Sixth Street Specialty Lending, Inc. Q2 FY2022 Earnings Call

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 and 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. 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 second quarter ended June 30, 2022, and posted a presentation to the Investor Resources section of our website. The presentation should be reviewed in conjunction with our Form 10-Q 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 second quarter ended June 30, 2022. 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 provide highlights for this quarter's results and then pass it over to Bo to discuss this quarter's origination activity and portfolio. Ian will review our quarterly financial results in more detail. I will conclude with final remarks before opening the call to Q&A. In addition to today's earnings call, earnings press release, investor presentation and Form 10-Q, we also published a letter outlining a number of perspectives we thought would be valuable to our stakeholders. Consistent with our approach to provide additional communication during the first few months of the pandemic, we wanted to share our framework to continue the confidence our stakeholders have placed in the stewardship of their capital. Given the outsized impact of the macroeconomic environment on markets and their forward business, we thought it would be helpful to take the same approach with this quarter's earnings release. We encourage and welcome any feedback. After market closed yesterday, we reported second quarter financial results with adjusted net investment income per share of $0.42, corresponding to an annualized return on equity based on that adjusted net investment income of 9.9%. Inclusive of marks in the fair value of our investments, we also reported adjusted net loss per share of $0.30. Our adjusted net loss per share this quarter was driven overwhelmingly by unrealized losses as we incorporated the impact of wider market spreads on the valuation of our portfolio. Given this impact on our financial results, I'd like to spend a moment on the importance of our quarterly valuation framework. As we said before, we believe that an intellectually honest framework for portfolio valuation is the bedrock for effective risk management. In determining fair value of assets at a moment in time, using inputs from the market is critical. As a result, we have incorporated the impact of market spread movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors specific to each investment. One of our most important jobs is capital allocation, and this cannot occur without marking our assets appropriately. We will continue to follow this framework as we have since inception and we're confident it allows us to make sound investment and risk management decisions based on the market signals. We've weighed out our framework more extensively in the letter I mentioned earlier. Our investment income reflected a period where our results were driven by the core earnings power of our portfolio with little contribution from activity levels driving other income. 93% of this quarter's total investment income was generated through interest and dividend income compared to 85% across 2021 and 79% across 2020. The anticipated positive asset sensitivity of our portfolio, combined with more normalized activity levels driving other income should further supplement our earnings results for the remainder of the year, providing support for an increase in our base dividend level, which I will discuss in a moment. Unrealized losses during the quarter resulted in a partial unwind of previously accrued capital gains incentive fees that we have discussed in prior quarters. Given this unwind is tied primarily to unrealized gains from our investments, consistent with how we've treated this line item in prior periods, we've adjusted this quarter's results to exclude the impact of this noncash expense reversal, which was approximately $0.12 per share. Reported net investment income and net loss per share for Q2 were $0.54 and $0.18, respectively. Due to the strength of our historical credit performance and generating cumulative net realized gains in excess of unrealized losses, the remaining $0.09 per share of capital gains incentive fee on our balance sheet will continue to provide a cushion to any negative impact of market spread movements on net asset value. At quarter-end, our net asset value per share declined by approximately 3.4% from $16.84, which includes the impact of the Q1 supplemental dividend, to $16.27. As discussed, the primary driver of this decline was $0.66 per share of unrealized losses from the impact of credit spread widening and lower implied equity values on the valuation of our portfolio. Note, this approach to incorporate credit spread movements within our valuation framework follows the fair value requirement for BDCs under the Investment Company Act of 1940 and is in accordance with GAAP. Ian will walk through the other drivers of this quarter's net asset value bridge in more detail. Turning now to a few thoughts on the current market environment. With the possibility of a recession on the horizon, we remain highly focused on our risk management framework to guide our investment and capital allocation decisions. As we address those and other topics in our letter, we'll focus our time today on the impact of rising rates on our income statement. We expect to see meaningful positive asset sensitivity in the back half of the year. The combination of the rising rates in Q2 are now well above our average floor levels on our debt investments and the shape of the forward LIBOR or SOFR curve support that expectation. The rising rates will drive incremental interest income and outweigh the increases in the cost of our liabilities. To date, this has been largely muted because applicable reference rate resets occurred during earlier in the quarter. Based on the shape of the forward curve and reset dates of our issuers, we project the remainder of this year that rate movement loan will result in approximately $0.13 per share of incremental net investment income purely from the core earnings power of the portfolio relative to what we experienced in Q2. In addition, to the extent we see portfolio growth over this period, the core earnings power of our business will be further enhanced. In previous periods of rising interest rates, for example, from 2017 to late 2018, the reality of asset sensitivity has been called in question, given the tendency of the BDC sector to sacrifice spread in order to prioritize asset growth. Given the spread environment today, our strong relative capital base and significant liquidity, we are well positioned to retain the asset sensitivity. Ian will provide an update on our full year guidance later on. While we view the rising rate environment in a positive light with respect to our earnings profile, we are cognizant of the impact more broadly on our borrowers of rising rates, coupled with inflationary pressures on import prices and a more challenging operating environment. As Bo will discuss, despite these rising costs, the overall health of our borrowers' financial position remains strong. Based on our updated view of forward earnings yesterday, our Board approved the third quarter base dividend of $0.42 per share to shareholders of record as of September 15, payable on September 30. This represents an increase of $0.01 per share to our quarterly base dividend. There were no supplemental dividends declared related to Q2 earnings based on our formulaic supplemental dividend framework, largely due to lower activity-based fees during the quarter, as mentioned earlier. In a spread widening period where valuations experience downward pressure, the NAV limiter in our framework also serves to retain capital and stabilize net asset value. We would note that following dialogue with and feedback from existing shareholders, our Board approved to change the payment date timing of our quarterly base dividend such that the record date and payment date will occur during the same fiscal quarter. This change has no material impact on our financial results or accelerates the payment of the base dividend by approximately 15 days each quarter relative to our past practice. With that, I'll now pass it over to Bo to discuss this quarter's investment activity.

