Earnings Call Transcript - BXSL Q4 2022

Operator, Operator

Welcome everyone to the Blackstone Secured Lending Fourth Quarter and Full-Year 2022 Investor Call, hosted by Michael Needham, Head of Investor Relations. During the call, your lines will remain on listen-only. Now, I would like to hand over to Michael. Please go ahead.

Michael Needham, Head of Investor Relations

Thank you, Colby. Good morning and welcome to Blackstone Secured Lending's fourth quarter call. Earlier today, we issued a press release for the presentation of our results and filed our 10-Q, both of which are available on our shareholders section of our website, bxsl.com. We will be referring to that presentation throughout today's call. I'd like to remind you that today's call may include forward-looking statements which are uncertain and outside of the firm's control and may differ materially from actual results. We do not undertake any duty to update these statements. For some of the risks that could affect results, please see the risk factors section of our most recent annual report on Form 10-K. This audio cast is copyrighted material of Blackstone and may not be duplicated without consent. With that, I'll turn the call over to BXSL's Co-Chief Executive Officer, Brad Marshall.

Brad Marshall, Co-CEO

Thank you, Mike, and good morning, everyone. Joining me today are Interim CFO, Kevin Kresge and our newly appointed Co-CEO, Jon Bock. I, as well as many others on this call, are quite familiar with Jon's impact on the BDC industry. As both a top-ranked equity research analyst and BDC executive, Jon is an exceptional thought leader in the BDC space, as well as a long-time friend. I'm thrilled to have his partnership as we continue to expand our business. Turning to this morning's agenda, I'd like to start with some high-level perspectives before Jon and Kevin go into detail on our portfolio and fourth quarter results. Turn to slide four. BXSL reported another excellent quarter with significant growth in investment income, higher net asset value, and strong credit performance. Net investment income, or NII, increased 13% quarter-over-quarter to a record $0.90 per share, which represents a 14% annualized return on equity. This powerful performance reflects the quality and strength of our well-sourced portfolio. At year-end, 98% of our portfolio was senior secured with a loan-to-value ratio of 47.5%, with zero investments on non-accrual, and only 1% of our assets marked below 90. Our net asset value increased to $25.93 from $25.76 the previous quarter, also reflecting the portfolio's strength. As a result, I'm thrilled to report that BXSL has raised its regular quarterly dividend by 17% to $0.70 per share beginning in Q1 2023. That represents a 10.8% annualized yield for shareholders based on the higher fourth quarter NAV of $25.93 per share. This marks the third time in the last year and a half that we've raised our regular dividend, which we believe represents the highest dividend yield for any listed BDC with a predominantly first lien senior secured portfolio. Since we went public in late 2021, we've increased our regular dividend by 40%. Later in the call, Jon will speak to the durability of that higher dividend, which remains very well covered by our fourth quarter net investment income of $0.90 per share. Slide five provides additional highlights on our portfolio activity and strong liquidity position. Fourth quarter sales and repayments were $219 million, offset by $177 million of new investment funding, which remains below historical levels. Our weighted average yield on debt investments increased by 9.1% last quarter to 10.7% at quarter-end, driven by higher base rates. We closed out the year with $1.1 billion in liquidity. Turning to slide six, we ended the year with $9.6 billion of investments and leverage of about 1.34 times, which was effectively flat quarter-over-quarter. Importantly, the ending yield on our 98% floating rate debt portfolio expanded approximately 350 basis points over the last 12 months, with more potential upside from here. Turn your attention to slide seven. Here we outline BXSL's strong NII per share growth. We've illustrated how interest rates could impact the year-end portfolio. You can see that if we apply December 31 rates to that portfolio, NII jumps to $0.96 per share. This transition to increasing base rates has continued since year-end. Looking at this chart, I think market investors understand that base rates could drive up NII. But today, I'd like to dive into just one of the tools that is available to and unique to Blackstone that informs our view on macro conditions. As many of you know, Blackstone's position as the world's largest alternative asset manager allows for distinctive and differentiated insights gained across our