GOLUB CAPITAL BDC, Inc. Q2 FY2021 Earnings Call

Welcome to the GBDC's March 31, 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 various 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 call, please visit the Investor Resource tab on the homepage of the company's website and click on the Event/Presentation link. GBDC's earnings release is also available on the company's website in the Investor Resource section. As a reminder, this call is being recorded for replay purposes. I would now like to hand the call over to David Golub, Chief Executive Officer of Golub Capital BDC. Thank you, sir. Please go ahead.

Thank you, operator. Hello, everybody, and thanks for joining us today. I'm joined by Chief Financial Officer, Ross Teune; Senior Managing Director, Greg Robbins; and Managing Director, Jon Simmons. Yesterday, in the afternoon, we issued our earnings press release for the quarter ended March 31, and we posted an earnings presentation on our website. We're going to be referring to this presentation throughout the call today. For those of you who are new to GBDC, our investment strategy today, and since inception, has 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 March 31 is that GBDC's results were strong. GBDC had both strong net investment income and continued strong credit performance. We'll discuss 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 March 31 quarter, and then he's going to hand it off to Jon and Ross for a more detailed review of the quarter's results. I'll then come back at the end to provide some closing commentary and open the line for questions. With that, Gregory, let's take a closer look at GBDC's results for the quarter and the key drivers of those results.

Thank you, David. Turning to Slide 4, for the quarter ended March 31, GBDC's adjusted NII per share was $0.29, adjusted EPS was $0.55, and ending NAV per share was $14.86. The key drivers of those strong results are summarized on Slide 6. First, our portfolio companies generally continue to perform well. This won't come as a surprise if you happened to see the Golub Capital Middle Market Report for March 31, which we published about a month ago, based on actual financial data from Golub Capital's middle-market borrowers. The report for calendar Q1 showed the highest rate of year-over-year profit growth since we began tracking data in 2013. 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, GBDC took advantage of attractive market conditions to continue to optimize its balance sheet. We executed a second unsecured bond issuance, building on the success of our inaugural offering last year. We also closed a new corporate revolver. These financings are consistent with the strategy you've heard us discuss before: low-cost, flexible financing with limited near-term maturities. Finally, middle-market new deal activity was solid. It wasn't a record origination quarter like the December quarter, but it was meaningfully improved from last year's June and September quarters. Let's 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 7 summarizes the positive trends in the internal performance ratings of GBDC's portfolio in the post-COVID period. Specifically, since March 31, 2020, we've seen essentially no increase in the percentage of the portfolio performing materially below expectations in categories 1 and 2. Those two categories constituted only 1.1% of the portfolio at quarter end. We have seen upward credit migration, a steady increase in categories 4 and 5, and a corresponding decrease in category 3. To remind folks, categories 4 and 5 are loans performing at or better than our expectations at underwriting, and category 3 are loans that are performing or expected to perform below expectations. In the quarter ended March 31, categories 4 and 5 increased from 81% of the portfolio as of 12/31 to 86.9% of the portfolio as of 3/31. Category 3 decreased from 17.9% to 12% over the same period. The proportion of the portfolio rated 3 as of 3/31 was pretty close to our pre-COVID normal of around 10%. A second key indicator of continued credit improvement is that nonaccruals remain very low. In fact, nonaccruals declined quarter-over-quarter from 1.2% to 1% as a percentage of investments at fair value at 3/31 and are now back to pre-COVID levels. We'll come back to this point in our usual discussion of GBDC's financial results. Slide 8 shows two other indicators of improving credit quality, no net realized losses and solid net unrealized gains. This slide provides a bridge from GBDC's $14.60 NAV per share as of 12/31 to its increased $14.86 NAV per share as of 3/31. Let's walk through the bridge. First, adjusted NII per share was $0.29, in line with our quarterly dividend; second, no realized losses were recorded during the quarter; third, net unrealized gains were $0.26 per share. These unrealized gains reflect the continued reversal of unrealized losses incurred in the March 2020 quarter. In fact, our strong unrealized gains through the post-COVID period have driven reversals of over 85% of the March 2020 unrealized losses on a price basis. Let's now take a closer look at our results for the quarter ended March 31. For that, let me hand the call over to Jon Simmons to walk you through the results in more detail. Jon?

