Sixth Street Specialty Lending, Inc. Q2 FY2025 Earnings Call

Good morning, and welcome to Sixth Street Specialty Lending, Inc.'s Second Quarter Ended June 30, 2025 Earnings Conference Call. As a reminder, this conference is being recorded on Thursday, July 31, 2025. I will now turn the call over to Ms. Cami Senatore, 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, 2025, 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, 2025. 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.

Good morning, everyone, and thank you for joining us. With me today, our President, Bo Stanley; and our CFO, Ian Simmonds. Before we get started, I want to take a moment to express profound sorrow following the tragic events that unfolded in our city earlier this week. On behalf of our entire company, our hearts go out to the victims and their loved ones. Our thoughts and prayers are with the families, first responders, and local firms affected by this senseless and random act. After the market closed yesterday, we reported the second quarter adjusted net investment income of $0.56 per share or an annualized return on equity of 13.1% and adjusted net income of $0.64 per share or an annualized return on equity of 15.1%. As presented in our financial statements, our Q2 net investment income and net income per share, inclusive of the accrued capital gains incentive expenses, were $0.54 and $0.63, respectively. As a reminder, any differences between the adjusted and reported metrics are noncash expenses related to accrued fees on unrealized gains from the valuation of our investments. The difference between adjusted net investment income and adjusted net income of $0.08 per share in Q2 was largely related to net unrealized gains from the impact of tightening credit spreads from the valuation of our investments and the positive portfolio of company-specific events. I'd like to frame an important shift we see unfolding in the sector following the mini credit cycle that took place over the last few years beginning in mid-2022 with the rapid rise of interest rates. Through that cycle, public BDCs, including SLX, experienced idiosyncratic credit issues, putting downward pressure on net asset values. While the average public BDC saw its net asset value per share decline by 10.1% from the fourth quarter 2021 through the first quarter of this year, SLX's net asset value per share increased by 1.2% over the same timeframe, or 2% through Q2. Even with the rise of nonaccruals and the losses we recognized, our disciplined approach to capital allocation allowed us to overrun our cost of equity and grow net asset value. Over this period, we generated a total economic return calculated as change in net asset value plus dividends of 42.6%, more than doubling the average of our public BDC peers, which stood at 19.1%. We expect that credit issues are predominantly behind us. This is evidenced by an improvement in nonaccruals for SLX this quarter and also for the sector more broadly, which experienced a marginal decrease in nonaccruals for Q1. While we don't have pure data for Q2, we expect the trend to continue this quarter. This should result in a convergence between net investment income and net income for the sector. Under the premise that credit has broadly stabilized, we anticipate the focus for the sector to shift from credit quality to dividend coverage as portfolio yields decline due to a combination of lower forward rates and tighter portfolio spreads. For SLX, adjusted net investment income in Q2 of $0.56 per share exceeded our base dividend by 22%. This robust dividend coverage is tied to our ability to source and execute on differentiated investment opportunities. This is clearly demonstrated by our weighted average spread on our new first lien investments in the second quarter of 6.5%, which compares to the public BDC sector average of 5.3% on new issue first lien loans for the first quarter. Again, we don't have comparable Q2 data for our peers, but we expect the weighted average portfolio spread to decline further this quarter. We continue to caution that there has been complacency in the sector. In addition to the pursuit of AUM growth, we believe this is largely driven by a backward-looking focus on LTM metrics that reflect an elevated rate and spread environment that's no longer indicative of today's investment landscape. What matters today and always is the forward view, and we believe our approach will continue to positively distinguish our earnings profile. Looking ahead, we estimate the quarterly earnings power of our business to exceed our base dividend level, assuming stable credit, leverage in the middle of our target range, and conservative fee incurred. As of June 30, our net asset value was $17.17 per share, representing an increase of 70 basis points from $17.04 as of March 31. Yesterday, our Board approved our base quarterly dividend of $0.46 per share to shareholders of record as of September 15, payable on September 30. Our Board also declared a supplemental dividend of $0.05 per share related to our Q2 earnings to shareholders of record as of August 29, payable September 19. Net asset value per share adjusted for the impact of the supplemental dividend that was declared yesterday is $17.12. We estimate that our spillover income per share is approximately $1.30. 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 sharing some thoughts on the M&A environment and how that's impacting activity in our portfolio. As we've discussed for several quarters, the M&A market has yet to deliver the meaningful rebound that many had anticipated in 2025. This muted transactional environment is clearly reflected in the leveraged loan market where M&A-related loan volume was down approximately 31% in the second quarter compared to the first, and second quarter loan volume marked its lowest levels since the fourth quarter of 2023. From our perspective, a meaningful reacceleration in M&A requires a catalyst in one of three areas: economic growth, interest rates, or time. Given the prevailing uncertainty around trade policy, a surge in near-term growth appears unlikely. And the forward curve suggests rates will remain higher for longer. This leaves time as the most important factor. In an environment of slower growth and elevated rates, sponsors and management teams need a longer runway for portfolio company earnings to grow and generate an appropriate return on investments. While we can't predict the future, we estimate the timing of M&A activity taking an inspiration from the Hubbert peak theory, which was used in the 1950s to estimate when U.S. oil production would peak. Utilizing data sourced from PitchBook, the median buyout multiple at peak levels in 2021 has declined roughly 3 turns compared to the median for closed buyout deals year-to-date. If we assume no multiple compression from the peak in 2021 and an average annual EBITDA growth rate of approximately 9%, consistent with historical S&P earnings growth, it would take approximately 4 to 5 years for a buyer to earn an appropriate multiple of money on their investment. If we apply the same assumptions but include the re-rating of multiples since the rate hiking cycle, this lengthens the timeline to 6 to 7 years, implying an additional 2 years needed to grow earnings until an appropriate multiple of money is achieved. Based on our analysis, the earlier wave of investments from the pre-COVID vintages are now approaching the 6- to 7-year mark, which should moderately increase M&A activity in the next few quarters. As for the record-setting post-COVID, pre-rate hiking vintages of 2021 and early 2022, which we estimate make up more than 40% of the current private equity net asset