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Golub Capital: Arranges New Revolver – Follow Up

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NEWS

On July 10, 2018 the BDC Reporter wrote an article about Golub Capital’s (GBDC) prior day 8-K.

Here is a link to the article : “Golub Capital: Major Change In Secured Borrowings“.

In the 8-K GBDC gave notice of its intention to repay all the outstandings under its 2010 on balance sheet securitization.

Most notably, GBDC planned to redeem $205mn of senior notes on July 20, 2018.

At the time, the BDC did not announce where the proceeds for this refinancing were to be drawn from.

The BDC Reporter made the following surmise in the afore mentioned article:

“As a result, and based on outstandings at March 31, 2018 $205mn in debt was outstanding on the 2010 securitization, collateralized by 79 loans with a value of $340mn.

No word has been provided about how GBDC will refinance the debt.

Cash on the balance sheet is not sufficient.

We expect the BDC will draw on one or both its existing Revolvers and/or expand the existing arrangements or enter into a new Revolver”.

On July 23, 2018 GBDC filed a new 8-K. See attached.

Therein, the BDC reported entering into a new $300mn Revolver facility, helmed by Morgan Stanley.

The new Revolver is priced at one month LIBOR + 1.90%.

The investment period of the Revolver lasts till January 21, 2019.

After that date, the interest rate increases to LIBOR + 2.15%.

The facility matures in March 2019. 

The proceeds from the Revolver were used to repay the 2010 unsecured notes and the securitization was wound up.

Not clear from the 8-K filing is what value of assets were pledged as security for the Revolver.

Apparently, the Revolver itself will be replaced by another on-balance sheet CLO securitization no later than 2019.


ANALYSIS

Chicago Two Step

This is step two of GBDC’s attempt to unwind itself out of the 2010 CLO securitization, which has now been accomplished.

The cost of borrowing is very low at an all-in rate of 4.0% (LIBOR at 2.1% + 1.9% spread).

Relative

Still, that’s higher than the 2010 CLO pricing of 3 month LIBOR + 0.95%, which adds up to 3.25%, based on the latest numbers.

Moreover, GBDC is more vulnerable to the likely increase in 1 month LIBOR that might continue through the life of the Revolver.

By the time of the maturity of the Revolver, the all-in cost of the borrowing (not including fees) may be as high as 4.5%-5.0%.

On the other hand, we do not find any reference to any unused line fee, which would otherwise increase the cost of this facility.

Advance

The advance rates on the loans pledged as security are very high, as illustrated by this extract from the Credit Agreement:

Loan Type Maximum Advance Rate
Broadly Syndicated Loans 77.5%
First Lien Loans 75%
Recurring Revenue Loans 70%
Unitranche Loans for which the Senior Leverage Ratio as of the Cut-Off Date is less than 5.00 : 1.00 70%
Unitranche Loans for which the Senior Leverage Ratio as of the Cut-Off Date is greater than or equal to 5.00 : 1.00 and less than 5.50 : 1.00 67.5%
Unitranche Loans for which the Senior Leverage Ratio as of the Cut-Off Date is greater than or equal to 5.50 : 1.00 65%
Second Lien Loans 50%
FLLO Loans (first pay debt * applicable advance rate) – first out debt / last out debt

Missing

The press release does not discuss the next step of issuing a new CLO, as the documents filed in the 8-K appear to envisage.

Nor is there any update about GBDC’s debate with regulatory authorities about the use of this type of vehicle, which has been an ongoing theme for a long time.

Finally, unclear is what happens – if anything – to the other existing on-balance sheet securitization from 2014, which we discussed in our article.


VIEWS

Admittedly, this subject is about as dry as the Gobi Desert in mid-August but deserves to be followed for two reasons.

First, to keep track of GBDC’s interest expense.

Second, as a window into the greater challenges of financing BDCs in the new era.

Let’s start with GBDC:

Rubik’s Cube

This very popular and competent BDC is in the midst of a complex liability management exercise.

The process is far from over, given that this Revolver is really a warehouse for another CLO raising and will be wound down in a few months.

Moreover – as noted above – key questions remain about the use on balance sheet CLOs in 40 Act vehicles such as BDCs and the SEC’s likely future rulings.

Also, the other GBDC Revolver – a $170mn facility squired by Wells Fargo reaches the end of its re-investment period in September of this year.

Unless we’ve missed an 8-K along the way – and we’ve checked – there is no public information available suggesting that facility has been extended or refinanced.

We may learn more when GBDC reports earnings in a few days. (See the BDC Earnings Calendar for the details).

This means that every on balance sheet financing which GBDC is a party to (we’re leaving out the SBIC, which is a yet different story) is in some sort of transition.

How GBDC finally settles it’s liability management – which will undoubtedly happen and without any drama – will be critical to the BDC’s earnings for years to come.

There are too many moving parts for us to speculate as to whether financing costs will increase, decrease or stay the same.

For the moment, we’ll limit ourselves to reporting and leave the cost estimates to others.

Been Here Before

Now to the second subject:

The GBDC example is also important in the bigger context of the cost benefit analysis of debt borrowings by BDCs, especially when secured by “high quality assets”.

