Sixth Street Specialty Lending, Inc. Q2 FY2024 Earnings Call

Good morning, and welcome to Sixth Street Specialty Lending, Inc.'s Second Quarter ended June 30, 2024, Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Thursday, August 1, 2024. I'll 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 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.'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 second quarter ended June 30, 2024, 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-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, 2024. 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 are our President, Bo Stanley; and our CFO, Ian Simmons. For the call today, I will provide highlights of this quarter's results and then pass it over to Bo to discuss activity in the portfolio. Ian will review our financial performance in more detail, and I will conclude with final remarks before opening the call to Q&A. After the market closed yesterday, we reported second quarter adjusted net investment income of $0.58 per share or an annualized return on equity of 13.5% and adjusted net income of $0.50 per share or an annualized return on equity of 11.6%. As presented in our financial statements, our Q2 net investment income and net income per share inclusive of the underlying of the non-cash accrued capital gains incentive fee expense were both $0.01 per share higher. At June 30, our net asset value per share reached a new all-time high at $17.19, representing an increase of 2.7% year-over-year and an annualized growth of 3.4% since inception, part of the impact of special and supplemental dividends distributed over that time. We don't want to sound like a broken record, but our outlook for this sector remains consistent with what we've said in our previous earnings calls. The higher for longer interest rate environment provides support for BDC operating earnings, but the tails within portfolios are growing on the margin. Our Q2 quarterly results reflected a continuation of these themes. Adjusted net investment income of Q2 exceeded our quarterly base dividend level by 26%. As we assess our projected dividend coverage over the long term, we look at the shape of the forward interest rate curve. As of today, the forward rate curve bottomed out at a terminal rate of approximately 3.5%. Based on this curve, we believe that our base dividend of $0.46 per share remains well supported by operating earnings in this interest rate environment. As we have said in our last two earnings calls, we expect to see dispersion between operating and GAAP earnings as the higher base rate interest rate may ultimately lead to credit deterioration potential for credit losses. We’re starting to see this plan in Q1 results as net income ROEs for our peer set were approximately 140 basis points below operating ROEs. We slightly outperformed these results in Q1. This dispersion highlights the growing tails within portfolios that we've been talking about for several quarters. Before passing it to Bo, I'd like to take a big step back to emphasize that we are in the business of creating value for our shareholders, which at a minimum means earning our cost of equity, but our goal has always been to exceed it. Given the rapid change in the current environment in private credit, one key question that operators should be asking ourselves is what the required spread on investments is to earn that cost of equity. This is a framework that guides us to maintain investment selectivity and discipline in a competitive market environment. We are actively passing on deals getting done at spreads that would generate an estimated return that is below the industry’s cost of equity. We acknowledge that a pricing floor exists in the BDC and capital should not be allocated to investments when close to certain spreads. We'll walk through this in detail now to clearly demonstrate that operating a successful BDC is about disciplined capital allocation. We’ll start with the assumption that the average cost of equity for publicly traded BDCs is 9.4%. This is based on data sourced from Bloomberg across our peer set, which incorporates continued treasury. For simplicity, we’ll assume management and incentive fees, leverage cost of funds, and operating expenses are based on the LTM average for the sector. While management incentive fee structures as well as leverage vary across the industry, these minor differences do not result in a different conclusion. Using the current three-year SOFR swap rate of approximately 4% and 1.5% LIBOR, over a three-year average life, the required portfolio spread to earn a 9.4% cost of equity is approximately 620 basis points from SOFR. It is important to note that this outlook reflects leverage at the top end of the range indicated by rating agencies to be designated investment grade, and before factoring the impact of credit losses. Historically, annual credit losses have averaged approximately 100 to 130 basis points on assets. Accordingly, before accounting for credit losses, the required spread applying our cost of equity assumption is 750 to 780 basis points. To explicitly show why we are passing on deals getting done at a spread of 450 basis points and below, the return on equity before credit losses is 6.3% and 3.4% to 4% asset losses. At these spreads, the sector is not earning its current dividend yield, let alone its cost of equity. While we acknowledge this must be viewed on a portfolio basis, we outlined the map to be illustrative yet constructive in the path to shareholder value creation. For us specifically, our cost of equity is lower than the factor based on the Bloomberg data, and we have had significantly lower credit losses than the long-term industry average. Taking a look at our portfolio, the weighted average spread of new investments this quarter was 6.6%. If we apply a spread of 660 basis points to our unit economics model, including activity-based fees on a three-year profile average leverage at 1.2x and credit losses between zero and 50 basis points, the output is 11% to 12% return on equity. Again, the math is basically a weighted average of one quarter's new investments, which compare this to a weighted average spread in the portfolio at fair value of 8%. This clearly indicates that we are continuing to exceed our cost of equity. Our track record of generating a 13.5% annualized ROE and net income since our IPO in 2014 further demonstrates its consistency. Yesterday our Board approved a base quarterly dividend of $0.46 per share to shareholders of record as of September 16th, payable on September 30th. Our Board also declared a supplemental dividend of $0.06 per share related to our Q2 earnings to shareholders of record as of August 30th, payable on September 20th. Our net asset value per share pro forma for the impact of the supplemental dividend that was declared yesterday is $17.13. So we estimate that our spillover income per share is approximately $1.15. With that, I'll pass over to Bo to discuss this quarter's activity.

