Goldman Sachs BDC, Inc.
Q1 2016 Earnings Call Transcript

Published: 11 May 2016

[Operator:]

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. First Quarter 2016 Earnings Conference Call. [Operator Instructions]. 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 beliefs 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 included in the forward-looking statements as a result of a number of factors including those described from time to time in the Company's SEC filings. 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 home page 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, May 10, 2016, for replay purposes. I will now turn the call over to Brendan McGovern, the Chief Executive Officer of Goldman Sachs BDC, Inc.

[Brendan McGovern:]

Thank you, Dennis. Good morning, everyone and thank you for joining us for our Q1 earnings conference call. I will start by providing an overview of the first quarter. Then I will turn the call over to Jon Yoder to discuss our investment activities. Jonathan Lamm, our CFO, will take you through a detailed discussion of our financial results and finally, I will conclude with some closing remarks before we take questions. So with that, Q1 net investment income was $0.58 per share as compared to $0.52 per share for Q1 of 2015 and $0.62 per share for Q4 of 2015. The year-over-year improvement in NII per share reflected higher earning assets, coupled with a reduction of incentive fees owing to unrealized portfolio markdowns. As compared to Q4 of 2015, NII per share was modestly lower due to higher incentive fee and lower other income. As we announced after close yesterday, our Board declared a $0.45 per share dividend payable to shareholders of record as of June 30. This quarter net investment income exceeded the dividend by almost 30%, continuing the trend of extremely strong dividend coverage that our business model and expense structure is designed to produce. In fact, since our IPO more than a year ago, net investment income has exceeded dividends by a total of 18%. Moving on to investment activity, thematically the first quarter was notable for its relatively muted transaction volumes. However, we continue to benefit from a stable balance sheet and we produced modest net portfolio growth while remaining well within our target leverage ratio. Moreover, we do not recognize all origination fee revenue up front, but rather be amortize this fee income over the life of the loan. As a result, we're not dependent on new originations each quarter to produce one-time fee income to cover our dividend. In a quarter like this, when some competitors struggle to repeat higher NII levels given lower industry-wide transaction volumes, the quality of our income becomes apparent. Also, as a reminder, during Q1 our Board of Directors approved a 10b5-1 plan for GS BDC to purchase up to $25 million of its common stock if the stock price is below our most recently announced NAV, subject to limitations. This plan commenced in March and we believe the new plan provides shareholders with the benefit of NAV accretion in the event the Company is able to buy back shares below NAV. Since the plan took effect March, the Company did not purchase any shares under the plan as our stock traded above NAV. Finally, moving on to credit quality. First, we're pleased to report that two investments we discussed last quarter, GTL and Securus, showed positive trends and a reversal of a portion of the unrealized mark-to-market declines in prior quarters. These investments benefited from a favorable court ruling that stayed a new regulation which had the potential to put downward pressure on both companies' revenue. As a result of the court ruling, both companies have continued produce strong financial results and cash flow and deleveraging trends. Thus far in Q2 we have continued to see positive mark-to-market gains and trading levels for these two investments. Offsetting this positive event, however, was the markdown of our investment in Hunter Defense which was placed on nonaccrual status during the quarter. I would like to pause here for a moment, so we can give you as much transparency on this investment as possible. Hunter makes shelters and other ancillary products that are used by the U.S. military in mobile troop deployments. We owned $20 million in face amount of a second-lien loan which were marked at 45% of par at quarter end. Our initial investment thesis centered on a few key themes. First, Hunter is far and away the market share leader for its products and for a large portion of its revenue, it is the only provider of products to its customers. Its business has very high barriers to entry which is a function of demanding regulatory and customer requirements. Demand for its products has historically been correlated with troop deployment which has been stable at what we believe have been trough levels for the last two years. And, finally, the company had a sensible capitalization with approximately 40% sponsor equity cushion beneath our loan and overall debt levels that were a relatively low multiple of cash flow in comparison with industry averages. As we fast-forward to our initial investment, the core attributes of our underwriting thesis remain intact. Hunter has maintained its strong market share position and key demand drivers of its business remain stable. Clearly, however, a nonaccrual is not the outcome we anticipated when we underwrote this investment. Looking back, we underestimated the degree and speed with which the Company's revenue could decline, even in the absence of -- changes to what we believe to be some of the key demand drivers of the business. While we don't believe the company's long term prospects have been permanently impaired, short term uncertainty persists. Over the course of the first quarter, the company experienced a disruption in revenue which we believe developed due to new military procurement systems order processing issues, as well as from changes in military spending prioritization. This abrupt change in the company's financial condition caused liquidity to tighten, resulting in the nonpayment of our interest at quarter end. Looking forward, we're hopeful that we can reach a consensual resolution among all the company's stakeholders, including the financial sponsor, who has capital beneath our second-lien loan. While the situation is fluid, at present we anticipate a consensual recapitalization and we're considering an incremental investment into the company. If successful, we believe this recapitalization may provide a pathway to recouping our investment as Hunter's business normalizes. Importantly, I want to note that Hunter is the only investment in the portfolio on nonaccrual status and represents just 1.2% of the portfolio at fair value and 2.3% at amortized cost. With that, let me turn it over to Jon Yoder.

