Private Eye: No signs of recession in Golub’s mid-market portfolio

Does the stock market know something the rest of us don’t?  The S&P 500’s more than 9 percent drop from New Year’s through February 10 suggests that the United States’s seven-year trot of economic growth, however plodding, may be heading for a concrete wall.

And fears of an imminent recession have real consequences. Financial buyers, for one, won’t pay as much for a company they think is about to tack into economic headwinds. Some avoid cyclical businesses. Others turn their attention from buying new companies to making sure their current portfolio companies survive a downturn.

So how are mid-sized portfolio companies actually performing? Are there any early warning signs of a recession? For that I checked in with Golub Capital, the mid-market lender that last year began publishing a quarterly index measuring both revenue and EBTIDA growth across a reasonably diversified portfolio of more than 150 companies, almost all of them sponsor-backed.

The bottom line: Revenue and EBITDA continue to grow. But the pace is more subdued.

Based on portfolio company results from October and November, fourth-quarter revenue grew 6.7 percent year over year across the portfolio, while EBTIDA grew 2.2 percent. That was down from year-over-year growth in revenue of 8.0 percent in the third quarter and growth in EBITDA of 4.0 percent. Taking a longer view, revenue growth is off from a near-term high of about 11 percent in late 2013, while EBITDA growth has fallen from a near-term high of about 11 percent toward mid-2014.

Golub Capital CEO Lawrence Golub told me the default rate across the portfolio remains negligible, at just 25 basis over the past 12 months. “Unsustainable, but that’s what it is,” he said. Golub added that the highest full-year default rate experienced by the firm over the past two decades was 3.1 percent, which took place in 2009, not long after the financial crisis.

Some sectors in the portfolio are doing better than others. Revenue at portfolio companies in the consumer discretionary category surged nearly 13 percent in the fourth quarter while earnings jumped nearly 18 percent. Industrials, by contrast, saw the slowest revenue growth of five key sectors, at just 1.7 percent, while EBITDA for industrials actually fell 2.8 percent. Golub Capital has little to no exposure to the oil and gas industry, utilities and materials. It also has limited exposure to financial services, such as banks and re-lenders, such as Golub Capital itself.

Golub called this a “peculiar time” in part because “we have seen very steady performance over the past five years-ish out of our portfolio companies.” And yet, for reasons Golub can’t fully explain, over most of that time public equity values rocketed higher. Then, over the last several weeks, they plummeted. “I don’t see any correlation whatsoever between the performance of mid-market companies who borrow from us and the stock market,” he said. “None. Zero. Zip.”

The Golub Capital portfolio reflects what’s going on in the U.S. economy, if not in the U.S. stock market. But revenue growth in the portfolio tends to beat that of companies in the broad-based S&P 500 index of companies by 4 percentage points or so. Golub sees three main reasons for this:

  • the absence from the portfolio of oil and gas companies, which have been crushed by the collapse of commodity prices over the last two years;
  • the relative lack of currency-exchange losses (due to the strengthening U.S. dollar), since mid-market companies tend to do most of their business in the United States; and
  • the positive impact sponsors have on the performance of their portfolio companies, such as by financing add-on acquisitions, and by providing strategic and operational advice. “Private equity owners make smarter decisions under changed circumstances than other owners do,” said Golub.

To be sure, mid-market companies in the Golub Capital portfolio face challenges. They may be largely immune to unfavorable currency exchange rates. But some of their products do have to compete with imported goods that are suddenly cheaper because of the stronger dollar. They also have to contend with higher labor costs, as workers become more expensive to recruit. Such factors contributed to the slowing earnings growth that the portfolio experienced in the fourth quarter.

Still, Golub doesn’t see anything looming that would pierce his optimistic view of the performance of his mid-market portfolio. Even higher labor costs can be seen as a positive, since it means companies are competing more vigorously for talent.

“That’s got to be a good sign for the economy — not a bad sign,” he said.

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Sherlock Holmes photo courtesy of ShutterStock