Thanks, Gregory. Please turn to Slide 10 for a summary of our results for the quarter. You can see on the right-hand side of the slide that for the quarter ended March 31, 2021, each of adjusted NII per share, adjusted net realized and unrealized gain per share, and adjusted EPS were consistent with the prior quarter's strong results. As a result, our NAV per share at March 31, 2021, increased to $14.86. On May 7, 2021, our Board declared a quarterly distribution of $0.29 per share payable on June 29, 2021, to stockholders of record as of June 11, 2021. This distribution is consistent with our goal of having quarterly cash distributions of approximately 8% of NAV on an annualized basis. Turning to Slide 11, new investment commitments for the quarter ended March 31 totaled $234.7 million. After factoring in total exits and sales of investments of $347.5 million, as well as unrealized appreciation and other portfolio activity, total investments at fair value decreased by 2.5% or $112 million during the quarter. As Gregory noted, originations this quarter were quite strong, but so were repayments. As of March 31, 2021, we have $44.7 million of undrawn revolver commitments and $160.6 million of undrawn delayed draw term loan commitments. These unfunded commitments are relatively small in the context of our balance sheet and liquidity position. As shown at the bottom of the table, the weighted average spread over LIBOR on new floating rate investments of 5.5% declined closer to pre-COVID levels. Slide 12 shows that our portfolio mix by investment type has remained consistent quarter-over-quarter, with one-stop loans continuing to represent our largest investment category at 81% of the portfolio. Slide 13 shows that GBDC's portfolio remained highly diversified by obligor with an average investment size of less than 40 basis points. As of March 31, 97% of our portfolio remained in first lien senior secured floating rate loans and defensively positioned in what we believe to be resilient industries insulated from COVID-19. Turning to Slide 14, this graph summarizes the portfolio yields and net investment spreads for the quarter. Focusing first on the light blue line, this line is the income yield or the amount earned on our investments, including interest and fee income, but excluding the amortization of upfront origination fees and purchase price premium. The income yield increased by 10 basis points to 7.5% for the quarter ended March 31, 2021. The investment income yield, or the darker blue line, which includes the amortization of fees and discounts, also increased by 10 basis points to 8% during the quarter. The income yield and the investment income yield both increased primarily due to higher fee income and discount amortization. Our weighted average cost of debt, the aqua blue line, increased by 10 basis points to 3% primarily as a result of the acceleration of deferred financing fees from early redemptions of $165 million in relatively higher-priced SBIC debentures. Our net investment spread, which is the green line, the difference between the investment income yield and the weighted average cost of debt, remained stable at 5%. With that, I'll hand the call over to Ross to continue the discussion of our quarterly results. Ross?

Thanks, Jon. Flipping to the next two slides, nonaccrual investments as a percentage of total debt investments at cost and fair value remained low and decreased to 1.4% and 1%, respectively, as of March 31. During the quarter, the number of nonaccrual investments decreased to six portfolio company investments from seven portfolio company investments as one portfolio company investment returned to accrual status. As Gregory discussed in his opening commentary, as a result of strong portfolio company performance, the percentage of investments rated 3 on our internal performance rating scale decreased to 12% of the portfolio at fair value as of March 31. As a reminder, independent valuation firms value at least 25% of our investments each quarter. Slides 17 and 18 provide further details on our balance sheet and income statement as of and for the three months ended March 31. Turning to Slide 19, the graph on the top summarizes our quarterly returns on equity over the past five years, and the graph on the bottom summarizes our quarterly distributions as well as our special distributions over that same time frame. Turning to Slide 20, this graph illustrates our long history of strong shareholder returns since our IPO. Slide 21 summarizes our liquidity and investment capacity as of March 31, which remains strong with over $800 million of capital available through cash, restricted cash, and availability in our revolving credit facilities. We also highlight our continued progress during the quarter on optimizing the right-hand side of our balance sheet. Three key highlights. First, on February 11, we closed on a $475 million revolving credit facility with JPMorgan, which matures on February 11, 2026, and has an interest rate that ranges from 1-month LIBOR plus 1.75% to 1-month LIBOR plus 1.875%. Second, on February 24, we issued $400 million of unsecured notes, which bear a fixed interest rate of 2.5% and mature on August 24, 2026. With the completion of our second unsecured debt issuance, our percentage of unsecured debt as a percentage of total debt increased to 38% as of March 31. Finally, on February 23, we decreased the borrowing capacity under our revolving credit facility with Morgan Stanley to $75 million. After the end of the quarter, we further amended this revolving credit facility to, among other things, extend the reinvestment period through April 12, 2024, extend the maturity date to April 12, 2026, and reduce the interest rate on borrowings to 1-month LIBOR plus 2.05% from 1-month LIBOR plus 2.45%. Slide 22 summarizes the terms of our debt capital as of March 31. And last, on Slide 23, we summarize our recent distributions to stockholders. Most recently, our Board declared a quarterly distribution of $0.29 per share payable on June 29 to stockholders of record as of June 11.

