Bain Capital Specialty Finance - Q2 2023

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the Bain Capital Specialty Finance Q2 ended June 30th 2023 earnings conference call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. If at any time during this call you require immediate assistance, please press star zero for operator. This call is being recorded on Wednesday, August 9th 2023. I would now like to turn the conference over to Katherine Schneider, Director of Investor Relations. Please go ahead.

Katherine Schneider (Director of Investor Relations)

Thanks, Enzo. Good morning, welcome everyone to our Bain Capital Specialty Finance Q2 ended June 30th 2023 earnings conference call. Yesterday, after market closed, we issued our earnings press release and investor presentation of our quarterly results, a copy of which is available on Bain Capital Specialty Finance's Investor Relations website. Following our remarks today, we will hold a question-and-answer session for analysts and investors. This call is being webcast, a replay will be available on our website. This call and the webcast are property of Bain Capital Specialty Finance, any unauthorized broadcast in any form is strictly prohibited. Any forward-looking statements made today do not guarantee future performance, actual results may differ materially.

These statements are based on current management expectations, which includes risks and uncertainties, which are identified in the Risk Factors section of our Form 10-Q that could cause actual results to differ materially from those indicated. Bain Capital Specialty Finance assumes no obligation to update any forward-looking statements at this time, unless required to do so by law. Lastly, past performance does not guarantee future results. With that, I'd like to turn the call over to our CEO, Michael Ewald.

Michael Ewald (CEO)

Thanks, Katherine, good morning to all of you, and thanks for joining us here on our earnings call today. I'm also joined by Mike Boyle, our President, and our Chief Financial Officer, Sally Dornaus. I'll start with an overview of our Q2 and the June 30 2023 results, and then provide some thoughts on our performance, the overall market environment, and our positioning. Thereafter, Mike and Sally will discuss our investment portfolio and financial results in greater detail. Yesterday, after market closed, we delivered strong earnings results. Q2 net investment income per share was $0.60, an increase of 20% quarter-over-quarter, driven by the continued benefit of higher interest rates across our portfolio.

Our net investment income return represented an annualized yield of 13.9% on book value and was well in excess of our Q2 dividend, demonstrating 158% NII dividend coverage. Q2 earnings per share were $0.45, driven by stable credit quality across our portfolio investments during the quarter. Our net income produced an annualized return on book value of 10.4%. These results in turn led to modest NAV growth during the quarter. Net asset value per share as of June 30th was $17.44, reflecting a 40 basis point increase from our $17.37 NAV as of March 31st.

With all that, we're very pleased to announce that our board increased our regular quarterly dividend by $0.04 per share, up 10.5% to $0.42 per share to shareholders of record as of September 29 2023. This represents an annualized yield of 9.6% on ending book value as of June 30th and an 11% annualized yield at BCSF's current trading levels. Importantly, this increase is in the regular dividend rate, represents the third increase for our shareholders in the past 12 months. Our dividend framework seeks to provide our shareholders with an attractive rate of return, while also seeking an appropriate level of cushion for future NAV stability and growth.

As we have been evaluating our dividend policy with our board throughout the past year, in light of higher earnings, we believe it is important to provide our shareholders the benefit of the higher income that the company is generating, while remaining prudent in setting the regular dividend level to a rate that the company can earn under various interest rates and economic scenarios. In the current environment, we believe the company remains well positioned to generate net investment income in excess of our newly announced dividend rate, while staying consistent with our objective of achieving NAV stability and growth over time. Our spillover income is estimated to be approximately $0.66 per share, which we believe is a healthy amount and provides for increased dividend stability. We expect to evaluate the potential for any additional distributions as we near the end of the year.

Turning now to the market environment. New middle-market loan volumes picked up a bit during the Q2 from Q1 levels. However, volumes remain low overall as compared to recent years, given muted LBO activity, as buyers and sellers continue their struggle to find enterprise value equilibrium in the current market environment. As the private credit markets have continued to grow in recent years, both on the supply and demand side of the equation, the value of a well-established direct lending platform with long-standing relationships and expertise is increasingly important to not only source attractive investments, but also have deep resources to diligence and work through complex situations.

For the new companies in which our private credit group platform invested during the Q2, we leveraged our in-house industry expertise within niche verticals such as aerospace and defense, and continued to partner with top-tier sponsors who value our prior relationship, working with them on past investments. We believe the lending environment for middle-market lenders continues to be attractive, given favorable terms and structures that are more lender-friendly. While we have begun to see a small amount of spread compression relative to peak levels in recent quarters, we are still seeing market spread pricing for new first lien term loans between 625 and 700 basis points.

