Golub Capital BDC, Inc. (NASDAQ:GBDC) Q4 2022 Earnings Call Transcript

Golub Capital BDC, Inc. (NASDAQ:GBDC) Q4 2022 Earnings Call Transcript November 23, 2022

Operator: Hello everyone and welcome to GBDC’s September 30, 2022 Quarterly Earnings 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 SEC filings. For materials we intend to refer to on today’s earnings call, please visit the Investor Resources tab on the home page of our website, which is www.golubcapitalbdc.com and click on the €œEvents Presentations€ link.

Our earnings release is also available on our website in the €œInvestor Resources€ section. As a reminder, this call is being recorded. With that, I’m pleased to turn the call over to David Golub, Chief Executive Officer of GBDC.

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David Golub: Hello everybody, and thanks for joining us today. I’m joined by Chris Ericson, our Chief Financial Officer. We also have a couple of new participants today: Matt Benton, who was recently promoted to a new role as Chief Operating Officer of GBDC, please join me in congratulating him, and Greg Cashman, who heads Golub Capital’s Direct Lending Group. For those of you who are new to GBDC, our investment strategy is, and since inception it’s 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. Yesterday, we issued our earnings press release for the quarter and for the fiscal year ended September 30, 2022, and we posted an earnings presentation on our website.

We’ll be referring to this presentation during the call today. One element of Golub Capital’s culture is what we call raise the bar exercises. These are efforts on our part to improve how we do things. Today, we’re going to introduce a new format for our earnings calls that came out of one of our raise the bar exercises. We’re going to cover five topics. First, I’ll discuss highlights of GBDC’s performance for the quarter and for the fiscal year ended September 30. Second, I’ll talk about the macro environment what we’re seeing in the economy and what we think this means for GBDC. Third, Greg Cashman will give us some real time market insight on two topics. Think of them as defense and offense. On defense, Greg will talk about the actions Golub Capital has taken and is taking to manage risk in light of the heightened macroeconomic uncertainties we’re all dealing with.

And on offense, Greg will talk about the opportunity set for new investments and why we think it’s quite attractive today. Fourth, we’ll go through financial results for the quarter and for the fiscal year in detail. And finally, I’ll come back to make some closing remarks and take questions. Before we jump in, I also want to mention that we plan to file a new and improved investor presentation over the next two weeks. We plan to file updates to this presentation on a quarterly basis going forward. We hope that you’ll find it to be a useful source of additional information on GBDC and on Golub Capital. So, let me start with highlights for the quarter. The overall headline is that GBDC’s performance was solid and that’s despite a second consecutive quarter marked by sharp downdrafts in debt and equity markets.

The first highlight is that adjusted net investment income was strong. Adjusted NII per share increased by 6% to $0.33 from $0.31 per share in the quarter ended June 30. The increase in adjusted NII per share was driven by higher base rates, continued credit stability, and GBDC’s low cost of funding. That said, we’re not immune to market downdrafts. Primarily as a result of spread widening, GBDC booked some unrealized losses this quarter and that caused NAV per share to decline by 1.7% from $15.14 to $14.89. The good news, as we’ll come back to in a moment, is that credit quality looks very solid from a fundamental perspective. Whenever we have a quarter marked by spread widening, you hear me say the same thing. You hear me say that mark-to-market losses from spread widening, they don’t matter in the long run.

What matters is minimizing permanent or realized losses. If we can avoid realized credit losses, the mark-to-market adjustments reverse over time as borrowers pay off, whereas their credit attributes improve, whereas market spreads narrow. The good news is that we think we’ll see some reversals of mark-to-market losses in future quarters. And there’s even more good news: given rising base rates and spreads, and given GBDC’s funding structure, there’s potential for further increases in NII in coming quarters. We’ll cover this in more detail later in this call, which brings me to a second highlight, dividends. We announced in our press release a 10% increase in GBDC’s quarterly base dividend from $0.30 a share to $0.33 a share, which equates to an 8.9% dividend yield on our 9/30/2022 NAV of $14.89.

Why are we increasing the dividend? Simply put, higher base rates and higher spreads have increased GBDC’s earnings power. On the asset side of the balance sheet, GBDC’s portfolio, which is almost all floating rate loans, it’s generating more interest income due to higher base rates and higher spreads. The forward rate curve tells us rates are likely to go up further from here, and today’s rates and spread widening are not yet fully reflected in this quarter’s earnings due to lag effects. On the liability side of the balance sheet, GBDC has locked in low cost, highly flexible debt capital. About half of GBDC’s debt is in the form of fixed rate unsecured notes and these notes have an average cost of about 2.7%. We believe interest income is likely to increase faster than interest expense in the coming period and this means GBDC’s earnings power is likely to exceed the 8.9% dividend yield GBDC posted in the 9/30 quarter.

We’ll provide more details on this on this call. I’d also note that GBDC is now fully through its €œcatch up€ for the income incentive fee. This means that as our portfolio continues to reset today’s higher base rates, and as we benefit from further base rate increases, 80% of incremental returns will increase GBDC’s NII. Looking forward, we believe GBDC is well-positioned to generate NII meaningfully in excess of the new quarterly base dividend of $0.33, giving us flexibility in calendar 2023 to consider a further dividend increase and/or potential supplemental or special dividends. The third highlight from the quarter is that GBDC’s credit quality remains strong. As you know, our strategy focuses on investments in resilient companies, in resilient industries, in resilient geographies, and with resilient owners.

