New Mountain Finance (NYSE:NMFC)
Q2 2016 Earnings Conference Call
August 4, 2016, 10:00 AM ET
Rob Hamwee – Chief Executive Officer
Steve Klinsky - Chairman & Chief Executive Officer of New Mountain Capital
John Kline – Chief Operating Officer
Shiraz Kajee – Chief Financial Officer
Jonathan Bock – Wells Fargo
Jeff Greenblatt – Monarch Capital Holdings
Good morning and welcome to the New Mountain Finance Corporation Second Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded.
I would now like to turn the conference over to, Rob Hamwee, CEO. Please go ahead, Mr. Hamwee.
Thank you and good morning, everyone and welcome to New Mountain Finance Corporation's second quarter earnings call for 2016. On the line with me here today are Steve Klinsky, Chairman of NMFC and CEO of New Mountain Capital; John Kline, COO of NMFC; and Shiraz Kajee, CFO of NMFC.
Steve Klinsky is now going to make some introductory remarks, but before he does, I would like to ask Shiraz to make some important statements regarding today's call.
Thanks, Rob. Good morning, everyone. Before we get into the presentation, I would like to advise everyone that today's call and webcast are being recorded. Please note that they are the property of New Mountain Finance Corporation and that any unauthorized broadcast in any form is strictly prohibited. Information about the audio replay of this call is available in our August 3, 2016 earnings press release.
I would also like to call your attention to the customary Safe Harbor disclosure in our press release and on Page 2 of the slide presentation regarding forward-looking statements. Today's conference call and webcast may include forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from those statements and projections. We do not undertake to update our forward-looking statements or projections unless required to by law.
Any references to New Mountain Capital or New Mountain are referring to New Mountain Capital LLC or its affiliates and may be referring to our investment advisor, New Mountain Finance Advisors BDC LLC where appropriate. To obtain copies of our latest SEC filings and to access the slide presentation that we will be referencing throughout this call, please visit our website at www.newmountainfinance.com.
At this time, I would like to turn the call over to Steve Klinsky, NMFCs Chairman who will give some highlights beginning on Page 4 and 5 of the slide presentation. Steve?
Rob, John and Shiraz will go through the details in a moment, but let me start by presenting the highlights of another solid quarter for New Mountain Finance. New Mountain Finance's adjusted net investment income for the quarter ended June 30, 2016, was $0.34 per share, in the middle of our guidance of $0.33 to $0.35 per share, and once again covering our Q2 dividend of $0.34 per share.
New Mountain Finance's book value was $13.23 per share, as compared to $12.87 per share last quarter. This is a $0.36 increase per share overall, despite negative performance of two our credits Transtar and Permian, which we have now classified as non-accrual defaults, and which Rob will discuss on this call.
We're also able to announce our regular dividend for the current quarter, which will again be $0.34 per share and annualized yield in excess of 10% based on Monday's close. The Company invested $136 million in gross originations in Q2 and had $146 million of repayments in the quarter, maintaining a fully invested balance sheet.
Finally, I would like to John Kline on his well-deserved promotion to President of NMFC. He has been with New Mountain's credit efforts since 2008 and is been a major driver behind the scenes of NMFC's success.
In summary, we are pleased with NMFC's continued performance and progress overall.
With that, let me turn the call back over to Rob Hamwee, NMFC's CEO.
Thank you, Steve. Before diving into the details of the quarter, as always, I'd like to give everyone a brief review of NMFC and our strategy. As outlined on Page 6 of our presentation, NMFC is externally managed by New Mountain Capital, a leading private equity firm with over $15 billion of assets under management and over 100 staff members, including over 60 investment professionals.
Since the inception of our debt investment program in 2008, we have taken New Mountain's approach to private equity and applied it to corporate credit with a consistent focus on defensive growth business models and extensive fundamental research within industries that are already well known to New Mountain, or more simply put, we invest in recession resistant businesses that we really know and that we really like.
We believe that this approach results in a differentiated and sustainable model that allows us to generate attractive risk-adjusted rates of return across changing cycles and market conditions. To achieve our mandate, we utilized the existing New Mountain investment team as our primary underwriting resource.
