Earnings Call Transcript - BBDC Q2 2024

Operator, Operator

At this time, I would like to welcome everyone to the Barings BDC, Inc. Conference Call for the Quarter Ended June 30, 2024. 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. At this time, I will turn the call over to Joe Mazzoli, Head of Investor Relations for Barings BDC.

Joe Mazzoli, Head of Investor Relations

Good morning, and thank you for joining the call. 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 quarterly report on Form 10-Q for the quarter ended June 30, 2024, 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. I will now turn the call over to Eric Lloyd, Chief Executive Officer of Barings BDC.

Eric Lloyd, CEO

Thanks, Joe, 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 2024 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, Matt Freund; Chief Financial Officer, Elizabeth Murray; and Barings' Head of Global Private Finance and BBDC Portfolio Manager, Bryan High. In the second quarter, BBDC delivered another strong set of results, fueled by best-in-class credit performance and the strength and stability of our franchise. Our focus on top-of-the-capital-structure investments and sponsor-backed middle-market issuers continues to serve investors well. I want to take a moment to note that in this market, unlike the larger-cap end of direct lending, we are not competing with investment banks for broadly syndicated loan issuance, and we generally see stronger documentation, meaning some of the BSL-style covenant packages you may have heard of in other direct lenders' portfolios are not present in ours. Our focus on the core of the middle market is reflective of lower leverage levels and more attractive risk-adjusted returns, which is why we find this to be the best segment of the market for BBDC and our shareholders. That core portfolio is complemented by a selection of nonsponsored and platform investments that we believe benefit our shareholders in the form of higher potential returns and diversification. Our portfolio strategy is outlined in greater detail on Slide 5. We continue to successfully invest throughout the market and deliver compelling returns to our shareholders. As we reflect on the first half of 2024, the performance of BBDC has been strong against a relatively benign economic backdrop. Interest rates, while elevated, have been stable for several quarters. Credit performance appears to be holding up broadly across the industry, save for a few idiosyncratic examples. While we have done well in this stable economic and interest rate environment, the market activity of the past week suggests change may be afoot in the lending ecosystem. These changes may include a decrease in interest rates, which we think will have an overall positive impact on our business as it further improves credit metrics in the existing portfolio and sparks a sentiment shift among sponsors and may spur further deal activity, which in turn may drive higher spreads and additional transaction fees. Turning to some specifics of BBDC, net asset value per share was $11.36, compared to $11.28 for the prior fiscal year end, reflecting an increase of 0.7% and a testament to the portfolio stability. Net investment income for the quarter was $0.40 per share and meaningfully outearned our dividend of $0.26 per share. Perhaps most importantly, in a metric that we are particularly proud of, our nonaccruals as a percent of fair value were unchanged quarter-over-quarter at 0.3%. As our investors know, the stability of our performance is a result of our focus on thorough and conservative underwriting at the top of the capital structure and within more defensive industries. With a more uncertain landscape ahead of us, we are confident that BBDC's strategy and portfolio are well-suited to deliver strong results for our valued shareholders across a wide range of economic and market conditions. Digging a bit deeper into the portfolio, we continue to actively maximize the value in legacy holdings acquired from MVC Capital and Sierra. Our goal remains to divest these assets at attractive valuations, as we did this quarter. Barings-originated positions are now 90% of the portfolio at fair value, up from 76% of the portfolio at the beginning of 2022. Also, just to remind you all, potential losses from these assets are protected by credit support agreements limiting downside risk for BBDC investors. Our investment portfolio continued to perform well in the second quarter. There is no substitute for fundamental credit analysis, which has always been at the core of our investment philosophy and is reflected in the health of the BBDC portfolio today, including the acquired Sierra and MVC assets; our total nonaccruals are an industry-leading 0.3% on a fair value basis and 1.5% of the portfolio on a cost basis. This is down from 1.5% on a fair value basis and 2.5% on a cost basis as of December 31, 2023. Turning to the earnings power of the portfolio, the weighted average yields at fair value were 11.1%. We remain conservative on our base dividend policy, and our Board declared a third quarter dividend of $0.26 per share, consistent with the prior quarter. On an annualized basis, the dividend level equates to a 9.2% yield on our net asset value of $11.36. We believe the best measures of the portfolio's performance, nonaccruals, net asset value, and NII were extremely compelling for the June quarter and anticipate continued strength in the quarters ahead. Before I turn the call over to Matt, I want to highlight that while the future operating environment may be uncertain, the long-tenured team we have here in the North American Global Private Finance business, coupled with the capabilities of teams across Barings, will also contribute to our asset sourcing and underwriting. We are extremely confident in our ability to continue delivering compelling value to our shareholders. We have designed our portfolio to have resiliency to weather economic stress and to have the liquidity and expertise to play offense in what we believe will be an even more attractive environment for middle-market direct lending in the second half of the year. I'll now turn the call over to Matt.

