2023-06-13 06:22:15 ET
Summary
- Goldman Sachs BDC has low management fees, conservative assets, and a diversified portfolio, making it an attractive long-term income investment vehicle in those respects.
- However, GSBD's poor underwriting history and gradual erosion of earning power make it overvalued in the market.
- Investors should consider staying away from GSBD shares until they trade at a substantial discount to NAV, around 30-40%.
Introduction
Goldman Sachs is a name commonly associated with the ultra-wealthy and their private banking services. However, it is less known that Goldman Sachs Asset Management is an advisor to a BDC, called Goldman Sachs BDC ( GSBD )? This article is about Goldman Sachs BDC and its suitability as a long-term income investment vehicle.
First, some motivating remarks about the BDC form, and how we will evaluate GSBD.
BDCs specifically invest in loans granted to middle market businesses - these are businesses that are too large for the typical business loan from a bank, but too small to be able to access the bond markets. Typically, these loans carry an interest rate of prime plus 2 - 4%, and are often floating rate loans.
BDCs also use leverage to juice up their returns, and find a way to earn money to pay for the management fees. The leverage liabilities consist of bonds, notes, and baby bonds, and have varying interest rates as a function of the rating and asset portfolio of the issuer. BDCs are limited by law to remain at or below a debt to equity ratio of 2, but generally BDCs managements opt to remain far below 2.
BDCs by law must pay out at least 90% of their net investment income as dividends. This means that BDCs are very limited in their ability to retain earnings. This implies that their credit quality and underwriting are key figures for investors to monitor and evaluate. Generally, BDCs with poor underwriting lose NAV over time, and their shares tend to fall in value over time.
Running all this are managements, either internal or external, that need to be paid according to their respective fee schedules. A key consideration is to see whether and to what extent the fee schedule incentivizes the management to act in the interest of the shareholders.
All of these general facts about BDCs motivate these six centrally important questions, which I will answer about Goldman Sachs BDC.
- Are management & incentive fees in alignment with shareholders?
- Are balance sheet leverage levels reasonably close to a debt to equity ratio equaling 1?
- Do assets tend to be on the conservative side: emphasis on senior secured debt instruments, preferably with floating rates?
- How has GSBD's credit quality been in recent years?
- Is GSBD competitive with other BDCs in terms of its debt vis-a-vis leverage with low interest rates?
- Is there wide diversification by industry, with tilt away from cyclical sectors of the economy?
I will also compare GSBD with BDCs for which I have also written articles: Ares Capital Corporation ( ARCC ), Golub Capital ( GBDC ), and FS KKR ( FSK ), and Owl Rock Capital ( ORCC ) as applicable.
Management Fees Aligned With Shareholders
BDCs generally charge three fees: a base management fee, an income incentive fee, and a capital gains incentive fee. Only the first two are really significant, so we will examine only those two here. I will preface each part with a quotation from the most recent 2022 10-K Filing:
Base Management Fee
The Management Fee is calculated at an annual rate of 1.00% (0.25% per quarter), in each case, of the average value of our gross assets (excluding cash or cash equivalents (such as investments in money market funds) but including assets purchased with borrowed amounts) at the end of each of the two most recently completed calendar quarters.
GSBD charges a flat base management fee of 1.00% of gross assets. Notice that there is no step-down of the management fee based on the amount of leverage the BDC has taken.
Out of the BDCs for which I have written articles this year, GSBD has the absolute lowest base management fee so far:
GSBD | ARCC | GBDC | FSK | ORCC | |
Assets below debt to equity ratio of 1 | 1.00% of gross assets/year | 1.50% of gross assets/year | 1.375% of gross assets/year | 1.50% of gross assets/year | 1.00% of gross assets/year |
Assets above debt to equity ratio of 1 | 1.00% of gross assets/year | 1.00% of gross assets/year | 1.375% of gross assets/year | 1.00% of gross assets/year | 1.50% of gross assets/year |
From the shareholder's perspective, the lower the fee is, the better. GSBD stands out among these as simply the best.