portfolio of businesses in private equity, credit, and real estate. Within Blackstone Credit alone, we have over 3,100 companies across our liquid and private businesses. As debt originators, we often receive real-time information from our companies and have direct access to sponsors, management teams, and market participants. This results in market views that are core to our investment process. And we use data and technology to integrate it into our portfolio decisions. One differentiated resource we want to share is our CEO Survey from our Blackstone portfolio companies, which can offer unique insights. First, while those responding CEOs ranked slowing economic growth as the top macro issue they face, Blackstone's private equity companies saw year-over-year revenue growth in the fourth quarter, and most of these CEOs expect near-term revenue growth to remain healthy. Second, responding CEOs indicated that inflation is decelerating in major categories: wages, raw materials, energy, and pricing. Lastly, a sign of confidence in the operating environment is management teams' willingness to invest in projects for growth and efficiency. What's interesting is that a majority of the CEOs expect to maintain or increase their level of investment with the largest areas being software, technology, and services to improve productivity. This also supports BXSL's thematic industry selection in these areas. To be sure, despite the slower overall inflation, certain inflationary pressures remain. For example, some cooling in the labor markets and base foreign exchange rates have helped to moderate wage pressure, but it remains well above levels considered consistent with the Fed's inflation target. We think that supply-demand imbalances in the labor markets will cause the Fed to keep rates higher for longer. Today's economy has many more job openings than there were before the pandemic. The vast majority of responding CEOs expect their company's employment levels to be flat or positive. This muddling along in the economy should keep credit performance generally strong, particularly for those managers capable of underwriting large-scale businesses. Before turning it over to Jon and Kevin, let me leave you with a final overarching thought. When we created BXSL and BCRED, our non-traded BDC, we told investors that we would lead the market with best practices, including lowering our fees so we could bring a more defensively positioned portfolio that would protect capital in more challenging market conditions, yet still deliver attractive returns. That philosophy continues to serve us well. We operate at a cost structure about 30% lower than that of our listed peers. We amortize original issue discount over the life of the loan, and we don't scrape upfront fees for fund assets to the manager because that's something we believe runs contrary to true investor alignment. Most importantly, that alignment comes with the benefit of Blackstone's differentiated scale. Across our platform, the benefits of that scale abound, especially in uncertain economic environments where our portfolio management and Blackstone advantage teams can, I believe, add significant value. Recall, we have an internal Blackstone team of 112 people who work with our portfolio companies, including over 20 professionals in or affiliated with Blackstone Credit. This team not only takes an active role in watching over our companies, initiating ongoing discussions with our sponsors but also adds value to our portfolio companies by giving them access to Blackstone's operating resources to drive both revenue and cost synergies that are significant to the portfolio company and the private equity sponsor. For example, in 2022 alone, the Blackstone Credit Advantage team was able to reduce portfolio company costs by $66 million across the Blackstone Credit platform, bringing almost $250 million in savings since the inception of the Blackstone Advantage Program. Through these cost-saving initiatives alone, the team has added more than $3 billion of enterprise value to the Blackstone Credit portfolio—a significant benefit for our sponsors. Additionally, across the full Blackstone portfolio, companies have generated over $500 million in revenue from cross-selling to one another. The scale and impact of what we sometimes call the Blackstone economy, in which portfolio companies across our credit platform are meaningfully engaged, differentiates Blackstone Credit, which can be especially impactful in a slowing economy. The impact of this specialized team and its end investor benefit is immense and we believe entirely unique to the Blackstone Credit Group. We also expect it to be a major differentiator of our platform and performance over time. So, with that, I will turn it over to Jon to speak about the portfolio.