In fact, the weighted average spread on our new portfolio company, first lien debt investments in the Q2, was approximately 670 basis points, which produced a weighted average yield of 12.2% when factoring in current base rates and amortization of original issue discounts. The weighted average net-to-EBITDA leverage on these new loans was 4.5x, reflecting conservative capital structures. In addition to the new first lien loans in which we invested during the Q2, we also made an initial equity investment into Legacy Corporate Lending HoldCo, LLC, a newly formed portfolio company created to invest in middle-market ABL loans. By way of background to this new investment, Bain Capital Credit recently announced that it formed a partnership with Legacy Corporate Lending, an independent asset-based lending company focused on serving the needs of North American middle-market borrowers.

We believe the ABL space is compelling as the asset class benefits from growing deal volumes and increased non-bank penetration, and provides for attractive risk-adjusted returns with differentiated return profiles. Over the past few years, we've evaluated various acquisition opportunities and whether to buy or build an ABL platform, and we're fortunate to partner with a talented and experienced leadership team who brings years of ABL and commercial lending experience to build the business organically. While our initial investment in the company is modest, we believe it could be an attractive growth investment for BCSF over time and provides us with differentiated deal flow in a market which is tangential and complementary to our existing core middle-market corporate focus.

Our portfolio companies continue to perform well in light of a more complex operating environment, as demonstrated by stable credit quality metrics across our portfolio, with no investments added to non-accrual status during the quarter. Almost 40% of our investments were originated after January 1 2022, a period when rising rates and higher expectations of an economic slowdown were very much central to the investment decision. Overall, we feel good about the health and quality of our portfolio, as our underlying borrowers have largely proven to be defensible thus far this year. I will now turn the call over to Mike Boyle, our President, to walk through our investment portfolio in greater detail. Mike?

Mike Boyle (President)

Thank you, Mike. Good morning, everyone. I'll start with our investment activity for the Q2 and then provide an update on our portfolio. New investment fundings during the Q2 were $198 million across 46 portfolio companies, including $120 million into six new companies. Sales and repayment activity totaled approximately $228 million, resulting in a net funded portfolio decline of $30 million quarter-over-quarter. This quarter, we remained focused on investing in first lien senior secured loans, with 81% of our new funding within first lien structures and 15% in investment vehicles, which comprised an additional $30 million contribution to our Senior Loan Program. The remaining 4% was comprised of equity investments, driven primarily by our new investment to Legacy Corporate Lending that Mike Ewald just highlighted.

With new originations, we continue to leverage our long-standing relationships with private equity sponsors who value our ability to minimize execution risk when financing their deals, paired with our deep industry expertise across many niche verticals. Turning to the investment portfolio, at the end of the Q2, the size of our portfolio at fair value was approximately $2.4 billion across a highly diversified set of 142 companies operating across 30 different industries. We have continued to grow our diversification by portfolio company with the highest number of borrowers within our portfolio since inception, growing 16% year-over-year. Our portfolio primarily consists of investments in first lien loans, given our focus on downside management and investing in the top of capital structures.

As of June 30th, 64% of the investment portfolio at fair value was invested in first lien debt, 4% in second lien debt, 2% in subordinated debt, 4% in preferred equity, 11% in equity and other interests, and 15% in our joint ventures. As we have highlighted to our shareholders in prior earnings calls, the decline in our stated first lien exposure has come down given the growth of our investment vehicles. Notably, 95% of the underlying investments held in these vehicles consist of first lien loans, resulting in a look-through first lien exposure of approximately 82% across the entire portfolio. We remain focused on investing in structures that provide us with strong lender controls.

94% of our investments are structured with documentation containing financial covenants tied to management forecasts, and we have majority control positions in nearly 80% of our debt tranches, allowing us to drive eventual outcomes at our discretion. As of June 30 2023, the weighted average yield of the portfolio at amortized cost and fair value were 12.8% and 13%, respectively, as compared to 12.3% and 12.5%, respectively, as of March 31 2023. This increase was primarily driven by higher reference rates across the portfolio. 94% of our debt investments bear interest at a floating rate, positioning the company favorably as interest rates have continued to rise beyond reference rate floors. During the quarter, we continued to execute on our investment strategies within our joint ventures.

Our JV investments represented 15% of our overall portfolio at fair value, including 10% in the International Senior Loan Program, or ISLP, and 5% in the Senior Loan Program, the SLP. ISLP's investment portfolio as of June 30th was approximately $687 million, comprised of investments in 39 companies. 98% of the portfolio was invested in senior secured floating-rate loans. As of June 30th, SLP's investment portfolio was approximately $830 million, comprised of investments in 60 different portfolio companies. 100% of that investment portfolio was invested in senior secured loans. Moving on to portfolio trends. Credit quality was stable quarter-over-quarter.

