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Bain Capital Specialty Finance: IIIQ 2021 Conference Call – ANNOTATED

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Q3 2021 Bain Capital Specialty Finance Inc Earnings Call

Nov 4, 2021 (Thomson StreetEvents) — Preliminary Transcript of Bain Capital Specialty Finance Inc earnings conference call or presentation Thursday, November 4, 2021 at 12:00:00pm GMT

Corporate Participants

Katherine SchneiderBain Capital Specialty Finance, Inc. – IR OfficerMichael Alexander EwaldBain Capital Specialty Finance, Inc. – CEO & DirectorMichael John BoyleBain Capital Specialty Finance, Inc. – PresidentSally Dee Fassler DornausBain Capital Specialty Finance, Inc. – CFO

Conference Call Participants

Finian Patrick O’SheaWells Fargo Securities, LLC, Research Division – VP and Senior Equity Analyst

Presentation

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

..” I’m also joined by Mike Boyle, our President; and our Chief Financial Officer, Sally Dornaus.

I’ll start with an overview of the results of our third quarter ended September 30, 2021, and then provide some thoughts on the overall market environment and our relative positioning. Thereafter, Mike and Sally will discuss our investment portfolio and financial results in greater detail.

So beginning with our third quarter results. Q3 net investment income per share was $0.34. Our net investment income covered our dividend level by 100% for another consecutive quarter, and we are pleased that our NII dividend coverage was not reliant on fee waivers by the adviser this quarter, as a result of the progress that we’ve made over the past year in growing our NII earnings power.

BDC Reporter Notes: BCSF has made real progress in “covering” its dividend from non-subsidized earnings. Last quarter, compensation costs were $16.7mn, but $7.2mn was waived, leaving a net cost of $9.5mn. This quarter, gross compensation was a lower $13.3mn (lower incentive fee), but with no waiver, so the net cost was $13.3mn. That’s a $3.8mn improvement in 3 months.

Net asset value per share was $17.03 as of September 30, a modest increase of approximately 10 basis points from our [NAV] as of June 30.

BDC Reporter Notes: By contrast with the improvement noted above, the increase in NAV Per Share is substantially below the BDC average – which is around 2% – for the IIIQ 2021 over the prior period. The BDC’s NAV Per Share remains (14%) below its level pre-pandemic, placing BCSF in the bottom fifth of all public BDCs by this metric. Not surprisingly perhaps, at time of writing the stock price remained (19%) below its end of 2019 level.

Subsequent to quarter end, our Board declared a fourth quarter dividend equal to $0.34 per share and payable to record date holders as of December 31, 2021. This represents an 8% annualized yield on ending book value as of September 30.

BDC Reporter Notes: The quarterly distribution remains (15%) below its level through March 2020. Therafter, the effect of lower interest rates and a Rights Offering resulted in a dividend cut. As a result, BCSF’s total annual dividends paid out have dropped for the past two years.

So during the quarter, we continue to see high volumes of new loan origination in the middle market, driven by a favorable macro environment backdrop and elevated sponsored M&A activity. Q3 gross originations were $286 million, approximately 35% higher than Q2 gross origination volumes. Our portfolio also continued to exhibit a healthy amount of sales and repayment activity totaling $255 million and in line with the prior quarter. As a result of this activity, our net investment activity totaled $31 million.

BDC Reporter Notes: While BCSF – along with most other BDCs – was active this quarter and increased its AUM, over the course of 2021 the BDC is one of the rare players to report a lower portfolio size, down (5%). By way of contrast, Ares Capital (ARCC) has grown its AUM by 14%.

While the current market environment remains competitive, BCSF benefits from Bain Capital Credit’s Private Credit Group platform, which has a track record of investing in the middle market for over 20 years and has developed long-standing relationships with our global sourcing partners over this time. Our team is further augmented with the greater resources of the broader Bain Capital platform as we utilize the deep industry expertise within Bain Capital Credit’s industry research team to uncover companies in niche industries and can leverage insights and relationships across the firm, providing us with a competitive edge when performing diligence. Bain Capital’s global platform has allowed BCSF to maintain its selectivity and discipline when choosing which new investment opportunities to underwrite.

Recently, we view the relative value as being more attractive in Europe given the frothiness of the U.S. market, leading to higher levels of investing activity out of our European offices. These trends have persisted throughout the year and continued here into the third quarter with approximately 2/3 of our new originations being comprised of companies domiciled outside of North America. Having a local team there and a long-standing presence across 2 offices in Europe has allowed us to uncover leading players in their niche markets, where we are finding more attractive relative risk-return trade-offs.