We don’t play in highly cyclical or volatile areas like energy or crypto or real estate or aviation. And so far the data shows our strategy is working. I’ll share a few highlights now, which we’ll come back to a bit later in the session. Realized losses for the quarter and for the fiscal year were once again low and were more than completely offset by realized gains. For the quarter, we had just less than $1 million of realized losses versus $4 million of realized gains. For the fiscal year, we had just $2.5 million of realized losses versus realized gains of $21.4 million. Over 90% of investments in GBDC’s portfolio had an internal performance rating of 4 or higher as of September 30. This is a level consistent with our loan performance ratings pre-COVID, and the percentage of investments on non-accrual measured at fair value also remained low at just 1.3% of our portfolio.

The fourth and final highlight: GBDC is well-positioned for the uncertainties we’re all facing in the coming period. This is not our first rodeo. Historically, we’ve navigated difficult periods well. In fact, difficult periods have tended to be good for our business and good for our investors. We’ve curated GBDC’s portfolio to be resilient to interest rate risk and to credit risk. More than 90% of the portfolio consists of floating rate first lien, first out senior secured loans to what we believe to be resilient companies backed by private equity sponsors with whom we have deep and long standing relationships. GBDC has a highly flexible and durable funding structure with ample liquidity. 47% of its debt funding is in the form of unsecured, longer dated, unsecured notes and that’s complemented by a $1.2 billion corporate revolver with undrawn capacity and that’s materially over collateralized.

Because GBDC is defensively positioned, it’s also very well suited to play offense in what’s become a very attractive new origination environment. We’ll go into more detail about our outlook for originations later in the presentation. In short, we believe GBDC’s results for both the quarter and the fiscal year were solid. Now, let’s take a step back, look at the macro picture and unpack what it means for GBDC. As you know, Golub Capital has a unique perspective on the economy. We lend to hundreds of middle market companies, we receive monthly financials from many of them, we’re in constant dialogue with a host of smart private equity firms and management teams. So, we’re getting actual results and insight on the portion of the economy we lend to almost in real time.

What we’re seeing is the economy is muddling through. It’s not booming like it was a year ago, but it’s muddling along with real growth. Companies are able to keep their revenues up and for the most part they’re increasing prices directionally with inflation. Margins are down a bit, that’s a topic we’ll come back to, but from our vantage point, consumers are spending and businesses are doing pretty well. The big question is, where to from here? We’re in a confusing environment. It’s marked by conflicting vectors and an unusually wide range of possible scenarios. There are a number of vectors that point in a negative direction, including high inflation, rising rates, quantitative tightening, declining fiscal stimulus, worsening consumer sentiment, and there’s the wealth effects from the recent sharp losses in both equity and debt markets.

But there are also vectors that point in a positive direction. We have very low unemployment, generally healthy consumer balance sheets, corporate profits which are still strong despite some recent signs of slowing growth, and low inventories in most durable goods sectors largely as a consequence of supply chain issues. So, in short, we’ve got a bunch of forces that are pulling in different directions right now. And it’s all happening against the backdrop of a disrupted international environment. There’s the war in Ukraine. There’s tension between Russia and the West. There’s tension between the U.S. and China. There’s tension in multiple democracies between right and left factions, and there’s still concern about Iran and North Korea to name a few.

So, back to the big question, where to from here? I don’t think anybody knows. If you’re looking for a historical parallel, if you want to say, €œWell, 2023 is going to be just like€ €“ I don’t think that you’re going to find a good one. I don’t think we’ve seen this combination of vectors before. Now €“ and looking at it, we think muddling growth is the most likely scenario for the near future, but there’s a range of possible alternative scenarios. So, what does this mean for GBDC? We think it’s prudent to manage GBDC in this environment such that it’s going to perform well if we’re right about muddling growth. And we want it to be resilient in case the unexpected happens. I’m going to pass the mic to Greg Cashman, Head of Direct Lending at Golub Capital, to say more about how we’re playing defense and offense with this macro perspective in mind.

Greg Cashman: Thanks David. I’m going to focus first on how we’re managing risk in today’s environment. I’ll talk about what we are seeing today, what we are doing differently, and what we aren’t doing differently. And I’ll talk about what we’re seeing in terms of new investment opportunities. Let’s start with what we’re seeing today. As David mentioned, GBDC’s credit quality generally remains strong. Realized losses and non-accruals have been low, while internal performance ratings have been comparable to pre-COVID levels. Those are some of the quantitative ways we look at credit performance. We also assess how we’re doing on credit with a qualitative lens based on what we see and hear from sponsors and management teams. And what we’re seeing today is that our borrowers generally fall into one of three buckets.

Most are performing well and seeing growing profits. Then there’s a smaller group of borrowers that are growing a bit slower than expected, but still doing okay. And finally, there’s a group that’s seeing falling profits due to margin pressure, usually due to wage pressures, rising input costs or both. When we talk to sponsors and CEOs of companies in that last group, they typically tell us that they just raise prices or they plan to raise prices shortly. Will those price increases stick? And if they do, will they be enough to offset rising costs? Well, in most cases, they probably will, because we seek to invest in market leaders that we believe are resilient to inflation. But the reality is, it’s too soon to tell. So, let’s shift and talk about how we’re managing risk in-light of what we’re seeing in the macro environment.

