Earnings Call Transcript - GBDC Q1 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Golub Capital BDC Earnings Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. With that, we'll begin the call.

Jon Simmons, Managing Director

Good afternoon and welcome to GBDC's December 31, 2021 quarterly earnings conference call. Before we begin, I'd 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 we intend to refer to on today's earnings call, please visit the Investor Resources tab on the homepage of our website, www.golubcapitalbdc.com and click on the Events/Presentations link. Our earnings release is also available on our website in the Investor Resources section. As a reminder, this call is being recorded for replay purposes. With that, I'll turn the call over to David Golub, CEO of GBDC. David, take it away.

David Golub, CEO

Thank you, Jon. Hello, everybody, and thanks for joining us today. I'm joined here by Chris Ericson, our Chief Financial Officer; Gregory Robbins, Senior Managing Director; and Jon Simmons, Managing Director at Golub Capital. On behalf of our whole team, we hope the New Year is off to a great start for you. Yesterday afternoon we issued our earnings press release for the quarter ended December 31 and we posted an earnings presentation on the 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 is and since inception it 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 today is that GBDC had another strong consistent quarter. For the quarter ended December 31, adjusted net investment income (NII) per share was $0.31, adjusted EPS was $0.37 and ending NAV rose to $15.26 per share. During the quarter, GBDC made a quarterly distribution of $0.30 per share. And you'll recall that the Board decided in November 2021 to raise GBDC's dividend in light of the company's sustained strong performance. Now I'll hand the floor to Gregory, Jon, and Chris to elaborate on GBDC's performance for the quarter. And following that, I'll provide some closing commentary and then open the line for questions. Gregory, over to you.

Gregory Robbins, Senior Managing Director

Thank you, David. Slide 6 describes two key themes that contributed to GBDC's success in the quarter ended December 31. We've discussed these themes on our last several earnings calls, and we've said that we expected them to continue. In our view, more of the same is a good thing. The first theme is strong portfolio performance. I'd call your attention to the Golub Capital Middle Market Report, or GCMMR for December 31, which we published several weeks ago. The median revenue and EBITDA growth rates in October and November from the pre-COVID period in 2019 to the same period in 2021 exceeded 20% for the third consecutive quarter. Strong earnings growth across GBDC's portfolio was reflected in the continued improvement of key credit metrics. The second theme is robust origination. The Golub Capital platform had its best year ever from an origination perspective in calendar 2021, and calendar Q4 was particularly strong. This led to the very strong portfolio growth at GBDC. Importantly, we believe that portfolio growth came in the form of very attractive new investments. We'll take a closer look at the data on credit metrics and portfolio growth later in the presentation. Turning to slide seven. Let's walk through how our two key themes contributed to growth in NAV per share relative to the quarter ended September 30. As you can see, GBDC out-earned its now higher quarterly dividend with $0.31 of adjusted NII per share. In addition, adjusted net realized and unrealized gains totaled $0.06 per share, reflecting the excellent credit quality of GBDC's portfolio. Let's now take a closer look at our results for the quarter. With that let me hand the call over to Jon Simmons to walk you through the results in more detail. Jon?