BDC Reporter Notes: This preference for European deals differentiates BCSF from virtually all its peers. We’ll be very curious to see whether over a 3-5 year period (we have a long term perspective) this makes any material difference where earnings and credit losses are concerned. We have no opinion on the subject at the moment, but we do point out that the BDC format was created to help capital short American businesses. In this and so many other ways – like the multi billion dollar companies being financed by the likes of ARCC and the CLO equity stakes owned by multiple players – we’ve come a long way from the original intent of the BDC format in 1980.

Importantly, our underwriting standards have not diminished despite the increase in competition in the space. 100% of our new originations to new companies during the quarter benefited from financial covenants, which is consistent with our overall portfolio where about 95% of our debt investments also have covenants.

Similarly, our credit quality trends remain stable. Company performance for the vast majority of our portfolio has been better than expected in 2021 and we have not witnessed the second wave of defaults or amendments as demonstrated by their again being no investments on nonaccrual status as of quarter end.

BDC Reporter Notes: Of course, non accruals alone don’t tell us everything we need to know about credit quality. As BCSF’s own investment ratings show for another quarter, a tenth of investment assets are under-performing (about a quarter of a billion dollar’s worth), very much like the quarter before but much better than at the height of the crisis in 2020.

Turning now to our liabilities. We’ve remained hard at work on improving our liability structure. During the quarter, we repurchased 25% of our $150 million 8.5% notes as we were able to take advantage of an opportunity to reduce a portion of this relatively expensive debt at a discounted price to our make-whole premium prior to maturity. This allowed us to reduce the weighted average interest rate on debt outstanding to 3.0%, an improvement of approximately 20 basis points quarter-over-quarter. It’s also worth mentioning that the remaining $112.5 million of this debt matures in 2023, and our non-call period expires in June 2022, representing an opportunity to further reduce our aggregate weighted average cost of debt.

Subsequent to quarter end, we continue to enhance the right side of our balance sheet as we took advantage of low treasury rates and strong investor demand levels in the institutional unsecured debt markets. In October, the company issued $300 million of investment-grade 2.55% unsecured notes maturing in October 2026. These notes are 40 basis points tighter than the 2.95% March 2026 notes that we issued earlier this year. Pro forma for this issuance, unsecured debt represents approximately 53% of the company’s debt outstanding as of September 30, a significant improvement from 30% as of September 30 and one which enhances the company’s balance sheet flexibility. We continue to look for ways to further optimize our financing flexibility and costs in order to drive earnings accretion for our shareholders.

BDC Reporter Notes: We’ve been adding to our own database BDCs average borrowing cost, a data point that is not always available or easy to find. The 3.0% BCSF has now achieved is one of the lowest rates amongst the 18 BDCs that we have numbers for. By the way, the current winner in the low cost of debt capital seems to be Sixth Street Specialty Lending (TSLX), reporting 2.26% as of the IIIQ 2021. Where BCSF is concerned, a sub-3.00% yield seems in the cards

Michael John Boyle Bain Capital Specialty Finance, Inc. – President

Thanks, Mike. Good morning, everyone. I’ll start with our investment activity for the third quarter and then provide an update on our portfolio.

Q3 new fundings were $286 million across 39 portfolio companies, including $229 million in 10 new companies, $46 million in 28 existing companies and $11 million in the [ISLP]. Sales and repayment activity totaled $255 million.

As Mike highlighted earlier during the call, our new investment activity this quarter benefited from Bain Capital [Credit’s] global sourcing capabilities as approximately 65% of our new originations were sourced from our offices in Europe.

Our largest new investment commitment during the quarter was an investment source from our London office. The company is an Israel-based global provider of an on-the-move broadcasting technology for news and sports reporters. Our ability to win this investment was driven by the early insights and knowledge that we’re able to obtain through leveraging Bank Capital Credit industry research team in the broadcasting sector. These early insights were very valuable in our diligence at the outset of our investment in the company and our ongoing relationship with the management team enables us to successfully retain our financing incumbency as the company was recently sold to another private equity buyer during the quarter.