value, sellers need 6 to 8 additional quarters to reach an acceptable multiple of money, implying a further delay of the broad-based return of M&A activity that many are predicting. We recognize there are additional factors at play, and this timeline will vary for different segments of the market. For example, investment-grade M&A is likely the first to return given the favorable regulatory environment. These businesses are also less levered compared to non-investment-grade companies, which means they have less sensitivity to interest rates. While the widespread return of M&A in our markets remains a future prospect, we have observed a noticeable shift in market sentiment beginning in late June and strengthening through July. In addition to some green shoots related to the buy-and-bill strategies, we have more notably seen a pickup in non-M&A-related activity within sponsored portfolios, such as duration management transactions. We expect these types of financings to be a prominent theme in the second half of the year as sponsors work to optimize their portfolio of companies in preparation for an improved exit environment. We believe we are very well positioned to provide the kind of complex bespoke capital solutions these situations require, creating attractive risk-adjusted returns for our shareholders. Turning now to activity in the second quarter. We provided total commitments of $289 million and total fundings of $209 million across 13 new investments and 4 upsizes to existing portfolio companies. To characterize our origination activity in Q2, approximately 30% of our commitments were sourced outside the sponsor channel. The remaining 70% came through the traditional sponsor-backed finance market, where we will leverage our deep relationships and platform scale to deploy capital into investments that are on an appropriate risk-adjusted return for our business. An example of our nontraditional transactions in Q2 is our direct-to-company investment in Ingenovis Health. This was an accounts receivable securitization financing, where the combination of our deep knowledge and specific health care themes, combined with the long-standing track record in asset-based loans, created a unique investment opportunity for SLX shareholders. With the resources in place across the Sixth Street platform, including dedicated ABL and health care teams, we have the ability to source and underwrite these off-the-run transactions that diversify our assets as well as our return profile relative to the sector. Another differentiated investment in our portfolio is Caris Life Sciences. As a reminder, we made initial debt and equity-linked investments in Caris in 2018 and subsequent equity-linked investments in 2020 and 2021. We fully exited our debt security in 2023, and the company recently completed an IPO in June. We still hold an equity position today, which is valued quarterly based on the company's closing stock price on the last day of the quarter. While equity positions are a small part of our overall portfolio, our ability to embed potential incremental economics into our business through unique thematic sourcing and disciplined underwriting serves as a competitive advantage for our shareholders. I'd like to spend a moment providing an update on one of our existing portfolio companies, Lithium Technologies that had previously been on nonaccrual status. During Q2, we navigated their sale process and restructuring of the business, working closely with the new sponsor to negotiate and drive an outcome. As a result of the restructuring, we hold a smaller loan that is paying cash interest and an earn-out equity security. This transaction had no material impact on our net asset value in Q2 as the realization of our original investment was consistent with our valuation as of March 31. Lithium has therefore been removed from nonaccrual status following the restructuring. Moving on to repayment activity. The second quarter marked the third consecutive quarter of elevated payoffs. Total repayments in Q2 were $389 million. This repayment activity contributed to another strong quarter of activity-based fee income, excluding other income totaling $0.11 per share in Q2 relative to our 3-year historical average of $0.05 per share. The repayment activity we experienced during the quarter was driven by a mix of refinancings and M&A activity. Of the exits that involve refinancing transactions, the majority were completed at lower investment spreads. Our portfolio continues to reflect our disciplined capital allocation as only 6.2% of our investments by fair value as of quarter end had a contractual spread of 500 basis points or below. While we don't have the comparable Q2 peer dataset available yet, this is nearly 5 times less than the average of 29% of public BDC portfolio spreads of 500 basis points or below as of March 31. A large portion of our payoffs during the quarter came from older pre-2022 vintages, reducing our exposure to these assets to 29% of the portfolio by cost. This compares to 59% or roughly double pre-2022 vintage exposure for the public BDC sector average as of March 31. We view this as a positive differentiator for our business as it reflects greater exposure to newer vintage assets that were originated following the commencement of the rate hiking cycle in early 2022. Given this greater exposure to new vintage assets, 37% of our exits were post-2022 investments, resulting in incremental economics for shareholders driven by prepayment fees. Moving on to the portfolio metrics and yield. Despite recent competitive dynamics, we remain committed to high documentation standards that provide robust downside protection. At quarter end, we maintained effective voting control of 78% of our debt investments, averaging 2 financial covenants, consistent with historical levels. After managing prepayment risk, the fair value of our portfolio as a percentage of call protection is 94.1%, which means we have protection in the form of additional economics that would flow through net investment income should our portfolio be repaid in the near term. As of June 30, the weighted average total yield on our debt and income-producing securities at amortized cost was 12.0% compared to 12.3% as of March 31. Given the meaningful payoff activity we experienced in Q2, the decline primarily reflects payoffs of higher-yielding assets exceeding the yields of new investments funded during the quarter. While credit spreads have remained competitive in Q2, our omnichannel sourcing capabilities enabled us to put capital to work in a disciplined manner demonstrated by a weighted average spread on new first lien investments of 652 basis points, compared to a spread of 533 basis points on new issued first lien loans for the BDC peers in Q1, as Josh mentioned earlier. Moving on to the portfolio composition and key credit metrics across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attachment and detachment points of 0.3x and 5.0x, respectively, and our weighted average interest coverage remained consistent at 2.1x. As of Q2 2025, the weighted average revenue and EBITDA of our core portfolio of companies was $377 million and $114 million, respectively. Median revenue and EBITDA were $147 million and $46 million, respectively. Finally, overall portfolio performance is strong with a weighted average rating of 1.10 on a scale of 1 to 5, with 1 being the strongest. The Lithium restructuring resulted in an improvement in nonaccruals quarter-over-quarter from 1.2% of the portfolio at fair value to 0.6%. As of June 30, we have 2 portfolio companies on nonaccrual status. With that, I'd like to turn it over to my partner, Ian, to cover our financial performance in more detail.

