Bain Capital Specialty Finance - Q4 2022

Transcript

Operator (participant)

Greetings, welcome to the Bain Capital Specialty Finance Q4 and fiscal year earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Katherine Schneider, Investor Relations. Please go ahead, ma'am.

Katherine Schneider (Director of Investor Relations)

Thanks, Rana. Good morning, everyone, and welcome to Bain Capital Specialty Finance Q4 and year-ended December 31, 2022 conference call. Yesterday, after market close, we issued our earnings press release and investor presentation of our quarterly and year-end results, copy of which are 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, and a replay will be made available on our website. This call and the webcast are property of Bain Capital Specialty Finance, and any unauthorized broadcast in any form is strictly prohibited. Any forward-looking statements made today do not guarantee future performance, and actual results may differ materially.

These statements are based on current management expectations, which include risks and uncertainties, which are identified in the Risk Factors section of our Form 10-K 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 Chief Executive Officer, Michael Ewald.

Michael Ewald (CEO)

Thank you, Katherine. Good morning, everyone, and thank you for joining us on our earnings call today. I'm here with Mike Boyle, our President, and our Chief Financial Officer, Sally Dornaus. I'll start with an overview of our Q4 and year-ended December 31st, 2022 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. Beginning with our results, Q4 net investment income per share was $0.37, equating to an annualized yield on average book value of 8.7%. Our net investment income covered our dividend by 103% during the Q4. Q4 earnings per share were $0.67, equating to an annualized return on average book value of 15.7%.

For the full year 2022, Net Investment Income per share was $1.59, equal to a 9.3% return on equity. This was up over 100 basis points from our 2021 NII return on equity. Our NII covered our dividend by 115% during the year. Earnings per share for 2022 were $1.63, representing a total return on equity of 9.8% for the full year of 2022. Consistent with our 2021 earnings, our annual net earnings exceeded our dividend payout for a second consecutive year.

We believe this is an important metric for measuring not only attractive levels of Net Investment Income generated across our portfolio, but also overall credit performance of our portfolio and is a testament to Bain Capital Credit's experience investing in the middle market. Our returns were driven by high-quality interest income earned from our middle market borrowers and strong credit performance as demonstrated by overall net realized and unrealized gains across our portfolio during both the Q4 and full year. Our Net Asset Value ended the year at $17.29 per share, up from $16.98 from the previous quarter and up from $17.04 as of Q4 2021, reflecting the portfolio's strength.

We are especially pleased with the strong performance in 2022 during a period of greater market volatility that occurred throughout the H2 of the year. At year-end, we estimate that our spillover income per share is approximately $0.32. We believe this is a healthy amount of undistributed income and beneficial to the stability of our dividend. For the second consecutive quarter, our board increased our regularly quarterly dividend by approximately 6% or $0.02 per share to $0.38 per share to shareholders of record as of March 31st, 2023. This represents an annualized yield of 8.8% on book value as of December 31st. On a year-over-year basis, we increased our regular dividend level by 12%, driven by the higher levels of interest income being generated by the company.

Our Q1 regular dividend represents an 11.7% annualized yield based on BCSF's current trading levels. We believe this is a very compelling level for investors on both an absolute and relative value basis across the BDC sector. Our investment portfolio is largely comprised of a highly diversified portfolio of first lien, senior secured floating rate notes. The strong credit quality health of our portfolio is reflected by low non-accrual rates, as over 98% of our debt investments at fair value are performing loans that are paying interest currently pursuant to their contractual terms. Furthermore, we are in a solid capital structure position, with over 40% of our outstanding liabilities comprised of low-cost fixed-rate debt maturing in 2026.

We ended the Q4 with a net leverage ratio of 1.14x, right in the middle of our target range of between 1.0 and 1.25x, providing us with additional dry powder to capitalize on new investments in the current environment. As compared to prior loan vintages in recent years, we are seeing higher market spreads, tighter documentation, and more favorable overall structures. While we see compelling returns within the middle market opportunity set, we are also mindful of high inflation, high interest rates, and a slow growth economic backdrop for middle market companies. We believe having a disciplined investment approach and prior experience investing through several cycles will be increasingly important to navigate potential risks ahead. Bain Capital Credit has 25 years of experience investing in the middle market, and our senior leadership has remained consistent over that long-standing history.

