Goldman Sachs BDC, Inc. (GSBD) Q2 2019 Earnings Report, Transcript and Summary

Good morning. My name is Dennis and I will be your conference facilitator today. I would like to welcome everyone to the Goldman Sachs BDC, Inc. Second Quarter 2019 Earnings Conference Call. [Operator Instructions] I will now turn the call over to Ms. Katherine Schneider, Head of Investor Relations at Goldman Sachs BDC. Katherine, you may begin your conference.

Thanks, Dennis. Good morning, everyone. Before we begin today's call, I would like to remind our listeners that today's remarks may include forward-looking statements. These statements represent the Company's belief regarding future events that, by their nature, are uncertain and outside of the Company's control. The Company's actual results and financial condition may differ possibly materially from what is indicated in these forward-looking statements as a result of a number of factors including those described from time to time in the Company's SEC filings. This audiocast is copyright material of Goldman Sachs BDC Inc., and may not be duplicated, reproduced or rebroadcast without our consent. Yesterday after the market closed, the Company issued an earnings press release and posted a supplemental earnings presentation, both of which can be found on the homepage of our website at www.goldmansachsbdc.com under the Investor Resources section. These documents should be reviewed in conjunction with the Company's Form 10-Q filed yesterday with the SEC. This conference call is being recorded today, August 2, for replay purposes. So with that, I'll turn the call over to Brendan McGovern, CEO of Goldman Sachs BDC.

Thank you, Katherine. Good morning everyone, and thank you for joining us for our second quarter earnings conference call. As usual, in terms of the agenda for the call, I'll start by providing an overview of our second quarter results; from there, John Deere will discuss our investment activity and portfolio metrics before handing over to Jonathan Lamb, who will discuss our financial results in greater detail. Finally, I'll conclude with some closing remarks before we open the line for Q&A. So with that, net investment income per share was $0.47 in Q2, which equates to a 10.9% annualized NII return on common equity. Our net investment income covered our dividend by 104% during the quarter. As we announced after the market close yesterday, our Board declared a $0.45 per share dividend payable to shareholders of record as of September 30, 2019. This equates to a dividend yield of 10.5% based on the net asset value per share at the end of Q2. During the quarter, gross originations were $117.3 million and were comprised of 100% in first-lien debt investments, consistent with the strategy that we began to implement more than a year ago of shifting our focus towards more senior assets. In addition, and as previewed on prior calls, we dissolved our Senior Credit Fund joint venture partnership with Cal Regents during the quarter. You'll recall that we entered into the joint venture partnership in 2014, as the JV allowed us to utilize our middle-market lending platform to originate lower risk, lower yield first-lien investments, through a structure that employed leverage above the previous regulatory debt limit. In light of the passage of the Small Business Credit Availability Act, which relax the leverage limitation, we can now own these assets directly on balance sheet without diminishing overall returns on equity. As a reminder, we reduced our base management fee to 1% of gross assets upon the adoption of reduced asset coverage ratio, and before we added the assets previously held in the SCF directly to our balance sheet. We did this in the expectation of the extension of our balance sheet and in order to pass along the benefits of scale to our shareholders. We're grateful to Cal Regents for their partnership in the joint venture and I'd like to thank them for continuing to be a client of our firm. In connection with the dissolution of the SCF, the company received its pro rata portion of the JVs assets following repayment of the SCFs debt obligations. This resulted in the company receiving $215 million of debt investments at amortized cost comprised almost inclusively of first-lien loans. When taken together, the combination of strong growth of first-lien originations and the receipt of our share of the SCF assets more than offset the significant repayments experienced during the quarter. As a result, balance sheet assets grew by $122 million at amortized cost, and the portfolio composition shifted markedly toward more senior assets. At quarter-end, first-lien assets comprised 68% of total investments versus 36% at the same time last year. We are pleased with this repositioning into higher credit quality assets and anticipate that this trend will continue. With that, let me turn it over to Jon Yoder.

