Barings BDC, Inc. (NYSE:BBDC) Q2 2024 Earnings Call Transcript

Barings BDC, Inc. (NYSE:BBDC) Q2 2024 Earnings Call Transcript August 8, 2024

Operator: At this time, I would like to welcome everyone to the Barings BDC, Inc. Conference Call for the Quarter Ended June 30, 2024. [Operator Instructions] Today’s call is being recorded, and a replay will be available approximately 2 hours after the conclusion of the call on the company’s website at www.baringsbdc.com under the Investor Relations section. At this time, I will turn the call over to Joe Mazzoli, Head of Investor Relations for Barings BDC.

Joe Mazzoli: Good morning, and thank you for joining the call. Please note that this call may contain forward-looking statements that include statements regarding the company’s goals, beliefs, strategies, future operating results and cash flows. Although the company believes these statements are reasonable, actual results could differ materially from those projected in forward-looking statements. These statements are based on various underlying assumptions and are subject to numerous uncertainties and risks, including those disclosed under the sections titled Risk Factors and Forward-Looking Statements in the company’s quarterly report on Form 10-Q for the quarter ended June 30, 2024, as filed with the Securities and Exchange Commission. Barings BDC undertakes no obligation to update or revise any forward-looking statements unless required by law. I will now turn the call over to Eric Lloyd, Chief Executive Officer of Barings BDC.

Eric Lloyd: Thanks, Joe, and good morning, everyone. We appreciate you joining us for today’s call. Please note that throughout today’s call, we’ll be referring to our second quarter 2024 earnings presentation that is posted on the Investor Relations section of our website. On the call today, I’m joined by Barings BDC’s President, Matt Freund; Chief Financial Officer, Elizabeth Murray; and Barings’ Head of Global Private Finance and BBDC Portfolio Manager, Bryan High. In the second quarter, BBDC delivered another strong set of results, fueled by best-in-class credit performance and the strength and stability of our franchise. Our focus on the top of the capital structure investments and sponsor-backed middle-market issuers continues to serve investors well.

I want to take a moment to note that in this market, unlike the larger cap end of direct lending, we are not competing with investment banks for broadly syndicated loan issuance, and we generally see stronger documentation meaning some of the BSL style covenant package you may have heard of in other direct lenders portfolios are not present in ours. Our focus on the core of the middle market is reflective of lower leverage levels and more attractive risk-adjusted returns, which is why we find this to be the best segment of the market for BBDC and our shareholders. That core portfolio is complemented by a selection of nonsponsored and platform investments that we believe benefit our shareholders in the form of higher potential returns and diversification.

Our portfolio strategy is outlined in greater detail on Slide 5. We continue to successfully invest throughout the market and deliver compelling returns to our shareholders. As we reflect on the first half of 2024, the performance of BBDC has been strong against a relatively benign economic backdrop. Interest rates, while elevated, have been stable for several quarters. Credit performance appears to be holding up broadly across the industry, safe for a few idiosyncratic examples. While we have done well in this stable economic and interest rate environment, the market activity of the past week suggests change maybe a foot in the lending ecosystem. These changes may include a decrease in interest rates, which we think will have an overall positive impact on our business as it further improves credit metrics in the existing portfolio and sparks a sentiment shift among sponsors and may spur a further deal activity, which in turn may drive higher spreads and additional transaction fees.

Turning to some specifics of BBDC. Net asset value per share was $11.36, compared to $11.28 for the prior fiscal year end, reflecting an increase of 0.7% and a testament to the portfolio stability. Net investment income for the quarter was $0.40 per share and meaningfully outearned our dividend of $0.26 per share. Perhaps most importantly, in a metric that we are particularly proud of, our nonaccruals as a percent of fair value were unchanged quarter-over-quarter at 0.3%. As our investors know, the stability of our performance is a result of our focus on thorough and conservative underwriting at the top of the capital structure, and within more defensive industries. With a more uncertain landscape ahead of us, we are confident that BBDC strategy and portfolio are well suited to deliver strong results for our valued shareholders across a wide range of economic and market conditions.

Digging a bit deeper into the portfolio, we continue to actively maximize the value in legacy holdings acquired from MVC Capital and Sierra. Our goal remains to divest these assets at attractive valuations as we did this quarter. Barings originated positions are now 90% of the portfolio at fair value, up from 76% of the portfolio at the beginning of 2022. Also, just to remind you all, potential losses from these assets are protected by credit support agreements limiting downside risk for BBDC investors. Our investment portfolio continued to perform well in the second quarter. There is no substitute for fundamental credit analysis, which has always been at the core of our investment philosophy and is reflected in the health of the BBDC portfolio today, including the acquired Sierra and MVC assets, our total nonaccruals are an industry-leading 0.3% on a fair value basis and 1.5% of the portfolio on a cost basis.

