Bain Capital Specialty Finance, Inc. Q2 FY2021 Earnings Call

Good day, and welcome to the Bain Capital Specialty Finance Second Quarter ended June 30, 2021 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Katherine Schneider, Investor Relations. Please go ahead.

Thanks, Eli. Good morning, and welcome to the Bain Capital Specialty Finance Second Quarter ended June 30, 2021 Conference Call. Yesterday after market close, 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 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. With that, I’d like to turn the call over to our Chief Executive Officer, Michael Ewald.

Thanks, Katherine, and good morning, everyone. Thank you for joining us on our earnings call here. I’m joined today by Mike Boyle, our President, and our Chief Financial Officer, Sally Dornaus. I’ll start with an overview of our second quarter ended June 30, 2021 results, and then provide some thoughts on 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 close, we delivered another consecutive quarter of positive results for our shareholders. Q2 net investment income per share was $0.34 and produced an attractive net investment income annualized yield of 8% on equity. Our net investment income covered our dividend level by 100%. The health and strength of our portfolio continued to trend positively this quarter as we witnessed improving credit quality trends across our diversified portfolio of middle market companies, and we continue to maintain no investments on nonaccrual status. These results drove strong earnings and NAV growth for our shareholders as Q2 earnings per share were $0.66 as a result of net gains across our portfolio. Net asset value per share was $17.01 as of June 30, reflecting a 1.9% increase from our NAV as of March 31. Subsequent to quarter end, our Board declared a third quarter dividend equal to $0.34 per share and payable to record date holders as of September 30, 2021. This represents an 8% annualized yield and ending book value as of June 30. During the second quarter, we witnessed favorable macroeconomic trends as financial markets continued to rally, notwithstanding inflationary pressures as economies fully reopened. Spreads in the broadly syndicated loan market continued to tighten for larger companies, while spreads within the direct lending market were relatively stable quarter-over-quarter and largely back to pre-COVID levels. These market conditions drove strong levels of sponsored loan volume in the middle market, driven by increased LBO and add-on activities. Against this backdrop, we continue to execute on our middle-market direct lending strategy, consistent with the long-standing tenets of our approach. Our balance sheet was well positioned going into the second quarter as a result of the sequential improvements that we made in recent past quarters to better position the company to take advantage of investing in attractive new lending opportunities. Q2 gross originations were $213 million, down from first quarter 2021 volumes of $384 million but higher than Q4 2020 levels of $173 million. Originations during the second quarter were relatively split between commitments to new portfolio companies and commitments to existing companies through our incumbency advantage across the Bain Capital Credit platform. This platform’s focus remains on the core of the middle market, which we define as companies between $25 million and $75 million of EBITDA. The median EBITDA of our new originations in Q2 was approximately $43 million, consistent with our overall median of $42 million. We continue to favor this segment of the market as these are scaled middle market companies with diversified end market revenue streams that lack access to the broadly syndicated loan market due to their size. We benefit from an illiquidity premium in this market segment and are able to structure securities that provide us with strong lender control such as financial covenants. We believe the Bain Capital Credit platform has significant competitive advantages in this segment of the market, given our long-standing presence there that’s entrenched with our deep sourcing relationships that accumulated over two decades. Furthermore, Bain Capital Credit’s global team and resources allow us to source a wider funnel of opportunities and remain selective in the investment opportunities that we pursue on behalf of BCSF. In fact, throughout the year and continuing during the second quarter, we have seen robust activity out of our European offices. We’ve found many of these investment opportunities to be increasingly attractive relative to opportunities sourced through our North American offices, given a seemingly higher level of optimism in the U.S. that has driven spreads tighter. These trends allow us to increase the size of our loan portfolio within the international senior loan program, or ISLP, which is our joint venture focused on direct lending opportunities to European and Australian borrowers. Quarter-over-quarter, ISLP’s investment portfolio at fair value grew by 23%. Our investment in the ISLP has the potential to drive our earnings higher for our shareholders over time as we grow that portfolio. Turning to our capitalization. We ended the second quarter at a net leverage ratio of 1.12x, which reflects the midpoint of our target net leverage ratio of between 1x and 1.25x. We believe the company is on a strong financial footing to take advantage of new yield-accretive investment opportunities to grow earnings, even while remaining disciplined in our credit selection. Subsequent to quarter end, we optimized the company’s liability structure through repurchasing $37.5 million of the company’s $150 million, 8.5% notes due 2023. We were able to take advantage of an opportunity to reduce a portion of the company’s 2023 notes at a discounted price to our make-whole premium prior to maturity. Looking forward, we remain focused on making continued improvements to our liability structure over time and believe the company has a stronger balance sheet than ever before as we have fortified it through diverse and flexible financing structures. I will now turn the call over to Mike Boyle, our President, to walk through our investment portfolio in greater detail.