Income Incentive Fee
Our Investment Adviser is entitled to receive the Incentive Fee based on income from us if our Ordinary Income (as defined below) exceeds a quarterly “hurdle rate” of 1.75% [of NAV] .
- No Incentive Fee based on income is payable to our Investment Adviser for any calendar quarter for which there is no Excess Income Amount;
- 100% of the Ordinary Income, if any, that exceeds the hurdle amount, but is less than or equal to an amount, which we refer to as the “Catch-up Amount,” determined as the sum of 2.1875% multiplied by our NAV at the beginning of each applicable calendar quarter comprising the relevant Trailing Twelve Quarters is included in the calculation of the Incentive Fee based on income; and
- 20% of the Ordinary Income that exceeds the Catch-up Amount is included in the calculation of the Incentive Fee based on income.
Translating this 10-K-ese back to annual rates, after the base management fee is paid, 100% of the amount between the first 7%/year and 8.75% of returns, and 20% of the amount above 8.75%/year of returns are paid to the investment manager.
This sets the tone for the underwriters - how much risk / return tradeoff they will take when issuing loans. Without bogging down into painful details, GSBD's income incentive fee schedule is comparable with those of ARCC, GBDC, FSK, and ORCC. The hurdle rate for GSBD is also comparable.
GSBD's base management fee stands out as among the lowest of the largest BDCs on the market.
Balance Sheet Leverage
Balance sheet leverage has a magnifying effect on underwriting losses to NAV. Higher leverage causes underwriting losses to be more meaningful to NAV per share. This means that we want BDCs to be in control of how much leverage they employ, and not try to chase leverage for the sake of immediate gain in management fees.
Below is a table of GSBD's leverage levels.
(millions) | Total Liabilities | Total Equity | Debt to Equity Ratio |
Q1 2023 | 2,025.4 | 1,580.4 | 1.282 |
2022 | 2,088.9 | 1,502.4 | 1.390 |
2021 | 1,936.6 | 1,614.4 | 1.200 |
2020 | 1,697.2 | 1,615.1 | 1.051 |
2019 | 799.2 | 676.1 | 1.182 |
2018 | 687.1 | 709.9 | 0.968 |
2017 | 572.8 | 725.8 | 0.789 |
2016 | 525.4 | 665.1 | 0.790 |
2015 | 444.1 | 688.7 | 0.645 |
In 2019, the law was changed to raise the allowable amount of leverage in a BDC from a debt to equity ratio of 1, up to 2. This meant that most BDCs across the board stepped up their leverage from 0.9-1 up to around 1.3. GSBD is no different from the rest of the pack.
GSBD has shown restraint and followed the pack in terms of leverage levels in the BDC balance sheet.
Conservative Asset Portfolio
BDCs in general can choose to invest in many types of debt and equity investments, of varying levels of riskiness. The first lien senior secured debt stands out as the most conservative type, and so income investors would be interested in seeing a high percentage of first lien senior secured debt in GSBD's balance sheet.
The chart below is an excerpt of the Q1 2023 10-Q filing that describes the composition of the GSBD assets (in thousands of dollars):
What stands out here is the 86.9% allocation to first lien senior secured debt in GSBD, an allocation that makes GSBD's assets rock solid. We can also compare this figure to those of ARCC, GBDC, FSK, and ORCC:
GSBD | ARCC | GBDC | FSK | ORCC | |
% Allocation to Senior Secured Debt | 86.9% | 42.1% | 94.6% | 60.3% | 71.3% |
Among the large BDCs on the market, GSBD has one of the most conservative asset portfolios.
GSBD Has Poor Underwriting Quality
The rate at which a BDC gains or loses NAV is largely driven by the quality of its underwriting. Long term income investors should want to see NAV be a stable value, with the long run average NAV annual change rate as close to zero as possible.
