Earnings Call Transcript - BXSL Q3 2022

Operator, Operator

Welcome, everyone to the Blackstone Secured Lending Third Quarter 2022 Investor Call. It is hosted by Michael Needham, Head of Investor Relations. My name is Chris and I'm your event manager. During the presentation, your lines will be on mute. I would like to remind everyone that the call is being recorded for replay and transcription purposes. And with that, I will hand the conference over to the host, Michael. Sir, please go ahead.

Michael Needham, Head of Investor Relations

Thank you, Chris. Good morning and welcome to Blackstone Secured Lending's third quarter call. Joining me today are Brad Marshall, Chief Executive Officer, and Kevin Kresge, Interim Chief Financial Officer. 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 website. 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. On results, we reported GAAP net income of $0.58 per share for the third quarter and net investment income of $0.80 per share. With that I'll turn the call over to Brad.

Brad Marshall, CEO

Thank you, Michael, and good morning, everyone. I appreciate you joining our call today. As Michael highlighted, we have reported another outstanding quarter, showcasing robust growth in investment income and stable credit performance. Net investment income rose by 29% quarter-over-quarter to an unprecedented $0.80 per share, reflecting a 12.4% annualized net investment income yield on third-quarter net asset value. We anticipate further increases in net investment income in the near term due to higher rates. Our stronger earnings have also led to increased dividends. In September, we raised our regular quarterly dividend by 13% to $0.60 per share, which corresponds to a 9% annualized yield based on the net asset value from September 30. Including special dividends, our yield for the past year was 11%, achieved from a portfolio primarily composed of first lien senior secured loans during a time when short-term rates averaged below 1%. Additionally, we repurchased $164 million of shares during the quarter below book value, which contributed $0.02 to net investment income accretion and $0.09 to net asset value accretion. Kevin will provide more details on our share repurchases. As many of you know, we recently celebrated the one-year anniversary of BXSL as a publicly traded entity and will soon mark four years since its launch. When we established BXSL and BCRED, our non-traded BDC, we committed to leading the market with best practices, including reducing our fees to build a more resilient portfolio that would safeguard capital in challenging market conditions, while still delivering appealing returns. Today, you will learn how that strategy has unfolded concerning our sector choices, our seniority in the capital structure, and the sizes of the businesses we finance. To illustrate with some data as of September 30, 0% of our assets are on non-accrual, and only 1% of our private assets are valued below 90. Our average interest coverage over the past 12 months is 2.7x, and our portfolio companies have shown healthy EBITDA growth quarter-over-quarter. We are seeing similarly strong metrics throughout our more than $80 billion U.S. direct lending platform. We believe this quality emphasis will ensure resilience amid a more challenging macroeconomic landscape. Before handing it over to Kevin to review our financial results, I want to touch on a couple of themes. First, net investment income growth, with higher rates and a favorable asset liability profile, is driving significant growth in our investment income. Secondly, credit; BXSL was designed to excel in more challenging credit environments, and we are confident in the resilience of our business. Lastly, in terms of outlook, we believe BXSL is well-positioned to provide high and growing income and dividends for our investors, benefitting from our extensive platform, positive net investment income tailwinds, and defensively structured portfolio. The third quarter indicates the start of a substantial expansion in our earnings. BXSL outperformed its dividend by 33% owing to a favorable asset liability profile, with nearly 100% floating rate investments and 58% fixed rate debt at an average coupon of less than 3%. We expect further growth in net investment income in the near term as the portfolio fully reflects recent rate increases. Our average base rate rose from 1.1% in the second quarter to 2.5% in the third quarter, and it would have been 3.5% at quarter-end if all loans had reset on September 30. With 76% of our assets tied to LIBOR, the blended base rate would be 4.3% if all loans reset yesterday. If the September 30 base rate of 3.5% had been in place for the entire quarter, we estimate that third quarter net investment income would have been 13% higher, or an additional $0.10 