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.
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On Golub Capital BDC's first-quarter conference call, David Golub fired three warning shots at the business of lending to private equity buyouts.
1. Credit quality is decliningGolub 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.
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"
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
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.
The article 3 Warnings About These High-Yield Stocks originally appeared on Fool.com.
Jordan Wathenhas no position in any stocks mentioned, but he does enjoy following the ebbs and flows of the middle market. Find him on Twitter byclicking here.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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