Sixth Street Specialty Lending, Inc. Q4 FY2021 Earnings Call

Good morning and welcome to Sixth Street Specialty Lending Inc.’s fourth quarter of fiscal year ended December 31, 2021 earnings conference call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Friday, February 18, 2022. I will now turn the call over to Ms. Cami VanHorn, Head of Investor Relations.

Thank you. Before we begin today’s call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements that are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Sixth Street Specialty Lending Inc.’s filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. Yesterday after the market closed, we issued our earnings press release for the fourth quarter and fiscal year ended December 31, 2021, and posted a presentation to the Investor Resources section of our website, www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with our Form 10-K filed yesterday with the SEC. Sixth Street Specialty Lending Inc.’s earnings release is also available on our website under the Investor Resources section. Unless noted otherwise, all performance figures mentioned in today’s prepared remarks are as of and for the fourth quarter and fiscal year ended December 31, 2021. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending Inc.

Thank you, Cami. Good morning everyone and thank you for joining us. With us today is my partner and our President, Bo Stanley, and our CFO, Ian Simmonds. For our call today, I will review our full year and fourth quarter highlights and pass it over to Bo to discuss our originations activity and portfolio metrics. Ian will review our financial performance in more detail, and I will conclude with final remarks before opening up the call to Q&A. After the market closed yesterday, we reported fourth quarter adjusted net investment income and adjusted net income per share of $0.63 and $0.57 respectively. This resulted in a full year adjusted net investment income per share of $2.16 or a return on equity of 13.6%, and a full year adjusted net income per share of $3.12 or a return on equity of 19.7%. These results were primarily driven by record levels of both funding and repayments, which helped us operate within target leverage levels throughout the year while also experiencing meaningful activity-driven income. At quarter end, we had approximately $0.20 per share of cumulative accrued capital gains incentive fees on the balance sheet and approximately $0.11 per share would be payable in cash if our entire portfolio were to be realized at the quarter end mark in normal course. The rest of the accrued fees are tied to unrealized gains from the revaluation of our debt investments inclusive of call protection, which if prepaid would require recognition of fees and investment income and trigger a reversal of previously accrued capital gain incentive fees related to these investments. In Q4, the impact of such reversals was $0.03 per share. This was offset by a similar amount from realized and unrealized gains that were above our prior quarter valuation marks, resulting in a reversal of less than $0.01 per share of accrued capital gains incentive fees on the balance sheet. As we discussed in previous quarters throughout 2021, we have excluded accrued capital gain incentive fees announced in the presentation of adjusted results on the basis that the expense accrual requirement creates noise around the fundamental earnings power of our business. As of December 31, 2021, the amount of capital gain incentive fees due to the advisor in cash was zero because the gains driving this fee accrual were unrealized. Throughout 2021, we continued to focus on capital efficiency by distributing a record level of $3.59 per share during the calendar year through a combination of our base, supplemental, and special dividends. Over that period, we’ve generated a total economic return to shareholders measured by the change in net asset value per share plus dividends per share of 19.1%, exceeding our average annual economic return rate since IPO of 12.9% through 2020. These returns were primarily driven by the over-earning of our base dividend through net investment income, accretive capital market transactions, and realized and unrealized gains on investments. Yesterday, our board approved a base quarterly dividend of $0.41 per share to shareholders of record as of March 15, payable on April 18. Our board also declared a supplemental dividend of $0.11 per share related to our Q4 earnings to shareholders of record as of February 28, payable on March 31. Our year-end net asset value per share pro forma for the impact of the supplemental dividend that was declared yesterday is $16.73, and we estimate that our spillover income per share was approximately $0.42. We would like to reiterate that our supplemental dividend policy is motivated in part by tax and distribution considerations and that our goal of steadily building net asset value per share over time remains very much part of our philosophy. The distribution of the special and supplemental dividends this past year has significantly reduced our excess tax obligations, generating an estimated annual savings of $0.08 per share relative to retaining that capital. With that, I’ll now pass it over to Bo to discuss this quarter’s record investment activity.

