Hiroshi Watanabe
Earlier this year in July, I issued a bullish thesis on Bain Capital Specialty Finance (New York Stock Exchange: BCSF) indicating a clear buy given the strong state of the underlying fundamentals and the presence of a ~10% discount to NAV. In other words, I saw no meaningful justification for why BCSF should trade at such a discount.
The only reason that could theoretically push the multiple down here was exposures beyond the top-tier assets, which together accounted for about 33% of the total asset base. However, if we look further into the exposures coming from joint venture vehicles, we arrive at a top-tier portion that accounts for about 84% of Bain’s assets. While this is not the highest level one could find in the BDC space, it is certainly not below the sector average in any way, shape or form. remarkable aspect, which should bring the P/NAV down to 0.93x (according to current statistics).
Since my previous article was published, BCSF has clearly outperformed the BDC index.
Y diagrams
The main reason behind alpha is purely related to the strong Q2 2024 Earnings Report, after which the share price assumed a strong and favorable momentum.
Now let’s look at the Q2 2024 earnings statement and see what the key data points were that are worth considering in the context of my current investment case.
Thesis review
As noted above, Q2 2024 performance yielded positive results, especially in relation to BCSF's P/NAV metric, which continues to indicate a significant discount.
Total investment income for the quarter amounted to $72.3 million, which is a slight decline compared to $74.5 million in the previous quarter. Due to this decrease in the gross income figure, net investment income per share contracted accordingly, reaching $0.51 per share (i.e. $0.02 per share below the Q1 2024 metric). However, here I would like to underline the key reason behind this dynamic, which was that Bain Capital recorded lower income from other income categories that, by definition, are more volatile and not as critical in the context of the core underlying performance.
As a result of the NII generation levels achieved in the second quarter, base dividend coverage remained strong at 121%, which ranks among one of the most conservative coverage levels in the BDC space. Given the ~21% surplus, Management decided to add supplemental dividends to the equations, thereby increasing the total dividend paid for the quarter to $0.45 per share. On an annualized basis, this translates to a yield of ~10.5%, which could be considered attractive considering the conservative coverage level.
An additional layer that makes BCSF's business relatively safe is its leverage profile, which as of Q2 2024 stood at 1.03x (i.e. well below the industry average (1.16x). It is also below the BDC’s target range of 1.1x to 1.25x, implying that there is notable headroom to accommodate portfolio growth. Moreover, during the second quarter of 2024, Management improved the debt structure by increasing the commitment under its secured revolving credit facility by almost 30%, while extending the maturity to mid-2029. What is surprising here (in a positive way) is that even with the extended maturity and strengthened liquidity, the weighted average interest rate on outstanding debt fell 10 basis points to 5.1%.
One final point worth highlighting in terms of Q2 improvements relates to the credit quality of BCSF’s portfolio. Importantly, defaults declined to 1.0% (measured on a fair value basis), which is significantly below the industry average and indicative of a healthy portfolio (which has not been the case for many BDCs in the Q2 period). Additionally, looking at Q2 2024 data points, we see that 97% of the portfolio’s investments continue to perform in line with the projections that were incorporated into the underwriting process.
That said, there is an element of potential concern that emerges from the Q2 2024 data. Namely, net investment activity for the second quarter was negative $167 million, which will make it difficult for BCSF to grow and/or protect current levels of net investment income generation. This is also the largest decline in the past five quarters.
However, I would like to highlight several mitigating factors here.
First, gross origination amount during the second quarter was $307 million, which implies a 55% increase year-over-year. Momentum on the gross origination front appears to have strengthened, which sends an encouraging signal for overall transaction activity going forward.
Secondly, 86% of new investments were in the form of senior secured loans and the remaining 9% were made through joint ventures, which have a noticeable bias towards senior secured loans. In other words, the portfolio is increasingly focusing on senior secured loans, which should neutralize the key argument for applying the discount to net asset value.
Third, in making these investments, BCSF has maintained strict underwriting standards without sacrificing performance (weighted average return on investments is 11.6%). Median leverage levels have been set at 4.6x, which, in combination with the presence of documentation containing financial clauses linked to management forecasts (relevant for 95% of investments), allows for further de-risking of the portfolio.
Key risks
Given all the prevailing headwinds in the BDC space, such as spread compression, shallow M&A activity and rising defaults, the transaction market component is something to keep an eye on.
As explained above, this quarter BCSF posted a rather negative figure on the net investment funding front, meaning that the asset base during the third quarter will likely be lower than in the second. This, in turn, will cause net investment income to contract a bit or, in a positive scenario, remain unchanged. Since the portfolio quality is rock-solid and dividend coverage indicates a high margin of safety, the risks of a dividend cut are very limited. However, in case M&A statistics continue to show negative results for several consecutive quarters, the margin of safety would obviously disappear quickly.
However, once again, looking at the overall dynamics of interest rates, the odds seem to be in favor of dividend cuts in the near term. This should encourage buyers and sellers to transact as leveraged buyout activity gradually returns to more normalized levels.
The final result
Overall, the Q2 2024 results confirm that investing remains attractive for investors seeking defensive income streams. Base dividend coverage remains strong and portfolio quality embodies the right dynamics that are necessary to further de-risk the business profile. The only concern could be related to the depressed net investment activity. However, if we put things into perspective of the overall BDC sector statistics, where most BDCs have suffered from sluggish M&A markets, this should not serve as a reason to avoid BCSF. Instead, new investment financings allow Bain Capital Specialty Finance to slowly but surely improve portfolio quality without sacrificing return potential.
As a result, I remain bullish on this BDC and continue to believe that the ~7% discount to net asset value is unjustified.