This is down from 1.5% on a fair value basis and 2.5% on a cost basis as of December 31, 2023. Turning to the earnings power of the portfolio. The weighted average yields at fair value was 11.1%. We remain conservative on our base dividend policy, and our Board declared a third quarter dividend of $0.26 per share, consistent with the prior quarter. On an annualized basis, the dividend level equates to a 9.2% yield on our net asset value of $11.36. We believe the best measures of the portfolio’s performance, nonaccruals, net asset value and NII were extremely compelling for the June quarter and anticipate continued strength in the quarters ahead. Before I turn the call over to Matt, I want to highlight that while the future operating environment may be uncertain, the long-tenured team we have here in the North American Global Private Finance business, coupled with capabilities of teams across Barings will also contribute to our asset sourcing and underwriting.

We are extremely confident in our ability to continue delivering compelling value to our shareholders. We have designed our portfolio to have resiliency to weather economic stress and to have the liquidity and expertise to play offense in what we believe will be an even more attractive environment for middle-market direct lending in the second half of the year. I’ll now turn the call over to Matt.

Matt Freund: Thanks, Eric. Recall that BBDC is managed by Barings LLC, a credit-focused asset manager with nearly $410 billion of assets under management as of June 30. The bulk of the portfolio is sourced from the global private finance team, an organization with more than 100 investment professionals located around the globe, providing financing solutions to high-quality, market-leading, middle-market companies sponsored by top-tier private equity firms. BBDC deployed $78 million of capital this quarter, offset by $195 million of sales and repayments, resulting in net deployments of $117 million — I’m sorry, net sales and deployments of $117 million. Repayment activity skewed towards noncore acquired positions with assets determined to be noncore to our strategies, experiencing an $80 million reduction in fair market value quarter-on-quarter.

As Eric noted, we are executing the strategy we have been telegraphing for the past 1.5 years, simplifying the portfolio and selectively investing in what we believe are the most compelling middle-market direct lending opportunities in the market. Consistent with what we observed a quarter ago, we continue to see a tale of 2 markets when discussing deployment, largely bifurcated on size. LBO activity in our core markets, defined as sponsor-backed lending to sponsor platforms with $15 million to $75 million of EBITDA remained muted during the second quarter. We have experienced some level of refinancing activity within the portfolio, but at levels significantly lower than our broadly syndicated counterparts. As we approach the long awaited rate cutting cycle, we are optimistic that a change in the interest rate environment will have a catalytic effect on transaction activity.

Our team is constantly in touch with significant number of middle market sponsors and have heard a consistent drumbeat of optimism for a busy second half of the year, which has been echoed by investment bankers as well. We have continued to see an increase in the number of early-stage opportunities within the platform, but conversion rates through June were relatively modest. That said, we continue to support a wide range of borrowers executing add-ons for their existing portfolio companies and on more strategic acquisitions, demonstrating the benefit of our long-standing relationships and incumbency in our core area of focus. Turning to the portfolio, 75% of the portfolio consists of secured investments with approximately 66% of investments constituting first lien securities.

BBDC has experienced a stabilization of interest coverage during 2024 and finished the quarter with a weighted average interest coverage of 2.1x, above industry averages and demonstrating the merits of our approach to focusing on leading companies in defensive sectors and thoroughly underwriting their ability to weather a range of economic conditions. Given the current shape of the forward SOFR curve, we believe the portfolio now reflects the full negative impact of an elevation of rates and credit and cash flow metrics are likely to benefit from any decline in base rates going forward. Furthermore, as rates decline, our hurdle rate structure will continue demonstrating shareholder alignment with our manager. The median gross margin in the North American Global Private Finance portfolio, a portfolio similar to BBDC stood at 50%, up from 47%, 1 year earlier, demonstrating that companies we invest in have strong market positions, enabling them to successfully increase prices to combat inflationary pressure.

Furthermore, adjusted EBITDA margins for the same sample set were 22%, up from 21% in the prior year’s period. These results from our portfolio companies demonstrate the merits of our focus on lending to market leaders in defensive industries at reasonable leverage levels and our avoidance of cyclical industries, oil and gas, restaurants, retail, metals and mining among them. The portfolio composition remains highly diversified, with the top 10 issuers accounting for 24% of fair market value. Recall that the top 2 positions within the portfolio, Eclipse Business Capital and Rocade Holdings, our strategic platform investments that we own and provide BBDC shareholders with access to differentiating compelling opportunities to invest in asset-backed loans and litigation funding solutions, 2 specialized areas we believe provide attractive total return and diversification benefits, especially given Rocade lack of correlation to broader financial markets.

