Earnings Call Transcript - TSLX Q3 2022

Operator, Operator

Good day, and welcome to the Sixth Street Specialty Lending Inc. Q3 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised, that today's conference is being recorded. I would now like to hand the conference over to your speaker Ms. Cami VanHorn, Head of Investor Relations. Please go ahead.

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 third quarter ended September 30, 2022, 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 third quarter ended September 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.

Joshua Easterly, CEO

Thank you, Cami. Good morning, everyone, and thank you for joining us. With me today is my partner and our President, Bob Stanley; and our CFO, Ian Simmonds. For our call today, I will review this quarter's results and then pass it over to Bo to discuss our originations activity and portfolio. Ian will review our quarterly financial results in more detail, and I will conclude with final remarks before opening the call to Q&A. After the market closed yesterday, we reported third quarter financial results with adjusted net investment income per share of $0.47, corresponding to an annualized return on equity of 11.5%, and adjusted net income per share of $0.43 or an annualized return on equity of 10.6%. For the second consecutive quarter, our Board has increased the quarterly base dividend by approximately 7.1% or $0.03 per share to $0.45 per share to shareholders of record as of December 15th and payable on December 30th. This quarter's net investment income and the rise in our base dividend were driven by an increase in the core earnings power of our portfolio. As we previewed in prior quarters, we're now seeing the positive asset sensitivity from higher base rates impacting core earnings. Since we reported last quarter, the forward curve has deepened, resulting in core earnings in excess of what we previously anticipated. Over the last five years, the rolling four-quarter dividend coverage on our core earnings, core earnings defined as excluding all activity-based income averaged 102%. At the new quarterly base dividend level of $0.45 per share, we expect our core earnings to exceed this level and highlight the significant influence that all-in yields have had on the core earnings generated ability for our portfolio. Based on the enhanced levels of the dividend coverage that we anticipate extending through 2023 and an understanding of our anticipated leverage levels, our Board felt comfortable raising the quarterly dividend. As the operating environment continues to evolve, the Board will continue to evaluate further increases on a quarterly basis. This is consistent with our philosophy of establishing a base dividend level that we have a high degree of confidence in meeting each period and maximizing the efficiency of our capital base. While the base dividend level in Q3 was well-covered through core earnings, no supplemental dividend was declared related to Q3 earnings given the NAV bridge limiter in our distribution framework which serves to retain capital and stabilize net asset value. The revised level of our quarterly base dividend increases the quarterly booked dividend yield to 11% from our prior quarterly annualized book dividend yield of 10.3%. Our supplemental dividend framework remains in place, allowing for the opportunity to increase book dividend yields with future supplemental dividends. Turning now to the earnings summary, the $0.04 per share difference between this quarter's net investment income and net income was due to unrealized losses, primarily from wider market spreads and not as a result of material changes in the underlying credit quality of our investments. As Bob will discuss, the performance of our portfolio has remained strong. Growth in our reported net asset value per share from $16.27 to $16.36 was primarily driven by the accretive impact of issuing shares to sell the majority of our 2022 convertible notes, which matured in August. As you may recall from our conference call, our valuation framework includes the impact of market spreads movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors. Spread widening and lower implied equity values during this quarter resulted in approximately $0.05 per share of unrealized losses, thereby partially offsetting the increase in net asset value we experienced from the combination of accretion within notes conversion and earnings above our base dividend level. Turning now to a few thoughts on the current environment. We are seven months into the rate hike cycle, and the Fed has increased rates by 300 basis points year-to-date with the expectation of more to come. Despite this being the most rapid rate increasing cycle since the 1970s, it feels like we're in the mid-innings as corporates and consumers show the main sectors of the economy remain in a position of strength. In our view, the key to tame inflation will be real demand disruption, which we anticipate will be a long battle for several important reasons. First, over-stimulation during the pandemic, coupled with decades of low rates, low inflation, and increasing asset prices has resulted in strong corporate and consumer balance sheets and excess household savings for consumers. Second, while the interest rate increases continue, consumers have been somewhat insulated to-date from the immediate impact as mortgages are fixed in nature rather than floating rate or adjustable and wage growth has remained strong in an environment of historically low unemployment. This latter aspect has helped offset the effect of inflation on the levels of consumption. Third, given the Fed's ability to pivot is compromised by their need to tame inflation, it seems that the only way to create real demand disruption is through a rise in unemployment, which likely begins once we see a decline in nominal corporate earnings. As quantitative tightening continues, the monetary policy feeds through with its usual lag, the impact of rising rates will be felt differently across asset classes. Risky assets will likely struggle in an environment where the Fed keeps financial conditions tight. Returns for long-duration assets such as tech and biotech equities have been more meaningfully and negatively impacted by movement in rates, as small moves result in large changes to the net present value of future cash flows. On the other hand, private credit and, more specifically, our portfolio, is predominantly comprised of shorter-duration assets and is less sensitive to changes in rates and less sensitive to widening risk premiums, given the ability to reprice those assets every two to three years. The benefit to our portfolio of floating rate, short duration assets in a rising rate and spread environment is fundamentally dependent, however, upon credit selection and active portfolio management. We believe these factors will ultimately drive the dispersion in returns across the sector over time. Given our track record through COVID, 11 years investing through cycles and 25 years since our first direct mini-investment, we feel well positioned to navigate the uncertain macro environment and take advantage of the opportunities that it presents. With that, I'll turn it over to Bo to discuss this quarter's origination activity and portfolio.

