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Bain Capital Specialty Finance: IIQ 2022 Earnings Conference Call – Annotated

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  • IIQ 2022 results were solid with EPS higher than expected; NAV Per Share barely down and the quarterly regular distribution unchanged.
  • BCSF points to its recently formed U.S. loan focused joint venture as a source of potential EPS increase down the road – along with higher rates. The BDC Reporter discusses the impact of both the BDC’s joint ventures – highlighting opportunities and risks.
  • Investment activity was on the high side in the IIQ 2022 for BCSF, causing the BDC Reporter to ask again whether a larger portfolio and increased leverage – a feature of the BDC sector in the IIQ 2022 – is the right approach.
  • BCSF’s loan yield has substantially increased in the IIQ 2022, with even more on the horizon – changing a sector-wide downward dynamic than has been in place for years.
  • Credit quality at the BCSF was stable compared to the prior quarter and well within “normal” standards, despite the addition of 1 new non accrual in the quarter. This was partly offset by progress amongst pandemic-hit underperforming borrowers, now recovering.
  • Management indicate BCSF’s earnings should benefit further from higher rates in future periods, but without giving specific guidance. Pro-forma numbers indicate EPS could increase by a third over the latest results, but the analysts are assuming much more modest growth – partly because of one time fee boosts in the most recent quarter.
  • The BDC Reporter – which focuses on projecting only annual payouts over a 5 year horizon – is considering upping its own numbers from the current $1.36 annual level.


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

Good morning, and thank you for dialing into our earnings call. I’m joined here today by Mike Boyle, President; and Chief Financial Officer, Sally Dornaus. I’ll start with an overview of our second quarter ended June 30, 2022, results and then provide some thoughts on our performance, the 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 reported Q2 net investment income per share of $0.41, driven by higher levels of investment income earned across our portfolio investments during the quarter. Our Q2 net investment return represented a 9.6% annualized yield on book value and covered our dividend by 121%. Net asset value as of June 30 was $17.15 per share, a decrease of approximately 40 basis points quarter-over-quarter. Our NAV decline was primarily driven by net unrealized losses due to broad-based spread widening across our portfolio, partially offset by gains on COVID-impacted investments and excess net investment income versus our quarterly dividend.

Subsequent to quarter end, our Board declared a third quarter dividend equal to $0.34 per share and payable to record date holders as of September 30, 2022. This represents a 7.9% annualized yield on ending book value as of June 30.

BDC Reporter Notes: We covered BCSF’s results in the BDC Daily News Feed back on August 3 and in the BDC NAV Change Table. As the numbers suggest, earnings exceeded expectations and greatly outstripped the quarter before. The NAV Per Share drop was de minimis and the distribution was unchanged, even though management had plenty of room to provide shareholders with a hike as that 121% coverage number mentioned above shows. By those key metrics, the IIQ 2022 was a satisfactory one for the BDC.

So during the second quarter, we witnessed higher levels of market volatility, particularly in the broadly syndicated loan and equity markets, given the wider uncertainty in the macro economy stemming from the increased potential of an extended economic slowdown. This was against the backdrop of a rising interest rate environment as the Fed remains focused on its monetary policy to reduce high levels of inflation.

It is important to note that as credit investors, we are first and foremost focused on the downside risk management of our investments and the ability for a company to fully pay back our debt as opposed to equity investors who are seeking higher growth objectives and could face greater volatility in the coming months.

Our focus on downside management drives our long-standing investment approach of curating [BDC Reporter Notes: !] a diversified portfolio of middle market borrowers with a focus on top of the capital structure of first lien secured loan structures with strong documentation and covenant packages. And despite a more challenging market backdrop for our borrowers, our portfolio remains quite healthy given our historical focus on lending to companies in defensive sectors such as aerospace and defense, technology and business services. For select companies within our portfolio that were in the travel and hotel, leisure industries and more impacted by business closures due to COVID, we’ve been pleased to see the continued improving fundamental performance across our borrowers as reflected in the gradual gains on these investments (technical difficulty) orders. We do remain watchful of inflationary impacts across our portfolio, resulting from supply chain disruptions, higher freight costs and wage pressures as well as rising interest rates. Many of our companies that are facing higher costs have been able to pass through by implementing several price increases over the past (technical difficulty) while not experiencing a falloff in demand or revenue. However, the cycle can continue to contribute to higher inflation over the long term, which may lead to reduced demand over time.