Michael Ewald (CEO)

Within our internal risk rating scale, 91% of our portfolio as of June thirtieth, was comprised of risk rating one and two investments, indicating that the company was performing in line or better than expectations relative to our initial underwrite. Risk rating three investments comprised 9% of our portfolio at fair value. These investments reflect companies that have been impacted by inflationary impacts and rising interest rates. We remain focused on watching these companies closely. Risk rating four investments comprise 0% of our portfolio at fair value and included two portfolio companies on nonaccrual. No new investments were added to nonaccrual during the quarter. Overall, we believe our credit fundamentals remain solid across our portfolio. Our median leverage is 5.1x as of June 30th, as compared to 4.9x as of March 31st, and our median EBITDA of the portfolio was $58 million. I'll turn it over now to Sally, who will provide a more detailed financial review.

Sally Dornaus (CFO)

Thank you, Mike, and good morning, everyone. I'll start the review of our Q2 2023 results with our income statement. Total investment income was $75.7 million for the three months ended June 30th 2023, as compared to $74.7 million for the three months ended March 31st 2023. The increase in investment income was primarily driven by the benefit of rising interest rates across our large portfolio of senior secured floating rate loans, partially offset by lower other income. BCSF continues to benefit from high-quality sources of investment income, largely driven by contractual cash income across its investments. Interest income and dividend income represented 97% of our total investment income in Q2, with prepayment-related income representing less than 1%. Other income comprised only 3% of our total investment income.

Total expenses for the Q2 were $35.7 million, as compared to $42 million in the Q1. The decrease in expenses was driven by lower incentive fees. Net investment income for the quarter was $38.9 million, or $0.60 per share, as compared to $32.2 million, or $0.50 per share for the prior quarter. During the three months ended June 30 2023, the company had net realized and unrealized losses of $9.7 million. Net income for the three months ended June 30 2023, was $29.2 million, or $0.45 per share. Moving over to our balance sheet. As of June 30, our investment portfolio at fair value totaled $2.4 billion, and total assets of $2.7 billion.

Total net assets were $1.1 billion as of June 30th. NAV per share was $17.44, up from $17.37 at the end of the Q1, representing a 0.4% increase quarter-over-quarter. The increase in our NAV was driven by the outearning of our dividend, coupled with the relative stability in the value of our investments during the quarter. At the end of Q2, our debt-to-equity ratio was 1.33x as compared to 1.26x from the end of Q1. Our net leverage ratio, which represents principal debt outstanding less cash and unsettled trades, was 1.13x at the end of Q2 as compared to 1.16x at the end of Q1.

We are comfortable operating in the middle of our net target leverage ratio between 1x and 1.25x. As of June 30th, approximately 60% of our outstanding debt was in floating rate debt and 40% in fixed rate. The company does not have any debt maturities until 2026, and the weighted average maturity across our total debt commitments was 4.8 years at June 30th. Our debt funding continues to benefit from low fixed rate debt structures as we access the unsecured markets during a period of low interest rates. The weighted average interest rate on our unsecured notes is 2.75%. For the three months ended June 30th 2023, the weighted average interest rate on our debt outstanding was 5.2%, as compared to 5% as of the prior quarter end.

The increase was driven by higher SOFR rates on our floating rate debt structures. Liquidity at quarter end totaled $329 million, including $104 million of undrawn capacity on our revolving credit facility, $129 million of cash and cash equivalents, including $36 million of restricted cash and $96 million of unsettled trades, net of receivables and payables of investments. With that, I will turn the call back over to Mike for closing remarks.

Michael Ewald (CEO)

Thanks, Sally. In closing, we are pleased to deliver another quarter of strong earnings for our shareholders with NII well in excess of our dividend and NAV growth as our underlying borrowers continue to perform well. We're also delighted to deliver another regular dividend increase, reflecting the company's continued earnings growth and stability. Bain Capital Credit remains well positioned to execute on its direct lending strategy, given our platform's expertise, resources and relationships that have been built on 25 years of experience investing in this middle market. We remain committed to delivering value for our shareholders through producing attractive ROEs, and thank you for the privilege of managing our shareholders' capital. Sindhu, please open the line for questions.

Operator (participant)

Thank you. Ladies and gentlemen, we will now begin the question and answer session. Should you have a question, please press the star followed by the one on your touchtone phone. You will hear a three-tone prompt acknowledging your request. If you would like to withdraw your request, please press the star followed by the two. Once again, to register for a question, please press star followed by the one on your touchtone phone. There will be a brief pause while questions are being registered. Thank you. Our first question comes from Ryan Lynch from KBW. Please go ahead. Your line is open.

