Earnings Call Transcript - BBDC Q1 2022

Operator, Operator

At this time, I would like to welcome everyone to Barings BDC, Inc. Conference Call for the quarter and year ending March 31, 2022. Today’s call is being recorded, and a replay will be available approximately 2 hours after the conclusion of the call on the company’s website at www.baringsbdc.com under the Investor Relations section. Please note 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 the forward-looking statements. These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the section titled Risk Factors and Forward-Looking Statements in the company’s annual report Form 10-K for the fiscal year ended December 31, 2021, 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 would like to turn the call over to Eric Lloyd, Chief Executive Officer of Barings BDC. Please go ahead, sir.

Eric Lloyd, CEO

Thank you, operator, and good morning, everyone. We appreciate you joining us for today’s call, and I hope you and your families are doing well. Please note that throughout today’s call, we’ll be referring to our first 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 U.S. Special Situations and Co-Portfolio Manager; and the BDC’s Chief Financial Officer, Jonathan Bock. As we typically do, Ian, Bryan, and Jon will review details of our portfolio and fourth quarter results in a moment, but I’ll start off with some high-level comments about the quarter. After a record 2021, we carried that momentum into the first quarter of 2022 with strong net portfolio growth and an expanded equity capital base following the close of the Sierra acquisition and strong performance from our direct lending and cross-platform investment strategies. Let’s begin with the market backdrop shown on Slide 5 of the presentation. With rapid changes in the geopolitical and market landscape, broadly syndicated loan prices began to price an increased risk tied to both underlying inflation as well as concerns of an overly aggressive Federal Reserve. BDC equity prices also were not insulated from the current bout of market volatility, and we believe it is in these periods we’re well-capitalized, disciplined, and highly selective managers can source attractive risk-adjusted returns. Moving to the fourth quarter highlights on Slide 6. Net asset value per share was $11.86 compared to the prior quarter of $11.36. Our net investment income remained at $0.23 per share unchanged from last quarter. This is despite raising approximately $527 million in new equity with the close of the Sierra transaction. It is important to note the underlying stability of our net investment income is further enhanced by our incentive fee structure as our earnings continue to exceed our new 8.25% hurdle rate and remain in the investment catch up. As a result of these trends, our Board elected to increase our second quarter dividend to $0.24 per share equating to an 8.1% yield on our net asset value of $11.86. Regarding new investments, we had gross originations of $330 million in the first quarter on top of the $443 million portfolio acquired from Sierra Income. This was offset by $173 million of sales and prepayments at $132 million of which were sold to our JVs. Our investment portfolio continued to perform well in the first quarter with no new non-accrual loans, and the portfolio remains valued above original cost. With the onboarding of the Sierra assets, total non-accruals increased to 3% of cost from 2.2% of cost last quarter. However, on a fair value basis, total non-accruals are just 1.8%. 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 agreements. Slide 7 outlines summary financial highlights for the quarter. In the first quarter, robust investment activity and continued strong performance from cross-platform investments offset negative earnings drag associated with the increased share count, as total net investment income per share was at the $0.23 per share level. Net unrealized depreciation was $3.5 million associated with select marks on the investment portfolio and realized losses totaled $1.4 million. Following this year acquisition, net leverage, which is leverage net of cash, short-term investments, and unsettled transactions, was 0.89x, which is currently below our target leverage range of 0.9x to 1.25x. This attractive liquidity position allows us to look towards future growth with our portfolio of companies as well as selective opportunities in the current market environment. In these periods of market uncertainty, you can expect us to remain disciplined, keeping a focus on our core markets, our incumbencies across 287 portfolio of companies, and our cross-platform strategies. Additionally, our commitment to investor alignment further differentiates our focus on strong investor returns. Recall that Barings BDC incentive fee structure provides an earnings cushion against unforeseen events when our net investment income exceeds our hurdle rate which increased to 8.25% in connection with the Sierra close, a decline in earnings caused by non-accrual loans or yield compression, which first results in a lower incentive fee in sliding investors from those negative items. I’ll now turn the call over to Ian to provide an update on the market and our investment portfolio.