Let me start with what we aren’t doing differently. We continue to focus on lending to resilient companies in resilient industries in resilient geographies and with resilient owners. We’re not involved in interest rate sensitive industries like homebuilders or heavily cyclical or capital-intensive industries like E&P and real estate. Our focus is on defensive businesses with strong free cash flow profiles that will do well in a wide variety of different economic climates, even when we’re not feeling very optimistic about the future. What are we doing differently? We think that we’re good at what we do, but we also know that we’re not perfect. So, we’re looking hard right now for potential areas of weakness. This isn’t different in and of itself.

Identifying problems early has always been a key part of our portfolio management. What I want to highlight is that we’ve enhanced our credit monitoring screen with a view towards identifying tail risks on a granular, bottom-up, company by company basis. We’re looking hard at five key factors. First, interest rates. We’re looking for borrowers who may have potential liquidity or cash flow issues from increased base rates. Second, inflation. We’re looking for companies susceptible to contracting operating margins. This means looking closely at cost drivers and pricing power. I mentioned earlier that not every price increase that companies try to push through will stick. So, we’re focusing on cases where pricing power may have hit a limit. Third, recession resistance.

Some companies are more susceptible to recessions than others. In particular, we’re working to identify companies with material risk of falling revenues. Fourth, international exposure. We’re looking for companies with material exposure to U.S. dollar fluctuations or to customers or suppliers in areas of geopolitical tension or economic weakness. And fifth, quality of earnings. We’re looking at credits with high levels of EBITDA adjustments that may not be realized in practice. The goal of our enhanced credit monitoring today is to find higher-risk borrowers and allocate more resources to them, much as we did in March 2020. That covers how we’re thinking about risk. Now, I want to talk about opportunity. In short, overall deal activity is down and it is a highly attractive origination environment.

Why is market wide deal activity lower? Well, we’ve just been through an equity market downdraft and buyers and sellers can agree on value in a climate like this, sellers want the price they could have gotten three months ago or six months ago, buyers don’t want to pay it. The good news for us is that our 300+ incumbencies give us a robust access to opportunity even when the new deal market is slow. A lot of our sponsor clients see dislocations like the present one as great opportunities to grow their platforms with accretive add-ons. This means they need more capital and the logical party that they want to go to first is their incumbent lender. In the case of hundreds of borrowers, that’s us. In these cases, we know the company, we know the management team, and we know the sponsor.

We’ve seen how they perform. And we don’t need to negotiate a whole new credit agreement to give them the capital they need. During periods of slower M&A activity, we typically see an increase in the proportion of origination that comes from repeat borrowers. As a benchmark, about half of our origination volume over the last several years has come from repeat borrowers. That proportion is increasing markedly and we expect it to remain elevated for the rest of 2022 and into 2023. And we think these add-on opportunities are particularly attractive. The market is the most lender friendly that it’s been in recent years. Spreads have widened by 50 basis points to 100 basis points, leverage has gone down half to a full turn, and documentation terms are tighter, especially in areas we care a lot about like the definition of EBITDA.

As a result, we believe the opportunity set in our areas of focus is among the most attractive since the great financial crisis. With that, I’m going to turn it over to Chris Ericson to go through GBDC’s results for the quarter and fiscal year in more detail.

Chris Ericson: Thanks, Greg. Let’s turn to Slide 4, which summarizes our results for the quarter compared to the prior quarter. GBDC’s adjusted NII per share increased by $0.02 quarter-over-quarter to $0.33 per share. GBDC had an adjusted net realized and unrealized loss per share of $0.28, primarily from unrealized depreciation due to spread widening. Adjusted EPS was $0.05 per share, and we view this as a solid performance in the context of the downdraft in debt and equity markets during the quarter. Moving to Slide 7. This slide provides the bridge from GBDC’s NAV per share of $15.14 as of June 30, which declined slightly by 1.7% to a NAV per share of $14.89 as of September 30. Let’s walk through the components. As I just mentioned, adjusted NII was $0.33 per share and the company paid $0.30 per share of dividends.

Adjusted NII was offset by a loss of $0.28 per share from the net change in unrealized appreciation and depreciation on investments. In our view, these unrealized losses were driven primarily by spread widening in the market rather than fundamental credit issues. And finally, net realized appreciation and depreciation came to a gain of $0.01 per share. Slide 10 summarizes our origination activity for the quarter. Net funds growth declined quarter-over-quarter and there were two key drivers: one, exits and sales of investments outpaced new originations in the September 30 quarter; and the second, fair value adjustments on existing investments due to unrealized depreciation also contributed to the negative net funds growth. The asset mix, shown in the middle of the slide, remained fairly constant with our prior quarter originations.

Looking at the bottom of the slide, the weighted average rate on new investments increased by 120 basis points this quarter from a combination of higher base interest rates, as well as wider asset spreads on new originations. The weighted average spreads on new investments increased by 40 basis points over the prior quarter from 5.8% to 6.2%. We believe the combination of higher benchmark rates and increasing asset spreads creates a foundation for further increased returns at GBDC in future periods. Slide 11 shows GBDC’s overall portfolio mix. As you can see, the portfolio breakdown by investment type remained consistent quarter-over-quarter, with one-stop loans continuing to represent around 85% of the portfolio at fair value. Slide 12 shows that GBDC’s portfolio remained highly diversified by obligor, with an average investment size of approximately 30 basis points.

As of September 30, 94% of our investment portfolio was comprised of first lien senior secured floating rate loans and defensively positioned in what we believe to be resilient industries. I’ll now turn the floor over to Matt.

