Fitch Ratings has affirmed Bain Capital Specialty Finance's (BCSF) Long-Term Issuer Default Rating (IDR), senior secured debt rating and senior unsecured debt rating at 'BBB-'.

The Rating Outlook is Stable.

Today's rating actions have been taken as part of a broader review of business development companies (BDCs) which included 18 publicly rated firms. For more information on the peer review, please refer to 'Fitch Ratings Completes 2023 BDC Peer Review,' available at www.fitchratings.com.

Key Rating Drivers

The ratings affirmation reflects the strength of BCSF's relationship with Bain Capital Credit (a subsidiary of Bain Capital, LP), the first lien focus of the portfolio, a strong track record in credit within this vehicle and in vehicles with similar strategies, solid portfolio diversification, relatively low leverage, solid funding flexibility, a sound liquidity profile and improved dividend coverage.

Rating constraints specific to BCSF include elevated growth over a relatively short operating history as a business development company, which could yield asset quality issues given the competitive underwriting environment heading into the pandemic and below-average core earnings, which yields weaker interest coverage metrics.

Rating constraints for the BDC sector more broadly include the market impact on leverage, given the need to fair-value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend distribution requirements. Additionally, Fitch believes BDCs will experience weaker asset quality metrics in 2023 amid macroeconomic headwinds and higher debt service burdens and slower growth prospects at portfolio companies.

Fitch views BCSF's affiliation with Bain Capital, LP as supportive to the rating, as it provides BCSF with access to industry knowledge, relationships with sponsors and banks, investment management resources, deal flow, and workout expertise. At Dec. 31, 2022, Bain Capital, LP had approximately $160 billion in assets under management, including $59.5 billion in credit.

At Dec. 31, 2022, 68.3% of BCSF's portfolio was first lien loans, followed by 12.8% of debt and equity investments in the joint ventures (JV) International Senior Loan Program, LLC (ISLP) and Bain Capital Senior Loan Program, LLC (SLP). The proportion of first lien loans has declined in recent years given growth in these strategic partnerships, which consist largely of first lien loans, resulting in a look through first lien exposure of 83% for BCSF. While the equity investments in the JVs could yield more portfolio valuation volatility, the programs are expected to be higher yielding with leverage consistent with that of the BCSF balance sheet for ISLP and slightly higher for SLP.

BCSF's asset quality metrics have been solid historically, with net realized gains averaging 0.0% of the portfolio annually from 2019-2022, which is above the peer average and within Fitch's 'bbb' category benchmark range of -3% to 2%. At Dec. 31, 2022, BCSF had three investments on non-accrual status representing 3.9% of the debt portfolio at cost and 2.2% at value. Fitch believes that historical non-accrual levels of zero were not sustainable and expect higher interest rates and slower economic growth to keep them above historical levels.

BCSF's core earnings yields have been below the peer group average historically, given its focus on lower-yielding first lien investments. Still, the net investment income (NII) yield, defined as NII as a percentage of the average portfolio at cost, improved to 4.3% in 2022, from 3.7% in 2021 on higher dividend income given growth in the JVs. The NII yield should continue to benefit from growth in the JVs as well as rising rates and wider credit spreads.

BCSF's net leverage target is 1.0x-1.25x, which is generally in line with the peer average. Gross leverage was 1.25x at YE22 (1.14x net of unrestricted cash and foreign currency), down from a peak of 1.86x at 1Q20, which Fitch views favorably. The leverage ratio at YE22 implied a Fitch-calculated asset coverage cushion of 16.7%, which is within Fitch's 'bbb' category leverage benchmark range of 11%-33%.

At Dec. 31, 2022, 43% of BCSF's outstanding debt (at par) was unsecured, within Fitch's 'bbb' category funding, liquidity and coverage benchmark range of 35%-50%, which Fitch views favorably. Fitch expects BCSF will remain opportunistic about unsecured debt issuance, but that it will maintain unsecured funding within the 'bbb' category benchmark range.

Fitch views BCSF's liquidity position as sound. At Dec. 31, 2022, the firm had $59.8 million of unrestricted cash and $257 million of undrawn capacity on its secured facilities. The next debt maturity is in 2026, when $600 million of unsecured notes are due. NII coverage of the dividend improved to 115% in 2022 compared to 100% in 2021, benefiting from stronger earnings on higher rates and growth in dividend income. Interest coverage, defined as EBITDA / interest expense, improved to 3x in 2022 from 2.8x in 2021 but remains below the rated peer group average.

The Stable Outlook reflects Fitch's expectations that BCSF's asset coverage cushion will be managed at a level commensurate with the risk profile of the portfolio, the firm will continue to focus on first lien investments, unsecured funding will remain at least 35% of total debt and that BCSF will maintain sufficient liquidity and solid dividend coverage.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Factors that could, individually or collectively, lead to negative rating action/downgrade include a sustained increase in leverage above the targeted range; deterioration in the portfolio risk profile, such that first lien positions decline materially as a proportion of the overall portfolio; a spike in non-accrual levels; meaningful realized or unrealized losses; a sustained reduction in unsecured debt to below 35% of total debt; weaker cash-based NII coverage of the dividend; or an impairment of the liquidity profile.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Factors that could, individually or collectively, lead to positive rating action/upgrade over time include differentiated credit performance of recent underwriting vintages; demonstrated economic access to unsecured funding through market cycles; maintenance of unsecured debt to total debt above 40%; broader secured funding relationships; a reduction in leverage that is not accompanied by an offsetting increase in the portfolio risk profile; improved core operating consistency; and interest coverage consistently above 4x. Positive rating momentum would also be conditioned on the maintenance of solid dividend coverage and a strong liquidity profile.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The secured and unsecured debt ratings are equalized with the Long-Term IDR and reflect solid collateral coverage for all classes of debt given that BCSF is subject to a 150% asset coverage limitation.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are primarily linked to the long-term IDR and are expected to move in tandem. However, a material reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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