Golub Capital BDC, Inc. (GBDC) Q1 2013 Earnings Report, Transcript and Summary

Good afternoon and welcome to Golub Capital BDC, Inc.'s December 31, 2012 Quarterly Earnings Conference Call. Before we begin, I would 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 Golub Capital BDC Inc.'s filings with the Securities and Exchange Commission. For slide presentation that we intend to refer to on the Earnings Conference Call, please visit the Events and Presentations link in the homepage of our website, www.golubcapitalbdc.com and click on the Investor Presentations link to find the December 31, 2012 Investor Presentation. Golub Capital BDC earnings release is also available on the company website in the Investor Relations section. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Mr. David Golub, Chief Executive Officer of Golub Capital BDC. Please go ahead.

Thank you, Kim. Good afternoon, everyone, and thanks for joining us today. I'm joined today by Ross Teune, our Chief Financial Officer. Earlier today, we issued our quarterly earnings press release for the 3 months ended December 31, 2012 and we posted a supplemental earnings presentation on our website. We'll be referring to this presentation throughout today's call. I want to start today by providing an overview of the December 31, 2012 quarterly financial results. And then Ross is going to take you through the results in more detail. I'm going to then come back and provide an update on current market conditions. With that, let's go ahead and get started. I'd like you to turn to Slide 2 of the Investor Presentation. I'm pleased to report we had another strong quarter for the 3 months ended December 31, 2012, we generated net investment income of $9.6 million or $0.34 per share and that compares to $7.8 million or $0.30 per share for the September 30 quarter. Net increase and net assets resulting from operations, otherwise known as net income, for the quarter ended December 31 was $9.3 million or $0.33 per share as compared to $8.7 million or $0.34 per share for the quarter ended September 30. Let me describe briefly the reason for the $0.01 per share difference or the $300,000 difference between net investment income and net income for the 3 months ended December 31, 2012. It was primarily due to 2 valuation adjustments during the quarter, one up, one down, both on non-earning accounts. There is a $1.3 million valuation increase on Pillar Processing. This increase was attributable to an improvement in the company's trailing 12 months EBITDA. In addition, since we restructured this debt in July 2012, the company's been current with all interest payments and we've also received some significant principal repayments from liquidation receivables. The unrealized gain on Pillar was offset by an unrealized loss of $1.1 million on Extreme Fitness as this company's financial performance has continued to decline. There weren't any other notable valuation adjustments for the quarter. If you turn to Slide 4, you can see a rundown of investment activity during the quarter. New originations as we expected, were quite robust, totaling $262.2 million for the 3 months ended December 31. Sorry, my voice -- I've got a touch of laryngitis so I'm sorry if I sound a little hoarse. Originations set a record as business owners expedited deals on the expectation that tax rates on dividends and capital gains would increase on January 1. Repayments were also unusually high. So we had high originations and we had high repayments. In fact, at $145.8 million, repayments were higher than we expected at the time we had our last quarterly earnings call. Overall, the net result was an increase in investments of $95.4 million. If you look at that $95.4 million of new originations, I'm pleased to report that it had quite a good mix from the standpoint of our goal of increasing the percentage of one stop investments in the portfolio. Of the new investments, 61% were in one stop loans, 22% in senior secured loans, 15% in second lien loans and 2% in equities. During the quarter, we also made some important improvements to our liability structure. First, we received approval from the SBA for a second SBIC license. So we now have 2 SBIC licenses within the BDC and between the 2 of them, we can issue up to $225 million of fixed-rate, low-cost, highly flexible long-term debt. In addition, these SBIC licenses could become even more valuable if some legislation currently before Congress moves forward. That legislation raises the SBIC family of funds leverage limit from $225 million to $350 million. We're not counting on this legislation passing but we're very hopeful that it will pass. Second, on the liability structure front, we amended our revolving credit facility with Wells Fargo. The amendment, among other things, increased the size of the revolving credit facility from $75 million to $150 million and it extended the stated maturity date to October 20, 2017. I'm now going to turn it over to Ross to discuss the financial results in more detail and I'll be back at the end to give you an assessment of current market conditions and also to address questions. Ross, over to you.