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Matt Benton: Thanks, Chris. Let’s turn to Slide 13. One general point is that the rising interest rate environment really highlights the asset sensitive nature of GBDC’s balance sheet. I’ll come back to the theme in more detail on the next slide. But looking at the data on Slide 13, let’s start with the dark blue line, which is our investment income. As a reminder, investment income includes the amortization of fees and discounts. GBDC’s investment income increased by 170 basis points, primarily from a combination of rising interest rates and accelerated discount amortization from higher payoffs compared to last quarter. By contrast, our cost of debt, the teal line, increased only 70 basis points. Our cost of debt benefits meaningfully from our approximately $1.5 billion of unsecured notes that are fixed rate and have a weighted average coupon of 2.7%.

Combining these two factors, our weighted average net investment spread, the green line, increased by 100 basis points over the prior quarter. Note that the increase in GBDC’s net investment spread, combined with GBDC’s current GAAP leverage of 1.22x debt-to-equity, have pushed GBDC fully through the catch-up period on the income incentive fee. This implies that further increases to our weighted average net investment spread from higher base rates will increase NII. Now, let’s drill down on this point. On Slide 14, we’ve quantified the potential positive impact of higher base rates on GBDC’s NII earnings power. The key takeaway is that GBDC’s adjusted NII per share stands to benefit substantially from two key tailwinds in the coming period.

The first tailwind is that there’s a lag between when base rates change in the market and when loans in our portfolio reset to higher base rates, which happens once per quarter in most cases. Said another way, GBDC has about a quarter lag effect in its portfolio. The chart on this slide is our attempt to help demystify this dynamic for you. In other words, the average LIBOR or SOFR rate GBDC actually earned on its investments for the quarter ended 9/30 was meaningfully less than the market rates as of 9/30. The second tailwind is that base rates look likely to increase further from 9/30 levels based on the interest rate forward curve. Now these tailwinds will be offset to an extent as GBDC’s floating rate liabilities also reset to higher base rates, but crucially, this dynamic only applies to the 53% of GBDC’s debt stack that’s floating rate.

Said another way, GBDC’s floating rate liabilities represent less than 30% of GBDC’s total funding when you also include its equity capital. Consider that 95% of its total investment portfolio, including equities, is floating rate. To try to quantify the potential benefit of these tailwinds, Slide 14 shows our estimates of GBDC’s adjusted NII per share under two hypothetical scenarios. Now, let me describe how to read this chart. The leftmost bar shows GBDC’s actual adjusted NII of $0.33 per share for the quarter ended 9/30. On average for the quarter, the average LIBOR rate was approximately 300 basis points. The middle bar looks at what GBDC’s adjusted NII per share would have been in the 9/30 quarter if all of its floating rate assets and liabilities had been based on the LIBOR rate of 375 basis points, the rate at quarter-end.

In this scenario, all else equal, we estimate adjusted NII would have increased 12% to $0.37 per share. The right bar goes a step further and looks at what adjusted NII per share would have been if LIBOR had been even higher, 475 basis points, an increase of 100 basis points from actual quarter-end LIBOR. We think this is a realistic scenario given three-month LIBOR is currently above 460 basis points and is projected to go above 5% by January of next year. In other words, this scenario shows both the lag effect and the higher rates we expect in the future. All else equal, we estimate adjusted NII would have increased 24% to $0.41 per share. The bottom line is that we think GBDC’s NII per share has a lot of built-in momentum just from higher LIBOR rates that have already occurred, but have not yet flowed through GBDC’s results.

We aren’t assuming net funds growth, we aren’t assuming wider spreads on existing investments, for example, from amendment activity or increased payoffs or non-accruals. In our view, those are possible drivers of further NII upside. You’ll see additional detail on GBDC’s asset sensitivity in the Form 10-K if you’d like to drill down further. Now, let’s move to Slides 15 and 16 and take a closer look at credit quality metrics. On Slide 15, you can see that the number of non-accrual investments as of 9/30 remain the same at eight investments compared to 6/30. This is because the disposition of one non-accrual investment was offset by the addition of one new non-accrual investment. In addition, one of these eight non-accrual investments was disposed of after quarter-end for proceeds slightly higher than fair value as of 9/30.

On Slide 16, as David mentioned earlier, internal performance ratings have been strong and stable. Over 90% of investments have an internal performance rating of 4 or higher, which means they are performing as expected or better than expected at underwriting. And only 1.3% of investments have an internal performance rating of 2 or lower, which means they are performing materially below expectations at underwriting. We’re going to skip past slides 17 through 21. These slides have more detail on GBDC’s financial statements, dividend history, and other key metrics. The last slide I want to cover before handing it back to David is Slide 22. We believe GBDC has meaningful value embedded in its funding structure. Our stable, flexible, and low-cost funding structure helps us play offense in the attractive environment for new investments that Greg described earlier.

We ended the quarter with almost 800 million of dry powder from unrestricted cash, undrawn commitments on our meaningfully over collateralized corporate revolver and the unused unsecured revolver provided by our advisor. Our GAAP debt-to-equity ratio as of 9/30, net of unrestricted cash, was 1.17x. 47% of our debt funding is in the form of unsecured notes, the majority of which have maturities in 2026 and 2027. We issued these fixed rate notes with a weighted average coupon of 2.7% and did not swap these out to floating rate. Our weighted average cost of debt for the quarter ended September 30 was 3.7%, which we believe is among the lowest in our peer group of publicly traded BDCs. We believe our funding structure is a meaningful competitive advantage and will continue to be one for us.

I’ll turn it back over to David for closing remarks and Q&A.

