Barings BDC, Inc. Q2 FY2022 Earnings Call

At this time, I would like to welcome everyone to the Barings BDC, Inc. conference call for the quarter ended June 30, 2022. Please note that this call may contain forward-looking statements that include statements regarding the company's goals, beliefs, strategies, future operating results, and cash flows. Although the company believes these statements are reasonable, actual results could differ materially from those projected in forward-looking statements. These statements are based on various underlying assumptions, and are subject to numerous uncertainties and risks including those disclosed under the sections titled Risk Factors and Forward-Looking Statements in the company's annual report on Form 10-K for the fiscal year ended December 31, 2021, and the quarterly report on Form 10-Q for the quarter ended June 30, 2022, each as filed with the Securities and Exchange Commission. Barings BDC undertakes no obligation to update or revise any forward-looking statements unless required by law. At this time, I will turn the call over to Eric Lloyd, Chief Executive Officer of Barings BDC.

Thank you, operator, and good morning, everyone. We appreciate you joining us for today's call. Please note that throughout today's call, we'll be referring to our second quarter 2022 earnings presentation that is posted on the Investor Relations section of our website. On the call today, I'm joined by Barings BDC's President and Co-Head of Global Private Finance, Ian Fowler; Bryan High, Barings Head of Capital Solutions and Co-Portfolio Manager; and the BDC's Chief Financial Officer, Jonathan Bock. As we typically do, Ian, Bryan, and John will review details of our portfolio and second-quarter results in a moment, but I'll start off with some high-level comments about the quarter. Let's begin with the market backdrop shown on Slide 5 of the presentation. With significant economic uncertainty, Barings syndicated loan spreads increased due to increased macroeconomic fears tied to both underlying inflation and the potential of a Fed overcorrection. Loan prices broadly and BDC equity prices specifically were also not immune from increasing risk premiums, down 4% and 9% from the end of Q1 through July 31, respectively. Looking at second quarter highlights on Slide 6. Net asset value per share was $11.41 compared to the prior quarter of $11.86, down 3.8% driven primarily due to unrealized write-downs tied to macro market factors and spread widening as opposed to fundamental credit-related factors. Our net investment income increased to $0.29 per share compared to $0.23 per share last quarter as a result of increasing interest and fee income as well as the elimination of our income incentive fee due to our shareholder-friendly fee structure, specifically in the incentive look-back feature, which includes realized and unrealized gains and losses. Regarding new investments, we had gross originations of $352 million in the second quarter. This was offset by $299 million of sales and prepayments. Our investment portfolio continued to perform well in the second quarter with no new loans on nonaccrual. In total, with the Sierra and MVC assets, our total nonaccruals are 2.9% of the portfolio on a cost basis and 0.8% on a fair value basis. Ian will highlight later, our focus on select asset sales and restructurings in the acquired MVC and Sierra portfolios as we continue to maximize shareholder value while benefiting from the protection added by the credit support agreement. Additionally, our Board declared a third quarter dividend of $0.24 per share, equating to an 8.4% yield on our net asset value of $11.41. Slide 7 outlines summary financial highlights for the previous 5 quarters. In the second quarter, continued strong investment performance drove total investment income higher quarter-over-quarter to $56 million and net investment income to $32 million, both up from $44 million and $19 million in the first quarter. Realized losses of $10 million were principally a result of FX moves on assets that were repaid at par in the quarter with a corresponding offset in the unrealized depreciation associated with foreign currency borrowings under our credit facilities. Net unrealized depreciation of $45 million was primarily a result of mark-to-market on our assets as a result of higher spreads. As a result of the unrealized depreciation, Barings incentive fee cap eliminated the quarterly incentive fee further lowering expenses and increasing debt investment income to $0.29 per share. Net leverage, which is leveraged net of cash, short-term investments, and unsettled transactions, was 1.0x, which is currently toward the lower end of our target leverage of 0.9 to 1.25x. This attractive liquidity position allows us to remain steady partners with our existing sponsor clients as well as look towards investment opportunities that present themselves in the face of economic uncertainty. I'll now turn the call over to Ian to provide an update on the market and our investment portfolio.

