BCSF - NYSE

Good day and welcome to the Bain Capital Specialty Finance Third Quarter Ended September 30, 2022 Earnings Conference Call. Today's conference is being recorded. And at this time, I'd like to turn the conference over to Katherine Schneider from Investor Relations. Please go ahead.

Thanks, Cecillia. Good morning and welcome, everyone, to the Bain Capital Specialty Finance third quarter ended September 30, 2022, 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 and a replay will be 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-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. So with that, I'd like to turn the call over to our CEO, Michael Ewald.

Thanks, Katherine. Good morning and thank you all for joining us on our earnings call. I'm joined again today by Mike Boyle, our President; and our Chief Financial Officer, Sally Dornaus. I'll start with an overview of our third quarter ended September 30, 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. Yesterday, after market closed, we reported third quarter net investment income per share of $0.53, driven by very strong levels of income earned from our portfolio investments during the quarter. For Q3, net investment income return represented a 12.4% annualized yield on book value and covered our dividend by 156%. This is the highest quarterly level at NII that we have earned since our inception. The significant growth in our NII this quarter was driven by the benefits of rising interest rates, higher income related to fees earned on certain new originations and greater dividend income related to an equity co-investment payoff. Our Board has increased our regular quarterly dividend by approximately 6% or $0.02 per share to $0.36 per share, to shareholders of record as of December 31, 2022. This represents an annualized yield of 8.5% on ending book value as of September 30 and an 11% annualized yield at BCSF's current trading levels. Over the course of the year, we have observed base rates, namely SOFR and LIBOR, significantly increase. As we have previewed with our shareholders during prior earnings calls, we expected to see earnings growth during the second half of this year given the timing lag of rate resets across our portfolio. We are pleased to see this begin to contribute to higher earnings this quarter and we are well positioned to benefit further from any future rate increases. The increase in the regular dividend rate reflects our view of the company's earnings power under various interest rate and economic scenarios. Our Board will continue to evaluate further dividend increases on a quarterly basis. Net asset value as of September 30 was $16.98 per share, a decrease of approximately 1% quarter-over-quarter. Our NAV decline was primarily driven by net unrealized losses across our portfolio. During the third quarter, we continued to observe high levels of market volatility in the broadly syndicated loan and public equity markets, given concerns of slowing growth in the macro economy. In a potential recessionary environment, we believe our portfolio is on strong footing to endure a more challenging market backdrop. Across our portfolio, the median EBITDA of our company is just under $50 million. These are companies that are big enough to matter in their ecosystem and have staying power. Their customers and suppliers would be [indiscernible] worse off if they ceased operations. In uncertain times like today, these are the types of companies that have multiple growth levers to pull to be nimble. We have largely avoided smaller businesses as they tend to be less resilient during economic downturns. Importantly, we demand and received strong documentation as 93% of our debt investments are structured with lender-friendly terms such as financial covenants tied to management's forecasts. This puts in place near-term goal posts related to company financial performance, providing us with a seat early in any discussions to mitigate our potential risk in a downside scenario. We also have majority control positions and 80% of our debt tranches, allowing us to drive eventual outcomes at our discretion. Our middle market borrowers operate across a wide range of industries driven by our long-standing focus on investing in defensive industries as represented by our top exposures being aerospace and defense, iTech and business services. We have been shying away from direct consumer-facing industries that could experience more volatile demand during periods like today. Lastly, the majority of our structures are in first lien senior secured loans, supported by significant equity cushions provided by private equity sponsors behind our ones. Our focus on sponsor-backed companies provides them with a professional management, capital and depth of personnel, resources, oversight and alignment necessary to guide them throughout choppy macroeconomic periods. In the current environment, our portfolio companies continue to perform well and have proven to be durable thus far in light of the macro headwinds related to inflationary pressures and higher interest rates. We have not seen a wave of amendments across our portfolio of companies like we last saw in 2020 related to the COVID-19 pandemic, nor do we expect to during our forecast periods. Our portfolio management team has been focused on stress testing interest rate sensitivities across our investments to ensure sufficient cash flow coverage within our portfolio companies. We are pleased to see ample cushion for the vast majority of our companies and only very few names fall below the one times interest coverage level and we have put these on our focus list. Looking ahead, we believe we are well positioned to navigate the expected challenging economic and geopolitical times ahead. Our platform within Capital Credit is comprised of deep resources and expertise owned over many market cycles going back to our inception in 1998 and we can and do tap into the broader bank capital network for additional support, as needed. I will now turn the call over to Mike Boyle, our President, to walk through our investment portfolio in greater detail.

