Earnings Call Transcript - GBDC Q4 2020

Operator, Operator

Welcome to GBDC's September 30th, 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 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.golubcapitalbdc.com 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 Golub, Chief Executive Officer of Golub Capital BDC. Please go ahead.

David Golub, CEO

Thanks, Alicia. Hello everybody and thanks for joining us today. I am joined by Ross Teune, our Chief Financial Officer; Greg Robbins and Jon Simmons, both Managing Directors at Golub Capital. We and the rest of the Golub Capital team hope that you and your family are safe and, like us, you’re all recovering from eating too much over Thanksgiving. Yesterday afternoon, we issued our earnings press release for the quarter and fiscal year ended September 30th and we posted an earnings presentation on our website. We're going to refer to that presentation throughout the call today. For those of you who are new to GBDC, our investment strategy is, 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. Let me start today's meeting by sharing with you two headlines: the first headline is that GBDC’s results for fiscal Q4 were strong and were in line with the preliminary estimates that we filed on October 19th. The primary driver of the results was the continuation of trends that we described on last quarter's earnings call, and I'll discuss those trends in a minute. The second headline is that GBDC is very well-positioned as we head into fiscal 2021 with ample dry powder, liquidity, and flexibility to capitalize on what we expect will be an attractive investment environment in fiscal 2021. I'll discuss this in more detail in my closing remarks and after that we'll take your questions. Let's now take a closer look at GBDC’s results for the quarter and for the fiscal year and the key drivers of those results. Please turn to slide four. For fiscal Q4, GBDC’s adjusted net investment income per share was $0.28, adjusted EPS was $0.57, and ending NAV per share was $14.33. All of these were at the midpoint of the guidance we published previously. I said that the primary driver of these results was the continuation of trends that we talked about last quarter. What do I mean by that? Slide six outlines three key themes beyond just simple good underwriting that we believe drove GBDC’s strong fiscal fourth quarter. First, in calendar Q3, the U.S. economy strongly rebounded from the heavy degree of COVID impact in calendar Q2. Second, our portfolio companies generally continued to perform better than expected, especially the companies that are in COVID impacted subsectors. And third, private equity sponsors have generally continued to step up to support their portfolio companies. If the second and third of these themes sound familiar, they should; the story of this quarter was largely a continuation of the story of the prior quarter and just like fiscal Q3, these themes are reflected in the positive credit quality trends listed on the right-hand side of the slide. Let's take a closer look at each of the indicators on that slide, starting with performance ratings. Please turn to slide seven. In fiscal Q4, internal performance ratings continued to improve. Let me start with some context. You'll recall we highlighted in last quarter's earnings presentation the upward migration in internal performance ratings in fiscal Q3. There is an increase in loans in categories four and five, those are loans that are performing at or better than expectations at underwriting. And there was a decrease in category three loans. So, those are loans that are performing or expected to perform below expectations. The percentage of the portfolio performing materially below expectations that are in categories one and two also declined significantly between fiscal Q2 and fiscal Q3. All of these positive trends continued in fiscal Q4. In fiscal Q4, loans in categories four and five continued to increase; they went from 76% of the portfolio as of 6/30 to 78.9% of the portfolio at 9/30. Category three loans continued to decrease; they went from 22.3% at 6/30 to 19.7% at 9/30. And category one and two loans also declined quarter-over-quarter from 1.7% to 1.4%. The very small proportion of the portfolio that's in categories one and two, I think that's particularly important because it indicates that even in this COVID stress environment, significant credit impairment in the portfolio remains rare and idiosyncratic. The proportion of the portfolio rated three is still higher than we typically saw pre-COVID, but it's meaningfully improved from 3/31 and continues to go in the right direction. The second key indicator of improving credit quality is non-accruals. Non-accruals at fair value also declined; they went from 2% at June 30 to 1.7%. We'll come back to this point in our usual discussion of GBDC's financial results. Slide eight shows two other key indicators of improving credit quality: low net realized losses and solid net unrealized gains. So, this slide shows a bridge from GBDC's $14.05 NAV per share as of 6/30 to the $14.33 NAV per share as of 9/30. Let's just quickly walk through the bridge. Adjusted NII per share of $0.28 was in line with our dividend of $0.29 cents and consistent with the prior quarter. Net realized losses were very low at $0.02 per share and net unrealized gains were $0.36 per share. These unrealized gains reflect the reversal of another portion of the unrealized losses that were incurred in the March quarter. You've heard me say before that our top priority since COVID has been and continues to be to minimize GBDC's permanent or realized credit losses. In the long run, unrealized gains and losses wash out; all that matters for lenders like us, who tend to hold their loans to maturity, is whether or not those loans get repaid. So, we're pleased to report that in fiscal Q4, GBDC kept realized credit losses low and enjoyed another meaningful reversal of unrealized losses. With that, let me hand the call over to Greg Robbins; he's going to offer an update on our strategic response to COVID-19.