Turning to Page 7, you can see our total return performance from our IPO in May, 2011 through August 1, 2016. In the five plus years since our IPO, we have generated a compounded annual return to our initial public investors of 10.2%, meaningfully higher than our peers in the high-yield index and an annualized cash-on-cash return to our initial public investors of 10.6%.
Page 8 goes into a little more detail around relative performance against our peer set, benchmarking against the 10 largest externally managed BDCs that have been public at least as long as we have.
Page 9 shows return attribution. Total cumulative return continues to be driven almost entirely by our cash dividend which in turn has been more than 100% covered by NII. As the bar on the far right illustrates over the five plus years we have been public, we have effectively maintained a stable book value inclusive of special dividend, whilst generating a 10% cash-on-cash return for our shareholders fully supported by net investment income. We are very happy to be able to deliver this performance over a period of time, where risk-free rates have been effectively zero and will strive to continue this performance.
We attribute our success to, one, our differentiated underwriting platform; two, our ability to consistently generate the vast majority of our NII from stable cash interest income; three, our focus on running the business with an efficient balance sheet and always fully utilizing inexpensive, appropriately structured leverage before accessing more expensive equity; and four, our alignment of shareholder and management interest. Our highest priority continues to be our focus on risk control and credit performance which we believe over time is the single biggest differentiator of total return in the BDC space.
If you refer to Page 10, we once again lay out the cost basis of our investments with the current portfolio and our cumulative investments since the inception of our credit business in 2008 and then show what has migrated down the performance ladder. Since inception, we have made investments of $3.9 billion in 179 portfolio companies, of which only six, representing just $78 million of cost, have migrated to non-accrual and only two, representing $6 million of cost, have thus far resulted in realized default losses. Approximately 97% of our portfolio at fair market value is currently rated 1 or 2 on our internal scale.
Page 11 shows leverage multiple for all of our holdings above $7.5 million when we entered an investment and leverage levels for the same investment as of the end of the current quarter. While not a perfect metric, the asset by asset trend in leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical, fundamental support for our internal ratings and marks.
As you can see by looking at the table, leverage multiples are roughly flat or trending in the right direction, with only a few exceptions. Of the four loans that show negative migration of two and a half turns or more, one is to a business that is completing a sale process that we expect to pay off our loan in full by the end of Q3. The second one is a first lien loans to an energy service businesses that, while cyclically challenged, continue to have substantial liquidity, and which we expect to be current for the foreseeable future.
The final two Transtar and Permian have been placed on non-accrual this quarter. As we reported last quarter, Transtar has been challenged by several operational missteps, while Permian, an energy service business continues to be challenged by a downturn in its end market. As a result of these business challenges, it has become clear that it is necessary to restructure both company's balance sheet for which conversations are currently ongoing. We expect these restructurings to be completed prior to our next earnings call and will provide an update at that time.
The chart on page 12 helps track the Company's overall economic performance since its IPO. At the top of the page, we show how the regular quarterly dividend is being covered out of net-investment income. As you can see, we continued to more than cover 100% of our cumulative regular dividend out of NII. On the bottom of the page, we focus on below-the-line items.
First, we look at realized gains and realized credit and other losses. As you can see, looking at the row highlighted in green, we've had success generating real economic gains every year through a combination of equity gains, portfolio company dividends and trading profits. Conversely, realized losses including default losses, highlighted in orange, have been significantly smaller and less frequent and show that we're typically not avoiding non-accruals by selling poor credit at a material loss prior to actual default. The net cumulative impact of this success-to-date is highlighted in blue which shows cumulative net-realized gains of $44.7 million since our IPO.
Next, we look at unrealized appreciation and depreciation. As you see highlighted in grey, we have $77 million of cumulative net unrealized depreciation, an improvement of $22 million since last quarter. This improvement is largely driven by broad market gains across the portfolio. Credit specific gains also contributed to some degree with additional markdowns at Transtar and Permian more than offset by significant improvement at UniTek and a few others.
As you may recall, UniTek underperformed in 2014 and was subsequently restructured at the end of that year. During the restructuring, New Mountain and another lead lender took ownership of the Company and controlled the Board. Over the course of the last two years, EBITDA has improved from approximately $25 million to a current run rate in the low 40s.