Thanks, Ross. So to sum up, GBDC had a strong quarter. Adjusted net investment income matched our dividend, realized credit losses were nil, and unrealized gains were substantial, continuing the reversal of unrealized losses that we incurred in the March 31, 2020 quarter. Let's talk about our outlook for the rest of this calendar year, and then we'll take your questions. At the risk of sounding out of character, the headline is that I'm cautiously optimistic. We believe GBDC has four powerful tailwinds going into the coming period. One tailwind is GBDC's strong portfolio performance. We've highlighted through today's presentation the positive credit trends that we've seen over the last quarter and the last 12 months. Our pre-COVID underwriting has proved strong, and as a consequence, we won't be distracted in the coming period by needing to play defense on a troubled portfolio. A second tailwind is the economy. Many of the sectors we like to lend to are booming, areas like software, health care, and business services. Just look at the record profit growth that we reported in the Q1 Golub Capital Middle Market Report that Gregory referenced. Going forward, the economy is reopening, fiscal stimulus is taking effect, and monetary policies remain accommodative. These factors all point to likely continued economic strength for the next several quarters. A third tailwind comes from the strength of the private equity ecosystem in which we operate. The private equity industry has over $1.7 trillion of dry powder, according to Preqin data. In the first quarter of 2021, the private equity industry had its strongest ever fundraising quarter, according to Private Equity International. So we believe there's a lot of pent-up demand for sponsor-driven middle-market M&A now that COVID uncertainty is abating, and we anticipate that the coming period is likely to be one of robust private equity deal-making. Finally, a fourth tailwind is that GBDC has ample liquidity and flexibility to capture this attractive opportunity set. You'll recall that one of our key goals in navigating COVID was not only to fortify the company's balance sheet in the face of COVID-related uncertainty but also to put the company on even stronger footing to take advantage of new opportunities. I think we're in a good position to do that. That all said, you know I'm not by nature an optimist, so let me elaborate on three reasons why I'm only cautiously optimistic. First, from a macro perspective, while near-term economic prospects look bright, there is longer-term uncertainty, especially around inflation. Our economy is booming, and yet, at the same time, government and central bank policy right now is to apply even more fiscal stimulus and even more accommodative monetary policy. I don't know how that's going to play out. I don't think anybody can predict the outcome of this economic policy cocktail. A big question is whether price increases that we're seeing right now in commodities and wage pressure are going to translate into accelerating inflation, and I don't think anybody knows the answer to that yet. Second reason for caution: liquid credit markets are strong. High-yield spreads are at 20-year tights. If this rate continues, I'd expect to see some continued pressure on loan spreads, terms, and leverage in our market. As I've said many times, the middle market is insulated but not immune from what's going on in broader credit markets. Third reason for caution: COVID is still raging in many parts of the world. This isn't just a tragedy for all the people in those communities. It also means we're very likely to see new COVID variants develop, variants our vaccines may not protect us from. So we may not be done yet with this dreadful COVID virus. But enough on the cautions. There are always clouds in the sky. Overall, I think GBDC is very well positioned and that the coming period will likely play to our capital strengths. Thanks, operator. Please open the line for questions.

And your first question comes from Finian O'Shea with Wells Fargo Securities.

First question, David, regarding the outlook for origination. Historically, the Golub platform has been very active in large tranche offerings, some of which exceeded $2 billion. Those seem to be returning. However, it appears that today the syndication market is also very high, unlike in previous periods. Do you agree? Are these large market opportunities making a comeback? Additionally, do they indicate that lenders are competing more aggressively with the syndicated market, or is the demand from sponsors more favorable for you? I'll stop there.