Gregory Robbins, Managing Director

Thank you, David. Starting on slide 10, you can see that GBDC continues to execute on its three key goals for navigating the COVID-19 crisis. First, proactive management of our highly diversified first lien senior secured investment portfolio. Second, continued optimization of our balance sheet; and third, capitalizing on attractive new investment opportunities. Turning to slide 11, you'll recall that we described a three-phase strategy for proactively managing our portfolio during COVID-19. That entailed gathering information, developing strategic plans, and executing those strategic plans. We're now in phase three of our strategy and we have been implementing game plans for each affected borrower, working collaboratively with sponsors, management teams, and junior capital lenders. This strategy has produced meaningful results. Our team has executed more than 90 credit-enhancing amendments. We define a credit-enhancing amendment as one involving a spread increase, improved documentation terms, or an incremental equity infusion. We have talked at length about the strong sponsor support for our portfolio companies. Let me describe one flavor of this. Since COVID began, sponsors have put in over $700 million of new equity into GBDC portfolio companies. Slide 12 shows how GBDC has fortified its balance sheet at September 30th. GAAP leverage was 0.85 times, which is at the low end of our target range. Regulatory leverage was 0.76 times. GBDC had nearly $500 million of liquidity in the form of cash and borrowing capacity at quarter-end. We've also continued to take steps to optimize GBDC's debt capital structure. During the quarter, GBDC completed its fourth flexible, low-cost CLO. We remain one of a handful of BDCs with consistent access to this funding market on attractive terms, even during COVID. And on September 30th, GBDC received investment-grade ratings from S&P and Fitch, and priced its debut issuance of $400 million in unsecured bonds. The bonds have an interest rate of 3.375%, one of the lowest-cost debut unsecured bond issuances in the BDC space. GBDC used the proceeds primarily to pay down secured debt under revolving credit facilities, which has significantly expanded GBDC's unencumbered asset base without materially changing GBDC's overall leverage. As a result of these initiatives, GBDC has more flexibility and firepower. That flexibility and firepower put GBDC in a great position to capitalize on attractive opportunities. And as we've discussed in prior quarters and illustrate on slide 13, we believe GBDC has powerful competitive advantages which will help us deliver premium shareholder returns going forward. With that, let me hand it over to Jon Simmons to go through our financial results for the quarter ended September 30 in more detail. Jon?

Jon Simmons, Managing Director

Thanks, Gregory. So, just as a reminder, please note that in addition to the GAAP financial measures in the investor presentation, we're also providing certain non-GAAP measures. We refer to those non-GAAP measures as adjusted measures, and they seek to strip out the impact of the GCIC merger-related purchase premium write-off and amortization. We describe those adjusted measures further in the appendix of the earnings presentation. And we'll refer to them where appropriate as we think they're better indicators of our performance and are consistent with how we evaluate our own results. So, with that context, let's turn to slide 15, and I'm going to talk through the column on the right-hand side of the page to discuss the quarter in more detail. Adjusted net investment income per share, or as we call it, income before credit losses, for the September 30th quarter was $0.28. Adjusted net realized and unrealized gain per share was $0.29. This compares to adjusted net realized and unrealized gain per share of $0.66 for the June 30th quarter. The adjusted net realized and unrealized gain this quarter was primarily driven by the continued reversal of unrealized losses from the March quarter. Adjusted earnings per share for the quarter ended September 30th was $0.57. This compares to an adjusted earnings per share for the June 30th quarter of $0.94. Our net asset value per share at September 30th, 2020 increased to $14.33, up from $14.05 as of June 30th. On September 29th, we paid a quarterly distribution of $0.29 a share. And finally, on November 20th, 2020, our Board declared a quarterly distribution of $0.29 a share payable on December 30th, 2020 to shareholders of record as of December 11 2020. The distribution is consistent with our historical cash distributions, which approximate 8% of NAV annually. With that, I'll hand the call over to Ross to go through the quarterly results in more detail. Ross?