[Jon Yoder:]

Thanks, Brendan. As Brendan mentioned, the first quarter will be remembered for its muted industry-wide transaction volumes. However, we were very pleased to have navigated through this environment in order to produce net growth in the portfolio, as well as significant growth in our senior credit funds. During the first quarter we made new investment commitments of $47 million, including an additional $8 million investment in the senior credit funds. We received repayments of $30 million, the majority of which was driven by the full realization of our second-lien investment in iFly. This investment is another example of our ability to source proprietary transactions from family and founder-owned businesses, utilizing our firm's large network of relationships in this community. In this case, we were able to provide a company controlled by its founder with capital in order to significantly expand its operations and increase its value prior to a transaction with a private equity firm. As a result of the early prepayment, we were able to generate a gross IRR of 14% over a two-year investment period. As of March 31, our investment portfolio at fair value was comprised of 93% senior secured loans, including 38% in first lien, 28% in first lien, last-out unittranche, 27% in second lien, 2% in preferred stock and 5% in the senior credit fund. We also had $2.5 million of unfunded commitments, bringing total investments and commitments to $1.089 billion. The portfolio remains well diversified across investments in 39 portfolio companies operating across 27 different industries with no significant industry concentrations. As you know, we have very little exposure to the oil and gas industry at just 2.5% of total investment portfolio at fair value. Turning to the senior credit fund, we originated $56 million of investments in four new companies and six existing portfolio companies, bringing the total size of the investment portfolio to about $341 million. These new investments were comprised of 86% in first lien and 14% in second-lien senior secured loans, all of which were floating-rate loans containing interest-rate floors. The senior credit fund also had sales and repayments of about $1 million, resulting in net portfolio growth of $55 million during the quarter. This represented an increase of 19.2% quarter over quarter. Our investment in the senior credit fund now represents approximately 8% of the Company's net asset value and has generated a yield of 13.2% and 13.3% at amortized cost and fair value, respectively, over the last four quarters. We're excited about its performance and look forward to continuing to grow the fund in the quarters to come. The senior credit fund portfolio also remains well diversified across investments in 26 portfolio companies, operating across 19 different industries, again with no significant industry concentration. After we classified Hunter Defense as a non-yield-bearing investment the gross yield at cost and fair value of our total investment portfolio as of March 31, 2016, was 10.6% and 11.8%, respectively, as compared to 10.9% and 11.7% as of December 31. Looking forward, our transaction activity and pipeline has picked up in the second quarter and we look forward to discussing our activity in further detail on our next earnings call. I will now turn the call over to Jonathan to walk through our financial results.