Thanks, Josh. I’d like to start by sharing some perspectives on the broader credit markets and discuss the record levels of activity we experienced through Q4. In the leveraged loan markets, LCD first lien spreads ended the year 29 basis points tighter than where they started the year, and second lien spreads actually tightened 197 basis points. In Q4, first lien spreads saw a widening of 12 basis points while second lien spreads tightened by 11 basis points. In 2021, new leveraged loan issuance volumes reached a record level of $797 billion fueled by a new high of sponsor-backed middle market M&A volume of $55 billion in Q4 alone and general corporate M&A activity, in part a product of uncertainty from proposed tax changes that likely accelerated strategic plans on the part of business owners, given the robust valuation environment. 2021 saw a continued recovery theme play out for most risk assets. Total return for the leveraged loan index in 2021 was 5.2%, up from 3.1% in 2020. Although 2021 returns were robust, the range of outcomes by sector were once again divergent with cyclicals, such as energy, responding most significantly, and industries with high exposures to negative secular trends such as radio and television weighing down the index. Other sectors, such as equipment leasing, food services and products, and drugs also experienced returns below index average given the impact of supply chain issues and staffing cost pressures that have been a hallmark of the inflationary environment. Despite this, default rates for leveraged credit generally are at historic lows. These impacts meaningfully inform our approach to origination opportunities and reinforce our selective approach to themes and sectors. Understanding the unit economics and cost structures of borrowers remains a core component in our ability to appropriately position our portfolio to be resilient through economic cycles. Turning now to our investment activity, as Josh mentioned, earlier we generated record levels of commitments and fundings and experienced a record level of repayment activity in Q4 2021. As noted in our Q3 2021 earnings release, much of our investment activity was weighted towards the back half of 2021 and this continued with $835 million of commitments and $656 million of fundings during the final quarter. Our deal volume in the fourth quarter spanned across 15 new and four existing portfolio companies. We continued to invest across several themes, including software services given their attractive revenue characteristics and high variable cost structures. For the full year, our commitment and funding levels exceeded our previous record high figures with $1.4 billion of commitments and $1.1 billion of fundings. Total repayments for the year were just over $1 billion, which meant the net portfolio growth of $113 million for the year. To dive into further detail on our Q4 activity, we continued to focus on our specialized sector sub-themes, including software and business services. As we briefly mentioned last quarter, we agented a $975 million first lien loan to Boomey with a $379 million commitment and opportunistically contributed $150 million equity co-invest, both parts of the capital structure being alongside affiliated Sixth Street funds. Boomey’s high-quality scaled recurring revenue base with attractive retention characteristics follows our thematic approach to investing in industries where we have deep understanding and expertise. Other investments in the space during the quarter included Information Clearing House and several of our upsizes to existing portfolio companies, including Higher Logic, Reliaquest, and Piano Software. Outside of software services, our dedicated team of resources provides us the opportunity to diversify our portfolio by investing in other core areas of expertise. We expanded our retail ABL exposure during the quarter through a $300 million first lien term loan to Price Chopper Supermarkets to facilitate a merger with Topps Markets which closed in October. As agent, we committed $200 million across Sixth Street, including $75 million in PSLX and syndicated a portion to a third party, generating a syndication fee of more than $0.01 per share. We also leveraged the Sixth Street platform by working alongside our dedicated energy team to originate a direct to issuer $275 million first lien term loan to TRP Energy during the quarter. While we remain opportunistic to our exposure in the energy sector, this investment presented an attractive risk-adjusted return at the top of the capital structure and an opportunity to deploy capital in the most actively developed basin in the U.S. with low breakeven drilling inventory. At year end, our exposure to the energy sector represented 3.7% of our portfolio at fair value. In addition to macroeconomic factors, we attribute a meaningful portion of our elevated deal activity during the quarter to our relationship with borrowers and sponsors that we’ve built over the years. During the quarter, we leveraged our existing relationship through our commitment to PageUp. PageUp was an existing portfolio company before our investment in Q4, and we were able to benefit from the relationship to agent $190 million senior secured credit facility with speed and certainty of execution. Including upsizes, 28% of aggregate commitments during the quarter resulted from previous or existing portfolio companies. Turning to the repayment side, we had a record activity in Q4 with 10 full and five partial portfolio repayments totaling $528 million. Net portfolio growth for the quarter was $129 million. This robust level of repayment activity driven largely by M&A transactions during the fourth quarter resulted in a contribution to net investment income from activity-related fees of $0.19 per share. Of the $0.19 per share, $0.11 was driven by accelerated OID and $0.08 was driven by prepayment fees. To highlight one of our largest payoffs during the quarter, JCPenney repaid the outstanding balance on its $300 million asset-based FILO term loan with call protection, resulting in a 14.5% IRR. We believe our retail ABL strategy continues to be a core strength of ours as we’ve now generated a gross IRR of 20.4% on fully realized retail ABL investments. In addition to the ABL FILO, JCPenney also repaid the outstanding balance of its $519 million exit term loan during the quarter. As a reminder, in connection with JCPenney’s emergence from bankruptcy in December of 2020, our pre-petition term loan and notes were converted to non-interest paying instruments with rights to immediate and future distributions in cash and other instruments, including the exit term loan and the earn-out co and propco interest. Separate from the ABL and FILO, we have generated a 32.6% IRR and a 1.36x MLM from the combined impact of our JCPenney securities. As of December 31, 2021, investments in our retail ABL strategy comprise approximately 7.2% of our investment portfolio at fair value. Consistent with our investment philosophy in prior quarters, we have been selectively making equity co-investments alongside our debt positions, such as our investment in Boomey, as previously mentioned. During the quarter, we generated $22.4 million of realized gains at our equity investments, primarily in Nintex, Motus, Riskonnect, and EMS Linq. These positions generated an average MLM of approximately 5x based on our capital invested. From a portfolio yield perspective, funding and repayment activity this quarter has a slight positive impact to our weighted average yield on debt and income producing securities at amortized cost. Yield remained flat at 10.2% quarter-over-quarter and is on par with what it was a year ago. The weighted average yield at amortized cost on new investments, including upsizes this quarter, was 9.8% compared to a yield of 9.6% on exited investments. Our ability to maintain these yield metrics reflects our continued selectivity and our origination approach across themes and sectors. Moving onto the portfolio composition and credit stats, this quarter our portfolio equity concentration came down slightly to 6% on a fair value basis from 7% in Q3, and up about two percentage points from a year ago. The year-over-year increase is primarily driven by the increase in fair value of our existing equity positions given net new fundings in equity positions during the year were relatively flat. Across our core borrower from whom these metrics are relevant, we continue to have conservative weighted average attach and detach points of 1.0 times and 4.5 times respectively, with their weighted average interest coverage remaining relatively stable at 3.0 times. As of Q4 2021, the weighted average revenue and EBITDA of our core portfolio companies was $114 million and $32 million respectively. Finally, the performance rating for our portfolio continues to be strong with a weighted average rating of 1.13 on a scale of 1 to 5, with 1 being the strongest. We continue to have minimal non-accruals at 0.01% of the portfolio at fair value across two portfolio companies. With that, I’d like to turn it over to Ian to cover our financial performance in more detail.