Thank you, Bo. For Q2, we generated adjusted net investment income per share of $0.56 and adjusted net income per share of $0.64. Total investments were $3.3 billion, down slightly from $3.4 billion in 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 $17.17 per share prior to the impact of the supplemental dividend that was declared yesterday. Our average debt-to-equity ratio was 1.2x, up from 1.19x in the prior quarter, and our ending debt-to-equity ratio decreased from 1.18x to 1.09x quarter-over-quarter. Average leverage was higher than ending leverage, driven by the timing of repayment activity, which predominantly occurred towards the end of the quarter. We continue to focus on maintaining leverage within our target range of 0.9x to 1.25x. And since the regulatory change in late 2018, we have operated with an average quarterly debt-to-equity ratio of 1.03x. Leverage remains within our target range and above our historical average, providing ample capital for new investment opportunities. In terms of balance sheet positioning, we had approximately $1.1 billion of unfunded revolver capacity at quarter end against $159 million of unfunded portfolio company commitments eligible to be drawn or coverage of approximately 7x. Our quarter end funding mix was represented by 71% unsecured debt. As a reminder, we proactively completed several capital markets transactions during Q1, strengthening our balance sheet. Following these transactions, our capital, liquidity and funding profile remain in excellent shape. Further, we have no near-term maturities with our nearest obligation being $300 million of unsecured notes not occurring until August 2026. We did not issue any shares through our ATM program during the quarter. Pivoting to our presentation materials, Slide 8 contains this quarter's NAV bridge. Walking through the main drivers of NAV growth, we added $0.56 per share from adjusted net investment income against our base dividend of $0.46 per share. As Josh mentioned, there was approximately $0.02 per share of accrued capital gains incentive fee expenses related to this quarter's net realized and unrealized gains. There was a $0.13 per share reduction to NAV as we reversed net unrealized gains on the balance sheet related to investment realizations and recognized these gains into this quarter's income. The reversal of unrealized gains this quarter was primarily driven by early payoffs resulting in accelerated OID and call protection. There was a $0.09 per share positive impact to NAV, primarily from the effect of tightening credit market spreads on the fair value of our portfolio. Portfolio company-specific events increased NAV by $0.07 per share. And finally, there was $0.06 per share of net realized gains, mainly from equity realizations in ReliaQuest and Murchison. As Bo mentioned earlier, there was no material impact to net asset value from the Lithium restructuring as the realized value was consistent with our fair value as of March 31. As shown in our financial statements, there was an unrealized gain from the reversal of the previous unrealized loss that was equally offset by a realized loss this quarter. Moving on to our operating results detailed on Slide 9, we generated $115 million of total investment income for the quarter compared to $116.3 million in the prior quarter. Interest and dividend income was $97.2 million, down slightly from the prior quarter, primarily driven by lower dividend income and a decline in foreign base rates. Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were lower at $10.2 million compared to $14 million in Q1, driven by the significant Arrowhead prepayment fee that occurred in Q1. Other income was $7.6 million, up from $3.5 million in the prior quarter. Net expenses, excluding the impact of the noncash accrual related to capital gains incentive fees, were $61.4 million, up marginally from $60.7 million in the prior quarter, primarily driven by expenses incurred for the annual and special shareholder meetings held during the second quarter. Our weighted average interest rate on average debt outstanding decreased slightly from 6.4% to 6.3%. Before handing it back to Josh, I wanted to provide an update on our ROE metrics. Year-to-date, we've generated strong annualized ROEs based on adjusted net investment income and net income of 13.3% and 11.7%, respectively. We believe this reflects our broad originations platform, ability to embed economics into our portfolio, and disciplined capital allocation. Based on our year-to-date performance and our expectation of the quarterly earnings power of the business in the second half of the year, we anticipate generating a return on equity based on adjusted net investment income in the top half of our previously stated range of 11.5% to 12.5% for the full year. If activity-based fees remain elevated, as we have experienced in recent quarters, there is potential to exceed the top end of that range. With that, I'll turn it back to Josh for concluding remarks.