Thanks, Eric, and good morning, everyone. If you turn to Slide 9, you can see additional details on the investment activity that Eric mentioned. Our middle-market portfolio increased by $3 million on a net basis in the quarter, with gross fundings of $227 million, offset by sales and repayments of $224 million. New middle-market investments included 22 new platform investments totaling $156 million and $171 million of follow-on investments and delayed draw term loan fundings. We also had $108 million of net cross-platform investments in the quarter. Slide 10 updates the data we show you each quarter on middle-market spreads across the capital structure, and it is easy to reference that investment spreads across public and private asset classes have widened. Notice a degree of spread widening in the private credit category has a much more lagged effect when compared to broadly syndicated loan spreads, which are outlined in red. That said, we continue to see spread widening in our core market as a welcome benefit to long-term investment return, particularly for those who have flexible investment capital. Turn to Slide 11. Many of you have heard me outline the competitive dynamic at play in unitranche transactions. I'm pleased to see as a result of emerging underwriter discipline tied to potential economic fears that spreads began to widen ever so slightly and may likely continue their upward trend. While underlying covenant-light activity in these transactions remains high, we also continue to see improvements in loan documentation that tilt towards patient investors. In many years in this asset class, I'll outline that these changes are slow and gradual, but they do occur. And the key remains keeping focus on pricing discipline across your origination footprint. A bridge of our investment portfolio from March 31 to June 30 is shown on Slide 12. On Slide 13, you'll see a breakdown of the key components of our investment portfolio on June 30. As we have discussed in the past, the goal of this slide is to provide details on the key categories of our portfolio, which are the Barings-originated middle-market portfolio, the legacy MVC Capital and Sierra Income portfolios as well as our cross-platform investments. The middle-market portfolio remains our core focus and continues to grow. It makes up 56% of our portfolio in terms of total investments at fair value and 48% of our portfolio in terms of revenue contribution. Our Barings originated middle-market exposure is heavily diversified amongst obligors of 199 portfolio companies with a geographic diversification across the U.S., Europe, and APAC regions. Underlying yields on our middle-market investment portfolio of 7.9%, up from 7% last quarter and weighted average first lien leverage of 5.3x remain reflective of our boring is beautiful approach to credit. In addition to our middle-market exposure, we continue to draw upon Barings wide investment frame of reference to complement our core portfolio with $441 million of investments in the legacy MVC and Sierra portfolios, and $612 million of cross-platform investments. Two MVC assets and 5 Sierra assets remain on nonaccrual, unchanged from last quarter. As mentioned previously, total nonaccrual assets as a percent of fair value are 0.8%, all of which are covered by the respective credit support agreements with Barings. Our liquidation and redeployment efforts on the MVC and Sierra portfolios remain ongoing. Barings onboarded $627 million of assets from those two acquisitions. To date, we've generated $121 million of repayments across both portfolios. Turning to the Barings portfolio. No Barings directly originated loans are on nonaccrual and the total portfolio had no material modifications to the cash payment terms of our debt investments during the quarter. Our total investment portfolio is now made up of 65% first lien assets. Slide 14 provides a further breakdown of the portfolio from a seniority perspective. The core Barings-originating portfolio is 72% first lien. Note, the combined MVC Sierra portfolios are comprised of senior secured second lien, mezzanine debt, and equity investments, which brings the first lien component of the total portfolio down to 65%. Our top 10 investments are shown on Slide 15. Our largest investment is 5.3% of the total portfolio, and the top 10 investments represent 23% of the total portfolio. Recall our largest investment, Eclipse Business Capital, is backed by a large portfolio of asset-backed loans conservatively structured inside of the collateral net liquidation value. The overall portfolio remains diverse from an industry perspective as well with 294 investments spread across 31 industries. I'll summarize my market comments with a simple thought that boring is beautiful investment favors patience and most importantly, pricing discipline. With an increased level of macroeconomic uncertainty, we expect private equity sponsors to be highly selective with regard to new investments and instead favor support of existing investments. Our strong set of portfolio incumbencies across our U.S. and European sponsor universe allows us to be patient with our sponsors, providing growth capital to existing investments. I also believe there are circumstances where certain private lenders will be in need of liquidity, and this creates both stress and distressed sellers as well as stressed and distressed portfolio companies. Our wide investment frame of reference across the capital stack allows us to target and underwrite these opportunities. And this gives me confidence in the future as I know we have both the investment acumen, patience, and flexible capital base to drive attractive returns. I'll now turn the call over to Jon to provide additional color on our financial results.