Jon Bock, Co-CEO

Thank you, Brad, and good morning, everyone. I can't tell you how much I've looked forward to walking through the strength and stability of the BXSL portfolio with you. The best place to start is to tell you very briefly why I chose to join Brad and the team at Blackstone Credit. I'm sure you all see us drive the immense scale and broad capabilities that Blackstone brings to private credit markets. Yet what surprised me, and it may also surprise you, is how Blackstone pairs the power of its unique scale with world-class shareholder alignment to drive attractive performance and investor returns. Brad alluded to this. This isn't something I take for granted; BXSL's fee structure is materially lower than the average publicly listed BDC. BXSL also has a performance fee look-back mechanism, and the management team has regularly demonstrated an industry-leading ability and willingness to align with shareholders. I spent my entire professional career in BDCs and private credit early on as a sell-side analyst before I became an operator and Chief Executive. When BXSL was formed in 2018, Brad Marshall stated that Blackstone would lead the BDC market with best practices, and in my professional opinion, they've done exactly that. I'm thrilled to join the team, to be here today and join my colleagues. And that's actually a perfect segue to the portfolio. Remember, Blackstone's decision to focus on shareholder alignment upfront allowed BXSL to build a more defensive portfolio that better protects shareholder capital in more challenging market conditions. So, let's outline what a defensive portfolio looks like. Jump to slide eight, let's start with seniority: 98% of BXSL investments are in first-lien senior secured loans, and over 95% of those loans are to companies owned by private equity firms or other financial sponsors who have access to additional equity capital to support their companies. The portfolio is highly equitable, with an average loan-to-value of 47.5%. But it's not just that we're senior in the capital structure. More importantly, we're focused on senior with companies of the right size in the right industries. Focusing on size, our portfolio companies have an average EBITDA of $167 million relative to $116 million as of Q4 '21, and we continue to orient the portfolio to larger, more durable businesses. Furthermore, recent data from Lincoln suggests that companies with greater than $100 million of EBITDA grew more than two times that of companies with less than $50 million of EBITDA in 2022 through Q3. Slide nine focuses on our industry exposure where we believe investing in better companies, in better neighborhoods, drives strong returns over time. This means focusing on key sectors with low default rates and lower CapEx requirements such as software, healthcare, and professional services, which account for over 36% of the investment portfolio. Diving into portfolio quality further, jump to slide 10. Here we compare the BXSL portfolio to the Lincoln International Private markets database. Many of you know Lincoln as a leading valuation provider to the private credit and BDC space as they value and review over 5,000 private credit investments each quarter. Lincoln, in partnership with several faculty members of the University of Chicago Booth School of Business, created the Lincoln Senior Debt Index, the leading Private Credit index which allows investors and managers to truly drill down into loan-level performance data for the entire private credit marketplace. This is an extremely valuable index. So, in comparing BXSL, you can see that our weighted average EBITDA of $167 million is double the Lincoln market average of about $78 million. EBITDA growth for our portfolio companies is also double that of the Lincoln benchmark. Importantly, our portfolio companies have EBITDA margins that are 35% higher. Let's talk about interest coverage because interestingly this is a stat that gets widely shared on other listed BDC earnings calls. The way it’s calculated by BDC managers varies widely. In some cases, certain sectors or types of loans are excluded. In other cases, managers exclude negative EBITDA companies, both decisions that obscure the averages and leave investors looking for better transparency. When we calculate interest coverage, we include all private company EBITDA, including companies that have borrowed on a recurring revenue loan, so if managers exclude these types of loans or underperforming loans from their metrics, we do not. We currently sit at least 12 months average interest coverage of 2.3 times today, which is slightly higher than the market average of two via Lincoln. This difference remains resilient when interest rates are applied at December 31 levels through the portfolio, bringing our average interest coverage to 1.7 times versus the private credit market's 1.4. We attribute this stability to our focus on larger, more profitable, higher-growth businesses. Yet we also hear from our investors and other market participants that it’s less about averages, particularly those averages obscured by exclusions, and more about the tails, mainly the percent of one’s portfolio below an interest coverage ratio of one-time on a forward basis using higher rates. If we run the December 31 spot rates, we can see that BXSL would have roughly 8% of its portfolio with an interest coverage ratio below one, compared to the Lincoln private credit markets database, which has more than twice that amount—a very stark difference. For these reasons, I think we're positioned better than the private credit market. Further, we don't believe that less than one times coverage in our portfolio driven by higher rates directly translates to potential credit losses for companies where fundamentals and the outlook remain healthy. We believe that the market is right: averages won't tell the story of direct lending performance; the tails will—and we seek to limit our tail risk through our focus on better larger businesses in more resilient sectors. We continue to see favorable results. Blackstone has also built its conservative credit culture on a foundation of structural protections for investor capital while focusing on larger deals. Note that when Blackstone leads or co-leads, the vast majority of our deals have structural protections against asset stripping and collateral release to prevent any shifting of assets out of our collateral package, and almost none allow for uncapped EBITDA add-backs, all materially better than the leveraged loan market. Let's turn to amendments. We work with our portfolio companies constructively in the regular course. To provide an idea of the scope of the 23 amendment requests we received in the quarter, 56% of those were related to M&A or add-on activity, and 43% were related to SOFR rate hedging or other technical adjustments. We did not have any companies that needed immediate interest, principal, or covenant relief in the quarter. To be clear, should our companies face more challenging times, we have a large operational team that Brad mentioned that can help them reduce expenses, improve operational efficiencies, or source new revenue channels. We believe our portfolio and scale set BXSL apart from the rest of the private credit field, and our dividend increase further reflects our confidence in the future. Jump to slide 11. As Brad mentioned, we elected to raise our dividend by nearly 17% from $0.60 to $0.70 per share, with a current dividend yield at NAV of approximately 10.8%. The absolute dividend level generates what we consider to be an attractive return. I also want to highlight how Blackstone's shareholder-aligned approach allows us to pay this elevated distribution, even in a lower rate environment. Many of you are familiar with the concept of BDC math, which essentially asks this: at what spread over the base rate must a BDC lend to generate the dividend they promised investors? As you might expect, that answer can vary widely depending on the BDC. Higher-cost BDC fee structures characterized by higher base management fees and higher incentive fees or all original issue discounts that require these BDCs to originate at a wider spread on assets may be associated with higher risk loans in order to meet the dividend obligation. At today's base rates, we estimate BXSL, at our future fee structure of 1% and 17.5% incentive with a look-back, would need to originate at approximately SOFR plus 400 to meet its dividend obligation before prepayment fees—well below the current investment opportunity set, and all else equal, as of December 31. Additionally, let's say base rates were to fall to 2%, BXSL would need to originate or invest at roughly a SOFR plus 600 level to meet that same return—all well within the strike zone of private credit across cycles. As compelling as math may be, I want to leave you with a somewhat philosophical view of our approach to dividends. We believe the best dividend policy can support both a steady and stable distribution and long-term NAV growth, and we believe BXSL's low-fee, shareholder-aligned approach does exactly that. With that, I'll turn it over to Kevin to go over the financials.

