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Golub Capital’s Winning Formula

BACKGROUND: Golub Capital BDC (GBDC) announced on March 21st the  pricing of a secondary offering of 1,750,000 shares at a price of $19.03, a substantial premium to Net Asset Value Per Share of $15.74 at December 31, 2016. The effective price to adjusted Net Investment Income  multiple was nearly 15.0x, annualizing the latest quarterly results.

Prior to the March 21, 2017 secondary, GBDC issued an identical number of shares as recently as August 2016 at a price of $18.35. Since going public in 2010 at a price of $14.50, GBDC has been a serial equity capital raiser-always at a premium to book value-which has allowed the BDC to expand eight-fold in terms of total assets.  Not surprisingly, GBDC has garnered a highly positive reputation amongst both retail and institutional shareholders over the years, as well as the admiration of many of its peers.

The BDC Reporter seeks to analyze-in a two part article- the key ingredients of the Chicago-based BDC’s success with investors over its 7 seven year tenure as a public company, and what other less successful BDCs might learn therefrom. However, in Part II, we’ll also point out a couple of risks that shareholders and prospective investors might want to consider in any assessment of this high flying BDC.

We will be leaning principally on GBDC’s latest 10-K for the fiscal year ended September 2016, and the 10-Q for the quarter ended December 31, 2016. See above.

Analysis of Golub Capital’s Key Performance Metrics

CREDIT PERFORMANCE:

Of course, Golub and most every other BDC out there, is primarily a lender, so we’ll begin there:

GBDC’s overall credit performance over the past seven years has been amongst the very best of all BDCs active over that long a period. As the latest balance sheet underscores, net Realized Losses have amounted to just ($9.4mn), a little over 1% of capital raised. At December 31, 2016, thanks to a number of Unrealized Gains on equity positions in the portfolio, the existing portfolio is carried at a slight premium to cost of $14.2mn, which means that net-net, GBDC remains in the black from a portfolio value standpoint.

GRAVITY

The BDC Reporter likes to remind long term investors in the BDC space that-over time-most Business Development Companies will see their book value erode from investment losses. The BDC structure-with its requirement that no earnings can be retained and the risks inherent in lending and investing in non-investment grade companies, combined with the use of leverage by the BDCs-is almost a guarantee that book value per share will deteriorate over time. That’s why investing for the long term in this segment of the financial markets has to be assessed in Total Return terms. However, we’ve had a very positive lending environment since the end of the Great Recession in April 2009, with credit losses in leveraged lending at levels way below historic averages, boosted by a slowly growing economy, massive amounts of market liquidity and that hard to quantify intangible: the increased credit caution that follows the sharpest recession in a generation.

AVOIDED THE POTHOLES

Of course, the above notwithstanding, many of GBDC’s peers have managed to stumble-some seriously-even in this benign environment-and racked up credit losses and under-performing investments way above what investors might have expected. As we’ve shown GBDC has avoided any material credit stumbles, unlike those that have happened to other BDCs that were also in business from 2010 such as Apollo Investment, Blackrock Capital, Triangle Capital, Fifth Street Finance, OHA Investment and several others.

HOW ?

So what’s the secret of GBDC’s credit success  ?  The Investment Advisor to the BDC would point to its broad origination work; sensible underwriting policies; experienced management team and such. However, all lenders make similar pronouncements, which makes reading the identi-kit descriptions in the filings so amusing, and yet still begs the question why some BDCs have succeeded-like GBDC-and some have not.

We don’t have a definitive answer, but here are our best guesses:

BOOK THE BEST

First of all, Golub has not reached for yield when seeking out borrowers to lend to. Unlike many other BDCs whose average yield from loans average 10%-12% (or more), GBDC’s number is 7.7% (not including the effect of fees).  Pricing-when adjusted for loan and borrower size-is the best indicator for investors unable to review the financial statements of the thousands of non investment grade borrowers out there-is the best indicator of credit risk. After all, every new loan is typically offered up to a cohort of potential lenders who pore through the books, the business plan and the prospects of the company involved, as well as assess the chosen capital structure and terms required.  On individual accounts the credit market is sometimes wrong, but over time and over thousands of loans those assessments-and the pricing that results-is as good as a harbinger of credit risk as you’ll find.

In the case of GBDC, they’ve chosen to trade yield for lower risk borrowers. Moreover, the BDC is principally invested in Unitranche loans where they provide the bulk of the capital not invested by the Private Equity sponsor and/or management. Effectively that means some portion of every loan has a higher risk, but GBDC avoids many of the inter-creditor issues and unsecured status that mezzanine, subordinated and second lien lenders face when booking loans with double digit yields. A lender sitting at the top of a capital structure have obvious advantages when credits turn sour. In the case of GBDC 94% of its loans are Senior or Unitranche.

Of course, there are plenty of other lenders making Unitranche loans that have had loads of credit troubles. The structure itself is not a silver bullet. We get the impression that GBDC has been deliberately targeting the very best (and this is a relative term in the non investment grade leveraged world) borrowers, and are a favorite amongst the private equity community, which helps even in the dog-eat-dog world of leveraged lending.

