Golub Capital BDC Inc (GBDC) 2011 Q4 法說會逐字稿

Good afternoon. Welcome to the Golub BDC Incorporated September 30, 2011 quarterly and fiscal year-end earnings conference call. Before we begin, I would like to take a moment to remind our listeners that remarks made during this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements other than statements of historical facts made during this call, may constitute forward-looking statements and are not guarantees of future performance or results, and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements, as a result of a number of factors including those described from time to time in Golub Capital BDC Incorporated filings with the Securities and Exchange Commission.

For a slide presentation that we intend to refer to on the earnings conference call, please visit the Events and Presentations link on the homepage of our website www.golubcapitalbdc.com and click on the Investor Presentations link to find the September 30, 2011 investor presentation. Golub Capital's BDC's earnings release is also available on the Company's website in the Investor Relations section. As a reminder, this conference is being recorded Friday, December 9, 2011. I will now turn the call over to David Golub, Chief Executive Officer, of Golub Capital, BDC. Please proceed.

Thank you. Good afternoon, everybody, and thanks for joining us today. I'm joined today by Ross Teune, our Chief Financial Officer. I hope you've been able to review our earnings release and the investor presentation we posted on the website. Ross and I will be referring to this presentation throughout the call today. I'd like to start today by providing an overview of the September 30 financial results.

Ross is then going to take you through the results in more detail. I'll then come back and give you an update on new origination activity for the first two months of our fiscal quarter -- first fiscal quarter for 2012. As well as to provide you with some information on a hedge that we put in place that effectively fixes the interest rate on our SBIC debentures that we've drawn, but where the ultimate rate on those debentures won't be determined until the March 2012 SBA pooling date. With that, let me get started. As highlighted on Page 1 of the investor presentation, net investment income for the quarter ended September 30, was $6.5 million or $0.30 a share as compared to $6 million or $0.28 a share for the quarter ended June 30.

The increase in net investment income was driven by both an increase in our weighted average earning investments of $15.1 million, and an increase in our weighted average net investment spread of 20 basis points. If we look at net increase and net assets or what I think of as net income for the quarter ended September 30, it was $3 million or $0.14 a share as compared to $6.5 million or $0.31 a share for the quarter ended June 30. The decrease for the quarter ended September 30 was primarily a result of two factors. First was unrealized losses on investments of $1.8 million or $0.08 a share, which were caused by a combination of market yield adjustments and write downs on two non-earning investments, and the second factor was an unrealized loss of $1.7 million or $0.08 a share on the mark-to-market adjustments on the broadly syndicated loans that are referenced in our total return swap. And I just want to highlight that the unrealized loss on the total return swap has already partially reversed as of November 30, the appreciation on the total return swap has been roughly $1.4 million, so $1.4 million of this $1.7 million loss in the September 30 quarter, has already reversed.

Turning to Page 3 of the investor presentation, new originations for the quarter totaled $60 million. That's down from $136 million in the June 30 quarter. We expected the decline, in fact we talked about the expectation of a decline here in our last call, earnings call. Originations were unusually high in the June 30 quarter. Prepayments also slowed during the quarter and overall net funds growth was $21 million for the quarter, or about 5%. As I said in previous calls, one of our goals is to increase the percentage of investments in unitranch and junior debt in the portfolio. And I'm pleased to report that we continue to make progress toward that goal in the quarter ended September 30.

Of our originations, 68% were in the unitranch product category and that allowed us to increase the overall percentage of unitranch investments in the portfolio, from 35% of total investments at June 30 to 39% as of September 30. As I mentioned, our weighted average investment spread increased by 20 basis points this quarter, in large part due to the shifting asset mix. Given current market conditions and I'm going to talk a little bit more about this later, we continue to focus on unitranch investments. Having said that, we have recently seen some compelling risk reward opportunities in subordinated debt, and we've closed several attractive sub debt opportunities in the December 31 quarter. After Ross discusses the financial results in more detail, I'm going to come back and provide some additional color on new investment activities since the September 30 quarter end. With that, Ross, I'm going to hand it to you.