Ryan Lynch (Managing Director of Equity Research)

Hey, good morning. Thanks for taking my questions and, and really nice quarter. First one I had was just on the, the Legacy Corporate Lending investment. The investments that are made in, in that vehicle, will those all, show up as investments in that portfolio company, or will you be making any investments from that team? Will any of those investments go directly on your balance sheet?

Mike Boyle (President)

Hi, good morning, Ryan. Thanks for the question. All of the investments will end up in that, in that entity, so they won't be directly on our balance sheet.

Ryan Lynch (Managing Director of Equity Research)

Okay. Then what is kind of the expectation? I know it's a new investment, kind of a new formation of a strategy and a team at your company. I mean, what is sort of the goal for kind of growth of that business, you know, over the next year or two?

Mike Boyle (President)

Sure. We've modeled a number of different scenarios depending on how the market evolves over the next year or two. I think in our base case, we could see that growing to be a 5% position in the portfolio. There is, you know, potential upside from there if we think the market opportunity continues to be compelling, to be slightly larger than 5% over time.

Ryan Lynch (Managing Director of Equity Research)

Okay. On that, I guess, I guess it depends on what sort of specific investment they're making, because it sounds like that team can do a lot of things. I would assume, you know, accounts receivable financing is probably going to have a different, you know, return than like a machine or equipment financing. I guess, what are sort of the overall returns that are expected on those investments? Are those investments are going to be financed with, I'm assuming, a combination of capital from Bain as well as leverage in that entity? Ultimately, when this entity gets sort of full scale or scaled, which I'm not sure of the timeframe of that, but it sounds like, you know, there, there'll be a period of time before it does that, what sort of return, what is the return expectation that you, that you hope to generate from this investment?

Mike Boyle (President)

Sure. Baseline returns that we're looking at for the investment on the equity are about, you know, 15%-16%. We do think they'll be slightly lower than that as we ramp and build diversification, but we do have an expectation that over the next six to 12 months, that portfolio should be operating at that mid-teen level of return. Given the highly cash-generative nature of those investments, we think it will be, you know, producing some nice net investment income for BCSF over time.

Ryan Lynch (Managing Director of Equity Research)

How will they, how will they be financed? Will you finance with leverage also in, in the fund as well?

Mike Boyle (President)

Yes. It's a, it's a combination, so there will be some leverage at the, at the, the company, but then we'll also be contributing equity every time we make a new loan.

Ryan Lynch (Managing Director of Equity Research)

What sort of leverage, roughly, would you expect to run that, operate that entity at?

Mike Boyle (President)

Yeah, probably between 2x and 3x, 2x and 3x leverage.

Ryan Lynch (Managing Director of Equity Research)

Okay. All right, I appreciate all the comments on that. The, the other question I had was, you mentioned, which is, Mike, you mentioned, that you're starting to see a little bit of tightening in, in spreads. Still, still very attractive spreads in the marketplace, but starting to, you know, kind of see a little bit of tightening, which is not uncommon and not, not something. Is something we've heard from, from other platforms out there today. I'm just curious, outside of the little bit of spread tightening, are there any other, sort of changes in, in the quality of deals? Whether are you starting to see any sort of pressure on any other terms or, or structures besides just the spreads, for the new deals out there, while still keeping in mind that the, you know, the overall deals are still a, a really good environment for, for deploying capital?

Michael Ewald (CEO)

Yeah, Ryan, you know, not really, I think is the short answer. We're definitely seeing some, some pressure on that spread, like we said, call it 25-50 basis points. As you point out, on, you know, 11%-12% kind of percent returns at the asset level, that's not really that, that big a move necessarily. On the leverage front, that's another, you know, pinch point at times. As you saw, our average for last quarter was about 4.5x, so that's still pretty conservative. That's really driven by the math, you know, given how high rates, base rates are, how much debt can a company afford? Cutting 25 basis points out to spread is really not going to alter that much. We haven't seen pressure there.

The third pressure point then would be just general documentation, things like covenants. You know, as you know, our, our, our, our philosophy is very much focused on getting financial covenants in, in over 90% of our deals. That's really at least a term that we would not give on. And other documentation terms like EBITDA definitions and things like that are still, in our estimation, pretty tight and pretty lender-friendly. It really has just been a little bit on the spread side where we've seen the competition.

Ryan Lynch (Managing Director of Equity Research)

Okay, understood. That's all for me. Nice quarter, and I appreciate the time today.