We've installed a new management team that is effectively exited unprofitable businesses and cut experience cost, while meaningfully improving core operating performance. We believe that New Mountain's private equity operating expertise and Board oversight has been highly valuable to UniTek.
I will now turn the call over to John Kline, NMFC's President to discuss market conditions and portfolio activity. John.
Thanks, Rob. As outlined on Page 13, since our last call on May 5, we have seen continued strong performance in the credit markets driven by positive fund flows into leverage credit, limited new issues supply and an increased desire for yield in the current low rate environment. Brexit, once perceived as a risky event for market participants, instead acted as a further callus for investors to put more dollars to work in leverage credit. Looking forward we expected a strong credit market combined with significant private equity dry powder will create a robust yield environment in the fall.
Turning to Page 14, NMFC is well-positioned in the event of future rate increases as 85% of our portfolio is invested in floating-rate debt. Therefore even in the face of a material rise in interest rates, assuming a consistently shaped yield curve, we would not expect to see a significant change in our book value. Furthermore, at the table at the bottom of the page demonstrates, a rise in short-term rates will generally increase our NII per share.
Moving on to portfolio activity, as seen on Pages 15 and 16, investment activity increase significant from Q1. Total originations were $136 million offset by $146 million of repayments and $12 million of sale proceeds, yielding a modest net source of cash of $22 million. Our new originations consisted of a balanced mix of new platform investments, opportunistic purchases in the secondary market and add on investments to existing portfolio of companies.
Additionally, as mentioned on our last call we invested $28 million into SLP-II which continues to ramp at a consistent pace. Since the end of the quarter, we have maintained our origination momentum with a total of $80 million new originations, offset by $43 million of repayments and sales, resulting in a $37 million use of cash.
As we stand today, we are fully invested with our future originations expected to be funded by cash proceeds from certain near-term portfolio exits as well from availability in our SBIC program.
Page 17 shows that the during the quarter our origination by asset type are consistent with our rough historical mix of 50% second-lien and 50% first-lien inclusive of the SLP facility. Meanwhile, our sales and repayments were 66% first-lien and 34% second-lien. Asset yields as shown on Page 18 remained consistent with last quarter at 10.3%.
Despite the stronger market, which had pushed spread modestly lower, we continue to have success finding portfolio investments with attractive yields in our core defensive growth industries like software, healthcare, distribution and logistics and business services that we believe will perform well in various economic environments.
On Page 19, we show our balance portfolio across defensive growth-oriented sectors and our continued balanced between first and second lien investments. On the lower right, it's important to note the vast majority of our portfolio continues to perform at or above our expectations.
Finally, as illustrated on Page 20, we have a broadly diversified portfolio with our largest investment at 3.7% of fair value, and the top 15 investments account for 39% of fair value.
With that, I will now turn it over to our CFO, Shiraz Kajee, to discuss the financial statements and key financial metrics. Shiraz?
Thank you, John. For more details on our financial results and today's commentary please refer to the Form 10-Q that was filed last evening with the SEC.
Now, I would like to turn your attention to Slide 21. Portfolio had approximately $1.53 billion in investments at fair value at June 30, 2016 and total assets of just over $1.58 billion. We had total liabilities of $741.3 million, of which total statutory debt outstanding was $600 million, excluding $121.7 million of drawn SBA-guaranteed debentures. Net asset value of $843.3 million or $13.23 per share was up $0.36 from the prior quarter. As of June 30, our statutory debt-to-equity ratio was 0.71.
On Slide 22, we showed the historical NAV per share and leverage ratios which are broadly consistent with our current target statutory leverage of between 0.7 and 0.81. We also show the NAV adjusted for the cumulative impact of special dividends which portrays a more accurate reflection of true economic value creation.
On Slide 23, we show our quarterly income statement results. We believe that our adjusted NII is the most appropriate measure of our quarterly performance. This slide highlights that, while realizations and unrealized appreciation and depreciation can be volatile below the line, we continued to generate stable net investment income above the line.
Focusing on the quarter ended June 30, 2016, we earned total investment income of approximately $41.5 million. This represents a $0.6 million or 1.5% from the prior quarter largely attributable to an increase in interest income. Total net expenses of $19.7 million, up slightly from the prior quarter.
