Golub Capital has proved its mettle through multiple cycles. It survived the financial crisis to become No. 1 in middle-market lending, in no small part because many of its competitors blew up or didn't have the reputation to raise money in a downturn. Its alumni were profiled in The Big Short for their recognition that pre-financial crisis lending was anything but prudent.
It's safe to say that the firm's culture is built on the basis of conservatism, an understanding that minimizing losses is the best way to maximize profits. And being one of the largest players in the arena, it has the informational benefit of seeing a significant portion of investable opportunities. It's a huge advantage to see more deals, even if you choose not to invest in them.
On Golub Capital BDC's (NASDAQ:GBDC) first-quarter conference call, David Golub fired three warning shots at the business of lending to private equity buyouts.
1. Credit quality is declining
Golub Capital sees that the quality of middle-market borrowers is generally in decline. Even though spreads -- the interest-rate premium over risk-free assets like U.S. Treasuries -- are rising, the risks are rising faster.
Spreads have widened modestly but the middle market remained highly competitive and most of the deals we see today are not passing our credit screens. Either the underlying business isn't adequately resilient or the financial structure is too aggressive or both. Interestingly many of these deals are getting done right now. They're just not getting done by us. Our deal rejection rate at or near an all-time high.
We're obviously closer to a peak in the credit cycle than the bottom -- 2009 was six years ago, after all. And it's in the top of market cycles that financiers who have exhausted all the quality opportunities start looking at lower-quality opportunities. No one wants to twiddle their thumbs, even if doing nothing is preferable to taking bad risks.
2. Junior debt is "downright unattractive"
[M]iddle-market junior debt, which has historically been a meaningful part of the Golub Capital BDC portfolio -- we're finding middle market junior debt in general to be downright unattractive right now. Attachment points are too high, pricing is too low and importantly structural protections including covenants are weak. This is an area where we have not seen a meaningful degree of widening -- spread widening or structure improvement since September. We think there is a situation where there are too many players chasing too few middle market junior debt deals and consequently we're sticking with our strategy of deemphasizing junior debt at this time.
Attachment points are generally the multiple of EBITDA at which loans are made. A business that produces $10 million in annual EBITDA might sell for $80 million. Senior-debt investors "attach" from zero to four times EBITDA, providing $40 million in loans. Junior-debt investors might "attach" from four to six times EBITDA, getting in line behind the senior lenders with $20 million in capital. The equity investors provide another $20 million. All told, the lenders and equity holders invest $80 million in a buyout.
The equity is the first to take losses, but junior-debt holders have very little protection after that. Because these are cash-flow loans -- leveraged lending is not about collateral -- any decline in a company's profits or valuation multiple can chew through the junior lender in a heartbeat.
Golub Capital believes that the reward for the junior slices of debt in the middle market do not outweigh the risks. Interestingly, many BDCs, which have historically played in junior debt, are turning to senior debt and so-called "unitranche" lending, in which they take the entire debt position, rather than the bottom slice.
3. The easy money is gone
2014 came with a large number of surprises, collapse of oil prices, the ruble, the return of the European debt crisis, the globalization of quantitative easing, Ebola, a very big move in the U.S. dollar and strengthening. We talked about that last quarter, a marked decline in real-estate prices in China that at least has me nervous, reversal of fund inflows in high yield and probably syndicated loans. We think the pace of these surprises is unlikely to ebb, that the "everybody is a genius" part of the credit cycle is probably over, and that now is a time where it makes sense to be careful out there. That's certainly the strategy we are pursuing. [Emphasis by author]
American economist Hyman Minsky coined the term "Ponzi finance," which describes a borrower's ability to pay its debts so long as others are willing to lend the borrower more and more money -- hence the word "Ponzi."
BDCs made a killing in recent years riding the cycle up, and having their loans refinanced by other investors. But when the cycle turns, returns are no longer hinged on the generosity of other lenders. They start coming from the underlying performance of the borrower.
Golub believes the cycle is clearly in its later stages. The easy money is over, and now, credit quality will take center stage. The companies that made smart risks will be rewarded as their interest payments come in. Those that relied more on the loose underwriting of other lenders than the performance of their borrowers will inevitably see capital losses.
Whether or not we're at the very peak of a credit cycle is largely guesswork. But Golub Capital's insight into the middle market should not be ignored. Clearly, they see warning signs that indicate that we're closer to the top than the bottom.