Thanks, Josh. I'd like to start by layering on some additional thoughts on the broader market backdrop and more specifically, how it relates to the positioning of our portfolio and the way we're thinking about the current opportunities in the market. Although we cannot predict the impact, timing or severity of the Fed's actions on the economy, we feel confident that our portfolio is defensively positioned for a couple of important reasons. First and foremost, we follow a differentiated approach to underwriting, which includes analyzing and understanding, among other things, the unit economics of our portfolio of companies. We are heavily invested in businesses that are characterized by having predominantly variable cost structures, strong recurring revenue attributes, high switching costs and low customer concentration. We believe these fundamental characteristics will be key in the ongoing inflationary environment as we expect companies with pricing power and variable cost structures will be better positioned than those with large exposure to commodities, high fixed costs and limited ability to pass through price increases. Secondly, we remain invested at the top of the capital structure with 90% of our portfolio by fair value in first lien loans. In this environment, with market expectations indicating that credit losses are likely to increase, we feel that our positioning at the top of the capital structure in definitive industries will serve to preserve our capital and support our robust return on equity profile. Our top 2 industry exposures are business services, followed by financial services at 14.7% and 11.5% of the portfolio at fair value, respectively. Note that the vast majority of our exposure to financial services are B2B integrated software payment businesses with limited financial leverage and underlying bank regulatory risk. While we present our industry exposures based on the end market that our borrowers serve, from a broader lens, approximately 81% of our portfolio of companies represent software and services oriented businesses with high levels of recurring revenue and resilient business models. Retail ABL exposure remained relatively low at 5.9% of our portfolio on a fair value basis at quarter-end. However, we expect the inflationary environment and high rate environment will likely create interesting opportunities for us to become more active in the space. Now I want to spend a moment on how we're viewing investment opportunities and portfolio activity against the current market backdrop. During the quarter, high yield and broadly syndicated loan markets were mostly on the sidelines given the environment. Although liquid markets were quick to react, the private markets have been much slower to reprice and largely remain in a period of price discovery between buyers and sellers in terms of valuation. We anticipate there will be more opportunities to provide direct lending solutions as sponsors remain active in looking to deploy capital as well as privately held companies looking to bolster their balance sheets. Our omnichannel approach to sourcing is critical in driving these opportunities. With the potential for increased deal flow in the second half of 2022, we continue to be very selective with our investment opportunities and have set a high bar for allocating our capital during this period. As we've said in the past, our primary priority is generating attractive risk-adjusted returns for our shareholders, which requires us to be disciplined in our approach to deploying capital. As it relates to the portfolio activity, we had $379 million of commitments and $325 million of fundings across 8 new investments and upsizes to 2 existing portfolios of companies during the quarter. Consistent with our focus on maintaining a defensive portfolio, our 2 largest investments, CrunchTime and Merative, were in software services companies with deeply embedded underlying products, resulting in high-quality recurring revenue basis. CrunchTime was a first lien term loan where our relationship with the company from a previous successful investment that we exited in 2017 allowed us to act quickly to support the acquisition of Zenput, a highly complementary business to CrunchTime's enterprise management solutions. As for our investment in Merative, formerly known as IBM Watson's Healthcare business, we partnered with Francisco Partners to provide funding for a complex transaction involving the carve-out of certain software assets. We leveraged the power of the Sixth Street platform as well as our deep relationship with the sponsor to provide financing in the form of a senior secured credit facility to support the acquisition and carve-out with speed and certainty of execution. Both of these investments follow our thematic approach of underwriting the underlying sectors and industries that we believe are defensive and stable in the current