Bo Stanley, President

Thanks, Josh. Let me first provide our thoughts on the current direct lending environment and how our business is positioned to serve borrowers as well as stakeholders for the period ahead. The volatility experienced across nearly every asset class year-to-date has only underscored the value proposition of private credit for borrowers. New issued leveraged loan volumes are down 86% in Q3 relative to the same period last year and high-yield bonds year-to-date reached their lowest level since 2008. In addition to the limited number of deals getting done in the public credit markets, we are also seeing a pullback from banks as they focus on satisfying regulatory-driven capital ratio requirements. Given these dynamics, there has been an increasing number of borrowers and sponsors turning to the direct lending market, including those seeking larger financings. We believe this broadening of the opportunity set is a net positive for our sector, and specifically for our business and our stakeholders, given our ability to be a solutions provider at scale through co-investments with our affiliated funds. With fewer financing options available for borrowers, we're seeing a shift towards a more lender-friendly environment. Not only are we seeing higher overall yields driven by higher base rates, but spreads have also widened as well. During Q3, LCD first lien and second lien spreads widened by 10 and 152 basis points, respectively. We're also seeing issuers willing to pay higher fees in order to get deals across the finish line, which allows us to pick our spots and remain selective. With these deal dynamics likely to persist for some time, we believe our ability to play offense in this environment, given our strong balance sheet positioning, will allow us to be a valuable partner to our sponsor and management teams in addition to generating attractive risk-adjusted returns for our stakeholders. While we recognize that the terms are moving into a more lender-friendly direction, there is no free lunch. On the opposite side of the coin, borrowers of many leveraged credit issuers are feeling pressure from sustained inflation, higher interest rates on debt obligations, and a very tight labor market. Similar to our approach during COVID, we are actively monitoring our portfolio of companies by staying in close communication with management teams, so we're able to respond quickly when necessary if credit quality issues look likely to arise. Based on the ongoing real-time conversations we're having with our borrowers, however, we feel very good about the health and positioning of our current portfolio as we continue to be largely invested at the top of the capital structure and in software and business services sectors that provide mission-critical products and solutions to their customers. Moving to originations activity, we had $385 million of commitments and $274 million of fundings across seven new investments, six upsizes to existing portfolio companies, and some small incremental allocations to structured credit investments during the quarter. We've mentioned in prior quarters that our pipeline was building leading into the back half of the year. And this quarter's new funding, along with our expectations for Q4 funding activities, continues to support that view. Several of our new investments in Q3 reflected the evolution we're seeing in the direct lending market of larger financings, as few of ours are able to access the traditional DSL market to meet their capital requirements. In August, we arranged and closed a $375 million term loan commitment to support an operational turnaround by Bed Bath & Beyond. As access to traditional sources of capital has become more constrained, our ability to invest alongside affiliated funds has allowed us to be a valuable solutions provider for the company during this time of need. Given the transactional complexity, we were able to drive better pricing and terms, which supports our robust asset-level yields. Additionally, our expertise in the retail ABL space allowed us to underwrite the investment with speed and certainty based on our years of experience executing on this theme. Since commencing investment operations, Bed Bath & Beyond represents the 25th retail ABL transaction that we've completed with a total of $1.1 billion of capital deployed in SLX through the strategy. At quarter end, our retail ABL exposure increased to 8.4% of the portfolio on a fair value basis. Also this quarter, alongside affiliated funds, we arranged and closed a $535 million senior secured credit facility to support Bain Capital's acquisition of LeanTaaS. We believe that Bed Bath & Beyond and LeanTaaS are both examples of how the scale of the Sixth Street platform allows us to source and underwrite strong risk-adjusted returns across both the sponsored and non-sponsored landscape. Our investment thesis in LeanTaaS was supported by an inherently sticky underlying product in the software space, resulting in a high-quality recurring revenue base that is increasingly important in this current environment. This investment reflects our continued focus on software and business services themes that comprise 78% of our portfolio on a fair value basis at quarter end. Given our familiarity with the space and our balance sheet flexibility, we're able to provide a level of deal customization that sets us apart from our competition. On the repayment side, wider spreads have led to a slowdown in refinancing activity, resulting in less portfolio turnover over the last couple of quarters. We had one full and one partial investment realization, totaling approximately $16 million in Q3. Our full investment realization of Mississippi Resources was related to the proceeds available from dissolving the business. We received our final distribution at the end of September, and the remaining debt was repaid, resulting in a small realized gain. Since quarter end, Frontline and Biohaven, our two largest portfolio companies based on fair value as of 9/30 were repaid during the first week of October, driven by previously announced M&A. As of quarter end, our weighted average mark on Biohaven was 110%, reflecting the impact of the anticipated fees embedded in our underlying exposure to this portfolio company that has since been crystallized in the $0.11 per share of activity-based fees, which will flow through investment income in Q4. Our weighted average yield on debt and income-producing securities at amortized cost was up to 12.2% from 10.9% quarter-over-quarter and is up about 200 basis points from a year ago. The weighted average yield at amortized cost on new investments, including up-sizes this quarter was 12.6% compared to a yield of 10% on investments that were partially paid down. Moving on to portfolio composition and credit stats, across our core borrowers from whom these metrics are relevant, we continue to have a conservative weighted average attach and detach point on our loans at 1x and 4.4x, respectively, and the weighted average interest coverage remained stable at 2.6 times. As of Q3 2022, the weighted average revenue and EBITDA of our core portfolio companies was $149 million and $44 million, respectively. The performance rating of our portfolio continues to be strong, with a weighted average rating of 1.12 on a scale of 1 to 5 with 1 being the strongest, representing a positive change from last quarter's rating of 1.13. After the realization of Mississippi Resources during the quarter, we have only one portfolio company on non-accrual representing less than 0.01% of the portfolio at fair value with no new names added to non-accrual during Q3. The strength and improvement of these metrics quarter-over-quarter illustrate our confidence in the underlying credit quality of our portfolio. With that, I'd like to turn it over to Ian to cover this quarter's financial results in more detail.

