Episode 143: David Golub of Golub Capital on Private Credit

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Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, I'll be your host. We've got a great podcast for you today on private credit, and we're joined by the president of Golub Capital, David Golub. David, thanks for being on.

David: Oh, it's my pleasure. Good to be with you, Stewart.

Stewart: I want to start this one off the way we start them all off, which is where did you grow up, what was your first job, and a fun fact?

David: Right. I grew up just north of New York City in a suburb called New Rochelle, and my first job was as an assistant in the New Rochelle Hospital emergency room, and the first morning of my first job, we had the only person who died the entire period I was there. It was my introduction by fire. A fun fact, I am the son of a psychiatrist and a psychologist.

Stewart: Oh, wow.

David: Many people think that children of psychiatrists and psychologists are all a little nutty, and my response is, "Yeah, they are, and so is everybody else."

Stewart: And so is everybody else, that's it. So, Golub Capital bears your name. I'd love for you to tell me a little bit about... You have such a great vantage point. Can you give us a little bit of background about Golub? How it started, where you're focused, et cetera? That would be a great place to start, I think.

David: Sure. Golub Capital got started in 1994, so just under 30 years ago, and we are today one of the leaders, one of the pioneers in a segment of the private credit universe. We make loans to companies that are backed by private equity firms. Most of those companies that we back are what we call middle market companies. They generate between about 10 and 100 million dollars of EBITDA, so they're bigger than a typical venture capital-backed company, but they're not big enough to be publicly listed. They're not big enough to be issuing bonds in the high yield market.

They tend to be, and we seek for them to be, resilient companies that are in resilient industries that are backed by top-quality private equity firms. We're really known for two things, Stewart. We're known first for our mantra. Our mantra is a phrase, it's gold standard. What we mean by gold standard is that we seek to treat other people the way we would want to be treated if we were on the other side of the table, so we're very focused on nurturing relationships and repeat business over time. The second thing we're known for is, we've got a very long history of being very good at credit. Having low defaults and low credit losses in our funds, and having that be something that inures to the benefit of our investors.

Stewart: That's really helpful. And so, can you transition into describing Golub Capital's investment philosophy?

David: There are two core principles that really underlie both why we do things the way we do them and how we do them. The first of those core principles is that investing is no different from any other business. It's a business, and in order to be good at investing, you have to have a set of sustainable competitive advantages. You have to have an edge. There are few geniuses out there. Warren Buffet's a genius, Bill Ackman's a genius, but they're few. The vast predominant number of investing businesses can't rely on a genius. We don't rely on a genius. I am not a genius investor. We rely on a set of competitive advantages that give us a source of edge and that have enabled us to produce premium returns over time, and that I think position us to be able to do so in the future. I'll talk a little bit more about those competitive advantages later in today's podcast.

The second principle is, again, kind of old-fashioned. It's that relationships matter. We don't buy that new Wall Street mantra that everybody's a counterparty. We think good businesses work with the same parties over and over again. They have the same customers, they have the same suppliers, they have the same investors. Because of that continuity, everybody is looking out for each other. Everybody wants everybody else to be successful. You're not just looking out for yourself, you're not just seeking to take advantage in a situation. So, with those two principles in mind, it's probably not surprising that we're not in a wide array of different businesses. We're not a multi-strategy investment firm.

We focus on one thing and doing that one thing really well. That one thing is making loans to middle market companies backed by private equity firms. Today, if you look at it, we've got about 200 private equity firms that we've done multiple loans for. We call those repeat sponsors. Those repeat sponsors have constituted about 90% of our origination each year, going back a long time, so those are the repeat customers I was talking about before. We have a set of investors who've been invested with us since the beginning of the firm. Most of our investors have been with us for a very long time. The way we run our business is very consistent with those two principles.

Stewart: That's really helpful. You kind of touched on this a little bit, but Golub Capital lends to hundreds of middle market companies, right? As you define them, and that gives you a unique vantage point on the US economy. So, what are some of the themes you're seeing in terms of portfolio company performance?

David: It's very interesting, Stewart. We live in a very uncertain period, and so I do think that the vantage point that we have seen, mostly monthly financial information from hundreds of different US middle market borrowers, does give us a vantage point that's distinctive. Let me tell you a little bit about what we're seeing. We publish a middle market index every quarter, and in that middle market index, we report on the growth in revenue and in EBITDA for our median borrowers in a variety of different industries. In both calendar Q4 22 and calendar Q1 of 23, we saw a significant improvement in revenue growth and EBITDA growth versus calendar Q2 and Q3 of 2022. A lot of people have been talking about an impending recession and talking about the impact of higher interest rates in a negative light, but data that we're seeing is actually pretty positive.