environment. Notably, although we only closed the Merative transaction at the end of June, pricing in terms of this transaction was agreed to back in February, and it was that date that becomes a reference date for determining the impact of spread movements through the end of Q2. While there's been no deterioration in performance, that approach has resulted in an unrealized loss on the name of the loan for a fair value determination of approximately $0.02 per share in Q2. Other new investments during the quarter include several new deals and upsizes to existing portfolio of companies such as Staples as well as investments in the energy space to merchants in oil and gas, which increased our energy exposure to 3.2% of our portfolio on a fair value basis as of the quarter end. Similar to prior periods of market volatility, we made purchases of BB and BBB CLO liabilities, which comprised approximately $29 million of fundings during the quarter. As one of our core opportunistic investment themes, at certain moments in time, these investments present an efficient use of capital on their return profile. We purchased these securities at a significant discount to par with a yield to 3-year recovery of approximately 12.5% with significant subordination to protect against future credit losses. We believe our expertise in the structured credit market further highlights the benefit of the broader Sixth Street platform in terms of providing TSLX with differentiated deployment opportunities especially in times of market dislocation. Moving on to the repayment side, there were $212 million of paydowns across 6 full and 1 partial investment realizations. Of the 6 full repayments, 2 were paydowns driven by refinancings, which we participated in, thereby offsetting the paydown with subsequent new fundings during the quarter. Although the repayment activity in Q2 was in line with historical averages, the vast majority of our paydowns occurred during the first month of the quarter. As spreads widened more meaningfully in the back half of Q2, we saw a slowdown in repayments resulting in lower activity-based fees. For reference, 65% of repayment activity during the quarter occurred in April. Our largest payoff, Illuminate, occurred on April 1 and represented 30% of total repayment activity. This investment generated an 11.5% IRR and a 1.5x MOM during the whole period of 4.6 years, reflecting the older vintage nature of the payoffs in Q2 resulted in limited OID in the quarter's net investment income. Supporting the performance of our portfolio this quarter was the announcement on May 10 of Pfizer acquiring all the outstanding shares of Biohaven. Our weighted average mark on Biohaven increased from 104% to 111% during the quarter, reflecting the impact of the anticipated fees embedded in our underlying exposure to the portfolio of companies. While incorporated in the Q2 fair value mark, the expected fees will eventually flow through investment income at the time of payoff, resulting in the crystallization of activity-related fees, increasing our capital base and creating incremental investment capacity for new deployment opportunities. Our weighted average yield on debt and income-producing securities at amortized cost was up to 10.9% from 10.3% quarter-over-quarter and is up about 80 basis points from a year ago. The weighted average yield at amortized cost on new investments, including upsizes this quarter, was 10.1% compared to a yield of 9.5% on exited investments. Moving on to the portfolio composition and credit stats. Across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attach and detach points on our loans of 0.8x and 4.6x respectively, and their weighted average interest coverage remained relatively stable at 2.6x. As of Q2 2022, the weighted average revenue and EBITDA of our core portfolio of companies was $140 million and $34 million, respectively. The performance rating on 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, representing no change from the prior quarter. We continue to have minimal nonaccruals at less than 0.01% of the portfolio at fair value with no new names added to nonaccrual during Q2. The stability of these metrics quarter-over-quarter illustrates there has been no deterioration in the underlying credit quality of our portfolio. While historical data is important, we recognize what really matters is future performance. We believe we've done a good job positioning our portfolio to date, but as always, time will tell. Finally, the strong pipeline that we referenced during our last earnings call continues to provide us with attractive deployment opportunities. Given our strong liquidity and capital position, that is true to be a competitive advantage relative to peers that operated with higher levels of financial leverage. We expect this aspect to extend in the current period of volatility as access to capital may become more constrained.