Thanks, Mike. I’ll begin by discussing our investment activities for the second quarter and offer an update on our investment portfolio. In Q2, we funded $213 million in new investments across 32 portfolio companies, which includes $111 million directed toward 8 new companies and $102 million toward 24 existing ones. Our sales and repayments totaled $258 million. The new portfolio originations included a diverse range of middle-market borrowers from various industries such as business services, automotive, healthcare, and pharmaceuticals. Our originations in Q2 benefited from Bain Capital Credit’s global sourcing capabilities, with over 60% of our new investments in new portfolio companies sourced from our offices in Europe and Australia. The largest commitment this quarter was a first lien unitranche loan at LIBOR plus 700 basis points, with a 100 basis point floor, to an incumbent portfolio company we've been invested in since 2019. We led this deal, seizing a compelling opportunity to increase our loan, which is structured to include call protection and strong controls through a tight covenant package. The company specializes in manufacturing flow control products used in the transportation, delivery, and storage of liquefied petroleum gas, industrial gases, and liquefied natural gas. We view this investment favorably due to the company's stable, recession-resistant business profile, its recurring revenue from a large installed base, and its attractive unlevered free cash flow. As for the investment portfolio, by the end of the second quarter, its fair value was $2.3 billion, encompassing a highly diversified set of 104 companies across 28 industries. The majority of our investments are first lien loans to sponsor-backed middle-market businesses. As of June 30, 81% of the fair value of our portfolio was in first lien debt, 5% in second lien debt, 1% in subordinated debt, 7% in equity interests, and 6% in the international senior loan program (ILSP). By the end of June, the fair value of ISLP’s investment portfolio was approximately $395 million, with investments in 21 companies across 12 different industries, all allocated in senior secured floating rate loans—89% first lien and 11% second lien. We were pleased to see growth in ISLP's portfolio size quarter-over-quarter, attributed to our platform's ability to source attractive investment opportunities outside the U.S. Our portfolio yield remained steady quarter-over-quarter. As of June 30, the weighted average yield on the investment portfolio was 7.5% at amortized cost and 7.7% at fair value, compared to 7.6% and 7.8% respectively as of March 31. As mentioned during last quarter's call with our shareholders, we continue to aim for an 8% yield target while maintaining focus on senior secured loans. Regarding portfolio quality trends, credit metrics for our borrowers remained stable quarter-over-quarter. The median leverage of our investments was 5.3x, slightly up from 5.2x at the end of March. The median EBITDA of the portfolio also remained relatively steady at $42 million. We are pleased to report an improvement in credit quality trends within our internal risk rating scale. As of now, 89% of our portfolio at fair value consists of investments rated 1 and 2, where rating 1 indicates the highest credit performance. This percentage increased from 87% in the previous quarter. Investments rated 3 made up 11% of the fair value portfolio, down from 13% previously. Importantly, the number of companies in the risk rating 3 category decreased from 12 to 9, as three companies were upgraded to a rating 2 due to strong performance and an anticipated par exit for one of the borrowers. There continue to be no investments classified as risk rating 4, our lowest ranking in terms of credit quality. Our risk rating 1 and 2 investments carry a weighted average fair value mark of 98.5% at par, marking a gradual improvement of around 70 basis points from the last quarter. Risk rating 3 investments have a weighted average fair value mark of approximately 85% at par, up from 82% at the previous quarter-end. As discussed in earlier quarters, these investments involve borrowers in industries more affected by the pandemic, including consumer transportation, aerospace and defense, and selected business services. The fair valuation improvements noted this quarter indicate positive financial trends among most of these companies. However, we believe it's prudent to take a cautious stance regarding fair valuations as economies fully reopen and businesses adjust back to normal conditions. Therefore, we see the potential for net asset value appreciation, believing these are high-quality companies with proven value propositions. Nonaccrual metrics within our portfolio were positive, remaining stable quarter-over-quarter. As of June 30, we had no investments on nonaccrual status for the second consecutive quarter. Sally will now provide a more detailed review of our financials.