Thank you, Bo. As Josh and Bo mentioned, we finished the year with a strong quarter from an earnings and investment activity perspective. In Q4, we generated net investment income per share of $0.63, resulting in full year net investment income per share of $1.97. Our Q4 net income per share was $0.57, resulting in full year net income per share of $2.93. As Josh noted, we accrued $0.19 per share of capital gains incentive fees in 2021; however, none of this amount was payable at year end. Excluding the $0.19 per share that was accrued this year, our adjusted net investment income and adjusted net income per share for the year was $2.16 and $3.12 respectively. At year end, we had total investments of $2.5 billion, total debt outstanding of $1.2 billion, and net assets of $1.3 billion or $16.84 per share, which is prior to the impact of the supplemental dividend that was declared yesterday. Following this quarter’s net funding activity, our ending debt to equity ratio was 0.95 times, up from 0.9 times in the prior quarter; however, due to the quarter end timing on a number of fundings, our average debt to equity ratio decreased slightly from 1.01 times to 0.99 times quarter-over-quarter. For full year 2021, our average debt to equity ratio was 1 times, up from 0.91 times in 2020 and well within our previously stated target range of 0.9 to 1.25 times. Our liquidity position remains robust with $1.2 billion of unfunded revolver capacity at year end against $156 million of unfunded portfolio company commitments eligible to be drawn. Our year end funding mix was represented by 74% unsecured debt and our weighted average remaining life of debt funding was 3.6 years compared to a weighted average remaining life of investments funded by debt of only 2.4 years. Consistent with our historical cadence, we expect to amend our existing credit facility in early 2022. Looking across our debt maturities, we have approximately $100 million remaining principal value of 2022 convertible notes that will mature in August of this year. Similar to our approach on the early conversion on a portion of these notes last year, in accordance with the requirements under the indenture, we announced to holders earlier this year that we will be settling our 2022 converts with primarily stock and a small portion of cash, creating an equity issuance in Q3 2022 related to the remaining principal outstanding. We would expect the conversion to be marginally accretive to NAV per share at the time of conversion. We will continue to assess the impact of the settlement of the converts on our leverage and return profile and look for ways to optimize ROE through the same tools we’ve used in the past, including through the use of special dividends. Given interest rates are clearly top of mind for many of our constituents, I’d like to hit on the Fed’s latest guidance, specifically the expectation for the forward yield curve. At the time of our Q3 2021 earnings call in November last year, we didn’t expect reference rates to reach the average floor levels of our debt investments until Q4 of 2023. We now expect reference rates to return to our average floor level of 1.08% during Q2 of this year. Given that 98.9% of our debt investments are floating rate in nature and 53% of our portfolio is funded with equity, a rising rate environment provides an earnings tailwind for our business once we reach our average floors. To give an illustrative example of the impact once we reach our floors, assuming our balance sheet remains constant as of Q4 2021, for every 100 basis point increase in rates, we would expect approximately $0.14 per share of uplift to annual net interest income. Again, in a rising rate environment, the sooner rates rise through our floors, the sooner we will benefit from this positive asset sensitivity of our matched floating rate exposures. Conversely, to the extent expected rate rises take longer to reach our floors, we anticipate a potential negative impact to net interest income. Moving to our presentation materials, Slide 10 contains this quarter’s NAV bridge. Walking through the main drivers of NAV growth, we added $0.63 per share from net investment income against our base dividend of $0.41 per share. There was a $0.40 per share reduction to NAV primarily from the reversal of net unrealized gains on our equity positions as we booked these gains as realized upon sale. There were minor impacts from changes in credit spreads on the valuation of our portfolio and there was a positive $0.07 per share impact from the early conversion of a portion of our convertible notes and the impact from our dividend reinvestment plan. Finally, there was a $0.39 per share positive impact from other changes, primarily realized gains on investments of $0.31 per share. A large portion of this was driven by our investments in Nintex, Motus, Riskonnect, and EMS Linq, as Bo mentioned earlier. Slide 11 contains an NAV bridge for full year 2021 for your further reference. Moving onto our operating results detailed on Slide 12, total investment income for the quarter was $78.3 million, up 10% compared to $71.2 million in the prior quarter. Walking through the components of income, interest and dividend income was $61.8 million, up slightly from the prior quarter. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were $14 million, up from $10 million in the prior quarter due to higher portfolio repayment activity. Other income was $2.6 million, up from $1.8 million in the prior quarter. Net expenses excluding the impact of the non-cash accrual related to capital gains incentive fees were $32.5 million, up slightly from $31.2 million in the prior quarter. This was primarily due to higher incentive fees from this quarter’s over-earning. There was no waiver of management fees during Q4 given this quarter was below the one times threshold. As Josh mentioned, during the year we’ve generated a return on equity on adjusted net investment income of 13.6%. For a year of record fundings that were met with heavy repayment activity, we managed to increase our average financial leverage year-over-year to one times and we exceeded our full year 2021 beginning year ROE on adjusted net investment income target of 12%, or $1.90 per share. Further, net realized and unrealized gains on our investments contributed to a record high ROE on adjusted net income of 19.7% for 2021 compared to 15.9% in 2020. As we look ahead to 2022, based on our expectations for our net asset level yields, the movement in reference rates, cost of funds, and financial leverage, we expect to target a return on equity of 11% to 11.5%. Using our year-end book value per share of $16.73, which is adjusted to include the impact of our Q4 supplemental dividend, this corresponds to a range of $1.84 to $1.92 for full year 2022 adjusted net investment income per share.