All right, great, thanks, Brendan. During the second quarter, fixed income markets were generally stable and transaction volumes modestly increased compared to the first quarter. However, we witnessed a decline in rates as expectations grew throughout the quarter that the Fed would begin easing monetary conditions. We believe the Fed's recent action to cut rates is driven in part by fears and some evidence of a slowdown in global trade. However, within the U.S. middle market, fundamentals remain solid with continued quarterly year-over-year revenue and EBITDA growth. Furthermore, we believe the U.S. middle market is more insulated from the global trade tensions faced by larger multinational companies, as most middle-market sized companies are producing goods and services in the U.S. for consumption in the U.S. Against this backdrop, the market to provide capital remains competitive, whether in private debt, or frankly, other asset classes. To navigate this environment, we are focused on lending opportunities with companies in the core of the middle market. These are companies that are large enough to be scaled in institutional not quite large enough to tap into the syndicated capital markets for their borrowing needs. In our view, the lower-middle market is generally not offering enough incremental return to compensate us for the risk of lending to smaller companies. While upper middle market companies have significant negotiating leverage with private lenders, given they generally have the option of borrowing in the syndicated capital markets where covenants are rare, due diligence is limited, and spreads are tight. One example that illustrates this dynamic is our investment in Datto which was repaid in full this quarter as a result of a refinancing provided by the syndicated capital markets. Datto provides business continuity and disaster recovery software, hardware, and services to protect essential data for small and mid-sized businesses. During the fourth quarter of 2017, we let our first lien unitranche facility to finance the acquisition of Datto and its subsequent merger with Autotask, a SaaS-based business that deepened the company's product breadth and competitive positioning. The capital we provided also enabled the company to reinvest in sales and marketing which was strategically important, given the company's high growth model. At the time we made this loan, the company was smaller and preferred a private direct loan led by our platform. Our first lien term loan was priced at LIBOR plus 800 basis points with financial maintenance covenants, call protection over a 3 year period and 2 points of OID. The company grew significantly following our investments, and in April, Datto was able to refinance our loan to take advantage of more borrower-friendly terms available to them in the broadly syndicated loan markets. For example, the rate was decreased by 375 basis points, financial maintenance covenants were limited and call protection and OID were reduced meaningfully. The difference in the terms and structure between the deal we privately negotiated and the syndicated deal leads to the advantages of focusing on private transactions for companies in the core of the middle market. Turning to specific investment activity for the quarter, new investment commitments and fundings were $117.3 million and $165.5 million respectively, which included net fundings of $60.9 million of previously unfunded commitments. 100% of new investment commitments were in first lien, floating rate debt investments. These new investment commitments were across 5 new portfolio companies and 7 existing portfolio companies. Sales and repayment activity totaled $154.6 million, driven by the full repayment of investments in 6 portfolio companies. As previously discussed, the dissolution of our Senior Credit Fund joint venture partnership during the second quarter was completed. In connection with this, the Company received its pro rata portion of the SCF investments, which are now reflected directly on our balance sheet. Regarding portfolio composition, as of June 30, 2019 total investments in our portfolio were $1,533.7 million at fair value, comprised of 92.9% senior secured loans, including 67.8% in first-lien, 6.6% in first lien/last out unitranche, and 18.5% in second lien debt, as well as 0.5% in unsecured debt and 6.6% in preferred and common stock. We also had $74.7 million of unfunded commitments as of June 30 bringing total investments and commitments to $1,608.4 million. As of quarter end, the Company had 187 investments across 101 portfolio companies, operating in 37 different industries. The weighted average yield on our investment portfolio at cost, at the end of the second quarter was 8.7% as compared to 9.3% at the end of the first quarter. The weighted average yield of our total debt and income producing investments at cost was 9.8% at the end of Q2 as compared to 10.7% at the end of Q1. The quarter-over-quarter decline was primarily driven by bringing the low yielding assets on to our balance sheet from the senior credit fund. A lesser contribution was from the decline in LIBOR and some of our higher yielding investments being repaid. Turning to credit quality, the underlying performance of our portfolio companies overall was stable quarter-over-quarter. The weighted-average net debt-to-EBITDA of the companies in our investment portfolio was 5.5x at quarter end versus 5.3x at the end of the first quarter. The weighted average interest coverage of the companies in our investment portfolio at quarter end was 2.3x, which was modestly up from the prior quarter at 2.2x. I will now turn the call over to Jonathan, to walk through our financial results.