Below are presented figures from past 10-K filings from GSBD that show its underwriting.
(millions) | Net realized and unrealized gain (losses) | Total Equity | NAV Change Rate |
2022 | -173.3 | 1,502.4 | -10.34% |
2021 | -44.6 | 1,614.4 | -2.69% |
2020 | 66.2 | 1,615.1 | 4.27% |
2019 | -43.7 | 676.1 | -6.07% |
2018 | -28.4 | 709.9 | -3.85% |
2017 | -30.4 | 725.8 | -4.02% |
2016 | -35.6 | 665.1 | -5.08% |
2015 | -28.0 | 688.7 | -3.91% |
Average | -3.96% |
The average NAV Change rate of -3.96% stands out as quite terrible, as an investor who holds GSBD for a decade could see about 1/3 of the earning power of the capital in each share eroded away by underwriting losses.
By a peer comparison, GSBD stands out by far and away as among the BDCs with the worst underwriting:
GSBD | ARCC | GBDC | FSK | ORCC | |
Average Annual NAV Change Rate | -3.96% | +0.3% | +0.23% | -0.84% | -0.37% |
This fact alone of the gradual erosion of the earning power of a share of GSBD should merit GSBD a price on the market that is at a substantial discount to NAV.
However GSBD trades near par value, next to Ares Capital, with the best underwriting of the group, which does not stand to reason.
On this metric alone, I would consider GSBD to be very overvalued by the market. In the short run the market is a popularity contest, but in the long run the market is a weighing machine, and I would stay away from shares of GSBD until they trade substantially at a discount to NAV, perhaps a 30-40% discount.
Low Cost Of Leverage
It is important for BDCs to have a low cost of leverage since any cost savings are directly passed on to the shareholder through dividends. Below are figures displaying GSBD's cost of leverage, and in comparison with the AAA bond yield, a benchmark for how low corporate debt rates can go.
(millions) | Interest Expense | Total Liabilities | Cost Of Liabilities | AAA Bond Yield |
2022 | 77.1 | 2,025.4 | 3.81% | 4.07% |
2021 | 54.8 | 2,088.9 | 2.62% | 2.70% |
2020 | 38.0 | 1,936.6 | 1.96% | 2.48% |
2019 | 35.6 | 1,697.2 | 2.10% | 3.39% |
2018 | 25.2 | 799.2 | 3.15% | 3.93% |
2017 | 18.6 | 687.1 | 2.71% | 3.74% |
2016 | 13.7 | 572.8 | 2.39% | 3.67% |
2015 | 9.9 | 525.4 | 1.88% | 3.89% |
The cost of GSBD's liabilities on average have been lower than the AAA bond yield, a plus for shareholders. However, I would consider this point to be largely moot in light of GSBD's atrocious underwriting history, since I rank the long term erosion of earning power a far greater concern than the extent to which low cost of liabilities can make up for it.
Assets Diversified Across Industries
GSBD's assets are largely diversified across industries, and is very much diversified away from cyclical industries. This is an important consideration as a long term investor wants to see that there are no pockets of sensitivity on the balance sheet.
However, I would consider this point to be largely moot in light of GSBD's atrocious underwriting history.
Conclusions
- GSBD's management fees cause management to be largely aligned with shareholder interests
- Balance sheet leverage is maintained at a value equivalent to that of peers - 1.3x debt to equity
- Assets are invested in largely conservative first lien senior secured debt
- GSBD's underwriting is by far the worst of the peer group that I have analyzed so far, and merits GSBD trading at a substantial discount to NAV. Shares are currently extremely overvalued.
- GSBD has low cost of leverage and has assets that are widely diversified by industry, however these are moot points in light of GSBD's poor underwriting history.
I would stay away from GSBD's shares until the market marks these shares down to a substantial discount to NAV - on the order of 30-40% discount.
For further details see:
Goldman Sachs BDC: 13% Dividend Yield Does Not Compensate For Poor Underwriting