per share. Our credit performance remained solid during the quarter, and we believe we will continue to excel from a credit perspective. Over the last four years, we have invested BXSL's capital with a focus on downside protection by prioritizing the top of the capital structure and collaborating with resilient sectors, large companies, and leading sponsors. I would like to highlight a few metrics that explain why we are optimistic about our portfolio's resilience. First, seniority; 98% of BXSL's investments are in first lien senior secured loans, and over 95% of those loans are made to companies backed by private equity firms or financial sponsors with access to additional equity capital to support their businesses. Our portfolio is highly equitized, with an average loan-to-value ratio of 47%, lower than the market average of 55% for leveraged buyouts in the past year. Second, sectors; Blackstone Credit has expanded its team by more than 30% over the last year, focusing on enhancing resources in key sectors characterized by low default rates, such as technology, healthcare, and sustainable resources. We estimate that over 85% of BXSL's portfolio is invested in sectors with annual default rates below 2% since 2007, according to Fitch, which is significantly below the S&P leveraged loan index that sits at 55% for similar low-default sectors. Third, scale; we believe larger companies have better resources to navigate challenging macroeconomic conditions. Our average portfolio company EBITDA increased to $162 million, and we have structured our portfolio towards larger, more durable businesses. Our companies saw estimated EBITDA growth of 5% quarter-over-quarter on a same-store sales basis, compared to 2% for the S&P leveraged loan index. Our weighted average EBITDA margin stands at 30%, in contrast to 18% for S&P companies leveraged 2x or higher. Moreover, we estimate our portfolio's average interest coverage is approximately 2.7x based on the last twelve months and 2.2x based on annualized third-quarter market rates. In both scenarios, about 2% of the portfolio has interest coverage under one time, dominated by two companies, for which we believe earnings profiles are improving, while the remaining loans were deliberately arranged with lower than average LTV and larger liquidity reserves. Lastly, we have not encountered a significant increase in amendment requests. However, should our companies face more challenging times, similar to the immediate aftermath of COVID, we have a large operational team to assist them in reducing expenses, enhancing operational efficiency, or identifying new revenue streams. Over 20 professionals affiliated with Blackstone Credit are dedicated to managing and improving our investments, alongside more than 100 operational professionals across Blackstone's broader platform. We believe having access to an operational team that can actively engage with our portfolio companies benefits the BXSL and BCRED franchises and will continue to set our platform and performance apart over time. Therefore, despite the macroeconomic challenges looming ahead, we are optimistic about the future for BXSL shareholders. Blackstone is keenly focused on enhancing shareholder experience; we have significantly lowered our fees compared to the average public BDC and opted out of fee scraping for the manager. We have implemented a performance look-back mechanism and recently completed a $263 million buyback, including repurchases made after the quarter-end. If you consider pro forma earnings based on September 30 rates against yesterday's closing share price, that equates to over a 15% net investment income yield—not 12 or 13, but 15%—from a portfolio of performing first lien assets at a 47% loan-to-value ratio. While our asset and liability structure has positioned us well for this outperformance, a significant part of that yield is also attributable to our lower fees compared to competitors. For credit, we are at 0% non-accrual, with only 1% of BXSL's portfolio marked below 90. Our emphasis on sector selection, size, and recent vintage bodes well for the future. Even with the anticipated challenges, we are structured to be defensive. Across BXC, as mentioned, our headcount has increased by over 30% in the past year as we continue to enhance our sector verticals, geographical outreach, portfolio management, and operating resources. We believe that BXSL's access to operational resources and executives placed alongside companies across various functions will significantly influence outcomes in the coming years. With lower fees and expenses, a promising earnings outlook, some of the top credit metrics, and a robust platform to support our companies, we are confident that Blackstone will emerge as a net winner in the upcoming quarters. I will now hand it over to Kevin.