Matt Freund, President

Thank you, Eric. BBDC is managed by Barings LLC, which is a credit-focused asset manager managing nearly $410 billion in assets as of June 30. The majority of our portfolio is sourced from our global private finance team, which consists of over 100 investment professionals worldwide providing financing solutions to leading middle-market companies backed by top private equity firms. This quarter, BBDC deployed $78 million in capital, but this was offset by $195 million from sales and repayments, leading to net sales and deployments of $117 million. Repayment activity was mainly focused on noncore acquired positions, where we saw an $80 million reduction in fair market value compared to the previous quarter. As Eric mentioned, we are implementing the strategy we have communicated for the past 1.5 years by simplifying our portfolio and selectively investing in what we consider the most attractive middle-market direct lending opportunities. We are observing a division in the market regarding deployment, primarily based on size. Activity in our core markets for sponsor-backed lending to companies with $15 million to $75 million in EBITDA remained low during the second quarter, and we have seen refinancing activity within our portfolio but at much lower levels than our broadly syndicated peers. With the anticipated rate-cutting cycle approaching, we are hopeful that changes in the interest rate environment will stimulate transaction activity. Our team maintains close contact with a significant number of middle-market sponsors, and we've consistently heard optimism for a busy second half of the year, a sentiment echoed by investment bankers. While we have noted an increase in early-stage opportunities, conversion rates through June have been rather modest. However, we continue to support various borrowers in executing add-ons for existing companies and on more strategic acquisitions, leveraging our well-established relationships in our core focus area. Looking at the portfolio, 75% consists of secured investments, with about 66% being first lien securities. BBDC has seen a stabilization in interest coverage throughout 2024, ending the quarter with a weighted average interest coverage of 2.1x, which is above industry averages. This showcases the effectiveness of our approach to focusing on established companies in defensive sectors and thoroughly assessing their capacity to endure diverse economic conditions. With the current forward SOFR curve, our portfolio now reflects the full negative impact of elevated rates, and we expect that credit and cash flow metrics will improve with any decrease in base rates. Additionally, as rates decline, our hurdle rate structure will illustrate alignment with our shareholders. The median gross margin in the North American Global Private Finance portfolio, similar to BBDC, reached 50%, up from 47% a year ago, showing that our investments are in strong market positions enabling them to raise prices against inflation. Furthermore, adjusted EBITDA margins for the same sample increased to 22%, compared to 21% in the prior year. These outcomes highlight the advantages of focusing our lending on market leaders in stable industries at reasonable leverage levels while avoiding cyclical sectors like oil and gas, restaurants, retail, metals, and mining. The portfolio remains highly diversified, with the top 10 issuers representing 24% of the fair market value. Notably, our top two positions, Eclipse Business Capital and Rocade Holdings, are strategic investments that provide unique opportunities in asset-backed loans and litigation funding, areas we believe offer attractive returns and diversification benefits, particularly due to Rocade's lack of correlation with broader financial markets. Regarding portfolio quality, risk ratings showed minimal changes in the quarter as issuers experienced some stress, with 9% classified as risk ratings 4 and 5 compared to 8% in the previous quarter. Nonaccruals were valued at $6 million of the portfolio's fair market value, representing only 0.3% of assets, which we believe is among the lowest nonaccrual levels in the industry. We remain confident in the credit quality of our portfolio. We expect BBDC's unique reach and scale, along with our focus on the middle market's core, to sustain positive results for our shareholders in the future. The BBDC portfolio is designed to endure various economic environments and interest rate conditions. To support this, BBDC was structured to align fees with credit performance hurdles. Following the rate increases of the past two years, nearly all publicly listed BDCs have reported earnings exceeding their hurdle rates, diminishing the distinction between different hurdle levels. As base rates decrease, BBDC investors will benefit from our high hurdle rate compared to other industry participants, with BBDC's rate at 8.25% versus an industry average of 7.03%. We foresee this hurdle rate distinguishing the relative value for BBDC shareholders in the upcoming quarters. Should BBDC's pre-incentive fee returns fall between 8.25% and 10.3%, shareholders can expect a stable return of 8.25%, whereas BDCs with lower hurdle rates will see the same pre-incentive fee returns but lower net returns. Another aspect of BBDC's fee structure is the total return hurdle, which aligns credit performance with incentive fees paid to Barings LLC. While credit performance is crucial for a BDC, less than half of externally managed publicly traded BDCs include losses in their return hurdle. By integrating our hurdle rate structures with a robust stock buyback program and credit support agreements for part of our assets, we believe that Barings prioritizes shareholder interests among the best in the market. I'll now turn the call over to Elizabeth.