Turning to the portfolio quality. Risk ratings exhibited minimal movement during the quarter as our issuers exhibited the most stress classified as risk ratings 4 and 5 were 9% on a combined basis quarter-over-quarter and compared to 8% in the immediately preceding quarter. Nonaccruals accounted for $6 million of the fair market value of the portfolio and 0.3% of assets, which we believe is one of the lowest levels of nonaccruals across the industry. We remain confident in the credit quality of the underlying portfolio. We expect BBDC’s differentiated reach and scale, coupled with our focus on the core of the middle market to continue driving positive outcomes for shareholders in the quarters to come. The BBDC portfolio is a through-the-cycle portfolio designed to withstand a variety of economic environments and prevailing interest rate levels.

To this end, BBDC was structured to align both fees and credit performance hurdles as outlined on Slide 14. With the increase in base rates experienced over the past 2 years, effectively all publicly listed BDCs have delivered earnings in excess of their hurdle rates, the relative distinction between hurdle rate levels has fallen out of focus. As base rates begin to fall, BBDC investors will again benefit from the impact of a high hurdle rate at BBDC compared to other industry participants. BBDC’s hurdle rate of 8.25% compares to an industry average of 7.03% among our externally managed public peers with some managers having significantly lower hurdles. We anticipate this hurdle rate will differentiate relative value for BBDC shareholders in the quarters to come.

To the extent, BBDC’s pre-incentive fee returns fall between 8.25% and 10.3%, shareholders can expect the stability of an 8.25% return, while BDCs lower hurdle rates will experience the same pre-incentive fee returns would receive lower net returns. The second component to BBDC’s fee structure I want to comment on is the total return hurdle sometimes referred to as a look back. The look back is designed to align credit performance of BBDC with incentive fees paid to the manager, Barings LLC. As we all know, credit performance is foundational to a BDC, but less than 50% of externally managed publicly traded BDCs have a look back that incorporates losses into their return hurdle. When our hurdle rate structures are combined with a strong stock buyback program and credit support agreements covering a portion of our assets, we feel that the shareholder focus at Barings is among the best in market.

I’ll now turn the call over to Elizabeth.

Elizabeth Murray: Thanks, Matt. On Slide 15, you can see the full bridge of the NAV per share movement in the second quarter. NAV per share was $11.36 as of June 30, which is a decrease of 0.6% over the prior quarter and an increase of 0.2% year-over-year. Our net investment income exceeded the $0.26 per share dividend by $0.14 per share or 35%. Net unrealized depreciation from investments, CSAs and FX equaled $0.29 per share and was partially offset by net realized gains on the portfolio and FX of $0.07 per share. The net realized gain in the portfolio was predominantly due to the exit of our investment in core scientific partially offset by our exit in Highland, a Sierra investment, which is covered by the CSA was primarily reclassed from unrealized depreciation.

You may recall, during the first quarter, we recognized a loss of $7.6 million on the restructuring of our debt investment in Core Scientific into equity. During the second quarter, as I previously mentioned, we fully exited our investment in Core Scientific and recognized a gain on the sale of the equity of $8 million. We are pleased to say we experienced full par recovery of this investment plus a $0.4 million gain on exit. The valuation of the credit support agreements decreased by approximately $0.9 million. The fair value of the Sierra CSA decreased from $35.4 million in the first quarter to $32.6 million as of June 30. During the second quarter, the Sierra portfolio had sales and repayments of approximately $32 million and had 29 positions remaining in the portfolio down from 36 positions as of March 31.

The fair value of the MVC CSA increased from $16.1 million to $18 million as of June 30, driven by unrealized depreciation in the underlying portfolio with 4 positions remaining. Our net investment income was $0.40 per share for the quarter, compared to $0.28 per share in the prior quarter and $0.31 per share for the second quarter of 2023. Investment income in the quarter was primarily driven by dividends from joint venture and platform investments and our incentive fee expense was lower quarter-over-quarter due to unrealized depreciation fueled by acquired positions and incentive fee cap. Our net leverage ratio, which is defined as regulatory leverage, net of unrestricted cash and net unsettled transactions was 1.07x at quarter end, down from 1.17x in the quarter ended March 31, and currently sits within our long-term target of 0.9x to 1.25x.