Thank you, Bo. For Q2, we generated adjusted net investment income per share of $0.42 and adjusted net loss per share of $0.30. At quarter end, total investments were $2.5 billion, up slightly from the prior quarter as a result of net funding activity, partially offset by the impact of lower valuation marks on our portfolio. Total principal debt outstanding at quarter end was $1.3 billion and net assets were $1.2 billion or $16.27 per share. Our average debt-to-equity ratio decreased slightly quarter-over-quarter from 0.95x to 0.9x, and our debt-to-equity ratio at June 30 was 1.06x, up from 0.91x at March 31. The decrease in our average debt-to-equity ratio was driven by repayment activity in the beginning of the quarter, with leverage dropping to a low of 0.86x in April. As Bo mentioned, we saw a pause in repayments in the latter half of and increased fundings during the last few weeks of the quarter, resulting in a higher reported leverage metric at June 30. More specifically, net funding activity in isolation would have resulted in a leverage ratio of 1.02x at quarter-end, with the delta to our reported quarter-end figure of 1.06x being the impact of valuation marks on our investment portfolio. Before turning to our results, I would like to reiterate the strength of our liquidity, funding profile and capital position. At quarter end, we had $1.2 billion of undrawn capacity on our revolving credit facility against only $155 million of unfunded portfolio of company commitments available to be drawn based on contractual requirements in the underlying loan agreements. In addition to having significant liquidity, we remain well below the top end of our previously stated target leverage of 1.25x, providing us with the ability to capitalize on attractive investment opportunities for our shareholders. We believe this combination of liquidity and our capital position, which proved its value and importance during the pandemic, positions us well across varying operating scenarios and enhances our competitive positioning. Our capital allocation framework remains top of mind for us as well given current market dynamics, and we've elaborated on this subject in our letter. As it relates to our debt maturity profile and any impact on liquidity, the remaining principal value of our convertible notes settled on Monday, August 1, with no material impact on our liquidity. As mentioned in prior quarters, earlier this year, we elected to settle the converts primarily with stock, resulting in an equity issuance earlier this week of approximately 4.4 million shares. Close to 80% of the outstanding principal amount was settled in stock and the corresponding equity issuance translated to approximately $0.08 per share of accretion to our net asset value, which will be reflected in our Q3 financial results. This transaction improved our capital positioning by lowering our leverage ratio and increasing our capital base, thereby creating additional capacity to invest in interesting new opportunities as they arise. Quarter-to-date, our net funding of new investments amounts to approximately $145 million. Pro forma for the settlement of these convertible notes early this week and inclusive of the impact of net fundings and broad market credit spread tightening of approximately 50 basis points since quarter-end, we estimate our current leverage is 1.04x, with liquidity of approximately $1 billion. After the settlement of these convertible notes, our funding mix is comprised of 57% unsecured debt and 43% secured debt. Moving to our presentation materials. Slide 8 contains this quarter's NAV bridge. As Josh mentioned, the impact of credit spread widening on the valuation of our portfolio was by far the most significant driver of NAV movement this quarter with unrealized losses of $0.66 per share. Again, absent permanent credit losses, we would expect to see a reversal of these unrealized losses related to credit spreads over time as our investments approach their respective maturities. The estimated impact of broad market credit spread tightening since quarter-end that I referenced earlier represents approximately $0.16 per share unwind of the unrealized losses we saw during Q2. Walking through the other drivers of NAV movement this quarter, we added $0.42 per share from net investment income against the base dividend of $0.41 per share. There was a $0.12 per share uplift to NAV related to the unwind of previously accrued capital gains incentive fees, which Josh also mentioned earlier. And finally, there was a $0.04 per share decline in NAV from the unwind of unrealized gains as a result of paydowns. Moving on to our operating results detail on Slide 9. Total investment income for the quarter was $63.9 million compared to $67.4 million in the prior quarter. Walking through the components of income, interest and dividend income was $59.1 million, up slightly from the prior quarter, driven by net funding activity during Q2. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were lower at $3.2 million compared to $6.9 million in Q1, given the lower impact on income measures from repayment activity that we highlighted earlier. Other income was $1.6 million compared to $1.8 million in the prior quarter. Net expenses, excluding the impact of noncash accrual related to capital gains incentive fees, were $31.4 million, up approximately 5% from prior quarter. The increase in net expenses quarter-over-quarter was primarily driven by the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 2.3% to 3.1%. There is a lag to the impact of rising interest rates on the weighted average interest rate on average debt outstanding and the increase this quarter is largely explained by the movement in base rates from the prior quarter. Before I discuss our guidance for the remainder of the year, noting for those that track this metric, as of the end of the quarter, we estimate that our spillover income per share is approximately $0.56. Year-to-date, through June 30, we have generated adjusted net investment income per share of $0.90, corresponding to an annualized return on equity of 11%. This compares to the target return on equity that we have articulated throughout 2022 of 11% to 11.5% or $1.84 to $1.92 on a per share basis. Based on the impact of the positive asset sensitivity in our business that Josh referred to earlier, resulting in higher anticipated net investment income combined with the strong overall health of our portfolio, we expect to exceed the top end of our target range for full year 2022. With that, I'd like to turn it back to Josh for concluding remarks.

