Goldman Sachs BDC: Risks Are Rising (NYSE:GSBD)

Shares of Goldman Sachs BDC (NYSE:GSBD) corrected sharply after BDC reported fiscal second-quarter results earlier this month. The biggest takeaway from Goldman Sachs BDC’s second-quarter earnings report was that the company saw a the significant increase in the unaccrued percentage, which presents net investment income and hedging risks for BDCs. Although Goldman Sachs BDC supported its dividend with net investment income in Q2’24, the risk matrix was negatively impacted here, and I’m shorting BDC to hold.

Previous assessment

A restart of Goldman Sachs BDC loans and a very solid distribution coverage in excess of 1.20X led me to a Buy rating on BDC in June: Lock In A High-Quality 12% Yield On The Drop. However, with a considerable change in the unemployment rate in the second quarter as well as the potential headwinds arising from the Federal Reserve’s first interest rate cut, I believe a downgrade must be prudent.

Goldman Sachs supports its dividend with NII, but NPL risks are rising

Goldman Sachs BDC primarily operates a first lien strategy and focuses on high quality collateralized debt. The company’s first lien focus was a primary reason for me to recommend GSBD for the first time in my January 2024 coverage. BDC Investments was valued at $3.5 billion at the end of the June quarter, and the Goldman Sachs BDC portfolio was composed of mainly of first guarantees… which represented 97% of investment assets for GSBD.

During the second quarter, Goldman Sachs BDC placed two portfolio companies in non-accrual status, which unfortunately led to an exaggerated increase in BDC’s non-accrual percentage: at the end of the June quarter, the non-accrual percentage -accumulation of Goldman Sachs BDC reached 3.4% (on a fair value basis) which represented an increase of over 100% over the quarter.

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(Source: Author)

With the sharp rise in the non-recovery rate in Q2’24, Goldman Sachs BDC faces higher net investment income risks going forward. However, Goldman Sachs BDC still had a relatively robust dividend coverage profile in Q2: the dividend coverage profile was 1.31X compared to 1.22X in the previous quarter.

Goldman Sachs BDC’s net investment income trend looked quite solid in Q2’24 given the context surrounding the company’s weakening balance sheet quality. Goldman Sachs BDC generated $107.0 million in interest on its variable rate loans, down 4% year-over-year and 3% quarter-on-quarter. Higher dividends and other income had an offsetting effect on Goldman Sachs BDC’s financial performance. BDC’s total net investment income, which includes all sources of income, fell to $108.6 million in Q2’24, showing a 3% decline Y/Y and Q/T.

Goldman Sachs BDC Rating

Concerns about lower federal funds rates, which are a drag on BDCs investing in variable-rate loans, and Goldman Sachs BDC’s weak second-quarter earnings report weighed on BDC valuation earlier in the month. The increase in the unaccrued percentage in particular created a surplus of negative sentiment, but shares of Goldman Sachs BDC showed signs of stabilization.

Shares of Goldman Sachs BDC are valued at a P/NAV ratio of 1.04X, which compares to a long-term (3-year) average price-to-NAV ratio of 1.07X. Ares Capital (ARCC) and Blue Owl Capital (OBDC) trade at P/NAVs of 1.07X and 0.98X…and I have a particularly favorable view of Blue Owl Capital as the company recently announced a merger with Blue Owl Capital. Corporation III (OBDE), which I believe could act as a re-rating catalyst: a 12% yield priced below NAV (rating upgrade).

In my last piece on Goldman Sachs BDC, I said that GSBD could trade at a P/NAV ratio of 1.10X, which implied a fair value of around $16. As the non-accumulation trend is negative and has led to concerns about NII’s performance, I am no longer willing to assign a premium to the company’s NAV. Given the deterioration in balance sheet quality in Q2’24, I believe a 1.0XP/NAV is appropriate to account for the possibility of higher investment losses and weaker NII performance going forward. This P/NAV ratio implies a fair value of $13.67 per share and represents the company’s net asset value.

Risks with Goldman Sachs

The biggest risk for Goldman Sachs BDC, as I see it, is a continuation of the negative non-accumulation trend. Since Goldman Sachs BDC is also almost exclusively invested in variable rate loans, I think BDC will have weaker net investment income growth going forward…which is a risk that adds to the risk of higher losses of investments if not the accumulated investments cannot be brought back to the state of performance. What would change my mind about Goldman Sachs BDC is if the company fails to support its dividend with net investment income.

Final thoughts

Goldman Sachs BDC’s second quarter earnings report revealed a major weakness: the non-accrual percentage trend is a significant challenge for BDC and its investor base. Although Goldman Sachs still supported its dividend with net investment income in Q2’24, I see an unfavorable risk matrix, especially regarding BDC’s future net investment income. The risks here have clearly increased here, and if Goldman Sachs BDC fails to recover or restructure its commitments, the BDC’s net asset value could be affected. As a result, dividend investors should expect BDC to report higher investment losses in the future, which would negatively impact NII’s performance and Goldman Sachs BDC’s dividend coverage profile. While I don’t expect a dividend cut in the near term, dividend risks have clearly increased, which is why I’m downgrading my rating from buy to hold.