Bain Capital Specialty Finance: Cut to NAV Still Unwarranted (NYSE:BCSF)

Earlier this year, in July, we issued a bullish thesis on Bain Capital Specialty Finance (NYSE:BCSF) indicating a clear buy given the robust state of the underlying fundamentals and the presence of a ~10% discount to NPV. In in other words, we have seen no meaningful justification as to why BCSF should trade at such a discount.

The only reason the multiple could theoretically fall here was exposures beyond the first collateral assets, which together represented about 33% of the total asset base. However, if we further dissect the exposures coming through the joint venture vehicles, we arrive at a first tranche of collateral that explains 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 or in any way shape or form. notable aspect, which should reduce P/NAV to 0.93x (based on current statistics).

Since the publication of my previous piece, BCSF has clearly outperformed the BDC index.

The main reason behind the alpha is purely related to the strong earnings report in Q2 2024, after which the share price took a strong and favorable momentum.

Let’s now look at the Q2 2024 earnings package and see what the key data was worth considering in the context of my current investment case.

Revision of the thesis

As noted above, Q2 2024 performance delivered positive results, particularly in BCSF’s P/NAV metric, which continues to show a significant reduction.

Total investment income for the quarter came in at $72.3 million, which marks a slight decrease compared to the $74.5 million result in the previous quarter. Because of this decline in the top line, net investment income per share contracted accordingly to $0.51 per share (ie, $0.02 per share below Q1, 2024). However, here I would like to highlight the key reason behind this dynamic, which is that Bain Capital has seen lower income from other income categories, which is by definition more volatile and not so critical in the context of underlying performance basic.

As a result of the NII generation levels achieved in Q2, core dividend coverage remained solid at 121%, which is among the most conservative coverage levels in the BDC space. Given the ~21% surplus, management decided to add additional dividends to the equation, increasing the total dividend paid for the quarter to $0.45 per share. On an annualized basis, this translates to a return of ~10.5%, which could be considered attractive given the conservative coverage level.

An additional layer that makes BCSF’s business relatively safe is its leverage profile, which in Q2 2024 was 1.03x (ie, well below the sector average of 1.16x). It is also below BDC’s target range of 1.1x to 1.25x, implying that there is considerable room for portfolio growth. In addition, during Q2 2024, management improved the debt structure by increasing the commitment from the 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 extended maturities and strengthened liquidity, the weighted average interest rate on outstanding debt fell 10 basis points to 5.1%.

One last thing worth highlighting in terms of improvements in Q2 is related to the credit quality of the BCSF portfolio. Importantly, defaults fell to 1.0% (measured on a fair value basis), which is both significantly below the sector average and indicative of a healthy portfolio (which was not the case for many BDCs in Q2). Additionally, looking at data points from Q2 2024, we will see that 97% of portfolio 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 stemming from the Q2 2024 data points. Namely, net investment activity for Q2 hit a negative $167 million, which will make it more difficult to grow and/or protect current levels of net investment income generation for BCSF. This is also the biggest decline in the last 5 quarters.

However, here I would like to point out several mitigating factors.

First, initial gross during the second quarter was $307 million, representing a 55% year-over-year increase. Momentum on the gross initiation front appears to have strengthened, which sends an encouraging signal for global futures trading activity.

Second, 86% of new investments came in the form of senior secured loans and 9% were unwritten through joint ventures, which have a notable bias towards senior debt instruments. Namely, the portfolio gradually becomes more focused on the first lien, which should neutralize the key argument for the existence of the NPV discount.

Third, by making these investments, BCSF has maintained strict underwriting standards without sacrificing yield (weighted average yield on investments is 11.6%). Median levels of leverage reached 4.6x, which, in combination with the presence of documentation containing financial agreements related to management forecasts (relevant for 95% of investments), allows to reduce the additional risk of the portfolio.

Key risks

Of all the prevailing headwinds in the BDC space, such as spread compression, shallow M&A activity and increased non-accruals, the market component of deals is something we need to be aware of.

As explained above, this quarter BCSF recorded a fairly negative figure on the net investment funding front, meaning that the asset base in Q3 will most likely be lower than in Q2. This, in turn, will cause net investment income to contract slightly or, in a positive scenario, remain where it is flat. Given that the quality of the portfolio is solid and the dividend coverage indicates a large margin of safety, the risks of a dividend cut are very limited. However, if the M&A statistics continue to appear in a negative fashion for several quarters in a row, the margin of safety would obviously disappear quickly.

However, again, looking at broader interest rate dynamics, the odds seem stacked in favor of a dividend cut in the near term. This should stimulate buyers and sellers to trade and LBO activity should gradually return to more normalized levels.

The bottom line

Overall, the Q2 2024 earnings report confirms that the investment case is still there and attractive to investors looking for defensive income streams. Basic dividend coverage remains strong and the quality of the portfolio embodies the right dynamics that are needed to further de-risk the business profile. The only concern might be related to depressed net investment activity. However, if we put things in perspective of the general statistics of the BDC sector, where most BDCs have suffered due to inactive M&A markets, this should not serve as a reason to avoid BCSF. Instead, the new investment funds 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 NAV is unwarranted.