Kevin Kresge, Interim CFO

Thanks, Jon. I'll start with our operating results on slide 12. In the fourth quarter, net investment income was a record $144 million, or $0.90 per share, which was up 34% year-over-year. Our revenues were up $59 million, or 31% year-over-year, with combined fee and dividend income, flat quarter-over-quarter. Payment-in-kind or PIK income declined to $10 million from $11 million last quarter and represented less than 4% of total investment income. Meanwhile, net expenses were up just $25 million compared to last year's fourth quarter, driven largely by interest expense. GAAP net income in the quarter was $122 million, or $0.76 per share, up from $0.73 per share a year ago. This is despite $22 million of unrealized losses this quarter. These unrealized markdowns resulted in a $3 million capital gains incentive fee reversal, or $0.02 per share that benefited NII this quarter. Next, turning to the balance sheet on slide 13, we ended the fourth quarter with $9.6 billion of total portfolio investments, of which approximately 98% are floating rate at a weighted average yield of 10.7%. This compares to $5.5 million of outstanding debt, with a weighted average cost of just 4.3%. The spread between our floating rate assets and low-cost mostly fixed-rate liabilities provides the company with the potential for additional earnings growth if rates continue to rise. As a result of strong earnings in excess of the dividends in the fourth quarter, NAV per share increased to $25.93, up from $25.76 last quarter. Next, slide 14 outlines our attractive and diverse liability profile, which includes 58% of drawn debt and unsecured fixed-rate bonds with a weighted average interest rate of less than 3%, which we view as a key advantage in this rising rate environment. Additionally, BXSL ended the year with $1.1 billion of liquidity in cash and undrawn debt. We believe this provides us with significant flexibility and cushion. Our ending debt-to-equity ratio was 1.34 times, in line with last quarter. Importantly, we ended the year with no assets on non-accrual and maintained our three investment-grade corporate credit ratings. Additionally, we have a low level of debt maturities over the next few years with just 6% of commitments maturing prior to September 2024, and an overall weighted average maturity of nearly four years. Moving to an update on our share repurchase program, which has been accretive to shareholders. As you may recall, BXSL instituted a $262 million share buyback program at the time of our IPO. In 2022, we repurchased 11 million shares at a weighted average price of $23.97, representing an 8% discount to current NAV, one of the largest executed share repurchases in BDC history. In keeping with our focus on shareholder alignment, I am also happy to report that the BXSL Board has approved an additional $250 million discretionary share repurchase program. Our management team will continuously monitor investment opportunities in the direct lending marketplace as well as our own shares. In closing, we believe BXSL is very well-positioned to generate earnings in excess of our dividend as rates on our 98% floating rate investments continue to reset higher. As Brad mentioned, we estimate our fourth quarter NII per share would have been $0.06 higher, or $0.96 total, if the average base rate was hypothetically at December 31 levels for the entire quarter, all else being equal. There is additional offset potential from here given the recent 25 basis point Fed rate hike, with the potential for more increases in the future. We remain positive about the outlook given our best-in-class origination and portfolio monitoring teams, our strong defensive portfolio designed to protect capital in times of stress, and the earnings upside potential as a result of rising rates. And with that, I'll ask the operator to open it up for questions. Thank you.

