Bain Capital Specialty Finance, Inc. (BCSF) Q3 2020 Earnings Report, Transcript and Summary

Good morning, and welcome to the Bain Capital Specialty Finance Third Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Katherine Schneider. Please go ahead.

Thanks, Irene. Good morning, everyone, and welcome to the Bain Capital Specialty Finance conference call for the third quarter of 2020. Yesterday after market close, the company 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 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 President and Chief Executive Officer, Michael Ewald.

Thanks, Katherine, and good morning to everyone and thank you for joining us on our earnings call this morning. And I'm joined today by Mike Boyle, our Vice President and Treasurer; and our Chief Financial Officer, Sally Dornaus. I'll start with an overview of our third quarter results and provide some thoughts on our portfolio performance, the company's positioning, and the overall market. Thereafter, Mike and Sally will discuss our investment portfolio, credit quality, and financial results in greater detail. We are pleased to have delivered strong financial results to our shareholders in the third quarter. Net investment income was $0.33 per share, driven by solid net investment income earned by our investment portfolio. Earnings per share were $0.80, driven by net appreciation in our investment portfolio due to the reversal of a portion of the unrealized losses recognized in the first quarter. Net asset value per share as of September 30 was $16.27, reflecting a 2.9% increase from our NAV as of June 30. During the third quarter, the portfolio benefited from the spread tightening that we witnessed across credit markets. We are pleased to see a meaningful recapture of the NAV decline that the portfolio experienced in Q1 as a result of COVID-19. Given the high-quality nature of our portfolio, we believe there is still significant embedded upside potential in our portfolio to recapture a greater portion of the remaining unrealized losses as spreads and company performance remains stable and our loans are repaid at par. As of September 30, our total investment portfolio had a weighted average fair value mark as a percentage of par of 95.7% as compared to the weighted average fair market value of 98.5% at year-end. In addition, we continued to demonstrate meaningful progress in deleveraging our balance sheet while delivering stable net investment income to our shareholders. As of September 30, our net leverage ratio was 1.33x, down from 1.42x as of the end of Q2 and significantly down from the end of Q1 where it was 1.78x. The decline in our leverage ratio this quarter was attributed to par principal repayments and sales activity, together with the increase in our net assets during the quarter. As a result of this deleveraging, we have significantly improved the strength of the company's balance sheet. First, we have greater asset cushion to withstand any potential volatile periods ahead. And second, we have better positioned the company to take advantage of new yield accretive investment opportunities to grow earnings. Based on the current portfolio, our target leverage range remains 1.0x to 1.5x, and we're now just about in the middle of that range. We are comfortable operating there given the high foreseen exposure within our portfolio while also maintaining significant asset coverage should market conditions change. During the third quarter, credit quality and importantly credit clarity continued to improve as exhibited by the following trends in the portfolio. We've observed improving revenue, cash flow, and liquidity trends at our borrowers as a result of more normalized economic activity and cost-cutting measurements actioned earlier this year. The average loan-to-value of our investments is approximately 46% and we believe these valuations continue to hold true in the current environment. For example, within our portfolio, we have observed sponsors being able to attract new minority equity investments at valuation similar to levels that existed pre-COVID-19. We believe our active portfolio management and ability to come to amenable solutions within our portfolio companies and sponsors is a reflection of the significant resources of our adviser. These improvements are reflected in our overall risk rating trends and nonaccrual rates. As of September 30, 13% of the total investment portfolio at fair value was in a higher risk rating bucket of either a 3% or 4%, down from 16% as of the end of Q2. Nonaccruals declined quarter-over-quarter to just 0.2% of the total portfolio at both cost and fair value as a result of no new investments being added to nonaccrual status and the successful resolution of one of our prior nonaccruals. Following a period of low new deal activity in Q2, middle market transaction volumes rebounded in Q3 on the backs of sponsor and lender receptivity to new investments and a rebound in economic activity. In the near term, however, we remain cautious given the continued risks in the economy such as lingering systemic unemployment, especially in the service industries, and slow and uneven corporate recovery. In such an environment, we have been focused on capitalizing our incumbency advantage with existing borrowers as sponsors seek to take advantage of tuck-in acquisition strategies. This allows us to benefit from underwriting an existing portfolio company with a demonstrated history of performance and clean EBITDA, while further benefiting from improved documentation, lower leverage, and increased economics in order to compensate us for higher risk premiums today. During the third quarter, all of our new investment funding activity was to existing borrowers. We are also beginning to see opportunities for new platform transactions in the fourth quarter and beyond, and will continue favoring companies in defensive industries that are less tied to consumer consumption. We believe the company is well positioned to take advantage of such opportunities to expand the core earnings of the company. Subsequent to quarter end, our board declared a fourth quarter dividend equal to $0.34 per share and payable to record date holders as of December 31, 2020. This represents an annualized 8.4% yield on ending book value as of September 30. Based on the current attributes of the investment portfolio, we believe this dividend level is sustainable in this current market environment. As Sally will discuss further, it is important to note that our net investment income is largely comprised of high-quality contractual cash interest income. PIK income or payment-in-kind income represents less than 5% of our total interest income. As deal flow normalizes and M&A activity begins to pick back up to more normalized levels, sales and repayment activity levels should increase as well providing the company with incremental income through prepayment related fees, including the acceleration of original issue discount or OID, providing further support to our current dividend strategy. I will now turn the call over to Mike Boyle, our Vice President and Treasurer, to walk through our investment portfolio in greater detail.