Ian Simmonds, CFO

Thank you, Bo. For Q3, we generated adjusted net investment income per share of $0.47 and adjusted net income per share of $0.43. At quarter end, total investments reached $2.8 billion, up from $2.5 billion in the prior quarter as a result of net funding activity. Total principal debt outstanding at quarter end was $1.5 billion and net assets were $1.3 billion or $16.36 per share. Our average debt-to-equity ratio increased quarter-over-quarter from 0.9 times to 1.15 times, and our debt-to-equity ratio at September 30 was 1.16 times. The increase was driven by portfolio growth from new investments during the quarter, combined with minimal repayment activity. As both reviewed, the repayment activity we experienced in the first week of Q4 brought our debt-to-equity ratio down to approximately 1.05 times. Before diving into more detail on our quarterly results, I would like to highlight the strength of our liquidity, funding profile, and capital position. As we head into the remainder of the year, our liquidity position remains robust with $846 million of unfunded revolver capacity at quarter end against $184 million of unfunded portfolio company commitments eligible to be drawn. And our funding mix at quarter end comprised 52% unsecured debt and 48% secured debt. Our balance sheet positioning was further enhanced post quarter end from the payoff of our positions in Biohaven and Frontline totaling approximately $146 million. Pro forma for these payoffs, which were the two largest positions in our portfolio at quarter end, we have close to $1 billion of liquidity. On top of the activity-based fees earned, these payoffs also increased our capital base by creating incremental investment capacity for new deployment opportunities into a more appealing investment environment. The accretive equity issuance that occurred at the beginning of August relating to the conversion of maturing convertible notes resulted in the issuance of approximately 4.4 million shares, providing us with additional balance sheet flexibility during a time when capital has generally become more constrained across the sector. One aspect of our balance sheet that is different this quarter is that we no longer show a dividend payable at quarter end. This is as a result of the change we discussed on our last earnings call to bring forward the payment date of our quarterly base dividend to occur on the last business day of the quarter. The most recent base dividend payment date was September 30, hence, the dividend that has previously been declared for Q3 dividends was paid to shareholders. That will be the case in future periods as well. During September, our 10b5-1 stock repurchase program was triggered, resulting in repurchases of $3 million, which represents approximately 180,000 shares at an average price of $16.62. The existence of this program is consistent with our objective of allocating capital to accretive opportunities for our shareholders, and we will continue to prioritize capital efficiencies throughout this ongoing volatile and uncertain environment. Yesterday, our Board renewed this program and reset the total size to $50 million. Given the premium on capital availability and the more compelling new investment environment that Bo spoke about earlier, our program trigger will be reset to activate at $0.01 below the most recent reported net asset value per share. Moving to our presentation materials, slide 8 contains this quarter's NAV bridge walking through the main drivers of NAV growth, we added $0.47 per share from adjusted net investment income against our base dividend of $0.42 per share. There was a positive $0.08 per share impact from the conversion of the convertible notes that was settled primarily through an equity issuance above net asset value. There were negative impacts from changes in credit spreads on the valuation of our portfolio amounting to $0.05 per share. And finally, movement in foreign exchange rates drove unrealized losses on our foreign currency denominated investments, which were offset by unrealized gains on our foreign currency denominated debt outstanding. It's worth spending a moment on the financial statement presentation of our foreign currency denominated investments as this can cause some confusion. Our philosophy when funding foreign currency investments is to borrow the par amount of that investment in local currency