[Jonathan Lamm:]

Thanks, Jon. We ended the first quarter of 2016 with total portfolio investments at fair value of $1.087 billion, outstanding debt of $428 million and net assets of $678 million. Our net investment income was $0.58 per share as compared to $0.62 per share in the quarter ended December 31. As Brendan mentioned earlier, our Board of Directors declared a second quarter dividend of $0.45 per share payable to shareholders of record as of June 30. The first quarter of 2016 was the third quarter in a row where we significantly out-earned our dividend on a net investment income basis. This is a testament to the strong earnings power of our portfolio, as well as to our incentive fee structure. During the quarter, our average debt-to-equity ratio was 0.62 times as compared to 0.63 times during the previous quarter. We ended the first quarter with a debt-to-equity ratio of 0.63 times as compared to 0.61 times at December 31. The increase in ending leverage was primarily attributed to our net portfolio growth in the quarter. Turning to the income statement, our total investment income for the first quarter was $31.3 million, down 2% from $31.9 million last quarter, primarily driven by a decline in other income. In addition, interest income declined marginally, primarily due to lower average income-earning assets in our investment portfolio, partially offset by higher prepayment-related income. We believe that our dividend continues to be well-supported by the income-earning assets in our portfolio, even while we remain in the middle of our target debt-to-equity ratio. Total expenses before taxes were $9.9 million for the first quarter as compared to $9.2 million last quarter. Expenses were up quarter over quarter, primarily driven by higher incentive fees in the quarter. The higher incentive fees are attributed to higher pre-incentive fee earnings in the quarter as net unrealized depreciation was lower than in the prior quarter. As a reminder, our incentive fee calculation takes into account net realized and unrealized losses and, therefore, can display some volatility from one quarter to the next. We believe this feature provides the proper alignment of incentives as the fee is based on total returns. We ended the quarter with net asset value per share at $18.67, down 1.6% versus last quarter, driven by unrealized depreciation and partially offset by over earnings of the dividend from net investment income. Our supplemental earnings presentation provides a NAV bridge to walk you through these changes. As Brandon mentioned earlier, during the quarter we put in place a 10b5-1 program to repurchase up to 25 million of our shares on a programmatic basis when the market price is below our most recently announced net asset value per share. There were no share repurchases triggered under this program in the first quarter. We believe this type of program reflects the confidence we have in the value of our investment portfolio. As of March 31, we had $142 million of available borrowings under our senior secured revolving credit facility, providing ample liquidity to grow the portfolio to the high end of our target debt-to-equity ratio. As mentioned during last quarter's earnings call, we made favorable changes to the senior credit fund's debt facility by increasing the total size to $350 million which dovetails nicely with the continued growth of the senior credit fund portfolio. Finally, we're pleased to report that Standard & Poor's reaffirmed our BBB- investment-grade rating during the quarter with a stable outlook. With that I will turn it back to Brendan.

[Brendan McGovern:]

Thanks, Jonathan. Overall, we believe this quarter provided further evidence of the Company's ability to generate very solid net investment income to support a stable dividend. At the core of our value proposition to investors is our commitment to deliver a high quality, sustainable Street income to investors. We do that by sourcing proprietary loans with attractive risk/reward characteristics, while employing an expense structure that incentivizes prudent risk management. While we're disappointed to have placed one investment on nonaccrual status this quarter, we're pleased with the overall health of the portfolio. The underlying credit metrics at our portfolio of companies remains strong and stable and just 1.2% of our assets at fair value are on nonaccrual. Furthermore, we continue to effectively utilize your equity capital. Our investment portfolio to date has produced income well in excess of our dividend, yet at just 0.63 times leverage we have additional capital to opportunistically deploy into additional high-quality assets that produced income to support distributions to our shareholders. So with that and on behalf of the team, we thank you for your time and your continued support. And now, operator, please open up the line for questions.

[Operator:]

[Operator Instructions]. And your first question is from the line of Doug Mewhirter with SunTrust. Please go ahead.

[Unidentified Analyst:]

This is actually [indiscernible] on for Doug. My first question is do you anticipate any challenges in managing the recapitalization of Hunter Defense because of your second-lien position?