Thanks, Ian. We hope people take the time to read our letter, as we outline what we really think matters in driving shareholder returns. Brevity isn't one of our strengths. We apologize in advance. With a clear understanding of what is important in driving the results of our business, we will continue to create value for our stakeholders and serve our portfolio of companies, management teams and financial sponsor partners with creative financing solutions. In closing, I want to wish everyone a wonderful rest of the summer with their friends and loved ones. With that, thank you for your time today. Operator, please open up the line for questions.

Our first question comes from the line of Finian O'Shea with Wells Fargo.

Can you provide details about the new BDC that Sixth Street has on file? Will it align with the same origination line as what Sixth Street currently has? Will it also align with TSLX? Additionally, how does the investment style compare?

We are limited in what we can discuss due to private placement regulations. However, I can tell you that this investment strategy is quite different from that of Sixth Street Specialty Lending, so there should be minimal overlap. For the last 10 to 12 years since the formation of Sixth Street Specialty Lending, our main focus has been on creating shareholder returns. The direct lending market has expanded significantly, and there are aspects of that market that we cannot engage in given TSLX's capital resources and our reluctance to continuously raise equity. Due to private placement rules, it's challenging to provide more details at this moment. However, I can assure you that this will not affect Sixth Street Specialty Lending's focus or limit its opportunities in any way.

Okay. That's helpful. As a follow-up, one of your BDC peers yesterday lowered its base fee to accrue on NAV essentially instead of assets this week. Seeing if you have any sort of initial thoughts on that, what it might mean for the industry, how you think about it?

I can express my thoughts without being too sarcastic. One point I want to make is that the peer has had a long-standing history of performance issues and has also altered their investment strategy over the years. If you examine the yield on their investments, their debt investment portfolio currently reflects about a 7.7% yield with an effective fee nearing 70 basis points based on the net asset value. Consequently, their net yield before applying leverage or incentive fees stands at roughly 7%, not factoring in other costs. In contrast, looking at our SLF portfolio, our yield based on amortized cost is 10.9%. When applying the same calculations and adjusting for 1.5%, that brings us to 9.4%. Hence, we are still outperforming by 240 basis points before considering aspects related to credit loss. Moreover, we are achieving a significantly higher return on equity while utilizing less financial leverage. They have undergone a strategic shift and have dealt with performance setbacks on the credit side, which is not surprising but may align with their current strategy. Additionally, I found the purchase at NAV somewhat puzzling given that their stock price is considerably below NAV, and since the affiliate is also owned by others, that added another layer of confusion, though I believe there were valid reasons for making that decision.

Our next question comes from the line of Mickey Schleien with Ladenburg.

Good morning, everyone. Josh, in your prepared remarks, you mentioned that you expect your fee income to improve in the second half of the year. Can you help us understand how this reconciles with the rising rate environment? Typically, we would expect rising rates to limit prepayments. Additionally, why was fee income somewhat lower this quarter compared to historical levels?

Yes. First of all, we do not operate a mortgage book. This is relevant to your question about mortgage spreads. However, considering the widening spreads, we don't have a rate-sensitive book regarding prepayments; instead, we have a spread-sensitive book. With spreads increasing, borrowers see limited incentive to refinance, and current valuations in the private markets require time to adjust. Looking ahead, despite the widening spreads, we anticipate M&A activity will rise over time, leading to some churn in our portfolio. However, there is currently a disconnect in valuations in the private markets that is preventing this churn. Additionally, Biohaven, which I cannot address in detail as I'm not part of that management team and the acquiring company is Pfizer, represents a change of control transaction with significant call protection. This will unfold in the upcoming quarters, though I can't specify if it will be in Q4 or later. Overall, we expect M&A markets to improve; while they didn't in Q2, there will be opportunities for certain buyers and sellers to align, resulting in a slight increase in portfolio churn. We will also consider specific items like Biohaven, which we have insights into.

I appreciate that. And I understand. Josh, one last question. If we look at the leveraged loan market sort of as an indicator of where defaults might go, the distressed ratio is a little north of 3%. Looking at your crystal ball out for the rest of this year and going into next year, do you expect defaults to climb to those levels? And how do you expect your portfolio to behave in terms of credit given the trends that we're seeing in the economy?