Thanks, David. I'm going to start on Slide 4 of the presentation. As David mentioned, we originated $262.2 million of originations this quarter, which is a quarterly record. Exits from repayments and sales were also high, totaling $145.8 million. As I'll discuss in a few slides, this heightened level of repayments during the quarter contributed to an increase in fee amortization, as well as an increase in fees from prepayment penalties. Taking into account other variables such as net fundings and revolvers, change in unamortized fees, change in net -- change in unrealized gains or losses, overall, net quarterly funds growth was $95.4 million, up about 14% from September 30. If you look at the asset mix at the bottom of the slide there, due to the high percentage of one stop transactions that we originated this quarter, the overall percentage of investments in one stop loans increased to 47% of total investments, with senior secured investments declining to 33%. The percentage of junior debt investments and equity investments remained stable at about 20%. Flipping to the balance sheet on the next slide, we ended this quarter with total investment of approximately $768 million, total cash, unrestricted cash of about $60 million and total assets of $839 million. Borrowings were $400.5 million, up $48 million from the previous quarter due to an increase in the debentures of $11.5 million and an increase in our revolving credit facility $36.7 million. So a total breakdown of the $400.5 million of debt: $174 million in our CLO securitization, $135 million of SBIC debentures and $91.5 million in our revolving credit facility. Total net asset at the end of the quarter was $419.6 million. This was up about $44 million for the quarter due to the common stock offering that we completed back in October. Given the growth in our investments of $95.4 million, our growth was financed about equally between debt and equity. From a GAAP perspective, our debt-to-equity ratio remained stable at 0.95x, calculated for our regulatory calculation. Our debt to equity ratio was also stable at 0.63x. Flipping to your statement of operations on Slide 6. Total investment income for the quarter was $18.6 million. This was up $2.4 million from the prior quarter. Total investment income included $2.4 million of fee amortization, up from $1.6 million for the quarter ended September 30. In addition to investment income -- I'm sorry, in addition to interest income and fee amortization for the quarter, we also had $0.9 million of income from prepayment penalties and other fees. On the expense side, total expenses of $9 million increased by $0.6 million during the quarter, primarily due to an increase in management and incentive fees driven by an increase in total assets and increase in investment income. Looking at the net gain and loss in investments, we had a small net gain of approximately $100,000 on total sales of $14 million, which is primarily more liquid senior secured loans. And we had a net unrealized loss of $0.4 million on investments which David provided some commentary in his opening remarks. Turning to Slide 7, these charts graphically summarize the breakdown of our new originations and end-of-period investments. As shown in the gray bar on the left-hand side, we originated 61% of our new investments in one stop loans, increasing the overall percentage of one stop loans to 47% of the total investment portfolio at December 30, as shown on the right-hand side. We're quite pleased with asset mix at the end of December with senior secured loans at 33%, one stop loans at 47% and junior and equity investments at around 20%. Turning to Slide 8, I'll walk you through the changes in our yields and investment spreads for the quarter. Focusing first on the gray line, this line represents the interest income or all income earned on the investments, excluding the amortization of discounts and origination fees, primarily due to an increase in prepayment fees during the quarter. This interest income yield increased from 9.5% from the quarter ended September 30 to 9.7% for the quarter ended December 31. Excluding prepayment fees from both quarters, the interest income yield would've been flat quarter-over-quarter. Including amortization of fees and discounts, the total yield on the investments, the dark blue line at the top of the chart, the yield was 11.2%. Again, this increased this quarter due to the unusually high level of prepayments that we experienced. Turning to Slide 9, for new investments, the weighted average rate on new middle-market investments was 8.3%. This was up modestly from the previous quarter due to a lower percentage of senior secured assets originated this quarter and is slightly above the average rate on investment that paid off during the quarter. Again, the weighted average rate on our new investments is based on the contractual interest rate at the time of the funding. For variable rate loans, the contractual rate would be calculated using the LIBOR rate, the spread over LIBOR and the impact of any LIBOR floor. For fixed rate loans, it would be the stated fixed rate. As shown on the middle of the slide, the investment portfolio remains predominantly invested in floating rate loans, with floating rate loans comprising nearly 90% of the total portfolio at the end of December. Turning to Slide 10 and 11, the overall fundamental quality continues to remain very strong with non-earning assets as a percentage of total investments on a cost basis at 1.1% and 0.3% as a percentage of total investments on a fair value basis. Looking at a risk ratings on Slide 11, portfolio risk ratings remained stable with over 90% of the investments in our portfolio, rating the top 2 categories of 4 or 5. During the quarter there were no new non-earning accounts added. As a reminder, independent valuation firms valued approximately 25% of our portfolio as of December 31. Turning to Slide 12, our board declared a distribution of $0.32, payable on March 28, 2013 to shareholders of record as of March 14. Flipping to Slide 13, we ended the quarter with $21.4 million of unrestricted cash and $39 million of unrestricted (sic) [restricted] cash. Restricted cash is held in a securitization vehicle, a revolving credit facility or SBIC, and this cash is available for new investments that qualify for acquisition by these entities. In addition, subject to leverage and borrowing base restrictions, we had approximately $58.5 million available for additional borrowings on our $150 million revolving credit facility. With regards to our SBICs, we had $15 million in available and approved debentures as of December 31. That was available in our first or existing SBIC entity. As David previously mentioned, when we received approval for our second SBIC license in December and in early January, we received a commitment approval for $37.5 million. This commitment may be drawn upon subject to customary regulatory capital requirements and including an examination by the SBA. I'll now turn it back to David who will provide some commentary on current market conditions.