Thank you, Ian. Before we wrap up, I’d like to take a moment to reflect on our business performance, starting with the beginning of the global pandemic nearly two years ago. The pandemic created an unprecedented environment for all of us, presenting one of the toughest challenges our business has faced to date. The immediate and uncertain economic downturn that began in Q1 2020 truly tested the resilience of our business and the principles guiding our operations. Throughout 2020, we aimed to communicate our approach to managing our inherently fragile asset base by building a robust business model and developing principles to address volatility and uncertainty. This included investing in high-quality sectors with a selective approach towards financial sponsors and management teams, enhancing the strength of our balance sheet by converting fixed-rate liabilities to floating-rate ones, ensuring liquidity options, and maintaining leverage levels significantly below regulatory limits. Our objective during any market dislocation is to position ourselves not only to withstand volatility but also to grow and create value. Looking back, we believe we successfully achieved this goal, allowing us to be proactive during a time of disruption. Over the past two years, we are proud to report that we have generated an average annual economic return of 17.5% for our shareholders, significantly above industry averages and higher than our historical average annual economic return of 12.2% since our IPO. We think our performance demonstrates the effective implementation of our framework and principles. For those who have reviewed our presentation, we added a new slide today that illustrates the consistency and resilience of our returns since our IPO almost eight years ago. This slide presents key return metrics based on return on equity using adjusted net income and from an economic perspective, which includes net asset value per share plus dividends. While I've already discussed our performance, I want to highlight the strength of our returns during this period, with adjusted return on equity of 15.9% in 2020 and 19.7% in 2021. Although our BDC peers have reported solid returns for 2021, they came off a notably weak prior year where their average return on equity was below 1%. Our ability to navigate through economic cycles is a key factor in how we generate returns for our shareholders. Ian has already shared our financial performance expectations for 2022, but I'd like to add that we are optimistic about the opportunities ahead. We continue to see limited yield compression in our assets and anticipate low credit losses thanks to our disciplined investment selection and the health of our existing portfolio. We also begin the year with substantial liquidity and the capacity to increase return on equity through financial leverage, in line with our target leverage ratio. In closing, I want to express our excitement about returning to a more normalized post-COVID environment as we progress through 2022. From a work perspective, the Sixth Street team officially returned to the office earlier this year, with our New York team in a new location, and it’s incredibly motivating to reconnect in person. To my colleagues and partners, both internal and external, we look forward to experiencing 2022 together in person. Thank you for your time today. Operator, please open the line for questions.

