BDC Update: Bain Capital Specialty Finance

August 18, 2023

Ch-Changes

The BDC Reporter and the BDC Credit Reporter have both undertaken an in-depth analysis of Bain Capital Specialty Finance (BCSF). With the information gathered therefrom, and with some basic assumptions about the future direction of interest rates and of the BDC's net book value per share, we've rejigged our long-term forecast for both BCSF's payouts and ultimate value.

Unsure

We'll admit, though, that we have more than normal doubts about the results due to several uncertainties, including the current running rate of earnings, overstated due to a temporarily understated incentive fee. Then there is a question mark about how successful a new ABL venture the BDC has just launched will be. Next is the lack of clarity about how management will wield its currently ever-growing undistributed taxable income in years ahead when rates - and investment income - drop. There is also the very important - but unknowable issue - of how fast and how much the Fed will reduce rates through 2027.

One More Wrinkle

We've also taken to projecting what we expect will happen to every BDC's net asset value per share in the years ahead. The BDC Reporter has a very important BDC NAV Change Table showing changes in this metric for every quarter from IVQ 20127 to the current period. The data therein serves as a starting point and with what we learn from the BDC Credit Reporter about the short-term and long-term credit characteristics of BCSF's portfolio, we estimate what NAVPS is most likely to look like in 5 years.

Book Value Debate

In the Expected Return Table in column H, you'll see we're expecting a (10%) decline in NAVPS by 2027 - an average enough state of affairs for a BDC. Historically over the last 5 years, BCSF dropped by (14%), but much of that had to do with issuing stock below book - an unusual event we don't expect will be repeated. As of the IIQ 2023, NAVPS is actually higher than our starting point at the end of December 2022. In fact, we don't anticipate any material NAVPS erosion in the short term. Down the road, though, we're a little less sanguine and BCSF has little in the way of offsetting items that might boost its net book value.

Unchanged

We struggled with ourselves - given the above - whether we should cut the Terminal Multiple that we use to value a BDC from 12.5x - which is appropriate for a stable NAV BDC - to 11x, which is more appropriate for a BDC with eroding net book value over time. We decided to stick with 12.5x given the popularity of BCSF in the market - a complete judgment call.

Bottom Line

We've reduced our projection for the 2023 payout - after three-quarters of dividend announcements, including a recent raise to $0.42 a period - to $1.6000 per share. We expect BCSF will reach a "peak payout" in 2024 at $1.6800 and repeat that in 2025, helped by tapping surplus income if need be. Eventually, a 2% decrease in rates from about 5.5% today to 3.5% in 2027 will reduce earnings power even if the new ABL business is as successful as management hopes and despite booking wider spread loans in the 2022-2024 period. By 2027, the dividend drops to $1.6000. That's still a hefty increase over the $1.3600 achieved in 2021 - before rates began to pop - but below the $1.6400 achieved in 2019 prior to the Rights Offering.

Valuation

December 3, 2022

Foreshadowing

With no guidance from the BDC and the ultimate destination of interest rates unknowable, there's a chance that our projections are too low.

That's what we wrote on August 23, 2022 about Bain Capital Specialty Finance (BCSF) following the IIQ 2022 results. We also predicted management might increase its quarterly distribution to $0.36 after 10 quarters stuck at a payout of $0.34.

As Expected

Following the IIIQ 2022 results, we have a clearer picture. The IVQ 2022 distribution WAS increased to $0.36 as we anticipated. For all of 2022, the payout increased to $1.3800, up 1.5% over 2021, but still (16%) behind the 2019 level.

Less Expected

Earnings jumped in the IIIQ 2022 - boosted by special items of $0.12 per share - to a Net Investment Income Per Share of $0.5300. The analyst consensus for EPS in 2023 is now $1.70, from $1.49 when we last wrote, boosted by the prospect of higher rates and a portfolio close to maximum leverage.

Small Changes Made

All this has caused us to change our dividend outlook for 2023 and 2024. Instead of $1.4400, we've upped the annual payout to $1.5200 in both years. However, recognizing that rates may not stay at peak levels forever, we are sticking with our $1.4400 a year dividend for 2025-2026, and now 2027. Management has historically been Scrooge-like where distributing earnings are concerned and we expect that to continue, with much of the profits being retained to smooth out distribution levels over the longer term.

Unchanged

As a result, the Target Price remains $18.00, as we're not changing our assumption about a 12.5x terminal multiple either.

Slumped

As this Yahoo chart shows, BCSF has dropped in price since our last update by about (10%) - or twice the level of the BDC sector in that period. That accounts for most of the total return increase, along with the higher 2023-2024 payouts. BCSF is trading roughly halfway between its 52 week high and low.

Modest

On a price to 2023 earnings basis BCSF is trading at a lackluster 7.8x multiple and at a discount of (22%) to net book value. Yet the total return promised - albeit decent - remains well behind many of its peers. Maybe all this reflects the general BDC sector miasma. Three quarters of the universe we track is trading below net book value per share and most everybody is priced - like BCSF - halfway between the best and worst price of the year. The much increased estimate for 2022 and 2023 earnings in recent months - not to mention the 6% increase in he distribution - has not juiced BCSF's price.

What Happens Next

For our part from an investing standpoint, we're doing nothing where BCSF is concerned. The price is not yet right and we don't hold the BDC in our model portfolio.