through our multicurrency revolving credit facility. This gives us both an asset and a liability denominated in local currency. Therefore, any movement in the FX rates applying to that investment impacts both the asset side and the liability side of our balance sheet in an equal but offsetting way. In the schedule of investments, depending on the movement of the relevant foreign currency relative to the US dollar, this can appear as though the valuation mark has declined when the US dollar strengthens. However, it's important to note that movement in the fair market value of an investment due to changes in foreign currency rates is distinct and separate from a change in the valuation mark caused by credit or widening spreads. Looking at the limited number of foreign currency denominated investments we hold in isolation without including the offsetting impact from the foreign currency liability can, therefore, lead to an incorrect conclusion. To use a specific example, let's look at the Canadian borrower in our schedule of investments, Acceo Solutions, Inc., where we hold a first lien term loan. The valuation mark at quarter end is 101.0. At the end of Q2, the valuation mark on Acceo was 101.25, so from a credit perspective, there's been very limited movement quarter-on-quarter. Over that same period, however, the fair market value as a percentage of cost has fallen from 104.2 to 97.5, representing a significantly larger decrease in value than that represented by the limited decrease in the valuation mark. For Acceo, this divergence was the impact of the strengthening US dollar over the period. Taking into account our natural hedge created by borrowing in local currencies, the value of our Canadian dollar debt expressed in US dollar terms decreased in an equal and offsetting way over the same period. At quarter end, the fair value of our foreign currency denominated investments represented approximately 4.6% of our portfolio. None of those investments are on non-accrual status, and each of the investments was rated one, consistent with that of the overall portfolio that Bo referenced earlier. Now for our operating results detailed on slide 9. Total investment income for the quarter was $77.8 million, up 22% from $69.3 million in the prior quarter, driven by increased all-in yields and net funding activity. Walking through the components of the income, interest and dividend income was $74.7 million, up 26% from the prior quarter. Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were lower at $429,000 compared to $3.2 million in Q2, given the lower impact on income measures from repayment activity that we highlighted earlier. Other income was $2.7 million, up from $1.6 million in the prior quarter. Net expenses, excluding the impact of the non-cash reversal lines of capital gains incentive fees were $40.3 million, up from $31.4 million in the prior quarter. This was primarily due to higher interest expense on higher average outstanding indebtedness. The upward movement in reference rates increased our weighted average interest rate on average debt outstanding from 3.1% to 4.3% and higher incentive fees as a result of this quarter's earnings. Before turning it back to Josh, I'd like to briefly provide an update on our ROEs. The two main drivers of our outperformance on an ROE basis have been the strength of our all-in yield on assets and our ability to avoid credit losses since inception. We have actually generated net realized capital gains. At the beginning of this year, we communicated an annualized ROE target of 11% to 11.5% based on our expectations over the intermediate term for our net asset level yields, cost of funds, and financial leverage. Year-to-date, we've generated an annualized ROE on adjusted net investment income of 11%. Given the strength of our investment pipeline, continued positive impact from higher all-in yields and our expectations for fee-related activity for the remainder of the year including the $0.11 per share of fees that were crystallized in October from the payoff of Biohaven that we mentioned earlier, we believe we are on pace to exceed the top end of our previously stated target range for 2022 NII per share of $1.84 to $1.92. This implies Q4 NII in excess of $0.54 per share and a full year ROE on adjusted net investment income of greater than 11.5%. With that, I'd like to turn it back to Josh for concluding remarks.

