Earnings Call Transcript - GSBD Q2 2020

Operator, Operator

Good morning. This is Dennis, and I will be your conference facilitator today. I would like to welcome everyone to the Goldman Sachs BDC, Inc. Second Quarter 2020 Earnings Conference Call. Please note that all participants will be in listen-only mode until the end of the call when we will open up the line for questions. Before we begin today's call, I would like to remind our listeners that today's remarks may include forward-looking statements. These statements represent the Company's belief regarding future events that by their nature are uncertain and outside of the Company's control. The Company's actual results and financial condition may differ, possibly materially, from what is indicated in those forward-looking statements as a result of a number of factors, including those described from time-to-time in the Company's SEC filings. This audiocast is copyrighted material of Goldman Sachs BDC, Inc. and may not be duplicated, reproduced or rebroadcast without our consent. Yesterday, after the market closed, the Company issued an earnings press release and posted a supplemental earnings presentation, both of which can be found on the homepage of our website at www.goldmansachsbdc.com under the Investor Resources section. These documents should be reviewed in conjunction with the Company's Form 10-Q filed yesterday with the SEC. This conference call is being recorded today, Tuesday, August 11, 2020, for replay purposes. I'll now turn the call over to Brendan McGovern, Chief Executive Officer of Goldman Sachs BDC.