Thanks, David. I'm going to start on Page 4 of the investor presentation, kind of providing some portfolio highlights. As David previously mentioned, we closed on new investment commitments totaling $59.8 million for the quarter. Exits from repayments and sales totaled $28.9 million for the quarter, which resulted in overall net funds growth of about $21 million. As shown in the asset mix table, we continue to make progress in shifting the asset mix from senior secured investments to more unitranched and junior debt investments. During the quarter, the percentage of senior secured assets declined by 3%, and the percentage of unitranch investments increased by 4%. And just looking on a year-to-date basis, the percentage of senior secured assets declined by 22%, declining from 66% of the portfolio at September 30, 2010, down to 44% at the end of this quarter.

We still have some more work to do in this area, but we have made considerable progress over the last 12 months. Flipping to the next page, just looking at the balance sheet, as of September 30, total assets were $559.6 million, which includes total investments of $459.8 million at fair value, and total cash and restricted cash of $69.8 million. Total liabilities were $243.1 million which primarily consists of debt of $237.7 million. The debt consists of $174 million in floating rate debt issued through our securitization vehicle, $61.3 million of fixed rate SBA debentures, and $2.4 million on a revolving credit facility.

As of September 30, net assets were $316.5 million, and our net asset value per share was $14.56. Turning to Page 6, looking at the Statement of Operations, total investment income for the quarter was $10.8 million, an increase of 7.5% quarter-over-quarter. This increase was primarily attributable to an increase in average investments outstanding, as well as an increase in the average yield on investments which I'll provide some more color on, on the following slide. On the expense side, total expenses were $4.4 million which increased 6.4% during the quarter. This was primarily due to an increase in interest expense, due to higher average debt outstanding, and an increase in management fees due to higher average investments outstanding. Net losses on investments and derivatives for the quarter were $3.5 million which was comprised primarily of net unrealized losses.

Due to the net loss on investments, we reversed previously accrued incentive fees, resulting in a negative incentive fee for the quarter of $176,000 as kind of shown in the expense categories. Turning to Slide 7 or Page 7, the chart on the left provides a break down of our new originations by product category. For the quarter ended September 30, 68% of our new originations were in unitranch investments, 30% in senior secured investments, with the remaining 2% in equity investments. The chart on the right provides a break down based on total investments. Turning to Slide 8, I'll walk you through the changes in our yields and investment spreads for the quarter.

I'd like to focus your attention first on the red line, which represents the interest income yield. The interest income yield represents all income earned on the investments, excluding the amortization of discounts and origination fees. Our interest income yield continues to increase, reflecting our progress in shifting the asset mix. For the quarter ended September 30, the interest income yield increased 50 basis points from the prior quarter to 9.1%. And looking on a year-to-date basis, we have increased the interest income yield by 100 basis points from 8.1% to 9.1%. Including amortization in fees and discounts the total yield on investments, the dark blue line for the quarter ended September 30 was 9.9%.

As we've previously noted, our total yield on investments will fluctuate on a quarterly basis depending on the level of run-off in the portfolio, because on prepayments we've taken income, any remaining unamortized fees. The cost of our borrowings, the green line, increased slightly from 3.2% from the previous quarter, to 3.3% for the quarter ended September 30. Turning to Page 9, for new investments, the weighted average rate on new investments was 8%. The weighted average rate on new investments is based on the contractual interest rate at the time of funding. For variable rate loans, the contractual rate would be calculated using the current LIBOR, the spread over LIBOR, and also taking into account the impact of any LIBOR floor.

For fixed rate loans, it's the stated fixed rate. The 8% this quarter compares favorably to the weighted average rate of 7.2% for investments that were sold or paid off. So in a sense, we picked up 80 basis points on the new assets compared to the old assets that ran off. As shown in the middle of the page, the investment portfolio remains predominantly invested in floating rate loans. In regards to credit quality and non-earning loans, I refer your attention to Pages 10 and 11. Overall, fundamental credit quality remains strong, with nearly 90% of the investments in our portfolio rated a four or a five, and non-earning loans representing 0.6% of our loan portfolio at fair value. However, as David mentioned earlier, continued weakness in two non-earning investments negatively impacted our quarterly financial results.