Importantly, as over 90% of our debt investments are structured with financial maintenance covenants, detailing certain performance metrics that the company needs to maintain, we have early insight to foresee issues that may arise for our portfolio of companies. And we have a seat at the table to mitigate our potential risk type scenario given our majority control position in approximately 80% of our debt tranches.

Looking ahead, we believe the company is well positioned in the current environment to continue to drive attractive earnings for our shareholders, primarily from 2 main sources. First, the higher interest rate environment provides us with a near-term opportunity to generate excess net investment income above our regular dividend as the vast majority of our investments are comprised of floating rate loans against a large portion of long-term fixed rate debt in our capital structure. We would expect to see a greater combination of earnings growth due to the increase in rates in the coming quarters given the timing lag of rate resets across our loans.

And second, the recent formation of our senior loan program joint venture allows us to drive attractive risk-adjusted returns while maintaining our focus and underlying exposure (technical difficulty) originated first lien loans to sponsor-backed middle-market companies. While BCSF’s investment in the SLP represented just 2% of our portfolio with fair value as of quarter end, we can grow this investment over time as we identify new loan opportunities, and this can contribute to higher levels of interest income and dividend income for our shareholders. During the second quarter, for example, BCSF’s investment in the SLP produced an annualized return on equity of 15%.

BDC Reporter Notes: As a reminder, BCSF has TWO joint ventures, one invested in U.S. loans (“SLP”) and the other mostly in foreign assets (“ISLP”). Each are with different partners, but have in common that the vehicles are funded by the partners with both junior debt and equity, with a third party providing the most senior financing. Both involve loan portfolios with relatively high yields not very different from the level achieved on BCSF’s own balance sheet. The ISLP yields 7.1%, the SLP 7.8% and BCSF itself 8.5%. Of course, because of the use of leverage, the return on the joint ventures exceeds what’s earned on loans held on the balance sheet. The AUM of the two JVs is approaching $1bn, and will go even higher as the full commitments are deployed. By comparison, total investment assets on BCSF’s balance sheet – net of the joint ventures – amounts to just over $2bn at fair market value. This means that one-third of the investments managed (albeit not all owned) by BCSF are in off balance sheet vehicles – on the high side by BDC standards.

We imagine the advantages to BCSF from having these two vehicles – besides the above average return achieved thanks to the use of leverage – include the ability to transfer assets off the main balance sheet to the JVs. This can very quickly – and without the need for either raising new equity (as occurred during the pandemic) or emergency dispositions – keep the BDC’s leverage within pre-set target limits. Using joint ventures as a release valve in this way has become a very regular feature of the BDC sector.

The joint ventures – given the leverage – should benefit from higher interest rates over time even though some of their borrowings are floating rate but are also more subject to generating unrealized losses. Again it’s the leverage as well as the fact that values tend to be tied to market prices, which are very volatile during times of economic stress. Likewise – because of the leverage – the prospect of higher than average credit losses exist. All in all, investors should keep a close eye on developments at these two JVs, which already account for 20% of equity capital.

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

Thanks, Mike. Good morning, everyone. I’ll start with our investment activity for the second quarter and then provide an update in more detail on our portfolio. During the second quarter, the company had high levels of originations driven by an active quarter of M&A across the middle market that drove both new loan commitments as well as commitments to existing borrowers to facilitate growth or acquisition. Q2 new investment fundings were $482 million across 50 portfolio companies, including $254 million in 11 new companies, $217 million in 38 existing companies and $11 million in the ISLP. Sales and repayment activity totaled approximately $332 million, resulting in net funded portfolio growth of $150 million quarter-over-quarter.