Thanks, Ross. So as we previously communicated, we completed the common stock offering in mid-October. We did it in anticipation of strong originations and fourth calendar quarter of 2012. We raised about $44 million in new capital through the offering and we quickly deployed it. In fact, due to the quick deployment, we've talked about the deployment earlier in this call, we decided to raise additional funds in mid-January through our second common stock offering. We raised approximately $69 million in net offering. And these proceeds are going to be used to invest in new portfolio companies and to capitalize our new SBIC entity. In the 2 recent stock offerings, Golub Capital entities purchased a total of $4 million worth of the shares, primarily for the purpose of awarding stock compensation to members of our team. This increases the total value of shares purchased for employee compensation to over $10 million during the last 12 months. One of the things we're very proud of is that the ownership of GBDC by Golub Capital employees, and we think it is very important to fostering alignment between our investment team and our shareholders and that it's a key part of our long-term success. Let me hit briefly on current market conditions and our outlook for calendar 2013. As expected, our deal pipeline in the first calendar quarter of 2013 is much slower than it was last quarter. It's not anemic. We're still getting some deals done, but there's no question that we and others in the market are feeling the pull forward effect of last quarter. We remain cautiously optimistic that new deal flow in calendar year 2013 is going to improve in the coming months. The reason for that is fundamentals. We think the fundamentals remain strong for an increase in M&A activity and that includes a slow but improving economy, historically low interest rates, a strong appetite among businesses for growth through acquisitions and private equity firms looking to deploy plentiful capital commitments. Not surprisingly, given the new deal activity has slowed so far this quarter, Ross, is seeing some continuing spread compression and leverage creep in the new deals that are getting done. It's not as dramatic as the trends that we're seeing the liquid credit markets but as I've said before, the middle markets was not immune from broad market trends. I'm going to stop there and open the floor for questions. Before I do so, I want to just do something I think I always on these calls but I want to draw special attention to it this quarter. I want to thank everybody for giving us the confidence of being shepherds of their capital. We take that very seriously and I want to thank you for your time and support today. Operator?

[Operator Instructions] Our first question is from the line of Jim Young with West Family Investments.

David, the spread compression and leverage creep that you had mentioned in the middle market segment, can you please quantify that for us?

I'm sorry, Jim. We are having a little bit of static on the line. Can you repeat the question, please?

You mentioned spread compression and leverage creep in the middle market area. Could you please quantify that issue for us?

You were asking about leverage creep and spread compression? It's hard to say because it's so early in the year so far but we're seeing, I'd say in the range of 25 basis points of spread compression. And again, about I'd say a quarter turn of leverage creep. In that range, where we are right now, it's not entirely clear where we're going to end up because we're in a period right now of relatively light transaction volume. I think the bigger question, and I don't think anyone really knows the answer to this is, what's going to happen going forward. We're planning on an environment where we may see continuing spread compression and leverage creep and we're setting ourselves up to use our origination engine to find very attractive transactions if that happens.