Kevin Kresge, Interim CFO

Thank you, Brad, and good morning, everyone. Despite the challenging macro environment, we achieved strong third quarter results, showing significant earnings growth driven by rising interest rates and supported by our portfolio's defensive positioning and solid capital structure. I will outline the main factors behind our earnings growth, details on our capital structure, an update on our share repurchase program, and our outlook for future earnings potential. In the third quarter, net investment income reached $132 million, or $0.80 per share, a 29% increase from $0.62 last quarter. Revenues rose $49 million, or 21%, quarter-over-quarter, despite no significant prepayments and no dividend income, indicating that our revenues were almost entirely from recurring interest. Payment-in-kind income was stable quarter-over-quarter, with new PIK allocations representing under 5% of total investment income. This highlights our portfolio companies' ability to pay cash interest despite increasing rates. Concurrently, net expenses increased by just $13 million compared to last quarter. Nearly 60% of our interest expenses were fixed at a weighted average rate of 2.97%, which provided significant operating leverage in this rising rate environment. GAAP net income for the quarter was $96 million, or $0.58 per share, a 23% increase quarter-over-quarter, even with $36 million in net realized and unrealized losses primarily due to market declines as credit spreads widen. This was partially mitigated by strong performance from our portfolio companies. In a tough M&A environment, we managed to generate $34 million in realized gains this quarter, primarily from a single equity position in a software company, which yielded over three times our initial investment. As previously mentioned, our dividends for the quarter included a regular dividend of $0.60, up 13% from $0.53 last quarter, along with a special dividend of $0.20. As a result, our NAV per share at the end of the quarter was $25.76, showing a slight decrease from the previous quarter but would have been around $0.07 higher if not for the special dividend. Turning to our capital structure and liquidity, which we consider a key advantage for BXSL, we concluded the third quarter with $9.7 billion in total portfolio investments, nearly all on floating rates at a weighted average yield of 9.1%. This is against $5.5 billion of outstanding debt with a weighted average cost of just 3.7%. Notably, 58% of our drawn debt consists of unsecured fixed-rate bonds below 3%, giving us an edge in the current rising rate environment. The difference between our floating rate assets and lower-cost mostly fixed-rate liabilities opens up considerable potential for additional earnings growth as rates increase. Our debt-to-equity ratio at the end of the quarter was 1.33x, slightly down from last quarter and nearing our target range of 1x to 1.25x. If share buybacks had not occurred, and net capital had been used to pay down debt, our leverage would be at 1.22x. We ended the quarter with $1.1 billion in liquidity from cash and undrawn debt, an increase from $890 million last quarter, as we repaid debt using loan proceeds. This provides us with tremendous flexibility. Furthermore, we face low levels of debt maturities in the coming years, with only 6% of commitments maturing before September 2024, and an overall weighted average maturity of almost four years. Importantly, we finished the quarter without any assets on non-accrual and maintained our three investment-grade corporate credit ratings. Now regarding our share repurchase program, which has benefited shareholders, we initiated a $253 million share repurchase program at the time of our IPO, activated if BXSL shares are undervalued. During the quarter, we repurchased nearly 7 million shares for approximately $164 million at an average price of $23.82, representing an 8% discount to NAV. Consequently, this led to about $0.11 of NAV accretion in the quarter, including $0.09 from purchasing shares at a discount and $0.02 from higher NII per share due to fewer shares outstanding. After the quarter ended, we repurchased an additional $47 million at an average price of $23.65, reaching the program's full capacity. Overall, we repurchased 11 million shares, which reflects our commitment to enhancing shareholder value alongside growing earnings and increasing our dividends. Looking ahead, we believe we are well positioned for substantial earnings growth in the coming quarters as rates on our nearly entirely floating rate investments continue to rise. We estimate that our third quarter NII per share would have been $0.10 higher, or $0.90 total, if the average base rate had been at the September 30 level throughout the entire quarter, all else being equal. There is further upside potential considering the recent 75 basis point Federal rate hike and the anticipation of more increases. While we are pleased with our third quarter results, we remain optimistic about the fourth quarter outlook, thanks to our defensively structured portfolio designed to preserve capital during challenging times, along with potential earnings increases from rising rates. With that, I will now open the floor to questions.

