Imperial Optical Midco, Inc.: Restructured in IIQ 2024

Rated CCR 3 Following Restructuring. Not An Important Underperformer

August 16, 2024

A great deal has happened at Imperial Optical Midco in a short time - a company that we've had no reason to write about before. As of the IQ 2024, the company's $139mn in unitranche loans were valued at a modest (14%) discount to cost and its very small preferred and equity stakes had been written down to zero. The company was rated 3 on our 5 point scale and - frankly - not on our "trouble ahead" radar. Now we hear from Golub Capital (GBDC) - which just became Imperial's sole BDC lender following the acquisition in early June 2023 of non-traded Golub Capital BDC 3, which had previously also been involved - that things had gone terribly wrong:

Imperial Optical is a full-service vision care platform that offers optometric patient care and retail eyewear products through 280 locations across the U.S. Our exposure to Imperial Optical at March 31, 2024, consisted of $96.9 million base amount of senior secured debt at premerger GBDC and $41.7 million base amount at premerger GBDC 3.

The company has been underperforming our and the sponsor's expectations for some time. With the support of the sponsor, last year, we undertook a two-pronged strategy. First, the company implemented an operating turnaround plan, including a new CEO. Second, it explored strategic alternatives. As of 03/31/2024, we believe there was a high probability of a strategic exit. However, over the course of the quarter end at 06/30, it became clear this was not going to happen. Accordingly, we shifted to a singular focus on the operating turnaround. We rightsized its capital structure and took control of the equity and Board. We worked closely with existing management and other key stakeholders to ensure alignment. This restructuring drove the majority of GBDC's net realized and unrealized loss in the quarter.

Emphasis is ours.

By the end of the IIQ 2024, GBDC's exposure following this debt for equity swap amounted to a $41mn - at cost - unitranche loan due in 2029 and $54mn in "LLC Units". Both positions are valued at cost given that they are freshly minted. The net realized loss involved - a number which GBDC never specifically mentions in its filings - was somewhere between ($35mn) and ($38mn).

For GBDC, which prides itself on a long track record of almost spotless credit underwriting and a highly granular portfolio where the average individual exposure - before the merger - was only $15mn, this is already a major credit reverse. (Not helping matters is that GBDC is also a lender to Pluralsight - another company in deep trouble which is undergoing a debt for equity swap and also likely to show up as a realized loss in the next couple of quarters). Management did not shy from admitting the reverses - calling them "disappointing".

The BDC has one of the better long-term track records where net realized losses are concerned. From September 2018 to June 2024, total permanent losses have amounted to only ($89mn) - a pittance for a BDC with a portfolio approaching $8bn at cost and with $4.2bn of par equity. Those losses amount to only (8%) of what GBDC has generated in Net Investment Income over the given period. However, Imperial accounts for roughly 40% of all net realized losses since the end of 2018...

The Imperial Optical episode does underscore the danger of taking on too much single name exposure. The total cost of capital advanced before the restructuring was $138mn, nearly 7x its post-merger average of $21mn. The shareholders of GBDC - both the old and the new - will have to hope the company will eventually be sold for a large gain that will offset some percentage of this quarter's realized loss. In the interim, though, we calculate that approximately ($15mn) of annual interest income has been forgone. That's equal to about (2%) of the BDC's annual revenues and (4%) its Net Investment Income, going by the latest results.

From an administrative standpoint, we have written down the company from a corporate credit rating rating of 3 to a 5, to reflect the restructuring and loss of capital and immediately written the now-GBDC controlled business back to a 3 again. Given that the business is de-leveraged; interest is being charged at only 1% over the reference rate and the capital is valued at cost, Imperial Optical is not going to be listed as an Important Underperformer.

The main point of that denotation is to warn of possible losses ahead. As we've seen, those have already occurred and - may we say - chipped away at GBDC's valuation credibility. To discount debt by only (14%) for a business that shortly after recorded a (25%)-(27%) realized loss is disturbing to those of us relying on the quarterly valuations to make informed investment decisions. We'll chalk this one up as an exception to the rule given GBDC's long history of previously getting this right. Like Ronald Reagan, though, we shall "doveryai, no proveryai" ("trust but verify" ).

We are in the midst of undertaking a full portfolio of GBDC's 380 companies. Through the IQ 2024, we rated the BDC's credit performance as ABOVE AVERAGE based on a multitude of data points, some of which are quoted above. That may change following our latest survey.

Readers may want to review the database of GBDC's Important Underperformers, which we're in the process of updating. There are 6 Company Files currently - including Pluralsight - and ($40mn) in further losses projected but that may change in either direction after we complete our research and update the holdings.