investments at cost and fair value increased modestly to 2.3% and 1.6% respectively as of March 31, 2020. During the quarter the number of non-accrual investments increased to a total of 10. As David discussed in his opening commentary primarily due to the COVID-19 outbreak the percentage of investments rated 3 on our internal performance ratings increased to 26.5% of the portfolio at fair value as of March 31, 2020.

Thanks Ross. So to summarize today's discussion, the COVID-19 outbreak led to credit stress and wider spreads in calendar Q1 2020. This in turn caused large unrealized losses in GBDC's portfolio. Our key priority now is to proactively manage the portfolio to minimize realized credit losses. If we are successful, the rest will take care of itself. At GBDC we have a long and industry-leading track record of keeping credit losses low including from many prior periods of market uncertainty and volatility. We believe we enter this period with a series of compelling competitive advantages that are stronger than ever including our experienced team, scale, sponsor relationships and industry expertise. Our track record, our competitive advantages and the deep sense of humility should position us well to manage GBDC through these challenging times. With that let me thank you for your time today and for your partnership. Operator please open the line for questions.

Hi, good morning or good afternoon. Thank you for having me on. I hope everyone is doing well. David, my first question is about the proceeds from the rights offering. I believe Greg provided some details, but can you offer more insight into the division between paying down debt and new commitments? Additionally, regarding new credit-enhancing commitments, what kind of opportunities do you currently have in your pipeline?

Great. So let me address each of those two questions. So let's talk first about rights offering proceeds. I don't have an exact answer for you right now but I can give you a directional answer. Let's start with the goals that we're undertaking to apply the rights offering proceeds to pursue. We want to use the proceeds to fortify liquidity and to create more flexibility. So that combination will equip us to play both offense and defense within the portfolio and capitalize on what Gregory was talking about, the attractive lending environment that we're anticipating is going to develop once the M&A market regains its footing. So we're currently thinking that we'll use about $140 million of the proceeds to retire several older debt facilities that are no longer in their reinvestment periods. There's the 2014 CLO that's been winding down and there's the two SLF facilities. By paying off those facilities, we create a large amount of unencumbered assets to add to what is already a large amount of unencumbered assets on GBDC's balance sheet. We're also in discussions to expand one or more of our long-term bank facilities. In combination, the increase in unencumbered assets and the increase in size of one or more of our long-term bank facilities should put us in a position where we have ample liquidity, we have significant availability under our debt facilities and we have hundreds of millions in unencumbered assets. So I'm pleased with how that's developing. We also plan to continue to explore other debt alternatives including unsecured notes when the market becomes more attractive for this. Second question you asked and if I understood it right was, what's the pipeline look like for these credit enhancing incremental investments that you've heard me talk about? The answer is it's good. We're in a lot of discussions right now with sponsors as you would imagine to address longer-term amendments and in many cases, those amendments will include some combination of new investment by sponsors, deferral of interest by junior debt providers, some improvement in our credit position, in some cases a re-pricing of our loans, in some cases a new investment by us on attractive terms. So we've got a large number of those that we're working on right now and I think that sort of transaction is going to be the focus of what we're working on over the course of the next three or four months. And we're going to continue to look at the potential to do new deals but the truth is there's not much new going on right now. As Gregory put it, the M&A market is dead because buyers and sellers can't agree on the day of the week. So it's both timely for us to be focused on these credit enhancing incrementals in our own portfolio and there's also not much competition for time in respect of that.

Thank you for the insights. I have a follow-up regarding the Morgan Stanley credit facility amendment. We understand that the commitment was extended by just one quarter, and it seems there will need to be cash proceeds to address that. You briefly mentioned exploring other forms of unsecured and additional debt, but is there anything we should be aware of regarding the upcoming reduction in credit capacity?

So I think what you're alluding to is that in our filings last quarter we indicated that we extended, but not permanently, a portion of the Morgan Stanley bank facility. We are in discussions with Morgan Stanley and with our other bank providers about the right mix of commitments under our long-term bank facilities. The truth is we don't need all of that Morgan Stanley facility. So maintaining it in its current form is not something that that we would like to pursue but we've got a number of different options that are attractive. We're going to make a final decision on that in the coming weeks.

Okay. Thank you. And just one final for me. I will hop back in. On the dividend, recently reduced to $0.29 as part of the portfolio update, is the BDC able to earn that payout through the rights offering transaction? A

There are several factors currently impacting NAV per share. Recently, we experienced a significant unrealized loss that has decreased NAV per share. For GBDC, my goal is to establish a consistent dividend that gradually increases over time, similar to what we achieved for about a decade before the COVID-19 quarter. We need to evaluate where NAV per share will stabilize after considering the COVID-19 uncertainties. Once we gain more clarity on that, we can provide a more definitive answer. For now, we, like many others, will need to navigate through the uncertainties brought about by the COVID-19 situation.

Hey, good afternoon. First I wanted to just touch again on the rights offering. I know you guys gave some general commentary on kind of the thoughts behind why that was done but was one of the primary reasons behind the rights offering, you did have to do with any concerns of potential covenant breaches surrounding any of your securitizations and the potential impact of diverting cash flows to pay down those securitizations versus cash flows that were required to be paid out the dividend regarding RIC status?