Thanks, Jon. We ended the second quarter of 2019 with total portfolio investments at fair value of $1,534 million, outstanding debt of $847 million and net assets of $693 million. Our net investment income per share was $0.47 as compared to $0.55 in the prior quarter. Earnings per share were $0.40 as compared to $0.06 in the prior quarter. During the quarter, our average debt-to-equity ratio was 1.11 versus 0.98 in the prior quarter. We ended the second quarter with a debt to equity ratio of 1.22 versus 1.02 at the end of Q1. The increase in our balance sheet this quarter was primarily driven by bringing the SCF assets on balance sheet. The SCF investments were comprised of 99% in first-lien debt. As we discussed in prior quarters, our utilization of higher balance sheet leverage will be dictated by asset composition. This is a reflection of prudent risk management practices which are a core competency of Goldman Sachs. We will seek to maintain a meaningful cushion relative to the regulatory asset coverage requirement as we have done historically. Turning to the income statement, our total investment income for the second quarter was $38.4 million, which was up from $36.5 million last quarter. The increase quarter-over-quarter was primarily driven by an increase in prepayment related income. Total expenses were $18.9 million for the second quarter, as compared to $13.8 million in the prior quarter. Expenses were up quarter-over-quarter, primarily driven by an increase in incentive fees as well as an increase in interest expenses due to higher average borrowings during the quarter. Now we're stable quarter-over-quarter, we ended Q2 with net asset value per share at $17.21 versus $17.25 in the prior quarter. In connection with the Senior Credit Fund dissolution, the company realized a loss of $0.7 million or approximately $0.02 per share, driven by a write-off of the SCFs deferred financing costs. The company had $47 million in accumulated undistributed net investment income at quarter end, resulting from net investment income that has exceeded our dividend. This equates to $1.16 per share on current shares outstanding. With that, I will turn it back to Brendan.

Thanks, Jonathan. In summary, we are pleased with the significant progress we have made repositioning the balance sheet following the passage of the Small Business Credit Availability Act, last year. Our focus on first lien originations, the restructuring of our JV and repayment activity on second liens has caused our first lien exposure, as a percentage of assets, to nearly double over the past year. As a result, we believe we are well positioned as we head towards the back half of the year and into 2020. As always, we thank you for the privilege of managing your capital and we look forward to continuing to work hard, on your behalf, over the remainder of the year. With that Dennis, we'll take some questions.

[Operator Instructions] And your first question is from the line of Finian O'Shea with Wells Fargo.

Just to start with a couple of questions on the SCF broadly, obviously there's a lot of names here, but looking at fair value, many of them are, say between $0.95 and $1. Would you attribute this more to market spreads from origination?

Yes. I'm going to have John Lamm to walk through some of the accounting based on the movement of the SCF over to the balance sheet and there is a few things to point out. I'll come back and talk about what's [ promissory ].

Yes. So Fin, just to clarify in terms of the SCF assets coming on balance sheet, the transaction to wind down the SCF closed on May 8. And in that transaction, we effectively moved or distributed all of the assets pro rata between ourselves and our joint venture partner. Our half of the asset came on to the GSBD balance sheet. It came on at amortized cost and then were immediately marked to fair value. So you do see some fluctuation or volatility between the unrealized -- across those assets that came on balance sheet relative to an unrealized reversal in the Senior Credit Fund line item.

And so Fin your question -- sorry, I don't know if there is any follow-up questions there, but your question on margin [ like ]. Yes, this is a portfolio that we've shown, through our filings, going back in time, so there was some transparency on them, the movement over to the balance sheet, economically is a bit of a loss here. So when you look at the market, it's consistent with what you've seen on our SOI for the SCF going back away, high quality performing loans, most of which are at or near amortized costs and a couple of names where we've had some unrealized losses and you see that kind of filtering through in those marks. This is a portfolio that, you know Fin, is a little bit different than what we had historically done on balance sheet, so the direct origination loans on balance sheet, because we had these assets in the SCF, which was itself a levered vehicle. So there is, I would say, significant diversity requirements in order to get the financing and as a result, really what we were doing is lightly syndicated deals and that -- not that through direct origination. So some of these loans are quoted, so it marks those are oftentimes reflection of observable market quotations and so again, the move over to the balance sheet was really something we thought was prudent in order to simplify the Company's balance sheet, we think that has benefits about how we finance the book going forward. From here, we do think there are some opportunities to continue to rotate some of these assets into the more directly originated transactions. We've already taken some actions in that regard. It will be a bit of a process. These are mostly lightly syndicated deals, but certainly, lower yielding in general. And I think over time, we'll be able to reposition some these assets consistent with the more directly originated deals that we've done historically.