In addition, unrealized losses primarily caused by mark-to-market adjustments on the broadly syndicated loans referenced in our total return swap, also negatively impacted our quarterly financial results. As David indicated, we view these mark-to-market adjustments on the broadly syndicated loans as temporary, as the marks were driven by market yield adjustments and were not due to any credit related issues. Due to the post-september 30 market rally in the broadly syndicated loan market, as well as an increase in the net interest accrued on the loans in the TRS, the fair value of the TRS was negative $0.5 million as of the end of November. Which is a $1.4 million increase from the fair value at the end of the quarter. Just as a reminder, independent valuation firms valued approximately 25% of our investments as of September 30.

Turning to Page 12, the Board declared a distribution of $0.32 a share, payable on December 29 to shareholders of record, as of December 19. Turning to Page 13, overall liquidity remains strong as of September 30, with $69.8 million of unrestricted and restricted cash. In addition, we had $38.7 million of available SBIC debenture commitments, and availability of $72.6 million on our revolving credit facility. In regards to our SBSC debentures, on September 30, 2011, we received exemptive relief from the SEC, allowing us to modify the asset coverage requirement to exclude our SBIC debentures from this calculation. I'll now turn it back to David who will provide some commentary on new investment activities since the end of September, as well as provide some details on a hedging contract that we entered into this quarter and he will close with some closing remarks.

Thanks, Ross. So we're on a late schedule this quarter because of the Fiscal Year End, and given that I thought it would be useful as we approach the end of our first fiscal quarter of 2012, to provide you with some information on the current market environment and our activities since quarter end. We think the environment for middle market lending right now is very favorable. Post the August credit dislocation, credit spreads have widened, transaction structures remain conservative, and as a consequence, we've been quite active and new originations have been very strong. For the first two months of the quarter, we've already closed on over $100 million of new investment commitments. Of these new commitments, 46% were in second lien and subordinated debt investments, as I mentioned earlier we've seen more attractive sub debt opportunities recently.

18% were in unitranch investments, 33% in senior secured and 3% in equity. The weighted average rate on the new investment commitments was 10.7%, which compares favorably to the interest income yield Ross alluded to of 9.1%, that we reported on the investment portfolio for the quarter ended September 30. Also, before I wrap up, I want to give you some details on the hedging transaction that I referenced. In September, we entered into a 10 year US Treasury futures contract, reflecting a yield of 2.08% in an amount of $25 million with the intention of fixing the rate on $25 million of SBIC debentures we've already drawn. For those of you who don't remember how the SBIC program works, we draw debentures under this program, but their interest rate gets fixed twice a year.

The next time when they get fixed will be in March, so we thought rates were at a very attractive level at 2.08% and decided to look to lock in that rate. So this transaction insulates us against adverse changes in the 10 year US Treasury rate, between September 2011 and the SBIC's pooling date in March. The only downside to this hedge is that we will have to reflect changes in the value of the hedge through our P&L, whether they be good news or bad news, we will have to reflect changes in the value through our P&L until we unwind the hedge at the time of the pooling date in March. So to sum up, the market environment we think right now is very favorable. Not saying we are not concerned about all the sources of uncertainty in the world. We are. Whether we're talking about the European financial crisis or the stubbornly high level of unemployment in the US, or the new normal in US government circles of political dysfunction. Despite all of that weakening, Golub Capital BDC is well positioned to deliver solid results in fiscal 2012.

I've said this before but I'll say it again. We don't need robust economic growth to have a good year. Flat is good enough. The portfolio is in solid shape from a credit perspective, not saying it's perfect. We have a couple of problem children and that's the nature of our business. But overall, it's very solid and I feel very good about the Golub Capital platform. We are pleased that Golub Capital was ranked the number one traditional middle market book runner for the third quarter by Thomson Reuters for traditional middle market loans under $100 million. We were also ranked number one for the year through September 30.

We've completed transactions now as a platform with over 160 different private equity sponsors, and multiple transactions with over 80 of them. So we feel we've got a lot of momentum going into next year. As always, I want to thank everyone for their time and support. And with that operator, I'd like to open up the line for questions.

(Operator Instructions) Our first question comes from the line of Greg Mason from Stifel Nicolaus. Please proceed with your question.

Great. Good afternoon, gentlemen. David, could we dive into the TRS a little bit? Reading through your Q, the earnings from that -- the TRS come through the realized and unrealized gains bucket. Could you break out what the earnings from that versus the mark-to-market was in the third quarter?