Operator, Operator

Thank you. And the first question is from Finian O'Shea at Wells Fargo. Please go ahead.

Finian O'Shea, Analyst

Hi, everyone. Good morning. Appreciate the color there on the interest coverage and the portfolio. What are the interest coverage ratios you're seeing today in the market for new deals?

Brad Marshall, Co-CEO

Thanks, Finn. Interest coverage is in line with where the existing portfolio is. Or said differently, the capital structures are being set up with a little bit less leverage today, given where rates and spreads are in this environment. A lot of deals that we're looking at are around two times coverage, stepping down a little bit to the extent base rates get into the low-to-mid fives.

Operator, Operator

And the next question is coming from the line of Casey Alexander, Compass Point. Please proceed.

Casey Alexander, Analyst

Hi, good morning. First of all, welcome to Mr. Bock to the Blackstone management team. We're happy to see him there. I have two questions. First, I appreciate your thoughts around the dividend and the base dividend. Given your current earnings power, the base dividend doesn't meet the RIC requirements for required distributions. How do you plan to address this? Do you have a formal process in mind for distributing the additional income you expect to earn beyond the base dividend? Some BDCs have a formula they use. How do you manage the RIC requirement and handle the extra income beyond your current base distribution?

Jon Bock, Co-CEO

Thanks, Casey. This is Bock. So, I'll start with really our focus on what we believe truly drives long-term value. Our view is that BDCs that institute steady and stable growing base dividends and have a level of NAV growth associated are generally the types of BDCs that generate the best valuations. You can expect to see clearly that while we have raised the dividend, there is going to be a level of earnings excess. That level of earnings excess enters dividend spillover and grows NAV. To the extent that we start to approach a level of special distributions that would be required as a result, we'll deal with that as we come to it. We find that there is more value relating to NAV and the compounding inside given the small cost of excise tax of 4%. Over time, as you see the market opportunity grow and BXSL grow along with it, you can easily manage those payouts to drive long-term return.

Casey Alexander, Analyst

All right. My second is, and I appreciate the information that you gave on slide 10, the types of companies that fit the fundamentals that you are lending to also have deal sizes that are well in excess of the average size in the marketplace. Given co-investment privileges, does Blackstone have deep enough pockets to absorb those entire deals or would you think more in terms of partners on some of those deals? How do you contour managing the deal size that comes with those types of characteristics?

Brad Marshall, Co-CEO

Yes, Casey, it's Brad. If you look at our private portfolio, about 80% of the deals that we do, we're the sole or lead lender. Once a deal gets above $2 billion, it requires us to bring in partners. As you exceed a certain size, we will be co-investing alongside others, which is partly why our fee structure is so attractive. If other managers are coming in alongside us in those deals, the best ROE for investors for these types of large deals is to invest in BXSL because of the fee structure that Jon went through.

Operator, Operator

And the following question is coming from the line of Robert Dodd, Raymond James. Please go ahead.

Robert Dodd, Analyst

Hi, guys, and welcome, Jon. Regarding the data on slide 10, Jon, you talked about at the December spot rates you'd have 8% of the portfolio under one times interest coverage. December is your peak though. Have you looked at what, say, intra the proportion or indeed your proportion versus the length of the portion would be under 1 at peak rates, which are maybe 100 basis points higher than December?