Ross Teune, CFO

Great, thanks, Jon. Turning to slide 16, this slide highlights our total originations of $141.2 million and total exits and sales of investments of $172.4 million for the quarter ended September 30th. As we noted on last quarter’s earnings call, we started to see a pickup in deal activity and that trend has continued into the current quarter. Factoring in unrealized appreciation and other portfolio activity, total investments at fair value decreased slightly by 0.3% or 12.2 million. As of September 30th, we have $41.6 million of undrawn revolver commitments and $100.2 million of undrawn commitments on delayed draw term loans. These unfunded commitments are relatively small in the context of GBDC's balance sheet and liquidity position. As shown in the table at the bottom, the weighted average rate of 7.6% on new investments and the weighted average spread over LIBOR on new floating-rate investments of 6.5% both increased from the prior quarter. As a reminder, the weighted average interest rate on 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 17 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 investment category at 82% of the portfolio. Turn to slide 18, 97% of our investment portfolio remained in first lien secured floating rate loans and defensively positioned in what we believe to be resilient industries. It is worth noting that we updated our industry classification this quarter using the S&P 2018 industry codes. We think this change provides investors with more detail and transparency about the industry exposure of our underlying portfolio relative to industry classifications that we were using previously. Turn to slide 19, 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 the investments, including interest and fee income, but excluding the amortization of upfront origination fees and purchase price premium. The income yield decreased by 30 basis points to 7.4% for the quarter, primarily due to the continued decline in LIBOR. The investment income yield, or the dark blue line, which includes the amortization of fees and discounts, also decreased by 30 basis points to 7.8% during the quarter, primarily due to the decline in LIBOR. Since our variable rate debt facilities are not subject to a LIBOR floor, our weighted average cost of debt, or the aqua blue line, decreased by 50 basis points to 2.7%. 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, increased by 20 basis points to 5.1%. Flipping to the next two slides, non-accrual investments as a percentage of total debt investments at cost and fair value remain low and decreased to 2.4% and 1.7%, respectively, as of September 30th. During the quarter, the number of non-accrual investments decreased to nine investments, as one portfolio company investment was restructured and returned to accrual status. As David discussed in his opening commentary, as a result of stronger portfolio company performance, the percentage of investments rated three on our internal performance rating scale decreased to 19.7% of the portfolio at fair value as of September 30th. As a reminder, independent valuation firms value at least 25% of our investments each quarter. Slides 22 and 23 provide further details on our balance sheet and income statement as of and for the three months ended September 30. Slide 24, the graph on the top summarizes our quarterly returns on 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 timeframe. Turning to slide 25, this graph illustrates our long history of strong shareholder returns since our IPO. Slide 26 summarizes our liquidity and investment capacity as of September 30th, and highlights the recent initiatives to further enhance the right side of our balance sheet. As Gregory mentioned, during the quarter we issued $189 million in notes through a term debt securitization on August 26. Proceeds were used to redeem all outstanding notes issued in the 2014 debt securitization and outstanding debentures issued by one of our SBIC subsidiaries, GC SBIC IV. We also issued $400 million in unsecured notes on October 2nd, the proceeds of which were used to pay down existing debt, including a full repayment of the revolving credit facility with Deutsche Bank. Slide 27 summarizes the terms of our debt facilities as of September 30th, prior to the closing of the bond deal on October 2. And lastly, slide 28 summarizes our long history of consistent distributions. Most recently, our Board declared a distribution of $0.29 per share payable on December 30th to stockholders of record as of December 11th. With that, I'll turn it back to David for some closing remarks.

David Golub, CEO

Thanks, Ross. So, to sum up, GBDC had a strong fiscal Q4. Adjusted net investment income remained consistent, realized credit losses were very low, and unrealized gains were substantial, reflecting the continued reversal of unrealized losses that were incurred in the March quarter. I mentioned in my opening comments that we think GBDC is well-positioned. I want to elaborate now on why we think that's the case. First, credit. We think the company's portfolio is nicely diversified, it's defensively positioned, and we're poised to see more reversals of unrealized losses in coming quarters. Second, dry powder and balance sheet flexibility. The company's GAAP leverage is low at 0.85 times debt-to-equity, that's below our target. Liquidity is abundant and our capital base is strong and flexible. Third, the deal environment. M&A now is muted because of COVID-related uncertainty, but we think that in 2021 conditions are going to improve and private equity firms are going to accelerate their investment activity. Consider that private equity has its largest reserves of dry powder ever; it's over $1.5 trillion according to data from Preqin. To put that in context, the whole of the current syndicated loan market is $1 trillion. So, the continuing growth of private equity is, in our judgment, a near certainty and represents a large tailwind for sponsor finance firms like ourselves. Fourth, competitive advantages. In important ways, this COVID impacted period has been playing to our strengths. It's hard to form new relationships; it's hard to form deep bonds over Zoom. So, there's a natural tendency for sponsors to want to work with lending partners they already know. For us, that's been very helpful because we already have a lot of great relationships. Now, as I've told this group before, more than 80% of our originations each year, going back nearly a decade, have been with a core group of about 200 sponsors that we've done multiple deals with. Incumbencies are a similar story. Pre-COVID, the existing lender tended to be in the pole position when a company needed more capital or the company was getting sold from one sponsor to another sponsor. Post-COVID, we think it's proving even more true for the reasons that I just noted. Again, it's the difficulty of switching versus doing due diligence and creating new relationships over Zoom. All these things accentuate the competitive advantages of larger established lenders like Golub Capital. Our other competitive advantages are also important, including our large buy and hold capabilities, our reputation for reliability, our market leadership in one stops, our deep industry expertise, our ability to partner with sponsors on a wide range of different kinds of transactions: large or small, traditional senior or one stops, buy and hold or syndicated. That's why our game plan for fiscal 2021 is going to sound very familiar. It's stay humble and cautious and lean on these competitive advantages that have served us well. Thank you. Operator, please open the line for questions.