Given the current market backdrop, we have heightened our focus on our portfolio companies' debt service coverage and free cash flow metrics. For companies that are on our watch list, we are looking ahead and focusing on our alignment with private equity sponsors on near-term value preservation and liquidity management. This is especially important to get ahead of any potential issues that may arise so we can identify problems early and preserve value to maximize our outcome in any downside scenario. 93% of our debt investments are structured with documentation containing financial covenants tied directly to management's forecasts, and we have majority control positions in 80% of our debt tranches, allowing us to drive eventual outcomes at our direction.

Bain Capital Credit's industry research team continues to provide us with even deeper sector expertise across many verticals and allows us to uncover companies in niche industries that are expected to be strong performers over the coming years. Recently, we have been digging in further to uncover industries that may have less susceptibility to inflationary pressures, and more importantly, we are looking to avoid acutely impacted sectors for new investments. We believe this deep industry expertise will be increasingly important in a higher default cycle and allow us to avoid businesses that may be in more cyclical sectors. We remain focused on resilient companies with rational capital structures and investments that add meaningful insulation to equity volatility. I will now turn the call over to Mike Boyle, our President, to walk through our investment portfolio in greater detail.

Mike Boyle (President)

Thanks, Michael. Good morning, everyone. I'll start with our investment activity for the Q4 and then provide an update and more detail on our portfolio. New investment fundings during the Q4 were $221 million across 44 portfolio companies, including $101 million in five new companies, $102 million in 38 existing companies, and $18 million in the ISLP. Sales and repayment activity totaled approximately $162 million, resulting in net funded portfolio growth of $59 million quarter-over-quarter. For the full year, investment fundings were $1.5 billion. Total sales and repayment activity for the year were $1.4 billion. We were pleased with our ability to modestly grow our investment portfolio size while staying within our net leverage target range.

Our new investing activity for the Q4 and full year are comprised of a mix of new fundings to new portfolio companies and existing portfolio companies. During the year, our new investment fundings, excluding investments in our joint ventures, were comprised of approximately 65% to new companies and 35% to existing companies. Our incumbency advantage across our large portfolio of middle market borrowers provides us with the ability to provide add-on capital to existing borrowers with whom we have an existing relationship. In 2022, we benefited from higher market spreads on new originations. On our first lien investments that we originated to new companies during the Q4, the weighted average spread was approximately 695 basis points, which was 150 basis points higher as compared to our new first lien originations one year ago in Q4 of 2021.

Not only are we able to underwrite new first lien loans at higher spreads and yields, we have also seen leverage levels on new loans decrease as lenders are focused on maintaining leverage-free cash flow and fixed charge coverage ratios. We remain focused on structuring tight documentation, particularly around leverage covenant levels and EBITDA definitions to limit add backs. Turning to the investment portfolio, at the end of the Q4, the size of our investment portfolio at fair value was $2.4 billion across a highly diversified set of 132 portfolio companies operating across 31 distinct industries. We continue to maintain our focus on first lien senior secured structures.

As of December 31st, 68% of the investment portfolio at fair value was invested in first lien debt, 13% in joint ventures, 6% in second lien or subordinated debt, and 13% in preferred or common equity. It is worth highlighting that while the overall percentage of first lien investments have come down over the past year, this is largely attributed to our investment vehicles or joint ventures, which comprise of over 96% first lien senior secured loans. As of December 31st, 2022, the weighted average yield on the investment portfolio at amortized cost and fair value was 11.4% and 11.6% respectively, as compared to 10.2% and 10.6% respectively as of September 30th, 2022. This increase was primarily driven by higher reference rates on our loans.

These yields are also meaningfully higher on a year-over-year basis and up approximately 380 basis points. 95% of our debt investments bear interest at a floating rate, positioning the company favorably as interest rates have continued to rise beyond the reference rate floors across our loans. During the quarter and throughout 2022, we continued to execute on our investment strategies within our joint ventures of investing in senior secured middle-market loans. We continue to see the benefit of higher interest rates flowing through our JVs as almost all of our investments are floating rate loans. At year-end, our JV investments represented 13% of our overall portfolio at fair value and generated strong performance in line with our target expectations.

