Golub Capital BDC, Inc. (NASDAQ:GBDC) Q4 2023 Earnings Call Transcript

Golub Capital BDC, Inc. (NASDAQ:GBDC) Q4 2023 Earnings Call Transcript November 21, 2023

Operator: Hello, everyone, and welcome to GBDC’s Earnings Call for the Fiscal Year and Quarter Ended September 30, 2023. 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 homepage of our website, which is www.golubcapitalbdc.com, and click on the Events Presentations link. Our earnings release is also available on our website in the Investor 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.

David Golub: Hello, everybody, and thanks for joining us today. I’m joined today by Chris Ericson, our Chief Financial Officer; and by Matt Benton, our Chief Operating Officer. For those of you who are new to GBDC, let me start with a quick recap on our investment strategy. Our investment strategy is and since inception, it has been, to focus on providing first-lien senior secured loans to healthy, resilient middle market companies, generally companies that are backed by strong partnership oriented private equity sponsors. Yesterday, we issued our earnings press release for the quarter and fiscal year ended September 30 and we posted an earnings presentation on our website. We’ll be referring to this presentation during today’s call.

I’m going to start as usual with some headlines and I’m going to then lead into a summary of performance for the quarter, then, Matt and Chris are going to go through financial results for the quarter in more detail, and finally, I’ll wrap up with our outlook for the coming period. After that, we’ll take some questions. The headline is that GBDC had an excellent fiscal fourth quarter, you got a glimpse of this in the preliminary fiscal Q4 results that GBDC announced on October 17th. Let me touch on some of the highlights. Adjusted net investment income per share was $0.50 a record. Also of note, this represented an adjusted NII return on average equity of 13.3%. Adjusted earnings per share came to $0.60, this corresponds to an adjusted return on equity of 16%.

Credit results were very strong. We had net realized and unrealized gains for the quarter of $0.10 per share. We saw a decrease in non-accruals and we saw stable internal performance ratings. These factors altogether drove a $0.19 increase quarter-over-quarter in NAV per share, a sequential increase of 1.3%, bringing NAV per share to $15.02 as of September 30th. GBDC’s excellent results for the quarter capped off a very strong fiscal 2023. Over the year, we saw $1.73 of adjusted NII per share, $1.52 of adjusted earnings per share, $1.40 per share of distributions paid, you’ll recall that GBDC increased our base quarterly distribution by $0.07 per share during the fiscal year, and introduced a new variable supplemental distribution framework.

We saw strong credit results, I view fiscal 2023 as one of GBDC’s best years ever from a credit perspective and GBDC’s Investment Manager during the year permanently reduced its base management fee rate from 1.375% to 1.0% per annum that was effective July 1. In short, we executed on our investment strategy. We leveraged the competitive advantages of the Golub Capital platform and we raised the bar for shareholders. With that, let me hand the floor to Matt to walk through our results in more detail.

Matthew Benton: Thanks, David. I’m going to start on Slide 4. As David just previewed, GBDC’s earnings for the quarter ended September 30 were record setting. Adjusted NII per share was $0.50, a 13% which will increase from the prior quarter’s $0.44 per share of adjusted NII. This corresponds to an adjusted NII ROAE of 13.3%. Net income per share increased to $0.60 from $0.43 per share in the prior quarter and represented an adjusted ROAE of 16%. GBDC’s record profitability was driven by three key factors, first and foremost, Credit. GBDC had a net realized and unrealized gain on investments of $0.10 per share. This gain was due to both strong credit fundamentals and tightening credit spreads in the market. The second key driver was continued higher base rates.

Finally, fiscal Q4 benefited from the previously announced reduction of GBDC’s base management fee rate to 1% per annum. The portfolio and balance sheet update generally reflects the continuation of trends from the June 30, 2023 quarter. Net funds declined by $8.4 million sequentially. While we saw a modest uptick in deal activity in calendar Q3 relative to the first half of the year, the pace of new investments remains muted. This is perfectly fine for GBDC. Its model doesn’t depend on fee income from new originations or repayments to drive strong returns. The overall credit performance of GBDC’s investment portfolio remained strong. Non-accruals continued to decrease. Non-accruals as a percentage of total debt investments at cost decreased to 1.6% from 1.8% at 06/30/2023.