Thanks, Mike. Good morning, everyone. I'll kick it off with our investment activity this quarter and then provide an update on the credit quality of our portfolio. New investment fundings were $29 million into 16 companies. All of our new fundings in the quarter were to existing portfolio companies. Sales and repayment activity totaled $90 million, driven by pay-downs across our portfolio. During the quarter, we continued to see net repayments of revolvers and delayed draw facilities. Our revolving utilization across these credit facilities is closer to normalized levels at approximately 28% as of September 30. We believe this is a reflection of the health and strong liquidity profiles of our companies given the sequential improvement demonstrated over the past 2 quarters. At the end of the third quarter, the company had significant liquidity, consisting of cash and undrawn capacity on our secured facilities of approximately $363 million against our $153 million of undrawn investment commitments, representing coverage of 2.4x. We believe our portfolio is well positioned in the current environment. At the end of the third quarter, the size of our investment portfolio at fair value was $2.5 billion across a highly diversified set of 107 portfolio companies operating across defensive industry. Our average investment size is less than 1% of the total portfolio at fair value, resulting in significant diversification. The weighted average portfolio yield at amortized costs was 6.9%, up from 6.6% as of Q2 due to the increased spread following recent amendments. Our investments consist largely of first lien loans to sponsor backed middle market businesses with a median EBITDA of $44 million. As of September 30, 87% of the investment portfolio at fair value was invested in first lien debt, including 1% in first lien last out debt. The remaining portfolio was comprised of 6% second lien debt, less than 1% subordinated debt, and 6% in equity interest. We continue to favor middle market companies within the core of the middle market. These companies have diversified revenue streams and top line resiliency. Furthermore, we're able to benefit from strong documentation within our loan structures, which places us in a strong position to manage downside risk. This is evidenced in our portfolio as we have over 90% of our debt investments with both financial maintenance covenants and effective control rights. The industries that our portfolio companies operate within are largely comprised of defensive sectors that are less tied to consumer consumption. Our top line industries -- our top industries include technology, aerospace and defense and healthcare. We continue to believe that we have limited exposure to industries experiencing the most severe impacts of the pandemic. Within our internal risk rating scale, 87% of our portfolio at fair value was comprised of ratings 1 and 2, indicating that the underlying portfolio companies are performing in line or better than expectations. The weighted average fair value mark on these investments was 97% of par as of quarter end compared to an average mark of 99.5% of par at year-end 2019. The remaining 13% of the portfolio was classified as a risk rating 3 or 4. These investments have experienced some impact from the pandemic. Within our risk rating three investments, our portfolio companies have well understood value proposition and we have an informed view of their path to recovery over time. 90% of our debt investments classified as a risk rating 3 or 4, are first lien senior secured debt. This places us at the top of the capital structure and minimizes our downside risk. As of September 30, our risk rating 3 and 4 investments had a weighted average fair value mark of 84% of par. And it is our expectation that we'll recognize a par repayment on the majority of these investments over time. As Mike mentioned earlier during the call, no new investments were added to nonaccrual status during Q3, reflecting overall stable credit quality. As of September 30, one of our total 107 investments was on nonaccrual status, representing 0.2% of the investment portfolio, both cost and fair value. Sally will now provide a more detailed financial review.