Brendan McGovern, CEO

Thank you, Dennis. Good morning, everyone, and thank you for joining us for our second quarter earnings conference call. I'm joined on the call today by Jon Yoder, our Chief Operating Officer; and Jonathan Lamm, our Chief Financial Officer. I'll begin the call by providing an overview of our second quarter results including comments regarding the performance of our portfolio. I'll also provide an update on our proposed merger with our affiliated business development company, Goldman Sachs Middle Market Lending Corp, which we refer to as MMLC. Jon Yoder will then discuss our portfolio in more detail with respect to the current environment before turning it over to Jonathan Lamm to walk through our financial results. Finally, I'll conclude with some closing remarks before we open the line for Q&A. So with that, let's get to our second quarter results. Q2 net investment income per share was $0.45 on after-tax net investment income of $18.2 million. The Company’s NII once again fully covered the dividend during the quarter. Our GAAP earnings per share was $0.86, which represents the highest quarterly EPS produced by the Company since inception and reflects the solid net investment income generated during the quarter, as well as net gains in our investment portfolio, partly resulting from the tightening of overall market credit spreads. Net asset value per share increased to $15.14 per share, an improvement of 2.9% from the end of the first quarter. Investments on non-accrual remained unchanged quarter-over-quarter and represented 0.1% at fair value and 0.9% at cost of the total portfolio. We believe these are strong results in any environment, but particularly in light of the challenging economic environment that we operated in during the second quarter. As we announced after the market closed yesterday, our Board declared a $0.45 per share dividend, payable to shareholders of record as of September 30, 2020. This equates to an annualized dividend yield of 11.9%, based on net asset value per share at the end of Q2. We attribute our strong performance during the quarter to our focus on investing in businesses that we believe are durable and less prone to significant impact from economic cycles. Our largest sector exposures, which include software, healthcare, and IT-enabled business services have thus far demonstrated resilience in this crisis. For example, our software portfolio companies averaged 18% year-over-year revenue growth rates in the first quarter of 2020, and preliminary numbers suggest that they maintained high single-digit to low double-digit year-over-year revenue growth rates even during April and May when lockdowns were in effect. Customer retention metrics were also strong, which we believe reflects the mission-critical nature of the applications. Our healthcare portfolio is primarily comprised of businesses engaged in providing outpatient healthcare services or outsourced hospital services. These businesses were negatively impacted by lockdowns issued in March that prohibited so-called non-essential medical services. In response, our portfolio companies reforecast their business plans for the remainder of the year with conservative assumptions about the duration of lockdowns and the time it will take to return to more normalized demand for medical services. However, as the second quarter progressed, the lockdowns were lifted sooner than expected in many geographies and customer demand began to rebound quicker than most companies forecast. In most cases, businesses providing non-essential medical services were among the first to resume operations after the recent lockdown orders. In general, this has resulted in patient volumes, revenues, and liquidity that are better than these companies had forecast for this stage of recovery. In analyzing corporate performance during this remarkable period compared to typical economic cycles, one dynamic that stands out is the extraordinary response from business owners and management teams to quickly and aggressively adapt business plans in the face of uncertainty. In the early phases of typical recessionary cycles, companies are often slow to respond as the commencement, depth, and duration of recessions are difficult to forecast. In this environment, however, given the obvious devastating impacts from the global health crisis and ensuing lockdowns, companies acted swiftly to adjust business models in recognition of the challenging operating environment. Expenses were cut, large capital outlays were put on hold, and balance sheet focus on liquidity was the main priority. By and large, private equity sponsors and business owners were acting rationally to ensure the ability of companies to grow through to the other side of this environment. In our view, this decisive and proactive management has been and remains a significant benefit for lenders. While there is certainly a long way to go before the broader economy returns to normal and the possibility of additional lockdowns remains, we're pleased thus far by the efforts undertaken to preserve value in this crisis. Next, I want to provide an update on our previously announced merger with MMLC. On June 11th, we entered into and announced an amended and restated agreement and plan of merger that was unanimously approved by the Board of Directors of this company, following the recommendations of each company’s special committee consisting exclusively of their independent directors. The consideration has been changed from a fixed exchange ratio to a net asset value for net asset value exchange whereby the exchange ratio will be determined at closing so that the MMLC shareholders will receive GSBD shares, representing a proportional ownership of the combined company equal to MMLC's proportional contributions to the combined company’s net asset value. In connection with this amendment, GSAM has agreed to extend the variable incentive fee cap for an additional year through the end of 2021. As a reminder, the variable effective fee cap provides that incentive fees payable to GSAM will be reduced if net investment income falls below $0.48 per share without the implementation of the incentive fee cap. GSAM also agreed to reimburse GSBD and MMLC for all fees and expenses incurred and payable by GSBD or MMLC, or on their behalf in connection with the transaction, subject to a cap of $4 million with respect to each of GSBD and MMLC. This transaction creates a number of significant benefits for shareholders that I'd like to reiterate: First, we currently expect the merger to be accretive to GSBD's NII per share in the short and long term. Second, we also expect the transaction to result in significant deleveraging for GSBD, which creates more capacity to deploy capital into today’s attractive investment environment, while at the same time adding a greater margin of safety to maintain GSBD's investment-grade credit rating and compliance with regulatory and contractual leverage ratio requirements. Third, the merger is expected to result in overall improvement in GSBD's portfolio metrics, including a higher portfolio yield and greater single-name diversification. It is also worth noting that MMLC has only one investment on non-accrual status, representing less than 0.1% of the portfolio at fair value and 0.7% at cost. Finally, the combination more than doubles the size of GSBD and is expected to result in benefits of scale including improved access to diversified funding sources, cost synergies, and greater trading liquidity. For all these reasons, we are very confident that this transaction is in the best interest of shareholders of both companies. The record date for shareholders eligible to vote on this transaction is August 3rd, and a Special Shareholder Meeting is scheduled to occur on October 2nd. In the coming days, shareholders will receive proxy materials and statements. So, we encourage everyone to take the time to vote in favor of the merger. With that, let me turn it over to Jon Yoder.