Thanks, Josh. I'd like to start by sharing some observations on the broader macroeconomic environment and how that's impacting deal activity in the private credit markets. Over the last few weeks, the US economy has started to show signs of softness, evidenced by an increase in unemployment claims and reduced corporate pricing power. This data suggests there may be room for rate cuts on the horizon, which we anticipate will encourage a rebound in deal activity from historically low levels experienced over the past two years. While not yet back to the pre-rate hike levels, green shoots in the deal environment contributed to another busy quarter for our business in terms of deployment and repayment activity. In Q2, commitments and fundings totaled $231 million and $164 million, respectively, across eight new and five existing portfolio companies. We continued to benefit from the size and scale of our capital base as we participated in several large-cap transactions during the quarter. This underscores the power of the platform as we can toggle between small and large-cap opportunities based on where the relative value and risk-reward is appropriate for our shareholders. Further, we can maintain a steady deployment pace and further diversify the portfolio through periods of higher competition for lower deal activity. As a result of our wide originations funnel, we continued to source new investment opportunities this quarter with 83% of total fundings in new portfolio companies. To highlight our largest funding this quarter, we agented and closed on a senior secured credit facility to Merit Software Holdings. This investment is reflective of our core competency in the middle market where our direct relationships position us well to be a solutions provider for companies like Merit. Through our connectivity across the Sixth Street platform, we have multiple touchpoints with the company from the inception of the business, which allowed us to execute on the transaction. Additionally, our expertise in niche markets allowed us to move quickly and with certainty to finance this company that represents a best-in-class SMB vertical market software business. On the repayment side, tighter spreads triggered a long-awaited reemergence of pay-off activity as borrowers took advantage of the opportunity to lower their cost of financing and address near-term maturities. We expect $290 million of repayments from six full, four partial, and 20 structured credit investment realizations, resulting in $127 million of net repayment activity for the quarter. Our repayment activity was largely driven by refinancings, including a takeout by the high-yield market, two refinancings in the private credit markets, and one refinancing to a bank loan. We also experienced a payoff in our retail ABL transaction, which I'll discuss further in a moment, and opportunistically sold $25 million of our structured credit investments. The majority of our payoffs came from older vintage assets, with five of our six full payoffs being from 2020 and 2021 investments, and the other being from 2017. We had $0.04 per share of activity-based fee income from these realizations, representing an increase from last quarter but still below our long-term historical average, as older investment realizations contain lower embedded economics compared to newer vintage names. Following this quarter's repayments, 58% of our portfolio is represented by investments made after the start of the rate hiking cycle. We believe our exposure to newer vintage assets positively differentiates our portfolio relative to the sector and increases the potential for incremental economics through our call protection, accelerated OID, and other activity-based fees should repayment activity persist in the second half of the year. Our two largest payoffs during the quarter, ReliaQuest and Homecare Software Solutions, were driven by refinancings in the private credit market. While both of these portfolio companies were successful investments for SLX, generating mid-teens IRRs on a gross unlevered basis, we passed on the refinancing transactions given the reasons Josh highlighted earlier related to the importance of disciplined capital allocation. Another payoff during the quarter that illustrates a specialized theme within our portfolio was our investment in $0.99. We leveraged our expertise in the retail asset-based lending space to form our original underwriting thesis back in 2017. Over the 6.7-year hold period, we worked alongside the borrower through several amendments, maturity extensions, and restructurings, ultimately resolving the investment through a Chapter 11 bankruptcy in April. To support the company during the case, SLX provided a DIP term loan that was funded in April and repaid in June. We generated an unlevered gross IRR of 12.7% for SLX shareholders on the total investment, including a 12.0% IRR on the original term loan and a 55.7% IRR on the DIP term loan. While this opportunity set is in flows, we've seen increased activity recently driven by shifts in consumer demand for goods and services and more specifically to experiences. Post quarter end, we funded a new investment in this theme and expect to see this trend continue in the second half of the year. From a portfolio yield perspective, our weighted average yield on debt and income-producing securities at amortized cost declined slightly quarter-over-quarter from 14.0% to 13.9%. The weighted average yield at amortized cost of new investments, including upside, for Q2 was 12.5% compared to a yield of 14.1% on fully exited investments. To provide some color on the investment portfolio today, credit quality remains strong with total non-accruals limited to 1.1% of the portfolio by fair value. Our internal risk rating improved quarter-over-quarter from 1.15 to 1.14, with one being the strongest. Overall, we are pleased with the performance of our portfolio companies and feel that the management teams of our borrowers have been generally successful in executing on cost-cutting initiatives and managing liquidity through a challenging operating environment. We have not experienced a material increase in amendment requests related to covenants or liquidity, which is another positive indicator of the health of the portfolio. On a weighted average basis across our core portfolio companies, continued top-line growth of approximately 4% quarter-over-quarter has contributed to deleveraging and sufficient liquidity despite higher interest costs. While spread tightening has led to an increase in repricing requests, this has largely come from portfolio companies demonstrating strong growth momentum and robust performance. Moving on to the portfolio composition, the weighted average attached and detached points at 0.6 times and 5.0 times, respectively, and our weighted average interest coverage increased slightly from 2.0 times to 2.1 times quarter-over-quarter. As a reminder, interest coverage assumes we apply reference rates at the end of the quarter to steady-state borrower EBITDA. As of Q2 2024, the weighted average revenue and EBITDA of our core portfolio companies was $310.4 million and $104.4 million, respectively. There were no new investments added to non-accrual status during the quarter. With that, I would like to turn it over to my partner Ian to cover our financial performance in more detail.