Our current leverage provides ample capacity to seize opportunities and pursue attractive deployment opportunities in the quarters to come. Our funding mix remains highly defensible, both in terms of seniority and asset class, including the significant level of support provided by the unsecured debt in our capital structure. At June 30, our unsecured debt accounted for $1 billion of our funding and equated to approximately 70% of our outstanding debt balances. We continue to maintain significant flexibility in our capital structure with the next bond maturity in the second half of 2025 and maintain a ladder of maturities out to 2029. Barings BDC currently has $215 million of unfunded commitments to our portfolio companies as well as $65 million of outstanding commitments to our joint venture investments.

We have available cushion against our leverage limit to meet the entirety of these commitments called upon. As mentioned earlier, the Board declared a third quarter dividend of $0.26 per share, a 9.2% distribution on net asset value and is consistent with our second quarter 2024 dividend. During our earnings call in February, we disclosed the Board authorized a $30 million share repurchase plan for 2024. We continue to be active users of our share repurchase plan. The second quarter was no exception as we repurchased more than 190,000 shares during the period and have repurchased a total of almost 310,000 shares in the first half of 2024. Our focus on share repurchases is one example of BBDC’s thoughtful approach to aligning our interest with shareholders.

I’ll wrap up our prepared remarks with the net on our investment pipeline. Thus far in the third quarter, we have made $56 million of new commitments and funded $46 million. With that, operator, we will open the line for questions.

Q&A Session

Operator: [Operator Instructions] Your first question comes from Robert Dodd with Raymond James.

Robert Dodd: I mean you talked about disruption in the market, which obviously you were seeing over the last week. And then Matt, you talked about there’s a drumbeat of optimism about activity in the second half. So can you — can you kind of reconcile those 2 things generally in the market disruptions and volatility and things like that result in a slowdown in activity, but the activity — the thought had been — would rebound, but the last week, how much has that changed the thought on where you think activity could go in the second half of the year?

Bryan High: Robert, this is Bryan. In terms of the volatility of the market, I do think that one of the benefits of private credit, and we’ve seen some deals pulled from the broadly syndicated market this week, just given some of that volatility is better execution at the end of the day. So if I sort of anecdotally talk about our pipeline, we’ve definitely seen an increase in activity. Whether or not that ultimately ends in deals being closed is sort of to be determined, but I do think that there is a natural tension of a need for liquidity in private markets and folks looking to monetize, maybe not at the ideal time, but because they want to raise the new fund, they’re looking to ultimately sell platforms to a new sponsor to a strategic. So we are seeing more activity again, from a pipeline perspective, whether or not that ultimately closes, we’ll have to wait and see.

Matt Freund: Yes. The other comment that I would add, Robert, maybe I should have been more specific in my prepared remarks. I think that we feel that we’re closer now to a rate cut cycle than we ever have been. And as we think about the private equity firm that we’re interacting with, while they’ve all consistently told us that the cost of debt capital doesn’t move the needle for them, I think that we’re actually going to test that theory because as rates start to come down, I just think the cost of capital for the overall capital structure is going to reset, and when that happens, we would expect more sponsor-to-sponsor LBO activity to pick up.

Robert Dodd: Got it. Got it. And then just on credit. I mean your loan accruals are really good [indiscernible] on fair value and low on the cost base as well. Any — how would you expect that to evolve over the next — I mean, this is very much a gut-feel kind of question to be fair, over the next, say, 12, 24 months. I mean, there may be rate cuts, which is good on interest coverage, et cetera. But the economy is a little softer and rates have been high for a long time. So liquidity reserves at portfolio companies might be smaller than they were. So can you give us any thoughts on how you expect credit in particular your portfolio, like to evolve over the next couple of years, you kind of answer that question, but…

Matt Freund: Yes. I’ll start and then turn it over to Bryan. Look, I think that you were kind, honestly, to give us part of the answer to your question in the way that you asked it. And so — as we think about projecting our credit quality, we feel like we’re in a very good position today. As we think about any sort of catalytic events that may accompany a rate reduction or perhaps economic volatility and/or weakness, we just don’t know what the causes of that uncertainty might be. And so while we feel that the portfolio is very well positioned now, it’s really hard to prognosticate a different set of scenarios, creating a different constitution to the portfolio. But we — I think — I feel very comfortable with where we are from a diversification perspective as well as from a quality of underwriting perspective that we’ve implemented over the past several years. It’s resulted in the portfolio we have today. Bryan, I don’t know if you have any thoughts, macro.

Bryan High: I mean, macro-wise, obviously, Robert, you probably have seen more than we have from all the various portfolios in the market, but it certainly feels like there is an uptick in stress across the marketplace. That being said, I do think our portfolio has held in relatively well. And we’ve got the resources to deal with the issues if and when there’s a broader macro softening that is sort of unavoidable at that time.