Yes, the net interest income piece doesn't get earned until the interest income is actually paid, and so most of what occurred in the quarter was the unrealized mark-to-market adjustments on the broadly syndicated loans. I think we had $40,000 in realized gain, which represents interest income that was kind of received on those loans.

And can you talk about how that -- the payment comes to you? Is it once a quarter payment? When will we see that income come through the realized gains line?

That income does come on a quarterly basis, so you will see some of that income come through for the quarter ended December 31.

Okay, great and then just overall, what is your expectations of your ROE on your committed capital to the TRS? Now that you've kind of fully invested that $100 million facility.

Well that's a good question Greg. I mean, I think that I can tell you that on a steady state basis, we anticipate a low to mid teens return on that. But when I say steady state, what I mean is that, as we saw this quarter, there will be some period to period volatility in that because of the mark-to-market on the individual loans. I think in general we won't see volatility of the order that we've seen in the last quarter. We've had an unusual degree of volatility in credit markets generally, so I anticipate that, that will modulate. But what we're looking at here, is a return in our expectation is a return in the mid teens.

Okay, great and then this was $100 million TRS. Is there any idea of can you up size that? Do you want to up size that? Do you want to do more of this?

We do not have the intention or plan of up sizing it at this time.

Okay, great and then one more question and I can hop back in the queue. What, what changed in the fourth quarter where you wanted to take on more second lien and sub debt? What were you seeing there that made you want to really go after that market in the fourth quarter?

Well, I wouldn't suggest to you that something changed where we really wanted to go after it. I think what I'd tell you is that there are, this is always a very granular micro set of factors. I mean, we simply saw a number of transactions, post September 30, where we found attractive risk rewards in sub debt. And we didn't go into the quarter saying, hey let's make a whole bunch of commitments to sub debt, but what we have seen is that in the recent period, we've identified a number of subordinated debt investments that we thought were quite attractive. You know, there is and you can see this if you look at the charts from this investor presentation and prior investor presentations from quarter-to-quarter. There are significant variations in the mix of the new assets that we put on, and that's a reflection of a lot of different factors. I think that it would be a mistake for you to conclude that something's changed in how we're looking at the world or in our assessment of the goals of our portfolio. We quite simply just saw a couple of opportunities and took advantage of the opportunities we saw.

Great.

Our next question comes from the line of Joel Houck from Wells Fargo.

Good afternoon. Maybe you could comment on, obviously the pipeline over $100 million into December and can you give us a sense for what you're kind of looking as we head to the calendar year-end? Are you seeing sponsors still looking to close before year-end, or do you see some of those deals spilling over into 2012?

It's a mix, Joel. I think what we've seen as a pattern going back to the fourth quarter of 2010, is at the risk of sounding a little nerdy is a bit of a sign wave. So in the fourth quarter of 2010, we had a very big origination quarter. We told you at the time that, that was in part a function of deals being pushed into that quarter by sellers who were concerned about the possibility of tax law changes. The degree of activity in the fourth quarter of 2010, actually caused the first quarter of 2011. I'm talking calendar quarters now just to avoid confusion, caused the first calendar quarter of 2011 to be slow. And then the second calendar quarter to once again be robust, and the third quarter to be a little slow, and now we're seeing the fourth quarter again robust, So there's a kind of on, off pattern that I think goes back to Q4 of last year.

If I had to guess, my prediction is that we're going to see a continuation of that into next year. And if, as I expect, there's discussion next year in Washington about tax law changes and the possibility of capital gains taxes going up, then I think we're likely to see another surge of activity in the fourth quarter of 2012, the fourth calendar quarter of 2010.

Yes, that makes sense and I guess the tax -- the capital gains tax rate would go up automatically if nothing's done through Congressional acts, so that's interesting. Now, I guess switching gears, if you look at you guys have plenty of capacity for near term growth in terms of cash and unused availability of the line, but you're also in the enviable position of having your stock trade at a nice premium to book value. Can you give us a sense for, how you balance the raising more equity capital versus increasing leverage, and perhaps getting too tight to the BDC constraint?

