I have been actively covering and investing in Golub Capital BDC (GBDC) for many years, and this article is an update for the calendar Q2 2017 results. My purchases are usually during general BDC (business development company) market pullbacks, similar to the one we have experienced since early May.
However, I have not purchased additional shares since early 2016 as discussed in “BDC Buzz Begins 2016 Purchases,” but I will likely be purchasing shares later this year. If you would like notifications of my upcoming purchases and current allocations, please subscribe to Sustainable Dividends.
Why do I like GBDC?
This article discusses many of the reasons to invest GBDC including:
- Excellent credit platform and underwriting history/standards
- Best-of-breed fee structure designed to cover dividend each quarter at the expense of management
- Stable-to-growing NAV per share
- Paying out undistributed/spillover income to shareholders as special dividends rather than retaining internally
- Access to SBIC leverage and accretive equity offerings
GBDC Historical Yield
GBDC is an outlier among BDCs for many reasons and its pricing typically commands a premium giving it a lower yield. There are many reasons for this including the ones listed above but mostly due to the quality of assets providing consistent returns to shareholders, which is why many investors view GBDC similar to a bond rather than a stock.
Fiscal Year 2017 Portfolio Update
On October 10, 2017, GBDC announced that it originated $ 128.9 million in new middle-market investment commitments during the three months ended September 30, 2017. Approximately 85% of the new middle-market investment commitments were one stop loans, 14% were senior secured loans, and approximately 1% was equity securities. Of the new middle-market investment commitments, $ 125.1 million funded at close.
More importantly, the announcement also discussed an overall 6.5% decrease in the total portfolio and 6.6% decrease in its SLF likely due to increased debt repayments.
- Total investments at fair value are estimated to have decreased by approximately 6.5%, or $ 116.8 million, during the three months ended September 30, 2017.
- Total investments at fair value held by Senior Loan Fund are estimated to have decreased by approximately 6.6% or $ 21.3 million.
“Total investments at fair value are estimated to have decreased by approximately 6.5%, or $ 116.8 million, during the three months ended September 30, 2017 after factoring in debt repayments, sales of securities, net fundings on revolvers and net change in unrealized gains (losses). Total investments at fair value held by Senior Loan Fund LLC, an unconsolidated Delaware limited liability company that invests in senior secured loans and is co-managed by Golub Capital BDC, Inc. and RGA Reinsurance Company, are estimated to have decreased by approximately 6.6%, or $ 21.3 million, after factoring in debt repayments, sales of securities, net fundings on revolvers and net change in unrealized gains (losses).”
Dividend Coverage Discussion
GBDC has consistently covered its dividend, and on November 16, 2016, the company declared its first special dividend of $ 0.25 that was paid in December 2016. There is a good chance for an additional special dividend in calendar Q4 2017 as the company continues to grow undistributed income and gains on a GAAP basis.
Higher quality BDCs tend to support regular dividends with recurring NII and pay special/supplemental dividends supported by additional income and/or capital gains usually through equity investments, similar to Main Street Capital (MAIN). Many BDCs retain undistributed income and some incur excise taxes rather than pay out to shareholders as they see it as “cheap capital” to reinvest and grow the portfolio. GBDC has chosen to a pay special dividend to avoid excise tax and will raise capital through accretive equity offerings as needed. See discussion below:
“So many managers are reluctant to first to pay out special distribution because they earn fees on capital that they keep within the vehicle. Our approach is a little different. Our approach is to think about this from the perspective of what’s good for shareholders and that led us to the inclusion that the right answer was to pay a special distribution.”
For calendar Q2 2017, GBDC hit my best-/base-case projections covering its dividend after excluding $ 0.6 million accrual for the capital gain incentive fee. As mentioned in previous reports, GBDC has predictably boring NII of $ 0.32 each quarter (see table below) that is mostly due to its fee structure combined with strong portfolio credit quality. My financial projections (discussed later) use a wide range of assumptions, but because of the incentive fee hurdle, the dividend is consistently covered by design.
“Turning to the following slide, the tables on the top provide a summary of our quarterly distributions and return on equity over the past five quarters. Our regular quarterly distributions have remained stable at $ 0.32 per share, which is consistent with our net investment income per share when excluding the GAAP accrual for the capital gains incentive fee.”