Our first question comes from Finian O’Shea with Wells Fargo Securities. Your line is open.

Hi everyone, good morning. Josh, on the outlook for earnings, you touched on higher average leverage helping you more recently this year and such. Can you talk about the outlook to keep running at these levels, if your origination footprint or if it’s the overall private market activity lifting things up here?

Thank you, Finian. In response to your question, our outlook on earnings remains consistent with what we've historically experienced since going public in 2015, which has typically been in the range of 10.5% to 12%. We are currently facing two main factors: slightly higher leverage than in the past, but in a much lower interest rate environment, which means we are actually achieving a higher return on equity compared to historical levels. As for our increased origination footprint, this year has seen record origination of over a billion dollars. With slightly rising rates, I anticipate that activity and portfolio turnover may decrease somewhat. However, I feel optimistic about the upcoming year because we have a surplus of capital and liquidity to take advantage of the investment environment. With lower portfolio turnover, as we do not rely on origination for our economic gains, we can maintain a bit more leverage and drive returns that way. Bo and Fishman, do you have anything to add, or Ian?

We remain optimistic about the opportunities available. I agree with Josh that while last year was a strong M&A environment, we expect it to be fairly strong this year, though likely not at the same level due to the interest rate environment. Nonetheless, we are positive about the opportunities and the deals we are currently observing.

Thanks everyone, that’s helpful. As a follow-up, is there any change in the cadence on front end leverage, and can you remind us, I think historically that’s employed on about half of the portfolio names?

Yes, I’ll provide an exact percentage shortly. Our attachment points, which are crucial, have not significantly changed. They have historically ranged from 0.5 to 1 on an EBITDA basis, and we are currently in that range, closer to 1. Overall, our attachment points remain consistent. I will follow up with the specific percentage related to the proportion of our portfolio that has front leverage, but from a risk perspective, those attachment points have not shifted.

Okay, thanks so much.

Thanks, Finian.

Thank you. Our next question comes from Kevin Fultz with JMP. Your line is open.

Hi, good morning, and thank you for taking my questions. The portfolio weighted average EBITDA was $32 million this quarter, which has been trending down in recent quarters. Just curious if that’s driven by finding more attractive opportunities or smaller borrowers, or if it’s being driven by something else you could possibly shine a light on.

Yes, good question, Kevin. I think last quarter it was $37 million. If we look back, in 2019 it was $33 million, in 2018 it was $31 million, and in 2017 it was $25 million, so it seems to be within that range. It also depends on what's included in that core number, which usually represents about 75% to 85% of the portfolio. For instance, we did one second lien this quarter with a much larger EBITDA that wasn't part of that core number. It varies from quarter to quarter, but honestly, our strategy hasn’t changed at all. We're still focused on the same quality and size of companies, for the most part, and the same margin profile, so our underwriting approach remains consistent. I wouldn’t focus too much on the quarter-to-quarter fluctuations since it really depends on what's included in the core number and what's excluded, which has generally stayed in the historical range.

Okay, thanks Josh, that’s helpful. Then just one follow-up, 2021 was clearly an incredibly strong year for deployment and portfolio growth. Can you talk about your expectation for the pace of investment portfolio growth in 2022?

Sure. I think what we’ve modeled is interesting when you consider the economics of our business. Adding assets allows us to generate a higher return on equity due to financial leverage. With increased portfolio turnover and without asset growth, we can still generate more revenue from activity-based fees, such as accelerated original issue discount since we defer all of our OID rather than taking it upfront, along with certain prepayment fees. In terms of our modeling, we estimate a couple hundred million dollars of net portfolio growth, but our confidence in the projected returns is limited. This is primarily because achieving a favorable environment like we experienced last year, which included substantial origination and repayment activities, can lead to a boost from higher leverage along with increased activity levels and fees. That's what drives exceptional years. However, we feel fairly confident about our return levels for this quarter and this year.