BDC Reporter Notes: We just have to say that in a IIQ 2022 which was generally more active than some might have expected, BCSF was VERY busy. We don’t know what to make of this degree of busy-ness except to point out the fact and wonder aloud – not for the first time – why so many BDC managers are keen to grow their portfolio size and leverage in the face of a possible recession ? Is this wise – an opportunity to acquire assets and boost earnings – or foolish given the credit difficulties that might be right round the corner ? We don’t have an answer, but we’ll say BCSF is far from alone in this great leap forward.

We remain selective with the investments that we pursue as we are canvassing a large pipeline of opportunities. Our global presence allows us to assess differentiated opportunities in our pipeline to evaluate the best relative value and risk reward. Bain Capital Credit’s industry research team provides us with deep knowledge across many industry verticals and allows us to better understand more complex companies when we’re evaluating investments. 94% of our new fundings this quarter were comprised of first lien senior secured loans. Our new investments continue to favor U.S. domiciled companies, as we’ve been more active in the U.S. versus Europe, given the increased geopolitical risks stemming from Europe this year. Our industry mix across new originations continues to be highly diversified and speaks to our ability to perform deep diligence across many sectors. The largest industries that we invested in during the second quarter include high-tech, aerospace and defense and health care and pharmaceuticals. In addition, we remain focused on negotiating higher spreads and tighter covenant packages on new investments to reflect the increased risk profile we have observed in today’s market.

BDC Reporter Notes: Rightly or wrongly, it’s probably the focus on booking first lien loans – typically sitting high on the balance sheet with 60% of the enterprise value junior to BCSF that gives management the confidence to press ahead in all market conditions. This is a very different world – as we recently covered in a long term overview of how the BDC industry has changed in the past twenty years – from what obtained in the Great Recession. Then , most of the investments held by the BDCs then active – which did not include BCSF at that time – were in second lien or subordinated loans; the equity of CLO vehicles; preferred and equity. Even if you were not there at the time – as we were – you can imagine the bloodbath of losses that followed when the economy tanked. This time round, players like BCSF seem to be betting that even if borrowers get into trouble – as they will and must – their first lien presence and the control they have over any resolution – will result in little in the way of net losses. Is this a case of “Who Dares Wins” or a big mistake ?

Turning to the investment portfolio. At the end of the second quarter, the size of our investment portfolio at fair value was $2.3 billion across a highly diversified set of 122 portfolio companies operating across 31 different industries. The risk profiles across our investments have remained relatively consistent given our long-standing focus on the top of the capital structure. As of June 30, 71% of the investment portfolio at fair value was invested in first lien debt; 4% in second lien debt; 2% in subordinated debt; 3% in preferred equity; 9% in equity interest; and 10% across our joint ventures, broken out between 8% in the ISLP and 2% in the SLP. Within our joint ventures, over 95% of our underlying exposures are comprised of first lien senior secured loans.

As of June 30, 2022, the weighted average yield on the investment portfolio at amortized cost and fair value was 8.5% and 8.8%, respectively, as compared to 7.9% and 8.1%, respectively, as of March 31, 2022. The increase was primarily driven by higher reference rates on our loans. 95% of our debt investments accrue interest at a floating rate, positioning the company favorably as interest rates have continued to rise beyond reference rate floors across our loans.

BDC Reporter Notes: It’s a funny old world. Just about every BDC has a portfolio almost exclusively composed of floating rate loans. Yet, some BDCs – like BCSF – have reported what are substantial increases in their yields, while others have not. Over time, though, we expect higher rates to show up in virtually every BDC’s portfolio yield. In this case , the yield at cost has increased by 5%. Given the downward pressure on yields BDCs have faced for years now, this turnabout is remarkable and just getting going.

Turning to our joint venture investments. Our JVs continued to perform well during the quarter. As a reminder, these investments allow us to have increased capacity and flexibility to invest both internationally and in lower-yielding, low-risk, first lien loans as we seek to generate attractive risk-adjusted returns for our shareholders through these structures. ISLP’s investment portfolio at fair value as of June 30 was approximately $541 million, comprised of investments in 31 portfolio companies operating across 14 different industries. 100% of the investment portfolio was invested in senior secured floating rate loans, including 96% in first lien and 4% in second lien. BCSF’s investments in the ISLP generated a low double-digit return during the second quarter, in line with our targeted return for this investment.