Thanks, Fin. Good to hear from you. So let me take a step back in answering that question because I think there are a number of trends that are running in different directions. The first trend is the development of a large unitranche product that sponsors can use if they want it. I think there's definitely been a marked change over the last couple of years. We've been the leader, as you point out, in providing these large unit tranches. But it's not just us. And I think sponsors increasingly look at the possibility of financing their deals with the large unitranches. One of the options on the menu in a way that even as recently as three or four years ago wasn't the case. Now under what circumstances do sponsors prefer doing a large unitranche to doing a broadly syndicated first lien, second lien deal? That's the second question. And you're 100% right that when the broadly syndicated markets are hot, it is possible sometimes to get a combination of pricing, leverage, or terms that are more attractive in the syndicated market than are possible to get in a private one stop. But even when markets are receptive like they are now, there are often transactions where a private one stop makes more sense, maybe because the sponsor needs to move more quickly than the syndicated market will permit or needs to arrange a deal with more confidentiality, doesn't want to share information with many market participants. Or it's a situation in which the company is going to be doing serial acquisitions, and we're growing the company; it's going to be easier using a one-stop capital structure as opposed to a more complicated multilayer capital structure. So my view is there's a secular trend toward increased market share for larger one-stops, and that's going to continue. There will be ups and downs in that secular trend that will be driven by what we're seeing in the M&A market and what we're seeing in the broadly syndicated market. I think right now, to your point, we're seeing a particularly robust syndicated market, and it's harder for private lenders to compete with than during periods when those markets are choppy. One thing I think we can all be certain of is that choppy markets will return at some point, and one has to look at these trends over an extended period. Makes sense?

Yes. No, absolutely. It's very helpful. And I'll just do a follow-on on your economic commentary regarding the item of inflation, potentially labor inflation. We are seeing, on a higher level, more viewpoints that suggest that that's a potential concern. Do you see anything in your portfolio of companies that are more labor-intensive, perhaps, restaurants, so forth? Any indications of emerging pressure on that front?

I'm seeing trends in our portfolio that are reflective of what we're all reading about in the front pages of the financial press, which is that it's increasingly challenging in many areas of the country to hire. And I think that can be a good thing or a bad thing, depending on how one looks at it. I think the good aspect of it is that it's leading to some higher wages in some areas, which, over the course of the last two decades, have seen stagnant wages and that's probably a good thing. It's a bad thing if this becomes part of accelerating inflationary expectations, which then drives inflationary expectations into other areas. I think it's going to be very interesting to watch the Bureau of Labor Statistics data over the coming months. And tomorrow, actually, is the next release. One of the pieces of data I like to look at, I think is really interesting, is they release a month-over-month version of inflation in addition to their annual version. If you look at the recent month-over-month data, it's been accelerating. I'm very interested to see whether we're going to see continued acceleration or whether we're going to see a stabilization.

Interesting. And we'll check that out tomorrow. Congrats on the quarter.

Thanks, Fin.

Your next question comes from Ryan Lynch with KBW.

I wanted to ask a couple of questions about your thoughts on the underwriting process for different themes. You are clearly a significant lender in the software sector, and it appears that lending based on annual recurring revenue is becoming much more common, especially during COVID and now as we recover. Can you discuss how you evaluate lending based on ARR compared to cash flow for software companies or other businesses with recurring revenue?

Sure. Let me provide some context first, just for those who perhaps aren't so familiar with what we're talking about. Golub Capital has been a leader in providing financing to the sponsor-backed buyouts of software companies for many, many years, more than a decade. About eight years ago, in addition to lending to more mature software companies that are generating significant cash flows, we began lending to companies that were at an earlier stage. We refer to these as recurring revenue loans. These are companies that have a proven Software-as-a-Service model. They've got a great product, loyal customers, and significant recurring revenues that are growing rapidly. Their clients are renewing their business with them at high rates. But because these companies are growing rapidly and investing a lot in sales and marketing, they are either not highly profitable or, in some cases, not profitable at all. Traditional credit metrics don't look the same with these companies as they do with the more mature software companies. We were a pioneer in identifying this recurring revenue loan niche as being an attractive niche. We've been very active in it; over the last eight years, we've had virtually no losses in this space. It's been a very successful space for Golub Capital. As we look at those loans, the key underwriting criteria boil down to whether we believe there'd be a strategic buyer who would want to buy the company at a price that would be more than sufficient to get us out if the growth projections of the company were not fulfilled. If something happened that caused the company's business plan to increase revenues at a rapid rate not to be sustainable, we want to ensure there's an appropriate second way out for us so that we are not subjected to a significant credit loss. This is tricky, as we're dealing with companies that are not highly profitable and are in earlier stages of development. It requires enormous amounts of underwriting expertise, industry expertise, and skill. I think it's something we're very good at. I don't believe it is inappropriate to say that there are commentators suggesting that some people active in this space may not have the necessary level of expertise to be as active as they currently seem to be. This is not the easiest lending to master. It's tricky.