Ian Fowler, President and Co-Head of Global Private Finance

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 $125 million on a net basis in the quarter, with gross fundings of $261 million, offset by sales and repayments of $136 million. New middle market investments included 16 new platform investments totaling $164 million and $97 million of follow-on investments and delayed draw term loan fundings. We also had $69 million of net new cross-platform investments in the quarter. Slide 10 updates the data we show you each quarter on middle market spreads across the capital structure. While we have witnessed volatility in the public markets, it is well understood that the private markets react to market volatility at a much slower pace. And further, the strength of the capital flows into the direct lending asset class may also offset the potential spread widening effects of a more fearful marketplace. As a result, market conditions remain generally competitive across direct lending as evidenced by generally stable spreads, loosening terms, and higher leverage levels. Turning to Slide 11. A theme we outlined last quarter that continued in the first quarter is that unitranche executions remain near all-time spread types when compared to first lien, second lien, traditional executions. And the level of Cov-Lite unitranche volume again was an all-time record. This is again a symptom of substantial capital inflows into direct lending, and I don’t expect it to slow down anytime soon. A bridge of our investment portfolio from December 31 to March 31 is shown on Slide 12. On Slide 13, you’ll see a breakdown of the key components of our investment portfolio on March 31. 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 now our 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 53% of our portfolio in terms of total investments at fair value and 50% of our portfolio in terms of revenue contribution. Our Barings originated middle-market exposure is heavily diversified amongst obligors of 184 portfolio companies with a geographic diversification across the U.S., Europe, and APAC regions.

Jonathan Bock, CFO

Thanks, Ian. Turning to Slide 17. Here’s a full bridge of net asset value per share movement in the first quarter. Our net investment income matched our dividend, net realized gains and losses on our investment portfolio and foreign currency transactions drove a decrease of $0.02 per share, while our unrealized depreciation totaled $0.04 per share. The Sierra transaction, including the credit support agreement, accounted for $0.28 of share. Additional details on this net unrealized depreciation are also shown on Slide 18. On the middle-market portfolio, price appreciation and credit performance resulted in $2 million of net depreciation with the remaining $4 million of depreciation due to FX moves, which are offset by our borrowings. Our cross-platform investments saw total appreciation of approximately $11 million, largely driven by the very strong operating performance in Eclipse Business Capital, our asset-based lender. The legacy MVC portfolio saw total net unrealized depreciation of $2.1 million. And near the bottom of Slide 18, you can see that the credit support agreement decreased by approximately $400,000 from last quarter. 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 remained stable at $0.23 per share for the quarter, driven by a $4 million increase in total investment income. The increase in interest income can be attributed to continued portfolio growth, as well as the Sierra assets being added to the portfolio on February 25. Higher dividend income from our investment in Eclipse Business Capital and 2 of our joint venture investments were also strong contributors to earnings in the quarter. The increase in total investment income was also met with higher interest and financing fees as well as an increased share count following the close of the Sierra transaction. The first quarter also saw the payment of an incentive fee to the manager as pre-incentive fee net investment income exceeded our new 8.25% hurdle rate.

Unidentified Analyst, Analyst

It’s Jordan on for Finian today. I was hoping you guys could give us a little more context about Eclipse Business Capital. It looks like it’s been performing well. It looks like you took a bigger dividend this quarter. So is there anything you can add there on how that’s performing and whether this is kind of a run rate dividend or maybe it’s a catch up?

Jonathan Bock, CFO

Sure. So I’ll start with one item and then pass to my colleague, Bryan, for the second as it relates to kind of the synergies between both ourselves and Eclipse. But the short line is, Jordan, in periods of market uncertainty or geopolitical volatility, what you’ll find is these underlying obligors that keep higher outstandings. And so as you have a higher level of outstanding plus a continued level of measured growth, the opportunity or profit effectively falls down to the bottom line. Our expectation on run rate here, we were operating under-levered, and so we have the ability to increase the dividend payout. Typically, we like to profile at around an 8% cash distribution. And so you can kind of expect that, that will probably normalize over time, but the underlying cash generation, or the NAV of the business, still remains intact and also continues to be amplified by our strong partnership with Eclipse and our cross-platform and special situations team. Bryan, if you just want to outline that partnership and the growth in deal I think that would be very worthwhile.

Bryan High, Head of U.S. Special Situations and Co-Portfolio Manager

Sure. Thanks, Jon. Yes. I think, generally speaking, the thesis is playing out on Eclipse. They have a strong management team and a platform that has a niche in the market and there’s a growing nonbank market, which is helping them with a little bit of wind behind ourselves, generally speaking. And then as Jon mentioned, the strategic fit from an origination perspective for both Eclipse and Barings, frankly, and seeing new deal flow that they otherwise wouldn’t see has been a consistent theme, and the pipelines for both of us are growing as a result of that. And then if you just sort of think about the resilient performance that they have had and will have, given the underlying collateral base that backs their loans, we think it’s sort of a great place to be given where we are in the cycle and they should continue to benefit from a rising rate environment as well.

Unidentified Analyst, Analyst

Okay. That’s helpful. It seems like you may have taken on another joint venture this quarter from the Sierra transaction. Can we expect this to be a permanent addition to your existing joint ventures, or will it possibly be integrated into another one? Any insights on how you plan to manage this, considering you are nearing your non-qualifying bucket limit?

