2023-08-08 09:27:05 ET
Summary
- Goldman Sachs BDC offers a high yield of over 12% and strong net investment income coverage.
- The recent increase in NAV could be an early sign a possible trend reversal of previously declining NAV per share.
- Increases in its higher-risk portfolio holdings should be monitored closely, as it could indicate underwriting challenges and result in NAV declines.
Goldman Sachs BDC ( GSBD ) presents a good income investment opportunity with an enticing yield of over 12% and a robust net investment income coverage ratio. Its consistent payout of the $0.45 quarterly dividend speaks to its predictable dividend policy even if an increase might have been desirable.
In my view, a more consistent increase in NAV will contribute to the long-term rerating of the stock to its historical levels. The recent increase in NAV in its second quarter earnings, reported last week, could be an early indication of a reversal of NAV declines. However, this should be monitored closely as a single quarter does not yet present a sufficient basis for a definitive conclusion.
Net asset value and portfolio quality
Goldman Sach BDC’s declining net asset value ((NAV)) per share has long been a concern for some investors. Seeking Alpha analyst Stephen Nemo has viewed this decline in NAV as an indication of poor underwriting and has suggested that this merits a much larger discount to NAV. The declining NAV is certainly something that merits close attention by investors but does not, in my view, necessarily suggest that the stock should trade at a more substantial discount to NAV. Nevertheless, a declining NAV makes a discount to NAV more reasonable than for a similarly situated BDC where the NAV has been growing.
In the second quarter of 2023, Goldman Sachs BDC reported an increase of 1% in its NAV per share on a quarter-over-quarter (QoQ) basis. While this is not a substantial increase it merits close attention after the BDC has reported several quarters of NAV declines on a QoQ basis. In my view a reversal of the trend of NAV declines may justify a rerating by the stock in the near future. Nevertheless, one should be cautious not to assume that a single quarterly increase in NAV per share signifies a reversal of a trend.
GSBD NAV Per Share (Author created based on company fillings)
In the second quarter Goldman Sachs BDC also reported a meaningful increase in the percentage of its overall portfolio in category 3. According to the company category 3 indicates that the investment’s risk has increased materially since origination or acquisition and that "the borrower may be out of compliance with debt covenants however, payments are generally not more than 120 days past due". In the second quarter of 2023 the percentage of its overall portfolio in category 3 increased from 3.3% in the first quarter of 2023 to 7.6% more than doubling the total value of its portfolio in this higher risk category.
GSBD Loans Per Risk Category As a Percentage of the Portfolio (Author created based on company fillings)
Management also commented on the increase in category 3 in its latest earnings call by noting that:
So that migration [from category 2 to category 3] was really driven by a couple of names that were facing some liquidity pressures during the quarter. And we were in active discussions with the sponsors during the quarter. We expect them to support these companies. But because it was unresolved, we thought it was prudent to downgrade those investments for meeting category 2 to category 3. And I think you've gotten to know us, we were quite conservative with respect to how we look at our ratings categories. So as soon as those situations are hopefully resolved shortly, we'll reflect on them appropriately.
From these comments it is hoped that management has been overly cautious in reclassifying these loans from category 2 to category 3. It will, however, be important to monitor these movements closely in the months ahead particularly as there was an increase in category 3 in the first quarter of 2023 as well albeit not to the same extent as the second quarter. Despite the increase in category 3, the bulk of its portfolio remains categorized in category 3. As seen in the chart above, category 2 loans represent more than 85% of its portfolio. Management has explained that category 2 involves a level of risk that is similar to the risk of the BDCs initial cost basis at the time of origination or acquisition and the borrower is generally performing as expected.
The company has also long maintained a substantial portion of its loans in higher quality loans with more than 90% of its portfolio being first lien senior secured loans. Management has also indicated that in the next quarter it will only focus on directly originated first lien senior secured debt. In my view, this continued focus on higher quality origination will assist Goldman Sachs BDC well to navigate any potential headwinds up ahead.
The dividend and net investment income
Goldman Sachs BDC has effectively paid the same $0.45 per share quarterly dividend since its inception. This has occasionally been supplemented by special dividends . The BDC currently has a dividend yield of 12.76% which is the second highest of the major BDCs considered in the peer comp charts below.
Major BDCs Dividend Yield as a Percentage (Author created based on data from BDC Universe)
Its dividend also appears to be adequately covered by net investment income ((NII)). Goldman Sachs BDC currently has a one-year average NII dividend coverage ratio of more than 126%. This represents the highest NII coverage ratio of any of the major BDCs considered in the peer comp charts below.
BDCs 1-Year Average NII Coverage as a Percentage (Author created based on data from BDC Universe)
The one-year average NII coverage ratio would also have been higher but for the reduction in NII coverage in the first quarter of 2023 arising from the incentive fee paid to management. At the time management explained that :
The decrease in net investment income was due to the increase in our incentive fee. As a reminder, our incentive fee calculation is based on a 12 quarter look back inclusive of a total return limiter where any unrealized losses resulting from markdowns offset pre-incentive fee net investment income.”
Such higher incentive fees are not paid frequently but nevertheless have an impact on the NII coverage ratio. Considering the high average NII coverage ratio, even after the higher incentive fee was included, a special dividend seems possible. However, management has not given any clear indication of when such a special dividend can be expected other than noting that
In terms of the special, we're taking a long-term view of how to manage our balance sheet accordingly, looking at what our spillover is with future run rates, and will be opportunistic to the extent that it makes sense from a shareholder perspective to potentially issue a special down the road, but something that we're evaluating and we’ll continuously assess and what makes the best sense for the balance sheet and shareholders.”
Therefore, the dividend at Goldman Sachs BDC appears quite stable at present and seems unlikely to be reduced in the immediate future. The strong NII coverage ratio also suggests that the BDC could be ripe for a special dividend even though management has suggested that this would be dependent on a number of factors such as the balance sheet.
Valuation
Goldman Sachs BDC currently trades near NAV with a discount to NAV at around 0.07% which is around the middle of the pack in the peer comp chart below. This valuation is well-below its 3-year average valuation of an 11% premium to NAV. Nevertheless, given declines in NAV in previous quarters a slight discount to NAV might be warranted as investors are effectively pricing it for where they believe the NAV would be in the future.
BDCs Price/NAV (Author created based on data from BDC Universe)
Should the increase in NAV witnessed in its most recent earnings report persist in the quarters ahead this may contribute to the market rerating the BDC to a level closer to its 3-year average premium to NAV. When considering the BDCs 5-year average dividend yield of around 10.75% it also suggests that the stock is somewhat discounted on a historical basis.
Conclusion
Goldman Sachs BDC offers a compelling yield of just over 12% and boasts very strong net investment income coverage. While concerns about declining NAV persist, a recent modest increase could suggest a possible trend reversal, although investors should monitor this closely in the quarters ahead.
The rise in higher-risk portfolio holdings (category 3) warrants monitoring, though management's explanation provides some comfort. A further increase in category 3 could be suggestive of underwriting challenges and may then again contribute to NAV declines. A strong increase in defaults and rise in category 3 and 4 loans is accordingly a material risk to the investment thesis for Goldman Sachs BDC.
For further details see:
Goldman Sachs BDC: Compelling Yield But Watch Higher-Risk Portfolio Holdings