ISLP generated an annualized income return on equity of 11.5% in Q4 and 10.4% over the course of 2022. ISLP generated an annualized income return on equity of 21.5% in Q4 and 19.5% in 2022. ISLP's investment portfolio at fair value as of December 31st was approximately $708 million, comprised of investments in 38 portfolio companies operating across 17 different industries. 98.5% of the investment portfolio was invested in senior secured floating rate loans, including 96% in first lien, 3% second lien, and 1% in equity interest. As a reminder, our ISLP is our joint venture focused on investing across Europe and Australia, both markets in which Bain Capital Credit has a long-standing presence and experience investing within.

While Europe has experienced greater market volatility throughout 2022 than the U.S., we feel good about the underlying health of our portfolio companies across our diversified portfolio. Our largest sector exposures include business services, high-tech industries, and healthcare and pharmaceutical companies, which have been resilient sectors versus more industrial-focused companies in Europe. As of December 31st, SLP's investment portfolio at fair value was approximately $547 million, comprised of investments in 48 portfolio companies across 21 different industries. 100% of the investment portfolio was in senior secured loans, including 96% in first lien and 4% in second lien. Moving on to portfolio credit quality trends. They were stable quarter-over-quarter.

Within our internal risk rating scale, 91% of our portfolio at fair value as of December 31st 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 8% of our portfolio at fair value. These investments reflect companies that have been impacted by inflationary pressures resulting from supply chain disruptions, higher freight costs and wage pressures, as well as rising interest rates. We remain focused on watching these companies closely. We do not currently anticipate near-term restructurings or defaults. Risk rating four investments comprised less than 2% of our portfolio at fair value and included three portfolio companies on non-accrual. We believe our credit fundamentals remain solid across the portfolio.

Our median portfolio leverage is 5.1 x as of December 31st, down from 5.6xas of September 30th. The net asset value of BCSF benefited from these stable credit trends, as well as the strength of our travel and aviation portfolios, where we have observed continued strong fundamental performance. Sally will now provide a more detailed financial review.

Sally Dornaus (CFO)

Thank you, Mike, and good morning, everyone. I'll start the review of our Q4 2022 results with our income statement. Total investment income was $62.4 million for the three months ended December 31st, 2022, as compared to $58.8 million for the three months ended September 30th, 2022. 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. Total expenses for the Q4 were $37.3 million, as compared to $28.7 million in the Q3. The increase in expenses was driven by greater incentive fees due to a higher cumulative net return earned by the company.

As a reminder, we net our capital losses, whether realized or unrealized against pre-incentive Net Investment Income for the purposes of calculating incentive fees and measure our cumulative net return against our hurdle rate over a trailing three-year period. While this can create periods of volatility within our incentive fee stream, we believe this provides us with the proper alignment with our shareholders, especially during periods of elevated market volatility. Net Investment Income for the quarter was $24.2 million or $0.37 per share, as compared to $30.1 million or $0.47 per share for the prior quarter. Our Net Investment Income was lower during the quarter due to higher incentive fees earned from prior quarters, given our three-year total return look-back feature. Excluding the impact of the look-back, Q4 NII would have been approximately $0.43 per share.

Net investment income per share for the full year 2022 was $1.59 per share. During the three months ended December 31st, 2022, the company had net realized and unrealized gains of $19.3 million. GAAP income per share for the three months ended December 31st, 2022 was $0.67 per share, bringing earnings per share for 2022 to $1.63. Moving over to our balance sheet. As of December 31st, our investment portfolio at fair value totaled $2.4 billion and total assets of $2.6 billion. Total net assets were $1.1 billion as of December 31st. NAV per share was $17.29, up from $16.98 at the end of the Q3, representing a 1.8% increase quarter-over-quarter.

Our NAV increase during the Q4 was primarily driven by net gains related to travel-related investments that generated strong performance. At the end of Q4, our debt-to-equity ratio was 1.25x, unchanged from the end of Q3. Our net leverage ratio, which represents principal debt outstanding less cash, was 1.14x at the end of Q4 as compared to 1.2x at the end of Q3. During the quarter, we continued to improve our liability structure. We increased the size of our Sumitomo credit facility to $665 million, up from $635 million.