Michael Ewald (CEO)

Thanks, Ryan.

Operator (participant)

Thank you. Our next question comes from Derek Hewett, from Bank of America. Please go ahead. Your line is open.

Derek Hewett (Senior Equity Research Analyst)

Good morning, everyone, and congrats on, on the good quarter. My first question is about the incentive fee. It was a little bit lower than expected. Was the calculation, was that impacted by the realized losses during the quarter? Should we expect the, the fee to the incentive fee to normalize beginning in the Q3?

Sally Dornaus (CFO)

Yeah, so it, it doesn't, it, it doesn't have to do with this quarter. It's because of our look back and the COVID quarter, causing a bit of noise. When you do the calculation on a cumulative basis, and you take what you, what you've taken prior, you, you would have noticed last quarter and the quarter before were sort of at an elevated rate. it's gonna cause this quarter and the next quarter to be slightly lower, and then it'll start to normalize again.

Derek Hewett (Senior Equity Research Analyst)

Okay. Thank you [crosstalk].

Sally Dornaus (CFO)

Just the way the math kind of shakes out.

Derek Hewett (Senior Equity Research Analyst)

Yeah. Okay, that makes sense. Then the yield on the international JVs in aggregate remained really attractive. How should we think about the growth in that international JV portfolio going forward? Do you wanna kinda keep it where it's at, at a roughly 15% of the overall portfolio? Do you think there's a little bit more room for growth?

Michael Ewald (CEO)

There is some room for growth, Derek, but I don't think it'll be, you know, it'll be a couple percentage points, not, you know, not a step function in terms of growth. We are continuing to see interesting opportunities, particularly internationally. I would note there has been some churn in that portfolio as well, where we're able to replace assets that are harvesting with new assets. Limited growth there, but we have been very pleased with the yield profile coming out of, of both joint ventures.

Derek Hewett (Senior Equity Research Analyst)

Okay, great. Then my last question is just around the, the overall funding strategy. I mean, you, you, you have some time because your bonds aren't due for another few years or so, but all, all of the bonds are due in 2026. Just given what we've seen, some other BDCs do within the funding unsecured funding markets recently, what is, what is the strategy in, in terms of kind of staggering the bond maturities?

Michael Ewald (CEO)

We are focused on looking at laddering maturities and recognize that the unsecured market is, you know, is open today. We are, you know, managing the fact that we do have plenty of runway to the existing securities. So we're, we're always managing when the market is open, vis-a-vis the needs of the existing liability stack.

Derek Hewett (Senior Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from Arren Cyganovich from Citi. Please go ahead. Your line is now open.

Arren Cyganovich (VP and Equity Research Analyst)

Thanks. In your commentary, you mentioned kind of a muted LBO activity, with buyers and sellers kind of having a hard time reaching equilibrium. You know, what do you think will, will, will get them to, you know, move on and, you know, you have any idea of, of timeframe when, when that could open back up?

Michael Ewald (CEO)

Yeah, Arren, look, it's a good question. Yeah, I think there's a little bit of, of probably pent-up-ness, right, that's happening, in, in the sponsored market, that there's obviously plenty of dry powder there. While it took a pause, I think, you know, there's gonna be increasing pressure to actually invest. I think there's also, a matter of once we start getting some economic stability, and understanding what, whether there's a recession, if there's gonna be a recession, and what the recovery looks like, so you can get a little more confidence about, different growth vectors. I think at that point, sponsors are certainly gonna be, willing to potentially pay more for assets, on a forward-looking basis than, than they might be right now. I, I think that's all part and parcel with it.

In talking to advisors in the space, you know, kind of the tip of the spear, there, there seems to be an increase or an uptick in pitch volume there. Yeah, that then translates into an actual transaction, you know, several weeks or a couple of months later. From a timing perspective, it does seem like, there could be a rush post-Labor Day to get some fresh, fresh deals out into the market. We're hopeful that the second half of the year ends up picking up a little better than, I guess, the fourth quarter of the year starts picking up a little bit more.

Arren Cyganovich (VP and Equity Research Analyst)

Thank you.

Operator (participant)

Thank you. As a reminder, if you do wish to register for a question, please press star followed by the one on your telephone keypad. One moment. Thank you. There appear to be no further questions. I'll return the conference back to Michael Ewald for closing remarks.

Michael Ewald (CEO)

Great. thanks, Sindhu, and thanks again for everyone's time and attention today. We're very pleased to share the results of the Q2 here with you. We look forward to talking with you again soon. Thanks very much.

Operator (participant)

Thank you. This does conclude today's conference call. Thank you all for attending. You may now disconnect your lines.