Joshua Easterly, CEO

Thank you, Ian. As we all know, periods of economic uncertainty present both significant risks and significant opportunities. On the opportunity side, these movements of volatility and market dislocation result in a shift of waste and the opportunity set from M&A to an opportunity set that requires private capital to be creative solution providers. Given our capabilities and expertise in the specialty lending situations, we believe we have built an all-cycle business model that is well-positioned to take advantage of this shift in the operating landscape. We know that the best vintages are often underwritten in these kinds of uncertainties, and we're ready to take advantage of the opportunities ahead. Although I shared brief views on the broader macroeconomic backdrop, I remain bullish on our ability to underwrite robust risk-adjusted asset-level returns and generate strong, consistent ROEs for our stakeholders. Over the last five years, in a largely benign credit environment, still resulted in a wide dispersion in returns generated by managers in this sector, mostly driven by dispersing credit costs. This is evidenced by the net realized losses of 100 to 150 basis points on an annualized basis in the sector, based on Cliffwater Direct Lending Index over the trailing five-year period through Q2 2022, compared to net realized gains for SLF for the same period. We believe that this dispersion will only expand as the operating backdrop becomes more complex. As rates continue to rise, managers spend a lot of time talking about the impact from increased fee rates and asset sensitivity. While rising rates will be beneficial to the sector in the near term, long-term outperformance is ultimately driven by the ability to avoid credit costs through the cycle. We believe we will continue to achieve this by following our same playbook that led to cumulative net realized gains since inception. As one of our favorite bands once put it, 'nothing else matters'. I'm sure Metallica will appreciate the call out on our earnings call today. As the year is coming to an end, I want to wish everyone a wonderful holiday season ahead with their friends and loved ones. We look forward to a busy and productive remainder of the year, and thank you for your continued support throughout the uncertain world we're living in today. Operator, please open up the lines for questions.

Operator, Operator

Thank you. Our first question will come from Jordan Wathen or Finian O'Shea with Wells Fargo.

Jordan Wathen, Analyst

Hi, it's Jordan Wathen from Fin. You mentioned LeanTaaS in your prepared remarks. We've observed that it has a larger portion of the weighted average compared to funding this quarter. We've also heard that borrowers are finding it more challenging to secure these weighted averages. I'm interested in how you view this situation. Are you adjusting your terms in response? Are you gaining more economic benefits from this current expansion? Any insights you can share would be appreciated.

Joshua Easterly, CEO

Okay. Thanks, Jordan, and hello for us. And again, sorry for the technical difficulties this morning. I think that part was driven by competition and structuring considerations. I think the general comment that delayed draw term loans being more difficult in this environment to come by is most definitely true. That transaction was earlier in the pipeline. And quite frankly, for us, I think in this environment, we'd rather have less unfunded forward commitments and drive economics in this environment. So I think that the observation was true. That deal was, there were some idiosyncratic considerations and it was much earlier in the pipeline, in the environment.

Jordan Wathen, Analyst

Okay. And then just more generally on the market. We just saw with Emerson, a deal that kind of closely matched the old school bank terms where private credit was kind of in the back seat behind the banks. So for you just want to…

Joshua Easterly, CEO

That is the wrong assumption. The Emerson term loan A and term loan B are both actively pursued. There is no back seat for the banks. That conclusion is incorrect. It's not a silo; it’s not categorized as first lien or second lien. It operates as per-use capital where banks maintain it on their balance sheets, and the only distinction is amortization. The term loan B has a much higher spread compared to the private credit markets. Blackstone has found a way to effectively leverage their relationships with banks to negotiate some amortization, creating a financial instrument that works for them in this environment given the returns on capital. The marginal capital from the private credit market has much wider terms for use. Therefore, the assumption that it is in a back seat or a follow condition is incorrect; it is all paired to usage.

Jordan Wathen, Analyst

No, that's good to hear. Thanks for clarifying that. That's it for me.

Operator, Operator

And one moment for our next question. And that will come from the line of Kevin Fultz with JMP Securities. Please go ahead.

Kevin Fultz, Analyst

Hi, good morning. Thank you for taking my question. Both touched on this a bit in this prepared remarks, but I just want to dig in a bit into the investment landscape a bit more. Given the evolution of market conditions over the past two to three quarters, I'm curious if you could talk about how that's translated to deal pricing leverage or improved documentation in the deals that you're originating right now compared to six to 12 months ago?