Operator, Operator

Thank you. Your first question comes from Casey Alexander from Compass Point. Please go ahead.

Casey Alexander, Analyst

Yes, good morning. And first of all, let me say that we have loved BDCs for their commitment to share repurchase programs. I think it's entirely impressive that you completed the entire share repurchase program, which was true to your promise as a pre-IPO company. And regarding the impressive statistics you provided about your portfolio metrics, and the small number of amendment requests, I still think it's reasonable to ask how you are preparing a plan relative to the interest rates that you see because it’s just math to help ensure that your last dollar of interest doesn't tip that company and help them get through the cycle?

Brad Marshall, CEO

Well, thanks for those comments, Casey. As we've said, from the start, wanting to lead the market with best practices has always been core to Blackstone's program. As it relates to reaching out to companies and working through what will be a challenging or more challenging period from a cash flow standpoint due to rising interest rates, we’ve had conversations with some sponsors, but largely, it's not on top of their mind right now. A little of that is because of what we said earlier: our interest coverage across the portfolio is actually pretty high, so they're not looking at the rate environment as being a material headwind for them going into next year. What I would say just generally though, Casey, and we've talked to some investors about this, is that interest rates do not impair businesses. It's certainly a headwind, and part of the calculus that they need to manage. But interest rates alone are not terribly problematic. What gets a company, especially with sponsor-backed businesses, so sponsors will support their businesses through transitory periods. Interest rates are arguably transitory. It's really all the other factors that create problems, such as secular headwinds with respect to investment issues particularly to companies, whether it's regulatory or other. But interest rates alone on a singular level do not drive defaults. So we are talking to companies, and some of them are reaching out to us, we're reaching out to some, but that is not a top of the list right now.

Casey Alexander, Analyst

All right. Thank you for that. My one follow-up question is obviously, there's a lot of exposure to the software space. I think it would give investors some comfort if you could provide some color as to the performance of your companies in the software space.

Brad Marshall, CEO

Yes, sure. So software companies are probably our best performing sector right now. I think that's largely because we're in profitable businesses with very good revenue visibility and very sticky top-line growth. We're seeing so far quarter-over-quarter EBITDA growth of around 4% or 5% in our software sector, and the average EBITDA of those businesses is $184 million. So think about that, these are three-plus billion-dollar enterprise value businesses, and their margins on average are about 26%. What that means, Casey, is that they're generating a lot of free cash flow to service interest and manage through what could be a market with more headwinds. Lastly, I would mention that we are at the very tip top of the capital structure, first in securities, and in our software sector, we are 43% loan to value and that's based on our view on value today, not when we made the investment, but today. So we're in a good place in the capital structure, we're seeing a lot of equity subordination from large companies that are generating growth.

Casey Alexander, Analyst

All right. Great. Thank you for taking my questions.

Operator, Operator

The next question is coming from the line of Finian O'Shea from Wells Fargo. Please go ahead.

Finian O'Shea, Analyst

Hi, everyone. Good morning. Thank you for a follow-up here and appreciate the color you gave on the portfolio Brad tying together some of that still good EBITDA growth at the higher base rates still making their way through. What's your sort of feel on where interest coverage glides into next year? Or where things will ultimately settle based on the forward curve right now?

Brad Marshall, CEO

Thanks, Fin. So based on the forward curve, where it peaks right now, we think interest coverage will be at 1.8x. We expect that 10% of our companies will have interest coverage below one time. Again, that doesn't — 10% doesn't necessarily alarm me, given the ability to work through a solution with a small subset of our companies. And that's assuming they don’t actually grow, which we think they will.