Great, that’s helpful color. I’ll leave it there. Congratulations on a really nice quarter.

Thanks.

Our next question comes from Melissa Wedel with JP Morgan. Your line is open.

Good morning everyone, appreciate you taking my questions today. Many of them have actually been asked already, so hoping that we could turn to a couple of new investments. It looks like in the human resources space, there were a few new holdings listed, if I’m looking at this right - Employment Hero holdings and PrimePay intermediate. Was hoping we could walk through those briefly, and maybe you could talk about the opportunity there and the resilience of those businesses as you see it.

Yes, I’ll hand it over to Bo. Thank you for that question. Generally, software businesses in the human resources sector operate on a B2B basis, so Bo can elaborate on this. My guess is that Employment Hero is one example, and PageUp might be another.

Yes, I think that’s it exactly, I think PrimePay would be tangential. That’s a sector that we’ve been quite active in over the past decade. Obviously as businesses continue to digitalize and manage their businesses, HR is an important function for back offices, so these businesses, including Employment Hero, which is an Australian-based company, really help with the onboarding, the hiring, and tracking of employees through the system with a very tight labor market. It’s imperative that these companies do this in a fashion that is more constructive than in the past, so again it’s a sector that we really like. As it relates to Employment Hero, this is a low leverage security with high return on invested capital and really good retention rates, so that’s really where we’re focused on these. They really become mission-critical functions for the human resources departments, and again highlighted in an environment where a tight labor market, it’s really important for people to be agile with their technology solutions. That was across all of those investments that we made this quarter.

Okay, thanks for that. As a follow-up, could we get an update on American Achievement? It looks like maybe that one had a little bit of a markdown further in the fourth quarter. Thank you.

Yes, thank you. American Achievement was a relatively small investment. It was affected by COVID and is around $18 million, if I recall correctly. They operate in the yearbook, class rings, caps, and gowns sector. Unfortunately, they missed the selling season in 2020, but we expect 2021 to be better. The good news is that the industry structure is quite solid with only a few key players, so we hope it will bounce back to approximately pre-COVID levels. However, it has faced challenges due to COVID and its seasonal nature, but it's still a minor position for us.

Thanks Josh.

Thank you. Our next question comes from Kenneth Lee with RBC Capital Markets. Your line is open.

Hi, good morning, and thanks for taking my questions. Wonder if you could just share with us any updated thoughts around opportunities for more junior capital structure investments. I see you touched upon equity coinvestments in the prepared remarks, just wanted to see what the opportunities are over the near term. Thanks.

Yes, like we’ve already said, we’re going to be opportunistic in capital structure investments we make, probably our first pure second lien investment in a long time this past quarter in a software name with a sponsor we knew very well that came along with an equity coinvest. We’ve got a great track record on our equity coinvest program. I think Bo mentioned, I think realized investments this quarter was five times their money on realized equity coinvest, so we’ll continue to be opportunistic. The environment is, quite frankly, obviously an interesting environment, which is valuations have come up, people might think that’s an opportunity, people might think that’s a risk. On high-quality businesses, we’d probably think that’s an opportunity, and the interest rate environment, so we’ll keep focused on what we do, which is investing in high-quality businesses that can pass along pricing to their customers, but we’ll be opportunistic. Bo, any comments?

No, the only thing I’d say, if you look at the equity coinvest levels over time, that really hasn’t changed. We’ve always kind of picked our spots and made investments, particularly in areas that we had strong thematic views that we thought could be supplementary to our returns on the debt piece, but that level of activity really has not changed over time. We’ll continue to be opportunistic and, again, focus on those opportunities where they’re available to us in sector themes that we’ve been following and feel like we have a real view on.

Great, that’s very helpful. Just one follow-up, if I may. On the liability side, especially in the context of a potentially rising rate environment, I wonder if you could just talk about how you see the funding mix or position, and whether there could be any potential over the near term. Thanks.

Yes, I'll start and Ian can pick up. We have always held the view that we match our assets with our liabilities, which means in a rising rate environment, our portfolio generates more income. Half of our book is effectively funded with fixed rate liabilities in the form of equity, which have a fixed rate dividend profile, so the payout ratio should increase accordingly. However, we do not make a significant directional call on rates beyond how we are positioned, given the nature of our equity book. We have always swapped our liabilities, and we will certainly continue to do so. This is important because in a downturn, like in 2020, we actually experienced net interest margin expansion despite the industry's risk of rising credit costs. We want to avoid having a fixed rate liability profile where, during an economic downturn, rates drop to zero, resulting in reduced income and even larger credit costs, which would be worse. Therefore, we will likely maintain our current profile, and our book's floating rate nature indicates that there is inherent asset sensitivity. Ian, do you have anything to add?