Given the higher levels of investing activity from our European offices, we increased the size of our investment to the International Senior Loan Program or ISLP, during the quarter. As of quarter end, ISLP represents the company’s largest investment at 6.1% of the total portfolio at fair value, an increase from the prior quarter end at 5.7%. The company earned approximately 10% annualized return on this investment during the third quarter. While this is in line but on the lower end of our double-digit return objectives, we estimate this to improve in the coming quarters based on the continued ramp of the portfolio. The company’s total equity commitment to the ISLP also allows for this investment to grow over time with the potential to drive greater net investment income to BCSF.

BDC Reporter Notes: The ISLP JV is a recent initiative, launched in February 2021. The partner involved is Pantheon, a huge alternative asset manager. BCSF has a 71% stake, and contributed $371mn in assets at the formation of the venture. Pantheon kicked in $50mn in cash. To date, BCSF has sold $440mn of investment assets to the JV. Like so many other BDC joint ventures, this is an off balance sheet vehicle partly financed by third party debt – in this case a $300mn revolver from JP Morgan at a current cost of 2.4% and whose outstandings are $218mn. For many BDCs, these sort of vehicles seem to be a risk-less ways to boost their overall yield and to side-pocket some investment assets. However, during the pandemic and even before, several BDC joint ventures ran into trouble. Some have had to be unwound; or emergency capital injected and/or are trading at severe discounts to their cost. Given that the ISLP is already BCSF’s largest single investment; is leveraged 2:1 and is scheduled to grow further, investors might want to pay more than average attention to how performance plays out. We’ll certainly be watching.

Turning to the investment portfolio. At the end of the third quarter, the size of our investment portfolio at fair value was $2.4 billion across a highly diversified set of 105 companies operating across 29 different industries.

BDC Reporter Notes: We compared the number of reported portfolio companies at BCSF against Apollo Investment (AINV) and Oaktree Specialty Lending (OCSL) – which have similar portfolio size where asset value is concerned. AINV reports 140 companies and TSLX 67.

Our investments largely comprised of firstly in loans to sponsor-backed middle-market businesses. As of September 30, 80% of the investment portfolio at fair value was invested in first lien debt. 5% in second lien debt, 1% in subordinated debt, 8% in equity interest and 6% in the international senior loan program.

Portfolio yields were relatively stable quarter-over-quarter. As of September 30, 2021, the weighted average yield of the investment portfolio and amortized cost and fair value were 7.5% and 7.6%, respectively, as compared to 7.5% and 7.7%, respectively, as of June 30, 2021. We remain focused on improving the yield of our total portfolio to an 8% yield target while maintaining our focus on senior secured loans.

BDC Reporter Notes: Management has been promising to boost the portfolio yield to 8.0% while remaining mostly in first lien debt (i.e. “safer”) but has not spelled out how this square gets circled. Competition is high, loan margins are under pressure. What will be different in the future – except a potentially higher yield from the JV – than before ?

Moving on to portfolio credit quality trends. Credit metrics at our borrowers were stable quarter-over-quarter. The median leverage through our investment was 5.1x, an improvement from 5.3x as of June 30. The portfolio of median EBITDA was $45 million, highlighting our focus on the core middle market. This is a market segment that we continue to favor in which we can win deals based on sponsor relationships and [build]diligence capabilities rather than solely competing on pricing and terms.

Within our internal risk rating scale, credit quality trends were stable. 90% of our portfolio at fair value was comprised of risk rating 1 and 2 investments with the risk rating 1 being the highest risk rating in terms of positive credit performance. The percentage of the portfolio was modestly up from 89% as of prior quarter end. Risk ratings to investments comprised 10% of our portfolio at fair value, down from 11% as of prior quarter end, driven by a reduction in the number of companies due to positive underlying credit performance. There continues to be no investments classified as a risk rating 4, our lowest risk rating in terms of credit quality. Our risk rating 1 and 2 investments have a weighted average fair value mark of approximately $0.99 on the dollar, reflecting a continued gradual improvement of approximately 40 basis points quarter-over-quarter. Our risk rating 3 investments have a weighted average fair value mark of approximately $0.84 of par, and this was relatively flat to prior quarter end valuations at [84.5%] at par.

While a handful of these companies have had to amend forecasts again due to the impact of the Delta variant, we continue to see strong sponsor support for these COVID rebound names and importantly, liquidity has not been an issue. Many of these companies are starting to see demand return and adjust to more normalized levels. We continue to believe these investments have the potential to contribute to NAV appreciation as we expect our original investment thesis to remain intact.