As a percentage of total debt investments at fair value, non-accruals decreased to 1.2% from 1.5% at 06/30/23. To put this in context, non-accruals are now back where they were in March and June of 2022. Turning to internal performance ratings, these also remain strong. Investments in rating categories 1 and 2 represented 30 basis points of the total portfolio at fair value. This is the lowest level of 1s and 2s since March 2018. NAV per share increased by 130 basis points on a sequential basis to $15.02. NAV per share is now more than 200 basis points higher at the start of the year, even as GBDC delivered higher distributions to shareholders during this period. Higher profitability and higher NAV, we obviously think this is a good combo. And finally, net leverage declined modestly to 1.21 times.

Turning now to distributions. The Board declared a regular quarterly distribution of $0.37 per share payable on December 29, 2023 to shareholders of record as of December 8, 2023. You’ll recall that the Board increased GBDC’s base distribution from $0.33 per share to $0.37 per share in the quarter ended 06/30/23. Adjusted NII per share significantly exceeded the company’s regular quarterly distribution, resulting in a distribution coverage ratio of 135%. Moreover, based on the new variable supplemental distribution framework we discussed last quarter, the Board also authorized a supplemental distribution of $0.07 per share, payable on December 15, 2023 to shareholders of record as of December 1, 2023. As a reminder, goal, the variable, supplemental distribution framework is to give shareholders a clear line of sight into how we plan to balance the likelihood that GBDC will continue to generate excess income, all else equal on the one hand with our focus on NAV growth and resilience on the other hand.

You can find additional details about the variable supplemental distribution framework on Page 23 of the earnings presentation. In total, the Board approved $0.44 per share of distributions in respect of fiscal Q4 performance. This corresponds to an annualized dividend yield of approximately 11.7% based on GBDC’s NAV per share as of September 30th, 2023. I’m going to turn it over to Chris now to provide more detail on our results.

Christopher Ericson: Thanks, Matt. Turning to Slide 7, you can see how the key earnings drivers Matt just described translated into solid growth in NAV per share. The combination of high short-term interest rates, attractive credit spreads, and GBDC’s locked-in, low cost leverage profile drove record adjusted NII per share of $0.50, a level meaningfully higher than dividends paid out. In addition, the reversal of prior unrealized appreciation on investments contributed to $0.10 per share of adjusted net realized and unrealized gains. Together, these results drove a net asset value per share increase to $15.02, up $0.19 per share from the prior quarter. Let’s now go through the details of GBDC’s financial results for the quarter ended September 30, 2023.

We’ve already covered the key points on Slide 9, so we’ll start on Slide 10, which summarizes our origination activity for the quarter. Net funds growth quarter-over-quarter was modestly negative as fundings of new investment commitments, delayed draw term loan funding and positive fair value changes of existing investments were outpaced by exits and sales of investments. Market wide deal activity has been slow since last year and remained slow in the September 30th quarter. While we saw a modest uptick in deal activity in calendar Q3 and in our pipeline for calendar Q4, our sense is that a significant rebound is more likely to be a 2024 event. Amid this relatively slow new deal environment, Golub Capital has remained highly selective, closing approximately 1.4% of deals reviewed calendar year-to-date.

That’s meaningfully lower than our typical 2% to 4% selectivity rate and reflects our focus on quality over quantity. The asset mix of new investments shown in the middle of the slide remained predominantly one-stop loans. Looking at the bottom of the slide, the weighted average rate on new investments decreased by 20 basis points this quarter. The decrease was primarily due to tighter spreads on new investments, which tightened by 50 basis points sequentially. This is generally consistent with what we are seeing in the market. Spreads on new transactions have tightened since earlier in the year, but they’re still relatively attractive, especially in the context of other deal terms like EBITDA definitions, equity leakage, and leverage still remaining more lender friendly.

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. We are big believers in moderating asymmetric credit risk through position size, which we believe has served GBDC well in previous credit cycles and will continue to be important in the context of future credit cycles. As of September 30, 2023, 94% of our investment portfolio consisted of first-lien senior secured floating rate loans to borrowers across a diversified range of what we believe to be resilient industries.