As mentioned on prior calls, due to the merger of our Wells Fargo credit facilities and consistent with the methodology since IPO, the investment advisor will continue to wave management fees on the leverage associated with those assets that share the same underlying yield characteristics with investments leveraged under the legacy SLF credit facility.
This results in an effective annualized management fee of 1.4% for the fourth quarter, which is in line with prior quarters. It is expected, based on our current portfolio construct, that the 2016 effective management fee will be broadly consistent with prior years and it is important to note that the investment advisor cannot recoup management fees previously waived.
In total, this results in second quarter adjusted NII of $21.8 million or $0.34 per share, which is in line with guidance and covers our Q2 regular dividend of $0.34 per share. In total, for the quarter ended June 30, 2016 we had an in increase to net assets resulting from operations of $44.7 million.
The Slide 24 demonstrates our total investment income is recurring in nature and predominantly paid in cash. As you can see 89% of total investment income is recurring, and cash income remains strong at 94% this quarter. We believe this consistency shows, the stability and predictability of our investment income.
Turning to Slide 25, as briefly discussed earlier, our adjusted NII for the second quarter covered our Q2 dividend. Given our belief that our Q3 adjusted NII will fall within our guidance of $0.33 to $0.35 per share, our Board of Directors has declared a Q3 dividend of $0.34 per share, in line with the past 17 quarters. Q3 quarterly dividend of $0.34 per share will be paid on September 30, 2016 to holders of record on September 16, 2016.
Finally on Slide 26, we highlight our various financing sources. As mentioned on our last call, during the second quarter we further upsized our NMFC credit facility from $110 million to $123 million. We also issued $50 million of five-year senior unsecured notes at a fixed rate of 5.313%. Taking into account SBA-guaranteed debentures, we had $933 million of total borrowing capacity at June 30, 2016.
As a reminder, our Wells Fargo credit facility's covenants are generally tied to the operating performance of the underlying businesses that we lend to, rather than to the marks on investment at any given time.
At this time, I would like to turn the call back over to Rob.
It continues to remain our intention to consistently pay the $0.34 per share on a quarterly basis for future quarters, so long as the adjusted NII covers the dividend in line with our current expectations.
In closing, I would just like to say that we continue to be pleased with our performance to-date. Most importantly, from a credit perspective, our portfolio overall continues to be very healthy. Once again, we would like to thank you for your support and interest, and at this point, turn things to the operator to begin Q&A. Operator?
[Operator Instructions] The first question comes from Jonathan Bock of Wells Fargo Securities. Please go ahead.
Good morning and thank you for taking my question. Good to hear from you guys. So, one small item is, we were making a read through, Rob, related to SLF-II where we saw an equity commitment, both yourself and your partner, roughly $35 million, debt outstanding to the vehicle of $71 million, yet the fair value of assets at $167 million. And I'm just curious because, either I can read, which is certainly possible, but is there another piece or debt part outstanding that's allowing you to hold that asset level above both the debt and equity commitment to the vehicle?
No. There is nothing strong going on, so either there is a typo in something that we've put out, which I hope is not the case or Jonathan you are maybe conflating two different things. Where are you seeing the $167 million?
We'll take it offline, it's probably certainly our mistake, but we do understand that the SLF are important growth avenues which kind of gets to our next quarter. In terms of the ability to attach the senior secured marketplace, where are you seeing most of the deal flow coming through that channel. You could either, A, kind of move to your authenticated type markets; or B, participate as passive investors alongside perhaps a direct originator doing the L-550 [ph] stretch right whether it's a non-terrace or golf [ph] et cetera knowing that your part of that process. How are you, looking at sourcing opportunities there, because both can be attractive based on your views of the industry being originated in, but it gives us a sense of how to model where we should think about yield will be going in that portfolio?
It's a good question Jonathan, and I think again, not to beat the dead horse here, but we do start with the industry and the business, and only then think about the scale of the capital structure and whether it's broadly syndicated or clubbed upward, in some instance a direct origination led by us. So those are really all outputs. So we could do -- we could see three great business that we underwrote for private equity and that somebody else purchased and they all three could be click-a-category, club deals, that would be three club deals in a row. But they could just have easily, be three syndicated deals or three direct originations for us. So, it's really a function Jonathan of the flow that falls into that box that we focus on which are these defensive growth businesses that we know and like through our private equity efforts. So, it's very hard for me to say, because we're not electing for those categories -- the categories of type, we're selecting for business and industry.