As of June 30, SLP’s investment portfolio at fair value was approximately $433 million, comprised of investments in 45 portfolio companies operating across 20 different industries. 100% of the investment portfolio was invested in senior secured floating rate loans, including 95% in first lien, 5% second lien. BCSF’s investment in the SLP generated a mid-teens return during the second quarter as this joint venture has a higher target return than the ISLP.

Moving on to portfolio credit quality trends. Credit quality was relatively stable quarter-over-quarter. Within our internal risk rating scale, 92% of our portfolio at fair value as of June 30 was comprised of risk rating 1 and 2 investments, indicating the companies were performing in line or better than expectations relative to our initial underwriting.The weighted average fair value marks across our debt investments in these categories decreased approximately 40 basis points quarter-over-quarter, down to approximately 98% of par. This was primarily due to broad-based spread widening across our borrowers and partially offset by gains on travel-related investments in our portfolio.

Risk rating 3 investments comprised 7% of our portfolio at fair value. While we have seen select upgrades in recent quarters in travel-related companies, this has been offset by a few companies that were downgraded to a risk rating 3 due to inflationary pressures. As Mike mentioned earlier in the call, we have been pleased to see our companies demonstrate pricing power as they seek to mitigate margin compression in the current environment. We believe these companies continue to have high-quality value propositions with its customers, and our investment theses continue to remain intact. Our risk rating 3 investments have a weighted average fair value mark of 86% of par. And it’s important to note that 97% of these investments are first lien senior secured loans.

During the second quarter, we placed 1 portfolio company on nonaccrual status, contributing to the modest uptick in risk rating 4 investment. This investment represented 1.4% of total investments at fair value and 2.2% at amortized costs as of June 30.

Overall, we believe our credit fundamentals remain sound in our portfolio. Our median leverage attachment point is 5.4x as of June 30, a modest improvement from 5.5x as of March 31. Loan to value on our debt investments remains strong as we typically underwrite our investments with a significant equity cushion behind our loan. While we have seen some pressure to lower enterprise valuations in the middle market, particularly within certain sectors such as software and technology, these investments are often structured with lower levels of LTV, providing for greater equity cushion to withstand greater changes in valuation.

BDC Reporter Notes: We’ll have much more to say when we get round to undertaking a full fledged credit review of BCSF in a few weeks. In the interim, we refer readers to the BDC Credit Table which shows that total underperforming assets in the IIQ 2022 were essentially unchanged in absolute and percentage terms. Having one new non accrual is not disturbing in and of itself.

Sally will now provide a more detailed financial review.

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

Thank you, Mike, and good morning, everyone. I’ll start the review of our second quarter 2022 results with our income statement. Total investment income was $52.4 million for the 3 months ended June 30, 2022, as compared to $46 million for the 3 months ended March 31, 2022. The increase in investment income was primarily due to higher other income. Given the timing lag of reference rate resets on our loans, we would expect to see a greater benefit of rising interest rates impact our portfolio during the back half of the year.Total expenses for the second quarter were $25.6 million as compared to $24.3 million in the first quarter. The increase in expenses was driven by greater incentive fees as a result of higher long-term net gains across our portfolio and interest and debt expense given the size of our portfolio increasing quarter-over-quarter.Net investment income for the quarter was $26.7 million, or $0.41 per share, as compared to $21.7 million, or $0.34 per share, for the prior quarter. Our net investment income covered our dividend by 121%.

During the 3 months ended June 30, 2022, the company had net realized and unrealized losses of $9.5 million. As Mike mentioned earlier during the call, our net losses were primarily driven by markdowns due to broad-based spread widening across our portfolio, partially offset by select net gains on improving company fundamentals. GAAP income per share for the 3 months ended June 30, 2022, was $0.27.