Thank you, Ian. It's a tricky investment environment driven by the imbalance between supply and demand of capital. Competition is elevated, and it's increasingly difficult to generate outsized returns. However, Sixth Street was built to navigate such complexity. We have a long and proven history of delivering for our shareholders through challenging backdrops, including the energy market volatility that started in late 2014 and continued into 2015 and 2016, the global pandemic in 2020 and 2021, and most recently, the interest rate hiking cycle of 2022 and 2023. Through past dislocations, we have consistently proven our ability to protect capital and generate value. During these years, SLX generated an average annualized return on equity of 13.7%, a significant outperformance compared to the 7.5% average for our public BDC peers over the same years. While today's market presents a different set of challenges, our core strategy remains unchanged, leveraging a deep bench of talented individuals who work collaboratively to source and underwrite investments that differentiate our return profile. This investor-first approach is not just a guiding principle; it is deeply embedded in our firm's culture and business model. To appreciate our strategy, one must first understand the framework of our industry. The path to outperformance in the highly regulated BDC sector is exceptionally narrow. First, there is little to no opportunity for differentiation through leverage or financing as the liability side of the balance sheet offers no real source of excess return. Second, most industry participants operate on a similar cost structure of fees and expenses. Consequently, outperformance must be generated almost exclusively on the asset side by sourcing differentiated investments and, just as importantly, minimizing investment losses. This is ultimately accomplished by the team, which becomes the real differentiator. This is the core of the Sixth Street model, where our platform has consistently shined. For over a decade as a public company, the human capital advantage has delivered strong risk-adjusted returns for our shareholders. Looking forward, we will lean on these proven capabilities, remaining steadfast to our promise to be an investor-first firm dedicated to building a robust business that compounds value over the long term. With that, thank you for your time today. Operator, please open up the lines for questions.

And our first question comes from Brian McKenna with Citizens.

Josh, I'm curious how you think about portfolio diversification as it relates to risk. Some of your larger peers have average position sizes of 20, 30, 40-plus basis points. I look at the average position at SLX continues to be around 90 basis points. So how do you balance managing risk through diversification but also sizing positions appropriately in order to match your conviction in an investment?

Yes. It's a good question. Look, I think we've done a really good job of managing risk on an idiosyncratic basis. At the end of the day, this is all about idiosyncratic underwriting. When you look at SLX's loss history and the inverse of that NAV growth over time compared to the rest of the industry, I think it speaks for itself as it relates to our risk management - set of risk management parameters, to be honest with you. At the end of the day, this business is about originating and underwriting credits that have an asymmetrical risk profile where you cut off the left tail and minimize losses. As we mentioned in the script, that's the only path at the end of the day to outperformance. Because of the regulatory framework in the industry, you don't have the ability to do it through capital structure or financing costs. It's just about your portfolio yields compared to your losses and your risk management, and I think we have the best-in-class track record of that.