Over the course of 2022, this facility more than doubled in size, reflecting our continued efforts to further strengthen the company's balance sheet and funding profile. Subsequent to quarter end, we announced Kroll Bond Rating Agency, or KBRA, assigned the company an investment-grade rating of BBB and stable outlook. We are pleased to now have three investment-grade ratings from well-known and regarded rating agencies. Our capital structure is durable, with a large portion of our outstanding debt and fixed rate on secured debt obligations. These structures provide the company with greater financial flexibility to withstand greater periods of volatility ahead. As of December 31st, approximately 57% of our outstanding debt was in floating rate debt and 43% in fixed rate. The company is well-positioned to benefit from higher interest income across our portfolio, given its large portfolio of floating rate loans.

As of December 31st, holding all else constant, we calculate that a 100 basis point increase in rates could increase our quarterly earnings by approximately $0.04 per share. Our Form 10-K provides further detail on our sensitivity to various changes in interest rates. Available liquidity consisting of cash and undrawn capacity on our credit facilities was approximately $317 million. This compares to $304 million of undrawn investment commitments. For the three months ended December 31st, 2022, the weighted average interest rate on our debt outstanding was 4.3% as compared to 3.7% as of the prior quarter end. The increase is driven by higher SOFR rates on our floating rate debt structures. With that, I will turn the call back over to Mike for closing remarks.

Michael Ewald (CEO)

Thanks, Sally. In closing, we were pleased with the execution of our investment strategy on behalf of our shareholders during the Q4 and the entirety of 2022. We demonstrated high and attractive levels of investment income earned across our portfolio and strong credit performance across our middle market borrowers while mitigating risk wherever possible. As we look forward into 2023, we believe our portfolio is on strong footing to navigate greater periods of volatility ahead and that we are well-positioned to capitalize on attractive growth opportunities. We remain committed to delivering value to our shareholders by producing attractive returns on equity, and thank you for the privilege of managing our shareholders' capital. Operator, please open the line for questions.

Operator (participant)

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Please hold while we poll for questions. Our first question comes from Arren Cyganovich with Citi.

Arren Cyganovich (VP, Equity Research Analyst)

Thanks. I was wondering if you could talk a little bit about the health of your portfolio companies and how they're dealing with the rising interest costs and any other inflationary impacts to their businesses?

Mike Boyle (President)

Sure. Happy to talk through it. We did highlight in our remarks that the net leverage of our portfolio companies on average is 5.1x, which was actually down from 5.6x one quarter before, which I think indicates the continued strong earnings of the portfolio. We've also been focusing in on the interest coverage ratios across the portfolio, where historically we've been north of 2x interest coverage. We've really focused in, although that has come down as rising interest rates. We are still around that 2x mark across the overall portfolio.

Any names that are, you know, closer to 1.5x interest coverage fall into that risk rating three basket, where we are, you know, focused on the near term outlook for those companies and making sure we're avoiding any sort of restructuring or default. Companies overall have been performing quite well, although it has been a much more challenged environment.

Michael Ewald (CEO)

Hey, Arren, I'd also add that from an inflationary perspective, we've been, I guess, pleased and surprised to the extent to which our portfolio companies have been able to increase prices themselves, in order to hold their gross margins, if not necessarily constant, but certainly up there. Of course, the negative consequence of that is that just kinda keeps the inflationary spiral going, right? Overall, they've actually performed pretty well from a profitability perspective as well.

Arren Cyganovich (VP, Equity Research Analyst)

Thanks. Maybe just about the origination environment, obviously it seems much more lender-friendly today, but also I would imagine deal activity is probably lower. What's your outlook in terms of, you know, originations going forward?

Michael Ewald (CEO)

Yeah, I think deal activity is definitely lower. I think we continue to see muted sales and churn in the portfolio. Having said that, we continue to see some strength on the, on the add-on front where, if private equity sponsors are holding their investments longer, they're trying to bolt on some acquisitions in the meantime. You know, you'll have seen the stats in our remarks and in our, in our filings that, we are active both on the new deal front, but also especially so on the add-on front. You know, it's always hard to look in a crystal ball, right?