The economic analysis on Slide 13 continues to showcase the asset-sensitive nature of GBDC’s balance sheet in an environment of rising interest rates. Let’s walk through how to interpret the chart. Start with the dark blue line, which is our investment income yield. As a reminder, investment income yield includes the amortization of fees and discounts. GBDC’s investment income yields increased by 60 basis points, primarily from rising interest rates and recognizing previously deferred interest from one former non-accrual investment returning to accrual status during the quarter. By contrast, our cost of debt, the teal line, only increased 10 basis points. As a result, our weighted average net investment spread, the gold line, increased by 50 basis points over the prior quarter.

With that, I will turn the floor back over to Matt.

Matthew Benton: Thanks, Chris. Let’s move on to Slides 14 and 15 and take a closer look at credit quality metrics. The overall message is that credit trends remain solid and stable. On Slide 14, you can see the non-accruals decreased by 30 basis points sequentially to 1.2% of total debt investments at fair value. We returned one investment to accrual status, which was offset by the addition of one investment to non-accrual status in fiscal Q4. Slide 15 shows the trend in internal performance ratings on GBDC’s investments. As of September 30, 2023, around 85% of GBDC’s investments were rated 4 or 5, which means they’re performing as expected or better than expected at underwriting. The proportion of loans rated 1 and 2, which are the loans we believe are most likely to see significant credit impairment, remain very low at 30 basis points of the portfolio at fair value, the proportion of loans rated 3 increased modestly to 14.6%.

You’ll recall in our prior conversations that Category 3 loans are performing below expectations or are expected to perform below expectations. When a loan migrates to Category 3, it automatically triggers heightened scrutiny and oversight. It doesn’t mean that we necessarily expect a default or loss. Given today’s uncertain environment, we think it’s prudent to be proactive about moving credits down to Category 3. We’d rather have false positives than miss opportunities for early intervention. This idea of airing on the side of enhanced scrutiny was also the motivation for the portfolio resiliency work that we first described in Q4 of 2022. You’ll recall that this work was designed to screen our middle market portfolio for potential vulnerability on a number of dimensions.

For example, interest rates, inflation, quality of earnings, and to focus our resources on shoring up credits that appeared more vulnerable. We didn’t see meaningful surprises in our recent quarterly portfolio resiliency review, and we haven’t seen meaningful new problem credits year-to-date. As we’ve discussed in prior quarters, we don’t believe that backward looking average credit metrics are particularly useful for identifying credit issues. We believe our approach of evaluating risk Obligor by Obligor on multiple forward-looking dimensions is a more rigorous foundation for managing the portfolio prospectively, as opposed to a review of interest coverage ratios and historical financial results. That said, in the spirit of providing some additional context around our portfolio and based on the information from portfolio companies available to us, as of September 30, 2023, we did want to provide some specific portfolio-level credit statistics for everyone.

Let’s start with interest coverage. The weighted average interest coverage ratio for GBDC borrowers is 1.9 times, and 8.3% of GBDC’s portfolio company investments at fair value have a portfolio interest coverage below 1 times. We also wanted to share how interest coverage might change in the context of even higher base rates. When we adjust for potential higher rates 50 basis points above current base rates, again, based on information currently available to us and as of September 30, 2023, we would expect a proportion of our portfolio at fair value with sub-1 times interest coverage to grow only to 10%. We attribute this stability to our focus on lending to resilient borrowers and resilient industries. Finally, we wanted to share underlying portfolio leverage.

The weighted average loan-to-value for the portfolio was 46%, based upon the fair value of the portfolio as of September 30, 2023. As a reminder, these credit metrics are based on financial information received from and that are the responsibility of our portfolio companies. It is often provided on a lag as compared to the period presenting. Okay. We’re going to skip past Slides 16 through 19. These slides have more detail on GBDC’s financial statements, dividend history, and other key metrics. I’ll wrap up this section by reviewing GBDC’s liquidity and investment capacity on Slides 20 and 21. Let’s focus on the key takeaways on Slide 21. Our weighted average cost of debt for the quarter ended September 30, 2023 was 5.2%, which we believe is among the lowest in our peer group.