And just on the stock -- sorry I was no speaker. From Jon's commentary, the unrealized -- the outstanding unrealized losses were transferred. We can do the math, it all washes out obviously. But if you breakdown about $9 million unrealized, how much of that was the SLF?

So About $4.5 million from the SCF offset by a reversal in the SCF position, so it's really flat when you think about it in total contracts.

And another question on originations; does the advisor GCM receive any fees upon origination before allocating to the BDC and other funds?

Hey Fin, great question. And by the way, I know you wrote a nice piece about this issue and we thank you for sort of frankly shining the spotlight on this issue. So the answer to your question is no, we do not -- as a manager or otherwise take origination or structuring fees or anything like that for ourselves before the asset goes to the company. All of the origination fees, structuring fees, any other type of those fees goes to our shareholders. I think the fundamental way we think about that is what we've described to our shareholders is that the investment strategy is a direct lending, direct origination strategy, and our shareholders pay us a management fee to execute that strategy. And so in light of this strategy that seems to us to be nothing more core to the strategy than originating structuring deals. So that is the purpose of the management fee is, as I say, to compensate us for pursuing that strategy and that's why, fundamentally, we think that's the right way to handle the issue.

Sure. Just to expand on the subject and we can only observe what we see. But in your -- if you were to take a view on this issue, are managers perhaps considering this as part of the deal-related expenses? Would it otherwise go to G&A? Is it just sort of a wash or are manager sort of taking the view that upfront work is distinct from a base or incentive fee, just asking your opinion on that?

Yes, Fin, this is Brendan. I don't think we want to speculate on other managers and their practices. I think that wouldn't be appropriate and I encourage you to sort that out with those managers specifically. We've always been quite open and transparent with our investors whether it's in the ProPT or other pools of capital where we definitely ran that complete transparency. There is a lot of different ways managers may negotiate those outcomes with their clients and investors. As you know Fin, in some cases managers will get a base management fee. Then they also charge back to the vehicles other administrative costs of the vehicle. That's fairly common in our industry as well. That's also not something that we do. I think Jon Yoder articulated this well. We look at our services overall to the company and we look at our base management fee as the primary source of how we do get compensated and of course -- and there is incentive income to the extent of our performance. You also know within that incentive fee calculations there are many ways that different managers may calculate that, which may skew outcomes in different areas. And so for us, what we've basically done is, put in place a structure where we're really only getting paid to the extent of that performance, we’re limiting our incentive to the extent of losses, whether they realized or unrealized. So I'm much more comfortable speaking about the Goldman Sachs BDC and our practices versus speculating on the thoughts and the strategies and negotiations other managers might have.

Your next question is from the line of [ Madison Jaden ] with Raymond James.

I'm on the line here for Robert. So first question we had was, as it relates to some of the portfolio companies, can you provide any more color regarding EBITDA growth. So I saw from the investor presentation, it seems to be a pretty good uptick in median EBITDA, but for the portfolio companies you're familiar with, are you seeing any softening of EBITDA growth over the last quarter or even the last year?

Yes. No, good question. Overall, we will continue to witness. Jon Yoder in the prepared remarks talked a lot about the strategy, our focus on the core of the middle market and in particular US-based companies that are consuming and producing business services that are consumed here in the US. So we continue to see that economic backdrop as being a pretty solid one for the companies to whom we're lending and that's manifesting itself in stable growth at those companies across the entirety of the portfolio. Of course, there is always going to be a few outliers that are bucking trend, sometimes comps are growing significantly greater than the average and other companies not performing. But on balance, Matt, we continue to see a good backdrop that's giving rise to growth overall in the companies. You referenced some of the data, just about the medium size of the EBITDA in the company, there may be some math around the transfer of the SCFs assets, and the companies is in that portfolio tend to be a little bit bigger than the companies that we have on balance sheet, still a middle market core of companies. But on balance, a little bit bigger and so I think when you look at that number in isolation and a little bit challenging for you to get any sort of trend lines out of that.