Mickey, you addressed the point well. In our letter, we indicated that there is no broad-based free ride. We believe our portfolio performs differently in a rising interest rate environment. Rising rates may trigger a default cycle, particularly if we are experiencing stagflation with inflation and low growth. Credit spreads are an indication that the return required to extend credit should be higher due to anticipated defaults and losses. While I cannot predict the exact number, there are multiple ways to assess the situation. Historically, the average single B has experienced a net spread post losses of 200 to 250 basis points, which suggests that we should consider prior losses along with current spreads. Overall, it's clear that defaults and losses are expected to rise, and in the BDC space, investors can only account for net investment income minus realized losses. This is critical. Additionally, our portfolio is positioned defensively, with around 80% concentrated in the top capital structure of business services and software—industries with recurring revenue and variable cost structures, and minimal inputs likely to cause inflation. Thus, we are optimistic about our pricing power. Our portfolio companies address significant and valuable problems for their customers. Year-over-year, our portfolio growth has been about 31%, with a quarterly growth of 7.2%, which annualizes to 28%. Though we are seeing some deceleration, our companies possess various levers to manage costs due to their variable cost nature. Overall, I am confident about our portfolio and the future earning potential of our business in light of rising rates. We have substantial embedded earnings power, as we possess more capital and liquidity that can be leveraged in a better lending environment. I'm feeling enthusiastic about our prospects.

I appreciate that, Josh. Thanks for all the transparency. We certainly appreciate it very much.

Our next question comes from the line of Kevin Fultz with JMP Securities.

You touched on this a bit in Mickey's question. Clearly, portfolio credit quality is in excellent shape with nonaccruals at cost of 0.1%. Just curious from where you sit, Josh, and how you think about things, are there certain verticals that you see as more at risk in the current environment, whether that's due to inflation, labor issues, geopolitical risk or recession fears that you're monitoring more closely as the macro environment continues to evolve?

Yes, that's a great question. We are very optimistic about our portfolio. We have been careful in how we built it, considering the characteristics of the companies and our investment in the capital structure. If we look at the broader context of what's happening in the world, policymakers need to manage inflation. Unfortunately, controlling inflation often means reducing consumer spending. This entails implementing restrictive monetary policy, which decreases disposable income and raises the cost of capital for companies, impacting their investment and hiring decisions. Therefore, we can expect rising unemployment and deteriorating consumer conditions, with reports indicating that consumer and credit card debt have increased. We are in a challenging environment. The crucial question is whether the Fed can navigate towards a soft landing, managing consumer spending without harming the economy too severely. The market is currently assessing this. Our portfolio is primarily B2B, which means we have limited exposure to consumer sectors, particularly outside of asset-based lending. Our cost structure is also not significantly influenced by commodities affected by inflation, so we advise caution regarding low-margin businesses reliant on commodity inputs, as they may lack pricing power. Additionally, businesses closely linked to consumer spending will likely face challenges moving forward. Overall, I feel fairly confident about our portfolio positioning. However, it is important to note that our economy is interconnected, and B2B sectors will also be impacted. Nevertheless, I believe we have a more insulated and defensive portfolio.

Our next question comes from the line of Kenneth Lee with RBC Capital Markets.

Just one on the CLO investments you mentioned. You talked about it being an efficient use of capital. Just wondering whether you could just further flesh out how these investments compare with your more traditional debt investments? And as well, how do you think about the risks, especially under potential macro deterioration compared with most of your other debt investments?

It's a great question. We have maintained this strategy over time, investing significantly in 2015, 2016, during the COVID period, and again in 2018 and 2019 when there was a market disruption due to forced selling influenced by mutual funds. In assessing the loss-taking capacity of those securities, we observe that default rates on broadly syndicated loans are extremely high and likely to remain so for an extended period. While we analyze each portfolio and the underlying assets, it's important to note these assets can change during the initial investment phase. Historically, private loans have provided about a 400 basis point premium over BBB-rated securities and a 200 basis point premium over BB-rated securities. Currently, the spread premium has narrowed to flat or even negative 300 basis points, making the relative value less attractive, with recovery yields in the low teens. We believe investing in CLOs represents a more efficient use of our capital and offers a source of liquidity which private loans do not provide. Our dedicated team is focused on these investments, leveraging our unique insights. We aim to utilize our shareholders' capital effectively to generate total returns, both through spreads and capital appreciation. For instance, purchasing a BBB security at a price of 90 or 89 offers substantial loss-absorption capacity, even in a default scenario. Given that forward losses have been zero for BBBs, even with a 10-point original issue discount and strong spreads, this approach appears to be a clear choice.

Got you. Very helpful there. One follow-up, if I may, just on the valuation changes. It sounds like from the prepared remarks, a lot of it was mainly spread-driven. Wondering how much did the idiosyncratic factors drive some of the fair value changes within the portfolio?