Total investment income increased due to accelerated accretion of discounts and an increase in prepayment fees resulting from increased debt investment payoffs during the quarter. These increases were partially offset by a decline in income from its investment in Senior Loan Fund LLC (“SLF”) that was attributable to a decline in the credit performance of the SLF’s portfolio. The annualized quarterly return for the quarter ended June 30, 2017, was 3.4% (see below). The quarterly return was negatively impacted primarily as a result of a mark-to-market unrealized loss on one middle-market non-accrual loan.
“Turning to Slide 14, this slide provides financial highlights for our investment in our senior loan fund, which had a disappointing quarter. The annualized total return for the quarter ended June 30 fell to 3.4%, primarily due to an unrealized loss on one portfolio company investment.”
Since the beginning of 2013, GBDC’s portfolio yield has declined from 9.5% to 7.7% but still covered its dividend with core NII. The company is not reliant on non-recurring fee and dividend income, and as mentioned in previous reports, there is the potential for higher yields from reinvestment and growth of its SLF in the coming quarters as discussed on a recent call:
“We do see an opportunity to continue to grow our senior loan fund over time. We have grown it now to substantial size. If we get to the, up $ 350 million in assets today, and we think that there will be opportunities for us to continue to grow that. We are nowhere near a constraint on the use of our 30% bucket. But we are not going to rush it. We are not going to push it. We are going to grow it as we see appropriate loans to put into that joint venture.”
“I’d repeat what I’ve said in prior quarters, which is it’s our intention over time to grow SLF but we’re going to do it if, as and when we identify attractive traditional senior secured loans to go into it and in this challenging environment, our expectation is that that’s going to be a relatively slow process.”
There was a recent increase in portfolio yield from 7.7% to 7.9% due to “the shift back to higher yielding one-stop loans” and “a few large payouts on existing loans”.
“Turning to Slide 8, the weighted average rate of 7.3% new investments this quarter was up from 6.4% last quarter, primarily due to the shift back to higher yielding one-stop loans. Due to a few large payouts on existing loans with high relative spreads, the weighted average rate on investments that paid off increased to 7.9%.”
“Shifting to the graph on the right-hand side, this graph summarizes investment portfolio spreads, focusing first on the light blue line. This line represents the income yield or the actual amount earned on the investments including interest and fee income, but excluding the amortization of discounts and upfront origination fees. The income yield increased to 7.9% for the quarter ended June 30. This was primarily due to higher prepayment fees. The investment income yield or the dark blue line, which includes the amortization of fees and discounts, increased to 8.7% for the quarter due to an acceleration of OID amortization caused by an increase in payoffs and runoff in the portfolio.”
On January 12, 2017, GBDC announced that it had received approval for a third license from the Small Business Administration (“SBA”) that gives the company access to a maximum of $ 350 million of SBA debentures. I have assumed that the company will keep leverage consistent with the previously discussed target levels (see below):
“I think we are comfortable going a little bit higher than 1.0 GAAP leverage. We tend to focus more heavily on regulatory leverage. We’ve talked before about having targets in place of a little bit over 1.0 on GAAP leverage and approximately 0.75 on regulatory leverage.”
“Our GAAP debt-to-equity ratio was 0.94 times, while our regulatory debt-to-equity ratio was 0.63 times. These are slightly below our targets due to the small follow-on equity offering that we completed in June. As of June 30, we had over $ 150 million of capital for new investments through restricted, non-restricted cash, availability on our revolving credit facility, an additional debentures available through our SBIC subsidiaries.”
As mentioned in previous reports, there is a good chance that the proceeds of the recent equity offerings were used to capitalize its SBIC IV and Senior Loan Fund (“SLF”). Management mentioned the following on a recent call:
“A portion of the net proceeds may be utilized to capitalize SLF. A portion of the net proceeds may also be used to capitalize SBIC VI, our SBIC subsidiary, following which we expect SBIC VI to issue debentures guaranteed by the SBA and make investments in accordance with our investment strategy.”
“Assuming we find attractive investment opportunities to deploy, one of the ways is to grow our SBIC debentures outstanding. And we do view that program as being a very attractive source of financing. There are, probably everybody knows there are restrictions on what kinds of loans can go into in SBIC. So it’s not as simple as saying, hey, we are just going to deploy those in the next few deals we do. We need to match appropriate transactions to ensure eligibility and compliance with all the SBIC rules.”