Sure. This is obviously a subject that we spend a lot of time thinking about. We want to as we've discussed in the past, we want to continue to grow Golub Capital BDC in a very shareholder friendly, and methodical way. We think it would be good for shareholders if we are able over time to increase the float, and increase the market cap of the Company. But we're not interested growing for the sake of growth, and we're not interested in issuing shares at values that we think don't reflect the value of the Company. So we're in the as you put it, Joel, enviable position of having a stock that trades at a premium. We're also in the enviable position of having a platform where if we can't grow through the BDC, it's really not a big problem. So what I'd tell you is, we're going to look at this the way we've looked at it historically which is, if there is an opportunity to grow the capitalization of the BDC that we think will be good for existing shareholders, then we will pursue it. And if it's not good for existing shareholders, then we will not.

Alright, thanks for the answers.

I'd also just make one other comment on this and Joel, you've heard me say this before, but for the benefit of others on the call. We are in a small category of BDC's that has not sought approval for issuance of new shares at below book value, and as a philosophical matter, it's really not something we believe in.

That's a good point. Thank you.

Our next question is from the line of Heath Ritchie from Delphi Management. Please proceed with your question.

Thanks. I was wondering if you could discuss dividend coverage, and sort of what your outlook is for the stability of the dividend? Thank you.

Thanks, Keith. Our dividend right now is $0.32 a quarter. We, if you look at our performance since IPO, that's a good approximation of our average level of earnings. This quarter a bit lower because of our unrealized losses, some of which we think will reverse. Our dividend policy is to change our dividend rarely, and to have our dividend be at a level that we feel confident we can cover with earnings over time. With obviously some degree of volatility, but we want it to be at a level that we believe we can cover over time so that we're looking at a steady to increasing NAV over time. That's a restatement of our dividend philosophy. At a practical level, we've said on prior calls and I feel comfortable repeating here that one of our goals over the coming quarters is to increase our return on equity. And as we increase our return on equity, we would anticipate revisiting our current dividend with our Board, and looking at the possibility of increasing it.

Thanks.

Our final question comes from the line of Ross Haberman from Haberman Management. Please proceed with your question. Mr. Haberman, your line is open. Please check your mute button and proceed with your question.

I think we lost Mr. Haberman. Maybe we can go to the next question.

Certainly. We have a follow-up question from Greg Mason with Stifel Nicolaus.

Great, thank you. The reversal incentive fees this quarter, David, was that a reversal of some realized gain incentive fees, or past NOI incentive fees this quarter? Can you talk about that a little bit?

It was a reversal of the capital gains components. A reversal of previously accrued incentive fees related to the capital gain component, not related to net investment income.

And then David, you have one of the favorable management fee calculations that includes unrealized depreciation and your NOI incentive fee. Kind of given the fact that probably some of that has reversed here in the fourth quarter but if we didn't have that, is there a way that capital gains, excuse me, the depreciation in the portfolio, ever works its way off of the NOI incentive fee. Or is it kind of, if we look at your balance sheet today where you've got cumulative unrealized gains today of negative $1.5 million, if those weren't to reverse for theory sake, does that, you kind of always sit there as a negative $1.5 million on your NOI for each quarter?

If you recall the way that the incentive fee works, there's a cap structured into it. So you would look at that loss that we've had below the net investment income line, and that would impact the calculation of whether we're hitting our cap. And our cap, just to refresh your recollection is 20% of cumulative net income from the IPO date. I think the point you're making is quite correct, which is if you were to look at this quarter and compare our fee structure to others in the industry, and just run the numbers on what our fee structure is producing versus others, you would see there's quite a considerable difference both on the management fee line where it would increase by roughly 50% if we were like other BDC's who charge 2% on assets. And it would also increase at the incentive fee line, if we calculated our incentive fees differently.

Okay, great. Thank you, David.

(Operator Instructions) Our next question comes from the line of Casey Alexander from Gilford Securities.

Looking at your presentation, it shows that you've had the highest yield on your pay offs of any time in recent history. Is that kind of due to the seasoning of the portfolio, or is that more a one off of a pay off that happened this quarter?

You know, I think I'd be very careful. I think more the latter. It's not off a big end, right? You've got roughly $40 million of pay offs, so in any one quarter that number can be highly impacted on by what happens to have paid off.

Okay. I think my other questions were answered. Hang on. Yes, that was it, thank you.

Our next question comes from the line of David Miyazaki from Confluence Investment Management. Please proceed with your question.