Operator, Operator

Thank you. Our first question is from Robert Dodd with Raymond James. Please go ahead.

Robert Dodd, Analyst

Hi guys and congratulations on the quarter on multiple fronts. A first housekeeping one if I can: with the termination of the Deutsche Bank facility after you did the unsecured notes, will there be any acceleration or accelerated expenses tied to that in the next quarter?

David Golub, CEO

Ross, I'm going to let you handle that.

Ross Teune, CFO

Yeah, no, nothing material, Robert.

Robert Dodd, Analyst

Thank you for your comments, David. You mentioned that you expect to see additional unrealized appreciation in the portfolio. Given that there's still about $1 per share of depreciation considering the fair value of the portfolio relative to its cost, what gives you the assurance that you will recover more? Is the recovery so far related to the $700 million in additional equity provided by sponsors? Is the anticipated appreciation dependent on the willingness of private equity to invest more money, or what factors contribute to your confidence in recovering that value?

David Golub, CEO

Sure. Let's revisit the context. As of March 31, we had write-downs due to various factors. One factor was a market-wide spread widening caused by uncertainty related to COVID. The second was the expectation that lockdowns and other COVID impacts would adversely affect credit independently of spreads. It's challenging to separate these factors, but two main components were involved: one related to spreads and the other to credit. Now, nine months later, we have significantly more information about the COVID impact and company performance. Two developments have occurred. First, spreads have narrowed as the markets have mostly recovered since March. Second, specifically regarding our portfolio, we’ve experienced better than anticipated performance. We mentioned this when discussing the June 30 quarter and again in the September 30 quarter. Why have we seen this improved performance? There are several reasons. One is sound underwriting. Another reason is that management teams have effectively adapted, reducing costs, identifying new revenue streams, and managing their operations to ensure profitability and cash generation despite challenges. Additionally, sponsors have provided considerable support, whether through advice, operational assistance, or equity investments. It's difficult to pinpoint which factors are contributing to the improvements in valuations and unrealized gains, but the positive aspect is that all these factors are gaining momentum. What do I mean by this? The economy is performing better than expected, management teams are delivering strong results, and sponsors remain very supportive. My optimism isn't due to a single factor; it's a combination of several. However, I don’t want to imply that this is guaranteed. There are numerous uncertainties that we, as investors and individuals, are facing today. COVID is still an issue, and a widely administered vaccine is not yet available. We also encounter various potential risks. Nonetheless, as I look at our situation today, I am cautiously optimistic about our capacity to manage the portfolio, minimize realized losses, and maintain unrealized gains.

Robert Dodd, Analyst

Thank you. I have one more quick question. Your comments suggested you are more optimistic about 2021 than you are now, and since we are now in December, there is only one month left in the year. What is the activity level looking like? It seems to have ramped up in the fourth calendar quarter. What are you observing in terms of activity? When you mention that the M&A market is muted, does that refer to closings or activity? Are people just not in a rush now and less concerned about tax changes next year, or is there something happening this year compared to things moving into next year?

David Golub, CEO

So, again, just putting in context. So, in calendar Q2, very low activity, everybody was responding to the surprise of COVID. And there was very little new deal activity anywhere, even in sectors that were less COVID impacted. In calendar Q3, we started to see some comeback, particularly in less COVID impacted sectors, including software, including some elements of healthcare. And you can see in the reported results that we discussed today, a meaningfully higher level of new originations in the quarter ended September 30th than the quarter ended June 30th. I anticipate that the quarter ended December 31st will continue that trend. We'll see more improvement; we'll see a higher level of originations in calendar Q4 than we saw in calendar Q3. And we're seeing that more broadly. In other words, it's not just software and a few niches within healthcare, it's broader than that. But if you compared activity in calendar Q4 2020 and calendar Q4 2019, calendar Q4 2020 is muted relative to calendar Q4 2019. And I think it's going to be into 2021 until we start seeing year-over-year increases in M&A activity and new origination activity. The key factor is going to be very simple. It's going to be reduced uncertainty related to COVID.