David Golub: Thanks, Matt. To sum up, GBDC’s performance for the quarter and for the fiscal year ended September 30 was solid. Net interest income benefited from higher base rates and higher spreads, and both are likely to go up further. Credit quality remained strong, realized losses remained low, and we announced an increase in GBDC’s dividend and we indicated that we believe the company could expect to consider a further increase in the future. With that, let me open the line for questions.

Q&A Session

Operator: Our first question will come from the line of Finian O’Shea with Wells Fargo Securities. Please go ahead.

Jordan Wathen: Hi, good morning. This is actually Jordan Wathen for Fin today. Appreciate the disclosure €“ hey, good afternoon. Appreciate the disclosure on NOI upside from rising rates. I was just curious and maybe you could give us some context on how rising rates might impact the interest coverage of your borrowers, understanding that maybe that’s not relevant for some of the recurring revenue loans, but maybe the larger portfolio as a whole?

David Golub: Look, we’ve got a number of headwinds that are impacting borrowers in the coming months. One source of headwinds is a slowing economy. And we talked some about that in our prepared remarks. A second source of headwinds is higher base rates. Now, there are as many different stories here as there are different borrowers in some of the discussions that we’ve been having with investors recently. I’ve been making the, I think, really the important point that average interest coverage ratios aren’t really very informative. We as lenders, we don’t lose money on our average credits. We lose money on the tail. We lose money on our worst credits. And that’s why I thought what Greg Cashman talked about in today’s call is so important.

What we think we need to be doing right now on the defense side is undertaking a granular, bottoms up review of all of our loans in order to identify the ones that are most vulnerable. Part of that vulnerability, Jordan, is the impact of rising rates. There are other sources of issues for borrowers as well in today’s environment. I think that granular focus is the right way to protect the portfolio. I don’t think there’s a lot of conclusion that we’re going to be able to draw by looking at interest coverage ratios in and of themselves. Let me give you another example of why I think interest coverage ratios are problematic. One of the largest sources of friction in investment committee discussions and discussions with sponsors over the last couple of years has been EBITDA adjustments.

When folks calculate interest coverage, they’re generally not using cash EBITDA, they’re using an adjusted EBITDA. And you can’t buy beer with adjustments. So, again, if credit was easy, if everything could be reduced to a set of formulas and ratios, I guess it’d be bad for our business because it would mean investors don’t need us to make credit judgments. I don’t think it is easy. I think credit is very difficult and something that requires a great deal of judgment. I think this is an area that illustrates the point. Interest coverage is going to be something that we’re all going to need to look at prospectively on a credit by credit basis in the context of how the company is doing? Is it growing? Is it not growing? What kind of cash taxes, what kind of CapEx, what kind of other uses of cash are important for that company?

I’m sorry if I sound passionate on this, but I’m frustrated with the degree of focus on one ratio. I don’t think it tells us much.

Jordan Wathen: No, I appreciate that. And so, maybe just ask a different way. Have you seen any uptick in amendments recently and amendment requests? And would you characterize them as being, you know, forward looking? Maybe a little worried about where their interest costs are going over the next say 6 to 12 months?

David Golub: So, no really have not yet seen an increase in amendment requests, but I think we will. I think that the coming period is going to be one that involves significantly more challenges for borrowers and for lenders than the period that we’ve been in. So, will there be companies that get into credit stress more so in 2023 than in 2022? Yes. Will there be a need for more amendments? Yes. Will some of those amendments be related to rising rates? Yes. I don’t think we’re seeing the full impact yet because we’re still early in this credit cycle and because the increases in rates have been reasonably rapid, but all of that’s coming.

Jordan Wathen: Okay. And then one last one if I could just sneak it in there. You had about $2 million of deferred interest income that snuck into the top line this quarter, but was that related to Paradigm, the exit of the nonaccrual or maybe the dermatology associates company coming back upon accrual. I’m just curious if you could, kind of break that out?

David Golub: So, Chris Ericson help me on this one. I think it’s the second of the two Jordan mentioned, but please confirm.

Chris Ericson: Yeah. He’s correct. It’s both, both of them. We saw some topside benefits.

Jordan Wathen: All right. Thank you. That’s all from me.

Operator: Your next question will come from the line of Robert Dodd with Raymond James. Please go ahead.

Robert Dodd: Hi. And congratulations on the quarter. Just to dig on the credit quality for the forward outlook as much of anything else, have you seen multiple comments about margin pressure, etcetera, etcetera, have you seen any impact on end demand? When I look at the new non-accrual, to me, looks like it is arguably, let’s call it a semi-discretionary health care business, maybe. And that was something obviously that you know, at the margin a consumer might reduce usage of. Is it, you know, are you seeing anything on that side or is it €“ to your point, right, is it all margin currently on labor costs or input costs, etcetera?

David Golub: So, I hesitate to use the word all, Robert, because, you know, sit situations vary across the portfolio as large as ours, but the overwhelming pattern is companies that are sustaining revenues, in many cases continuing to grow revenues. To the degree they’re producing disappointing results, it’s not because of a revenue shortfall. It’s because of a margin shortfall. And when you then pull back piece of the onion to understand why there is a margin shortfall. It’s €“ again, the most common patterns relate to wage increases and raw material price increases that they have not yet may not be able to. So, I don’t mean by saying have not yet, it’s a sure thing they will be able to, but have not yet passed through in the form of price increases. I think that’s reflective not just of our experience at Golub Capital. I think that’s broadly what we’re seeing outside of our portfolio, as well as within our portfolio.