Moving over to our balance sheet. As of June 30, our investment portfolio at fair value totaled $2.3 billion and total assets of $2.4 billion. Total net assets were $1.1 billion as of June 30. NAV per share was $17.15, down from $17.22 at the end of the first quarter, representing a 40 basis point decrease quarter-over-quarter. Approximately 80 basis points of our NAV decline was driven by net unrealized credit losses. This was offset by 40 basis points of gains resulting from our excess $0.07 of net investment income per share above our regular dividend.

At the end of Q2, our debt-to-equity ratio was 1.14x, up from 0.99x at the end of Q1. Our net leverage ratio, which represents principal debt outstanding less cash, was 1.07x at the end of Q2 as compared to 0.89x at the end of Q1. We believe our capital structure is durable with large portions of our outstanding debt in fixed rate and secured debt obligations. These structures provide the company with greater financial flexibility to withstand greater periods of volatility ahead. As of June 30, approximately 57% of our outstanding debt was in fixed rate and 43% in floating rate.

Against our portfolio of floating rate loans, this positions the company well to drive higher interest income across our portfolio. As of June 30, holding all else constant, we calculate that a 100 basis point increase in rates could increase our quarterly earnings by approximately $0.03 per share. Our Form 10-Q provides further detail on our sensitivity to various changes in interest rates.

BDC Reporter Notes: Since the end of the IIQ 2022 we’ve already had a 75 basis point increase and another 50-75 basis points is likely in September. We sure you’ve heard the ceaseless debate about how much the Fed will increase by, but never in doubt is that there will be a higher rate. Not all the increases will show up in the IIIQ 2022, but most should be in play by the IVQ. On a pro-forma basis, projecting EPS will grow to $0.45 quarterly or $1.80 annually does not seem unreasonable. As a reference point, BCSF’s Net Investment Income Per Share in 2021 was $1.36. This suggests a POTENTIAL one third increase in the BDC’s profitability is in the cards. Even that may be too modest a projection if spreads continue to widen; leverage is maxed out and the Fed pushes rates even further up.

Yet, the analyst consensus for NIIPS in the IIIQ and IVQ 2022 are for $0.35 and $0.36 respectively and for all of 2023 $1.49 ($0.3725 per quarter). Who to believe ? The analysts or pro-forma calculations ? To date, our own 5 year projections have remained at $1.36 per annum in annual distributions from BCSF. Chances are, though, we might shortly permanently increase our expectations.

Subsequent to quarter end, we were active in continuing to enhance our liquidity position as we increase the size of our Sumitomo Credit Facility to $485 million, up from $300 million. We are pleased with our ability to further diversify our lender mix with unchanged pricing terms on our existing facility. Available liquidity consisting of cash and undrawn capacity on our credit facilities was approximately $386 million, including the $185 million of new commitments to our Sumitomo Credit Facility that we closed in July. This compares to $283 million of undrawn investment commitments.

For the 3 months ended June 30, 2022, the weighted average interest rate on our debt outstanding was 3.2% as compared to 2.9% as the — as of the prior quarter end. The increase was driven by higher SOFR rates on our floating rate debt structures.

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

Thanks, Sally. In closing, we are pleased to deliver a solid (technical difficulty) for our shareholders, marked by higher levels of net investment income and only a modest NAV decline driven by broad-based spread widening.

Notwithstanding a wider uncertainty (technical difficulty) economy, we feel good about the health of our middle market borrowers across our diversified portfolio to navigate these challenging times, and we believe the company is well positioned to drive attractive earnings for our shareholders going forward.We thank you for the privilege of managing our shareholders’ capital. Elaine, please open the line for questions.

Questions and Answers


(Operator Instructions) We take our first question today from Ryan Lynch of KBW.

Ryan Patrick Lynch Keefe, Bruyette, & Woods, Inc., Research Division – MD

I apologize, I was hopping around, if you guys already previously explained this, but can you explain what was the driver of the big increase in other income? I know that’s usually driven by capital structuring fees and amendment fees, but just what happened this quarter? And then I would assume that this was a one-off quarter and it would resume sort of kind of normalized levels at the $1 million level or less going forward? But just any color on that would be helpful.