Yes, definitely, that's helpful. And then kind of last question we had I guess somewhat related to the first as well. Are you seeing any divergence between the BDC Goldman portfolio and the private credit group as a whole if you're willing? I mean anything specific to the BDC industry we should be looking at?

No, as you know and as Robert knows as well, in our complex, we do have the public BDC. Obviously, we're speaking directly to the shareholders of that vehicle here today. We manage other pools of capital that are also focused on direct lending, but what we do, Matt, is we tend to cross allocate those investments among those different vehicles and that's pursuant to a rather prescribed allocation process that's really negotiated with the SEC on this exemptive relief order, and as a result, there is very significant overlap of the portfolio companies here and in those other vehicle. So there is not different strategies around lean type or type of company in those other vehicles. We like the simplicity of having pools of capital that are directly pursuing the same strategies.

[Operator Instructions] And we have a question from the line of Michael Ramirez with SunTrust.

I'll guess we have another question on this morning. First, I guess we understand you have not provided a targeted leverage range, so maybe you could just please layout some sort of parameters condition that you will consider operating above or below the current level? And then secondly, could you please help us better understand the role of Goldman Sachs Wealth Management channel plays with sourcing new investments?

Yes, sure. So thanks very much for both the questions. I mean on the first one, I have a few thoughts and perhaps Brendan and Jonathan might have some too. But in terms of the leverage ratio, what we've said before and continues to be the case is, when we think about leverage, it's a function of the nature of the assets, that we have in the portfolio. And so right now, as we talked about in our prepared remarks and we've talked about in the past, we're seeing -- we're really have been focused on repositioning or positioning the portfolio into more senior assets -- first lien assets. I think Brendan gave some statistics around how we basically doubled the percentage of the portfolio in first Lien year-over-year. And that's just a, I think a function of our view as to where we might be in the credit cycle and thus the better risk adjusted returns where those might be. In another time, if this was 2009 or 2010, we probably would be saying, look, it's a better time to be the better risk-adjusted returns might be in second liens or even subordinated debt, and so with those types of assets, we will be very likely have a very well, we would definitely have a very different leverage profile with that asset composition. So that's why we're not specific about a leverage target because frankly again our -- the amount of leverage we use as a function of the composition of the assets that we have. Regarding your second question on Wealth Management, so it's a really unique and interesting channel for us. For those who haven't heard about this before. I mean just -- I'm just going to summarize it by saying, Goldman has an ultra-high net worth, private wealth management business of 500 wealth advisors scattered across a dozen offices in the United States and the typical clients that they are working with or the prospects that they're prospecting, tend to be the types of people that are own -- have significant net worth and own businesses and invest significantly in private businesses. So they're talking to the middle-market owners and investors on a kind of virtual constant basis. And so it's a great place for us to find deal flow. Now I would say that we're also in an environment right now where private equity activity is highly elevated compared to historical norms, not to say that it's necessarily going to reverse, but certainly, we've been in a time period where private capital markets continue to expand quite quickly whereas private -- public capital markets are really not expanding, or in some places, even shrinking. So in that context, when you've got a lot of private equity money, a lot of people who are looking to put money to work in a private market, it's probably more competitive than it's been historically for investing into those types of businesses. And especially, the competition from private equity firms is different. I think the simple example I would give you is, if you're a business owner and you've got a $20 million EBITDA business and you're thinking through what you want to do next, you want to take out a loan, so that you can invest in your business and try to grow it to $25 million or whatever over a couple of years or do you want to sell it and recognize value now. Well, it's a function of what kind of multiple you can get to sell it. And so given equity valuations are relatively high, including in private capital markets, more business owners are choosing to sell to private equity is our observation rather than take out loans to continue grow the businesses and pray for a higher valuation later. And so that's impacted a little bit the overall deal volumes that we're seeing from that sort of non-sponsored family-found or ancestral-owned business channel that we have. But with all that being said, it's still a very important channel to us. We do see a lot of unique deal flow in that space. We've had some really interesting equity co-invest that we've been able to do alongside our loans in that channel that you've oftentimes can't access when you're working with the sponsor. So it's been a really nice channel for us and we continue to spend a lot of time in it. We continue to see hundreds of deals from that channel on an annual basis.