Thanks, Ian. And turning to Slide 17. Here's the full bridge of NAV per share movement in the second quarter. Our net investment income exceeded our dividend by $0.05 per share. Net realized losses on our investment portfolio and foreign currency transactions drove a decrease of $0.09 per share, while our unrealized depreciation totaled $0.41 per share. Additional details on this net unrealized depreciation are shown on Slide 18. Of the total $45 million in unrealized depreciation in the second quarter, approximately $32 million was attributed to price or spread widening. Of this, our cross-platform investments total depreciation of approximately $20 million. Notably, the legacy MVC portfolio saw a total depreciation of $11 million with the majority tied to underlying credit performance, while the Sierra portfolio had total depreciation of $16 million, $12 million of which was attributed to price movements, predominantly tied to CLO equity positions and the Sierra joint venture. Near the bottom of Slide 18, you can also see that the credit support agreements decreased $13 million as a result of increasing rates and discount rates. Slides 19 and 20 show our income statement and balance sheet for the last 5 quarters. As we've discussed, our net investment income per share increased to $0.29 for the quarter driven by a $12 million increase in total investment income as well as the elimination of the income incentive fee resulting from unrealized marks on the investment portfolio. From a balance sheet perspective on Slide 20, total debt to equity was 1.23x at June 30, although this level is artificially high given the timing of certain asset sales, and was 1x after adjusting for cash, cash equivalents, and unsettled transactions. Turning to Slide 21, you can see how our funding mix ties to our asset mix, both in terms of seniority and asset class. Compared to the end of 2020, our reliance on secured bank debt has decreased with the issuance of $725 million of unsecured debt in the public and private markets, and we have continued to diversify our balance sheet to match our diverse portfolio of assets. Details of each of our borrowings are shown on Slide 22, which shows the evolution of our debt profile over the last 3 quarters. Jumping to Slide 23, you can see the impact of our net leverage using our available liquidity to fund our unused capital commitments. Barings BDC currently has $212 million of delayed draw term loan commitments to our portfolio companies as well as $67 million of remaining commitments to our joint venture investments. The table shows how we have the available capacity to meet the entirety of these commitments if called upon while maintaining a cushion against our regulatory leverage limit. Slide 24 updates our paid and announced dividends since Barings took over as the investment advisor to the BDC. As Eric mentioned, the Board declared a third quarter 2022 dividend of $0.24 per share and an 8.4% distribution on net asset value. Now turn with me to Slide 26, which shows a graphical depiction of relative value across the BBB, BB, and B asset classes. As Ian outlined, we saw improved spreads in the quarter across all asset classes as a result of increased fears of stagnation or stagflation. For reference, single B liquid loan spreads are LIBOR plus 643 basis points, up from LIBOR plus 439 basis points last quarter. Rising base rates and improved spreads across liquid markets also correlate to private markets as demand for private alternatives falls in the face of rising risk-free rates. Said differently, many investors who tend to migrate towards a nominal investment hurdle often have less demand for the exotic when their return objectives can be met with traditional public assets. As a result, managers like ourselves need to maintain strict investment discipline in how this illiquidity premium to public markets is priced over cycles. We speak often of our pricing premiums relative to liquid credit in our calls, and this translates into the actual results shown on Slide 27, which outlines the spread premium on our new investments relative to liquid credit benchmarks. Notice that our investment illiquidity premiums in the second quarter fell as rising spreads in liquid loans caused by fear were not fully repriced into the direct lending assets given those loans were originated and committed to prior to the spread widening. Excluding certain equity investments, Barings BDC deployed $338 million at an all-in spread of 836 basis points, which represents an 11 basis point spread premium to comparable liquid market indices at the same risk profile. However, in the previous quarter, we deployed $281 million at an all-in spread of 768 basis points, which represented a 293 basis point spread premium to comparable liquid market indices at the same risk profile. All-in investment spreads increased which will have a positive income benefit. Looking forward to our new transactions in the pipeline, we expect to see improvement in spread pricing as new transactions model in increased risk premiums, which will drive BBDC investment income higher. As Ian said, both patience and pricing discipline define long-term investment performance. At Barings BDC, we demonstrate both. Now I'll wrap our prepared remarks with Slide 28, which summarizes our new investment activity so far during the third quarter of 2022, and our investment pipeline. The pace of new investments remained steady compared to the last 2 quarters, with $215 million of new commitments, of which $171 million have closed and funded. Of these new commitments, 93% are first lien asset senior secured loans, 19% are in cross-platform investments, and 23% are European or Asia Pacific originations. The weighted average origination margin was roughly 7.6%, and we've also funded approximately $12 million of previously committed delayed draw term loans. The current Barings Global Private Finance investment pipeline is approximately $2.6 billion on a probability-weighted basis, and is predominantly first lien senior secured investments. As a reminder, this pipeline is estimated based on our expected closing rates for all deals in our investment pipeline. I'll now turn it over to Eric.