[Operator Instructions] Our next question is from the line of Jonathan Bock with Wells Fargo Securities.

David, while we have seen some compression on the asset side of the balance sheet or in general, in the middle market, could you perhaps maybe talk about some of the opportunities on the liability side as it relates to strong CLO issuance, particularly on balance sheet securitizations? And how perhaps that might fit into near-term liability strategy over the next 12 to 24 months?

Sure. I think, John, you may have a really important point, which is one of the attributes of our business is that we have to manage both the left-hand side and the right-hand side of our balance sheet at the same time. One of the things we've been historically very focused on at Golub Capital is making sure that we have low cost, highly flexible state financing against our middle-market loans. So one of the ways in which we've historically done that is through the securitization market. And we have an existing securitization that's priced at LIBOR plus 2.4%. That pricing was very attractive at the time that we entered into the transaction. Now I think if you were to look at that pricing in recently completed transaction, you'd see that there have been some recently completed transactions that are at levels that are [Audio Gap] [Technical Difficulty]

[Operator Instructions] Please go ahead, Mr. Golub.

Kim, do you know when I was cut off?

Unfortunately, I do not. I do know you were answering Mr. Bock's question.

David, you had just started by saying that you had utilized the securitization market and it cut off right after you were about to give us what the new spreads were on securitization, liabilities. And so it's like L plus 2.42% (sic) [2.4%] and now it's perhaps something a bit tighter?

Thank you, John. I apologize for the technical difficulties, everyone. So yes, as I was saying, I think one of the important things that's part of our job is to manage the right-hand side of the balance sheet, as well as the left and that means making sure that we're minimizing our cost of funds while at the same time using debt that's safe and flexible and long duration. One of the sources of debt we like that has those attributes is securitization debt. We put in place a securitization facility at LIBOR plus 240 in 2011. I think there is an opportunity today to look at extending our use of securitization financing at lower spreads, spreads have come in a bit, particularly over the last 3 or 4 months and I think there are opportunities for us in the sub-LIBOR 200 range to develop new sources of financing. That market is moving quickly these days and so I don't want to give a specific number other than to say there was a recent AAA-rated middle-market CLO that is priced at approximately LIBOR 170.

Great. That's an excellent color. And just as we try to get a sense of risk, kind of broadly speaking, obviously, the opportunity in senior debt on a risk-adjusted basis is strong. Could you perhaps give us some views as to how you approach subordinated or second lien debt? So this would be outside of your typical one stop or goal facilities, and maybe walk through items that you check on the risk mitigation list in light of the fact that it is a bit more competitive. And so to the extent that you're competing at higher leverage levels, perhaps being a bit more on the game is needed now more than ever?

Let me just amplify the point that you're making, John. I think if you asked us to assess the market opportunity today, we would very emphatically say that it's much more attractive in the middle-market senior secured loans and our one stop positions than it is in subordinated debt. That characteristics that has created the opportunity, the massive reduction, the number of providers on the senior side simply isn't the case on the junior debt side. There are a lot mezz funds, there are a lot of insurance company affiliates, there are a lot of a high-yield funds with crossover capabilities. And with the high-yield market at 6%, the middle-market mezz opportunity in the low double digits looks very attractive on a relative basis even if on a risk-adjusted basis, it doesn't look so attractive to us. So we have deemphasized mezz, we have deemphasized mezz for the last couple of years but we are continuing to do so. We think the environment for mezz is more negative today than it was a year ago. And that doesn't mean that we won't ever do a second lien or a subordinated debt investment. We will, but we're being very selective in doing so and focusing on companies that are particularly resilient, companies with particularly robust equity cushions and companies with particularly robust opportunities for us to develop second ways out or ways of managing the credit if things go wrong. So you'll see us focus on companies of particularly high quality when we're looking at mezzanine transactions today.

And then just one question on the competitive dynamic in the senior space. There are at least, as we've kind of looked around, 2 extremely large entities, both with low-cost capital, whether it -- one's part of a large industrial or another part of a large insurance company conglomerate. Could you perhaps maybe give us a sense, are bids in the senior space, while they're tighter, are they still rational and is that competitive dynamic tilting perhaps a little bit away where risk-based pricing is starting to get maybe beyond the appetite. Not that this quarter could be an aberration but maybe looking out, let's say, new deal flow is a bit modest. Are your competitors acting rationally?