Hello, thank you for taking my question, David. Just a quick comment. We are obviously big fans of your fee structure, so we would like to see that spread throughout the industry. And of course, we are also fans of your philosophical opposition to issuing equity below NAV, so I just wanted to make that comment. A couple other things. With regard to -- there's a lot of work that's been done with regard to vintages and how they perform. We've seen a lot of problems come out with the '06 and '07 vintages and then the '08 and '09 vintages for underwriting have been very good. How do you think that the '11 vintage is going to play out over the next few years for the industry? Not necessarily for you guys.

I think the '11 vintage will be unusually strong in terms of credit results. I think that there's a longstanding pattern in this industry which is that the first couple of years after a downturn, credit results are particularly strong for those vintages. It's largely a function of a combination of conservative capital structures, and businesses that are being underwritten off of trough EBITDA, cyclically trough EBITDA. So the easiest time in our business to underwrite credit is shortly after a downturn has ended. So my expectation would be '11 would look pretty good.

And I guess that's even considering the fact that, in the first half of the year we did see some tightening of spreads and some loosening of covenants a little bit. But you don't think that it got to the point in the industry where that's going to compromise the overall vintage for the year?

That's correct. I think that again, I think your statement is exactly right which is, we saw some tightening of spreads and some loosening of credit standards, but even when that was most profound which was the June, July area before the August changes in credit markets generally. We still were looking at overall structures with typically 40% junior capital, 40% equity in them and with -- not a cyclically high EBITDA so EBITDA that was still -- had positive momentum. So look, I think the factor that could make me wrong is if we have a gigantic explosion in Europe which causes a double dip recession of profound proportions in the US. I think that's a possibility, but I don't think that's, I think that's a low probability event right now. I think the much more likely scenario is one of continuing muddling growth in our economy, and in that scenario, my expectation would be 2011 underwriting would holdup pretty well.

Okay, great. That's very helpful, and then you talked a little bit about the origination post the end of the quarter, and pardon me if I missed this, but have you seen a lot of repayments since the end of the quarter?

We did not comment in our comments about repayments. I take it back. We did. Ross, go ahead.

Yes, no, we've seen about $33 million of repayments through November, so certainly a little bit higher than where we ended up this past quarter which was what, $28 million in repayments, so it will be a little bit higher this quarter but not a significant increase in prepayments.

Okay, thanks a lot guys.

There's a little bit of uncertainty, I just want to add an asterisk around that. You always get somewhat surprised by some prepayments around 12-31, as borrowers look to use some excess cash sometimes to pay down debt balances. So I want to just add the asterisk there that we haven't seen this whole movie yet on repayments in this quarter.

And our next question is from the line of JT Rogers from Janney Montgomery Scott. Please proceed with your question.

Good afternoon, David. Given where the market is right now, what is your alls ideal asset mix and how long does it take to get there given the current pace of investment and repayment you're seeing?

That's a great question. So let's flip to Page 4 of the presentation that has the asset mix progression quarter-over-quarter that Ross referenced in his comments. And if you look at that chart, you can see that we're currently running with roughly 44% senior secured debt, 39% unitranch, 15% second lien and sub debt and 2% equity. Our ideal would be approximately 10% less in senior secured debt with that 10% mixed between the other asset categories. I think we want to be dynamic in this. It's not a one-time set and forget type mix goal, but if you ask me today where I'd like us to be that would be a good approximation of where I'd like us to be. And I think we will make substantial progress toward that goal in the 12-31 quarter. So I think you can see in this chart as Ross pointed out, we've moved the mix over 20 points in a year, and we're talking about moving it approximately 10 more, and we shared with you the numbers for our originations to date this quarter. So I think we're pretty close. We're pretty close.

And it looks like you're continuing to rotate a portfolio at a good pace in December, definitely on the numbers you shared. Are there any industries that you're focusing on given the macro environment or are there any -- anything that you all are stressing for new investments?

When you say stressing, do you mean avoiding or do you mean emphasizing?

Focusing on. Either way, are there any industries you're avoiding in particular or there industries that you are focused on that you like the growth you like the fundamentals you're seeing in them?