[Brendan McGovern:]

Look, actually as we alluded to the situation right now is live; it is fluid. As I mentioned in our remarks, sitting here today we're optimistic that we will get to a consensual outcome with all the stakeholders within that capitalization. That includes the first-lien lenders, other lenders in the second-lien tranche, as well as the equity capital holders beneath us. So sitting here today one of the things I would highlight with this particular investment and again I alluded to it at the outset, was the sensible capital structure that was put in place when we underwrote the loan. In particular, when you look at the percentage of second-lien debt relative to first-lien debt it's actually basically an even dollar basis, such that we were not a very small slice of the capital structure. And as the business experienced volatility, that serves to dampen what would otherwise be a very difficult outcome for that second-lien tranche. So sitting here today we're optimistic. There's ongoing and constructive dialogue between all the stakeholders and that, as I alluded to, includes first-lien lenders as well as the capital that is beneath us in this capital stack.

[Unidentified Analyst:]

And then we noticed that a lot of your new investments and exits were in second-lien loans. Are you seeing more opportunities in the second-lien market or are you redirecting more of the first-lien opportunities to the senior credit funds?

[Jon Yoder:]

I wouldn't necessarily say that we're directing first-lien loans to the senior credit funds. Certainly with every new investment that comes in we try to optimize the best return that we can get for our BDC shareholders and figure out whether the better risk-adjusted return is going to be through the senior credit fund or on balance sheet. This quarter you accurately point out that our major repayment was a second-lien loan. Our major origination was a second-lien loan as well, so there isn't really any overall change in the portfolio composition. We do think that there are potentially places where there are attractive second-lien investments being made, but there are also attractive places where there are first-lien investments to be made. So we're really taking each investment that comes in on an investment-by-investment basis and not being dogmatic about saying we're only going to do first liens or we're only going to do second liens. Our belief is, again, evaluate each situation individually and evaluate where is the best attachment point from a risk-adjusted return basis in the company's capital stack.

[Operator:]

Your next question is from the line of Derek Hewitt with Bank of America Merrill Lynch. Please go ahead.

[Derek Hewett:]

Given the isolated Hunter Defense second-lien nonaccrual, could you guys talk about the underlying fundamentals of the second-lien portfolio, specifically maybe EBITDA growth, leverage, cash flow coverage or maybe any sort of qualitative comments or observations that you are currently seeing?

[Brendan McGovern:]

We gave some data about the overall portfolio construction in Jon's remarks. The second-lien portion of the portfolio continues to be one of the smaller buckets within the total capital stack and, as Jon very accurately described, what we're looking to do overall with our investors' capital is find the best risk-adjusted return that we're seeing in the space. So as we look at Hunter specifically, I wouldn't necessarily tie that to being symptomatic of a second-lien characteristic. I think the issues, as we discussed in some detail, are very specific to the nature of that investment. And furthermore, that was a second lien that was structured in a manner which is very different than what a typical, for example, syndicated second-lien loan might look like which is very deep in the capital structure and a very small slice of the capitalization. So I caution you to not draw broad sort of conclusions about just what we're calling along the first lien, the second lien, etc. We're looking overall to optimize the overall attributes of the portfolio. In terms of the broader question regarding the overall health of the portfolio, the overall health of the book and again as I alluded to in my remarks, we do feel good about the overall credit quality within the portfolio. The things that we look to evidence that is looking at the portfolio's operating metrics we continue to see some growth in revenue, growth in EBITDA across the portfolio on a holistic basis. When you look at the weighted average attachment points of our portfolio, they are still quite modest relative to what we see both amongst our private debt peers as well as, of course, the syndicated markets. So overall, as I alluded to, we do feel good about the overall credit quality of the portfolio. We're certainly not pleased to see Hunter go on nonaccrual, but rest assured we're spending a lot of time, effort and energy getting that particular investment back on a good, positive footing as we described.