I don't see irrational acting. I think we have a great deal of respect for GE Capital and Madison Capital, for our 2 primary competitors in the middle-market senior space. And I don't see signs of irrationality at all.

Our next question is from the line of Ryan Lynch with Stifel Nicolaus.

You guys had a pretty dramatic shift from your senior secured loans to your one stop loans this quarter. Is that more of a function of kind of the market providing more attractive opportunities in the one stop loans or is that just kind of part of your continued strategy to rotate into more one stop loans?

Can I choose C? Both A and B? I think it's both factors. One of the things we like about our business models having a very broad product suite is an ability to shift our originations to where we see the best opportunities from a risk reward standpoint. I think in calendar Q4 we saw the best opportunities from a risk reward standpoint in our one stop product. In addition, it was a quarter in which sponsors saw a particular value in one stops as well. Bear in mind, if you're a sponsor and you know you've got a looming 12/31 deadline that you absolutely, positively need to meet in order to achieve your tax objectives, certainty and reliability become particularly important to you. And one of the great advantages of our one stop product versus more complicated multilayer capital structure is that we're able to provide that high degree of reliability.

Right now, you guys have about 47% in the one stop. Is that kind of your ideal, about half of your portfolio in one stop -- is that where you guys would kind of ideally like to be running your portfolio at?

I can answer that question for today. This is something we're going to reevaluate all the time. As Ross said earlier today, I think as we look at the market and market conditions today, we feel very good about this portfolio construction. We reserve the right to change our views.

Okay. And then one last question. Just kind of broadly speaking about your portfolio, are you guys seeing any EBITDA or revenue trends in the underlying businesses? Are they still performing strong? Have you guys seen any trends just kind on the macro level?

I said this last quarter. I would repeat what I said last quarter. We've seen signs in the portfolio of slowing growth. The easy comparisons have largely gone away but we're not seeing any signs of dip into recession. We're seeing isolated signs of weakness of the sort that you'd expect for where we are in the credit cycle. Overall, I'm very pleased with the performance of the portfolio. From a credit perspective, it's in very good shape.

[Operator Instructions] We have a follow-up question from the line of Jonathan Bock with Wells Fargo Securities.

One last item, more of an industry question. And it deals with back-end leverage. As tighter spreads have come in or as spreads have tightened, people have found the ability to bring on a partner back-end lever loan and maybe back into a higher yield spread. Can you perhaps talk about the appropriateness of such -- I'd imagine you've done it many times, but the appropriateness of that in the BDC structure and whether or not that's something you would be considering in an environment where spreads are conceivably tighter?

Sure. So just for the sake of everyone on the line who may not be so familiar with this form of financing, what we and a number of competitors have done from time to time, some more frequently than others, is to make a loan and put the loan on our books and then to arrange with a third party, usually a bank, to buy a first-out position in the loan. So to just give a concrete example, we would make a $30 million loan and we would then sell $20 million of that position to a bank, Comerica, just pick one there, they happen not to be in this business, where pursuant to a waterfall, the bank would have the first rights to principal repayments and to the collateral in the event of a downside scenario. So because of the improved credit position that the bank would have in this scenario, the bank would look to get paid a lower interest rate than we would be charging on the loan. The way we look at this, John, is it's a form of financing. There's really no difference between bifurcating a loan into a first out and a last out and using leverage. The only difference is whether the leverage involves a degree of cross collateralization. What we have found generally is that the cost of first-out leverage is higher than the cost of securitization lever. Put that in, again, in concrete terms. So if a typical securitization leverage all-in cost today would be LIBOR plus 200, you would typically have to pay a bank LIBOR plus 300 with some kind of LIBOR floor for a typical first-out position. So we would need to be convinced that the benefits of the bifurcated structure offset something like 150 basis points incrementing cost. And I would say in our experience, we typically haven't seen ample justification for that.

And there are no questions at this time.

Thanks, everyone, for participating. Apologies again for the technical difficulties and I look forward to reporting to you again in the next quarter.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a good day, everyone.