Thanks, Mike. Good morning, everyone. I'll start with our investment activity for the third quarter and then provide an update in more detail on our portfolio. New investment fundings during the third quarter were $433 million across 59 companies, including $270 million in 9 new companies, $107 million in 48 existing companies, $41 million in the ISLP and $15 million in the SLP. Sales and repayment activity totaled approximately $397 million, resulting in net funded portfolio growth of $36 million quarter-over-quarter. We believe the environment for middle-market lenders has been increasingly attractive in recent history as we have been benefiting from improving economics and terms. Given the increase in credit spreads and base rates, not only are we able to underwrite new first lien loans at higher yields but we have also seen leverage levels on new loans decrease as lenders focus on maintaining free cash flow and fixed charge coverage ratios. Furthermore, we have used the current market as an opportunity to tighten document terms, particularly around covenant levels and EBITDA definition. Our investing activity has been focused on underwriting new companies as well as add-on activity for existing portfolio companies to complete add-on acquisitions. New LBO activity continues but at a lower level as sponsors still continue to show interest in the highest quality companies expected to perform over the current economic outlook. Overall, we believe the current environment provides an attractive opportunity for lenders such as ourselves to be selective and pick our spot. Turning to the investment portfolio. At the end of the third quarter, the size of our investment portfolio at fair value was $2.3 billion across a highly diversified set of 130 portfolio companies operating across 32 different industries. Our portfolio company diversification has grown almost 25% on a year-over-year basis. We continue to maintain our focus on first lien senior secured structures. As of September 30, 70% of the investment portfolio at fair value was invested in first lien debt, 4% in second lien debt, 2% subordinated debt, 3% in preferred equity, 9% in common equity interest and 12% across our joint ventures, including 10% in the International Senior Loan Program and 2% in the Senior Loan Program. Within our joint ventures, over 96% of our underlying exposures are comprised of first lien senior secured loans. As of September 30, 2022, the weighted average yield on the investment portfolio amortized cost and fair value were 10.2% and 10.6%, respectively, as compared to 8.5% and 8.8%, respectively, as of June 30, 2022. The increase was primarily driven by higher reference rates on our loans. 94% 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 of our loans. Investments in Europe totaled 17% of the portfolio at fair value as of September 30 compared to 16% in the prior quarter. Although we have an increased focus on our portfolio companies operating across Europe, given macroeconomic headwinds, this portfolio remains healthy, given the underlying seniority of the loans as well as the sector mix with an emphasis on software and health care business models. ISLP's investment portfolio at fair value as of September 30 was approximately $623 million, comprised of investments in 34 portfolio companies operating across 15 different industries. 96% of the portfolio are first lien loans, 3% second lien and 1% equity interest. As of September 30, SLP's investment portfolio at fair value was approximately $571 million, comprised of investments in 51 portfolio companies operating across 22 different industries. 100% of this investment portfolio is invested in senior secured loans, including 96% in first lien and 4% in second lien. Moving on to portfolio credit quality trends. They were relatively stable quarter-over-quarter. Within our risk rating scale, 90% of our portfolio at fair value as of September 30 was comprised of risk ratings 1 and 2s, indicating that the investment is performing in line or better than expectations relative to our initial underwriting. Risk rating 3 investments comprised 8% of our portfolio at fair value. During the third quarter, we placed 1 new portfolio company on nonaccrual status, contributing to the modest uptick in risk rating for investments totaling just under 2% of the portfolio. Overall, we believe our credit fundamentals remain solid across the portfolio. Our median leverage attachment point is 5.6x as of September 30, modestly up from 5.4x as of June 30. Sally will now provide a more detailed financial review.