Jon Simmons, Managing Director

Thank you, Gregory. Slide 9 summarizes our results for the last several quarters, during which GBDC achieved consistent and expanding adjusted NII, as well as strong adjusted net realized and unrealized gains, EPS, and distributions. Turning to slide 10, this was another strong quarter for originations at GBDC, with new investment commitments totaling $867.7 million. After factoring in total exits and sales of investments of $661.8 million, as well as unrealized appreciation and other portfolio activity, total investments at fair value increased by 5.1% or $251.9 million during the quarter. As of December 31, 2021, GBDC had $41 million of undrawn revolver commitments and $267.2 million of undrawn commitments on delayed draw term loans. These are both relatively small commitments in the context of GBDC's balance sheet and liquidity position. As shown in the bottom of the table, both the weighted average rate and spread over LIBOR on new investments increased a bit quarter-over-quarter. Slide 11 shows that GBDC's portfolio mix by investment type remained consistent, with one-stop loans continuing to represent approximately 80% of the portfolio at fair value. Flipping to slide 12, this slide shows that our portfolio remained highly diversified by obligor, with an average investment size of less than 30 basis points. As of December 31st, 94% of our portfolio was comprised of first lien senior secured floating rate loans and defensively positioned in what we believe to be resilient industries. Turning to slide 13. This graph summarizes portfolio yields and net investment spreads for the quarter and over the past several quarters. 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 10 basis points to 7.1% for the quarter ended December 31. The investment income yield, which includes the amortization of fees and discounts, remained flat at 7.7% for the quarter. Our weighted average cost of debt decreased by 10 basis points to 2.7%. And then finally, our net investment spread, which is the difference between the investment income yield and the weighted average cost of debt, increased by 10 basis points to 5%. With that, I'll hand the call over to Chris to continue the discussion of our quarterly results. Chris?

Chris Ericson, Chief Financial Officer

Thanks, Jon. Flipping to the next two slides, non-accrual investments as a percentage of total debt investments at cost and fair value remained low at 1.2% and 0.9%, respectively, as of December 31st. During the quarter, the number of non-accrual investments declined from six to five due to the disposition of one portfolio company investment. As Gregory discussed in his opening commentary, as a result of continued strong portfolio company performance, the percentage of investments rated 3, meaning companies performing or expected to perform below our expectations at underwriting on our internal performance rating scale, decreased to 6.6% of the portfolio at fair value as of December 31st. As a reminder, independent valuation firms value at least 25% of our investments each quarter. Slides 16 and 17 provide further details on the balance sheet and income statement as of and for the three months ended December 31, 2021. Turning to slide 18, 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 time frame. Turning to slide 19, this graph illustrates our long history of strong shareholder returns since our IPO. As illustrated, investors in GBDC's 2010 IPO have achieved a 10% IRR on NAV since inception and a bit higher than that based on our current stock price. Slide 20 summarizes our liquidity and investment capacity as of December 31, which remains strong with over $1.2 billion of capital available through cash, restricted cash, and availability in our various credit facilities. We also highlight our continued progress in optimizing the right-hand side of our balance sheet. Two key highlights: First, on October 13th and 15th, respectively, we issued an additional $200 million of 2026 unsecured notes at a price resulting in a yield to maturity of 2.667% and an additional $100 million of 2024 unsecured notes at a price resulting in a yield to maturity of 1.809%. Second, on November 19th, we amended our revolving credit facility with JPMorgan, primarily to increase the accordion feature, which now allows us to increase the facility up to $1.5 billion from $712.5 million. In addition, we entered into a series of agreements, most recently on December 17th, to increase the aggregate commitments outstanding under the JPMorgan facility to $1.1875 billion from $475 million as of September 30, 2021. Slide 21 summarizes the terms of our debt facilities as of December 31, 2021. Slide 22 summarizes our recent distribution to stockholders. Most recently, our Board declared a quarterly distribution of $0.30 per share payable on March 29, 2022 to stockholders of record as of March 4, 2022. With that, I will turn it over to David for some closing remarks.