Of course, that subject has become even more pressing with the advent of the Small Business Credit Availability Act and the desire by so many BDCs (although not GBDC asset) to jump on the bandwagon.

The cost and the terms of the arbitrage between a BDC borrowing and then -reinvesting that capital into loans/investments of its own will be critical in determining if higher leverage can be achieved accretively.

Question Number 1: Whither The On Balance Sheet CLO ?

The GBDC example leaves open the question whether CLO securitizations – often seen as the “best” and “cheapest” form of financing for BDCs will be allowed to go forward.

Or will some BDCs go forward regardless with this type of financing , but with the pall of possible SEC action hanging over them.

Question Number 2: How Far With Secured Lenders Go ?

We also learn something from the GBDC experience with this Revolver how aggressive bank lenders are prepared to be with certain BDCs- but mostly – with certain kinds of portfolio assets.

As we see above, secured lenders are prepared to advance just over three quarters of the value of “broadly syndicated loans” but “only” 50% on second lien loans.

(Typically those advance rates – regardless of category – go to zero when the underlying borrowers default or fail to pay. Then the BDC has to come up with new assets to fill the void).

That may have the not surprising effect of causing BDCs anxious to “lever up” to focus their own lending on certain types of loans that their bank lenders prefer.

A 75% advance rate implies a 3:1 debt to equity multiple and asset coverage of 133%, both below even the new BDC standard.

Ironically when BDCs can load up on aggressive secured borrowings where senior lenders provide generous advance rates, the unsecured debt to those funds becomes riskier.

Moreover, BDC – by relying more heavily on secured lenders who have pushed the envelope of their asset coverage – put themselves more at risk of defaulting or having a liquidity squeeze in the next crisis.

Many BDCs who barely survived the Great Recession because of too much reliance on their inexpensive – but jumpy – secured lenders promised themselves – and their shareholders – “never again”.

Much action was taken to lower leverage levels, raise unsecured debt and diversify portfolios.

However, that was a decade ago and the lessons learned are in danger of being unwound thanks to both the aggressive advances of the bankers and the growth ambitions of the BDCs.

Question Number 3: Is there a positive arbitrage between borrowing and lending ?

The key issue in the short run, though, that will determine if “leveraging up” is worth doing for any reasonable BDC, intrigued by the possibility of accretively increasing Return On Equity to shareholders, will be the cost of capital.

In this case – and as the GBDC example illustrates despite the very low margin spread the BDC pays – market conditions are not helping.

The best type of loan assets that a BDC can own in a portfolio are averaging a gross yield of 7.0%, pressed down by all that intra-lender competition and credit strong borrowers after years of economic expansion.

To finance those assets with 100% debt is expensive – in a relative sense.

For example, GBDC recently negotiated down its Revolver to 1 month LIBOR + 2.15%.

That’s a true cost of 4.25%.

Then there is the unused loan fee of 0.50%-2.00% per annum.

Let’s assume a borrower is three-quarters drawn and charged 0.5%.

That adds 0.125% to the annual cost. As do, debt arrangement fees when spread out over the life of a facility.

Then there are all the incremental operating costs for finding, booking, monitoring, valuing and managing all those new loans.

This varies widely by BDC.

GBDC’s apparent cost is relatively low at 0.3% of assets at cost.

Other BDCs can range up to 1.0%.

For this hypothetical example we’re going to assume 0.5%.

So even before we get to the issue of manager compensation, the cost of adding and financing new loan investments is 5.0%.

Management Fees will add – typically but less in the case of GBDC – another 1.5%, or 6.5% in total.

Apply the ever present “Incentive Fee” of 20%, and the net result to shareholders is a 0.4% return on an asset yielding 7.0%.

More…

Of course, even the most aggressive secured lenders want to see some junior capital beneath them which requires the raising of unsecured debt in some portion.

Then there are the eventual credit losses which managers and investors appear to have forgotten about when working out the economics of their leveraged lending.

Once again – as we’ve illustrated on other occasions – there is very little – if any – benefit in targeting high quality loan assets.

The oft made promises by many BDC,s before the Act was enacted and shortly after, that the new legislation would allow them to build bigger but “safer” portfolios just won’t work in dollar and cents terms.

That may explain why most of the BDCs that have received shareholder approval to leverage up have been steering away from those sort of promises.

Instead, those BDCs are pledging to stick with the higher yielding, higher risk loans that has been their bread and butter all along.

It’s just a matter of simple math.

The consequence, though, is likely to be a paltry ROE for shareholders and a material increase in risk, everything else equal.

Conclusion

GBDC is in the process of re-working most of its debt liabilities.

So are many other BDCs, both as part of a normal process and in light of the Act.

The BDC Reporter does not know how this is all going to play out even for GBDC.

However, there is much to learn in the dry-as-dust amendments and refinancings of BDC debt that will determine the returns and risks for the sector in ways that were inconceivable just a few months ago.

Our initial conclusion – and we’re keeping an open mind – is that earnings will increase as BDCs embrace higher yield loans to make the numbers work, and to take advantage of generous advance rates, but credit and liquidity risks will rise disproportionately higher.

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