Thank you, Mike and good morning, everyone. I'll start the review of our third quarter 2022 results with our income statement. Total investment income was $62.8 million for the 3 months ended September 30, 2022, as compared to $52.4 million for the 3 months ended June 30. The increase in investment income was primarily driven by the benefits of rising interest rates, income related to fees earned on certain new originations and greater dividend income. Total expenses for the third quarter were $28.7 million as compared to $25.6 million in the second quarter. The increase in expenses was driven by an increase in interest and debt financing expenses, given higher base rates partially offset by a decrease in incentive fees. Net investment income for the quarter was $34.1 million or $0.53 per share as compared to $26.7 million or $0.41 per share for the prior quarter. Our net investment income covered our dividend by 156%. During the 3 months ended September 30, 2022, the company had net realized and unrealized losses of $23.1 million. GAAP income per share for the 3 months ended September 30 was $0.17 per share. Moving over to our balance sheet. As of September 30, our investment portfolio at fair value totaled $2.3 billion and total assets of $2.5 billion. Total net assets were $1.1 billion as of September 30. NAV per share was $16.98, down from $17.15 at the end of the first quarter, representing a 1% decrease quarter-over-quarter. At the end of Q3, our debt-to-equity ratio was 1.25x, up from 1.14x at the end of Q2. We had a large receivable on our balance sheet at quarter end which drove our leverage ratio to the wider end of our stated range of 1 to 1.25x. Pro forma for this, our debt-to-equity ratio would have been 1.17x. Our net leverage ratio which represents principal debt outstanding less cash, was 1.2x at the end of Q3 as compared to 1.07x at the end of Q2. During the quarter, we continued to improve our liability structure. We increased the size of our Sumitomo Credit Facility to $635 million, up from $300 million. In the current environment, we were pleased with our ability to attract new lenders in the facility as we increase the diversification of our vendor group and we're able to hold the turns on our existing facility constant. In addition, we repaid the full principal amount outstanding of our $112.5 million on our senior unsecured notes due in 2023. The notes were repaid at par plus accrued and unpaid interest thereon. The stated interest rate on the notes was 8.5% which provided us an opportunity to lower interest expense and borrow through the increased capacity on our Sumitomo Facility at SOFR plus $175 million. We recognized the $0.01 per share loss during the quarter due to the extinguishment of the debt related to unamortized expenses through the stated maturity date. Our capital structure remains durable with a large portion of our outstanding debt and fixed rate unsecured debt obligation. These structures provide the company with greater financial flexibility to withstand greater periods of volatility ahead. As of September 30, approximately 56% of our outstanding debt was in floating rate and 44% in fixed rates. Against our portfolio of floating rate loans, the company is well positioned to benefit from higher interest income across our portfolio given the rise in rate. As of September 30, 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-Q 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 $311 million. This compares to $307 million of undrawn investment commitments. For the 3 months ended September 30, 2022, the weighted average interest rate on our debt outstanding was 3.7% as compared to 3.2% as of the prior quarter end. The increase was 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.

Thanks, Sally. We are pleased to deliver another strong quarter for our shareholders, driven by the high level of net investment income earnings. We believe our portfolio is on strong footing to navigate more uncertain times ahead given the underlying tenants of our portfolio construction. We remain committed to delivering value for our shareholders reproducing attractive ROEs and thank you for the privilege of managing our shareholders' capital. Cecillia, please open the line for questions.

[Operator Instructions] And we will now take our first question from Paul Johnson from KBW.

Congratulations on a nice beat this quarter. I'm just wondering how much of the EPS this quarter, $0.53 NOI, how much of that was just from onetime items?