Thank you, Mike, and good morning, everyone. I'll start the review of our third quarter 2020 results with our income statement. Total investment income was $46.8 million for the 3 months ended September 30, 2020, as compared to $47.9 million for the 3 months ended June 30, 2020. The decrease in investment income was primarily driven by a reduction in the size of the investment portfolio due to sales and repayment activity. Our investment income is comprised primarily of high-quality income, as the majority of our interest income consists of contractual cash-paying income. We take a conservative accounting approach to recognizing commitment fees or structuring fees on new investments by amortizing this over the life of the loan as opposed to taking fees upfront. PIK income or payment-in-kind represented less than 5% of our total interest income for the 3 months ended September 30. We believe the quality of our income is best-in-class, given these attributes. Total expenses for the quarter were $25.4 million in the third quarter as compared to $27.9 million in the second quarter. The decrease was driven by lower interest and debt financing expenses as our average borrowing levels and LIBOR declined. Net investment income for the quarter was $21.5 million or $0.33 per share as compared to $20 million or $0.37 per share for the prior quarter. This quarter, the weighted average fair value mark on our investment portfolio increased quarter-over-quarter to approximately 96% as of September 30, 2020. This was largely attributed to broad-based spread tightening across our investment portfolio and partially offset by decreased financial performance due to COVID-19 for certain portfolio companies. As we have discussed on prior earnings calls, we employ a robust valuation framework, in which nearly all of our illiquid investments are being reviewed by an independent third-party provider each quarter. We believe these additional layers of review provide for best-in-class valuation processes, especially during periods of increased market volatility. During the 3 months ended September 30, 2020, the company had net realized and unrealized gain of $30 million. GAAP income per share for the 3 months ended September 30, 2020, was $0.80 per share. Now on to our balance sheet. As of September 30, our investment portfolio at fair value totaled $2.5 billion and total assets of $2.6 billion. Total net assets were $1.05 billion as of September 30. NAV per share was $16.27 as compared to $15.81 at the end of the second quarter, representing a 2.9% increase quarter-over-quarter. At the end of Q3, our debt-to-equity ratio was 1.45x compared to 1.52x at the end of Q2. Our net leverage ratio, which represents principal debt outstanding less cash was 1.33x at the end of Q3 as compared to 1.42x at the end of Q2. We believe these are significant improvements to enhancing the strength of our balance sheet quarter-over-quarter. In August, we favorably amended our BCSF revolving credit facility to reduce the spread payable to 300 bps, down from 325. We also reduced the size of the facility to improve our overall borrowing cost given the large unused portion outstanding and while still retaining a meaningful amount of available liquidity. Over half of our total principal debt outstanding was comprised of CLO securitization structures and unsecured debt as of September 30. These structures position the company with a stronger balance sheet, as these facilities provide for greater durability in periods of volatility. Over time, we would like to see unsecured debt become a larger portion of our capital structure, given the benefits that these structures provide. For the 3 months ended September 30, 2020, the weighted average interest rate on our debt outstanding was 3.3% as compared to 3.7% for the 3 months ended June 30. The decline was attributed to LIBOR resets that occurred during the quarter. As of September 30, 2020, the company had cash and cash equivalents of $45 million and $318 million of aggregate capacity under its credit facility. As of September 30, 2020, 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 are pleased to have delivered strong earnings to our shareholders this quarter, notwithstanding the still challenging market backdrop. Our team continues to work hard in monitoring our existing investment to protect shareholder value while also focusing on identifying attractive new investment opportunities in the current environment. We believe the company is well positioned to take advantage of these new opportunities, given the improved strength of its balance sheet. We appreciate the support from our shareholders and entrusting us to manage your capital to produce attractive risk-adjusted returns. With that, I'd like the operator to please open the line for questions.