I would imagine that 2023 from a completely new LBO perspective is gonna be more muted than 2022, although we saw some of that slowdown already happen in the H2 last year anyway.

Arren Cyganovich (VP, Equity Research Analyst)

Got it. All right. Thank you.

Michael Ewald (CEO)

Sure.

Operator (participant)

Thank you. Our next question comes from Paul Johnson with KBW. Please go ahead, sir.

Sally Dornaus (CFO)

Good morning. Thanks for taking my question.

Paul Johnson (VP and Equity Research Analyst)

Adding on Arren's question a little bit, have you guys conducted any sort of test, I guess, with your portfolio in terms of just stressing portfolio companies with, you know, something like the forward curve or perhaps something even, you know, more extreme with that and gotten a sense, I guess, where your portfolio falls in terms of interest coverage or anything that you could provide along those lines?

Mike Boyle (President)

Sure. We do run a number of stress tests across our portfolio as a test of overall health in today's environment. What we've done is both run forward curves but also some snap adjustments, so interest rates, SOFR rates +5%, if they went there immediately and for a prolonged period of time to understand the interest rate coverage decay that would happen. That's an important factor when we're actually doing our risk ratings one through four. Names that are have more rapid decay in interest rate coverage are what fall into our risk rating three, which are still a fairly small percentage of our portfolio overall. That is to say, yes, we run stress tests, but we do feel quite good about the health of the portfolio.

As I said, we are about 2x interest coverage, based on today's and an LTM perspective of interest rate coverage in the portfolio. We do see that coming down if we run some of these stress tests, but we still feel like we're adequately covered across the portfolio.

Paul Johnson (VP and Equity Research Analyst)

Got it. Appreciate that. Thanks for the color on that. Another question I just had, you know, you guys have, you know, a fairly large percentage of your portfolio in the aerospace and defense industry, you know, around 15% or so. I know that's generally been, you know, a big sector for you guys. That, that industry has obviously undergone some massive, you know, probably changes over the last year or so. I'm just wondering, you know, your kind of thoughts on that sector and, you know, whether you find, you know, things to be, I guess, more attractive there, you know, you know, how you feel about your current portfolio, just, you know, any sort of color you can provide there would be interesting.

Michael Ewald (CEO)

Sure. I mean, if you break it up a little bit and take the kind of pieces separately, on the defense side, that's certainly been pretty steady and arguably that's a good place to be, you know, these days when you think about geopolitical concerns and the likely backdrop that that has for defense spending. On the aerospace side, a lot of that exposure has been more on parts and pieces and components and things like that. There's a little bit of aircraft leasing in there, but we focus a little bit more on the widgets, if you will. That certainly took a hit from COVID. It also took a hit, quite frankly, from the 737 MAX grounding.

However, coming out of COVID now, you know, you've certainly seen travel bounce back pretty considerably. You've also seen that the 737 MAX orders pick back up again. We think we're on the right platforms from a commercial aerospace perspective. The growing ones, we've seen that demand pick up pretty considerably again. We actually think it's a pretty interesting place to be today.

Paul Johnson (VP and Equity Research Analyst)

Yeah, thanks. That's interesting. One last question, smaller one. Just wondering if you're able to give any sort of sense of the incentive fee for next quarter, if you expect it to be anywhere, kind of, you know, in line with, I guess, what we had this quarter, $9.2 million, or any level you can provide would be helpful.

Sally Dornaus (CFO)

I think a little bit in our remarks, I talked about how our calculation works, and I think that the look-back, sometimes and did this quarter, causes a little bit of volatility, quarter-over-quarter. We're a bit higher than I would expect the run rate to be, although I think we have another quarter of this coming based on how we see the look-back calculation working.

Paul Johnson (VP and Equity Research Analyst)

Appreciate it. Thanks. That's all for me.

Michael Ewald (CEO)

Great. Well, it looks like there's no more questions. I really appreciate everyone's time today. Certainly if you have any other questions, please do reach out, and we'll look forward to updating you, in the normal course here. Thanks very much.

Operator (participant)

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.