Eric Lloyd: Yes. I mean I would highlight what Matt said on earlier, too, which is despite the increase in base rates, our interest coverage still is just over 2x, which we feel really great about. And so borrowing an idiosyncratic kind of event on specific credits, the overall portfolio health remains very strong.

Operator: Your next question comes from Finian O’shea with Wells Fargo.

Finian O’Shea: A question on the, I forget which one is which, but the private to public BDC, can you give us an update on where that is in its investment period or whatnot? And now that it seems like there is some precedence to merge these into the public regardless of price to NAV seeing your appetite to do that?

Bryan High: Yes. Thanks, Fin. I can’t provide specifics on private funds, but we don’t have any anticipation, at least currently of doing anything in BBDC or asking BBDC shareholders to consider anything at this time.

Operator: Your next question comes from Casey Alexander with Compass Point.

Casey Alexander: Matt, I got kind of a tricky one for you here. And maybe this is for Matt or for Elizabeth because it’s kind of a math question. At what degree of decline in base rates would bring the high end of the hurdle into play, and to what extent would that fully protect the current dividend?

Matt Freund: Yes. Casey, I appreciate your anticipation that I might be prepared for math related questions, so thank you for that. But I think that the numbers that we’ve been running kind of assuming all else equal with respect to credit quality and the composition of the portfolio from a leverage perspective, it’s somewhere between, call it, 4% and 4.5% is kind of how we think about the impact of that the hurdle rate being kind of preserved. And then I think that where we personally feel that the math starts to make BBDC look significantly more attractive than those with lower hurdle rates as we start to approach, call it, the high 3s. I think is where you see a lot more differentiation.

Casey Alexander: And — but when you model that out when the hurdle rate starts to take away incentive fee instead of net investment income, right? Is that still at a level that you think preserves the current dividend?

Matt Freund: Yes. We anticipate that that’s the case.

Casey Alexander: Okay. Great. Secondly, given the kind of personnel turnover earlier this year, can you — and maybe I missed this, I got on a minute or 2 late. Can you discuss any personnel updates as it relates to the origination team?

Bryan High: Yes, Casey, it’s Bryan. We — I think on the last call, Eric had mentioned that we had brought in a senior individual that used to be a part of the platform and was Co-Head of North America when he was here before. So including that person, we’ve made 3 new hires, and we’re not done. Two other managing directors are scheduled to join us in the early fourth quarter. So who have been in the middle — the core middle market where we focus for 20 to 25 years.

Eric Lloyd: I think important [indiscernible] Casey, on that the guy we brought back in who co-headed the business in North America was also the Chairman of our North American Investment Committee for a number of years. So there’s the consistency there. And we wanted to be prudent, but timely in our hiring, but also making sure we got the right fit and the right people.

Casey Alexander: Lastly, across the space, both cash flow and venture debt BDCs, there’s been growing difficulties in the software vertical. And when I look at your — at your mix, I’m guessing that Business Services is a fair amount of software. So I’m curious how the interest coverage is faring with your software investments and what you’re hearing from them about software spending plans? And if there’s any particular verticals that might be edgier than others?

Matt Freund: Yes, Casey, that’s a great question. I think that software has been a focus for the industry for some time now. And as we think about kind of other industry, you moated Business Services, but I wouldn’t even limit it to Business Services. There’s a variety of what folks are referring to as tech-enabled services and tech-enabled businesses that really are foundationally built around some software apparatus. And so as I think about our portfolio today, the overwhelming majority of the portfolio is a conventional cash flow lending portfolio. I can think of very few examples where that’s not the case. If I were trying to parse apart a different portfolio or industry-wide portfolios, the question I would ask would be around ARR-based facilities because I think that ARR is often — I mean, almost all ARR loans are software loans, but not all software loans or ARR loans.

And so I think that where we’ve seen a little bit of divergence from a cash flow coverage perspective are some of the issuers that are reporting ARR style facilities that have not converted to cash flow levels. And so in terms of kind of how the portfolio is performing, specifically as it relates to software, we’re feeling very encouraged, our portfolio of software issuers is not performing any differently than our nonportfolio portfolio — nonportfolio of issuers. But I do think that, that’s a very fair question, and it’s something that isn’t easily discernible whenever you’re looking at an SOI, for example.

Operator: At this time, there are no further questions in queue. I’d like to turn the call back over to Eric Lloyd.

Eric Lloyd: I just want to thank everybody for dialing in, listening to our update for this quarter, and we look forward to finishing the year strong on your behalf. Thanks very much.

Operator: This concludes the Barings BDC Second Quarter 2024 Earnings Call. Thank you for attending, and have a wonderful rest of your day.