Sally Dee Fassler Dornaus Bain Capital Specialty Finance, Inc. – CFO

I’ll start the review of our third quarter 2021 results with our income statement. Total investment income was $49.5 million for the 3 months ended September 30, 2021, as compared to $46.5 million for the 3 months ended June 30. The increase in investment income was primarily due to an increase in prepayment-related income and other income. Total net expenses for the third quarter were $27.8 million as compared to $24.6 million in the second quarter. The increase was driven by an increase in investment advisory fees as a result of no fee waivers by the adviser during the quarter.

As we have discussed with our shareholders in previous quarters, we have been focused on driving higher net investment income without the need for fee waivers to cover our regular dividend. This quarter, we are very pleased with our ability to achieve this for our shareholders given our continued focus. The net investment income for the quarter was $21.8 million or $0.34 per share as compared to $21.9 million or $0.34 per share for the prior quarter.

During the 3 months ended September 30, 2021, the company had net realized and unrealized gains of $1.6 million, including $4.1 million of net gains across investments and $2.5 million realized loss from the partial extinguishment of our 8.5% 2023 notes. This onetime impact is offset by the improvement to our financing costs in future quarters.

GAAP income per share for the 3 months ended September 30, 2021, was $0.36 per share.

Moving over to our balance sheet. As of September 30, our investment portfolio at fair value totaled $2.4 billion and total assets of $2.5 billion. Total net assets were [$1.1 billion] as of September 30. NAV per share was $17.03 as compared to $17.01 at the end of the second quarter, representing a 0.1% increase quarter-over-quarter. Our gains were attributed to broad-based net gains across the portfolio and partially offset by the realized loss from the extinguishment on our debt, as mentioned earlier.

At the end of Q3, our debt-to-equity ratio was 1.23x compared to 1.20x at the end of Q2. Our net leverage ratio which represents principal debt outstanding less cash was 1.15x at the end of Q3 as compared to 1.12x at the end of Q2. Our net leverage ratio continues to be in line with our stated target range of between 1 and 1.25x.

Turning to our capitalization and liquidity. Available liquidity, consisting of cash and undrawn capacity on our credit facilities was $355 million against our $225 million of undrawn investment commitments. This represents coverage of 1.6x as of September 30 as compared to 2x as of June 30. Pro forma as of September 30 for our October 2026 notes offering, our coverage is back to over 2x.

For the 3 months ended September 30, 2021, and the weighted average interest rate on our debt outstanding was 3%, an improvement from 3.2% at the prior quarter end, driven by our note repurchase.

As Mike mentioned earlier, our team remains focused on ways to further improve the cost of our liability structure in order to drive value for our shareholders. As of September 30, 2021, the company was in compliance with all terms under its secured credit facilities. With that, I will turn the call back over to Mike for closing remarks.

Questions and Answers

Operator

(Operator Instructions) We will now take our first question from [Paul Johnson] from (inaudible).

Unidentified Analyst

Just a couple, but I was curious on the repurchase of the 8.5% bonds during the quarter. It was a good opportunity to be able to ride those back at a discount, as you said. Is that more of a one-off opportunity type of thing that you took advantage of? Or is that something you think you would like to look at potentially doing again in future quarters prior to that non-call period?

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Yes. Thanks for the question. So we are always looking to opportunistically buy back that more expensive debt in our capital structure. So we do — we will try to be opportunistic going forward. But it’s hard to say exactly what we’ll be able to do between now and when the non-call is up in the summer of 2022.

Unidentified Analyst

Okay. And then just on the kind of a broad question, but on the sponsor activity, obviously, across the space, we’re seeing heightened repayments and just a very robust activity. Have you seen that carry over into the fourth quarter as well? And do you think that’s something you would expect to kind of just continue to play out as it is right now over the next couple of quarters?

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Yes. Look, I certainly think that the fourth quarter is shaping up to be fairly busy here as well, not just because of the economic recovery, but also concerns around whether taxes are increasing and some sellers trying to potentially get ahead of that by year-end. So I think the fourth quarter will be fairly busy as well.

Unidentified Analyst

Got you. And obviously, the international deal sourcing that you have has obviously helped quite a bit and be able to produce a lot of opportunities for you at a time when competition is at its highest here in the U.S. But I’m curious, as time goes on and that remains an attractive place for you to invest there? Or do you expect to see or maybe are you possibly already seeing competition pickup in those markets as well and potentially make it harder to find opportunities in Europe? Or do you still see that as maybe a less traveled space versus its nearest counterparts?