Elizabeth Murray, CFO

Thanks, Matt. On Slide 15, you can see the full bridge of the NAV per share movement in the second quarter. NAV per share was $11.36 as of June 30, which is a decrease of 0.6% over the prior quarter and an increase of 0.2% year-over-year. Our net investment income exceeded the $0.26 per share dividend by $0.14 per share or 35%. Net unrealized depreciation from investments, CSAs, and FX equaled $0.29 per share and was partially offset by net realized gains on the portfolio and FX of $0.07 per share. The net realized gain in the portfolio was predominantly due to the exit of our investment in Core Scientific, partially offset by our exit in Highland, a Sierra investment, which is covered by the CSA, primarily reclassed from unrealized depreciation. You may recall during the first quarter, we recognized a loss of $7.6 million on the restructuring of our debt investment in Core Scientific into equity. During the second quarter, as I previously mentioned, we fully exited our investment in Core Scientific and recognized a gain on the sale of the equity of $8 million. We are pleased to say we experienced full par recovery of this investment plus a $0.4 million gain on exit. The valuation of the credit support agreements decreased by approximately $0.9 million. The fair value of the Sierra CSA decreased from $35.4 million in the first quarter to $32.6 million as of June 30. During the second quarter, the Sierra portfolio had sales and repayments of approximately $32 million and had 29 positions remaining in the portfolio, down from 36 positions as of March 31. The fair value of the MVC CSA increased from $16.1 million to $18 million as of June 30, driven by unrealized depreciation in the underlying portfolio with 4 positions remaining. Our net investment income was $0.40 per share for the quarter, compared to $0.28 per share in the prior quarter and $0.31 per share for the second quarter of 2023. Investment income in the quarter was primarily driven by dividends from joint venture and platform investments, and our incentive fee expense was lower quarter-over-quarter due to unrealized depreciation fueled by acquired positions and incentive fee cap. Our net leverage ratio, which is defined as regulatory leverage, net of unrestricted cash and net unsettled transactions, was 1.07x at quarter end, down from 1.17x in the quarter ended March 31, and currently sits within our long-term target of 0.9x to 1.25x. Our current leverage provides ample capacity to seize opportunities and pursue attractive deployment opportunities in the quarters to come. Our funding mix remains highly defensible, both in terms of seniority and asset class, including the significant level of support provided by the unsecured debt in our capital structure. At June 30, our unsecured debt accounted for $1 billion of our funding and equated to approximately 70% of our outstanding debt balances. We continue to maintain significant flexibility in our capital structure with the next bond maturity in the second half of 2025 and maintain a ladder of maturities out to 2029. Barings BDC currently has $215 million of unfunded commitments to our portfolio companies as well as $65 million of outstanding commitments to our joint venture investments. We have available cushion against our leverage limit to meet the entirety of these commitments called upon. As mentioned earlier, the Board declared a third quarter dividend of $0.26 per share, a 9.2% distribution on net asset value, and is consistent with our second quarter 2024 dividend. During our earnings call in February, we disclosed the Board authorized a $30 million share repurchase plan for 2024. We continue to be active users of our share repurchase plan; the second quarter was no exception as we repurchased more than 190,000 shares during the period and have repurchased a total of almost 310,000 shares in the first half of 2024. Our focus on share repurchases is one example of BBDC's thoughtful approach to aligning our interest with shareholders. I'll wrap up our prepared remarks with an update on our investment pipeline. Thus far in the third quarter, we have made $56 million of new commitments and funded $46 million. With that, operator, we will open the line for questions.