Now, I'm not saying that we're seeing a booming economy. The growth in the economy has clearly slowed, and I would tell you that our portfolio is in some respects not representative of the economy as a whole. We purposefully avoid cyclical sectors. We don't do energy, we don't do home building, we don't do businesses that have heavy CapEx. But in the sectors that we operate in, the areas like business-to-business software and specialty distribution and healthcare services, what we're seeing in general is businesses are doing a pretty good job of adapting to challenging conditions. They're keeping prices up enough to be able to offset their increase in costs. They're controlling their costs. They're managing well their liquidity.

Now, I would tell you that this is the kind of environment, because it's a tricky one, where our selectivity probably helps the sample that we're looking at. The fact that the companies that we lend to are backed by private equity firms, and have the operating expertise and the resources that good private equity firms bring to bear, I think all of those things are advantages. I don't want to leave your listeners with the sense that we think, "Hey, everything's great," but I do think our perspective is that things are okay. Things are meaningfully better than you might expect listening to CNBC, or listening to Fox Business, or reading financial press these days, where the pundits are overwhelmingly very negative.

Stewart: That's really helpful. And so can you kind of translate that, and you have to some extent, into your outlook for the broader US economy?

David: Sure. Let me start by stating the obvious. We live in a period of great uncertainty, and while there are many confident voices out there saying, "Oh, a recession is about to happen," or, "We're going to see inflation go to blank percent," you won't catch me being one of those confident voices. I think the right attitude right now is humility. We've been through a period that's marked by a set of unprecedented or barely precedented events. If you're not very old, you didn't live through the Spanish flu, so this is your first global pandemic, COVID. If you haven't been in Brazil, you probably haven't gone through a period of galloping inflation of the sort that seemed to start in '21, in the early part of '22. It's been well-documented that the pace of increase that the Fed took in increasing base rates with a series of 75 basis point increases. They've never raised rates that fast before.

Something that's not so noted, the pace of deceleration of inflation since June of last year when it peaked at 9.5%. It's now clocking in at 4-something. I mean, that's a very rapid decrease. All of these are very unusual components of the situation that we find ourselves in. Nobody can look at the environment that we're in right now, having been through the history I just went through, and say, "Hey, this is just like 1974." It's not. I think the best we can say right now is maybe there'll be a recession, maybe we're in for a sustained period of muddling growth, and maybe we just need to watch carefully for new, unexpected events because we seem to be getting hit by an unusual number of unexpected events. If you follow that line of reasoning, what that drives you to is scenario planning as opposed to a scenario, and I think that's a smart way for investors to look at the world right now. Scenario planning, and making sure their investment strategies and portfolios are well-suited to a number of different potential scenarios.

Stewart: That's really helpful. I really like the style of this next question, because we're doing a live in-person event and there's a lot of this style of question. You've been through the great financial crisis and downturns over the last 28+ years. The question is, what lessons have you learned out of that vast set of experiences?

David: That's a great question. It highlights the value to all of us in looking to our past experiences as a source of wisdom and inspiration. I'd say two. The first one has got something to do with the last answer I just gave you. It's about staying humble. Now, if you look at the crises that I've seen up close over the course of my career, there's a pattern around crises hitting folks who thought they knew more than they knew, who were trying to optimize beyond what is optimizable. Let me give you some examples of that. Early in my business career, the 1987 crash came. One of the key causes of that crash was a financial innovation called portfolio insurance. It was the idea that equity investors could limit their downside, because as soon as stocks went down, they would start selling shares and buying fixed income in order to mitigate their losses. Well, it didn't work, because when everybody started to sell at the same time, we had a single day when stocks collapsed by more than 20%. In retrospect, portfolio insurance was an idea that worked intellectually, but not practically.

Second example: About 10 years later, I remember very clearly the collapse of long-term capital. Long-term capital had this whole series of bets that they were going to see prices of two things go back to their normal relationship. Because they had so many different what they thought were uncorrelated bets, they thought it was okay to have very high degree of leverage across their portfolio. Well, again, maybe in retrospect the word you'd use to describe their error was a lack of humility. When a number of things went wrong, and a number of these bets all went against them at the same time, the degree of leverage and the number of other copycat players who had the same bets that they had on caused a widening out of the relationship between these assets across different asset categories all at the same time, the opposite of their thesis.