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

Sure. Thanks for the question, Ryan. You’re right in pointing out that a large portion of the NII was driven by other income, which are new origination fees or commitment fees against our current portfolio. You’ll note we originated north of $400 million this quarter, which was a record high for BCSF in terms of new investments on a gross basis and that was a key driver of much of the commitment fees that we earned this quarter. I’d note that many of the repayments either were from syndicating that risk on to other players in the market or from pushing those assets down to the SLP or ISLP over the quarter. So our net origination number was a bit more measured. But I do think that this demonstrates a particularly strong quarter for us, demonstrating that origination capability. What I would say in terms of more run rate fees, I do think it would normalize back down to the $1 million to $2 million level, more in line with what we’ve seen in historic quarters on a routine quarterly basis.

BDC Reporter Notes: If we adjust for unusually high fees in the IIQ 2022, the running rate NIIPS might be closer to $0.35 and explain why the analysts are targeting relatively low EPS in the next couple of quarters.

Ryan Patrick Lynch Keefe, Bruyette, & Woods, Inc., Research Division – MD

Okay. All right. That’s helpful. And then I just had a couple of questions on just your overall international exposure. In the ISLP, can you break down — I think the majority of that portfolio is Europe, but could you just break down what percentage of that portfolio is Europe versus other like Australia or Canada, just what percentage of that exposure is in Europe?

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

Yes. About 90% of that exposure is in Europe.

Ryan Patrick Lynch Keefe, Bruyette, & Woods, Inc., Research Division – MD

90%, okay. And then — I guess things over there. Obviously, we all see — headlines are everything. I think things over there right now are okay, but I think everybody can see kind of this potential economic storm coming as we head into winter. So how as a shareholder or investor that’s looking at a pretty sizable exposure to these European businesses and with the risk, I think, kind of in the future and certainly unknown and unpredictable, how do we evaluate the risk of that portfolio? Or how do you guys evaluate the risk — the potential of that portfolio?

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

Yes. Ryan, thanks for the question. It’s certainly a very fair one. If you look at our European portfolio, it’s actually fairly similar to our U.S. portfolio, but there’s probably a bit more of a skew towards technology-related companies. So when you think about the potential looming energy crisis in Europe with the dearth of natural gas, for example, these are not manufacturing companies that are going to see a huge spike in their underlying costs. These are typically B2B software businesses that are helping a company operate (technical difficulty) more efficiently. It’s a pretty small piece of the cost bar overall for that company. It’s pretty well integrated into the overall operations of the company. It’s companies like that, that we’re investing in. So while we are certainly watching developments, geopolitical as well as macroeconomic, we’re not concerned about our particular portfolio being impacted. And as you’ll note, it’s still relatively (technical difficulty) relatively modest portion of the overall portfolio anyway.

Ryan Patrick Lynch Keefe, Bruyette, & Woods, Inc., Research Division – MD

Yes. Okay. And then I know you mentioned that you guys are seeing better opportunities in the U.S. versus Europe today for obvious reasons. But are you still making new investments in Europe today? And if you are, what is the nature of those companies? Like what do you have to see in order to make an investment in Europe today just given the uncertainty?

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

Look, as you point out, it’s definitely — we’re a little bit more U.S. focused right now in terms of the opportunity set, not (technical difficulty) we think is actually attractive. We are still seeing pretty consistent deal flow in Europe. But as I mentioned, the kind of companies that we’re looking at there or that we’re interested in (inaudible) are ones that are not going to be impacted by the looming energy crisis. So we are definitely skewing a little bit more towards U.S. right now and, again, mindful of some of those economic and geopolitical concerns in Europe.


(Operator Instructions)

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

Great. Well, it doesn’t appear that there’s any more questions at this point in time. Thanks again, everyone, for dialing in. If you do have any further questions, please feel free to reach out, and we’ll look forward to bringing you more news in the near future. Thanks very much.

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