Thank you, Bo. For Q1, we generated adjusted net investment income per share of $0.58 and adjusted net income per share of $0.50, total investments of $3.3 billion, down 1.9% from the prior quarter as a result of net repayment activity. Total principal debt outstanding at quarter end was $1.8 billion, and net assets were $1.6 billion or $17.19 per share prior to the impact of the supplemental dividend that was declared yesterday. Turning now to our balance sheet positioning. Our debt-to-equity ratio decreased from 1.19 times, as of March 31 to 1.12 times as of June 30, and our weighted average debt-to-equity ratio for Q2 was 1.17 times. The decrease was primarily driven by our net repayment activity during the quarter. As mentioned on last quarter's call, we closed an amendment to our $1.7 billion revolving credit facility in April, including extending the final maturity on $1.5 billion of these commitments through April 2029. We continue to have ample liquidity with $1.2 billion of unfunded revolver capacity at quarter end, against $250 million of unfunded portfolio capital commitments eligible to be drawn. We are pleased with the strength of our funding profile heading into the second half of 2024. Moving on to upcoming maturities, we have reserved for the $347.5 million of 2024 notes due in November, under our revolving credit facility. After adjusting our unfunded revolver capacity as of quarter end for the repayment of those notes, we have liquidity of $862 million. To go a step further, if we assume we utilize undrawn revolver capacity to reach the top end of our target leverage range of 1.25 times debt to equity and further drawdown for our eligible unfunded commitments, we continue to have $398 million of excess liquidity. Beyond the 2024 notes, our debt maturity profile is well-laddered with maturities in 2026, 2028, and 2029 for our outstanding unsecured notes. As we've said in the past, the unsecured market is our primary source of funding, and we continue to have access to this form of financing at levels that have increased in attractiveness over the course of the year. We have been pleased to see the broader development of the unsecured market over the last few years and view it as a positive for TSLX and the sector. Pivoting to our presentation materials, Slide 8 contains this quarter's NAV bridge, walking through the main drivers of NAV growth. The over-allotment shares issued in April related to our equity raise in February resulted in a $0.02 per share uplift to NAV in Q2. We added $0.58 per share from adjusted net investment income against our base dividend of $0.46 per share. There was a $0.03 per share positive impact to NAV, primarily from tightening credit market spreads on the fair value of our portfolio. Net unrealized losses from portfolio company-specific events resulted in an $0.08 per share decline in NAV. This was primarily related to the markdown of our investment in Lithium Technologies from 91.25 to 76.75 quarter-over-quarter. The company has not performed as expected, and our fair value mark reflects this assessment. At this stage, the company is in the middle of a strategic process, and there is a range of possible outcomes. Other changes included a $0.05 per share reduction to NAV as we reversed net unrealized gains on the balance sheet related to investment realizations and a $0.02 per share uplift from net realized gains on investments primarily from structured credit sales during the quarter. As for our operating results detailed on Slide 9, we generated a record $121.8 million of total investment income for the quarter, up 3% compared to $117.8 million in the prior quarter. Interest and dividend income was $112.2 million, slightly above the prior quarter of $112.1 million. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were higher at $4 million compared to $1.5 million in Q1, driven by increased activity-based fees from the elevated repayment activity experienced during the quarter. Other income was $5.5 million compared to $4.3 million in the prior quarter. Net expenses, excluding the impact of the non-cash reversal related to unwind capital gains incentive fees, were $66.8 million, up slightly from the $65.4 million in the prior quarter, driven by expenses incurred during the quarter for the annual and special shareholder meetings that were held in May. Our weighted average interest rate on average debt outstanding increased slightly from 7.6% to 7.7%, driven by our funding mix shift towards unsecured financing given that net repayment activity led to lower outstandings on our lower-cost revolver. Following the repayment of the 2024 notes in November, there will be a small positive economic impact of almost $0.01 per share quarterly in 2025 as the implied funding mix shift will lower our weighted leverage cost of debt. Before passing it back to Josh, I wanted to circle back to our ROE metrics. For the year-to-date period, we generated annualized adjusted net investment income of $2.32 per share, corresponding to a return on equity of 13.7%. This compares to our previously stated target range for adjusted net investment income of $2.27 to $2.41, which corresponds to a return on equity of 13.4% to 14.2% for the full year. We maintain this outlook heading into the second half of 2024. With that, I'll turn it back to Josh for concluding remarks.