Joshua Easterly, CEO

Yes, I'll let Bo take over, but I want to mention Emerson as a strong example. Generally speaking, the Term Loan B for Emerson would have performed exceptionally well in a broadly syndicated market due to its excellent credit and solid capital structure. It likely would have had 2 to 2.5 turns wider of first-lien debt and would have been priced 300 basis points tighter than the current Term Loan B. For Hamilton, the first-lien would have significantly less debt with much wider pricing, which illustrates the trend of tightening underwriting standards and increased spreads. Additionally, the private credit market played a crucial role in driving returns for that deal. Bo, do you have anything to add?

Bo Stanley, President

No, that's spot on. We continue to see support for better underwriting standards in the form of higher spreads. I think those higher spreads are anywhere in the range of 100 to 200 basis points plus from what we saw for comparable businesses just six to 12 months ago. We're also seeing a ton to two tons of leverage come down and better documentation in the form of less leakage, inability to layer in more data, et cetera. So all across the board, you're seeing stronger underwriting standards, particularly in the larger end of the market.

Kevin Fultz, Analyst

Okay. That's really helpful color. And then just one more, if I can, you were relatively active again this quarter investing in CLOs. Clearly, it's a small portion of the portfolio in aggregate, but still one that's growing. Can you talk a bit about the opportunity you're seeing investing in CLOs, how much capital you're willing to put to work there and if you view these investments as buy and hold or more short-term in nature?

Bo Stanley, President

We've always approached it not as traders, but rather as a parameter for assessing relative value. We continue to believe there is significant relative value due to the loss-taking capability in CLOs, which indicates potential losses in our investment securities. Typically, a cumulative decline of 1.5 to two times what we've observed in global financial prices is necessary. Additionally, there are BBB securities that offer yields comparable to the discounts seen in private credit. Thus, we view this as an excellent relative value investment, although it represents a relatively small portion of our overall portfolio.

Operator, Operator

Thank you, one moment for our next question. And that will come from the line of Ken Lee with RBC Capital Markets. Please go ahead.

Ken Lee, Analyst

Hi. Good morning, and thanks for taking my question. You mentioned in the prepared remarks having constant conversations with the portfolio company management teams, wondering if you could just talk a little bit more about what you're seeing in terms of any kind of amendment activity in the most recent quarter. Thanks.

Joshua Easterly, CEO

Yeah, it's Josh. The positive aspect of private credit is the opportunity for ongoing discussions. We did not see any significant amendment activity this quarter. Overall, the situation has been very stable. The portfolio is in excellent condition, reflecting a low level of activity concerning amendments and waivers. This distribution indicates the strength of our portfolio, which primarily comprises about 78% to 80% of existing assets related to software and business services that provide recurring revenue and flexible cost structures. Thus, we experienced no significant amendments and waivers this quarter.

Ken Lee, Analyst

Thank you, that's very helpful. I have a follow-up question. Regarding the debt paydowns, there was a slowdown this quarter, which you attributed to the current environment. In your opinion, what factors could lead to an increase in paydown activity in the future? Or do you anticipate that the activity will remain limited in the near term due to the macroeconomic climate? Thank you.

Joshua Easterly, CEO

Thank you, Ken. Let me address your question. It’s important for people to understand that paydowns usually lead to activity-based income, which can fluctuate throughout the year or from quarter to quarter. We experienced two significant paydowns at the start of Q4, specifically in the first week of October. This is expected to contribute about $0.11 per share of activity-based income to our Q4 earnings. Timing for this is uncertain. This year has been quite stable with overall portfolio turnover considering the widening credit spread environment. Typically, during periods of tighter credit spreads or when underwriting standards lower volatility, you would see more portfolio churn. Historically, we have achieved coverage from core earnings ranging from 98% to 105%. Our definition of core earnings focuses mainly on interest income, including regular amortization of OID. This has resulted in coverage of 98% to 102% for our dividend. With our recent dividend increase of 7%, our coverage has improved over historical levels based on core interest income. Thus, in an environment where activity levels rise, we are well-positioned due to our balance sheet leverage to continue generating interest income that supports our new dividend, along with income from increased activity levels. That will depend on tightening spreads and underwriting standards, but for us, some of our specialized lending-related portfolios may see turnover regardless of the broader environment. I hope this provides a comprehensive view of our earnings, the enhanced earnings capacity of the business, and the factors that influence income and return on equity.

Ken Lee, Analyst

No, that was great. That was great color there, and I really appreciate the answer there. Thanks, again.

Operator, Operator

Thank you. One moment for our next question. And that will come from the line of Melissa Wedel from JPMorgan. Please go ahead.