Finian O'Shea, Analyst

Okay. Thank you. That's helpful. And a follow-up on the valuation inputs table, it looks like a bit of an uptick in level two assets that you're classifying within the first lien book. Is this indicative of leaning into the liquid markets or I guess what else might be happening there?

Brad Marshall, CEO

We're not in BXSL leaning into the liquid markets, Fin. I don't know what's necessarily driving the uptick in what you're seeing. But I remember, we only invested 200 and some odd million dollars in the quarter. So it was a fairly light investment period for us, and those were all in private assets.

Operator, Operator

The next question is coming from Ryan Lynch from KBW. Please go ahead.

Ryan Lynch, Analyst

Hey, good morning. Yes. I just want to echo I really appreciate a lot of the granular details you guys provided on kind of the portfolio statistics, EBITDA margins, 85% of your portfolio is in defense sectors, and that sort of stuff was very helpful as we kind of think through your portfolio and credit quality going forward. One question I had was, obviously, earnings significantly above the dividend this quarter, we looked at the runway, like you said, $0.90, kind of at the end of the quarter versus the dividend of $0.60, the core dividend. I'm just curious, as we look forward, dividend earnings are going to be significantly above the current dividend. What are you guys thinking regarding sort of a dividend policy? Are you thinking it makes more sense to get that core dividend close to the earnings run rate? Or are you looking to supplement that with variable or supplemental dividends or specialty? Just how are you thinking about this good problem to have regarding dividends in regard to acceleration?

Brad Marshall, CEO

I think you characterize it the right way, Ryan. I think you broke up a little bit, but I think we got the question. You characterized it the right way, which is we are in a very fortunate position that our earnings are accelerating into this rate environment for all the reasons that we've mentioned. Yes, we're considering all those options right now, as you know, we have to pay out 90% of our income, and so we're trying to sort through with the board the best way to do that. In the meantime, based on our share price, we're paying out about a 10% regular dividend that we're out earning. And the rest is helping build NAV. We'll come up with a longer-term plan regarding the excess income on how to return that to investors.

Ryan Lynch, Analyst

And then, you mentioned kind of building up your operating resources or executives. Can you just talk about because I think you are one of maybe a few platforms that have kind of access to significant resources in the year, you guys may have the most, in fact. Can you just talk about what sort of advantage that gives you if a company starts to show some stress? I don't know if you can give any past examples of what you have done to sort of help out and work out those situations that that potentially gives you an advantage as if we go into a more choppy credit environment.

Brad Marshall, CEO

Yes. It is an enormous advantage, Ryan, and it starts very early, well before a company is stressed. We have five people on our team. If we've mentioned this in the past, all they do every day is call our companies that are performing and ask, how can we help? How can we lower your costs? Can we cross-sell your products across Blackstone? Let us be a good partner. That is unique in the credit space. We have put a lot of resources and energy into that effort. Why that's important is that we establish a relationship at an operating level very early with our portfolio companies. We get to know management; we have those conversations. We're not a passive lender trying to give capital to a company and expecting to get that back in five or six years. It's very important on the front end to invest in those relationships. So that down the road, when there is a bump in the economy or something specific to a company, we can actually go in with a relationship and play a more active role. We're able to play the most active role as an owner. But even before that, we can send in a SWAT team of operating executives, or a procurement team, or a cross-selling team, or a cybersecurity team to help them navigate through a tricky period. To give you an example during COVID, we had a company that lost 80% of their revenue over a short period. We sent in a SWAT team of our procurement team and operating executives to figure out how to help them through that period. We helped them lower their expenses through our procurement group and cross-sell their products across the entire Blackstone network. I think if you put all our buying power together, all our companies, we are something like the third largest company in America. We helped that company grow its revenue and navigate through a very, very challenging period. I could spend an hour talking about this, Ryan, but for the benefit of time, I won’t. But it is a real competitive advantage for us. What we do after we make an investment is very unique; and why I highlighted it during our prepared remarks is because in an environment like the one we're headed into, this will become a defining differentiator for our platform.