No. I don't think it was quite as you described it. I would describe it somewhat differently. I would say that COVID-19 created an environment in which we saw a much wider range of potential future scenarios than we typically do. So if you typically think about the future in terms of a bell curve and you shape your base case assumptions around the middle of the bell curve you can create an upside case and a downside case that are a little off of that base case and cover the vast preponderance of potential scenarios. In a COVID-19 world you can't do that. The curve is a very different shape. It's much flatter with much flatter tails. So as an asset manager in a COVID-19 world, we came to the conclusion that it made sense to have more flexibility in our capital structure to be able to manage effectively through a much wider array of different scenarios. Now in some of those scenarios we were concerned that we wouldn't have sufficient capital to be able to do these credit enhancing incremental investments and simultaneously to be able to make best use of the low-cost liabilities that GBDC contractually has. So I'm not saying Ryan that your question isn't the right question. I think that those concerns are among a whole slew of concerns that drove us to conclude that the rights offering was the right thing to do. I put that larger group of concerns under the rubric of an increased level of uncertainty in the environment and a desire to have a balance sheet that would work well in the context of a wider array of different forward scenarios. I feel very good about where we are now.

Okay. I mean, do you think that longer term, this will have you re-evaluate how you compose the right side of your balance sheet given that you guys ran with zero unsecured notes or unsecured debt which a lot of other BDCs have chosen to make that part of their liability structure which is obviously the higher cost debt, which is bad during the up times but in down time like this it creates a significant amount of unencumbered assets to become very important the downturn like this and I don't know if we're going to see BDCs do dilutive rights offerings like this, especially the ones with significant amounts of unsecured debt. So do you think that you will rethink your liability structure going forward as far as the composition of it goes?

We had already rethought our liability structure and as I commented on in the September quarter discussion and in the December quarter discussion, we had begun a serious evaluation of getting investment-grade rating and issuing unsecured notes. So I'm a believer in unsecured notes, I think that we have a place in the liability structure of a scaled BDC and I'm sure it's something we're going to be seeking to explore subject to that market normalizing in terms of costs.

Okay. And then just kind of a technical one. With unfunded commitments I think you guys had a $152 million at the end of the quarter. What was the level of unfunded commitments that were revolvers or commitments that were kind of at a full discretion of the borrower to draw down versus commitments that has some sort of like delayed draw term loan? Or were not at the full discretion of the borrower to draw down?

The vast preponderance of our ongoing commitments at quarter end were in the form of acquisition focused delayed draw term loans, I think we were down to $16 million of revolvers that were undrawn. Most obligors drew their revolvers in March of 2020.

We did break that down in our 10Q this quarter. Ryan. So its $17.5 million was the exact number of unfunded revolvers.

Thank you, Ross. Thank you, okay.

Let us review that with you offline, I think we still have some cushion before the NII incentive fee, look back would restrict NII incentives but also tell you that we don’t anticipate that NII incentive fees are going to be terribly high in the near term.

Hi everyone, afternoon and hope all is well. So just two quick ones. The first one revolving around sponsor attitude and willingness to put in more capital. So just any general commentary you can give there and specifically, I guess what we would be interested in, is whether or not there is any difference in willingness to put in more capital by industry. So, for example, for our retail portfolio company versus more of a staple say healthcare. Is there any difference in willingness to put in more capital? Thank you.

I would say there's not a difference based on industry. What matters most in discussions with sponsors about level of sponsor support are two factors. The first factor is to what degree they like the company and see the capacity for its performance to rebound and for it to be a successful investment for them. Sponsors for obvious reasons, as economic animals they want to focus their resources on those companies that are going to do well for them. The second issue which comes up sometimes and infrequently but sometimes, it's that a particular investment comes from an older fund and the sponsor has limited resources remaining that are available to it in that older fund. And it may have some competing needs in the context of COVID-19. So where we anticipate some of the most challenging conversations with sponsors are those that are in the second category where the sponsor would like to provide support but doesn’t have the capacity to do so to the degree would like to. I would say on balance—and look it's still early days, but on balance we've been very gratified by the way in which sponsors have engaged with us in a very solutions-oriented collaborative fashion.

Great, that's helpful. And then last one, just any color you can provide on the scale of amendment reliefs within the quarter and then through April whether or not that has sped up would be very helpful.

We had relatively little in terms of amendment activity in calendar Q1. There were roughly a dozen companies that were heavily impacted by COVID-19 where we agreed to reduce the cash piece spread of our loans and to have a portion of the spread be payable in PIK. Virtually all or I think all but one of our borrowers repaid their principle and interest in the quarter. I anticipate there will be a need for a lot of amendments going forward. I think most of those amendments are going to be in calendar Q3 actually as opposed to calendar Q2. Bear in mind that for most companies they had two good months and one bad month in Q1. So Q1 financial results will—in the preponderance of cases—not trip covenants. Q2 financial performance, however, is going to be harder for many companies not to trip covenants. So those financial statements would be due over the summer and that would be when I would anticipate the biggest crunch of amendments would be needed.

That's all from me. Thanks guys, I appreciate it.

Thank you. David Golub: And Selena, let’s do one more.

Excellent. I just want to thank everyone. This was a long call, I know, we wanted to provide a lot of data to help everyone understand the COVID-19 consequences and challenges perceptively. Hope this was helpful. Thank you for listening. Thank you for your partnership. And as always, please feel free to reach out to us if you have further questions. Look forward to chatting next quarter.

Thank you. That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.