Yes, I would categorize them into two groups. The first group involves broad-based spread movements, and as you know, we also have a small equity portfolio where equity premiums and risk premiums have widened. There weren't any significant performance-related markdowns throughout the portfolio; it's performing well. For the equity instruments we hold, valuations have declined. However, in terms of corporate finance, we should be able to generate returns moving forward from these low valuations, although it's not as clear since equities have longer durations and lack maturity. The second category is related to credit spreads. Frankly, if our views on credit are accurate, all the unrealized losses recorded should eventually reverse, as we will recover our principal at maturity or even before. Therefore, there are no significant performance markdowns in the portfolio; it was primarily due to widening spreads and decreases in equity valuations.

Our next question comes from the line of Robert Dodd with Raymond James.

Thank you for the insights on the NAV and the letter; I find that quite interesting. Moving on to another topic, historically, you have generated significant income from your fee structures and implemented strong call protection in loan agreements. While this may not be the case currently, looking ahead over the next few years, do you anticipate any resistance from borrowers regarding the level of core protection you include, especially given the increasing competitiveness in the private credit market? Or is it more that borrowers might not be particularly concerned since call protection is typically covered by acquirers during M&A transactions?

I believe that the call protection isn't typically covered by the acquirer during an M&A event; it comes from the seller's proceeds. Essentially, that falls under the seller's capital structure, meaning they bear the cost. First and foremost, I think the competitive environment is changing significantly, more so than in the past. This could be due to limited retail flows in the products or borrowers reaching the upper limits of their leverage, leading to reduced capital availability. We've noticed an increase in spreads, which was evident at the end of the last quarter and is reflected in our portfolio, along with broadly syndicated loans. Currently, we are observing rising reinvestment spreads, along with increases in fees and a decrease in leverage. This condition appears to be improving the lending environment. It likely also benefits private equity buyers as they can acquire assets at lower valuations. Overall, lending terms are becoming more favorable to lenders, while buyers are securing better terms due to the shift in valuation dynamics. As for our portfolio's net asset value, a key metric to consider is the fair value related to call protection, which indicates how much is flowing through unrealized and realized gains this quarter. Notably, our markdown was 94.1%, compared to 95.1% last quarter, suggesting that our book is currently the cheapest it has been in the last five quarters I’ve followed it.

Our next question comes from the line of Melissa Wedel with JPMorgan.

I'll reiterate prior comments about just appreciating the shareholder letter that you guys posted with a lot of detail about how you're thinking about the environment. I wanted to follow up on a comment you made earlier about sort of expecting an elevated pipeline perhaps in the second half. And I wanted to touch on that a little bit more. Do you think it would be fair to say that given the rate environment, a lot of companies wouldn't necessarily want to be in the market in the second half unless they had to? So perhaps the pipeline might be a little bit more stressed than what we've seen in the first half? And if so, how you're mitigating that?

Yes, I find it quite interesting. There is a significant amount of private equity capital available, meaning there are buyers ready to make transactions, and we are witnessing that. For example, the net fundings for July were $150 million, indicating strong demand for credit in M&A activities. Historically, the average net fundings range between $50 million and $75 million. We've already reached $150 million for this quarter up to July. If we conclude the quarter at approximately 1.01 times debt to equity, our effective debt to equity after the converts is currently at 1 times. We have utilized our capital strategically and it seems that we are busier now than we have been in the past year. There's a notable amount of private equity capital available, and buyers and sellers are beginning to agree on valuations. Sellers are moving away from the mindset of expecting market changes and are starting to adjust their expectations. Public companies are also showing a willingness to consider large take-private deals. The terms for lending and valuations are improving for buyers, which is encouraging. Overall, I am optimistic about the upcoming opportunities. We are currently positioned at the lower end of our target debt to equity and in comparison with others, we have more capital and liquidity. One competitor is at 1.5 times debt to equity, while we have significantly more capital available. I am excited about the future as we navigate through wider spreads and a higher base rate environment with a strong portfolio. Bo, if you have additional thoughts, feel free to share.

You took all of it. But yes, the only thing I would add is that, look, we'll see a lot of opportunistic M&A, and we're seeing that. The pipeline is as busy as it has been in quite some time with opportunistic M&A both from the private equity world that are seeing values that have come down and also from the corporate world where the best businesses are actually bolstering their balance sheets to be on the offensive. And then lastly, equity markets have been very cheap over the last in 3 to 5 years. And good businesses are now turning to the credit markets to bolster their balance sheets versus raising very cheap equity. So that combination has us quite bullish on the opportunity set in the second half of the year, combined with a much more favorable lending environment where we're seeing leverage come in, pricing and fees go up.

Yes, I completely understand your perspective. You articulated it even better than I did.