Jon Yoder, COO

Thanks, Brendan. The second quarter of 2020 will undoubtedly be remembered for years and decades to come as an extraordinary period, during which entire sectors of the global economy shut down on a more or less synchronous basis. Against this backdrop, we were pleased with our portfolio, as demonstrated by the strong principal and interest payment performance by our portfolio companies in the face of this adversity. In our diversified loan portfolio with 107 underlying portfolio companies, loans to just three companies were modified to defer principal and interest payments, representing approximately 2% of the portfolio at both cost and fair value. In one case, we agreed to defer the second quarter payments until October, but the company has already resumed making monthly payments in July, as the business and liquidity have rebounded. In another case, we collected monthly payments in April and May, but agreed to defer the June payment in exchange for a capital injection that is junior in the right of payment to our loan. In addition, we executed amendments this quarter that permitted two borrowers to switch from cash to paid-in-kind interest. These two investments represent less than 1% of the investment portfolio at both cost and fair value. Both of these amendments were executed in connection with new equity or other capital infusions by other investors in the companies. In the majority of cases, when negotiating amendments like these, we obtained compensation for agreeing to the amendment, which is typically in the form of a fee, an increased interest rate, or a capital injection or other form of credit support by the owner of the business. I would note that none of these amendments relate to non-sponsored businesses. While our focus this quarter was primarily on our existing portfolio, we were active across our platform in reviewing new investment opportunities. Deal volumes were quite low in the early part of the quarter, but we saw a steady increase as the quarter progressed. Terms of new deals are meaningfully better than the pre-COVID period and generally include wider spreads, tighter covenants, and better call protection. I'd also add that the underwriting process is significantly enhanced because now we can review a company's financial performance over the last few months to actually see how it performs during a recessionary period. While we will continue to be primarily focused on our existing portfolio in the current quarter, our platform remains highly engaged with middle market sponsors and owners to evaluate opportunities, and we are confident that the company will be a beneficiary of the improved investment environment. So, to turn to specifics for the quarter. During this quarter, we made two new investment commitments, one of which was to a new portfolio company and one was to an existing portfolio company, but both of these were negligible in size. We received $18.3 million in repayments, driven primarily by the full repayment of our second lien investment in DiscoverOrg, which was ZoomInfo and went public in an IPO on June 4th. It quickly raised to a market capitalization of over $18 billion. This would imply that the loan-to-value on our second lien investment in the company was approximately 7%. Last quarter, we spoke about drawdowns on revolving loan commitments that we’ve made to certain portfolio companies. This quarter, we experienced net repayments of revolving loan commitments, which we think is evidence that liquidity is generally solid across our portfolio companies. Given the muted originations and repayment activity this quarter, our portfolio composition as of June 30th is relatively unchanged quarter-over-quarter. Total investments in our portfolio were $1,424.5 million at fair value, comprised of 92.7% in senior secured loans, including 78.3% in first lien, 2.4% in first lien/last-out unitranche loans, and 14.4% in second lien debt, as well as 0.5% unsecured debt and 6.8% in preferred and common stock. We also had $60.8 million of unfunded commitments as of June 30th, bringing total investments and commitments to $1,485.3 million. As of quarter-end, we had 107 portfolio companies operating across 38 different industries. The weighted average yield of our investment portfolio at cost at the end of the second quarter was 7.5%, as compared to 7.7% at the end of the first quarter. The weighted average yield on our total debt and income-producing investments at cost was 8.3% at the end of the quarter, as compared to 8.5% at the end of Q1. The decline in yields during the quarter was primarily attributable to the decline in LIBOR. However, the vast majority of our portfolio has a LIBOR floor of 1% or higher. Therefore, we do not expect significant further headwinds, given current LIBOR levels. I'll now turn the call to Jonathan to walk through our financial results.

Jonathan Lamm, CFO

Thanks, Jon. During the quarter, we continued to maintain cash on our balance sheet in excess of our unfunded obligations for the time being. As a result, we had $105.8 million of cash and cash equivalents on our balance sheet as of the end of Q2 against unfunded investment commitments of approximately $60.8 million. While we are cognizant that maintaining this excess liquidity has a cost, we believe it remains prudent to have excess cash on hand during this extraordinary environment. We will continue to evaluate the level of this excess liquidity on an ongoing basis and would expect it to decline as the economic environment normalizes. Turning to our operating results. Our net investment income per share was $0.45, the same as in Q1. Earnings per share were $0.86, compared to a loss per share of $1.58 in the previous quarter. Our total investment income for the second quarter was $30.6 million, which was down from $32 million last quarter. The decrease was primarily driven by a decrease in interest income due to a decline in LIBOR. We ended with net expenses of $12 million for the quarter as compared to $13.4 million in the prior quarter. Expenses were down quarter-over-quarter, primarily reflecting the voluntary fee waiver in the quarter. During the quarter, our ending net debt to equity was 1.33 times versus 1.4 times at the end of Q1. We ended Q2 with net asset value per share at $15.14 as compared to $14.72 from the prior quarter, driven by unrealized depreciation on investments, primarily as a result of tightening credit spreads. The Company continued to have $46.6 million in taxable accumulated undistributed net investment income at quarter end, resulting from net investment income that has exceeded our dividend historically. This equates to a $1.15 per share on current shares outstanding. Consistent with prior years, we spilled over all of the undistributed net investment income into 2020, as we believe the cost of the spillover in the form of the excise tax is a small price to pay relative to the much higher cost of issuing new equity to replace that amount. With that, I will turn it back to Brendan.