Robert Dodd, Analyst

Understood. Thank you.

Operator, Operator

Our next question is coming from the line of Ryan Lynch with KBW. Please go ahead.

Ryan Lynch, Analyst

Hey, good morning. Thanks for taking my questions. First one that I just wanted to touch on, you mentioned you had one default in the quarter and restructuring, was that Rubio Restaurants or what portfolio company was that related to?

David Golub, CEO

Rubio's is currently in bankruptcy, and we are collaborating with the company and the sponsor on a restructuring plan to help it emerge from bankruptcy and succeed again. I believe the company is in good shape to achieve that. The other company you might be referring to, which is related to a calendar Q3 event, is a dental practice called Elite Dental. We also underwent a consensual restructuring with them, during which we reduced the company's debt and acquired an equity stake.

Ryan Lynch, Analyst

Okay, perfect. And then you kind of touched on this earlier and you mentioned in your presentation, but you executed 90 plus credit enhancing amendments since COVID with a focus on some of these most impacted COVID-19 impacted sub sectors. Just from a higher level, when you are looking to make a credit amendment to a company, and I know every situation is general, but maybe could you just walk through kind of the priorities that you look at? Are you guys looking to get higher spreads, more fees, tighter guardrails around your covenants, and what are you most wanting in return from the private equity sponsors in support of those amendments?

David Golub, CEO

It is hard to generalize, I think your introduction, your question is right. It's hard to give you a single answer to that question. Our key priority, and I think I've been very clear about this, our key priority is to minimize realized credit losses. So, if you were to rank order the things that are important to us, the first and most important of all things to us is help us avoid losing money. Beyond that, it's very much situation-specific and we look at all the facts and circumstances in a particular borrower and assess what's most important to us and what's most important to the sponsor and the company, and seek to create a win-win solution.

Ryan Lynch, Analyst

Sure. I have one last question about the issuance of unsecured notes. First, congratulations on achieving an investment-grade rating and on that note issuance with a very attractive rate. Currently, your balance sheet appears to be in excellent condition with very low leverage and quite a bit of diversity. However, looking ahead, it seems that about 20% of your liability structure consists of unsecured notes. Is this the level you plan to maintain going forward, or are you considering increasing that proportion? Or will your approach be more opportunistic, looking to enter the unsecured market when favorable rates become available?

David Golub, CEO

I'd say somewhere between two and three. So, yes, we would like over time to have a higher proportion of our debt in the form of unsecured notes and yes, we're going to be opportunistic and thoughtful about when we go to market because we think that our liabilities are a critical competitive advantage, we think it's one of the most important things we can manage.

Ryan Lynch, Analyst

Okay, that's all for me. I appreciate the time today.

Operator, Operator

Our next question is from the line of John Kemmerer with Zeke Capital. Please go ahead.

John Kemmerer, Analyst

Yeah. Hi, this is John. My question is in response to the Fed talking about the LIBOR phase-out yesterday. Just curious when we might see your first loan with a non-LIBOR benchmark? And then sort of related question, maybe you could just summarize for me the overall impact on your operations of this change?

David Golub, CEO

Certainly. There is an industry-wide initiative to transition from LIBOR to a new standard for floating rate loans called SOFR. We are involved with the Loan Syndication Trading Association and its special committee focused on the LIBOR transition. We anticipate that this transition to SOFR will be relatively smooth. We have established several internal working groups to ensure our systems and operational procedures are ready for the change, and we believe we are well-prepared. This situation is reminiscent of the Y2K transition; it requires extensive preparation, and once it occurs, it might feel less significant due to all the prior work invested in it. Currently, we are in the preparation phase for this transition.

John Kemmerer, Analyst

Got it. So, is there a timeline when you might originate the first loan with the new benchmark?

David Golub, CEO

Well, I think the loans are going to have LIBOR language with what's called fallback language, which means a specified language that shows what happens when LIBOR is removed. And we're starting to see that language within credit agreements now.

Operator, Operator

There are no further questions at this time.

David Golub, CEO

Great. Well, I want to thank everyone once again for tuning in for this quarter's call. Look forward to speaking to you all next quarter. And as always, if you have any questions before then please feel free to talk to any of us.

Operator, Operator

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