Thank you, Ian. During this time of significant growth in the private credit market, it's no surprise that competition has increased and spreads have tightened. As an investment manager, we view this time as an opportunity to further differentiate our business as being not only disciplined investors, but disciplined capital allocators. To us, that means having choices regarding what to invest in and when to invest. We create this optionality in our business in two ways. First, we size our capital base to the opportunity set. This means running a constrained balance sheet, such that we can operate within a target leverage range without broader market participation in deals that we do not think present appropriate risk-adjusted returns or meet our required return on equity. We accomplish this objective by taking a thoughtful approach to growth regardless of our ongoing ability to raise capital. Second, we invest in a platform that has a wide origination funnel. Despite the competitive backdrop that exists today, we remain active yet selective because of the benefits of the Sixth Street platform. This wide range of deal flow allows us to make calls on relative value, toggle between large-cap and middle-market exposure, lean into sector themes, and most importantly, pass on investments that do not meet the return profiles determined for our shareholders. As disciplined investors, we make these choices with shareholder returns top of mind, which we believe leads to better credit structures and ultimately translates to a lower credit loss over the long term and better shareholder experience. With that, thank you for your time today. And operator, please open the line for questions.

Thank you. We will now begin the question-and-answer session. Finian O'Shea from WFS, your line is now open.

Hey everyone. Good morning. Taking some of the opening comments on the market. There's I think a rapid change in private credit. You noted, assuming that refers to the amount of capital that's been raised and so forth. And then how you're passing on a lot of deals but due to yield the cost of capital down, would you say this relates to the deals you're passing on? Does it relate to market deterioration in credit underwriting or are there more firms out there that can do complexity at scale?

Good morning, Fin. In terms of the straightforward sponsor activity, I want to highlight two key points. First, there is a real concern about credit deterioration and weakened credit underwriting in these deals. In the sector of Business Development Companies, the amount of capital they need to maintain—specifically, their ability to leverage at only 1.25 times—combined with their fees and expenses, has placed them at a point where certain prices no longer yield a return on equity that is acceptable against the equity cost of the sector. This issue is evident in our sponsor-related activities. Looking at our spreads for this quarter, which largely consist of sponsor deals, they were above the sector average and our earnings, as well as exceeding our cost of equity. However, what we've funded so far this quarter has shown 20 to 30 basis points wider spreads. Moreover, our pipeline has shifted significantly from sponsor to non-sponsor deals, with current pipeline spreads around 860, not including fees, mainly consisting of non-sponsor activities. Thus, the main concern lies within the sponsor deals. It's crucial to recognize how the size of the origination platform aligns with the size of our capital, which is vital for continuing to enhance shareholder value.