That's really helpful color on your overall thought process and your history in that area. Kind of on that same topic though, obviously, certain businesses were significantly negatively impacted by COVID. Those businesses, if they survived, are likely to have major tailwinds as the economy reopens. Conversely, in some software needs, potentially, a lot of the growth for adoption as the economy has been digitalized and businesses have been working from home might have been accelerated or pulled forward during COVID, so some of that growth or adoption might not be as favorable going forward. How are you thinking about that in your underwriting process as you look at more deals in the software space at this point in time with hopefully the economy reopening and some of those acceleration of some of those trends fading?

Yes, I don't fully agree with your point. Each software company should be evaluated on its own merits. What we've observed in various areas of the software market is that there were impacts from COVID. While there was still revenue growth, the rate of that growth could have been stronger if our sales team had been able to travel and engage with customers face-to-face in the usual manner. If your assumption were correct, we would currently see significant declines in the growth rate of software companies overall. Referring to the Golub Capital Middle Market Index Report mentioned by Gregory in our opening comments, the data does not support that. Instead, it indicates continued strong revenue growth for software companies, and I believe this trend will persist.

Okay. That's fair enough. Just one last one, if I can, kind of switching gears to your capital structure. First, congrats on your second unsecured debt issuance. That was a very attractive rate. On that point, when you were initially discussing layering on some unsecured debt, did I get the impression that you were considering maybe having a third of your liability structure in unsecured notes?

It's a great question, Ryan. We always think about the debt structure in the same way, which is a balancing of multiple goals. The point you're making, if I'm understanding you correctly, is that 2.5% is really low, particularly by historical standards for unsecured debt. Would that drive us toward increasing the proportion of unsecured in our stack? The answer is yes, subject to other goals, including, as you pointed out, laddering maturities and our need for incremental capital. If you look at our balance sheet right now, we have a significant amount of unused capacity with almost none of the JPMorgan line drawn. So we want to be careful not to take on incremental unsecured that we don't need. But in the long run, if unsecured is as inexpensive as it is now, that does change the calculus for the proportion of our capital structure that it may make sense to have unsecured.

And your next question comes from Robert Dodd with Raymond James.

Congratulations on the quarter, and the portfolio looks in really good shape. On one of the comments you made, David, the liquid markets are hot. There is a concern that I think you have, not so much about the spreads, but the terms. If you were to look at things coming into your pipeline today versus maybe what was coming in January, has the expectation from the borrower or the hope from the borrower shifted even over that time frame on the structure side, let's say the pricing? Are people just asking for more and more? And can we expect that the structural protections to maybe weaken a little bit as we go forward from here?

So I think of these trends more broadly as whether we are in a borrower-friendly period or a lender-friendly period. Those trends tend to move in one direction until there's a turnabout. Since I would say June of 2020, we've been on a borrower-friendly trend. Over successive months and quarters since then, I would say that there has been movement that favors borrowers. That's true in pricing, terms, documentation terms, covenants, and levels of leverage. In liquid markets, those changes have been more pronounced than in private markets, but we are seeing it in private markets as well. It all goes back to that same phrase I repeat: we're insulated but not immune in the middle market from what’s happening in broader credit markets.

Understood. And another question, if I may. The BSL market doesn't offer delayed draw term loans, which is one of the benefits of pursuing these mega tranches. Are the existing borrowers in your portfolios experiencing any increase in interest in starting the process of adding or expanding DDTL opportunities, especially if the M&A market appears strong? Is there a possibility that these borrowers might look to expand further into DDTL? If so, does that provide additional incumbency protection? This could be a unique offering that the BSL market might not provide.

DDTLs are definitely a tool that some sponsors like to use, especially if they're doing buy-and-build strategies. And it is – you're correct that it's easier to do it in private deals. It is possible to do it in a syndicated deal. There are syndicated deals that have DDTLs, but it is easier to do in private deals. And it's less expensive for issuers in private deals. A significant portion of the business we do with existing companies in our portfolio comes in the form of acquisition financing, and that often is DDTLs. Not always; sometimes it's incremental term loans and DDTLs at the same time. Sometimes it's only incremental term loans. But being the incumbent vendor, the incumbent lead is immensely valuable because you're in the pole position. You're the go-to lender for incremental needs, except when there’s a compelling reason to do a global refinancing, which tends to be distracting and expensive.

I would now like to turn the call back over to David Golub for closing remarks.

Thank you, Brenda. I appreciate everyone joining us today. Thanks for your questions and for listening. As always, if you have any questions over the course of the coming quarter, please feel free to reach out. We look forward to talking to you again next quarter.

And this does conclude today's conference call. Thank you for your participation. You may now disconnect.