Thank you, Mike, and good morning, everyone. I’ll start the review of our second quarter 2021 results with our income statement. Total investment income was $46.5 million for the three months ended June 30, 2021, as compared to $49.8 million for the three months ended March 31, 2021. The decrease in investment income was primarily due to a decrease in other income and prepayment-related income. Total net expenses for the second quarter were $24.6 million as compared to $27.7 million in the first quarter. The decrease was driven by an increase in incentive fee waivers by the adviser, partially offset by higher interest and debt financing expenses. During the quarter, our adviser waived both a portion of its base management fee and incentive fee, demonstrating our continued alignment of interest with shareholders in supporting the regular dividend level. The company’s regular dividend level of $0.34 per share equates to an annualized yield of 8% on equity. We believe this is an attractive distribution level and is set at a rate that can be maintained over various market environments. Our focus remains on driving higher net investment income over time for our shareholders without the need for fee waivers. We believe that we have a pathway to demonstrating this over time. Net investment income for the quarter was $21.9 million or $0.34 per share as compared to $22.2 million or $0.34 per share for the prior quarter. During the three months ended June 30, 2021, the company had net realized and unrealized gains of $20.5 million. The largest unrealized gains were seen across industries that had been more impacted by the pandemic, reflecting our gradual recovery across these companies. The company’s net realized gains on investments were driven by a realized gain on a small preferred equity co-investment to Flow Control Group that we made alongside our unitranche loans. We realized a 2.6x multiple on our equity capital invested. GAAP income per share for the three months ended June 30, 2021, was $0.66 per share. Moving over to our balance sheet. As of June 30, our investment portfolio at fair value totaled $2.3 billion and total assets of $2.4 billion. Total net assets were $1.098 billion as of June 30. NAV per share was $17.01 as compared to $16.69 at the end of the first quarter, representing a 1.9% increase quarter-over-quarter. Our gains were attributed to net unrealized gains across the portfolio. At the end of Q2, our debt-to-equity ratio was 1.2x compared to 1.26x at the end of Q1. Our net leverage ratio, which represents principal debt outstanding less cash, was 1.12x at the end of Q2 as compared to 1.15x at the end of Q1. Our net leverage ratio was in line with our stated target range of between 1 and 1.25x. Turning to our capitalization and liquidity, available liquidity consisting of cash and undrawn capacity on our credit facilities was $428 million against our $213 million of undrawn investment commitments. This represents coverage of 2x as of June 30, up from 1.84x as of March 31. For the three months ended June 30, 2021, the weighted average interest rate on our debt outstanding was 3.2%, consistent with the rate during the prior quarter. As of June 30, 2021, the company was in compliance with all terms under its secured credit facilities. With that, I will turn the call back over to Mike for closing remarks.

Thanks, Sally. In closing, we were pleased to deliver another strong quarter of earnings and NAV growth to our shareholders, driven by the improving credit quality trends across our diversified portfolio of middle market borrowers. We also demonstrated our platform’s ability to consistently source attractive new middle market direct lending opportunities on a global basis. We believe our stock valuation continues to offer our shareholders a compelling investment opportunity as we have a diversified performing portfolio of largely first lien loans and are well positioned to capitalize on new opportunities to increase stockholder value over time. We thank you for the privilege of managing our shareholders’ capital and remain focused on doing so prudently. Eli, please open the line for questions.

We’ll now take our first question from Finian O’Shea from Wells Fargo Securities.

Michael, I have a question about your comments on inflation, particularly input inflation like labor, which seems to be a continuing challenge in the recovery. Can you discuss how significant this issue is for middle-market companies and what risk it could pose if it persists? Is the current situation something that many of your companies and your underwriting need to see reversed for everything to function properly, or do you believe these companies will manage to cope even if the current conditions last for a while?

Great question as there has certainly been a lot of coverage regarding labor issues. The challenges related to inflation and the availability of labor have significantly impacted service industries, particularly in restaurants, which is not a sector where we are heavily invested. In contrast, areas like business services that rely on more technical labor have not experienced the same level of labor shortage. Therefore, within our portfolio, the labor issue has not been as significant as one might expect based on media reports.

Okay. And then Michael or Sally, can you give an update on the outlook for the 8.5% sub notes? I think those still are eligible for call sometime next year, but just any update on your thinking and interest and hopefully, improving that part of the capital structure.

Sure. Thanks for the question. So we were able to purchase about $37.5 million, the $150 million tranche subsequent to quarter end at a discount to the make-whole premium. So that is a nice improvement in reducing that tranche. And I think will be a positive impact on earnings going forward. Those notes are callable in summer of 2022. And so we will opportunistically look to continue to take down those notes to the extent it’s possible. But if not, we were pleased that those notes were short-dated when we put them in place. And so we would anticipate that they would come out at the next call date.

