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Golub Capital: Joint Venture Slumping.

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NEWS

On April 9, 2018 Golub Capital (GBDC) issued a press release announcing certain preliminary results for the IQ 2018.

This is  regular quarterly feature of the BDC.

The press release indicated $136mn in new investments were originated in the period.

Moreover, at quarter end GBDC’s total investment portfolio was approximately 2.0% higher than at year end 2017.

Also, the BDC reported that total investments in GBDC’s Joint Venture with RGA Reinsurance Company dropped by (8.5%) , or $24mn.


ANALYSIS

Neither the new investments booked nor the size of GBDC’s overall portfolio is very surprising.

Both data points are similar to prior periods and in line with expectations.

Down. Again. 

However, the drop in the size of the JV is notable.

The JV is a major income earner for GBDC, and generates a far higher yield than the portfolio as a whole.

In the IVQ 2017, the JV yielded 11.4% versus 7.5% for new investments booked in the quarter.

Of $942mn of equity capital at par, GBDC has invested $93.3mn at cost in the JV, which ended last quarter at a FMV of $91.6mn.

Already in the IVQ of 2017, the size of the JV portfolio dropped by (7.2%).

In fact, the partners in the joint venture actually reduced the size of the third party senior financing of the JV from $300mn to $200mn.

The move was actuated – GBDC said – to reduce unnecessary unused line fees.

Smaller

GBDC has explained the continuing shrinkage in the size of the JV as caused by the difficulty of finding appropriate new lower-risk, lower yield loans in a highly competitive environment.

However, the JV has commitments from GBDC and RGA of $200mn, but only $107mn have been funded.

Nominally the re-investment period for the JV ends in August 2018.


VIEWS

Guesswork

Notwithstanding the decent yield being earned by GBDC from the JV we’ve been wondering for some time if there’s more to the shrinking size of the venture than just a shortage of loans.

The decision to reduce the loan facility by one-third is a drastic step and does not suggest the partners are intending to ramp up.

In fact, thanks to returns of capital pay-outs, GBDC’s capital at risk on a cost basis has been dropping.

We wonder if the partners will agree to wrap up the JV when August rolls around.

Switch ?

With the new BDC leverage rules – on which GBDC has been quiet so far – the Investment Advisor may seek to book these loans (or those of a similar character) on its balance sheet.

Thanks to the over-generous loosening of the leverage rules, GBDC could add close to $1.0bn to the $1.8bn at December 31, 2017 and still remain within the new asset to debt rules.

That’s considerably more than the entire size of quarter billion JV portfolio.

Steadfast

In the past GBDC – helped by having exemptive relief for counting its SBIC debt – has been willing to maintain relatively high levels of debt to equity in absolute terms.

At year end 2017, Debt To Equity was 0.86 to 1.00 and asset coverage of debt was 219%.

The regulatory coverage – thanks to the blind eye to SBIC debt – was higher: 270%.

The BDC’s exemptive relief and its excellent track record with credit have emboldened the otherwise cautious team at GBDC to push the leverage envelope in recent years.

That has allowed GBDC to maintain stable earnings and distributions despite the very real pressures of “spread compression”.

The new rules – if adopted – would allow GBDC to load up more assets directly on its balance sheet.

Management might convince themselves that this is the right course of action by pointing to the even safer credit profile of the JV loans than the on balance sheet portfolio.

While the all-in yield on GBDC’s “regular” loans average 8.5%, the senior secured loans in the JV yield 6.8%.

We don’t want to speculate too much because GBDC has not indicated a change is afoot.

Quick Calculations

Nonetheless, pulling out a spare envelope and making some calculations on the back shows that GBDC is able to borrow on its main Revolver at 2.15% over 1 Month LIBOR.

That’s an all-in cost of 4.0%. Plus, let’s add another 0.25% for unused loan fees, or 4.3% in total.

Given that – extraordinarily and to their credit – GBDC does not charge Management Fees on borrowed funds- the new assets would generate a Net Investment Income gain of 2.5%.

The BDC does charge a 20% Incentive Fee, so the net gain on investing in these “safer assets” would be 2.0%, virtually all of which (unlike so many others) would be in cash form.

That could materially boost Net Investment Income or, at the very least, compensate for winding up the JV.

Doing The Numbers

Just for fun, we calculate that if GBDC added $800mn of these “safer” loans to its balance sheet (partly funded by the return of its $90mn or so invested in the JV), Net Investment Income could increase by $16mn.

On a  per share basis that’s $0.30.

By contrast the JV generates about $10mn annually or $0.17 per share.

Other Alternatives

Of course – and we’re thinking out of our box here – GBDC could choose to do both and push risk and return in all directions.

Wait Up

With no word from the BDC itself – which unlike many of its peers has remained mum on how it intends to engage with the new rules – all the above is but speculation.

Still – even if only on paper – GBDC does have multiple options available at a time when the BDC seemed fully invested and fully sized.

We’ve been admirers of how the Investment Advisor has navigated the tricky waters of risk and return over the years, as has the market.

GBDC trades at a 12% premium to book and has been even higher.

We’re curious what path the BDC will take with so many earnings and Incentive Fee goodies available by dint of the new rules.

Last Word

We recognize that the special economics of GBDC may make growing the size of its loan portfolio accretive from an earnings standpoint.

That’s not the case for FSIC and AINV, when undertook our pro-forma analysis. Click here and here for those respective articles if you’ve been on a desert island and not read every word we write.

In fact, we may find GBDC may be The Exception To The Rule, or one of the members of a very select club of BDCs that can accretively take advantage of the new BDC rules.

NONETHELESS – scarred as we are by the Great Recession – we’re still not fans of maxing out a BDC’s leverage, even if the incremental loans booked are of the “safer” variety.

During a crisis or a recession (remember those) even the “better” companies/leveraged loans come under strain and there are inevitably defaults/bankruptcies and – yes – Realized Losses.

As we’ve pointed out before the market cannot tell in advance How Bad It’s Going To Get and tends to sell early and check back later.

The result can be a very large drop in book value in a short period, which results in breaking BDC and bank coverage requirements.

That in turn causes assets to have to be sold at discounts; renegotiations with flustered bankers and missing out on opportunities in markets where – as in some dystopian movie about an apocalyptic  future – there are few other competitors arond competing for loans on excellent terms.

In fact, when figuring in pro-forma credit losses even GBDC might make only a slight increase in earnings per share from jumping on the higher leverage bandwagon.

Is that modest gain worth the potential far greater downside and drama that comes around once a decade or so but can wreck a BDC’s economics forever ?

Look at what happened to KCAP (whose entire business model has changed after losing two thirds of its value), TICC (now Oxford Square, and also with a completely different business model),MCGC (eventually swallowed up by PFLT), SAR (which used to be GSV and only through the efforts of Saratoga Investment is in existence today), as well as ACAS, Allied Capital, Patriot Capital AINV, BKCC and several others.

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