Sure. So about $0.06 of that was from a onetime dividend coming out of 1 of an equity co-investment. So that's included in the dividend line item in investment income. Beyond that, there's another $0.06 which are basically commitment fees that we collected for underwriting deals in the quarter. We do think that there will continue to be that other income that will generate in future quarters but it will be variable based on the market environment.

Got it. Right. I'm curious how much -- how does that compare, I guess, to kind of previous quarters in the past in terms of that nonrecurring onetime dividend income coming from, I guess -- I'm sorry, not dividend, the fee income coming from commitment fees? Was this quarter relatively higher than past quarters? I'm just curious how that compares.

Yes. It's about in the middle of the range if you look at the last 4 quarters. So we've had some -- around $1 million. We've had some quarters -- like last quarter was closer to $8 million. So that $4 million range is kind of in the middle of what we've seen historically for commitment fees.

Got it. And then just on activity for the quarter, it was a fairly active quarter both from the originations repayments for you guys. I'm just curious what I guess, drove the higher level of activity this quarter, especially on the repayment side and do you expect that to continue? I guess, given your line of sight into the next quarter or so of activity would you expect that to continue?

I would imagine that repayments will slow down in the portfolio over time just given the macroeconomic backdrop. What drove many of the repayments this quarter were two things, one of which was dropping some assets from our balance sheet down into the joint venture, so the ISLP and SLP. We also -- some of the commitment fees we're just talking about are actually related to deals that we underwrote and then syndicated on to other players in the market. So that also flows through the sales and repayments line. So this quarter was much more driven by those 2 items as opposed to more traditional refinancings or fresh LBO activity that tends to drive repayments in a more normalized market.

Got it. That makes sense, that makes sense. And then on your portfolio, I mean, as far as your borrowers go and I imagine you're still receiving a lot of incoming information and updated forecasts that are obviously changing along with the environment. And I'm wondering if you could just kind of talk about the performance of your borrowers? I know you mentioned that it's been quite good, I guess, as far as you've observed. But just, I guess, how is interest coverage changing with the rate increase this quarter or the last few quarters? And then as well -- yes, I guess that's all. Just any kind of color on just the performance of these ones. And then I guess on top of that, you mentioned on the call, there's a company that fell below 1x interest coverage. And given the increase in, I guess, the performance 3-rated loans, I'm wondering if that's the same loan and if you can make any comments on that company as well?

Yes. Why don't I start and then Mike can jump in, too. I mean, I think generically, the performance of our portfolio companies, as you pointed out, has been pretty strong. I think that's based on the -- that we have sought out more defensive industries. I think that's been particularly helpful. I think the other thing I would point out is that we have been, I guess, pleasantly surprised that our companies have also been able to push out price increases of their own in this inflationary environment and that's helped keep their gross margins pretty stable. And I think from a top line perspective, again, we haven't really seen much deterioration yet as we obviously haven't necessarily entered a recession yet but it's more of a B2B focus than a B2C focus which is where we'd be more concerned. Mike, I don't know if you want to touch a little bit on the interest rate sensitivity modeling that we've done but we've definitely done more of a shock modeling perspective rather than trying to take the existing SOFR curve and overlay that in more companies. We're looking more at worst-case scenarios.

Sure. Yes. So about 10% of the portfolio is in risk rating 3 or 4 assets. Those are all situations where when we're running interest rate sensitivities and looking at capital structures and cash flow coverage, we are more concerned about the ability of those companies to pay their interest in higher rate environments. I'd say risk rating 3 is we still feel comfortable but there is increased risk that cash flow gets particularly tight. What we were commenting on in the interest coverage analysis with a few companies going below 1x, are situations where we're running, as Mike Ewald highlighted, a shock scenario where we have the interest rate step up, base rates north of 5%. And so that's part of what's informing those risk rating 3s where we are focused on making sure that those companies are able to continue to pay their cash interest.

[Operator Instructions] As there are no further questions at this time, I'd like to turn the call back to your speakers for any additional or closing remarks.

Thanks, Cecillia and thanks all of you for your time and attention today. We do really appreciate your support and we look forward to talking to you again next quarter. Have a good day.