Our next question comes from Ryan Lynch from KBW.

My first question is about the ISLP. You mentioned having good opportunities in the European markets and that the ISLP experienced substantial growth in this portfolio. I’m wondering if you would also hold international loans on your balance sheet, depending on the size of the loan you are committing to, or do all international loans go directly into the ISLP?

Sure. Thanks for the question, Ryan. So currently, the ISLP is about 6% of the investment portfolio. Then we also have about 10% of incremental non-U.S. holdings that are sitting on our balance sheet. So we do have the ability to hold loans both in the international senior loan program as well as on balance sheet. As we’ve discussed before, having that International Senior Loan Program up and running, driving 12% to 13% yield really has helped and will continue to help the yield profile of the overall portfolio. And so we are thoughtful of that yield increase that comes with the ISLP, and that’s a key part of why we plan to grow and focus most of the growth on ISLP versus growing the loans on balance sheet.

Yes, that makes sense. The markets have recovered well and are strong at this point, with activity significantly improving. Looking ahead to the second half of the year, the economic outlook appears positive. What goals do you have for BCSF? What do you hope to achieve with BCSF in the latter half of the year?

Yes. So one of the key goals that we’re focused on is really driving up the yield of the investment portfolio, up from the mid-7s up towards 8%. Which we think puts us in a position to earn and potentially out earn the $0.34 dividend over time. And we plan to do that while maintaining our focus on first lien debt, and that’s a critical part of why we’ve really expanded and opened the funnel to make sure we’re both capitalizing on opportunities in the U.S. but also abroad and also have some incremental opportunity to do second lien loans in the portfolio. Right now, we’ve been at the lower end of our potential allocation to second lien loans. And we do think there’s meaningful room to grow that basket if we do feel like the economy is truly turning around, and we’re able to find good risk return in some second lien loan positions.

Okay. Understood. And then just one last one. You guys obviously booked the portfolio and continued to see some nice gains this quarter. In your prepared commentary, you mentioned still taking a measured approach to your fair values and that there’s potential for additional net asset value appreciation over time. Based on that commentary, what is the baseline assumption you have about the outlook for the U.S. economy or specific portfolio companies? Are you anticipating a continued gradual recovery, a sharper recovery, or some bumps in the road? What economic backdrop are you using when you made those remarks?

Sure. We are experiencing a slow and gradual recovery. For our risk rating 3s, which include the companies and industries most affected by the economic disruption over the past year, these are currently valued at an average of $0.85 on the dollar. We believe that they will eventually reach par value, as they are all first dollar risk in their capital structures. Consequently, we feel they are well-protected from any potential volatility in the recovery ahead. As we have recently assessed more situations, we think there is a greater chance for a stronger recovery than what we initially expected with those markets. However, we aimed to maintain a cautious approach given the ongoing uncertainties and the emergence of new risks as some old ones dissipate.

We’ll now move to our next question from Derek Hewett from Bank of America.

Given the strong growth in the ISLP during the second quarter, I believe it was approximately over 20%. Are you seeing significant growth opportunities in the latter half of this year? And if so, are there any growth limitations from your capital partner?

We are continuing to see good growth opportunities as the economies in Europe and Australia offer many interesting investment prospects. Currently, the ISLP constitutes about 6% of the portfolio. Our investment partner in that joint venture is also planning to increase their investment to capitalize on opportunities throughout the remainder of the year and beyond. We believe that reaching closer to a 10% holding is attainable with additional capital from BCSF and from our partner in the joint venture.

Okay. Great. And then in terms of an investment being housed in the ISLP versus just on balance sheet. What is the distinction there?

Sure. The plan is for most investments outside the U.S. to be placed in the ISLP over time. It involves managing the investment mix within the ISLP and ensuring we target the appropriate leverage level. We aim to operate with a leverage ratio between 1x and 1.5x in the ISLP. We are actively managing this and contributing assets to ensure we achieve double-digit return profiles in the ISLP.

Okay. And what is leverage in ISLP right now?

Sure. It’s about 1.1x at quarter end.

It appears there are no further telephone questions, so I’d like to pass back to Michael Ewald for any final or closing remarks.

Thanks. And again, thanks everyone for joining us this morning. We’re very pleased with our results for the second quarter and looking forward to providing you the good news at our next call. Thanks very much.

Ladies and gentlemen, this concludes today’s call. Thank you for your participation. You may now disconnect.