David Golub, CEO

Thanks, Chris. So to sum up, GBDC had a strong quarter for the period ended December 31st. Adjusted net investment income exceeded our recently increased dividend. Realized and unrealized gains were solid. We added additional low-cost and highly flexible unsecured borrowings, and we had robust new originations that enabled the portfolio to grow nicely. Let's talk briefly about our outlook before I open the line for questions. We remain optimistic about the prospects for Golub Capital and GBDC in the coming period. To borrow a phrase Gregory used earlier, our overall outlook is that we expect more of the same. We pointed in recent quarters to one tailwind, which is the strength of GBDC's portfolio. Our internal performance ratings are in line with pre-COVID levels, non-accruals are low and we're seeing net realized and unrealized gains rather than losses. All that means we won't be distracted by needing to play defense on a troubled portfolio. A second tailwind is the strength and flexibility of GBDC's balance sheet. Chris alluded to this in his comments; low-cost highly flexible and fixed-rate unsecured debt now constitutes more than half of GBDC's debt funding. A third tailwind is the continued growth of the private equity ecosystem. Based on growth in private equity fundraising and the current level of private equity dry powder, we think the private equity ecosystem is on a flight path to double in size over the next three to five years. And that means the sponsor finance business will be in a position to grow along with it. In other words, we think Golub Capital is a leader in an attractive growing market. Finally, we believe the changes in the private equity ecosystem play to our competitive advantages. The biggest and strongest players in our market are getting bigger and stronger as leading private equity firms consolidate their relationships among a select few lenders. What do those lenders have in common? They have the scale, capabilities, expertise, and long-term track record to be strategic partners on a wide range of transactions. We expect these four tailwinds are going to continue for the foreseeable future. As always, our optimism is tempered by caution. We worry about Russian adventurism, about the potential for the Fed to raise rates too fast, about inflation, and about supply chain issues. But we're optimistic based on the strength of the Golub Capital platform and the proven resilience of GBDC's portfolio that we're going to be able to continue to serve shareholders well over the course of the coming period. With that, operator, please open the line for questions.

Operator, Operator

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

Jordan Wathen, Analyst

Good afternoon. This is Jordan Wathen on the line for Fin today. I want to ask about your late-stage lending book. It looks like it grew pretty solidly in the fourth quarter even though there is a little bit of volatility in public software and SaaS names. I'm curious how you kind of describe the demand for this capital when public markets take a breather and maybe whether or not you've seen a change in demand for these loans maybe say like November to January?

David Golub, CEO

Sure. So to give context for those who are on the phone who may not be as familiar as Jordan is, when we talk about our late-stage lending or growth lending business, we're talking about loans to software companies that are in a rapid growth mode and have made the decision to invest heavily in selling and marketing expenses at the expense of profitability during a period of rapid growth. We look at these companies using a different set of credit metrics because of the stage of development that they're at and because of this affirmative decision by the management teams and owners of these companies to focus on growth at the expense of profitability. It's been a long-standing strategy of Golub Capital. We've been doing this for more than eight years. It's been a very successful strategy. Our credit losses in our late-stage lending business have been very, very low. When the venture market and the IPO market are particularly strong, it puts a damper on our late-stage lending business because the companies that we're lending to have choices, and among the choices they have are issuance of equity as an alternative to issuance of debt. So during periods in which valuations are really high and venture firms are eager to deploy capital, it's harder to find attractive late-stage lending opportunities. So the fourth quarter was one of those periods. It was a period of relatively high stock prices, relatively robust venture fundraising, and venture deployment. So I'd describe it as a relatively unfavorable period for our late-stage lending business in terms of new lending activity. We have, as you point out, seen a drop in stock market prices in the tech sector. And in January that drop was particularly significant for young tech companies. So I'm cautiously optimistic that we're going to see a pickup in our late-stage lending business in calendar 2022. The first quarter always tends to be a bit seasonally slow, but it looks like we're headed into a period that's more favorable for this piece of our business. Does that answer your question, Jordan?

Jordan Wathen, Analyst

Yes, it does. That's helpful and good to know. So just to move on to another topic. You have one of the best fee structures in the industry with your total return hurdle. Many BDCs would have performed better for shareholders with such a structure, and not many would have performed worse. Considering the current trading environment for the BDC, do you believe the market is recognizing the value of the fee, or have you considered adjusting it to highlight the benefits of that structure more effectively?

David Golub, CEO

It's a good question. I think maybe one we need to give some more thought to. I would tell you that in my mind a key part of our fee structure is what we think is really important in addition to the features you mentioned is the hurdle rate. We have an 8% hurdle rate before the manager begins to receive net investment income incentive fees. And I think that's a really important part of the structure as well. I do think it's a very favorable overall structure from a shareholder perspective. And I think it has, over the course of the almost 12 years we've been public, done a nice job of aligning incentives between the manager and shareholders.