Jon Bock, Co-CEO

Yes. If you start to look forward, let's say to rates of 5%, you'll notice that that ratio still stays very, very close. For Blackstone, you'll see a level of stability in our portfolio given where we've focused. For the market, if you move forward, you'll start to see that tail increase over 20%. Our goal is to give you a view of what we see as of December 31 and then continue to adjust to what's factually there, because who knows where rates will be arbitrarily. But that’s really where it will trend. We believe it's an important item to focus on because, truly, it is what sits in the tails and how you manage it.

Robert Dodd, Analyst

I appreciate that, but that relates directly to the follow-up question. To your point, having just under one times interest coverage doesn't make much sense. It has to involve a combination of factors, such as decreasing lender credit, shrinking EBITDA, or issues within the business. Looking at slide 10, the LTM EBITDA growth stands at 17%, while the credit market is at 9%, meaning approximately 2 times again. For the tail, what percentage of the portfolio is experiencing negative EBITDA growth? That's where we are likely to encounter problems, more so than with interest expense. It's crucial to consider if the EBITDA is facing challenges and if there's a way to break down the tail of the portfolio using some of those other metrics.

Jon Bock, Co-CEO

So— or maybe asked differently, interest rates alone don't cause companies to default. Good companies will manage through a higher interest rate environment quite well, especially given the vintage of BXSL’s portfolio companies. About 20% of the companies that are closed on interest coverage have been performing in line or below expectations.

Operator, Operator

And the next question is coming from the line of Ryan Lynch, KBW. Please go ahead.

Ryan Lynch, Analyst

Good morning, and welcome, Jon, to Blackstone. The first question I had, kind of following up on the whole interest coverage discussion. I really appreciate the details you all provided in your prepared remarks as well as some of the details in the slides. I think it would be helpful, when you think about the portfolio, 8% falling below 1% interest coverage, which just sounds like that's pretty significantly better than most of your peers. But I would just love to hear, if that does occur, what are some of the remedies that you can implement to ease the stress of those companies? I would assume that the easiest one is trying to get the private equity sponsor to inject more capital into that business. But assuming that does not occur, what are some of the remedies that you can do proactively to allow those companies to transition through this kind of high interest rate period?

Jon Bock, Co-CEO

Yes, thanks, Ryan. A couple of things. One, half those companies, of the 8%, are companies that have negative EBITDA by design. These are recurring revenue loans, so it's a small portion of our portfolio, but their capital structures were set up with that in mind. With the rest of the portfolio companies, there are a couple of things. One, when we have these conversations with the sponsors, what they say when we run our models and we show them what we think interest coverage is, their reply is typically, one, they can cut costs in order to improve cash flow and service their debt. Two, they can inject equity, as you suggested. Three, you can fix some of your interest rate exposure, which I’m sure you’ll see more of across the industry as this year evolves. The fourth mechanism is most companies have revolvers they can use as long as it satisfies their covenants to fund any kind of slight misses in cash flow. These would be the four primary areas. We've had all these conversations with our portfolio companies that even get close. Thus far, the sponsors seem incredibly supportive given what I said earlier: if you're a good company, transitory issues like rates and inflation don't cause a company to default.

Ryan Lynch, Analyst

Yes, got it, that makes sense. Just the other question I had was, and I may be wrong on this, but I thought you guys' targeted leverage range was around 125. You guys have been running not materially above that, but closer to 130—the 130s the last several quarters. Did you guys change your expectations on where you’d want to run, or is there ever a point where you want to reduce that down to 125-ish?

Brad Marshall, Co-CEO

So, Ryan, remember in the quarter, we bought back another $47 million of stock, and we invested about $175 million. Those two things alone, which are entirely in our control, took leverage above our target of 1.25 times. If you remember from the last call, I indicated we have about $800 million of pay-downs coming, roughly $200 million, we saw in the fourth quarter. So, we have another line of sight over the next couple of quarters to additional pay-downs. That informs our buyback and investment pace.

Operator, Operator

And now I would like to hand the call over to Michael for closing remarks.

Michael Needham, Head of Investor Relations

Great. Thanks everyone for joining. Our team is available for any follow-up should you have them. Otherwise, we will speak to you again next quarter.