Brendan McGovern, CEO

Thanks, Jonathan. In closing, while we’re pleased with the Company’s strong performance during the quarter, we remain highly aware that we’re operating in an extraordinary environment and that we’re likely closer to the beginning than the end of the economic disruption caused by the ongoing pandemic. We are focused on working with management teams and the financial sponsors and owners of our portfolio companies to navigate through this challenging time. At the same time, we are keeping a careful watch for unique opportunities to create value for our shareholders. We believe that the proposed merger with MMLC is just such an opportunity, and we encourage our shareholders to take the time to vote in favor of the transaction at your earliest convenience. As always, we thank you for the privilege of managing our capital. And as always, we’re open to hearing from you, especially as all of us work through this extraordinary environment. With that, let’s open up the line for questions.

Operator, Operator

And the first question comes from Finian O'Shea with Wells Fargo Securities. Please go ahead.

Finian O'Shea, Analyst

Hi. Good morning. Thanks for having me on. I hope everyone's doing well. I was a little late, so I apologize if this has been discussed. I'm inquiring about the $2.1 million to $2.2 million fee waiver. I thought the waiver was meant to limit the incentive fee to earn 48. Is this quarter's waiver a one-time decision or is there a specific strategy behind it? It clearly assists in meeting the dividend, so that might be a factor. Any insight on this would be appreciated.

Brendan McGovern, CEO

Yes, Finian. It’s Brendan. I'll let Jon chime in if he has points here as well. But yes, this was over and above the contractual variable incentive fee waiver that we had put in place. And the view then was obviously this extraordinary environment. And as a means to further support the outstanding merger, we thought it made sense to continue to support companies with the incremental fee waiver. And we think ultimately, that's a benefit to shareholders to support the dividend here. And as we look forward to the merger and transaction, we talked a lot about the incremental benefits that the Company will get. We enumerated a bunch of those in the call here today, including deleveraging, but also very importantly including the accretion to net investment income on a per-share basis. So, as we sort of approach getting the merger over the finish line, we thought it was appropriate to drive incremental support to the company in that regard.

Finian O'Shea, Analyst

Sure. That's helpful. And just to follow up, appreciating all the dividend support and the waivers now and over time. Even with this rebound, your dividend is about 12% of book, which is probably high, even with your very good cost structure. I mean, it's perhaps earnable, but at least borderline. Do you have a longer-term view? Are you confident with a certain level of say leverage and spread that you're able to earn the dividend through the merger?

Brendan McGovern, CEO

Yes. I think that’s the main point here. As we look forward to the merger again, transaction done and benefits, the fact that we've got a big deleveraging that will take place with incremental asset capacity. And when you combine two companies, especially when you look at MMLC, with a lack of non-accruals and higher portfolio yields, we do continue to see the dividend as affordable pro forma for the merger.

Jon Yoder, COO

And let me add to that. The other benefit, as Brendan mentioned, is the deleveraging. And part of it is, obviously, we're in a much better spread environment today than we were pre-COVID. So, as we think about pro forma of the merger, the ability to deploy capital following our deleveraging into the better spread environment is also incredibly helpful. So, it's more than just the A plus B, it's also let’s say the incremental that we can do from there.

Finian O'Shea, Analyst

Sure, I appreciate the insights on the market outlook, which align with what we've been hearing this quarter. Can you provide an update on your activity in the non-sponsored channel? Is that area becoming more accessible, less so, or evolving similarly to the traditional sponsor market?