Very helpful. Thank you. And some follow-up on Europe that would seem to be most of your new deals this quarter. Can you remind us of the footprint you have there? Is there growth in that, or were those more the best deals you saw this quarter from the market?

Yes. So look, I would say when you look at your up from I think what you're referring to by number, but probably not necessarily by dollar amount. And so by dollar amount, I don't think that's a true statement. By number, that is a true statement under the exemptive relief strategy. We want to make sure SOX has the ability to continue to invest in deals. A lot of those positions that you're referring to are small kind of toehold positions. Our platform in Europe is growing and has been very successful. We've been in that market for a long time. And quite frankly, at the moment, the risk-return better on the fossil stuff is better in Europe than it is in the US. I think you would agree with me on that for sure. So but again, I think it's by number, not by dollar; by dollar, predominantly US still. We like the risk-return. For example, one of the larger things we did was add event which was a buyout of the eBay auction assets in Europe, and that has a nice spread compared to what you can find in the US.

Thanks so much.

Thanks, Fin. Have a good day.

Thank you. Our next question comes from the line of Brian McKenna with Citizens' JMP. Your line is open.

All right. Thanks. Good morning everyone. So you've talked a lot about the turnover within the portfolio since the Fed started raising rates. You've recycled a lot of capital over the past few years. Obviously, that's been good for the portfolio repositioning. But how should we think about the turnover from here? And this continued rotation into new vintages of loans? And then I guess what does all that mean for the underlying performance of the portfolio from here?

Yes, I would frame it this way. The premise is slightly off. The portfolio, which is mainly from the period after the rate hikes began, was largely influenced by the fact that we started below our target leverage before the rate hikes. Additionally, we managed to raise funds through a convertible and two equity raises. The changes in the portfolio composition weren't due to turnover; there has been limited turnover since the rate hikes began. You can observe that starting to increase in the activity-based fees. Looking ahead, if the market pivots in September and deal activity increases, which it has begun to do as spreads narrow, I anticipate more natural turnover in the portfolio. This will economically benefit SLF shareholders in the short term due to the seasonal increase in activity. For the first quarter, we saw a slight net repayment and a small pickup in activity-based fees along with that.

Okay, helpful. Thanks. And then just a bigger question here, Josh, will be great. Just get your thoughts on the broader macro. You're clearly there's a lot of puts and takes looking out over the next year, a lot of term rates have come in quite a bit recently. There's likely going to be several rate cuts into 2025. Capital market activity is accelerating. Public equity and credit markets are performing well, but it does seem like the economy is slowing here. So how are you guys thinking about the macro over the next year, and what's the base case expectation for some of these moving pieces when you're underwriting new deals today?

It's a challenging environment, but I'm optimistic about the recent vintages. These vintages have been underwritten in a higher rate environment, benefiting from a rate cut and increased demand. Given the improved underwriting standards and rate clarity in the tightening cycle, I'm confident that the vintages from the last couple of years will perform well. However, there will be challenges with older vintages, and we're starting to see that impact. We've discussed this for three quarters now—the difference between operating ROEs, which will be higher than total economic or GAAP ROEs, reflects the gap between net interest income and net interest asset. I expect this trend to continue. The economy is definitely slowing, which allows the Federal Reserve to pivot. This pivot should loosen financial conditions, stimulating demand and helping the economy stabilize. Overall, I have a relatively positive outlook on the macro picture.

Yep, got it. All right, great, thanks. I'll leave it there. Appreciate it.

Thanks. Have a good day.

Thank you. Our next question comes from the line of Mark Hughes with Truist Securities. Your line is now open, Mark.

Yeah, thank you. Good morning. Regarding the deal flow.

Good morning.

Good morning. Your rate on the deal flow, good morning. Has that changed materially over the last six months? If you're having to be more selective, how is that working out in terms of your success rate?

Yes, I would say that generally our success rate is probably a bit lower. What has changed is that we are interested in certain credits but at prices that don't attract us. We are very aware of the importance of driving shareholder returns and maintaining a good return on equity. The actions we take today will help generate the return on equity for 2025 and 2026. Even though we have a portfolio with a higher yield, we need to ensure that we earn our return on equity. So while our success rates are about the same, there are credits we like but dislike the prices.