46% 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 any of them out for floating rate exposure. We ended the quarter with almost $875 million of liquidity from unrestricted cash, undrawn commitments on our meaningfully over-collateralized corporate revolver and the unused, unsecured revolver provided by our advisor. GBDC’s robust liquidity represents 4.6 times its current unfunded asset commitments and almost 2 times the amount of our unsecured notes due in April of 2024. The diversification, flexibility, and low cost of GBDC’s funding structure is an important element that underpins our three investment-grade credit ratings from Fitch, Moody’s, and S&P.

I would highlight on the ratings front that Moody’s upgraded GBDC’s outlook to positive in early October. As a reminder, Fitch also has GBDC’s outlook as positive. We think this puts GBDC in select companies in this regard. Now I’ll hand it back over to David for closing remarks and Q&A.

David Golub: Thanks, Matt. So, to sum up, GBDC had an excellent quarter and an excellent fiscal year ended September 30. Higher rates helped, a lower base management fee also helped. But the key driver was strong credit results and GBDC’s strong credit results, they didn’t just happen. They were the result of Golub Capital’s processes working again. Over the last 13 years that GBDC has been a public company, its credit results have been best-in-class and fiscal ’23 was no different. Our origination team found us opportunities to lend to resilient businesses in resilient industries backed by top-quality sponsors. Our underwriting teams, they carefully selected borrowers that were likely to pay us back across a wide range of different scenarios.

Golub Capital’s selectivity ratio of just 1.4% on a year-to-date basis, it shows that deal teams are prioritizing quality over quantity. And our portfolio monitoring, it always emphasizes early intervention after careful name-by-name portfolio reviews. Let me wrap up by talking about our outlook. Overall, I’m cautiously optimistic. I want to talk some more about both the reason for the optimism and the reason for the cautiousness. Let’s talk about the optimism first. The economy continues to surprise to the upside, that’s a positive. We’re also seeing some improvement in middle market M&A activity. That’s also a positive. I think the competitive position of Golub Capital has really never been stronger, that’s a third positive. From a credit perspective, there are also some good signs.

As Matt reported, the vast preponderance of the portfolio is performing well. And while high rates add a higher fixed charge burden for borrowers, the flip side is extra interest income for GBDC, and this gives us a greater margin of safety. Finally, we now have over a year’s worth of data about how our portfolio companies are handling higher rates. And so we think we have a good handle on where vulnerabilities are most likely to emerge. And where we see that we’re on it. Okay, so that’s the reason for optimism. Let me talk now about the cautiousness. Why the cautiousness? I’m cautious because I don’t trust anybody’s macro predictions these days. Consensus was wrong in thinking we’d see a recession this year. It was also wrong about the post-pandemic boom, it was wrong about inflation being transitory, and then it was wrong about inflation being stubborn.

It’s been wrong a lot lately. By implication, I think we need to be very humble these days when we make predictions. Yogi Berra had it right when he said, “predicting things is hard, especially about the future.” I think that’s especially true today. Having said this, the very unpredictability, the environment that we’re in, it leads me to think that investors today ought to particularly value resilient investments. By resilient investments, I mean investments that will do well across a range of different macro scenarios. I think GBDC is exactly this kind of resilient investment. Our resiliency is partially attributable to the detailed company-by-company resiliency analysis that we previously discussed, which we now run on a quarterly basis.

We’ve also stepped up our engagement with sponsors and management teams, where we see potential for issues arising. From an earnings power perspective, GBDC’s asset sensitive balance sheet positions the company very well for a high interest rate environment like the one we’re in. GBDC’s new lower base management fee rate permanently raises GBDC’s ROE profile in any interest rate environment. And GBDC’s new variable supplemental distribution policy paves the way for more of this earnings power to be distributed to shareholders, when prudent to do so. Now, don’t mistake me for some kind of Pollyanna. I think optimism and caution, they actually go hand-in-hand in uncertain environments like the one we’re in right now. But GBDC has always done well by staying laser focused on credit and by continually raising the bar for shareholders.

That’s what we’re doing now, that’s what we did in 2023, and that’s how we plan to navigate the coming period. With that, let me open the floor for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Your first question comes from the line of Finian O’Shea with Wells Fargo. Your line is open.

Finian O’Shea: Hey, everyone. Good morning. David, I appreciate some of the macro commentary at the end. Just wanted to drill into that a bit. It sounds like there are green shoots in M&A, which should be good for activity. But can you juxtapose that against the meaningful direct lending inflows we’re seeing in the non-traded perpetual BDC channel? How is that impacting the terms and spreads we’re seeing today? And do you think there’s enough M&A to go around in light of this very powerful fundraising? Thank you.