Melissa Wedel, Analyst

Good morning. Appreciate you taking my questions today. Was curious to get your thoughts on sort of the supply side in private credit. You talked about the increase in demand that you've seen for private credit solutions in this environment. I know in the last few years, there's been a lot of capital formation within the private credit space. At this point, have you seen a lot of that capital deployed, or is there still a lot of competition? I'm just curious for that.

Ian Simmonds, CFO

Yes. The way I would frame it is that it's evident that the size of checks has significantly decreased for some large private credit investors in this space. Previously, we saw investments ranging from $500 million to $2 billion, but now they are writing much smaller amounts. Moving forward, I would suggest that the demand for credit will likely be lower, and the opportunities are shifting. While there will still be some focus on mergers and acquisitions, as well as buyouts and recapitalizations, there is a greater emphasis on our core specialty lending. Additionally, the supply of private credit is also shrinking, resulting in wider spreads and stricter underwriting standards. As the economy slows or stagnates, the demand for credit will undoubtedly decrease, but we are also witnessing a reduction in supply. This dynamic is reflected in the widening spreads and tightened underwriting standards, primarily driven by supply-side factors, as M&A activities are declining. I hope that clarifies things.

Melissa Wedel, Analyst

No, that's helpful. I appreciate that. If we could shift our focus to your ABL strategy, I know you mentioned one investment made during the third quarter, which is definitely a continuation of prior investments. Reflecting on when you were last actively involved in originating ABL investments, the environment was quite different in many respects, especially regarding inflation. I'm interested in whether you have adjusted your underwriting or approach to ABL due to the higher inflationary environment. Thank you.

Joshua Easterly, CEO

Yes, that's a great question. A bit of history on our ABL: this is a business we know very well. Regarding Bed Bath & Beyond, this highlights the strength of our platform. We originated that investment and sold it for more than our cost, which boosted syndication income for SLX this quarter. Our ability to provide comprehensive support to issuers with certainty allowed us to generate additional revenue that is valuable for our investors. It's important for people to recognize that. The environment has definitely changed. The advantage of these types of structures and loans is that we can assess the value of our collateral in the current landscape. If there's margin compression, the value of that inventory decreases, which means the amount we can lend against it also decreases. This makes our approach to the market quite dynamic. We've been in this industry for over 20 years and have invested throughout various cycles, requiring us to remain aware of macroeconomic conditions. Nonetheless, we have a structured method for these deals that helps us adjust our risk as circumstances change. Is that fair, Mike?

Unidentified Company Representative, Unidentified

Yes. No, I agree.

Joshua Easterly, CEO

And the good news is I think that opportunity is only getting bigger, which is post-COVID, when you think about the world, consumers had a lot of dollars in their pocket. They couldn't spend money on activities or vacations. So they bought goods, which created an environment where retailers had really, really good balance sheets, high gross margins, high EBITDA margins and that's kind of reversing. And so I think our capital in this environment will be very, very valuable.

Melissa Wedel, Analyst

Thanks, Josh.

Operator, Operator

Thank you. One moment for our next question. And that will come from the line of Robert Dodd with Raymond James. Please go ahead.

Robert Dodd, Analyst

Hi. I think you partially addressed this earlier in the call. Looking at the portfolio and the structure of loans moving forward, do you anticipate that highly structured loans, such as asset-based lending or special situations, will become a larger part of the portfolio in the next 18 to 24 months, depending on how long this late cycle lasts? In comparison, conventional loans like Emerson offer better leverage and yields, but they would be categorized as more traditional. Do you believe the appeal of these conventional loans with high yields will remain competitive with some of the special situations you engage in? How do you foresee the mix in the portfolio changing over the next couple of years? A significant portion of your excess return on equity comes from the activity fees related to the special situations you've handled.

Joshua Easterly, CEO

Yes. After COVID, the market was flooded with liquidity, and both corporations and retail sectors had strong balance sheets, meaning they didn't require our capital. Historically, this environment has offered us a 20% growth unlevered return. Considering the future total return for our business, I agree that much of our access has stemmed from businesses in similar positions, like Ferrellgas and retail ABL situations. I anticipate that these opportunities will significantly increase moving forward, especially as credit availability rises and corporations face tougher conditions. We have the chance to leverage our platform's expertise, which can provide solutions that yield exceptional returns for our shareholders. This ability to invest across various economic cycles allows us to derive high relative value from a risk-adjusted return standpoint, ultimately benefiting our shareholders. I believe this aspect of our business will certainly become more prominent. Historically, this has accounted for about 40% of our originations, although it represents a smaller fraction of our portfolio due to quicker turnover. However, I foresee a clear shift in this trend, requiring a different kind of platform, namely ours, which is well-equipped to navigate complexities and produce solid risk-adjusted returns. Other platforms, which are predominantly sponsor-focused and tied to M&A activities, may struggle in this regard. I am truly excited about the opportunities ahead. Moreover, we will pursue both avenues but will prioritize those with the highest risk-adjusted returns to enhance our return on equity for shareholders, supported by a broader perspective of the market. You're certainly onto something, Robert.