[Jon Yoder:]

Doug, just one thing to emphasize in Brendan's remarks there, in terms of the last dollar attachment point that we have in our second-lien book versus our first-lien book, it's not very dramatically different. And so when we go to underwrite companies, we're incredibly thoughtful and cautious about exactly where our last dollar attachment point is and that's regardless of whether again we're doing a first-lien or a second-lien type of investment. So you are not going to see -- I think a lot of people, when they think of second-liens they think of a deeply subordinated piece of paper where the last dollar is very deep in the capital structure. And that's not the type of second-lien book that we've put together.

[Operator:]

[Operator Instructions]. Your next question is from the line of Jonathan Bock with Wells Fargo Securities. Please go ahead.

[Finn O'Shea:]

Finn O'Shea in for Jonathan Bock this morning. Just a start with a couple of market-related questions. On the light transaction volume that we're hearing a bit about as sort of a volatility-driven stalemate, can you give any color in what you are seeing from the non-sponsored channels where you have your hands in there? And then, just in terms of seeing your focus on the senior credit fund type credits, is that more of a function of lower transaction volume in the lower middle market or is this just general caution from your behalf? Sorry for the two-part question there.

[Jon Yoder:]

Finn, addressing the first part of the question, what are we seeing from our non-sponsored channels, I would absolutely say that in the first quarter a lot of the low transaction volume commentary is most applicable to the sponsor-backed transactions, where clearly there was a lot less activity that there has been, frankly, in quite some time. In the non-sponsored side, we didn't see as much of a hit or slowdown in terms of our deal flow or pipeline of opportunities and I think the big reason for the differential is most of the opportunities that we see in the non-sponsored side are not change-of-control opportunities. They are growth capital. They are change of capital to take out some holders of equity that may have a minority stake in the Company or things of that nature. And so that activity stays pretty consistent regardless of transaction volumes in the private equity space. And we do feel good about the pipeline of opportunities that we have there as well. And then on the senior credit fund, Brendan, I don't know if you want to add anything.

[Brendan McGovern:]

Look, I think overall, maybe just to step back even a bit further, Finn, when you look at this quarter and when you look at the trends in the recent quarters, we have been operating I would say in the middle to maybe towards the lower end of our target leverage ratio. And just to remind everybody, our target leverage ratio is a half-a-turn, so $0.50 of debt per $1 of equity up to three quarters of a turn or $0.75 of debt per $1 of equity. And so within that range and frankly, I think what we have demonstrated even at the lower end of that range, our model is such that we're able to pretty helpfully over-earn the dividend. And so from an overall perspective we feel like we can be quite patient, we can be quite prudent and ultimately, optimize each available dollar that is there for us. We certainly, as Jon alluded to, do see the overall pipeline picking up, including in that non-sponsored space, where historically we would say we definitely think there is a very favorable risk/reward attribute to that market. And the SCF is a vehicle that if you look at the pace of organizations there, it has pretty steady, pretty measured, pretty consistent. We're really -- that is not a beta play of the broadly syndicated market. What we're doing there is really picking out, in many cases, again direct originations. When you look at our SCF growth this quarter, half of that was truly direct originations for that vehicle. They tend to be somewhat bigger companies with -- and we tend to focus more on first-lien obligations. And by virtue of that structure, we're able to produce an investment in the BDC's balance sheet into that SCF where the underlying assets are low-vol, first-lien loans. But with some central leverage we can produce low teens types of return on that equity investment, so something we do think is very, very outstanding risk/reward. Our hope is we will continue to successfully find opportunities to grow that as well. None of those opportunities are mutually exclusive, so we look at each investment as it comes through the pipeline on a discrete basis as we deploy capital.

[Finn O'Shea:]

Looking at the investment this quarter, DiscoverOrg, can you describe the allocation procedure between the core GS BD and the senior credit fund? Is that formulaic or is this just sort of a tailored allocation?