Ryan Lynch, Analyst

That's a really helpful color and detail on that. I do agree with you completely. That is a big competitive advantage. That's all from me. I appreciate the time today.

Operator, Operator

Our next question is coming from Kenneth Lee at RBC Capital Markets. Please go ahead.

Kenneth Lee, Analyst

Hi, good morning, and thanks for taking my question. Pretty good amount of debt paydowns in the quarter? I think it depends, you had alluded to potential pickup there. But just wondering, looking forward given the potentially slowing M&A activity. What sort of like your best sense of the outlook for debt paydowns over the next few quarters? Thanks.

Brad Marshall, CEO

Yes, so thanks, Ken, I appreciate the question. We're tracking about six different situations where companies are looking to potentially repay our debt, that will get to about $800 million of repayments if all of them happen. So over what time period that happens depends on their own processes. But that's what we're looking at, and we'll use those paydowns to both reduce leverage and make new investments in this environment.

Kenneth Lee, Analyst

Got you. Very helpful there. And then looking on the other side, what's your sense of the deal flow you're seeing? Obviously, some slowdown in M&A activity but then again, certainly seeing some pullback from banks and other competitors, but just want to get a better sense of the top of the funnel what you're seeing in terms of deal flow. Thanks.

Brad Marshall, CEO

Yes. The M&A environment has definitely slowed in part because we're in a period of more volatility, and part because the financing markets are a little bit broken right now in the public markets. So you've seen less activity. I will say though that 100% of the deal flow for new deals is going into the private markets. The fact that the public markets are broken has steered more deals into the private markets which helps to offset a slower M&A environment. From an investment, new deal standpoint, this is probably the best environment that we've seen in the 17 years that we've been doing this at Blackstone Credit. You've got very good base rates driving returns, wider spreads, better documentation, and attractive leverage setups. We expect that as we head into next year, a lot of sell-side processes that have been put on hold will start coming back into the market and we'll see a pickup in activity.

Kenneth Lee, Analyst

Great. Very helpful there. Thanks again.

Operator, Operator

Our final question comes from the line of Melissa Wedel from JPMorgan. Please go ahead.

Melissa Wedel, Analyst

Good morning. Most of my questions have been asked already. But given that you have completed the share repurchase authorization, I wanted to see, just get your comments on how you're thinking about having something in place as a tool to use opportunistically at the very least or on a regular basis going forward. Any contemplation about re-upping that?

Brad Marshall, CEO

Yes. We're definitely going to have a program in place. Appreciate the question. As you know, we're trying to balance leverage and buyback opportunity, and all that kind of goes into the calculus. But yes, we will definitely have another program in place after we meet with the board and finalize the specifics.

Melissa Wedel, Analyst

Okay. Certainly understand there's a lot of details to hash out there. But maybe we can just talk conceptually about share repurchases going forward. I think, as Casey mentioned, you guys made a commitment to that, that full authorization sort of upfront at the beginning of the process, and you've completed it. Would you view repurchases going forward with the same degree of commitment to completion or just as something to have as one tool in the toolkit?

Brad Marshall, CEO

I think it's another tool in our toolkit. Leverage right now for us is a little bit higher than where we'd like it, Melissa, at 1.33x; had we not done the buyback, it would have been 1.22x, I believe. So we want to manage risk along with buybacks and how we use our capital. But we definitely believe in the stock. I think that I've been buying, and many other employees at Blackstone have been buying. It is something that we will want to support going into the future. But we do have to balance our balance sheet and ensure that we have the right amount of capital to do both new deals and manage our leverage.

Michael Needham, Head of Investor Relations

Thank you everyone for joining our call. The Investor Relations team is available for any additional follow-up questions.

Operator, Operator

Thank you everyone. That concludes your conference call for today. Thank you for joining. You may now disconnect. Enjoy the rest of your day.