Could you clarify whether you are comfortable taking portfolio leverage up to the higher end of your target range in this environment, considering the increased macroeconomic risks? Also, how are you approaching leverage? Is that for the balance sheet alone, or does it also include the undrawn commitments mentioned in the shareholder letter?

Yes, that's a complicated question. I don’t believe we will ever take it up to 1.5x. We approach our balance sheet by reserving on front-funding commitments, which helps manage our capital. This also applies to our liquidity. Reserving front-funding commitments reduces our capital when they are funded, which increases leverage. We also reserve for credit spread widening, affecting our capital on a mark-to-market basis. It's important for us to have available capital for investments in our structure as well as new opportunities. Our target range is about 1.15 to 1.2, but it can change based on unfunded commitments, which impact our capital and liquidity. When assessing our business, the constraint we face is more about capital than liquidity, as we typically have more liquidity available than capital. This is a dynamic situation, and we regularly review our balance sheets and forecast pipelines. We are strategic about deploying our capital and understanding our cost of capital, as it contributes to creating shareholder value.

Our next question comes from the line of Ryan Lynch with KBW.

First question I had was you mentioned the investments you made in some CLOs in the quarter, kind of a two-parter on that. One, is that opportunity set still exist in the marketplace today? And then also, it sounds like you're seeing a ton of opportunities just in the private markets. But are there with the dislocations we've seen in kind of the liquid markets, which obviously contributed to the opportunities in the CLO markets. Are you seeing any direct opportunities to invest in any secondary positions, whether that's any sort of leverage loans or high-yield bonds in this marketplace? Or is it just limited right now to CLOs?

I believe the 630 was the lowest point for CLOs. During the quarter, our purchases remained relatively flat, but prices have increased by about 2 to 3 points. We haven't made any additional purchases. Regarding secondary purchases, we are definitely exploring options, but I don’t think they provide strong relative value compared to CLOs. This is not CLO equity, meaning there’s protection against losses in the structure. Generally speaking, when considering how to use our capital, we prefer to support our clients if it's justified on a relative value basis. If we're properly compensated, we would rather invest in private loans since that aligns with our business and client support. When considering liquid investments, I focus on relative value, which at this moment seems clear. Historically, we've done well with this approach. However, I prefer using our capital to back our clients. We have explored syndicated loans, but high-yield investments are more challenging due to implicit rates and longer durations. That said, we typically favor private credit because it has a shorter weighted average life. This factor makes its spread per weighted average life very attractive compared to high-yield options, where the weighted average life is less appealing. Syndicated loans also tend to be structured in a way that limits communication with their lenders.

Okay. Understood. The other one that I had was you mentioned a lot about your portfolio of companies having variable cost structures. Can you explain what that is exactly? I'm not sure if you're referring to maybe your software businesses, and I would assume if that's the case, maybe it's more like sales and marketing, they can make a toggle on and off. But I'm just curious, what is the variable nature of the cost structures that they can kind of toggle?

Bingo. Yes, you hit it.

To clarify, the commentary you provided about an additional $0.13 in earnings for the second half of 2022 reflects the total amount expected during that period. I assume that this amount would accumulate over the final two quarters, with a rough estimate of $0.05 for Q3 and $0.08 for Q4. $0.05 and $0.08. Yes. You're spot on, Brian, $0.05 and $0.08.

Ryan, to consider the impact of LIBOR on our portfolio this past quarter, the weighted average effect of LIBOR was approximately 107. We did not have any assets that were above our floors, resulting in very little asset sensitivity in our portfolio. If I'm not mistaken, we approached this on a reset-by-reset basis, and on that basis, we would be around 190 if everyone reset at the end of Q2. From there, it will increase. This perspective aligns with our asset sensitivity table for the quarter, which requires adjustments for the incentive fee since it is based on net investment income minus interest costs. However, given that we have reached the reset points and surpassed the floors, our portfolio is poised for significant growth.

I’m showing no further questions in the queue. I would now like to turn the call back over to Josh Easterly for closing remarks.

Thank you very much for your questions and for taking the time to read through the lengthy letter. I hope you skipped the disclosures, although they are important, as our Board would remind me. We truly appreciate your engagement. I wish everyone a wonderful remainder of the summer and a pleasant Labor Day with their families. We will be available in the fall, and as I mentioned, we are back in the office full time, so please feel free to visit us. It's great to be back on the road again, engaging with shareholders, stakeholders, portfolio companies, and sponsors. Thank you once again.

Thank you.

Thanks, everybody.

Ladies and gentlemen, this concludes today's call. Thank you for your participation. You may now disconnect.