[Jon Yoder:]

One of the benefits that we feel like we put in place with the senior credit fund is that it does provide a really unique sourcing benefit. So in the case of DiscoverOrg, that was an investment that we held a first-lien loan in our joint venture which was we think the right investment decision to put it there initially because of the risk/return characteristics and the better equity return we could get by putting it there. But then the sponsor decided that they wanted to take on some additional capital, some junior capital, in this case second-lien capital. And our thought process was again to effectively create what I will call a max position size in the senior credit fund which is about $18 million given the diversification that we're trying to create in that vehicle. And then the remainder went into the BDC. So we think that produces again the best risk-adjusted return and the best return on equity for BDC investors. By putting that $8 million of second-lien it takes it effectively up to an aggregate single position of $18 million which is more or less the top of what we like to do there from a single-lien basis.

[Finn O'Shea:]

And just to sort of clarify there; was the second lien, was that additional leverage for the Company?

[Jon Yoder:]

Additional leverage? Yes. I mean, there was no second lien previously.

[Operator:]

Your next question is from the line of Robert Dodd with Raymond James. Please go ahead.

[Robert Dodd:]

Going back to attachment point, if I can for a minute and I realize these are very modest changes, but it's been trending since the IPO at least, it's been moving up. Obviously the market attachment point has moved up, etcetera. How much of the moves, if any, in attachment point interest coverage, etc., this quarter were related to Hunter, where I presume there's been EBITDA deterioration along with the revenue and cash flow?

[Jon Yoder:]

Look, Robert, as an overall indicator it is marginally up this quarter. I think we went from 4.3 times to 4.5 times which again, as I alluded to, relative to the 11% asset yields, we think that's a very good balance of risk and reward. Risk being defined by leverage. So it is modestly up, but we still think best in class and certainly well below our peers. At least the ones who actually publish their data. So as you do think, though, about the cause of the move, it is on one hand Hunter which as we described in some detail certainly did have financial difficulties this quarter. Leverage did go up, that calculation is in the numbers. We also had a repayment, as we described, of iFly which is a company that has trended down in leverage rather significantly since we underwrote that loan. So with that investment coming out of the portfolio and with Hunter having its issues, the overall outcome is a modest tick-up in last to all attachment points.

[Robert Dodd:]

Just to get to Hunter for a second, if I can; and I realize it's probably limited in what you can say. You mentioned you may be willing to put in additional capital to support the restructuring, etc. How would you frame that in the context of obviously there is a sponsor behind you, there is equity behind you, but would you be willing to put in extra capital if that sponsor wasn't putting extra capital in, for example? How would you talk about that dynamic?

[Jon Yoder:]

For sure, we look at every situation like this on a facts and circumstances basis and every new investment decision that is made is a consequence of our teams' view of how that new money investment is going to perform. So while it's certainly, I think, a helpful fact if you have others in the capital structure who are willing and able to come along, especially if it's folks who have been junior in the capital structure, that's certainly a good fact pattern. Our investment decision is going to be solely a function of what our investment committee and our team thinks would be an appropriate use of our capital base. And so, in this case, as I alluded to, we're contemplating an additional investment. We will make sure that we size that investment appropriate for the overall capitalization of the Company, all with the hope of again using the benefit -- we've got permanent capital here. We do have the ability to take a longer term approach and rather than simply crystallize a loss here, our goal is to ascertain whether new capital can be part of a solution to recoup our initial investment. And that's our hope and expectation here.

[Robert Dodd:]

One more if I can, real quick. I think you did mention a pickup in the pipeline into Q2, particularly non-sponsored. If I heard that correctly then please correct me. If that's the case, how much of that, if any, is related to the development of the wealth management channel which is potentially a source for non-sponsored deals and those seeking growth capital, etc., etc., versus the more broader market and sponsored deals being more competitive?

[Jon Yoder:]

The vast majority of our non-sponsored deal flow and pipeline comes through our proprietary channels, being our wealth management channel and others throughout Goldman Sachs. So that's definitely the vast bulk of it.

[Operator:]

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

[Brendan McGovern:]

Thanks, everybody, for your time and for your questions. If you do have additional questions, please don't hesitate to reach out to directly to the team. Again, thank you very much and have a great day.

[Operator:]

Ladies and gentlemen, this does conclude the Goldman Sachs BDC, Inc. first quarter 2016 earnings conference call. Thank you for your participation, you may now disconnect.