Brendan McGovern, CEO

Yes, that's a good question. What we've mentioned before, and it's worth reiterating, is how we view our two main sources of sourcing. One comes from our sponsor partners and the other comes from our connections with middle market business owners. These tend to work in contrast to each other. When there's a lot of sponsor activity, many middle market business owners are likely to look to sell their companies to take advantage of strong bids from private equity firms. This means they're probably less inclined to borrow money to pursue growth initiatives. Conversely, in times of lower sponsor activity and potentially lower valuations, we typically see an increase in interest from non-sponsored business owners looking to borrow money to grow their businesses rather than selling at a lower enterprise value than they could have achieved. We're still in the early stages, and the shock to the system we experienced in March, April, and May led to a quiet period with little activity from both sponsored and non-sponsored sources. However, as volumes begin to rebound, we expect to see more activity from the non-sponsored side in the upcoming months and quarters. Based on our current pipeline, there are signs that this trend is already starting to emerge.

Finian O'Shea, Analyst

Okay. Thanks. And just one more, you gave your I think 3 modifications. Is this exclusive of immaterial or regular covenant releases, less material covenant releases?

Brendan McGovern, CEO

Yes. We are focused on the key amendments or changes to the existing loan documents that we discussed in our prepared remarks. As you may have heard, we had less than 2% of the portfolio consisting of three names for which we granted deferrals, and we switched to paid-in-kind interest for a couple of names, which also represented less than 1% of the portfolio. Overall, the modifications related to cash payment terms accounted for less than 3% of the total portfolio, which we consider fairly small. Additionally, there are typical minor amendments that occur in any quarter, but we do not view them as economically significant or noteworthy.

Jonathan Lamm, CFO

And Finian, I would say that it’s important to differentiate between payment amendments. We are very specific about that, along with other amendments. Jon mentioned your other categories, including waivers of payment schedules related to our portfolio. Overall, it accounted for about 6% of the portfolio on a fair value basis.

Operator, Operator

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

Robert Dodd, Analyst

Following up on Tim’s question regarding the dividend in relation to NAV, we are having some difficulty reaching the $0.45 dividend unless there is a further improvement in your investible assets after the waiver and when structural contractual waivers expire. Can you provide any clarification on possibly increasing leverage further? While it's clear that MMLC will decrease, are there other factors at play? It still feels a bit elevated.

Brendan McGovern, CEO

Yes, Robert, I’m happy to discuss this in more detail as we move forward. Jon touched on some key factors that will contribute to the net interest income growth going forward. Due to our deleveraging, we have additional investment capacity available. However, we wouldn’t suggest this is above any previously announced target. We recognize that the investment environment has improved, with higher yields, higher spreads, more upfront points, and better call protection. This quarter, the decline in investment income was largely driven by LIBOR. When looking at GSBD separately, it has a larger portion of fixed-rate debt, which means we experienced a bigger impact in this quarter when LIBOR went down, especially since some of our debt obligations are fixed. MMLC does not face this same dynamic. Additionally, we have opportunities to monetize currently non-income generating assets, particularly at GSBD, with examples like Hunter Defense, which is a non-income producing asset in the portfolio but shows strong performance, allowing us to reinvest in income-producing assets. This quarter, we also faced a lack of other income; we recorded about $300,000 from an amendment fee, while a year ago, this number was about $2 million. Considering all these factors, we see strong support for a significantly higher per-share income level on a pro forma basis.

Robert Dodd, Analyst

I appreciate that. One of the components is supporting the dividend. I have two questions here. Are you going to be affected in this environment?