As shown in the Interest Rate Sensitivity Comparison report, I consider GBDC to be one of the best-positioned BDCs for rising interest rates.
Risk Profile Discussion
I consider GBDC to be one of the safest BDCs as shown in my recently updated BDC Risk Profiles report and remains a component in my suggested “Risk Averse” portfolio for many reasons, including 90% of the portfolio in senior secured and One Stop loans and one of the lowest stated portfolio yields in the industry (typically indicating higher credit quality). GBDC’s continued focus on “quality over quantity” has led to a reduced portfolio yield but dividend coverage has remained relatively stable due to the investor friendly incentive fee structure (discussed later).
There was one investment added to non-accrual status during the quarter, Ignite Restaurant Group, with cost and fair value of $ 4.3 million and $ 1.6 million, respectively. Management has taken conservative marks with potential upside as discussed on the call:
Q. “Maybe let’s go with a quick postmortem on Ignite or Joe’s Crab Shack and just a bit more detail because I know you both limit losses, but also, I learned from them. And then also, a discussion on the opportunity for growth in SLF in light of the unrealized loss and perhaps the amplified effect of leverage and how that impacted return this quarter. So, thoughts on those two investments, Joe’s as well as the SLF please.”
A. “Sure. Let’s start with Joe’s. So, this is a company under the formal name Ignite. If you’re looking in our financial statements, you’ll find it under its corporate name, which is Ignite. For those of you who aren’t familiar with the story here, Ignite’s principal asset is a chain of restaurants called Joe’s Crab Shack that has not performed well in recent years. The company went into a bankruptcy proceeding this last quarter. It has a stalking horse bid from another large restaurant chain and the courthouse auction to resolve the bankruptcy is expected to take place later this month. We’ve taken our lumps on it. Our valuation reflects the approximate expected proceeds at the stalking horse bid level. So, we have some potential for upside if the auction results in a higher price.”
“We don’t have absent some unusual circumstances. We don’t have a meaningful level of downside from here. We were wrong on this credit. We pride ourselves on being wrong infrequently… And in this case, we underestimated the pace of shift in the restaurant sector. This company saw a very dramatic shift in it same store sales, which has persisted for an extended period of time. The restaurant faces a challenging space. We approach it cautiously. This one was an unusual one for us in that it was a participation in a loan facility that we did not lead and I think one of the learnings to go back to your questions on one of the learning from our standpoint is that in challenging sectors particularly, we’re going to be increasingly stringent about the investment decision to participate in deals led by others.”
However, portfolio credit quality remains strong with low non-accrual investments as a percentage of total investments at cost and fair value of 0.6% and 0.2%, respectively.
“Turning to Slide 10, the percentages of investments, risk rated up five or at four, our two highest categories remain stable quarter-over-quarter and continue to represent over 85% of our portfolio. As a reminder, independent valuation firms value approximately 25% of our investments each quarter.”
GBDC has increased its net asset value (“NAV”) per share in 19 out of the last 20 quarters after excluding the impact from its recent special dividend of $ 0.25 (see chart below). During calendar Q2 2017, NAV per share rose to $ 16.01 (from $ 15.88) mostly due to accretion from its recent equity offering at a premium to NAV per share.
“Net asset value per share rose in the quarter to $ 16.01 at June 30 from $ 15.88 at March 31 due both to earnings in excess of our quarterly distribution and accretion from completing a common stock offering on June 12 at a premium to NAV.”
“As summarized on the last bullet point at the bottom of the slide, on June 6, we entered into an agreement to sell 1.75 million shares of our common stock at a net price to us of $ 18.71 per share. Including the exercise of the underwriters option to purchase additional shares, we raised approximately $ 36.8 million in net proceeds. This price was 1.18 times our most recently reported NAV per share at the time of the share issuance.”
“The bottom of the page illustrates our long history of increasing NAV per share over time. For historical comparison purposes, we’ve presented NAV per share both including and excluding the $ 0.25 special distribution that we paid in December 2016.”
“As shown on the bottom of the slide, the portfolio remains very well diversified with investments in 188 different portfolio companies at an average size of $ 9 million per investment.”