No, the only thing I would add is that we’ve committed to the investment-grade market and have made a focused effort to shift our funding profile more towards the unsecured side over the past four years. We are pleased with this market and believe we can efficiently issue in it. However, we still have the flexibility of our existing revolver capacity, which we've built up over the last two years. While the mix will remain varied, I believe the current mix of about 75% unsecured is a solid indication.

Yes, the final point I want to make is that we believe our strength lies in underwriting unique credits and investing in corporations and their capital structures. While macroeconomic factors play a role, we primarily focus on an individual basis. We do not usually take directional positions on rates, as that is not part of our core strategy. Historically, this approach has placed us in competition with central governments and policymakers, and it can be a challenging business.

Got you, great. That’s very helpful. Thanks again.

Thank you. Our next question comes from Ryan Lynch with KBW. Your line is open.

Good morning, Josh, Ian, and Bo. Congratulations on a strong quarter and an impressive 2021. I wanted to discuss your comments regarding market activity and the outlook for originations because 2021 was such a strong year for you and the market overall. However, as we move into 2022, it seems that the advantageous trends and pent-up demand may have lessened, especially with rising rates potentially affecting valuations for some sponsor-backed businesses, possibly making them less willing to engage in transactions. Your business focuses a bit more on specialty lending, so I'm curious about your perspective on the outlook for the pipeline and the potential for portfolio growth in 2022.

Thank you, Ryan. It really depends on the specific line of business we’re discussing. We operate several lines, including the sponsor and non-sponsor businesses, and we also engage in more opportunistic lending, which involves good companies with poor balance sheets or weak business models that still have valuable assets, like our Asset-Based Lending. We have a diverse portfolio in what we do. Given the current valuation environment, companies that previously raised equity at high valuations are likely less inclined to do so now, which might boost activity in a lower valuation context. I recently read about large players in later-stage growth equity who are becoming more cautious, which could benefit our business. While buyouts and M&A activities may decrease, we have a strong origination platform. When assessing growth, it’s essential to consider net originations since net funding drives our economics. Additionally, one of the tailwinds we may experience is reduced portfolio turnover. I'm confident in the broad range of skills we possess across various types of deals. Even without the benefit of robust M&A activity, lower portfolio turnover suggests we can grow our net book, and we're observing interesting developments this quarter. Bo?

Yes, we’ve got a handful of interesting things that we’re working on in kind of a normal environment in Q1, where you’re rebuilding the pipeline from an M&A perspective. I agree with everything Josh said, which is if you look at historically over time, we’ve generally had a two-thirds to one-third ratio of sponsored to non-sponsored deals as we have other core sectors, such as Farmer Royalty, energy, that go direct to company quite often. Having that diversified stream of pipeline opportunities has helped us over time go through cycles where there’s less M&A. I would agree with you - we probably are going to see less M&A this year, that’s what we’re forecasting. However, I think we do have a large portfolio that we’re still going to do add-ons, you’ll have the ability to grow the existing portfolio from there, and then as Josh mentioned, lastly kind of the late-stage growth businesses, we have raised equity capital that’s been very cheap over the last couple of years. That’s going to become more difficult and they’re going to have to look to other solutions, such as credit solutions to continue to fund their businesses, which still have pretty robust unit economics in this environment.

That's really helpful information. As I look ahead to the year, it seems you have a significant deleveraging event approaching in the third quarter, as you've mentioned, and the specific amount may not be finalized yet since it involves a mix of cash and stock, but likely more stock with the convertible. Is your intention to increase leverage leading up to that deleveraging event, and does your co-investment policy allow for a larger allocation to TSLX compared to other funds, especially considering that this event is upcoming?

Yes, it’s a great question. You’re talking about the equity, settling the convert with that $100 million, roughly $100 million outstanding? What I can say is that we are not planning to raise equity moving forward. We have the capacity to increase our leverage. On the co-investment side, our primary focus for middle market specialty lending has always been SLX. We determine our investment sizes based on risk tolerance and business needs, so that is definitely an option. Additionally, we still have around $0.42 or so of spillover income, which allows us to effectively manage leverage and economics in the business through special dividends. We either aim to grow our portfolio and maintain our target leverage ratio with the additional $100 million of equity, or we can also create economic leverage in the portfolio through return of capital, which is something we haven't fully explored yet.

Okay, understood. Makes sense. Appreciate the time this morning.

Thanks, Ryan.

Thank you. As a reminder, if you wish to ask a question at this time, please press star then one on your touchtone telephone. Our next question comes from Robert Dodd with Raymond James. Your line is open.