Robert Dodd, Analyst

I appreciate that. As a follow-up, considering your expertise on the platform, have you noticed any increase in efforts to recruit talent from your team? If the market becomes more challenging, it could disproportionately affect your platform, and other companies might try to take advantage of your expertise. Have there been any attempts to recruit from your team, or if that's not the case, you don't need to address it? If it has happened, could you provide some insight?

Joshua Easterly, CEO

No, we haven't seen that. What I would say is that it requires a different mindset. There are cultural differences because where complexity exists, it demands private equity-style due diligence, extensive negotiations, and direct engagement. Frankly, it's often less profitable for general partners because it requires more manpower and time, and you don't hold onto an asset as long. Therefore, there are economic decisions involved. We aim to make choices that reflect our shareholders' and stakeholders' interests. Entering this business is quite different, especially when a sponsor provides a capital structure and conducts all the due diligence. The business dynamics are significantly different. One aspect I appreciate about our platform is the ability to navigate across cycles to create value. While some platforms can manage this, many traditional sponsor-based platforms lack the cultural foundation to do so, having made different economic choices. Consequently, we haven't observed any poaching efforts.

Operator, Operator

Thank you. One moment for our next question. And that will come from the line of Ryan Lynch with KBW. Please go ahead.

Ryan Lynch, Analyst

Good morning. I have a question regarding your interest coverage and your software portfolio. Historically, I view software investments as more resilient in economic downturns, which often leads to higher purchase price multiples and higher levels of leverage associated with those investments. You might disagree with this perspective, but if it holds true, how should we consider your interest coverage and the capacity of those borrowers to handle rising interest rates from near zero to 4% or 5% next year, especially since some of these businesses may be structurally stronger and more resilient, potentially leading to greater leverage compared to an average company?

Joshua Easterly, CEO

Yes, that’s a great question. I'm not sure our portfolio has significantly more leverage, but some of your points are accurate. First, interest coverage in our portfolio appears stable quarter-over-quarter on a last twelve months basis. This indicates that management teams are effectively managing pricing and cost structures. A strong aspect of software businesses is that they typically maintain gross margins of 80% to 85% and have variable costs underneath. Their revenues are generally predictable. When assessing the health of our software portfolio, it's useful to refer to forward-looking key performance indicators. For instance, revenue grew by approximately 6% from the previous quarter and 17% year-over-year. In terms of retention, a key factor for future revenue, retention in Q2 was 90% growth, and 105% net, with similar metrics of 91% growth and 103% to 104% net in Q2. The fundamentals of our software business show that interest coverage remains stable, and overall conditions are strong. Another positive aspect is the growth within the existing customer base; they are consistently buying new products and benefiting from pricing. I feel optimistic about our position, as this is reflected in both the forward-looking KPIs and the historical interest coverage metrics. This defensive posture is noteworthy, and it’s evident in the strong fundamentals of our portfolio. Bo, do you want to add anything?

Bo Stanley, President

I think that said it also, as I mentioned in the earnings call, our detach points have remained stable at 4.4x, that's across all borrowers, but we feel very good about the health of that software portfolio and the core earnings power.

Ryan Lynch, Analyst

That's helpful. I appreciate the specific statistics you provided on the performance of your software portfolio. Can you share the overall interest coverage? I know you mentioned it hasn't changed in the trailing 12 months this quarter, but what is the overall interest coverage of your portfolio?

Joshua Easterly, CEO

2.6, 2.6x.

Ryan Lynch, Analyst

Okay. It's pretty healthy. Okay. That's all for me. I appreciate the time today.

Joshua Easterly, CEO

Thanks.

Operator, Operator

Thank you. And speakers, I'm showing no further questions in the queue at this time. I'll turn the call back over to management for any closing remarks.

Joshua Easterly, CEO

Great. Thank you again for the technical difficulties earlier. I appreciate you hanging in for those 30 seconds that seem like a lifetime. I hope everybody has a happy Thanksgiving and a holiday season, and we'll continue working very, very hard. We think the environment is really interesting for TSLX and capital type of capital. And we look forward to chatting in the future. Thanks.

Ian Simmonds, CFO

Thanks. Thanks, everyone.

Operator, Operator

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