Okay. That's super helpful. And then one of your partners was speaking in a public forum recently. He talked about how an investable theme typically lasts about 1 to 3 years at Sixth Street. So what are some of the more attractive themes you're investing into right now? And really, what areas of the market are the best return opportunities per unit of risk? And then what are some of the sectors or themes you're shying away from?

Yes. I think the most challenging area right now, although we still find opportunities, is the on-the-run sponsored finance business. This space is currently quite crowded, but we do identify specific opportunities where there's industry overlap. Generally, we prefer off-the-run nonsponsor investments today; they are certainly more difficult to source and underwrite, but they typically yield higher excess returns. This includes sectors like speculative pharmaceuticals, asset-based lending, and energy, which are generally less saturated and have less capital involved. They also tend to attract less traditional private equity sponsorship. Bo, do you have anything to add?

The other thing I'd say is we continue to build out sector capabilities across the platform. Our shareholders are beneficiaries of that as we source deals across the capital structure. We still are active in the sponsor space, but it's going to be where our themes overlap. And we're not competing with commodity providers of capital.

Our next question comes from Mickey Schleien with Clear Street.

Josh, a high-level question to start about the sector in general. The growth of nontraded BDCs and other funds investing in private credit continues to broadly pressure loan spreads, and we saw a little bit of that in your portfolio. Do you think that process is a secular trend? And do you expect spreads for debt liabilities in the space to also compress or maybe for fee structures to come down and allow listed BDCs to maintain their arbitrage? Or do you think investors need to begin to accept lower ROEs in the sector? I realized Sixth Street may not be as exposed to these trends, but I think everyone would like to hear your views.

Yes, Mickey, congratulations on your new role. I'm glad you're here to share your insights. I previously discussed this extensively last quarter, and I recommend reviewing my letter on the subject which highlighted that about 90% of asset growth and flows came from the nontraded space, including interval funds and emerging interval funds. The challenge we face now is due to what I call complacency. Investors seem to be relying on historical returns, which are higher than what we expect moving forward. This is influenced by the higher spreads of the past compared to current reinvestment rates, along with the declining SOFR curve. As people assess past performance, we believe future returns will decrease, which needs to be addressed. I anticipate that flows will shift towards managers who can adapt and continue providing attractive returns on equity. Historically, it's rare to find balance sheet-heavy financials with an ROE expectation lower than 9%, whether it's banks, financial companies, or BDCs. Given that the 30-year treasury is close to 5%, expecting a 6% or 7% ROE seems uncompetitive in terms of risk-adjusted returns. We are at a point where the disparity between past and current economic indicators is obscuring the industry's direction, and I am genuinely concerned about the ongoing complacency. Regarding your other points about leverage, while a rally in investment-grade spreads would be welcome, the improvement at current leverage ratios is minimal and does not significantly enhance returns for investors. The final point is about fees. If the industry fails to achieve sufficient ROE, capital will shift, or companies will need to become more efficient, which is how the market operates. I realize I've taken a lot of time discussing this, but it's an important matter.

Yes, I agree, and I share all of your concerns. That's why I asked. A couple more questions, simpler ones. There was some migration in your internal risk ratings from 1 to 2. At a high level, can you tell us what drove that decline?

We had a few names that were lower-rated, which came off nonaccrual and were either upgraded or refinanced. Additionally, there were two specific names that changed from rating 1 to 2. These businesses are not performing as we initially planned, but they do have strong interest coverage, which is why we adjusted their ratings. Overall, the general trend showed a slight decline, but it was primarily influenced by these two specific names.

But you're not seeing that trend across the portfolio based on what I heard at the beginning of the call.

No. In fact, earnings for the quarter across the book were actually very strong quarter-over-quarter. I think, Cami, the earnings growth quarter-over-quarter. So when you look at Q1, our Q1 earnings for 2025 over last year's earnings, they're up in the mid-teens, low to mid-teens on an earnings basis. On an LTM basis, they're around 8%. So the portfolio is in very good shape. These are two idiosyncratic names. And again, still performing, still have strong interest coverage. They're just not performing to our original plan.