Quality of Management & Fee Agreement
As mentioned in the BDC Buzz Positions report, I purchased additional shares of GBDC (along with many other BDCs on 1/20/16) as I believe this is one of the higher quality BDCs. GBDC is consistently priced at a premium, likely related to investors seeking safer BDCs with predictable and consistent NAV per share growth and dividend coverage. Other reasons for its premium pricing include having a fee structure with a “total return hurdle”, access to increased SBIC leverage and its higher quality portfolio.
GBDC has one of the most investor friendly fee structures, with a base management fee that is calculated at an annual rate of 1.375% (compared to 1.50% to 2.00% for many) of average adjusted gross assets, excluding cash and cash equivalents. GBDC is a “high water mark” BDC which means that its incentive fee structure protects total returns to shareholders by taking into account capital losses when calculating the income portion of the fee. Incentive fees are paid after the hurdle rate is reached, requiring a minimum return on net assets of 8% annually. Once this hurdle is reached, the advisor is entitled to 100% of the income up to 10%. This “catch-up” provision catches up the incentives to 20% of pre-incentive fee net investment income and then the advisor is paid 20% after the “catch-up”. However, GBDC is currently between the 8% and 10% hurdles so its incentive fees are much lower and basically ensures dividend coverage.
Credit Platform & Scale: There are certain BDCs that benefit from having an external manager providing scale, relationships and an experienced credit platform. GBDC is clearly one of these BDCs with an external manager, Golub Capital, that has over $ 20 billion in assets under management, and I believe that this is an important distinction for many reasons including access to a larger deal pipeline and the ability to invest across multiple platforms with less conflicts of interest. Golub Capital is clearly one of the higher credit quality platforms with excellent underwriting and will likely continue to outperform to deliver consistent returns to shareholders.
“Our credit standards remain very high across the Golub Capital platform, our approval rate for new investments for the first half of 2017 was at the low end of our historical averages. Now we believe this borrower-friendly market is going to last forever. As I’ve said before, our plan is to sustain our high credit standards through this period and to prepare for a range of potential future scenarios.”
“We believe Golub Capital’s one-stop are gold facilities can be a win-win solution for both sponsors and investors. For sponsors, the gold facility gives them a straightforward capital structure, it’s simpler, it’s easier on day one and it can be scaled up over time easily as the sponsor looks to bring in tuck-in acquisitions.”
“For investors, the scalable gold offers us the opportunity to deploy increasing amounts of capital in companies we know and we believe are performing well and are likely to continue to perform well. As an example, in the last quarter, GBDC invested in $ 675 million Golub Capital led one-stop financing for pet debt.”
On February 27, 2017, GBDC and GC Advisors received exemptive relief from the SEC to permit greater flexibility to negotiate the terms of co-investments. This is a meaningful development that allows GBDC to take on larger investments and spread them across the platform for continued portfolio diversification. Historically, GBDC has had a steady inflow of new investments each quarter that has been partially offset by exits, sales and repayments:
“GBDC had relatively high originations in the quarter ended June 30. I attribute this to three factors. One a lot of hard work by the Golub Capital origination underwriting team. Two, success in leveraging the firm’s competitive advantages and three, a bit of good luck. Let me say a bit more about each of these.”
“Across a variety of private funds, separate accounts, funds of one, as well as the BDCs Golub Capital today manages about $ 18 billion [now $ 20 billion] in capital. So that GBDC represents about 10% of the total platform. We are big believers in diversification. So we do not feel comfortable making real lumpy commitments. So we today are frequently looking at transactions in that as big as the $ 200 million to $ 300 million size range, where we would hold the full facilities.”
“The first factor I mentioned was hard work. The hard work was finding attractive opportunities in a challenging environment. There’s no substitute for shoe leather and our team showed a lot of grid in generating these attractive opportunities. This is the kind of market where we believe being able be selective is critically important than through our origination channels, the Golub Capital team generated almost 1300 investment opportunities in the first half of calendar 2017 of which we closed about 2%.”
“Generally, if you look at the new financings we completed, they leverage our competitive advantages and this brings me to the second factor I wanted to talk about. One key competitive advantage we focused on is our capacity to deliver large scalable one-stop solutions.”
The information in this article was previously made available to subscribers of “Sustainable Dividends” along with:
- GBDC’s target prices and buying points
- Real-time announcement of changes to my personal positions
- Projected dividend coverage and worst-case scenarios
- Rankings and risk profile
- Suggested BDC portfolios
Disclosure: I am/we are long GBDC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.