Q €“ Robert Dodd: Got it. I appreciate that. One more if I can. I mean, you’ve talked obviously a more lender friendly environment out there. I mean, where were you seeing the most material shift, I mean, obviously, spreads are widening, but is it the EBITDA definition that’s improving materially or the OID? Can you give us any color on, you know, where the shifts are most cut out?

David Golub: I’d say it’s not one area, Robert. It’s a combination of areas. So, you mentioned spreads are wider. They are, I’d say they’re often 50 basis points to 100 basis points wider. I think OID is better. OID and closing fees are often up an incremental 1%, not always, but often. We’re seeing improved call protection. We’re seeing improved documentation terms around EBITDA definition and particularly around the capping of adjustments. So, it’s not one element. I don’t think it ever is. I think it’s when you see the shifts in market conditions from borrower friendly to lender friendly, and vice versa, it tends to move across a number of different dimensions in concert with each other.

Robert Dodd: I appreciate that. Thank you.

Operator: Our next question will come from the line of Jeff Bernstein with Cowen. Please go ahead.

Jeff Bernstein: Yes. Hi. I was €“ first of all congratulations on the quarter and really appreciate the format of the call this quarter and the transparency. So thanks for that. I wanted you to talk a little bit more about elasticity of demand. With your companies, in particular. Obviously out there in the world, we’re seeing companies where sales are growing 5% on a 10% increase in prices, but a decline in units, and at some point, it feels like that hits the wall, but talk more specifically about the kind of companies that you’re lending to and how you’re thinking about elasticity?

David Golub: So, I think what you’re asking is exactly the right question. And let me preface this by saying, I don’t think anybody knows the full answer yet. We can’t. We’re too early in the cycle and in this period of rising prices. If I look across the portfolio and again look for patterns, there are certain companies that have an easy time raising price without a significant impact on demand. So, imagine, for example, a mission critical business-to-business software company that has a 98% renewal rate and who’s fundamental product value proposition is that they save their client’s money. So that company has a lot of pricing power. If we compare that on the other side to companies that maybe are under more pressure in the current environment.

So, imagine a restaurant chain that’s dealing with an increase in protein prices and increase in wage rates at the same time and that’s much more challenging. So, I think we’re going to see an increasing dispersion of performance over the course of the next several quarters. We’re going to get much more clarity into which firms have pricing power, which firms are maybe reaching the end of their pricing power? And my expectation is that our portfolio is going to show pretty well through that, but we won’t come through unscathed. This is an environment that is different from what we’ve seen over the course of the last 15 years and what we’ve expected management teams haven’t confronted this before. So, I think we’ve all got to accept that there’s a collective degree of learning and of uncertainty in the current environment.

Jeff Bernstein : That’s great. And then I have one more. This is a question about a tail risk, but obviously having come through COVID, it’s a very visible, kind of tail risk. And that’s China exposure, China supply chain exposure, etcetera. You know, it’s going to be okay until it’s not okay. So, how are you thinking about that? How are you talking to your companies about it, etcetera?

David Golub: Well, supply chain issues have been a big theme, not just today, but really over the course of the last, well, since COVID hit. So, we’ve been working with sponsors and with borrowers on supply chain issues for some time. I’d say, as a generalization they’re better now than they were, not completely resolved, but they’re meaningfully better than they were. I think where you’re headed is, if China continues its zero COVID policy and/or if there are new geopolitical tensions that arise between U.S. and China, could that situation get worse? Could that take on a different flavor? And I think the answer to that is yes. So, I think management teams again, this is new in the last couple of years. I think management teams view China supply chain risk in a different way than it was viewed several years ago.

I think it’s viewed today as something that needs to be managed where contingency plans, you know, need to be in-hand. And I think that trend is likely going to continue.

Jeff Bernstein: That’s great. Thank you very much.

Operator: Your next question will come from the line of Paul Johnson with KBW. Please go ahead.

Paul Johnson: Yes. Hi, good afternoon. Thanks for taking my question and congratulations on a good quarter. I only had one or two questions here, mainly on the software ARR lending component of your portfolio. Just given it’s a larger component of the portfolio. It’s been a relatively successful area of the market for a lot of lenders. I’m just curious how leverage multiples have fared in that market on software loans? I’m just taking in observation from the public equity markets. Obviously, a lot of software companies are down meaningfully this year, again in the public equities mark, of course. And we’ve seen a number of high profile tech companies announcing layoffs, etcetera. I’m just curious how that market has fared? And I’m just trying to see if there’s any, sort of headwind I guess in terms of the companies themselves as for software renewal rates and growth in revenue and that sort of thing?

David Golub: So, great question, and let me try to give a nuanced answer because I think it needs a nuanced answer. So, first off, I think it’s really important in thinking about the kinds of borrowers we have in our recurring revenue loan segment. It’s really important to understand those are not like the consumer driven tech companies in the public markets that have seen the giant declines in valuation. We don’t lend to companies like Facebook and Snap and Netflix that are consumer facing. Our loans are to companies that are mission critical business-to-business software companies. Why is that so important? Well, it’s really important because you don’t have the same volatility around demand. If you are backing a mission critical business-to-business software firm, you’re very likely looking at a company with very high recurring revenues.

You’re also very likely in the case of one of our RRL borrowers, you’re looking at the company with significant revenue growth momentum. They have a value proposition to their potential clients that persuades their potential clients that those potential clients can save a lot of money by implementing a new piece of software. So, the business model is fundamentally much more resilient than many of the companies that have seen valuations fall in the public markets. Now, having said that, the source of funding for these companies is largely venture firms and late stage venture firms, and early stage private equity firms, many of whom have investments that crossover into technology sectors that have not done well. So, we are definitely seeing that there’s a growing demand for the kinds of companies that we’ve historically led to that pricing on new RRL loans is meaningfully higher, meaningfully better than it was, and that it’s harder for these companies to raise incremental revenue at valuations that are upticks from their last round.