Brendan McGovern, CEO

Yes. I'll take a crack at that. I'm sure Jon has some thoughts here as well. So again, the merger is deleveraging, there is incremental investment capacity, well within the capability of the team to quickly take advantage of the current market opportunity and deploy that capital into the current environment. So, you wouldn't see, for example, Robert, that excess capital taking a long time for us to get deployed and put out into this current market environment. And so, I don't think we would up the risk spectrum, in order to produce those higher yields in the current environment; it is quite supportive of that. In fact, you can get safer loans, lower leverage companies that got the ability to observe their performance during this pandemic and understanding their ability to resilience in this environment and make those loans at higher yields and higher spreads. And so, we think that's all in the capabilities. In terms of how we underwrite in this environment, obviously, we're all figuring out how to reengineer workflow processes or in the ordinary course. Every single company that we're investigating in, we're out meeting the company, we're meeting the management team, working on a local basis. And now, we have to do what's going to be the safest for our team and for our counterparties as well. So, there's a lot we could do with technology. There's a lot that we're able to do with the benefit of our third-party advisors as well, in certain cases, our consultant, of course, etc. So, we feel quite comfortable investing in this environment. One thing, I'd say as well, again, when you look at the component of our portfolio where we've been heavily invested in areas like software and healthcare, I suspect you'll see other managers who have seen resilience in those areas wanting to break in. Having been active in those spaces for quite a long time, having the benefit and depth of relationships I think puts us at an advantage as we're winning transactions in those sectors that have proven to be a bit more resilient.

Jon Yoder, COO

Yes, Robert, I would add a couple of points. First, the weighted average portfolio yield at GSBD has declined due to the drop in LIBOR. Now that we're below the floor, we don't anticipate much movement from here. Additionally, the average portfolio yield fell when we incorporated our former senior credit fund onto the balance sheet. We discussed this about a year ago when we executed that transaction. Our plan remains focused on the fact that these loans, while lower yielding and not central to our direct origination strategy, will eventually be monetized as they are repaid or mature, allowing us to redeploy capital into a higher spread environment. The second point is that public BDCs, including ours, have a significant advantage due to locked-in financing spreads over the next five years. Those seeking new financing to pursue private credit strategies today will face much higher spreads than pre-COVID levels. Our revolver, maturing in 2025, has an attractive spread of LIBOR at 187.5. Private credit managers, raising new funds now, won't find comparisons close to that spread, providing our BDC a cost of capital advantage. This means the overall spread environment for new loans is likely to remain elevated as those private credit managers, lacking locked-in low spreads, will have to charge higher spreads on their assets to achieve target returns. This positions public BDCs, including ours, favorably in the current landscape. Lastly, regarding underwriting, Brendan covered practical realities well. I want to emphasize that the best time to underwrite a loan is often during or just after a recession, as you can observe how companies perform in a pressured environment. We've had a decade without recessions in this country, making it challenging to gauge company performances through downturns. However, recent evidence provides valuable insights that enhance our underwriting capabilities as we look for high-quality, recession-resistant companies rather than distressed assets.

Robert Dodd, Analyst

If I may, I'd like to ask a follow-up question. Clearly, when we consider a recession, the healthcare sector seems to be quite resilient this time, but this resilience is influenced by the significantly different healthcare landscape. So, how does this recession fit in? It doesn't appear to align with the typical effects associated with a standard recession.

Brendan McGovern, CEO

No, that's a valid observation, and you're correct. There are certainly unique aspects to this recession. I believe you highlighted what I would consider the most critical factor, which is the effect on healthcare. Typically, we wouldn't anticipate significant cyclicality in the healthcare sector, but due to the cause of this recession, it has been impacted differently than usual. However, if we look past that, Robert, the primary effect of this recession can be seen as one with a different cause. In a standard recession, companies tied to retail, travel, leisure, and real estate are generally more cyclical and suffer greater impacts, with oil and gas also facing more challenges. This is not atypical. Yes, there are additional dynamics related to people’s apprehensions about being in crowds and public settings this time around. Yet, the overall impact of that demand disruption is playing out in a manner that is comparable to what we observe in other deeper recessions. Your observation is valid; there are certainly unique elements to this recession. But overall, what we are witnessing is demand disruption that isn't vastly different from that seen in other severe recessions.

Operator, Operator

At this time, there are no further questions. Please continue with any closing remarks.

Brendan McGovern, CEO

Great. Thank you, Dennis. And thank you all for joining us on the call. As always, if you have any additional questions, please feel free to reach out to the team. And I hope you have a great week. Thank you very much.

Operator, Operator

Ladies and gentlemen, this does conclude the Goldman Sachs BDC, Inc. second quarter 2020 earnings conference call. Thank you for your participation. You may now disconnect.