Jonathan Bock, CFO

Yes, Jordan, you can expect us to gradually scale that back. Our goal is to minimize any negative impact while maximizing profitability from the venture, and you can anticipate it to be returned to us as the loans are repaid. This was a side project, and you can expect it to diminish over time.

Casey Alexander, Analyst

Yes. First of all, congratulations on closing this year transaction on a timely basis. My first question is, if you were to see spreads start to really blow out in the liquid credit markets and the broadly syndicated loan market, would you still be open to taking advantage of that as a way of getting a little more deeper into your leverage ratio and then kind of waiting to directly originate when the directly originate markets kind of square up with liquid credit markets? Is that still an opportunistic strategy that the company would employ?

Jonathan Bock, CFO

Casey, this is Jon, and then I’ll pass to Eric because when you think of the size and scope of Barings across the liquid platform, that can be a great opportunity. You saw us participate in the liquid credit category, particularly when spreads widened out as a result of COVID. We’re not near those levels, but we rely heavily on the expertise and the close partnership with our liquid counterparts, both publicly and privately. And that continues to be a very, very important part of our platform that we all benefit greatly from. But I know, Eric, we always remain very opportunistic across all areas of Barings.

Eric Lloyd, CEO

Yes. Casey, I’d say, the short answer is yes, we would look at that. As Jon said, the levels aren’t there right now. But if they were to get there, we absolutely would look at that. Making sure that you pick up a true illiquidity premium is really important, as we all know, on the illiquid assets. And when spreads widen out, let’s just say, theoretically, right, the liquid spreads probably syndicated loans went to 700 over. All of a sudden, a 100 to 150 basis point premium on illiquid credit isn’t really attractive relative to when spreads are 300 over liquid credit and then all of a sudden you pick up 150 or 200. They are attractive. So it’s making sure you really pick up a proportionate amount of that liquidity premium. So we stay very close to the liquid side. And between Bryan, I and Thomas involved in the BDC, we absolutely would look at that if that were to occur.

Casey Alexander, Analyst

All right. Great. That’s very helpful. My second question is you picked up a number of, I think, 5 companies that are non-accrual at Sierra and have probably been on non-accrual for quite some time. I’m just wondering if in your guys’ analysis and diligence, is there anything salvageable? Or are those pretty much just debt issues?

Jonathan Bock, CFO

We actually look at the underlying collateral and believe there are future opportunities. You have a solid company, but with a weak balance sheet. Several individuals who joined us from the Sierra platform are actively working to realize that value. Given the scale and size of our platform, similar to others that Casey follows, the chances of achieving a successful outcome over time, not immediately but eventually, are much higher. It's a slow and steady approach for those companies, with fair value around $14 million.

Paul Johnson, Analyst

Just following up on the assets that you inherited from Sierra, not just the non-accruals, but really the entire book. I think it’s like $430 million or so that came over in the first quarter. Is the focus, I guess, to rotate out of these assets as you’ve kind of identified these opportunities? Or are you pretty comfortable with basically sitting on these assets and kind of allowing them to just sort of run off over time and focus on your other verticals that you’ve got going?

Jonathan Bock, CFO

I’ll give one initial thought. So when we underwrote the transaction, you always underwrite to hold and invest. But at the same time, we were very focused on shareholder alignment, and so again, brought to use the innovative tool of the credit support agreement such that our manager retains the downside on that credit portfolio. Believe it or not, over time, we found even in the MVC portfolio here that there are going to be individual portfolio incumbencies you want to continue with. And then there’ll be ones where, in certain instances, if you’re looking for the opportunities to exit, you can effectively raise your hand, and we’ve seen some of that as well. I’d expect it to be measured. The yield profile that we’re receiving off of those loans is attractive, right? They were originated in prior time periods at relatively strong spreads. And so we’re starting to find a good level of income contribution. And so there’s no immediate rush except for some of the special situations where we might find that we just don’t like the underlying risk return, and we’ve been cycling out of those near term. It’s not necessarily a dollar-based question and answer for you, Paul, but more of a philosophical one. We’re happy to own them, but we also find that there are going to be select assets where, over time, we’re just looking forward to the exits, and we are starting to see that as well.

Eric Lloyd, CEO

Paul, I think the good news is when we announced the deal over 6 months ago and then inherited the portfolio that the portfolio is performing at least in line with what we expected, probably a little bit better than what we expected from the asset underwriting that we did. And as Jon said, some are a little worse, some a little bit better. Some will probably rotate out of, so are the ones we’re very comfortable with that company were to refinance of stepping in and continuing to support that company. So I think the good news, on a blended basis, is the portfolio is performing at least consistent with, if not better than what we originally underwrote when we announced this deal 6 months ago.