So, there’s a greater interest on their part in using debt capital as an alternative to diluted equity. I think that we see a lot of opportunity in this segment prospectively. If you recall, we were very early, we were arguably the inventor of this segment in the 2014, 2015 time period. We’ve done very well with it over time. In the couple of years before maybe April, May of this year, we actually had pulled back some from this segment because we thought that competition had gotten too fierce and pricing had gotten too low. So, we’re pleased to see that some of that’s reversed over the course of the last couple of months.

Paul Johnson: Got it. Thanks. That’s very interesting. And I’m just wondering my last question, sort of on that. If you could give us a sense of these companies or the type of prospective companies, you know Golub software companies that Golub looks to finance in that market, are these companies that have, I guess, already achieved some level of desirable level of cash flow generation or would you kind of characterize these companies as still, kind of transitioning on some sort of pathway to some sort of cash flow generation target or even, kind of adding on to that, is this focus less on those two items and more just, kind of on the revenue growth line?

David Golub: The emphasis in our recurring revenue loan segment is on strategic value if things don’t work out as planned. So, it’s a second way out analysis that’s primary. If we’re wrong and this company’s efforts to grow rapidly and invest very heavily in growth, turn €“ if those efforts turn out to be a bad decision, is there still a base business here that’s large enough, that’s meaningful enough, that’s protected enough so that it will be valuable to a strategic acquirer? And that strategic acquirer will pay a price adequate to make us not lose money. So, typically, these loans are at a relatively low loan-to-value, but they’re high if you look at traditional credit metrics like loan-to-EBITDA or loan-to-cash flow measures.

And underlying this is, these companies have made an affirmative decision that they want to seek rapid growth. They want to invest heavily in sales and marketing in order to foster rapid growth at the expense of profitability. And that’s why the credit evaluation of these companies is so critical because we are not counting on the capacity of these companies to generate cash to pay interest in principle. So, we need to be very confident in their strategic value.

Paul Johnson: Got it. Appreciate the answer. Very helpful. That’s all from me.

Operator: Your next question will come from the line of David Miyazaki with Confluence Investment Management. Please go ahead. Your line may be on mute, David.

David Miyazaki: I’m sorry. Thank you for taking my question. I wanted to revisit some of the comments that you made at the opening, David, with regard to some of the countervailing vectors that are out there. I think in the BDC industries we’ve come through earnings for the last couple of quarters, we’ve seen €“ this is about everybody benefit from higher base rates. And we haven’t really seen defaults rise a whole lot. So, on the surface, it would look like, in general, the return risk profile of middle market lending has gotten better. But I think everybody kind of is expecting the non-accruals are going to rise. So, against the backdrop of better yields, better yield spreads, higher interest rates, better covenants, and a potential recession, do you think that the return risk profile of what you’re doing in lending is getting better or is it worse relative to what we’ve seen in the recent years?

David Golub: So, the answer is it’s better and worse at the same time and on balance I think, better. So, let me unpack that statement. If we’re going to see a continuation of muddling growth and perhaps a continuing slowdown from here and perhaps a recession, those are at the risk of stating the obvious, those are negatives from a credit perspective and those would reasonably be expected to increase credit losses, defaults, non-accruals, worsen performance ratings, increase volatility around credit results, all of which are negatives from a risk reward standpoint. At the same time, we’ve got a number of tailwinds. You mentioned several of them, David. One of them is, rising rates. Merely having 4% higher base rates that in itself pays for a significant amount of credit losses.

A second is higher spreads on new loans. We’ve talked about that spreads are very attractive right now. A third is that we’ve taken a number of fair value mark-to-market adjustments to reflect the higher spread environment and absent credit negative credit events, those are going to start to reverse over time as loans repay or as credit conditions for those companies, those specific companies improve or as spreads start to narrow again. So, we’ve got in respect of your question, we’ve got both kinds of vectors. We’ve got vectors that are pushing in the direction of more risk and we’ve got vectors pushing in the direction of more return. My own sense right now is that the balance is a favorable balance, but I think I got to be humble here and say, you know, we’ve got €“ we can be wrong, right?

I mean, the key assessment here is two-fold. There’s a macro piece and a micro piece. The macro piece is, do you think we’re going to have a period of muddling growth or a period of significant recession? Those are different. And the second, the micro piece is an assessment of how our portfolio is going to hold up in the context of the macro environment. I right now, I’m feeling €“ I’m at the view that muddling growth is more likely than a significant recession and that our portfolio will hold up quite well. I think those are the key criteria, the key variables that investors are going to need to assess.

David Miyazaki: And so when you think about the long cycles that you’ve run through, do you feel like we’re a little better than average or a little below average as far as return on risk go when you put those two together?

David Golub: That’s a really hard question to answer. I’m not sure how to think about that when we think about long cycles. My favorite time to lend Sorry. Go ahead.

David Miyazaki: I was just going to say, I’ll put this into context for you a little bit then. If we think about exposure to middle market lending, and how the attractiveness of the asset class can rise or fall and when rates are declining and covenants are weak and spreads are tight. It tends to lose the return side and at the same time the risk is getting worse because the covenants are getting weak. So, it just seems like right now that despite the fact that we’re coming into a bit of an economic slowdown, recession or muddling either way, that despite that that being apparently in front of us that relative to other points in the cycle of return and risk, the asset class of middle market lending seems €“ it sounds like it’s marginally better than most of the time.