Thank you, Jon. I want to take a moment to highlight that the Barings BDC Board approved a number of promotions and recognition of the work done on behalf of Barings BDC shareholders. Effective September 1, I'll assume the title of Executive Chairman of Barings BDC. Jonathan Bock will become the BDC's Chief Executive Officer, Jonathan Lansberg will become the Chief Financial Officer, and Elizabeth Murray will become the BDC's Chief Operating Officer and remain the Chief Accounting Officer. Ian Fowler will remain President of Barings BDC. I share the Board's confidence in the BDC's management team, and I'm very grateful for their leadership and dedication to the Barings BDC shareholders. With that, operator, we'll open the line for questions.

Congratulations to Bock and Elizabeth on their promotions. To start, it's clear that volatility has increased. I have two questions regarding originations: should we consider a shift towards cross-platform? Additionally, how does the impact on acquired portfolios affect your outlook for potential repayments?

You can expect to see the same level of cross-platform investment as we've had in the past, which we've estimated to be around 30%. We're also noticing an increase in prepayment velocity on both our ongoing and acquired investments. This is happening because we are actively repositioning some of our loans. Last quarter, we had about $57 million come off of Sierra, and you can anticipate similar outcomes in the future as the performance of that portfolio has exceeded our expectations.

Got it. And then just digging into credit a bit, obviously, with higher rates and higher debt servicing levels for companies and just really want to pick your brain given you guys almost have kind of four portfolios within your portfolio in terms of middle market, cross-platform, MVC, and Sierra. But just give us a sense for the underlying trends of portfolio companies in terms of REV and EBITDA growth and margins that you're seeing across the board?

I'll start with the two acquired portfolios, and lobby over to lateral over to Ian as it relates to the all-in Barings originated portfolio. But generally speaking, our credit performance on the underlying acquired portfolios is still very attractive. What you will find though, is the added alignment that came from a result of the credit support agreement, which is unique to Barings, continues to give folks, and more importantly, investors more confidence that not only do we have the patience and ability to work out those assets, but also the time frame and the proper shareholder protections to do so even in the face of a stagflation or stagnation environment. But Ian can speak directly to the Barings portfolio.

Yes. In terms of the portfolio, we've done a lot of proactive work in the last couple of quarters going through all of our portfolio companies, which obviously includes the BDC complex, and really focused on wage inflation, rising rates, and input cost inflation. Most of our portfolio, around 70%, are more defensive service sectors such as software, IT managed services, info services, financial services, and professional services. These sectors are really not impacted by input cost inflation, and where we do have manufacturing, it's more light niche high-margin manufacturing, more light assemblers versus heavy manufacturing. I feel very good about the portfolio and the way it's positioned. We still see revenue growth given the fundamental value of those businesses, the strength of those businesses, and the leadership in the industry of those businesses. They're able to pass through cost increases. Now there have been a few that have lagged in terms of putting through price increases, and we've seen a little margin degradation on those, but that would be a minority.

Just a follow-up on part of Kyle's question there. Can you give us a sort of state of the union on the CSA for MVC? Is that above water? Can you remind us how that plays out for that to ultimately settle, if applicable?

Yes, if we consider the future value of the payment while we continue to focus on a specific investment, that future payment would be close to the $23 million of a fully utilized Credit Support Agreement, assuming everything was liquidated at this moment. That would be the situation if we look eight years ahead without any changes. The depreciation seen on the credit support agreement is primarily due to the increase in rates and discount rates, which has led to a lower present value of that future payment. Moving forward, as we manage several strong investments with appealing equity potential, while also overseeing our existing investments with a focus on exits and repositioning, we believe we can handle our capital responsibly. We are confident that over time, we will be able to exit these investments without incurring a significant credit support premium or payment.

Yes. And let me throw in my congratulations on the personnel changes. I speak for the analytical community; I think we all take great comfort in knowing that we have now somebody highly qualified and capable in the CFO seat. Just messing with you. Congratulations Jon and Elizabeth. I have a couple of questions. Going to Slide 15. I noticed a new entry in that top 10, in Core Scientific. That is a name that's had a number of articles written about it and has arranged for a $100 million equity line with an investment bank. Is that an equipment finance structure, or is that a term loan structure? How is that particular one set up just because it's one that’s sort of been in the news?