Paul Johnson, Analyst

Got it. I appreciate that. Going back to the Eclipse business, I know you mentioned what influenced the write-up and how things are progressing well there. I'm curious if you see the increased dividend income we received in the first quarter as something sustainable moving forward, or if it's more of a temporary situation based on the current state of the ABL markets.

Jonathan Bock, CFO

I believe what it will highlight is the underlying profitability of the investment, which is reflected in BBDC’s income statement in two ways. It can appear through dividend distribution or through NAV growth. Typically, we aim for an 8% cash distribution on our cross-platform investments or joint ventures. This quarter was higher due to our operation from an under-levered base, given the $500 million in new equity raised from the Sierra deal. Consequently, while you might see a moderation in dividend income, the perspective on Eclipse as an operational subsidiary indicates that the underlying profitability remains robust. Therefore, you may not see a decrease in dividend income, but you can expect growth in NAV due to retained earnings in that underlying investment.

Ian Fowler, President and Co-Head of Global Private Finance

Yes, it’s Ian. I’ll take this and anyone else can jump in. It’s interesting in the first quarter in terms of deal flow and just being more robust in terms of the quality of the credits, in terms of the higher OID, lower leverage, and higher spreads, Europe was just on a relative value basis, a much more attractive market than the U.S. And to your comment regarding the geopolitical risk, you would think that wouldn’t be the case, but we’re seeing really good businesses in Europe that are new platforms that are coming to market. And just given our position as one of the top leading lenders to private equity firms, we’re really well positioned to take advantage of them, and that really brings in the benefit of the platform and our wide range of opportunities that we can pursue. So I don’t know how long that lasts, but just on a relative basis, it’s just been more attractive than the U.S. Unfortunately, on the U.S. side, we have our portfolio which has been really instrumental in terms of driving origination for our business. And quite frankly, going into a potential recession, being able to rely on add-on acquisitions, you’re basically looking at a portfolio that’s becoming larger in scale in terms of the business themselves and more diversified itself from a credit perspective that’s very attractive.

Robert Dodd, Analyst

Congratulations on closing the Sierra deal and achieving a strong quarter. My first question is about the cross-platform, which seems to represent about one-third of your revenues now. You're starting to approach the BDC limits regarding the amount you can have in these various joint ventures, which offer significant advantages by entering markets that are potentially less competitive and not as saturated with large amounts of capital. Do you plan to continue expanding the cross-platform mix in your portfolio? If so, are you considering any strategies to navigate the BDC nonqualified buckets with balanced end-of-quarter balance sheet management, or do you prefer to keep everything straightforward in that area?

Jonathan Bock, CFO

I think maybe just to dive into what the cross-platform investment bucket is, you can find that there is a healthy amount of which is qualified, right? And so the JVs, which you correctly pointed out, would be nonqualified given that’s how they are across all of the BDC space, but a number of the operating companies or in specific, some of the special situations or infrastructure opportunities, they certainly are. And so you’ll find us continue to manage diversification the way we always have. But at the same time, I think there are some growth opportunities that exist, Bryan, when you start to think of the infrastructure opportunities that exist in some certain areas across platform that are worth mentioning and at the same time, qualified investments.

Bryan High, Head of U.S. Special Situations and Co-Portfolio Manager

Yes. I think in the infrastructure space, specifically, I think we’re very interested in finding opportunities that similar to Eclipse have real asset value behind them, especially in this sort of part of the cycle where we’re late stage and you have some real collateral to sort of lean on, and that can be across multiple different silos in the infrastructure space. And it’s something that is a decent chunk of our pipeline today and has been a place where we’ve been deploying capital more recently. And we think the underlying fundamental value supporting those investments make them attractive, risk-adjusted return, when you’re trying to sort of maximize your return per unit of risk.

Eric Lloyd, CEO

Look, I think that’s very fair, Robert. And I think it’s a balance of things, right? To your point, the information is sooner and you maybe have a more intimate relationship with the management team. That being said, we’ve got dozens and dozens of research analysts on the liquid side, who also know their industries and their portfolio companies and their management teams extremely well. I wasn’t trying to insinuate that we would go way, way, way into the broadly syndicated market if there were so. But part of the benefit, I think, of the Barings platform is that we do have such a deep liquid credit team and experience and a great track record that on the margin where we see those opportunities, we would step into it. That doesn’t mean that you’re going to see us make a wholesale change or anything like that. But on the margin, where we see those attractive opportunities as we’ve stepped in, taking into account information flow, value, price, relative value, illiquidity credit, and all those other factors.

Operator, Operator

We reached the end of our question-and-answer session. I would like to turn the conference back over to Eric for closing comments.

Eric Lloyd, CEO

Thanks, operator, and I appreciate it. And thank you all for participating in the call today. Please stay safe, and have a great day.

Operator, Operator

Thank you. This does conclude today’s conference. You may disconnect your lines at this time, and thank you for your participation.