I would say that one of our main themes is that we’ve been quite effective in our assessments. We believe credit quality has likely reached its lowest point and should improve slightly moving forward, particularly regarding nonaccruals. Our focus will now shift to dividend coverage. We see a possibility of dividend cuts in this area for the first time due to a combination of reinvestment spreads and the SOFR swap curve. Our dividend coverage remains very strong due to our favorable economics, and we carefully consider our dividend in relation to our liabilities. We are optimistic about credit quality since the economy is growing, and we believe it should remain strong. However, we think the emphasis should now be on return on equities and how these compare to the commitments made regarding dividends.

Yes, I agree with that as well. And I do expect to see some dividend cuts. My last question, just a housekeeping question, maybe for Ian. What was the nature of the increase in the prepaid expenses and other assets on the balance sheet? It moved pretty meaningfully. I suspect it might be a receivable for investments you sold?

Yes, that's right, Mickey. We had one name that paid off on June 30, but the cash didn't come in until post-quarter end. So it was shown in the receivable rather than kept in the SOI.

Our next question comes from Finian O'Shea with Wells Fargo Securities.

I guess going back to the high level, Josh, I was interested in some of your opening remarks on credit. You described them as idiosyncratic, but also likely behind us. So I was wondering why. Idiosyncratic can mean a few things, basically one-off, but I would kind of think of it as coming from looser underwriting and seeing if you think that's something that's changed.

Yes. Look, I always look at our book and say, things are mostly behind us or we think behind us. I would also say that when you look at the shock of the rate hike cycle in mid-2022, there’s a lag relating to defaults. That lag is a function of historically that companies have cash on their balance sheet and some flexibility to manage things. Although there’s a shock, there’s a shock absorber, but that absorber gets worn out over time and shows up 2 years later. If you think about 2022, we're in mid-2025; I think generally, my feeling is that a lot of the credit issues have shown themselves. As for what we call idiosyncratic, when you look at what we got wrong, specifically on Lithium, it was a business that benefited from COVID. We clearly did not see that. As the COVID benefits waned and the industry structure in that business changed, we missed it. It was not generally because of high rates or commodity prices. It was a very idiosyncratic credit issue with that business model.

Yes. And Fin, the only thing I'd say is we never compromise our underwriting standards, as you know, but we sometimes get things wrong. That's something we missed.

Yes, no. Absolutely. And I was referring to the industry at large. I was interested in that. That makes sense to me. The answer is helpful. Just as a small follow-up, can you touch on the changes in the latest co-investment order and if the BDC still has priority on direct lending origination?

Yes, they do. The co-investment order just made co-investment slightly, quite frankly, easier and more manageable. But yes, you will see nothing different.

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

I think in the prepared remarks, you mentioned that about 30% of the originations in the quarter were driven by nonsponsored transactions. Wondering what your outlook is for the so-called Lane 2 or Lane 3 investments over the near term. Are you seeing more opportunities just given the macro backdrop?

Bo, go ahead.

Yes, sure. I'll take that. So yes, this quarter, it was about 70% sponsored and 30% nonsponsored. That's fairly close to where our historical levels have been over time. It's usually about 65% sponsored and 35% nonsponsored. Some quarters, like last quarter, you'll have more thematic nonsponsored coverage. We're generally positive about second-half activity being stronger than it was last year given that last year the election cycle probably paused some demand. The pipeline feels pretty robust. Now it's a competitive environment, and we're going to continue to be thoughtful on how we allocate capital. But we're seeing pretty strong demand across both sponsor and nonsponsor activity. So I'm not going to make a prediction on what that's going to look in the second half. It generally follows over the long arc of these numbers, that 65-35. But we seem to be seeing good activity across each of our thematic areas.

Great. Very helpful there. And just one follow-up, if I may. I think you touched upon this briefly. You mentioned the covenants and some of the documentation on the new investments. Just curious, for the more recent and new investments in the current environment, have you been seeing any kind of changes in terms and documentation?

We have not seen a change over the last few quarters. In fact, probably the last year in the documentation standards or covenant packages. They remain stable. I think in part because of how we source deals away from some of the more combed-over areas, but we have not seen a change in that.

Our next question comes from Arren Cyganovich with Truist Securities.

I was just wondering if you could talk a little bit about your thoughts on the push to open up retirement vehicles to private investment assets and if you have any expectations for how that might impact the direct lending market.