Jordan Wathen, Analyst

Thanks so much.

Operator, Operator

Your next question comes from the line of Ryan Lynch with KBW.

Ryan Lynch, Analyst

Good afternoon and thank you for my questions. My first question is about the recent investor interest in how rising rates are impacting BDC's operating earnings. I want to shift focus to the portfolio of companies or borrowers. Currently, they are dealing with higher labor costs and increased raw material input costs. Given that the Fed President mentioned they want to raise rates above 1% by July, if rates rise quickly enough to surpass the interest rate floors most loans currently have, how do you believe credit quality will hold up in your portfolio? Can your borrowers manage to pay these higher interest rates while also handling the other costs affecting their businesses?

David Golub, CEO

Thanks for your question, Ryan. When we consider the current situation for our borrowers, there are both positive and negative factors at play. It's important to acknowledge both sides. On the positive side, the economy is continuing to grow at a good pace. According to the most recent Golub Capital Middle Market Index results, median company revenue and EBITDA in the first two months of the fourth quarter are significantly higher compared to last year and even 2019, prior to the COVID impact. Growth and strong consumer spending are crucial aspects of what management teams are experiencing right now. On the negative side, they are contending with rising costs. Inflation, particularly affecting wages in various markets and industries, is a concern. Additionally, we're seeing significant increases in other input costs in some sectors. Currently, these inflationary cost increases pose a more substantial challenge than rising interest rates. As you noted, Ryan, the Fed's recent announcements suggest a strong possibility that LIBOR will rise above the minimum levels. However, the overall increase in interest expenses remains relatively minor. Therefore, I don’t expect rising rates alone to have a significant effect on credit performance. There are two main risks to credit performance that we're monitoring closely. The first involves companies lacking pricing power, which is something we actively evaluate during underwriting. While this issue may not dramatically affect our portfolio, it will impact the broader economy. Companies without pricing power will face shrinking margins since they won't be able to increase prices as quickly as their costs rise. This challenge is likely to be significant across the economy. The second risk is the possibility of the Fed acting too quickly. Many would agree in hindsight that the Fed has been too cautious until now. We are still observing the Fed implementing a quantitative easing program and purchasing securities, which is surprising given the current timing. After a prolonged period of being too slow, the concern now is that the Fed might accelerate its actions excessively, potentially reversing the recent growth in its balance sheet. If rates are raised too rapidly, it could counteract efforts to alleviate inflation, resulting in a notable weakening of the economy. These two risks are what we are focusing on and monitoring closely, and I am considerably more concerned about them than about the increased interest expenses affecting our borrowers' financials.

Ryan Lynch, Analyst

Understood. That's really good insight. I appreciate the thorough conversation about the various factors affecting our current position. I have a broader question regarding market activity. In your prepared remarks, which I agree with, you mentioned that the private equity ecosystem could potentially double in the next three to five years and its implications for private credit and direct lenders, especially those with large-scale platforms like yours. However, I'm curious about the near term. Revisiting the comments on rising rates, we've already seen them negatively impact multiples in the public markets. I would assume this is or will soon affect private market valuations as well. I think sponsors who have completed transactions in the past few years at specific multiples might choose to transact less frequently or hold onto their positions longer if those multiples decrease significantly. Could you connect your comments about the expanding total addressable market and the underlying growth trend with the potential challenges regarding multiples and sponsors' willingness to engage in transactions?