Yes, the average commitment this may be just the unfair snapshot, but the average commitment was lower in 2Q say compared to 4Q. Are you seeing more opportunity in the smaller end of the market?

No. I mean, no that's a reflection of the co-investment strategy where in European deals or large-cap deals in SLX for European yields is taking a smaller position. And so there's a whole bunch of on the European deals like $5 million to $6 million are dragging it down. But if you look at the core positions like Marriott at event, those are kind of $35 million to $40 million commitment. So it's a little bit more of that participation and how the co-investment strategy plays out.

Yes. I think you mentioned the word toe-hold.

Yes.

And then final question, you described how the spreads in the pipeline are looking better as you've shifted from the sponsor to non-sponsor. Is that the broader market helping support that? Or is that more intentionality on your part?

The advantage of being part of Sixth Street, which is an $80 billion platform, is that we have the flexibility to explore various opportunities. This quarter, we engaged in non-sponsor deals, such as a healthcare specialty pharma deal with Apellis, which we find appealing. I anticipate there will be more similar opportunities in the future. Additionally, we completed a retail asset-based lending financing that involved consumers, which was also a non-sponsored deal and occurred after the quarter ended. The positive aspect of having a significant inflow of opportunities allows us to be selective and ensure we are effectively maximizing shareholder returns.

Okay. Appreciate it. Thank you.

Thanks. Have a great day.

Thank you. Our next question comes from the line of Mickey Schleien with Ladenburg. Your line is now open.

Yes. Good morning, everyone. And Josh, not to beat a dead horse here, but I wanted to ask you a follow-up question on spreads. Do you think that it's just this issue of a massive supply of private debt capital that is overwhelming the potential for the Fed to cut rates that's causing this spread tightening? Or do you think we're approaching some sort of a floor?

It's a great question, Mickey. It's nice to hear from you again; we missed your voice on the last couple of earnings calls. You always ask insightful questions. I believe that private credit and private capital have become more institutionalized, with many allocators now recognizing the value proposition and allocating capital accordingly. Regarding demand for capital, the current M&A environment hasn't created the natural demand we expected. However, I anticipate that we will reach an equilibrium soon, especially with the Fed cutting rates and M&A activity increasing. Early on, the supply of capital outpaced the demand. We have always aimed to maintain discipline and consider the long-term experience for our shareholders, despite the real incentives for managers to utilize capital and earn fees. My hope is that as demand grows due to a more favorable M&A environment, it will stimulate investment and CapEx growth, leading to a better balance between supply and demand.

That's good to hear. If I could follow up, Josh, regarding the disintermediation of the commercial bank that has occurred in private credit over the years, what do you think the likelihood is that we will see increased regulation of private credit? Also, do you believe there is systemic risk developing that will become apparent in the future?

I have some thoughts on this. The concern about specific risks seems a bit exaggerated. First, unlike the banking system, taxpayers have essentially guaranteed private credit through the FDIC program, which supports asset choices for banks. Second, most systemic risk stems from asset-liability management issues, where entities hold long-term assets and short-term liabilities. However, in private credit, we are fully funded to match our liabilities, so there's no such issue. We discussed the softness in the market, but the average life of our leveraged assets is about two and a half years, while leverage itself is around four years. This results in minimal reinvestment risk, not to mention liquidity risk, which is where most systemic problems arise for financial institutions. Additionally, business development companies (BDCs) in private credit maintain three to five times the amount of capital compared to banks, and their risk-bearing capital ranges from 45% to 50%. In contrast, banks typically operate with about 8% capital at one times leverage. Thus, the notion of significant systemic risk in private credit, especially regarding shareholder losses, seems misplaced. I began by discussing return on equity, and if we compare two business models—one where a company has 8% capital and borrows short versus another with 50% capital that is fully funded—the expected return on equity for the latter should be lower. Surprisingly, the return on equity requirement for private credit and BDCs is about the same, even though the private credit model is sturdier due to its capital structure and asset-liability management. Does that clarify things for you, Mickey?

That's very helpful. And I appreciate your clarity on that. And my last question, Josh, just switching gears. Lithium Technologies, which I think is part of Corals, if I'm not mistaken, is a customer care, software-based customer care company. I realize that at any moment in time, credit can run into headwinds. I'm more curious whether there's something underlying the headwinds at Lithium that would cause you concern over the sector in general, because that is a focus of yours, and as well, other BDCs.