August 23, 2022

Distanced

Frankly, we've steered away from investing in Bain Capital Specialty Finance (BCSF) for the last couple of years, despite the BDC's famous external manager (Bain Capital). We were taken aback by how management over-leveraged the BDC in the months leading up to the pandemic. When Covid struck, in the IQ 2020 BCSF's debt to equity reached 1.86x, and then had to undertake a dilutive Rights Offering in the spring of 2020 to right the ship.

Cut

The BDC's distribution level in 2019 was $1.64, or $0.41 per quarter. Because of the Rights Offering and the Fed-induced lower interest rates, BCSF's regular distribution dropped (17%) at an admittedly difficult time, but many others BDC peers managed to avoid both dilution and dividend cuts.

We Have Company

We're not alone in having pulled back from the BDC. As this chart below shows, BCSF's stock price has never returned to its level in February 2020, just before these setbacks:

Keeping An Open Mind

Of late, though, we're ready to forgive and forget. We've recently completed an overview of the BDC's IIIQ 2022 results, including a review and annotation of the most recent conference call transcript, as well as updated the latest analyst projections for earnings in 2022 and 2023. We get the impression management - despite never admitting any fault - have learned useful lessons from the 2020 reversal. This includes placing more weight on two off balance sheet joint ventures - one in which to place international loan assets and the other U.S. loans. Like with many BDCs, this provides BCSF with a safety valve to reduce assets on its balance sheet almost at will, which can be sold to the joint ventures. Moreover, the JVs are generating - thanks to their own use of leverage - superior returns that are a source of higher EPS going forward.

Less Is More

On balance sheet leverage levels have been reduced, with a debt-to-equity ratio now of 1.14x and a net leverage ratio, which represents principal debt outstanding less cash, at 1.07x. That's in the middle of the pack leverage-wise by BDC standards, and given a portfolio heavily weighted towards first lien debt, in which Bain is the lead lender 80% of the time, a relatively reasonable approach. What's also different/better than before is that more than half of the BDC's own debt is fixed rate and not maturing for years to come and liquidity is ample. Heck, BCSF even has an investment grade rating from Moody's.

Rosier

Just as BCSF has become a "safe pair of hands" - to use an expression that originated in cricket - its earnings and distribution prospects have improved. As is the case elsewhere in the BDC eco-sphere, the higher reference rates both announced and promised by the Fed are the moving force. In the IIQ 2022, the BDC's portfolio yield was already headed higher, but most of the benefit to the bottom line lies ahead as borrowers re-set their loans at the new, higher levels. In combination with those fixed rate financings not increasing in cost, this means EPS is headed higher. There should also be an ever bigger return from the joint ventures, both due to asset growth and from higher rates.

Eye To Eye

Even the analyst community - which has been slow to adjust its projections - is getting on board. Checking today, we noted that the consensus for 2023 is for EPS of $1.49. This would represent a 10% increase over the actual EPS - measured as Net Investment Income Per Share - in 2021.

No Help There

BCSF itself has also been slow in adjusting its dividend. Management likes to set a regular quarterly payout and not fuss with "specials" if they can. Through the IIIQ 2022, the distribution remains unchanged at $0.34 - unchanged in 10 quarters - the longest streak in the BDC's relatively short history.

Sticking The Proverbial Neck Out

However, we expect a change is coming, even if management was coy on its most recent conference call about the matter. Our guess is that BCSF will increase the quarterly distribution to $0.36 from $0.34 in the IVQ 2022 or the IQ 2023. (In our 5 year dividend projection, we've chosen the former timetable, which makes little difference to the total return). Thanks to those higher earnings to come from the JVs; some potential asset growth going forward and the likelihood that the Fed will not be bringing rates back to their pre-2022 levels, we're projecting BCSF should be able to continue paying out $0.36 every quarter through 2026.

Elephant In Room

We've taken into account potential credit losses that might occur, which we expect to remain mild as measured by realized write-offs. Admittedly, the JVs might fluctuate in value as the markets move down, but BCSF has a lot of latitude to manage these entities through difficult time, including adding more capital if need be. Also we are taking comfort from the high diversification of the different loans BCSF holds both on balance sheet and off - with nearly 200 counter parties involved. Unlike some of its peers, BCSF does not seem to be making any big bets on any one borrower, sector or even geographical region.

Some Numbers

As of the IIQ 2022, BCSF's existing portfolio is valued at 99% of cost and total realized losses to date - see the 10-Q - amount to (5%) of all equity capital raised. Underperforming assets are on the low-ish side at 8% of the portfolio. See the BDC Credit Table. For what it's worth, BCSF strung together 7 quarters of higher NAV Per Share till this latest quarter, which only slipped up by (0.4%). See the BDC NAV Change Table.

Changes To Valuation

None of this is a guarantee that things won't go awry in the future, but we're relatively confident about BCSF. However, we've not changed the terminal multiple we use for valuation (12.5x the 2026 distribution), but the Target Price - thanks to that higher payout - has risen to $18.0. That implies a price increase of 23%. That may seem high, but at $18.0, BCSF would still be trading below its level before the pandemic and (10%) below its all time high.

Another Wrinkle

With no guidance from the BDC and the ultimate destination of interest rates unknowable, there's a chance that our projections are too low. We're not going to get into multiple pro-forma scenarios but just remember that when BCSF was paying out $1.64 a year in distributions, its stock price popped over $20 a share a few times.