Which has proved very well in the past, so then maybe attacking in a different way. I mean John, i think you mentioned there is opportunity for given private equity, capital and sidelines business activity basically to likely pick up. You see more of an opportunity to work on privately negotiated second-liens in which case you've -- you benefit from substantial covenant and pricing premiums. Is that private kind of second lien options really come into the fray? Or are the transactions that you would expect coming on the wave of new deal activity this year. Is it going to be more of a dealer brought type of transaction that produces high yield, but you know well, but might actually come at a bit of a lower spread than if you were able to do it as part of a privately negotiated kind of club deal?
I mean there is a lot there. I would say that we think deal activity is going to go up across the board, both on more private club deals and also broadly syndicated deals brought by dealer. I think you bring up a really important point on the second lien market, and that market is definitely evolving. I think one or two years ago, I think larger investment banks were probably more active in that business. And I think that as you and lot of other market watchers know, that market is evolving to really become more of a private market. And so we're fine with the way we feel like we have good sourcing avenues, no matter where the market goes.
Then so -- credit is a question that is entered into a lot of investors mind and certainty how enticed the dividend policy et cetera. And we've seen that you've been certainly able to more than maintain earnings as well as do so by kind of focusing on cyclical types industries and investments. And the question is Rob, is now really a period where your investors should expect earnings growth? And you know what, no, can actually be a good answer because it allows them to look at the dividend yield in a different light as much more sustainable for a manager who is happy running in place instead of continually trying to grow earnings or reach for yield which might present NAV issued down the road.
And Jonathan, I think I have been very consistent about this for some time know, which is we are absolutely not focused on growing NII and growing the dividend. In this interest rate environment, we believe getting a 10% ROE is pretty attractive and we want to do that while taking as little risk from a credit perspective as possible. So, unless we have a material change in the underlying interest rate environment, our focus is to continue to deliver what we believe is a tremendous of excess spread while keeping the credit profile as high quality as possible.
And how would you define the impact so clearly, LIBOR has gone from 30 to 60 to 78 or so. Now, one of the questions, I mean you've largely absorbed the impact of that higher LIBOR but still been able to maintain ROE. How, in terms of the pain that perhaps could come to the extent LIBOR creeps up a little bit more, how should we think about your ability to mitigate, remaining negative earnings impact?
Yeah. It's almost down to zero Jonathan. I mean we've got a little slide on Page 14, that refer to the point of maximum pain is plus or minus 50 bps and that's $0.01 a share annually. So, like you say, we've absorbed most of it, and there is very -- we're comfortable if we happen to reach that point of maximum pain and stop right there, we're comfortable, we can handle that. Again, it's $0.01 out of the $1.36.
Then the final question, we noticed that portion of Permian Tank and Transtar were placed on non-accrual. You know, and while the portion is placed on non-accrual, really the majority of the loan, can you walk us through why some get put on non-accrual, why the others wouldn't and really what is the credit situation there, how it unfolds and the impact, is there more -- would you expect more to come or you can isolate it to a certain business divisions, et cetera. More color on those credits will be very helpful.
So, from a policy perspective and historically to the extent that debt being reinstated in a proposed restructuring, and that debt is either cash pay or expect what we believe that it's highly likely to be collectible. GAAP requires us to put that into the not on non-accrual. And that's what we've done. In UniTek, it's made sense and it meant then we were doing the same thing with Permian and Transtar. Based on our current best information and belief, as to how those restructuring which are very much in progress will play out. And then once the restructuring is finalized, we have final numbers which could be higher or lower.
So, in terms of the underlying things going out of the business, as I said in the prepared remarks Jonathan, because they are both private companies with private restructuring until they are finalized, I really can't go into any further detail based on confidentiality issues and constraints, but we'll -- I'd expect both of those to be completed by our next call, and we'll go through with more details.
Very helpful. Thank you so much.
You are welcome Jonathan. Good talking with you.
[Operator Instructions]. The next question comes from Jeff Greenblatt of Monarch Capital. Please go ahead.