Operator, Operator

Your first question comes from Robert Dodd with Raymond James.

Robert Dodd, Analyst

You mentioned the disruption in the market that you've observed over the past week. Matt, you also talked about a growing optimism regarding activity in the second half of the year. Can you clarify how these two points reconcile? Typically, disruptions and volatility in the market lead to a slowdown in activity. There was an expectation that activity would bounce back, but considering last week, how has this changed your outlook on the potential for activity in the latter half of the year?

Bryan High, Head of Global Private Finance and BBDC Portfolio Manager

Robert, this is Bryan. In terms of the volatility of the market, I do think that one of the benefits of private credit, and we've seen some deals pulled from the broadly syndicated market this week just given some of that volatility, is better execution at the end of the day. So if I sort of anecdotally talk about our pipeline, we've definitely seen an increase in activity. Whether or not that ultimately ends in deals being closed is sort of to be determined, but I do think that there is a natural tension of a need for liquidity in private markets and folks looking to monetize, maybe not at the ideal time, but because they want to raise the new fund, they're looking to ultimately sell platforms to a new sponsor or a strategic. So we are seeing more activity again, from a pipeline perspective; whether or not that ultimately closes, we'll have to wait and see.

Matt Freund, President

Yes. The other comment that I would add, Robert, maybe I should have been more specific in my prepared remarks. I think that we feel that we're closer now to a rate-cut cycle than we ever have been. And as we think about the private equity firm that we're interacting with, while they've all consistently told us that the cost of debt capital doesn't move the needle for them, I think that we're actually going to test that theory because as rates start to come down, I just think the cost of capital for the overall capital structure is going to reset, and when that happens, we would expect more sponsor-to-sponsor LBO activity to pick up.

Robert Dodd, Analyst

Got it. Regarding credit, your loan accruals are performing well on fair value and low on the cost base. How do you expect that to change over the next 12 to 24 months? This is somewhat of an instinctive question, but there may be rate cuts, which would benefit interest coverage. However, the economy is a bit softer, and rates have been elevated for an extended period. Therefore, liquidity reserves at portfolio companies might be lower than before. Can you share your thoughts on how you anticipate credit, particularly within your portfolio, to develop over the next few years? You touched on this earlier, but...

Matt Freund, President

Yes. I'll start and then pass it to Bryan. I appreciate that you provided part of the answer to your question in the way you phrased it. As we consider our credit quality outlook, we believe we are currently in a strong position. When it comes to potential events that could arise from a rate decrease or possibly economic challenges, we are uncertain about the factors contributing to that unpredictability. Although we feel confident that our portfolio is well-positioned at the moment, it's quite challenging to predict different scenarios that could alter the portfolio's composition. However, I am very comfortable with our diversification and the quality of underwriting we have established in recent years, which has shaped the portfolio we have now. Bryan, do you have any macro insights?

Bryan High, Head of Global Private Finance and BBDC Portfolio Manager

I mean, macro-wise, obviously, Robert, you probably have seen more than we have from all the various portfolios in the market, but it certainly feels like there is an uptick in stress across the marketplace. That being said, I do think our portfolio has held in relatively well. And we've got the resources to deal with the issues if and when there's a broader macro softening that is sort of unavoidable at that time.

Eric Lloyd, CEO

Yes. I mean, I would highlight what Matt said earlier too, which is despite the increase in base rates, our interest coverage still is just over 2x, which we feel really great about. And so borrowing an idiosyncratic kind of event on specific credits, the overall portfolio health remains very strong.