Yes. I mean, I think it's a little too early to tell. I think it is a very complicated issue. I like the idea of giving access to returns and alternatives to individual investors. They've obviously had some of that through the BDC sector on the private credit side. To be honest, I'm a little concerned that the incentives are not exactly right and that there was a decent prophylactic around alternatives where you had either super sophisticated individual investors or institutions that could do the work. I'm a little concerned about their ability to do the work and individual investor protections. Hopefully, that gets cleared through and people are responsible in that way. I mean, I can tell you, if you roll back 15 years when we started in the BDC industry and you talk to individual investors, I think this is not supposed to be snarky at all, but the vast majority did not understand the difference between return on capital and return of capital and dividend yield and ROE. There was a whole individual investor pool that was chasing high dividend-paying stocks, not realizing that it was return of capital, not return on capital. Some of that still exists. The people on this call, which have been significantly upgrading contributions to this space, have been doing that work for, on the research side, to make sure that people understand that. So I have mixed feelings; I'm concerned. I understand why GPs want access because it's a big TAM and big growth. But at the end of the day, we have to take care of our clients, and our job is to provide something of value to clients, not – that focus still needs to be – should remain, which is everything works well when you provide value to your customer, and the entire ecosystem takes care of itself. I would urge the space to keep that as their North Star.

Got it. That's helpful. And then just a quick one on new investments. There was an 8% stake in structured credit. Can you maybe just talk a little bit about what that is and what kind of the underlying assets are in that?

Yes. I'll hit that real quick. On occasion, we buy a structured credit portfolio, which is of corporate loans, typically broadly syndicated loans. Those securities are rated securities, typically BB or BBB. They offer competitive risk-adjusted returns with subordination. We've come in and out of that market throughout the years. In Q2, we sold 8 structured credit investments that we bought for a price of 97.5 and had a whole bunch of carry that we sold for 102, I think. We've come in and out of that market.

Our next question comes from Melissa Wedel with JPMorgan.

I appreciate the context that you provided around sort of second half activity levels that you might expect to see. I'm curious if you're also expecting sort of repayment activity to remain elevated in the second half to sort of match that? Just note, looking at the net repayments over the last couple of quarters, they've been pretty sizable, and I know you don't manage to that necessarily on a quarterly basis, but just trying to put a framework around that.

Yes, the good news for SLX shareholders is that we have significant exposure to assets from the period after the '22 rate hiking cycle, which typically yield higher spreads. Our accounting practices mean we only recognize the upfront fee on day one if there's a syndication, and those usually come with call protection. When those assets are called early, they generate excess income. Therefore, I anticipate that repayments will remain high due to our unique exposure that others may not have, as we continued investing during the rate hiking cycle. In the short term, this should benefit net investment income thanks to increased returns and fees. As mentioned earlier, we have a robust pipeline, and we'll replace these assets with ones that we find particularly valuable.

Right. Okay. And then I just wanted to follow up on looking across the portfolio. Now that you've had a few more months after some tariff announcements, I'm just curious if you're still seeing low exposure across the portfolio. Has your view changed on that at all?

No. I mean, look, I'll let Bo hit it. I think the answer is no. I think our tariff exposure is actually reduced post-quarter end. But go ahead, Bo.

That's exactly right. We had very low exposure, less than 1% of the portfolio based on fair market value. There were really 3 names that we believed had direct exposure, and we weren't certain about the impact. Since our last update, one of those 3 names has actually been paid off, so it's now down to 2 small names.

Our next question comes from Paul Johnson with KBW.

Congrats on the good quarter. Can I just ask, so what drove the higher other income this quarter versus last? Was that just the repayment activity in the quarter?

Sorry, Paul. You cut out. I think the question was, what drove higher other income?

Yes. This is Ian. I'll take that one. It's really just a number of miscellaneous exit fees that were embedded in transactions that paid off during the quarter.

And sorry if I didn't catch it, but did you guys disclose what the prepayment income was, the accelerated prepayment income per share this quarter?

From a per share basis, the prepayment income was about 1/3 of activity-based fees, or around $0.06 per share specific to prepayment fees.

Yes. Ian, correct me if I'm wrong. In the other income line, there were exit fees, which are very close cousins to prepayment fees. So the other income line was, how much?

Other income was about $0.07 per share.

I think it's reasonable to consider prepayment and excess fees as being between $0.11 and $0.13 per share on a gross basis. They are similar in nature. The key difference is that prepayment income has been in the contract from the very beginning, whereas an exit fee may have been added later, right, Ian?

That's right.

Okay, I understand. That’s very helpful. Sorry, please continue. I didn't mean to interrupt anyone.

No, no. I'm just saying they're the same thing. Go ahead.

Okay. So in terms of the structuring fee income though, I mean, from the kind of sponsor portfolio optimization that you mentioned with some transactions or add-on activity there. Is there any sort of structuring fee income that would come along with that?