DIVERSIFICATION

Second, we’re impressed with the highly diversified nature of GBDC’s portfolio. At December 31, 2016, GBDC had 182 borrowers in portfolio. When you add in the borrowers in GBDC’s Joint Venture there are nearly 250 companies on the books one place or another. By way of contrast TPG Capital (TSLX), which has a similar portfolio size, has only 52. Likewise, another peer New Mountain Finance has 97. Those are both very well run BDCs which have also been successful in the credit department, but we believe the “granular” nature of GBDC’s portfolio is a good defense against out-sized losses. Some BDCs have chosen to take bigger positions in a smaller number of borrowers (see FS Investment or FSIC) as a strategic decision, but we prefer when lenders keep exposure small.

ILLUSTRATION

For example, both Ares Capital (ARCC) and GBDC have exposure to troubled Competitor Group, which lenders had to take control of in the spring of last year. ARCC has $62mn in exposure at cost, GBDC “only” $16mn. Of course, when the company was performing ARCC was earning much more for the same amount of credit work, but when “things fall apart”, GBDC will be sleeping better at night.

RESEARCH NOTES

The BDC Credit Reporter-sister publication to the BDC Reporter-is in the process of tracking every under-performing company at every public BDC. We recently completed our review of GBDC. In our view, even more impressive than the fact that GBDC had only 10 Watch List loans on our list was that only 2 of those (including the aforesaid Competitor Group) had a cost basis greater than $10mn. (The other wayward credit is NTS Technical Systems with $27mn of exposure-mostly in the Unitranche).

The result of this “stay small” strategy is that GBDC’s individual bad loan write-offs have been modest in size.

OTHER STRENGTHS

Outside of credit, GBDC does a lot of other things right:

Investment income quality has been very good.Let us explain what we mean:

One of the BDC Reporter’s main (many ? ) complaints is that many BDCs (even some well respected names) are bulking up investment income with Pay In Kind interest. That’s non-cash income which gets folded into the principal of the original loan and paid (if at all) only at the maturity of the debt. In the interim shareholders pay tax on the income generated and the Investment Advisor, rather than writing down the asset and forgoing the “funny money” involved, receives both a Management Fee and an Incentive Fee (in many cases). Or a BDC will charge a borrower a pre-determined fee but only to be paid at maturity and books the non-cash income into earnings for years in advance of receiving the payment (a popular technique in venture lending but adopted in different forms by BDCs of all stripes). Of course when loans get into trouble the PIK income and the exit fees don’t get paid but by then shareholders have paid their taxes and most Investment Advisors don’t repay their fees generated therefrom. This “funny money” is boosting the Investment Income and Net Investment Income of many BDCs at the moment, allowing them to claim that earnings are meeting their distribution liabilities, even while having to borrow or sell assets to make up the difference between what’s coming in as cash income and going out in cash expenses. In not a few cases a fifth or more of a BDC’s Net Investment Income is derived from such non-cash sources. The most egregious examples are amongst the BDCs involved in double digit yield lending.

LITTLE PIK

However, GBDC-with its lower risk-lower return approach-boasts good earnings quality in our minds. PIK income in FY 2016 was less than 1% of total investment income, and less the year before.

NOT PAYING UP

Another attractive feature of GBDC and one of the key reasons that earnings are as high as they are is that the BDC has kept its cost of debt capital low. Unlike many other BDCs which have expanded their portfolios by borrowing at high yields with Baby Bonds or even Convertible issues, GBDC has relied on debt securitizations, secured Revolvers and SBIC financing (still the best deal in the market for long term money). The result (see page 66 of the latest 10-Q) is that GBDC has funded half its portfolio at an average borrowing cost of 3.4%. (Despite higher LIBOR rates in the past year, the securitizations average interest rate has been below 3.0% !).

FAIR DEAL

Add to the equation a generous management fee (1.375%) and incentive fee, which together cost shareholders about 2% per annum of total average assets (a very good number by the standard of the BDC world), and no wonder shareholders are enthusiastic about GBDC.

STEADY EDDY

It does not hurt that the Investment Advisor has maintained a steady dividend of $0.32 a quarter for the past 6 years, burnishing the BDC’s reputation with every new pay-out as a “coupon clipper” or a bond substitute.

LOOK OUT BELOW

None of the above is rocket science, nor is GBDC the sole BDC to have worked out a formula for success with investors. Nonetheless, where many of its peers have tried and failed GBDC has been undoubtedly successful, and deserves its premium to date. However, it’s the BDC Reporter’s obligation to be the kill-joy, and point out what might go wrong in the years ahead. It’s easy to get complacent after reviewing 7 years of unbroken success. However, the very features of GBDC’s business model that have fueled its out-performance could yet end up causing a reversal of its fortunes. In our next article we’ll have a look at what might go wrong, and why.  When investors are paying a 30% premium to NAV for GBDC , receiving a yield of just 6.7% for lending to non investment grade companies late in an economic expansion and investing in a sector where 30%-50% drops in price are commonplace, they should be more interested in what we have to say in Part II than the praises given in Part I.