Hi everyone, congratulations on the quarter and on 2021, and frankly on having a six-year track record where the lowest ROE you generated is 11.6%, which kind of brings me to my question. How much faith, bluntly, should we have in your guidance of 11% to 11.5%, when the only times it’s only been that low were in 2014, 2015 when you were under-levered and had one-time expenses? Can you walk us through a little bit what are the assumptions that lead to the lowest expected ROE in six years for the business?

That’s a great question, Robert. I believe we’ve provided the same guidance consistently every year. Imply what you want on that, but we've maintained the same guidance. The 11% to 11.5% return on equity is more challenging in a lower interest rate environment, which actually offers a greater value proposition to our shareholders considering the current rates. When examining activity level income, we model our business using those ROEs with very low activity level income. Last year, we projected only about $0.18 per share, and if you look back, our ROEs were in that same range of 11% to 12%. This included approximately $0.18 per share in accelerated original issue discounts and prepayment fees, along with another $0.10 in amendment fees and other income, totaling about $0.28 per share in non-pure interest income. The actual results came in around $0.58 per share in those categories. Historically, our lowest year with similar levels was in 2016, at about $0.26 per share. We generally model very conservative levels of contribution from non-interest income, which is why we consistently outperform our ROE range. This conservative approach to modeling the business accounts for credit losses, activity levels, and effective communication, all of which have historically driven our performance outcomes.

Got it, I appreciate that you do tend to repeat the guidance. The other topic, structuring or structures available in the market right now, you have tended to focus on ensuring that you have core protection in your structures. It’s a very competitive market out there, as we know. It certainly looks from the figures on Page 5 of the presentation that you’re still able to structure those deals the same way, with a lot of potential core protection still in them. Do you expect that to change in terms of if the market remains this competitive, is the ability to structure with that kind of potential embedded fee income going to persist, or do you think that’s going to over the next year?

I would say the environment has become more competitive. We do a pretty good job, as about 90% of our portfolio has call protection. I'll provide the exact figure for call protection later, but we still maintain a significant amount. We concentrate on areas where we can add value to clients, in industries we understand, which often leads us to get the last look. This includes selling off revolvers and some first-out items, which definitely enhances our capital efficiency and the call protection we can achieve. Currently, about 85% of our portfolio has call protection, which aligns with historical figures. In a competitive environment, our portfolio yields have remained stable on a vintage-by-vintage basis. Bo, do you have anything to add?

What I would say is it’s been an intensely competitive environment over the last two to three years. We have not seen an acceleration of that over the last three to four quarters - it’s remained intensely competitive. We haven’t seen stark changes in deal terms, our ability to get call protection and other features, such as covenants that protect us and our investors. That has not changed. We continue to pick our spots, generally play in areas that we’re bringing more to the table than just capital, have some expertise, can provide certainty, and that allows us to be a value-add and it gets to some of these call features that we think are an important part of the fixed income book.

Yes, and I’ll point you to one place in the earnings deck that I think will be helpful to quantify this, which is on Page 8 of the earnings presentation. We lay out the fair value as a percentage of call price, so that kind of gives you an estimate of how much upside’s in the book if it gets called away. I think the fair value today is 95.2% of the call price of our book. It was 96.7% last quarter, so there’s actually more embedded economics in the book, and that’s ranged from 94.6% a year ago to 95.2% today, so it’s kind of in the range.

Yes, that was the number I was actually referring to, I meant Page 8, not Page 5. That’s the point, right - this includes this quarter versus last quarter in this competitive environment.

That’s a mix issue, because call protection is a declining asset, and so the portfolio turnover, and there was new vintage stuff as a higher percentage of our book which you would expect has more call protection, so that’s a bit of the kind of the mix issue.

Got it, thank you.

Thank you, and I’m currently showing no further questions at this time. I’d like to turn the call back over to Josh Easterly for closing remarks.

Sure. I want to revisit Fin's question. Regarding the mix of first out and last out, it has consistently been around 40/60 to 60/40, and we are currently within that range. Specifically, it's 43% first liens and 50% last out, so that mix hasn't changed. I also want to highlight that 2021 was a strong year for Sixth Street and our direct lending business, but I believe 2020 was even better since we achieved significant returns in both years. I'm very proud of our team. I'm looking forward to seeing everyone in the spring and hope you enjoy your President's Day weekend. This is the first time we’ve held our earnings call before that weekend, so enjoy it, and we appreciate your support. Ian, Cami, Mike, and Bo are here for any follow-ups. Thank you.

Thanks everybody.

This concludes today’s conference call. Thank you for participating. You may now disconnect.