No, I might take a deeper look into this because different people in the industry approach it in various ways. Some take their upfront fees and divide them between a structuring fee and an Original Issue Discount (OID). The issuer typically doesn't mind if you receive two points upfront, splitting half into a structuring fee and half into OID. This method results in a smaller OID that gets amortized over time. If you take more income upfront, when there is a prepayment, the accelerated OID is reduced because you’ve already collected the income. That’s not how we handle our accounting. Unless there's a syndication fee, we don't take a structuring fee; it all counts as OID. When the portfolio changes, we experience more accelerated OID than if we had taken a structuring fee. All of our fees are effectively deferred and categorized as OID from a structuring standpoint. Different people do it differently, and it’s an important detail. In the first scenario, new activity will increase net investment income on a marginal basis. In our case, repayment activity and portfolio changes will drive net investment income. Apologies for going into detail.

No, I got it. That makes sense. And again, helpful answer there. Last one for me, just on the Lithium restructuring positive. It seems that, that was done without any additional write-down or loss on the investment this quarter. But can I just ask, just on the earn-out securities. So what exactly, I guess, is kind of triggering the payout there based on revenue or EBITDA? Or is there any sort of sales that are taking place within the company? And also just kind of what's maybe the expected kind of realization timeline there? And that's all for me.

Yes, sure. So again, this was split into two securities, which were an interest-earning debt security that is smaller and then an equity participation in all cash flows generated beyond that. The expectation is that the duration will be about 3 years to fully realize the value on that equity, and there's a chance that we can overperform that. We took a view of what those cash flows would look like over the 3 years, and that's how we valued the equity security.

They're loan amortized, right, Bo?

And our last question comes from Robert Dodd with Raymond James.

Congratulations on the quarter. I'd like to revisit the repayment issue briefly before moving on to a different topic. Referring to Ian, we expect the full year net interest income return on equity to be in the upper half of the previous guidance, and if fees remain high, it could exceed that. According to Josh, we anticipate repayments will remain high. Additionally, your fair value to core protection has significantly increased this quarter. Does this suggest that you expect less core protection in the third quarter, and potentially the second half of the year compared to the first half, or is that not reflected in the net asset value? Can you clarify how you can have high repayments without also having high repayment fees, depending on the asset's vintage? If repayments are elevated, why wouldn't the fees be elevated as well? It seems that this hasn't been considered in your fair value to core protection ratio from the presentation.

Yes. So what I would say is, look, my comment as it relates to repayments is a Q3 look. Ian's comment was a full year look. So let's start with that, right? Ian was talking about full year guidance. I was talking about in the next quarter. That's kind of what we have visibility into. Obviously, the fees and the amount of fees is a little bit of a function of what vintage, and we don't control that. So I'm not sure there's a huge disconnect in what we all said; we're just trying to round it out.

I appreciate that, and I would like to break this down further. Regarding your second question, I was initially going to inquire about the retro peak oil model, but let's take a simpler approach. Typically, for balance sheet-heavy financials, an ROE greater than 9% is required to trade at book value or higher. If institutional investors are the main drivers of valuation, that point is worth noting. Considering the significant capital raised, particularly through evergreen funds, which are not institutional capital, these funds are driving spreads and volumes more than public vehicles. With that in mind, do you believe that an ROE of 9% is sufficient for the industry, given the activity of evergreen funds and the sources of primary capital?

Yes. I mean, I'm a big believer that markets are typically not very efficient in the short term but very efficient in the long term. What I would say is if you have an individual investor or an RIA who's sitting in front of that, an individual investor, they should, at some point, pick their head up and say, I can buy something at a discount to book in the public markets and earn a 9% versus buying something at par and have daily liquidity versus buying something at NAV and rebuying something at NAV because I'm not redeeming. That focus may need to be brought to light if people are performing their role as fiduciaries. In the short term, that disconnect might exist, but in the long term, my hope is that if markets are doing their job and people are active fiduciaries, they'll put their clients on the best risk-adjusted return on capital and look at alternatives, liquidity premiums, optionality, and discounts to book. Ultimately, it should come out in the wash. You would want to own something where you have daily liquidity instead of not and where you might get gated. People have to experience that firsthand to realize it. So my belief is that it will work its way through.

At this time, I'd like to turn the call back over to Josh Easterly for closing remarks.

We live in New York City, and I want to acknowledge that life is fragile and unpredictable. This week brought unexpected events that reminded us to cherish our loved ones and show them affection. I'm also reflecting on the achievements of Sixth Street Specialty Lending since 2014, both before and after going public. The team has excelled through various market conditions, and I'm incredibly proud of my colleagues. Our platform is exceptional for discovering unique investment opportunities for our investors, and it's a joy to work alongside such talented individuals. These thoughts are important to me. Thank you for your time today, and I wish everyone a peaceful remainder of the summer.

Thanks, everyone.

Thank you for your participation. This does conclude the program, and you may now disconnect. Everyone, have a great day.