David Golub, CEO

So it's a really interesting question. So let's think about this a couple of different ways. Right now, there are three different principal kinds of ownership of middle-market companies in the U.S. They're family-owned businesses, they're publicly owned businesses and they're private equity-backed businesses. So if you're right, and there's a period of multiple contraction, what impact would that have on likelihood of M&A activity stemming from each of those different forms of ownership? I think it would likely increase the amount of public to private activity because we'd see public market valuations go down. And when we see public market valuations go down, we typically see a degree of mispricing of some companies and their stocks, and that in turn catalyzes some activity. So for public companies, I think that'd be a plus from an M&A activity standpoint. For family-owned businesses, it might be both a plus and a minus: a plus because it might drive a need for liquidity; a minus because families might see that they'd be better off waiting and selling in a better environment. And I kind of see the same dynamic happening in the private equity ecosystem, where it's both a plus and a minus. You're right that it might lead some private equity firms to want to hold some portfolio companies longer to grow and to, in essence, generate a better dollar return on their investment by just taking longer. On the other hand, the pressure on sponsors to show good rates of return is a mitigant to this longer holding period pattern. Longer holding periods make it harder to achieve the rates of return that private equity firms seek. So I think it's complicated. I'm not sure how I see this all netting out. I come back to the main point, which is you've got existing unused capital that the private equity firms have in their coffers and need to spend within a defined time period. There's enormous fundraising that's been going on for the last several quarters, record after record being broken. So I think, both of those argue for robust new private equity spending. So I think on balance, I still think even if we see an equity market decline, you're likely on balance still to see a robust private equity-backed M&A environment.

Ryan Lynch, Analyst

That's helpful. And David, I'll give you a pass on not being able to see the future with complete clarity. That’s all right. One last one, if I can. And this is just kind of a small minor one on GBDC. But if I look at your guys' equity portfolio, it's still very, very small relative to the overall size of your portfolio. But it has been growing over the last several quarters. And if we look at the commitments, again, still a very small portion of your portfolio but commitment size on a quarterly basis as a percentage of investments in a quarter has increased pretty materially 5% two quarters ago, 3% a quarter ago, and 8% on new commitments. So any insights you could provide into that? I know it's still really small and it's not a huge change, but that was something that stood out a little to me.

David Golub, CEO

Yeah. I think it's a good point. It is still small. We plan for it to continue to be small, but we have seen some what we think are very attractive opportunities in some what we call yield-oriented preferreds. These are preferreds in mostly software companies that nest themselves between the debt and the equity. They're relatively low attachment point on a loan-to-value basis, and in companies that we know well and have a lot of conviction in. So we have done more of those in the last several quarters than we've done historically and we see it as an attractive new part of the portfolio.

Ryan Lynch, Analyst

Okay, understood. Appreciate the comment.

Operator, Operator

Your next question comes from the line of Robert Dodd with Raymond James.

Robert Dodd, Analyst

Hi everyone, congratulations on the quarter. I have a follow-up question related to Ryan's point. We've observed significant growth in the private equity ecosystem and it continues. A major contributor to this growth is larger funds or platforms managing increasingly larger funds, which requires them to engage in bigger deals. Given that the private credit market is expanding and capturing more market share—as we discussed last quarter regarding larger unitranche deals which are expected to rise—do you believe that your participation in the growth within the private equity ecosystem will necessitate a larger involvement in extremely large deals, including those over $2 billion that may have specific loan terms? Will this area of your portfolio increase as part of your overall mix?

David Golub, CEO

It's a great question and I don't know. We'll see. I think that element of the market is going to continue to grow and our participation in it is going to be a function of whether we think the opportunities are attractive. But I want to make a really important point, which sometimes isn't understood. While Golub Capital is a market leader in these mega unitranches, I think in 2021, calendar 2021, we were lead or co-lead in roughly half of them. It's not most of what we do. If you were to do a carving of the GBDC portfolio by level of EBITDA, the vast preponderance of the portfolio, in the neighborhood of 80%, is in the form of loans to companies with less than $75 million of EBITDA. So we're not committed to this large market strategy as the only source of deal flow for us or even the main source of deal flow for us. It's a part of our business. When we see attractive opportunities in that area, we're going to take advantage of them. But if that market got overheated, if that market shrunk in size unexpectedly, it's really not a big problem.