Good morning, Rob. Just a -- I had a quick question, and I'm trying to -- again on a big picture basis, look through your portfolio capacity NAV number, and by the way, it's nice to see that, that rise this quarter is somewhere the credit markets have stabilized. But as a -- effectively a debt substitute in my mind the most important numbers are always sort of been what is the par value if you are underwriting is good and you get paid off on time? You show a cumulative depreciation number of $77 million, I think on one of the slides which has improved somewhat since the last quarter. I'm trying to -- if I can roughly figure, how do I look at that $77 million, because on 64 million shares that's hypothetically a $1.20 above the NAV that could be recouped if effectively, you would know where the mark-to-market is, but I guess some of that is stuff that's gone non-accrual, correct?
Yes. That is correct.
So, is there a way to sort of -- obviously the extent that can be paid off at par, and I hope it will is non-accrual, but since that $77 million could be paid up at par, that's what we hypothetically look forward to in terms of rise of NAV over time, correct?
Yes. That is correct. And we've done the math there for you. I think the number is that you are looking at, and this is, if you take the restructured equity components, and anything that troubled like a Transtar or a Permian or Sierra Hamilton, anything rated three, et cetera. Leave all that stuff at the mark, right, but take all the non-troubled stuff at par.
Exactly, the stuff that you are rating one or two…
That you expect to pay off.
That basically gets you to a $13.90 NAV. So, it effectively recovers 60% of that number on a dollar basis.
So, that's as compared to your $13.20 or whatever you just…
$13.20 to be exactly.
So aside from the continuation of the 10% yield, which I agree with you is almost perplexing light so high in this environment. But, you still have that element of potential NAV appreciation as your investments pay off assuming you have no further defaults?
That is correct. And plus on the other stuff, the troubled stuff, could go up like UniTek could do down like depending on how some of these restructuring play out et cetera. That is correct. All else equal…
Well, then as a follow-up to that. I took note of a statement you made which I am tremendously supportive of, which is, you said you prefer to continue a favorable use of well-structured and efficient debt financing over the more expensive equity component of selling stock. And I know in the past you have said, you will not sell stock below NAV, which obviously is important, but I also view it important not selling stock below the $13.90 number hypothetically, because to me as an investor, I've written to move down in the unrealized, I'd like to write it back without getting diluted. So, to what extent can I look at the $200 million of future availability, it looks like you have on all your debt lines combined, and that about it to the extent that effectively your portfolio was trading at a discount to par. As we discuss that, you will focus more on using that debt and doing subsequent equity raises. Are you looking at that the same way, I am, or are there different factors you are looking at?
I think it's similar. I think we are in our own minds constrained on the debt left by the 200 of availability than the statutory constraint. We've always talked about -- obviously we don't want to get too close to the one-to-one statutory constraint. We've always talked about running the business, 0.75 plus or minus. So, we'll never use that full 200 with that liquidity cushion. But the constraint will be around how much more debt to get to that plus or minus 0.75, or it could be 0.78, it could be 0.72, and of course using the SBA debt does not impact the statutory, so we'll use that as maximum capacity.
We do look, when we think about equity issuances, we do look at things other than just stated. But that is likely, I mean that $13.90 is an important market. Frankly the $13.75 that we went public at is another important marker, so all of those are markers beyond just looking at book value.
And last question. I noticed a slight trend, which I'm not sure is significant, by maybe you can comment on the percentage of the portfolio of companies I believe under $100 million of EBITDA. I think over the last few quarters, it's moved to the 60s, close to 70s. I assume that's because the opportunity set there makes it easier for you to negotiate on-off with the borrower rather than being part of a club deal where your subjected and published by others? Is that a great way to look at that, or how should I look at that if it means anything at all?
I think there is two elements to that. I think what you just said is one element and I think the other element is our ramping up of the SBA facility.
That's a good point. Okay.
Which trends to smaller businesses. Yes, so those are two components to that trend.
Thanks for answering the questions and congratulations on another good quarter.
Thank you. Thanks for your support. We appreciate it.
This concludes our question and answer session. I would like to turn the conference back over to Rob Hamwee for any closing remarks.
Great. Thank you, operator. Well, thank you everyone for taking the time to join us this morning and we look forward to speaking again next quarter. Have a good day.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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