Operator, Operator

Your next question comes from Finian O'Shea with Wells Fargo.

Finian O'Shea, Analyst

A question on the, I forget which one is which, but the private to public BDC. Can you give us an update on where that is in its investment period or whatnot? And now that it seems like there is some precedence to merge these into the public regardless of price to NAV, seeing your appetite to do that?

Bryan High, Head of Global Private Finance and BBDC Portfolio Manager

Yes. Thanks, Fin. I can't provide specifics on private funds, but we don't have any anticipation, at least currently, of doing anything in BBDC or asking BBDC shareholders to consider anything at this time.

Operator, Operator

Your next question comes from Casey Alexander with Compass Point.

Casey Alexander, Analyst

Matt, I got kind of a tricky one for you here. And maybe this is for Matt or for Elizabeth because it's kind of a math question. At what degree of decline in base rates would bring the high end of the hurdle into play, and to what extent would that fully protect the current dividend?

Matt Freund, President

Yes. Casey, I appreciate your anticipation that I might be prepared for math-related questions, so thank you for that. But I think that the numbers that we've been running, kind of assuming all else equal with respect to credit quality and the composition of the portfolio from a leverage perspective, it's somewhere between, call it 4% and 4.5%, is kind of how we think about the impact of that the hurdle rate being preserved. And then I think that where we personally feel that the math starts to make BBDC look significantly more attractive than those with lower hurdle rates as we start to approach, call it, the high 3s. I think is where you see a lot more differentiation.

Casey Alexander, Analyst

When you model that out, does the hurdle rate start to reduce the incentive fee instead of the net investment income? Is that still at a level that you believe will maintain the current dividend?

Matt Freund, President

Yes. We anticipate that that's the case.

Casey Alexander, Analyst

Okay. Great. Secondly, considering the personnel turnover earlier this year, could you provide any updates regarding the origination team?

Bryan High, Head of Global Private Finance and BBDC Portfolio Manager

Yes, Casey, it's Bryan. I think on the last call, Eric mentioned that we brought in a senior individual who was previously part of the platform and served as Co-Head of North America. Including that person, we've made three new hires, and we're not finished yet. Two additional managing directors are set to join us in early the fourth quarter, both with 20 to 25 years of experience in the core middle market where we focus.

Eric Lloyd, CEO

I think it's important to note, Casey, on that the guy we brought back in who co-headed the business in North America was also the Chairman of our North American Investment Committee for a number of years. So there's consistency there. And we wanted to be prudent but timely in our hiring, but also making sure we got the right fit and the right people.

Casey Alexander, Analyst

Lastly, across the space, both cash flow and venture debt BDCs, there's been growing difficulties in the software vertical. And when I look at your mix, I'm guessing that Business Services is a fair amount of software. So I'm curious how the interest coverage is faring with your software investments and what you're hearing from them about software spending plans? And if there's any particular verticals that might be edgier than others?

Matt Freund, President

Yes, Casey, that's a great question. Software has been a focus for the industry for some time now. While you mentioned Business Services, I wouldn't limit it to just that. There are many tech-enabled services and businesses that fundamentally rely on software. Currently, the majority of our portfolio consists of conventional cash flow lending. There are only a few exceptions to this. If I were to look into different portfolios or industries, I would consider ARR-based facilities. Most of these loans are linked to software, but not every software loan falls into the ARR category. We've noticed some divergence in cash flow coverage with issuers reporting ARR-style facilities that haven't yet converted to cash flow levels. Regarding our portfolio's performance related to software, we're feeling very encouraged; our software issuers are performing similarly to our non-software issuers. This is a valid question, and it's not always easy to analyze when looking at certain financial metrics.

Operator, Operator

At this time, there are no further questions in queue. I'd like to turn the call back over to Eric Lloyd.

Eric Lloyd, CEO

I just want to thank everybody for dialing in, listening to our update for this quarter, and we look forward to finishing the year strong on your behalf. Thanks very much.

Operator, Operator

This concludes the Barings BDC Second Quarter 2024 Earnings Call. Thank you for attending, and have a wonderful rest of your day.