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Yes. Look, it’s a good question. And I think what I’d point you to is Europe certainly isn’t just one monolithic market, obviously, right? So I would say there’s different pockets where the competition has picked up. We’ve had an office open there, focused on middle-market direct lending since 2007. And so we’ve had a long-standing presence there. I’d tell you, the U.K. market, for example, is probably the easiest in which to compete, especially for let’s say, American players looking to move over there, same language in legal insoles to understand it’s an easy trip, et cetera.

So I’d say that market, sure. I think we’re definitely seeing some more signs of increased competition there. But there’s a whole lot of other regions, Benelux, Nordics, et cetera, that are certainly less travel today, and we think it’s going to be a little harder to potentially break into those markets, also just because they’re smaller. So I think it really depends on which particular country or region you’re looking at within Europe?

Operator

(Operator Instructions) We will now take our next question from Finian O’Shea from Wells Fargo Securities.

Finian Patrick O’Shea Wells Fargo Securities, LLC, Research Division – VP and Senior Equity Analyst

Can you go over again the international versus U.S. breakdown this quarter? And how much you dropped into the ISLP?

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Sure. So we highlighted about 65% of our net — our new originations were out of Europe. And so we ended up dropping some assets down into the ISLP, so the ISLP position size went from 5.7% up to 6.1%. And but the overall European exposure is sitting at about 19% of the portfolio between the combination of loans sitting in the ISLP as well as loans sitting directly on our balance sheet made outside of the U.S.

So we are in a position where we have ample room to grow, both within the ISLP as well as on our balance sheet relative to the 30% basket that can constrain assets outside of the U.S.

Finian Patrick O’Shea Wells Fargo Securities, LLC, Research Division – VP and Senior Equity Analyst

But did you make some decisions to not fully grow the ISLP with all of that non-U.S. origination to keep some of it on the core balance sheet, more than normal, it seems? Or is…

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Sure. So every quarter, we go through and look at loans sitting on the balance sheet versus the ISLP vis-a-vis that 30% basket and yield optimization in the portfolio. And so we have chosen to stay at that 19% level between the ISLP and on balance sheet loans. But I would anticipate that we would continue to move loans into that ISLP program as we seek to manage the 30% test and the opportunities that we see across Europe.

Finian Patrick O’Shea Wells Fargo Securities, LLC, Research Division – VP and Senior Equity Analyst

Okay. And then it looks like the ISLP return went up from what — correct me if I’m wrong, looks like a pretty similar portfolio size. Did the earnings go up in some way for the SLP? Or were you just retaining earnings earlier?

Michael Alexander Ewald Bain Capital Specialty Finance, Inc. – CEO & Director

Sure. So the earnings have gone up because leverage there is targeted to run between 1 and [1.25] similar to the leverage level at BCSF overall. And when we originally structured the ISLP, we were at the lower end of that leverage range. And as we drop some assets in, we actually increased the leverage, which drove the yields up in — across the ISLP complex.

CONCLUSION

We’ve been warning for some time that although BDC sector metrics are looking pretty good across the board, a large number of BDCs are not generating sufficient UNSUBSIDIZED earnings to cover their current dividend level. Obviously this creates the risk that when and if a manager seeks to get paid in full, earnings might be insufficient to pay its distribution and a cut of some sort might be forthcoming.

Certainly BCSF has been in this group for some time. As a result, we were pleased to see that the BDC – as promised – has been able to generate sufficient earnings at last to meet its $0.34 a quarter payout, now in place for 7 quarters in a row.

Going forward, though, the BDC’s earnings outlook seems constrained. AUM is unlikely to grow by much, given that the BDC is close to its 1.25x net debt to equity target. Higher earnings will also attract higher incentive fees. The BDC will be looking for a slightly higher yield from the existing portfolio and lower debt service costs, as discussed above. Still, the analyst consensus for EPS in 2022 is only $1.37, 1 cent higher than the estimate for 2021.

What about BCSF’s stock price outlook ? The BDC has traded as high as $16.45 in the past 52 weeks. At a dividend of $1.36, that’s a 12.1x multiple and an 8.2% yield. At its height pre-pandemic and before its dividend cut, BCSF traded at a 12.5x multiple of its then-dividend. Should that reoccur, BCSF could find a new high of $17.0, an 8.8% price increase over the opening price on Thursday of $15.62, and 3.3% over the 52 week high.

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