I'd say no real change from where we've been for quite some time. We're avoiding businesses in industries that are particularly economically sensitive. For example, anything construction related, or real estate focused, we're avoiding. We have found significant opportunities in mission critical business-to-business software, and in areas within healthcare services where there's not a lot of reimbursement risk Medicare, Medicaid reimbursement risk. We're very focused on avoiding Medicare and Medicaid reimbursement risk within our healthcare portfolio. So I would say resilient sectors, defensive sectors, are of particular interest to us, and if I were to cite two that we found a fair bit of opportunity in recently, it would be mission critical business-to-business software and healthcare service away from Medicare and Medicaid reimbursement risk.

Great. Just one last question. From a credit perspective, for the $45.1 million of free ranked investments you have in the portfolio, what are the trends you're seeing in those assets generally? Are they improving? Are they getting worse?

Again, very good question. I'd say as a generalization across our portfolios, we're seeing most companies showing improved profitability year-over-year despite the widely reported economic statistics that caused a market change in sentiment in August. So on the ground, what I think of as being the main street results as a generalization, we're seeing businesses continue to succeed in generating improvements on a year-over-year basis. Having said that, there's some isolated examples where that's not the case, which is pretty normal. It's hard for me to gauge any patterns or conclusions from those exceptions from our portfolio. They just seem to be exceptions.

Great. Thanks a lot.

Our final question comes from the line of Ross Haberman from Haberman Management. Please proceed with your question.

I just had two quick questions. I was wondering, I got on a little late, if you could shed some more light on some of your problem children as you describe them? And are they actually, any of them in default or bankruptcy today?

So we have, if you look at Slide 10, we have $2.89 million in our number two ranked category, that consists of three loans. Two of those loans we wrote down in the quarter, one of them is a company called Den-Mat, which we actually -- the company was sold this quarter and so we're now out of that situation. The two others fall into this category of, as I said, just kind of exceptional cases that don't reflect particular trends we see across the portfolio. One of them is American Fire Protection and the other is Promise Solutions. The good news is, these are small positions and we're cautiously optimistic that we're not going to see further losses on these three positions. But one of the fun parts of this job is that we get to deal with work out credits, and it's one of the things I think we at Golub Capital do really well, but I'm being a little sarcastic. It's not so much fun. It's just a slog to deal with situations where companies are not performing at the level that you'd like them to be performing in.

I know you haven't done a lot of experience with this but typically, will you just want to get rid of it and write it down or if it goes through bankruptcy will you end up taking it up and say convert it to equity? Will you go through the whole conversion or try to get rid of it as quickly as possible, and not spend the time and the effort on it because as you said it's a small position and not worth the time?

Our philosophy on it is that we're in the business of maximizing recovery value, and every nickel counts, and so if the right answer from the standpoint of maximizing recovery value is for us to convert our position to equity and basically become the owner of the company, we'll do that. We have the capability to do that. We've done that before. If the right answer is to have the company be sold and to take our licks and keep moving, then we'll do that. It's very specific, granular decisions that are -- got to be based on the facts and circumstances of that credit. One of the advantages that we have with our scale is that we have a specialist work out department, and we have great people there and whatever needs to be done, we can do.

Got it and just I just have one follow-up question regarding you talked about growth of the subordinated debt group. How big would you grow that is the first question and do you in many cases also have the senior debt in those same credits?

How big would we grow that? So if you look again at that chart that we were talking about with respect to mix, on Page 4 of the presentation, we right now are at about 15% in second lien and subordinated debt, and I can see in an environment where second lien and subordinated debt assets were particularly attractive that we could grow that to as high as 20% to 25% of the portfolio. So obviously going to be something that we're going to vary based on the attractiveness of those assets relative to unitranch and other assets. Right now we particularly like unitranch assets relative to subordinated debt, so we're more focused on building the unitranch portfolio than we are on building our subordinated debt piece.

That's the first part of your question. The second part was do we tend to own both senior and subordinated debt in the same deal. And the answer is, sometimes yes and sometimes no. It again, is dependent on the nature of the particular credit that we're talking about and sometimes we see advantages to being in both and sometimes we only want to be in one or the other.

Got it. Again the best of luck. Appreciate the help.

There are no further questions at this time. I'll turn the call back to you.

Thank you. Well, again, on behalf of both Ross and myself, we appreciate your taking the time to join us today for the update on Golub Capital BDC, and as always, if you have further questions, please feel free to call either of us. Look forward to speaking to you again in a quarter.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.