That's great color, I appreciate it. One more follow-up if I may I guess more of a housekeeping thing. I apologize if I missed it on the prepared remarks, but did you guys provide the spillover income for this quarter? I believe last quarter it was about $1.14.

It's $1.16.

[Operator Instructions] You have a question from the line of Arren Cyganovich with Citi.

You mentioned the high level of the overall purchased price is still elevated relative to different parts of the cycle and I think the senior loan debt leverage level that we're seeing also are somewhat higher. I think it was increased modestly in this quarter. What your comfort level of doing senior loans when you're kind of in the mid-5s whereas in the prior cycle you probably see those around 4 or less.

Yes, Arren, thanks for the call. I think that's a topic that a lot of folks are talking about in general. I think unfortunately it's hard to dispel the entirety of the market down to a single number. We would agree that as a general matter, leverage is moving up and I hope they will not persist. I think Jon talked about this, we're seeing purchase price move up at a rate significantly in excess of where our leverage is, which is giving rise to a greater cushion of equity junior capital beneath us and the capital check, which is definitely important consideration. And when you look at the sort of the absolute levels of the numbers in general, the way we come out of this is, is going to be on a company-by-company basis. So there will be many situations where we'll look at a potential financing for a 3x levered business, and gained that to be more risky than something that might be a 5.5x, 6x or even slightly beyond that. The factors that might influence that would be, what's the cyclicality of the business? What's the flexibility in a company's capital structure? What's the concentration of their revenues, of their suppliers, of their key man? Are they growing or are they not growing? Is there a cash flow profile of the business that might rapidly deleverage the business? So I certainly get and appreciate the question. I think it's a tough one to get pinned down to in terms of what's the number where you tap out. It's much more about looking at every company, looking at downside scenarios to the extent that company does not perform as you expect and you hope what's going to happen to that capital structure relative to your attachment point as a lender that's where we tend to focus. And I think we've seen a bit of a leveling out of the absolute quantum of leverage relative to the cash flow of the companies. Frankly, another devil in the details is how are you defining EBITDA? What's the denominator of that calculation? And taking a disciplined approach to the types of EBITDA that you will finance and EBITDA adjustments, for example, that you might be, not appropriate to finance. Typically, the way that works out for us, is in a competitive transaction, we'll look at a company on above the basis, we look on what we think is the appropriate capital structure relative to that risk profile, and frankly we oftentimes lose. There are others who might be willing to offer a higher quantum of debt, but that's fine, there's plenty of opportunity for us at putting in diverse channels the likes of which Jon described at length here. So I know it doesn't directly answer your question, but hope that gives you a little bit of insight into our thought process.

One thing that I would just add to that and that's very well said, but one thing that I would add as well is for sure there is -- as you point out, there has been a lot of focus in on the part of investors as to what are the leverage levels of the loans that are being made. And I agree with Brendan, first of all, while certainly the overall trend of history since the financial crisis has been leverage levels have crept up, I [indiscernible] significant moves on the whole, really over the last I don't know couple of years that's kind of reached a point where it's more or less leveled off, and I think one of the things to point out there is, investors who are investing into private credit are doing it because it's a current income strategy and there is a limit to how -- I mean companies only produced so much cash flow and that dictates kind of like the most debt they can put on because obviously then you need cash flow to be able to service your debt and so, if a company only have so much cash flow, it can't take on unlimited amounts of debt. And so -- and I contrast that with equity markets, which -- clearly there is no natural upper bound as to what someone can pay for a company. It's all of course in the IV holder, and so, that's what's causing this divergence, as Brendan pointed out that -- whereas equity, they can always pay another turn or another 2 turns or another 3 turns for a business; debt you can't not if you're trying to produce current income for your investors. So we've seen this dynamic where even though leverage levels have crept up, loan to values have actually been coming down, given that sort of natural cap on the amount of leverage you can put our business.

At this time there are no further questions, please continue with any closing remarks.

Well, thank you, Dennis. And of course, thank you for all of you for dialing in on an August Friday. If you do have any follow-up questions, please do not hesitate to reach out to our team and enjoy your weekend. Thank you.

Ladies and gentlemen, this does conclude the Goldman Sachs BDC Inc., Second Quarter 2019 Earnings Conference Call. Thank you for your participation. You may now disconnect.