David Golub: Thanks, Fin. So it’s interesting, we are seeing some countervailing forces right now. On the one hand, we started off, say, summer of ’22 in a particularly lender-friendly environment. The BSL market was dislocated as a consequence of the rise in interest rates and the swoon in equity and debt markets generally. There wasn’t a robust ability for borrowers to get new deals done in the broadly syndicated market. And consequently, there was a lot of demand in the private market — in private credit markets, even though M&A was relatively slow, that meant there was a robust pool of deals for us and for other private credit players to choose from. In the last, I would say, six weeks, we’ve seen a pretty significant increase in the level of M&A activity.

And I think from an origination standpoint, Q4 will be a markedly higher quarter for us and for the industry than the last several quarters have been. Having said that, to your point, we’ve seen a lot of fundraising in direct lending strategies aimed at very large deals, aimed at this BSL replacement market. We play in that market, but that’s about, it’s 20% of what we do, whereas we have a whole series of competitors where it’s basically 100% of what they do. We’ve seen some very significant spread compression and shift toward more borrower friendly terms and activity in that space. And that’s been a trend for months now, but I do think that it’s accelerated in the last six weeks or so. For us, this is not a great problem because our focus is on the traditional middle market.

I do think you’re going to start to see indicia of spread compression in next quarter’s earnings reports from the players who focus on the larger market.

Finian O’Shea: That’s helpful. Thank you. And also appreciate the color you gave on interest coverage. For the names that have tighter interest coverage, I’m sure that’s sort of a spectrum. To what extent are you seeing sponsors put money in? And if not very much, do you see ’24 — 2024 as sort of a make or break timeframe in the need for the sponsor to come up with money and capitalize these companies that, that is, if interest rates remain high? Just any color on that topic? Thank you.

David Golub: So the question is, what about companies that are tight on interest coverage or fixed charge coverage? How are they managing that? And the answer is, we’re seeing a number of different approaches. We’re absolutely seeing sponsors step up and put incremental equity in in a large number of cases. We’re also seeing companies undertake other strategies in order to create liquidity. Sometimes that’s the creation of a HoldCo note or a new PIK preferred issuance. Sometimes it’s also growth. Growth has done a good job for many of our borrowers of creating more free cash flow generation that’s enabled the formerly tight ratios to look better. So we’re seeing different companies approach this in a variety of different ways. I don’t think there is one clear pattern to point to. I do think that private equity sponsors are, in general being pretty constructive in addressing liquidity needs in their portfolio companies.

Finian O’Shea: Awesome. Thanks so much.

Operator: Your next question comes from the line of Robert Dodd with Raymond James. Your line is open.

Robert Dodd: Hi, guys. Congratulations on the quarter on the credit quality. So, two questions, one iskind of a follow on to Fin and David your comments there that you’ve seen some spread compression in the upper end of the market and also that the terms are shifting to a little bit more borrower-friendly at that end of the market. And I think it was Chris or maybe Matt in their prepared remarks said that you’ve seen the overall spread compression, but the EBITDA definitions and total leverage were still favorable overall. And so that would tend to imply that you hadn’t seen that shift in the bulk, like the 80% of the other stuff. How confident are you that the terms will continue to be diverged between the top end of the market and the more core middle market as we go into 2024 or do you think they’re going to converge in 2024, even in the core middle market is going to shift to a much more borrower-friendly set of structures?

Hopefully that question is clear enough?

David Golub: Yeah. Here’s how I would describe it, Robert. There is always — think of it as a pendulum. There is always a swinging between more borrower-friendly and more lender-friendly conditions. And the swing tends to happen first in the broadly syndicated market. Today, that market is not terribly active. So the first place we’re really seeing it is in the BSL replacement market, the larger end of the direct lending market. And to Fin’s point, that’s the place that’s seen the most inflows — the most capital inflows through these non-traded BDC structures. I don’t think the middle market and the larger market are disconnected. I think, things tend to happen in the middle market with a lag and to a more modulated degree, and I think that’s the pattern we’ll see again in 2024.