Sure. I know we don't often discuss individual portfolio companies, but I want to emphasize that the structure will be for equipment financing. As you're familiar with the companies involved, both our firm and our parent company have a significant and successful equipment leasing operation. This investment will be made in collaboration with that group, linked to the underlying machines, featuring a solid amortization schedule and a strong net return.

I anticipate that it will align with my expectations. Let’s move to Slide 13. When we examine the fair value yield of the four investment segments you've mentioned, it really comes down to calculations. Could you provide an update on what the fair value yields of each segment might be by the end of this quarter? I suspect that the cross-platform segment will experience less fluctuation compared to the other three, as it consists of more customized investments, many of which have fixed rates.

Bryan, perhaps on the cross-platform if you want to speak to the potential for yield increase as a result. The majority of what you'll focus on, there are quite a bit of floating rate components in the cross-platform investments. We can go to Ian as it relates to the fact that everything we do there has a floating rate and will also increase. But Bryan, do you want to provide a little bit of color on those points?

Sure. I think on the traditional sort of debt instruments in the portfolio, a lot of them are floating rate. So you would see some increase there. But clearly, Eclipse is in that column. That's a return on equity effectively. And if you think about their portfolio, the benefit of LIBOR floors is going away. So there are a lot of puts and takes there as what I would say, Casey. The other three columns are much more floating rate in nature just across the board. So they would probably move more so than the cross-platform as a whole, but I would say that still the majority of the investments on the cross-platform side are floating rate as well, just at a lower percentage.

Can you provide your thoughts on how much you expect the three segments in the middle market, MVC, and SIC sleeves to change quarter-over-quarter?

MVC is unlikely to change significantly. As a result, there is a small amount of fixed-rate exposure. However, this exposure is minimal. In contrast, the Sierra portfolio is primarily floating rate, so there should be a net benefit from that.

Let me congratulate everyone on their new positions. Eric might be the winner if this means he won't have to deal with earnings calls as frequently. Moving on to a question about bit, Sierra mentioned $57 million in repayments this quarter. A significant portion appears to have been a reduction in the size of their loan joint venture, meaning there were many repayments or sales within that. Can you provide any insight? It generated $1.6 million in dividend income and is positively impacted by floating rates. However, how quickly do you expect to wind that down, considering it's a Sierra asset? On the other hand, it may have some good prospects in the midterm.

I'll start by saying that the way the joint venture was structured was less efficient compared to what Barings could implement with our lending partners. They had the ability to design a loan structure backed by substantial collateral, making the financing aspect much more efficient for withdrawing funds. Regarding the wind down, it should progress quickly. The reason, Robert, is that our strategy with joint venture investments is to broaden our perspective and enhance diversification. We do not simply buy liquid collateral and over-leverage in hopes of achieving a better yield profile. You can anticipate a rapid progression tied to the collateral as we continue to invest and redeploy. While it has generated over an 8% net return, which is impressive, when you assess the investment opportunities within Ian's and Bryan's areas, the yield and net return prospects are higher with significantly less price volatility. In the Eclipse case, you have the benefit of when macroeconomic uncertainties increase, folks tend to hold loan outstandings. The growth of that book has been very strong because not only is the interest income high, but it's because folks are holding their loans out longer. The credit performance remains very, very good, and the ability for the Eclipse team in terms of their partnership with Bryan and the Cap Solutions team at Barings, their ability to partner and provide solutions on a number of bespoke transactions has only increased. You could bias returns higher, not only through both a rate benefit but also through an underlying growth benefit as when stresses occur, people turn to their assets to borrow. That's been very positive. Across the rest of the network, you're starting to find a much higher net return as a result of increasing base rates, which is what you would expect from us. We also have to compete with the substitutes of IG or increasing spreads on liquid markets. We remain very positive looking forward on both interest income contribution from our private markets businesses and direct lending as well as the cross-platform and the joint ventures.

Ladies and gentlemen, we have reached the end of today's question-and-answer session. I would like to turn this call back over to Mr. Eric Lloyd for closing remarks.

Thank you, operator, and thank you to all of you who participated in today's call. Like you, I'm very proud of the promotions that we put forth and what we've done in the last 4 years, and I'm confident the new management team will build on that with great success. Please stay safe and have a great day.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Enjoy the rest of your day.