Robert Dodd, Analyst

Understood. Yes, to be fair I mean I think you gave us last quarter it was 15% to 20% of your portfolio last quarter. The question's whether it's going to grow rather than how significant it is today, but I appreciate that color. One more if I can. Kind of without asking necessarily about volume I mean as we get into 2022 and LIBOR phasing out how has that – less about the existing deals in the book and more potentially pipeline. Is the transition to SOFR going – SOFR plus CSA going – as expected, or any stickiness to LIBOR still out there? There were still LIBOR deals being done in January from what I heard so I'm just curious.

David Golub, CEO

My sense is that the transition market-wide is going very smoothly. I think an enormous amount of work was done by the industry to prepare for this. And sure there will be some grindiness, given the scope and nature of the transition. There'll be some issues that arise. But from my vantage point to date, it's going exceptionally smoothly.

Robert Dodd, Analyst

Appreciate it. Thank you.

Operator, Operator

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

Ray Cheeseman, Analyst

Thank you for taking my question. You guys have built a very high-quality mousetrap, tremendous stable results over many cycles, high-quality credit portfolio. I'm wondering, you started by saying that the big guys are getting bigger and succeeding as the other side of the equation has been reducing the number of people they do business with. And the question is kind of a corollary to Robert's before. Do you think that your platform, at $5 billion or a little bit better, and the growth path you're currently on is optimal, or should you be bigger or the risk is if you're bigger, does that kind of force you to do deals you might not want to do?

David Golub, CEO

So what's the right size for Golub Capital? It's a really interesting question that we regularly consider. Let me provide some context. GBDC is one of the vehicles we manage at Golub Capital, along with a series of private funds and several private BDCs. Overall, we manage about $45 billion across our platform, making us one of the largest players in the sponsor finance marketplace. Being one of the largest players brings significant advantages. We have a wide range of products and can assist private equity firms with financing for both small and large companies. Our investment team is among the largest, with over 160 people, which allows us to have in-depth expertise across various industries. This expertise helps private equity firms quickly get up to speed and add value during the diligence process and ownership phase. We are market leaders in the unitranche product, which we pioneered, and it has proven to be an effective way for sponsors aiming for buy-and-build strategies to efficiently manage their balance sheet through multiple transactions as they grow. There are numerous advantages we have due to our scale. When I made those earlier comments, I was thinking about how many successful private equity firms—though they are indeed doing larger deals—are also undertaking more deals overall. These larger firms engage in more activities within a given year. The successful private equity firms follow a pattern: they have a capital markets group that builds relationships with a select group of lenders that they repeatedly work with. For these firms, partnership orientation, reliability, reputation, and track record are crucial, as well as capabilities. These capabilities are much stronger for large-scale players like Golub Capital that offer a broad product suite and have a substantial underwriting team. I believe this trend will likely persist in the future. The private equity industry already comprises a set of successful firms that are gaining market share and performing well compared to the industry overall, and I expect this to continue. Furthermore, I anticipate that the private debt industry will consolidate around a small group of leading players that the top private equity firms see as strategically significant partners. Regarding your question about our optimal size, I believe we have opportunities for growth from our current position, partly because I expect the private equity ecosystem to expand. I mentioned earlier that I think it could roughly double within the next three to five years. Additionally, we have a chance to gain market share as the industry consolidates, allowing us to grow not only with the industry but potentially faster than it. However, we are committed to methodical growth—careful, disciplined, and planned growth. That's been our approach since GBDC became public, and that will continue to be our strategy moving forward.

Ray Cheeseman, Analyst

Thank you for a very robust answer.

Operator, Operator

There are no further questions at this time. I would like to turn the call back over to the presenters.

David Golub, CEO

Great. Thank you everyone for joining us today. Very much appreciate your time and attention. And as always, if you have questions, feel free to reach out to us. Otherwise we look forward to talking again next quarter.

Operator, Operator

This concludes today's conference call. You may now disconnect.