[Operator Instructions] Our first question is from Finian O'Shea of Wells Fargo Securities.

Michael, can you talk about top line yields in this environment. Do you -- are you willing and able to engage in higher-yielding strategies? Or is the market backed out? Any kind of opportunity you identify there for the BDC and what style would drive that? Any context on growing the top line yields today?

Sure, thanks for the question. Go ahead, Mike.

So we have seen a number of opportunities to increase yields in -- on the top line and some of which has already been seen by the 30 basis point increase in our yield of our portfolio quarter-over-quarter. We do think there is -- there has been some spread widening in the market that we can still continue to capture going forward in both first lien and unitranche securities. So we will primarily focus on that strategy, which we think we can increase yield still. Secondly, in subordinated debt is always a small portion of what we do, but we do believe that there will be opportunities to increase yield from second lien debt going forward as well.

And what sort of -- as the pipeline reemerges, newer origination you're looking at now, I assume is mostly first lien. What kind of spread ballpark are you looking at? Or spread -- and all-in yield as well.

Sure. So I'd say spreads have widened between kind of 50 basis points, between 50 and 75 basis points all in from before the pandemic. And so we do think there is continued opportunity to ramp in the 8% total return context in first lien and unitranche debt sales.

That's helpful. And then just a follow on the comments on -- from Sally, more unsecured debt being a goal for the BDC. Would that -- does that indicate that you would like replace or reduce the CLO component? Or would it kind of be like 3 even legs to the stool?

Yes. So we go through that analysis a lot to just figure out, but we think the most efficient way is to use those facilities. And so I think the plan would be to have some balanced approach between all of our facilities, but certainly to increase the unsecured portion.

Our next question is from Ryan Lynch of KBW.

First one, the market activity over the spring and summer months has been obviously extremely slow given the downturn, which worked out okay for you guys as you were looking to deleverage your balance sheet. At this point, you guys have done a good job of getting your leverage kind of right in the middle of your targeted leverage range and now market activity is starting to pick back up. At this point, given the place that your balance sheet is in, do you guys -- are you guys looking to grow and deploy capital to new investments and potentially grow leverage? Or is the thought just to kind of keep leverage here or even continue to push it lower as you guys have in the past?

Yes. Thanks, Ryan. It's a good question. Look, as I mentioned in the remarks, our range is still 1x to 1.5x. As you point out, we're at 1.33x in now. So we're kind of in the middle there from a net perspective. There certainly isn't any borrowing of doing new deals. I think if we found the right deal, we'd be happy to do it. Clearly, activities picked up. We are certainly seeing a lot of deals. We're also actively bidding on deals. So it's not a matter of not seeing them or proverbially not being open for business because we very much are. I'd say there're certainly some deals that have gone away from us. There's -- I think a lot of people have been pent-up for a while. And so there's a fair amount of aggressive action around some of the better quality companies out there, and we just haven't been willing to meet some of those requests out in the marketplace. As I mentioned, I think we're still a little bit concerned about the state of the economy, what's going on with the virus coming into the winter here, et cetera. And so we have been fairly cautious. If we find the right deal, I think we'd be happy to lead that or to participate in that. The other point I would make too, is the flip side of that coin is we haven't seen as much repayment activity because there hasn't been that much general market activity, right? So we would expect that to pick up here in the fourth quarter and going into next year as well. So if you think about it, that further would reduce our leverage, giving us further room within our range, if you will, to make new investments as well. So it's a bit of a moving target, I'd say, from that perspective, if that makes sense.

Yes. Certainly. That's helpful. Can you just talk about BlackBrush Energy that was an investment previously on nonaccrual. Can you just talk about what was the outcome for that? Was that restructure? Was that -- did that just come back on accrual status? Just what happened with that investment?

