Tight Credit Spreads And Rising Defaults Will Pressure Middle Market Lender Earnings

Catalysts

About Golub Capital BDC

Golub Capital BDC provides first lien senior secured loans to resilient, private equity backed middle market companies across diversified industries.

What are the underlying business or industry changes driving this perspective?

• Sustained compression in lending spreads across fixed income markets, combined with lower base rates, is likely to reduce reinvestment yields as higher coupon loans repay. This may pressure revenue growth and net investment income over time.
• Persistent credit cycle conditions with elevated default and stress levels in leveraged loans increase the probability that today’s benign nonaccrual metrics normalize higher. This could drive more realized and unrealized losses that weigh on net income and book value.
• Rising competition from both public credit markets and large private lenders for high quality middle market deals is pushing terms and pricing toward borrowers. This could erode GBDC’s risk adjusted returns and compress net margins on new vintages.
• Greater reliance on maintaining very low funding costs through capital markets issuance and bank facilities exposes GBDC to refinancing and spread risk. Any reset higher in its own borrowing spreads would likely narrow its net investment spread and earnings power.
• Increased dispersion between strong and weak direct lending managers may pressure GBDC to prioritize conservative underwriting and share repurchases over portfolio growth. This could potentially limit asset growth and fee earning revenue if market conditions remain challenging.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Golub Capital BDC's revenue will decrease by 5.1% annually over the next 3 years.
• Analysts assume that profit margins will increase from 43.3% today to 44.7% in 3 years time.
• Analysts expect earnings to reach $332.9 million (and earnings per share of $1.26) by about December 2028, down from $376.6 million today.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 15.3x on those 2028 earnings, up from 9.6x today. This future PE is lower than the current PE for the US Capital Markets industry at 25.2x.
• Analysts expect the number of shares outstanding to decline by 0.76% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.77%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• A prolonged period of tight credit spreads across all fixed income markets combined with lower base rates could continue to compress GBDC's investment yields, eventually forcing a reset of the dividend policy and putting sustained pressure on revenue growth and earnings.
• The current credit cycle, with leveraged loan defaults running at roughly two and a half times historical averages, may ultimately flow through to higher nonaccruals and larger realized and unrealized losses than currently observed, which would erode net asset value per share and depress net margins.
• Increasing competition from public credit markets and large private lenders, especially in larger cap and continuation vehicle transactions, could further weaken loan terms and spreads for even high quality borrowers, reducing risk adjusted returns on new originations and lowering long run earnings power.
• If subprime consumer stress and cost inflation broaden into a wider economic slowdown affecting middle market borrowers, revenue and EBITDA growth across GBDC's portfolio companies could decelerate more sharply, driving weaker credit performance and lower net investment income over time.
• Secular growth in private credit as an asset class, supported by strong demand for floating rate income products and scaled managers with differentiated track records, may sustain elevated investor appetite for vehicles like GBDC, which could support valuation multiples and lift the share price above what current earnings trends alone would justify.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $15.0 for Golub Capital BDC based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $745.3 million, earnings will come to $332.9 million, and it would be trading on a PE ratio of 15.3x, assuming you use a discount rate of 9.8%.
  
• Given the current share price of $13.76, the analyst price target of $15.0 is 8.3% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.