Yeah. Lithium is purely idiosyncratic. So it probably, like, the one thing I would be critical on the margin of us in this space is that when COVID hit, everybody thought about businesses that were negatively impacted by COVID. There were some businesses that were positively impacted by COVID. This was a software business that had a levered engagement online and through social media platforms. That was probably a positive tailwind that's unwound, so it's purely idiosyncratic.

Okay. I appreciate that. That's all for me this morning. Thank you for taking my questions.

Thanks, Mickey.

Thank you. Our next question comes from the line of Kenneth Lee with RBC. Your line is now open.

Hey, good morning. Thanks for taking my question. Sounds like in terms of the new originations, new investments you're seeing, there might be a little bit of a spread tightening across the industry. I wonder if you could just comment about what you're seeing in terms of documentation and terms on some of these newer deals. Are you seeing any changes more recently? Thanks.

Yeah, look, I would say document stocks have been pretty stable. So I think underwriting standards remain good in private credit. I mean, the question again is, is like where we sit on the cost curve, what's the required spread during your cost of equity? And if I was critical in one place, it would be people not understanding where they sit in the cost curve or where they're leaning too much into their back book. But the things you do today are the ROEs in 2025 and 2026. But the way to average financial covenants and all that stuff is basically the same. The docs are in pretty good shape. That's right.

Great, very helpful. Just one follow-up, if I may. More broadly regarding the complex investment opportunities, will we need to wait for a macro slowdown to see more opportunities, or could we see a potential increase in complex investment properties when M&A activity picks up? Thanks.

I think the situation is quite complex for two reasons. First, we are in an environment with low interest rates, which leads to poor capital allocation. This complexity will stem from the unresolved issues of past mistakes, and it will persist regardless of circumstances. On the positive side, as mergers and acquisitions increase, attention may shift towards some of our competitors, making their situations easier to address due to fewer resources. Therefore, we are faced with two interrelated factors: the growing complexity, which presents us with opportunities, and the increased focus on M&A activity. As a result, I feel optimistic about our prospects in the coming years.

Great. Very helpful. Thanks again.

Thank you. Our next question comes from the line of Paul Johnson with KBW. Your line is now open.

Good morning. Thanks for taking my question. So just with the development of liability management exercises and development recently Pluralsight realizing obviously process not a newer portfolio, but I'm just wondering your thoughts on whether those types of events increase the risk of sponsor concentration issues where you have an adverse event with one of your common partnering sponsors and there's risks to deal flow as well as just kind of the calculus of working within the lender group as well?

I don't have much to add regarding Pluralsight. While we were once involved, I can't provide any specific insights now. From my understanding, the situation seemed to deviate slightly from the existing documentation for our portfolio. The good news is that there were no lenders harmed, unlike in the broadly syndicated loan market where a prisoner's dilemma often arises. In this case, such pressure did not exist. Additionally, I believe concerns about sponsor concentration are overstated. Historically, around 55% of our portfolio has come from sponsors, and 35% from non-sponsors. Currently, we have no sponsors above 10% in our book, and in terms of the group, we have about 45% to 30% from sponsors. I don't see a direct connection between these issues, but I hope that answers your question.

Yes, it's very helpful. I appreciate that. I mean do you think that that an event like that is just the result of that credit underlying bad that documentation or is this lawyers that are basically at fault here?

I would never assign blame. I can't comment on specific closures as I'm not involved. However, we are aware that events occur in our business. We've been effective in managing credit, but issues still arise. This is part of our operations, as we focus on understanding what the future holds by using past data and industry patterns as a guide. We are assessing future risks because asset values depend on projected cash flows and business performance going forward, and there may be times when our predictions are not accurate. This is a critical aspect of the industry and depends on where capital is invested, but I cannot provide insights specific to Pluralsight; I appreciate your understanding.

Thank you. I'm showing no further questions at this time, and I would now like to turn the call back to Josh Easterly for closing remarks.

And look, we all appreciate everybody’s thoughtful and engaging questions. And I hope everybody has a great end of the summer with their families. We’ll talk in November; it's going to be a crazy November my guess. So, thank you. We're always around. We love the engagement, and we'll keep working hard for our shareholders. Thanks.

Thank you, and this does conclude the program, and you may now disconnect.