And I’m just kind of thinking about your publicly traded stock on one side would say that because you’re trading a valuation that’s lower than average, that many investors don’t agree with that thesis. And on the other side, I’m curious what your limited partners are saying on the institutional side? Do they feel like middle market lending is a more attractive space? So, that’s kind of where I’m trying to figure out where your thoughts are relative to those two groups?

David Golub: That’s interesting, David. I definitely think that if you look at institutional investor sentiment right now, there’s a wide view that relative to traditional fixed income, which has performed terribly relative to public equities, relative to a variety of different alternative categories that that middle market lending has performed well and has good prospects from here. So, we’re seeing continued shifts of capital in institutional landscape toward the segment with an asterisk. And the asterisk is, what’s called the denominator effect, meaning that institutions who have target percentages of their portfolio allocated to equities are actually seeking to increase their dollars to equities right now because the decline in equity markets has put them under their target percentages.

So, there’s an interesting dynamic in discussions with institutional investors right now. They would like to be moving away from equities, but their portfolio management criteria are telling them they should be moving toward public equities. I think just to go back to your question, I think now is a very intriguing time for most investors to be increasing their allocations to our asset class, principally because it’s so hard to find other asset classes that are performing well and that are likely to perform well prospectively. So, I’d add to your judgment, I think now is good time to invest in the space from a long cycle risk reward standpoint. I also think part of risk reward is relative and I think in a period where rates are going up, it’s hard to get excited about traditional fixed income.

And I think public equity markets, which have come down from their highs, are still not looked at as being cheap by most investors. I’m curious your view on this.

David Miyazaki: Well, I mean, my crystal ball is less accurate than your own. I think that if I look at in the public market valuations for the BDCs, there’s a pretty big separation between operating fundamentals and valuations right now where a lot of really solid operating fundamentals are paired up with historically low valuations. And so, there is a disconnect there and I’m not sure if that’s just because the public markets get things wrong so often or if they’re accurately predicting a suboptimal return risk environment for middle market lending. To me, I think you’re right that the outperformance of private credit is notable, but part of that comes from just having a shorter duration profile and then rising interest rate environment. But I think that if the defaults can remain low, that’s really the whole key here. And will be the determinant of whether or not this is a really good return risk environment. So, I wish I had a better crystal ball too.

David Golub: I think you’re asking the right questions. I agree with, I agree with the approach that you’re taking to it. I agree with your assessment that we’re going to know in retrospect based on where defaults and credit losses go. And I think that’s the assessment we as investors need to make right now.

David Miyazaki : Great. Well, thank you very much. Appreciate your time.

David Golub: Thanks, David.

Operator: Our next question will come from the line of Ronald Phillis with Ivernia Capital.

Q €“Ronald Phillis: Hi, Dave. Thanks for €“ and this is my first time on the call. I want to thank you for taking some pretty pointed questions and not dodging them. It’s very helpful. We’re investors in your LPs, not the BDC, and that’s the reason for me being on the call. And I think that most of my questions have been answered, and I was going to go down the lines of your previous caller Dave, but you did such a great job of being clear that I want to thank you again. One thing that I’m not sure of because is it less transparent and it kind of goes into my attempt to understand the favorable market conditions that you have right now is how the inflows into the private credit markets have gone, you know, over the, you know, three months, six, nine time frames, both institutionally and from a retail standpoint?

So, I think the retail €“ if I’m not mistaken, the retail numbers as that have gone into the private credit market have been the latest growth component to the market. And, you know, that’s my question for you. Thank you.

David Golub: Sure. Thank you for the question. So, let’s talk about two components to it. Let’s talk about the demand side and the supply side. On the demand side, we’ve got a number of growth vectors in private debt. One is the growth of the private equity ecosystem, which has grown dramatically over the course of the last 10 years, and based on fundraising and dry powder in private equity ecosystem is likely to continue to grow. A second is the gaining in share from the broadly syndicated market of the private debt market. The number of private equity borrowers who are now borrowing from private debt providers as opposed to issuing broadly syndicated loans, it’s grown very dramatically and I think there’s a continuing share shift toward private debt.

So, you’ve got a couple of dynamics that are growing the demand side. On the supply side, we’ve seen sources of capital. We’ve seen the BDC sector. We’ve seen the institutional sector that David Miyazaki was talking about. And in the last couple of years, we’ve also seen through the non-traded BDC sector, we’ve seen the growth of retail. The retail funds flows are reported with a lag, so I don’t have good insight into what’s happening right now. What I can tell you is that since May, there’s been a fairly dramatic slowdown in new funds flows into non-traded BDCs. And that’s not surprising in the context of the degree of volatility that we’ve seen in markets generally and the decline in public trading market values. So, I think right now what we’ve got is a bit of a supply demand mismatch where there’s significant demand in excess of supply and that’s what’s causing the more lender friendly conditions.

Ronald Phillis: Thank you. Appreciate it.

David Golub: So, I just want to take this opportunity to thank all of you for joining us for today’s call. Thank you for your partnership. If we did not get to a question that you wanted to get answered, please feel free to reach out either Chris or Matt or I would be happy to get back to you, and we look forward to chatting with you again next quarter. Thanks very much.

Operator: This concludes today’s conference call. Thank you all for joining. You may now disconnect.