Sure. So we did restructure that investment over the quarter, where we originally were a first lien lender to that business. We reinstated incremental debt on the business, so less leverage. So there is a new first lien that we own. And we also now own the equity of the business. We do think that, that positioning will drive us to a place where we'll recover our original investment as well as some incremental return from there. So with the help of our restructuring and distress team at Bain Capital, we focused on that amendment over the quarter, and we're pleased to move it off nonaccrual over the course of the third quarter.

And then just one last one on the dividend. I think you said you guys feel that you're comfortable with the current level of the dividend. You gave some commentary on as market activity picks up, you guys expect to have greater repayments, which increases OID income which will be helpful. Also higher spreads are currently in the marketplace, which helps yields as well in your portfolio. Obviously, we're also in the midst of the pandemic, and there's some investments on your portfolio that have some pretty sizeable markdowns, which, for us, are higher risk of credit issues in the future or potential nonaccrual. So when you've made that comment about being comfortable with the current level of the dividend, are you guys factoring in some uptick or some increased level of nonaccruals or credit issues in the future?

Yes. Look, I wouldn't say there's necessarily an uptick there. I mean we're looking holistically across the portfolio. And I think some companies continue to get healthier as we've seen. I don't think anything necessarily got worse over the quarter. So I think things have stabilized amongst some of the companies that weren't performing as well. And as you remember, we did a number of amendments in our portfolio at the end of the second quarter, which we think position those companies fine for the time being. So there's nothing that overly concerns us about any potential increases going forward. I think the other point to make there too is, as Sally pointed out, I pointed out as well. The vast, vast, vast majority of our income is actually cash income and our PIK income and I think that also speaks to the health of the portfolio, right.

Our next question is from Derek Hewett of Bank of America.

Most of my questions were already addressed. But maybe for Sally, what was driving the 30 basis point improvement in the portfolio yield? And I'm looking at it on a cost basis, was -- did that have to do with that nonaccrual resolution? Or were there other factors involved?

Yes, there're a combination of things. Certainly that, but we had some positive momentum with our portfolio during the quarter as well as -- which we saw some of it in the second quarter where LIBOR floors were beneficial to us. So it was, yes, a combination of things.

And what percentage of the portfolio had LIBOR floors? And what is the average floor?

The average -- Mike, you have that?

Sure. So about 75% of the portfolio has LIBOR floors and those floors are at 1%.

Our next question is from Sam Choe of Crédit Suisse.

I think there was a question already asked about portfolio growth, but just wanted to ask it a little differently. We've had 2 quarters of net investment declines, I mean, which is obviously due to your defensive stance and kind of your prudence during the time of uncertainty. But I guess in the event that you guys have to be conservative longer, and you see those net investment declines through 2021. How would you feel about your portfolio? I know you mentioned that better level of repayments will help your dry powder and lowering the leverage. But what are some of the other factors we need to watch out for?

Yes. Look, I mean, I think in terms of being conservative, I think we're conservative because we're concerned about the economy broadly and the market environment. I think we're actually in a very good place from a balance sheet perspective. So I don't feel like we're being forced to be conservative because we're necessarily concerned about our leverage level, we think it's well within our target levels. So we are definitely looking at that. The other point I would make in terms of some of the repayments that you've seen is some of it has actually been revolver repayments, right? So we saw a huge drawdown of those revolvers at the end of the first quarter. Some has been paid back over the second quarter and over the third quarter as well. So I wouldn't read too much necessarily into some of the repayments from that perspective. Again, what we haven't seen is a full-scale repayment change of control type transactions. That just hasn't flown through the portfolio yet. We expect to see more of that in the fourth quarter for sure, where entire positions will be taken out, which I think, again, frees up further capital to potentially invest in some higher-yielding investments than what we have now today as well. We just, quite frankly, hasn't found anything that compelling from a risk-reward perspective out there to date. But certainly, if we did, we'd be happy to make that investment.

[Operator Instructions]

Great. Well, hearing no further questions, we want to thank everyone again for their time today. I certainly appreciate the questions. Anything else comes up in the meantime, please do feel free to reach out. Otherwise, we look forward to speaking with you again in another 3 months or so. Thanks a lot.

Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.