Third example: In the financial crisis, the biggest source of losses was a series of bets on real estate, on mortgages. In particular, on dodgy mortgages. On the theory that real estate doesn't go down in value, or it doesn't go down in value much, or it only goes down in value in one market, but not across multiple markets at the same time. Well, but sometimes it does. Again there, maybe we look back and we say there's a humility problem there, in thinking that there couldn't be a larger more systematic correction in real estate prices. One of the key lessons I've learned is to stay humble, don't be so sure.

A second key lesson I'd identify is very specific to our business. We're in the lending business. We make a lot of loans, we keep a diversified portfolio, but we're not perfect. What I've learned in respect of our business is, it really helps if you can detect problems early. If you can figure out, "Well, where are the companies in your portfolio that maybe have a higher probability of getting into trouble?" Can we focus on those early? Can we talk to the management teams and the sponsors that control those companies early? Can we talk about ways to augment management, to add more capital, to change strategy, to take a variety of potentially different steps that would all have the effect of increasing margin for error? What we found over and over again is that early detection, early intervention, those dramatically improve outcomes. It's very hard to manage a difficult situation once it's on fire. Those are two I'd throw out there. I think it's a great question. I think that'd be a great question for you to ask other guests, as well.

Stewart: It was right when I started my career, Black Friday in '87. I was sitting in a bullpen at a financial services company, and there was a Quotron. You probably remember Quotrons. I shared it with the guy in the next cube over. There was a slot cut out, and it would just swing back and forth so we could both use it, and the quote would be, "Up 500, down 600." Just bouncing back and forth. The data was completely lost. It was just that the whole system was overwhelmed. You couldn't see what the real numbers were. It was just crazy.

When you mentioned that, that just sparked that memory in my head. We're kind of on the tail end of our podcast here, and I just want to ask you about specifically insurance investors, right? Which is our audience, our focus. Our community, really, is insurance investment professionals all over the world. There's been a lot of money allocated to private credit by insurance companies. What are some of the issues that you'd recommend insurance investors keep in mind when they're thinking about whether to and how to invest in private credit strategies?

David: Let's take the "whether" part of your question first. The private credit market is now a multi-trillion dollar market. It's too big to ignore, and I think insurance companies would be well-served not to ignore it because there are a lot of niches within private credit that are very attractive from a risk/reward standpoint. One of the things that I think many insurance companies find attractive about our niche is that in addition to an attractive risk/reward, it offers floating rate exposure, so insurance companies don't have to take interest rate risk alongside credit risk the way that they do in traditional fixed-income investments.

Now, there are many ways to access the private credit market. And I want to highlight two points on the second part of your question, the means of accessing it. The first point is, be careful who your manager is. Private credit's a young area, there's not enormous historical data on it. You want to make sure that you're working with a high-integrity, well-performing manager who's got real competitive advantages. Differences between managers really matter in our market.

The second point is, you may want to look at capital efficiency. There are parts of the private credit market which have developed structures for insurance company investors to make investments that are particularly good from a regulatory capital standpoint. Rated note structures, for example. There are also some structures that have been developed that offer very significant tax efficiency. ICOLI would be an example. I'd focus on manager, and I'd focus on structure. Make sure that both fit your needs as an insurance investor.

Stewart: That's really, really good advice, and I'm glad that you took it in that direction. This is the part in the podcast where I typically get a chance to ask somebody some question from like your way past, right? Golub was founded by your brother in '94, and when the firm was founded, it had to be... I mean, I founded this firm. I mean, it's scary when you're first starting out, right? So, what lessons did you learn when the firm was first started that are still serving you today?

David: I'd be interested, Stewart, if you would agree with this. One of the remembrances I have about the early days of the firm, we did things that were foolish. We did things that if we knew everything we know now, we never would've tried. And yet, in many cases, those things worked. We had the audacity to try things that folks who knew better or know better might not have had the audacity to try. One of the learnings for me about that, and reflecting on that, is it's important to be audacious sometimes. It's important to think big and be careful, both at the same time. As a small entrepreneurial company, it's easy to think big. As a big company, it's easy to be careful. Good businesses do both of those things in a balance.

Stewart: That's really interesting. I mean, podcasts for us, right, was not my idea. It was from a client. I said, "Nobody is going to care about these podcasts, like nobody." I couldn't be more wrong. I mean, our podcast traffic's been terrific, and I really think that's great advice. That, at times, you need to be audacious. I really like that a lot. I've learned a lot, David. I really have. I've learned a lot about private credit and about sponsored finance. I really want to thank you for taking the time and coming on the show today, so thanks for being on.

David: My pleasure.

Stewart: We've been joined today by David Golub, President of Golub Capital. Thanks for listening. If you like us, please rate us, review us on Apple Podcast. We certainly appreciate it. My name's Stewart Foley, and this is the insuranceaum.com podcast.

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